Part One
WE ALREADY HAD A 'SUBPRIME' MORTGAGE CRISIS, THIS IS THE SECOND IN A ROW
In his recent op-ed, Paul Krugman wonders aloud about our "Ponzi era", about how we all could have not noticed, basically, about financial services in general. He concludes, in essence, that we lived an era of post hoc, ergo propter hoc, regarding those looking the part in money management. {But read the comments section for the good stuff}
Many others, including the ever-readable Martin Wolf, have looked in detail at how "we" missed it, how the latest junk-credits from Wall Street went undetected until it was too late.
Greenspan himself has indicated that he relied on the collective wisdom of market participants, ending up shocked that they failed to secure the (long-term?) interests of shareholders.
For my own part, I initially underestimated what would become the full scope of the problem. I think it is because I didn't imagine that Green Tree Financial had left the collective conscience.
REMEMBER GREEN TREE FINANCIAL?
Well apparently, not too many people do. I remember it vividly, however.
Did the quantitative people in the departments at the ratings agencies (Moody's, S&P) have more than a degree? Did someone from the "real" credit area take an elevator down to look over the shoulder of their proverbial CDO Queen? Was there a risk-policy committee? God knows, the implication of Green Tree made it to the radar screen of leading economists (and, as best I recall, Greenspan's purview. Update: yes, see here).
There should be more hearings, right?
Anyway, here is the story of Green Tree Financial and the manufactured housing bust.
I've pulled some quotes, that make it rather plain just how much it looks like the very same sub-prime crisis that eventually grew to $700-1,800 billion.
The question becomes, how did we have two sub-prime crises in a row, in rapid succession, even?
A Boom Built Upon Sand, Gone BustFrom 1991 to 1998, annual sales of manufactured homes more than doubled, to 374,000 from 174,000.
One company, one man and one accounting rule drove that growth.
The rule, a rarely used accounting convention called ''gain on sale,'' encouraged Green Tree to make as many loans as possible and allowed it to report more than $2 billion in profits that never existed.In their rush to lend, Green Tree and its rivals made loans to borrowers who had little chance of paying them back. Tens of thousands of those people have already defaulted and have been evicted. Conseco alone has repossessed 25,000 homes so far this year, after a record 28,466 in 2000. By the time the industry's hangover ends later this decade, hundreds of thousands more low-income borrowers will lose their homes. They will wind up with huge debts and ruined credit because their homes are worth far less than what they owe.
Securitization provided Green Tree with ready access to capital from the bond buyers, and that enabled it to finance as many loans as it wanted. At the same time, gain-on-sale accounting allowed Green Tree to record income from every loan that it made.
On April 28, 2000, with the company's shares at $5.63, Mr. Hilbert quit. He received a $72 million severance package, including the right to use Conseco's private jet up to 20 times a year. All told, Mr. Hilbert's pay from 1993 to 2000 was $530 million.
Mr. Coss did not do quite as well. His pay, tied to Green Tree's reported profits, totaled about $200 million from 1993 to 1998, including a $30 million severance package.
More references:
April, 19998:
April, 2000:
[This one reads like a bad omen for the Bank America and Merrill "merger", yes?]
December, 2002:
It was a good time to be in "fixed" income in mortgages at Merrill:
A peek at what may show up on the 'expenses deed' of a CDO:
Merrill Lynch collected about $5 million in fees for concocting Costa Bella, which included mortgages originated by First Franklin.
POLICY AT POINT OF MAXIMUM DEPARTURE - FLAPS AT FULL
0.0% to 0.25% as a target for funds, discount rate down to 0.5% and "excess" reserves at 0.25%
There is a case that zero is not a good rate of interest.
Dividend and credit rates are overwhelmingly attractive now.
[Remember the summertime and the ideologues who were issuing statements that the Fed needed to fight inflation? How ridiculous was that, in hindsight...]
THE RETURN OF THE CARRY TRADE - WE'RE ALL ON THE DOLLAR NOW?
The cost of hedging yen is nearly zero. The Euro is probably not far behind.
That means there is a huge reservoir of liquidity available for sensible risk, credit or otherwise.
Based on data from the NYSE, Cramer said today that bank stocks had been the subject of a classic "bear raid", focusing his criticism on the repeal of the up-tick rule and ... the SEC (?).
No word on naked shorts. The figures appear to reflect just intra-day trading volume.
Well, the day hasn't begun, but here it is:
What card issuers have really cared about for a very long time is _raising_ credit limits to boost throughput so they could pinch off more dough from the financial system. Yes, the _financial system_, which was the real customer for card issuers. We card holders are just hazel stumps to be coppiced and sold as wands for the magicians of finance.
-Commentor, Naked Capitalist
"Level III" Crisis
Fed goes to DEFCON 5, as ... a big firm disappears with few knowing exactly why, other than that there was no will to save it.
(chart via Alea):
NEGATIVE NOMINAL RATES ON US T-BILLS
The most notable historical market for this past week was that t-bill auction brought negative yields.
I'd bet that is the second time in U.S. history that there has been a negative nominal yield.
Last week's very small backwardation in the gold market got explained as sticky lease rates.
Didn't want to miss this one, since we get a new record (or two!) almost every week now:
Dec 3rd, FT
The Markit iTraxx Crossover index rose above 1,000 basis points for the first time since it was created in 2004, ...The index, composed of 50 mostly junk-rated companies in Europe, rose 60 basis points to highs of about 1,020bp, according to Markit, the data provider.
It was trading at about 700bp, or a cost of €700,000 to insure €10m of debt annually against default over five years, on November 1. Before the credit crunch it was below 200bp.
The Super Contango is now a Giant Super Contango.
Prices here.
(I don't want to be around when this rubber band snaps.)
INABILITY TO ISOLATE "THE PROBLEMS" LEADS TO RADICAL DOUBT
If you want a qausi-seminal piece that will challenge you in every direction, have a look, maybe, at the Sam Jones bit in the Alpahville about Synthetic CDOs and, by incorporation, the pieces by Felix Salmon and Alan Kohler.
It doesn't aspire to be "seminal", but it juxtaposes market structure with technological understanding, for example,
For the monolines and insurers, this wouldn’t have been such a dreadful problem had they not also invested in the underlying notes of many CDO structures: a move that led to the rating agencies downgrading them, and thus exposing them to collateral calls on their billions of leveraged super-senior swaps.
Citi’s dalliance with LSS conduits and the commercial paper markets was equally catastrophic. In the summer of 2007, it caused the collapse of several large conduits in Canada. That in turn precipitated a global buyers strike in asset-backed CP. Which spread, in turn, to a buyers strike of all financial CP. Thus ratcheting up the threat of banking collapses, and indeed, leading directly to them, in Germany, and in the UK (Northern Rock).This goes well beyond the ongoing talky-talk about originate-to-distribute market structure.
This new ABS lending program from the Treasury/Fed is quite a powerful construct, providing 'levered financing' to the market. Woo-hoo!
This term-financing for up to a year for a variety of initial asset types, subject to a (one-year?) price-volatility haircut. The collateral must be "AAA", highest quality. In addition to the price/market-risk haircut, the Treasury then backstops the Fed with an equity pool, for the credit risk.
Two things I don't like, based on a quick first-read.
- 'AAA' may not be the part of the market that needs the most help. I'd like to see a broader range of collateral. All qualities may need help, to the extent the market is shut down, but still.
- The Treasury ought not to be the one managing the collateral, unless it intends to immediately enter into a forward purchase agreement with someone in the marketplace (and take a residual risk to lubricate the deal, maybe).
The Fed using it's balance sheet during crisis is just fine. However, with this latest construct, the Government looks like it is too much both the supply and the demand for funds. Of course, it's just $200 billion, so no need to wring hands over it, either.
"Dual-action" may be fine to address a blip in a market or smooth things over, in a market that isn't huge. It may even be a powerful "can-do" in a near deflationary environment.
But, on face, it doesn't seem a sound recipe for the long-term or for much larger asset classes, like commercial real-estate or private-label RMBS (nor does 1-yr term financing, given the duration of the underlying collateral of those instruments)
INKLINGS FOR HIGHER DIVIDEND TAXES AND FOR HIGHER TOP-RATES
After hearing two-step commentators plugging interviewees incessently with "won't new taxes be bad for the economy?", I did some lookup (apart from whether that implied a dissolution of the Pigou Club should be imminent).
In 1932, Hoover and the congress raised taxes on everyone AND expanded the tax rolls, even though they made the rates more progressive.
Obama's plan is to cut taxes in the lower brackets and to raise them in the top. I suspect one could make a strong case for that, during a severe downturn. Although not accurate, one could think of it like a wage compression for high-income wage-earners. As if on cue, events have actually accommodated Obama's plan. (During the primaries, I found his rate cuts fiscally irresponsible ...).
Camp Obama has already addressed any impact on small business income, by proposing credits for business owners who continue to invest in their business, by hiring new employees. This could strengthen already good businesses, rather than prop up weaker ones.
DIVIDEND DIS-INCENTIVES
Although it makes good theoretical sense to parallel capital gains rates with dividend tax rates, it may make sense to raise the capital gains tax rate to 20% and the dividend tax rate to something higher (25%?), temporarily. This will provide a disincentive for firms to pay dividends, for a time.
I don't have the figure, but I suspect that the marginal propensity to consume dividend income is a lot less than would be worrisome.
Finally, resetting the cap-gains rate now, while market valuations are low, could arguably offer a "catch-up" for the period in which tax-rates were set too low, leading to the fiscal imbalances during the Bush years, even if those deficits were not related to the lowering of the cap-g rate in the first place.
Here is an interesting assessment from someone who lived through the Great Depression, with a privileged point of view:
"Marriner S. Eccles, was the Chairman of the Federal Reserve from 1934 1948
In his 1951 memoir Beckoning Frontiers, Eccles detailed what he believed caused the Great Depression.
...
Eccles wrote:“As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth — not of existing wealth, but of wealth as it is currently produced — to provide men with buying power equal to the amount of goods and services offered by the nations economic machinery.
Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.
Which may just be a long way to suggest that a touch of redistribution ...
HOW A CREDIT 'WORK-SLOWDOWN' HAS CREATED ITS OWN PROBLEMS AT GM
More evidence of how credit-card and auto-finance lenders are creating the conditions that they fear the most, more than a mild recession, piled in today, as GM revealed that its auto sales were falling like a stone under the weight of it's non-finance "finance arm", owned by Cerberus-R-Us, who cut off the flow of credit a wile back, including leases.
GMAC said on Monday [Oct 13th] it would only lend to consumers with a credit score of 700 or above. Combined with an earlier decision to curtail leasing, that could cut GM's U.S. market share by up to 2.5 percentage points in 2009, Amaturo said.
GMAC, 51 percent owned by Cerberus Capital Management which also owns Chrysler LLC, financed 43 percent of GM's vehicle sales in the second quarter
HONG KONG LIVES!
Hong Kong has some notoriety for its property booms and busts, just have a look at the chart, to refresh your memory.
While changes in home prices are scary on the way down, you'll notice that Hong Kong lives. Better than that, they thrive (the stock market is up).
Not everything is the same or parallel (HK's market has some unique structural quirks), but ... you cannot help but wonder if 50 years of rising prices in the U.S. has created an unusually soft psyche on the issue of the resilience of economies in the face of price swings and the value of real-estate, in the long run.
These violent price swings are typical of Hong Kong. The property bubble before the handover saw prices rise 70% (54% in real terms) from Oct 1995 to 1997. Then there was a traumatic burst, coinciding with the Asian Crisis, and property prices fell 44% in one year (Oct 1997 to 1998). From the peak to the mid-2003 trough, prices fell 66% in nominal terms (61% in real terms).
AIG DETAILS
Just when you thought your jaw couldn't drop to the floor, again, this year, you learn something new.
AIG lost $18 billion - billion - in its securities lending business. (h/t Felix Salmon)
Now, I'm out of it, but securities lending used to be one of those super-great, side businesses that turned an "extra" 2-5% a year, at almost no risk required.
So, to have lost $18 billion ... well, one just has to stagger back. 'Securities lending' must have been a euphemism for Casino Royal. Although this bit of information is in no way conclusive, it raises the prospect, not of some bets gone wrong, but of an almost abject loss of internal controls.Of the two big Fed loans, the smaller one, the $38 billion supplementary lending facility, was extended solely to prevent further losses in the securities-lending business. So far, $18 billion has been drawn down for that purpose.
For securities lending, an institution with a long time horizon makes extra money by lending out securities to shorter-term borrowers. The borrowers are often hedge funds setting up short trades, betting a stock’s price will fall. They typically give A.I.G. cash or cashlike instruments in return. Then, while A.I.G. waits for the borrowers to bring back the securities, it invests the money.
In the last few months, borrowers came back for their money, and A.I.G. did not have enough to repay them because of market losses on its investments. Through the secondary lending facility, the insurer is now sending those investments to the Fed, and getting cash in turn to repay customers.
Gas crack spreads go negative.
Very rare (I doubt it is a first, though).
Valero, however, is zooming (up 25% in the past 5 days) on relief in the the broader backdrop of their position in the industry, I'd hazard.
The post-mortem on Porsche's VW coup-extraordinaire continues:
According to reports the big trade that caught out the hedge funds was actually shorting ordinary shares versus preferred. As Bloomberg reports, the trade failed when ordinary shares effectively controlled by Porsche sky-rocketted and the differential between the two widened the wrong way - the pref falling some 14 per cent on Tuesday.
FEAR NOT
The good folks over at Calculate Risk have two scary looking calculations, related to negative home equity.
Two pieces out today, outlining a topic near and dear to this blog's screed: policy response that anticipates knowing what you do not know (as a modus of action, not a paralytic).
The sad part is that at lot of the "unkowns" are "known unkowns", at least to those who have a grasp of financial markets structure and modern financial instruments. That is, 'the collective' is smart enough today, there is enough expertise mucking about, that we know the data that we need, for decision and risk mitigation (even crisis risk mitigation). For some reason, that data is either behind closed doors or no one is (or has been) gathering it, in a systematic fashion. What's more, the people looking at it *may* not know how to interpret it, have events moving so fast they haven't the time to stop and 'think it over', or have actually reached the wrong conclusions, for any number of reasons, some good (poor but reasonable inference), some not (ideological).
Greg Mankiw: But Have We Learned Enough? (NYT) As always, Greg does an excellent job explaining things (in my no-count estimation, that is). He slips when he goes for the NLRB, while mentioning housing, yet skips the Home Loan Board. via Blodget, They Didn't See the Great Depression Coming, Either.
TWO, GREAT UNCERTAINTIES TO HAVE BEEN WRESTLED DOWN IN THE EARLY DAYS
The foundations of the current panic are rooted in two great uncertainties: the value of home collateral backing assets and the overall asset quality of major bank's balance sheets.
The first was laid bare last year, as a threat to financial institutions, against the backdrop of rising policy rates.
The impact of the first uncertainty on the second has been greatly misjudged. Policy makers - and others - failed to understand early on the caustic market impact that the unkown scope of the problems would create, the risk-aversion that would result. At the same time, estimates of the impact ranged from the modest ($100-$200 billion, losses on subprime issuance) to the fantastic (Nouriel Roubini, et. al.), with no systematic data or regulatory voice with enough authority to ... adjudicate those figures or their systemic ... implications (i.e. how the distribution of the risk was spread throughout the interlocking system).
The propagation of the panic occured when the small, but meaningful, steps taken to quell the initial faultline ... stopped working. Managements, who had just raised modest amounts of capital, assured investors (and regulators?) that asset quality was 'manageable', and then went bust, bankrupt, with vague explanations, like, "a run on the bank". Regulators were unable (or unwilling) to mitigate these steps in the chain, lacking central authority and a generalized, systematic plan for the both the scope and the individual asset classes at the root of the problem. Although they did prevent AIG's massive book of derivatives from a bankruptcy, the resulting mixed record has only mitigated, but not quelled, the two main uncertainties. Why? Well, it is in part because that record has also raised questions about the Treasury/Reserve's ability to continue to quell The Great Unkowns. The Fed usually wins such Titan clashes, but it's hard to "bring that to the bank", this time (pun intended).
Of course, once you unleash the hounds of war, so to speak, the Pandora's box is open. People are free to let their imaginations wander, to discount every impending crisis, to indulge in "doom" (and profit from it). What's important analytically is not to confuse these imaginings with the two principle uncertainties, at least in the early part of the crisis. (Later on, it is a multi-front war, arguably).
A JOURNEY OF 1,000 STEPS, BEGINS ...
Now, "the system" has already been through one "feedback step" of a loop - the outcome of the first step is now the input to the next, by my reckoning only (there is always Hope that I'm wrong). Authorities have used all their conventional tools, almost to the maximum, but have failed to come up with a plan, yet, to deal decisively with the two uncertainties.
There are many paths to dealing with uncertainty. Standing by - standing by - with a bucket of taxpayer capital to throw around generically when 'the system' migrates to the next phase seems like a poor choice, whether or not it eventually works.
On the other hand, amounts can be tallied and made known, alongside plans to reduce leverage and risk through systemic unwinds, particularly of certain derivatives and leveraged spread risks. One of the key tools of the USG, its guarantee and its long-term holding period, can be used at the margin, to provide a stochastic floor under the value of home collateral, to directly reduce uncertainty. This may prove costly, in the short and mid-term, but it is sure-footed.
I'm sure there are plenty of other proposals to weigh and consider. It's easy enough to figure out whether they will 'work' to address the two large uncertainties.
THE NEXT STEP?
A general fiscal stimulus is not sufficient to either of the primary uncertainties. Although it may smooth-over the eventual, realized risks, it does almost nothing ex-ante to reduce the uncertainties in any quantifiable way.
The best way to think about the fiscal stimulus, therefore, might be as dealing with the ... er, "choppy outcome" of the first step (unless we are fortunate, yet, that it reverses, even to a large degree).
Given that the scope and size of the problems remain ... unquantified and not decisively mitigated, going into part two, "stimulus" ought to focus on the long-term and on structural advances that raise the expectation, not of reflation (even in the mid-term), but of long-term variables, such as productivity, efficiency, and future capital availability.
CAN G-7 MINISTERS GET AHEAD OF THE CURVE?
I have to say that this note is worrisome, because I do not understand why these fully synthetic structures have not been "targeted" to be unwound, dismantled. Perhaps no one has the legal right to initiate the process by which the structure is terminated?
Whatever the case, there is no cash asset tied up in these structures, legally (they are built on reference only to other instruments). To me, that means that they can and ought to be unwound. Maybe a lot of them have been ...
The prospect that regulators would let a multi-billion dollar, off balance-sheet, Damocles sword hang over the capital of banks, in a way that is now an obvious, self-fulfilling danger is ludicrous. They should act and act soon. This is a kind of low-hanging deleveraging, right?
If there is more to dismantling the synthetic mountain of cards than just calculating the net NPV required to 'unwind' the "legs" of the trade, please let me know. Otherwise, the right people have to get on the phone and these particular assets ... need to end, for a time, I think. (That's quite a lot different than "nuking" all CDS contracts, etc.).
SYNTHETIC CDO
