Revisiting a Debate We Should be Past

Recently, Felix Salmon, Clusterstock, and others have been mentioning an essay from the Hoover Institute about the financial crisis. Now, I haven’t yet linked to the essay in question… I will, but only after I’ve said some thing about it.

I was on the front lines of the securitization boom. I saw everything that happened and am intimately familiar with how one particular bank, and more generally familiar with many banks’, approach to these businesses. I think that there are no words that adequately describes how utterly stupid it is that there is still a “debate” going on surrounding banks and their roles in the financial crisis. There are no unknowns. People have been blogging, writing, and talking about what happened ad naseum. It’s part of the public record. Whomever the author of this essay is (I’m sure I’ll be berated for not knowing him like I was for not knowing Santelli — a complete idiot who has no place in a public conversation whose requisites are either truth or the least amount of intellectual heft), unless it’s writing was an excesses in theoretical reasoning about a parallel universe, it’s a sure sign they don’t what they are talking about that they make some of the points in the essay. Let’s start taking it apart so we can all get on with our day.

For instance, it isn’t true that Wall Street made these mortgage securities just to dump them on them the proverbial greater fool, or that the disaster was wrought by Wall Street firms irresponsibly selling investment products they knew or should have known were destined to blow up. On the contrary, Merrill Lynch retained a great portion of the subprime mortgage securities for its own portfolio (it ended up selling some to a hedge fund for 22 cents on the dollar). Citigroup retained vast holdings in its so-called structured investment vehicles. Holdings of these securities, in funds in which their own employees personally participated, brought down Bear Stearns and Lehman Brothers. AIG, once one of the world’s most admired corporations, made perhaps the biggest bet of all, writing insurance contracts against the potential default of these products.

So Wall Street can hardly be accused of failing to eat its own dog food. It did not peddle to others an investment product that it was unwilling to consume in vast quantities itself.

(Emphasis mine.)

Initial premise fail. I had a hard time finding the part to emphasize since it’s all so utterly and completely wrong. Since I saw everything firsthand, let me be unequivocal about my remarks: the entire point of the securitization business was to sell risk. I challenge anyone to find an employee of a bank who says otherwise. This claim, that “it isn’t true that Wall Street made these mortgage securities just to dump them on them the proverbial greater fool” is proven totally false. There’s a reason the biggest losers in this past downturn were the biggest winners in the “league tables” for years running. As a matter of fact, there’s a reason that league tables, and not some other measure, were a yardstick for success in the first place! League tables track transaction volume–do I really need to point out that one doesn’t  judge themselves by transaction volume when their goal isn’t to merely sell/transact?

In fact, the magnitude of writedowns by the very firms mentioned (Merrill and Citi) relative to the original value of these investments imply that a vast, vast majority of the holdings were or were derived from the more shoddily underwritten mortgages underwritten in late 2006, 2007, and early 2008. In fact, looking at ABX trading levels, as of yesterday’s closing, shows the relative quality of these mortgages and makes my point. AAA’s from 2007 (series 1 and 2) trading for 25-26 cents on the dollar and AAA’s from early 2006 trading at roughly 67 cents on the dollar. The relative levels are what’s important. Why would Merrill be selling it’s product for 22 cents on the dollar if the market level is so much higher (obviously the sale occurred a few months ago, but the “zip code” is still the same)? This is a great piece of evidence that banks are merely left holding the crap they couldn’t sell when the music stopped.

Now, onto the next stop on the “How wrong can you get it?” tour.

It isn’t true, either, that Wall Street manufactured these securities as a purblind bet that home prices only go up. The securitizations had been explicitly designed with the prospect of large numbers of defaults in mind — hence the engineering of subordinate tranches designed to protect the senior tranches from those defaults that occurred.

Completely incorrect. Several people who were very senior in these businesses told me that the worst case scenario we would ever see was, perhaps, home prices being flat for a few years. I never, not once, saw anyone run any scenarios with home price depreciation. Now, this being subprime, it was always assumed that individuals refinancing during the lowest interest rate period would start to default when both (a) rates were higher and (b) their interest rates reset. [Aside: Take note that this implicitly shows that people running these businesses knew that people were taking out loans they couldn’t afford.] Note that the creation of subordinate tranches, which were cut to exactly match certain ratings categories, was to (1) fuel the CDO market with product (obviously CDO’s were driven by the underlying’s ratings and were model based), (2) allow AAA buyers, including Fannie and Freddie, an excuse to buy bonds (safety!), and (3) maximize the economics of the execution/sale/securitization. If there were any reasons for tranches to be created, it had absolutely nothing to do with home prices or defaults.

Further, I would claim that there wasn’t even this level of detail applied to any analysis. We’ve seen the levels of model error that are introduced when one tries to be scientific about predictions. As I was told  many times, “If we did business based on what the models tell us we’d do no business.” Being a quant, this always made me nervous. In retrospect, I’m glad my instincts were so attuned to reality.

As a matter of fact, most of the effort wasn’t on figuring out how to make money if things go bad or protect against downside risks, but rather most time and energy was spent reverse engineering other firm’s assumptions. Senior people would always say to me, “Look, we have to do trades to make money. We buy product and sell it off–there’s a market for securities and we buy loans based on those levels–at market levels.” These statements alone show how singularly minded these executives (I hate that term for senior people) and businesses were. The litmus test for doing risky deals wasn’t ever “Would we own these?” it was “Can we sell all the risk?”

But wait, there’s more…

Nor is it plausible that all concerned were simply mesmerized by, or cynically exploitive of, the willingness of rating agencies to stamp Triple-A on these securities. Wall Street firms knew what the underlying dog food consisted of, regardless of what rating was stamped on it. As noted, they willingly bet their firm’s money on it, and their own personal money on it, in addition to selling it to outsiders.

One needs the “willingly bet [their own] money on it” part to be true to make this argument. I know exactly what people would say, “We provide a service. We aggregate loans, create bonds, get those bonds rated, and sell them at the levels the market dictates. It isn’t our place to decide if our customers are making a good or bad investment decision.” I know it’s redundant with a lot of the points above, but that’s life–the underlying principles show up everywhere. And, honestly, it’s the perfect defense for, “How did you ever think this made sense?”

And, the last annoying bit I read and take issue with…

Nor is it true that Wall Street executives and CEOs had insufficient “skin in the game,” so that “perverse” compensation incentives created the mess. That story also does not pan out. Individuals, it’s true, were paid sizeable bonuses in the years in which the securities were created and sold.

[…]

Richard Fuld, of failed Lehman Brothers, saw his net worth reduced by at least a hundred million dollars. James Cayne of Bear Stearns was reported to have lost nearly a billion dollars in a matter of a few months. AIG’s Hank Greenberg, who remained a giant shareholder despite being removed from the firm he built by New York Attorney General Eliot Spitzer in 2005, lost perhaps $2 billion. Thousands of lower-downs at these firms, those who worked in the mortgage securities departments and those who didn’t, also saw much wealth devastated by the subprime debacle and its aftermath.

Wow. Dick Fuld, who got $500 million, had his net worth reduced by $100 million? That’s your defense? And, to be honest, if you can’t gin up this discussion, then what can you gin up? The very nature of this debate is that all of these figures are unverifiable. James Cayne was reported to have lost nearly a billion dollars? Thanks, but what’s your evidence? The nature of rich people is that they hide their wealth, they diversify, and they skirt rules. So, sales of stock get fancy names like prepaid variable forwards. Show me their bank statements–even silly arguments need a tad of evidence, right?

Honestly, at this point I stopped reading. No point in going any further. So, now that you know how little regard for that which is already known and on the record this piece of fiction is, I’ll link to it…

Here ya go.

Although, Felix does a great job of taking this piece down too (links above)… Although, he’s a bit less combative in his tone.

Nor is it plausible that all concerned were simply mesmerized by, or cynically exploitive of, the willingness of rating agencies to stamp Triple-A on these securities. Wall Street firms knew what the underlying dog food consisted of, regardless of what rating was stamped on it.

How to Fix the Crisis in Six Easy Steps

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…

Rick Santelli is a Lesson for our Children

So, by now you’ve heard of the rant of some guy I’d never heard of before (not to be confused with Barron’s Michael Santoli). Does anyone else find it amusing that Mr. Santelli was ranting on the floor of an “open outcry” trading pit? That’s right, he was ranting about wasteful spending to help homeowners while standing on a monument to the past of finance and inefficient execution.

Mr. Santelli, while I completely accept the fact that you are most likely compensated based on how many viewers you reel in and your entertainment value, and certainly not based on the quality of your journalism (this is CNBC after all, the house of Cramer), analysis, or even grasp of reality, you should still, every now and again, try reading something. From the details of the plan one could learn some simple things:

1. The plan is available only to those people whose mortgages are owned by Fannie or Freddie or those whose mortgages were backed by Fannie and Freddie and put into securities by them. Fannie and Freddie have strict limits on whose mortgages can go into those pools. They have to have high FICO scores, relatively low LTVs, and there is a maximum size allowed. Please note that this restriction, in and of itself, totally disqualifies sub-prime mortgage loans. Let me repeat: sub-prime mortgages and agency-backed mortgages are a totally disjoint set of mortgage loans–there is no overlap.

2. The program does not reduce principal owed. So, in essence, there is no forgiveness of debt, but only a reduction in interest rates and, perhaps, an extending of the term of the loan to reduce monthly payments. People still owe the same amount as before. Sounds like a welfare state to me…

3. The program doesn’t allow refinancing of second homes or investment properties. So all the speculators that own 3 houses on that were supposed to be flipped cannot refinance any mortgages except for the single first mortgage on the house they currently reside in.

4. Second mortgages aren’t covered under the plan. All the people who took out HELOCs to borrow money to buy stocks aren’t going to be bailed out either.

5. There is about $75 billion being used to help stabilize the multi-trillion dollar mortgage market. This number alone implied that there is some selection process to weed out unworthy people from being given government funds.

Look, I want the economy to improve as much as the next guy, but I think swelling the unemployment rolls by one idiotic reporter might be the kind of change I can believe in. Oh, and let’s finally close down the value-destroying open-outcry trading pits. Maybe removing that friction in our economy can help us save a few dollars.

I was going to stop here, but I’ll be honest… the complete and total stupidity of Santelli and those knuckle dragging dinosaurs who still use hand motions to make money, add trnsaction costs, and keep the computers at bay (not all of them, but most of them, I’m sure) on the floor of the C.M.E. are the reason middle America hates everyone in finance. Further, it’s the reason we need a bailout. How often did I hear “not my problem” or “because that’s where the market is” or any number of other, totally tone-deaf incantations from the mouths of people making seven-digit bonuses? Often. And, to be honest, do we have even single piece of tape with Mr. Santelli yelling about taxpayers paying for Citi? Bank of America? How about AIG? No? Well, we gave Merrill Lynch $15 billion and around $4 billion of that was immediately blown through to mint 696 seven-digit bonuses.

At least I can take comfort in knowing that Mr. Santelli will be forgotten in 100 years and that his rant likely has no lasting impact on our society–it showcases the worst, most base and uninformed stupididty. Children, pay attention in school or you’ll wind up working on the CME trading floor for CNBC.

Detailed Causes of the Crisis and Post-Crisis

Since this is a political season, and with the economic crisis, I think everyone in finance understands there is a sort of “silly season” that ensues. We certainly noted the sort of irrational behavior that would immediately make an economist question their beliefs. To me, though, the most offensive form of this stupidity comes from those who believe the Community Reinvestment Act and Fannie and Freddie sparked the whole crisis. Mr. Ritholtz rails against this notion over and over again. Oddly, I haven’t seen anyone else tackle this issue… Of course, I’m also way behind on reading my feeds. I even wrote Mr. Ritholtz an email (something I always tell myself is useless afterwards, since I don’t ever get a response, but is usually cathartic) noting that he was being very informative by setting the record straight. Well, maybe I expressed this sentiment with a tirade…

Every time I hear a Republican talking head on a news program saying Fannie and Freddie caused the problem I want to jump through my T.V., explain that the answer “betrays not even a modest understanding of the contributing factors to the current crisis, it’s scope, and magnitude” and begin to rattle off about flawed ratings agencies, excessive leverage (for investment banks and funds), over-reliance on models, a flawed compensation model for Wall St., managements needs to one-up their own earnings and those of competitors, explosive year over year growth of unproven financial technologies, over-reliance on “fast money” to distribute risk, fund’s need to earn outsized returns to attract assets, funds’ need to buy crappy bonds to build a “relationship” that would allow them to get “good” bonds from banks, poor disclosure from companies (specifically investment banks, as I’ve discussed on my blog), and extremely low rates for a very long time. Of course I’m just a normal guy who actually knows what’s going on, I don’t get invited onto these shows.

(Emphasis added, mine.)

Let’s tackle these, shall we?

1. Excessive Leverage — If the plot of the credit crisis had included a deus ex machina it would have been an instant de-levering of troubled investment firms. This didn’t happen and several collapsed. I don’t want to be repetitive, but the Deal Professor says it plainly when he says, “Sometimes, You Can Only Raise Capital When You Don’t Need It” … If a firm is highly levered, as Bear was, Lehman was, Fannie was, Freddie was, and A.I.G. was, then when the market gets bad, losses pile up, and credit tightens it’s a death spiral. There’s a large distance between well-capitalized and insolvent, but once you move from adequately-capitalized to under-capitalized it’s probably impossible not to hit insolvent or bankrupt. Oh, and let’s not forget how this became a problem in the first place … the rules were relaxed in 2004.
2. Flawed Rating Agencies — This is pretty obvious. Moodys errors. Rating agencies noting any deal, even one “structured by cows,” would be rated. And lastly, the smoking gun that seems to be the largest caliber, the fact that … well, I’ll let Mr. Raiter speak for himself:… “Mr. Raiter said that the residential mortgage rating group at S.& P. had captured the largest market share among its main competitors — 92 percent or better — ‘and improving the model would not add to S.& P.’s revenues.‘” Wow! Honesty, stupidity, incompetence … all on display. Now, to be honest, I have no idea what difference these problems made. What I do know is that the rating agencies were used as a means of outsourcing risk management and credit analysis. While it shouldn’t be a huge shock that the rating agencies missed the mark, the magnitude by which they missed is a huge problem if everyone took their ratings as fundamentally true. What these “statistical rating agencies” should have been doing is running securities and mortgage loans through abhorrently conservative scenarios and fixing ratings based on those…. they didn’t. They were argued down to “realistic” scenarios based on past experience. The issues above merely compound the problem.
3. Over-Reliance on Models — Related to the rating agencies’ issues, this one is a great catchall for terrible risk management. Let’s be honest, no one saw the fundamentals in housing getting so bad. That’s not the issue, I didn’t see it so I can’t exactly blame others for not seeing it. What I can do, however, is blame risk management professionals for not preparing for it. When you have, as Citi did, tens of billions of dollars in highly correlated assets, you should know there’s a risk of tens of billions of dollars in writedowns. When you have tens of billions of dollars in commercial mortgages, as Lehman did, you should realize the risks there. Similar lessons for WaMu, Wachovia, and CountryWide. Instead, though, like the rating agencies, there was a push to have “realistic” or “back tested” results. Let’s go to Mr. Viniar, C.F.O. of Goldman, for his take: “Even scenario analysis, which can address some of VAR’s deficiencies, came up short … [This] ’caused us to look at more-extreme scenarios than we used to look at,’ says Viniar. ‘It made us expand out the tails of what we deemed a realistic possibility.'” Logical, concise, and conservative. It seems Goldman didn’t attempt to show lower risk numbers so that they could deploy more capital or be looked upon as safer by the stock market. No, they looked at more extreme scenarios. They reacted quickly. However, in quoting this passage I sandbagged you, dear readers. This quotation is actually much more relevant to this situation than one would think–it comes from 2001! Mr. Viniar, people probably won’t remember (seems like a lifetime ago), but I noted before, was the guy who convened a firm-wide meeting on exposure to the housing markets. The takeaway is that the firm that looked at the most extreme scenarios, not the ones that models said were most likely, weathered the storm the best.
4. Flawed Compensation Model — This one is pretty obvious. Lots of money flowed into people’s P.A.’s (that’s “personal account”) each year based on fees and mark-to-market gains for complex structured products. In many instances these risks were distributed and off the balance sheets of investment banks. However, these businesses were grown, and none of the risks were well understood–the people in the lead, though, lead the charge to increase their compensation. I was personally aware of a senior trader/banker/whatever that pushed a firm, one that has seen tens of billions in writedowns and may or may not still be alive, who pushed for balance sheet commitment of 2-3x the current size in the C.D.O. business. This would have exposed this institution to writedowns larger than most firms equity base. This proposal was shot down, but still… Clearly making eight digits was going to someone’s head. Now, we all know that I believe one should be accountable for their decisions, so it shouldn’t be a surprise that when one has made tens of millions of dollars in bonus and salary, but their decisions lead an institution to take massive losses, reduces shareholder value significantly (keeping in mind shareholders might be woefully unaware of the risks being taken), and leads to thousands of people losing their jobs, merely being fired isn’t enough. Especially since these issues are only beginning to be understood when these people are fired, usually. Becoming an instant millionaire is a huge, huge problem. It’s the “swing for the fences if you’re down” mentality, and it’s also the “worry about the tail events if they happen” mentality. Put simply, there should be the ability to claw-back compensation based on performance for years. Perhaps a ten year lockup of wealth is extreme, but given these issues and famous blowups in the past, and taking into account the tradition of good times to last several years, maybe ten years is harsh but not extreme. Maybe employees should be allowed to hedge exposure to stock prices after a few years, but still have risk if negligence is discovered or things go wrong that were set in motion by that person. Obviously something drastic needs to be done, perhaps merely paying less is sufficient, but I doubt it.
5. Management Pressures — Highly correlated to the flawed compensation model, it’s the case that management was pushed hard to get earnings up. Having seen the “budget” process (an odd name, I thought, since a budget, to me, merely means expenditures) up close, I saw people come up with reasonable numbers, submit them to senior management, and be told, “More!” Well, guess what <expletive>s? If someone tells you they can reasonably deliver something and you always add 10-20% to those numbers, there is more risk taking and less rationality to how that profit is achieved. Maybe the long term effects of pushing the envelope are much worse than not taking those risks to begin with. This is one reason Goldman seems to outperform so often, they understand what they are getting themselves into. They truly work together and achieve revenues through teamwork instead of edict. Now, underperformance is punished, but setting reasonable goals is step one when trying to exceed them. The next generation of management should fight their bosses tooth and nail not to set unreasonable baseline expectations and should figure out objective measures that reflect an employee or business’s effectiveness. The tyranny of quarterly earnings shouldn’t make grown ups act stupidly because they can’t “just say no.” Here’s a hint: if you run a company with a nine- or ten-digit balance sheet and you don’t realize your business is complex enough that you shouldn’t manage to the next ninety days, then you should step aside. Seems simple to me. Maybe that’s why Google doesn’t bother with quarterly guidance.
6. Explosive Growth of Unproven Financial Technologies — Being a bit of a purist I am hesitant to call financial products or methods “technologies,” but I’ll use that word for now. The truth of the matter is, these products had never seen a massive downturn. Sub-prime loans as we know them today hadn’t seen a recession until now. C.D.O.’s backed by structured products hadn’t existed during a protracted period of fundamnetal credit distress before. This was known and talked about often. For as much as this was talked about, it was an observation that was never extrapolated. Hedging and risk management still looked at historical levels of distress and credit problems. The market had grown by orders of magnitude, but that wasn’t part of the equation. Quite simply, the fact that these markets grew so much so fast meant no one had a good handle on the feedback effects of this growth. This is somewhat obvious and very moot, so I won’t dwell on the problems of such massive growth.
7. Over Reliance on “Fast Money” To Distribute Risk — Anyone who knows structured products understand this point. Basically, the fair-weather buyers are “fast money.” This client based is distinct from “buy and hold” or “real money” accounts. Here is where the shell game of wall street really kicked into high gear. Hedge funds would buy bonds with the intention of selling at a profit later. Investment banks would, to show strength of the market, put out “bids” or interest to purchase securities they had just created at a higher price than they had just sold said securities at. Hedge funds would then immediately sell back to Wall St. firms, at a profit, to take advantage of their desire to show the market their securitizations “trade well” or “at a premium.” When firms are making money on the securitization, they can afford this. Speaking more generally, hedge funds just “trade bonds around” more. In recent years insurance companies and banks, the institutions that buy securities and rarely sell them (for a myriad of reasons), went from 70+% of the buying base for structured products to 20-30% of the buying base. This means that in a bad market 70-80% of the bonds that exist can be sold (dumped?) at a moments notice. Add in the fact that during this period there was explosive growth (as noted above) and you see why when the markets hit trouble the huge wave of selling occurred, liquidity dried up, and prices plummeted.
8. The Flawed Model for Relationships Funds have with Wall St. (coupled with Funds’ Needs for High Returns to attract Assets) — The way a bank figured out if a hedge fund was a good customer was, basically, how much a fund helped that bank get out of risk (stupidly, as stated above, since banks were likely to be more hurt by a fund owning assets and were more likely to wind up needing to repurchase those assets, but I digress…). However, when assets were in short supply relative to demand, only the top clients were able to purchase securities banks were creating. So, one might wonder, how did a nascent fund, at the bottom of the food chain, get access to the desirable securities? Easy solution: they purchased the undesirable securities to “help out” a Wall St. firm. These were more risky, although they were generally carried a higher rate of return in the event of no credit problems. These new funds, then, showed higher returns, attracted more money, and bought more securities from banks. Net effect? Most funds had a poor mix of products–higher risk bonds or assets that would get hit much harder than generic securities and more generic securities. Keep in mind that, to get high returns, funds were buying C.D.O. products and other structured products that had higher returns in general, but funds also levered these products and thus funds were much more exposed to moves in the market. Funds, as everyone knows, get paid a percentage of assets under management and returns, so to grow their revenue stream many funds just had to buy lots of securities (and, to establish a strong enough relationship to be allocated enough securities, plenty of lower quality securities). This was the prisoner’s dilemma of the syndicate system–funds cooperated every time. (Just to put some numbers on it, when a fund would try to buy residential or commercial mortgage backed securities it was possible for demand to outstrip supply 2- or 3-to-1. Accounts with strong relationships usually got 100% to 80% of the requested amount of bonds being issued. Weak relationships or smaller firms could receive as little as 10-20% of their desired allocation.) This is a complex process and nuanced point, feel free to email me for more explanation.
9. Poor Disclosure from Companies — This is a point I’ve raised before. I won’t go over it again. The short story is that firms got away with a lot because they didn’t tell anyone what they were doing.
10. Extremely Low Rates for a Very Long Time — I’ve raised this point before as well (between the numbered lists). Rates were very low and, suddenly, a product that trades at 50-100bps over L.I.B.O.R. traded 50-100% higher than L.I.B.O.R. If your benchmark was treasury rates to outperform your benchmark meaningfully you needed to get much higher spreads, and thus take higher risk. This is why C.D.O.’s experienced such explosive growth (see the problems the growth cased above). Low rates also made it more attractive to get a floating rate mortgage, which a huge majority of sub-prime mortgages were. This was part of the ex-post concern with Alan Greenspan’s encouraging people to take out A.R.M.’s.

In short, Fannie and Freddie were part of the problem, but not in and of themselves. In fact, if Fannie and Freddie had caused these problems by selling banks their bonds, then we wouldn’t have a problem at all. Why? Because Fannie and Freddie would be “on the hook” for the bonds they guarantee. If these bonds went bad no firms would have taken losses on them (since the government stepped in to keep them solvent and backstopped their obligations). Okay, now that I’m done ranting I’m going to rant on something new. The post-crisis narrative of what went wrong… (don’t you love the rise of the word “narrative”?).

1. The failure of rating agencies, risk managers, and risk management models. This has been getting the most press because it’s easy to explain (not why these things failed, but the fact they failed).
2. Sheer size. This is pretty silly, if you ask me. Bigger doesn’t have to mean riskier. The practices that get a firm to a massive size could be an issue. Super-concentrating the health of the markets with very few players could be a huge problem. The “Too Big to Fail” issue might fit some situations, but didn’t cause this crisis. No one wants to have to rely on the government to save them.
3. Executive pay. This is a limited view on the actual problem. In fact, in most firms, C.E.O.’s aren’t the highest earning individuals.
4. Hedge funds and short selling. Really? Let’s trace the logic here (or lack thereof): a firm runs it’s business poorly and I bet it will decline in value. Clearly I am at fault there. The “free markets at all costs except losses” crowd, like those currently at Treasury, are putting a band aid on an amputated leg here. Especially with the very firms begging to be protected turning around and getting fees from products circumventing the bank on short selling. (What a stupid move, some firms deserve to be in worse trouble.)
5. Everything else. Why get into the details of the actual causes when you can distill down issues to “good” versus “bad” and simple fights? No one has…. so I’m doing it! But I doubt all the other things will make it into the popular understanding of what went wrong.

There you go. My hands are tired, so I’ll stop here. Feel free to comment and ask questions.

Fannie and Freddie: Dangerously Off Message? Mission Drift (Seemingly) on Parade.

Well, Fannie and Freddie, bailed out, now have market capitalizations of $834MM and $381MM respectively; around $1.2 billion in total. 

Now, let’s keep that in mind as we read this Barron’s story:

The most prominent potential trouble spot is Stuyvesant Town and Peter Cooper Village, a giant complex with 56 buildings and more than 11,000 apartments along the East River. It was sold by longtime owner MetLife (ticker: MET) for $5.4 billion in 2006 to two prominent real-estate investors, privately held Tishman Speyer and BlackRock Realty Advisors. At the time, the sale was widely viewed as an extremely rich, top-of-the-market transaction. That view is being borne out.

[…]

[Rental] income at Stuyvesant Town/Peter Cooper Village last year fell to $108 million from $112 million in 2006, owing in part to slower-than-anticipated conversion of apartments to market rents. Rental income — rental revenue less expenses — covers just 35% of estimated annual interest costs of $300 million.

[…]

A pre-funded interest reserve of $400 million designed to tide over bondholders until the project could meet interest expenses is now down to about $175 million, meaning that Tishman Speyer and BlackRock may have to pony up more cash by 2010 or risk losing control of the 80-acre project and their large equity investment. When the new landlords arranged the financing in 2006, they projected that rental income would triple, to $336 million, by 2011. To reach that goal, rents would have to double from their current average around $1,800 a month — an unlikely scenario.

[…]

It’s touch to say what Stuyvesant Town/Peter Cooper Village is worth now, but it’s probably less than the $5.4 billion purchase price. If the complex were resold today, the buyers might not get enough to pay off the project’s $4.4 billion of debt, wiping out their equity of $1 billion and some $900 million of additional funds, including the $400 million interest reserve, that were contributed to the deal. 

(Emphasis mine.)

Ha! Wow! Okay, got that? $3 billion in debt could be in peril of not getting paid back fully, if Barron’s “perhaps” scenario comes to fruition. Okay, so what does this have to do with Fannie and Freddie? Well, for this answer, we need to examine something else. Look at this S.E.C. filing. Go to pages S-50–Stuyvesant town is in Loan Group 2. Now, look throughout the document and notice that Loan Group 2 backs the Class A-1A. What is this mysterious A-1A? It’s the class that is sold to Fannie and Freddie. Ouch. Here 66% is backed by Stuyvesant Town.

Obviously, as with any structured product, there are serious structural caveats to all of these basic interpretations. First, these classes have bonds subordinated to them. However, those bonds, being as this loan was rated “investment grade” (see here for an example from another securitization, although it’s in the Barron’s story and the S.E.C. filing as well) don’t take into account much, if any, of the principal cash from this loan–subordantion is, as an effect, lower.

And, further, what of this “conversion of apartments to market rents?” Curbed covers the whole situation in extreme detail… But, let’s look at this post in particular:

Tishman Speyer is using various law firms and private investigators to crack down on stabilization violators, but the crackdown has caught many innocent people in its vast net […]

[The New York Times ran a story] on Tishman Speyer’s crackdown on rent-stabilized tenants at Stuy Town, and the charges of harassment made by those tenants caught in the crossfire. Of the 800 stabilized leases denied renewal by Tishman Speyer since December 2006, about 40% of those cases were later dropped, and 30% resulted in the tenant vacating the apartment. The remaining cases have not been resolved yet. This means that, more often than not, Tishman Speyer has tried to kick out a rent-stabilized tenant who had every right to be there. Or, they just got lazy and didn’t follow up. Or, they felt bad and decided not to force the issue. Um, we’ll assume it’s mostly the first explanation.

(Emphasis theirs! [Except for the “theirs just before this”–you don’t see that ever!])

And what of the Times article they reference? Well, let’s read that too…

Stuyvesant Town and Peter Cooper Village are only the most recent examples of harassment complaints in scores of rent-regulated buildings that have been bought by international developers and private equity firms in recent years. Tenant advocates say that as those firms have sought to increase profits from those buildings, many have used aggressive tactics to dislodge rent-regulated tenants. The vacated apartments can then be rented to tenants at market rates.

The average monthly rent at Stuyvesant Town in 2006 was $1,241 for rent-stabilized units and $2,767 for market-rate units.

(Emphasis mine.)

Well, I see why they can’t make hit the targets set by their projections… 

So let’s review. Fannie and Freddie most likely (we’ll pretend there’s a chance that they didn’t, but there really isn’t) bought the debt that enabled two real estate firms to acquire, with a very agressively underwritten set of income assumptions, a $5.4 billion property (portfolio of buildings, technically two properties). This debt was, at the time, thought to be way too much (as noted by Barron’s). In order to meet these very aggressive projections these two firms engaged in a very aggressive campaign to convert apartments to market rates (a difference in rent of over a factor of 2). Note that aggressive, with respect to their actions, is my own intepretation.

Hmmmm… sounds odd, no? Well, now let’s see what Fannie has to say about their charter:

The Federal Housing Enterprises Financial Safety and Soundness Act (“FHEFSSA”) of 1992 modernized the regulatory oversight of Fannie Mae and Freddie Mac. […] [It] established HUD-imposed housing goals for financing of affordable housing and housing in central cities and other rural and underserved areas.

(Emphasis mine.)

Well, maybe they define that narrowly, right? Let’s see, looking into the FHEFSSA (wow!) of 1992: 

(7) the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation have an affirmative obligation to facilitate the financing of affordable housing for low- and moderate-income families in a manner consistent with their overall public purposes, while maintaining a strong financial condition and a reasonable economic return; and

(Emphasis mine.)

Oh. Right. Not narrowly defined, really. Well, so I guess a reasonable interpretation (please correct me otherwise, bailed-out out G.S.E.’s) is that they worked against their charter? 

So, we have Fannie and Freddie, at the very least taking a very very loose interpretation of their charter, to buy debt to facilitate a private transaction that winds up decreasing affordable housing. That debt now sits on their books, it’s value likely impaired from a credit perspective, not just a technical mark-to-market perspective, and the notional value is larger than their current market capitalization. Also, keep in mind, they likely have levered it in some fashion, so it could easily be enough to wipe out the current equity value. Ow!

I’m glad I read that several-day-old Barron’s article and did some digging, otherwise I never would have put this together. Thank you Rupert Murdoch!

(FYI–I don’t own any stock or securities of either agency, except, of course, as a U.S. taxpayer whose funds are being used to prop them up…)

Bold Statement: Time to Start Partying

I’m making a bold statement here: We’ve turned a corner. The Worst is over. Our evidence?

1. The Fannie and Freddie issue was always odd because, for as long as I can remember, there was an implicit guarentee that was unquestioned in all ways. It was a bullet point on every presentation about agency debt. It was a sub–bullet point on every presentation about agency M.B.S. Well, if Fannie and Freddie were always meant to be supported by the government, then why would people doubt that was the case? If the government guarntee was always pre-supoposed, why doubt it? Well, finally, the common sense statement that everyone doubted has been made explicit–which shouldn’t have needed to happen. However, I would claim, when you start doubting the obvious it’s a sign of a bottom. Especially now that the doubt has been quashed and the market is back to “pricing to reality.”

2. Lehman is resolved. As the rumors and estimates piled up Lehman has gotten crushed. Clearly this firm was the last big unknown as it dominated the news constantly. We knew every gyration and hiccup of the Korean Development Bank and their flirting and courtship with Lehman. Amazing. Well, with their announcement today, we know their losses, their plans for selling stakes in their businesses, and the extent of their real estate woes. Coupled with the mortgage market recovering slightly and stabilizing (see #1 above) the losses from mark to market aren’t likely to spiral far from here.

So, with these two very recent events, it seems reasonable to assume we’re out of the woods… I’ll be bold and predict, then, the reasonable assumption matches reality.

Update: Quite a tizzy over at Seeking Alpha about this post. I’m not calling a bottom here. I left a comment there if you would like to see it.

Fannie and Freddie: We All Support You (Even if We Don’t Support That Decision!)

Well, it seems like this slow motion trainwreck is finally going to compel some action.  Jeeze. The more one reads the more ridiculous this whole thing is…

1. Fannie and Freddie are not created equal (no one “in  the know” ever thought they were…). Apparently Freddie is under-capitalized and Fannie is still smelling the flowers on their way to being under-capitalized (from the NYT article):

Then, last week, advisers from Morgan Stanley hired by the Treasury Department to scrutinize the companies came to a troubling conclusion: Freddie Mac’s capital position was worse than initially imagined…

While Freddie Mac’s accounting woes make it easier for regulators to force the company into conservatorship, there was more resistance from Fannie Mae, according to people familiar with the discussions. Once the government took action against Freddie Mac, however, confidence in Fannie Mae would certainly waver. Given Fannie Mae’s declining financial condition, the company has few options but to concede to the government’s demands.

Fannie Mae is resisting? 

2. Taxpayers are about to own a whole lot of crap. Of course I already noted the large amount of non-prime mortgages sitting on the G.S.E.’s books (and the poor credit metrics)… But, apparently, the marking to market of these securities isn’t hurting their capital position. Oh, holdon, stop celebrating–it’s because they don’t mark the portfolio. Here ya go (from the NYT article):

Freddie Mac’s portfolio contains many securities backed by subprime loans, made to the riskiest borrowers, and alt-A loans, one step up on the risk ladder, the company has not written down the value of many of those loans to reflect current market prices.

Executives have said that they intend to hold the loans to maturity, meaning they will be worth more, and they need not write down their value. But other financial institutions have written down similar securities, to comply with “mark-to-market” accounting rules. Freddie Mac holds roughly twice as many of those securities as Fannie Mae.

(emphasis mine).

3. It also seems that complaints from foreigners are causing the Treasury to take these steps:

The proposal to place both companies, which own or back $5.3 trillion in mortgages, into a government-run conservatorship also grew out of deep concern among foreign investors that the companies’ debt might not be repaid. Falling home prices, which are expected to lead to more defaults among the mortgages held or guaranteed by Fannie and Freddie, contributed to the urgency, regulators said.

Investors who own the companies’ common and preferred stock will suffer. Holders of debt, including many foreign central banks, are expected to receive government backing. Top executives of both companies will be pushed out, according to those briefed on the plan.

(emphasis mine).

Now, let me make a point here: The decision to back only debt and not preferreds and common stock is completely arbitrary.

Let’s fly off on a tangent and ask ourselves what would happen if government backing of the debt occurred as a singular event–nothing else happened. Well, then, the guarantee that everyone thought was in place would be in place. The market, credit conditions, and the housing market would most likely wipe out equity anyway. So, then, why does the government need to do this explicitly? Just take over day-to-day operations… They are regulated entities, it’s not a stretch to strike a deal where the regulator ousts management and takes over!

Making this guarantee explicit, by the way, will also make holders a hefty profit as spreads will undoubtedly rally for agency debt–a nice gift to foreign holders of this debt at the expense of the shareholders current financial holdings, it seems.

4. I would look for a very, very serious revisiting of a lot of transactions. This would clearly be very controversial, but if I were advising regulators and the government, I would start taking a strict view of the G.S.E.’s charters, and unwinding whatever I could. No way the G.S.E.’s should have ever owned subprime loans or bonds. I also have a feeling that there are clauses that allow for some kind of “regulatory put” on many transactions if  deemed outside the G.S.E.’s authority or charter. Will the government go through these? Maybe. Truth be told, they need to de-lever these behemoths and raise capital cushions somehow. 

5. Look for a big Merrill-like trade. Who could be the buyer? I wonder…

Did you catch Bill Gross on CNBC just now? They asked if he had been approached by the Treasury about any government-led solution, presumably asking if PIMCO would participate. Gross said he couldn’t comment, which means the answer is yes.

Okay… now about an hour until the details are confirmed. We’ll see what happens.

On Recent Stories: Something for Everyone

I haven’t had the opportunity, in a long time, to cobble together some real thoughts. However, here are a few quick takes on what is going on recently…

1. Citi continues to shuffle deck chairs. Now, I don’t know what they could be doing right now to fix their situation. The problem they are facing is that they need to control costs in an environment rife with morale problems. As one commenter on Dealbook pointed out, I don’t know who believes that Jamie Forese is asking a subordinate to become his equal–indeed that’s probably not even within his power to do. I also don’t know why there is such a massive use of management consultants–in a large bank with an everything-needs-signoff-from-the-C.E.O. culture it’s hard to imagine someone who runs a department of 200 people can go out and hire McKinsey … Those managers can’t even upgrade their own travel arrangements to first or business class! Anyway, the real issue with these measures is that the worst abusers are powerful and find their way around these policies and senior management’s time is better spent doing other things than approving new computers and offsite meetings.

IRONY ALERT: As I was writing this post, I saw this item from Research Recap:

McKinsey sees considerable scope for investment banks to cut their noncompensation costs – possibly up to $2 billion in recurring savings.

…

McKinsey said its experience indicates that data, printing, supplies, delivery and professional services usually yield the fastest results; restructuring real estate and IT spending may take longer but generate much larger savings.

McKinsey said its analysis suggests that “executives can embark on this additional belt tightening without harming a bank’s culture and morale.”

Of course, morale at most investment banks is already so low that a further whack at expenses is unlikely to make it any worse.

(emphasis mine.)

Honestly, you can’t make this stuff up…

2. Lehman is approaching a deal to sell a stake in it’s asset management unit,  Neuberger Berman, to a private equity firm. This is a good start for a relationship, of the kind I have already opined on, between Lehman and a business that should be looking for disintermediation. I would, if I were Mr. Fuld, look to sell a stake in the asset management unit, get an equity investment in Lehman itself, and form a permanent J.V. with whatever top-shelf private equity firm will be winning the auction. Maybe Lehman can try cross-selling … “Mr. Kravis, I see you own a part of our asset management division, can I interest you in some cheap real estate debt? With gas prices so high who couldn’t use some hard assets?” Feel free to fo read my prior post–I go into a lot more detail there about the nuances of what the structure, in an ideal world, should look like.

3. Fannie and Freddie are falling … in slow motion! I have no idea, none at all, why the failing and bailout of Fannie and Freddie are both taking so long. Guess what? If Fannie and Freddie are woefully undercapitalized now then what’s the catalyst for things to get better? There is none. This whole situation doesn’t make sense. Are they waiting for the G.S.E.’s to be insolvent? We already know they are leveraged instutions completely concentrated in markets that are dead, dying, or woefully sick. I guess I don’t understand the rationale for waiting to take action… From the WSJ:

The Treasury probably doesn’t need to make a decision imminently unless the companies lose their ability to tap debt markets at reasonable costs, said Joshua Rosner, a managing director at research firm Graham Fisher & Co.

If the Treasury is forced to inject capital into Fannie and Freddie, though, that is likely to be part of a restructuring that would likely wipe out the value of previously issued common and preferred shares and lower the value of subordinated debt.

[Obligatory paragraph about what the stock did today.] …

Fannie increased its holdings of “liquid” investments, cash and short-term securities that can easily be sold, to $103.6 billion, up 43% from June. The move gives the company more flexibility to reduce its future borrowings if market conditions worsen, company officials said.

(emphasis mine.)

In what world is $100+ billion of anything easily sold? Simply stupid. Especially with the Fed pressuring the Treasury Department to ease up on wiping out certain equity holder because of the destruction wiping out parts of the G.S.E.’s capital structure would cause. Have any of these people ever seen markets function in the face of uncertainty? Oh, right … the last year or so. Well, at least that’s going well…

4. The next big problem is here: distressed companies. People expect that this will be the next set of losses and economic distress. Corporates have been fairly resilient, as a sector, to this economic downturn. Part of this is the lag that corporates have from the time consumers start tightening the purse strings to the time that effect is seen on the bottom line. Nothing else to say, really, the numbers are all moving in the same direction.

5. Random Assortment of other things…

A. Remember the rating agencies? Well, now one is going to sell you something that will tell you how much you’re going to lose on the C.D.O. paper you bought because they said was safer than it actually was after using their flawed ratings methodology… Apparently the part of their suite that worked was the part that picked out the downgrade candidates.

B. In a slight nod to my political views, there is finally hard data that we, as a society, have a vested interest in investing in those amongst us that have the least.