Friday, October 31, 2008

Mortgage Servicer Proposal

There is no shortage of proposals by thoughtful people on how to get out of this financial/economic mess the world finds itself in. I do hope that we see the Treasury moving forward on its original plan to buy up a good chunk of the mortgage backed securities. I want to see the Treasury make some money in this market!

John Geanakoplos and Susan Koniak have an interesting oped in the New York Times today, addressing the role of the master servicer in mortgage pools.

I have been saying for some time that the incentives of the servicing organizations are key to how homeowners in default are treated. And that the terms of the mortgage trust that bought the mortgages, appointed the servicer, and sold the mortgage backed securities are the determining factors. The NYT piece argues, albeit with a lack of specificity, that the servicers are loath to renegotiate with homeowners in arrears as it will benefit some MBS owners and hurt others. I wish they had given some examples of how that would happen. If there had been only one class/tranche of MBS created, then the incentives of all would be aligned: renegotiation might make sense, say by lowering the interest rate in return for a higher likelihood of principal repayment. But with differing classes of security holders, conflicts will exist. The higher tranches won’t want to lower interest rates for a higher likelihood of repayment of principal, as they are first in line for both interest and principal. Also, there were triggering events in a lot of these pools that will benefit the higher tranches if they occur – so avoiding those events might not be in the higher tranches’ interests.

I am not sure I agree with the authors’ proposal for government-appointed trustees. No, wait, I am SURE I don’t like that proposal. What I could see working would be some legislation to change the terms of the mortgage pool contracts, or at least to give the servicers some indemnification from lawsuits.

A Republican Halloween?

I was afraid that the signs in my front yard would deter trick or treaters, but that doesn't seem to be the case -- all kinds of little munchkins showing up right now! I also wonder if the signs will make it through the night. Last election, I did have my Bush signs thrown in the bushes.

One little girl was dressed up as Palin, an amazing costume. Very cute.

Saturday, October 25, 2008

Oil Demand Elasticity

Some data on oil price elasticity are starting to arrive.

Gasoline demand in the US has fallen relative to year-earlier numbers for 26 consecutive weeks, with demand last week being 6.4% below the same week last year.

According to the EIA, and as reported by Forbes, US petroleum product demand fell in the last four-week period by 8.5% relative to the same four-week period last year.

Not sure what percent change in price to use to calculate a rough elasticity. If we use a 100% change in price, which is excessive, we get an elasticity of -.085 which is not too bad. I have always thought that an elasticity of -.20 was reasonable for a period of 2-3 years. I expect we are to see more "demand destruction" even though prices have come way down -- and many of these changes will be irreversible.

Some people might say that we are not observing price elasticity but income elasticity -- as the economy slows, oil demand drops. To some extent this is true -- to the extent that the slowing economy is due to non-oil factors. But we should expect some of the demand reductions to show up as GDP decreases. That is, some economic activity is no longer undertaken at high oil prices, and that shows up as a reduction in GDP. The decline in demand for oil should be attributed in that case to price increases, not to income falling.

Simply Incredible Price Volatility

Oil was at $147 per barrel in July of this summer. On Friday, about three months later, it was at $64.

The Canadian dollar, one year ago, bought more than one US dollar. On Friday, the US dollar bought 1.28 loonies.

This is incredible volatility, and to be honest, is quite hard to explain on the basis of fundamentals.

I was predicting for a long time that oil prices were too high, and that the economic forces of demand cutbacks and supply increases would bring us back from the skyhigh levels we were seeing. But the price went much higher than I would have anticipated, and it took a long time for the price to peak and start falling. Then once it started falling, it just has not stopped.

Either the price significantly overshot in the last year or it is now seriously undershooting -- or, very possibly, both.

Could it be that investment flows from hedge funds and general investors caused this incredible volatility? Or is it just that given the uncertainties in the world at this time, value is so hard to pin down? It is still true that oil demand and supply are both very inelastic, so in a sense you can have prices move a lot and not be too far away from equilibrium in regard to quantity.

Whatever the reasons, it is hard to make investments in alternative energy, or in oil production, given the volatility. As with the credit crisis, financial market turmoil has real effects.

Wednesday, October 15, 2008

That Great Cooling Sound

Listen carefully, and you will hear the sound of the mainstream media reporting on record cold temperatures and Alaskan glaciers growing for the first time in 200 years.


On second thought, maybe you won't hear anything at all.

No, the recent data do not fall into line with accepted wisdom, so don't expect to hear about it.

Monday, October 13, 2008

Moral Hazard

With McCain and Obama fighting to come up with the best plan for giving homeowners relief, especially in the form of forbearance on defaults, I wonder why anyone rational would keep up their mortgage payements?

Equity Stakes vs. Buying Bad Assets

There are a lot of policy options being considered, but the two big alternatives are buying equity stakes in banks vs. the original idea of buying bad assets from the banks, predominantly mortgage-backed securities.

Judging from the huge increase in stock prices today, it seems that the market prefers the equity injection (if there was any news today, it was about that -- and the Morgan Stanley deal).

I understand the basic rationale there, that with the normal 10 to 1 leverage of banks, an injection of $100 of equity can support $1000 of new loans.

But will that additional equity be used for new lending, or will it go to just shore up cash on the balance sheet and/or pay off some existing debt? Given the risk aversion of banks right now, who is to say that they won't just buy more Treasury bills with the new cash?

I still like the buying of mortgage assets for four main reasons:

1. It goes to the heart of the original problem, which is uncertain value of banks' assets, and that has caused interbank lending to fall off.
2. It directly removes risk from the banks' balance sheets and thereby stands a good chance of increasing lending.
3. If done by auctions, it will establish prices for all assets in the same class, creating a spillover benefit that helps us sort out good banks from bad banks, even for banks that do not sell any assets.
4. And it still gets cash onto banks' balance sheets, that can be used for new loans.

Of course, these two options are only mutually exclusive in that the Treasury only has $700 billion to play with. Perhaps they will do some of both.

Saturday, October 11, 2008

The Fundamentals of Value

The Dow is off about 33% in one year, with 20% of that coming in the last couple weeks.

I've been looking around for evidence that we have lost a third of our labor force, but that doesn't seem to have happened (in fact, labor supply has now increased tremendously, as some of our most productive workers decide they can't retire quite yet). And I looked to see if a hurricane or some kind of natural disaster destroyed a third of our capital base. Nope, nothing like that either. Not even a bad Supreme Court decision that would impact our still-strong legal regime of markets and private property.

Folks tell me that stock valuations are down because of fear that corporate earnings will be low.

Anyone who has done a discounted cash flow valuation of a company should be deeply disturbed by what is going on. In a typical valuation, with say 5 years of explicitly forecasted cash flows and then a perpetuity at the end, upwards of 75% of the total value will derive from the perpetuity value. Said differently, the first five years of cash flow make up only 1/4 of the total value of the company.

As an example: Suppose we have a very simple company that produces $10 of cash per year forever, and that the appropriate discount rate is 10%. The value of the company is then $100. Note this is a weird company, with no growth at all -- more like a bond than a company. Suppose a nasty recession next year is forecast to take the first year of cash flow away entirely. Wow -- the value of the company falls to $91. An even nastier recession is forecast, with no cash flows for two whole years -- and value falls to $83.

And bear in mind that in our real world, we are not looking at losing even one year of earnings, just lower earnings.

Folks also say that capital constraints will prevent companies from taking advantage of growth opportunities. That might be true for the short run. But are these growth opportunities going to disappear entirely? Doubtful. They will wait for capital constraints to release.

There have to be some real good deals out there right now. For instance, you could buy GM for about $3 billion. That's right, you can own all of General Motors for the low price of 3 billion dollars. One of the two largest auto manufacturers in the world, with a franchise in Europe that is to die for, and a great stake in Asia as well. And not exactly chopped liver in the US, especially if you get off the two coasts and get into the good old heartland, where folks still like to drive Chevys.

What a sale that is! KKR could write a check for $3 billion without even checking to make sure they have that much in their checkbook.

Sure, GM has some liabilities, and they have a lot of debt outstanding. But just think of the option value on that equity.

Wednesday, October 08, 2008

Two Paradoxes: Interbank Lending, Commercial Paper

The talk is that the interbank lending market has frozen. Rates for overnight borrowing are around 5.4%, much higher than the Federal Reserve's discount rate, which is at 1.75%. Paradox: why would anyone borrow in the private market rather than from the Fed?

Second paradox is commercial paper, another market that is supposedly freezing up. Volume is down signficantly, true, you can see that in Federal Reserve data. But rates are not very high, say 3% for 3 month paper. Those data seem more consistent with a drop in supply of commercial paper rather than a drop in demand to hold. If demand to hold paper were low, then volume would go down but rates would go up.

There is a theory to reconcile these paradoxes, I think. And it reinforces the general idea that incomplete and asymmetric information is driving a lot of the patterns in all the markets.

Let me use loosely, as we sometimes do in our models, the idea of "good" banks and "bad" banks.

In the interbank market, the good banks -- those who know they are solvent -- will borrow from the Fed. The bad banks don't want to undergo the examination that I believe they will get from the Fed if they show up at the discount window. So they go to the interbank market and get charged an appropriate risk adjusted rate. And there is not much lending going on in that market, with credit being rationed on the basis of knowing that a counterparty is of decent risk.

A similar idea explains the commercial paper market -- essentially a credit rationing story. Only the best credit risks can sell their commercial paper. And they get a reasonable rate charged -- around 3%. The worse risks just cannot sell any paper at all. So the rate we see in this market is low, but that is because we are seeing only the best risks using the market.

So the Fed is stepping in to both markets, trying to get reserves to even the bad banks, and letting the marginal borrowers still access the commercial paper market.

Now Jean-Claude Trichet Speaks Out

Jean-Claude Trichet, head of the European Central Bank, has urged financial market participants to "collect themselves."

The scary thing is that he may have a point.

Tuesday, October 07, 2008

Gary Becker Speaks Out

Professor Gary Becker of Chicago has an excellent column in the WSJ today.

Here is one particularly good section:

"The main problem with the modern financial system based on widespread use of derivatives and securitization is that while financial specialists understand how individual assets function, even they have limited understanding of the aggregate risks created by the system. That is, insufficient appreciation of how the whole incredibly complex financial system operates when exposed to various types of stress. In light of such limitations, it is difficult to propose long-term reforms. Still, a few reforms seem reasonably likely to reduce the probability of future financial crises."

I think this does hit one nail on the head -- that participants did not know how the system as a whole would behave when under stress.

The best analogy is that of soldiers marching over a bridge. The longstanding rule is to break cadence, or there is a risk that the frequency of the march will hit the natural frequency of the bridge and cause a positively reinforcing, amplifying force that can cause the bridge to collapse. In differential equations courses, this film of the Tacoma Narrows collapse is often used to illustrate the concept.

In the mortgage backed securities markets, participants were in some sense walking in step and did not realize it. One place where I really see this is in the complexity of all the MBS, which given the point we are in now, really exacerbates the problems of valuation. A little less tranching and fewer bells, whistles and triggers on these securities would be really nice right about now.

Monday, October 06, 2008

The "How To" Questions of Reverse Auctions

The Treasury plan is to buy mortgage backed securities (MBS), instead of purely whole loans (the mortgages themselves). They have the authority to buy the underlying mortgages, but I am not sure there is $750 billion of those available. Most of the mortgages went into pools, on which the MBS are defined over. And then some of the MBS went into secondary pools, on which collateralized debt obligations (CDOs) were created. What a mess.

So how will Treasury buy the MBS? It is easy to just say, well, by reverse auction. Current owners of the MBS submit offers to sell (price and quantity specified). The government accumulates the bids, from lowest price to highest price, and keeps track of cumulative volume offered. When that dollar volume hits what the government has agreed to buy in that auction, the price associated with the last accepted offer (or first not accepted offer)becomes the price that all offers are paid. That would be a nondiscriminatory auction. An alternative would be a discriminatory auction, whereby all accepted offers get the price they offered their MBS at. For several reasons I won't elaborate on here, I think the nondiscriminatory auction is the way to go.

But this begs the question of: what is being offered? Not all MBS are the same! If we were buying, say, shares of GM from different holders, there would be no problem, one share of GM being equivalent to another.

So the big issue is how to define the characteristics of MBS that will be accepted in any given auction. There is even the simple matter of different coupon rates, so that you cannot even say that $100 of face value is the same across different MBS even if credit issues are equivalent. But credit issues are the real big one.

I still think that the way to go will be to define ranges of credit characteristics that will enable a MBS to qualify for an auction. Prime candidates for the qualifying characteristics: Date of mortgage issuance, original rating of MBS, degree of subordination in pool (ie what tranche), prepayment history of pool, current default rates, etc. Just the kinds of things that the rating agencies would use to give a rating -- hey, maybe that will be some more work for our friends the rating agencies!

My colleague Bob Aliber has a neat idea, which I think has some merit. He suggests having sellers put all their MBS into a new pool, and define new securities with equal claims to the cash flows from that pool. Then the sellers offer these new securities to the government.

Note that this is essentially creating new CDOs out of the MBS. Neat. Put all the MBS into a pool, and define just one class of collateralized mortgage obligation on that pool. This is in fact essentially what CDOs did, and you can now see why maybe they made original sense -- to pool a bunch of disparate risks together. (Of course, the original CDOs then created multiple tranches on those secondary pools, which in Aliber's plan would not happen.) What this plan also may help to solve is the risk of getting just the absolute worst "lemons" from the sellers. If they have to pool everything together, they can't cherry pick and keep the best.

My thinking has been that Treasury will buy the MBS using pooling techniques of some kind, and then will pool all the MBS and create new securities, ie, CDOs, on that new pool and sell off those claims.

We shall see. It does look like Paulson is moving fast. Given the market turmoil today, that would be good.

Whew, What a Day

Nice quote in this story on CNBC:

"We'd actually like to see a little more panic," said Matt Cheslock, a senior specialist at Cohen Specialists.

Saturday, October 04, 2008

The Government's Significant Role in the Causes

I wish we had more people in the media documenting the negative role of government interventions in the housing and mortgage industry and in particular the supportive role that government actors played in creating this whole mess. Right now, populist opinion is heavily weighing against the greed and predation of private enterprise and thinking that government regulation will be our saving grace. Please let's not let that pendulum swing too far.

Tom Sowell had a nice piece today, "Do Facts Matter?" where he points out the role of Fannie and Freddie in buying subprime and Alt-A mortgages, and the strong lobbying by various politicians for easy credit.

Fannie and Freddie did indeed buy hundreds of billions of MBS created from subprime and alt-A trusts. Without the easy money from these government-sponsored entities, with their clear US taxpayer guarantee and subsidy, the housing market would definitely have been less heated. I won't lay all the blame on their doorstep, but they share in it heavily, and this should make rational people remember that while markets are not perfect neither are political regulatory mechanisms. We still await that legendary benevolent dictator -- and it appears that Paulson will not have his chance at the job!

Some of the Pork

Besides the tax break for children's arrows, here is another good one:

"Representative Mike Thompson, Democrat of California, said he switched his vote to support the bill in order to help the economy. He would not say whether the insertion of a measure to give tax breaks for auto racing tracks, which he had previously tried to get passed, played a role in his decision. One such race track is in Thompson's district. The addition of such sweeteners was criticized by some who said the bailout bill was being loaded with wasteful earmarks."

Full article, which is not focused just on the pork, is from the Boston Globe.

Friday, October 03, 2008

Deep Disappointment

On the part of Democrats, that is. Palin not only did not fall on her face, but she did a fine job. Do I wish she had more at-hand knowledge of policy issues -- of course. But she has certain qualities that are very important. Anyone who can get up on that stage against Senator Biden and hold her own the way she did -- well, I give her credit for having some real sisu (look it up, Finnish word that has no clear translation to English, but very roughly it means I WILL GET THE JOB DONE.)

David Brooks of the NYT has a very fair evaluation.

Thursday, October 02, 2008

The Behemoth Bailout Bill

I wonder if the function

y = f(t)

where y = dollar amount of non-credit market tax breaks and subsidies
and t = days that Congress has to write the emergency stabilization bill (aka as the bailout)

converges to a positive number or if it goes to infinity. I suspect the latter.

A good story on the "children's bow and arrow" tax break is here. CNBC almost makes it sound like it is a reasonable thing to include in the bill.

My question: If the arrow tax is such a bad thing, why not get it taken care of in a bill that is at least somewhat related to taxes?

Why can't our elected congresspeople have the courage to put this bill to a straightforward up or down vote? Can it really be that these pork barrel items are needed to get support? Someone is opposed to the bill in principle but will vote for it if a business in their area gets some kind of break? Please give me a break.

And, where is dear John McCain, he of principled opposition to earmarks and government waste? How can he ever again rail against earmarks if he is not willing to take a stand right now?

Wednesday, October 01, 2008

A Mortgage Backed Mystery

As I review some of the terms of mortgage backed securities, I am really struck by the complexity that the designers of these securities created. Too clever by half, I am afraid.

A $1 billion pool of mortgages went into a trust, and out came 20 tranches of different securiies. The top few were called A level, as they got first dibs on any payments. Then the middle 15 or so were "mezzanine" and they got second dibs on payments, but of course in order of M1, M2, M3.....

Then at the very bottom were the equity and unrated tranches who were last to be paid and first to incur losses.

But this was not the only complexity. There was a lock out period which meant that principal payments went only to the A tranches initially. There was something called overcollateralization, meaning that the face value of the MBS sold was less than the principal value of the mortgages. Overcollateralization was enhanced by capturing excess spread, the difference between the average interest rate on the mortgages vs. the average rate paid on the MBS. Then there were triggers that would be evaluated a couple years into the pool performance that would determine if this over-collateralization would be released to benefit the equity or the higher rated tranches.

Plus there was an interest rate swap on the whole pool, converting a fixed payment by the mortgage trust to a LIBOR payment from the swap counterparty.

Very complicated.

There is simply no way that anyone can value such a complex scheme. No way. You've got default risk, prepayment risk, 20 different tranches, the triggering events, ....

But here is the real mystery. Why all this complexity? If you look at how Fannie Mae creates MBS, they throw everything into a pool and create just one class of MBS pass-through security out of it. Of course, it is easy for them, because they guarantee the payments, so everything is highly rated.

Therein lies the secret to what was going on. The creators of the subprime MBS were optimizing the tradeoff between the A rated MBS versus the lower-rated tranches. They were facing prices of MBS that were higher for high rated securities than for lower rated ones. And the relationship between price and rating was nonlinear, in that as rating went up, price went up by even more. This is what made it feasible to essentially put more risk on the lower class MBS, and less risk on the higher rated ones. If the relationship between price and rating was linear, then you cannot benefit from trading risk between the classes.

I can imagine that the underwriters would go to the rating agency and show them the deal, and the raters would say something like: "No, to get AAA you have to give the top tranches more security." Thereby came all the bells and whistles: reduce the size of the AAA tranche, increase the overcollateralization, create some trigger events that would benefit the AAA.

As I put this issue to one of my finance colleagues, he brought up what we call the Modigliani-Miller Theorem: that the value of the firm cannot be increased by moving claims to that fixed value between the debt and equity holders.

The application of that concept to MBS is simply that this trading of risk between the different tranches could not have created any value. What one tranche gained, another lost.

So why was it done, and to such an extent? Good question, and we are living with the complex consequences.

I think it was essentially taking advantage of errors in ratings and errors by the capital markets in pricing securities rated by the agencies.

The Senate Bailout Monstrosity

We have gone from a nice clean three page bill that was short on oversight to a 450 page monstrosity.

Do we need any more evidence on why Congress deserves its abysmally low approval rating -- 18% according to RealClearPolitics?

A bunch of tax provisions and special benefits to buy votes have made their way in. From the article cited in the above link:

"And tucked away in the tax provisions is a landmark health care provision demanding that insurance companies provide coverage for mental health treatment—such as hospitalization—on parity with physical illnesses.

Really a bill onto itself, the mental health parity measure has been a bipartisan priority for top lawmakers in both chambers but has stalled because of disagreements again over how to pay for its estimated $3.8 billion five-year cost. In the current climate, that seems to be no longer a stumbling block, and if the Treasury plan becomes law, it will also."

Right. Nice work, guys. A true hat trick: many can say they voted against the original bill but then voted for a better one, and they can brag to certain special groups that they got their bacon as well.