Posted on 09/22/2008 4:54:27 PM PDT by Praxeologue
I asked:
“If these investments were ultimately going to make someone a big profit would the lending institutions be so eager to offload them?”
You answered:
“Yes, they would be eager to off load them, because anyone carrying them has to pay 12% and upward to borrow money. And not one financial institution is solvent with that kind of cost of capital. You can’t borrow at 12 and lend it at 6 and make it up on volume.”
So really, your answer is:
“Yes, that’s a definite NO. Because they would not make big profits on these bad investments due to the cost of capital.”
And that is why they are called “illiquid” (new buzzword - has a nicer ring to it than “bad debt” or “foolish investment”, doesn’t it?), and that is why they are so eager to unload this garbage on taxpayers.
Not to mention that no one even knows what security or real property is behind this bad paper. A lot of it is derivatives two or three times repackaged from the original transaction.
And what kind of knowledgeable investor doesn’t take the cost of their investment capital into the equation when calculating the value of a securities purchase?
I’ll tell you - it’s the kind that expects to drop their bad paper on the government.
Thank you for peeling another layer from the onion.
And the cost of capital of the major banks then stuck with it, is not a fixed item, but exactly the variable whose movement *is* this crisis. Last year, major wall street banks could routinely borrow money for 5% to 6%. That was approximately where short term rates were, at the top of the Fed's tightening cycle. Since then the Fed has cut short term rates to 2%, but the interest rate on these bank's notes and bonds outstanding has jumped to double digits. 10% for some, 14% for others.
The phenomenon is known as "discredit" in the historical literature of bubbles and their aftermath. People become unwilling to lend to a tainted institution, except at exorbitant rates, and those rates themselves render that institution unprofitable. It is fear of getting stuck with losses that causes this, of course. But that fear is a self fufilling prophecy - if the rates a bank can borrow at are driven high enough, none is profitable.
The reason the commercial banks are still standing and the investment banks have all been destroyed, is the commercial banks fund themselves mostly through deposits, which being FDIC insured, can still be raised at 3% rates (on CDs etc). Even the commercial banks are paying high rates on the remainder of their capital, however - their notes and preferreds are yielding 8% to 9% right now. Since those are only a fraction of their total funding cost, though, they are around break-even lending at 6% or so. If, on the other hand, they pile into treasury securities seeking maximum safety and liquidity, they earn only 1-3% on the credit side.
Every financial institution is fundamentally a credit rating. They need to be able to borrow more cheaply than they lend, long term, or there is no economic reason for them to exist. After their failure to forsee or predict the blow up in mortgages, no one in the past year has trusted ratings from agencies. As a result, A rated corporates yield 12% in the finance sector, and 10% in the real estate sector. Simultaneously treasuries are well bid at 2%, and utilities or other industrial companies can borrow at 5% to 6%.
These spreads are unprecedented for top rated companies and for financial companies. They are what would be normal in a down part of the cycle for junk bonds, where a third are expected to default within about 5 years. That was the bond market expectation over the past year, and it will fufill itself if sustained.
The banks all follow ABX indices, which are benchmark bundles of mortgage backed bonds, tiered by initial credit rating and divided up by time of issuance. Those deals entered into in the first half of 2007 are the worst of the bunch, those in both halves fo 2006 nearly as bad. Few were done after that. In the worst period the quotations dropped to 50 cents on the dollar for the AAA rated senior tranches. The lower ones, nearly worthless.
Fundamentally those are forward looking bets on the scale of losses that will be experienced on residential real estate, peak to trough. They are trading like put contracts on house prices. Darn near it. The underlying assumption behind the pricing seen, is that everyone underwater will mail in the keys, and that in addition each workout will cost on the order of 30% of the initial loan amount, to deal with legal costs of foreclosure, listing, maintenance, realtor fees, and commission etc on the resale. That, in addition, the peak to trough decline in house prices will be on the order of 40%. Maybe 50% in the areas with the larger price run ups in the bubble.
Those are very conservative assumptions, but they are what the secondary market reflects. At the same time, since A corporates with finance risk are available yielding 12-14%, the rate of discount required to hold such paper has soared to those levels. So you have things that may be worth 40 cents or may be worth 70 for the best tranches - eventually - but then they are discounted to yield 15% or more. On those terms, a few vulture investors are interested.
Understand, though, the usual buyers of this sort of speculative debt all went bankrupt last summer and fall. They owned this stuff in the first place, with leverage. They can't buy it now, they already blew out. And banks aren't going to lend a dime to anyone investing in it. They got here by that heads we win, tails you lose game and they are not eager to repeat it. Therefore, no one can borrow money to fund new investments in this stuff. It would have to be pure equity financing, from players previously on the sidelines.
While a few mortgage funds were created for that sort of thing in the first half of this year, the amounts are piddling. The private equity types (Lone Star e.g.) have taken up more of it. Meanwhile, every leveraged gunslinger in the world was instead betting the farm on the "end of the world" trade.
Which consisted of shorting financials and the dollar and going long commodities. That is where all the offshore risk money has been - not looking to buy up this paper. The alternative investment you needed to compete with peddling it, was "short Lehman with 90% borrowed money".
That is the reality of the thing.
Now, objectively speaking this huge spread is arb-able. I mean, you can short treasuries and buy corporates and earn the spread between them on zero capital, as long as the corporates don't actually default. Why hasn't that been the profitable trade?
Because the banks have been doing the reverse - dumping their corporates regardless of cost and piling into treasuries. Why? Basel II capital adequacy standards, pretty much. Huh?
When a bank holds a US treasury, it needs no reserves against it for possible losses. When it holds a corporate bond on the same amount, it needs 8% of the value of the bond, minimum, set aside as a reserve. Risk adjusted assets are the denominator and capital the numerator of the most widely watched indicator of bank strength.
If you lose half your capital in mortgages, even only a paper write down, your risk measures are going to soar and stick out and say "short me" among your competitors. But if you respond by moving an equal amount from corporates to treasuries, voila, your risk drops, your capital required drops, and your tier one capital rating remains its robust former self. Of course, your earnings drop - treasuries aren't paying much in the way of interest. And corporate rates go up. But that is collective action for you.
The first bank to stop playing that game and go long risky corporates in a big way might have made a killing. Or might have seen its tier one capital fall by half and the sharks gather and been killed. Wanna bet the bank?
IT WILL BE A WIN FOR THE FINANCIAL ESTABLISHMENT AND FOR GOVERNMENT
//////////////////
No mention of the People
Remember of by and for THE PEOPLE.
KILL THE BAILOUT
A week after the election, there will be a nationwide bank shut down and troops will be in the streets - regardless of who wins.
Mark your calender - November 11.
Interesting post, but disconcerting that you view long-term losses on non-performing mortgage loans to be in the range of 40% to 50% of face value. Contrary to my post to you on another thread, that makes likely (net) losses $1++ trillion. Staggering.
Based on your understanding of bubbles, I am probably not alone in being interested to know what role you believe government should play, and not play, in regulating the capital markets, both on an ongoing and extraordinary basis.
This is HS (BS with malice). These guys packaged and sold the stuff in the first place. If they got it back from the guys they sold it to, well, what goes around comes around.
The taxpayers?
It will be a win for the government because these assets are trading well below their intrinsic value.
By intrinsic he means the "inflated by phony lending practices" value?
The government could make a large profit.
It sure won't be the taxpayers. IF the government ever makes a profit the Dems will call it a SURPLUS and spend it before they even collect it.
End of story.
L
Being that the name of the song is "We're a gonna cover all yer lyin' thievin' arses" I guess ole Barney Fwanks would just love that tune.
I have nothing but respect for Friedman, and I understand that the deflationary period, or the “bust” part of the cycle, is when we feel the pain. But the best we can hope for is a sort of Faustian bargain. Either we have deflation and precipitous economic collapse, or we have more inflation in the hope that buying time will prevent total collapse. Because the immediate collapse of our currency is unthinkable, I do not advocate allowing banks to fail willy-nilly. However, that does not mean we don’t have to have some sort of deflation. Bad investments must be liquidated, and people must be encouraged to switch from consumption to saving. We also have to be careful not to debase the currency too far in our effort to prop the currency up.
This debate has always seemed to me like debates over limiting the state to the express powers of the Constitution. Wouldn’t we all like to live under the rule of law? Wouldn’t it be great if we could dismantle the welfare and regulatory superstructure that prevents us from being as productive as we could be? But aside from the fact that politicians are by definition incapable of standing athwart the expansion of the state, there is no way we can dismantle every addition to the federal government since the Civil War. Doing so would lead to the sort of calamity that results in revolution. It would confuse the people too much.
Likewise, I regret the amount of control that the central government exerts over our money. However, to attempt to liberate money from government-inspired inflation, and to reinstitute a free market, would be disastrous to the economy. It doesn’t much matter that it’s their fault that it’d be disastrous, the fact remains. I don’t like our monetary policy any more than I like a “living Constitution.” I’m not naive enough to think anything can be done to rectify things.
I also should say that Great Depression interpretation is hampered by the fact that the government was not consistent in its response. It first allowed banks to fail, then did all it could to stop the panic. If deflation was the worst possible path, why did the depression last more than a decade after deflation was curbed?
“People become unwilling to lend to a tainted institution, except at exorbitant rates, and those rates themselves render that institution unprofitable. It is fear of getting stuck with losses that causes this, of course. But that fear is a self fufilling prophecy”
You sound like FDR: “We have nothing to fear but fear itself.” Speculators serve a vital economic function by trying to anticipate future prices. When they prove to be prophetic, people blame the speculators for creating the very future they were attempting to foresee. So much for risk.
I thank God there are people who refuse to invest in shaky enterprises. If public education needed loans to stay afloat, it would have collapsed long ago. There ought to be obstacles to wasting money.
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