Stupid Things People Say, Volume III

From Sunday’s Chicago Tribune article about foreclosure sales:

These sorts of foreclosure auctions have created a win-lose proposition in communities, though. A home buyer gets a steal on a nice home that otherwise would have sat vacant. But in return, neighbors see their own property values erode.

No, no no. The neighbors property values have already declined by the time the auction takes place. The auction just lets everyone know by how much. The house in question for the article is going to be offered for $460,000. If RDG (the auction buyer) can get more —ie “within the values of the community” I’m sure they will raise the price. But I suspect “the values of the community” are delusional.

 

The Angry CEO

Lately, it has been hard not to notice that a good number of financial institutions have either gone under, or been forced to merge with other institutions before they failed.

So what are we to do? I’ve decided, strictly as a public service, to offer up my services as the Angry Libertarian CEO. First let’s look at how much Reuters reports some of the other, professional and highly trained silver back CEOs took home:

Company	Reuters reported CEO Compensation (USD)
Merrill Lynch	17,307,600
Wells Fargo	12,568,900
National City	3,419,170
Washington Mutual	18,000,000

Do I have the primate skills that the silver back CEOs of the above have? The firm handshake, the steady gaze, the reassuring pat on the shoulder? The Ivy League MBA? The full head of slightly silver hair? The connections? Nope. Not a chance in Hell.

But what I do offer is a much, much lower draw. For only $1,000,000 I’ll drive your company into the ground like a bird that just hit the side of a skyscrapper.

Oh, one other thing I almost forgot — the compensation needs to be in cash up front. No stock options or checks please.

 

Cowardice thy name be NBC

Saturday Night Live or SNL for short, has been a mainstay of American comedic television for over 30 years. Best known for its inventive original skits superb cast of all star comedic acting talent, it is often remarked that the show quality ebbs and flows over time, an undisputed mainstay throughout its years has been the its political satire sketch comedy such as weekend update . Thus naturally come election years or major news stories they often hit proverbial comedic gold! The mixture of wonderful writing, quality actors, and dialogue typically so close to the real thing it is both frightening to contemplate how poignant the parody but also so funny the audience is left in stitches.

SNL has hit in the past—recall Dana Carvey’s impression of Bush I—but most recently notable have been the instant classic sketches featuringTina Fey portraying Republican Vice Presidential Nominee Sarah Palin in an impression that can only be called ‘uncanny’ in a Palin-Clinton Speech, a Palin-Couric Interview, and the Biden-Palin VP debate (complete with Queen Latifa playing Gwen Ifill). Thus far all three sketches have been major headline news on every network come the following Monday morning, drawing many viewers back to SNL again. Fueling this surge is the high accessibility of recent SNL skits on the internet placed there directly by NBC itself.

On Saturday October 4, 2008 SNL presented a skit titled “Washington Approves the Bailout” focusing on many of the ludicrous aspects of the current economic situation. The sketch instantly became a hit with links to the official NBC posting of the video appearing all over the web almost immediately. Then suddenly chaos ensued. Withing a matter of hours on a lazy Sunday mid-day as citizens awoke and checked their digital communications, countless numbers clicked on links sent by a friend, family member, or co-worked promising a hilarious video, only to be met with a cryptic message that the sketch was no longer available and apologizing for the inconvenience. Instantly as the so commonly do, conspiracy theories began to run wild. For two days one in the know would hear every theory from space aliens to the illuminati. Then finally on Tuesday afternoon the truth broke and a now far less funny, edited version was put back up on the internet by NBC. Unfortunately for the American public, the truth was far more sinister than Martians or Free Mason wannabes. The truth was that NBC lawyers had pulled the sketch. Though NBC officially did not mention this in their statement:

“Upon review, we caught certain elements in the sketch that didn’t meet our standards. We took it down and made some minor changes and it will be back online soon.”

Apparently the sketch’s portrayal of Herb and Marion Sandler was considered a liability since it pointed out their acts of corrupting US Government officials and their severe culpability in the current financial meltdown affecting the US. Additionally as a faux C-SPAN video SNL had a chyron on-screen text shown below the Sandler lookalikes that would normally serve to identify the subject on-screen stating: “Herbert & Marion Sandler: People who should be shot”. Supposedly this is to be part of the basis of the video edit, as it may be misconstrued as a death threat to some people and/or offensive.

Now this is not the first time that SNL has turned against one of its funniest components. Norm MacDonald was fired from his stellar and unparalleled stint as the anchor of the weekend update sketch for making too many side splitting hilarious OJ Simpson jokes. Do not worry if you are confused, you are not alone. Many fans and casual watchers alike have asked themselves why a comedian would be fired for raising a dieing show’s ratings by making hysterical jokes at the expense of a public figure who is himself, well…. a joke. The answer was unfortunately the same then as it is in now in the case of the Bailout Sketch: NBC Cronyism and Politically Correct Cowardice.

Thus an entire American populace is left one step closer to an Orwellian Nightmare in which our right to speech and thought even as basic as humor is subject to regulation by the State at the whims of the ruling oligarchical elite. That is unless a line is drawn in the proverbial sand, saying “This far and no further”. For those looking to stand up and fight back by saying “NO!” to the tyranny of the minority, by saying “NO!” to those who would tell you how to think and how to laugh; stand up and wave the banner of Free Thought high in the sky. Spread the UNEDITED VERSION as far and wide as you can. Show it to your parents, siblings, spouse, grandparents, cousins, friends, co-workers, and to anyone you possibly can. The sketch is downright hilarious to anyone with a single drop of a sense of humor in their entire body, and (based on the talk of the town prior to the pulling and editing of the video) the quote “people who should be shot” is one of the most memorable gems of the bit. So much so in fact that to one who has seen the original, the edited version leaves one feeling quite dissatisfied. Make sure that the memories of original version Do Not Go Gentle into That Good Night! Together it is possible to prevent NBC from pulling a Lucas on this classic!

Ultimately it is a matter of “How dare NBC!?!”. How DARE they back off from calling a spade a spade? How dare they a non-news organization try to hold themselves to a journalistic standard when speaking about the rich and powerful whom have destroyed people’s lives (some figuratively others literally)? How dare they back down from vilifying scumbags who wrecked the entire world economy so that they could glean a few extra shiny nickels! To paraphrase from one SNL’s own skits, I invite them to grow a pair, and if they can’t, I will lend you mine. So in case anyone else is looking to make a bumper sticker or t-shirt:

...because NBC doesn't have the juevos!

 

Fit to Fail [with apologies to James Burke]

“The tree of capitalism must be refreshed from time to time with the
blood of investors and bankers.” — Angry Political Optimist

 

James Burke once wrote, in an essay entitled “Fit to Rule”, that the modern world was connected to root events having to do with Linnaeus. His penchant to catalog and organize nature led to Darwin’s Galapagos trip; and from that Karl Mark derived his economic theories giving rise to Communism. Nietzsche’s interpretation, itself misinterpreted, philosophically enabled Nazism and Hitler and the “manifest destiny” derivative in the hands of J. P. Morgan and Getty gave rise to capitalism. Finding root causes is always an interesting journey. So when one looks around today, especially with politicians eager to cast the blame on others, it’s good to try and establish what exactly the root cause of the current fiscal mess might, in fact, be.

The story begins in 1933 at the end of the Great Depression with the passing of the Glass-Steagall Act by Congress (F.D. Roosevelt administration) which prohibited banks from selling investments and created firewalls between investment banking, commercial banking and insurance. Soon after, in order to resolve the mismatch in maturities in loans, and because banks couldn’t loan enough to support the post WWII baby boom, the Federal National Mortgage Association or “Fannie Mae” was created as part of the New Deal in 1938 (FDR administration) to provide a secondary market for mortgages. This organization purchased loans from banks which then allowed them to continue to service and lend. And all was good — the greatest generation prospered.

For thirty years, FNMA had a near monopoly on the secondary market, then, in 1968, FNMA was privatized by L.B Johnson because of Vietnam War fiscal pressure. Now, as a private entity, FNMA could generate profits, yet FNMA still obtained special treatment under regulatory and tax laws. As a consequence of this, investors perceived minimal risk in the company. In 1970, the Federal Home Loan Mortgage Corporation (FHLMC) or Freddie Mac, was created under the Emergency Home Finance Act. The FHLMC purchased mortgages on the secondary market, aggregated, tranched, and sold them as asset backed securities (ABS). Between them, FNMA and FHLMC was estimated to hold approximately 90% of all US mortgages accounting for 46% of the national debt.

Then Congress exempted FNMA and FHLMC from the FDIC Bank Holding Company Act capital/asset ratio reserve limit of 3%. Fannie and Freddie were free to leverage their assets. In 1999, the Graham-Leech-Bliley Act, supported by Robert Rubin (Clinton-Administration) repealed the 1933 Glass-Steagall Act and allowed banks to invest in securities, offer securities, and a cafeteria of financial services. This provided an immediate market for FNMA stock, especially as these shares were considered low risk investments and were returning high returns on investment. The 1995 interpretive letter approving low income mortgage securities as viable investments under the 1977 Community Reinvestment Act (12 CFR parts 25, 228, 345, and 563e) provided another market for FNMA. Commercial banks could now invest CRA dollars in FNMA legally. In 1992 Congress (H.W. Bush administration) mandated (GAO report number GAO-04-269T) that Fannie and Freddie increase their purchases of mortgages for low-income and medium-income borrowers and specified that approval metrics such as the ratio test should henceforth include unemployment and welfare payments as sources of income. HUD (Clinton administration) established ‘quotas’ for FNMA and FHLMC to insure 50% of all their loans be to minorities by 2001. Since FNMA and FHLMC are secondary markets, they pressured originating banks to offer more minority loans.

(The story accelerates to Internet time.) FHA regulations are written with loopholes that allows 0% down-payment mortgages. Down payment assistance market develops to exploit the loophole. The Zero Down Payment Act of 2004, introduced by Rep. Pat Tiberi (R-OH) (G.W. Bush administration), requires the Federal Housing Administration (FHA) to offer federally insured mortgage loans to certain eligible households to buy a house without a down payment. In 2005, FNMA revises its loan approval criteria to support post hurricane rebuilding.

The Rating Reform Act of 2006 passes into Law requiring the use of “Nationally Recognized Statistical Rating Organizations” or “NRSROs”. As a result, internal credit analysis at investment banks deteriorate. In 2007, FASB 157 is imposed on corporations requiring that assets be marked to market. Also in 2007, the Office of Federal Housing Enterprise Oversight (OFHEO) increased the FNMA conforming loan limit upwards to $729,750. This increase in allowed principle increased profit for FNMA. All these regulations and acts let FNMA and FHLMC offer securities at net interest margins that were extremely profitable. FHA mortgages with 0% down make it impossible for banks to compete. Banks have to match terms in order to compete. Financial houses have to develop new instruments in secondary markets to compete with FNMA and FHLMC.

At this point the dominoes are all aligned and ready to go. Backtrack in time slightly and pick up a second parallel thread. Two events occur: investors realize that a few lines of software, a pretty business plan, and a catchy name do not a market make; and two planes make unauthorized landings into downtown Manhattan. The 1-2 punch of the Internet bubble bursting and 9/11 sends the economy into a recession. The Federal Open Market Committee (“Fed”) ratchets interest rates lower and makes a horrible mistake, leaving them low for far too long. Liquidity is generated with nowhere to go since money markets and deposits are generating low returns. Well, there is always real estate.

Quants on Wall Street create new classes of securities to access this liquidity — Collateralized Mortgage Obligations (CMOs) and Structured Investment Vehicles (SIVs). Quants are not stupid and know that these are risky, so they create credit default swaps (CDSs) to cover and distribute the risk. Markets develop to trade these instruments. Purchases go global. Trillions of dollars are traded in these vehicles.

With easy money and low interest loans, more houses are constructed, exceeding the number of available buyers, even at 0% down. The value of real estate drops on market fundamentals (law of supply and demand). The underlying value of mortgages drop. Loans are valued at more than the house or real estate they are collateralized with. Because many houses were purchased on speculation, and the dollars invested are essentially zero, owners walk way leaving banks with securitized assets that are non-producing. The primary cascade starts.

As underlying values tank, derivatives such as CMOs and SIVs collapse and swap liabilities under CDS’s increase. FASB 157 requires assets to be marked to market and assets are devalued accordingly. As assets are devalued, new capital to make up the difference is required. However, the complex interconnection of derivatives and new investment vehicles do not provide mechanisms to evaluate risk. Few are willing to invest without an understanding of the risk involved. Bank and investment company outlooks become speculative and their stock prices reflect this. Rating agencies downgrade the companies. This triggers additional capital requirements written into the CDS contracts. The cascade increases. FASB 157 becomes virtually impossible to implement since there effectively is no market. Liquidity stops because 1) banks can’t value what they own; and 2) they don’t loan assets they have because they might need them for capital.

People don’t understand because political parties are off blaming each other. News commentators spew gloom and doom scenarios. Runs on money markets ensue. Money markets sell short term securities to cover withdrawals and the market for commercial paper, which is funded through the money markets, dries up. Liquidity in commercial loans drops. Companies cannot access their lines of credit by commercial paper (bonds, etc,) Companies have to restrict operations and downsize.

People without jobs cannot pay mortgages. Second stage of cascade begins. Consumers look at institutions and decide that their money isn’t safe. They withdraw funds — banks become insolvent and are seized by the FDIC. Other banks stocks fall as result. Confidence erodes further.

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So if we look at the root cause of all this, while Wall Street has it’s share of responsibility, you don’t discipline a dog for urinating on a fire hydrant — he’s just being a dog. Similarly, investment bankers do what they do — borrow and lend money and attempt to make markets. In this case, the road to hell is paved with good intentions and shares of Fannie Mae stock.

 

Primum non nocere

Once there was a group, established by a society, which was endowed with a high level of respect. Members of this group were fragmented in their beliefs and practiced their craft in accordance with their beliefs. Some, enamored with righteousness and a belief in the primacy of the Church, believed that society’s ills were the work of demons and established laws and rituals to expunge them. Men of high status were called evil and their works questioned. Others, no less righteous, insisted that there were fundamental humours that were required to remain in balance for good health, and periodically vented and tapped these to release them from the body. As may be expected all this venting and tapping had some unintended consequences — the patient died. At some point, around the 1850s, some members of this group stepped back and performed a little critical analysis noting that the patients untreated had as much change of survival as patients treated. This observation led to a complete philosophical paradigm shift. A phrase was taught to all who entered this profession: “Primum non nocere —First, do no harm.” Physicians use this expression to note that human acts with good intentions may have unwanted consequences.

In the last few weeks, various treatments to the illness of the financial markets have been tried. These included federal takeover of Fannie Mae and Freddy Mac (Why are there two of them anyway?), the fire-sale manipulation of Bear Sterns, the abandonment and bleeding of Lehman Brothers, what amounts to the acquisition of AIG, and most recently the promise of some new and radically untried set of procedures. These include the suspension of short sales, the acquisition of asset backed securities by the government, the FDIC like insurance of money market mutual funds, and the opening of FED credit lines to cover corporate paper and short term liquidity needs.

In order to implement many of these policies, the regulatory bodies — the SEC, the FED, the Treasury — need Congressional approval. As any first year economics student is taught, actions and expenditures by the government have attached multipliers and consequences on the macroeconomic landscape, not all of which can be accurately predicted. It would prudent then for Congress to do the minimum necessary to treat the problem. Doctors Bernanke, Paulson and Cox have a prescribed treatment plan — one that doesn’t involve additional economic incentive payments, additional mortgage subsidies, or riders to support venting of additional humours. Congress should realize that these prescriptions are for Main Street and not for just Wall Street.

Keeping the Act to enable these prescriptions to the minimum necessary will surely test the wills of both sides of the aisle. It will be difficult enough to fill in the details without loading up the bill with each party’s pet programs and election-year incentives. And as for the details, a couple of suggestions:

1. Let’s go easy on the shorts. Markets work best by including all information and short sales provide a valid channel of information. By all means, lets clamp down on the ‘naked’ shorts, but an accross-the-board ban on shorts is a bad thing.
2. If the Treasury is going to buy securitized mortages, CMOs and SIVs, the so-called “toxic paper”, then let’s value the asset on the basis of discounted cash flows and not mark-to-market. Especially when a viable market doesn’t exist. Not only will this eliminate a bad accounting practice, but it will rapidly establish a mechanism for global markets to understand the risk/value of assets already on their books. It will also eliminate the death spiral of under-capitalization, Agency rating downgrades and further capitalization reserve requirements which are weighing down Goldman Sachs and Mogan Stanley. It probably would have helped Merrill Lynch and Lehman Brothers also.
3. Providing FDIC-like insurance to Money Markets and Mutual Funds needs to be thought through. We don’t want to make the funds more attractive than deposits and cause a massive unintended shift of capital from the commercial banks. That would just shift the crises from Wall Street to Main Street. Perhaps insurance coverage could be adjusted to equalize over the return on investment on any given instrument — treating deposits and funds equally after weighting.

But most importantly, moderation and minimal intervention.

After all, when the heart surgeon cracks you for that triple bypass, he doesn’t usually divert to perform a liposuction, or have his OR technicians perform a manicure on the patient, no matter how beneficial to the patient’s image. Anything that diverts attention from the heart attack is to be avoided. Perhaps the Congressional motto should be changed to “Primun non nocere”. Congress take note.

 

Chemotherapy and Economic Warfare

Chemotherapy is a process I term ‘differential death’. Powerful poisons are administered to the body in hope that cancer cells are killed off either preferentially or at a higher rate than healthy body cells, albeit with the understanding that a certain amount of healthy cells will die during the process. Chemotherapy works only when there exists some finite difference between the growth of the cancer and growth of healthy cells that can be exploited.

In the following arguments, I assert some premises which I believe are supported by observation. One of these premises is that the Government of the United States includes some people who are very intelligent and very clever, despite the obvious inanity of the politicians. Pare away the first layer of politicians, the Congress, the executive branch, and their support ,and there are groups of people who have a very detailed and complete understanding of the various processes occurring in the world. There are also ‘think tanks’ whose stock in trade are ideas, plans and processes, most of which are vetted very thoroughly.

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In the recent economic turmoil, the Federal Open Market Committee (The ‘Fed’) made certain statements, raised interest rates multiple times, and even manipulated the acquisition of Bear Sterns. It opened its discount window, once only available to regulated entities such as banks, to unregulated financial firms. While this was hailed as good in the first few instances, as the rates were lowered again and again, voices began to be heard suggesting that the Fed’s monetary policy was in error. In the aftermath of Bear Sterns, more and more editorials in the Wall Street Journal began to address the ‘moral hazard’ of making such liquidity available; the ‘moral hazard’ of Congresional action on bailouts of mortgage companies who made questionable loans; and the decline of the dollar worldwide. Since food commodities and oil are predominately denominated in dollars, the result of the weak dollar has been a run up of commodity prices. The restrictions on investment resulting from the ‘mortgage crises’ generated large amounts of liquidity that would have gone into SIVs and CMOs, but instead went into commodity speculation, exacerbating already high commodity prices.

Yet the ‘Fed’ does nothing. The White House talks about the global significance of a ‘strong dollar’ yet does nothing. The Treasury Secretary makes strong dollar statements one day and recants them the next. What is going on here? These are, in fact, some of the previously mentioned intelligent and clever people. If the news commentators, abjuring their fascination with Amy Winehouse, or other pop-tart-du-jour, can see and comment on the effects of a weak dollar, then it should be blindingly obvious to even politicians.

These events did not occur in a global vacuum. Let’s look at a few of the boundary conditions. China is a developing economy whose growth is poised at double digits. China’s labor markets provide US companies with a means of inexpensive labor for manufacturing. As a result, China sells an enormous amount of goods to the US. While China’s trade balance sheet is balanced insofar as imports and exports, the balance in trade with the US greatly favors exports. Further China is “The Middle Kingdom”, whose negotiation policy is “You give me this, and I’ll take that”. Repatriating profits from a business venture in China is tantamount to impossible. The only way to successfully do so is to create a Chinese corporation with a Chinese national, route the profits to this new corporation and purchase something from a party in which you, the original company, have an interest. Chinese economic development officials are literally dumbfounded at the concept that you, as a businessman, would not want to leave your money in China. China is about dominance and about regaining their (largely hypothetical) position as the Middle Kingdom: the number one military, industrial and political entity of the world.

The US buys goods from China. In return, China obtains a large amount of US currency. Money which is stationary is useless, so China uses this source of funds to invest in various opportunities including those in the US, buying US Treasuries. China also invests in other financial instruments which are dollar denominated. China is also gowing, and uses a significant amount of energy resources. This creates a huge demand for oil and other ‘portable’ sources of energy. Finally, China has a political system which favors central control which makes its responses a tad arthritic.

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Economic inequity has been a casus beli for as long as man has existed. So if one were to fight a war with a major power, how would one go about it? Iraq is not a major power. Success in the war in Iraq under whatever one wants to characterize as success, can be obtained through force of arms. Similar arguments can be forwarded for most of the medium sized countries, but the real question is how does one wage war on a China, or a Russia. Even smaller countries such as Venezuela and Iran, due to their economic coupling, cannot be warred upon by force of arms. This is especially true for those countries with their own capable militaries and those with strategic nuclear weapons.

To successfully challenge China, Russia, Iran or Venezuela, they must remain unaware that the war is even being fought.

The United States is by far the most dynamic economy of the world. In its normal course of business, hundreds of companies are created and destroyed each year, with novel companies rising to the top of the capitalization structure in fields which didn’t exist even as much as five years ago. Companies providing basic commodities adapt or are driven under by the competition. A 20% bear market drop in the Dow represents the GDP of almost half of the rest of the world. The markets have legacy sayings — Wall Street sneezes and the rest of the world gets the flu.

So if, by analogy we view the United States as the body and the influence of China as malignant cells, how can we wage war to eliminate this influence. Strangely enough, depressing the value of the dollar is one very astute way. The results of this particular brand of chemotherapy is already showing results. Yes, it’s painful, and yes we are losing our hair, but as a result of the rise in commodity prices, business in China is becoming unprofitable. Even Wall-Mart is reconsidering its manufacturing operations there. Manufacturers, faced with shipping costs that are three to four times the production cost in China, have to sell at markups to cover these costs. It becomes cheaper to manufacturer the products here in the United States. Factories which were moth-balled are being re-opened. It is estimated that the current shipping and energy costs amount to an 9% tarrif on Chinese goods.

The rise of dollar denominated oil has forced China to finally raise its subsidized fuel price to its population by 18%. This has an immediate adverse effect on economic growth which is propelled by both energy and capital. And the Chinese citizens who worked their way to the middle class only to find their manufacturing jobs eliminated, become a burden and place demands for a support net on the government. More money flows into social security and less into the military. And the present value of the investments China has placed in US Treasuries and financial institutions is dwindling. The capital investments they do have are decreasing in value both due to inflation and exchange rates. China has recently allows its currency to increase with respect to the dollar in response to this. This only further makes its products less competitive. So as long as the US can withstand the pain of the chemotherapy, China’s influence will lessen.

While the main force of this attack I believe is China, a more subtle attack is being waged on Saudi Arabia and Russia. This attack consists of inflating the incomes of these countries beyond their ability to control. Saudi institutions like KAUST reflect the belief that money can buy prominence in research and technology, as well as stability and respect. Enormous sums are being spent in developing universities with the belief that a religiously restrictive and closed society can become host to a modern research institution. What both Saudi Arabia and Russia don’t understand is that the wealth and power of the United States is not in its things but in its attitudes, freedoms and optimism. When the price of oil falls, as it must, programs in these countries dependent on this cash flow will cease to function. Chavez in Venezuela is spending his oil revenue on vote buying social programs and doing little to build his country’s infrastructure. When the revenue is no longer there to support the programs, they too will cause more problems for Chavez than the United States ever did.

So as long as we can take the pain and adjust a little, we can limit the influence of the cancer. After all, hair can grow back. America needs to see to the aspects of our society that allow this to work — that is creativity, flexibility, inexhaustible energy and freedom.

 

Banks Don’t Read the Fine Print Either

When you receive your brand new credit card in the mail, you also receive a sheet with the terms and conditions of the arrangement you have established with the issuing bank. These terms govern how the bank views and manages its relationship with you. Typically these terms and conditions are variable in the sense that the issuing bank can revise and modify the terms without regard for you, the consumer. It’s a contract with you where you don’t have the benefit of legal representation, or even a voice in the process. Moreover, these term sheets tend to be very fine print, dense and written with a lawyer’s attention to comma placement and nuances the average reader would overlook. The last one I reviewed was about eight pages of 6 point type (Except of course for the Schumer box.)

What happens is, of course, that the consumer never reads the fine print. They read the box and the APR, but typically gloss over the billing cycle period, the ‘adjustments’ to the interest rate as a function of your payment behavior, grace period exceptions to cash advances, cash advance fees, late fee charges, overlimit fee charges, and the like.

Apparently financial institutions pull the same tricks with each other although I suspect that the fine print extends to 50 or so pages. Take, for example, a collateralized mortgage obligation (CMO) where the servicing agreement permits the servicer (the organization which actually accepts your mortgage payments and sends you notices, etc.) to advance payments on behalf of defaulted homeowners (essentially additional loans at 12% or more interest). These ‘servicer advances‘ go back into the trust and terms may be written so that these funds go to the junior security holders. That is to say the mezzanine tranche or lower quality segments of the portfolio.

For those unfamiliar with how asset-backed securities are offered, there are usually three segments or tranches: the senior or low risk, the middle or mezzanine, and the retained or equity tranche which is usually high risk. The equity and mezzanine tranches are subordinated to the senior tranche in that all senior obligations are paid out prior to any payment to the other tranches.

In the event of a foreclosure, the servicer advance funds are paid out first to these junior securities, even before the holders of the senior AAA rated securities receive any payment. Consequently, the foreclosed home sale may produce no proceeds to the AAA holder and may in fact generate a liability. If the servicer owns the junior security, then there is no incentive whatsoever to resolve defaults. The subordination of senior debt to the servicer advances makes the AAA rating of these senior securities a myth.

Additionally, terms in some securities permit borrowers to sell collateral and reinvest the proceeds in other assets, including ‘junk’ bonds. Most permit unlimited amounts of swaps obligations with debt that is senior to or equal to the original priority of repayment. Because the terms do not specify an acceptable risk level for these assets, the collateral backing the debt is compromised. Thus an AAA rating is meaningless — by the time the swap obligations are satisfied, or if the repurchased asset becomes valueless, nothing is left to payout the original debt.

So given the complexity of these arrangements, traders who participate in these markets are likely to look at a security and view its price, its predicted paper return and its rating and leave it at that. No one reads into the fine print, and even if they do, they are faced with much the same choice as the credit card consumer. The security is written and offered as-is. Optimistic traders (especially ones who never have experienced a down market) purchase the security confident in its value, until that is, the underlying asset defaults and sets off a chain of events which leaves the ‘investment grade security’ well below grade. These traders are like consumers who run up credit card debt trusting in low rates and generous payment terms, and who miss a payment, and subsequently find that a great deal becomes a terrible deal with little or no warning.

And now we have a liquidity crisis. No one wants to borrow or loan against securities that have been found out to be riddled with loopholes. While politicians wring their hands in anguish over the poor defaulted homeowner, the real Aegean stable is the financial industry. Until the term sheets are rationalized and simplified to the point where a trader knows his asset’s value, the confusion and resultant liquidity lock will remain. Alt-A packages are likely engineered in the same manner and they haven’t been touched yet. Look for another round of grief as these securities are reassessed.

 

Subprime & Homeless: Part 2

Home ownership has been elevated to an American right. This belief, directed at mortgage companies and lenders, has fueled the Alt-A and sub-prime mortgage explosion. The results were predictable. The unpredictable part was that the securitization of debt, its aggregation into trading instruments, and the resultant distribution of risk penetrated so deeply into the world financial markets. Unfortunately, distribution of risk is not elimination of risk, as we are now seeing.

The US Census Bureau establishes current home ownership at 68.9%, up from the level sustained from 1980 to 1995. (current US Census data and sustained level.)

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Looking at these data, we note that up to Bill Clinton’s effort to provide housing to all in the late 90’s, the percentage of ownership was 64.5%. After Clinton, Bush, the Federal Housing Authority, Fanny Mae and Freddie Mac got into the picture, the US Census numbers (2006) showed 68.9% ownership, a whopping increase of 4.4%. Let’s pull some quick facts from the census. Round off the population to 300,000,000. Of these people, there are approximately 105,000,000 housholds (or potential homeowners). Figure the median value of a home, again approximating the census data, as $120,000. Do the math and you can see that 4.4% increase in home ownership resulted in about 4.62 million new homes or about $554.4 billion in new loans.

Now while this is more pocket change than I’ll ever carry around, it doesn’t quite add up. The 2007 estimate of the US GDP was $13,790 billion. The newly originated loans constituted only 4% GDP. This is approximately the same cost as the annual defense budget as a percent GDP — hardly something that could tank the world financial market.

Yet we see the numbers in the papers all the time. Banks have liquidity problems. Credit default swap derivatives exposure is estimated at $26 trillion.

• 2/28/2008 Fannie Mae posts $3.56 billion loss
• 1/25/2008 Societe General posts $7.2 billion loss
• 2/27/2008 Bond Insurer MBIA default loss estimate $13.7 billion
• 2/25/2008 Bond insurer AMBAC looking to raise $3 billion in capital
• 2/18/2008 National Rock bank London nationalized to secure $107 billion
• 2/22/2008 Credit default swaps loss is $2 trillion

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The answer to this is clear. The current mess has very little to do with homeownership per se and everything to do with investing. If we only had an increase in 4.4% ownership, then the additional debt must have been acquired by people purchasing real estate for investment purposes and homes to flip, also for investment purchases. Add to that the clever derivatives instruments, where a lot of financial engineers and derivatives traders boasted of their multi-million dollar salaries, and you can see that the core of the “irrational exuberence” is based on making very risky bets on an upside market.

When the bubble bursts, and the risk becomes apparent, and bites you in the ass, the taxpayers of the United States are once again called upon to bail out Wall street and stupid, greedy investors. So now we are engaged in assuading the market through rate cuts to resolve liquidity problems, forcing the dollar lower and inflating the cost of essentials like food and energy. All because of the dictum:

 

What affects Wall Street eventually affects Main Street

 

Thanks to the Angry Virginian for comments and suggestions as to breaking this rant into digestible chunks.

 

When You Dine on Sushi, You Dine with the Reverend Moon!

The taste of succulent albacore with a hint of wasabi and soy sauce… Eel perfectly laid out over rice… A tasty roll of crab, expertly wrapped in fresh seaweed. For many, sushi is a tasty way to break free from the tyranny of bland, generic American cuisine. But wait just a minute Ms. Sashimi! Before you have another bite, realize this: When you dine on sushi, you dine with the Reverend Moon!

That’s right, that tasty bit of fish puts you in league with the Unification Church, and it’s leader the enigmatic Rev. Sun Myung Moon. But what do you mean, Angry New Mexican? I don’t believe in mass weddings, the insufficiency of Christ’s sacrifice courtesy of John the Baptist’s failings or a literal kingdom of God on earth. I mean, I don’t even read the Washington Times, a redoubt of the Moonies since its founding. How can I possibly be in league with the Moonies?

My dear sushi-eating readers, you are in league with Rev. Moon, and I’m about to explain why. To start off with, none of this is “new.” The Chicago Tribune and the East Bay Express pointed this out several years ago. But time and time again, I’ve found the American people woefully unaware of their role in the New World Order [Moonie Edition]. You see, Rev. Moon’s route to your California roll was revealed to the world in 1980 with his speech the Way of Tuna. In it Rev. Moon outlines his plan to build the Kingdom of Heaven on earth starting first with the oceans, hence the Way of Tuna. The means is simple — build a Korean chaebol, of the likes of Samsung or Hyundai (whose yes-men seem to alternate control of South Korea’s government), but build this chaebol in fish. The building of ships, fishing and distribution network in the US and Korea will all exist in one big happy (Moonie) family, under the guise True World Foods.

Rev. Moon started assembling his empire in the late 70’s, buying key companies and slowly taking over the town of Gloucester, MA. The Moonie fisherman have since also moved into Bayou La Batre, AL and Kodiak, AK. Gloucester does much of the processing and their 22 distribution centers are located in places like Elizabeth, NJ and Elk Grove Village, IL. According to The Trib, TWF brings in $250 million dollars a year in revenues. While not a monopoly, TWF does have a substantial market share, and taking direction from Rev. Moon, has played a key role in the sushi explosion in the US in the last 30 years. On the TWF site, I found a choice quote, I felt our readers would enjoy:

“What we believe makes True World Foods LLC unique in the marketplace is our corporate culture. Its underlying principles are that we look to live our lives for the sake of others, believe in the philosophy of oneness and instill the idea of teamwork to all our employees.”

Oneness indeed… how wonderfully Moonie. So before you have that next yummy California roll, just remember: The Reverend Moon thanks you for your investment.

Aside: You may notice the “Hates America” tag. I have decided, following the Mildly Piqued Academician (in homage to Angry Midwesterner), to tag all my rants with “Hates America” from here on out. I give it a fig leaf of justification by noting that readers of the Washington Times are part of the Grand Neoconservative Conspiracy (TM), and therefore must hate America.

 

The Double Edged Troll

It’s always amusing when someone’s words and efforts come back to bite them in the ass and its especially gratifying when a politician spends millions on attack ads, succeeds in imprinting a memetic theme into the national lexicon, and then has it used against him.

In the last Illinois Gubernatorial election, Rod Blagojevich launched a year long, expensive, negative television campaign against challenger Judy Baar Topinka. These ads were characterized by black and white images of Ms. Trobinka with the video and words sufficiently out of sync to portray her as a recent stroke victim, with a sad “I don’t quite understand how she could have gone so bad” undertone, followed by the now immortal tag line:

What was she thinking?

Estimated to have been viewed over 200 times by the average Illinois citizen, Ms. Topinka’s public image suffered to the point where she was unable to recover. She lost the Governorship.

Now Governor Rod, in his effort to “support” (pay off) those who funded his re-election campaign (the Illinois Education Association, the American Hospital Association, and the Unions) has proposed the Gross Business Receipts Tax, and is bypassing the mostly hostile legislature by appealing to the people with slick ads (view ad). He has in support the Citizens for Tax Fairness, Health Care and Education who have been running their own continuous slick ads. A quick look at the structure of this PAC shows that the principle contributors are (surprise!) the Illinois Educational Association, The American Hospital Association, etc.

But this tax is so bad, that the business community has responded by creating their own Illinois Coalition for Jobs, Growth and Prosperity, which is issuing their response ads. Listening to one such ad on the radio, the mandatory paid for by the Illinois Coalition verbiage was followed by a woman asking:
“If Mr. Blagojevich were standing here right now, I would have one question for him.”

Mr. Blagojevich, What were you thinking?

[Quick Update: Between the time I wrote this, and its publication, the Illinois House held a “test vote” on the Governor’s Gross Retail Tax proposal. Total for the tax: 0; total against: 107; balance conveniently absent. Even more amusing, on the day before the vote, the Governor issued a statement suggesting that the representatives vote NO on his own proposal. Moral: Those at the vanguard of the charge should occasionally look behind them and see if anyone is following.

Now one has to wonder, given the cost of running a high impact television add campaign for several months, what better use the IEA, AHA, etc. could have made with that money (perhaps some paper for the school copy machine.) One can also speculate that if the various groups were confortable with the risk of investing that sort of capital, then perhaps the anticipated payback (payoff) was larger than what was actually made public.

As as for the Governor, his lament that the only recourse after the failed GRT will be to delete billions in services to reign in the budget—well that is what the blowdried, empty-headed troll should have done in the first place.