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.

So in the last segment we reviewed the securitization of our portofolio with the following results:

  Loans to Cashmere Coats Loans to Used-Car Salesmen Loans to Bums
  Securitized Loan to Cashmere Coat Securitized Loan to Used-Car Salesman Securitized Loan to Bum
Rate 2% 4% 6-8%
Risk Low Medium High
Joe’s Rating AAA BBa ‘junk’

In any industry, there are clever little engineers that can make interesting things. The finance industry is no exception, except for a couple of salient facts. Most of these engineers are young (after all their products didn’t exist as much as 10 years ago), and most have never lived through a significant down market. So a certain set of eternally optimistic financial engineers looked at the mezzanine tranche (the Loans to Used Car Salesmen), and asked whether they could do something to strengthen the sales of this group.

One thing that they came up with was to apply a bit of insurance theory. Develop a product that could spread the risk even further than securitization. Take the pool of loans from the used-car salesmen and insure that pool against loan loss. That is to say, if any of those loans went south, the insurer (Guido) would cover the face value of the loan and the person who actually invested in (read bought) that tranche, would be guaranteed his principal back. Of course nothing is free so the person who was packaging the loans, me in this case, would pay a premium for that insurance just like I do on my house or car. However, in return for the insurance, the credit rating of the used-car-salesmen offer would improve as the risk would decrease. Joe would rate it higher — maybe A or AA. This means that since the risk was lower I would give only 2.5% or maybe 3% interest on the package to the investor.

The ABS package wouldn’t be AAA but it would be higher than BBa. And even though I had to pay Guido some cash for his protection, I ended up with a larger spread in rates. 6% – 2.5% is 3.5% for me verses the 6% – 4% or 2% I would normally get for unenhanced used-car-salesmen loans.

And Guido, even though he was betting my used car salesmen were a good risk and pricing my premiums as such, would spread his risk by protecting a large pool of such loans. Hey! It works for insurance with only minor glitches like Hurricane Hugo and Katerina.

So my new offerings look like this.

  Loans to Cashmere Coats Loans to Used-Car Salesmen Loans to Bums
  Securitized Loan to Cashmere Coat Securitized Loan to Used-Car Salesman Securitized Loan to Bum
Rate 2% 2.5% 6-8%
Risk Low Low-Med High
Joe’s Rating AAA AA ‘junk’

 

Thus with this piece of financial ingenuity we have created a new market. The companies in this market include ACA, AMBAC, FSA, and MBIA.

ACA recently saw its stock plummet 57% due to downgrades on its holdings. MBIA’s trillion dollar portfolio is under stress from $2.4 billion in debt obligations related to subprime mortgages as well as AMBAC. FSA has taken a $215 billion dollar hit. Fitch, a rating agency (Joe’s friend), has downgraded obligations of several banks, including Barclays.

The problem here is that the risk was incorrectly estimated — i.e., the people offering the securitized holdings were optimistic to just plain wrong. Spreading your exposure over a pool of equally bad obligations does not increase the quality, so the insurers did, in fact, not reduce their exposure to defaults. This is similar to major insurance companies issuing policies over a wide geographic area, noting that tornados, hurricanes and fires are localized events, only to have an asteroid strike the earth.

 

Next installment: Adding more structure.

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.)


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

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.

Home ownership has been elevated to a quintessential American right. Having a home (and a mortgage) is proof of your worthiness as a person and as a citizen of the United States. This belief is driving much of the legislation directed at mortgage companies and lenders, and in fact has fueled the Alt-A and sub-prime mortgage explosion. But how reasonable are these expectations?

The National Association of Realtors puts the current ownership (without factoring in foreclosures) at 68.9%. This is confirmed by US Census data. An earlier report of the US Census Bureau data established the home ownership rate at between 64 and 65% up to 1995. Some economists have suggested that the sustainable level of home ownership is around 60%. This means that 40% of the population of the United States should not own a home. At least some local governments appear to understand this. It is illustrative to consider the composition of this 40%.

There are valid life choices that mitigate against home ownership. A young and very mobile population are not good candidates for the commitment that owning a house requires. The real-estate taxes I pay on my house alone would rent a nice apartment for a year. Then there is maintenance, lawn care, etc. Your mobility is restricted if you own a home by the market conditions. Many homeowners are saddled with dual homes and payments when they relocate to change employment until the market improves or the price is reduced to sell. For highly mobile members of the workforce, homeownership is not warranted.

There are also what I classify as two types of mental deficiency: functional and dysfunctional. The functional type includes people who are otherwise normal appearing who can participate in society yet are incapable of planning and making the long term strategies and commitments required to own a home. (Britney Spears comes to mind). They have no awareness of the consequences of their actions in the long term. These people are better served by the rental market.

As for for those with dysfunctional mental deficiencies, state institutions existed in the United States up through the 1950’s to house people with behaviors which were deemed problematic in a free society. These problems could be related to alcoholism, pharmacological dependency, or pathological conditions such as Downs. A lot of these facilities were of the “out of sight, out of mind” class and were bastions of repression and intolerance. (Nursing homes enjoy the same status today.) Coinciding with new liberal thought and an era of enlightened psychological analysis, many of these facilities were shuttered and razed. The result, as should be unsurprising, is that many of the former occupants reverted to their inclinations and live on the streets of our cities — the homeless.

Since they are no longer out of sight, and indeed far too visible, many well-intentioned efforts to provide for them have been initiated. Care for the homeless has been a hue and cry of the liberal left for the last twenty years, interesting in that the ‘problem’ was created by their meddling in the state institutions in the first place. The cynic in me questions why they even bothered since the majority don’t vote anyway. Nonetheless, they are homeless, and well-intentioned people are tasking our legislatures to provide for them. Providing a means for these people to obtain a mortgage is idiocy.

Seattle Hobo
Seattle near Pike’s Place Market, August 30th 2007

Finally there are the homeless by choice. These are the people who would prefer not to appear on the tax rolls and registries of governmental units for whatever reason. To some, it is enduring freedom to do whatever they want, and to do it whenever they please. These have been around for a long time probably commencing with the Revolutionary War — certainly since the Civil War and demonstratively so after the Great Depression. They constitute the tramps, hobos, and sadly, even the bindlestiffs (hobos who robbed the bindles of other hobos).


From these observations, it should be apparent that many citizens are homeless by choice and that no government policy is going to change this. Trying to increase home ownership over a demonstratively sustainable level has accomplished nothing except contributing to the current subprime mess.

In our 12 Angry Men email discussions, one Angry Man asked why one of us didn’t rant about the “subprime mortgage meltdown”. After some consideration, and at the risk of offending those in finance with considerable more precision than I can provide, I delve into the topic. One of the reasons for the reluctance to address the topic is its complex nature. To truely understand what occurred, you have to understand securitization and structured investment vehicles. But as one who participated in a company who securitized credit card receivables, as I researched, I discovered several underlying commonalities. In fact, there is a lot of commonality with the way Congress and our government manages the Federal budget. When one sees so many threads aligned together, there is a suspicion of a whole cloth of consensual conspiracy, a tapestry of belief that underlies the way we view risk.

Before 1970, banks maintained portfolios of loans, serviced those loans, and generally covered the amount loaned by use of deposits, or by debt incurred by the bank itself. Regulatory agencies required that banks maintained a certain level of liquidity reserves, i.e. they couldn’t loan more than say 80% of the amount they had on deposit . When loans matured and the principle was paid, it could be relent to another. This serial process set limits on the amount of growth in the country as growth requires a pool of capital to finance that growth. The more capital available, the more growth. This was particularly true in the home building and mortgage industry. Mortgages were particularly bad because the cash assets were tied up in fixed terms of 20 or more years. Demand was high for new homes.

The solution was to package loans up as a “managed asset” and sell them, transferring the long term debt, future cash flows and risk to third party investors. Two benefits arose from this: accounting rules treated the movement of debt to a third party as a sale, and thus the debt could be moved off the bank’s balance sheet (and reduce the liquidity reserve required by regulators); and the bank received immediate cash, albeit discounted, from the sale which allowed it to originate more loans. Investors who purchased the asset received the interest cash flow and eventually the principle back. Moreover, such asset backed securities (ABS) could be traded between investors like any other security. Trading is important in that it allows information relevant to the asset, such as credit quality, to be reflected into the price of the asset. Assets which aren’t traded have no mechanism to establish their value (price).


Now if I go out onto the street and lend the first 100 people I meet $1000 each, with their promise to pay it back in one year with some interest, (say 6%), I have receivables of $100,000. Further, I make them sign a piece of paper that says that they will pay me back. Now I go to another person, who happens to have some money he wants to invest. Hey, I’ll trade you this package of notes for $100,000 and you can keep the interest. Does he take the offer — I suspect not. What would I have to do to entice him into taking the offer?

First I would need a plan as to how I would collect the principle and interest, i.e. how I would service the loan. The investor doesn’t want to be bothered with running a collection operation. So either I have to do it or I have to hire someone to do it for me — both at a cost. Hmm. I could create a spread in interest rates. Charge each person a higher rate than I offered to pay the investor and use the difference to pay for the servicing. Hey, I could even wet my beak a little. I charge 6% and offer the investor 4% and use the 2% to pay for servicing.

But then I remember that the forth and fifth person I loaned the money to were bums. Hmm. How likely is it that they will just drink up the money and never pay me back? But that first guy has a cashmere coat and a nice haircut — he would probably pay me back. But the 10th guy was a used car salesman. Maybe I had better look at these loans and arrange them in order of who is likely to pay me back. In fact, it sure would have been better to look a little closer a them before I handed them the money. So I divide up the loans in to three piles. All the bums in pile three, all the used car salesmen in pile two, and all the cashmere coats in pile one.

So now my plan is to take all of the loans to guys in cashmere coats and package them up as an asset based security. Since the risk is very low that these guys will default and not pay me back, I am essentially giving away a sure thing. For sure things I offer a 2% rate.

The used car salesmen loans, I also package up. These guys are more risky so I offer the package for 4%. And since many of these investors don’t know me personally, I need to convince them that I haven’t slipped a bum or two into the used car salesmen group. So I go to Joe the Bookie. Now Joe really doesn’t know much more than I do, although he has one advantage — everybody knows Joe. Joe make a cursory glance through my package and doesn’t recognize any bums, sees a few car salesmen he knows, and decides that my package is worth a couple of B’s (It’s not really A list material, but it’s not that BBa-d either.) So when I offer this to my customers, I tell them “Joe says it’s not too BBad.”

The remaining bums are kind of a problem. I know I can’t package them up and offer them. (I mean, I could try, just to get rid of them, but I’d have to offer 6-8% and Joe would say to toss them in the junk.) No, these I’ll have to keep and make an aggressive attempt to collect my money. Hopefully, the 2% I get to keep for servicing will cover any loss. And who knows, some of the bums are trying to reform.

So I manage to sell of a couple of groups of my packages and get back some of my money. Plus the 2% is generating some cash flow. I decide to take the money from the sale and lend it out again, but this time I’m going to be really really careful about lending it to bums. I’ve just learned how to securitize my debt — cool beans. Since my assets are loans, these are asset-backed securities (ABS). If they were loans collateralized by homes, or mortgages, they would be mortgage backed securities (MBS).

  Loans to Cashmere Coats Loans to Used-Car Salesmen Loans to Bums
  Securitized Loan to Cashmere Coat Securitized Loan to Used-Car Salesman Securitized Loan to Bum
Rate 2% 4% 6-8%
Risk Low Medium High
Joe’s Rating AAA BBa ‘junk’

[News flash!!! — Today the government announced that ‘bums’ are henceforth to be known as ‘homeless people’ and that since it is in everyones’ interest to own a home, the government is going to make it easier to loan money to the homeless people. Fanny and Freddie are no longer going to require that the homeless people put down 20% on an empty refrigerator box to live in.]

As I look around, I see that all of my friends are loaning money right and left, competing with Fanny and Fred. I better get on this bandwagon if I want to stay in business. I guess I’ll accept a few more used car salesmen this time, and maybe a few more bums —err homeless people than I initially planned.

Next installment: How to give used car salesmen cashmere coats.