Passbook Savings: a Cure for the Banking and Real Estate Crisis

Just like hemlines, banking practices change with the times. Downpayments have come back into fashion, much to the consternation of credit lovers everywhere, who thought themselves the vanguard of the cashless society. Would-be home buyers find themselves scrambling for something to put on the barrelhead. Personal finance writers have suggested that they borrow from retirement accounts or life insurance policies, or through margin loans collateralized by their stocks and bonds. Other suggestions include finding out if your employer has a program to assist employees to buy homes, or making a withdrawal from the First National Bank of Parental Munificence. The one thing that gets little or no attention is the simplest way of all to put together a downpayment: clamp down on spending and build up savings.

Reading this advice, one senses little movement up the learning up. The subprime mess, and the credit crunch and banking crisis that ensued, are the product of a 60-year expansion in the availability of consumer credit. Almost unheard of before World War II, 30-year mortgages became readily available for returning GIs. The 20% downpayment typically required until the 1980s was a sharp departure from the 50% downpayment usually needed in the 1930s and before. Credit cards , an innovation that came to fruition in the 1950s, allowed just about anyone to sign chits, formerly the reserve of the wealthy at their exclusive clubs. Levels of household debt grew ever larger, and downpayments required for home mortgages and car loans grew ever smaller. Government policy encouraged and facilitated borrowing, with deductions for mortgage interest (and, for a while, even interest on personal debts like credit cards), and sponsorship of entities like Fannie Mae and Freddie Mac to create a secondary mortgage market.

The growth of the credit monster reached its high water mark in the last few years, with the emergence of the no doc, no downpayment, option to defer repayment mortgage. What a wonderful innovation! Your aspirations, your dreams didn't need to be limited by your educational attainments, career choices, income or net worth. You simply sat down with a mortgage broker, shuffled some papers around, and ended up with much to boast about at cocktail parties.

We're now in the processing of learning how the story ends. Like all no free lunch stories, the denouement is that there is no such thing as a free lunch. Lenders have a bad habit of expecting repayment. You don't enhance your lifestyle by borrowing. All you do is frontload it. You're able to consume more sooner. But your consumption later in life is constrained by the fact that you have loan repayments to make. (Think about your student loans if you don't believe this point.)

The subprime mess stems in part from the fact that the borrowers simply didn't have adequate financial resources for traditional (i.e., prudent) loans, and therefore resorted to teaser rate, no downpayment, option ARM loans. Whether they had moderate incomes and couldn't easily save, or made good incomes but wouldn't save, they weren't prepared for the risks of using easy money to finance their homes. Squirrels that store a lot of acorns survive the winter. But we're now seeing what happens to squirrels that aren't so thrifty.

Policymakers seeking to address the subprime and associated messes are calling, variously, for lenders to give borrowers breaks, taxpayer funded assistance for low and moderate income defaulting homeowners, Federal Reserve interest rate cuts, and the imposition of new duties on mortgage brokers and lenders. But are we dealing with the illness or just treating symptoms? How about encouraging people to help themselves?

A baseline problem is that personal and household balance sheets have been deteriorating for many years. Savings rates are now effectively zero, and sometimes negative. On average, Americans are borrowing to finance their current lifestyles. The myriad ways of providing consumer credit --and delaying its repayment--seem innovative and even wondrous. But so did the Titantic.

As our credit-besotted nation piles up on icebergs of unmanageable debt, perhaps we should consider treating the illness. Personal and household balance sheets need to be strengthened. The medication needed is well-known: savings. But like other medications, it's easy to forget to take, especially when yet another sale at the mall beckons with siren song. The government has contributed to the problem by making it easy to borrow. The government should now contribute to the solution by making it easy to save.

Here's our proposal. The first $10,000 of interest income (and equivalents like dividends paid by money market funds) should be exempt from taxation (with $20,000 exempt for couples filing jointly). By exempt, we mean exempt: no regular tax, no alternative minimum tax. All interest income and equivalents above $10,000 (or 20K for married couples filing jointly) should be taxed the same as qualified dividends (which, for those of you who aren't lucky enough to receive qualified dividends, are taxed at lower rates than the salary or wage you earned working from 9 to 5). This proposal will provide an incentive to those with moderate or middle class incomes to save in the pedestrian, low interest accounts available to them. Passbook savings, money market accounts and CDs might enjoy renewed popularity. People who badly need savings might start to put a few nickels away. With some time and effort, they might accumulate a decent downpayment, qualify for a loan that won't wreck their finances in a couple of years, and attain true home ownership. Perhaps, just this once, the middle class could get a break.

Yes, this proposal would also benefit the well-to-do. Those with a lot of savings would pay lower taxes on interest income. But the banking system would benefit from larger amounts of retail deposits. As we are in the process of learning, the big banks were (and perhaps still are) heavily funded by short term, easily spooked money. Old-fashioned savings accounts and CDs are much more stable sources of funding. And if there's one thing banks need now, it's stability.

The many years of central bank sponsored easy credit have fueled asset bubbles. Banks, being at the heart of the credit extension process, have in effect become speculators in asset values. That hasn't worked out real well. Let's ease them back toward their traditional roles as lenders to borrowers who are well-prepared to repay the loans.

Environmental (?) News: banana spill in the North Sea. http://www.wtop.com/?nid=456&sid=1287933.

How Banks Took Derivatives Too Far

We’ve recently learned that major banks guaranteed the value of some of the derivatives they sold. Hedge funds were promised that if CDO interests that they bought fell below a certain value, the bank selling the interests would buy them back at a guaranteed price. Asset-backed commercial paper issued by bank-affiliated SIVs was 10% to 50% guaranteed by the banks sponsoring the SIVs.

More recently, it was reported in the Wall Street Journal (11/1/07, P. C3), that some money market funds that invest primarily in tax-exempt securities (i.e., municipal securities) bought short term, tax-exempt investments through so-called “tender-option bond programs.” These investments were derivatives synthesized from long term municipal bonds into short term investments that money market funds could purchase. Some of these synthetic instruments, however, were given low investment ratings, and Merrill Lynch, which underwrote these puppies, guaranteed to pay them if the underlying municipal bonds didn’t pay in full. Some money market funds, nervous about Merrill’s recently announced losses, have sold their holdings back to Merrill, not wanting to find out later whether its ability to honor its guarantee will hold up.

CDO interests; asset-backed commercial paper; now synthetic tax-exempt investments. All of a sudden, this isn’t very much fun any more. How much of the derivatives market have the banks guaranteed? Have they guaranteed other types of derivatives? Are their balance sheets and income statements accurate? Have they fully disclosed the risks from these guarantees? With all these contingent liabilities, are there questions about the safety and soundness of some major banks?

This adds to the cognitive dissonance already abundant in the financial markets. The Norman Rockwell version of the derivatives market is that it consists of a bunch of freckle-faced kids sipping frappes and trading contracts that repackage and shift risk to parties that choose to bear it. Volatility is supposedly damped. Market efficiency is supposedly enhanced. Smiles spread across many faces.

But these guarantees don’t shift risk. They retain it. The banks offering the guarantees were, in essence, giving the investors a put option, the ability to offload the derivative in case it turned out to be a turkey. Risk wasn’t shifted. Volatility, as we now know, has been exacerbated. Market efficiency, as we now know in spades, has been undermined by the credit crunch. Smiles are few and far between.

If these deals were so bad for the banks, then why did the banks do them? In a word: fees.

The banks got underwriting, advisory, servicing and perhaps other fees for doing derivatives offerings. Fee income came into vogue for commercial banks over the last 15 years, as risk-based capital requirements were gradually implemented. Banks were encouraged to offload the risks of commercial lending and make their money as intermediaries in the credit process. Fees were supposed to be a low risk way of making profits. That’s one of the reasons why you’re clobbered with charges for being one hour late in paying your monthly credit card statement, going $1 over your credit limit, and bouncing a check even one time after 10 years as a loyal customer. Banks love fee income, much more than they love having you as a customer. Investment banks love fee income, too, especially if they aren’t proprietary trading powerhouses.

Smackdowns of retail banking customers generate fees at a clip of $20 or $30 at a time. If you trample a large enough number of customers, it becomes real money. But derivatives deals provide millions of dollars of fees and other compensation per deal, a seemingly more efficient way to make money. Like moths drawn toward a flame, the banks moved into the derivatives market in their usual herd-like fashion, and did deals in abundance.

Evidently, they found the going tougher than expected. Some money managers, it would appear, realized that there were worms in them thar cans they were buying, and negotiated guarantees. The guarantor-banks, instead of selling derivatives, wound up selling put contracts for derivatives. This was a good deal for the money managers, who wound up with heads I win, tails you lose investments. But the guarantor-banks got lost on the way to Lake Wobegon.

Derivatives contracts can serve bona fide and valuable purposes when used in ways for which they were intended. But altering them so that they don’t really pass a lot of risk—transferring the upside, but not the downside isn’t much of a risk transfer—undermines the purpose of having a derivatives market. Suspicions arise that risk management got lost in the rush to record entries in that nice fee income category that would please stock market analysts and regulators. But risk, if unmanaged, remains coiled up, perhaps hard to see against the leaf cover on the forest floor, but ready to strike if the opportunity arises.

Derivatives have been taken too far. They’re not a magical instrument that will solve all problems in the financial markets. Like a socket wrench or a pair of pliers, they are tools, and nothing more. Like all tools, they must be used properly and wisely. Some shrinkage of the derivatives market, along with standardization of products and much greater transparency, would be a good thing.

Crime News: pet sitter that overfed potbellied pig charged with animal cruelty (no, we're not kidding). http://www.wtop.com/?nid=456&sid=1283269.

How Long Term Interest Rates Limit the Federal Reserve's Options

You get the impression that, all public protestations aside, the Fed would like to bail out the CDO and mortgage-backed securities markets. Its surprise half-point fed funds rate cut on September 18, and the more recent quarter-point cut on Oct. 31, won't have much impact on overall economic growth for months, perhaps many months, since interest rate changes need time to work their way through the system. (Check to see if the interest rates on your credit cards have dropped--you'll see what we mean about things taking time.) The justification in the economic data for these cuts was skimpy, especially the quarter-point drop on Oct. 31. But the financial markets wailed loudly and threatened to throw a monumental fit, so the Fed indulged them. The best of all worlds for the Fed would be to take monetary action that can be explained as beneficial for the economy as a whole, but which quietly alleviates the pain that so many market participants are feeling.

Yet, in spite of the Fed's interest rate cuts, the major banks reported some mega losses for the third quarter, topped by Merrill's $8.4 billion. This illustrates a limitation on the Fed's ability to deal with the subprime mess.

The Fed's power to affect interest rates is focused on the short term debt market. Fed funds are overnight loans that banks make to each other. Overnight is about as short a term for a loan as you can get.

But CDOs and other mortgage-backed securities are usually medium to long term investments. Most mortgages are paid approximately 2 to 10 years after they are taken out. That's roughly how long people wait to either refinance or sell their homes. Consequently, mortgage-backed securities tend to have longer terms than fed fund loans. Of course, it's possible to create short-term derivatives from mortgages. But at the end of the day, someone has to hold the right to the long term payments. So, there will always be longer term interests in any securitization of mortgages. And given the trillions of dollars of mortgages that have been securitized, the long term interests exist in large quantity. Perhaps one might think that lowering long term interest rates would increase the value of mortgage-backed securities (in the way it would increase the value of a traditional bond). If that could be done, we'd have a bailout, presto quick. But let's look at interest rate movements.

Since June 2004, the Fed has raised the fed funds rate from 1% to 5.25%, and then moved it back down to 4.5%. Short term interest rates, such as banks' prime lending rates and interest rates on money market funds, followed the upswings and downswings in the fed funds rate closely. What about longer term rates?

The most important long term security in the financial markets is the 10-year U.S. Treasury Note. It serves as the benchmark for all other debt of comparable maturity, because it is effectively free of credit risk. Credit risk, as we know so well from the credit crunch, is the murkiest of all risks that debt instruments bear. Eliminate credit risk, and you can get a much clearer picture of the time value of money. The 10-year Treasury Note is issued in abundance, since it is the Treasury Department's principal long term borrowing instrument. (Thirty-year Treasury bonds were not issued between 2001 and 2006.) Investment banks and other market players use the 10-year note as a hedging tool (because of its creditworthiness and easy availability), and institutional investors worldwide seek out the 10-year note as a safe haven.

During the time that the fed funds rate was moving within a range of 4.25 percentage points, the 10-year Treasury Note, starting in June 2004, varied between roughly 3.9% and 5.3%, a range of 1.4 percentage points. Moreover, the 10-year note was often the most inverted part of an inverted yield curve, dropping even as the fed funds rate was rising.

In other words, changes in the fed funds rate don't have much impact on longer term interest rates. In June 2004, the 10-year Treasury Note was yielding at around 4.7% when the fed funds rate was 1%. Today, it yields around 4.3%, even though fed funds rates today are 3.5 percentage points higher. The Fed can cut short term interest rates as much as it wants, and it won't have much impact on mid to long term interest rates.

It's also important to remember is that a drop in longer term interest rates may not increase the value of CDOs and other mortgage-backed securities. A drop in longer term interest rates can increase the frequency of refinancings, as borrowers seek to lower their monthly payments by getting a new and cheaper mortgage, and using it off the old one. Thus, in an environment of falling interest rates, the pool of mortgages supporting an existing mortgage-backed security may pay off faster than investors had hoped. They receive their principal back sooner, and must now re-invest at the lower prevailing rates. This represents a loss of long term income to them. Thus, a drop in longer term interest rates, which would ordinarily increase the value of existing longer term debt, may actually decrease the value of a mortgage-backed security. (However, the opposite isn't likely to be true--an increase in longer term interest rates probably won't do much to increase the revenue stream from the mortgage pool, but would depress the value of that stream.)

So, even if the Fed could lower long term interest rates, such a move might backfire by hurting the value of mortgage-backed securities. This is probably an important reason why three major banks and the Treasury Department have proposed a Super Conduit (or Super SIV, as some commentators call it) to bail out SIV-bedeviled banks. This is one respect in which the Fed can't ride to the rescue. Holders of mortgage-backed securities will likely have to work their way through their problems themselves. The fact that an ad hoc solution like the Super Conduit was even proposed tells you that there are no obvious solutions to the problem (see our blog at http://blogger.uncleleosden.com/2007/10/governments-plan-for-dealing-with.html).

The financial markets have been pouty ever since the Fed signaled that their Halloween candy might have to last for a while. Inflation risks are rising (as we predicted in http://blogger.uncleleosden.com/2007/09/did-fed-lower-interest-rates-because-of.html), and the Fed may be constrained from more interest rate cuts. That may be just as well, since it is doubtful that interest rate cuts could do much to alleviate the subprime mess. But they could fuel inflation. Let's not forget that the foundation of today's prosperity (yes, the economic data continues to show that the U.S. is prosperous, housing downturn notwithstanding) emanates from Fed Chairman Paul Volcker's unwavering stand against inflation at the end of the 1970s and in the early 1980s, which threw the U.S. into a painful recession that saw unemployment rise to more than 10%. Inflation is the biggest asset bubble of all, one that pumps up the price of all assets, and working our way out of an inflationary bubble would be far more painful than dealing with the current mortgage mess.

Legal Update: coin-flipping judge gets the boot. (That's right; a judge flipped a coin to make a decision.) http://www.wtop.com/?nid=456&sid=1285391.

Risk Management: Should the Investment Banks Have Remained Partnerships?

To state the obvious, investment banks have a risk management problem. Merrill just wrote of $8 billion and its CEO abruptly retired. Bear Stearns' president left under a cloud this past summer, and questions now swirl around its CEO. Questions also swirl around the CEO of Citigroup. Senior executives at a number of banks have hit white water in their careers. An analyst downgrade of Citigroup today contributed to a 362 point drop in the Dow Jones Industrial Average.

These are supposed to be smart people. And they're supposed to have smart people working for them. How could it be that they'd record losses in the hundreds of millions or billions--and just for one quarter? You'd think they'd have effective risk management systems, not only because that's part of their jobs, but also because the consequences can be so great.

But are the consequences so great? Stanley O'Neal, the now retired CEO of Merrill, reportedly left with $161 million. You could buy a jet and a yacht with that much money and still have plenty left over for caviar and champagne. Chances are many other departed executives didn't end up homeless and selling apples on the sidewalk. Of course, they suffered embarrassment and probably some loss of income. Their careers may have been sidetracked for a while. They may have to hold onto the leased Mercedes instead of upgrading to a Bentley. But peanut butter and crackers remain scarce in their diets.

Once upon a time, investment banks were partnerships (specifically, what lawyers would call general partnerships). Legally speaking, this meant each partner was liable to the full extent of his personal wealth for the firm's debts. If the firm had catastrophic financial results, a partner's coop apartment on Park Avenue was at risk. As were his Cadillac, art work, watches, china, savings, and investments. In other words, he could lose everything he had.

All of the partners were bound to pay the debts and liabilities that every other partner incurred on behalf of the firm. If a partner on the trading desk made some bad bets on bonds using margin and lost money, the partners in the mergers and acquisition department were at risk for payment of the margin debt. And if the partners in M&A gave some ill-conceived advice about the value of a deal, and wound up having to settle a class action lawsuit, the partners on the trading desk were at risk for paying the judgment in the class action lawsuit. All of the partners were bound by and bound to each other.

Consequently, the partnerships took risk management very seriously. When the fellow in the office next door can deprive you of your home, and you can deprive him of his, both of you will carefully evaluate the risks of your activities against the rewards. Downside risks concentrate the mind wonderfully, and partnerships concentrated on risk management.

Fast forward to 2007. All of the investments banks have become corporations. The ownership of corporations is embodied primarily in their common stock, which provides limited liability to shareholders. You can lose the amount of money you invest in the stock, but you can't lose more than that. The limited liability feature of corporations has allowed them to accumulate vast amounts of capital. It's the characteristic that, first and foremost, encourages investors to commit their capital to the corporation.

But investors hate to lose the money they've invested in the stock. Even if they won't lose their homes, cars and big-screen TVs, they still feel the pain of downside risk.

The top executives that run the major investment banks, however, are heavily insulated from the risks of doing a poor job. Compensation agreements provide golden and even platinum parachutes. Failure is punished by dumping shiploads of money on the poor performer. Executives are given the incentive to take excessive risk. How else will they make more money than by failing?

There is no possibility that the major investment banks can be reconstituted as partnerships. They're too big and far flung. Furthermore, they've lost the special culture of mutual trust blended with mutual scrutiny that successful partnerships have. Instead, their massive risk management failures present corporate governance problems of the first degree.

Management is the first line of defense in risk management. Management has failed. The Board of Directors are the next line of defense. By all appearances, they have failed, having placed too much reliance on management. Granted, CDOs and other asset-backed securities are complex. But it's the responsibility of the Board to supervise management, and, in particular, to prevent management from damaging the corporation. Directors should change executive incentives, so that management suffers real and painful financial losses if the company suffers losses. Heads I win, tails you lose executive compensation agreements reward taking excessive risk. If so-called top tier executive talent won't sign up without such protection, don't hire them. These executive compensation arrangements haven't been producing top tier financial results; try something different. Pass real risk of loss onto the CEO and concentrate his or her mind wonderfully.

Animal News: abusive feeding by a petsitter? http://www.wtop.com/?nid=456&sid=1283269.

Will Price Fixing Be Part of the Bank-SIV Bailout?

On Monday, Oct. 29, 2007, Allan Sloan, a Fortune magazine columnist, reported that the proposed bailout vehicle for SIV-bedeviled banks--which we call the Super Conduit--would "pool not only money but analytical information as well." Here's a link. http://money.cnn.com/2007/10/26/magazines/fortune/citishelter.fortune/index.htm?postversion=2007102914.

The mortgage-backed securities and derivatives that are held by the SIVs, and which would be bought by the Super Conduit, are creatures of mathematical models. Their structures and supposed values have been derived from mathematical modeling. "Analytical information" would be central to placing valuations on these things.

The pooling of pricing information is a feature of price fixing schemes. Airlines reservations systems and stock markets (which consolidate quotes from a number of dealers) are examples of potential venues for collusion. Indeed, the Antitrust Division of the Justice Department and the SEC have found collusive behavior in certain such venues.

The collection of analytical information by the Super Conduit could provide an opportunity for the banks participating in the Super Conduit to compare notes and reach agreement on prices. Such an amiable way of doing business would probably be, for those banks, a welcome change from the free market low-ball/no-ball bidding of independent third parties that might have been asked for quotes in recent months. Assemble at 3:00 p.m. and swap analytical information, establish prices at 4:00 p.m., and be at the gentleman's club by 5:00 p.m. for cocktails. No need to get their French cuffs soiled by short, nasty and brutish experiences in competitive markets.

Think of the benefits of such a process. Prices can be set high enough to soften the losses of SIV-burdened banks. The same high prices can be used as reference points for accounting valuations--what a relief to be able to use a monopolistic price instead of a competitive price. Vulture funds and other third party bidders offering bona fide free market prices can be smugly shooed away, or at least told to go around back to the kitchen door of the gentleman's club, where they might be sold a few table scraps that no one else wants. The Super Conduit doesn't need to trade with anyone except the banks that it's meant to bail out. So there can be a nice, closed derivatives market for banks only. Non-banks need not apply, thank you.

The banks sponsoring the Super Conduit might well try to use the involvement of the Treasury Department as protection from antitrust liability, under a legal doctrine called Noerr-Pennington. Whether or not that approach truly works is unclear, since Noerr-Pennington traditionally applies to the notion of members of an industry petitioning the government to act. In this case, the Treasury Department isn't taking any real action. It's just offering encouragement and moral suasion. It has no significant jurisdiction over the banks' mortgage and derivatives problems, and couldn't act in a formal way. So its presence may have no prophylactic legal effect.

So what if the Super Conduit rigs prices? Who loses?

For one, the investors in the Super Conduit will eventually lose out if it overpays for its assets. Mortgage-backed and other asset-backed securities are nothing more than streams of income that pay out whatever they pay out, and overpaying for them doesn't increase that stream of income. These investors will primarily consist of the purchasers of commercial paper issued by the Super Conduit. The commercial paper will probably be guaranteed by banks participating in the Super Conduit (otherwise, no one in their right minds would buy the stuff). So if there are losses, then those losses may well eventually rebound back at the guaranteeing banks. The Super Conduit may be nothing more than a vehicle for deferring recognition of losses. That's unlikely to foster safety and soundness in the banking system. A banking system won't be healthy if it's got a bunch of losses hanging like the Sword of Damocles over its head. Take a look at Japan in the 1990's, if you want an example.

On a larger scale, the biggest loser will be the U.S. financial markets. The subprime mess and credit crunch are a serious blot on the reputation of the derivatives markets. The path to redemption and recovery lie in standardizing derivatives products (to make pricing easier) and making the market more transparent--publicly displayed quotes and trade reporting would probably do much to rebuild investor confidence. Concocting a vehicle that could be used as a smoke-filled room to swap pricing information and come up with unusually high prices available only to Wall Street insiders would only confirm suspicions that model-based derivatives have little value to Main Street and are mostly used to benefit the big players on Wall Street.

Animal News: is Bigfoot in PA? http://www.wjactv.com/slideshow/news/14447006/detail.html.

How the Brokerage Firms Dealt the Hedge Funds a Mortgage-Backed Ace in the Hole

The Associated Press reported on Friday, October 26, 2007, that broker-dealer subsidiaries of some of the largest bank holding companies gave price guarantees to hedge funds that bought mortgage-backed securities from them. See http://www.wtop.com/?nid=111&sid=581261. Reportedly, Bank of America, Citigroup and JPMorgan Chase are the bank holding companies involved. While not all the details of these guarantees are known, it seems that if the hedge fund tried to sell the mortgage-backed security and couldn't get a minimum guaranteed price, the broker would provide liquidity to the hedge fund in some manner. The broker might buy back the security, find another buyer for it, or pay a penalty to the hedge fund. One way or another, it would seem that if the mortgage-backed security's price fell below a specified level, the security pretty much belonged to the broker, not the hedge fund.

Could you get a brokerage firm to guarantee that if you bought a stock from them, they'd protect you if the price of the stock fell below a specified level? We didn't think so. They might try to sell you a product like a put option if you wanted protection, and that would allow them to earn another commission from you. But they wouldn't take the risk themselves that the stock price might fall below the level you wanted to protect. So this guarantee of mortgage-backed securities is unusual, to say the least.

The guarantee, which hasn't been exactly highly publicized amidst the subprime mess and credit market blowup, explains a lot. This is one reason why brokers were able to sell so many mortgage-backed securities to hedge funds. What they were really selling was Lake Wobegon, that wonderful place where, among other things, all investments do above average.

The guarantee is likely to be one reason by so many bank holding companies have recently been announcing so many losses. With hedge funds facing numerous withdrawal requests but unable to sell their mortgage-backed securities in the open market, they've no doubt turned to the brokers that guaranteed a minimum price for those hot tamales.

The guarantee is also likely to be one reason why the Federal Reserve has been so concerned about the subprime mess and credit crunch. It could cause major blowback on the bank holding companies that are the parent corporations of the brokerage firms that issued the guarantees. The Fed has relaxed regulatory requirements to allow the commercial bank subsidiaries of these bank holding companies to lend badly needed liquidity to their broker-dealer affiliates. This was part of a quiet bailout of the banks we discussed this past August. http://blogger.uncleleosden.com/2007/08/federal-reserves-quiet-bailout-of.html.

The existence of the guarantee raises a few questions. First, did the bank holding companies adequately account for the mortgage-backed securities that were protected? One might wonder whether the bank holding companies could truly treat these securities as sold to the hedge funds, when the bank holding companies bore the risk of loss on them below a certain price level. Ordinarily, a company can't account for an asset as sold if it still holds some aspects of ownership, and bearing risk of loss is a strong indication of ownership. Should the mortgage-backed securities that were guaranteed have been carried on the bank holding companies' balance sheets? And even if the bank holding companies could validly keep these guaranteed mortgage-backed securities off their balance sheets, did they maintain appropriate reserves for the possibility that they might have to honor the guarantees?

Another question is whether the bank holding companies adequately disclosed the risks associated with the guarantees. These guarantees meant that if the market for mortgage-backed securities fell far enough, big time blowback would happen. SEC regulations say that public companies should make disclosures about their market risks (that's in 17 C.F.R. 229.305, for those of the lawyerly persuasion). Should the bank holding companies have made market risk disclosure about the guaranteed mortgage-backed securities, and, if so, did they?

A third question is when did the Fed find out about these guarantees? It's obvious such guarantees have implications for the safety and soundness of the nation's banking system. It's also obvious that these guarantees would explain why so many mortgage-backed securities of questionable liquidity could be sold. And it's additionally obvious that selling a whopping shipload of these mortgage-backed securities could create a lot of stress for the financial system. It would be one thing if a brokerage firm that has no commercial bank affiliate and therefore isn't regulated by the Fed issued guarantees such as these. Such a firm would not put federally insured deposits at risk. But a bank holding company that has an investment banking subsidiary can do just that through risky investment banking activities (and aren't just about all of them pretty risky?). It's the Fed's job to know about things like these guarantees while they are being made, not after the fact when they've apparently caused large losses.

One final thought. The guarantees may be part of the reason why there are few sales of mortgage-backed securities. The hedge funds know that they don't have to sell if the bona fide third party bids get below a certain level. So sales don't occur if the market really nosedives. Why is that bad? Because normal market mechanisms are disrupted. There are vulture funds and other junkyard investors out there, looking for mortgage-backed bargains. But they can't do a trade if the hedge funds are putting the guaranteed securities back to the brokerage firms. Thus, no price floor is established and the market price is indeterminate, which is another way of saying zero. Many important accounting, lending and investment decisions can't be made without a positive market price. But the guarantees may be impeding the establishment of market prices. But the hedge funds aren't about to forgo their guarantees and trade in the open market, so there's no easy way out of this gridlock.

Food News: the source of chocolate cravings? http://www.wtop.com/?nid=106&sid=1266102.

Choosing Financial Stocks in a Time of SIVs and Credit Crunches

Many large commercial and investment banks announced painful writedowns and large losses for the third quarter of 2007. Some other banks, though, have announced relatively moderate writedowns and continued earnings strength. Are the latter a good buy?

One lesson from the high tech boom of the 1990s is that when you have a distressed industry, think carefully before investing in the apparent winners. Recall the telecom industry circa 2000 and 2001. Company after company was announcing writedowns and losses from aggressive expansion and industry overcapacity. Some companies folded. But WorldCom kept announcing strong financial results. You might have thought WorldCom would be a good investment.

Fastforward to June 2002. WorldCom publicly admitted to having engaged in an accounting fraud involving billions of dollars. Those glowing earnings reports were bunk. Shareholders were hung out to dry. The biggest difference between WorldCom and the losing telecom companies was that WorldCom was willing to lie about its performance.

The financial services industry is currently living in a world of turmoil, with much of the turmoil stemming from CDOs and other mortgage-related derivatives that are traded only by appointment and often have no open market price (especially not after the credit crunch began). These “assets” are the source of a lot of the recently announced losses. Valuing them is often a matter of judgment. The bank can use a mathematical model for valuation, but there’s wiggle room in the models and they haven’t been exactly spot on when it came to predicting cash prices (see http://blogger.uncleleosden.com/2007/08/how-computers-did-in-financial-markets.html).

Only the banks and their auditors know what actually happened with this past quarter’s accounting. But here are a couple of thoughts. A bank that wanted to avoid a bad third quarter this year could have given itself the benefit of the doubt at every turn and come up with results that didn’t look bad. This would have been a dangerous tack. If the real estate sector continues to decline (as many predict), circumstances in the fourth quarter may compel more writedowns at year end. And if a bank’s writedown this past quarter was relatively small, the writedown at year end may have to be relatively gargantuan (because those benefits of the doubt tend to evaporate as asset values slide).

Of course, there’s also the possibility that a bank with a serious CDO-subprime problem may have taken the opposite approach and been highly aggressive in writing down hinky assets. Then, at year end, it might report relatively positive results for the fourth quarter. Concerns have been aired that the banks reporting large writedowns may be creating "cookie jar reserves” that they could tap into in the future to smooth out more turmoil in their earnings. If such is the case, they are likely to have a problem with the authorities, since maintaining cookie jar reserves is considered bad accounting form.

Nevertheless, if you’re going to take a flyer on a stock in a volatile sector like financial services, do you want the one that might report improvement in the future, or the one that might have spent too much time primping in front of a mirror? Is it possible that the banks reporting strong results now simply are better managed and avoided riskier plays? Yes, that’s possible, and maybe it’s true. But WorldCom was considered a well-managed company until it blew up. Think and research carefully before plunging into stocks of banks and other companies holding volatile assets.

Ironic News: a lock of Che's hair sells for $100,000. http://www.wtop.com/?nid=456&sid=1278591. The old revolutionary must be turning over in his grave at the thought that his hair might have been subjected to capitalism.

What if the Super Conduit for SIVs Fails?

The Super Conduit proposed by three major banks and the Treasury Dept. seems to be moving forward. It has reportedly received indications of interest to the tune of $60 billion, mostly from other commercial banks. The Super Conduit is searching for $80 billion to $100 billion of funding, so $60 billion sounds pretty good. But maybe we should be cautious. An indication of interest isn’t a commitment. And a commitment these days is kind of like a wave of the hand on the Street. All kinds of people are trying to walk away from commitments. Private equity guys don’t want to do deals that no longer offer yacht-buying profits. Banks don’t want to fund private equity deals with bonds that offer them, the lenders, little in the way of meaningful rights. Mortgage companies don’t want to buy back stupid mortgage loans they made which, not surprisingly, have now defaulted. So the indications of interest for the Super Conduit might not quite make it to the altar if things start to look kind of hinky.

And there’s much about the Super Conduit that could be hinky. It will supposedly buy “good” mortgage-backed securities from distressed bank-affiliated SIVs, and will make money by charging them fees and paying them discount prices. If it actually operates that way, it will be the largest pawnshop on Wall Street.

But trying to make the Super Conduit profitable seems to involve a square hole-round peg problem. The assets that it would buy consist primarily of mortgage-backed securities, and the value of those puppies depends on the fortunes of the real estate market. No one, not anyone, not even economists on the payroll of real estate trade associations, is predicting anything except further decline in the real estate markets for the next year or two. How can you make a profit from assets that are likely to deteriorate? Only by being a real vulture and paying super-low prices that leave the bank-affiliated SIVs by the roadside, barefoot and pregnant. In that case, though, the Super Conduit wouldn’t serve its primary purpose of bailing out the SIV-bedeviled banks.

So the Super Conduit may end up paying not-such-low prices. And that would increase its risk of losses. What if it ends up being a bust? In order to avoid total breakdown of the credit markets, the participating banks would have to ensure that the investors that buy the Super Conduit's commercial paper would be paid out in full. If the banks did that, though, they'd be looking at taking the losses themselves.

But that’s where we are now. Banks are looking at taking losses, and have proposed the Super Conduit in order to avoid doing so. If the Super Conduit fails, what’s the next step? What is Plan B? Surely, all those really smart people on Wall Street and in the Treasury Department realize that the Super Conduit may sustain losses, and therefore have a contingency plan in their hip pockets ready to go. Otherwise, they wouldn’t have proposed the Super Conduit in the first place. Right?

We’re dealing with a severely weakened administration that has a demonstrable problem with contingency planning. A certain foreign policy adventure whose name shall not be spoken is Exhibit A in this regard. The emergency plan for Katrina is Exhibit B. You get the picture. These people struggle futilely to shift the point of aim away from their own feet.

The Super Conduit is intended to operate for about a year. Maybe the plan is to keep the SIV-bedeviled banks on life support until a Democrat takes office in January 2009. That’s a cute way of saddling the opposition with a nasty mess. But what if a Republican wins the 2008 presidential election? Not the highest-odds bet in London right now, but a nontrivial possibility given the Democrats’ demonstrable history of aiming at their own feet. In that case, the Republicans will have done it again to their feet.

The Treasury Department’s involvement in the Super Conduit implies the potential for a taxpayer-funded bailout if all else fails. The Treasury Department has vehemently denied that any such measure is within contemplation. Let’s hope so. If it happened, we’d be Japan in the 1990’s. After their stock and real estate markets crashed in 1989-90, the Japanese banks, with encouragement from the Japanese government, kept funding bad loans instead of recording the losses they had sustained. Japan lost the opportunity to invest in new industries and technologies. Instead, the Chinese became the new Asian powerhouse. While Japan still has a much larger economy than China, China’s vitality is much larger than Japan’s. It is a foregone conclusion that China will surpass Japan, probably before many of us begin to collect Social Security.

Wall Street has made a bunch of bad investments in real estate and related derivatives. We shouldn’t keep funding doggy investments. The banks should write off their losses and move on. If that means that some banks may be hampered for a while, so be it, even if there is a near term economic slowdown. If the troubled banks develop liquidity problems, funding is available at the Fed discount window. That’s what it’s there for. But let’s not fund the stupid real estate investments they made and then hid from view in SIVs and conduits. You can’t build wealth by throwing good money after bad. If America is to remain competitive with the rising economic powers in Asia and a resurgent EU, we shouldn’t deplete our capital assets by continuing to fund reckless and poorly conceived investments created by fast money financiers.

The losses from the SIVs and conduits are perhaps so great that they’d cripple some banks. If so, sell the banks to new owners. If they’re too big for any one buyer, break them up into constituent parts—retail, investment banking, credit cards, etc. Then sell or spin off the constituent parts. And fire some people with the nicest of the corner offices. If the big banks learn that they aren’t too big to fail, and their high-ranking executives learn the meaning of accountability, they’ll start evaluating and managing their risks responsibly.

Animal News: the parrot--a fire alarm that doesn't need a battery. http://www.wtop.com/?nid=456&sid=1275565.

SIVs, Conduits and the Credit Crises in Our Future

Esoteric investment vehicles called SIVs and conduits have become cocktail party topics. The U.S. Treasury and the nation's largest commercial banks are sponsoring a bailout of banks affiliated with distressed SIVs and conduits, to the tune of $80 to $100 billion dollars. The G-7 and IMF issued statements at meetings held this weekend expressing concern about the credit crisis and encouraging central bank action to limit its impact. Financial journalists write about the losses sustained and the losses to be incurred in the future, and the financial engineering games that created the losses. Economists are quoted on cable television predicting recession, or not.

It's clear from both the Fed's surprise half-point interest rate cut in September and the Treasury's sponsorship of the super conduit that supposedly will stabilize the debt market that the government thinks the credit crunch is serious and an ongoing problem. There's plenty of speculation about whether or not the Fed will cut interest rates further, and even a little commentary on the possibility that the taxpayers will have to provide some money to bail out the big banks. In other words, there's plenty of talk about how those responsible for the mess can be insulated from risk. But there's little discussion about the need for increased government oversight to prevent the kind of reckless excess that characterized the CDO market until recently.

The government that simply reacts to the crisis of the moment, and doesn't plan for the next recurrence of problems, is doomed to be unprepared for the next mess. Generals and admirals are sometimes accused of preparing to fight the last war. But at least they are doing something about the future. While the financial regulators and Congress have issued some statements and even held a few hearings, no substantial steps have been taken to prevent a recurrence of the problem.

Market forces have worked poorly in this situation. We have to consider that markets aren't machines or automated processes. They consist of the interactions of people, and people can be irrational, oblivious, gullible, and, most importantly, greedy yet fearful. All of this means that people--and therefore markets--can screw up.

First, over-investment in mortgages resulted in the creation of vast quantities of risky derivatives (CDOs and others of their ilk) that few understood. The valuations ascribed to these investments were based on the assumption that the real estate market would continue rising indefinitely. That a perpetually rising real estate market had never before occurred in the history of the world was no impediment to the belief that it would happen now.

Then, when the ship hit the fan (well, you know what we mean), investors froze up and refused to invest in anything except gilt-edged investments like U.S. Treasury securities. Investors didn't conduct much of a reasoned analysis of anything, especially if it might have something to do with asset-backed securities. They simply wouldn't touch private sector debt. Perhaps this was an overreaction. But it was understandable in light of the absence of transparency in the derivatives markets. In the absence of reliable information, why risk your capital?

Contrast the credit markets with the stock markets. Even with Friday's drop, the Dow Jones Industrial Average is up about 8.5% for the year. The stock markets are vastly more transparent than the derivatives markets. Even though they are sometimes volatile, there hasn't been a freeze up in the stock markets since the Depression. Even after the 1987 crash, investors kept buying, because there is so much information available about stocks that many felt they could reasonably assess their chances.

Without an improved regulatory regime in the derivatives markets and for hedge funds, future crises like the current one are a given. The financial services sector of the U.S. economy has grown larger even as the manufacturing sector has shrunk. Whether or not this makes much sense from the standpoint of national policy can be questioned. There is nothing about America that gives it any special advantage in financial services. Unlike our pool of intellectual capital in the Silicon Valley, our pool of creative talent in the entertainment industry (entertainment is America's second largest export, after commercial aircraft), or our vast farmlands, Wall Street's talents and products are fairly easily replicated in other nations. And that's happening. London is a serious challenger to New York. And China is promoting the growth of its financial markets. Much and perhaps most of the growth in investment capital (i.e., savings) today is overseas. The Chinese, Japanese and other Asians are compulsive savers. The OPEC and other oil producing nations are piling up vast amounts of oil profits to reinvest. There is no particular reason why those savings must flow to Wall Street, and increasingly, they won't, especially with the dollar falling in value.

Nevertheless, the government seems intent on protecting the financial services industry. In that case, it should do so the right way, and build for the long term. Although not without its faults, America does two things really well compared to most of the rest of the world. Americans truly believe in integrity and honesty, and these values have been infused into the processes of American life. When Americans go to a government office, they expect to be able to conduct their affairs in accordance with law, and not have to pay petty bribes to petty functionaries just to get the day-to-day processes of the government to operate. There really aren't that many other places in the world where this is true.

Similarly, Americans expect to be treated fairly and honestly when buying or investing in something. They expect prices to be fair, and howl when they think they've been taken advantage of (witness the controversy over Apple's recent $200 price cut for the iPhone). In most other countries, bargaining is a way of life, and you have live with the bargain you made. Opacity in the market is an advantage for the seller that the seller will strive to maintain.

Thus, Americans do integrity and honesty really well. Let's infuse a serious dose of integrity, honesty, transparency and responsibility into the derivatives markets and the hedge fund industry. Sure, this means increased regulation. But it also means greater investor confidence and a competitive advantage over other nations that don't do integrity and honesty as well.

Animal News: pet cockroaches. http://www.wtop.com/?nid=456&sid=1273362. Some people are weird.

The Government's Plan for Dealing with the Credit Crunch

It can be informative to ask simple questions. Amidst all the details, complexities and nuances of the subprime mess and the credit crunch, let's ask a simple question. Why is the Treasury Department involved in dealing with this situation?

As you surely know, several major banks, along with Treasury, have proposed the formation of a special investment vehicle (which we call the "Super Conduit") to purchase mortgage-backed assets from structured investment vehicles (SIVs) affiliated with banks that have run onto the shoals of the subprime mess. These purchases would help the SIVs repay commercial paper that the affiliated banks have guaranteed. If the banks were required to pay on their guarantees, they'd have to book a bunch of losses because the SIVs' assets may not be valuable enough to repay the banks for fulfilling the guarantees. It's not clear this proposal will work (see our preceding blog at http://blogger.uncleleosden.com/2007/10/super-conduit-new-clothes-for-banks.html). Whether or not it does, there remains the question why the Treasury Dept. is in the picture at all.

The Treasury Department doesn't have primary regulatory responsibility for banking. The Federal Reserve and other banking agencies have that hot tamale. The Treasury Department doesn't have primary responsibility for regulating the financial markets. The SEC and the CFTC perform those duties. While the Treasury Dept. has authority to regulate U.S. Treasury securities auctions, and require reports of cash transactions with banks (if they exceed $10,000), these areas are hardly affected by the subprime mess. So Treasury doesn't have a whole lot of legal jurisdiction here. Does that mean we have government employees doing work they don't have to do? Pigs would waltz on the Moon first.

There appear to be two basic reasons why Treasury stuck its nose into this particular latrine. First, the banks sponsoring the Super Conduit are acting a bit like a cartel. The Super Conduit, from a banker's perspective, could be viewed as "stabilizing" prices of CDOs. Others might characterize it as a group of powerful banks getting together and fixing prices (instead of letting them go way down where their competitors could buy them for a song). That could violate the antitrust laws. However, if the banks involve the government in their discussions, they might be able to rely on a legal doctrine called Noerr-Pennington to dodge antitrust liability.

Second, and probably more important, the Treasury Dept. appears to be lending its stature to the discussions. In the uncertainty and opacity of the subprime mess, leadership is sorely needed, and Treasury may have been one of the few parties that could provide it.

One might ask why the Federal Reserve, which was instrumental in organizing the 1998 bank bailout of Long Term Capital Management, isn't actively involved in the Super Conduit. There could be a simple reason. The Fed is the primary regulator of all major U.S. commercial banks. It can also ensure that the major investment banks have access to credit (by telling the commercial banks to lend to the investment banks, which is more or less what the Fed did after the 1987 stock market crash). If the Fed took the lead in these discussions and encouraged all the major banks to participate, it could be viewed as implicitly guaranteeing the financial viability of the Super Conduit. That is a can of worms the Fed wouldn't want to buy.

Treasury, on the other hand, doesn't have the legal authority to make or fulfill any such guarantee. So it's in a position to lend its stature and engage in moral suasion, without having to deal with claims of a guarantee.

It all sounds so cute and clever, no?

No.

The fact that Treasury, a department of the federal government with no significant jurisdiction in the matter, involves itself with the subprime mess tells you that the government has no plan for dealing with the crisis. It never saw the credit crunch coming, and didn't prepare for it. It purposely turned away from regulating the derivatives market and hedge funds, to the point where it didn't have even basic information about the scope and extent of the problems. The government didn't realize how abusive to customers some mortgage brokers and mortgage companies could be. It didn't realize how esoteric and detached from financial reality CDOs had become. It was unaware of the tremendous amount of leverage hedge funds were using to invest in CDOs. The leverage created hair trigger conditions for a downturn if CDOs took even relatively small losses (since leverage would magnify the impact of the losses). It didn't understand how far the bank-affiliated SIVs and conduits had gone in pursuing a strategy of borrowing short term (with commercial paper) and investing in longer term CDOs. This strategy is particularly weird considering that the yield curve was inverted for much of the past few years (so the cost of borrowing would squeeze profit margins unless the SIVs and conduits took larger and larger risks in search of earnings).

Consider the government's response to the crisis. The Fed first turned up the liquidity spigot, then made the largely symbolic move of lowering the discount rate, and finally announced its surprise half-point fed funds rate cut. Now, we have Treasury, with no jurisdiction, stepping in as a sponsor of the Super Conduit. Do we get the impression that the government is winging it? Are these people making it up as they go along? Does this bring back memories of the halcyon days of youth, when the conversation in the huddle of a touch football game might sound something like, "okay, Tommy, you go to the left down the sideline, and Jimmy, you go out on the right and slant in, and Pete, you line up on the right end and come back to me so I can give you the ball for a reverse if I want to, but maybe I'll keep the ball and throw it, or maybe I'll run with it around the end, or . . . "

The primary responsibility for the subprime mess and the credit crunch doesn't rest with the government. It falls on the mortgage brokers, mortgage companies, investment bankers, hedge fund managers and other players who saw the real estate markets as the newest and best source of fast money, the easy way, get it while you can, and the devil take the hindmost. But the process of holding these parties accountable will take a while, in many cases proceeding with all deliberate speed in the courts.

The government was a facilitator par excellence of all this exuberance, what with the Fed's easy credit policies and the tax code favoring speculative investment over old fashioned working, earning, thrift and prudence. So the government should help with the cleanup. But it is going to need luck if it keeps throwing Hail Mary passes and tries to be the first player in 60 years to score with a drop kick.

The government has no choice except to muddle through the current situation. However, just to prove that bureaucrats can move up the learning curve, a more proactive regulatory regime for the problem children of the subprime mess and credit crunch would brighten the future of the financial markets.

Crime News: burglar cleans up mess he made. http://www.wtop.com/?nid=456&sid=1272472.