Engineered Panic

WHILE stock markets around the world continued to tumble, nobody seemed to be pointing to the elephant in the room. This current collapse of investor confidence has, it is being said everywhere, been prompted by severe problems with the US subprime property lending market where money has been extended to borrowers with poor credit ratings who are now defaulting on their payments.

But why should investors have panicked? A mortgage is probably the most reliable of loans, because it is secured against the property. If the borrower fails to make payments, the lender repossesses the house or apartment. For sure in a weakened market, the property may not be worth as much as was advanced against it. Equally, the lender will have lost projected income from the interest that the borrower would have paid, had the loan run to term. But in the end, most, if not all, of the value that had been advanced by banks and mortgage companies is still intact. The money has not disappeared into thin air as with Enron, or any other major corporate fraud or a country defaulting on its debts. There are other factors, of course, in the subprime market’s troubles, such as unsecured credit card debts, but the basic proposition that investors in securities based on the subprime property lending market are in danger of losing every cent is pure hokum. The panic that has ensued and the market liquidity injections of central banks and the general air of doom and gloom that is gripping investors around the world is based upon fantasy, because the underlying assets — the bricks and mortars — are still intact.

This being the case, then another reason must be sought for this dramatic decline in share values. There have in fact been two events that have caused the massive sell-off. The event currently driving down prices is the herd-like rush to cash. Any crowd in panic has the IQ of a rabbit. The stock markets are no different. Investors’ fears are feeding on each other. Most cannot see the bottom of the market, since they do not have the time to think. Their phones are ringing off the hook. They are mesmerized by the tumbling red figures surging on their computer screens. Automated sell orders, cash calls, breached covenants are all creating chaos, particularly in sophisticated market segments, such as stock lending. The terror of ruin tightens its grip by the hour. The more important earlier event will be harder to pinpoint. Key investors quietly sold their shares days, maybe even weeks, ago as the analyst community ratcheted up its phony warnings. They now sit on piles of cash waiting to buy back into the market when values have slid far enough. They probably already know the “floor price” and their return will stop the panic and restore confidence. They will have banked handsome profits and be back in shares at bargain basement prices, all because they anticipated how successfully other investors could be stampeded by nonsensical analyses.

View from the Quant Floor [John Derbyshire]

In today's Radio Derb, I pass some remarks about "quants"—i.e. quantitative analysts, the guys who do the heavy number-crunching in Wall Street's back offices. These guys generally (though by no means always—it's pure meritocracy on the quant floor) have a Ph.D. or two in math and allied subjects. They are very smart:

IQs up around three sigmas from the mean for their population group.

(Above three sigmas, you're in the top one or two per thousand.)

Well, here is something on the recent market ructions from an actual quant—an exceptionally knowledgeable & accomplished one, who's been doing this stuff for 20 years. I've doctored it slightly to remove identifying traces, and to improve the English. (These guys tend to think too fast to be bothered with formal grammar, and are anyway often recent immigrants with a first language other than English.)

"On the off chance that you or the folks at NRO are interested, I thought I'd relate a few of the goings on from the quantitative space of the financial markets. ...

"The program trading systems known as 'statistical arbitrage' have been running for years now and have become very popular. Some of them have made billions of dollars by exploiting small statistical abnormalities in the relationships between various stocks. But the problem is that the vast majority of these programs work based on an assumption of eventual convergence, so as more people do the same thing, the spreads between instruments begin to close and more leverage is required to get the same level of absolute return on the investment. These days, many of these strategies run from 3 to 10 times leverage (I've even heard of one which runs at 12 times leverage) meaning for every dollar they have invested, they have borrowed an additional 3 to 10 dollars and invested that as well.

That causes you to accumulate something called 'liquidity risk', meaning it will take you something like 3 to 10 times as long to sell the position in an emergency.

"When the credit market had its crisis, it caused just such an emergency. Several large players needed capital to meet their margin, so they sold in the most liquid market they have which was the US equity stat-arb space. The problem is, there are only so many assets available in the US market, and only so many statistical abnormalities, so since many of these guys all had the same mathematical training, and were using the same data, they were all finding the same alpha. It's like 10 guys each digging a gold mine only to discover a mile below the earth that they were all mining the same vein, and now the ground above them is too weak to support the roof. The selling by the big players caused stop-loss limits to be triggered at other firms, so there was more selling which caused more triggers to be hit and so on, and so on.

"Ironically, it's the best companies (those with the best forward prospects) that are most aggressively being sold off, and the less healthy companies which are being bought up, so this liquidity crisis is actually causing a fairly large value inefficiency in the market, and if someone can figure out when to try to catch the falling knife, they are going to make a lot of money. The economy is still in pretty good shape in spite of this market issue, but their assets are being systematically mis-priced in the market anyway. That can only happen temporarily since the market is so naturally self-correcting, and on that correction someone is going to make a killing.

"As for my personal quantitative strategy, since it identifies value from a different basic operating paradigm than statistical arbitrage, I'm having a small loss (less than 2%) and a rise in volatility, but nothing outside the expectations of the model. In point of fact, my year is still going quite well, but that isn't the case with most of the industry. I was on a conference call yesterday with [name of a renowned quant], and of the [three-digit number] people on the call, I think I was the only one who was still at a healthy profit on the year."

08/10 10:28 AM

There is no reason to panic but this article requires two clarifications.

1) It is true that home loan mortgages are secured by real property. The problem this year is with the loan to value ratio. Once the lenders started low down and no down loans the LTV immediately became jeopardized. Something similar happened in the late 70’s and early 80’s when the banks accepted transactions involving purchase money seconds — the so-called ‘wrap around’ loans. That practice was supposedly forbidden by bank lending policies but a form of that also has returned though they are not called wrap arounds any more. This is a problem because the bank experiences costs while holding foreclosed properties and if there is no value in the property over and above the amount secured by the mortgage — the bank WILL lose money.

2) The bad LTV ratios lead us to the second problem. The lenders were making low to no LTV loans in a rising housing market. Apparently the underwriters without that rising home prices would add equity to cushion the collateral. Instead, housing prices stopped rising and reversed. And the more houses that go into foreclosure the more house prices will decline. Add to that the massive unsold inventories of new homes. SO the problem spirals for the banks which abandoned good underwriting practices as more and more borrowers have less and less equity.

Banks will inevitably tighten lending standards. The risk to the rest of us lies in the potential for this to trigger a recession.

On the whole this perspective is wrong for one simple reason. Long long ago, back when I was a boy, you got a mortgage by going to a local bank. The bank got the money for those loans from deposits on hand, back in the days when people had savings accounts - in banks - that paid real rates of interest.

All this has disappeared in the last 30 years. A mortgage is a paper asset that is instantly sold by the broker to someone who bundles mortgages to sell as "investments." The bundled asset is purchased not by folks with cash, but by investment banks who borrow from the money-markets.

Long long ago the potential losses from default on a property were minimal because the risk was already accounted for in the interest rate charged everyone (a simple calculation), AND banks only lent on a fraction of the market value of the property, a value that it well knew because it knew local conditions where it operated.

Fast forward to the present. First price - you have to understand that real estate brokers don't just act as middlemen in a transaction. They are also market makers, and will themselves buy property available at lower than what they have pegged the local market price to be. Real estate prices are not "free-market prices" but set at the maximum price that can be paid by the next marginal buyer who spends more than he can afford on a subprime interest only teaser rate mortgage. The pricing levels are closer to those of monopolies than those of a free market. This is enabled by the fact that in any local real estate market there is generally one and perhaps two dominant brokers. They got this way and can operate this way because the banks give them easy credit to be able to "support" the local market. The bank gets the money because the federal reserve prints it and gives it to them.

So, if you are not funding transactions through these kinds of loans anymore, voila, the price takes a beating, immediately by the ratio of the difference between what you can afford w a no money down 3% interest only loan and what the next guy who can actually qualify for on a 20% down, 30 year fixed interest rate loan at current market rates. If you do the math, you can see a 20-50% immediate drop in the price of real estate transactions at the margin.

Further let us look at the financial markets. You have $100M in CDO's say. But the face value of the investments is $1B and the rest comes from money borrowed from the money-market (read printed by the Federal Reserve) at the current MM rate. Suddenly your interest rate goes up by 1% and the return from the CDO tranches you own goes down by 5% because of defaults. You just lost the retirement fund you manage 10 times over again. Furthermore, you cannot even get out of this ridiculous position because there is noone who will purchase this pile of pieces of paper that you own, being 3 steps removed from any actual person with a mortgage making payments.

Why is it different this time? Well, we began to see the whole hyperinflated investment banking world enabled by Alan Greenspan come unraveled with the stock market adjustment in 2001. But, he succeeded in turning that around by lowering interest rates to 1.75% and dropping any pretense of lending standards. He exorted folks to go out and take these seemingly inexpensive loans - this injected A LOT of cash into the economy to get it going again.

The amazing thing is that it worked. But it resulted in the real estate price and asset bubble that we have today and which is coming unraveled.

What is the next trick to inject a lot of cash into the economy? I don't know. Real estate has probably run its course, and the problem is stressed consumers. What can Bernake do this time to get money in the hands of people? You tell me.

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