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Tuesday, August 28, 2007

Various Basics

It's a busy day for me, but briefly:

There are very interesting comments by Rob of ExurbanNation at the post below. If you ask a question over at his blog I bet he'll answer. I've been following him for a while; he's very analytical and rigorous in his thinking.

Conference Board consumer confidence for August took a drop. Current situation dropped from 138.3 in July to 130.3, and future expectations dropped from 94.4 to 88.2. What's notable about the current situation drop is that gas prices continue to come down and extremely high food prices are being slightly mitigated by changes in supply and brands in the supermarket. So this represents another force creeping into the equation, and I doubt most of it derives from the credit crunch. I think consumers are beginning to see indications of weakness in the general economy.

Case Shiller numbers came out and showed hefty drops for home prices. Of the "official" numbers, Case Shiller is by far the best. But only their 10 city index has much of a history, and the index lags. Housing Tracker is actually better to see immediate trends, because it deals with list prices on the MLS rather than sales prices. As I wrote yesterday, the changes in financing availability and underwriting terms are distorting median price computations because of the shifts in levels of homes sold and in areas of homes sold. Case Shiller figures same house sales, so it is immune to that distortion. However, Case-Shiller is a lagging index and it also smoothes out the curve, nor does it cover anything except single-family housing. OFHEO is pretty useless at the current time, IMO. A couple of years ago it diverged from reality, and it's been diverging ever since. With the restoration of more careful appraisals, it will gradually come back to reality, but it will be a while.

Howard at Oraculations pointed me to John Mauldin's article on the credit crunch. I thought the explanations were very good, especially of the dynamics of the MBS-CDO problems. Start with Howard's post here, because Mauldin's stuff is long. I do want to caution that the problems with commercial credit are more extensive than just the aspect Mauldin discusses. From top to bottom, there are major problems. There are problems with many leveraged buy-outs, stemming from mostly the irrational expectations about the amount of debt that companies can carry. There are problems with credit-rating of firms (Mauldin's comments about the role of the risk-rating firms are apt; they are the driving force behind the current panic that just ended). There are big, big problems with some recent commercial mortgage packages. There is no stone you lift up under which you do not find some unpleasant critters.

More about the credit ratings firms:
These are outfits like Moody's, S&P & Fitch. The function of these firms is to evaluate the creditworthiness of companies and various bonds or other debt obligations that will be traded. They have fallen down on the job severely. The worst of it is that in our regulatory system, the ratings of these NRSRO's are given weight. What decides what entity can hold what type of obligation, or how transactions are risk-weighted, are the ratings that these firms have assigned! So if they fall down, the entire regulatory system becomes less and less effective. All the checks and balances basically become exercises in futility.

The problem is that the system does not allow for competition. Suppose I have a yummy lot of ABS (asset-backed) up for sale. I want to tranche it out and sell it for the maximum. I pay one of these firms to look the pool over, tell me how to structure the tranches for maximum ratings, and then slap their ratings on the various tranches that will be sold to investors. I don't pay two of them, and I can shop around, so there is clear conflict of interest. There is no non-interested party rating this stuff. Now one can feasibly argue that since their entire business was based on the viability of their ratings, the ratings firms would have to be crazy to drop their vigilance. It is, in effect, the same thing as a car company selling cars that tend to fall apart within three months. However, just think about the Big Three automakers in the US, and you will see that this can and does happen.

The short-term crisis is over. It was generated by Paribas announcing that it had no idea what the heck its funds were really worth, and closing them for a period to figure out. Paribas reopened its funds, and the crisis in ABCP (short term asset-backed paper) is now largely resolved. But the underlying crisis will play out for over a year. The reality is that the ratings of a lot of traded securities mean very little, so now before buying or selling the values have to be recalculated. You can see how that would seize up the credit markets in a hurry; it takes a long while to do it, and the more complex the debt instrument is the longer it takes. When no one knows what's going to happen, the revaluations incur a lot of uncertainty, which also affects pricing.

Treasury seems to be accepting the investment graded MBS paper at 85% as collateral for loans, so that's how the short-term crisis was abated. That action set a floor for the short-term market value of this paper. From here on it will have to be reanalyzed if you want to hand it off at a higher rate than that. The net effect was to surgically remove a lot of money from the financial system. See Shadowstats & M3.

The process of separating the sheep from the goats has begun, and some credit terms are already loosening. But risk premiums and avoidance are now firmly back as factors, and this will cause a big drop in commercial construction and renegotiation on everything from LBOs to the marketing of ABS and MBS. From here on out, the better deals will be distinguished from the dicier deals. It will probably work as at least a three-step downward staircase. The first step is the one we just took.


Comments:
MOM, what is it that gives specific companies a privileged position in the ratings game--is it anSEC regulation, actual legislation, or what? Is the rule stated in terms of specific company names, or is it just constructed in such a way that no one else is eligible?

Seems to me that either:

1)The government should not designate rating agencies, but leave that choice up to those selling & buying the securities, OR

2)Designated rating agencies should face very specific and detailed performance standards
 
Nothing but custom and regulation. They are private, for profit companies. The government doesn't really designate them. NRSRO is short for Nationally Recognized Statistical Rating Organization.

The theory has been that if private companies found their ratings good enough to trade by, so would the regulators. In theory, that should have worked. In practice, at this pass it has failed.
 
I vaguely recall this business about the rating orgs coming up 20 or 30 years ago, along with panic over "infrastructure" about which nothing was done. Congress felt fine about beating up on accounting firms with Sarbanes Oxley; why has no one ever noticed the conflict of interest at the debt rating orgs? Seems like it's an easy fix: require a wall between the rating org and the consulting org.

As an insurance person, how would I go about finding out if A.M. Best's is up to the same no-good?

Carol
 
Carol - I really don't know how. The worst of it is that is quite difficult to check these things sometimes. I figured out the misratings on the tranched MBS only because I do calculations of portfolios, but the full information isn't generally available to the public.

I don't want to make anyone panic, but I have been amazed at things like the disaster bonds.
 
MOM, thanks for the kind words. Right back atcha.

The insidious part of ratings is that they don't cross product lines. "Rated the best Yugo model in America by J.D.Powers" doesn't mean the car is any good. A triple "A." 5 Star CDO is relative to other CDOs not that it is as safe as prime corporate debt that may hold the same rating.
 
MOM, by disaster bonds, do you mean using bonds to finance the wind insurer of last resort in Florida? Isn't that how they ended up making that horror look solvent? At least until the next Andrew.

Carol
 
My understanding is that there are several issuers. I know I read of one that paid 20%. Of course, if there's a disaster, you lose everything.

People are buying the darndest stuff.
 
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