I'm Moving

I'm fed up with being ignored so I'm moving to Butt Hole Road in Crapstone

I really don't expect anyone who can actually help to read all the way back to last summer and, the post below may not be clear enough ...
1. In order to be in compliance with SEC regulations, a privately issued MBS has to meet very specific structural requirements, one of which is that the issuer look like an actual corporate that has an equity like structure.
2. This equity class of the MBS is typically placed with institutional investors.
3. If no institutional investors can be found to purchase the equity, the Wall Street firm that executes the MBS transaction may be dumb enough to hold it itself.
4. Because the equity can not be rated - it is at the bottom of the cash flow chain - the issuer may employ a derivative strategy to artificially rate the equity.
5. The derivative turns out to be a credit default swap (CDS) which is issued by a credit worthy entity like AIG or Fannie Mae or Freddie Mac or Bear Stearns or Lehman or JP Morgan - shall I go on?
6. The CDS issuer uses a reference security having the same rating that the MBS equity needs.
7. The MBS equity holder (the actual issuer is a wholly owned subsidiary of some eleemosynary institution - I think?) employs leverage to finance the MBS equity.
This part I have to guess about:
8. The CDS referenced security is likely some private label MBS that was considered to be very unlikely to default, e.g. it possessed investment grade ratings. Further, it would seem that MBS issuers (I use issuer to really mean their sponsors - Bear & etc.) used the same referenced security - the size of the defaulted CDS' implies that.
9. Under the terms of the CDS contract, if the referenced security defaults, the CDS issuer is required to make a principal payment equal to the notional amount of the swap contract.
10. Like all insurance contracts, the issuer of the CDS contract is only required to keep a fraction of the notional amount of its outstanding contracts as capital.
11. When the referenced security defaulted, AIG and the rest were required to pay up - they lacked the necessary capital and the whole thing fell apart.

The point that I have been trying to make is, that if the referenced securities regain their investment grade ratings and if MBS holders can be assured that the ratings have a sound footing, the market should be restored.

Banks Do What Banks Do Best

Look back to my entries from November 14th and 18th. Also, I have tried to make the point that managers in the banks and investment banks do not have a clue as to what these securities really are nor do they really understand how they ended up owning them in the first place. This is really why the banks are desperately trying to get the "government" to take them out of the whole mess by buying the defaulted securities. I don't have the time to write about this right now. Keep in mind, that 1. the ABA is the strongest lobby in the US, 2. banks will never admit that they are as incompetent as they are, 3. the problem is credit default swaps and the fact that underlying assets all got downgraded and 4. people at the fed and the treasury have been lied to and they do NOT have a clue either.

All right ... because nothing substantive has been done, I must conclude that the people who are groping for a solution really do not know how to proceed. Throwing $350 billion at the banks may have kept them afloat, but it has done nothing to solve the underlying problem - no liquidity complicated by a lack of confidence.

Liquidity is necessary for the efficient functioning of the capital market. It exists in the macro, system wide, and micro, security specific or market sector sense of the word. The lack of liquidity in the MBS sector led to the liquidity crisis in the entire capital market. The idea behind TARP was to add liquidity to the banking system and the banking system would add liquidity to the market. All it did was reward incompetence.

I touched on a solution like this in past posts but never really formed the idea. So ... the problem started because "mortgage related securities" held by Bear Stearns, Merrill, Lehman, AIG and everyone else, could not be financed by their holders. The notional value of the MBS exceeded the capital of the firms that owned them - the MBS could not be sold - the firms lost all of their ability to carry other positions (because they were insolvent) - and the credit market ceased to function. I don't think that it's too late to fix the problem by providing cash flow to the securities that defaulted owing to the foreclosure of their underlying collateral.

Keep in mind:
1. Credit default swaps, referenced by or tied to MBS, created the mess when they were downgraded.
2. Very few people, especially those at the credit rating agencies and the GSE's and the management of ANY firm involved in this mess, understood the risk associated with the subject CDS's.
3. When liquidity dried up, managers did what managers do best, they panicked, and all parties involved tried to get out at the same time compounding the problem and leading to the current crisis.
4. When the managers met with the fed, all they cared about was getting out of the MBS, not trying to fix the cash flow - remember, they don't know anything about the mortgage market. If they did, no prudent person would have let this mess happen in the first place - right?
5. Everyone involved in this mess, from mortgage originators to the investors who bought this crap, have a responsibility to fix it.
6. The MBS market is extremely efficient, it would have to be to finance the trillions that it has. The players involved know the collateral and know exactly what it would take - as it relates to interest and principal payments - to get the defaulted securities back on a cash flow basis.
7. If the $350 billion that went to the banks under TARP were used to provide cash flow to the securities underlying the defaulted CDS's, we would not be in this mess.
8. Is it too late then, to put the cash into propping up the MBS and therefore, the CDS? That is, can the market be rebuilt? If it can, all of the parties that got us into this mess are made to stay in the game and to pay in some way for their incompetence.

I'm not sure that what I suggest will work. I'm pretty sure though, that it's a lot better than throwing good money after bad by giving it to the banks and letting them do whatever they please with it.

What do you think?

There Is No substitute For Intelligence

"I'll be long gone before some smart person ever figures out what happened inside this Oval Office."
Washington DC, 12 May, 2008

It all starts with effective leadership ...

Understanding Risk or Not

The Sunday Times magazine had an article on understanding risk in the capital markets. It was an interesting article. It discussed a system referred to as VaR or value at risk. In a nutshell, the system is set up so that a portfolio manager can assess the potential P&L of a given position as its market value fluctuates. VaR is a good system - variations of it have been in use at banks for many years. It has been considered so reliable, that bank regulators have endorsed it and the Basel Committee has used it to determine compliance with regulatory capital requirements. Remember though, that the model was developed for banks ... banks, that historically bought only treasury securities and took all of their risk in lending to corporate clients.

What does this have to do with the mortgage crisis and why should we care? Simple ... if one has read what I have written in the past, one knows that the limitation of any trading system, is the people that are involved with it. The Times article seemed to miss this point. To actually believe that any valuation system can be relied upon all of the time illustrates, not only the folly of relying on computer models, but the limitations of the small minds in Wall Street.

The following is the lead-in to one of my posts from a while back: avarice |ˈavəris| noun: extreme greed for wealth or material gain - Harry's definition; an uncontrollable urge to look the other way when, in the face of making huge amounts of easy money, otherwise astute managers allow their staff to do deals they do not understand - even remotely.

The way that the deals get done, is to remind everyone just how reliable the models are and how careful everyone has been as it relates to VaR and, therefore, the soundness of the firms capital.

In summary: remember, that Wall Street firms are like all corporations, e.g., their organizational chart looks like a pyramid. Further, owing to time constraints, the higher you go on the chart, the further away from reality the managers become. Now, let's pretend that I'm a senior trader (who has always been profitable) and that I see an opportunity to make a big score. Generally, these opportunities occur due to disruptions in the market value of a security that is relative to another security or sector of the market - the security is said to be cheap. So, I can buy the cheap collateral, restructure it into collateralized debt obligation, like a CMO, get it rated and place it in the market and make a two or three percent profit. To the extent that the deal is $2 billion in size, two percent equals $40,000,000 - nice days work, non? Have you all read Catch 22? The catch in this deal is, that in order to get it rated, I have to come up with a buyer for the bottom most tranches ("the equity") of it. Let's say that a major institutional buyer - AIG say, tells me that they'll take 50% of the equity if we take the other 50%. Let's further assume, the equity is two percent of the deal, or $40 million. My pitch to management now becomes, "hey, this deal is so sound, that AIG will take 50% of the equity if we take 50%" management, "what's in it for us"? me, "$40 million" management, " how much do we have to buy and what's the risk"? me, "half, $20 million and the models tell us the risk is manageable" management, "so we put up $20 million, that we can borrow, and we can make $40 million? ... done! it's a no-brainer"

Now, the preceding scenario was carried out dozens of times during the last three or four years at every firm that was involved in the mortgage market. The astute among you will see the flaw, that is, "that we can borrow". What happened, is that each of the firms that are getting bailed out, and those that did not, borrowed the cash that was necessary to finance the portion of the deals that they, and their idiotic models, decided had risk characteristics that were manageable.

The models can't measure liquidity. When liquidity dries up, it does so from the bottom up. This means, that the lowest rated securities loose their ability to finance first. As soon as lenders realized that there was no market for the MBS, they pulled their lines and the firms that owned the securities had to use their own capital or sell the securities. The loses exceeded the firms capital and down we go.

I'm making this all seem pretty simple. In fact, it was. If any of the firm's management took the time to think about the nature of the collateral they were using to collateralize these securities, we hope, that the deals never would have gotten done. But, look back at my definition of avarice - could everyone have been blinded by greed? Can the models measure that variable?

I'll state this one more time; any reasonable person knows that real estate is the most vulnerable market of all to economic cycles - it's always been boom and bust. How, therefore, could a reasonably prudent manager look at a collateral pool filled with loans having LTV's of 100% - at the obvious top of a cycle - and think that the deal was sound?

Here is the best example that I know of: in 1989 or 90, on behalf of the trust of the same name, Goldman Sachs sold Rockefeller Center to a large Japanese investor. Rockefeller Center IS THE trophy piece of real estate in the US. The sale price was $1.3 billion and the date coincided with a peak in the cycle for real estate. In 1993 or 4, post Japanese bubble, a group led by Goldman and the Rockefeller Trust bought it back for about $600 million. So, the best piece of real estate in the US lost more than half of its value in about five years. Everybody in the US real estate market knows this. How then, could they let the single family market get so far away from reality?

Could it be avarice?

Metaphor

One of my favorite scenes in movies is from the Godfather. It's the one in the Corleone driveway where Sal Tessio asks Tom Hagen to spare his life. Tom turns him down and Sally, perhaps in an attempt at reconciliation, asks Tom to tell Michael that, "it was only business". Under similar circumstances albeit, not so final, I had a boss, as he was showing me the door, use the same line. I mention this, because much of what has gone wrong in this country in the last several years can trace its roots to the attitude expressed in that line - it's only business.

A little background - I was on the express bus down to Wall Street. In those days (early eighties), I subscribed to both the Wall Street Journal and the NY Times. I enjoyed reading the editorial pages of the Journal, it's good to see just how delusional the right can be. Anyhow, the following headline caught my eye, "Business Schools Require Ethics Course". I have to admit to a certain confusion caused by the story, e.g., in my mind, one is either ethical or not and taking a course in ethics will never change that fact. Further, it will only make it easier for the unethical to exploit the ethical. The deans at Harvard and Warton however, detected a shift away from traditional morality in the attitudes of their aspiring MBA students. However, reading this article really cemented the difference in the way that I approached business and the way almost everyone else in the Street did. It also forced a debate between myself and those to whom I was close, wife, friends and some colleagues, the result of which was the realization that I was a square peg in the round hole of Wall Street. What I never quite got however, was the fact that, everyone in the Street is convinced that the "here's to your buddy - tried and true - screw him before he screws you" attitude. Armed with this rationale, the MBA's are freed to go on offense. I think, that this is the root of business ethics and also the reason why your writer finds himself among the working poor.

I have alluded to the profit centric nature of all of the players in the mortgage debacle in previous posts. Really though, it pervades all of big business. Advertising is propaganda and caveat emptor is the Holy Grail of merchandising. Take a look at the chart of any commodity index for the last year, you'll quickly discover that supply and demand had nothing to do with the run-up in the prices of food and energy - it was all about trading profits for which consumers pay. In an environment where bank cost-of-funds is below 1%, is the fact that they charge upwards of 25% on credit cards justified? Look at the attitude of the "big three" auto makers before Congress - were they contrite? Do they feel entitled to the amount of money they make? Do they care about energy consumption? This IS the attitude of the majority of American business and consumers are going to continue to pay ... or are they?

So, is it only business? Who is to blame, we who pay or they who charge? THINK!