Archive for the ‘Fixed Income’ category

Why Stress Test Really Means Guesswork

March 15, 2009

Well, we’ve heard a ton about stress tests recently. Want some details on what a stress test entails? The Journal has some details about the tests here. Now, as much as I think GDP and unemployment are fine things to project forward for economists, let’s walk through the way one would use this to actually price an asset. Let’s start with something simple, like a 10-year treasury note (note that treasury bond specifically refers to bonds with a 30-year maturity). Here are all the components one would need to stress test the value of a treasury note.

  1. Characteristics of the note itself: coupon, payment dates, maturity dates, etc.
  2. What the yield curve would look like at the date you’re pricing the note.

Why would one need to know the shape of the yield curve (term structure of rates)? This is important, in order to “PV” the bond’s cashflows most accurately, one would discount each cashflow by it’s risk–the simplest proxy is to discount each cash flow by the rate of interest one would need to pay to issue a bond maturing on that date. For the government, this rate of interest is the point on the treasury yield curve (actually, the par zero curve) with the same maturity date. An example would be, if I were going to price a cash payment I will receive in two years, and the government can currently issue two-year debt at 5%, I should discount my cash payment (also from the government, since it’s a treasury note) at 5%. Treasuries are the simplest of all instruments to value.

Here’s an example, form the link above, of what a treasury yield curve might look like:

Normal Yield Curve

Now, it is completely and totally guesswork to figure out, given unemployment and GDP figures, what the yield curve will look like at any date in the future. Indeed, one can plug these projections into a model and it can come up with a statistical guess… But the only thing we know for sure about that guess is that it won’t be accurate, although it might be close. However, things like inflation will drive the longer end of the yield curve and monetary policy will drive the shorter end, so these certainly aren’t directly taken from the stress test parameters, but would need to be a guess based on those parameters. This is a large source of uncertainty in pricing even these instruments in the stress test.

Next, let’s examine a corporate bond. What would we need for a corporate bond?

  1. Characteristics of the bond: coupon, payment dates, maturity dates, special features (coupon steps, sinking funds, call schedules, etc.), where in the capital structure this bond sits, etc.
  2. What the yield curve would look like at the date you’re pricing the bond.
  3. The spreads that the corporation’s debt will carry at the date you’re pricing the bond.

Oh no. We already saw the issues with #2, but now we have #3. What will this corporations credit spread (interest/yield required in excess of the risk free rate) at the time of pricing? Will the corporations debt, which could trade at a spread of anywhere from 5 to 1500 basis points, be lower? higher? Will the corporations spread curve be flatter? steeper?

Here is a good illustration of what I’m referring to (from the same source as the figure above):

Credit Spread

There, the spread is the difference between the purple line and the black line. As you can see, it’s different for different maturity corporate bonds (which makes sense, because if a company defaults in year two, it’ll also default on it’s three year debt.. but the companies’ two year debt might never default, but the company might default during it’s third year, creating more risk for three year bonds issued by that company than two year bonds). It shouldn’t be a surprise, after our exercise above, to learn that the best way to compute the price of a corporate bond is to discount each cashflow by it’s risk (in my example above, regardless of whether the company defaults in year two or year three, the interest payments from both the three year and two year debt that are paid in one year have the same risk).

Well, how does one predict the structure of credit spreads in the future? Here’s a hint: models. Interest rates, however, are an input to this model, since the cost of a firm’s borrowing is an important input to figuring out a corporation’s cashflow and, by extension, creditworthiness. So now we have not only a flawed interest rate projection, but we have a projection of corporate risk that, in addition to being flawed itself, takes our other flawed projections as an input! Understanding model error yet? Oh, and yes unemployment and the health of the economy will be inputs to the model that spits out our guess for credit spreads in the future as well.

Next stop on the crazy train, mortgage products! What does one need to project prices for mortgage products?

  1. Characteristics of the bond: coupon, payment dates, maturity dates, structure of the underlying securitization (how does cash get assigned in the event of a default, prepayment, etc.), etc.
  2. What the yield curve would look like at the date you’re pricing the bond.
  3. The spreads that the debt will carry at the date you’re pricing the bond.
  4. What prepayments will have occurred by the date you’re pricing the bond and what prepayments will occur in the future, including when each will occur.
  5. What defaults will have occurred by the date you’re pricing the bond and what defaults will occur in the future, including when each will occur.

Oh crap. We’ve covered #1-3. But, look at #4 and #5 … To price a mortgage bond, one needs to be able to project out, over the life of the bond, prepayments and defaults. Each is driven bydifferent variables and each happens in different timeframes. Guess how each projection is arrived at? Models! What are the inputs to these models? Well, interest rates (ones ability to refinance depends on where rates are at the time) over a long period of time (keep in mind that you need rates over time, having rates at 5% in three years is completely different if rates where 1% or 15% for the three years before). General economic health, including regional (or more local) unemployment rates (if the south has a spike in unemployment, but the rest of the country sees a slight decrease, you’ll likely see defaults increase). And a myrid of other variables can be tossed in for good measure. So now we have two more models, driven by our flawed interest rate projections, flawed credit projections (ones ability to refinance is driven by their mortgage rate, which is some benchmark interest rate [treasuries here] plus some spread, from #3), and the unemployment and GDP projections.

I will, at this point, decline to talk about pricing C.D.O.’s … Just understand, however, that C.D.O.’s are portfolios of corporate and mortgage bonds, so they are a full extra order of magnitude more complex. Is it clear, now, why these stress tests, as they seem to be defined, aren’t all that specific, and potentially not all that useful?

How to Fix the Crisis in Six Easy Steps

February 26, 2009

There is a lot of chatter about different plans, market anticipations, and pitfalls when it comes to “fixing” the economy and, specifically, nationalization. Despite the fact that I don’t have the same reach as several uneducated members of the media, I figured I’d share what I think the way forward is, regardless.

Step 1: Nationalize Citi and Bank of America. Let’s be honest, with recent talks of expanded stakes, ringfenced assets, and no end of the losses in sight, it’s probably time the U.S. Government came to grips with the fact that they already own the losses and the positive impact of letting shareholders keep the upside is nonsensical. Further, these institutions will need more money for a long time to come. And, if you’re paying attention, you know that the markets seem to twist and turn with the news coming out of financial institutions. Nationalization rumors depress the markets, talks of further government action scare away new capital, and the fundamental health of these firms makes current investors run.

Step 2: Begin lending. With so much chatter and anger about institutions not lending, it almost makes me wonder why there is such a deep lack of understanding. These sick institutions are trying to shrink their balance sheets and have a ton of souring assets on them. They have to raise capital to support their current asset base, so why do we really expect these banks and other firms to lend? Some would claim that lending for the sake of lending got us into this mess, but they are either telling only part of the story or don’t get it–excessive leverage and poor risk management got us to this point. In fact, I suspect that defaults on even the riskiest loans would be much lower if bank capital was free enough to continue making mortgage loans based on normal requirements for returns and risk/reward.

So, how do we begin lending? Simple, start a government bank. Well, not exactly, but the government now owns Fannie, Freddie, AIG, Citi, and BofA (see step 1). Clearly the government now (by step 2) has the infrastructure and technical know-how to manage the logisitical issues of setting up and running a lending platform. Now the government can lend directly and not wait for sick banks to do it. Further, they can underwrite to fairly normal lending standards and get a premium return on their capital. Also, rather than poaching the nationalized entitites’ “talent,” the government cam employ many out of work finance workers throughout the country (after all, lending in Missouri should probably be done by people in Missouri).

Step 3: Begin replenishing bank assets with new, cleaner assets. With all of these souring assets on the books of banks, their capital base being eroded, and leverage decreasing, TARP capital is probably being deployed very inefficiently and, obviously, conservatively. Well, since step 2 involves lending and creating assets, the government should then implement an auction process–all assets the government creates would then be auctioned off, much like treasury bonds are, to banks. Since the government would be lending based on normal underwriting standards (as compared to the previous paradigm of loan underwriting), these assets would have a strong credit profile and will likely perform much better than legacy assets. JP Morgan, for example, should jump at the chance to generate higher levels of retained earnings by buying assets when the rates it needs to pay are at historically low levels, once its capital frees up. This solves the chicken-and-egg problem of curing sick banks, hurting from consumer defaults and depressed economic activity, to free up the credit markets and getting economic activity to increase despite a lack of credit.

One could easily permute this plan in many ways. One possible way is to offer to swap new assets for legacy assets at current market levels to facilitate a much more immediate strengthening of the banks’ balance sheets. Another variation could include some partial government guarentee on assets it originates. I’m sure there are thousands more ways one could add bells and whistles.

Step 4: Broaden the Fannie and Freddie loan modifications and housing stabilization plan to the government’s new properties. I suppose this should be some sort of addendum to step 1, but it’s important enough to require some emphasis on it’s own. With Citi and Bank of America being so large, I’m sure the housing stabilization plan will have a much broader reach once those are wards of the state. We’ve all heard the arguments for stopping foreclosures and refinancing borrowers… When the house next door is foreclosed upon, your house loses tens of thousands of dollar in value, increases housing supply, etc.

Step 5: Break up the institutions that are owned by the government. Markets have been clamoring for Citi to be broken up for years. Bank of America shareholders probably want Merrill to be broken off A.S.A.P. (ditto for Countrywide). Chew up these mammoth institutions and spit out pieces that, in the future, could fail because they aren’t too big. This should be done to AIG, Citi, Bank of America, and both Fannie and Freddie.

Step 6: Immediately implement a new regulatory regime. This is pretty much a “common sense measure.” President Obama has begun to call for this, and it’s pretty clear that with no more major investment banks around, the S.E.C.’s role needs to be re-defined. I’ve already laid out my thoughts on what this new structure should look like.

Between all of these steps, we should have the tainted institutions out of the system, credit will start to free up, banks asset base will become more reliable, and systemic risks will go down as we significantly decrease the number of firms that are “too big to fail.” Seems logical to me…

Blunt Regulatory Instrument

February 20, 2009

Clusterstock decides to bludgeon the whole thought of regulators beginning intensive reviews of banks. Although they don’t do it themselves–the post essentially highlights a quotation from Yves Smith at Naked Capitalism. The post there (at NC) makes this statement:

In the early 1990s, when Citi almost went under, it had 160 bank examiners working SOLELY on its commercial real estate portfolio (Citi has a lot of junior debt against buildings that turned out to be see-throughs).

I would welcome reader input … but it is pretty clear 100 people and a few weeks (or even a few months) is grossly inadequate for a bank the size and complexity of a Citigroup. Citi has operations in over 100 countries. All 100 examiners can do is make queries along narrow lines, and work with the data presented. This scale of operation won’t allow for any verification or recasting of data. There isn’t remotely enough manpower.

And do you think these examiners are in any position to assess the risks of CDS, CDOs, swaps, foreign exchange exposures, Treasury operations, prime brokerage, to name just a few? I cant imagine US bank examiners have much competence in FX risk (Citi trades in a lot of exotic currencies, too), and that’s one of the easier to assess on the list above.

(Emphasis mine.)

Now, let’s be honest, this seems like a pretty simple claim to make: there’s so much going on, how can 100 people really analyze a complex institution? Well, I’ve never heard of a “proof by question” so I’ll assume there’s some sort of reason behind this claim. I also wonder what people who make this claim think of management’s ability to understand and analyze the positions of the firm. Surely there are many fewer than 100 members of senior management who make decisions affecting the entire firm. Can these people actually understand the ship they are steering? Here, I think we can make a stronger, more substantiated claim: history supports the answer of “no.” When Chuck Prince, Stan O’Neil, Dick Fuld, Ken Lewis, and Jimmy Cayne would get on earnings calls and talk to analysts about their comapnies’ workings and risk exposures, we all learned they didn’t know what they were talking about. The predictions turned out to be wrong–they had exposures they didn’t know about and did an extremely poor job of disclosing. So, having 100 people, less focused on all the fluff (P.R., dealing with analysts, managing egos, staff turnover, the decor of the firm, meeting with clients, etc.) can only give an improved understanding of the firms.

It’s important to make some further distinctions. First, the bank regulators have no purview over the investment bank, at all. As a matter of fact, banks go through a lot of trouble to ensure that there is no cross-pollution between these sorts of entities for exactly this reason, they don’t want investment banks to be regulated according to bank rules and regulations. Anyone who has ever heard the term “bank chain vehicle” or “broker dealer entity” knows what I’m talking about. Nothing in the article indicates that bank regulators will be going into broker dealers and breaking them down beyond, possibly, what has already been ringfenced and moved to the bank chain. Further evidence in support of this is when a regulator in the article specifically refers to “Tier 1 capital,” which is purely a bank metric. I’ll re-assert my belief that larger banks that have received aid due to issues in their broker dealer (Citi and BofA) will most likely have their troubled assets subject to the same scrutiny JP Morgan’s banking operations or a large bank like Fifth Third Bank will endure.

Let’s also not forget that bank regulators have a very different relationship with the institutions under their purview than securities and investment banking regulators. For example, the OCC and other bank regulators actually have personnel that are housed within the institutions. Securities regulators, by contrast, get reports and speak with compliance people and lawyers at investment banks. Personnel at investment banks are actively discouraged from speaking with S.E.C. staffers, for example, without being chaperoned by other people and without being pre-briefed. While I doubt this is how things continue to operate, it shows a huge difference in what sort of head start these regulators likely have in understanding these banks already.

One also needs to consider the advances in technology (since the 1990’s, referenced above) and the fact that government staffers have poured over the books of these firms several times now. Given all this information, it seems that someone needs a better argument than “It’s clearly very hard!” to show that this new regulatory scrutiny can’t get a handle on the problem, let alone that regulators aren’t able to make better decisions with the information they will gain.

Commercial Developers: Not a Credible Threat

January 9, 2009

Ok, I’ve been tardy in posting. I’m very sorry about that, lot’s of things are going on. This post is, obviously, a bit delayed, but I think it’s important that people realize why this is amongst the dumbest ideas ever and will demonstrate how one can try to pull the wool over the eyes of the public.

On December 22nd I was startled to see a WSJ news alert title “Developers Ask U.S. for Bailout as Massive Debt Looms” in my email. This is potentially the most ridiculous thing I’ve ever heard of.  There are a few reasons I believe this. First, though we’ll need to know a few things about commercial properties and how they are financed…

1. Unlike residential mortgages, there are multiple metrics for value and credit worthiness of a commercial property. Residential properties can be looked at with a few paramters in mind, but there is a certain amount of behavioral science that undergirds mortgage models. For residential mortgages, one mainly considers FICO score and LTV (ratio of loan amount to value). However, these are not created equal: FICO is used to ascertain probability of default and LTV is used to figure out loss severity with a binary “under water or not” input into default probability as well. The intuition here is that how much one expects to lose is the probability you lose anything at all times the severity (percentage of loan value) of that loss. We can debate if the world is this simple (it isn’t, I’ll win that one), but that’s how one analyzes individual mortgages in the context of a pool. Note what is NOT in there, the actual rate of interest or income of the borrower (theoretically contributes to FICO, but FICO is largely a black box).

Commercial mortgages, on the other hand, are sized to two parameters: LTV and DSCR. DSCR is the Debt Service Coverage Ratio and is net cash flow (NCF) from the property divided by the monthly interest payment, and has traditionally been constrained to 1.20x as the minimum acceptable ratio. Further, the cashflow is the result of a detailed underwriting process where every line item (most important being rent, obviously) is analyzed and researched to find the correct assumptions. Values, unlike residential properties which are dollars per square foot, are determined by capitalization rates or cap rates for commercial properties. The cap rate is the NCF divided by the value of the property. So, if a property that generates $10 million “trades” at a 10% cap rate (which is ridiculously high, bubble cap rates were around 4% and normal cap rates are around5-7% for regular properties), it would “trade” at $100 million (trades being used to denote the theoretic level it could be bought or sold).

What we see here is that there are three elements of analyzing a loan here: the actual cashflow the property generates is scrutinized, the ability to service debt from that cash flow constrains the size of the loan, and the valuation of properties constrains the size of the loan along a different, but not unrelated, dimension.

2. The riskiest properties in the commercial mortgage market are structured as much shorter-term loans. If you are a developer and you aren’t refinancing a mortgage on a cashflowing property, you don’t get a 10-year fixed-rate loan. You get a two-year loan whose interest rate floats (although there is a cap purchased, so the property or developer has a maximum payment) and is extendable if you meet certain conditions and pay certain fees. These sorts of loans are made on newly-constructed complexes with no current cashflow, properties undergoing a severe renovation or being repositioned in such a way as to introduce a lot of uncertainty (adding floors, changing building type, etc.), and other risky properties.

Less risky properties get 10-year fixed rate loans, but they aren’t 10-year amortizing loans, they are 30-year amortizing loans that come due in 10 years. This is called a 10-year balloon payment. This means that in ten years the average commercial property will only have paid back 20% of their loan when the remaining 80% comes due. Clearly this is a regime meant to discourage unlevered ownership.

3. For very large loans, in addition to floating rate loans, commercial properties have low leverage mortgages and the additional debt comes in the form of mezzanine debt. Why is this important? Well, mezzanine debt, for those who aren’t familiar with the term, is debt against equity–the owner puts up his/her ownership stake as the collateral of the debt. So, if one fails to make a payment on the mezzanine debt, the mezzanine debt holder can take the property. Note, however, this is unlike a bank foreclosing on your house–the mortgage in this scenario is above the mezzanine debt and is undisturbed by the default of the mezzanine debt. The mortgage holder is still owed money, but from whom the checks are coming is irrelevant to the mortgage holder. This structure exists for a number of reasons, including tax and accounting reasons, but one reason it is to often used is that mezzanine debt makes it much easier to transfer the property’s ownership versus having one large mortgage.

It shouldn’t surprise anyone, though, that this complexity allows investment banks to get deep into the process of lending and distributing debt. The buyers of the lowest pieces of mezzanine debt are completely different than the buyers of the AAA bonds backed by the senior mortgages (yes, the mortgages are securitized, but mezzanine debt cannot be–for boring details on this to look into REMIC rules and other minutia).  The natural buyers of the lowest pieces of mezzanine debt are firms that, in the event of default, can own the property and operate it well. This is an important fact. Some buyers of commercial mortgage debt will refuse to purchase debt on a property, especially large or complex properties, if a smart firm with a good track record of operating properties isn’t in the first in line to take over the property in the event of a default (called the first-loss debt position).

Now, let’s explore what actually happened over the past few years. 2006 was the year underwriting standards totally died. Highly levered transactions became the norm, case-in-point is the EOP transaction. This was financed with floating rate debt and was very highly levered–EOP’s portfolio was yielding about 4% to 5% on the purchase price (although, this was on the final purchase price which was settled on in 2007, but the underwriting and debt commitments were all negotiated in 2006). Here’s another dirty secret about Blackstone’s buyout of EOP: the rating agencies, to rate debt, have to do their own underwriting of the properties and come up with their own, conservative, cashflow. Most, if not all, of the underwriting the rating agencies used was directly from Blackstone. This was not uncommon when the rating agencies were involved in a transaction with a large client who had a good brand name. EOP is merely illustrative of a top-of-the-market deal. Although, there are other huge examples.

Benchmark underwriting standards went from a 1.20x DSCR to 1.15x or 1.10x, although LTV’s stayed at 80% (although valuations were sky-rocketing).  A huge percentage of loans were interest-only, so the balloon payment went from 80% of the loan to 100% of the loan. Think about that… A borrower is constrained by their ability to make payments on the debt, but they are only constrained to 1.10x their debt payments, which don’t include amortization payments, and the constraint is based on your expected future cashflows (which, obviously, assume rent growth!), not your current cashflows. Starting to get the picture? Properties became over-levered in the instance where any problems developed.Who pushed for this? Developers and property owners. As a matter of fact, the push to grow market share and revenue meant that banks needed to lend more so they could sell more debt and securitize more. 2006, for these reasons was the peak of lending on commercial properties. Between 2005 and 2006, I would estimate, 40-50% of all the currently outstanding commercial mortgage debt was originated (the chart in the WSJ article bears this out).

2007 was the year that problems began to occur. Spreads blew out to record levels (at the time, those records are being smashed all the time). Within six months of relaxed standards being instituted, they were rolled back. It was also during this year that supply of debt, including the unsold inventory referred to as hung debt, far outstripped demand. Because of the large percentage of “fast money,” or hedge funds, in the real estate debt markets (see #7 in that post), when spreads moved against them the largest players took huge losses and shut down (“blew up”). Also, CDO’s were a huge consumer of this sort of debt, and the non-corporate CDO market stopped completely in 2007. Seeing the headwinds for reduced demand? So, in essence, the marginal buyers of debt who could live with relaxed underwriting standards, because they needed to get enough debt to issue a CDO or invest their new $1,000,000,000 they raised, disappeared.

2008 was, in essence, more of the same. The same pressures and lack of demand persisted and debt prices continued to sink. Also, more buyers of debt left the market or shutdown, compounding the problems.

So, now, we can examine the request for bailout funds by developers. In the next three years, there is, according to the article, citing some firm I never heard of, $530 billion coming due ($160 billion in the next year). Well, I can count, so let’s count backwards. The vast, vast majority of mortgages are 10 year mortgages with a balloon payment, so those loans made in 1998 with this structure will be coming due. Rents are up significantly since then (page 23), perhaps 40%. Cap rates have also compressed significantly. Taken together, these two facts mean that someone with a stable property, who got a mortgage in 1998, is coming due  this year and has 40% more cash coming in from the property and can lever that cashflow much more now. I think those people will be fine refinancing. Ditto for all normal loans coming due in the two years after that.

What’s left? Well, all the risky, shorter term loans. These are 2 year loans that can be extended by one year up to a total term of five years, traditionally. In my estimation 95% of the floating rate loans I’ve seen conform to this structure.  Well, two years ago means originated in late 2006 or early 2007. Three years ago is 2006 or 2005 (very top of the market). You see the pattern. These loans are the riskiest projects, undertaken at the top of the market. These loans were made with aggressive assumptions underlying their underwritten cashflows, top-tick valuations, and higher levels of allowable leverage than at any other time in recent memory (certainly in the time this market has been considered mature). Seems like I just made the case for the developers, no? Absolutely not. Common sense tells us that these risky loans aren’t the normal apartment buildings, malls, retail space, and industrial space–those are the 10-year loans we talked about. These risky loans are for acquisition and re-positioning of hotels, construction projects resulting in marginal increases in commercial space, and highly levered purchases of portfolios of properties. Not exactly the sort of properties that are the backbone of our economy.

Even worse for developers is the fact we discussed above: short term loans are designed to transfer owners. Defaulting on a highly levered property usually means the property owner becomes someone as good, if not better, at running that same property type. No one will come to their office to see the front door padlocked and the bank selling the building for the majority of these loans. Oh, and the majority of those 40-50% of loans I estimated were made in 2005 and 2006, based on frothy valuations and underwriting, will be coming due in 2015 and 2016–those numbers, then, can’t be in the numbers presented by developers.

The conclusion? Devleopers are using big numbers to scare people into putting money up to backstop the riskiest of their highly-levered projects. As a matter of fact, there was quote in the WSJ article.

“The credit crisis has got so bad that refinancing of even good loans may be drying up,” says Richard Parkus, head of commercial-mortgage-backed securities research at Deutsche Bank.

(Emphasis mine.)

HA! “Even good loans” … The unread part of that is, “Not just bad loans, but…”

Further, this just can’t be true at all:

There’s widespread agreement that a record volume of commercial real-estate loans made during the boom years are starting to come due. According to Foresight Analytics, the $530 billion of commercial mortgages that will be maturing between now and 2011 includes loans held by banks, thrifts and insurance companies as well as loans packaged and sold as commercial-mortgage-backed securities — or CMBS.

(Emphasis mine.)

Unless we are defining “boom years” as 1998 to 2001, this isn’t just suspect it’s patently false. No significant amount of loans turned into CMBS is coming due between now and 2011. At least the WSJ is consistent…

Unlike home loans, which borrowers repay after a set period of time, commercial mortgages usually are underwritten for five, seven or 10 years with big payments due at the end. At that point, they typically need to be refinanced.

[…]

At the heart of the financing scarcity is the virtual shutdown of the market for CMBS, where Wall Street firms sliced and diced commercial mortgages into bonds. During the recent real-estate boom that took off in 2005 and lasted through early 2007, that market fueled the lending to real estate because banks could sell easily the loans they made.

(Emphasis mine.)

Wow! Five, seven, and ten year loans, made between 2005 and early 2007 are coming due between now and 2011! The disproving of these are left as a simple exercise for the reader.

Look, as a reader of Dear John Thain, you know that I’m not always right. I’m probably missing something. Let’s see what else the WSJ has to say:

What’s not clear is how soon the crunch will come. The Real Estate Roundtable, a major industry trade group, predicts that more than $400 billion of commercial mortgages will come due through the end of 2009. Foresight Analytics estimates that $160 billion of commercial mortgages will mature next year.

Jeff DeBoer, president and chief executive officer of the Roundtable, says the group came up with its estimate by looking at the $3.4 trillion of commercial real-estate loans outstanding. It’s not unusual for roughly 10% of the industry’s debt to roll over every year, he says, referring to refinancings.

This year, some $141 billion worth of commercial real-estate debt owed by property owners and developers to lenders came due, according to Foresight Analytics. Most of that was refinanced or extended by existing lenders. The lion’s share of those loans was made between five and 10 years ago. Despite the recent decline in property values, the underlying buildings were still worth well more than their mortgages and were generating sufficient cash to pay debt service.

(Emphasis mine.)

Well, I guess not. So, the larger number is a guess based on the “take a large number and multiply it by 10%” rule. The smaller number is similar to what was experienced in 2008, where most of the debt was refinanced or extended by lenders. Further, those properties that make up the “lion’s share” were worth much more than their mortgages and generating sufficient cash to pay their debt service. Oh, and they were originated between 5 and 10 years ago, as I conjectured above. Seems like there is no justification, whatsoever, for spending a dollar on “bailing out” commercial mortgage developers. (I really want to put a Q.E.D. here…).

The Easiest Hardest Question Ever

January 7, 2009

I was reading Felix’s post, recently (I know, I’m behind on everything… I’m posting on that soon too), where he cites a Tanta piece on negative amortizing loans. And it prompted me to have a very specific memory.

Here’s my email to Felix…

————-

Subject: Here’s something funny-scary …

… that your post on option ARMS got me thinking about. No one, and I literally mean NO ONE, who works in securitized products knows very basic things about the loans, as you touched on. But the people securitizing the loans and selling the bonds don’t know very basic things that fall under the “you should be shot for not knowing something this basic” category… Here’s what I asked a whole bunch of these master’s of the universe and none of them knew the answer, they all guessed.

“When I, as an individual who has a mortgage on my home, have a fixed rate amortizing loan on a thirty-year amortization schedule, and I send in a curtailment (excess principal payment that doesn’t pay off the loan but reduces the principal balance faster than scheduled) what happens to all the subsequent payments?”

Here’s why this is tricky…

1. If you curtail the loan then your interest payment reduces. However, this means your payments are no longer “level” … They change from month to month. This is because amortization schedules set based on simple interest computation (rate*loan balance) but the principal is set to keep the payments level. When you curtail the loan, you destroy this balance.

2. If your interest payment reduces once, but the overall payment doesn’t change, then you have a loan that starts to amortize much faster than before. Why? Well, the bank can’t charge you interest for that month on a principal balance that is lower, right? So if your payment is “x” and you paid off 5% of your loan, because the interest portion of your payment is 5% lower, if the payment hasn’t changed that money that would have gone to interest on the paid off amount goes to principal repayment. This compounds the same problem for next month’s payment.

3. No one was aware of loans being recast. It doesn’t seem to be the case that loans are recast once someone sends in more than their payment, and it also doesn’t seem to be the case that loans are recast on any sort of schedule (annually, for example). Not a single person thought this happened.

Most common answer was “principal balance goes down” …. And once the details were asked? One usually got a hand wave and an answer of “Curtailments are so rare, this is unimportant.” Even the people modeling the actual cashflows didn’t understand what happens to loans when curtailments come in. They would model it as a partial prepayment of the pool, but not alter anything else (after all, curtailments are rare! why bother modeling them correctly?). Ha!

-DJT

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I did call some mortgage companies and it seems they do “turbo” the loan, essentially, by keeping payments level and applying more to principal … But this, obviously, makes it les than a 30-year loan. However, some mortgage companies will allow you to recast the mortgage totally for payments that are large enough.

Another “Holy Shit!” Moment in Compensation: The P.A.F.

December 19, 2008

Wow. Seriously, wow

This year, up to 80% of the stock portion will come via what Credit Suisse is formally calling a “Partner Asset Facility,” of the illiquid assets, largely corporate loans.

Bankers won’t receive a return on the PAF program for eight years, although they can start to collect some of the principal in 2013. If the firm finds outside buyers for the assets, it will pay the proceeds to itself first, then provide the rest to employees.

The PAF applies only to senior bankers within the firm’s investment bank, which includes merger advisory, capital markets and leveraged finance. Those in Credit Suisse’s private bank and asset-management division aren’t subject to the PAF.

I’m going to play both sides of this one… But, how do you know it’s a good move? Hiede Moore’s post, in the next line, offers the proof:

The announcement elicited livid reactions from senior bankers, many of whom questioned whether it was legal. Many said they believed they were being unfairly punished for risky assets bought by colleagues in distant parts of the firm.

I’m not crying for these bankers, exactly, but they missed the point. To be honest, it’s a tremendous incentive for everyone to work together for the good of the firm. These same “livid” investment bankers, I’m sure, have been pushing transactions onto their counterparts in capital markets and trading for years. I know this, specifically of C.S.F.B. Their investment bankers would constantly use the “relationship” reason for doing a given transaction that resulted in real estate exposure for their firm (or leveraged finance commitments). So bankers, as a whole, shouldn’t say they are being unfairly punished for their colleagues decisions to make loans that they asked them to make. Now those bankers will not push loans they think might make it into their compensation! (There was a rumor that something like this happened a long time ago at Salomon Brothers.)

Now, why might this be a bad ideas? Honestly, all the reasons are highly technical. First, the investment is much longer dated than normal equity: first principal distributions come in 2013 and the investment will be zero-return for 8 years. This is a bit unfair, as the vesting and return of cash should be similar to normal equity plans if employees are given no notice. It’s only polite as it concerns things like paying college tuition. That being said, this is a program for senior employees and, thus, they should have planned for bad times and not gambled with their entire lifestyle. The two largest issues, though, are where the firm is using this to their advantage instead of being “just” about it. First, Credit Suisse pays itself before employees. That seems tacky.. pro-rata, maybe? Even pro-rata withe the firm counted more… Second, this makes C.S.F.B. employees much less mobile. When a bank is trying to figure out how to make the bankers being recruited from C.S.F.B. whole on what they lose when they depart their current firm (standard practice), it’s likely that their P.A.F. holdings will be valued at, or near, zero.

Now, despite the problems, I think this is a great lesson and a fair mechanism. And, unlike the clawback, if the firm loses money on the investment, so are the people getting paid in P.A.F. units… So you don’t have to worry about going after an employee, they get reduced along with shareholders.

The Real Problem with the Citi Bailout

December 3, 2008

We all know that Citi was “bailed out” last week. However, as far as I can see, Citi’s is a unique situation for several reasons:

  1. The company was not taken over, and
  2. Management was allowed to stay on, and
  3. The government is shouldering losses coming from securities that are already identified.

Taken together, these leave a huge hole in this “living bailout” (I call it that because, obviously, Citi was in dire straights but was allowed to survive, essentially, as it existed before) that, obviously, Treasury never thought out (setting aside my prior concerns). I’ll put the problem into a single statement…

When taxpayers agree to pay for losses of a company that is continuing to operate, but the losses being referenced pertain only to specific assets, there are a huge amount of games that can played and the government has no way to stop or monitor what is truly going on.

As a matter of fact, as I write this the news of the G.A.O. report (PDF) on T.A.R.P. is making the rounds. One of the main criticisms is the lack of monitoring of bailed-out institutions. And those institutions don’t have explicit guarantees like Citi does. It is extremely surprising to me that, for example, there aren’t auditors or officials from Treasury meeting with traders and executives of Citi’s mortgage groups regularly. As a matter of fact, I would station some people on the trading desks where these assets are being managed to give status reports and monitor the situation. Further, Hank Paulson’s and Vikram Pandit’s interests are aligned here. Vikram shouldn’t want these assets languishing or Citi being accused of sitting on assets that might lead to a taxpayer loss in the future and Hank Paulson should want to know Citi still feels some obligation to minimize taxpayer’s exposure to losses.

Now, the question of what “games” can be played is the next natural question. Well, if I’m a trader, I mark my own position every day. In mortgages, there is little to no verification of these prices–the markets are so illiquid that only the people that trade the product know the actual value of a given instrument. This conflict, in general, is controlled for by the organizational structure: the person most likely to know the product as well as, if not better than, the trader is the trader’s boss. Obviously, the trader’s boss has little incentive to allow his employees to incorrectly mark the trading book because he can be held accountable. With this “living bailout” though, what incentive does Citi have to sell assets in a liquidity-challenged environment? If no pressure is applied from Treasury, and how can they apply pressure without being deflected if they aren’t “on the ground,” then why wouldn’t Citi just hold assets they currently view as having positive value? Citi likely has assets that are obviously going to go bad, in which case there is likely no way they can offload those assets (perhaps around, oh, say… $29 billion worth…), and assets they view as merely undervalued due to liquidity concerns. Why would I seek out a guarantee on further losses for assets I can sell today? If losses are guaranteed then what’s my downside in just holding illiquid assets?

Because Citi won’t absorb all the losses on the assets viewed as undervalued, those assets are worth more to Citi than others. And, as a trader that gets paid based on his/her personal P&L, I have every incentive to avoid losses that I view as not being inevitable and I have a defensible reason to not mark my position merely to the price I can sell it today. Another nuance comes from how traders actually mark their books…

  1. A trader buys mortgage bonds, loans, or any other security. The current profit or loss of that trade (we’ll call it “the bonds” or “the position”) is the purchase price and there is no net P&L.
  2. The trader then enters into another transaction that is considered a hedge for the position. This transaction could be buying credit protection, shorting treasury bonds, or any number of other possibilities. We’ll refer to these transactions as “the hedges.” This trade generates no net P&L.
  3. On an ongoing basis the position is marked “flat” to the hedges. This means that, dollar for dollar, any loss or gain in the hedges is added or subtracted from the original position so as to generate no net P&L. This isn’t perfect, but it’s theoretically very clean since the point of the hedges is to eliminate the risk in the position.
  4. Generally, a price movement in the position that isn’t reflected in similar price movements in hedges is marked manually–usually this takes place at month-end. However, if the original position is sold then the difference between the most recent marked price and the sale price will generate positive or negative P&L as well.

So here’s a good question: Why does a trader, now, have any incentives to hedge? A better question, though, is why would I mark my positions accurately versus hedges? Can’t I make the claim that all the gains in the position, as evidenced by losses in the hedges, should be taken as P&L but only 10% of the losses, as reflected by gains in the hedges, should be taken as P&L? Because the positions hedging the guaranteed mortgage positions are either derivatives or other products that likely aren’t also guaranteed this asymmetry becomes problematic. It’s not even clear that whatever scheme generates the most profits for Citi isn’t the correct way to account for the gains and losses of a typical hedged mortgage position in this atypical arrangement. I know that traders are asking these very questions. However, the possibility that taxpayers could shoulder costs while Citi also books profits whose existence depends on taxpayer-funded guarantees is troubling.

I don’t think anyone would disagree that this arrangement is complicated enough that a higher degree of oversight is required (and should be desired by all parties) to ensure that nothing improper is going on for the sake of taxpayers and Citi’s reputation. One thing we’ve learned from A.I.G. is that even if billions of dollars are at stake expenditures on the order of one hundred thousand dollars can become P.R. nightmares. Treasury should be auditing all of Citi’s mark-to-market procedures and setting standards to protect taxpayers (more so than non-“living” bailouts). Also, as I stated before, there is no reason that there shouldn’t be some sort of watchdog presence on the trading floors to ensure Treasury is keeping watch and being kept in the loop.