Monday, April 27, 2009
Personal Note
Every day on my way home as I approach where 50 meets the BW Parkway, I realize a little bit of me has died. Here I am spending my favorite time of day stuck nose-to-ass with my fellow commuters. We all hate each other. It's perfectly natural.
Thursday, April 23, 2009
Cheaper Than Wind Down
If you're stomach gets tied up in knots at the injustice and perhaps corruption of the bank bailouts, just consider one thing. Banks are not like other companies. When they fail, they are unwound via the FDIC, not through bankruptcy. FDIC has all the powers of a bankruptcy judge, plus the powers of a U.S. Trustee. Plus, it has its own (federally backed) money on the line.
Chrysler's impending bankruptcy will cost a lot, but the people taking the biggest hit are investors and employees. Through bankruptcy, contracts such as leases can be dissolved by the judge.
If, for example, Citi goes into receivership (the bank equivalent to bankruptcy), the FDIC will insure all the covered deposits and sell off all remaining assets to cover other major creditors. Most likely, the FDIC would be left holding onto all the toxic assets because there is no demand for them.
When you think it through, it becomes apparent that there is a sense of imperative to kickstart the secondary market for securitized loan assets. Not only does it preserve the capital standing of the banks, it provides a preventative balm in case any of the major banks do in fact go under. If there is a functioning secondary market, the FDIC could auction off the assets to make creditors whole, or it could preserve them on its own books, taking the income stream to supplement the fees it charges to FDIC participating banks.
But, we're still a long way off from having a functioning secondary market. Right now, all of our hard earned tax dollars are sitting on the books of the banks to keep their capital levels in compliance. That money is not being used for lending or for buying securitized loans from other loan originators. But, merely surviving, the banks are paying interest on that money. Interest that goes back to the Treasury.
If we just let the creative destruction of capitalism runs its course, the tax payer would still be out all that money (and probably more) as the FDIC takes on losses it cannot absorb, and there would be no hope of recovering any of that money. This way, at least we get interest.
Chrysler's impending bankruptcy will cost a lot, but the people taking the biggest hit are investors and employees. Through bankruptcy, contracts such as leases can be dissolved by the judge.
If, for example, Citi goes into receivership (the bank equivalent to bankruptcy), the FDIC will insure all the covered deposits and sell off all remaining assets to cover other major creditors. Most likely, the FDIC would be left holding onto all the toxic assets because there is no demand for them.
When you think it through, it becomes apparent that there is a sense of imperative to kickstart the secondary market for securitized loan assets. Not only does it preserve the capital standing of the banks, it provides a preventative balm in case any of the major banks do in fact go under. If there is a functioning secondary market, the FDIC could auction off the assets to make creditors whole, or it could preserve them on its own books, taking the income stream to supplement the fees it charges to FDIC participating banks.
But, we're still a long way off from having a functioning secondary market. Right now, all of our hard earned tax dollars are sitting on the books of the banks to keep their capital levels in compliance. That money is not being used for lending or for buying securitized loans from other loan originators. But, merely surviving, the banks are paying interest on that money. Interest that goes back to the Treasury.
If we just let the creative destruction of capitalism runs its course, the tax payer would still be out all that money (and probably more) as the FDIC takes on losses it cannot absorb, and there would be no hope of recovering any of that money. This way, at least we get interest.
Friday, April 17, 2009
Quick Note on Unemployment
In a downturn, unemployment rates are an indicator of how bad the economy is performing. Side note: in a steady state unemployment rates reflect national labor and tax policies (among other things).
So, when looking at the numbers tallied by BoL, remember that the major category of job loss nationwide is in construction and industries related to home repair and sales. Included under that umbrella are a lot of positions that had previously been held by undocumented laborers who were paid under the table or through other shifty means. Needless to say, those workers aren't in line to get state and federal benefits (which is good, I guess, from a fiscal perspective).
I would hate to speculate just how bad the unemployment rate would be if all who lost their jobs were counted. Would 10% be too high?
So, when looking at the numbers tallied by BoL, remember that the major category of job loss nationwide is in construction and industries related to home repair and sales. Included under that umbrella are a lot of positions that had previously been held by undocumented laborers who were paid under the table or through other shifty means. Needless to say, those workers aren't in line to get state and federal benefits (which is good, I guess, from a fiscal perspective).
I would hate to speculate just how bad the unemployment rate would be if all who lost their jobs were counted. Would 10% be too high?
Thursday, April 16, 2009
Toxic Assets and Insolvency
It has become axiomatic that the major players in finance are insolvent. Insolvent can mean different things, depending on how you define it. Let's be absolutely clear about one thing: none of the major banks are insolvent -- except from one perspective.
Insolvency is a statement reflecting data on an institution's balance sheet, on which are listed assets, liabilities, and cash reserves. Thanks to the FDIC, all banks in the US have more than enough cash reserves. Where banks are weak is in the assets category. This will remain true even with the easing of the mark-2-market rules, all thanks to toxic assets. Here's why.
In our era, toxic assets are derivatives, the value of which ultimately reflecting the performance of various loans, including the dreaded subprime mortgages. As those loans go sour, the bundles of loans (MBS, ABS), take a hit. Now, a bundle of loans has a diminishing value over time anyway, resulting from the fact that as people pay down their loans there is a diminished future cash stream associated with the bundle. Think of it this way, a bundle of 100 separate $300k mortgages (each with the same interest rate) is worth 300k plus 30 years of compounded interest. Fifteen years later, the bundle has lost half of its total value (from a creditor's perspective).
But, these toxic assets are mostly full of relatively recent loans, so pay down over time is not a material factor in the reduction of bank assets. What about foreclosure and delinquency? Yes, this is certainly a factor in some of the MBS and ABS -- especially those underwritten with a lot of 2005 to 2007 mortgages originated in CA, FL, NV, and AZ. But, this amounts to a reduction in value in the 10-40% range, not a total wipeout.
Back to basics, then: the vast majority of mortgages and commercial loans are performing. Therefore the bonds created by bundling them (and the subsequent derivatives created in relation to that bond) should be maintaining 60-90% of their value. Why, then, are they not?
First. Consider fear. Not fear of blank-eyed zombies with blood smeared down their shredded French cuff shirts. Rather, consider fear of 10% unemployment and bottomless foreclosures. Consider plunging home values due to lack of demand (and lack of liquidity) for mortgages. Consider fear that major institutions currently dragging the corpses of subprime lenders may not make it through the year. Most importantly (from the perspective of toxic assets), consider the fact that the ratings on all MBS and ABS are suddenly deemed meaningless. Consider the political fear of zombie banks.
Now, couple that fear with the real failures of IndyMac and Bear Stearns. And the stupidity of AIG being a net seller of CDS without holding a cash reserve like it does for its properly regulated insurance products. The result is WaMu. WaMu was crushed because depositors left unprotected (at that time) by FDIC insurance pulled out their money because of rumors of WaMu's imminent demise. WaMu overnight became the first and only insolvent commercial bank during this crisis. Failure came to it.
Now, in that climate, what do you think WaMu's and IndyMac's ABS and MBS would fetch on the secondary market? I have heard the going rate was 5 cents on the dollar. With mark-to-market rules in place, everyone holding similar assets has to mark down the value of those assets to reflect the going rate. In an instant, the top 20 banks in the country, the top 100 banks in the world, have shrunk the assets on their balance sheet by a considerable margin.
Basic accounting: Equity = Assets - Liabilities.
If you listen to Goldman, you might think that there's no problem at all because CDS and the CDOs they spawn should cancel out the risk created by underperforming MBS and ABS. In the abstract, that's true, and I believe that most of the remaining banks will pull through, despite the recklessness and hubris of the liquidity bubble.
In reality, however, problems remain. All those derivatives have other uses than sale, resale, and hold to maturity. They are also collateral.
Picture yourself owning a pawnshop. Uriah comes in looking for some cash to borrow. He's going to take that cash and make a bunch of smaller loans to some dudes he knows, at a higher interest rate than the pawn shop is charging him. Everyone wins. He tells you he can pledge his 60" plasma TV and a crate of canned tuna to secure the loan. You knows plasmas are good and will resell at a good price if Uriah defaults. And you can always eat the tuna.
Just after Uriah leaves, you turn on the TV and watch a news report telling you that new research shows that plasma TVs cause eye cancer. Sales are expected to plummet. By the time you get ahold of Uriah on his cell phone to tell him he's either gotta pledge more collateral or return a big bunch of money pronto, he's already loaned the cash out. You know one thing, the next guy coming in with a TV for collateral is getting kicked to the curb.
The funny thing is, a couple of Uriah's dudes were using the cash to buy smaller plasma TVs, with the idea being that Uriah would take the TVs off their hands if they fail to pay him back.
As a pawnbroker, what do you do? Wait to see if Uriah pays you back? If he pays you back all, or most, then the crisis is averted. If he only pays you back ten percent, then you're stuck with a plasma TV that you can't resell, plus you're out the cash you loaned to Uriah. You better hope you have enough cash in reserve to pay the rent on your commercial real estate lease.
What does Uriah do? Some of his friends pay up. Some are late. Some don't pay at all and Uriah can take possession of the TVs they bought. No matter what, he's burned. He'll either go out of business altogether, or only lend out money under stricter conditions in the future. Uriah has become risk averse.
You have a sister who specializes in eye cancer. It is clear to her that Plasma TVs do not in fact cause eye cancer, or if they do, the risk posed is minimal. Yet, you are still stuck with a TV that has no market value because there is no demand for them. The intrinsic worth of the TV still holds: you can watch the hockey playoffs in hi-def; PS3 blows your mind, etc. Knowing that the health threat is overblown, you want your business partners and creditors to let you keep the asset value of the TV up near what you paid for it (the amount originally loaned to Uriah).
That's where the banks are today, which is why the m2m rules have been eased. It's the equivalent of you, the pawnbroker, placing a $500 dollar price tag on the TV in your store, but no one would pay more than $10 today for it.
A month goes by and Uriah hears on the radio (not watching TV, of course, because he doesn't want eye cancer) that there is actually only a small chance of plasma TVs causing eye cancer. Suddenly the market for plasma TVs rebounds. Not robust like it had been (everyone's still wary, wondering what if the next news will be bad news), but product is moving again. He has already sold most of the repossessed TVs at a huge loss. He recoups a little bit by selling the remaining repossessed TVs are the lifted market price, but he'll never get back to where he thought he would be. His friends are out cash and have no TV (yes, people who have lost their homes to foreclosure).
Meanwhile, you learn of the improved market conditions. You get a bunch of bidders on the TV, some are even willing to pay $700 for it. Things are looking up, right?
Well, here's where the problem is. What if you learn that the TV is health-friendly, but by this time the eye cancer scare has led to dramatic increase in layoffs in the TV and TV-related industries. Those layoffs lead to decreased spending, which leads to other business failures completely unrelated to plasma TVs. Soon, unemployment is up, spending is down, and everyone's looking at everyone else with extreme suspicion (hence the run up in corporate bond yields). Okay, great, go ahead and try to sell that TV, buddy.
That's where the banks will be. That's why Goldman's reassurances are to be taken as a best-case scenario. That's why the government needs to do only one thing right now: cure the ills of unemployment (either with benefits or job creation, or both). That is all that matters in our current era. Every other problem can wait.
The intrinsic value of the reference entities of the toxic asset is still good. Therefore the banks are still solvent, except from a regulatory perspective that requires banks to maintain certain capital requirements (of which these assets play a part in determining). But, without a leveling off of unemployment or a means to ease the pain of unemployment, the economy will continue to deteriorate, and more people will fail to pay their debts (diminish the values of reference entities in derivatives), further deteriorating the value of the toxic assets.
Insolvency is a statement reflecting data on an institution's balance sheet, on which are listed assets, liabilities, and cash reserves. Thanks to the FDIC, all banks in the US have more than enough cash reserves. Where banks are weak is in the assets category. This will remain true even with the easing of the mark-2-market rules, all thanks to toxic assets. Here's why.
In our era, toxic assets are derivatives, the value of which ultimately reflecting the performance of various loans, including the dreaded subprime mortgages. As those loans go sour, the bundles of loans (MBS, ABS), take a hit. Now, a bundle of loans has a diminishing value over time anyway, resulting from the fact that as people pay down their loans there is a diminished future cash stream associated with the bundle. Think of it this way, a bundle of 100 separate $300k mortgages (each with the same interest rate) is worth 300k plus 30 years of compounded interest. Fifteen years later, the bundle has lost half of its total value (from a creditor's perspective).
But, these toxic assets are mostly full of relatively recent loans, so pay down over time is not a material factor in the reduction of bank assets. What about foreclosure and delinquency? Yes, this is certainly a factor in some of the MBS and ABS -- especially those underwritten with a lot of 2005 to 2007 mortgages originated in CA, FL, NV, and AZ. But, this amounts to a reduction in value in the 10-40% range, not a total wipeout.
Back to basics, then: the vast majority of mortgages and commercial loans are performing. Therefore the bonds created by bundling them (and the subsequent derivatives created in relation to that bond) should be maintaining 60-90% of their value. Why, then, are they not?
First. Consider fear. Not fear of blank-eyed zombies with blood smeared down their shredded French cuff shirts. Rather, consider fear of 10% unemployment and bottomless foreclosures. Consider plunging home values due to lack of demand (and lack of liquidity) for mortgages. Consider fear that major institutions currently dragging the corpses of subprime lenders may not make it through the year. Most importantly (from the perspective of toxic assets), consider the fact that the ratings on all MBS and ABS are suddenly deemed meaningless. Consider the political fear of zombie banks.
Now, couple that fear with the real failures of IndyMac and Bear Stearns. And the stupidity of AIG being a net seller of CDS without holding a cash reserve like it does for its properly regulated insurance products. The result is WaMu. WaMu was crushed because depositors left unprotected (at that time) by FDIC insurance pulled out their money because of rumors of WaMu's imminent demise. WaMu overnight became the first and only insolvent commercial bank during this crisis. Failure came to it.
Now, in that climate, what do you think WaMu's and IndyMac's ABS and MBS would fetch on the secondary market? I have heard the going rate was 5 cents on the dollar. With mark-to-market rules in place, everyone holding similar assets has to mark down the value of those assets to reflect the going rate. In an instant, the top 20 banks in the country, the top 100 banks in the world, have shrunk the assets on their balance sheet by a considerable margin.
Basic accounting: Equity = Assets - Liabilities.
If you listen to Goldman, you might think that there's no problem at all because CDS and the CDOs they spawn should cancel out the risk created by underperforming MBS and ABS. In the abstract, that's true, and I believe that most of the remaining banks will pull through, despite the recklessness and hubris of the liquidity bubble.
In reality, however, problems remain. All those derivatives have other uses than sale, resale, and hold to maturity. They are also collateral.
Picture yourself owning a pawnshop. Uriah comes in looking for some cash to borrow. He's going to take that cash and make a bunch of smaller loans to some dudes he knows, at a higher interest rate than the pawn shop is charging him. Everyone wins. He tells you he can pledge his 60" plasma TV and a crate of canned tuna to secure the loan. You knows plasmas are good and will resell at a good price if Uriah defaults. And you can always eat the tuna.
Just after Uriah leaves, you turn on the TV and watch a news report telling you that new research shows that plasma TVs cause eye cancer. Sales are expected to plummet. By the time you get ahold of Uriah on his cell phone to tell him he's either gotta pledge more collateral or return a big bunch of money pronto, he's already loaned the cash out. You know one thing, the next guy coming in with a TV for collateral is getting kicked to the curb.
The funny thing is, a couple of Uriah's dudes were using the cash to buy smaller plasma TVs, with the idea being that Uriah would take the TVs off their hands if they fail to pay him back.
As a pawnbroker, what do you do? Wait to see if Uriah pays you back? If he pays you back all, or most, then the crisis is averted. If he only pays you back ten percent, then you're stuck with a plasma TV that you can't resell, plus you're out the cash you loaned to Uriah. You better hope you have enough cash in reserve to pay the rent on your commercial real estate lease.
What does Uriah do? Some of his friends pay up. Some are late. Some don't pay at all and Uriah can take possession of the TVs they bought. No matter what, he's burned. He'll either go out of business altogether, or only lend out money under stricter conditions in the future. Uriah has become risk averse.
You have a sister who specializes in eye cancer. It is clear to her that Plasma TVs do not in fact cause eye cancer, or if they do, the risk posed is minimal. Yet, you are still stuck with a TV that has no market value because there is no demand for them. The intrinsic worth of the TV still holds: you can watch the hockey playoffs in hi-def; PS3 blows your mind, etc. Knowing that the health threat is overblown, you want your business partners and creditors to let you keep the asset value of the TV up near what you paid for it (the amount originally loaned to Uriah).
That's where the banks are today, which is why the m2m rules have been eased. It's the equivalent of you, the pawnbroker, placing a $500 dollar price tag on the TV in your store, but no one would pay more than $10 today for it.
A month goes by and Uriah hears on the radio (not watching TV, of course, because he doesn't want eye cancer) that there is actually only a small chance of plasma TVs causing eye cancer. Suddenly the market for plasma TVs rebounds. Not robust like it had been (everyone's still wary, wondering what if the next news will be bad news), but product is moving again. He has already sold most of the repossessed TVs at a huge loss. He recoups a little bit by selling the remaining repossessed TVs are the lifted market price, but he'll never get back to where he thought he would be. His friends are out cash and have no TV (yes, people who have lost their homes to foreclosure).
Meanwhile, you learn of the improved market conditions. You get a bunch of bidders on the TV, some are even willing to pay $700 for it. Things are looking up, right?
Well, here's where the problem is. What if you learn that the TV is health-friendly, but by this time the eye cancer scare has led to dramatic increase in layoffs in the TV and TV-related industries. Those layoffs lead to decreased spending, which leads to other business failures completely unrelated to plasma TVs. Soon, unemployment is up, spending is down, and everyone's looking at everyone else with extreme suspicion (hence the run up in corporate bond yields). Okay, great, go ahead and try to sell that TV, buddy.
That's where the banks will be. That's why Goldman's reassurances are to be taken as a best-case scenario. That's why the government needs to do only one thing right now: cure the ills of unemployment (either with benefits or job creation, or both). That is all that matters in our current era. Every other problem can wait.
The intrinsic value of the reference entities of the toxic asset is still good. Therefore the banks are still solvent, except from a regulatory perspective that requires banks to maintain certain capital requirements (of which these assets play a part in determining). But, without a leveling off of unemployment or a means to ease the pain of unemployment, the economy will continue to deteriorate, and more people will fail to pay their debts (diminish the values of reference entities in derivatives), further deteriorating the value of the toxic assets.
Thursday, April 2, 2009
I Should Be Paid More
On the morning of March 4, the S&P 500 was just under 700. It is now trading at just under 840. Yeah, a 20% gain.
What is the significance of March 4? Simply this: that is the day I called the bottom. Granted, the S&P 500 went down another 20 points in the week following my pronouncement, but it has only gone up since. Pretty good for a petty bureaucrat.
Why am I awesome? Well, go read the news from the week leading up to my bottom call and tell me you would have made the same call. You would not have done so. Admit it ;-).
I revisit this today as a followup, not just as an opportunity to brag. The credit markets will now completely thaw thanks to the mark-to-market rule revisions. For the record, I do not favor the revision, but it will help to stabilize the secondary market and shore up major banks' capital positions. Of course, it's all smoke and mirrors, but that's the way it's gonna be.
There are still more gut-wrenching job loss statistics on the way, but I truly believe that these figures are a lagging indicator. The news will ask the question: why is Factor X (whether it be the stock market, consumer spending, consumer confidence, whatever) increasing while unemployment is still so high?
All of these good tidings will soften the coming fall of GM and Chrysler. Hopefully they will be disaggregated expeditiously.
Will we see another 20% increase over the next month? Maybe. I wouldn't be surprised. I won't make any pronouncements about it, though.
What is the significance of March 4? Simply this: that is the day I called the bottom. Granted, the S&P 500 went down another 20 points in the week following my pronouncement, but it has only gone up since. Pretty good for a petty bureaucrat.
Why am I awesome? Well, go read the news from the week leading up to my bottom call and tell me you would have made the same call. You would not have done so. Admit it ;-).
I revisit this today as a followup, not just as an opportunity to brag. The credit markets will now completely thaw thanks to the mark-to-market rule revisions. For the record, I do not favor the revision, but it will help to stabilize the secondary market and shore up major banks' capital positions. Of course, it's all smoke and mirrors, but that's the way it's gonna be.
There are still more gut-wrenching job loss statistics on the way, but I truly believe that these figures are a lagging indicator. The news will ask the question: why is Factor X (whether it be the stock market, consumer spending, consumer confidence, whatever) increasing while unemployment is still so high?
All of these good tidings will soften the coming fall of GM and Chrysler. Hopefully they will be disaggregated expeditiously.
Will we see another 20% increase over the next month? Maybe. I wouldn't be surprised. I won't make any pronouncements about it, though.
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