Citi’s Earnings: Even Cittier Than You Think

Well, Citi reported earnings this past week. And, as many of you know, there are a few reasons you’ve heard to be skeptical that this was any sort of good news. However, there are a few reasons you probably haven’t heard… (oh, and my past issues on poor disclosure are just as annoying here)

On Revenue Generation: First, here are some numbers from Citi’s earnings report and presentation, Goldman’s earnings report, and JP Morgan’s earnings report:

These numbers should bother Citi shareholders. Ignoring the 1Q08 numbers, Citi–whose global business is much larger and much more diverse than it’s rivals–generates no more, if not slightly less, revenue than the domestically focused JP Morgan and much, much less than Goldman. But it gets worse. Goldman’s balance sheet was $925 billion vs. Citi’s $1.06 trillion in assets within it’s investment banking businesses, roughly 10% larger.  I’d compare JP Morgan, but they provide a shamefully small amount of information. As an entire franchise, however, Citi was able to generate their headline number: $24.8 billion in revenue, on assets of $1.822 trillion. JP Morgan, as a whole, was able to generate $26.9 billion, on assets of $2.079 trillion. JP Morgan, then is 14% larger, by assets, and generstes 8% higher revenue.

These numbers should be disconcerting to Citi, it’s no better at revenue generation than it’s rivals, despite having a larger business in higher growth, higher margin markets. Further, in an environment rife with opportunity (Goldman’s results support this view, and anecdotal support is strong), Citi was totally unable to leverage any aspect of it’s business to get standout results… and we’re only talking about revenue! Forget it’s cost issues, impairments and other charges as it disposes assets, etc.

On The Magical Disappearing Writedowns: Even more amazing is the lack of writedowns. However, this isn’t because there aren’t any. JP Morgan had writedowns of, approximately, $900 million (hard to tell, because they disclose little in the way of details). Goldman had approximately $2 billion in writedowns (half from mortgages). Citi topped these with $3.5 billion in writedowns on sub-prime alone (although they claim only $2.2 billion in writedowns, which seems inconsistent). But, that isn’t close to the whole story. Last quarter, in what I could find almost no commentary on during the last conference call and almost nothing written about in filings or press releases, Citi moved $64 billion in assets from the “Available-for-sale and non-marketable equity securities” line item to the “Held-to-maturity” line item. In fact, $10.6 billion of the $12.5 billion in Alt-A mortgage exposure is in these, non–mark-to-market accounts. There was only $500 million in writedowns on this entire portfolio, surprise! Oh, and the non–mark-to-market accounts carry prices that are 11 points higher (58% of face versus 47% of face). What other crap is hiding from the light? $16.1 billion out of $16.2 billion total in S.I.V. exposure, $5.6 billion out of $8.5 billion total in Auction Rate Securities exposure, $8.4 billion out of $9.5 billion total in “Highly Leveraged Finance Commitments,” and, seemingly, $25.8 billion out of $36.1 billion in commercial real estate (hard to tell because their numbers aren’t clear), are all sitting in accounts that are no longer subject to writedowns based on fluctuations in market value, unlike their competitors. These are mostly assets managed off the trading desk, but marked according to different rules than traded assets. If one doesn’t have to mark their assets, then having no writedowns makes sense.

On The Not-so-friendly Trend: This is a situation where, I believe, the graphs speak for themselves.

Do any of these graphs look like things have turned the corner? Honestly, these numbers don’t even look like they are decelerating! Compare this with the (relatively few) graphs provided by JP Morgan.

These aren’t directly comparable, as the categories don’t correspond to one another, and JP Morgan uses the more conservative 30-day delinquent instead of Citi’s 90+-day delinquent numbers. However, JP Morgan’s portfolio’s performance seems to be leveling out and even improving (with the possible exception of “Prime Mortgages”). Clearly, the pictures being painted of the future are very different for these institutions.

On the Stuff You Know About: I’ll be honest, this business about Citi benefiting from it’s own credit deterioration was confusing. Specifically, there is more going on when Citi refers to “credit value adjustments” than just profiting from it’s own Cittieness. However, Heidi Moore, of Deal Journal fame helped set me straight on this–the other things going on are dwarfed by the benefit I just mentioned. Here’s the relevant graphic from the earnings presentation:

And, via Seeking Alpha’s Transcript, the comments from Ned Kelly that accompanied this slide:

Slide five is a chart similar to one that we showed last quarter which shows the movement in corporate credit spreads since the end of 2007. During the quarter our bond spreads widened and we recorded $180 million net gain on the value of our own debt for which we’ve elected the fair value option. On our non-monoline derivative positions counterparty CDS spreads actually narrowed slightly which created a small gain on a derivative asset positions.

Our own CDS spreads widened significantly which created substantial gain on our derivative liability positions. This resulted in a $2.7 billion net mark to market gain. We’ve shown on the slide the five-year bond spreads for illustrative purposes. CVA on our own fair value debt is calculated by weighting the spread movements of the various bond tenors corresponding to the average tenors of debt maturities in our debt portfolio. The debt portfolio for which we’ve elected the fair value options is more heavily weighted towards shorter tenures.

Notice that Citi’s debt showed a small gain, but it’s derivatives saw a large gain (the additional $166 million in gains related to derivatives was due to the credit of it’s counterparties improving). Why is this? Well, notice the huge jump in Citi’s CDS spread over this time period versus cash bonds, which were relatively unchanged. Now, from Citi’s 2008 10-K:

CVA Methodology

SFAS 157 requires that Citi’s own credit risk be considered in determining the market value of any Citi liability carried at fair value. These liabilities include derivative instruments as well as debt and other liabilities for which the fair-value option was elected. The credit valuation adjustment (CVA) is recognized on the balance sheet as a reduction in the associated liability to arrive at the fair value (carrying value) of the liability.

Citi has historically used its credit spreads observed in the credit default swap (CDS) market to estimate the market value of these liabilities. Beginning in September 2008, Citi’s CDS spread and credit spreads observed in the bond market (cash spreads) diverged from each other and from their historical relationship. For example, the three-year CDS spread narrowed from 315 basis points (bps) on September 30, 2008, to 202 bps on December 31, 2008, while the three-year cash spread widened from 430 bps to 490 bps over the same time period. Due to the persistence and significance of this divergence during the fourth quarter, management determined that such a pattern may not be temporary and that using cash spreads would be more relevant to the valuation of debt instruments (whether issued as liabilities or purchased as assets). Therefore, Citi changed its method of estimating the market value of liabilities for which the fair-value option was elected to incorporate Citi’s cash spreads. (CDS spreads continue to be used to calculate the CVA for derivative positions, as described on page 92.) This change in estimation methodology resulted in a $2.5 billion pretax gain recognized in earnings in the fourth quarter of 2008.

The CVA recognized on fair-value option debt instruments was $5,446 million and $888 million as of December 31, 2008 and 2007, respectively. The pretax gain recognized due to changes in the CVA balance was $4,558 million and $888 million for 2008 and 2007, respectively.

The table below summarizes the CVA for fair-value option debt instruments, determined under each methodology as of December 31, 2008 and 2007, and the pretax gain that would have been recognized in the year then ended had each methodology been used consistently during 2008 and 2007 (in millions of dollars).

Got all that? So, Citi, in it’s infinite wisdom, decided to change methodologies and monetize, immediately, an additional 290 bps in widening on it’s own debt. This change saw an increase in earnings of $2.5 billion prior to this quarter.  In fact, Citi saw a total of $4.5 billion in earnings from this trick in 2008. However, this widening in debt spreads was a calendar year 2008 phenomenon, and CDS lagged, hence the out-sized gain this quarter in derivatives due to FAS 157 versus debt. Amazing.

And, while we’re here, I want to dispel a myth. This accounting trick has nothing to do with reality. The claim has always been that a firm could purchase it’s debt securities at a discount and profit from that under the accounting rules, so this was a form of mark-to-market. Well, unfortunately, rating agencies view that as a technical default–S&P even has a credit rating (“SD” for selective default) for this situation. This raises your cost of borrowing (what’s to say I’ll get paid in full on future debt?) and has large credit implications. I’m very, very sure that lots of legal documents refer to collateral posting, and other negative effects if Citi is deemed in “default” by a rating agency, and this would be a form of default. This is a trick, plain and simple–in reality, distressed tender offers would cost a firm money.

The Bottom Line: Citi isn’t out of the woods. In this recent earnings report I see a lot of reasons to both worry and remain pessimistic about Citi in the near- and medium-term. If you disagree, drop me a line… I’m curious to hear from Citi defenders.

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.

Commercial Developers: Not a Credible Threat

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

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

————-

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.

The Real Problem with the Citi Bailout

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.

In The Year 2010: Residential Mortgage Edition

Okay, in a series I just thought of, called “In The Year 2010” I will sit here and guess what will be going on by the end of 2010 with respect to various products. (Inspired by the Conan O’Brian skit “In The Year 2000”). This is a thought experiment, nothing more.

Residential mortgages. What can be said about where they’ve been that hasn’t been said already? I can’t even pepper that sentence with links because I wouldn’t know where to start. I mean to cover this product from the capital markets side, but let me starts by saying that this industry will probably be scared of it’s own shadow when it comes to making loans–probably for quite some time. Gone will be the sub-prime loans we all know and, well, we all just know them… 720 FICO, 25% DTI, 72% LTV? Greenlight. 600 FICO, 50% DTI, 90% LTV? Redlight. It’ll nearly be that simple.

Now, given that the loans will likely be much cleaner, what will the capital markets products look like? Easy! Well… hold on. First, there are some powerful subtleties. First, Fannie and Freddie won’t be nearly the same presence as they were in the residential mortgage markets in general, and probably sub-prime and Alt-A mortgage markets specifically (buying AAA’s). That’s one source of liquidity down. Second, CDO buyers are gone (this product will be a different post, but keep in mind CDO’s are not all mortgage related). CDO’s would buy the lower credit pieces, such as BBB’s (including BBB+, BBB, and BBB- … For Moody’s lovers, Baa1, Baa2, Baa3) and lower rated classes. Oh, and not as many investment banks are around. Guess what they bought? The residuals. Residuals were the 1-5% of the securitization that was unrated by the agencies and took the first losses of every pool. Banks “took these down” assuming they would pay off and that was how they would make their money. Most of those banks are also either not around or hurting.

So, we have fewer AAA buyers, fewer buyers of the lowest rated pieces, and fewer buyers of the lowest unrated pieces. Hmmmm…. I’m guessing there will be less securitization volume. However, I do think there will be securitizations going on. The financial technology is sound–slice up risk to those who can best take said risk. However, securitizations will be much simpler beasts. Gone will be the reliance on the rating agencies to evaluate risk. I doubt anyone will see a AA+ and a AA tranche on deals, risk will be cut into much broader swathes.

With these facts in mind, will AAA’s (or, more generally, high quality low-leverage securities) have a home? Well, at 10+% returns with banks paying 5% to the government for billions in new equity capital (just an example), which they can still lever over 10x (from what I can tell banks generally run 11-15x leverage), AAA’s seem like a good buy. Now, granted, those estimates for returns aren’t adjusted for losses, although AAA’s taking a loss hasn’t happened yet to my knowledge. This would seem to indicate that banks (there are no more investment banks) have a compelling value proposition when it come to holding market-rate AAA securities that are higher quality than found in ABX, but still not prime. Even if these AAA’s only returned 7%, and with current prime mortgage rates at around 6.5% that seems ridiculously unlikely, with 5% cost of capital they could be making over 20% ROE (way over, I’m being conservative and fudging downward). A lot of the these numbers aren’t apples to apple, but we’re also guessing at the future, so we use what we have.

If AAA’s have a home, the next question is what becomes of the lower-rated pieces. Well, my belief is that these will go wholesale to hedge funds and specialized funds focused on these products. The returns will be something in the 20-30% realm, near current levels. Credit analysis will drive value in this market, but if loan pools are kept clean enough then there can be sufficient liquidity to ensure a given securitiation can be sold (i.e. there will be enough funds bidding to ensure that, at a price, bonds will be sold). This is probably the easier problem than the AAA’s to be honest. The hedge funds that will do a lot of work to get a good return already exist, AAA buyers will need to convince themselves that they should be doing those transactions before anything starts happening.

Lastly, I think a market that will grow is the whole loan market. There will be a lot more trading volume in raw loan positions–transactions that aren’t driven by securitizations and don’t need to have tranches of risk in order to sell. Without going too much into the details, this market will be driven by dynamics of servicing arrangements, accounting rules, and detailed credit analysis. Currently this market is thriving, but in the form of “scratch and dent” trades of non-performing and re-performing (people that stopped paying and restarted paying later) pools of mortgage loans.

So, to sum up, what I believe the residential mortgage market will see is a return to simpler times. Selling off loans either a pool of actual loans or in two tranche securitizations seems reasonable. Indeed, this theme will most likely hold for other products as well, but the reasons fit here, so I’ll call it now and risk sounding redundant later.

Now, just to mess with everyone, I’ll use a newly added WordPress feature: polls! Tell me your thoughts on this…

The Financial Markets Stabilization Act We Should Have Seen

This comes from a comment I left on Barry Ritholtz’s “Bailout Plan Open Thread” the other evening. The basic premise is that the “Bailout Bill” as we know it basically says we need to go out and “lift” the street out of toxic crap. Then, the world will be better. It’s at least a bit less like the Underpants Gnomes in the sense that the toxic crap and the freezing up of the credit markets are linked… However, here’s the plan we should see if we, as taxpayers, really want our money going to help us.

1. Purchase only loans or securities that have the right to control loans directly or modify loans. The magic of the C.D.O. is that it’s backed by things that are backed by other things. So, if I buy some sub-prime–backed bonds and C.D.O.’s backed by those same bonds, I’m buying two securities being affected by the same loans. Just buy the loans. With the loans being controlled by the government, they are now free to…

2. Recast all delinquent loans to be much longer, have lower interest rates, and be much harder to abuse. Guess what interest rate you get on a forty year mortgage?  A lower one! Why? Because the duration is much higher. Why? If I make five basis points per year over the life of a forty year loan I’m making more money than if I earn five basis points over the life of a thirty year loan. Thus, the interest rate where I make the same amount of money should be lower on the forty year loan. The government doesn’t even need to smash any potential profits to make loans more affordable.

3. Offer financial institutions two options: sell the government’s bailout fund loans or securities at the price the government offers to purchase them at, or sell them at their mark and give the government equity. Why? Because if the bank isn’t willing to sell at a reasonable bid, furnished by the government, then their mark is over-inflated and they are trying to avoid an adverse hit to earnings–the government should receive more compensation for bailing out the bank. This should be applied to each position one at a time–no securities should be purchased in aggregate, that’s too easy to game. As a matter of fact, that’s how sub-prime worked to begin with: pools of loans got more and more barbelled and the bottom loans defaulted. On average they were normal, in reality they were crappy enough to break the securities. Oh, and the equity should have voting rights. Of course, there are questions to be answered.

4. Lend directly to people and small businesses. If the economic fears are all about the seizing up of the credit markets, we should be able to fix these problems by lending to those that live and die by financing. Create very strict standards for qualifying for these loans. FICO and income requirements, unlike sub-prime loans had. For businesses, underwrite loans to actual income and asset levels and only lend very conservative amounts of leverage.

5. Immediately raise capital requirements across the board. As Steve Davidoff notes (Lesson #4 when one follows that link), when you need to raise capital the most, you can’t. He concludes, as I have before, that this is a wonderful argument for raising capital requirements. Also, less levered institutions are more sound in general–there is more room for error. And, as one could guess, the competitive “flavor of the day” businesses, like C.D.O.’s and sub-prime, are much more levered because financing these products is viewed as a way to win business. This is why the institutions with cheap balance sheet are experiencing huge writedowns due to counterparty exposure with financing arrangements. Citi disclosed writedowns of  billions in warehouse lines where C.D.O. issuers were holding bonds with nearly no equity, on Citi’s balance sheet.

6. Required compensation reform. It’s well documented, conjectured, and even assumed that Wall St.’s compensation scheme is to blame for a lot of the mess we’re in. Swing for the fences and jump ship to another bank if it doesn’t work. That’s what it seems the most recent round of large bonuses for executives and traders that caused this problem were following. It’s simple, if you need money from the American people, you sign on to these reforms. Otherwise one might encounter a moral hazard due to government subsidized capital. Honestly, it shouldn’t be that hard to come up with an onerous set of restrictions and requirements for paying people exorbitant sums of money.

7. Immediate and broad consumer protections and consumer financial product reform. Rather than have banks start to do whatever they want to reduce their risk (I’ve heard reports of people with home equity lines in good standing paying their bill one day late and having the entire line canceled) require they treat their consumers fairly. Completely restrict the ability for banks to raise rates on things like credit card debt–to retroactively increase rates on existing debt is ridiculous in the first place. In an economy driven by spending and credit, for better or worse, putting consumers further at risk of defaulting on their obligations is stupid. Eliminate binding arbitration of consumer debt–just invalidate it completely, retroactively. I would prefer this practice be eliminated altogether, but if we’re keeping to the topic at hand I’ll only put forth that proposal. Lastly, put strong disclosure requirements in place for all consumer debt products, including new loans or recast loans. Require institutions to show the annualized rate, over the life of the loan, if interest rates rise 2%, 4%, 5%, and if the forwards are realized. Require large print, plain English disclosures. Some people will say Im trying to babysit people, but, honestly, how can one argue against requiring banks tell their customers basic information about their loans? Right, one can’t.

This is what we should have gotten to both get the economy and markets moving in the right direction and ensuring the confidence in institutions and consumers are both restored. Just my opinion..

I will destroy this village in order to save it!

Can you identify where the title of this post comes from? (Most likely other places, too.)

I was reading this three part series on how a space war with China will affect space assets well beyond the scope of any actual conflict. The relevant quote:

But if the short term military consequences to the United States are not that bad, the long term consequences to all space-faring nations would be devastating.  The destruction … satellites hit during the first hour of the attack considered here could put over 18,900 new pieces of debris over four inches in diameter into the most populated belt of satellites in low Earth orbit. … [Over the course of] the next year or so—well after the terrestrial war with China had been resolved—the debris fields would fan out and eventually strike another satellite. 

These debris fields could easily cause a run-away chain of collisions that renders space unusable — for thousands of years, and for everyone.  Not only is this a quickly growing and important sector of the world’s economy … , but space is also used for humanitarian missions …

Interestingly, it seems like this is exactly what’s going on in the securtization markets right now. Conduits, or investment banks that commit their own capital for making loans which aren’t meant to be held, only securitized, are basically shut down. Why are they shut down? Spreads on Commercial Mortgage Backed Securities have reached astronomical levels relative to where they have been, making it completely uneconomical for re-financing. The longer the conduits stay shut down, the more they downsize. The more they downsize, the less capacity there is. The less capacity there is, the more illiquid the mortgage market becomes for borrowers due to the lack of ability to create new bonds. (This is a very nuanced cause and effect, but many players only buy “new issue” bonds and many indices track newly issued bonds. Once there is a lack of new bonds and those indices become concentrated in older bonds that may have been more aggressively underwritten the sector could become unattractive.) From here, two things happen: borrowers start defaulting because they can’t get new loans, and the aforementioned illiquidity in bonds backed by these loans (in an environment where risk, in the form of defaults, is rising) causes spreads to move even wider (larger spreads = higher rates on commercial mortgages).

Well, this pattern continues, and even the WSJ is talking about how little sense it makes.  (FYI–Caveat emptor for people who consume the WSJ stories on complex derivatives products. There are some issues with how it describes these that I will discuss in a later post.)

At what point would one decide to exit such a market? When does a market seem completely unattractive? Was this disaster necessary to ensure a return to sound credit analysis? Only time will tell.

T-Minus 12 Months to the Rally

One trend recently is that many funds or money managers that can raise opportunistic money have started to call asking for distressed opportunities to invest in. These funds are all looking for high return (18-20%) opportunities and usually take a few months to get up and running in addition to a few more months to start sourcing actual buying opportunities. (These funds usually employ leverage, so high return hurdles don’t refer to nominal spreads.) With so many platforms springing up, from both established players and nascent funds, how long can it be before these players fall prey to competition? If you are the same bid for bonds and loans that the larger, relationship firms are, how do you invest your newly raised funds? How long before they relax their return hurdles and the lower parts of the various debt capital structures finds buyers at tighter levels? I guess we’ll see…

Mindset Arbitrage

One interesting observation about the securitization process is that many of the securitized products are meant to aggregate a risk so it can be distributed to capital market participants (hedge funds, opportunity funds, insurance companies that buy securities, and money managers and banks).

For example, Commercial Mortgage Backed Securities are used to source risk from real estate investors that own and operate real estate assets. This is a cash flow based market where people that manage buildings have a well defined plan for extracting more dollars to the bottom line (raise rents, lower expenses, re-capitalize the entity that owns the building, etc.). When your day-to-day business is servicing tenants, collecting rents, staffing a building, and maintaining the property you aren’t use to thinking about duration or what rating the rating agencies have assigned your loan. Things like day count conventions and their effect on the yield vs. the coupon isn’t your expertise. These are all esoteric things that some traders and bankers spend years not understanding in any rigorous way.

Residential Mortgage Backed Securities source risk from homeowners and mortgage originators. Here people’s assets secure loans and allow risk to be quantified by analyzing statistical data which, in aggregate, should hold closely to some historical trends. One can view how high LTV loans made to borrowers with a FICO score between 600 and 620 have performed in a given state over the past five years and extrapolate the performance of other loans with the same characteristics (recent problems arose when people didn’t care about the loan characteristics, just that they could get bonds or what rating the bonds had).  I don’t think I have to explain that, given all the examples in the media trying to explain CDOs (but really securitized products in general), it should be Q.E.D. that people taking out mortgages didn’t fully understand how the risk was being laid off nor how it would affect them (even the banks got sloppy).

Even corporate CDOs took instruments from a market where securities are valued based on the fundamental credit quality and technical factors and sold instruments that were valued using correlation trading models.  Obviously this is a bit different since these are all sophisticated (theoretically) institutional accounts. However, no one was prepared for, nor did they understand fully, the implications of things like the Ford and G.M. downgrades to junk or how the price movement in CDO tranches was going to show a disconnect because of the types of accounts that held them. (What this means is that the lowest tranches, which take losses first, become the worst risk in the pool. Essentially, then, these “equity tranches” became proxies for Ford and G.M. Since these equity tranches were held by accounts that have to mark to market, they dropped in price to reflect liquidity concerns. The tranches above them were generally held by insurance companies, or non–mark to market accounts. Dealers, proprietary trading desks, and hedge funds had all put on trades that went long equity tranches and short the tranches above them assuming the relative spread would move predictably. Unfortunately, for them, there was no price movement in the tranches they were short, since those accounts didn’t have to mark to market, and thus didn’t need to sell to prevent further losses while the equity tranches dropped in value.)

Even starting a fund is an exercise in mindset arbitrage. Some manager looks to buy assets, like mezzanine debt, which generally trades on price or as a spread to a benchmark interest rate, by raising equity for a fund. All they are doing is taking the returns they know are out in the capital markets, adding leverage, and going to investors that are very focused on R.O.E. (return on equity). This is probably the worst example here, despite being quite valid, because the level of sophistication can be quite high. However, with lots of money chasing high returns, sometimes due diligence and other metrics of reliability and quality fall by the wayside.

It should become apparent, now why there is money to be made re-packaging risk–essentially you are outsourcing the placement and structuring of that risk so that the person who is willing to get paid the least for taking a particular risk gets it. This is why it is possible for one to sell securitized products at a net interest rate less than the underlying assets.