The Formula That Killed Wall Street by Felix Salmon for Wired
- the deliberate actions of Dr. Frankendodd, et. al. in the Democrat Congressional leadership to take down the home mortgage industry;
- the constant barrage of cyber-attacks on U.S. Defense Department computers – all traced back to Communist China;
- the multitude of federal government “bailouts” and related actions by the Democrat-controlled Congress and Obama Administration that have suddenly made $Trillion deficits “normal”;
- the Wall Street financial tycoons’ failure to pay attention to what their hedge fund and derivative “whiz kids” were doing in the basement;
- AIG’s fraudulent “insurance” of credit swaps and other exotic financial deals;
- the appointment of a bumbling and ineffective Treasury Secretary who failed to notice the dangerous banking activities going on under his nose at the NY Fed;
- Communist China’s predatory efforts to use their huge reserve of U.S. dollars (that we funded through deficit spending) to build a worldwide economic empire; and
- (re-Imperializing) Russia’s saber-rattling decisions to sell missile and nuclear technology to Iran and forward deploy strategic bombers (andmore importantly – electronic reconnaissance aircraft) to our southern doorstep in Cuba and Venezuala – …
…this Designated Conservative is beginning to wonder, “Are we at war?”
UPDATE 2: This video below shows some of the unintended(?) consequences of the Democrat Congressional leadership’s propensity for ramming through giant spending bills that cannot possibly be read by anyone in the time allowed before a vote (much less actually debated). It makes one wonder exactly for whom Senator Chris Dodd of Connecticut believes he is working…. Maybe the better question is, “What did Senator Dodd know about what Senator Dodd was doing, and when did he know it?
The following is another extended excerpt from John Mauldin’s email financial newsletter. As usual, he gets right to the core of all things financial. His conclusion is that much of our current financial crisis (and related mess at AIG) is the result of unintended consequences from a poorly-thought-out rating system for mortgage securities and the federal government’s (read AIG’s former Congressional friend(s), “Dr. Frankendodd“) post-Enron “mark-to-market” accounting rules:
Thoughts from the Frontline Weekly Newsletter: The Law of Unintended Consequences
Rules have consequences…. If I told you that the US government was going to give multiple tens of billions of taxpayer dollars to hedge funds and private investors, you would justifiably not be happy. I think the word angry would come to mind. But that is exactly what is happening, as a result of rules that were written for a time and place seemingly long ago and far, far away….
In the beginning there were ratings agencies, and they rated corporate bonds from the very highest of credit quality (AAA) down to junk (CCC). Now AAA means that the chances of losing money are very, very low. With each level of increased incremental risk comes a lower rating. If a corporate bond was at risk for losing just one dollar, it was rated all the way down to junk. And that was fine. Everybody knew the rules of the game.
But then investment banks asked the agencies to rate a large group of home mortgages in a pool known as a Residential Mortgage Backed Security (RMBS). The investment bank would divide the pool (the RMBS) into various tranches. The highest-rated tranche would be given a rating of AAA. Let’s say that the AAA tranche was 92% of the loan pool. The AAA tranche would get the first 92% of all monies coming into the pool before the other investors were paid (again, really oversimplified, but that is the net effect). That would mean that the pool could have 16% of the home loans default and lose 50% of their value before the AAA tranche would lose even one dollar.
We all know now, though, that some of those AAA-rated tranches are in fact going to lose money. And the rating agencies are now writing down the ratings on the former AAA tranches…. What I am writing about today are plain vanilla mortgages grouped together in securitized pools.
I wrote three weeks ago, “The downgrades by Moody’s today of 2,446 different classes of Residential Mortgage Backed Securities will be a real blow…. Fitch and S&P are also piling on with downgrades. Most of them see RMBS’s go from AAA all the way down to junk. This has some very bad unintended consequences.
Let’s say a bank has a loan portfolio of 1,000 individual mortgages valued at an average $200,000, for a total portfolio value of $200 million. The loan officers were not very good, and it turns out that 18% of the homes went into foreclosure and lost an average of 50%. That means 180 homes went into foreclosure and that the bank lost an average of $100,000 per home, or $18 million overall. The bank was charging 6% interest, so in a few years it would at least have its original investment back, although the losses would eat into capital.
Note that the remaining 82% of loans are still performing and are carried on the books at full value (again, oversimplified). There is real value in the remaining loan portfolio. But what if the bank invested in a RMBS that was rated AAA, and 18% of the loans in the security went bad? Remember, the AAA tranche gets the first 92% of income. The loss to the RMBS is 9% of capital. The losses to the AAA tranche are only 1%. Hardly a catastrophe. Annoying, but something you can deal with.
Except for some very nasty rules. Remember, a bond is downgraded to junk if it loses even $1. Now, let’s take it to the real world. Say a bank buys a $1-million AAA portion of that large RMBS. It can use that AAA debt in its capital base, and can actually lever it up about five times, as the rules only make the bank take a 20% “haircut” on an AAA bond. But if the bond goes to CCC, the bank must now move the entire bond to its “risk-impaired” portfolio. And because most institutions cannot buy junk paper, there are very few buyers out there who will want to buy it — mostly hedge funds and private capital. The price on that paper might easily drop to $.50 on the dollar because of the potential for a 1% loss.
The accountants, being conservative and living with new mark-to-market rules, make the bank take a $500,000 loss…. If they have to sell to get the capital required to follow the regulations, they will lose $500,000. And they lose this on an asset that the rating agencies say might lose $1 ten years from now. Again, at the risk of oversimplification, if they keep the security that also means that the bank loses roughly $10 million in lending capacity. They have to reduce their loan book or raise more capital.
Here’s the truth. That bond should never have been rated AAA to begin with, and it shouldn’t be rated CCC today. The ratings agencies took a perfectly fine corporate bond rating system and tried to bootleg it onto a security that has an entirely different set of circumstances….
While I can’t go into specifics, I have looked into these bonds with some real interest. Let’s assume that you can actually buy an AAA tranche of an RMBS at $.60 on the dollar. That means that 80% of the mortgages would have to go into foreclosure and lose 50% before you would ever lose a penny. There are AAA bonds selling at steep discounts that are composed of mortgages with 80% loan-to-value in 2005, a 7% interest rate, and 90+ percent performing loans. These loans are being called in as mortgagees take advantage of lower rates and refinance….
If you buy the loan at $.60 on the dollar, and it gets refinanced, you get an immediate capital gain of almost 50%! If it keeps on being paid, you get an effective rate of about 10%. So, why wouldn’t there be a lot of institutions standing in line to buy such a dream investment? Because banks fear the danger that the security will get downgraded, just like the thousands of such instruments that have already been downgraded, and then their regulatory capital will be impaired. The technical banking term is that you would be screwed. So (banks) don’t buy what would be a very good performing asset, because of the rules.
So, who can (and does!) buy? Hedge funds and private investors with liquidity. But these “vulture capitalists” (among whom are many of my friends) know that the sellers are operating from a position of weakness. And because there are not enough of them to buy the bonds on offer, the prices of these bonds are very low. Smart money managers are raising money to exploit these distressed sellers.
So, in effect, we are giving banks taxpayer money while forcing them to sell assets that might be worth $.95 cents on the dollar in a less-stressed world. We are shoveling money in the front door while it is being pushed out the back door to my friends at the hedge funds….
Some simple rules changes would solve a lot of this problem.
- First, let’s recognize that the root of this particular problem is the ratings system. …the Federal Reserve should call in the rating agencies and have a “come to Jesus” meeting. They are at the heart of the problem, and they need to fix it. They need to change their ratings system for packaged securities like RMBS’s.
- …if you modify the rules so that banks and other institutions can use those bonds (with an appropriate haircut) as part of their regulatory capital, then you immediately get a large number of buyers into the market, and that will make prices go up and mean that banks will need less taxpayer money….
- Marking assets to market when there are no markets is illogical. I have spent some time looking at these securities. Like kids, they are all different. And some are really different. Yet we make a bank mark an asset down because one that is in the same broad class is impaired. Like giving every 13-year-old in school an “F” in math because one kid failed….
We do not need zombie banks. For whatever reason, the Obama administration seems to be afraid to use the “N” word (nationalization). If a bank is insolvent, yet deemed too big to fail, then take it over, repackage it, and sell it back to the private market with some options that will allow for taxpayers to at least have the potential to get their money back. But do it quickly rather than dithering, as is happening now, because that will just cost more in the long run.
But as a start, change the accounting rules so that we stop shoveling taxpayer money in the front door to banks and out the back door to hedge funds. That can be done quickly if the administration simply says “do it.”…
This cycle needs to be broken. Mary Schapiro? Tim Geithner? Are you listening?”
John Mauldin (John@FrontLineThoughts.com) Copyright 2009 John Mauldin. All Rights Reserved
John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to: http://www.frontlinethoughts.com/learnmore.