It Was a Wonderful Life – And Then Came Securitization

Via Money Morning:

There are two major problems with securitization.

First, in modern securitization markets, nobody is really responsible for the credit risk. Instead of taking loans onto their own balance sheet, and losing money if they default, mortgage companies merely sell the loans they originate to Wall Street, pocketing a fee for doing so. Wall Street, in turn, retains very little of the resultant mortgage packages: It sells them on to investors, who can hardly expect Wall Street to be responsible for each individual mortgage.

Thus, all the parties involved in originating the transaction became salesmen. Since it was no longer necessary to have a balance sheet to originate mortgages, mortgage brokers became pure sales operations.  The sales business being what it is, the more unscrupulous and aggressive the sales operation, the more business it did.

That’s how we ended up with so-called “Liar Loans.”

In newly unveiled draft legislation, the U.S. Treasury Department has proposed to reduce this problem by making securitization originators keep 5% of the resultant credit risk. This seems a sensible move, and should help matters considerably, even if it does reduce the attraction of the more-exotic securitizations.

A second problem with securitization, highlighted by the Massachusetts court decision, is that of documentation.  As I can testify from experience, securitizations are by far the most tiresome of all Street transactions to document, with a non-standard securitization creating incalculable costs while taking 18-24 months to complete.

You can see why the more complex transactions were complicated: Hundreds – or even thousands – of mortgages were being bundled and sold as a bundle to maybe tens of thousands of investors.

Read the full article here

Credit Default Swaps Should Not Be Banned

Via zero hedge:

The bottom line is: in every trade there is a buyer and a seller. What needs to happen is the risk skew has to be eliminated and everyone has to be on equal footing. If an AIG or Goldman is aware that they can sell CDS in a company X all the way to zero because if the bet goes against them, they will be “rescued” by a moral hazard encouraging Federal Reserve. In doing so they will squeeze the natural market to a point where enough opposite bets emerge in order to arrive at some imbalanced equilibrium. The imbalance would disappear if Goldman were to realize that it has the same risk/return profile as a Carl Icahn or any other CDS player. If you want to have an efficient CDS market, remove the government backstops of its core players: AIG some years ago, which was more an implicit understanding of their TBTF status, and Goldman Sachs and all the TBTF banks currently, courtesy of explicit guarantees by the government. That is the first and critical step to making CDS trading sensible.

Even with a myriad of cons, CDS has its pros. Credit Default Swaps provide the most liquid and effective mechanism to express a directional bias. With equity volumes ransacked courtesy of HFT systems and various algos that have taken the equity market to unsustainable valuations all with the administration-backstopped desire to provide the “image” to the retail public (and their 401(k) holdings) that things are ok, it is next to impossible to hedge positions for the downside, as every equity short gets run over (courtesy of the Fed), and purchased puts expire worthless: in essence the equity market is broken from a hedging perspective. This only leaves fixed income as some semblance of providing a hedging opportunity. This of course excludes cash bonds (good luck finding borrow to offset long bonds anywhere even close to 1:1), thus leaving asset managers with only CDS as a natural hedge to any and every risk imaginable: from corporate, to duration, to interest rate, to counterparty.

All those who would see CDS extinguished, should consider that without this most liquid product, there will practically be no way to express bearish opinions on the most critical part of the  capital structure. And as we live in a valuation vacuum and true enterprise values are well below the equity tranche for the bulk of corporations (yet above 0, we hope), CDS is precisely the principal and only way to express a valuation bias for such time as the Fed decides to stop fighting the market and tightens (which may or may not happen in our lifetimes). Absent CDS, we will revert to the day when the mutual funds could only go directionally long, and when selling begins, look out below with no natural bids on the way down. A CDS ban is to the fixed income market, as a shorting ban is to equities…

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How ETFs Are Like Mortgage-Backed Securities

Via FT Alphaville:

Bedlam Asset Management takes a look at exchange traded funds in its latest market commentary. Specifically, at how — largely because of greed — a sound concept has once again potentially been bastardised by the financial industry.

As Bedlam notes, ETFs started off as a simple and good idea. They were convenient for investors, easy to understand, affordable, the natural successor of earlier market structures  like futures.

But then — unhappy with the ETFs’ solid but low returns — the industry turned to financial rocket scientists to try and beef up the ETF game. Or as Bedlam observes:

Like alcoholics, investment bankers can never have enough, but in the ETF markets they had made a mistake. For the annual management charges and the dealing commissions were set at a low, thus fair, price to make them attractive.

Having established these precedents, it proved hard to raise the profitability for their managers and thus skin the investor. Banks really dislike steady, recurrent low fee income from low-risk products as they can never cover their bloated overheads; so they consulted their rocket scientists.

They invented the ‘Almost as Safe ETF’, but with a much higher fee base. Some started using derivatives and other opaque financial instruments to offer an increase in value twice that of the price gain of the underlying gold or other commodity. These attracted more trading and higher fees too.

The next phase, as Bedlam notes, was similar to the development of asset-backed mortgage securities. The industry thinking appeared to be:

Why not have gold ETFs not backed by gold at all but say by gold shares, with price differences smoothed out through ever-liquid derivatives and hedges?

And the risk (and fees) just kept getting greater:

The ability to play around globally in multiple types of listed paper generated even more commissions; and because these vehicles were far more complex — but still very safe — management fees charged could be higher for enhancing the rise or fall relative to the underlying commodity. The die was cast. As it worked so well, and profitably, for bullion and then hard commodities why not apply it to others such as sugar, cocoa or coffee? Why not to anything not nailed down? So ETFs spread like a virus; the market went fissile. Having dredged most commodities — yes, there are even lean hog ETFs over which you can buy an OTC put — investment bankers took the final leap of taking it back into actual listed companies.

Read the full post here

In Defense of Financial Innovation

Robert Shiller writing in the FT:

The problem is that financial breakdowns come with low frequency. Since flaws in the financial system may appear decades apart, it is hard to figure out how some new financial device will behave. Moreover, because of the low frequency of crises, people who use financial instruments often have little or no personal experience with the crises and so trust is harder to establish.

When people invest for their children’s education or their retirement, they are concerned about risks that will not become visible for years. They may not be able to rebound from mistaken purchases of faulty financial devices and they may suffer if circumstances develop that create risks that could have been protected against.

Thus, to facilitate financial progress, we need regulators who ensure trust in sophisticated products. They must work towards clearing the way to widespread use of better products, concerning themselves with both safety and creative ideas. They must not simply be law enforcers against the shenanigans of cynical promoters, but also be open to making complex ideas work that have the potential to improve public welfare. Unfortunately, the crisis has sharply reduced trust in our financial system.

…Unfortunately, people do not trust some good innovations that could protect them better. The innovations in mortgages in recent years (involving such things as option-adjustable rate mortgages) are not products of sophisticated financial theory. I have proposed the idea of “continuous workout mortgages”, motivated by basic principles of risk management. The privately issued mortgage would protect against exigencies such as recessions or drops in home prices. Had such mortgages been offered before this crisis, we would not have the rash of foreclosures. Yet, even after the crisis, regulators seem to be assuming a plain vanilla mortgage is just what we need for the future.

Another example of a potentially useful innovation is the target-date fund (also called life-cycle fund) that invests money for people’s retirement in a way that is specifically tailored for people their age. Such a fund plans for young people to take greater risks and for older people to invest more conservatively. Target-date funds, first introduced by Wells Fargo and BGI in the 1990s, are growing in importance, but few people commit the bulk of their portfolio to such funds, or make use of target-date funds that might make adjustments for their other investments. It appears that people do not fully trust that these funds are designed correctly, or would protect them from crises.

…It is critical that we take the opportunity of the crisis to promote innovation-enhancing financial regulation and not let this be eclipsed by superficially popular issues. Despite the apparent improvement in the economy, the crisis is not over and so the public continues to support government-led interventions. Doing this means encouraging better dialogue between private-sector innovators and regulators. My experience with regulators suggests that they are intelligent and well-meaning but often bogged down in bureaucracy. Regulatory agencies need to be given a stronger mission of encouraging innovation. They must hire enough qualified staff to understand the complexity of the innovative process and talk to innovators with less of a disapprove-by-the-rules stance and more that of a contributor to a complex creative process.

Read the full article here

Financial Innovation Under Fire

Peter Coy writing in BusinessWeek:

Leave it to Wall Street to give innovation a bad name. Americans prize out-of-the-box thinking in technology and culture, but they fear it in finance—understandably, thanks to innovative disasters like credit default swaps, collateralized debt obligations, and “negatively amortizing” mortgages whose principal grows instead of shrinking.

In spite of the public’s mistrust, entrepreneurs and academics are plunging ahead. They’re working on ideas they hope will help the consumer borrow more safely and build wealth more reliably. Some are ambitious, like reducing homeowners’ exposure to declines in local housing prices. Others are fanciful, like an electronically rigged wallet that becomes harder to open when your bank account is low, an idea from the Massachusetts Institute of Technology.

The big problem: It’s hard to tell the beneficial ideas from the ones that are self-serving or dangerous. Many top economists, including former Federal Reserve Chairman Alan Greenspan, once lauded subprime mortgages as a fantastic innovation. With this fresh in mind, there’s a risk that government will overreact and suppress good ideas along with bad ones.

Read the full article here

Credit Rating Agencies Took “Bribes” for Higher Ratings

Alternative title: How the Fed Contributes to Crises

Hat tip to Washington’s Blog for bringing this story to my attention. Morningstar Advisor posted a great piece back in June when they held a conversation with Ed Kane, Martin Mayer, and Walker Todd–three people who have great depth and experience in understanding the plumbing, history, and effects of the regulatory infrastructure of our financial markets. Below are some highlights:

[Finance professor Ed] Kane: One has to remember that these are profit-making institutions. Issuers will would pay more money for a good rating than a bad one, and issuers are very clear what kind of ratings they want. This is a straight-forward way to pay bribes without ever violating the law, it appears, and the credit rating organizations do not take formal responsibility for their incompetence or negligence.

[Prolific financial journalist, Brookings Institution scholar, and the author of more than 30 books on financial market issues Martin] Mayer: One of the untold scandals of this country is that our museums are stuffed with fake old masters because the people who authenticated paintings for the Mellons and Morgans of this world were paid a percentage of the price for the authentication. If they said it was no good, they got a few hundred bucks. If they said it was great, they got $100,000. Same story in the credit-rating organizations.

[Former Federal Reserve attorney and economist Walker] Todd: Right. They also drop the ball. I’ve been around failing banks and financial crises since 1974, and the rating agencies have dropped the ball almost every time. They were always at best late to the party.

Mayer: John Heimann [former comptroller of the currency] used to say that the function of the ratings agency is to go on the battlefield after the battle is over and shoot the wounded.

Read the whole Morningstar discussion after the jump…

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Krugman: How Did Economists Get It So Wrong?

Paul Krugman wrote a lengthy piece in the New York Times Magazine today. It is a very hard critique and analysis of the failure of current macro and financial economic thought, which didn’t even come close to predicting the current financial malaise. I don’t agree with all of it, particularly his love affair with Keynesian economics. But it is still very worthy of your time and a recommended read. A point where I agree with Krugman: the failure of EMH.

Below is an excerpt:

As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.

It’s much harder to say where the economics profession goes from here. But what’s almost certain is that economists will have to learn to live with messiness. That is, they will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic “theory of everything” is a long way off. In practical terms, this will translate into more cautious policy advice — and a reduced willingness to dismantle economic safeguards in the faith that markets will solve all problems.

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Good and Bad Financial Innovation

Felix Salmon comments on the Simon Johnson and James Kwak article, “Before the Next Meltdown”. He has some valid issues with it, which he addresses below:

Simon Johnson and James Kwak have an important article on financial innovation in the latest issue of Democracy. The broad thrust of the article I agree with — as you might expect, given that after listening to my last debate on the subject, James Kwak came to the conclusion that “obviously I agree most with Salmon”. (Thanks, James!)

That said, there are significant chunks of the Johnson and Kwak article that I disagree with, and I feel that it’s probably long past time that the “financial innovation: good or bad?” debate allow itself to make some nicer distinctions than have generally been made until now. So with the clear proviso that I’m on the “financial innovation: bad” side of the broader debate, here’s where I take issue with Johnson and Kwak.

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Before the Next Meltdown

From Democracy Journal

An interesting article by Simon Johnson and James Kwak:

If innovation must be good, then financial innovation should be good, too. If finance is the lifeblood of our economy, then figuring out new ways to pump blood through the economy should foster investment, entrepreneurialism, and progress. Right? This, in any case, has been the mantra throughout three decades of deregulation and expansion of the financial sector.

And yet today, financial innovation stands accused of being complicit in the financial crisis that has created the first global recession in decades. The very innovations that were celebrated by former Federal Reserve Chairman Alan Greenspan—negative-amortization mortgages, collateralized debt obligations (CDOs) and synthetic CDOs, and credit default swaps, among countless others—either amplified or caused the crisis, depending on your viewpoint. The journalist Michael Lewis recently argued that the credit default swaps sold by A.I.G. brought down the entire global financial system—and found that the A.I.G. traders he talked to completely agreed.

Recent financial innovation is not without its defenders, of course. As current Fed Chairman Ben Bernanke said in a speech in May:

We should also always keep in view the enormous economic benefits that flow from a healthy and innovative financial sector. The increasing sophistication and depth of financial markets promote economic growth by allocating capital where it can be most productive. And the dispersion of risk more broadly across the financial system has, thus far, increased the resilience of the system and the economy to shocks.

Intellectual conservatives and bankers have mounted an even more fervent defense of financial innovation. Niall Ferguson has claimed, “We need to remember that much financial innovation over the past 30 years was economically beneficial, and not just to the fat cats of Wall Street.” Bernanke and Ferguson are being too generous. For the past 30 years, financial innovation has increased costs and risks for both individual consumers and the global economy. To take the most obvious example, consumers bought houses they could not otherwise have bought using new mortgages they had no hope of repaying, creating a housing bubble, while new derivatives helped hide the risk of those mortgages, creating a securities bubble. The collapse of those bubbles has shaken the world for the last year. Today’s challenge is to rethink financial innovation and learn how to separate the good from the bad.

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