Posted on 09/13/2008 9:26:35 AM PDT by tcostell
We might have just been whistling past the graveyard, but my co-workers and I all had a good laugh this week. The drama that had us so pre-occupied was the negotiations of various parties for Lehman Brothers. For those who don’t understand what’s happening, here’s the way it’s playing out:
Lehman, like many large financial institutions had dealt heavily in the highly obfuscated credit derivatives and mortgage bond market. It’s a gross simplification, but in essence what they were doing was borrowing money to buy mortgage bonds, and then using the bonds themselves as collateral for additional borrowing. That in itself isn’t a big deal at all. It’s basically the way that the entire banking system works. When that same practice is done with US Treasury bonds no one blinks an eye, nor should they.
But the reason no one needs to worry about that practice where Treasury bonds are concerned is that, within certain very well understood limits, a Treasury bond will be worth pretty much the same thing tomorrow as it’s worth today. US Treasury bonds are rated AAA and represent a minimum risk of repayment. So little in fact, that for years I’ve been joking that “if the US ever defaults on a bond issue, then you won’t need to buy gold because the only commodity that will be worth anything at all will be bullets”. Anyway for that reason Treasury Bonds are considered "riskless" and make excellent collateral for additional borrowing by banks.
Until very recently it was the general market consensus at least that many mortgage bonds were AAA rated as well and therefore justified the same investor confidence as Treasury bonds. As you have certainly guessed by now, that’s turned out not to be the case.
(Excerpt) Read more at freenj.blogspot.com ...
The real villains in this mess, besides the fools that invested in an alphabet soup of junk paper backstopped by highly speculative and highly leveraged collateral, are the ratings agencies, Moody's and Standard and Poor's, who gave triple A ratings to all those mortgage backed securities. Not only was the collateral bad, but the firms that issued them are going bankrupt.
I'm not into hysterics or doom and gloom predictions, but the huge credit derivatives market is on the brink, and the U.S. government (read taxpayers) has now put itself in the position of guaranteeing the solvency of these entities.
I disagree that the bonds are junk. I will grant you that the ratings agencies should have been a little more on top of their game, but the fact is, many of these bonds carry (or carried) insurance. It was only the liquidity crunch crushing the insurers which lowered the rating on the debt. and even then the debt still isn't worth nothing.
As I tried to say, the collateral on the debt is still mostly sound. There is nothing wrong with the overwhelming majority of mortgage bonds. But because accounting practices haven't kept up with the market, the industry doesn't have an effective way to represent that.
Back in the day there was an idea called portfolio insurance. It was a hedging strategy designed by a friend of mine which was the accepted practice in the 80's... until October 1987. you see it worked fine for 1 person, but if everyone did it, then it wouldn't work at all.
Same principle. the villains aren't at all clear here... and it's wrong to make it seem like that's so.
Do you know why they weren't? Because they where in bed with the companies issuing the bonds. As for the bond insurers, They got taken in by the ratings agencies like everyone else, and have only avoided bankruptcy by the skin of their teeth.
"the villains aren't at all clear here... and it's wrong to make it seem like that's so."
They are all too clear.
The mortgage lenders who didn't care whether the borrower could afford or would repay the loan because they weren't going to hold on to it anyway.
The borrowers who couldn't be bothered to read or understand what they where signing, or whether they could actually afford the home.
The investment banks who took all of these mortgages and bundled them together and sold an alphabet soup of derivatives that nobody understood.
The rating agencies who where in bed with the companies they where supposed to be rating.
The federal government who looked on all of this with a nod and a wink because the social goal of home ownership was being met, and where receiving political contributions from the investment banks, Fanny Mae and Freddy Mac not least.
The list goes on and on. We've had asset bubbles before, and they are necessary corrections to out of balance supply and demand situations. The problem of excessive leverage in the credit derivatives market is what worries me.
We're looking at a real possibility of the investment banks folding up one after another, and now the Fed wants to bail them all out because they're "too big to fail". We're talking trillions of dollars of liability that the Fed wants to underwrite. I have to believe that they'll eventually see the light, but who knows? We're in uncharted waters here.
If you have some evidence of wrongdoing let me know and I'll put you in touch with a girl I know at the Federal DA's office.
But absent actual evidence I'm going to go ahead and continue to believe that they just made a systemic error of failing to include the possibility of a "portfolio insurance" phenomenon developing with the bond insurers. It's a mistake that's been made by smart people before.
There was certainly some wrongdoing at the bottom end of the scale with the Realtors and mortgage brokers, but I think it was probably only a little bit more common than a normal level of "criminal activity" and most Realtors and mortgage brokers were in the "honest to scrupulously honest" range.
As for your alphabet soup comment, there was nothing wrong with their practices and their still isn't. The models are accurate to within their stated limits and it's a falsehood to claim otherwise.
It's an issue I have a complete understanding of, so I know this to be so. I don't mean to condescend, but it's a complicated issue that most people don't have the time or facility to learn about even if they have the intelligence to understand it. I'm not saying you lack intelligence, I'm only saying that you haven't had the time or inclination to go to the trouble of learning how the models actually work. Few people who aren't in my business ever do. And since I have that knowledge, I'm asking you to take my word for it that the models are sound.
Unfortunately there are no big villains here.
I don't have to, Mr. Smug. The SEC and the Attorneys General of several states are already taking action.
"As for your alphabet soup comment, there was nothing wrong with their practices and their still isn't. The models are accurate to within their stated limits and it's a falsehood to claim otherwise."
You can look out on the economic landscape and say that? Talk about living in an ivory tower. Models are great, until they stop working. Is any one still issuing mortgage backed securities? I assure you they aren't. The model is broken. How about sub-prime mortgages? Are many of those still being written, or any at all? No, because that model is broken, too.
Reality eventually catches up with all of these schemes. That's why the smart boys on Wall Street have to constantly come up with new ones.
They may be investigating but I doubt that there will be any action taken against the ratings agencies. In any case, absent evidence to the contrary I'm going to assume that they were just wrong. I have no time or energy to waste with baseless allegations.
As for the rest of your comment, I thought I addressed those issues in this essay well enough so that anyone could understand them, but you seem to be so consumed with your desire to find someone to blame that you're uninterested in the facts.
OK ... fair enough.
A little? Are you forgetting WPPPS? How about the S&L crisis of the 80s? Good grief. This is a systemic problem.
Hence the need for a systemic fix: The rating agencies should carry the insurance to cover the loss if they're wrong.
This problem is not the fault of the rating agencies, and it's an untenable solution to expect them to carry insurance on every bond issue they rate. They will simply no longer rate any bonds.
Besides this isn't a problem with the bonds. The bonds are worth less than they used to be but they are not worth nothing as the current market would lead you to believe. This is a liquidity risk problem, and what we need is a way to value liquidity risk that can be put in place with something close to our current accounting regulations.
I wrote another way that future issues like this can be effectively addressed, but I don't think it's something that will be seriously considered because it's a little too 'cutting edge'. It's designed around an economic theory of markets which isn't exactly accepted wisdom yet, but is well thought of by those who are aware of it.
You can read about it here if you like.
Disagree there.
The bonds are worth less than they used to be but they are not worth nothing as the current market would lead you to believe.
Restating the obvious is not an argument in support of your position. In fact, it argues for mine, that coverage need only extend to the degree of loss acceptable to the buyer. In instances of uncertainty, the cost of insurance on a potential rating term or a larger loss would go up to allocate the pooled resources. Now, I'm not advocating this as a regulation, but as a market opportunity, although, if there is an instance of willful blindness and/or complicit duplicity (see "Arthur Anderson") they should go to jail. The real point is: don't make a prediction for profit unless you are willing to back it up. Such would weed out the wishful thinkers in a hurry and institute the necessary gut-check when analyzing the data.
I hold a patent on a business method for pricing risks to environmental assets, a market subject to both singularities and massive unknowns. It is not entirely dissimilar.
But I'm not in the insurance business so on that topic I'll defer to better minds. If you think you have a way that this will work without it requiring regulation then more power to you. Have at me... tell me when you're ready to meet private equity partners and I'll get my Rolodex.
As long as unconstitutional means to socialize risk remain, this is somewhat true. I'll note that some of the holders of tax-exempt charitable foundations racketeered their way into creating the regulatory mess that hollowed out this economy in the first place.
If you think you have a way that this will work without it requiring regulation then more power to you. Have at me... tell me when you're ready to meet private equity partners and I'll get my Rolodex.
I may just take you up on that some time next year.
I'm not all vituperation here.
Will do.
As to serious: I've put ten years into developing these ideas on a broad scale. Getting a patent on such a method as a pro se wasn't a small matter; that alone took nearly eight years. We've got to develop ways of withdrawing from this regulatory heroin or we're toast economically. People have no idea just how huge the successive effects of tort and regulation have inflicted on wealth generating processes.
I couldn’t agree more ... unfortunately the only way I’ve ever heard of it being done was with rifles and that has lots of unintended consequences.
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