Month: April 2010

What Should the US do about Housing Finance?

What Should the US do about Housing Finance?

Posted on by David Merkel

The US Government seeks your opinions on housing finance.? Send them here, to http://www.regulations.gov, and let them know what you think.? As for me, my opinions to their seven questions are here.? If you agree, echo them.? If you disagree, state your own case to the Treasury.

My Answers

  • How should federal housing finance objectives be prioritized in the context of the broader objectives of housing policy?

There should be no housing policy.? People will house themselves, even if the government does nothing.? Charities will spring up to effect this; Americans care, but private charity is more efficient than the bureaucracy.

  • What role should the federal government play in supporting a stable, well-functioning housing finance system and what risks, if any, should the federal government bear in meeting its housing finance objectives?

No role, aside from preventing and prosecuting most mortgage fraud.? Let the market regulate who gets homes.? Subsidizing housing has not led to sustainable gains in the percentage of those in single family housing.? It has led to a large amount of foreclosures, by allowing marginal borrowers to gain financing.? No surprise that there are a lot of failures.

  • Should the government approach differ across different segments of the market, and if so, how?

No.? Do not discriminate.? But better, get out of mortgage finance; Fannie and Freddie have lost money since inception.? You have done horribly.? Respect that, and exit the business.

  • How should the current organization of the housing finance system be improved?

Close down Fannie and Freddie.? Give the closed blocks of mortgages over to GNMA.? And after that, get out of all mortgage lending.? The government does not do it well.

Aside from that, phase out the mortgage interest deduction.? It has seduced many into buying more than they can afford.? Better to have lower housing prices that people can afford without subsidy.

  • How should the housing finance system support sound market practices?

Ban mortgages where payments can rise by more than 20% over the original payment.? Even above average people are lousy at understanding mortgage terms.? Payments must be capped.? That means fewer people will get mortgages, but most of those denied should not get mortgages.

Beyond that, insist that all mortgages have 20% down, with no second liens or mortgage insurance. ?In the short run, that will slow origination, but in the long run, it will lead to health in the mortgage sector.

  • What is the best way for the housing finance system to help ensure consumers are protected from unfair, abusive or deceptive practices?,

Most of the unfair, abusive or deceptive practices stem from two areas: 1) loan payments that can rise too much.? My 20% cap on rises in mortgage payments would solve that easily.? But there is 2) Appraisal abuse.? There is no incentive for appraisers to do the right thing, so eliminate them, and let the 20% down payment be the protection against default.

  • Do housing finance systems in other countries offer insights that can help inform U.S. ?reform choices?

The US is unique, given its risk-taking culture, and the use of private entities to title land.? I don?t think that other nations have relevant data to help us, aside from basic ideas like ?Don?t overlend.?

Those are my thoughts, and I will relay them to the government.? I hope that you do the same, whether you agree with me or not.

The Rules, Part IX

The Rules, Part IX

Posted on by David Merkel

A few readers have asked me where they can find a list of my “Rules” posts.? You can find such a list here.? One further note on the “Rules” posts — I’m not exactly sure how many there will be, but if I write all of them, there will be around 50 of them.? Should I live so long, and readers still enjoy the series, maybe I would write the last one in 2011.

Here’s tonight’s rule: Attempting to control a system changes it.

Maybe tonight’s rule deserves the “Duh!” award, but it reminds me of reading THE ART OF WAR, by Sun Tzu.? Most of what Sun Tzu writes about is really basic, but it is amazing how many times generals neglect his easy advice, and bullheadedly persist in unwise courses of action.

Well, it is that way in politics and economics as well, and we don’t seem to learn from history.? Go back to the 1960s, when economists discovered there was seemingly a tradeoff between unemployment and inflation.? All they had to do to minimize unemployment was raise inflation.? So, easy; print more money, and there will be less unemployment.

It didn’t work that way.? People got used to the inflation and assumed that inflation would occur at that higher level indefinitely, and unemployment didn’t drop.? Instead, we got stagflation in the 1970s.

I would point out the same thing to those who run the Eurozone if they would listen to me.? I feel privileged to have 29% of my readership coming from outside of the US.? Most of that is in Europe, with significant amounts in Canada, Israel and the financial centers of Asia.

The Euro was never supposed to be an area where the nations would be joint-and-severally liable for each other’s debts.? Indeed, nations were supposed to restrain their borrowing so as to avoid such and occurrence.? Bailouts change behavior.? Those that are bailed out see less need to change radically.? Those that are near being bailed out do not see a reason to stop borrowing.? Those that are in no imminent trouble, but would like more latitude in borrowing see a green light to borrow more.? Upshot: bailing out Greece leads to many perverse consequences.? It lowers the probability of individual nations defaulting in the short run, while raising the risk of total system failure in the intermediate-term.? The Eurozone is not a nation; there is little sympathy across national borders such that they would send tax dollars to bail another nation out of their debt crisis.

Or, consider US Monetary policy (or, most developed nation monetary policies, they have been pretty similar): the continual effort to promote prosperity via monetary policy, contra William McChesney Martin, Jr.? Monetary policy can’t create prosperity.? It can restrain inflation.? Attempting to use monetary policy to create prosperity was the Greenspan and Bernanke era.? They lowered interest rates, and raised asset values.? That is no prosperity, though, because the assets throw off the same cash flows.? Only the discount rate has changed.? Any asset has a higher Net Present Value when the discount rate declines.? That is all that Greenspan and Bernanke ever did, to a first approximation, is lower the discount rate.? The wealth effect stimulated consumption and additional indebtedness.

Or consider US housing policy.? We have spent bundles of money trying to entice marginal buyers to buy homes.? It is as if those that don’t own homes are inferior — a threat to society.? But have all of the efforts to increase the home ownership rate worked?? The jury is out; maybe in two years we will know for sure, but to me it seems that encouraging home ownership has been a disastrous social experiment.? I’m not an environmentalist, but isn’t it greener to have dense cities with apartment dwellers?? Face it, many people can’t maintain the discipline of a mortgage payment, regardless of what incentives are offered on the front end.

Or, consider US medical policy.? There was a time when medicine was relatively inexpensive, and people avoided using the medical system.? That was prior to offering a tax deduction for employer paid medical care, and Medicare.? Once people get separated from paying the immediate cost, they are far more willing to seek expensive care.? The insurance industry itself lost money for 20 years, because it failed to see the change in behavior the would happen once people were insured.? That is why my main recommendation for healthcare is to remove the tax deduction for all.? (Maybe leave the deduction on HSAs, and things like them.? Those are first party payer systems, and people won’t spend aggressively with them.

This is a major reason why I am a skeptic about the recent health bill.? You can’t get something for nothing.? A bill that cuts costs should result in less services, unless greater freedoms are allowed, and this bill does the opposite of that.? Single-party payer systems work because they restrict access to care, something that Americans will have a hard time adjusting to.

Or, look at the Japanese economy over the last two decades.? Keynes triumphs.? Low interest rates, and a lot? of government spending on marginal projects.? Huge increase in government debt.? Is the nation better off?? Hard to tell; wait to see if they survive to 2020 without a debt crisis.

Summary

In economics, one of my firmest beliefs is that you can’t get something for nothing.? A government increasing regulation may change the behavior of an area of the economy, but will not increase overall economic well-being.

Full disclosure: If you enter Amazon through my site, and buy anything, I get a small commission.

The Rules, Part VIII

The Rules, Part VIII

Posted on by David Merkel

Illiquidity is a function of total transaction costs, which can be considered barriers to entry. (and exit…)

Not everything can be liquid; not everything should be liquid; not everything will be liquid.

I ran into the concept of complete markets for the first time while taking a graduate level economics of risk class at UC-Davis.? Lots of time spent on the Arrow-Debreu model. Quoting:

The Arrow?Debreu model applies to economies with maximally complete markets, in which there exists a market for every time period and forward prices for every commodity at all time periods and in all places[citation needed].

But as with many other economic models, the assumptions are unrealistic aside from some special cases like widely traded options and commodities markets.? For markets that are by necessity thin (which in the Arrow-Debreu sense as I read it is most markets) examples being buying or selling a certain house, an obscure bond, or offering/receiving credit default on a thin slice of a securitization, there is no way that complete markets could exist.

It takes effort to make a market in any commodity/security.? You have to know something about the commodity/security, and know about the buyers and sellers.? What motivates them?? What is their “bite size? (what their normal position size is)”? When should I be concerned that some market player knows something that I don’t?? How much can I bid and offer under normal conditions, and at how tight of a bid-ask spread?? How much must I offer under stressed conditions, and how wide of a bid-ask spread will the market players tolerate?

It costs money to make a market, and so, market-makers conserve on making markets, and only offer deep markets on widely traded instruments.? The same is true for markets that offer delivery at different times and places.? Things that many people want, over long periods of time, that are highly standardized, can develop into broad futures and options markets.

But what lends to illiquidity?

  • Specialness implies lack of information.? An obscure fixed income security might have a very high yield compared to its rating and likely maturity.? The costs of research, and the efforts that must be expended in bargaining drive many players away from unusual securities.
  • An asset subclass can be new, and there are few transacting in it.? That is another version of the former problem.
  • A security might be fungible but illiquid because of a large number of legal steps one has to go through in order to move the security.? Examples would include selling loans on the balance sheet, or selling real estate supported by tax credit, or credit tenant leases.
  • Lack of information can also relate to the size of the asset in question.? Big players with large research staffs focus on large and maybe mid-cap assets.? But few of size focus on micro-caps, they could not put enough money to work.

Now, when I was a bond manager, because my client had a large amount of long noncallable liabilities, I bought less liquid debts when I received adequate compensation to do so, but not more than my client’s balance sheet could tolerate.? That allowed me to make better money for my client, but without increasing risk.? Hey, use the advantages that you have.

But remember, even if you understand the illiquid security perfectly well, but you don’t understand your own liquidity situation, you might find yourself in a situation where you have to sell, but few others understand the security, and no good bids are offered.

I would add that even in liquid markets, there are large order sizes that render markets illiquid, at least for a time.? Having owned 10, 20, 30% (even 80% ugh) of a given bond issue, I knew that I could only accumulate and decumulate in dribs and drabs, and contented myself with being a pseudo market maker, who could buy if the price was attractive, hold under all conditions, and sell if a loony buyer or buyers showed up.

Phrasing it differently: we only hold illiquid assets, or illiquid amounts of assets when we know a lot more than the market.? We have paid the barrier to entry, and are the heavy hitter now.? We make money off of superior knowledge, though illiquidity means that trades will be infrequent.

Book Review: Slapped by the Invisible Hand

Book Review: Slapped by the Invisible Hand

Posted on by David Merkel

In one sense, but not in every sense, this is the best book on the crisis.? I give Yves Smith credit for diving deep on economics and finance, and laying bare the intellectual bankruptcy there.? Simon Johnson and James Kwak did an excellent survey of regulatory difficulties in banking and more.? Barry Ritholtz probably wrote the best book, because he has a knack of combining informative and entertaining.

But what makes this book a winner is that he lays bare the root cause of the crisis: we need safe short-term liabilities in order to transact. Banks provide the short term medium of commerce, so that no one has to consider whether their dollars are changing in value month after month.

But when there are alternatives to banks that seem cheaper in the short run in creating stable securities, the banking system gets hollowed out.? That can be as simple as money market funds, or as complex as AAA structured securities that finance complex obligations.

At such a point, being a bank is not so valuable, and banks mimic the innovations in order to compete.

Though not an innovation, repo funding was a star of this crisis.? Repo funding is a short-term means of gaining liquidity through borrowing while offering high quality liquid assets as collateral.? It is very stable most of the time, but when liquidity gets scarce, the system as a whole can unwind.

The book focuses on “safe” liabilities: bank deposits, both before and after deposit insurance, repo funding, and AAA short securities from securitizations.? People want to keep their purchasing power safe.? But when the safety of any safe security comes under question, the system falls apart.

That is the nature of a systemic crisis.? What is previously regarded as safe is not safe.

I have one main policy recommendation as a result of this book — regulate the repo markets.? They were a main factor for contagion in this crisis.

I liked this book a lot, and recommend it.? I also like the title a lot, because the invisible hand does deliver negative consequences to those who act foolishly.? Punishment is needed for a capitalist system to survive.

Quibbles

Though it is a book, it is really five essays that have been sewn together with some extra copy in order to make it into a book.? Also, you don’t have to be bright to benefit from the book, but you can’t be dumb.

Who would benefit from this book

Anyone looking to understand the fundamental reasons behind the crisis will benefit.

If you want to buy it, you can find it here: Slapped by the Invisible Hand: The Panic of 2007 (Financial Management Association Survey and Synthesis)

Full disclosure: the author e-mailed me on a day where one of my favorite bloggers praised the book as the best book on the crisis.? So I said I would review the book, and his publisher sent me a copy for free.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I usually do.

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

The Rules, Part VII

The Rules, Part VII

Posted on by David Merkel

In a long bull market, leverage builds up in hidden ways within corporations, and does not get revealed in any significant way until the bear phase comes.

If I were to change that sentence, I would change the word “corporations” to “organizations.”? Why?? Everyone attributes greed to the corporate sector, but the same is true in different ways of governments and nonprofits.

Year to year, organizations measure progress.? Corporations look at profits.? Politicians look at whether they are still in office or not the success of programs passed.? Those that run non-profits look at how they have done on their missions, amid scarce resources.

But, when things are good for a long time, institutional laziness sets in.? I remember being out at some party at a golf course in Philadephia in 1996, when our best salesman uttered the inanity, “Let the stock market pay your employees.”? Really, he was a decent fellow, and brighter than most who sold for us, but his statement reeked of the bubble logic that assumes that stock markets are magic.? They always go up.? Corporations and individuals come to rely on the stock market going up, because it always beats bonds and cash over long enough periods of time.? That is true, but less so than most think, and the time periods have to be longer than most can tolerate.

Back to topic.? Non-profits are slaves to the stock market.? Giving goes up considerably when there is appreciated stock to give.? People donate more from wages when they are secure in their homes, and they think their retirements will go well, (fools that they are).

Governments are also slaves to rising asset values.? When housing prices fall, sales drop, and transfer taxes plummet.? But real estate taxes fall as well.? My property taxes dropped by 30% — I can hardly believe it, even though I thought they overshot 3 years ago.

Governments also get used to the boom, and begin forecasting increases in wage taxes, capital gains, real estate, and all other taxes.? They rely on the increase, and borrow beyond that.? But more insidiously, since they run on cash accounting they begin to fudge accruals to make the cash accounting look good.

Tough negotiations with the public employees union?? Offer less of a wage increase, and a generous increase to the pension benefit. That will reduce the present cash costs, leaving others to deal with the costs shifted into the future.

Cash costs of paying your debts too high?? Wall Street has many derivatives that can lower your cash cost today, at a price of probably or certainly raising your cash costs in the future.? Ask Jefferson County, Alabama; they will tell you.? Greece and Italy did much the same to enter the Eurozone, amid winks from those that presently disapprove.

“Can’t we raise the spending rate on our endowment?” naive nonprofit board members ask.? Tell them to look at the 10-year Treasury yield — that is a reasonable proxy for sustainable distributions.? Most nonprofit board members don’t know up from down economically; they tend to favor the present over the future.

Corporations are the same, but they do it differently.? They run on accrual accounting, so they tend to tweak accounting to make net income look good, relative to cash flow.?? Also, they buy back stock, which increases leverage.? Even raising the dividend increases leverage, because it is like junior debt, corporations know their stock prices will fall if it isn’t paid or increased.

Buffett says something to the effect of, “Until the tide goes out, you don’t know who is swimming naked in the harbor.”? Bear markets reveal optimistic assumptions and accounting chicanery.? This is true for any organization, because we all rely on the same economy.? Yes, the wealthy support some organizations more than others, but many governments rely on taxes from the wealthy more than they realize.

This even applies to individuals.? Who paid attention to the increases in debts, especially junior debts like home equity lending during the boom?? My last firm did, and I wrote about it at RealMoney, but it felt lonely at the time.? Silent seconds, low LTV lending, mortgage insurance, and other means of getting people into housing that they couldn’t afford looked like like the pinnacle of success for US housing policy.? Now, with all of the wounds the banking system has taken, and all of the foreclosures, past, present and future, many are beginning to think differently, but you can’t see that in government policy.? Many people are not capable of bearing the fixed commitments associated with home ownership, and there is no way that government policy can materially change that.? But the government continues to encourage high home ownership and asset prices, merely delaying the inevitable reconciliation of bad debts and lower housing prices.

It’s the nature of a boom.? Free money brings out the worst in us, leading many to borrow more to get even more prosperity that seems to never end.? When the bust comes, it ends, with interest compounded.? The positive dynamic becomes a negative one, until sufficient debt is compromised, cancelled, or paid off.? There’s no way around it, but our government will fight on hopelessly.? They always do.

The Rules, Part VI

The Rules, Part VI

Posted on by David Merkel

History has a nasty tendency to not repeat, when everyone is relying on it to repeat.

History has a nasty tendency to repeat, when everyone is relying on it not to repeat.? Thus another Great Depression is possible, if not likely eventually.

When people rely on the idea that a Great Depression cannot occur again, they tend to overbuild capacity, raising the odds of another Great Depression.

I think I wrote those between 1999 and 2002.? I kept a MS-Word file at work and home, and when ideas would strike me, prior to my time of being asked to write at RealMoney, I would write them down, and later revise them, until I had something that I thought was worth keeping.? I eventually ended up with 6 pages.? At some point in time, I concluded that my musings needed to be more structured, and I reorganized them so that similar thought were near each other.? I am fairly certain I wrote the three phrases above at different times.

I have sometimes said that to be a good contrarian, you don’t analyze opinion, you analyze reliance.? How much have people invested in an idea?? Are those that have invested in an idea long-term holders with a strong balance sheet, or short term holders that are reliant on total returns?? Do those who have invested in an idea have to get returns in the short run in order to survive?

The idea may be right or wrong, in the long run or the short run.? But near turning points, short-term money seems to be near-unanimous in its opinion that “this is the best way to make money.”? Seemingly free money brings out the worst in us.? We were created to work, but we would rather speculate, if given the opportunity.? I criticize myself here as much as anyone else; maybe I should have been a Mathematician or a Chemist.? That’s what I started out as in College, before being seduced by the simple beauty of Economics 1 & 2, which hid the complexity, and lack of ability to estimate their models.

“It’s Different this Time.”? So say many investors during booms.? Following momentum is a great strategy when few are doing it, less good when many are doing it, and troublesome near market breaks.

The same is true of governments.? They happily accept credit for a good economy, and then during busts, they borrow from the future in order to make the present better.? The first few times they do it, is works amazingly well, and so they assume that it is a rule: let the government borrow, and let the central bank lower rates a lot, and voila! the recession ends.? They don’t notice the increases in debt, public and private, and that useless economic capacity is not disappearing, because it gets financed at lower and lower rates.? We tend to be lazy, and not think of better uses for resources until there is financial failure forcing us to do so.

The cost of eliminating recessions too quickly and prolonging boom cycles, is that the debts build up.? Consumers and investors lose fear, and take on more debts than is prudent.? Debt-based economies are more complex and fragile than economies with lower leverage.? Particularly when financial entities are highly levered, the odds of a crisis are high.

As my wise former boss once said, “We don’t make the mistakes of our parents, we make the mistakes of our grandparents.”? Our parents typically warn us of the problems they survived, but not those that their parents did.? Thus we fall into the forgotten problem, and why big busts tend to recur about once every two generations.

The knowledge is out there, but culturally, we don’t use it.? The past is irrelevant; this is a new era.? It’s different this time.? Alas, the hubris of man is one of the few infinite things that he has.? Few study economic history, particularly most economists.

As such, we build up productive capacity using debt, assuming that high compound growth will make it work, and fall into another bout of debt deflation.? It may not be the Great Depression, it might be like Japan for the last two decades, or, maybe… it could be another Depression.? Or, something entirely different… the US Government builds up so much debt, and is constrained politically from inflation or higher interest rates, that it decides to default on external obligations.? Not likely, I know, but hey, there are a lot of unusual things going on, and unusual tends to beget unusual, at least in the short run.

But, how many are truly invested for total disaster?? And which total disaster?

  • Depression.? Buy long Treasury bonds, sell gold.
  • High inflation.? Buy TIPS, foreign bonds, and commodities. Sell long bonds.
  • Hyperinflation. Buy Gold and Silver.? Sell bonds short, if it is still legal.? Look for alternatives for practical currency.
  • Civil unrest? Choose your home with care.? There is nothing to buy or sell here.? Survivalism would work for short periods, but almost all long-term solutions rely on a stable civil government.

My estimate is that few are invested for a crisis.? That does not mean that a crisis is coming, but that if a crisis comes, since most are not prepared, the selloff would be hard.

-=-==-=-=-=-=-=–=-==–==–=-=-==–==-=-=-

Moving to the short run, there are many who say that the current rally is tapped out, and will fail soon.? That may be, but there is a lot of liquidity generated by the Fed’s low short rate policy, and many in the short run will borrow short to fund a long term asset, like a stock, which has a higher yield.? Eventually that will fail, but in the short run it is temporarily self-reinforcing.

My view: favor the momentum in the short run, but realize that most of this rally is anticipating profit margins in the economy that have never been obtained in the past.? Trim exposure, or be ready to do so.? Remember, bond yields are proving to be greater competition day by day.

Thoughts on Maiden Lane II

Thoughts on Maiden Lane II

Posted on by David Merkel

I hate working in an information vacuum.? Look, I lack the advanced analytics of major Wall Street firms.? A Bloomberg terminal is powerful, but not as good as the major investment banks, or third party specialists.

My friend jck gave me constructive criticism regarding my post on Maiden Lane III.? I am still waiting for the 2009 audit report for Maiden Lane III.? It should be published soon.? The 2008 report said that there were no gains or losses.

jck said that I should look at the decrease in book value in liabilities over time — that would measure the success of Maiden Lane III over time.? But any payment on the liabilities should stem from a diminution of the assets.? Even though the assets are held at fair value, and the liabilities at book value, this would still remain true.? Thus the gap between assets at fair value and liabilities at book value have significance.? So here it is for Maiden Lane III:

Maiden Lane 3

With ML III there was an investment of $5 billion of equity, there is still a loss against that yet, though not much.

But there is a similar graph for Maiden Lane II:

Maiden Lane 2

There is a rhythm to this because assets are revalued in the first month of the quarter, whereas liabilities are fixed, at least subject to paydowns and draws.? I would not be surprised to see a further improvement in the gap by the end of April, even as credit metrics continue to decline.

The Maiden Lane II Portfolio

Aside from two privately placed interest only securities, the rest of Maiden Lane II could be modeled.? Here are the credit metrics:

Rating Principal $K Percentage
AAA 1,719,167

5.0%
AA 2,173,090

6.3%
A 2,166,569

6.3%
BBB 1,211,229

3.5%
BB 2,648,188

7.7%
B 4,955,596

14.4%
CCC 16,362,857

47.6%
CC 2,456,082

7.1%
C 687,387

2.0%
Total 34,380,166

The average credit rating is B-, with a downward tendency.? 56.7% of the portfolio is rated CCC and below, and 71.2% of the portfolio is rated B and below.? But what types of collateral are in the portfolio?

Alt-A 4,289,185

12.4%
HELOC 1,012,497

2.9%
Home Equity 8,644,853

25.0%
Subprime RMBS 13,581,921

39.3%
Fixed WL 500,599

1.4%
Floating WL 6,519,656

18.9%
Total 34,548,712

All of it is housing related.? None of it is agency quality.

What sort of origination vintages does the portfolio have?

Issue Year Principal $K Percentage
2000 503 0.0%
2001 1,657 0.0%
2002 690 0.0%
2003 112,273 0.3%
2004 747,871 2.2%
2005 5,630,124 16.3%
2006 17,635,093 51.0%
2007 10,251,954 29.7%
2009 168,547 0.5%
Total 34,548,712

The average vintage is mid-2006, which is lousy for any debt portfolio on residential real estate in the US.? I would expect bad performance from a portfolio with these characteristics.

Compared to ML III, ML II has better collateral, but worse vintage years.? Both are messes.? I am not saying that the Fed will necessarily lose money on either one, but I question the valuations on the assets.? If Blackrock is doing the valuations, maybe I should be quiet — who has more knowledge than they do?

All the same, I still question the ability of two Fed vehicles to extract liquidity out of illiquidity, and on favorable terms.

Thoughts on Maiden Lane III

Thoughts on Maiden Lane III

Posted on by David Merkel

After losing their court cases to keep bailout data secret, the Federal Reserve has finally complied with the minimum of what is lawful, and published PDFs of the Maiden Lane Portfolios.? The data is minimal – principal amount, deal/tranche description, and CUSIP (if any).? Out of the goodness of their hearts (not), the Fed locked the PDFs, making it impossible to copy the data into Excel easily.

I printed the documents and scanned them in using OCR, and pasted them into Excel.? Even with 99% accuracy, it took a while to scrub the data of the smallest portfolio, Maiden Lane III, which was the bailout of AIG.? I hope to do a similar analyses of II (likely) and I (maybe, tall order).

I don’t have access to advanced analytics that the best bond shops do.? If anyone wants to improve on what I have written here, e-mail me; I can send you an Excel file with correct CUSIPs and principal amounts.? It will save you two hours of time in your analysis.

Here are my main findings:

  • The average rating on the bonds in the portfolio is B-, with 61% rated CCC or lower.? (Composite rating of Moody’s, S&P, and Fitch.)
  • 98.3% of the portfolios are some type of CDO.
  • On average, the deals owned were originated in 2006, with 73% between 2005 and 2007, and 96% between 2004 and 2008.

Here are some tables:

Rating Principal $K Percentage
AAA 386,339

0.7%
AA 330,375

0.6%
A 1,203,294

2.2%
BBB 7,575,198

13.6%
BB 1,500,841

2.7%
B 10,662,978

19.2%
CCC 22,734,918

40.9%
CC 8,934,106

16.1%
C 2,066,434

3.7%
D 216,211

0.4%
Total 55,610,694
Collateral Type Principal $K Percentage
CDO 21,666,184

39.0%
CF-CDO 4,900,206

8.8%
CF-CDO-SP 28,078,341

50.5%
Other 965,963

1.7%
Total 55,610,694

98%+ CDOs.? 50%+ structured product CDOs.

Issue Year Principal $K Percentage
2002 803,181

1.4%
2003 726,377

1.3%
2004 7,332,735

13.2%
2005 17,666,522

31.8%
2006 10,127,922

18.2%
2007 12,730,293

22.9%
2008 5,403,463

9.7%
2009 820,201

1.5%
Total 55,610,694

Offering Some Color

In the bond market, it is not uncommon for a broker to give, or for a portfolio manager or trader to ask for “color.”? Fill in the details; why is this bond so great, or lousy?? Though I don’t know all of the deals in detail, I have enough information to explain how lousy the collateral is that AIG gave the Fed.

First, the average rating on the bonds in the portfolio is B-, with 61% rated CCC or lower.? For those not familiar with ratings:

  • AAA means you can survive a Depression
  • BBB means that you can survive a normal recession.
  • BB is junk grade, and the strongest that might not survive a normal recession.
  • CCC means economic conditions must be perfect for the company to stay current on its debt.
  • D is default.

For those not familiar with managing credit-sensitive bonds, the difference in likely default losses is minuscule between AAA and BBB bonds.? That is why they are called investment grade.? Below BBB, loss rates turn up with a vengeance.? For the portfolio to be B- rated on average, with 61% CCC and below is very bleak indeed.

Now, these are CDOs, and over half are CDOs with structured products in them.? CDOs themselves are a structured product in their own right.? Structured products, when they default, tend to be total losses (or close to it), unlike corporates, where recoveries are 30-40% or so of the face amount.? Add to this that CDOs tend to be the worst performing structured product in a crisis.

With 61% of the portfolio rated CCC or below, and 80% rated B or below, there is a large possibility that the $56 billion of notes will have a hard time exceeding the $22 billion of fair value that the Fed marks the assets at.? These are horrible quality notes, and the structure inherent in the notes makes them weaker in a stress scenario.

Finally, the vintage of the bonds in the portfolio is concentrated in the worst years, credit-wise, to be originating deals.? My rule of thumb is that deals originated after 2005 are bad, 2005 and 2004 are suspect, and 2003 and before are fine.? Half of the deals were offered 2006 and after, and 80%+ 2004 and after.

As the bubble grew, deals issued later had worse credit characteristics.? Perhaps deals in 2009 are improvements over 2008, but there was credit devaluation 2003-2008.

Summary

AIG probably took the Fed for a ride here.? Personally, I suspect the Fed, despite all of the Ph.Ds that they employ, did not have enough “street smarts” to reject such a portfolio when the crisis hit.? One unwritten rule about CDO ratings is that if they go down,? they will go down much more, and often to default.? CDOs are among the shakiest asset sub-classes out there.? Why did the Fed accept them as collateral?? A lesson to all, do not make decisions during a time of panic; almost all of us make bad decisions then.

Again, if you want to help me with this and have more resource for analysis than an ordinary Bloomberg Terminal might have, please contact me.? Thanks.

Book Review: 13 Bankers

Book Review: 13 Bankers

Posted on by David Merkel

Simon Johnson and James Kwak write a popular blog, The Baseline Scenario.? They have written a? very credible book on the crisis, which I have .? It covers all of the bases in a methodical way, and there was little with which I could find fault, and it does so without conspiracy-mongering, or name-calling, while still finding fault with a great many parties.

The intro to the book begins with the 13 bankers meeting Pres. Obama at the White House in March 2009.? (Thus the name of the book.)? The Obama Administration treats the bankers with kid gloves, because they are afraid of a crash in the banking/economic system.? But like the old saw, where if you owe the bank $1000 and can’t pay, you have a problem; but if you owe the bank $10 billion, they have a problem — the US government concluded that they had to protect the banks in order to protect the system as a whole.

Now, part of this stems from a false belief system, thinking that we had to bail out the banks — we didn’t need to bail out the banks.? We could have resolved them through a new Resolution Trust Company.? Rather than bail out holding companies, we could have let holding companies fail, and protected the few operating subsidiaries that people and institutions rely upon.? But part of this stemmed from the influence that large banks exercised over the US Government.? So many in the government benefited from campaign contributions from banks.? Many had worked for the banks and had friends there; many wished to work there eventually.

The book takes us back to the beginning of the US, and all of the arguments over whether we needed a central bank or not.? This is one of the few places where I disagree with Johnson and Kwak.? I don’t think we need a central bank, though we do need to regulate credit in order to avoid banking panics.? They view Jefferson as right in viewing large banks as being a threat to government sovereignty, but naive that a central bank was not needed, while Hamilton was more practical, but would not see the risk of political corruption.

Think of the Greenspan era, which was central banking at its worst.? The least little squeak during a recession would make Greenspan open up the monetary spigots, and he would keep them on well beyond when stimulus was needed.? Because of demographics, his actions did not lead to price inflation, but asset inflation.? Thus the bubble that we face now.? Extra dollars did not chase goods; extra debt chased assets.

They take us through the international crises of the ’90s which largely did not affect the US, but would sound familiar to us today.? We don’t think of ourselves as having aristocrats in the US, but major CEOs seem to play that role well.

They catalogue the changes in policy that allowed for securitization, for swaps, for unregulated swaps, for increases in leverage, for decreases in regulatory oversight, and increasing influence over US policy by financial companies. Further, with the regulators outsourcing much of their responsibility for setting capital levels to the rating agencies, there was a further opportunity for failure, as the rating agencies rated novel securities for which they had no track record.

With sloppy regulators like the Office of Thrift Supervision, the stage was set for and a race to the bottom in lending standards.? In the short run, more lending promoted higher profits, but in the long run sealed the demise of many lenders.

The crisis hit, and the leverage that had been built up was unsustainable.? It rippled through many areas of the financial sector, hitting the firms that had cheated most the hardest.? Over two years, from February 2007 to March 2009, the first wave of the crisis shook the banks, and many failed.? Many smaller banks continue to fail, having no influence over the government.

Their solution to part of the crisis is modest, at least, more modest than I would pursue.? They suggest that the six largest banks be broken up.? Good, let’s do that.? They suggest consumer safeguards; yes, protect dumb people to some degree, but make them wear a scarlet letter “D.” (My thought, not theirs – you can’t have it both ways.? There should be stigma if you can’t protect yourself.)

It is a very good book and one that I would heartily recommend.

Quibbles:

You have to have average intelligence to read this book.? It is not a book that everyone can read.? Also, very few graphs.? No pictures.? That doesn’t affect me, but many other people have a hard time reading a book with little in graphics.

Who would benefit from this book:

Almost everyone would benefit.? It does a great job laying out the problems, and the solutions that they offer are eminently reasonable.? Again, you have to be willing to read a book where the words are big, the sentence structures are complex, and you already understand something about economics.

If you want to buy the book, you can buy it here: 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown.

Full disclosure: I received a free copy of their book at the Fordham Conference, as did all of the other attendees.? I never promise to review a book that I receive for free, and I never promise a favorable review. That said, when I receive free books, if I have a lot of them (normal), typically I do triage and pitch the ones that look like losers.? I do a similar filtering when book agents e-mail me to review books.? I really only have time for good ones.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I usually do.

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Post 1200

Post 1200

Posted on by David Merkel

Every hundred posts, I take a step back and try to consider where we have been.? Perhaps because it is recent, I will examine my move to use Twitter.? I have been on Twitter for 3 weeks, and I have 350+ followers.? If you want to follow me on Twitter, you can do so here.? Most of what I do on Twitter is point people to articles I think are important in somewhat near real-time.

Should I persist in doing Twitter, I will not do huge posts of links on a given topic.? But, if you ask me, I will gather up my Tweets, and post them once a week here.? Let me know in the comments.

It was with some reservations that I decided to use Twitter.? Ordinarily, I write longer posts, and 140 characters does not allow much to be said.? But there is the challenge.? Can I boil down something to its essence?? Make it catchy so that others retweet it?? Summarize it well so that someone can pick up the argument in a few seconds?? That is what I have been aiming for.

I will add one plug.? I am glad that before I started tweeting that I installed TweetDeck.? I have used it from the beginning, and it has made using Twitter far more productive than otherwise.

Now, as for the last four months, the market has been more bullish than I have been.? I have done better than the market, but not by much.? My risk posture is a lot lower than the market in aggregate, and my sensitivity to economic cyclicality is lower than normal.? It is a tough environment, and most people that I respect are reducing risk exposure.? I have done the same, but less so.

It is a puzzling time, but I am still reducing risk exposure, and will do yet more in April.? There is only so far that profit margins can expand.? I think that expectations of profit margins are near their peak.? So are stocks, most likely.

I hope all of you have been enjoying the “Rules” series.? There are maybe 30 more posts to go there.

I appreciate the comments you make and the e-mails that you send, but I don’t have time anymore to answer every email and comment.? My sad apologies; I wish I could do more with my time.

And now, thanks to those who read me, listed in order of the number of visitors (credit Quancast):

  • Merrill Lynch and Company (US)
  • Citicorp Global Information Ne…
  • GOLDMAN SACHS COMPANY (US)
  • UBS AG (US)
  • JPMorgan Chase & Co. (US)
  • Verizon Business (US)
  • US Department of the Treasury …
  • Morgan Stanley Group (US)
  • Fordham University (US)
  • The Drexel University Campus (…
  • Johns Hopkins University Appli…
  • Bloomberg Financial Market (US…
  • AMAZON.COM (US)
  • CITIGROUP (US)
  • LEHMAN BROTHERS (US)
  • New York University (US)
  • WELLS FARGO BANK (US)
  • Toronto Dominion Bank (CA)
  • SCANSAFE (US)
  • Royal Bank of Canada (CA)
  • Harvard University (US)
  • Dow Jones-Telerate (US)
  • Colonial First State Investmen…
  • BLOOMBERG, LLP (US)
  • GOLDMAN SACHS COMPANY (GB)
  • Raymond James Financial (US)
  • Mellon Bank (US)
  • DEUTSCHE BANK (US)
  • Fidelity Investments (US)
  • Google (US)
  • Verizon Business (CA)
  • The Vanguard Group (US)
  • Merrill Lynch and Company (GB)
  • Dean Witter Financial Services…
  • Bank of America (US)
  • American International Group D…
  • Northrop Grumman Corp. (US)
  • Arris Group (US)
  • MAN Financial (US)
  • HSBC Bank plc, UK (GB)
  • GNA Corporation (US)
  • Daniel J Edelman Limited (GB)
  • Credit Suisse Group / CANA (US…
  • Credit Suisse Group / CANA (SG…
  • Community Health Care of the C…
  • Barclays Capital (GB)
  • Stanford University (US)
  • Warszawa (PL)
  • RCN NEW YORK COMMUNICATIONS, L…
  • United States Senate (US)
  • UBS (CH)
  • U.S. HOUSE OF REPRESENTATIVES …
  • Royal Bank of Canada (US)
  • PNC Bank (US)
  • OCLC Online Computer Library C…
  • Morgan Stanley Group (GB)
  • Michigan State Government (US)
  • Macmillan/McGraw-Hill School P…
  • KOCH INDUSTRIES (US)
  • International Fund Services (I…
  • GuavaTech DUPLICATE (US)
  • Georgetown University (US)
  • FT Interactive Data (GB)
  • City of Oakland (US)
  • Citadel Investment Group, L.L….
  • BT Corporate (GB)
  • AllianceBernstein L.P. (US)
  • Choice One Communications (US)
  • STARBUCKS COFFEE COMPANY (US)
  • UBS (GB)
  • RTM – Rede de Telecomunicações…
  • ROBERT W. BAIRD COMPANY (US)
  • Payless ShoeSource (US)
  • Pathway Communications (CA)
  • Oxford University (GB)
  • NSW Premiers Dept (AU)
  • Nesbitt Burns (CA)
  • MessageLabs Limited (GB)
  • LloydsTSB CMF (GB)
  • Indiana State Library (US)
  • H&R Block (US)
  • Fiberpipe (US)
  • Federal Home Loan Mortgage Cor…
  • Federal Deposit Insurance Corp…
  • DEUTSCHE BANK (GB)
  • BT AMERICAS (US)
  • Baruch College (US)
  • Barclays Global Investors UK (…
  • Litton Computer Services (US)
  • National University of Singapo…
  • KDDI Europe Ltd (GB)
  • CERFnet customer – Qualcomm (U…
  • WEBCOM (CH)
  • Vermont Telephone Company (US)
  • University of Tulsa (US)
  • THE CAPITAL GROUP (US)
  • Susquehanna Investment Group (…
  • SunTrust Service Corporation (…
  • Scotia McLeod (CA)
  • Routed Connection (GB)
  • Qwest Corporation (US)
  • Petercam S.A. (BE)
  • PCD Network Solutions (US)
  • Northwest Nexus (US)
  • Nildram (GB)
  • Morningstar (US)
  • MORGAN, KEEGAN & COMPANY (US)
  • Moody’s Investors Service (US)
  • MONTAG ANDCALDWELL (US)
  • Macquarie Bank (AU)
  • LloydsTSB Bank Plc (GB)
  • Ignite Technologies (US)
  • Henderson Global Investers (GB…
  • Gelber Group, LLC (US)
  • FINANCIAL SECURITY ASSURANCE (…
  • Dow Jones International (GB)
  • Credit Suisse Group / CANA (GB…
  • COMMONWEALTH BANK OF AUSTRALIA…
  • BLOOMBERG (GB)
  • Beckman Instruments (US)
  • Banque Paribas (US)
  • BANK OF ENGLAND (GB)
  • Arcap (US)

=–=-=-=-=-=-=-=-=-=–=-=-=-=-=-=-=-=-=-=

That is quite a list of eminent firms/organizations.? I may not make the ten/twenty best lists, but I have a really good group of readers, and I appreciate the time that they spend on me.

To that end, I appreciate the following blogs who support me:

  • Abnormal Returns
  • FT Alphaville
  • Naked Capitalism
  • Alea
  • The Big Picture
  • Economics Roundtable
  • RealClearMarkets
  • And more

As one final note, in the interests of transparency, how much do I earn off my blog in a year?? ~$2000.? Most of that comes through commissions from Amazon.? Book reviews are my way of providing some payback for the time that I spend writing.? My best estimate says that I earn considerably less than minimum wage, so let any who think that I am in it for money consider otherwise.? I write what I write because I believe it, and because I think it is important.

Blessings on you, my readers, so I ask God.? May the remainder of 2010 be so good to us as the first quarter.

Humbly Yours,

David

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