Real Estate and Mortgages – Page 29

Book Review: Street Fighters

Posted on 16 May 200916 May 2009 by David Merkel

This week, amid everything else I was doing, I read the entirety of the newly released book, “Street Fighters: The Last 72 Hours of Bear Stearns, the Toughest Firm on Wall Street,”? written by Kate Kelly, Wall Street Journal reporter who covered Securities firms like Bear Stearns, and wrote three major articles as it declined.

Here is how the book works: it takes you from Thursday evening to Sunday evening during the crisis.? When a new topic or person is brought in in an important way, Kate Kelly does a flashback to give readers the needed background.? It detracts from the urgency of the rest of the story, but does flesh out how Bear Stearns came to this ugly situation.

Culture matters in an organization.? A well-run organization, such as existed under Ace Greenberg developed pride in the organization, because it worked so well.? But pride, once engendered, is a fickle mistress.? Under James Cayne, once he stopped checking the details, and even major issues like exposure to the mortgage markets, pride was destructive.? Alan Schwartz believed that Bear Stearns was a great institution, and it blinded him regarding raising capital.? They couldn’t need additional liquidity, until it was too late to raise it.

Kate Kelly interviewed many people extensively for her book, and includes footnotes where parties don’t agree with her renderings.? She does make? the? last 72 hours live, with all of the uncertainty and fear of the situation.? I liked the book, and would recommend it.? That said, there are other books out on Bear Stearns, and I have not read them.

It’s a Small World After All

Now, what are the odds that a kid I used to stand with at the bus stop to go to kindergarten would end up in this book that I am reviewing?? To an actuary, it boggles the mind.? There is a “bit player” who appears twice in the book, my old friend Pat Lewis.? He lived three doors down from me, and was the popular, tall athlete, while I was a short nerd who tried my best in athletics.? We were both long distance runners, but he was my better by far.

After many years, I came back into contact with him in 2000 or so, when he had gotten a job in risk control at Bear Stearns.? I met him for lunch during an actuarial conference in midtown Manhattan — what a place to meet for two guys from the Milwaukee suburbs.? We caught up on each other lives and careers.? Me, married with seven children (then — eventually eight) — he, unmarried, but still more handsome than me.? Both of us are risk managers — he at Bear, me at F&G Life.? As the book records, Pat and those working with him try to create mathematical models that will highlight the risks of Bear.? James Cayne, not understanding the value of them, kills the project.

There are other references to him in the book, but this is a tale where those more powerful would not listen to reason.? Pat Lewis is a standup guy, and stated what he believed, even when things were chaotic.

Lessons

Though the book gives its own set of lessons, I want to give a few of my own.

Love beats fear… we need friends

Bear might have felt like a big swinging dick after LTCM, where they stiffed the rest of the securities industry by refusing to pony up capital, but that cemented the view of the rest of the industry: Bear was not a team player.? That cost them when their disaster hit.? My conclusion: love beats arrogance in the long run.? Better to have friends than to suffer alone.

Don’t take your eye off the ball

Cayne clearly took his eye off the ball thinking that the business would do fine without close attention — he could go off and play bridge and smoke pot.? Inattention destroys businesses.

Risk control wins in the long run.

Cayne ignored risk control.? He was happy with a high ROE, and did not look closely to see how it was generated.

Liquidity is lifeblood — consider the BONY box.

Goldman is the only securities firm to come through this crisis almost unscathed.? Rather than pressing it to the limit, they would add assets during good times to the BONY box.? That is, they would save safe assets to protect themselves in the long run.? What a wise strategy.? No wonder that they run our government.

Summary

This is a good book that deserves to be read by those that want a clear view of how Bear Stearns went down.? It is engaging and informative.

As For Me

Here are some posts that I wrote during the crises:

If you want to buy the book you can buy it through the link in my leftbar. ?? Or, you can buy it here:

Street Fighters: The Last 72 Hours of Bear Stearns, the Toughest Firm on Wall Street

For those that want to sponsor me, anytime that anyone buys at Amazon after entering through my my site, I get a small commission, and your price at Amazon remains the same.

Stressing Bank Tests

Posted on 11 May 200911 May 2009 by David Merkel

Perhaps we have it easy in the life insurance industry. Solvency is defined on two criteria: risk-based capital, and a variety of cash flow testing schemes, both contingent and noncontingent. Truth is, it’s not that easy, but the life insurance industry has been more proactive on risk management than the banks.

I have not talked much, if at all about the “bank stress tests” for one major reason: in life insurance, there are detailed rules for performing cash flow analyses. With the bank stress tests, the adverse scenario posited higher unemployment, lower residential housing prices, and lower real GDP than “baseline” estimates.

Okay, that’s nice, but as is often said, the devil is in the details. Did the banks get relief from the scenarios? It seems so. Why? When I first saw the adverse scenario, I said to myself, “Not adverse enough. Aside from that, how do you translate the adverseness into actual credit losses?”

The latter question is a critical assumption, particularly for complex financial institutions. There is no immediate good answer, so how did the US government simplify matters? We do not know, but we do know that the financial institutions pushed back.

What concerns me the most is that the stress scenarios did not explicitly consider weakness in commercial mortgage pricing. This is a process that is in its early phases. Much as REIT stock prices have fallen, and CMBS prices have fallen, the impact has yet to be realized on commercial whole loans on bank balance sheets.

It is very difficult to transform the macroeconomic assumptios of the stress test into usable credit loss data. Reasons:

Differences in bank lending practices makes uniformity tough.
Attempts at getting accurate on a company-specific basis introduces the ability of the company to tilt the analysis their way. Also, company specific loss estimates lack credibility.
Loss estimates on new lending classes also lack credibility.
Estimates of how sensitive loss estimates are to unemployment, GDP and residential housing prices lack credibility for most lending classes. We don’t have enough data.

Now I have done stress tests at life insurance companies. You estimate how much you can take in credit losses without having to dip into surplus assets over a 1, 3, 5, 10, etc-year periods. You compare those statistics to worst few credit losses over 1, 3, 5, 10, etc-year horizons to get an idea of the likelihood of such large losses. That has its troubles, but it is better than nothing. The life insurance industry keeps pretty extensive statistics on its asset losses.

I didn’t get too encouraged by the results of the stress tests. They were easy tests to pass for many because:

The stress scenario isn’t that severe. I give it better than 50% odds of occurring. A real stress test has perhaps a 5% chance of occurring.
The stress scenario isn’t very prolonged, like the Great Depression.
Creating the models that connect the economic assumptions to the loss costs is problematic. Errors are unlikely to be on the conservative side — both the banks and the regulators are incented to be aggressive, because they don’t want to cause specific panic over their company, or general panic over the banks. Remember, their is a large number of people who think this panic is merely confidence/liquidity, and not solvency. (Then why are we raising capital or selling assets?)
There are many new lending classes that have not gone through a full asset default cycle, so their default loss properties in an era of debt deflation won’t be calculable. We don’t have the data.

When I look at the modest cost of $75 billion of capital to raise, I think of all the capital raised prior to this — and now a measly $75 billion will assure the future solvency of the system. This is only an opinion, but I think that number is too low, particularly with the troubles in commercial real estate being so early in its cycle. Remember 1989-92? The degree of overbuilding now is greater than then. The losses should at least be proportionate.

My simple bit of investment advice is to underweight the securities (bonds, preferred and common stocks), of the companies that failed an easy test. That means underweighting:

Bank of America
Citi
Fifth Third
GMAC (debt, there is no public common)
Keycorp
Morgan Stanley
PNC
Regions Financial
SunTrust
Wells Fargo

At least, this will be worth watching as a basket from 5/8 on. It may give us clues to the economy as a whole. I expect that it will underperform, but I am more certain that it will covary very highly with the market as a whole. Let’s see what happens.

One Dozen Notes on our Current Situation in the Markets

Posted on 8 May 20098 May 2009 by David Merkel

I’m leaving for two days.? I might be able to post while I’m gone, but connectivity is never guaranteed, particularly in southwestern Pennsylvania.? (Sometimes I call it “the land that time forgot.”) Apologies to those that live there — Pittsburgh is the capital city of Appalachia.

Here are a few thoughts of mine:

1) Many have been critical of Buffett after a poor showing in 2008.? Much as I have criticized Buffett in the past, I do not do so here. The mistake that many make in analyzing Berky is forgetting that it is first an insurance company, second an industrial conglomerate, and last an investment vehicle for Warren Buffett for stocks, bonds, derivatives, etc. With most of his investments, he owns the whole company, so you can’t tell how Buffett’s investing is doing through looking at the prices of the public holdings, but by reading Berky’s financial statements. By that standard, 2008 was not a banner year for Berky — book value went down — but it was hardly a disaster. Buffett remains an intelligent businessman who deserves the praise that he receives.

From The Investor’s Consigliere, he agrees with me.? Berky is more like a special private equity shop than like a mutual fund.

2) I’m past my limit for cash for my broad market portfolio.? I have sold bit-by-bit as the market has risen.? I’m planning on buying more of my losers, or finding a few new names to throw in.? Will the current “bull market” evaporate?? There are some sentiment measures that say so.? Also, when cyclicals lead, I get skeptical.

3) As correlations rise, so does equity market risk.? Are we facing crash-like risks now?? I don’t think so, but I can’t rule it out.? My opinion would change if I knew that major foreign investors were willing to “bite the bullet” and recognize the losses that they will experience from investing in Treasuries.

4) My initial opinion of Ben Bernanke, which I repudiated, may be correct.? My initial opinion was that he would be a disaster.? Now that the transcripts of the 2003 Fed meetings are out, he was among the most aggressive in loosening policy, which was the key blunder leading into our current crisis.? It also explains the novel policies adopted by the Fed over the last 18 months.

5) Investors are geting too excited about a recovery in residential housing.? Such a recovery is not possible while 20%+ of all residential properties are under water.? Foreclosures happen because of properties under water where a random glitch hits (death, disaster, disability, divorce, debt spike (recast or reset), and disemployment).

6) I have long had GM and Ford as “zero shorts.”? Sell them short, and you won’t have to pay anything back.? Though Ford is prospering for now, GM is declining rapidly.? In bankruptcy the common is a zonk.? With dilution, the common will almost be a zonk.

7) I worry over our government’s involvement in the markets.? First, I am concerned over contract law.? The bankruptcy code in the US strikes a very good balance between the needs of creditors and debtors.? I worry when the government tampers with that.? I fear that the Obama administration does not grasp that if they attempt to change certain regulations, it will have a disproportionate effect on the economy.

8) I have almost always liked TIPS.? Do I like them now?? Of course, particularly if they are long-dated.

9) Much as I do not trust it, we have had a significant rally in leveraged loans and junk bonds.

10) Did major banks support subprime lenders?? Of course many did.? No surprise here.

11) The EMH exists in a dynamic tension with its opposite.?? Because many, like me, are willing to hunt out inefficiencies, the inefficiencies often get quite small.? So it is that those that come into investing with no hint that the EMH exists think it is ridiculous.? Coming from a household where the EMH had been stomped on for many years (thanks, Mom) made me ill-disposed to believe it, and not just because we subscribed to Value Line.

12) He who pays the piper calls the tune.? To the degree that the government gets involved in business, it will intrude into lesser details that should only be the province of shareholders.? What this says to management teams is “don’t let the government in in the first place,” which should be pretty obvious.? Major shareholders with secondary interests are often painful.? With the government, that secondary interest is regulation, which makes them a painful shareholder.

With that, I bid all of you adieu for a time.? May the Lord watch over you.

Are Most of the Financing Problems Solved?

Posted on 5 May 20095 May 2009 by David Merkel

Coming out of a recession, and even more so if it is debt deflation, the key question to ask is whether most of the financing problems are solved.? It is not yet true in residential real estate, and is far from true with commercial real estate, and the banks that finance real estate.

The current rally is driven by hopes of government policy, and short-covering.? Debt levels are still way too high, and the economy needs them lower for strong sustainable growth.

So, resist the rally and sell into it, but don’t leave the game entirely.? Who can tell how long this run will last?

To What Degree Were AIG?s Operating Insurance Subsidiaries Sound? (2)

Posted on 29 April 200929 April 2009 by David Merkel

The Securities Lending Fiasco

Most, if not all life insurance companies engage in securities lending to some degree.? AIG did it in a big way, involving almost all of their life subsidiaries.? When a life insurer lends out its bonds, they receive back safe liquid collateral equal to 100-102% of the par value of what they lent out.? Most companies leave well enough alone at that point.? After all, you still receive the income on the bonds you lent out, plus securities lending fees.? The borrower receives the income on his collateral, less securities lending fees.? The borrower sells the bonds he borrowed, hoping to buy them back cheaper.

So far, so good, but AIG added a wrinkle to the game.? The safe liquid collateral was a slack asset to them.? Why not replace it with equally safe and liquid assets that offered considerably more yield, like bonds backed by AAA-rated subprime or Alt-A mortgage collateral?? After all, AIG was already writing financial reinsurance through default swaps on such mortgages, why not add to a winning bet?

They did so in a big way:

Subsidiary	Realized sec lending losses	2007YE Surplus	RSLL / 2007YE Surplus
American General L&A IC	(977)	471	-207%
AIG LIC	(871)	440	-198%
AIG Annuity IC	(7,110)	3,729	-191%
Am Int LIC of NY	(771)	553	-139%
First SunAmerica LIC	(653)	501	-130%
The Variable Annuity LIC	(3,562)	2,838	-126%
American General LIC	(3,790)	5,704	-66%
SunAmerica LIC	(2,281)	4,716	-48%
AIG SunAmerica LAC	(424)	1,151	-37%
Merit LIC	(50)	705	-7%
American Life IC (Alico)	(470)	6,718	-7%
Delaware American LIC	(1)	24	-4%
Life Companies Total	(20,960)	27,550	-76%

It took an amazing amount of skill to lose 76% of the surplus of the affected life companies.? One company, American General L&A IC, lost more than double its surplus.? Wow.? Why did this turn out so wrong?? The assets were mismatched to the liabilities in two ways:? 1) The mortgages had longer lives than the securities lending transactions.? Even if there were no credit issues, there was no way to assure that the mortgage bonds would be worth the same at the beginning and end of the transaction.

2) Though AAA-rated, they were not credit risk-free.? Non-prime mortgages were made to borrowers of lower quality.? Of their own, they wouldn’t be investment grade, much less AAA, without credit support.? That credit support came through subordination.? Other investors would take the first X% of losses before the AAA bondholders would take any losses.? That X-factor was set too low.? In order to maintain a AAA rating, the X-factor not only has to be high enough that losses don’t harm the AAA investors, it has to be high enough that other investors would think that it would be almost impossible for losses to harm the AAA investors.

Subsidiary	Net capital contributed / 2007 Surplus (neg = divs)	2007YE Surplus	Net capital contributed (neg? =? divs)
American General LIC	123%	5,704	7,004
AIG Annuity IC	167%	3,729	6,223
The Variable Annuity LIC	113%	2,838	3,213
SunAmerica LIC	57%	4,716	2,696
AGC LIC	12%	7,729	895
American General L&A IC	185%	471	872
First SunAmerica LIC	153%	501	768
AIG LIC	167%	440	736
Am Int LIC of NY	101%	553	557
AIG SunAmerica LAC	25%	1,151	284
New Hampshire IC	19%	1,369	265
American Life IC	3%	6,718	211
Commerce and Industry IC	7%	2,688	180
UG Mortgage Indemnity Co of NC	55%	55	30
21st Century IC	0%	663	2
AIG Auto IC of NJ	0%	18	–
AIG Centennial IC	0%	335	–
AIG Excess Liability Co.	0%	1,248	–
AIG Hawaii IC	0%	65	–
AIG National IC	0%	18	–
AIG Premier IC	0%	162	–
Am Gen Property IC	0%	18	–
Am Int IC	0%	367	–
Am Int IC of Delaware	0%	45	–
Am Int Specialty Lines IC	0%	638	–
Audubon IC	0%	42	–
Delaware American LIC	0%	24	–
F book	0%	–	–
Landmark IC	0%	146	–
New Hampshire Indemnity Co	0%	102	–
Pacific Union Assurance Co	0%	67	–
UG Residential IC of NC	0%	194	–
United Guaranty IC	0%	24	–
United Guaranty Residential IC	-2%	496	(10)
Hartford Steam Boiler IAIC of CT	-26%	43	(11)
AIG Casualty Co	-5%	1,884	(103)
Hartford Steam Boiler IAIC	-22%	720	(158)
Lexington IC	-5%	4,551	(250)
Merit LIC	-38%	705	(270)
AIU IC	-33%	1,398	(463)
American Home Assurance Co	-8%	7,297	(571)
National Union Fire IC	-6%	12,157	(787)
Totals	30%	72,089	21,313

As a result of the securities lending losses, and the troubles at AIGFP, the Fed and Treasury began the bailout of AIG.? (Look at the above table to see the amount pumped in and taken out of each subsidiary on net.)? Why did they indirectly bail out life insurance companies that they do not regulate including one that mainly serves foreigners (Alico), by bailing out the AIG holding company?

I can’t be totally certain here, but I suggest that all major state insurance regulators should send Ben Bernanke, Tim Geithner, and Hank Paulson some really nice gifts, because had AIG’s life companies failed, the state guaranty funds would have been hard pressed to come up with something north of $10 billion by surcharging the other insurance companies doing business in each state.? At a time like this, where many life insurers, particularly ones facing credit risks, and those having variable policies, where profitability has declined along with the stock market, the surcharges could have kicked additional life insurers over the edge, and who knows how big the cascade would have been.

(Note to corporate bond managers managing insurance money: this is why you don’t own insurance bonds in your neck of the industry.? The company you manage money for already has contingent credit exposure to all of their peers through the guaranty funds.)

AIGFP was the bigger issue, but the domestic life companies of AIG posed a separate, distinct issue that the US Government addressed, right or wrong.

Nonidentical Twins: Solvency and Liquidity, Redux

Posted on 4 April 20095 April 2009 by David Merkel

Another post deserving a brief update: Nonidentical Twins: Solvency and Liquidity.? The accounting rules have changed on mark-to-market accounting, but it won’t help financials at all, because now the accounting will be distrusted.? Even Goldman Sachs, who covertly runs our government, 😉 believes that is so.? Cash flows talk, and estimates of future free cash flows drive stock prices.? Accounting rules do not affect free cash flows, and the best accounting systems try to make earnings approximate free cash flows.

Here’s one more difficulty with changing the accounting standards: companies have the choice when they buy an asset of labeling it held to maturity, available for sale, or a trading asset.? The accounting varies depending on the choice, but held to maturity means that there is no mark-to-market.? So why didn’t financial firms tag assets to be held to maturity?? Because if you sell too many assets so tagged, your auditors get annoyed, and would try to compel you to tag all of them as available for sale, at which point mark-to-market applies.

So, let’s take a trip to Bizarro-world, where companies never have to do asset impairment, ever.? You can hold a security at par even after it has declared bankruptcy.? Only when the bankruptcy settlement payment is made in cash or new securities, would the value change on the balance sheet.? How would investors in bank stocks operate in Bizarro-world?

For one, during times of credit market stress, they would significantly reduce the price-to-book multiples that they would be willing to pay for banks.? Book values aren’t trustworthy without impairment done on a good faith basis.

There is no free lunch with accounting rules.? Make them more liberal, and investors become more conservative.

Many bank managers might say, “It’s a money good asset; if I hold it long enough, I will get par.? Why should I be penalized today?”? They should be penalized for two reasons:

The probability of getting par back has declined.
The ability of the bank to hold the asset to maturity has declined.

The first reason is simple enough.? The second reason is not well-understood.? Those that argue against mark-to-market accounting implicitly assume that all financial institutions have the capability of holding until the asset matures (pays off in full).? But that is not always true.? Many seemingly strong financial institutions (rated AAA or AA!) — recently found they could not hold their assets to maturity.? If a bank has to raise liquidity prematurely, those mark-to-market prices (if done fairly, which I think is rare) reflect the true value of the assets.

This is why I believe that most liquidity problems are really solvency problems, but the banks are clinging to old prices, and don’t want to admit that things have changed.? As we joked at AIG domestic life companies back in the early 90s: “Oh, almighty actuary! Utter the weasel-words that allow this rusty tub to stay afloat so that we can continue to draw on our salaries!”? (Yeh, it was that bad in that unit then.? The rest of the company was better, supposedly.)

Substitute? the word accountant for actuary, and that is what the present fair value rules are creating.? What it means is that a company must break due to a lack of cash flows before it goes insolvent.? That puts our accounting on the level of Madoff and other Ponzi schemes.? No one is broke until there isn’t a dollar left in the till.

It’s a lousy way to do business, but investors will adjust, and lower valuations.

Of Course not at Par; That’s Par for the Course

Posted on 31 March 2009 by David Merkel

There are several truths well-known to educated investors that have been glossed over in all of the discussions of mark-to-market accounting, or SFAS 157.? (Really SFAS 133, but SFAS 157 clarified it.)

Accounting rules have little impact on stock prices.? Almost every academic study on accounting rules supports that idea.? Why?? Investors attempt to estimate the stream of free cash flows that an asset will throw off.? Accounting rules can help or hinder that.? Because SFAS 157 attempts to calculate a present value of cash flows for level 2 and 3 assets, it aids in that estimation.
Parties involved confuse regulatory with financial accounting.? Mainly due to the laziness of financial corporations in the boom phase of our markets, they looked to minimize effort, and make the accounting the same for regulatory and financial purposes.? This was foolish, because there is no one accounting method that is ultimate.? Every financial statement answers one main question.? For GAAP, the balance sheet asks “What is the net worth?”? Regulatory accounting would ask “Is net worth positive under conditions of moderate stress, including the possibility that markets go illiquid, and we have to rely on cash flows to pay off the liabilities?”
There are always two ways to do accounting.? You can do mark-to-market, or you can do book value accounting with impairment.? Darkness encourages skepticism.? In a period where there are few credit risks, book value? accounting will be well-received.? In an era where credit risks are significant, book value accounting will be no help, investors will distrust book value, and the effect might be less than where fair value estimates are provided. ? Regardless, the cash flows will still flow.
Equity-like investments deserve equity-like accounting.? They should be market to market, as equities are.? With derivatives, this is the reason that we mark them to market, their values are so variable.? So we should mark speculative mortgage investments: estimate the future cash flows, and discount them at a high, but not equity-like interest rate.
But what of assets that are seemingly money good, but the few trades that have happened indicate a value at 60% of par, possibly because of The Bane of Broken Balance Sheets, or Time Horizon Compression.? Here’s the problem: we have a lot of people alleging that those values can’t be right.? Let them stand up and start buying to prove it all wrong.? Part with precious liquidity to gain uncertain yield.? It is quite possible that we are in a depression, and as such, there are too many assets relative to the ability to fund them — asset values must fall.? Don’t immediately assume that the few trades in the market are ridiculous because they are lower than your current marks.
Some argue that there is an inconsistency between loans and bonds.? Bonds get marked to market, while loans are marked at book.? There is no inconsistency.? The loans are held to maturity, unless sold.? The bonds could be held to maturity as well, in which case they are at book value, and only changed if there is a need for a writedown, the same as the loans.? Most companies have not chosen that option, largely because they want the right to sell assets if they want to.? But that locks in their accounting; if they want the ability to sell, they must accept balance sheet volatility.
We have to differentiate SFAS 157 from misapplications of SFAS 157, which might be driven by the auditors.? SFAS 157 does not mean last trade.? In thin markets, companies are free to use discounted cash flow and other analyses to estimate fair value.
Now all of this said, practically, SFAS 157 leads to overestimating the value of assets.? In the consulting work I have done, companies are not willing to mark their volatile assets down to levels near their fair value, much less last trade, which is worse.? They are hoping for some huge return of risk-taking to appear, and revalue their assets. What if present conditions persist for five to ten years, where there are too many debts relative to the wilingness to fund them, as in the Great Depression?? In that situation, SFAS 157 would prove to be too flexible, with banks marking assets higher than warranted.

The anti-SFAS 157 arguments rely on an assumption that things aren’t so bad — that mean-reversion is right around the corner.? We are in a situation where marginal cash flows to purchase dud assets aren’t there.? Mean reversion is a long way off, and the valuations of financial assets reflect that consistently.? Try selling a bunch of whole loans held at par.? See what the offers are.? Why aren’t banks doing that to raise liquidity?? Because the prices don’t justify it.

You can’t fight cash flows.? Accounting exists to partition cash flows into periods, so that analysis of businesses can be done, and debt financing can be secured.? In the end, cash flows win out, regardless of the accounting methods.

Thus my opinion: SFAS 157 is a good standard, and I am no fan of the FASB generally.? There are misapplications of SFAS 157, forced by auditors, I believe.? SFAS 157 already offers decent flexibility to management teams — let them use that flexibility, but no more.? After that, let the regulators set their own solvency rules.

-==-=-=–==–=-=-=-==–=-==-=-=-

PS — What foes of SFAS 157 are unwilling to admit, is that lenders lent money near the peak of an amazing bull market, and now the collateral values lent against are far less than imagined at the time of lending.

It’s like the FRAM oil filter ad — “you can pay me now or pay me later.”? There is a great deal of hubris involved in arguing that the market as a whole is out-of-whack.? (Much as I had hubris toward the end of the bull phase… let me stab myself.)? In ordinary bear markets, there is some strength somewhere to support asset values.? That is not true now.? We are dealing with something not normal over the last 70 years, and overall market values are reflecting that.? Eventually accounting values will get there, as they did in the thirties.

The Great Omission

Posted on 27 March 200927 March 2009 by David Merkel

This seems to be the era for dusting off old articles of mine.? This one is one year old, I wrote it on April Fools’ Day — Federal Office for Oversight of Leverage [FOOL].? (Today I would simplify it to: Federal Office Overseeing Leverage.) I would recommend a re-read of that article, and encourage those at the Treasury to realize the enormity of what it is trying to do.

Well, now the Treasury ain’t foolin’ around.? They think they can harness systemic risk.? Check out the speech of Mr. Geithner, and his proposed policy outline.? What are the main points of the policy outline?

1) A Single Independent Regulator With Responsibility Over Systemically Important Firms and Critical Payment and Settlement Systems

Defining a Systemically Important Firm
Focusing On What Companies Do, Not the Form They Take
Clarifying Regulatory Authority Over Payment and Settlement Activities

2) Higher Standards on Capital and Risk Management for Systemically Important Firms

Setting More Robust Capital Requirements
Imposing Stricter Liquidity, Counterparty and Credit Risk Management Requirements
Creating Prompt-Corrective Action Regime

3) Registration of All Hedge Fund Advisers With Assets Under Management Above a Moderate Threshold

Requiring Registration of All Hedge Funds
Mandating Investor and Counterparty Disclosure
Providing Information Necessary to Assess Threats to Financial Stability
Sharing Reports With Systemic Risk Regulator

4) A Comprehensive Framework of Oversight, Protections and Disclosure for the OTC Derivatives Market

Regulating Credit Default Swaps and Over-the-Counter Derivatives for the First Time
Instituting a Strong Regulatory and Supervisory Regime
Clearing All Contracts Through Designated Central Counterparties
Requiring Non-Standardized Derivatives to Be Subject to Robust Standards
Making Aggregate Data on Trading Volumes and Positions Available
Applying Robust Eligibility Requirements to All Market Participants

5) New Requirements for Money Market Funds to Reduce the Risk of Rapid Withdrawals

6) A Stronger Resolution Authority to Protect Against the Failure of Complex Institutions

Covering Financial Institutions That May Pose Systemic Risks

i. A Triggering Determination

ii. Choice Between Financial Assistance or Conservatorship/Receivership

Options for Financial Assistance

Options for Conservatorship/Receivership

iii. Taking Advantage of FDIC/FHFA Models:

Requiring Covered Institutions to Fund the Resolution Authority

(As an aside, did anyone else notice that point 6 didn’t make it into the introductory outline?)

The Great Omission

There’s a bias among Americans for action.? That is one of our greatest strengths, and one of our greatest weaknesses, and I share in that weakness.? Whenever a crisis strikes, or an egregious crime is committed, or a manifestly unfair scandal develops, the klaxon sounds, and “Something must be done!? This must never, never, NEVER happen again!”

So, instead of merely having a broad-based law against theft/fraud, and allowing the judges discretion for aggravating/extenuating circumstances, we create lots of little theft/fraud laws to fit each situation, fighting the last war.? Oddly, because of specificity of many statutory laws, it weakens the effect of the more general theft/fraud laws.

The Treasury will fight the last war, as they always do, but there is a great omission in their fight, even to fight the last war.

Why did they ignore the Fed?? Why did they ignore that many of the existing laws and regulations were simply not enforced?? For much but not all of this crisis, it was not a failure of laws but a failure of men to do their jobs faithfully.

Consider this opinion piece from the Wall Street Journal today.? There is some disagreement, which helps to flesh out opinions.? I think a majority of them concur with the idea that the greatest creator of systemic risk, particularly since 2001, was easy credit from the Federal Reserve.? It’s been my opinion for a long time.? For example, consider this old (somewhat prescient) CC post from RealMoney:


		David Merkel
		The Fed Vs. GSEs: Which Is Most Threatening to the Economy?
		2/24/04 1:35 PM?ET
I found Dr. Greenspan’s comments about Fannie and Freddie this morning a little funny. I agree with him that the government-sponsored entities, or GSEs, have to be reined in; they are creating too much implied leverage on the Treasury’s balance sheet. They may prove to be a threat to capital market stability if they get into trouble; they are huge. Well, look to your own house, Dr. Greenspan. As it stands presently, the incremental liquidity that the Fed is producing is going into housing and financial assets. The increase in liquidity has led to low yields, high P/E ratios and subsidized issuance of debt. All of this has led to stimulus for the economy and the equity and bond markets, but at what eventual cost? The Fed has far more systemic risk to the economy than the GSEs. No stocks mentioned

Since then, the GSEs have failed, and the Federal Reserve is trying to clean up the mess they created in creating the conditions that allowed for too much leverage to build up.? Now they are fighting deleveraging by bringing certain preferred types of private leverage onto the balance sheet of the Fed/Treasury/FDIC.

The first commenter in the WSJ piece makes some comments about monetary aggregates, suggesting that the Fed had nothing to do with the housing bubble.? Consider this graph, then:

Outpacing M2 (yellow) for two decades, MZM (green), the monetary base (orange) and my M3 proxy, the total liabilities of banks in the Federal Reserve really began to take off in the mid-90s, and accelerated further as monetary policy eased starting in 2001.

This brings up the other part of the omission: bank and S&L exams were once tougher, but became perfunctory.? The standards did not shift, enforcement of the standards did.? Together with increased use of securitization, and to some extent derivatives, this allowed the banks to lever up a lot more, creating the systemic risk that we face today.

There are other problems (and praises) that I have with (for) the Treasury’s proposals, and I will list them in the addendum below.? But the most serious thing is what was not said.? The government can create as many rules and regulations as it likes, but rules and regulations are only as good as how they are executed.? The Government and the Fed did not use its existing powers well.? Why should we expect things to be better this time?

Addendum

Praises

A single regulator for large complex firms is probably a good idea.? Perhaps it would be better to limit the total assets of any single financial firm, such that any firm requiring more than a certain level risk based capital would be required to break up.
Higher risk-based capital is a good idea, but be careful phasing it in, lest more problems be caused.
With derivatives, most of the proposal is good, but the devil is in the details of dealing with nonstandard contracts.

Problems

Risk based capital should higher for securitized assets versus unsecuritized assets in a given ratings class, because of potentially higher loss severities.
You can’t tame the boom/bust cycle.? You can’t eliminate or tame systemic risk.? It is foolish to even try it, because it makes people complacent, leading to bigger bubbles and busts.
Hedge funds are a sideshow to all of this.? Regulating them is just wasted effort.
With Money Market funds, my proposal is much simpler and more effective.
Do you really know what it would take to create a macro-FDIC, big enough to deal with a systemic risk crisis like this?? (The FDIC, much as it is pointed out be an example, is woefully small compared to the losses it faces, and it is not even taking on the large banks.)? It would cost a ton to implement, and I think that large financial services firms would dig in their heels to fight that.? Also, there would be moral hazard implications — insured behavior is almost always more risky than uninsured behavior.
Very vague proposal with a lot of high-sounding themes.? (late addition after the initial publishing, but that was my first thought when I read it.)

Liquidity and the Current Proposal by the US Treasury

Posted on 24 March 2009 by David Merkel

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.

The March FOMC Statement

Posted on 19 March 2009 by David Merkel

Below you will see my summary of the FOMC Statement and how it changed.? Before I give you that, let me summarize what I think the changes are, the market impact, and whether I think it will work.

The Changes

The Fed will expand its balance sheet massively, buying another $750 billion of agency mortgage-backed securities, $300 billion of long Treasuries, another $100 billion of Agencies, and expand eligible collateral for the TALF to include who knows what.
The crisis involves the real economy in a big way now, not just the financial economy.
The crisis is definitely global.
They have ceased to forecast when it will end.
They are pursuing recovery, not growth now.

The Market Impact

The Dollar fell roughly 2-3%.? Gold rallied 4%+.
The ten-year sector of the nominal Treasury curve fell the most in yield terms, around 50 basis points. Biggest rally since 1962.? The long end fell 30 basis points. Agencies outperformed Treasuries.? Mortgages lagged.
TIPS outperformed nominal bonds with the long end falling 40 basis points, and the 10-year 55 basis points, leading inflation expectations to rise.

Will this work?

I?m skeptical.? This is just a bigger shift of financial obligations from the balance sheet of financials to the Fed, at prices unfavorable to the Fed, because their own statements will make them buy dearly.? When they unwind these trades, they will take significant losses, eliminating seniorage income to the US Treasury.

Lowering Treasury, Agency and conforming mortgage rates, assuming that it can be done in the long run (not likely), will not help consumers or corporations.? Forcing a small spectrum of interest rates down does little for collateral values.? People are inverted on their debts, and this does not solve that.? You might get a few refinances out of that, but that?s all.? Credit card, auto, and other debts are unaffected, and the TALF is still pie-in-the-sky.? Can it work?? Corporate bonds, bank debt, Commercial real estate loans, etc. ? there is no effect.? It only makes life better for the US Government, Fannie, Freddie, the FHLB, and those seeking conforming mortgage loans.

There is no real debt reduction here, and debt levels are the cause of this crisis, not interest rates on the debt.? I don?t think this will work, but this is another case where ?the beatings will continue until morale improves.?? Ben Bernanke is too certain of what is the correct move, given his Ph.D. studies.? It would be better and simpler to follow an inflationary course that hits at the root causes of debt by giving every adult a $5,000 voucher good to pay off a debt to any regulated financial institution.? Consumers win, banks win, and foreign creditors lose.

Current Recommendation

I don?t think this rally will hold, so when upward momentum fails, sell long duration fixed income positions.

Fed Statements Compared

(I reordered the January Statement to make the compare better.)

January 2009 Information received since the Committee met in December suggests that the economy has weakened further.	March 2009 Information received since the Federal Open Market Committee met in January indicates that the economy continues to contract.	My Thoughts Basically the same.
Industrial production, housing starts, and employment have continued to decline steeply, as consumers and businesses have cut back spending.	Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending.	There is a hint of deepening of the crisis, especially how falling asset values and diminishing credit affect behavior.
Conditions in some financial markets have improved, in part reflecting government efforts to provide liquidity and strengthen financial institutions; nevertheless, credit conditions for households and firms remain extremely tight.	Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment.	No hint of improving credit now. Lack of credit having real effects on business activity.
Furthermore, global demand appears to be slowing significantly.	U.S. exports have slumped as a number of major trading partners have also fallen into recession.	Recession abroad, not merely slowing.
The Committee anticipates that a gradual recovery in economic activity will begin later this year, but the downside risks to that outlook are significant.	Although the near term economic outlook is weak, the Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth.	No longer forecasting a recovery this year. Near term outlook is weak.
In light of the declines in the prices of energy and other commodities in recent months and the prospects for considerable economic slack, the Committee expects that inflation pressures will remain subdued in coming quarters.	In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued.	Weakness is widespread and not contained by country or sector. Economic slack is here now, and not prospective.
Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.	Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.	Same
The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability.	In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.	No longer are they pursuing growth, but recovery.
The Federal Open Market Committee decided today to keep its target range for the federal funds rate at 0 to 1/4 percent. The Committee continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.	The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.	The Fed funds rate, now irrelevant, will stay irrelevant for a long time.
The focus of the Committee’s policy is to support the functioning of financial markets and stimulate the economy through open market operations and other measures that are likely to keep the size of the Federal Reserve’s balance sheet at a high level. The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant. The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.	To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.	What was a possibility now is coming. If all of it is executed, the Fed?s balance sheet will grow from $1.9 to $3.0 Trillion. Credit easing, the attempt to manipulate key market interest rates using Fed credit, will be the majority of Fed policy now.
The Federal Reserve will be implementing the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.	The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses and anticipates that the range of eligible collateral for this facility is likely to be expanded to include other financial assets.	TALF, should it get off the ground, will include rasty stuff that we never imagined the Fed would buy.
The Committee will continue to monitor carefully the size and composition of the Federal Reserve’s balance sheet in light of evolving financial market developments and to assess whether expansions of or modifications to lending facilities would serve to further support credit markets and economic activity and help to preserve price stability.	The Committee will continue to carefully monitor the size and composition of the Federal Reserve’s balance sheet in light of evolving financial and economic developments.	This isn?t just a financial markets crisis anymore. It is now affecting almost every part of the business world.