Structured Products and Derivatives – Page 17

The Whole Earth is Owned; Debts Net Out to Zero

Posted on 21 April 201022 April 2010 by David Merkel

Tonight’s post could be one in the “rules” series, but since I did not get this idea prior to 2003, when I started investment writing at RealMoney.com, it does not qualify for me.? But here it is:

At the end of the day, the world as a whole is owned 100%.? There are people with short positions, calls, puts, etc., and even things more exotic.? Those are noise around the real economy that produces the goods and services of our world.

Beyond that there are debt transactions in order to own assets, or purchase products and services.? But every debt is an asset to another party, and cancels out across the globe.? There are no debts on net in the world.

Does that mean that debts are irrelevant?? No.? Debts are relevant for two reasons: 1) Highly indebted economic systems are inflexible, because there are too many fixed claims.? They are far more prone to crises.? 2) The debt of financial companies is very important because they often borrow short-term to finance longer-term assets.? In the current crisis, repo funding is the great example of this.

A financial firm thinking long run would not do repo financing because it can be easily pulled.? It would float long debt equal to the term of the assets that they want to finance.? But that might make their margins inadequate.? Don’t you know that short rates are volatile, and that they tend to be lower then long term rates most of the time?

Well, maybe.? But when debts increase, parties step forward to finance long credit via short borrowing.? That is an essential element of the credit system when it is in bubble mode.? (Side note: the exception to this is lending against sticky checking and savings account liabilities.? Those liabilities are sticky only because of deposit insurance.? The policy question there is whether the insurance premium is set too low. In hindsight, the answer is yes, though at my prior employer, we talked about the inadequacy of the FDIC, and bank reserving regularly.)

Though all debts net out to zero across the global economy as a whole, a lot depends on who owns the debts.? If the debts are owned by those who are borrowing money, risks of a debt crisis rise.? The layering of debt upon debt, and borrowing short to lend long decrease financial system resilience.

Finally, the willingness to make loans to marginal borrowers is really a statement that lenders are willing to make an equity investment in someone they are lending to, or some property that they are lending against.? Formally, it is all a loan, but economically the lender is betting on prosperity, much as a stock investor might.

When I wrote my piece on the residential housing bubble at RealMoney back in May of 2005, I did not focus on the high prices much; instead, I focused on the financing issues:

Amount of debt vs assets
Borrowing short term to buy a long-lived asset, a house.
Quality of the debt underwriting

And, much the same when I wrote my piece on subprime mortgages in November 2006, too much leverage, the teaser rates are short term borrowing, and the loan underwriting was horrible.? As with residential mortgages generally, subprime mortgages were even more set up for failure.

If you want to find a bubble, focus on the financing.? The rise in asset prices is not sufficient, assets must be misfinanced for there to be a bubble.

When I was writing at RealMoney, I did a series of four articles to illustrate market dynamics:

Managing Liability Affects Stocks, Pt. 1
Separating Weak Holders From the Strong
Get to Know the Holders? Hands, Part 1
Get to Know the Holders? Hands, Part 2

I wanted them to have similar titles, but it was not to be.? Even for managing equities, understanding the balance sheets of companies, and those that own companies can make a difference.? When stocks are owned by those that can truly buy and hold, downside is limited.? When stocks are owned by those who are under pressure to earn money in the short run, upside is limited.

But what of liabilities for which there are no assets?? What of underfunded municipal and corporate pension plans?? With the corporate plans there is bankruptcy and the PBGC.? With municipalities, and the Federal Government it is more questionable.? There are few assets to lay claim to, even if there were a right to do so.? They rely on increased taxation, and the willingness of the courts to enforce pension promises.? This will prove politically difficult, and perhaps prove to be a greater challenge to the constitution than anything previous, because the economic demands are far greater than what the US taxpayer has been willing to bear.

Still, the greater challenge for countries is the ability to continue to manage debt issuance.? As we see with Greece today, that is not a simple thing.? Countries can be misfinanced, as much or more so than corporations.

Risk management is primarily management of liquidity, and planning to avoid? liquidity risks over the long haul.? Easy to state, hard to do.? The siren song of the short-run is so compelling, but the long–run eventually arrives, and when it does, it comes to stay.? Plan your life, or your corporation’s life such that you control your destiny, and are never in a spot where you are forced to do anything.? That takes discipline, but the man who controls his own soul is ready to rule things far greater.

The Rules, Part VI

Posted on 7 April 201020 June 2017 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

Posted on 6 April 2010 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:

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:

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

Posted on 4 April 2010 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

Posted on 3 April 2010 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.

A Summary of What Bank Reform Should Be

Posted on 31 March 201031 March 2010 by David Merkel

I’ve thought about the issue for a while, and I want to summarize what the key areas for bank reform are, so that you all can know why legislation like the Dodd Bill won’t achieve much.? There are five key areas that have to be addressed to avoid “Too Big to Fail”:

Limit short-dated funding, and encourage liquid assets.? Place strict limits on banks regarding funding that is likely to run in a crisis.? Encourage asset-liability match across the whole yield curve.? For the cognoscenti, match partial durations.? For bank CEOs, hire some life actuaries to help you.? (We’re cheap — for what you get!? Plus, we have an ethics code superior to others in the financial sector.? Wait.? You don’t want that?!)
Limit the ability of operating banks/thrifts to lend to, invest in or enter into derivative transactions with other financial companies.? This is the critical provision to avoid contagion-type effects.? Most proposals ignore this.
Fix the accounting.? Go to a principles-based approach, and reveal the complexity embedded in securitization and derivatives.? Limit the amount of derivatives that can be written for purposes that do not reduce risk.
Raise the capital required as a percentage of assets, and make the capital required disproportionately rise with the assets.
Fix the risk-based capital [RBC] formula. The banks should copy the appointed actuary function of Life Insurance Companies. Then do industrywide experience studies on asset performance, so regulators will know how risky the assets really are, and then the regulators can feed the results into the risk-based capital formulas, and benchmark what banks lend well and badly by category, which would lead to much better overall risk control, and very frustrated bank managements, because capital would go up, and ROEs down.

Note that I have not mentioned Glass-Steagall.? My view is let banks do what they want with assets, but let the RBC formula limit risky asset categories.? Equitylike risks should be funded with equity.? What could be simpler?? Such a policy would have commercial banks out of equitylike businesses in a flash.

That is the heart of the matter.? But I want to expand on point 3.? Imagine a bank that has bought a Single-A slice of a trust-preferred collateralized debt obligation, 5% of the tranche.? Rather than placing the asset on the balance sheet at the amount paid, the following should happen:

The asset side of the balance sheet should have an asset equal to 5% of the assets of the CDO.
The liability side of the balance sheet should have two entries — one for 5% of the AAA and AA part of the deal, which are loans levering up the single-A interest, and one for 5% of the BBB and below part of the deal, which provide protection to the single-A tranche.

That is the real economics of the deal, though it is far messier than reporting one single-A bond.? As it happened with the not-so-hypothetical CDO that I describe, the liability for BBB and below is zero now, and the AAA and AA part of the deal have value equal to the loans.

As for swaps, they are an exchange of this for that.? Place this and that on the balance sheet.? Let RBC limit the exposures.

We can get really complex about preventing bank defaults, but the main trick is making sure short-term funding does not run.? A close second, is preventing investment in other financials, which destroys the possibility of contagion.

If we can do those two things, preventing too big to fail will be a breeze.? But who has the guts to do that?

Book Review: ECONned

Posted on 26 March 2010 by David Merkel

Many of you have heard of the blog Naked Capitalism, and its pseudonymous writer, Yves Smith.? Well, she has written what I regard as an ambitious book, ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism.? It is ambitious for several reasons:

It tries to be comprehensive about all aspects of the crisis.
It digs deeper than most, analyzing flaws in economic and financial theories that underpinned the errors of the crisis.
It looks at the political angle of how laws and regulations were subverted, while alleging conspiracy probably too much, when ordinary greed in the open and stupidity could cover the causes of the crisis.

There is a tension between capitalism and democracy.? We don’t like to talk about it, but it is there.? Property rights are human rights, and should be protected.? Governments often determine that certain contracts are not valid on public policy grounds.? (I.e., gambling, prostitution, arson, assassins, etc.)

Democracies also do not like rivals for power.? If business gets too big, to the point where it is influencing the decisions of the government, democracy fights back.? I write this as one who would err on the side of property rights rather than democracy.? Property rights are a direct descendant of the eighth commandment, “You shall not steal,” whereas the form of government of any nation is a thing of relative indifference.? Many nations have different ways of ruling themselves.? It is not yet proven that democracy is the best form of government.? Personally, I think it is more prone to corruption than most governmental forms.? But it has the advantage of motivating the people.

I draw the line when businesses use political power to exclude rivals.? It is one thing to be really clever, and dominate your market, like Google.? It is another to have a natural monopoly like the old AT&T, before technology obsoleted them.? But it stinks to have a system where major financials, who have nothing of patentable value, hold the nation hostage, saying “Bail us out or the financial system fails.”

I argued against the bailouts, as did Yves, but the government caved under the asymmetry of “Heads we win, Tails you lose.”? It came up tails for all of us.

Yves digs deeper than many critics.? She questions the assumptions of the economics profession,with its gloss of pseudo-science.? She pokes at the questionable assumptions underlying much of finance theory.?? She looks at those who got it right regarding the crisis, and were marginalized as a result.? Where I differ is that there isn’t necessarily a conspiracy behind unwillingness to listen to discordant theories.? Academic guilds ignore researchers who question their closely held beliefs, regardless of the truth of the matter.? They know that it couldn’t be true, and the outsider doesn’t really understand their discipline.? I do not charge them with ill intentions, but stupidity.

What I really appreciated about the book was its willingness to challenge academic economics and finance.? She did it well, but left little in her wake as to what to look to as a substitute.? The willingness of economics to engage in pretend games with high level math is ridiculous.? If we restarted economics from scratch today, whether mathematical or not, it would not look like much of the sterile games that are played in leading economic journals.? Ask the question: how many benefit outside the economics profession from what is written in economic journals.? Answer: precious few.

I have many more things to say about this book, but this review is long enough as it is.? Let me say that there are few books that I have marked up as much as this one.

Quibbles

I do not go in for conspiracy theories.? Usually, most evil can be performed outside of darkness; people still don’t notice for the most part.

Yves should have spent more time on the enablers of the crisis — yield hogs.? You can’t buy protection on a company that you think will die, unless there is a yield hog out there that wants extra income that they think they are getting for free.? AIG was the largest of them, but by no means the only one.

She complains a bit much about “free markets.”? Aside from trading with the enemy, why should trade be constrained?? Why should I try to take away the property rights of my neighbor?? Beyond that, suppose you are right.? Where would you draw the lines?? It is one thing to criticize, and quite another to propose new policy.? Personally, I make an effort that when I suggest that something be demolished, that I recommend something else to take its place.? It is easy to be a critic, but hard to be a builder.

Who would benefit from this book:

Most people would benefit from the book, if they read it realizing that the things that happened do not require that parties conspired to make this happen.? Those who would especially benefit include economics and finance professors; they need the criticism.

If you want to buy the book, you can buy it here: ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism.

Full disclosure: The publisher sent me the book for free.? I spent several hours reading it in full.? If you enter Amazon through my site and buy anything, I get a small commission (6-7% typically).? But, your costs don’t rise versus going to Amazon directly.? I have avoided doing a “tip jar” because I would rather people benefit from the books I review, while allowing Amazon to pay me indirectly.

Broken?

Posted on 25 March 2010 by David Merkel

As I looked over the carnage that was the bond market yesterday, I was reminded of my piece 17 months ago called Broken?.? But as I read that, I said to myself, “Who are you kidding?? Yes, things were bad today, but nothing like when the bond market was falling apart out of fear of corporate credit risk.”

True enough, but I found yesterday disturbing.? Why?

1) Increasing chatter of troubles in the Eurozone, given Fitch’s downgrade of Portugal, and an increased insistence that Greece will not be bailed out, leading to a drop in the Euro.? Many say that it is impossible that the EU would not prop up Greece, but consider the German mindset here.? They traded their hard Deutschemarks for Euros.? They expect a hard Euro.? Their view is that if you want the benefit of being in the Euro, you must behave like Germans.? Anything else would be profoundly unfair — benefits come to those who have discipline.? There are two alternative views of what it means to be in the Eurozone, and they can’t be reconciled.? At most, one of those views will survive.? I think the German version is more likely.

My view is by no means the consensus, but without Germany on board, there is no Greek bailout.? The IMF is too small to truly help Greece.? If Greece were to default, it would harm banks in Europe, but it is a lot cheaper to help local banks than to help Greece.? That makes me a little bullish on the Euro, because if Greece defaults and leave the Eurozone, it sends a warning to other profligate nations, and leaves the core of the Eurozone stronger.? Beyond that, vacations in Greece would become the rage, as they would be very cheap, even including the frictions of exchanging Euros into “New Drachmas.”

Here’s a 12-month graph of the Euro:

My view is that the Euro will weaken further if they bail out Greece, and rally if they don’t.? Guess which the Germans will choose?? They will favor a strong Euro, even if it means shrinking the Eurozone.

2) I want to find the guy(s) who taught me when I was a young and impressionable mortgage bond manager (age 38, I came to the game late) that swap spreads could not go negative; sorry, it ain’t true.? John Jansen used to complain about the 30-year swap spread, but now we are negative at 10 and 7 years as well, and 5 years is not far away at +7 basis points.

But why?? If swap yields represent the levels that AA banks fund at, then how can they yield less than a AAA government?

Here’s my answer, though there are other good ideas to consider.? As a corporate bond manager, I underweighted two names that I really did not like, GE and AIG.? Though AAA, they traded as if they were single-A, and they had a lot of debt outstanding.? I always felt they were too levered, and that the rating agencies were giving them too much credit for being big.? Having run the GIC desk of a small well-capitalized insurer, with lower ratings, less leverage, and a higher ROE than other larger competitors, I was/am biased against firms with bad credit profiles that get good ratings only because they are big.? That they could fail is not conceivable.? Please ignore that AIG did fail, and that GE Capital would have failed in late 2008 or early 2009 without the TLGP.? The US Government played favorites, ignoring CIT, Advanta and others.

But, it is inconceivable the the US Government would fail.? That said it is issuing a lot of debt, and it is hard to absorb it all, so yields have to widen.? Very highly rated corporates offer some diversification, so they trade at lower yields than the behemoth that needs more and more liquidity.? Look at the lousy 5-year auction yesterday.? The Street is choking on Treasury paper.

The move in Treasury yields was large, but not overwhelming, maybe 98th percentile in severity:

3) Then there was the move in mortgage bond yields.

Up 15 basis points, near the Treasury move, but much more than the move in swaps, which are closer to how mortgages fund.

Looks like about a 10 basis point move, which means mortgages cheapened by 5 basis points or so.? That’s big!

Further, there was the change in the MOVE [Merrill Option VolatilityEstimate] index.? Think of it as the VIX for Treasury securities.? Up considerably:

All of this is somewhat panicky in terms of feel.? Is this a turning point? If it is, how much steeper can the curve get, or will the Fed genuinely tighten?

4) On a day like this, where things are falling apart, it does not help to hear Bill Gross say that he likes stocks over bonds.? I know, this is not nearly as serious as the above three, but I agree with him, weakly.? Bonds don’t have much upside here.? Large cap high quality stocks, which are a decent proportion of the S&P 500, still seem cheap.? Maybe that is true only in a relative sense, but I will stick with Jeremy Grantham here.

Here are two more wrap-ups of the day:

Summary

Be careful.? We live in a world where few governments are following orthodox rules of finance.? Indebted governments may turn to inflation, or higher taxation, or default.? At present, there is no decided answer to what will likely happen.? Governments are still trying to figure it out, hoping that some marginal nation like Greece will choose a course of action that tells them what or what not to do.? In a sense, we are waiting for some entity to make a bold move that changes the game, and then others will decide whether to do that, or, the opposite action.? Until then, keep your powder dry, and be nimble.

Dumb Regulation is Good Regulation — How to Regulate the Banks

Posted on 16 March 2010 by David Merkel

Should regulation be dumb?? In one sense yes, in others, no.? It really depends on how well the regulators understand the risks involved, and how much they can encourage professionalism among profit center heads and risk managers.? As those two increase, regulation can be smart.? ?Follow these detailed rules to calculate the capital you need to be solvent 99% of the time.?

But when either of those two aren?t true, dumb regulation may be in order:

Strict leverage limits, reflecting the worst outcome from underwriting poor quality loans.
Disallowing risky types of lending, regardless of capital level.
Disallowing liabilities that can run easily.
Disallowing products that commonly deceive buyers.
Disallowing certain types of contracts that fuddle accounting.
Those regulated may not choose their regulator.? The highest regulator assigns a regulator to you.? The highest regulator must evaluate the jobs that lower regulators are doing, and eliminate/lessen regulators that do not use the powers they have been granted, and get co-opted by those that they regulate.

If everyone were smart, things could be different.? Deceiving people would not take place, and managements would not take undue risks.? Limits could be looser, and products would be designed for discriminating buyers.

But, face it, we are dumber than we think, myself included.? Consumer choice is a good thing, though it implies that some will be deceived, no matter where one places the line of demarcation.? Along with that, some bank will not fit the rules and go insolvent, though it previously passed the solvency tests.

Dumb Regulation: Insurance in the US

My poster child for relatively good dumb regulation is the insurance industry in the US.? The industry is far less free-wheeling than the banking industry, and under most circumstances, the solvency margins are set high enough to have few insolvencies.? There is room for improvement, though:

Make risk based capital charges countercyclical.? Perhaps tinkering with the Asset Valuation Reserve would do that.
Have some sort of rigorous testing for capital relief from reinsurance treaties.
Ban surplus notes in related party transactions.
Ban all forms of capital stacking, especially where the transactions go both ways.? I.e., subsidiaries can?t own securities of any companies?in their corporate family.? All subsidiaries must be owned by the holding company.
More rigorous testing for deferred tax assets.
Assets as risky as equities, including limited partnerships, should be a deduction from capital.
Securitized bonds that are not ?last loss? should have higher RBC charges than comparable rated corporates, because loss severities are potentially higher, and assets that are originated to securitize are always lower quality than those held on balance sheet.
A standardized summary of cash flow testing results should be revealed.

As for the banks, they need to do that and more:

Insurance companies list all of their assets.? Banks should as well.
Intangible assets should be written to zero for regulatory capital purposes.
Risk-based capital standards need to be tightened to at least the level of insurance companies, if not tighter.
Some sorts of lending to consumers should be banned.? I am talking about complex agreements, that individuals with IQs less than 120 can?t understand.? Insurance policies have to be Flesch-tested.? Bank lending agreements should be the same.? If some argue that the poor need access to credit, I will say this: the poor need to get off of credit.? Credit is for the upper-middle-class and rich.? Poor people should not go into debt.
Standardized summaries of terms and fees must be created for consumer lending, with large, friendly letters, and simple language that all can read.

What I am saying is that accounting has to be more conservative, and that regulators have to require larger amounts of capital to support their business, particularly at the banks.? Financial products must be made simpler for consumers to understand.? More transparency is needed everywhere, and if the financial companies complain, tell them that they will all be in the same goldfish bowl, so no one will gain an unfair advantage.

Preventing Too Big to Fail

As part of preventing too big to fail, the Risk based capital [RBC] percentage should rise with the amount of risk-based capital.? Say, when RBC gets over $10 billion, the percentage of capital needed for RBC grades up to 50% higher than the level needed at $10 billion by the time RBC gets up to $50 billion.

Here is my example of how it would work:

Equity [RBC]	Assets	E/A Ratio	Marginal E/A Ratio	Marginal Income	Income	ROE	Marginal ROE
10.00	100.00	10.00%	10.00%	2.00	2.00	20.00%	20.00%
26.25	200.00	13.13%	16.25%	1.90	3.90	14.86%	11.69%
42.50	300.00	14.17%	16.25%	1.80	5.70	13.41%	11.08%
58.75	400.00	14.69%	16.25%	1.70	7.40	12.60%	10.46%
75.00	500.00	15.00%	16.25%	1.60	9.00	12.00%	9.85%

I have assumed that firms undertake their highest ROE projects first, and do progressively lower ROE projects later.? Now, by raising capital requirements on bigger firms, a common response is, ?Well, then they will just take on riskier loans to compensate.?? Sorry, but that dog don?t hunt.? If they take on riskier loans, their RBC goes up even more rapidly, because loan quality is reflected (or, should be reflected) in RBC formulas prior to adjustment for bank size.

More Dumb Regulation

Dumb regulation bars certain lending practices, and raises capital levels higher than is needed over the long run.? So be it.? Smart regulation is far more flexible, and trusting that companies and consumers know what they are doing.? Unfortunately, when financial firms fail, there are often larger repercussions.? It is better to limit regulated financial companies to businesses where the risks are well-understood.? Let the less understood risks be borne by those outside the safety net, and bar those inside the safety net from holding any assets in those companies.

That brings me to the Volcker Rule, which is a good example of dumb regulation.? My preferred way would be to do something similar through adjusting the risk-based capital formulas ? Equity-like risks should be funded through a 100% allocation of equity. Few banks would take on that level of speculation at that level of capital used.

If you need proof, look at the life insurance industry. Companies used to hold a lot more equities prior to the tightening of RBC rules. Now they hold little, except at a few mutual companies that are flush with capital.

That also has preserved the insurance business in this crisis, leaving aside mortgage and financial risks, where the state regulators still have no idea what they are doing ? that a proper reserve level would leave most of the companies insolvent today, but had it been implemented ten years ago, would have preserved the companies, but eliminated much of their profits.

At the Treasury meeting with bloggers in November 2009, I commented that the insurers were better regulated for solvency than the banks.? One of the reasons for that is that they do harder stress tests, and they look longer-term. Life and P&C insurers survive the process because of better RBC standards, and ?scaredy cat? state regulators. What a great system, which prior to the crisis, was criticized as behind the times.? (I suspect that if we ever get a national regulator of insurance, there will be a big boom and bust, much as in banking at present. It is easier to corrupt one regulator than fifty.)? The more state involvement in bank regulation, the dumber (better) bank regulation will be.

What to Do

So, if one is trying to regulate banks for solvency, there are seven things to do:

Set risk-based capital formulas so that few institutions fail.
Make it even less likely that larger institutions fail.
Limit the ability of financial institutions to invest in other financial institutions.
Regulators must benchmark the underwriting culture, and raise red flags when underwriting is poor.
Insure that equity is truly equity.
Institute a code of ethics for risk managers.
Make sure that balance sheets fairly reflect derivatives.

It is almost always initially profitable to borrow short and lend long.? That said, it is a noisy trade.? Who can be sure that short rates will remain below the rates at which one invested long?? Another component of a good risk-based capital formula is that there is no investing in assets that are longer than the liabilities that fund the financial institution.? (For wonks only: regulated financial institutions should be matching assets versus liabilities as their most aggressive posture.? Unregulated financials can do what they want.? And no investing in unregulated financials by regulated financials.)

One of the great subsidies banks get is the cheap source of funds through deposits.? It is only cheap because depositors know the FDIC is there.? The FDIC should raise its fees to absorb that subsidy back to the taxpayer.? Keep raising it until you see banks begin to shift to repo and other short-term sources of funding.

As a clever old boss of mine once said, ?A banks liabilities are its assets, and its assets are its liabilities.?? The idea is this ? banks that focus on their deposit franchises have something of real value ? that is hard to replicate.? But any bank can invest their funds aggressively, which will lead to defaults with higher frequency.? It is true of insurers as well, most financials die from bad investing policies, and short-term liabilities that require complacent funding markets.

That?s why there has to be a focus on liabilities in regulating solvency.? Financial institutions, even simple ones, are opaque.? Most die from the deadly combo of illiquid assets and liquid liabilities.? Those that have funded the bank in the short run refuse to roll over the loans at any price.? Assets can?t be liquidated to meet the call on cash, and insolvency ensues.? Those that have read me for a long time know that I don?t buy the malarkey that some managements will trot out, ?We?re not insolvent; we merely have a liquidity crisis.?? Hogwash.? You took too much risk, because the first priority of risk control is liquidity management.? Assets are only worth what you can sell them for, or, what cash flows they can generate.? If assets can?t generate cash flows or sale proceeds adequate to service liabilities, then you are insolvent, not merely illiquid.

Cash flow testing for banks should focus on the ability of the bank to finance itself without recourse to selling assets.? To the extent that selling assets is allowed in modeling, they must be Treasury quality assets.

The essence of a good risk-based capital formula is that it forces intelligent diversification, and forces adequate liquidity.? No assets should be bought that the liability structure of the bank cannot hold until maturity.? There should be no concentration of assets by class, subclass, or credit, that would be adequate to lead to failure.

My view is that a proper risk-based capital regime would start with asset subclasses, and double the capital held on the largest subclass, and 1.5X the capital on the second largest subclass.? After that, within each subclass, the top 10 credits get twice the level of capital, the next 10 1.5x the level of capital.? Having managed assets in a framework like this, I can tell you that it creates diversification.

Beyond that, no modeling of asset correlations would be brought into the modeling because risky asset correlations go to one in a crisis. Any advantage derived from diversification should be accepted as earned, and not capitalized as planned for.

Securitization deserves special treatment: risk based capital should higher for securitized assets versus unsecuritized assets in a given ratings class, because of potentially higher loss severities, and assets that are originated to securitize are always lower quality than those held on balance sheet.? Capital charges should be raised until banks don?t want to securitize as a matter of common practice.

Eliminating Contagion

In order to avoid systemic risk and contagion, banks should not lend to or own other financial firms.? That would end contagion.? At least that should be limited to a percentage of assets, or through the RBC formula. Think of it this way, financials owning financials is a form of capital stacking across the country as a whole.? In a stress situation it raises the odds of a deep crisis.? Setting a limit on the ability of financials to own the assets of financials is the single most important step to avoid contagion.? I would set the limit at 5% for equity, and 20% for debt.

Regulating Underwriting

Most of the real risks came from badly underwritten home mortgage debt, whether conventional, Alt-A and Jumbo, or subprime.? Underwriting standards slipped everywhere.? Commercial mortgage lending hasn?t yet left its marks ? there is a lot of hope that banks can extend maturing loans rather than foreclose and take losses.

For much but not all of this crisis, it was not a failure of laws but a failure of regulators to do their jobs faithfully. ?Regulators should have looked at indicators of loan quality, and raised red flags when they saw standards deteriorating.? Where I worked, 2003-2007, we saw the deterioration, and were amazed that the regulators had been neutered.

Let Equity Be Equity

Beyond that, there was a dearth of true equity, and a surfeit of preferred stock, junior debt, trust preferreds, and particularly, goodwill. ?Equity has to reflect assets that are high quality and that are not needed to support short-term obligations from the cash flow tests.

Code of Ethics for Risk Managers

One reason the banking industry is worse off than insurance, is that they don?t have many actuaries.? Actuaries have a code of ethics.? They tend to be ?straight arrows? telling it like it is.? Bank risk managers need the same thing, together with the rigorous education that actuaries receive.? Accept no substitutes: CFAs and CERAs are no match for FSAs.

Reflect Derivatives Properly

Derivatives must come onto the balance sheet for regulatory purposes, revealing leverage increases/decreases, counterparty risk, overall sensitivity to the factors underlying the contracts.? Any instrument that can cause cash to flow at the regulated entity should be on the regulatory balance sheet.

Other Issues

I would not create a prospective guarantee fund. The insurance industry has a retrospective fund that has worked fairly well.? ?Do you really know what it would take to create a macro-FDIC, big enough to deal with a large systemic risk crisis like this one?? (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.

Though it is not bank reform, we need to end the Greenspan/Bernanke Put.? The Fed encouraged risk-taking by the banks by not allowing recessions to damage them.? They tightened too late, and loosened too early, and that pushed us into a liquidity trap. Monetary policy that is too loose creates perverse incentives for the solvency of financial institutions in the long run.

Bonuses to executives skew incentives.? Bonusing a financial executive on current earnings creates perverse incentives.? It is a form of asset/liability mismanagement, because cash flows in the short run, while the value of the institution is a long-run issue. Far better to incent using long dated restricted common stock.? The only trouble is, it doesn?t incent as well as cash.? Tough, sorry, but that is a loss that must be accepted for the good of the system as a whole.

Summary

Dumb regulation is good regulation.? Regulators should be risk-averse, and take actions that limit ROEs for banks in order to promote solvency, and reduce the likelihood of liquidity crises.? The remedies that I have proposed here will do just that.? May we use them to regulate our financial sector better, for the good of all in our nation.

A Few Notes From the Fordham Conference

Posted on 13 March 2010 by David Merkel

I will have a more comprehensive post tomorrow on my thoughts on bank regulation, but I will offer a few thoughts here.? One thing I found interesting at the conference was what did not get much play in terms of what helped to create the crisis.

It was fascinating that no one talked about why the US bailed out holding companies, rather than letting them fail, and merely backing up the operating subsidiaries. This is significant.? The moment you put money into a holding company, it goes everywhere.? Regulators should only care about operating subsidiaries, and let the holding companies fail; let the costs be borne by the stockholders and bondholders of the failed company, but protect the regulated entities.

Also, few fingered the Fed?s monetary policy, where Greenspan and Bernanke created a culture of lenders who knew that the Fed would ride to their rescue when thing got modestly tough.? Unlike William McChesney Martin, who joked that the Fed?s job is ?to take away the punch bowl just as the party gets going,? Greenspan and Bernanke were slow to remove the punch bowl, and quick to bring it back, creating lenders who would rely on the Fed to allow them to take too much risk.

Another miss was not blaming the failure of neoclassical economics to explain, much less predict the problems that we experienced.? Why invite any neoclassical economists at all to the conference?? The few economists that were ahead of the asset bubbles were ignoring neoclassical economics.? Neoclassical economics is a failed discipline that needs to be replaced by something that realizes that applying math to economics does not yield significant increases in understanding.? The Austrians, those who follow Minsky, and the non-linear dynamic school understand what is going on better, because they treat economics the same way we understand ecology.? And, no, applying math to ecology doesn’t help that much.

Preventing Too Big to Fail

There are three main ideas as I see it, in preventing “Too Big to Fail.”? The first is changing risk-based capital [RBC] policy to raise capital requirements on larger institutions.? Use RBC to discourage banks from getting too large.

The second idea, which also wasn’t talked about much at the conference, was to limit regulated entities from owning or lending to other financial institutions.? Do you want to limit contagion?? Well, if you do, you must limit the amount that regulated banks own of/lend to other financials.? That even applies to subsidiaries with the same ownership group.? Keep it clean.? If you are going to have financial holding companies let them own all subsidiaries directly to avoid capital stacking.? Ban cross-guarantees among subsidiaries.

The third idea, which I have touched on is that regulators should ignore holding companies and never, never, NEVER bail them out.? Bailouts should only come to regulated entities, and only after the resources of the holding companies have been drained to zero.

On Detecting Fraud

I appreciate what was said on detecting fraud by one presenter: check for adverse selection, honest businessmen won?t do business that way.? Also, it never make sense for a secured lender to accept inflated appraisals.? In short, the originate to securitize model allows originators to make substandard loans that they will not hold onto.

This is why I say look for gain-on-sale accounting. There is something perverse about making money simply because a sale is made.? Under the GAAP principle of release from risk, which I believe is misapplied, financial entities should recognize profits more slowly than is the current practice.

When I was a buy-side analyst, I would analyze a company’s management culture for short-termism. Any management team that seemed too aggressive would get negative marks in my book and I would avoid them, or short them.

Remember you can never get pricing, volume and quality at the same time in lending. Companies that go for volume, or sacrifice quality are begging for trouble.? Financial companies are in a mature industry, so beware companies that grow fast.? Also beware of long dated accruals.? Accrual quality declines with length of time until payment and likelihood of payment.

Those that want to have regulators war-game future problems and predict black swans have their work cut out for them, even considering what I have said already.? But most of their attention should be fixed on the areas of the market where the greatest increase in lending is occurring.? Where debt is increasing the most is usually the area where there will be the most financing problems in the future.

One more note for regulators: look at the high short interest.? The shorts are doing you a favor.? They spend a lot of time analyzing who they think is cheating the system, and then they put their money on the line.? I would tell regulators to use the shorts as a guide.? Don’t automatically trust that there is something wrong, but use it as a guide to now begin your own due diligence into the solvency of the financial institution in question.

More Tomorrow — until then.