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When are we being Chicken Littles?
Posted by: Lance on Wednesday, October 01, 2008

Let us look at one of the ways that we are being panicked unnecessarily, and why incidentally we can help many of these financial institutions in the fashion I discussed in my last post. In my next post we will discuss ways in which we are not being misled, and why we in my mind should do something about this.


 
In my previous post I discussed the balance sheets of our most highly leveraged institutions. Let us look at them a little closer. Let us go back to Lehman Brothers as a textbook case of what has been happening and why some of what we are being told is exaggerated.

It is no accident that the dominoes in the investment banking world have fallen in precisely the order of their gross leverage. Bear Stearns, Lehman and then Merrill. The next domino is Morgan Stanley in terms of both leverage and market pressure. We see the same pattern in Europe.

So let us look at Lehman Brothers.

Just prior to their collapse Lehman reported 600 billion in assets. Think about that number and reflect on why our government buying 700 billion in assets is such a tiny number relative to the problems we are facing. This is just one institution.

So why would an institution with 600 billion in assets be in trouble?

First, what are those assets? They include mortgage backed securities, commercial real estate and a host of securities including treasury bonds and bills. Most of those assets were not going to disappear.

The problem is that Lehman had only 20 billion in shareholder equity. What does that mean? It means it had liabilities of approx. 580 billion! To put it in plain english, they owed that much to various creditors in the form of customer obligations, counterparties, preferred stock holders, subordinated debt and senior bondholders. To figure out how much equity that the common stockholders had in the company you take 600 billion, subtract 580 billion and you get 20 billion. Given what happened to their stock price, and the lack of buyers for the company investors felt that 600 billion in assets was a bit fishy, subsequent accounting seems to have borne that out.

That does not mean that the assets were not substantial. The problem is that when one has 600 billion in assets and only 20 billion in equity your leverage is 30 to 1 (600 divided by 20 equals 30.) Therefore if the assets were written down by only a bit more than 3% it would wipe out the equity and make them officially bankrupt (3.4% of 600 billion is 20.4 billion.) In fact, it seems they were bankrupt.

So, were customers or counterparties at risk? Should this have led to a systemic problem? Not really. Those 600 billion in assets are worth something, in fact they are worth quite a lot. In Lehman's case the equity plus various bondholders added up to 143 billion. So, the markdowns would have to exceed 143 billion before customers or counterparties were at risk. That would be exceedingly unlikely. What our treasury was concerned about was not customers or counterparties, but the bondholders!What our treasury was concerned about was not customers or counterparties, but the bondholders! The goal there, with Bear Stearns (and with far more justification, Fannie and Freddie) was to protect the bondholders from the risk of default.

That is right folks, that is who your tax dollars bailed out in Bear Stearns and each other case, bondholders. We should be sickened.

So what does an institution in Lehman's case try and do to shore themselves up? Raise capital so that their assets are even larger than their liabilities. They can issue stock, sell preferred stock which pays interest but it is only paid if they have the cash to do so, etc. The problem with Lehman was they were so weak that investors wouldn't pay them enough per share issued to raise the amount of capital they needed. Preferred stock is only attractive if people believe you will stay in business as well and you are likely to be able to pay the dividend. Lehman was pretty much shut out of all the traditional methods of raising capital.

Is this an institution the plan I proposed would apply to? Possibly not. The key would be to force them to mark their assets lock stock and barrel to market, possibly sell the problematic ones at fire sale prices and see if the resulting write downs left enough cushion of shareholder equity and debt holders to eat through to keep the capital injection safe in case of default. The key is that stock and bondholders before accepting such a deal would have to see that the action would improve their situation enough to risk being wiped out in the case of stockholders, and having to stand in line for payment in a default situation in bondholders case.

Stockholders would never agree to such a deal unless they felt there was no other way, so it would be the bondholders who would hold the key. If the capital would be sufficient to allow the company to survive, they would go along with it. If all it would accomplish was for a failing institution to go on losing money a while longer they would just ask for bankruptcy. The balance sheet would be the key.

From the taxpayers standpoint, the treasury would make the same calculation. If a sufficient amount of capital would leave too thin a cushion of bondholder liabilities to cover us in the case of default, we allow them to go into bankruptcy or call in the FDIC (for banks) to liquidate.

Let us go back to Hussman:
Look at the insolvent balance sheet again. The appropriate solution is not for the government to purchase bad assets with public money. The only way such a transaction would add to the institution's capital would be for the government to overpay for those assets. Rather, the government should either a) provide new capital, taking a claim in front of the company's bondholders and stockholders, or b) execute a receivership of the failed institution and immediately conduct a “whole bank” sale – selling the bank's assets and liabilities as a package, but ex the debt to bondholders, which preserves the ongoing business without loss to customers and counterparties, wipes out shareholder equity, and gives bondholders partial (perhaps even nearly complete) recovery with the proceeds.
Let's now look at Morgan Stanley:

For example, consider Morgan Stanley's balance sheet as of 8/31/08. Total assets were $988.8 billion, with shareholder equity (including junior subordinated debt) of $42.1 billion, for a gross leverage ratio of 23.5. However, the company also has approximately $200 billion in long-term debt to its bondholders, primarily consisting of senior debt with an average maturity of about 6 years. Why on earth would Congress put the U.S. public behind these bondholders?
Why indeed?

The answer is the credit markets. When Lehman failed one systemic risk was a problem, that is the risk that without knowing who was in what kind of shape nobody wants to be the bondholder left holding the bag. Hence the run on money markets following Lehman's collapse.

The answer isn't to bail Lehman or others out, it is to clarify for the market who is and isn't solvent. That however will have to wait for another post.

The key point to be made, is that the nonsense about systemic risk due to customers and counterparties not being made whole with a cascade of defaults is not true, and there is no excuse for our media, our politicians and others to try and panic us into believing otherwise. We can survive a large number of failed financial institutions, even if it is not pleasant.

I should also point out that our commercial banks are not as leveraged as the investment banks, so they are far less problematic.

 
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Previous Comments to this Post 

Comments
Very informative. Thank you. I am slowly coming around to oppose a bail out, even though its looks like it is coming through anyways.
 
Written By: Harun
URL: http://
A bit OT, but gave me a chuck.

NSFW (due to bad language, no nudity)

link
 
Written By: jpm100
URL: http://
chuckle*
 
Written By: jpm100
URL: http://
Bailout is a done deal. Now I am looking for investments. There will be some seriously undervalued stocks and real estate. IMO thinks will begin to stabilise and rise by second quarter 2009. UNLESS, the economic meltdown continues in Europe. That is a big possibility.
 
Written By: kyleN
URL: http://impudent.blognation.us/blog
Look at the insolvent balance sheet again. The appropriate solution is not for the government to purchase bad assets with public money. The only way such a transaction would add to the institution’s capital would be for the government to overpay for those assets.
I don’t think that’s correct. Right now, because of mark-to-market, those assets are worth $0 on the balance sheet even though they have some value. The purchase of those troubles assets (i.e. those for which there’s no market), allows the companies to then add the purchase price to their bottom line asset-wise, whereas before they had a big fat goose egg. Thus, there’s no "overpayment" unless the assets are truly worth $0 (which we all know they are not).
 
Written By: MichaelW
URL: http://qando.net
Michael,

That seems right to most people, but I am going to with all the respect in the world disagree.

Actually few of these have no value, and those that do probably should. These are not bonds, or loans, which we see with extreme discounts to par (say from 70-100% discounts.) They are synthetic securities. Thus all this talk of "hold to maturity" is very misleading, because it assumes these securities work like bonds. They don’t. The various tranches of these assets can easily have no or very little value, that is why their yields were so high even after all the fees extracted by Wall Street, because they carried much more risk. If they didn’t why were their yields so high relative to traditional bonds? I think it should be pointed out that most of the people we have commenting on this, including smart people like Bernanke and Paulson do not understand these securities. Perilously few do (which should lead to a discount as well.) I don’t either in detail, but I do know enough to understand that others understand them even less, though many many will claim they do, including experienced derivative traders.

The only reason their ratings were above junk (many even got AAA ratings) was because of very flawed models which assumed that when packaged together the risk of enough defaults in the underlying loans, mortgages, and other paper would not be high enough to sink them, whereas as individual paper each would have a risk of default. That has turned out to be false, diversification only helps for specific risk. Market risk was hardly factored in at all.

So, these securities have several tranches that are highly impaired, the equity tranche in fact in most of these is worthless.

The lower rated tranches are either worthless or not far from it.

Also, mark to market accounting reflects a risk premium. Sure, the tranche I am buying at 50 cents on the dollar is now paying, but the question is will it pay over the life of the security? Highly questionable. Some will, some will not depending on how stressed the economy gets, how far housing prices drop etc.

Therefore they should carry a large discount. If they didn’t, why would any buyer in their right mind buy them? You can buy 2 year a rated commercial paper and get double digit yields right now. Heck, why buy them for a 7-10% yield in any market when that is your upside and you have a significant risk of large principle loss?

Arnold Kling discusses this very well (my emphasis in bold):
It is not expected future home prices that determines the default probabilities. It is the distribution of the possible paths of future home prices. Under scenarios where prices hold steady or rise, defaults will be less. Under scenarios where prices fall, defaults will be more.

The problem is that the impact on security values is asymmetric. The upside is limited. The better the scenario for house prices, the fewer defaults. However, the benefit of house prices rising by, say, 10 percent as opposed to 5 percent, goes to the homeowner, not the security holder.

In the other direction, the worse it is for house prices, the worse it is for the securities. As prices fall, not only do you get more defaults, but you recover less of your loan balance on each foreclosure.

Because of this asymmetry, security prices tend to have low values relative to the "expected" path of house prices. In my view, these low security prices are correct. The conventional wisdom, as represented by Cline, is that the securities are undervalued. That is why the conventional wisdom is that this is a profit opportunity for the government.

In fact, what this represents is a classic opportunity for government to do what Nassim Taleb criticizes Wall Street for doing: taking short option positions that work out well most of the time but which under rare circumstances blow up.

It is exactly like the game I describe in which we roll a 6-sided die and you win $1 if it comes up 1,2,3,4, or 5 and you lose your whole bank account if it comes up a 6. If house prices stay close to where they are today, that is like rolling a 1,2,3,4, or 5, and the bailout will show a profit, of perhaps tens of billions. On the other hand, if house prices fall another 30 percent, the $700 billion will be pretty much wiped out.

The U.S. Treasury will be betting a lot of the net worth of the the American people that there won’t be a severe further decline in house prices. Feelin’ lucky, punk?

I’ll be more daring than he, this is almost certainly a ginormous money loser. The securities the government purchases will mostly make reasonable returns if we pay above mark to market rates, the ones that fail will wipe out all those profits and more under the housing prices fall another 10-15% scenario. The distribution of risk in these securities is very lumpy. For short options that is a very bad characteristic.

If they fall more than that we will lose everything. I am not optimistic that prices will be limited in many markets to only 10-15% more downside. Remember that if most of the country actually rises, but substantial price declines continue in other places, we lose huge amounts on them and only get interest on the winners. That is how these suckers are structured. They are not bonds and the market is not underpricing them on average when adjusted for risk.



 
Written By: Lance
URL: http://asecondhandconjecture.com
Kyle,
UNLESS, the economic meltdown continues in Europe. That is a big possibility.
I think that is pretty much baked into the cake, and while you may be right about the US, only if pain is sharp and swift.

Still, I am looking to February and March as possible turning points to look at. First we will probably have at least one violent upswing that fails.
 
Written By: Lance
URL: http://asecondhandconjecture.com
Actually few of these have no value, and those that do probably should. These are not bonds, or loans, which we see with extreme discounts to par (say from 70-100% discounts.) They are synthetic securities.
Synthetic securities? I’m not sure what you mean by that, but I can assure these are very real securities. And I still don’t see anywhere in your explanation how all of the MBS (which are being valued at $0 on the books) don’t retain at least some value. They are simply payment streams after all, and for most of the underlying mortgages the payments are being made.
Thus all this talk of "hold to maturity" is very misleading, because it assumes these securities work like bonds. They don’t. The various tranches of these assets can easily have no or very little value, that is why their yields were so high even after all the fees extracted by Wall Street, because they carried much more risk.
Well, they are in fact called "bonds" and just because they carry more risk relative to traditional bonds, that doesn’t make them work any less like bonds. Either way, I’m not sure any of this is relevant to the fact that, whatever their risk, these securities are not completely worthless, so much so that an overpayment is necessary to add capital to distressed companies’ books. By the same token, I’m not trying to argue that buying up troubled assets is a money maker for the government, nor a terribly good thing for the distressed companies other than in the very near term. But the assertion that these MBS have no value whatsoever I believe is very wrong.
So, these securities have several tranches that are highly impaired, the equity tranche in fact in most of these is worthless.
What’s an "equity tranche"? Are you referring to the junior most tranches? Interest Only tranches? What? Either way, I understand that some of these bondholders will get screwed because, well, the various risk management premiums and safeguards were either insufficient to protect them, or poorly structured to begin with. But again, that doesn’t mean that all the troubled assets are worthless and have no value. It actually doesn’t even mean that these lower valued (what you refer to as worthless) tranches can’t be profited from by a new purchaser (the government). The original bondholder will get screwed, of course, since he/she/it won’t make back what was paid in the first place. But that’s their position right now. If a new buyer steps into place and gets the securities for a bargain price (considering the extremely high risk), then the potential for profit has been reborn. The new buyer could still lose, but not as much as the original buyer. The point is, there is still some value there for a new purchaser, and the purchase price will increase the asset side of the ledger for the distressed company.
Therefore they should carry a large discount. If they didn’t, why would any buyer in their right mind buy them?
Agreed on the large discount, but remember that the buyers are not in their right mind. There’s a great deal of panic going on between uncertainty as to the stability of any particular company (much less one’s own), and with what the government is going to do, if anything. IMHO, nothing quells natural market activity more than the biggest elephant in the room stomping around looking for peanuts and threatening to rearrange the room in the process.
It is exactly like the game I describe in which we roll a 6-sided die and you win $1 if it comes up 1,2,3,4, or 5 and you lose your whole bank account if it comes up a 6. If house prices stay close to where they are today, that is like rolling a 1,2,3,4, or 5, and the bailout will show a profit, of perhaps tens of billions. On the other hand, if house prices fall another 30 percent, the $700 billion will be pretty much wiped out.
I think that’s a pretty good analogy. But if things are really so bad that we can’t even glimpse the bottom yet, then (a) it doesn’t really matter much what the government does right now (i.e. we’re phucked), and (b) it’s awfully suspicious that Buffett is making big moves into the market, and people like Soros and Cuban are threatening to.
I’ll be more daring than he, this is almost certainly a ginormous money loser. The securities the government purchases will mostly make reasonable returns if we pay above mark to market rates, the ones that fail will wipe out all those profits and more under the housing prices fall another 10-15% scenario. The distribution of risk in these securities is very lumpy. For short options that is a very bad characteristic.

If they fall more than that we will lose everything. I am not optimistic that prices will be limited in many markets to only 10-15% more downside. Remember that if most of the country actually rises, but substantial price declines continue in other places, we lose huge amounts on them and only get interest on the winners. That is how these suckers are structured. They are not bonds and the market is not underpricing them on average when adjusted for risk.
Maybe so, but where would be without me playing bull to your bear ;)
 
Written By: MichaelW
URL: http://qando.net
how all of the MBS (which are being valued at $0 on the books) don’t retain at least some value.
Sorry, I guess I was unclear. They are not all being valued at zero, not even close. If that were true everybody would already be toast. It is actually much like the example I posted before, where the troubled assets are about 5% of the portfolio, marked down about 40%.
they are in fact called "bonds" and just because they carry more risk relative to traditional bonds, that doesn’t make them work any less like bonds.
CDO’s for example are not bonds, at least as we have generally understood them. They do not work like bonds. They in fact behave much more like equities (in fact, most of the worst tranches held on bank books is called the "equity tranche.") Many of those are at zero and will not receive any payment. There is no payment stream. Many of the tranches are very unlikely to receive anywhere near the expected payment stream.
But the assertion that these MBS have no value whatsoever I believe is very wrong.
As I said, that is not the situation or the argument. Maybe some people are claiming that, but I assure you that that has no bearing on my analysis, nor are these institutions unable to sell these securities at some price.

In fact, many are being held on their balance sheets at well above market value now, especially at banks which have the ability to do so for some time as long as they can claim they plan to hold them for a long time. In the banks case the issue is that they are having a harder and harder time justifying not marking these assets down as the payments are definitely going to be impaired, and regulators are rightly suspicious they are just hiding the losses.

If a new buyer steps into place and gets the securities for a bargain price (considering the extremely high risk), then the potential for profit has been reborn. The new buyer could still lose, but not as much as the original buyer. The point is, there is still some value there for a new purchaser, and the purchase price will increase the asset side of the ledger for the distressed company.
That is exactly right. That price that the new buyer right now wants is the market price. The banks and other institutions don’t want to do that because then they have to mark down that lower price on their balance sheet and they know it will be ugly.

IMHO, nothing quells natural market activity more than the biggest elephant in the room stomping around looking for peanuts and threatening to rearrange the room in the process.
Absolutely. In fact, one of the reasons (and Dale has pointed this out) that banks are refusing to mark the assets down or sell them is that they think they can get a better price from the government.
it’s awfully suspicious that Buffett is making big moves into the market, and people like Soros and Cuban are threatening to.
As noted before, I think we should be doing what Buffett is doing. He is not buying the assets, he is supplying capital at a very steep price. There is plenty of value if people are willing to sell at market prices. The problem is the institutions don’t want to do so.

Hmm... Maybe I should do a post on exactly how these things work, because understanding how an equity tranche and other aspects of this works is one of the keys to this whole deal.

These are good questions Michael, and I am sorry Wall Street has made things so complicated that normal ways to look at this do not work very well. The market isn’t out of its mind actually. The prices on these securities fell long before this panic. The panic is because the effect of them falling is so dire. They originally fell because they deserved to fall.

Maybe so, but where would be without me playing bull to your bear ;)
I would guess that I will not be bearish that much longer. My ten years as a bear may end much sooner than I expected if the market keeps falling at this rate. Besides, how has being a bull worked out fer yah! ;^)
 
Written By: Lance
URL: http://asecondhandconjecture.com
Sorry, I guess I was unclear. They are not all being valued at zero, not even close. If that were true everybody would already be toast. It is actually much like the example I posted before, where the troubled assets are about 5% of the portfolio, marked down about 40%.
OK, well that’s my misunderstanding then. From what I’ve been reading these assets were already be marked at or close to $0 thus putting the companies into distress.
CDO’s for example are not bonds, at least as we have generally understood them. They do not work like bonds. They in fact behave much more like equities (in fact, most of the worst tranches held on bank books is called the "equity tranche.") Many of those are at zero and will not receive any payment. There is no payment stream. Many of the tranches are very unlikely to receive anywhere near the expected payment stream.
Ah, I didn’t realize you were referring to CDO’s. I’m assuming that the "equity tranche" is basically the same as with MBS in that they are the first to be wiped out? Also, if I understand correctly, aren’t credit default swaps a big part of CDO’s, and where a good source of the problem lies in the current problems? How does that fit into the analysis?
The banks and other institutions don’t want to do that because then they have to mark down that lower price on their balance sheet and they know it will be ugly.
Again, I think this was my misunderstanding in that I was under the impression the banks would be getting something whereas on the books they had nothing.
As noted before, I think we should be doing what Buffett is doing. He is not buying the assets, he is supplying capital at a very steep price. There is plenty of value if people are willing to sell at market prices. The problem is the institutions don’t want to do so.
Yeah, I agree that creating/facilitating a market for these things is the best plan.
Besides, how has being a bull worked out fer yah! ;^)
Well, it’s easy being bullish when you got out of the equities market a year and a half ago and put everything into speculative real estate and money markets ... wait ... D’OH!
 
Written By: MichaelW
URL: http://qando.net
I’m assuming that the "equity tranche" is basically the same as with MBS in that they are the first to be wiped out?
Yes. But it is actually worse. I’ll put something up on this with illustrations this evening, but imagine a pool of various MBS and other types of debt instruments lowest rated tranches combined together. In essence you take the BBB tranches and make a super MBS like vehicle. It now has a AAA tranche and then lower rated tranches below that. So, you take the worst part of an MBS and turn it into AAA! How cool is that. Lead into gold, financial alchemy and it worked just as well. Now imagine what the equity (BBB) tranche of that is risk wise.

Since nobody wanted the unrated "equity tranche" guess what the securitizers kept on their books? Ta Da! Instant massive losses in any downturn of the housing market.

Now to normal human beings such as us, the idea that you could take the riskiest part of an MBS subprime tranche, combine it with scores of other similar tranches, and turn even the highest rated tranche of such toxic waste into anything but a risky investment seems quite astounding. That anyone would buy the lower rated tranches or count it as an asset even more so, but we lesser mortals know nothing compared to the masters of the universe.

Their models said that by being diversified with thousands of underlying mortgages, spread across the country geographically that the CDO’s were nevertheless safe. Their models based on efficient markets and all kinds of academic whiz bangery figured that the real estate market could not be that overpriced and the actual levels of defaults of even subprime would be very low and only strike localized areas at any one time. The number of faulty assumptions was pretty dang high, but that is the gist of it.

The upshot, even the AAA rated tranches have been seriously impaired or wiped out, lower rated tranches have suffered horribly as well needless to say.

So, going back to my 600 billion in assets at Lehman, you don’t need many of these kinds of things in your portfolio with gross leverage of 30-1 to leave you bankrupt.
 
Written By: Lance
URL: http://asecondhandconjecture.com
Also, if I understand correctly, aren’t credit default swaps a big part of CDO’s, and where a good source of the problem lies in the current problems?
Kind of.

Credit Default Swaps (CDS) were written against many CDO’s to protect banks against default. They act as insurance. The problem, will the other person pay up? Possibly not because they were busy writing other CDS to protect them against having to pay up, that guy was doing the same and on and on. That is how you get $55 Trillion or whatever in CDS’s which is larger than the entire worlds GNP. So, if you take out a claim everybody starts settling up. Sadly, everyone of these people is claiming their CDS as an asset. If anybody in the chain cannot pay it screws everybody. Poof, multiples of the original piece of toxic wastes par value disappears from various peoples balance sheets. Realize that in many cases the CDS was accepted without any collateral or reserves from the counter party. For example a hedge fund that wrote a number of these far in excess of their underlying capital which may itself be in illiquid investments.

It gets worse. Who is the counterparty to just about everybody? The banks. So yeah, you paid for a CDS to protect you, but you are also receiving payments to protect somebody else’s toxic waste. Fine if only some of these things go bad, but if everybody is underwriting everybody else and all the CDO’s are getting stressed at the same time, how are you protected? You just owe the other guy and he owes you. thus nobody is protected and everybody has paid tons of fees to accomplish nothing. If somewhere in the daisy chain of CDS underwriters somebody cannot payoff, then kablooey, we have chaos.

A good example of that is AIG which was huge into underwriting CDS’s. Especially to Europe. Because they were a AAA rated company nobody bothered to require they hold any reserves for these things. Stupid, but that is what our brightest eggs did. Therefore, when the bills started coming due AIG was up a creek. They would have set up the biggest daisy chain of writedowns on assets imaginable across the world, and most importantly in Europe which is leveraged to the hilt and has banks disguising it by claiming these CDS’s as assets.

And just think, according to Bithead, the CRA required investment banks to create these structures in such a stupid way, rate them AAA, and trade CDS’s with no required reserves between themselves while employing gross leverage ratios of 20, 30, 40 or more. To not lever these things up and do all those things would get you called racist. Don’t you see the connection? They have no responsibility for this at all so we should bail them out.
 
Written By: Lance
URL: http://asecondhandconjecture.com
Credit Default Swaps (CDS) were written against many CDO’s to protect banks against default. They act as insurance.
Right, I know that part. But I read somewhere that there are a bunch of CDO’s that were essentially just CDS. Or maybe those were CMO’s? Hmmm ... I’ll have to find where I got that from and get back to you.
 
Written By: MichaelW
URL: http://qando.net

 
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