Day: March 24, 2009

Translation: We Really, REALLY, Hate You Guys!!

Translation: We Really, REALLY, Hate You Guys!!

From an earlier post, point 4:

?We hate you guys. Once you start issuing $1 trillion-$2 trillion [$1,000bn-$2,000bn] . . .we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.? [emphasis mine]

So said Mr. Luo, a director-general at the China Banking Regulatory Commission.? I?ve been saying for a long time that China is stuck, and that we are their problem, and not vice-versa.? There may come a point where they stop buying US Dollar-denominated debt, and let existing debt mature, but that will come after a shift in their own economy where they are no longer driven bythe promotion of their exports.? There aren?t many large good alternatives to US debt for parking the proceeds from exporting aggressively.

So today, we get another volley from China as they realize that they are stuck holding US Dollar denominated assets that they are more certain than ever will depreciate.? They see injustice in having bought too many dollars in exchange for the exports they paid to promote to the US.? Excerpting from the article:

People’s Bank of China Governor Zhou Xiaochuan said he wants to replace the dollar, installed as the reserve currencyWorld War II, with a different standard run by the International Monetary Fund (IMF). after

China, the top holder of US Treasury bonds with 739.6 billion dollars as of January, according to American figures, earlier expressed concern over its investment as the world’s largest economy battles a deep recession.

“The outbreak of the crisis and its spillover to the entire world reflected the inherent vulnerabilities and systemic risks in the existing international monetary system,” Zhou wrote in an essay posted on the bank’s website Monday.

Zhou’s comments come ahead of the G20 summit from April 2 in London, where world leaders and international organisations including the IMF are to discuss reforming the financial system.

He suggested the IMF’s Special Drawing Rights, or SDR, could serve as a super-sovereign reserve currency as it would not be easily influenced by the policies of individual countries.

Russia has also proposed the summit discuss creating a supranational reserve currency. The IMF created the SDR as an international reserve asset in 1969, but it is only used by governments and international institutions.

“The reform should be guided by a grand vision and start with specific deliverables,” Zhou wrote. “It should be a gradual process that yields win-win results for all.”

However, China’s proposal was unlikely to lead anywhere because the SDR is not a currency system backed up by a government, independent Shanghai-based economist Andy Xie said.

Xie said the proposal was probably a protest aimed at Washington’s plan to buy one trillion dollars of its own debt, diluting the value of China’s dollar reserves and raising fears of inflation.

“It’s a sad situation: China is America’s banker. America owes so much to China, but it’s not afraid of China,” he said. “China is America’s hostage. It’s not the other way around.” [emphasis mine]

As the world’s main reserve currency, US dollars account for most governments’ foreign exchange reserves and are used to set international market prices for oil, gold and other currencies.

As the issuer of the reserve currency, the US pays less for products and borrows more easily.

Strategic Drawing Rights are a cute idea, but it would be too small? to support global trade.? Like the Euro, it is a political construct, but one with less dedicated political and economic support.

As I commented in my piece, It is Good to be the World?s Reserve Currency, there’s no good alternative to the US Dollar yet. Like the mercantilists of old, who bought gold dear, and sold it cheaply, so will it be for China — they bought US Dollar claims dear, but will sell them more cheaply.?? This is the price of forced industrialization.

There will come a time when the US Dollar is no longer the world’s reserve currency, but there needs to be a worthy competitor, or a willingness to do without a single clearing unit.? This is an age of computers, so there does not need to be a single dominant unit of exchange, but habits die hard.? It will probably take some disaster to dislodge the US Dollar, and force the changeover.? Whether that comes through inflation, default, partial default, or war remains to be seen.

Liquidity and the Current Proposal by the US Treasury

Liquidity and the Current Proposal by the US Treasury

One of the earliest pieces at this blog was What is Liquidity?, followed by What is Liquidity? (Part II).? I’ve written a bunch of pieces on liquidity (after doing a Google search and being surprised at the result), largely because people, even sophisticated investors and unsophisticated politicians and regulators misunderstand it.? Let’s start with one very simple premise:

Many markets are not supposed to be liquid.

Why?

  • Small markets are illiquid because they are small.? Big sophisticated players can’t play there without overwhelming the market, making volatility high.
  • Securitization takes illiquid small loans and transforms them into a bigger security(if it were left as a passthrough), which then gets tranched into smaller illiquid securities which are more difficult to analyze.? Any analysis begins with analyzing the underlying loan collateral, and then the risks of cashflow timing and default.? There is an investment of time and effort that must go into each analysis of each unique security, and is it worth it when the available amount to invest in is small?
  • Buy-and-hold investors dominate some markets, so the amount available for sale is a small portion of the total outstanding.
  • Some assets are opaque, where the entity is private, and does not publish regular financial statements.? An? example would be lending to a subsidiary of a corporation without a guarantee from the parent company.? They would never let and important subsidiary go under, right?? 😉
  • The value of other assets can be contingent on lawsuits or other exogenous events such as natural disasters and credit defaults.? As the degree of uncertainty about the present value of free cash flows rises, the liquidity of the security falls.

When is a securitization most liquid?? On day one.? Big firms do their due diligence, and put in orders for the various tranches, and then they receive their security allocations.? For most of the small tranches, that’s the last time they trade.? They are buy-and-hold securities by design, meant to be held by institutions that have the balance sheet capacity to buy-and-hold.

When are most securitizations issued?? During the boom phase of the market.? During that time, liquidity is ample, and many financial firms believe that the ability to buy-and-hold is large.? Thus thin slices of a securitization get gobbled down during boom times.

As an aside, I remember talking to a lady at a CMBS conference in 2000 who was the CMBS manager for Principal Financial.? She commented that they always bought as much of the AA, single-A and BBB tranches that they could when they liked the deals, because the yield over the AAA tranches was “free yield.”? Losses would never be that great.? Privately, I asked her how the securitizations would fare if we had another era like 1989-92 in the commercial property markets.? She said that the market was too rational to have that happen again.? I kept buying AAA securities; I could not see the reason for giving up liquidity and safety for 10, 20, or 40 basis points, respectively.

Typically, only the big AAA tranches have any liquidity.? Small slices of securitizations (whether credit-sensitive or not) trade by appointment even in the boom times.? In the bust times, they are not only not liquid, they are permafrost.? In boom times, who wants to waste analytical time on an old deal when there are a lot of new deals coming to market with a lot more information and transparency?

So, how do managers keep track of these securities as they age?? Typically, they don’t track them individually.? There are pricing grids or formulas constructed by the investment banks, and other third-party pricing services.? During the boom phase, tight spread relationships show good prices, and an illusion of liquidity.? Liquidity follows quality in the long run, but in the short run, the willingness of investors to take additional credit risk supports the prices calculated by the formulas.? The formulas price the market as a whole.

But what of the bust phase, where time horizons are trimmed, balance sheets are mismatched, and there is considerable uncertainty over the timing and likelihood of cash flows?? All of a sudden those pricing grids and formulas seem wrong.? They have to be based on transactional data.? There are few new deals, and few trades in the secondary market.? Those trades dominate pricing, and are they too high, too low, or just right?? Most people think the trades are too low, because they are driven by parties needing liquidity or tax losses.

Then the assets get marked too low?? Well, not necessarily.? SFAS 157 is more flexible than most give it credit for, if the auditors don’t become “last trade” Nazis, or if managements don’t give into them.? More often than not, financial firms with a bunch of illiquid level 3 assets act as if they eating elephants.? How do you eat an elephant?? One bite at a time.? They write it down to 80, because that’s what they can afford to do.? The model provides the backing and filling.? Next year they plan on writing it down to 60, and hopefully it doesn’t become an obvious default before then.? Of course, this is all subject to limits on income, and needed writedowns on other assets.? I have seen this firsthand with a number of banks.

So, relative to where the banks or other financials have them marked, the market clearing price may be significantly below where they are currently marked, even though that market clearing price might be above what the pricing formulas suggest.

The US Treasury Proposal

The basics of the recent US Treasury proposal is this:

  • Banks and other financial institutions gather up loans and bonds that they want to sell.
  • Qualified bidders receive information on and bid for these assets.
  • High bid wins, subject to the price being high enough for the seller.
  • The government lends anywhere from 50-84% of the purchase price, depending on the quality and class of assets purchased.? (I am assuming that 1:1 leverage is the minimum.? 6:1 leverage is definitely the maximum.)? The assets collateralize the debt.
  • The FDIC backs the debt issued to acquire the assets, there is a maximum 10 year term, extendable at the option of the Treasury.
  • The US Treasury and the winning private investor put in equal amounts, 7-25% each, to complete the funding through equity.
  • The assets are managed by the buyers, who can sell as they wish.
  • If the deal goes well, the winning private investors receive cash flows in excess of their financing costs, and/or sell the asset for a higher price.? The government wins along with the private investor, and maybe a bit more, if the warrants (ill-defined at present) kick in.
  • If the deal goes badly, the winning private investors receive cash flows in lower than their financing costs, and/or sell the asset for a lower price.? The government may lose more than the private investor if the assets are not adequate to pay off the debt.

I suspect that once we get a TLGP [Treasury Liquidity Guaranty Program] yield curve extending past 3 years, that spreads on the TLGP debt will exceed 1% over Treasuries on the long end.? Why?? The spreads are in the 50-150 basis point region now for TLGP borrowers at 3 years, and if it were regarded to be as solid as the US Treasury, the spread would just be a small one for illiquidity.? (Note: the guarantee is “full faith and credit” of the US Government, but it is not widely trusted.? Personally, I would hold TLGP debt in lieu of short Treasuries and Agencies — if one doesn’t trust the TLGP guarantee, one shouldn’t trust a Treasury note — the guarantees are the same.)

One thing I am unclear on with respect to the financing on asset disposition: does the TLGP bondholder get his money back then and there when an asset is sold?? If so, the cashflow uncertainty will push the TLGP spread over Treasuries higher.

Thinking About it as an Asset Manager

There are a number of things to consider:

  • Sweet financing rates — 1-2% over Treasuries. Maybe a little higher with the TLGP fees to pay.? Not bad.
  • Auction?? Does the winner suffer the winner’s curse?? Some might not play if there are too many bidders — the odds of being wrong go up with the number of bidders.
  • What sorts of assets will be auctioned?? [Originally rated AAA Residential and Commercial MBS] How good are the models there versus competitors?? Where have the models failed in the past?
  • There will certainly be positive carry (interest margins) on these transactions initially, but what will eventual losses be?

The asset managers would have to consider that they are a new buyer in what is a thin market.? The leverage that the FDIC will provide will have a tendency to make some of the bidders overpay, because they will factor some of the positive carry into the bid price.

I personally have seen this in other thin market situations.? Thin markets take patience and delicate handling; I stick to my levels and wait for the market to see it my way.? I give one broker the trade, and let him beat the bushes.? If nothing comes, nothing comes.

But when a new buyer comes into a thin market waving money, pricing terms change dramatically after a few trades get done.? He can only pick off a few ignorant owners initially, and then the rest raise their prices, because the new buyer is there.? He then becomes a part of the market ecosystem, with a position that is hard to liquidate in any short order.

Thinking About it as a Bank

More to consider:

  • What to sell?
  • What is marked lower than what the bank thinks the market is, or at least not much higher?
  • Where does the bank know more about a given set of assets than any bidder, but looks innocuous enough to be presumed to be? a generic risk?
  • Loss tolerances — where to set reservation prices?
  • Does participating in the program amount to an admission of weakness?? What happens to the stock price?

Management might conclude that they are better off holding on, and just keep eating tasty elephant.? Price discovery from the auctions might force them to write up or down securities, subject to the defense that prices from the auctions are one-off, and not realistic relative to the long term value.? Also, there is option value in holding on to the assets; the bank management might as well play for time, realizing that the worst they can be is insolvent.? Better to delay and keep the paychecks coming in.

Thinking about it as the Government and as Taxpayers

Still more to consider:

  • Will the action process lead to overpriced assets, and we take losses?? Still, the banks will be better off.
  • Will any significant amount of assets be offered, or will this be another dud program?? Quite possibly a dud.
  • Will the program expand to take down rasty crud like CDOs, or lower rated RMBSand CMBS?? Possibly, and the banks might look more kindly on that idea.
  • Will the taxpayers be happy if some asset managers make a lot of money?? Probably, because then the government and taxpayers win.

Summary

This program is not a magic bullet.? There is no guarantee that assets will be offered, or that bids for illiquid assets will be good guides to price discovery.? There is no guarantee that investors and the government might? not get hosed.? Personally, I don’t think the banks will offer many assets, so the program could be a dud.? But this has some chance of success in my opinion, and so is worth a try.? If they follow my advice from my article Conducting Reverse Auctions for the US Treasury, I think the odds of success would go up, but this is one murky situation where anything could happen.? Just don’t the markets to magically reliquefy because a new well-heeled buyer shows up.

Add a New Chapter to the Bankruptcy Code, Redux

Add a New Chapter to the Bankruptcy Code, Redux

Given the news of the morning, I thought I would dust off my four-month old proposal Add a New Chapter to the Bankruptcy Code.? Until we limit our dear government’s power to encourage the private sector to borrow money until it chokes, we need something that enables timely reduction of debt in TBTF (too big to fail) institutions, delevering them? with minimal impact to taxpayer and the rest of the economy.

This morning we have the following articles:

In my proposal, the Treasury Secretary would initiate the process, but then would get handed off to a special bankruptcy court for adjudication of claims.? The Treasury becomes the DIP lender, but otherwise is a minor player in the process.

Why not let the Treasury do it all?? Wouldn’t it be faster?? Yes, it would be faster, but at a price.? The current Bush/Obama administration policies have relied heavily on intelligent discretion from regulators.? We haven’t gotten that yet.? Even really intelligent regulators are men with limited time.? Even big organizations staffed with Ph.D. economists and other bright people like the Federal Reserve are less than the sum of the parts, as the bureaucracy enforces groupthink (and the Treasury is even worse).

When the Treasury Secretary or the Fed Chairman acts with discretion, there is always the charge of unfairness that can be laid at their doors.? Why is the credit of the US going to support special interests?? You say that it is for the good of the nation, but then why aren’t equity and preferred shareholders wiped out, management thrown out, and bondholders forced to compromise, and accept back equity in the new firm in exchange for their debt claims?

Our bankruptcy processes are transparent, fair, and even speedy (for what is being done) in the US; we just need to augment them for firms that pose risk to a large portion of the financial and economic systems.? But regulatory discretion in bailing out firms in this crisis has been a disaster.? Speed kills; a handoff to the bankruptcy court with the US Treasury backstopping the firm in the short run would be the best minimalist solution, stopping contagion, and allowing for an orderly resolution of competing claims under conditions transparent to the US taxpayer.

Leave AIG to its own Devices, and let it Fail if Need be

Leave AIG to its own Devices, and let it Fail if Need be

When I was a young actuary, I worked for the now defunct Pacific Standard Life.? In 1984, PSL discovered Universal Life Insurance, and sold so much of it that it went insolvent, and was bought out of bankruptcy by Southmark.? I came to the company in 1986, but by 1988 I had my concerns.? Aside from the aggressive investment policy (junk bonds), Southmark had interlaced the capital of their subsidiaries, with one subsidiary owning the preferred stock of another, and vice-versa.? They even did a deal with ICH, exchanging preferred stock.? So long as neither defaulted, both looked more solvent, like two drunks holding each other upright.

My point for the evening is that there are clever ways to make an insurance company look more solvent than it should appear to be.? I mentioned the preferred stock manuever.? There are also deals regarding reinsurance.? A common traansaction is to sell of future profits in exchange for capital today.

Why do I write about this?? AIG again.? While I worked for the domestic life companies 1989-1992, I served as the actuary for the annuity line of business.? That involved the reinsurance treaties on annuities, which were designed to reduce the capital needs of the business, and thus increase leverage.? As I have sometimes said, “reinsurance is the ultimate derivative.”? If derivatives are opaque, reinsurance doubly so.? Tearing apart a reinsurance treaty is tough, and it takes significant skills that most auditors and regulators don’t have.

During my tenure at AIG, the reinsurance treaties were designed to decrease the capital needed to support the business.? Given the need for a 15% after-tax return on average equity (which was sometimes described as the “religion” of AIG), the easiest way to do it was to compromise the capital needed to support the business through reinsurance.? Equity goes down, ROE goes up.? That was the nature of AIG, and I could never be a lifer there because of the ethical problems I faced.

Now one of the assumptions that I have made about AIG is that the subsidiaries of AIG are well-regulated and solvent.? But why should I assume that things have gotten better since when I served in AIG?

If I had the Statutory data (regulatory accounting), I would look at all of the statutory statements of domestic insurers that AIG owns, and look for reinsurance and cross-shareholdings.? I would discount external reinsurance credits, and internal reinsurance I would check to make sure that reserves reinsured equal reserves insured.

If things are today like tkey were in the early 90s, I would expect to find the amount of capital needed to support the business compromised through reinsurance treaties.? Within a year, we will know if that is true.? There are some alleging large fraud here.

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Now, ther are other problems with the bailout of AIG, notably that it harms their competitors.? Government support may lead AIG to discount premiums because they don’t have to turn a profit in their current state.? This harms the rest of the industry.? Why should insurers with no government support have to battle an insurer with govenment support?

Also, as I have said before, there is no reason to bail out AIG the holding company, which is what our dear government has done.? We only care about the operating insurers, not the company that owns them.? For the nonregulated entities inside AIG, the only one that has a material impact on the rest of the world if AIGFP.? Guarantee this if the US government must, but stay out of the rest of AIG.? Let that go into insolvency, there is no compelling reason tfor the US to protect it with tax monies.

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