A Beautiful Model for Fraud

Take a look at this:

A Beautiful Model for Fraud and here is the accompanying article:

The great credit unwind of '08.

Domino Theory

Back in February, I posted on of Mark Heard's songs One of the Dominoes. From the song:

Heaven help a seeker of truth
In an age of lies
Gonna make himself believe
That the truth is whatever he buys
Gonna buy what the world says to buy
In a monotone
Gonna cry when the whole world cries
And the truth is known

Heaven heaven help me
I'm one of the dominoes
Chain reaction coming
Blow by blow

Some economic blog commentators that I read have been mentioning a kind of economic "Domino Theory" of their own. A series of cascading financial failures through derivatives and debt instruments that will lead to potentially horrific economic losses. I'm not sure I'm smart enough to understand all this stuff. I'm trying to educate myself on macroeconomic theory and wade through the complexities. Hopefully, I've made the right decisions.

Heaven heaven help me. I'm one of the dominoes.

New "Elephant" Oil Field Discovered in Brazil

From Business Week:

Petrobras announced Nov. 8 it has found between 5 billion and 8 billion barrels of light oil and gas at the Tupi field, 155 miles offshore southern Brazil in an area it shares with Britain's BG Group and Portugal's Galp Energy. Tupi is the world's biggest oil find since a 12 billion-barrel Kazakh field was discovered in 2000, and the largest ever in deep waters. Perhaps more important, Petrobras believes Tupi may be Brazil's first of several new "elephants," an industry term for outsize fields of more than 1 billion barrels.

Initially, Tupi will produce about 100,000 barrels a day but may ramp up to as much as 1 million before 2020—more than the biggest U.S. field in Alaska's Prudhoe Bay, says Hugo Repsold, Petrobras' exploration and production strategy manager. "It's monstrous," says Matthew Shaw, a Latin America energy analyst at consultant Wood Mackenzie in London.

The oil industry is known for its "boom and bust" cycles. There is little doubt that the high oil prices are fueling the current boom. Although the article touts that this kills the idea of "peak oil," in reality it doesn't completely disprove the theory. The real idea of peak oil -- as I understand it -- is that oil will become increasingly expensive to extract.

Furthermore, the increasing use of hydrocarbons produce other environmental challenges due to the pollutants its use creates. These costs are externalities and cannot easily be quantified.

The high oil prices will also spur investment and study into alternative sources of energy. This will also reduce demand for oil as these alternative energy sources come into use. So far, the biggest impediment to alternative energy uses has been the NIMBY problem and (up to now) relatively large start-up expense. The latter issue is quickly resolving itself; what remains is to convince the public that some scenic views may have to be sacrificed, and (in the case of nuclear energy, if needed) that disposal of nuclear waste will have to be effected.

At some point, we will need to consider public financing of infrastructure to support the alternative energy sectors. I would find an analogy in the creation of railroads and highways. The real problem is how to avoid the problems of the past, namely: private profits underwritten from the socialization of costs.

Debt Bomb

From CNN Money's The $915B bomb in consumers' wallets:

(Fortune Magazine) -- This past summer's subprime meltdown involved about $900 billion in now-suspect securitized debt, reckless lending, and consumers who buckled under the weight of loans they couldn't afford. Now another link in the consumer debt chain - credit cards - is starting to show signs of strain. And the fear that the $915 billion in U.S. credit card debt (an uncannily similar figure) may blow up has major financial institutions like Citigroup, American Express, and Bank of America strapping on their Kevlar vests.

...

The doomsday scenario would play out something like this: Just like CDOs and other asset-backed securities, credit card debt is sliced, diced, and sold off again as packages of securities. Rising delinquencies would hurt not only the banks involved but the securities backed by the credit card receivables. Those securities would decline in value as consumers defaulted, leading to bank losses as well as portfolio losses in the hedge funds, institutions, and pensions that own the securities. If the damage is widespread enough, it could wreak havoc on the economy much as the subprime crisis has done.

To be sure, there are key differences between the subprime market and the problems brewing with credit cards. The first is that while rising mortgage delinquencies were apparent for months before the subprime market blew up, credit card delinquencies are actually coming off unusually low levels.

...

But credit card debt is different from subprime debt in another way: Unlike mortgages, credit card debt is unsecured, so a default means a total loss. And while missed payments are at a historical low, they show signs of an uptick: The quarterly delinquency rate for Capital One, Washington Mutual, Citigroup, J.P. Morgan Chase, and Bank of America rose an average of 13% in the third quarter, compared with a 2% drop in the previous quarter.

...

If there is an international precedent the U.S. should be watching, it's actually that of the U.K. British consumers are just as overstretched as Americans, but since the real estate market there rose faster and fell earlier, they're about 18 months ahead in the credit cycle. Since the last quarter of 2005, credit card delinquencies and charge-off rates in Britain have risen as much as 50%, forcing banks to take huge write-offs.

It's a sign of the times that, according to one survey last month, 6% of British homeowners have been using their credit cards to pay their mortgages. That's suicidal, of course, given that credit card interest rates are more than double even the heftiest mortgage. Keep your fingers crossed that it's not a trend that crosses the Atlantic.

That doesn't sound good. At. All.

The T.V. pundits tell us that the housing meltdown is not the entire market. But let's see: so far we have seen a problem in:

1. An almost nationwide mortgage and housing meltdown; and

2. Credit card delinquency rates rising and interest rates and fees rising; and

3. Fuel, food, health care and education costs rising far faster than "core" inflation; and

4. A rapidly falling dollar; and

5. Drought in much of the country and flooding in others; and

6. Wages and social security payments not keeping up with inflation; and

7. A crumbling infrastructure (bridges failing and bridges to nowhere).

The credit problems are not the economy. It's just the tip of it.

We're All Subprime Now

Today, blogger Tanta, who writes for Calculated Risk, today wrote about predatory practices in the mortgage industry in HMDA Data on High Priced Loans. A clip:

This whole dynamic may be hard for the WSJ and its fellows in the Big Paid Media, so let me explain this very clearly. In 1975, some folks accused lenders of redlining, which means not granting credit at all to some people. The lenders said they weren't doing that. Congress passed HMDA, and then there was actual data about geographic lending patterns to analyze instead of anecdotes. Once we got some HMDA data under our belts, the Community Reinvestment Act came into being (in 1977) precisely because it was clear that redlining had been going on. CRA in essence forces lenders to show that they are willing to make loans in neighborhoods in which they are willing to take deposits (i.e., those deposits need to be "reinvested" in the neighborhood they came from in the form of loans, not just mortgage loans, to that neighborhood. You can't extract deposits from poor people and use them exclusively to fund loans to rich people.) CRA does not mandate price levels, or even address the question of price levels.

You may be surprised to hear this, but over time accusations of discriminatory lending practices did not go away. In a number of cases, "mystery shopper" tests were performed, in which a white applicant and a black applicant each applied for credit at the same instutition with identical credentials (employment, income, credit history, loan terms), and the results showed that black applicants were more likely to be turned down. This cast some doubt on the lenders' claims that loan rates in minority neighborhoods were a function of the lower credit quality of those borrowers. That became a hypothesis in need of some testing, you see, not an accepted explanation.

So the 1989 revision to HMDA forced collection of demographic data, for the precise purpose of testing the assumption that poor and minority people are just always bad credit risks. This resulted, as you might expect, in conjunction with CRA and other fair lending laws, in much higher rates of home mortgage lending in those areas that were once redlined.

But were these poor and minority people happy, at last? Why no, they weren't. Turns out, anecdotal evidence began to emerge that while these good people were finally getting loans, they were getting them at much higher interest rates than higher-income folks and whites generally got, and that this could not be accounted for by the difference in creditworthiness of the borrowers or the quality of the collateral (the latter proxied by census tract).

...

The bottom line is, as [Calculated Risk] notes, that "high-risk" lending was everywhere in the boom years. Of course there is a desire to collapse it all into the easy category of "subprime." And there has for a long time been a lot of political pressure to keep the association of "subprime" and "urban minorities" in place, because it has functioned as a good excuse for the subprime lenders (they "help" the poor and minorities, remember?). My view is that a whole lot of parties are very interested in maintaining rather than seriously analyzing a lot of faulty assumptions about risk, rates, and borrower credit characteristics. If this ain't "just a subprime problem," then an entire debt-based economy in which even the middle and upper middle class cannot afford homes given [real estate] inflation and wage stagnation is suddenly in question. The last thing certain vested interests want to hear is that, basically, "we are all subprime now."

My favorite comments:

At least then, when they say the problem is contained to subprime, they'd be correct.
daveNYC | 10.11.07 - 10:47 am |


What about the revelations coming forward that a lot of these sub-prime loans were to people who would/could /should have qualified for prime loans. My gut feeling is that the lending industry realized that there was more money to be had in the sub-prime market and rationalized the use of the product by telling borrowers your can always refinance. So while I can see the possibility that we are all becoming sub-prime candidates because of high LTV due to lack of down payments or low rates to buy the MacMansion, I cant help but feel it was the lenders looking to sack the borrower for higher fees and on top of that being bale to book unrealized profits from the fully adjusted loans. Now there is a racket!!
formerly known as... | 10.11.07 - 11:41 am | #


Down where the rubber met the road, '04-06 subprime was a broker-dominated and refinance-oriented business. Those brokers tend to chase after big fish. Which would you rather do? ONE loan for a cardiologist with a bunch of lates thanks to the ex-wife or TEN deals involving city bus drivers with gambling problems, immigrant cleaning ladies with thin credit files, single moms with three jobs, dancers with cash wages and voracious drug habits? - oh, wait, that's alt-a - anyhow, you get the gist. It's not that subprime was ever AIMED at low-income - quite the contrary - it's just that median income of those with impaired credit happens to lower.
Shnaps Parlor

The last paragraph raises an interesting point. We have been told that FICO scores are not related to race, sex or economic status. However, it is also true that women, minorities and lower-income individuals not only have less economic power as a group, but also are at a greater risk that the above examples and medical problems/debt are more likely to adversely affect their ability to pay their bills. Hence, lower credit scores.

The end result is that it contributes to the disparity between the wealthiest (who have the highest credit scores, due to the ability to weather unexpected expenses, and therefore who borrow at lower interest rates), and the poor (whose credit scores crash after one adverse event and have to borrow at higher interest rates). (BTW: I have been meaning to write about how banks charge fees on small balances that can quickly sap wealth from poor patrons.)

The answer is to provide social insurance on some costs (medical debt and education) and living wages that allow for even the poorest to save for the future. There are some costs which cannot be defrayed: rent, electricity and natural gas, food, transportation and personal hygiene. Even the lowest wage should be enough to cover these costs and provide enough to save for the future.

Introspection

From a link over at Sudden Debt, I found this quote today at TheStreet.com:

While many pros have been spending their time telling us why this market can't possibly continue to be so strong, the foolish bulls who harbor no doubts have been racking up some great profits. With the credit problems, slowing economy, real estate meltdown, high oil and weak dollar, it has been very easy to make a strong case that this market will likely crack and start downtrending. The logic is compelling but for one very important fact: prices keep going up. For whatever reason, buyers continue to buy.

I always worry about the fact that we have a tendency to be so stuck on our biases and preconceptions of how things are and how things work that we fail to see other truths beyond our scope of vision. In this Information Age, we are prone to congregate with like-minded people. As a result, we reinforce each others beliefs. However, because we think so much alike, we fail to take into consideration entire chunks of information outside of our predispositions.

I have generally been in the bearish camp in economic matters. I have thought that the amount of debt that is outstanding is unsustainable at either a personal or national level. However, I come to the table with my own bias of having been a bankruptcy attorney and having a series of tragic incidents color my judgment. But now that my luck is starting to change, I am starting to wonder if such beliefs will prevent me from maximizing my opportunities.

Let me make it clear: I still think I am right, but I am open to other information that would change my bias.

Alarming Parallels

An anonymous commenter over at Sudden Debt has alerted me to an article in The American Prospect entitled The Alarming Parallels between 1929 and 2007.

Testimony of Robert Kuttner
Before the Committee on Financial Services
Rep. Barney Frank, Chairman
U.S. House of Representatives
Washington, D.C.
October 2, 2007

Mr. Chairman and members of the Committee:

Thank you for this opportunity. My name is Robert Kuttner. I am an economics and financial journalist, author of several books about the economy, co-editor of The American Prospect, and former investigator for the Senate Banking Committee. I have a book appearing in a few weeks (The Squandering of America: How the Failure of Our Politics Undermines Our Prosperity) that addresses the systemic risks of financial innovation coupled with deregulation and the moral hazard of periodic bailouts.

...

Although the particulars are different, my reading of financial history suggests that the abuses and risks are all too similar and enduring. When you strip them down to their essence, they are variations on a few hardy perennials -- excessive leveraging, misrepresentation, insider conflicts of interest, non-transparency, and the triumph of engineered euphoria over evidence.

The most basic and alarming parallel is the creation of asset bubbles, in which the purveyors of securities use very high leverage; the securities are sold to the public or to specialized funds with underlying collateral of uncertain value; and financial middlemen extract exorbitant returns at the expense of the real economy. This was the essence of the abuse of public utilities stock pyramids in the 1920s, where multi-layered holding companies allowed securities to be watered down, to the point where the real collateral was worth just a few cents on the dollar, and returns were diverted from operating companies and ratepayers. This only became exposed when the bubble burst. As Warren Buffett famously put it, you never know who is swimming naked until the tide goes out.

...

A second parallel is what today we would call securitization of credit. Some people think this is a recent innovation, but in fact it was the core technique that made possible the dangerous practices of the 1920. Banks would originate and repackage highly speculative loans, market them as securities through their retail networks, using the prestigious brand name of the bank -- e.g. Morgan or Chase -- as a proxy for the soundness of the security. It was this practice, and the ensuing collapse when so much of the paper went bad, that led Congress to enact the Glass-Steagall Act, requiring bankers to decide either to be commercial banks -- part of the monetary system, closely supervised and subject to reserve requirements, given deposit insurance, and access to the Fed's discount window; or investment banks that were not government guaranteed, but that were soon subjected to an extensive disclosure regime under the SEC.

Since repeal of Glass Steagall in 1999, after more than a decade of de facto inroads, super-banks have been able to re-enact the same kinds of structural conflicts of interest that were endemic in the 1920s -- lending to speculators, packaging and securitizing credits and then selling them off, wholesale or retail, and extracting fees at every step along the way. And, much of this paper is even more opaque to bank examiners than its counterparts were in the 1920s. Much of it isn't paper at all, and the whole process is supercharged by computers and automated formulas. An independent source of instability is that while these credit derivatives are said to increase liquidity and serve as shock absorbers, in fact their bets are often in the same direction -- assuming perpetually rising asset prices -- so in a credit crisis they can act as net de-stabilizers.

A third parallel is the excessive use of leverage. In the 1920s, not only were there pervasive stock-watering schemes, but there was no limit on margin. If you thought the market was just going up forever, you could borrow most of the cost of your investment, via loans conveniently provided by your stockbroker. It worked well on the upside. When it didn't work so well on the downside, Congress subsequently imposed margin limits. But anybody who knows anything about derivatives or hedge funds knows that margin limits are for little people. High rollers, with credit derivatives, can use leverage at ratios of ten to one, or a hundred to one, limited only by their self confidence and taste for risk. Private equity, which might be better named private debt, gets its astronomically high rate of return on equity capital, through the use of borrowed money. The equity is fairly small. As in the 1920s, the game continues only as long as asset prices continue to inflate; and all the leverage contributes to the asset inflation, conveniently creating higher priced collateral against which to borrow even more money.

The fourth parallel is the corruption of the gatekeepers. In the 1920s, the corrupted insiders were brokers running stock pools and bankers as purveyors of watered stock. 1990s, it was accountants, auditors and stock analysts, who were supposedly agents of investors, but who turned out to be confederates of corporate executives. You can give this an antiseptic academic term and call it a failure of agency, but a better phrase is conflicts of interest. In this decade, it remains to be seen whether the bond rating agencies were corrupted by conflicts of interest, or merely incompetent. The core structural conflict is that the rating agencies are paid by the firms that issue the bonds. Who gets the business -- the rating agencies with tough standards or generous ones? Are ratings for sale? And what, really, is the technical basis for their ratings? All of this is opaque, and unregulated, and only now being investigated by Congress and the SEC.

Yet another parallel is the failure of regulation to keep up with financial innovation that is either far too risky to justify the benefit to the real economy, or just plain corrupt, or both. In the 1920s, many of these securities were utterly opaque. Ferdinand Pecora, in his 1939 memoirs describing the pyramid schemes of public utility holding companies, the most notorious of which was controlled by the Insull family, opined that the pyramid structure was not even fully understood by Mr. Insull. The same could be said of many of today's derivatives on which technical traders make their fortunes.

...

A last parallel is ideological -- the nearly universal conviction, 80 years ago and today, that markets are so perfectly self-regulating that government's main job is to protect property rights, and otherwise just get out of the way.

...

One last parallel: I am chilled, as I'm sure you are, every time I hear a high public official or a Wall Street eminence utter the reassuring words, "The economic fundamentals are sound." Those same words were used by President Hoover and the captains of finance, in the deepening chill of the winter of 1929-1930. They didn't restore confidence, or revive the asset bubbles.

The fact is that the economic fundamentals are sound -- if you look at the real economy of factories and farms, and internet entrepreneurs, and retailing innovation and scientific research laboratories. It is the financial economy that is dangerously unsound. And as every student of economic history knows, depressions, ever since the South Sea bubble, originate in excesses in the financial economy, and go on to ruin the real economy.

That is a lot of parallels to think about; and they are alarming parallels at that.

Securitization

Today, over at Sudden Debt, an anonymous commenter named Bernard left a comment on the post A Tale of Two Recessions:

Under the Basel Accord for every $100 of AAA securitized assets, a bank need only hold $0.60 of equity, to back up that debt. The theory is AAA assets are among the highest rated and thus the risk of default is virtually nil. However, for every BBB securitized asset, a bank would have to hold almost $5.00 of equity for every $100.

Gold: The Collapse of the Vanities

In other words, if a AAA-rated security is downgraded to BBB, the bank will have post up almost 10 TIMES MORE CAPITAL.

Where are they going to get that capital from at that point?

Are they going to sell the security?

I don't think so--there will be NO BID.

Bernard

The blog's author, Hellasious, responded thus:

Bernard,

You have hit upon a very important element in the whole MBS/ABS situation. While AAA paper won't be downgraded to BBB in one step, the combination of a series of consecutive downgrades and SIV assets going back onto balance sheets (and thus having to be covered by equity) means that the process of painful adjustment will take a long time. In other words, the credit crunch will last.

THIS IS NOT a replay of LTCM, for the simple reason that in its case the banks saved LTCM, so as not to get hurt themselves from the fallout. Today it is the banks/brokers that are in trouble: who's going to save THEM?

Or, to look at it another way: Who will save us from them?

A Response to Alex Taylor III

Today, Alex Taylor III wrote an article posted at CNN Money wherein he criticized Thomas Friedman of the New York Times in his article Debunking auto industry myths. That all fine and good; but in the process he made (I feel) an unfair statement:

It has been argued here before that if the government wants to be serious about improving fuel economy, all it has to do is boost the tax on gasoline. The revenue generated could be rebated to lower-income drivers who are truly disadvantaged or invested in mass transit. The auto companies aren't going to argue for such a tax because it would give them a black eye with consumers. And the government won't do it either, because of its anti-tax bias.

But Friedman, using his column as a bully pulpit, could argue for such a tax with impunity. And it would be a whole lot more effective than perpetuating the old myth about the ignorant luddites in Detroit who are withholding the small, fuel-sipping cars that Americans really want to buy.

But he has argued for a tax on gasoline. Here is a quote from his column back in February:

But at the same time, we have to impose a tax that creates a floor price of $3.50 a gallon for gasoline — forever. This is also about leverage. It says to all the parties: we are going to conserve enough gasoline and spur enough clean alternatives to fossil fuels that no matter what you all do in the Middle East, we will not depend on you for energy.

Another thing I take issue with is his statement that U.S. automakers and Americans don't need to change their habits:

That's wrong...and wrong. Forcing people to buy more efficient cars by ordering car companies to make them is like forcing people to lose weight by banning food companies from selling Big Macs and pizzas. The reason Americans consume so much gasoline is that they like their big pickup trucks, SUVs, and V-8 engines. The reason the automakers make them is because people want to buy them.



He also tries to defend them by saying:

American manufacturers DO build fuel-efficient cars but Americans don't buy them. Ford (Charts, Fortune 500) is currently offering cut-rate financing on the 2008 Escape Hybrid, while GM (Charts, Fortune 500) is subsidizing the smallest car in its lineup, the Chevy Aveo. And GM can brag all it wants about having more models - 30 of them - than any other manufacturer that get more than 30 miles per gallon on the highway, but it gets precious little credit for it in the marketplace.

The reason people (like me) don't buy them is because the quality is not as good as a Honda or Toyota -- even if it is cheaper. Furthermore, the Aveo's fuel economy is not as good as the Honda Civic or Fit or Toyota Echo or Yaris. (I know, I checked.)

Don't believe me? Here is the fuel economy for the Chevy Aveo:

City 26
Highway 35

And the Honda Civic:

City 30
Highway 38

You need only look at Consumer Reports or a similar opinion poll by consumers on what kind of car they want to buy to know that GM's economy cars have a ways to go in terms of quality. And as for the Escape Hybrid? It's hybrid engine is designed not to increase its gas mileage but instead to increase its power. That misses the point of hybrid technology.

Cram Down

Sorry about the lack of posts, but the internet here is rather persnickety. It doesn't work half the time; and when it does work, it seems that I can't post for one reason or another. I also have the problem that sometimes I can only read one e-mail, and then it just locks up.

Anyway, back to reality...

In the news today, Bankruptcy Change Could Save 600,000 Homes:

NEW YORK (CNNMoney.com) -- One consumer group estimates that 600,000 foreclosures could be avoided over the next two years by making a simple change to the bankruptcy code.

The Center for Responsible Lending (CRL) calls it a tweak, but it could be a significant change for homeowners and the market for mortgage-backed securities.

CRL's proposal - reflected in a House bill recently introduced - would make changes to the regulations for Chapter 13 bankruptcies, which don't wipe out debts, but rather establish a repayment plan.

Under current law, when a person files for Ch. 13 bankruptcy, judges cannot reduce mortgage debt owed on a person's primary residence, although they may modify mortgages on investment property or second homes.

Under the House bill, the bankruptcy judge would have the option of reducing what the homeowner owes the lender. Say a homeowner's property is worth less than what he owes. The judge could reduce the principal to match the home's current market value as well as reduce the loan's interest rate.

The rest of the original principal would then be treated as unsecured. That means it becomes a lower priority for repayment than the borrower's secured debt, such as the newly reduced principal on his home. Unsecured debts may be discharged.

OK, indulge me while I give you some "inside" information. Allowing a debtor to pay what the collateral is worth on a secured debt is called a "cram down" in bankruptcy lawyer-speak. A recent Supreme Court case already allowed debtors to cram down the interest rate to the discount rate plus a point or two (or three) on personal items such as cars, furniture and jewelry. Before the 2005 changes, you used to be able to cram down cars, furniture and the like to their value as well. After the BAPCPA law was passed, the feeling among the debtor's counsel was that we should make car dealers "eat steel" unless they agreed to negotiate with the debtor on the price.

The proposed changes in the bankruptcy law would allow debtors to "cram down" the debt to the value of the house in the current market and it seems that they propose that the interest rate rule in Till v. SCS Credit Corp. be extended to houses as well.

I agree with the article that this is more than a tweak, but it is probably a necessary tweak. The representative for the mortgage industry is quoted in the article as saying:

If investors in mortgage debt knew that mortgages could be adjusted by the courts without the consent of the lender, that could increase their perceived risk and change their valuation.

Yes, and some would argue that that is precisely the problem. That is to say: mortgage backed securities (MBS) are not currently getting marked-to-market, but instead are getting marked-to-model.

I admit I am just a lawyer -- not an economist or Wall Street whiz kid. But if I am understanding it right, this article at Sudden Debt: Rocks, Hard Places and Pricing Models probably explains it pretty well. From Hellasious's post:

Which finally brings us to the subject of the pricing models used to issue and mark-to-model all those structured finance securities. It is quite obvious that the primary variable in all pricing models is their sensitivity to credit risk, i.e. the risk of default. During the "virtuous" cycle, when credit risk goes down, such models indicated higher prices, which were used to issue structured finance securities at higher prices and with higher proportions of readily salable AAA-A merchandise. But as the cycle turned "vicious" those models started throwing out lower prices - and when the credit risks signaled by the CDSs jumped suddenly and substantially, as happened in August, those model-calculated prices moved radically down, causing havoc in the balance sheets of existing CDO holders such as banks, SIVs and hedge funds. The trouble was further enhanced by the fact that many holders were highly leveraged, i.e. they had borrowed heavily through ABCPs and prime-bank margin to buy those securities. Judging by market action quite a lot of margin came from the yen carry tactic. Live by the sword, die by the sword...

But why did participants choose to mark-to-model instead of mark-to-market? Two reasons:

(a) Because of the fragmentation in the structured finance business there were thousands of "made to order" issues that had next to zero secondary market liquidity. Usually the issuers pledged they would maintain a secondary market, but for practical purposes this was an empty promise. Even in good times the spreads between quoted bid-offer prices routinely exceeded 5 points ($50 per $1000 face) and in tiny amounts (eg $500k). We call this "trading by appointment only". Therefore, they couldn't truly mark-to-market because there simply was no active market.

(b) During the "virtuous" cycle marking-to-model served to hide the enormous embedded fees paid by real money buyers in the new issue market. For example, pension funds bought large amounts ($50 million and more) of such securities at par, a price that routinely included 5-8% underwriting fees - an atrocious percentage for AAA-A bonds when bought in size. I know of several instances where fees even exceeded 10%. By comparison, highly rated agencies and straight corporates are issued with fees of 0.5-1%.

Which brings us to what could be the "next shoe to drop". As defaults in the mortgage and junk loan sectors rise, as they are already, the models will calculate significantly lower prices, particularly for those issues that were put together with overly optimistic default assumptions. I won't be surprised to see some issues eventually model-priced at 10-20 cents on the dollar, even if their prospects for partial recoveries mean that their true values are double that. In other words, just as the models produced "garbage" prices on the upside, they have the potential to come up with "garbage" prices on the way down.

Also, some mortgage companies don't want to negotiate precisely because they win even if all of their properties go into foreclosure, apparently. From today column by Paul Krugman in the New York Times Enron's Second Coming?:

But Countrywide made more questionable loans than anyone else — and its postbubble behavior does stand out. As Ms. Morgenson reported in yesterday’s Times, Countrywide seems peculiarly unwilling to work out deals that might let borrowers hold on to their homes — even when such a deal, by avoiding the costs of foreclosure, would actually work to the benefit of both sides.

Why block mutually beneficial deals? As the article points out, Countrywide can make money from the fees it charges on foreclosures, while the losses from mortgages that could have been saved, but weren’t, are borne by others.

I think this is an example of moral hazard at work.

Actually, changing the bankruptcy laws to allow debtors to "cram down" their mortgage debts just might be the thing we need to bring back some sanity to this insane housing market in much of the country.

I'm Not A Central Banker, But I Can Play One In This Game

Monetary Policy Simulation Game

Hat Tip: Sudden Debt

Inflationary Depression Update

Most of the sites I explored to explain an inflationary depression turned out to be right-wing conspiratorial sites or Christian "the end is near" kind of sites (that often were also right-wing in their rhetoric). But I found a site written by David Petch that didn't come across as extremist or conspiratorial. Here is a some of what he wrote:

The US was the world’s power when it was the world’s largest exporter of oil and manufacturing center. Since the end of WWII, the US global output has declined from 50% to an estimated 20-22%. Dollars flow to sources of manufacturing, which now is the domain of China and India. The US economy has been rolling along with the aid of other countries purchasing US debt instruments to fund the current account deficit. Removal of this additional money and the US faces a sudden negative influx of capital. When this situation arises the US government has 2 choices:

Deflation, which would absolutely collapse the entire US economy to a functional level of less than 20% of the population.

Monetary inflation to cover the bills so that the economy hobbles along.

The important item to remember is that ALL global economies are linked and any country that expands its own currency will automatically cause monetary expansion of any country it does trade with. China has nearly 1 trillion US dollars in its reserve, but what if they lost 1 trillion with internal loans to cancel their reserves? They simply print a trillion of their own currency and buy more US debt. This perpetuates the cycle in which we exist, so until the consumer goes into the bunker, this facade will continue.

Once the consumer retreats and the bad loans begin to hit the banks, governments will have to bail out a multitude of companies to keep the economy running. Remember that if the debt is mopped up with mad money, then it matches and raises any money that evaporated, hence inflation. On this basis, it is nearly impossible to consider any form of deflation until the inflationary cycle is over.

War cycles are always inflationary and countries tend to go off of gold standards to ensure supplies and oil are not limiting to try and ensure victory. This has been the case for many currencies of the past 200 years and will continue into the future. Interestingly, Portugal, England, Spain and France during the 1500's to the 1700's were able to grow their economies by stealing gold from the South American countries during their global conquest phases. Their gold was basically free, which was able to feed their fleets and government purchases etc. With the abolishment of slavery and loss of control of the "New World" from feuds with other European countries and the locals, this form of a gold-backed currency system for funding wars and growth no longer exists. Stealing from other countries for nothing was a form of printing money except it came from the ground and went to European banks with no purchase of cash required. Today, instead of robbing countries of gold and silver, banks print money to allow credit expansion for citizens to go into debt to have a household containing the latest gadgets. Money today is basically digital, a total 360 going from physical to money transferred electronically.

Any attempt to implement a purely digital economy never could and never will exist. People would return to bartering and ignore the electronic money system, which would negatively affect government revenues. This would collapse economies, so I would hazard a guess this system would never fully be implemented. Most transactions nowadays are electronic but there always is the basic need to transfer money between individuals. Another reason to own gold and silver: the government can not trace it.

...

As I stated earlier, the amount of money circulating in the globe is expanding and just because the US is going through hard times does not remove inflation from the global scene. The scenario of an inflationary depression is what I would expect and is worse than a deflationary depression. During an inflationary depression the price of food and goods rises above many households’ range of affordability.

In the end, there will be a deflationary collapse following the current period of inflation and it will be due to a zero velocity of money compounded with plummeting manufacturing output. At this point in the future, owning cash and bullion will be important.

I don't know anything about David Petch's politics. But the explanation in Diatribes of Deflationists: Why They Are Still Wrong Pt. 2 comes across as a reasonable explanation of how an inflationary depression could happen.

Our Current Debt Problems Explained

The blog Sudden Debt has a good explanation of our current macroeconomic problems in the post Rocks, Hard Places and Pricing Models.

One great aspect of this post is that it defines commonly used acronyms and abbreviations on economic blogs and in news reports. Sadly, these abbreviations are rarely spelled out for ordinary readers and are thrown around by news reports, bloggers and commenters without definition or explanation. Here they are, with thanks to blogger Hellasious:

Abbreviation Key

ABCP: Asset-backed commercial paper
BIS: Bank for International Settlements
CDO: Collateralized debt obligations
CDS: Credit default swaps
CLO: Collateralized loan obligations
GFM: Global financial meltdown
ISDA: International Swaps and Derivatives Association
LBO: Leveraged buy-out
SIFMA: Securities Industry and Financial Markets Association
SIV: Structured Investment Vehicle

Here is a small snippet from his post:

American monetary policy and financial markets have been caught between a rock (huge debt) and a hard place (fundamental economic dislocations) for a considerable time; the effects have been visible since at least 2000, when the burst of the dotcom bubble necessitated sharp interest rate cuts and the strong dollar policy was abandoned by the Bush administration. The events of 9/11 further accelerated the rate cuts, to protect the US economy from the potential threats of a deflationary spiral.

Many blame Alan Greenspan for the current credit/asset bubble, unjustly in my opinion. The Fed was not responsible for the gutting of the American industrial base and the resulting explosion of the current account deficit, nor the deep neo-conservative tax cuts that ballooned debt. Finally, the Fed was certainly not responsible for the ruinous Iraq war. All the Fed could do was to combat the effects of these deeply misguided political choices with the blunt instrument of short-term interest rates. What was even worse, even this instrument became increasingly ineffective because the explosive rise of credit derivatives (CDSs), short-circuited monetary policy and kept driving long rates lower, even as the Fed was trying to push them higher (this "conundrum" was frequently mentioned by Greenspan). But this post is not an apologia for the past Fed Chairman. He can defend his own record while making a fortune as a best-selling author.

Inflationary Depression

The 1930s Great Depression was a deflationary depression. I have heard talk that the next Great Depression will be an inflationary depression. I heard this (and discussed it) many months before the Federal Reserve dropped interest rates (with the subsequent market movement toward protection against inflation).

Now I am once again trying to get my mind around this idea and trying to understand how an inflationary depression would potentially play out. From what I have read, Ben Bernanke was a student who studied the Great Depression and is trying to prevent it from happening again. The question is: will the cure end up being worse than the disease? Can reducing interest rates prevent a severe economic downturn while still maintaining international currency stability?

Stay tuned.

Moral Hazard Insurance

From Answers.com:

Moral Hazard: The risk that a party to a transaction. . .has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles.

I think that is very risk that the Federal Reserve took yesterday when it decided to lower its rate on a key short-term interest rate by half of a percentage point Tuesday to 4.75%. A bubble was created in the credit market which contributed to asset inflation in the housing sector. Obviously (to me, anyway), the fact that the markets immediately saw an increase in the price of gold, oil, metals and other commodities indicates that traders expect the Fed's action to lead to inflation in commodity prices -- particularly gold and oil. Oil is currently priced in dollars and gold is often bought as a hedge against inflation.

So where does one go to buy insurance against the moral hazard of bailing out speculative investors and financial institutions that made what they knew were bad loans?

Worst Is Yet To Come?

From the article Housing seer says there's worse to come:

So, with subprime mortgage losses and credit woes now the No. 1 topic in the markets, what does the former Goldman Sachs investment banker see next for the housing market and the U.S. economy?

Well, if you thought things were bad now, just wait. Think bank failures, recession, soaring default rates, home prices plunging by at least one-third and layoffs rippling across the economy. The unwinding could take five to seven years before the housing market hits bottom, he says.

As a former Wall Street insider, Mr. Talbott has a better appreciation than most for how large financial institutions operate. And what he senses now is a massive effort to conceal the extent of the toxic sludge buried beneath some of the biggest names in the business.

"Everybody is hiding and not disclosing losses," he says. "They're all winking and nodding at each other because they've all got this stuff on their books."

With 40 per cent of some banks' assets invested in residential mortgages, they won't be able to conceal their losses forever. Faced with rising defaults, banks are already pulling back on lending. The lack of credit, in turn, will exert a major drag on the economy, which for years has been fuelled by easy money. That's why Mr. Talbott says a recession in the next 12 to 18 months is a certainty.

...

The subprime meltdown has been described as a liquidity squeeze, which makes it sound like a temporary problem that can be cured with an injection of cash. But the problem is far more serious, he says.

"Giving a bank more cash doesn't solve the problem. What they're sitting on is huge losses and they can't recognize those losses without endangering their entire book equity and threatening bankruptcy and threatening a run on the banks."

I don't know if things will get that bad, but it's a potential scenario. I suspect this very scenario that could happen is what is worrying many Americans.

The Dangers of Retirement Hedge Funds

This is what an editorial in the New York Times entitled Pensions and the Mortgage Mess had to say about risky mortgages being added to pension funds today:

Even as the plunge continues in investments tied to dicey mortgages, government regulators remain skeptical of the need for new rules to cover these newfangled derivative products or the hedge funds that tend to buy them.

The Federal Reserve chairman, Ben Bernanke, rightly argues that these are important instruments, making credit more available and allowing risk to be spread broadly. But as the casualties mount to more than just a few buckled hedge funds, it is important to address the downsides.

There is a real danger that the casualties to come will include a more vulnerable set of investors: the pension plans of working Americans. Mr. Bernanke recently told Congress, “In most cases, I think that pension funds should probably not, you know, go heavily into these types of instruments.”

But faced with growing numbers of retirees, some pensions — including those for police and firefighters in Ohio and Dallas — have been unable to resist making these risky investments in an attempt to increase their returns. Public and private pension funds have also plowed tens of billions into hedge funds, which have been piling into mortgage-related securities.

Many pension plans lack the analytical skills needed to evaluate these investments, relying on outside advisers and rating agencies. But the stellar triple-A rating assigned to many of these bonds proved to be misleading — with the agencies now rushing to downgrade them.

So far there have been no reports of pension plans in trouble because of the mess in the mortgage market, but we fear that it might only be a matter of time. The fact that pension plans are insured — private plans by the Pension Benefits Guaranty Corporation, a federal agency; state and municipal plans by taxpayers — makes the case for enhanced regulation even stronger.

Protecting pensioners from bad investments will not be easy. A good place to start would be to make rating agencies more accountable, perhaps by asking regulators to monitor their quality. Pension law should also be changed to ensure that the premium that private pensions pay into the P.B.G.C. takes into account the risk of their investments.

What is crucial is to ensure that pension managers perform adequate due diligence to understand what it is that they are buying. Regulators must make sure of that.

Given what we have seen happen to the working class' retirement funds through corporate bankruptcy and schemes like this, I am not yet convinced that expanding Social Security into a full pension plan for the elderly isn't a better, more secure way to go. Can we really trust private entities with pension funds anymore? In any case, even if my idea is not adopted, premiums paid the the PBGC reflecting the risk of pensions failing due to riskiness of their investment portfolio would be a good start.

A New Beginning

As of Wednesday, I am leaving the private practice of law. I have taken a job with a private company and because of the all of the work involved in the move, will be blogging lightly until I get settled in to my new position late in the week. I have a lot of work to do to prepare for the transition to my new life.

This is a time of sweet sorrow for me. No more Seven Years of Bad Luck. My fortunes appear to have changed. For the first time in I don't remember how long, I feel that I finally have some hope for the future. The oil industry is booming, and I am going to try to ride the wave for as long as I can.

Now it's the story of the Seven Fat Cows and the Seven Skinny Cows. I think we may be entering into a new time of the Seven Fat Cows. But we shouldn't become complacent. We must prepare for the Seven Skinny Cows. Oil is a cyclical market, and it is notorious for being a "feast or famine" and "boom and bust" market. And I am not even entirely convinced that it is not being manipulated right now. In any case, you have to strike while the iron is hot, and it sure looks hot to me.

Is the Stock Market Manipulated?

At the Housing Bubble Blog this morning I found this comment intriguing:

Comment by Dawnal
2007-07-26 04:14:10

Another interesting day in the stock market. Up strongly at the open, faded through the day and coming back as the day ended. Up 68 for the day. Why? What was the news that would suggest that the market should be up?

The professional traders that post comments through the day at indexcalls.com have no doubts about why. They accept as fact that the government is manipulating the stock market on a daily basis. They note that the indices “gap up” frequently through the day. Several times yesterday there were mentions of stocks being purchased at prices over the ask.

Here is what one posted yesterday:

“When the PPT is engaged near All Time Highs,

you know beyond a shadow of a doubt that:

1) our financial markets are a joke
2) our economy is a dead man walking
3) the bankers control our government
4) we are completely screwed”

And Bill Murphy, a professional trader who publishes the daily MIDAS report at lemetropolecafe.com, said:

“For the umpteenth time the problems for US financial markets and the economy disappeared overnight. The DOW is called 65 higher…

Whenever the DOW looks shaky, for whatever reason, and has a really bad day, the PPT makes sure the “Mo” immediately turns back up; at least they make an effort to do so. It has been this way ever since 9/11…”

"PPT" probably refers to the Plunge Protection Team.

I am not quite sure what to make of comments like this. On the one hand, you could make the argument that the credit sector is not the entire stock market. And the comments being made are by individual traders who may be shortsighted in their reading the financial tea leaves. On the other hand, someone buying stocks over their market price sure smells of manipulation.

What bothers me most about some of this talk is the reference to how the "bankers" control the government. In the past, "bankers" became synonymous with "Jewish." What worries me is that there may be antisemitism starting to creep back into popular discourse. If we have a real crash, I fear it may become more pronounced. I am even more concerned considering the push by the White House toward the "unitary executive," the unwillingness to accept Congress' oversight authority and the use of fear (constant terror threat warnings) as an attempt at social control.

Sounds like a movement toward fascism. That is what is so scary about current events.

Mortgage Delinquencies Rising in Oklahoma

I got this from The Big Picture. I can't read the stories behind it (Barry gives the links) because they are behind subscription firewalls. Hey, I can't afford everything.


I can tell from the maps, however, that the Oklahoma City and Tulsa metropolitan areas are both getting hard hit. The area near Ft. Smith, Arkansas is getting even harder hit. I don't know what is causing that.

What is interesting is that this is happening at a time when the oil industry is starting to make a comeback in Woodward, Oklahoma (near the Oklahoma panhandle). But while there are several large oil companies in the Oklahoma City and Tulsa area (Devon, Chesapeake, Anadarko, Phillips, Williams), it is surprising that we have not seen the rush to hire new people.

The delinquencies are probably due to the closing of Firestone, Dayton and other industrial manufacturing plants locally. I reported on that earlier here and here.