brainsmile

Here's some statements I've been hearing around the press lately...

>the value of un-collateralized insurance policies issued to Hedge Funds and Investment Banks regarding the worth of Mortgaged Backed Securities

First off, there is no such thing as an un-collateralized insurance policy. All insurance companies back their guarantees with the value of their general account (i.e. all non-segregated assets the firm has). As such they are "collateralized". Now it is the case that the term "collateralized" when used amongst derivative traders has a different meaning. In deriv land, "collateralized" is generally understood to mean that there is an existence of a mark-to-market segregated account backing that guarantee/contingent claim. Financial insurers (MBIA, AMBAC, some business units of AIG, etc.) have guaranteed/insured various assets using either method. Although market participants generally believe that the latter method provides better security against the insolvency of the insurer, neither method provides bullet proof protection against an insurer failing to perform. Thus the value of any such guarantee can not thus be determined without looking at the contract that the insurer wrote and the examining the collateral provided to back the guarantee.

However some generalities can be made. Those insurers that provided mortgage insurance on individual loans when the borrower took out a loan in excess of 80% of home value (ex. PMI, Radian, etc.) would be making guarantees out of their general account. Those guarantees are virtually worthless at this point in time. The primary insured parties (creditors to those insurers) would be Fannie Mae and Freddie Mac, which in turn due to their nationalized status, means the general taxpayer is on the hook. For those insurers that guaranteed MBS and leveraged loan CDO debt (MBIA, Ambac, AIG, etc.), those guarantees were typically done via a derivative contract. Thus the insurer would have been required to post segregated collateral as those debt instruments tanked. However most insurers received waivers to avoid posting collateral since they did not have the wherewithal to do so and forcing them to attempt to do so would have resulted in their immediate liquidation. Consequently these guarantees are also viewed as worthless by market participants at this time. The primary insured parties (creditors to the insurers) were large domestic and international banks. The last large category of financial guarantees w.r.t. mortgages would be those insurers that provided "wrap guarantees" on private label mortgages (usually 2nd lien pools). Most of that stuff is also considered worthless at this stage and the affected securities trade at the backstop value of the underlying loan collateral.

>at least one in ten mortgages are in default/foreclosure/or in threat of foreclosure.

Actually this is not true. I don't doubt that you saw this somewhere, but reporting on this issue, even by the financial oriented press is at a very low level of accuracy. Total mortage delinquincy on 1st liens in the US is running at about 8%. If we throw in the value weighted impact of 2nd liens, I don't doubt that it could push the average up to 10%. But still that is delinquincies, not foreclosures. Depending on the state where the home is located, foreclosure procedures would not commence until the loan has been delinquent 6-12 months. If we look at the delinquincy stack, most delinquincies will be of the 30 day (one missed payment) or 60 day (two missed payments) variety. Thus the % truely in foreclosure proceeding is probably less than 3%. Unfortunately this is both a good news and bad news situation. It's good since the current number is lower. It's bad because 30 day delinquent loans are the feedstock, if you will, for 60 day delinquent loans. Which in turn are the material from which 90 day delinquent loans are "made". Put another way, todays foreclosures were the bad performers from last year's 60 day delinquent loans. Next year's foreclosures are the bad performers from today's 60 day delinquent loans. And the raw $ amount of this year's 60 day delinquent loans is far greater (more than 2x) that last year's 60 day delinquent loans. Simple extrapolation (which of course may be wrong) would thus point to higher foreclosures in the future. Those who argue that we have seen the bottom of the housing market should take note.

>I know where $165 Billion in taxpayer bailout funds were funneled.

Sorry, but I'm going to have to disagree. Money is fungible. That money went into large pools, buckets, rat holes, whatever. Those pools were also receiving money from many other sources. The pool then distributed money to many different entities. Saying that specific TARP dollars went to specific functions is like saying that all of my individual tax dollars went to buy 20mm mini-gun rounds and directly killed 12 civilians in Afganistan.

What I will say is that IF you take money from the US government, then you becomes accountable to the government in exactly the same way as you would to an investor from whom you raised capital in a share offering. When a corporation raises money in a share offering they are required in the offering circular to state what the money will be used for. Now, yes they lie half the time. But still they're required to state the use, and investors can query them on the use PRIOR to the transfer of funds. The fact that no such conditions were placed on the receipt of TARP funds indicates two things:

1) Those receiving the funds were going to have a higher % chance of doing things that in retrospect were "undesirable"

2) The investor (the US government) was a rank amateur. This is why the gov't should not be in the business of being in business. They will get ripped off every single time.


>Back in November 2007, everyone was saying banks and brokerage firms are not great stocks to hold

Back in 1991 everyone said bank stocks were horrible (this was in the middle of the 3rd World debt fiasco). It was actually a great time to buy. In 2007 everyone said sell bank stocks. And they were right. What does that teach us? That sometimes conventional wisdom is right. And sometimes its wrong. Doh. If markets were easier to predict, every pundit would be rich instead of trying to convince people he(she) called the market turn and should therefore get a speaking fee and appear on a TV show.

>If we were able to see the bank industry falling, why couldn't we see the current market situation?

Frankly I'd argue that the whole thing was predictable even before Nov '07. A friend of mine was the head of MBS research at a now defunct Wall Street firm came to visit back in, musta been early '06. He came to talk about a new model he had built that predicted delinquency & defaults on option ARMs, ARMS where the balance owed tends to increase over time (by about 3% a year at that time). A lot of math, statistics, etc. His model showed that if the average (over the previous few years) increase in nationwide home prices which was also about 3%/yr, stopped and home prices were stagnant, then delinquencies would about double. I was flabbergasted. I then said, OK, I can extend that and for normal new mortgages (where the balance is essentially static), if nationwide home prices decline by 3%/yr, the ratio of loan to home value will about correspond to that for option ARMs in your scenario, so I'd predict that delinquencies would also about double. We both sat there for a while in silence dumbfounded by what we had each said. Later that year my friend had to testify in front of a Senate subcommitte where they basically ripped him a new one for all the "risky" mortgages financial firms had created so homeowners could borrow more money. He didn't create IO mortgages or options ARM mortgages, and I wouldn't even blame the person who did. The person who did simply gave about 30 million Americans the ability to borrow more. But he did not give them the common sense to act correctly with that new freedom. Did people blame BMW for making the 504 horsepower M5 after some kids flew it off an embankment at the end of an airport runway in Florida a couple years ago, killing all 4 passengers? Needless to say national home prices have fallen by a lot more than 3%, and delinquencies have about quadrupled since early '06, with more yet to come. My friend's model actually worked pretty darn well. But truth be told, even though that info was right there in front of us, we didn't believe it. Even those of us such as my friend and I who were specialists directly in those instruments, we just refused to believe it. Why? See the answer to #1 above. If conventional wisdom can be both right or wrong, then unconventional wisdom can with even more variance be right or wrong. And that was such an unconventional prediction, you might as well have predicted that Lehman Brothers would default and pay unsecured creditors pennies on the dollar. And sadly of course that would have been correct as well.

For those of us directly involved in these instruments, I'd say that the end of 2Q '07 is when people realized it was all dust. But everyone outside our sector pooh-poohed the notion that anything other than subprime mortgages or maybe mortgages generally would be impacted. I can remember tons of corporate credit people yakking away at how the LBO market would be unaffected. It was around that time that some mortgage people realized they should short the hell out of corporates. At every step along the way since then more and more people/institutions who steadfastly maintained that they were unaffected have been sucked into the maelstorm.

And the reason is that its not about subprime. It's not even about "frozen credit markets" the most overused buzz phrase of the decade. Policy makers talk about freeing up credit markets so banks can lend more. That's not the problem. Then problem is that American consumers, American corporations and American governments (fed, state and local) borrowed TOO MUCH, not too little. Taken as a whole American consumers/corps/gov't have spent about 105% of their income for the last few years. They did that by borrowing money. They were able to borrow money because the most sophisticated debt market mankind has ever seen allowed them to borrow money based on their rising future income. But when their income did rise, what did they do? Did they pay off their debt? No, they borrowed even more based on supposedly even higher future income to come. That has now come to a crashing halt. US entities will need to adjust to a new scheme where they spend perhaps 90% of income. Even that figure is crazy large given the size of individual/corp/gov't debt loads. But it needs to happen. That is why the current gov't stimulus plans are doomed to fail. Those plans aim to get people to spend more. As I have said the problem isn't that they spend too little, its that they spend too much. I know someone about now is dying to launch into a broad Keynesian argument. Save it. I'm a neo-Keynesian. Berkeley econ, remember? But the Keynesian argument to jack spending is the solution for a problem where the economy is below equilibrium GDP. What if US GDP circa 2007 was ABOVE equilibrium GDP?! Above it precisely because spending was temporarily and unsustainably, at 105% of income. Then even neo-Keynesians will acknowledge that GDP must fall and attempts to stimulate through fiscal spending will fail and simply increase inflation.

>What would you do to fix it?

70 years ago this country suffered a significant drop in GDP. Although some attempts were made to stimulate the economy through government spending, basically individual Americans just gutted it out. For people who doubt that, check out the 1937 decline in GDP, the recession within the depression that came AFTER the big increases in gov't spending. Americans gutted it out, didn't blame others and took responsibility for their own situation. 15 years later the US was stronger than ever. Perhaps the same thing will happen this time. Perhaps it will only take 5 years. Or maybe 5 months. Who knows? Conventional wisdom, blah, blah, blah and all...

Frankly I don't worry too much about whether the recovery takes 5 months, quarter, years or more. I worry about bigger picture stuff. The US reacted a certain way to the Depression. But not all countries did. In Germany, rather than taking responsibility for their own situation, they started blaming others. Seven years later Hitler came into power. I don't think I need say any more about that series of events. What worries me is that present day American society has a heavy tendency to look for someone to blame. Where is the brave American politican who dares to say, "Fellow Americans, you borrowed way too much money. You're going to have to stop spending"? He'd be on the unemployment line.

>And how much lower can we go?

Assuming overall US spending drops from 105% of income to 90%, you are looking at around a 15% drop in GDP. That's with NO multiplier effect. Over time as debt loads are reduced, spending can probably trend back up to 95% of income (stupidly high IMO, but oh well...) such as prevailed throughout much of the 1990s. But there is a LOT of debt to be repaid. Very few market participants have priced in a 15% or even a 10% decline in GDP. Median economist estimates are probably in the 4-6% range for peak to trough GDP decline. Make of that what you will. If anyone knew for certain what was going to happen they wouldn't be chatting about it.

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DCM #1 (Founder)





"Nobody beats Vitus Gerulaitis 18 times in a row." - Vitus Gerulaitis on beating Jimmy Connors after 17 failed attempts.