It's official: The New York Times informs us that Washington is worried about the mortgage crisis.
Gee, do ya think so? At the epicenter of the crisis, (you guessed it) Southern California, home sales have declined by 48% and the state is in recession. Median house prices, which in today's two-tier America understate the problem, are falling. The Los Angeles Times, which like newspapers all over the country is ever willing to serve its real estate advertisers, blames this on "motivated sellers." Builder confidence is at a record low, even lower than during the 1991 recession. Oil is trading above $86.
A key index of sub-prime mortgage sentiment is falling through the floorboards. And that's not the half of it. Check out this truly astonishing article, which is appropriately titled, "The Eve of Destruction." Don't let its appearance on a California real estate blog fool you: What they're talking about is a nationwide tidal wave that will make the current troubles look easy by comparison. Unless the federal government bails out the banks in the next three or four months, that tsunami is going to hit nationwide, starting next spring and continuing for at least a year. Welcome to the White House, Mrs. Clinton!
The money quote:
The foreclosures and REOs* we are seeing today were caused by people who started defaulting in 2006. Now that prices are clearly off the peak, most of the people needing to refinance will not be able to get it. In short, many of the homeowners represented on this chart are going to default and become REOs.
Vicious cycle, anyone? As I noted in Bailout II and Bailout III, the question of the hour is not, not, NOT whether the federal government is going to try to rescue the banks and insurance companies. A bailout is baked in the cake. As if we needed any more confirmation, there was this from the Idiot-in-Chief's addled corporate waterboy, also known as his Treasury Secretary:
I have no interest in bailing out lenders or property speculators, Mr. Paulson said today [Oct. 16]. Still, we must recognize the very real harm to families affected by the housing downturn.
Nope, he's got no interest in bailing out lenders or speculators. But he'll try anyway. The question is whether it will succeed. Here's a hint:
The fourth issue that has garnered attention is whether greater liability should be imposed on securitizers and investors. In my view, this is not the answer to the problem. Imposing broad liability provisions on investors and securitizers would very likely generate significant unintended consequences. It would potentially paralyze securitization, a process that has been extremely valuable in extending the availability of credit to millions of homeowners nationwide and lowering the cost of financing. Again, balance is critically important. Congress should proceed with extreme caution so as to avoid cutting off investment inflows to the housing market.
Now tell me, does a confident government urge that reckless criminals be set free on the grounds that we need their money?
By the way, Democrats, where have you been hiding? Right now: Get out of your offices and go stand in the sun. See that shadow? It isn't going to bite you. Especially you, Hillary. If you wait until you get into office before you speak up, you're going to look like just another buck-passer. Your biggest risk is that the current administration will do just enough to make themselves look like they're trying, as they wait to drop this 3 million-degree potato in your lap, right there next to the defeat in Iraq and soon in Afghanistan.
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* REO = Real Estate Owned by a lender after foreclosure.
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* REO = Real Estate owned by a lender after foreclosure.
huh...no way dude. reo is like reo speedwagon. you know..that group from the 70's and early 80's. they had one album from 1974 called "ridin' the storm out".
for sure, it had some great songs on it like "find my fortune", "open up", "movin'", "it's everywhere", etc., etc.
classics i tell ya. classics.
I'm suprised that the private equity funds have not been implicated in the cause of the credit crunch by the Bloggers or MSM. P/E had been one of the biggest users of CDO/CLO's leading up to the crunch. Their need for credit went off the charts in H1/07 when $300BN was needed. P/E had been pillaging the balance sheets of the S&P mid caps for years. It was only when they treaded into the S&P 500 water's did the demand and supply credit diverge. There's more to the crunch than just some schmucks over-extending themselves to buy warm weather abodes.
Interesting comment. It would be great if you could post more on this, and do the long division, i.e., explain it in non-specialist terms. Think of an intelligent, curious 12th grader. That's about my level.
Collateralized debt obligations (CDO’s) are the mechanisms that Wall St. uses to turn poorly rated bonds into AAA rated bonds. Wikipedia has a pretty good article on them.
CDO’s were pioneered by Mike Milken in the late 80’s to facilitate leveraged buyouts, which today are known as private equity (P/E) transactions. The biz model of P/E is to lever up a healthy balance and siphon off the extra cash created in levering up. To add leverage P/E has to sell junk bonds. Given that there is a limited investor appetite for junk bonds, Wall St. came up with the idea of selling the bonds to a CDO. With some statistical alchemy and close relationships with the Moody’s and S&P’s of the world the CDO’s were able to get a AAA rating for any debt that they issued. Viola, “the street” turned junk bonds into US Treasury like AAA rated bonds. This “new technology” lead to a proliferation in available credit for P/E deals. Subsequently the size of P/E transaction grew over the last 5 years or so to the point where in May/June of this year Blackstone and KKR were telling investor’s they were close to doing a $100BN transaction.
The banks also got into the CDO racket. If P/E could sell junk bonds to CDO’s then the banks wanted to sell crappy mortgages (sub-prime) or any other loan the didn’t want for whatever reason. This provided the banks with increased liquidity and capital relief and at rates that implied better credit ratings than the banks themselves had.
CDO’s work off of “the carry trade”, the oldest game in finance. Borrow short term and lend long term. The CDO’s receive cash flows from the junk bonds or crappy mortgages that they own and pay cash flows to investors who purchased the short-term debt (commercial paper) from the CDO. And there-in lies the rub. For CDO’s to function properly the C/P investors have to continually roll over their investments in the CDO. If the C/P investors stopped rolling over, an event that the Moody’s and S&P said “would never happen” the banks were required (for a fee of course) to provide liquidity financing to the CDO’s. The C/P investor’s continued to roll over until August of this year, then s#^t hit fan.
Why did the C/P investors stop rolling their investments? A couple of reasons I suppose; 1.) Private equity’s demand for credit was going parabolic (remember, they were on the cusp of doing a $100BN deal early in the summer on top of the other deals that were being announced on a daily basis). They were probably stretching the supply/demand ratio of credit a bit too much, economics 101. 2.) the FED was in a tightening mode and the Treasury market was under a lot of selling pressure so interest rates were rising regardless of P/E excessive demand for credit. As a result C/P investors (credit investors in general) were starting to want higher rates on their investments. So the funding costs of the CDO’s were going up because remember, they borrow short term and invest long term so their carry trade was getting squeezed if not negatively carrying. By mid July the rumours on Wall St. were swirling that the value of the CDO’s was dropping real quick. Two weeks later the C/P investors were wondering if the CDO’s are still “really” AAA rated and as a result said: “no thanks” at the next roll over date. And guess what, the event that Moody’s and S&P said wouldn’t happen, happened. The banks were now required to step in and effectively buy all of the C/P that wasn’t rolled over. That amount is in the several hundreds of billions. Can you spell L I Q U I D I T Y C R U N C H?
When you get to the point in Bailout IV where Paulson is talking about “the fourth issue”, I believe what he is saying is, Congress can’t get an itchy trigger finger and kill securitization. Yes securitization lowers mortgage rates for homeowners but it also provides the “necessary” funding for private equity. If securitization goes away so does private equity and M&A. And M&A is Goldman Sachs golden goose. Paulson probably doesn’t want to see that happen.
This is why I think a crucial piece to the puzzle is being overlooked by the bloggers and MSM. There’s more to the crunch than the banks extending credit to uncreditworthy people, IMHO.
Thanks very much for your comment. It's interesting. I have a couple more questions for you, but before I ask them I want to be sure you know that I appreciate your taking the time to post here and value your knownledge.
First off, would you elaborate on the statistical alchemy by which junk bonds are turned into AAA-rated bonds? Do this is non-specialist language. I have a long attention span.
Secondly, yes, I have noticed this borrowing short and lending long. Could you analyze this is terms of the Finance 101 dictum about matching durations of borrowing and lending? I know just enough to be dangerous on this issue, so I thought I'd run this by you: Isn't the carry trade highly risky? Which is riskier, lending long/bottowing short or lending short/borrowing long? Or maybe they are equally risky, just in different directions. You clearly seem to understand the bond world, so I'd welcome your long division.
Finally, a nitpick. You used a term "C/P" that you didn't define. What were you referring to when you used that term? Thanks very much in advance.
C/P is commercial paper (if you do a Google search you will find the public domain rife with stories of how "asset backed commercial paper" is causing all of the concern we are facing). This is the debt instruments, typically 1mth to 3mth in term that the CDO's use to buy longer term, typically 5 to 10 yr assets (ie. junk bonds, crap mortgages, et al).
Again, there in lies the rub! The CDO's are "funding" long term assets with short term liabilities. Is this a risky strategy? It is, yes, that's why speculators do it because there is risk/reward associated with it. Is it overly risky, depends on your appetite. Everytime someone goes and takes out a mortgage they are playing the carry trade. Do I fund short term to buy my long term asset (property/house) or do I lock in a funding rate? If one were to "lock in" a long term rate that person would have a "matched duration" so to speak. If the person choose's a floating rate mortgage then they are assuming "carry trade risk" because, in general, short term rates are lower than long term rates. So to answer you above question, it would be "less risky" to borrow short term and lend long term.
The statistical alchemy (I'm going out on a limb here because I'm not a specialist, but I've had it explained to me, so here goes). Assume, there are 10 junk bonds available for investment. The statistican's (or derivative traders, or Moody's or S&P) will tell you that over a certain time period, only 1 or 2 of those bonds will default (ie go bankrupt). So if you were to pool all 10 of these junk bonds into say a "CDO" statiscally speaking you know that 2 will go bust and the other 8 won't. So the logic is this, (again, I'm not a specialist this is simply the way it's been explained to me). Then you break the CDO into 3 categories; a.) those that wont go bust, b.) those the have a slight chance of going bust, c.) those that will go bust.
These 3 categories are known as AAA, Mezzanine and Equity (equity is also known as toxic waste, and that's no joke.)
So what you're left with is a portfolio that used to be 100% junk and it is now 70 - 80% AAA, 10 - 20 % Mezzanine and up to 10% "toxic waste". Again, I'm not a specialist in CDO's so I don't really understand the drill down economics. Apparently hedge funds have ways to "hedge" the toxic waste portion so they end up buying that portion as well as the Mezzanine portion. And the remaining 70-80% AAA debt is sold to money market funds. So it was a bit of a stretch for me to say that all of the debt is AAA rated, but the vast majority of seemingly crap debt is now AAA rated. So overall, the CDO's cost of funding has gone down vis-a-vis funding the entire portfolio at junk bond levels
There's a lot in your reply, which is only logical because I asked several questions and invited a long answer. For which I thank you once again. I'm going to reply to a couple of things and then hit the hay. I've got a busy few days ahead, so if this gets a little disjointed it won't be because I'm not interested it will be because I lack the time. So I'd appreciate it if you'd look in here a few times next week if I don't get back to you this week. I appreciate your detailed and intelligent conversation.
Anyway, it occurs to me that the duration-mismiatching risk here is default. If you borrow short and fund long but the long bonds don't pay their coupons, then you could default on your short-term obligations. Correct? So, it would be incumbent upon the mismatcher to seek long-term quality. At least that's what my inner 12th grader tells me. Any thoughts?
As for the pooling of junk bonds into CDOs onn the theory that not all of 'em will go bust, well, my recollection of Investments 101 is that there's a concept called "co-variance" at play. Do these geniuses take it into account or is that one of those baby alligators they just sort of flush down the toilet and hope doesn't swim back up the pipe as a hungry, 30-year-old albino adult?
Investing in a bond exposes the investor to two risks: credit (default) risk and interest rate risk. Credit risk is the risk that the debtor/mortgagor does not pay their bills. This is what the "subprime" debacle is about, they are defaulting and as such not providing the cashflow required of them.
Interest rate risk is the risk that an investor buys a bond that yields 5% and henceforth yields rise and the investor is stuck with the lower yileding asset. Also, interest rate risk is the risk that you borrow short term and buy a longer term bond. Then when the FED raises interest rates, you are paying more for the money you are using for your investment. The duration mismatching that you mention is "specifically" related to interest rate risk. Not credit risk. You can invest in US Treasury's and not match your duration (or investment term, simply put) and you will have interest rate risk because the underlying assumption is that Uncle Sam will always pay their debts.
Regardless, it brings me back to my original comment and Merrill's earnings statement backs me up, this financial crisis is partly subprime but mostly related to leveraged finance related CDO's. My original contention is that the MSM is labelling the crisis as the result of soley subprime lending and I am here to tell you that Wall St. has made a big boo-boo with the way they were conducting business and there is going to be blood on the streets of mid-town/lower Manhattan and in London too. Merrill is just the shot across Wall St's/London's bow.
To answer your question about "co-variance", I say "well done grasshopper" but the propeller heads use Corellation coefficient instead of c/v. But you must admit Willy, they don't study co-variance in Grade 12, do they? Grade 12 has been a while since for me.
I'm traveling, which means that I'm away from that bond textbook that gathers dust somewhere on my shelf. When I get back I'll have to go review the duration issue.
Covariance, correlation coefficient. You say to-MAY-to, I say to-MAH-to. Point is that if you diversify by means of a bunch of securities that act like each other, you haven't really diversified at all. What you've (not you personally, but "you" as a figure of speech) done is fake it.
Not that Wall Street has ever faked it. No, they'd never do such a thing.
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