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Tuesday, September 30, 2008


Dexia did get its infusion of capital last night, but I'm sure CR will cover that.

However, this does not look good:
Banks borrowed the most since 2002 at the European Central Bank's emergency rate and deposited a record 44.4 billion euros ($64 billion) as money markets remained frozen.

Banks yesterday borrowed 15.5 billion euros from the ECB at the emergency overnight marginal rate. They lodged more than 1 billion euros in the ECB's overnight deposit facility for an unprecedented eighth straight working day. The ECB's deposit rate is 3.25 percent and the marginal lending rate is 5.25 percent.
So the bigger entities won't lend to each other and are sharply constraining lending to businesses.
The London interbank offered rate, or Libor, that banks charge each other for loans climbed 8 basis points to 5.22 percent yesterday, the largest jump since June, the British Bankers' Association said. The Libor-OIS spread, the difference between the three-month dollar rate and the overnight indexed swap rate, jumped to a record 231 basis points, after breaching 200 for the first time on Sept. 25. It averaged 8 basis points in the 12 months to July 31, 2007, before the credit squeeze.
It might loosen up a bit as the new quarter begins, but then the countdown to year-end begins. The only trusted financial entities are the central banks, so they are forced to be the intermediary between banks - i.e. banks deposit with them and other banks borrow from the central banks.

I know that a lot of this may sound as if the central banks are creating money, and thus seem inflationary, but the central banks are actually fighting a contraction of the effective money supply.

The problem with a frozen money market is that it indicates that the supply of credit to businesses is very tight. Unfortunately, short term funding of business working capital has become the norm in many areas.

In the US, money market funds have been the source of a lot of short-term capital. A guarantee of those funds is possible, but can't be indefinite. If there is no guarantee and very little interbank lending, depositors might lose liquidity. That would put the entire system into a tailspin as investors pulled out of money markets.

It looks to me as if something like TARP is the only way out.

The real economy worldwide was on a sharp and highly correlated downturn before all this. A withdrawal of business credit will make the real economy much worse than it needs to be, will cause higher defaults on all debt classes, and will thus further tighten up liquidity in the financial system.

If we don't do TARP than the only alternative is for the Fed to guarantee explicitly a certain portion of bank credit, but there's no good mechanism for that, and overall the Fed would have guarantee far more. Thus a TARPish solution is probably the cheapest option by far.

What's at stake here is business-to-business credit, which is dependent on the working capital that companies have. If you are not following this, consider the fuel oil example because the mechanics are the same:

1) Consumers have to come up with significantly more money to heat their homes using fuel oil than they did last year.
2) Because of this, far few consumers prepaid fuel oil contracts with their distribution company this year, or if they did, they prepaid a significantly lesser number of gallons. There is often a minimum prepay number of gallons, and many consumers couldn't afford it.
3) The heating oil companies usually use their prepaid contracts to buy product early in the season. They then deliver as requested. When customers who didn't prepay order fuel oil, the companies deliver oil that was purchased with prepay funds, and then turn around and use the revenue from those deliveries to buy more oil from the refineries to supply the prepaid customers.
4) Since the cost of the number of gallons of heating oil the distribution companies need on hand had greatly increased while the flow of early $$ to the distribution cos had dropped, the early orders from the refineries were much lower, and now fuel oil distribution firms are short of product. To maintain supply, the distributors can draw on credit lines if they have them, but that costs them more in interest, and in some cases intermediaries had some supplier credit. However even for gasoline distribution major suppliers had tightened up credit earlier in the year because the float was costing them too much.
5) Thus it is almost certain that distribution cos will be rationing the first round of deliveries to prepaid customers and perhaps to cash customers if they are really short. Because the distribution cos have to get the extra cash from the cash customers to buy more oil, they are more likely to ration deliveries to prepaid customers.
6) The net effect will be to significantly lower early refinery sales of heating oil, which has happened btw. That further constricts the ability of the refiners to buy crude.
7) Hypothetically, even if the price of crude were overnight to drop to $70, there would still be a constriction of the heating oil supply, because refiners are behind and probably won't catch up. So in fact prices would not drop as much for the end user (effective supply is still constricted), and the consumers still wouldn't end up being able to buy as much heating oil as they really need to keep warm. This is similar to the problem that the Fed is seeing with rate cuts - they are not propagating through to the bottom level of money consumers.

The same dynamic can work for all sorts of businesses. You can easily get a situation in which the demand is present and the manufacturer has orders to meet that demand, but the constriction of business to business credit and ancillary credit lines is such that the manufacturers can't get components, etc.

It is difficult in the US to tell exactly how bad it is because of hurricane disruptions, but the sharp trucking drop in July and August and the corresponding rail freight drop show that things were tightening rapidly before the latest round of credit problems. I know that suppliers are tightening credit terms across a wide range of industries.

It would not be surprising at all to get a temporary -2% ~ 3% drop in production just from a rolling credit constriction on working capital. That would add to the drag on economies from other factors to produce astonishingly bad GDP numbers in the fourth quarter.

I'd hit the panic button. I really would. TARP in its amended form may not be that great, but it's better than the alternative.

Monday, September 29, 2008

Money Markets

Dated Brent spot $91.44; WTI Cushing spot $97.90. Here.

For the first time, the weekly inventory report shows a significant shortage in supply, but most of that is due to the Gustav/Ike impact on the refineries:
Total products supplied over the last four-week period has averaged 19.5 million
barrels per day, down by 5.3 percent compared to the similar period last year.
Over the last four weeks, motor gasoline demand has averaged 9.0 million barrels
per day, down by 3.5 percent from the same period last year. Distillate fuel
demand has averaged 3.9 million barrels per day over the last four weeks, down
by 5.5 percent from the same period last year. Jet fuel demand is 4.5 percent
lower over the last four weeks compared to the same four-week period last year.
Pretty hefty demand drops. The relatively high drop in distillate demand is partly the effect of lower heating oil purchases.

The silver lining is that if these prices keep dropping it will help the global economy a bit.

Citi reports that Wachovia is "delicious, crunchy, with a sweet nutty core", but investors were not thrilled.

We seem to be getting close to a bottom on a lot of US company stocks, so I wouldn't let today's exchange movements rattle you too much. However, it looks like many retail stocks have a long way to fall.

The one component of the bailout bill that really must go through, even if the bailout bill overall doesn't go anywhere is the part about paying interest on bank reserves at the Fed. The Fed, along with other CBs, is now hurling money into the market. Most significantly, the increase of the 84 day TAF auction funds from 25 billion to 75 billion is aimed at controlling fears over the money market's liquidity and most specifically the supply of credit to the less sterling companies.
Discount rates
Term AA
1-day 1.47 4.53 1.37 2.67
7-day 1.85 5.97 2.19 4.46
15-day 1.93 5.75 3.20 4.43
30-day 2.13 5.91 3.14 5.55
60-day 2.13 6.01 3.52 3.10
90-day 2.09 n.a. 3.40 5.25
Trade data insufficient to support calculation of the 90-day A2/P2 nonfinancial rate for September 26, 2008.

Note that the shortage of money is now popping up in A2/P2 nonfinancials. This is where the real economy can take a massive beating, so the Fed will keep pumping. The 60 v 90 day asset-backed.

The Fed is moving to ensure that money will be available at year end:
Forward TAF Auctions
The forward TAF auctions are a new program designed to provide reassurance to market participants that term funding will be available over year-end. The timing and terms of the two forward TAF auctions will be determined after consultations with depository institutions that utilize the TAF program.

It is anticipated that there will be two auctions in November totaling $150 billion. These auctions will provide short-term (one- to two-week term) TAF credit over year-end.
The terms of the Wachovia buyout (it's banks, not everything) are not known, but the Richmond Fed issued a statement indicating it is involved somehow:
Richmond Fed Ready to Provide Liquidity in Wachovia Transition

Richmond, VA — The banking operations of Wachovia Corp., which is headquartered in Charlotte, N.C., are being acquired by Citigroup Inc. The transaction is being facilitated by the Federal Deposit Insurance Corporation and concurred with by the Board of Governors of the Federal Reserve and the Secretary of the Treasury.

Citigroup will acquire the bulk of Wachovia's assets and liabilities, including five depository institutions and assume senior and subordinated debt of Wachovia. Wachovia will continue to own AG Edwards and Evergreen.
In support of this transition, the Federal Reserve Bank of Richmond stands ready to provide liquidity as needed.

So regardless of whether the bailout bill passes, a major bailing operation has commenced.

In the UK, the chaos is growing. There is a lot of political wrangling about Lloyd's TSB takeover of HBoS, and RBS (Royal Bank of Scotland) got its shares whacked last week by the Fortis problems, and this week by disappointment over failure of the bailout plan to pass the house. RBS has significant US banking operations and was expected to get a decent boost from the bailout.


Well, well, well. Extreme nerves in trading on finances in Europe.

Hypo got its money (the name is confusing, the company is really mostly in real estate finance and owns banks, and their Irish purchase, Depfa, is the main current problem) and Brad & Bing got nationalized, (summary Fortis, Hypo, Brad & Bing) but European financials are still doing badly. It's going to be a long week.

Still great coverage over at CR's, and if you have the time to read the comments, there is an interesting mix of humor, wrath, misery and knowledge available.

I'm listening to the Treasury call that has been uploaded to the internet. I got the link here. It seems to be genuine.

In the US Wachovia is on the auction block. The JIT method of bank clearances is perhaps not as efficient an innovation as for manufacturing supply chains.

I think this India Times article about the change in credit markets there conveys the best picture of what is happening around the world and why all these governments are stepping in to support banks and buy bad debt. It's hard to think of a government that isn't doing something. From the article:
With the global liquidity crunch, making easy money a thing of the past, investors in the Great Indian Infrastructure story - that needs around $400 billion in the next five years - will have the upper-hand. At stake are sectors such as oil and gas, roads, railways, telecom, urban infrastructure, SEZ, healthcare, ports and airports.
While financing is still available for the right kind of projects and sponsors, the scenario has changed. Blue-chip infrastructure companies could raise $3-4 billion at around 8-9% earlier. But now companies will find it much more difficult to raise even $500 million. "Financial closures of key infrastructure projects will definitely be affected. Cost of funds has gone up. Projects that look to build roads and bridges will find it difficult to find lenders. It will be more difficult for small and medium-sized entities," said Gaurav Dua, Head of Research, Sharekhan.

The government support will, then, be crucial. But apart from slower economic growth and policy stagnation, the fiscal position of central and state governments can have a bearing on infrastructure investments.
Among the major Indian moves last week was the expansion of the foreign borrowing limit from 100 million to 500 million.

The relatively sudden Asian downturn is showing up in the form of rapidly declining cargo rates and loadings, and Asian shipping company stocks are falling rapidly.

US Consumer Alert: I spoke to my brother, and although he prepaid a heating oil contract he cannot get his tank filled. I am expecting finance-driven shortages to occur across the US NE as the distribution companies have to get payment from consumers in order to buy new stocks of fuel oil. Therefore, don't wait until the last minute and don't let your stocks fall low. You could be waiting for 30 days or so for delivery if you order at exactly the wrong time, which would be when everyone else is ordering. One thing you can do is call the company and tell them you can give them a check on delivery - they are so tight for funds that it would be motivational. I got a delivery early on my Mom's house in the NE for that reason, and then I paid the distribution company extra to help them out in this period. I got a very good deal under the circs - $3.60. Still way too high for most folks, so heating oil buys will be way down this year.

Sunday, September 28, 2008

Fortis Bailout In Progress

So tonight I can get some sleep.

Eventually we will all get used to the secondary explosions as banks crash, but for now it is still an unpleasant novelty, and the gentle splat sound of a soft landing on government $$ is the most welcome sound in the world.

There's really good coverage at Calculated Risk.

Saturday, September 27, 2008

Yes, I Watched The Debate

Very disappointing. I've never been a strong supporter of either candidate, although I did feel a first flush of hope in Obama. But last night Obama looked like such a fool that I can no longer pretend to myself that he is an alternative.

I still don't feel much hope in McCain, and I suppose I'm so disappointed because my vote for McCain will be mostly prompted by Fear Of Obama.

I think Obama's a very decent man who wants to do good. Last night I was badly shaken when he didn't even seem to understand the import and focus of Lehrer's importunate questions about how the bailout would change Obama's policy suggestions. 700 billion is a lot of money, and even if eventually it pays off, in the short term it adds a very substantial chunk to borrowings. This was the exchange (transcript of debate here):
LEHRER: All right. All right, speaking of things that both of you want, another lead question, and it has to do with the rescue -- the financial rescue thing that we started -- started asking about.

And what -- and the first answer is to you, Senator Obama. As president, as a result of whatever financial rescue plan comes about and the billion, $700 billion, whatever it is it's going to cost, what are you going to have to give up, in terms of the priorities that you would bring as president of the United States, as a result of having to pay for the financial rescue plan?

OBAMA: Well, there are a range of things that are probably going to have to be delayed. We don't yet know what our tax revenues are going to be. The economy is slowing down, so it's hard to anticipate right now what the budget is going to look like next year.

But there's no doubt that we're not going to be able to do everything that I think needs to be done. There are some things that I think have to be done.

We have to have energy independence, so I've put forward a plan to make sure that, in 10 years' time, we have freed ourselves from dependence on Middle Eastern oil by increasing production at home, but most importantly by starting to invest in alternative energy, solar, wind, biodiesel, making sure that we're developing the fuel-efficient cars of the future right here in the United States, in Ohio and Michigan, instead of Japan and South Korea.

We have to fix our health care system, which is putting an enormous burden on families. Just -- a report just came out that the average deductible went up 30 percent on American families.

They are getting crushed, and many of them are going bankrupt as a consequence of health care. I'm meeting folks all over the country. We have to do that now, because it will actually make our businesses and our families better off.

The third thing we have to do is we've got to make sure that we're competing in education. We've got to invest in science and technology. China had a space launch and a space walk. We've got to make sure that our children are keeping pace in math and in science.

And one of the things I think we have to do is make sure that college is affordable for every young person in America.

And I also think that we're going to have to rebuild our infrastructure, which is falling behind, our roads, our bridges, but also broadband lines that reach into rural communities.

Also, making sure that we have a new electricity grid to get the alternative energy to population centers that are using them.

So there are some -- some things that we've got to do structurally to make sure that we can compete in this global economy. We can't shortchange those things. We've got to eliminate programs that don't work, and we've got to make sure that the programs that we do have are more efficient and cost less.

LEHRER: Are you -- what priorities would you adjust, as president, Senator McCain, because of the -- because of the financial bailout cost?

MCCAIN: Look, we, no matter what, we've got to cut spending. We have -- as I said, we've let government get completely out of control.

Senator Obama has the most liberal voting record in the United States Senate. It's hard to reach across the aisle from that far to the left.

The point -- the point is -- the point is, we need to examine every agency of government.

First of all, by the way, I'd eliminate ethanol subsidies. I oppose ethanol subsidies.

I think that we have to return -- particularly in defense spending, which is the largest part of our appropriations -- we have to do away with cost-plus contracts. We now have defense systems that the costs are completely out of control.

We tried to build a little ship called the Littoral Combat Ship that was supposed to cost $140 million, ended up costing $400 million, and we still haven't done it.

So we need to have fixed-cost contracts. We need very badly to understand that defense spending is very important and vital, particularly in the new challenges we face in the world, but we have to get a lot of the cost overruns under control.

I know how to do that.

MCCAIN: I saved the taxpayers $6.8 billion by fighting a contract that was negotiated between Boeing and DOD that was completely wrong. And we fixed it and we killed it and the people ended up in federal prison so I know how to do this because I've been involved these issues for many, many years. But I think that we have to examine every agency of government and find out those that are doing their job and keep them and find out those that aren't and eliminate them and we'll have to scrub every agency of government.

LEHRER: But if I hear the two of you correctly neither one of you is suggesting any major changes in what you want to do as president as a result of the financial bailout? Is that what you're saying?

OBAMA: No. As I said before, Jim, there are going to be things that end up having to be ...

LEHRER: Like what?

OBAMA: ... deferred and delayed. Well, look, I want to make sure that we are investing in energy in order to free ourselves from the dependence on foreign oil. That is a big project. That is a multi-year project.

LEHRER: Not willing to give that up?

OBAMA: Not willing to give up the need to do it but there may be individual components that we can't do. But John is right we have to make cuts. We right now give $15 billion every year as subsidies to private insurers under the Medicare system. Doesn't work any better through the private insurers. They just skim off $15 billion. That was a give away and part of the reason is because lobbyists are able to shape how Medicare works.

They did it on the Medicaid prescription drug bill and we have to change the culture. Tom -- or John mentioned me being wildly liberal. Mostly that's just me opposing George Bush's wrong headed policies since I've been in Congress but I think it is that it is also important to recognize I work with Tom Coburn, the most conservative, one of the most conservative Republicans who John already mentioned to set up what we call a Google for government saying we'll list every dollar of federal spending to make sure that the taxpayer can take a look and see who, in fact, is promoting some of these spending projects that John's been railing about.

LEHRER: What I'm trying to get at this is this. Excuse me if I may, senator. Trying to get at that you all -- one of you is going to be the president of the United States come January. At the -- in the middle of a huge financial crisis that is yet to be resolved. And what I'm trying to get at is how this is going to affect you not in very specific -- small ways but in major ways and the approach to take as to the presidency.

MCCAIN: How about a spending freeze on everything but defense, veteran affairs and entitlement programs.

LEHRER: Spending freeze?

MCCAIN: I think we ought to seriously consider with the exceptions the caring of veterans national defense and several other vital issues.

LEHRER: Would you go for that?

OBAMA: The problem with a spending freeze is you're using a hatchet where you need a scalpel. There are some programs that are very important that are under funded. I went to increase early childhood education and the notion that we should freeze that when there may be, for example, this Medicare subsidy doesn't make sense.

Let me tell you another place to look for some savings. We are currently spending $10 billion a month in Iraq when they have a $79 billion surplus. It seems to me that if we're going to be strong at home as well as strong abroad, that we have to look at bringing that war to a close.

MCCAIN: Look, we are sending $700 billion a year overseas to countries that don't like us very much. Some of that money ends up in the hands of terrorist organizations. We have to have wind, tide, solar, natural gas, flex fuel cars and all that but we also have to have offshore drilling and we also have to have nuclear power.

Senator Obama opposes both storing and reprocessing of spent nuclear fuel. You can't get there from here and the fact is that we can create 700,000 jobs by building constructing 45 new nuclear power plants by the year 2030. Nuclear power is not only important as far as eliminating our dependence on foreign oil but it's also responsibility as far as climate change is concerned and the issue I have been involved in for many, many years and I'm proud of the work of the work that I've done there along with President Clinton.

LEHRER: Before we go to another lead question. Let me figure out a way to ask the same question in a slightly different way here. Are you -- are you willing to acknowledge both of you that this financial crisis is going to affect the way you rule the country as president of the United States beyond the kinds of things that you have already -- I mean, is it a major move? Is it going to have a major affect?

OBAMA: There's no doubt it will affect our budgets. There is no doubt about it. Not only -- Even if we get all $700 billion back, let's assume the markets recover, we' holding assets long enough that eventually taxpayers get it back and that happened during the Great Depression when Roosevelt purchased a whole bunch of homes, over time, home values went back up and in fact government made a profit. If we're lucky and do it right, that could potentially happen but in the short term there's an outlay and we may not see that money for a while.

And because of the economy's slowing down, I think we can also expect less tax revenue so there's no doubt that as president I'm go doing have to make some tough decision.

The only point I want to make is this, that in order to make the tough decisions we have to know what our values are and who we're fighting for and our priorities and if we are spending $300 billion on tax cuts for people who don't need them and weren't even asking for them, and we are leaving out health care which is crushing on people all across the country, then I think we have made a bad decision and I want to make sure we're not shortchanging our long term priorities.
I noticed this in Obama's books as well, especially the second. He'll often discuss an issue, apparently showing a great range of empathy for both sides and state a real objection, and then he'll ignore that and go on to state his position.

That may work for issues such as his position on abortion, but economics is a matter of hard parameters. Obama doesn't seem able or willing to comprehend that, or do the hard work to assemble any reasonable policy position. I don't think he's able to do this.

The next president - any conceivable president - will have a very hard time of it. Pretty much all the wiggle room is gone. After last night, I literally believe that Obama isn't capable of understanding it. Maybe he's not very bright. Maybe he just dislikes quantitative thinking. But for whatever reason, his current stated policies are an exercise in fantasy.

Next year's priorities need to run along the lines of making sure that poor people in the US have enough to eat. To be babbling about expanding early childhood education?

McCain did not impress me, but he appeared to understand that we have our butts in a tight crack and are going to be facing some very rough circumstances.

Anyone who watched last night's debate and can still consider voting for Obama loses my respect. There's a limit to how far one can defy reality and live. That man is currently outside the parameters of the land of the living. It's probably due to inexperience.

Friday, September 26, 2008

Keep Your Eyes On The Ball

The blah-blah about Fannie, Freddie, CRA and all these other affordable housing initiatives did not cause this situation. Yes, there are sloppy bits there, and losing loans. But nothing causative. The SEC had a lot to do with it, especially with their action in 2004 allowing leverage ratios to go as high as 40:1 for some funds, but the real problem arose from what the funds were trading with - the underlying investments.

The real source of the problem was the NRSROs. And sure enough, some of the people who worked there are now talking:
Frank Raiter says his former employer, Standard & Poor's, placed a ``For Sale'' sign on its reputation on March 20, 2001. That day, a member of an S&P executive committee ordered him, the company's top mortgage official, to grade a real estate investment he'd never reviewed.
``I refused to go along with some of this stuff, and how they got around it, I don't know,'' says Raiter, 61, a former S&P managing director whose business unit rated 85 percent of all residential mortgage deals at the time. ``They thought they had discovered a machine for making money that would spread the risks so far that nobody would ever get hurt.''
Raiter and his counterpart at Moody's, Mark Adelson, say they waged a losing fight for credit reviews that focused on a borrower's ability to pay and the value of the underlying collateral. That was the custom of community bankers who extended credit only as far as they could see from their front porch.

`Didn't Want to Know'

``The part that became the most aggravating -- personally irritating -- is that CDO guys everywhere didn't want to know fundamental credit analysis; they didn't want to know from being in touch with the underlying asset,'' says Adelson, 48, who quit Moody's in January 2001 after being reassigned out of the residential mortgage-backed securities business. ``There is no substitute for fundamental credit analysis.''
There certainly isn't. I strongly urge you all to read the article excerpted above, and then follow with this one. Because the NRSROs would give this stuff investment grade ratings, the major companies in the business (think New Century, a new type of blue chip!) just kept loosening their credit standards.

This thing did not bust until the first non-agency MBS started popping up with payment defaults on the first and second payments, and long after many independent brokers had realized that appraisal fraud appeared nearly universal in some outfits. Unfortunately, a lot of commercial mortgage backed securities were written very loosely at the end, and corporate debt is somewhat better but not much.

I am so glad Lehman's dead. It was one of the worst. It deserved to die.

And in the wake, there's a global crisis, and the reason that there is a global crisis is that unfortunately, a bunch of lenders elsewhere were doing the same thing they were doing in the US. The US alone couldn't do this.

Japan's in recession - with a trade deficit in August, nothing's going to help very much. Singapore's in recession, China's going to try to spend itself away from a growth recession, and is now loosening stock investment rules, as well as buying into their main banks. Shipping rates are collapsing. Australia's government is already buying their own RMBS. UK banks want a government bailout, Fortis is in trouble (big trouble). Deutsche Bank and others had to cancel their planned sales of yen-denominated bonds. This is rather grim, because the European banks are over-leveraged in comparison to the big US banks. Before I am accused of partisanship, read what the European economists have to say about it:
European banks face greater capital shortages than their U.S. counterparts, but have become too big for any one European country to save, according to an article published Saturday by European economists Daniel Gros and Stefano Micossi on the Centre for European Policy Studies’ Web site.
The “overall leverage ratio” - a measure of total assets to shareholder equity - of the average European bank is 35, compared with less than 20 for the largest U.S. banks, the economists say, and relatively small writedowns on their assets could have a devastating impact on a bank’s capital.
Daniel Gross, director of the Centre for European Policy Studies in Brussels, said euro-zone lenders are heavily exposed to the fall-out from the US credit crisis, describing the Paulson plan as a de facto rescue for the Euopean banking system.

It has emerged that French finance minster Christine Lagarde was one of those pleading with US Treasury Secretary Hank Paulson last week to bail out AIG, which had insured over $300bn of credit derivatives to European firms.

Mr Gross said Deutsche Bank deploys fifty times leverage and has liabilites of $2,000bn, equivalent to 80pc of Germany’s GDP. Fortis Bank has liabilities of 300pc of Belgian GDP. These dwarf the burden of any US bank on the US government balance sheet. He said EU states do not have the means to bail out these banks. Any rescue would have to come from the European Central Bank, yet it is not allowed to carry out bail-outs under the Maastricht Treaty law.
The war for money is entering the final stages. The crappy corporate debt in Europe is unbelievable, and the banks can't write it down properly.

If some sort of bailout plan isn't passed this weekend, it's very likely that one or more of the banks in Europe will roll over, and if one does, a bunch will.

So don't get petty about bailouts. There's no need to stuff money in Wall Street executive pockets, but the situation does warrant government infusions of capital.

I'm posting this after the European markets have closed. It's dire.

WaMu Fails, JPM Buys Deposits, Loans And QFC

Firesale, baby. FDIC press release:
On September 25, 2008, the banking operations of Washington Mutual, Inc - Washington Mutual Bank, Henderson, NV and Washington Mutual Bank, FSB, Park City, UT (Washington Mutual Bank) were sold in a transaction facilitated by the Office of Thrift Supervision (OTS) and the Federal Deposit Insurance Corporation (FDIC).
All deposit accounts and all loans have been transferred to JPMorgan Chase Bank, National Association, Columbus, Ohio (JPMorgan Chase Bank). All former Washington Mutual Bank will reopen for normal business hours as branches of JPMorgan Chase Bank.
JPM also bought the financial contracts according to FDIC:
In connection with the sale of assets of Washington Mutual Bank to JPMorgan Chase & Co., the FDIC transferred to JPMorgan Chase & Co., all Qualified Financial Contracts to which Washington Mutual Bank was a party. Qualified Financial Contracts include swaps, options, futures, forwards, repurchase agreements and any other Qualified Financial Contract as defined in 12 U.S.C. Section 1821(e)(8)(D).
So that tidies that up. But guess who gets left out in the cold? FDIC again:
JPMorgan Chase acquired the assets, assumed the qualified financial contracts and made a payment of $1.9 billion. Claims by equity, subordinated and senior debt holders were not acquired.

"WaMu's balance sheet and the payment paid by JPMorgan Chase allowed a transaction in which neither the uninsured depositors nor the insurance fund absorbed any losses," Bair said.

Washington Mutual Bank also has a subsidiary, Washington Mutual FSB, Park City, Utah. They have combined assets of $307 billion and total deposits of $188 billion.
Tell me more about covered bonds?

I am tremendously relieved that WaMu was wound up. This leaves the FDIC fund in much better shape than it could have been, and it is very good that the uninsured depositors were covered. WaMu is far and away the biggest US bank failure ever. TPG (the savior earlier this year) lost its investment entirely.

JPM Chase is now out in front on US deposits. JPM Chase said they valued the loan portfolio independently. We'll see. Chase wrote a bunch of unbelievably bad loans in Florida during the bubble, so they should have some expertise in the matter by now.

Both covered bonds and corporate debt are going south in Europe. I don't know what's going to happen there. Some of the corporate debt is really, really dicey:
The bonds have handed investors a 1.12 percent loss this month, the biggest decline since they tumbled 1.41 percent in June 1999, according to Merrill Lynch & Co.'s European Covered Bond Index. Investors are demanding the highest yields, or spreads, to buy the securities relative to government debt in almost eight years.
The spread on its $2 billion of 4.375 percent bonds due 2014 has surged to 678 basis points, from 26 basis points when the notes were sold in May 2007, according to Royal Bank of Scotland Group Plc prices on Bloomberg.

Even with the decline, investors are doing better than those holding European corporate securities. Investment-grade company debt in euros has lost 3.9 percent this month, the biggest decline since Merrill began compiling the daily data in 1999, while bonds of financial companies have lost 5.1 percent.

Wednesday, September 24, 2008

Creative Destruction Of Debt

I watched Bush's speech tonight. No text I can find to link to yet. It was a bad speech because it contradicted what both Paulson and Bernanke have been saying. The problem is that they are not telling the truth (Bush doesn't know that) about what they intend to do, and the average American is not so dumb as they think, and realizes that their overt statements about the plan don't make sense. Thus no support.

However, I think the real plan is what follows, and it can work provided we take equity in exchange for buying the assets. I like the Dodd plan in which the equity is gained if the assets are sold at a loss to Treasury.

Buy the debt tranches at current balance sheet values, most of which have been marked down at least 80%. Company gets money, treasury gets rights. Here's the kicker - securitizations have been sold mostly in tranches, so you have to get all extant tranches that have any value. Basically, you are going to aggregate the payment rights (securitized debts) back so that you end up pooling all the rights to payment of the underlying pool of loans. Now you effectively own the entire pool.

So, buy say at 80%. Now the taxpayer owns all or effectively all of the payment rights stemming from one pool, instead of a bunch of different institutions owning payment rights from one pool stemming from different tranches. Then deal with the underlying pool. It takes a lot of money to aggregate like this, but once you do you can do things with the underlying pool that you can't do otherwise. Now one player can give permission to violate the contractual provisions involved in the securitization, which, for example, may say that only a certain percent of the principal can be written down and so forth.

The moment you aggregate all the tranches on the pool, the collective value does go up. That is because when you calculate the value of the individual tranches, you have to figure various possibilities on payment streams to each tranche depending on your expectation for the entire pool. However, the entire pool will pay out only one way, so if one tranche is discounted by a certain set of circumstances, another tranche would in practice be upgraded. Obviously, when you are buying just one tranche, you can't assume that the possibility favorable to your tranche will happen, so you discount your individual tranche.

This mostly affects deeply tranched securitizations, and most of the Alt-A and subprime MBS are deeply tranched. If anyone doesn't understand this, I can explain further. It's a technical issue having to do with certain securitizations. The deeply tranched structure is supposed to support the value of the top tranches, but if there are significantly heavier than anticipated losses, the market value on the individual tranches, and thus the market value of all the individual tranches summed, will be below the expected aggregate return on all of the tranches over the pool lifetime. Thus if you have them all, your market value is higher than if they are owned by different parties.

When you have the rights of payment from the entire pool, you can add 4-5% on the value of the total tranches compared to buying them separately. .

Now you have acquired all the significant tranches at 80%, so you can instruct servicers to simply write down debt or write down interest payments. Say you have a bunch of loans with high DTIs - you can have the servicer adjust payments on the loans by writing down say 15-20% of principal or dropping interest rates to 4-5%. One rough sample:
Categories Principal Interest Periodic Rate Payment
Original $300,000.00 6.50% 0.54% -$1,896.20
Adjust Principal 80% $240,000.00 6.50% 0.54% -$1,516.96
Adjust Interest 70% $300,000.00 4.55% 0.38% -$1,528.98

Alright, so now you have some easy way out for the servicers. You authorize them to do such adjustments without letting the people go deeply into default as long as the borrowers are willing to provide income and asset information to qualify them for the new payment and as long as the borrowers are over their realistic DTIs with the old payment. Writing down the principal is a much better stability option, but it is hard to authorize under the terms of the current master servicing agreements unless the borrower has demonstrated that the borrower will default. If you own all the tranches, you can modify the master servicing agreement at will.

What you would get out of this are several benefits. First, if done well, after a year or two you should have improved the fundamental character of the pool. Second, you would have prevented quite a few foreclosures, and thus have avoided driving down the market value of the homes. Third, your borrowers are gaining some disposable income. If done widely, this could have a very good economic effect. The most important factors are cutting borrowers' debt payments to a more reasonable level and stopping foreclosures.

For the CC and auto securitizations, you can do the same. This actually would work; it would stimulate the economy directly, it would control rates of loss on housing, although housing will still go back to rational values supported by loan underwriting sufficient to verify that the borrower is expected to be able to pay the loan, and it would over time not result in huge losses on the Treasury deals.

If I were sure that this was the Paulson/Bernanke plan, I'd be for it (with the addition of the equity options to indemnify Treasury in the case of really bad debt).

Argument in favor of the proposition that it is the plan: 1) Up till now I have been able to closely predict the actions of the Bernanke Fed based on the strategy which I believe they are following. 2) Bernanke has written papers about the mechanism of deflation that make me think he would understand this. 3) Bernanke is strongly supporting the idea that this debt should be bought by the Fed. 4) We actually do know how to keep the loans from defaulting in such high numbers. Baird of the FDIC has been tramping the country pushing this idea for quite some time. However, in practice, it is not legally possible to execute the strategy when ownership of the payment rights on these pools is so diffused.

So I am tentatively favoring the plan, but I still want the equity options and oversight to make sure they are executed when necessary. I don't trust Paulson at all; this is a good theoretical plan that might in practice degenerate into a total FUBAR. Everyone will have more incentive to cooperate if the firms participating now realize that collective failure of the plan will cost them money later.

Tuesday, September 23, 2008

A New And Different Sort Of Treasury Auction

Bloomberg reports:
Federal Reserve Chairman Ben S. Bernanke said the Treasury Department should buy illiquid assets at ``hold-to-maturity'' values under its $700 billion rescue plan instead of at discounted ``fire-sale'' prices.
``I believe that under the Treasury program, auctions and other mechanisms could be designed that will give the market good information on what the hold-to-maturity price is for a large class of mortgage-related assets,'' Bernanke said. There are ``substantial benefits'' to buying assets at a cost close to the ``hold-to-maturity'' price, he said.

Analysts said Bernanke is essentially advocating that government use a pricing model that assumes that the debt will be paid in full over a long period of time.
But a lot of this paper is junk. I can see buying GSE bonds at holding values, but the problem with the rest of it is that the underlying loans are defaulting, and a lot of the bondholders ain't gonna get paid. I agree with the analysts, because the fire-sale price is the new hold-to-maturity price. I just don't agree with Bernanke.

How does one design an auction to render the "hold-to-maturity value"? Put in shills? Let people bid for it, and then go above the highest bidder?

This is why I advocate just advancing working capital and taking options convertible into stock in 5 to 10 years. Don't bother with this crap of buying debt. It's not illiquid. It's bad paper. And if the bank or company really isn't viable, then don't even bother fooling around with capital injections. Let it die.

You can't prop up the market for this stuff when homeowners are defaulting the way they are - and whatever we're seeing now is likely to trend a bit worse because of the weakening economy.

I guess I'm just going to crawl under the bed, assume the fetal position and suck my thumb for a while to enjoy the feeling of being in more adult company. This is starting to feel like I'm trapped in an SNL skit.

Another Runaround Day

I won't be posting until later.

Call your Congress Critters and insist on an equity stake in return for the purchased assets or extension of capital. Seriously, you do not want the government to just start handing around your money with no strings attached.

Global fundamentals are awful, with coordinated slides in basic economic stats in the big Asian countries, Europe and NA. Mixed in South America. So an injection of working capital is in the cards, but not FREE capital.

And would someone, anyone with a brain, gently take our two presidential candidates aside and explain to them that with a global recession assured, and major government interventions in many countries to prevent a global depression in the works, carbon cap and trade is suicidal? Please? Anyone?

Monday, September 22, 2008

Two IBs Apply For Bank Charter?

Goldman Sachs and Morgan Stanley:
The Wall Street that shaped the financial world for two decades ended last night, when Goldman Sachs Group Inc. and Morgan Stanley concluded there is no future in remaining investment banks now that investors have determined the model is broken.

The Federal Reserve's approval of their bid to become banks ends the ascendancy of the securities firms, 75 years after Congress separated them from deposit-taking lenders, and caps weeks of chaos that sent Lehman Brothers Holdings Inc. into bankruptcy and led to the rushed sale of Merrill Lynch & Co. to Bank of America Corp.
Well, that was approved quickly. Do they really have the required capital, or are they going to use the Paulson Bailout Fund to get it?

I don't approve of the Paulson Bailout Fund, because it imposes no haircut on those who are selling overvalued assets to the fund, and it gives control of all that money to essentially one person. Paulson has given no indication that he knows what he is doing. Less than none, really. The "Paulson Committee" repeatedly reviewed financial sector risks and hedge fund risks in the run-up to this debacle, and kept concluding that the problem was too much regulation. See, for example, this WSJ commentary on the 2006 Committee on Capital Markets Regulation report. There were international pushes to enhance hedge fund oversight, and he always kept insisting that he could put his fingers in the pie and pull out plums just as it was. Recently he came up with the idiotic covered bond mortgage plan, which will remain in my mind as one of the most clueless proposals of the last century.

Paulson is the last person who should have control over .7 T of the taxpayers' money.

Someone laughed at me over at CR's earlier this year when I said that in 2008, the auto and cc securitizations were going to bust, but:
Officials made the changes two days after unveiling plans for an unprecedented intervention in financial markets. The change to potentially allow purchases of instruments such as car loans, credit-card debt and other devalued assets may force an increase in the size of the package as the legislation proceeds through Congress.
No, this is not a good solution.

We do need some sort of intervention to support liquidity, so that new good loans to decent applicants can be made. That need not entail buying bad loans. It could, for example, come in the form of a government-backed funding pool from which banks could get low-interest loans for commercial lending and so forth, some temporary buying pool which imposed later costs on participants, and perhaps a suspension of mark-to-market for certain classes of debt assets, such as those currently paying. But just buying bad debt for no haircut is suicidal, and giving Paulson, who came out of GS, the free rein to do whatever he wants will create an opaque process with no checks and balances. Everyone - including me - will believe that Paulson is looking after the interests of a particular, small, group.

Also, any such intervention should include significant expansions of the budgets for the bank regulators, because over just the last month, the banking sector has aggregated the IBs. The bank regulators now have all those risks to oversee and not enough staff with which to do it.

The SEC really has been asleep at the switch. It allowed the massive leverage ratios which are killing the IBs off. So they don't need to have control over it.

If Congress decides to do this, it should give control over that .7 Trillion credit line to the FDIC. The FDIC is the agency that has the most experience in valuing and unwinding assets.

Update: CR thinks the same - that this plan is based on buying assets for far above rational value, thus effectively giving money directly to financial corporations. My theory is that if the government wants to recapitalize financial corporations, it needs to do so by taking convertible stock options with 5 and 10 year dates, and giving them the money, and then letting debt float on the market to find its own worth.

Thursday, September 18, 2008

We'll Guarantee Everything, Just Don't Stop The Music

We're going to insure money market funds, plus buy assets from institutions that haven't failed?

The Fed is buying agency and FHLB paper for its own account, plus extending non-recourse loans to depositories so they can buy the stuff. They say they will insure money-market funds. There is excellent coverage at Calculated Risk - see the TARP posts for a little dry humor.

For a short, succinct commentary on the situation, see UK Bubble's post:

Well, I suppose it all will get us to Monday. It's giving me a migraine. Another 20 minutes, another bailout proposal. It reminds me of a charity auction, with a really good auctioneer, in which everyone is convinced that the cause is righteous and the details don't matter. (The fallacy is that the ignored details have brought us to the point where charity is needed.)

China has announced initiatives to shore up its economy and equity market, including suspending stamp tax and government purchases of bank shares. Short summary. Some more detail.

I'm kind of worried about yen movements. India is feeling the heat; the financial meltdown should impact infotech revenues at the large software companies, and see this article on corporate advertising.

From the point of view of the real economy, what is important is sustaining the flow of credit to functioning companies. Stabilizing this mess in the short term is necessary. Letting the big financial companies eat up all the cash would be a dire mistake.

Note: On my explanatory post below, some of the comments were very good. Some were ridiculous. I also want to address the bizarre idea that CRA is the fundamental problem with US mortgages. I'll try to address the comments and the wacky CRA-as-Culprit meme when the Fed Juggling Show stops this weekend. Right now I feel both fascinated and dizzy.

But I will say that you can either swear undying fealty to the spinmeisters of one party or another, or you can have a stable economy. It's unfortunate that this is happening in a presidential election cycle, because of course politics tends to take over. But neither party can be assigned a disproportionate amount of responsibility for the total result because both have been involved deeply in mixing, baking and selling this lot of cupcakes.

Both parties must bear significant responsibility, and anyway, reforms will require addressing the causations, and in the process, the sacred cows of both parties are going to get gored.

We are going to have to put aside the demon/hero stuff if we want this to get better. Speaking of demons and heroes, I find it very interesting that Ranbaxy retained Giuliani to deal with its US-blocked imports. If I wanted to convince the FDA that my plants were up to spec that's not who I'd retain. Not that I want to mention anything about influence-trading, oh, no. Wouldn't do that.

A Cupful Of Water On A Burning Building

Reminder: That post I said I was writing about causation is below this one.

The much ballyhooed $180 billion swap facility extended by the Fed is a pittance, a few crumbs, a cupful of water thrown on a burning building. For comparison purposes, just look at this Wells Fargo page of summary statistics for 2006.

It was estimated that over $100 billion in loans by all entities were secured by businesses and property in Orange County, CA in 2006.

The UK move to ban shortselling financial shares will stem the pace of the slide, but that's about all:
The U.K.'s Financial Services Authority today banned short- selling of financial companies for the rest of the year and will require daily disclosure of all existing short positions in such firms when they exceed 0.25 percent. Three U.S. Securities and Exchange Commission rules that took effect today aim to reduce manipulative trades betting on a drop in share prices.
This is pure and simple global panic. The likely outcome are various pools of assets turned in for loans by governments and lending facilities by governments from those pools and the revenue. The only way to stem counterparty fears is to interpose a government-guaranteed entity to allow trading to resume.

For what it's worth, the recent movements in T-Bill yields show that the money markets are gone, frozen, locked tight, with recent 1 to 3 month bills having traded below 10 basis points (0.10%) for several days. The federal government is about the only financial entity that can raise money other than banks taking insured deposits.

The situation for businesses currently overloaded with debt, any type of businesses, is dire. A2/P2 nonfinancial overnight rates are still about 6%. See Fed publication:

A2/P2 (subprimey) nonfinancial credit is hanging out there in the stratosphere with the asset-backed.

Now what's going to happen to all those real world companies that need money?

Note that the blue curve (non-financial) has jacked up there in sync with the advance in production. According to these numbers, a bunch of retail outfits will go out of business or merge, and a bunch of production outfits will either go out of business or be forced to limit business activity due to funding crunches.

NACM's last few reports hinted as much, with the indications that payment streams had slowed. From the last report:
“Slow pay seems to be the biggest problem.” North noted that a manufacturer of valves and pipes reported, “Customers are looking for ways to slow payments.” A plastics producer replied, “We are having to exert more effort to get payment for receivables,” while a sheet metal firm reported, “We have some of the bigger customers attempting to extend terms.” North said, “On the flip side, international business seems strong, probably due to the weaker dollar, which makes U.S. goods more competitive abroad.” A food manufacturer responded that “international sales are increasing very fast,” a furniture manufacturer noted, ”Our sales are up on the international side,” while a producer of carpeting reported, “…sales to Latin and South America…have increased.”
“Providers of HVAC and electrical equipment services noted that they are seeing more NSF checks than ever before,” he said. Other survey responses that stood out include a supplier of transportation services that said, “Customers that have never been a problem are going beyond terms.” A repair service stated, “Many customers are expecting us to be their bank!” And reflecting on the “credit crunch,” a participant in the plastics industry reported, “We are seeing more companies close due to lack of bank funding.”
This is a classic credit crunch. As that blue line falls, the economy slides down. It's that simple.

How Did We Get Here?

See UK Bubble's current post on the topic:
So why are financial institutions collapsing so quickly? It is a lack of bank capital. Every prudent bank should keep a buffer to absorb losses. Roughly speaking, this buffer is the difference between total bank assets, which are basically loans, and total liabilities, which are deposits and loans from other financial institutions. Banks on both sides of the Atlantic minimized this difference; their capital. They reduced their buffer because holding capital meant reduced profits. Banks reduced their safety zone down to the absolute minimum. When the sub prime losses began to arrive, bank balance sheets could not cope. The buffer was too slim. This is one of the reasons why the Fed and the US treasury are finding it so hard to save Lehman. In principle, Lehman is on sale for $3.5 billion. Based on past valuations, this is a ridiculously low price. Yet why can’t Lehman find a buyer? Other banks simply don’t have the resources to pick up this bargain.
That's pretty much it.

The problem for the international financial system is not so much that US has dicey assets, but that these dicey assets are distributed across the world through most countries with decent or fast-growing economies. This is a global problem because there have been global bubbles, most specifically, global property bubbles. However, there has also been a commodity bubble, a number of equity bubbles, corporate debt bubbles, and the growth of thriving international markets in largely unregulated fields such as credit default swaps. Worse yet, property bubbles have dominated the big Asian players and several of the ME financial centers. While property bubbles have recurred across different markets throughout financial history, the global extent of the current property bubble is close to unique, and was partly fostered by an innovation known as....

The REIT structure (Real Estate Investment Trust) has huge tax advantages, but it requires distributing the bulk of your profits every year in most countries which have this structure. REITs aren't really allowed to hold sufficient reserves (to prevent tax evasion). Unfortunately, REIT structures have spread across large parts of the world, and encourage verticalization plus guarantee thin reserves. A good resource page on REITs. Note that Germany did not join (READ THIS LINK) the trend, and avoided an RE bubble. France was a late entrant, and thus is not facing a huge internal problem although it has some losses to bear.

REITs commoditize real estate, draw huge investment into real estate, and seem to create an atmosphere in which property bubbles blossom. One of the problems is that this creates correlations which are unfortunate in any easy-money environment, to say the least. While real estate values ought to be independent and local, large amounts of REIT investment tend to unify movements in property values across much larger areas and link property values to the overall investment climate and money flows. For example, you are likely to see a consistent sales trend by investors when stock markets go down, and a consistent buy-in by investors when stock markets go up. This is the last thing you ever want to create; unifying and correlating prices of different types of assets produces volatility in the financial system. Because the tax treatment of REITs is generally favorable, there has been an additional impetus for companies not to hold their own facilities, but to transfer ownership to REITs, use the capital, and lease the facilities back. This, in essence, strips some of the corporations of their last reserve position.

Systems of bank regulation vary across the globe. The most basic elements of bank regulation are enforcing required reserves and forcing correct reporting of assets and collateral valuation. Reserves, to be effective, should be risk-related. You can, for example, require your banks to keep 30% reserves, but that constrains the money supply and makes borrowing far more expensive. Limitations on bank-allowed activities and activities allowed to non-banks also vary widely around the world.

Locally, in the US:
Investment banks aren't real "banks" as we know them in the US, and the difference is important. US banks, credit unions and thrifts are regulated ( not always well) by one of the various agencies (FDIC, OCC, FRB, NCUA, OTS). Investment banks are non-bank financial institutions, and their primary regulation comes from the SEC and other exchange regulators. The SEC and exchange regulators do not have the same auditing structures nor mandates to control bank type risks, nor do they have the staff to do so.

For an example of the types of determinations and guidances made by US banking regulators, see the OCC's site which lists current issuances. Scroll down to about 2005 and look at the interagency guidances on things like complex structured finance (debt securitizations), appraisal standards, home-equity lending, non-traditional mortgages, and asset-backed commercial paper liquidity facilities. The strength of the examination-based system is that it looks at practices in situ and assesses risks as practices change. Its weakness is that it is largely reactive and depends on having enough examiners to examine practices as they change. In in an extremely fast-moving and complex environment there are a shortage of senior examiners who can assess and evaluate changing practices in a timely fashion. It's approximately a two-year cycle on most issues at best. Additionally, Congress has been limiting funding for bank regulators and so they were relatively short-staffed during the recent period.

To varying degrees, the bank, thrift and credit union regulators do go in, pull samplings of loans and deposits, and review loan portfolios for safety and soundness. FI examinations are really very comprehensive, but for going concerns every area doesn't get a thorough onceover every examination, and examination cycles may be more than one year. Further, the focus is not just on initial credit-granting programs, but on examining loss areas, which necessarily introduces another level of delay into the cycle. Examiners can and will beat an institution up for setting up new and innovative loan programs without adequate controls and risk assessments, but very often the real risks arise in implementation, so a program that looks decent up front blows up on the back end because of inadequate controls on underwriting, appraisal review, policy exceptions, etc. Loan assessments include risk of raised defaults, adequacy of loan loss reserves, and the risk of non-compliance with applicable regulations. However this applies to portfolios of held loans rather than complex structured debt (securitized loans) and equities (in the form of collateral, participation, or as capital), which are rated by....

NRSROs (Nationally Recognized Statistical Ratings Organizations) are an integral piece of the US regulatory structure. These firms have been granted determinative status by all the agencies. These non-governmental firms rate the debt quality for securities (such as mortgage and commercial mortgage bonds), corporate debt, etc. Until last year, all the NRSROs were paid by the firms issuing the securities, and there has in recent years been considerable competition for the business of the big players. It seems now demonstrated that this competition changed the results of the assessments. The agencies had not recognized any new NRSROs until last year, thus ensuring that a small group of private firms controlled risk ratings on trillions of dollars of financial assets. Let's just say that this was a recipe for disaster under certain circumstances, and go on to describe those circumstances.

When Gramm-Leach-Bliley was passed in 1999, the Glass-Steagall protections implemented to prevent a repeat of the Great Depression were largely repealed. See Wikipedia. One of the reasons Wall Street was pressing for the repeal of the Glass-Steagall protections was that other countries without the US financial regulations were getting a lot of business, and Wall Street argued with some passion and a lot of political cash that over time, the US economy was being disadvantaged by overly stringent regulation. It was true that money was flowing elsewhere, but recall that in the early 1990s the US economy was coming off a recession, and also recall that the US status as a reserve currency was largely the result of our stringent system of financial regulations. Also recall that Japan's asset bubble had already collapsed by the mid 1990s, and I think one could fairly argue that over time, the reverse of the IB arguments were true - the regulatory constraints in our financial system prevented soaring to the heights, but over time fostered a healthy economic climate and sustained growth. Some of the IB people are now willing to admit this contention. Greenspan refuses to even discuss it.

The distinction between activities allowed to banks and non-bank financial institutions was largely removed by the passage of GLB, and these institutions were allowed to conglomerate. Note that waivers granted by the Clinton administration earlier in the decade allowed evasion of Glass-Steagall, and GLB's passage essentially levelled the playing field as well as legalizing the 1998 merger that created Citigroup. ( The Clinton administration's role in creating the current situation is one of the reasons I considered Hillary's campaign truly an exercise in Boob Power. Not that the Republicans can escape blame, because a GOP-dominated Congress passed the legislation urged by the Clintons. )

The result was that overall regulation was reduced, the incentives to verticalize were massive, counterparty buffers were eliminated, and within less than 10 years, the financial system imbalances that produced the Great Depression in the US had returned.

Not only am I claiming that I know what caused the once-in-a-century event that Greenspan considers so random, but that it will recur very predictably if our regulatory system is not revamped.

My assertion is that if you create certain systems of incentives, human nature will reliably produce consistent and lunatic results. The system of incentives is:
A) Transportability (the belief that one can easily remove or transfer gains from one investment to a safe store in another investment),
B) Accurate short-term measures of gains, but no or very inaccurate long-term measures of gains,
C) Compensation for internal players on short-term measures of gains, paid in the short-term, and compensation high enough to overwhelm expectations of returns from on-going employment or investment,
D) A large consuming class of "outsiders" which are essentially unknowing but optimistic buyers of the end product of the investment-generating system.

A) is pretty obvious. Few people with other options would voluntarily dig for diamonds in a mine for low wages if they were searched every time they left the mine, and any diamonds found on their persons were confiscated. On the other hand, there are gold prospectors to this day in the US and in other places.

B) is less obvious. Our system of measuring profits, especially the profits of financial institutions that trade (investment banks rather than banks) is good at assessing returns on a quarterly basis, less effective at predicting returns on an annual basis, and horrible at predicting losses on a long-term basis, as numerous individuals who held large portions of stock in companies such as Thornburg Mortgage and Bear Stearns have now discovered.

C) is clear. The methods used to value financial assets are market-based, meaning that you tot up your losses or profit at the end of each valuation period based on the market value of what you have, what you exchanged, and any cash payments received at the end of the period. This is not true for banks. Because banks have assets (loans) and liabilities (borrowings in the form of loans from other institutions or deposits), banks are required to accrue ALLL (Allowance for Loan and Lease Losses). Thus there is a fundamentally different valuation process involved in market representations of loan portfolios held versus interests in financial assets of commoditized (securitized) securities backed by loans.

When you look at the gatekeepers of any system, you can intuitively assess risk by asking whether compensation rests on long-term performance or on short-term performance. Thus, a loan officer compensated in long-term stock vestings in his or her bank for reaching performance levels has a completely different set of interests than an individual mortgage broker who gets paid in YSP for each loan she writes. A loan officer who receives immediate and outright gifts of stock may have a large incentive to run it up for a few years, and then take his proceeds and run to another bank.

Needless to say, the people who set up all the non-bank mortgage companies were raking in the money, got the money immediately, and were able to transport (invest elsewhere) their gains. Within 5 years, many of these individuals racked up tens of millions of dollars in personal proceeds. The investment banks paid on levels that made many players wealthy within a few years. With such a compensation program, the incentive to ignore risk is monumental. Players are essentially paid to ignore risk. They do.

D) Maximizing your short-term returns with a blithe disregard for the longer term requires chumps and marks, and the chumps have been supplied by the globalized financial system abetted, in the US, by the NRSROs. Even though on most of the securities accurate financial filings reflected real risks, most investors (many of them institutional) relied on the ratings firms to make decisions about risk. For example, it can take several days to read through and analyze one set of MBS-related filings, and then additional days of research to evaluate counter-party risks. There just isn't time for most institutional investors. It is not that US debt issues are the only bad ones. The Spanish mortgage bonds are collapsing, the mortgages in the UK and Ireland are weak - the list goes on and on. But an atmosphere of heedless confidence is a prerequisite for bubbles, and we managed to generate that on a global scale. People are still ignoring the obvious in favor of the optimistic, such as recent pronouncements put out by some of the ME property developers touting their massive increase in population, without mentioning that most of the population increase comes in the form of foreign workers with no security, who are in many cases not even allowed to buy property.

For US persons, the concern has to remain the US. That is the part of the system we can control. Allowing financial institutions to conglomerate a la GLB creates a set of massive risks. If you are going to allow it, you have to restrict leverage ratios and pay a lot more for a vastly enhanced system of regulation with a vastly enhanced workforce of examiners. Restricting short-term vs long-term compensation is only one piece of a fix.

The primary reason for the enhanced risks to a financial system that involves vertical lines of production and conglomerated functions is that it destroys counterparty checks and balances. Here is a somewhat simple example using mortgages.

Old way:
Bank writes mortgages. It lays off portions of its larger commercial loans to other banks (participations), keeps some shorter-term and variable mortgages, plus home equities, and sells the other consumer mortgage loans either to GSEs or to larger institutions which then batch them and securitize them. When selling mortgages the bank often retains servicing rights on the mortgages.

In writing its mortgages, the bank employs:
- An independent appraisal staff. These appraisers are reviewed annually by the board to see if their loans have produced losses on default, and the approved appraiser list is checked against the lists provided by the mortgage buying entities. The appraisers know that, and know that their profitable relationship with the bank will be jeopardized if they overestimate valuations. Thus their incentive is to be conservative and protect the bank from loss. By doing so they are maintaining their business lines.
- Independent title companies. The title companies used are bonded, licensed and and insured. If there is a problem, they will end up covering it.
- Property insurance companies. The approved ones are state-licensed and examined. The incentive to the bank is just to make sure that they are covered and their risk of loss is controlled. Property insurance companies are also rated and approved by the entities buying the mortgages.
- Mortgage insurance, if required by the bank's loan risk assessment and/or the mortgage buyer. Again, these companies are reviewed by the major players, such as GSEs.

When the bank sells mortgages, it does so under a system of covenants and representations, which basically require the bank to take back loans that are not properly documented and evaluated. So, for example, if a loan defaults almost immediately after initiation, the bank is going to be stuck with it or get it back. Likewise, if the loan later defaults and loss review at the buyer turns up an erroneous original verifications of income, or bad DTIs, or misrepresentations of income, or a funky appraisal, the bank gets its bouncing baby back. If the buyer doesn't review on default but MI is involved, the mortgage insurance company does review.

Further, the fundamental structure of Fannie-type mortgage securities was the pass-through, in which Fannie bought back defaulted loans from the investment pool. The way this system evolved tended to maximize longevity of players and accountability of players. To preserve access to Fannie, one generally anted up when asked to do so. And the same was true for the title insurance company, etc. In general, it was a trust-based system with a lot of accountability for the end results. The aggregator (the GSE) took nearly full responsibility for the outcome and passed that responsibility back down the line.

In this system, the profit of each counterparty largely depends on meeting mutual commitments (sustaining line of business) plus controlling one's own risks. Management of risks is independent. If one of the companies becomes financially unstable, it will lose business rapidly and pose potential losses to the other parties, so company "certification", whether formal or informal, tends to take place at several levels. Adequate capitalization is one of the prerequisites for maintaining your business relationships. The system as a whole is much bigger than any one bank or company, so participants can fail or be shuffled off to pasture without rocking the entire system.

As it ended up in the GLB era of bright and shining financial innovation:
Investment bank buys holding company. Holding company owns a bank and a bunch of mortgage companies that are non-banks, an insurance company, a title firm, and an outfit that contracts for appraisals. In addition, IB wants to maximize profits, so it sets up a subprime servicing company of its own. IB will generate mortgages through this origination arm, plus securitize them, plus write interest rate swaps on the resulting securities. In order to get large enough pools of mortgages, the IB also buys from other such non-bank companies and banks. In order for the banks to get enough mortgages to sell, many of the banks do wholesale mortgages, buying loans from mortgage brokers to sell through to the aggregators.

Note that the IB gets profit from virtually every step in this process. When one leg of it fails, it can plausibly argue that it is merely moving money from one arm to another. Further, the eventual investment product does not truly protect the investors. Unlike the old-fashioned, non-innovative, Fannie pass-through mortgage bond, buyers of the resulting tranched bonds do accept the risk of default in most circumstances.

Access to capital under the old way (through GSEs) is accomplished by performing under your covenants and remaining solvent.

Access to capital under the new way is accomplished through plausible deniability. There are virtually no independent checkpoints - for example, mortgage insurance on this sort of pool is the exception rather than the norm. Because you are not actually getting rid of risks, the incentive to find out who done wrong is quite nonexistent in the captive portion of the business. Indeed, virtually the only independent checkpoint is the NRSRO who eventually gives your resulting mortgage bonds a credit rating.

When loans go bad that were purchased outside of the captive portion, they are passed back. In most cases, the banks who were doing wholesale mortgage ops then shove them back to the broker, who may or may not be able to cover the tariff. The broker is most likely effectively unsupervised and unregulated (brokers working for the GSEs are generally audited). There is a high correlation between mortgage fraud and default ratios and states with slim to none mortgage broker regulation.

If the loans don't default and result in a loss, no one ever checks for performance. There are no substantial audits. Until failure, there is no set of corrections working its way back down the system.

Throwing easy money on top of this type of structure is a recipe for a run-up and a crash. During the run-up phase, everyone is making money. Housing is appreciating (and so is commercial real estate). Sure, the underwriting quality tends to become worse every year, because there is no penalty for bad underwriting, good underwriting is expensive, and some goof is always going to cut standards and margins, thus forcing the other competitors to either sacrifice profit or standards. And the goof who cuts underwriting cuts expenses, and provides a better profit to the aggregator, so that goof gains business.

Yet no one's going to detect the fraud, because although maybe DTIs are too high and people can't pay their mortgages, yet the easy refi or sale for profit is always out there. The investors get paid, the IB gets big bucks, the NRSRO makes easy, large chunks of money, and the realtors are very, very happy. All of these people manage to maintain high levels of campaign donations to local, state and federal politicos, so the Congress Critters are very happy. The Congress Critters also like their cheap loans, and those cute and profitable real estate deals in which they just happen to be offered silent partnerships.

The only people who really see what's happening are the old-fashioned people working in underwriting. Many of them try to fight it. Most of them end up out of the business.

Here it is worth noting that in 2002 thousands and thousands of appraisers petitioned the FFIEC to control appraisal fraud originated from the contracting (loan originating) party. Here is one signer's comment:
10680. RENE C. CHIRINO 7760 W 20TH AVENUE #6 HIALEAH, FL 33016
CW is CountryWide. You can see how the honest brokers and appraisers got forced out. Many brokers attempted to contact federal and state authorities to warn of the problems in the mortgage market.

By 2005, the better part of the prospective buyer's market had already been vacuumed up. At this point, the universe of brokers, realtors, agents, appraisers had been skewed to the new, ignorant, criminal or just reckless, and the IBs accelerated their drive to buy originators and related companies. In 2006, loans started defaulting in the first and second month, but the IBs still didn't pull back. Instead they blithely started sending the loans back down the line for indemnity, or writing meaningless covenants into their broker contracts to sustain plausible deniability. In 2007, the originators started going bankrupt because they didn't have the assets to cover their losses.

At the worst point, Fannie's share of the overall mortgage market had dropped to about 25%. Inevitably, the GSEs loosened their guidelines. By late 2006 and through much of 2007, Congress was pressuring the GSEs to buy and guarantee the non-GSE MBS. They did buy and guarantee a lot of it, and much of their losses are coming from that portion of their business. Then Congress pressured the GSEs to buy jumbos. Then Congress passed laws cutting the required capital reserves of the GSEs. Now you own the GSEs.

So that's the story. No politician has an incentive to tell the truth about this. Both parties were deeply involved.

Further, I must note that other types of financial operations were experiencing the same sea change. From LBOs (Leveraged Buy Outs) that saddled companies with debt which nearly ensured their demise, to commercial mortgages that appeared to rely on future income streams derived from an alternate universe in which profits always go up, to junky corporate debt, historical standards of risk assessment were simply dumped in the trash.

The NRSROs (credit rating firms) were a big part of the entire process. The truth is so incendiary that their role has barely been publicly discussed. However, there were early warnings on the NRSRO situation as well (Enron, for example) and part of the 2002 Sarbanes-Oxley legislation was a mandate to SEC to buck up and start engendering more competition in that business. It did not happen. The SEC just started adding new NRSROs such as Egan-Jones and R&I.

I end this post by appending two texts from AEI.
AEI, Sept, 1998:
Statement No. 149

For Information Contact:

Charles W. Calomiris
(212) 854-8748

In November 1997, the Federal Financial Institutions Examination Council (FFIEC) released for comment a proposal to use private agencies’ credit ratings to set capital requirements for securitizated loans. The Committee opposes linking capital requirements to ratings. As the Committee has noted (Statement No. 81, February 1992), micromanagement of capital standards by setting arbitrary rules for measuring risk, or by passing the buck of risk measurement to ratings agencies, is no substitute for a regulatory process that encourages banks and bank debtholders to measure risk exposures properly by forcing them to bear the consequences of underestimating risk. The FFIEC proposal represents another example of dysfunctional regulatory micromanagement.

The use of private ratings to measure credit risk for purposes of establishing banks’ capital requirements is fraught with potential for abuse. Ratings traditionally have been issued as a service to investors. Consequently, private ratings agencies that overestimate a security’s credit quality place their reputations at risk with investors. Thus private agencies’ ratings are often reliable indicators of credit risk. But, when ratings are rendered to and paid for by bankers only for regulatory purposes, there is a risk that the ratings agencies will engage in a "race to the bottom," competing for fees earned for overestimating the credit quality of issuers.

The problem arises because ratings are used to reduce the capital ratios required of institutions that enjoy the protection of government safety nets. Potential abuse is greatest in closely held, non-publicly traded securitizations, where the penalties imposed by outside investors on ratings agencies that exaggerate credit quality would be negligible. Under the proposal, the benefits to originators from obtaining exaggerated ratings are large. For example, in some cases an exaggeration that elevates AA securities to AAA, and BB securities to BBB, would result in a near halving of currently required capital.

Other approaches to linking asset risk and bank capital are superior to the FFIEC proposal. Those alternatives include reliance on market discipline to encourage appropriate combinations of capital and asset risk by insured institutions (e.g., subordinated debt requirements).

AEI, Dec 2002:
Statement No.183

For Information Contact:

Franklin R. Edwards
(212) 854-4202
Paul M. Horvitz
(713) 743-4765

During recent years the effectiveness of credit-rating firms has come under attack from bondholders and the Congress because of a failure to predict more accurately the financial decline and ultimate insolvency of Enron and other high-profile firms. As a consequence, Congress in the Sarbanes-Oxley Act of 2002 directed the Securities and Exchange Commission (SEC) to study the credit ratings industry to determine if changes can be made that will improve the "role and function of the credit rating industry in the operation of the securities markets." As part of this study the SEC is directed to examine "any barriers to entry into the business of acting as a credit rating agency, . . ." (sec. 702(a)(2)(D)). The SEC is now in the process of reviewing the standards it uses for designating credit rating firms to determine if changes in these standards can be made that would improve the operation and efficiency of this industry.

The SEC adopted standards for designating credit rating firms in 1975 when it began to rely on the use of credit ratings issued by nationally recognized statistical rating organizations (NRSROs) in its rule 15c3-1 (the "Net Capital Rule") for brokers and dealers as an indicator of a security's liquidity. Since that time the use of NRSRO ratings in federal and state securities laws and regulations has expanded dramatically, as has reliance on those ratings by investors and the marketplace for determining the creditworthiness of debt securities. However, the term "NRSRO" remains undefined in SEC regulations, whether under the Net Capital Rule or elsewhere (such as the purchase criteria for money market mutual funds under rule 2a-7 of the Investment Company Act), as has the process for obtaining NRSRO designation from the SEC.

Currently the SEC reviews the qualifications of applicant credit rating firms to determine if they meet the criteria for becoming an NRSRO. In making its determination the SEC considers a number of criteria, including whether the rating organization is "nationally recognized," or is recognized in the United States as an issuer of credible and reliable ratings by the predominant users of securities markets. In addition, the SEC considers the operational capacity and reliability of the applicant--specifically, the firm's organization structure and financial resources, the size and quality of its staff, its independence from the companies it rates, its rating procedures, and whether the firm has internal procedures to prevent the misuse of nonpublic information and whether those procedures are followed.

Since 1975 there has been very little entry into the credit rating industry. At that time the SEC "grandfathered" Moody's, S&P, and Fitch. Subsequently, it designated as NRSROs Duff & Phelps in 1982 and McCarthy, Crisanti & Maffei in 1983, and IBCA in 1991 and Thomson Bank Watch in 1992 as NRSROs for banks and financial institutions. The SEC has not granted NRSRO status to any new entity since, despite several applications. Today, due to a series of mergers and acquisitions by Fitch, there are only three bond rating firms in the United States: Moody's, Standard & Poors (S&P), and Fitch. Moody's is a freestanding company specializing in rating activities; S&P is owned by McGraw-Hill which provides a variety of financial services; and Fitch is owned by FIMALAC, a large French company.

The Shadow Financial Regulatory Committee (SFRC) believes that the SEC should revise its certification standards to permit other qualified firms to become NSROs. In particular, the SEC's "national recognition" criterion is too exclusionary and has little to do with the ability of a new rating firm or an established foreign rating firm to provide informative and reliable credit ratings. Indeed, a "national recognition" criterion is a Catch 22--a firm cannot become an NRSRO unless it already is an NRSRO. The SEC should propose regulations that make explicit its criteria for designating and monitoring NRSROs and these criteria should have as their focus the ability of rating firms to provide credible and accurate credit ratings. A "national recognition" standard should not be part of these criteria.

Permitting more qualified rating firms to compete for the business of rating securities can be expected to lower the cost to issuers and investors. In addition, a more competitive rating industry should make rating firms more responsive to changes in the marketplace and over time should result in a more innovative credit rating industry.

While the SFRC considered the possibility of eliminating all impediments to entry into the credit rating industry, and in particular eliminating all SEC certification requirements for credit rating firms, the Committee believes that so long as the SEC (and other regulatory bodies) continue to rely on credit ratings as part of their safety-and-soundness regulatory apparatus, it will be necessary to have a process for certifying the quality of firms doing the rating. At some point, however, we may want to review this regulatory process.

Finally, critics of a more open credit rating industry argue that more competition may reduce the quality of credit ratings as credit rating firms compete to obtain additional business by providing more favorable ratings to issuers, especially since credit rating firms are typically paid by the issuers of the securities that they are rating. The Committee believes that this is unlikely. Firms that have been certified by the SEC will presumably have substantial "reputational capital" that they will not want to depreciate by diluting the quality of their ratings. Further, the SEC will still have the power to withdraw a credit rating firm's NRSRO designation if it determines that the firm no longer meets the certification requirements.

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