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Showing posts with label subprime. Show all posts
Showing posts with label subprime. Show all posts

Wednesday, November 12, 2008

Money men congressional testimony

Five big hedgies testified today before Congress, including Paulson, Griffin, Soros and Simons. Simons gave a very succinct and accurate summary of the causes of the current crisis.

Mr. Simons, the founder of Renaissance Technologies and a former mathematics professor who devises complex computer models to predict market moves, says there is plenty of blame to go around for the current financial crisis.

“In my view, the crisis has many causes: The regulators who took a hands-off position on investment bank leverage and credit default swaps; everyone along the mortgage-backed securities chain who should have blown a whistle rather than passing the problem on; and, in my opinion the most culpable, the rating agencies, which allowed sows’ ears to be sold as silk purses,” Mr. Simons says.

See my talk for related comments.

Before the money men testified, four finance professors had their say. From Andy Lo's (MIT Sloan School) testimony:

...[Government funding for training quants!]

6. All technology-focused industries run the risk of technological innovations temporarily exceeding our ability to use those technologies wisely. In the same way that government grants currently support the majority of Ph.D. programs in science and engineering, new funding should be allocated to major universities to greatly expand degree programs in financial technology.

...[Behavioral finance!]

Economists do not naturally gravitate toward behavioral explanations of economic phenomena, preferring, instead, the framework of rational deliberation by optimizing agents in a free-market context. And the ineluctable logic of neoclassical economics is difficult to challenge. However, recent research in the cognitive neurosciences has provided equally compelling experimental evidence that human decisionmaking consists of a complex blend of logical calculation and emotional response (see, for example, Damaso, 1994, Lo and Repin, 2002, and Lo, Repin, and Steenbarger, 2005). Under normal circumstances, that blend typically leads to decisions that work well in free markets. However, under extreme conditions, the balance between logic and emotion can shift, leading to extreme behavior such as the recent gyrations in stock markets around the world in September and October 2008.

This new perspective implies that preferences may not be stable through time or over circumstances, but are likely to be shaped by a number of factors, both internal and external to the individual, i.e., factors related to the individual's personality, and factors related to specific environmental conditions in which the individual is currently situated. When environmental conditions shift, we should expect behavior to change in response, both through learning and, over time, through changes in preferences via the forces of natural selection. These evolutionary underpinnings are more than simple speculation in the context of financial market participants. The extraordinary degree of competitiveness of global financial markets and the outsize rewards that accrue to the “fittest” traders suggest that Darwinian selection is at work in determining the typical profile of the successful investor. After all, unsuccessful market participants are eventually eliminated from the population after suffering a certain level of losses. For this reason, the hedge-fund industry is the Galapagos Islands of the financial system in that the forces of competition, innovation, natural selection are so clearly discernible in that industry.

This new perspective also yields a broader interpretation of free-market economics (see, for example, Lo, 2004, 2005), and presents a new rationale for regulatory oversight. Left to their own devices, market forces generally yield economically efficient outcomes under normal market conditions, and regulatory intervention is not only unnecessary but often counter-productive. However, under atypical market conditions—prolonged periods of prosperity, or episodes of great uncertainty—market forces cannot be trusted to yield the most desirable outcomes, which motivates the need for regulation. Of course, the traditional motivation for regulation—market failures due to externalities, natural monopolies, and public-goods characteristics—is no less compelling, and the desire to prevent sub-optimal behavior under these conditions provides yet another role for government intervention.

A simple example of this dynamic is the existence of fire codes enacted by federal, state, and local governments requiring all public buildings to have a minimum number of exits, well-lit exit signs, a maximum occupancy, and certain types of sprinklers, smoke detectors, and fire alarms. Why are fire codes necessary? In particular, given the costs associated with compliance, why not let markets determine the appropriate level of fire protection demanded by the public? Those seeking safer buildings should be willing to pay more to occupy them, and those willing to take the risk need not pay for what they deem to be unnecessary fire protection. A perfectly satisfactory outcome of this free-market approach should be a world with two types of buildings, one with fire protection and another without, leaving the public free to choose between the two according to their risk preferences.

But this is not the outcome that society has chosen. Instead, we require all new buildings to have extensive fire protection, and the simplest explanation for this state of affairs is the recognition— after years of experience and many lost lives—that we systematically under-estimate the likelihood of a fire.5 In fact, assuming that improbable events are impossible is a universal human trait (see, for example, Plous, 1993, and Slovic, 2000), hence the typical builder will not voluntarily spend significant sums to prepare for an event that most individuals will not value because they judge the likelihood of such an event to be nil. Of course, experience has shown that fires do occur, and when they do, it is too late to add fire protection. What free-market economists interpret as interference with Adam Smith’s invisible hand may, instead, be a mechanism for protecting ourselves from our own behavioral blind spots.

Tuesday, November 11, 2008

Michael Lewis on the subprime bubble



Michael Lewis nails it in this long Portfolio article. It's the single best piece I've read on the subject.

...In the two decades since then, I had been waiting for the end of Wall Street. The outrageous bonuses, the slender returns to shareholders, the never-ending scandals, the bursting of the internet bubble, the crisis following the collapse of Long-Term Capital Management: Over and over again, the big Wall Street investment banks would be, in some narrow way, discredited. Yet they just kept on growing, along with the sums of money that they doled out to 26-year-olds to perform tasks of no obvious social utility. The rebellion by American youth against the money culture never happened. Why bother to overturn your parents’ world when you can buy it, slice it up into tranches, and sell off the pieces?

At some point, I gave up waiting for the end. There was no scandal or reversal, I assumed, that could sink the system.

...Enter Greg Lippman, a mortgage-bond trader at Deutsche Bank. He arrived at FrontPoint bearing a 66-page presentation that described a better way for the fund to put its view of both Wall Street and the U.S. housing market into action. The smart trade, Lippman argued, was to sell short not New Century’s stock but its bonds that were backed by the subprime loans it had made. Eisman hadn’t known this was even possible—because until recently, it hadn’t been. But Lippman, along with traders at other Wall Street investment banks, had created a way to short the subprime bond market with precision.

Here’s where financial technology became suddenly, urgently relevant. The typical mortgage bond was still structured in much the same way it had been when I worked at Salomon Brothers. The loans went into a trust that was designed to pay off its investors not all at once but according to their rankings. The investors in the top tranche, rated AAA, received the first payment from the trust and, because their investment was the least risky, received the lowest interest rate on their money. The investors who held the trusts’ BBB tranche got the last payments—and bore the brunt of the first defaults. Because they were taking the most risk, they received the highest return. Eisman wanted to bet that some subprime borrowers would default, causing the trust to suffer losses. The way to express this view was to short the BBB tranche. The trouble was that the BBB tranche was only a tiny slice of the deal.

But the scarcity of truly crappy subprime-mortgage bonds no longer mattered. The big Wall Street firms had just made it possible to short even the tiniest and most obscure subprime-mortgage-backed bond by creating, in effect, a market of side bets. Instead of shorting the actual BBB bond, you could now enter into an agreement for a credit-default swap with Deutsche Bank or Goldman Sachs. It cost money to make this side bet, but nothing like what it cost to short the stocks, and the upside was far greater.

...But he couldn’t figure out exactly how the rating agencies justified turning BBB loans into AAA-rated bonds. “I didn’t understand how they were turning all this garbage into gold,” he says. He brought some of the bond people from Goldman Sachs, Lehman Brothers, and UBS over for a visit. “We always asked the same question,” says Eisman. “Where are the rating agencies in all of this? And I’d always get the same reaction. It was a smirk.” He called Standard & Poor’s and asked what would happen to default rates if real estate prices fell. The man at S&P couldn’t say; its model for home prices had no ability to accept a negative number. “They were just assuming home prices would keep going up,” Eisman says.

As an investor, Eisman was allowed on the quarterly conference calls held by Moody’s but not allowed to ask questions. The people at Moody’s were polite about their brush-off, however. The C.E.O. even invited Eisman and his team to his office for a visit in June 2007. By then, Eisman was so certain that the world had been turned upside down that he just assumed this guy must know it too. “But we’re sitting there,” Daniel recalls, “and he says to us, like he actually means it, ‘I truly believe that our rating will prove accurate.’ And Steve shoots up in his chair and asks, ‘What did you just say?’ as if the guy had just uttered the most preposterous statement in the history of finance. He repeated it. And Eisman just laughed at him.”

“With all due respect, sir,” Daniel told the C.E.O. deferentially as they left the meeting, “you’re delusional.”
This wasn’t Fitch or even S&P. This was Moody’s, the aristocrats of the rating business, 20 percent owned by Warren Buffett. And the company’s C.E.O. was being told he was either a fool or a crook by one Vincent Daniel, from Queens.

...That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all.

Saturday, November 01, 2008

My talk on the financial crisis

I was asked by the graduate students in our department to give a talk on the financial crisis. The talk is oriented towards physicists and other scientists, but everyone is welcome. Slides (pdf).

Institute of Theoretical Science, 4 pm Tuesday November 4.

Speaker: Steve Hsu
Title: The Financial Crisis

Abstract: After a brief review of basic financial topics such as valuation, markets and bubbles, I discuss the origins and consequences of the current financial crisis. The discussion focuses on issues such as leverage, securitization, mortgage finance, CDO (collateralized debt obligations) and CDS (credit default swaps). The talk is aimed at non-experts.

Monday, October 20, 2008

Incentives and bubble logic

Question: Were bankers and risk managers and investors who got us into this credit crisis plain stupid? Or were they just responding to incentives up and down the line?

Answer: Both. For many people, it was rational to participate in the mortgage bubble even if they thought it might (would) end in tears. On the other hand, even smart people can be taken in by bubble logic if everyone around them is convinced. For example, here is a 2006 discussion from Brad DeLong's blog of a column by Paul Krugman, making the case that most of the country was not experiencing a bubble, and that zoning was the main culprit for coastal price increases (hence prices were sustainable). If you were a CDO modeler in 2006 and believed that argument, you might not have even considered that your model assumptions were way too optimistic -- even with people like Robert Shiller (and me) shouting that we were in the midst of a gigantic bubble.


Some of the best journalistic coverage I have found of the mortgage bubble is from Ira Glass and This American Life (audio, pdf transcript). They get the "local color" right from top to bottom: self-interested individual borrowers, local mortgage brokers rushing to assemble as many loans as possible, to be sold to Wall Street banks and repackaged as CDOs, rated by agencies like Moody's and S&P that were making record profits from fees, and sold to investors chasing yield in the midst of a liquidity glut caused by low interest rates. From their coverage you can see the incentives were messed up from top to bottom, and that many individuals anticipated trouble ahead, but couldn't put up a fight without risking their careers or bonuses. Some excerpts below.

borrower: ...I wouldn't have loaned me the money. And nobody that I know would have loaned me the money. I know guys who are criminals who wouldn't loan me that and they break your knee-caps. I don’t know why the bank did it. ...Nobody came and told me a lie: just close your eyes and the problem will go away. That's wasn’t the situation. I needed the money. I'm not trying to absolve myself of anything. I thought I could do this and get out of it within 6 to 9 months. The 6 to 9 month plan didn’t work so I’m stuck.


mortgage broker ...it was unbelievable. We almost couldn’t produce enough to keep the appetite of the investors happy. More people wanted bonds than we could actually produce. That was our difficult task, was trying to produce enough. They would call and ask “Do you have any more fixed rate? What have you got? What’s coming?” From our standpoint it's like, there's a guy out there with a lot of money. We gotta find a way to be his sole provider of bonds to fill his appetite. And his appetite’s massive.

...my boss was in the business for 25 years. He hated those loans. He hated them and used to rant and say, “It makes me sick to my stomach the kind of loans that we do.” He fought the owners and sales force tooth and neck about these guidelines. He got same answer. Nope, other people are offering it. We're going to offer them too. We’re going to get more market share this way. House prices are booming, everything’s gonna be good. And ... the company was just rolling in the cash. The owners and the production staff were just raking it in.


Wall St. banker ...No income no asset loans. That's a liar's loan. We are telling you to lie to us. We're hoping you don't lie. Tell us what you make, tell us what you have in the bank, but we won't verify? We’re setting you up to lie. Something about that feels very wrong. It felt wrong way back when and I wish we had never done it. Unfortunately, what happened ... we did it because everyone else was doing it.

...All the data that we had to review, to look at, on loans in production that were years old, was positive. They performed very well. All those factors, when you look at the pieces and parts. A 90% NINA loan from 3 years ago is performing amazingly well. Has a little bit of risk. Instead of defaulting 1.5% of the time it defaults at 3.5% of the time. That’s not so bad. If I’m an investor buying that, if I get a little bit of return, I’m fine.


CDO packager: ... In 2005, we had an internal debate here because there were two banks coming to us, why don’t you do a deal with us, BBB securities, you get paid a million bucks in management fees per year. Very clear, just like that, in 2005. And we declined those deals. We just don't believe those BBB RMBS assets are money-good. And we thought if we do a CDO of those, that's gonna blow up completely. We were early in '05 by not wanting to do those deals. People were laughing at us. Saying you're crazy. You’re hurting your business. Why don’t you want to make ... Per deal, you could make a million dollars a year.

Thursday, October 09, 2008

The subprime primer


In case you haven't seen this, it's pretty funny (strong language warning).

Special bonus: The Making of Goldman Sachs. Leonard Lopate interviews Charles Ellis, the author of The Partnership.

Double plus good: the Times goes after Greenspan and those weapons of mass destruction, derivatives.

Sunday, October 05, 2008

Mortgage finance in pictures

This graphic is from TheDeal.com (via Paul Kedrosky). Note they give the notional to net ratio for CDS as $62 to $2 trillion, or 30 to 1. That ratio is a good proxy for the complexity of the network of contracts and how difficult it will be to disentangle.

Tuesday, September 30, 2008

Why no bailout?

Representatives in Congress received thousands of phone calls and emails from constituents against the bailout, which some wags have characterized as "no banker left behind" :-)

We can trace this popular reaction against CEOs and Wall St. to growing income and wealth inequality. Ordinary people no longer feel they have a stake in the system. Their reaction may be irrational (even the poorest American has a big stake in the continued functioning of the economy), but it was certainly predictable.

Next spring, unlike last year, less than half of the Harvard graduating class will take jobs in finance. I guess that signals a top in the market 8-/


Related posts:

financier pay

all about the benjamins

a reallocation of human capital

a new class war

non-residential net worth

working class millionaires

Wednesday, July 23, 2008

Asset-backed oversold? Paulson ready to get back in!

John Paulson made $15 billion for his fund ($3.7 billion for himself!) betting against subprime securities last year. Now Bloomberg reports that he's ready to get back in on the upside!

I'm as dismayed as anyone else about taxpayer dollars going to bail out mortgage holders, commercial banks and the GSE's (Fannie, Freddie). I complained about Fannie back in 2004 when Franklin Raines was still CEO and the story first got out about their smoothing of earnings and use of derivatives accounting.

But, on the other hand, maybe Uncle Sam can actually generate positive return by buying oversold securities! Rumor says that current prices of subprime mortgage backed securities suggest implied default rates which are unrealistically high (e.g., like 50% !). Barring a complete economic meltdown these assets are underpriced and will generate a handsome return for an intelligent investor willing to take some risk. Is Uncle Sam smart? Let's hope that the other Paulson negotiates some upside for us taxpayers in any bailout organized by the Treasury.

Bloomberg: John Paulson, the money manager whose wagers against the U.S. housing market helped him earn an estimated $3.7 billion last year, is now seeking to profit from Wall Street's search for capital to offset mortgage writedowns.

Paulson plans to open a hedge fund by December that will provide capital to the world's biggest banks and brokers as they add to the $345 billion they've raised in the past year, according to two people with knowledge of the matter. His Paulson & Co., which oversees $33 billion, hasn't set a size target for the fund, said the people, who declined to be identified because the plans aren't final.

The New York-based firm's credit funds rose as much as sixfold last year, helped by bets that rising defaults on subprime home loans would pummel the value of mortgage-backed securities. The meltdown has forced the world's biggest banks and securities firms to take $467 billion in asset write-offs and credit losses and led to the collapse of Bear Stearns Cos.

``Investors who are able to make money in a declining market and then rapidly turn around and profit from a rising market is highly unusual,'' said Thomas Whelan, president of Greenwich, Connecticut-based Greenwich Alternative Investments, which advises clients on investing in hedge funds.

Paulson declined to comment. His 2007 earnings made him the highest-paid hedge-fund manager, according to Institutional Investor's Alpha magazine.

Tuesday, April 29, 2008

Pop goes the housing bubble


Figure via Calculated Risk. Larger version here

I believe the outlines of the bust are becoming as visible as the bubble itself was to any astute observer a few years ago. But no bottom yet! If I had to guess, I'd say we are going to give back most of the integral over the curve from 1997 to 2007 or so, net of overall inflation during that period (say 20-30%). In other words, extend the blue trend line beyond the early nineties, and integrate your favorite curve minus this trend line from 1997-2007 to get the overvaluation. (Note the graph is of year over year price changes in nominal dollars, not absolute price.)

Or, just look at the figure below to see that prices might have to drop 30-40% to return to consistency with the long term trend.





As we've discussed before, house price increases tend to be quite modest if measured in real dollars. (Except, of course, for bubbles and special cases :-)

The Case-Shiller national index will probably be off close to 12% YoY (will be released in earlylate May). Currently (as of Q4) the national index is off 10.1% from the peak.

The composite 10 index (10 large cities) is off 13.6% YoY. (15.8% from peak)

The composite 20 index is off 12.7% YoY. (14.8% from peak)

Sunday, April 27, 2008

Soros tells it like it is

The Financial Crisis: An Interview with George Soros with Judy Woodruff on Bloomberg TV.

According to his estimates (see below), housing starts would have to go to zero (he gives a normal value of 600k per annum, but I think the correct number is about twice that) for several years to compensate for the inventory that will flood the market due to foreclosures. So, no recovery in the near future, and continued pressure on the dollar. He also has some nice things to say about academic economics :-)

Judy Woodruff: You write in your new book, The New Paradigm for Financial Markets,[1] that "we are in the midst of a financial crisis the likes of which we haven't seen since the Great Depression." Was this crisis avoidable?

George Soros: I think it was, but it would have required recognition that the system, as it currently operates, is built on false premises. Unfortunately, we have an idea of market fundamentalism, which is now the dominant ideology, holding that markets are self-correcting; and this is false because it's generally the intervention of the authorities that saves the markets when they get into trouble. Since 1980, we have had about five or six crises: the international banking crisis in 1982, the bankruptcy of Continental Illinois in 1984, and the failure of Long-Term Capital Management in 1998, to name only three.

Each time, it's the authorities that bail out the market, or organize companies to do so. So the regulators have precedents they should be aware of. But somehow this idea that markets tend to equilibrium and that deviations are random has gained acceptance and all of these fancy instruments for investment have been built on them.

There are now, for example, complex forms of investment such as credit-default swaps that make it possible for investors to bet on the possibility that companies will default on repaying loans. Such bets on credit defaults now make up a $45 trillion market that is entirely unregulated. It amounts to more than five times the total of the US government bond market. The large potential risks of such investments are not being acknowledged.

Woodruff: How can so many smart people not realize this?

Soros: In my new book I put forward a general theory of reflexivity, emphasizing how important misconceptions are in shaping history. So it's not really unusual; it's just that we don't recognize the misconceptions.

Woodruff: Who could have? You said it would have been avoidable if people had understood what's wrong with the current system. Who should have recognized that?

Soros: The authorities, the regulators—the Federal Reserve and the Treasury—really failed to see what was happening. One Fed governor, Edward Gramlich, warned of a coming crisis in subprime mortgages in a speech published in 2004 and a book published in 2007, among other statements. So a number of people could see it coming. And somehow, the authorities didn't want to see it coming. So it came as a surprise.

Woodruff: The chairman of the Fed, Mr. Bernanke? His predecessor, Mr. Greenspan?

Soros: All of the above. But I don't hold them personally responsible because you have a whole establishment involved. The economics profession has developed theories of "random walks" and "rational expectations" that are supposed to account for market movements. That's what you learn in college. Now, when you come into the market, you tend to forget it because you realize that that's not how the markets work. But nevertheless, it's in some way the basis of your thinking.

Woodruff: How much worse do you anticipate things will get?

Soros: Well, you see, as my theory argues, you can't make any unconditional predictions because it very much depends on how the authorities are going to respond now to the situation. But the situation is definitely much worse than is currently recognized. You have had a general disruption of the financial markets, much more pervasive than any we have had so far. And on top of it, you have the housing crisis, which is likely to get a lot worse than currently anticipated because markets do overshoot. They overshot on the upside and now they are going to overshoot on the downside.

Woodruff: You say the housing crisis is going to get much worse. Do you anticipate something like the government setting up an agency or a trust corporation to buy these mortgages?

Soros: I'm sure that it will be necessary to arrest the decline because the decline, I think, will be much faster and much deeper than currently anticipated. In February, the rate of decline in housing prices was 25 percent per annum, so it's accelerating. Now, foreclosures are going to add to the supply of housing a very large number of properties because the annual rate of new houses built is about 600,000. There are about six million subprime mortgages outstanding, 40 percent of which will likely go into default in the next two years. And then you have the adjustable-rate mortgages and other flexible loans.

Problems with such adjustable-rate mortgages are going to be of about the same magnitude as with subprime mortgages. So you'll have maybe five million more defaults facing you over the next several years. Now, it takes time before a foreclosure actually is completed. So right now you have perhaps no more than 10,000 to 20,000 houses coming into the supply on the market. But that's going to build up. So the idea that somehow in the second half of this year the economy is going to improve I find totally unbelievable.


...

Woodruff: When you talk about currency you have more than a little expertise. You were described as the man who broke the Bank of England back in the 1990s. But what is your sense of where the dollar is going? We've seen it declining. Do you think the central banks are going to have to step in?

Soros: Well, we are close to a tipping point where, in my view, the willingness of banks and countries to hold dollars is definitely impaired. But there is no suitable alternative so central banks are diversifying into other currencies; but there is a general flight from these currencies. So the countries with big surpluses—Abu Dhabi, China, Norway, and Saudi Arabia, for example—have all set up sovereign wealth funds, state-owned investment funds held by central banks that aim to diversify their assets from monetary assets to real assets. That's one of the major developments currently and those sovereign wealth funds are growing. They're already equal in size to all of the hedge funds in the world combined. Of course, they don't use their capital as intensively as hedge funds, but they are going to grow to about five times the size of hedge funds in the next twenty years.

Tuesday, April 22, 2008

Deep inside the subprime crisis

Moody's walks Roger Lowenstein (writing for the Times Sunday magazine) through the construction, rating and demise of a pool of subprime mortgage securities. Some readers may have thought the IMF was exaggerating when it forecast up to $1 trillion in future losses from the credit bubble. After reading the following you will see that it's not an implausible number, and it will be clear why the system is paralyzed in dealing with (marking to market) the complicated securities (CDOs, etc.) that are contaminating the balance sheets of banks, investment banks, hedge funds, pension funds, sovereign wealth funds, etc. around the world.

Here's a quick physicist's calculation: roughly 10 million houses sold per year, assume that 10% of these mortgages are bad and will cost the issuer $100k to foreclose and settle. That means $100B per year in losses. Over the whole bubble, perhaps $300-500B in losses, which is more or less what the IMF estimates as the residential component of credit bubble losses (the rest of the trillion comes from commercial and corporate lending and consumer credit).

The internet bubble, with irrational investors buying shares of pet food e-commerce companies, was crazy. Read the excerpts below and you'll see that our recent housing boom was even crazier and at an unimaginably larger scale. (Note similar bubbles in the UK, Spain and in China.)

The best predictor, going forward, of mortgage default rates (not just subprime, but even prime mortgages) in a particular region will likely be the decline in home prices in that region. The incentive for a borrower to default on his or her mortgage is the amount by which they are "upside down" on the loan -- the amount by which their indebtedness exceeds the value of the home. Since we can't forecast price declines very well -- indeed, it's a nonlinear problem, with more defaults leading to more price declines, leading to more defaults -- we can't price the derivative securities built from those mortgages.

Efficient markets! ;-)



The figure above compares Case-Shiller data on the current bust (magenta) to the bust of the 80s-90s (blue). (Click for larger version.) You can see we have some way to go before all the fun ends.


Wall Street (Oliver Stone):

Gekko: Greed, for lack of a better word, is good. Greed is right. Greed works. Greed clarifies and cuts through and captures the essence of evolutionary spirit. Greed in all of its forms, greed for life, for money, for love, knowledge has marked the upward surge of mankind. And greed, you mark my words, will not only save Teldar Paper, but that other malfunctioning corporation called the USA.

Gekko: The richest one percent of this country owns half our country's wealth, five trillion dollars. One third of that comes from hard work, two thirds comes from inheritance, interest on interest accumulating to widows and idiot sons and what I do, stock and real estate speculation. It's bullshit. You got ninety percent of the American public out there with little or no net worth. I create nothing. I own.

Carl Fox: Stop going for the easy buck and start producing something with your life. Create, instead of living off the buying and selling of others.



NYTimes: ...The business of assigning a rating to a mortgage security is a complicated affair, and Moody’s recently was willing to walk me through an actual mortgage-backed security step by step. I was led down a carpeted hallway to a well-appointed conference room to meet with three specialists in mortgage-backed paper. Moody’s was fair-minded in choosing an example; the case they showed me, which they masked with the name “Subprime XYZ,” was a pool of 2,393 mortgages with a total face value of $430 million.

Subprime XYZ typified the exuberance of the age. All the mortgages in the pool were subprime — that is, they had been extended to borrowers with checkered credit histories. In an earlier era, such people would have been restricted from borrowing more than 75 percent or so of the value of their homes, but during the great bubble, no such limits applied.

Moody’s did not have access to the individual loan files, much less did it communicate with the borrowers or try to verify the information they provided in their loan applications. “We aren’t loan officers,” Claire Robinson, a 20-year veteran who is in charge of asset-backed finance for Moody’s, told me. “Our expertise is as statisticians on an aggregate basis. We want to know, of 1,000 individuals, based on historical performance, what percent will pay their loans?”

The loans in Subprime XYZ were issued in early spring 2006 — what would turn out to be the peak of the boom. They were originated by a West Coast company that Moody’s identified as a “nonbank lender.” Traditionally, people have gotten their mortgages from banks, but in recent years, new types of lenders peddling sexier products grabbed an increasing share of the market. This particular lender took the loans it made to a New York investment bank; the bank designed an investment vehicle and brought the package to Moody’s.

Moody’s assigned an analyst to evaluate the package, subject to review by a committee. The investment bank provided an enormous spreadsheet chock with data on the borrowers’ credit histories and much else that might, at very least, have given Moody’s pause. Three-quarters of the borrowers had adjustable-rate mortgages, or ARMs — “teaser” loans on which the interest rate could be raised in short order. Since subprime borrowers cannot afford higher rates, they would need to refinance soon. This is a classic sign of a bubble — lending on the belief, or the hope, that new money will bail out the old.

Moody’s learned that almost half of these borrowers — 43 percent — did not provide written verification of their incomes. The data also showed that 12 percent of the mortgages were for properties in Southern California, including a half-percent in a single ZIP code, in Riverside. That suggested a risky degree of concentration.

On the plus side, Moody’s noted, 94 percent of those borrowers with adjustable-rate loans said their mortgages were for primary residences. “That was a comfort feeling,” Robinson said. Historically, people have been slow to abandon their primary homes. When you get into a crunch, she added, “You’ll give up your ski chalet first.”

Another factor giving Moody’s comfort was that all of the ARM loans in the pool were first mortgages (as distinct from, say, home-equity loans). Nearly half of the borrowers, however, took out a simultaneous second loan. Most often, their two loans added up to all of their property’s presumed resale value, which meant the borrowers had not a cent of equity.

In the frenetic, deal-happy climate of 2006, the Moody’s analyst had only a single day to process the credit data from the bank. The analyst wasn’t evaluating the mortgages but, rather, the bonds issued by the investment vehicle created to house them. A so-called special-purpose vehicle — a ghost corporation with no people or furniture and no assets either until the deal was struck — would purchase the mortgages. Thereafter, monthly payments from the homeowners would go to the S.P.V. The S.P.V. would finance itself by selling bonds. The question for Moody’s was whether the inflow of mortgage checks would cover the outgoing payments to bondholders. From the investment bank’s point of view, the key to the deal was obtaining a triple-A rating — without which the deal wouldn’t be profitable. That a vehicle backed by subprime mortgages could borrow at triple-A rates seems like a trick of finance. “People say, ‘How can you create triple-A out of B-rated paper?’ ” notes Arturo Cifuentes, a former Moody’s credit analyst who now designs credit instruments. It may seem like a scam, but it’s not.

The secret sauce is that the S.P.V. would float 12 classes of bonds, from triple-A to a lowly Ba1. The highest-rated bonds would have first priority on the cash received from mortgage holders until they were fully paid, then the next tier of bonds, then the next and so on. The bonds at the bottom of the pile got the highest interest rate, but if homeowners defaulted, they would absorb the first losses.

It was this segregation of payments that protected the bonds at the top of the structure and enabled Moody’s to classify them as triple-A. Imagine a seaside condo beset by flooding: just as the penthouse will not get wet until the lower floors are thoroughly soaked, so the triple-A bonds would not lose a dime unless the lower credits were wiped out.

Structured finance, of which this deal is typical, is both clever and useful; in the housing industry it has greatly expanded the pool of credit. But in extreme conditions, it can fail. The old-fashioned corner banker used his instincts, as well as his pencil, to apportion credit; modern finance is formulaic. However elegant its models, forecasting the behavior of 2,393 mortgage holders is an uncertain business. “Everyone assumed the credit agencies knew what they were doing,” says Joseph Mason, a credit expert at Drexel University. “A structural engineer can predict what load a steel support will bear; in financial engineering we can’t predict as well.”

Mortgage-backed securities like those in Subprime XYZ were not the terminus of the great mortgage machine. They were, in fact, building blocks for even more esoteric vehicles known as collateralized debt obligations, or C.D.O.’s. C.D.O.’s were financed with similar ladders of bonds, from triple-A on down, and the credit-rating agencies’ role was just as central. The difference is that XYZ was a first-order derivative — its assets included real mortgages owned by actual homeowners. C.D.O.’s were a step removed — instead of buying mortgages, they bought bonds that were backed by mortgages, like the bonds issued by Subprime XYZ. (It is painful to consider, but there were also third-order instruments, known as C.D.O.’s squared, which bought bonds issued by other C.D.O.’s.)

Miscalculations that were damaging at the level of Subprime XYZ were devastating at the C.D.O. level. Just as bad weather will cause more serious delays to travelers with multiple flights, so, if the underlying mortgage bonds were misrated, the trouble was compounded in the case of the C.D.O.’s that purchased them.

Moody’s used statistical models to assess C.D.O.’s; it relied on historical patterns of default. This assumed that the past would remain relevant in an era in which the mortgage industry was morphing into a wildly speculative business. The complexity of C.D.O.’s undermined the process as well. Jamie Dimon, the chief executive of JPMorgan Chase, which recently scooped up the mortally wounded Bear Stearns, says, “There was a large failure of common sense” by rating agencies and also by banks like his. “Very complex securities shouldn’t have been rated as if they were easy-to-value bonds.”

...The challenge to investment banks is to design securities that just meet the rating agencies’ tests. Risky mortgages serve their purpose; since the interest rate on them is higher, more money comes into the pool and is available for paying bond interest. But if the mortgages are too risky, Moody’s will object. Banks are adroit at working the system, and pools like Subprime XYZ are intentionally designed to include a layer of Baa bonds, or those just over the border. “Every agency has a model available to bankers that allows them to run the numbers until they get something they like and send it in for a rating,” a former Moody’s expert in securitization says. In other words, banks were gaming the system; according to Chris Flanagan, the subprime analyst at JPMorgan, “Gaming is the whole thing.”

When a bank proposes a rating structure on a pool of debt, the rating agency will insist on a cushion of extra capital, known as an “enhancement.” The bank inevitably lobbies for a thin cushion (the thinner the capitalization, the fatter the bank’s profits). It’s up to the agency to make sure that the cushion is big enough to safeguard the bonds. The process involves extended consultations between the agency and its client. In short, obtaining a rating is a collaborative process.

The evidence on whether rating agencies bend to the bankers’ will is mixed. The agencies do not deny that a conflict exists, but they assert that they are keen to the dangers and minimize them. For instance, they do not reward analysts on the basis of whether they approve deals. No smoking gun, no conspiratorial e-mail message, has surfaced to suggest that they are lying. But in structured finance, the agencies face pressures that did not exist when John Moody was rating railroads. On the traditional side of the business, Moody’s has thousands of clients (virtually every corporation and municipality that sells bonds). No one of them has much clout. But in structured finance, a handful of banks return again and again, paying much bigger fees. A deal the size of XYZ can bring Moody’s $200,000 and more for complicated deals. And the banks pay only if Moody’s delivers the desired rating. Tom McGuire, the Jesuit theologian who ran Moody’s through the mid-’90s, says this arrangement is unhealthy. If Moody’s and a client bank don’t see eye to eye, the bank can either tweak the numbers or try its luck with a competitor like S.&P., a process known as “ratings shopping.”

...From 2002 to 2006, Moody’s profits nearly tripled, mostly thanks to the high margins the agencies charged in structured finance. In 2006, Moody’s reported net income of $750 million. Raymond W. McDaniel Jr., its chief executive, gloated in the annual report for that year, “I firmly believe that Moody’s business stands on the ‘right side of history’ in terms of the alignment of our role and function with advancements in global capital markets.”

...Moody’s was aware that mortgage standards had been deteriorating, and it had been demanding more of a cushion in such pools. Nonetheless, its credit-rating model continued to envision rising home values. Largely for that reason, the analyst forecast losses for XYZ at only 4.9 percent of the underlying mortgage pool. Since even the lowest-rated bonds in XYZ would be covered up to a loss level of 7.25 percent, the bonds seemed safe.

XYZ now became the responsibility of a Moody’s team that monitors securities and changes the ratings if need be (the analyst moved on to rate a new deal). Almost immediately, the team noticed a problem. Usually, people who finance a home stay current on their payments for at least a while. But a sliver of folks in XYZ fell behind within 90 days of signing their papers. After six months, an alarming 6 percent of the mortgages were seriously delinquent. (Historically, it is rare for more than 1 percent of mortgages at that stage to be delinquent.)

Moody’s monitors began to make inquiries with the lender and were shocked by what they heard. Some properties lacked sod or landscaping, and keys remained in the mailbox; the buyers had never moved in. The implication was that people had bought homes on spec: as the housing market turned, the buyers walked.

By the spring of 2007, 13 percent of Subprime XYZ was delinquent — and it was worsening by the month. XYZ was hardly atypical; the entire class of 2006 was performing terribly. (The class of 2007 would turn out to be even worse.)


In April 2007, Moody’s announced it was revising the model it used to evaluate subprime mortgages. It noted that the model “was first introduced in 2002. Since then, the mortgage market has evolved considerably.” This was a rather stunning admission; its model had been based on a world that no longer existed.

Poring over the data, Moody’s discovered that the size of people’s first mortgages was no longer a good predictor of whether they would default; rather, it was the size of their first and second loans — that is, their total debt — combined. This was rather intuitive; Moody’s simply hadn’t reckoned on it. Similarly, credit scores, long a mainstay of its analyses, had not proved to be a “strong predictor” of defaults this time. Translation: even people with good credit scores were defaulting. Amy Tobey, leader of the team that monitored XYZ, told me, “It seems there was a shift in mentality; people are treating homes as investment assets.” Indeed. And homeowners without equity were making what economists call a rational choice; they were abandoning properties rather than make payments on them. Homeowners’ equity had never been as high as believed because appraisals had been inflated.

Over the summer and fall of 2007, Moody’s and the other agencies repeatedly tightened their methodology for rating mortgage securities, but it was too late. They had to downgrade tens of billions of dollars of securities. By early this year, when I met with Moody’s, an astonishing 27 percent of the mortgage holders in Subprime XYZ were delinquent. Losses on the pool were now estimated at 14 percent to 16 percent — three times the original estimate. Seemingly high-quality bonds rated A3 by Moody’s had been downgraded five notches to Ba2, as had the other bonds in the pool aside from its triple-A’s.

The pain didn’t stop there. Many of the lower-rated bonds issued by XYZ, and by mortgage pools like it, were purchased by C.D.O.’s, the second-order mortgage vehicles, which were eager to buy lower-rated mortgage paper because it paid a higher yield. As the agencies endowed C.D.O. securities with triple-A ratings, demand for them was red hot. Much of it was from global investors who knew nothing about the U.S. mortgage market. In 2006 and 2007, the banks created more than $200 billion of C.D.O.’s backed by lower-rated mortgage paper. Moody’s assigned a different team to rate C.D.O.’s. This team knew far less about the underlying mortgages than did the committee that evaluated Subprime XYZ. In fact, Moody’s rated C.D.O.’s without knowing which bonds the pool would buy.

A C.D.O. operates like a mutual fund; it can buy or sell mortgage bonds and frequently does so. Thus, the agencies rate pools with assets that are perpetually shifting. They base their ratings on an extensive set of guidelines or covenants that limit the C.D.O. manager’s discretion.

Late in 2006, Moody’s rated a C.D.O. with $750 million worth of securities. The covenants, which act as a template, restricted the C.D.O. to, at most, an 80 percent exposure to subprime assets, and many other such conditions. “We’re structure experts,” Yuri Yoshizawa, the head of Moody’s’ derivative group, explained. “We’re not underlying-asset experts.” They were checking the math, not the mortgages. But no C.D.O. can be better than its collateral.

Moody’s rated three-quarters of this C.D.O.’s bonds triple-A. The ratings were derived using a mathematical construct known as a Monte Carlo simulation — as if each of the underlying bonds would perform like cards drawn at random from a deck of mortgage bonds in the past. There were two problems with this approach. First, the bonds weren’t like those in the past; the mortgage market had changed. As Mark Adelson, a former managing director in Moody’s structured-finance division, remarks, it was “like observing 100 years of weather in Antarctica to forecast the weather in Hawaii.” And second, the bonds weren’t random. Moody’s had underestimated the extent to which underwriting standards had weakened everywhere. When one mortgage bond failed, the odds were that others would, too.

Moody’s estimated that this C.D.O. could potentially incur losses of 2 percent. It has since revised its estimate to 27 percent. The bonds it rated have been decimated, their market value having plunged by half or more. A triple-A layer of bonds has been downgraded 16 notches, all the way to B. Hundreds of C.D.O.’s have suffered similar fates (most of Wall Street’s losses have been on C.D.O.’s). For Moody’s and the other rating agencies, it has been an extraordinary rout.

...The agencies have blamed the large incidence of fraud, but then they could have demanded verification of the mortgage data or refused to rate securities where the data were not provided. That was, after all, their mandate. This is what they pledge for the future. Moody’s, S.&P. and Fitch say that they are tightening procedures — they will demand more data and more verification and will subject their analysts to more outside checks. None of this, however, will remove the conflict of interest in the issuer-pays model. Though some have proposed requiring that agencies with official recognition charge investors, rather than issuers, a more practical reform may be for the government to stop certifying agencies altogether. ...

Wednesday, April 09, 2008

$1 trillion in losses?

We've had $200B in write-downs so far. The Fed has taken about $300B of shaky debt onto its balance sheet. The IMF is talking about a global bailout of the US economy.

It took Japan well over a decade to clean up its banking system after their property bubble burst. I doubt the US is going to take all of its bitter medicine at once. Whither the dollar?

The figure below first appeared on this blog in 2005:





Financial Times: IMF fears credit crisis losses could soar towards $1 trillion

Losses from the credit crisis by financial institutions worldwide are expected to balloon to almost $1 trillion (£507 billion), threatening to trigger severe economic fallout, the International Monetary Fund said yesterday.

In a grim assessment of the deepening crisis delivered days before ministers from the Group of Seven leading economies meet in Washington, the IMF warns governments, central banks and regulators that they face a crucial test to stem the turmoil.

“The critical challenge now facing policymakers is to take immediate steps to mitigate the risks of an even more wrenching adjustment,” it says in its twice-yearly Global Financial Stability Report.

The IMF sounds an alert over the danger that banks’ escalating losses, along with credit market uncertainties, could prompt a vicious downward spiral as they weaken economies and asset prices, leading to higher unemployment, more loan defaults and still deeper losses. “This dynamic has the potential to be more severe than in previous credit cycles, given the degree of securitisation and leverage in the system,” the Fund argues.

It says that it is clear that global financial upheavals are now more than just a shortage of ready funds, or liquidity, but are rooted in “deep-seated fragilities” among banks with too little capital. This “means that its effects are likely to be broader, deeper and more protracted”, the report concludes.

“A broadening deterioration of credit is likely to put added pressure on systemically important financial institutions,” it adds, saying that the risks have increased of a full-blown credit crunch that could undercut economic growth.

The warning came as Kenneth Rogoff, a former chief economist at the IMF and currently Professor of Economics at Harvard University, said that there was a “likely possibility” that the Fund will have to coordinate a global policy package to prop up the US economy. “They [the US] would not go for a conventional bail-out from the IMF. The IMF could not afford it – they have around $200 billion, which the US would burn through in a matter of months. It would be a package where various countries would try and prop up global demand to cushion the US economy.” He added: “The US is going to be looking for help to prevent this banking and housing problem from getting worse.”

The report also highlights the threat posed by the rapid spread of the credit crisis from its roots in the US sub-prime home loans to more mainstream lending markets worldwide.

While banks have so far declared losses and writedowns over the crisis totalling $193 billion, the IMF expects the ultimate toll to reach $945 billion.

Global banks are expected to shoulder about half of the total losses – between $440 and $510 billion – with the rest being borne by insurance companies, pension funds, hedge funds and money market funds, and other institutional investors, predominantly in the US and Europe.

Most of the losses are expected to stem from defaults in the US, with $565 billion written off in sub-prime and prime mortgages and a further $240 billion to be lost on commercial property lending. Losses on corporate loans are projected to mount to an eventual $120 billion and those on consumer lending to $20 billion.

Friday, April 04, 2008

Credit crisis for pedestrians

Here is a 40 minute discussion of the credit crisis on NPR's Fresh Air. The "expert" is a law professor with a tenuous grasp of finance, a love of regulation and an axe to grind against Wall St. and former Senator Phil Gramm. Terri Gross, ordinarily an astute interviewer, can't seem to get beyond concepts like big bets at a big casino by unregulated fat cats. 8-/

Saturday, March 29, 2008

Privatizing gains, socializing losses



Roger Lowenstein, author of When Genius Failed: the rise and fall of Long Term Capital Management, writes cogently about the credit crisis and government intervention in the Times Magazine.

I'd like to hear a believer in efficient markets try to tell the story of Bear Stearns' demise. One week it was OK for them to be levered 30 to 1, the next week it wasn't? When the stock was at 65 people were comfortable with their exposure to mortgages, but then suddenly they weren't? Come on. When the stock was at 65, what was the implied probability of a total collapse, based on out of the money puts? Zero.

Markets are complex dynamical systems that undergo phase transitions. Even sophisticated institutional investors are mostly just following the herd. Prices can disconnect wildly from real value for long periods of time, until suddenly they jump, often overshooting in the other direction. Huge risks, which in hindsight are obvious, build up in plain view while escaping notice from all but a few Cassandras. Robert Rubin, the Chairman of Citigroup, former co-head of Goldman, former Treasury Secretary, doesn't know what a SIV is until after the crisis has hit. Tens of trillions of dollars in off the books credit default swaps are traded (often recorded on scraps of paper!) before Wall St. CEOs, central bankers and regulators realize the instabilities involved.

More from James Surowiecki in the New Yorker. (I love this month's cover :-)

NYTimes: ...Government interventions always bring disruptions, but when Washington meddles in financial markets, the potential for the sort of distortion that obscures proper incentives is especially large, due to our markets’ complexities. Even Robert Rubin, the Citigroup executive and former Treasury secretary, has admitted he had never heard of a type of contract responsible for major problems at Citi.

Bear is a far smaller company, and, it would seem, far simpler. But consider that as recently as three weeks ago, it was valued at $65 a share. Then, as it became clear that Bear faced the modern equivalent of a bank run, JPMorgan Chase negotiated a merger with the figure of $10 a share in mind. Alas, at the 11th hour, Morgan’s bankers realized they couldn’t get a handle on what Bear owned — or owed — and got cold feet. Under heavy pressure from the Fed and the Treasury, a deal was struck at the price of a subway ride — $2 a share.

It is safe to say that neither Jamie Dimon, Morgan’s chief executive, nor Ben Bernanke, the Fed chairman who pushed for the deal, know what Bear is really worth. For the record, Bear’s book value per share is $84. As Meredith Whitney, who follows Wall Street for Oppenheimer, remarked, “It’s hard to get a linear progression from 84 to 2.”

Capitalism isn’t supposed to work like this, and before the advent of modern finance, it usually didn’t. Market values fluctuate, but — in the absence of fraud — billion-dollar companies do not evaporate. Yet it’s worth noting that Lehman Brothers’ stock also fell by half and then recovered within a 24-hour span. Once, investors could get a read on financial firms’ assets and risks from their balance sheets; those days are history.

Firms now do much of their business off the balance sheet. The swashbuckling Bear Stearns was a party to $2.5 trillion — no typo — of a derivative instrument known as a credit default swap. Such swaps are off-the-books agreements with third parties to exchange sums of cash according to a motley assortment of other credit indicators. In truth, no outsider could understand what Bear (or Citi, or Lehman) was committed to. The thought that Bear’s counterparties (the firms on the other side of that $2.5 trillion) would call in their chits — and then cancel their trades with Lehman, perhaps with Merrill Lynch and so forth — sent Wall Street into panic mode. Had Bear collapsed, or so asserted a veteran employee, “it would have been the end: pandemonium and global meltdown.”

Perhaps. Or perhaps, after some bad weeks or months, Wall Street would have recovered. What is scary is the degree to which the Fed assimilated the alarmism on the Street: “These guys are so afraid of an economic cycle,” a hedge-fund manager remarked. And without public airing or debate, it stretched the implicit federal safety net under Wall Street.

To question intervention is not to dispute that markets need rules. But for nearly two decades, Washington has trimmed its regulatory sails. The repeal of Glass-Steagall, which once separated banks from securities firms, and the evolution of new instruments that circumvent disclosure rules have loosened the market’s moorings. Huge pools of capital have been permitted to operate virtually unregulated. Mortgages have been written to the flimsiest of credits. Swelling derivative books have made a mockery of disclosure.

The relaxation of oversight has implied an unholy bargain: let markets operate unfettered in good times, confident that the feds will come to the rescue in bad. In 1998, the Fed intervened to cushion the collapsing hedge fund Long-Term Capital Management; dot-com stocks immediately began their dubious ascent. Then, when the tech meltdown led to a recession and the Fed cut rates to 1 percent, adjustable-rate mortgages became as hot as the iPod. One rescue begets the next excess.

It is true that Bear’s shareholders have suffered steep losses. But the Fed went much further than in previous episodes to calm the waters. Notably, it announced it would accept mortgage securities as collateral for loans — enlarging its role as lender of last resort. (Wall Street jesters had it that the Fed would also be accepting “cereal box-tops.”) Then the Fed extended a backstop line of credit to JPMorgan to tide Bear over; finally, it agreed to absorb the ugliest $30 billion of Bear’s assets.

Monday, March 17, 2008

So long, Bear: fear crushes greed


Bear Stearns evaporated over the weekend. Its market cap plummeted from $20B a year ago to $3.5B on Friday to essentially zero this weekend, when JP Morgan acquired them for less than the real estate value of their building in Manhattan. Due to Fed guarantees made to JP Morgan, US taxpayers are on the hook for $30B of the most illiquid mortgage backed securities on Bear's books. The Fed intervened because had Bear been allowed to melt down there would have been chaos in and systemic risk to the financial markets ("too big and interconnected to fail"). The current crisis is much more serious than either the Long Term Capital collapse of 1998 or even the savings and loan crisis of the 1980s.

How do illiquid securities get priced? Ultimately, it's competition between FEAR and GREED. At the moment FEAR is winning -- there are serious mispricings in corporate and municipal bond markets due to gigantic risk premia and a flight to security. Mortgage securities won't bottom out until GREEDY capital (controlled by investors willing to take a risk today in hopes of future profits) is sufficient. The problem is that price recovery can't take place until market confidence returns and, additionally, the ultimate value of mortgage securities depends on future projections about the bursting housing bubble, default rates, overall macro trends, etc. It could take a long time for markets to clear, with the Fed (taxpayers!) acting as the buyer of last resort in the interim.

WSJ: ..."At the end of the day, what Bear Stearns was looking at was either taking $2 a share or going bust," said one person involved in the negotiations. "Those were the only options."

To help facilitate the deal, the Federal Reserve is taking the extraordinary step of providing as much as $30 billion in financing for Bear Stearns's less-liquid assets, such as mortgage securities that the firm has been unable to sell, in what is believed to be the largest Fed advance on record to a single company. Fed officials wouldn't describe the exact financing terms or assets involved. But if those assets decline in value, the Fed would bear any loss, not J.P. Morgan.

The sale of Bear Stearns and Sunday night's move by the Fed to offer loans to other securities dealers mark the latest historic turns in what has become the most pervasive financial crisis in a generation. The issue is no longer whether it will yield a recession -- that seems almost certain -- but whether the concerted efforts of Wall Street and Washington can head off a recession much deeper and more prolonged than the past two, relatively mild ones.

'Uncharted Waters'

Former Treasury Secretary Robert Rubin last week described the situation as "uncharted waters," a view echoed privately by top government officials. Those officials have been scrambling to come up with new tools because the old ones aren't suited for this 21st-century crisis, in which financial innovation has rendered many institutions not "too big too fail," but "too interconnected to be allowed to fail suddenly."

Bear Stearns's sudden meltdown forced the federal government to come to grips with the potential collapse of a major Wall Street institution for the first time in a decade. In 1998, about a dozen firms, with encouragement from the Federal Reserve Bank of New York, provided a $3.6 billion bailout of Long-Term Capital Management that kept the big hedge fund alive long enough to liquidate its positions. Bear Stearns famously refused to participate in that rescue.

The scale of the financial system's troubles are even bigger this time around. Since last summer, the Fed has lowered its target for the federal-funds rate, charged on low-risk overnight loans between banks, to 3% from 5.25%, and it is expected to cut the rate again this week. Last week, the Fed said it would lend Wall Street as much as $200 billion in exchange for a roughly equivalent amount of mortgage-backed securities.

But those moves have failed to soothe investors and lenders, who are worried about the true value and default risk of many debt securities or are hoarding cash to meet their own needs. As worries grew that failing to find a buyer for the beleaguered investment bank could cause the crisis of confidence gripping Wall Street to worsen across the financial system, federal regulators pushed Bear Stearns's board to sell the firm.

Who can forecast or model the future value of a complicated CDO tranche? Only a quant with a PhD. Are the real decision makers and risk takers on Wall Street in the mood to trust those calculations? Certainly not at the moment. Therefore, I predict, for now, very limited bargain hunting by just a few bold investors, and no end to illiquidity.

From a recent Fortune interview with Paul Krugman; he seems to be saying subprime is oversold and there's money to be made for the steely eyed:

Fortune: ...do you think the sense of crisis is turning into a crisis of confidence more than anything else?

I fluctuate on that. I look at the prices on subprime-backed securities. Even the AAA-rated tranche is selling for barely over 50 cents on the dollar, and the rest is essentially worthless, which amounts to a prediction that you're going to get really very little on this stuff. Even if every subprime borrower walks away from his house and a lot of money is lost in foreclosure, it's hard to get numbers that bad. So there might be some overselling in these markets. But on the other hand, a lot of the financial system looks like it's going to shrivel up and have to be rebuilt. And that's not too good.

The other risk is, of course, a dollar meltdown. As the Fed lowers interest rates and (effectively) prints money to stimulate the economy and prop up banks and securities firms, foreign investors must begin to question the future of the dollar as a store of wealth. The same crisis of confidence that brought down Bear could eventually bring down the US dollar.

Weighted US dollar index (NYBOT:DX):

Tuesday, February 12, 2008

Housing bubble: dynamics of a bust





The first figure is from today's WSJ and incorporates data from Q4 2007. The second figure appeared in the Economist some time ago and was discussed previously on this blog. Does anyone care to predict the future for bubble states like California, Florida and Arizona using the Japanese data as a guide?

Lower interest rates will not re-inflate the housing bubble (although they may affect the rate at which it deflates; note the BOJ dropped real interest rates below zero in the wake of their bust). People understand now, as they did not just a few years ago, that home prices can go down. This change in ape psychology (try putting that in your macro model!) makes all the difference.

Below is historical data compiled by Yale economist Robert Shiller showing that home prices have not on average provided attractive real returns (right hand axis is inflation adjusted returns for same house sales over time; previously discussed here -- the real rate of return was 0.4% between 1890 and 2004). This is yet another example in which market participants (home buyers) made decisions based on faulty assumptions that might have been easily corrected by a modest amount of research. So much for efficient markets!



Here's some detailed data from Case-Shiller and OFHEO indices (also from WSJ; note OFHEO only tracks conforming mortgages so has less sensitivity to the high end of the market):



Finally, it is worth noting that the subprime mortgage meltdown is merely a symptom of the real estate bubble. If home prices continue to fall we will see (as we are already beginning to) higher default rates in so-called "prime" as well as subprime mortgages.

WSJ: ...I assumed, for the sake of calculations, that California prices fell 8% last quarter from the third quarter, a huge number by historic measures but not out of line with Zillow's data. For Florida and Arizona I assumed declines of 5% and 5.5%. You could use other, more modest estimates for the recent declines: They won't change the outcomes much. I also assumed personal incomes in these states rose in line with recent and historic averages."

The results? In all three markets, the prices are well off their peaks when compared to incomes. But they remain far above historic averages.

Median prices in California peaked in 2006 at 13.3 times per capita incomes. Hard to believe, but true. They may be down now to about 11.1 times.

But that's still way above the ground. Throughout most of the 80s and 90s they ranged between six and seven times incomes.

Just to get down to seven times incomes, prices would have to fall 37% tomorrow.

Those who bought at the peak of the cycle may be pinning their hopes instead on "incomes catching up" instead. But they had better be patient. Even if house prices stayed exactly where they are, it would take around 10 years for rising incomes to bring the ratios back into any sort of alignment.

Saturday, January 26, 2008

Fake alpha, tail risk and compensation in finance

I highly recommend this essay in the Financial Times. It notes that current banking and money management compensation schemes create incentives for taking on tail risk (which is really beta) and disguising it as alpha. The proposed solution: holdbacks or clawbacks of bonus money. This would probably be a big improvement over the status quo (although how long would one have to wait to be sure that risk was properly priced on a group of thirty year loans?). When will shareholders smarten up and enforce this kind of compensation scheme on management at public firms? Clawbacks already happen in VC when early success turns into losses for a fund.

A minor quibble with what is written about VCs: in many cases "activism" is too strong a characterization -- it is the inventor/entrepreneur who does all the work.

FT: Bankers’ pay is deeply flawed

By Raghuram Rajan

Published: January 8 2008 18:04 | Last updated: January 9 2008 16:21

Summary: Raghuram Rajan says bogus alpha is created by hiding long-tail risks, as with structured products linked to subprime mortgages. A solution would be to hold in escrow a big chunk of bonuses until the full risks play out, meaning only true alpha gets jumbo rewards and reducing the hidden risks in the financial system.


Banks have recently been acknowledging enormous losses, yet those losses are barely reflected in employee compensation. For example, Morgan Stanley announced a $9.4bn charge-off in the fourth quarter and at the same time increased its bonus pool by 18 per cent. The justification was that many employees had a banner year and their compensation should not be held hostage to mistakes that were made in the subprime market. The chief executive, John Mack, however, assumed some responsibility and agreed to take no bonus for 2007 – although he got a $40m payout for 2006.

Even so, most readers would suspect something is not right here. Indeed, compensation practices in the financial sector are deeply flawed and probably contributed to the ongoing crisis.

The typical manager of financial assets generates returns based on the systematic risk he takes – the so-called beta risk – and the value his abilities contribute to the investment process – his so-called alpha. Shareholders in asset management firms, such as commercial banks, investment banks and private equity or insurance companies are unlikely to pay the manager much for returns from beta risk. For example, if the shareholder wants exposure to large traded US stocks she can get the returns associated with that risk simply by investing in the Vanguard S&P 500 index fund, for which she pays a fraction of a per cent in fees. What the shareholder will really pay for is if the manager beats the S&P 500 index regularly, that is, generates excess returns while not taking more risks. Hence they will pay for alpha.

In reality, there are only a few sources of alpha for investment managers. One of them comes from having truly special abilities in identifying undervalued financial assets. Warren Buffett, the US billionaire investor, certainly has it, yet this special ability is, by definition, rare.

A second source of alpha is from what one might call activism. This means using financial resources to create, or obtain control over, real assets and to use that control to change the payout obtained on the financial investment. A venture capitalist who transforms an inventor, a garage and an idea into a fully fledged, profitable and professionally managed corporation creates alpha.

A third source of alpha is financial entrepreneurship or engineering – creating securities or cash flow streams that appeal to particular investors or tastes. As long as the investment manager does not create securities that exploit investor weaknesses or ignorance (and there is unfortunately too much of that), this sort of alpha is also beneficial, but it requires constant innovation.

Alpha is quite hard to generate since most ways of doing so depend on the investment manager possessing unique abilities – to pick stocks, identify weaknesses in management and remedy them, or undertake financial innovation. Such abilities are rare. How then can untalented investment managers justify their pay? Unfortunately, all too often it is by creating fake alpha – appearing to create excess returns but in fact taking on hidden tail risks, which produce a steady positive return most of the time as compensation for a rare, very negative, return.

For example, an investment manager who bought AAA-rated tranches of collateralised debt obligations (CDO) in the past generated a return of 50 to 60 basis points higher than a similar AAA-rated corporate bond. That “excess” return was in fact compens ation for the “tail” risk that the CDO would default, a risk that was no doubt perceived as small when the housing market was rollicking along, but which was not zero. If all the manager had disclosed was the high rating of his investment portfolio he would have looked like a genius, making money without additional risk, even more so if he multiplied his “excess” return by leverage. Similarly, the management of Northern Rock followed the old strategy of taking on tail risk, borrowing short and lending long and praying that the unlikely event of a liquidity shortage never materialised. All these strategies essentially earn the manager a premium in normal times for taking on beta risk that materialises only infrequently. These premiums are not alpha, since they are wiped out when the risk materialises.

True alpha can be measured only in the long run and with the benefit of hindsight – in the same way as the acumen of someone writing earthquake insurance can be measured only over a period long enough for earthquakes to have occurred. Compensation structures that reward managers annually for profits, but do not claw these rewards back when losses materialise, encourage the creation of fake alpha. Significant portions of compensation should be held in escrow to be paid only long after the activities that generated that compensation occur.

The managers who blew a big hole in Morgan Stanley’s balance sheet probably earned enormous bonuses in the past – Mr Mack certainly did. If Morgan Stanley managed its compensation correctly those bonuses should be clawed back and should be enough to pay those who did well this year without increasing the bonus pool. At the very least, shareholders deserve better explanations. More generally, unless we fix incentives in the financial system we will get more risk than we bargain for. Unless bankers offer these better explanations, their enormous pay, which has been thought of as just reward for performance, will deservedly come under scrutiny.

The writer is a professor of finance at the Graduate School of Business at the University of Chicago and former chief economist at the International Monetary Fund

Sunday, January 20, 2008

A higher intelligence at Goldman

Michael Lewis (Bloomberg) has some interesting comments on Goldman Sachs' vastly superior performance during the subprime meltdown. In an earlier post we discussed the $4 billion they made by shorting the major CDO indices. (See here for another close reading of the WSJ story that uniquely sheds some partial light on what happened.) It really boils down, as I mentioned earlier, to the huge proprietary trading component at Goldman. They apparently don't hesitate to take positions against other business units at the firm.

What Does Goldman Know That We Don't?
2008-01-17 09:00 (New York)

Commentary by Michael Lewis

Jan. 17 (Bloomberg) -- In retrospect, the most intriguing subplot in the collapse of the subprime mortgage market has been not the size of the losses but their distribution.

Wall Street firms have a talent for getting themselves into trouble together. They all were long Internet stocks when Internet stocks collapsed and they'll all be long North Korean credit-default swaps whenever North Korea gets hot and then crashes.

What's odd about the subprime crash is Goldman Sachs Group Inc. A single firm took a position contrary to the rest of Wall Street. Giant Wall Street firms are designed for many things, but not, typically, to express highly idiosyncratic views in the market.

Even more surprising is how little Wall Street seems to have dwelled on how and why Goldman Sachs made its killing. There are insane conspiracy theories -- for instance, that former Goldman chief executive officer and current U.S. Treasury Secretary Henry Paulson tipped his old pals, etc. (But then, how did HE know?)

There is also the widely held opinion that people who work at Goldman Sachs are just smarter than ordinary people -- hence the lust to hire former Goldman employees to run other Wall Street firms, as Merrill Lynch & Co. did. (But why would any trader who could systematically beat the market waste his time at Goldman Sachs?)

So far as I can tell, there has been only one attempt to explain this strange event, and that was by a journalist, Kate Kelly of the Wall Street Journal.

[... skip recap of WSJ article ...]


Rolling Heads

All across Wall Street risk managers are being fired, reassigned or hovering under a cloud of contempt and suspicion. Heads must roll, and after the CEO, these guys are the most plausible to guillotine.

But at the same time it's pretty clear that a lot of these so-called risk managers never really had the power to manage risk. They had to consider the feelings, for example, of the guys who ran subprime mortgages. Morgan Stanley conceded as much when it said recently it was considering changing things around so that the risk manager reported to the CFO, rather than the heads of individual businesses.

But at Goldman there were two intelligences at work: one, the ordinary Wall Street intelligence, which was allowed to get itself in trouble, just as at every other Wall Street firm; the other, more like an extremely smart hedge fund that made its living off the idiocy of big Wall Street firms, including its own people.

A Higher Intelligence

And this second, higher intelligence was allowed to make a mockery of the labors of the first. I can't think of another example of a big Wall Street firm saying so clearly through its trading positions as Goldman Sachs did over the past year that it thinks the rest of its industry, including its own people, is a bunch of idiots. They have obviously designed their firm to take into account their idiocy -- without ever having to put too fine a point on it.


From now on, the ordinary traders and salesmen at Goldman Sachs can beaver away knowing that their opinions and judgments about the markets in which they operate are basically irrelevant. The guys at the top of the firm are making the market calls, and if the guys at the top disagree with them, well, they'll just take the other side of their trades. But then, why do you need the traders? And what happens when the guys at the top of the firm are wrong?

Tuesday, January 15, 2008

And the winner is...


We all know who the losers are in the subprime meltdown: shareholders of Citi, Merrill, Countrywide Financial, etc. One of the winners is profiled below, a hedge fund manager who made $15B (keeping $3-4B himself!) from the bursting subprime housing bubble.

WSJ: Trader Made Billions on Subprime
John Paulson Bet Big on Drop in Housing Values

By GREGORY ZUCKERMAN
January 15, 2008

On Wall Street, the losers in the collapse of the housing market are legion. The biggest winner looks to be John Paulson, a little-known hedge fund manager who smelled trouble two years ago.

Funds he runs were up $15 billion in 2007 on a spectacularly successful bet against the housing market. Mr. Paulson has reaped an estimated $3 billion to $4 billion for himself -- believed to be the largest one-year payday in Wall Street history.

Now, in another twist in financial history, Mr. Paulson is retaining as an adviser a man some blame for helping feed the housing-market bubble by keeping interest rates so low: former Federal Reserve Chairman Alan Greenspan. (See article.)

On the way to his big score, Mr. Paulson did battle with a Wall Street firm he accused of trying to manipulate the market. He faced skepticism from other big investors. At the same time, fearing imitators, he used software that blocked fund investors from forwarding his emails.

One thing he didn't count on: A friend in whom he had confided tried the strategy on his own -- racking up huge gains himself, and straining their friendship. (See article.)

Like many legendary market killings, from Warren Buffett's takeovers of small companies in the '70s to Wilbur Ross's steelmaker consolidation earlier this decade, Mr. Paulson's sprang from defying conventional wisdom. In early 2006, the wisdom was that while loose lending standards might be of some concern, deep trouble in the housing and mortgage markets was unlikely. A lot of big Wall Street players were in this camp, as seen by the giant mortgage-market losses they're disclosing.

"Most people told us house prices never go down on a national level, and that there had never been a default of an investment-grade-rated mortgage bond," Mr. Paulson says. "Mortgage experts were too caught up" in the housing boom.

In several interviews, Mr. Paulson made his first comments on how he made his historic coup. Merely holding a different opinion from the blundering herd wasn't enough to produce huge profits. He also had to think up a technical way to bet against the housing and mortgage markets, given that, as he notes, "you can't short houses."

Also key: Mr. Paulson didn't turn bearish too early. Some close students of the housing market did just that, investing for a downturn years ago -- only to suffer such painful losses waiting for a collapse that they finally unwound their bearish bets. Mr. Paulson, whose investment specialty lay elsewhere, turned his attention to the housing market more recently, and got bearish at just about the right time. ...

Friday, January 04, 2008

Understanding the subprime crisis

This is apparently the most downloaded economics (SSRN) paper on subprime. Van Hemert is a re-tooled theoretical physicist :-)

Understanding the Subprime Mortgage Crisis

YULIYA DEMYANYK
Federal Reserve Bank of St. Louis - Banking Supervision and Regulation

OTTO VAN HEMERT
New York University - Department of Finance

December 10, 2007


Abstract:
Utilizing loan-level data, we analyze the quality of subprime loans by adjusting their performance for differences in borrower characteristics, loan characteristics, and economic circumstances. We find that during the explosive growth of the subprime market in 2001-2006 the quality of loans monotonically deteriorated and underwriting criteria loosened. In this respect, the rise and fall of the subprime market resembles a classic lending boom-bust scenario, in which unsustainable growth leads to the collapse of the market. We show that the problems in the subprime market were imminent long before the crisis in 2007, securitizers were to some extent aware of it, but a high house price appreciation in 2003-2005 masked the true riskiness of subprime mortgages.

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