Thursday, March 13, 2008

Dominoes, how the spirals link to deleveraging

This morning's FT is a great one, I may keep it and frame it. Analysis is pouring in. Two articles, one by Mohamed El-Erian, head of Pimco, and the other by Albert Edwards, Global Strategist of the Societe Generale, offer great insights.

I was still digesting the Wolf piece in yesterday's FT. Naked Capitalism's input was helping greatly. Basically, Wolf, usually measured is freaking out and the numbers he throws around, inspired by Roubini dwarf the numbers I had at the end of my previous blog arguing for "enough liquidity?". Nouriel Roubini of RGE monitor now puts the damage of the crisis in the $3T. A trillion here and a trillion there and soon enough it is real money.

From the FT cover

There is deep concern that banks are pulling back on capital at risk, drawing liquidity from the markets and triggering contagion at hedge funds. This has caused fresh turmoil in the market for mortgage-backed securities, intensifying the pressure on housing.

"You have three vicious cycles going on simultaneously," said Lawrence Summers, a former US Treasury secretary.

"A liquidity vicious cycle - in which asset prices fall, people sell and therefore prices fall more; a Keynesian vicious cycle - where people's incomes go down, so they spend less, so other people's income falls and they spend less; and a credit accelerator, where economic losses cause financial problems that cause more real economy problems."

Fed officials insist the US will not end up like Japan, not because economics could not possibly deliver such an outcome, but because the US system will not allow problems to fester, and policymakers will take whatever steps are necessary to avoid a Japan-style recession.


Of course the FED action is designed to provide relief to the banks for them to work through their sub-prime losses (in the 700bn). The FED can cover that on reserves alone without printing money and adding to inflation. They are short of buying the stricken securities themselves. They are not printing money (yet).

Talking about the process of debt deleveraging El-Erian says in "Investors must decide how to avoid tumbling dominoes"


Initial losses occurred in sectors, such as US subprime, where market activities had clearly deviated from fundamentals. In trying to get back on side, the affected financial institutions had three choices: allow the losses to eat up their regulatory capital, raise new capital, and/or cut exposure to other areas that utilised balance sheets. Several institutions executed on the first two; yet they could not avoid the third. As liquidity dried up in the "tainted asset classes", they had to reduce other positions. In some cases, this was done through sales and the withdrawal of credit lines, including those extended to hedge funds. In other cases, it was done through imperfect hedging.

Whatever the approach, the result was a wave of falling prices that, in a manner that is reminiscent of past episodes of "market contagion", sequentially moved from tainted assets to those further up the quality curve.


As the liquidity goes down, the contagion spread up "the quality curve". The "frantic" FED injection is there to backstop the withdrawal of liquidity, it seems the relief is percieved as temporary. The liquidity injection euphoria quickly died yesterday. It seems it wasn't enough to float the other boats. The market deeped steeply after a sharp rally, showing the market is not buying that the FED has done "enough"..


It is also not surprising that US policymakers are now frantically looking for measures to contain the damage. Interest rate cuts and cash handouts to consumers are now being accompanied by larger direct injections of liquidity into the financial system and an attempt, albeit still modest, to target housing.


The fat lady won't sing until housing clears. The problem with housing is that, unlike stocks, there is tremendous inertia in the pricing. Loss aversion is very strong in individuals and therefore the housing market adapts with timescale in YEARS. Not hours or days like securities. In other words, no one KNOWS HOW TOXIC the securitized mortgages are and that is a self-feeding negative loop. There is no market for the subprime, the temporary liquid relief will need to go beyond 28 days, expect this facility to roll-over. So we are in it for the long haul. To this he says


Second, it will take time for the deleveraging process to abate unless policies are supported more forcefully by measures that target housing directly.

...

Fourth, when markets become more liquid it will be felt first by assets that are closest to the official funding windows. This speaks to possible opportunities in swaps, high-quality mortgages, bank capital and municipals.


However when the liquidity catches up, and housing is solved, closely monitor the above assets, they should be the first ones to get "better".

11 comments:

aarone said...

There *is* a market for subprime equity, it's just lower than anyone holding it wants to sell them for. And an long and the Fed is willing to print money (because that's what they're doing -- it doesn't matter if your "securities" are t-bills or gold ingots, if you' write on a piece of paper and say "this is a loan backed by this security, it is the literal DEFINITION of money) to keep them solvent, they'll hold onto their properties and either let the inflation eat the debt or the market to catch up to their too high asking price, either through inflation or growth.

It doesn't matter if it's Citi or your neighbor who leveraged his own mortgage to get an interest only on a rambler in a yuppifying neighborhood he intended to flip. No one is going to sell property for a loss as long as they can hold on to it. The difference is, your neighbor isn't getting as good a deal from the fed.

The TAF and FED auctions are basically giving banks full asking price as a loan to buy back their subprime properties at the price the banks feel they're worth. Meaning what they believe the fair market value will be, minus a hefty profit. So if they bought a house for $800,000, expecting to get $1 million, rather than sell for $900,000 and break even (after improvements, interest, and commissions -- to themselves), they'll borrow the $1,000,000 from the fed, and bid $500,000 for the property hoping to unload it for $600,000. Of course there's the risk that another big bank will know they can get $600k and bid $599K, but if you don't think there'll be collusion in these auctions, you don't realize that that there are fewer banks than oil or phone companies these days.

Regardless, it's still a sweet deal for the banks, who once they get their heads above water and a few breaths in their lungs, will then proceed to foreclose on your neighbor with the fixer-upper just like they're doing to the hedge funds now. And since the FED has a stake in that foreclosure now, congress won't feel any pressure to "protect the little guy" - who after all, is just like that hedge fund, leveraging his $60,000 equity into 2 $1 million dollar homes. That's the same 3% equity to debt ratio.

Marcf said...

a/ So there is NO CLEARING market is what you mean.

b/ I think negative on the "same as money". They are releasing treasuries, and sucking up the money in interest. The money the banks get is existing money not new money.

c/ agreed on inflation working for them :)

d/ I didn't know the collateral was priced at mark to bullshit (model) as opposed to mark to madness (market). I am not following the rest of your math... I am confused.

Andrew Meyer said...

aaron,

There is something quite frightening that I don't see in your logic. (you may have it and I'm just not seeing it).

What is important to understand about the subprime debt crisis is that there are "nonconformance laws" or rather, states that are nonconformance states.

Note, I am not a lawyer and my presentation may not be exactly accurate.

A nonconformance state is one where if you own an asset that is worth less than you owe. For example, you bought a house and have a $400K loan, and the house is worth less than that (say only $300K). You can mail the keys back to the bank without ever declaring bankruptcy.

So, essentially, when property values drop, people send the keys to their house back.

Now, what is further critical about this, is that the subprime market really started growing in late 2004, 2005, 2006 etc.

Now, remember that the percentage of home ownership peaked in 2003. What does this mean? A lot of the subprime loans went to people buying second houses.

1. Those people know they can send the keys in.
2. It won't effect their living standard to do so.
3. No one knows how many of these people will do so.
4. There is no transparency into CDO.

The situation we are looking at is very scary.

Marc, you asked a question about how we will know if the banks are kaput? Good question. I'm actually having lunch with people who will understand that better than I will and I'll tell you what they say.

Andrew Meyer said...

Happy St Patrick's Day, hopefully the luck of the Irish will bail us out.

Next week will be particularly interesting. There's a phrase my mother used "The hens will come home to roost."

Its hard to get a handle on what's happening. The most interesting thing which came up was the question of why the FED acted with J.P. Morgan?

Background:
When LTCM imploded in '98, the FED "organized" Merrill Lynch and Goldman Sachs to clean up the mess. The thinking is that the FED and Treasury called all the likely suspects in and started asking for "volunteers", or as the old Mafiosos used to say "I got a deal for 'ya, that you can't refuse..."

Marc asked what the FED's limits were. In their statements on Tuesday, at which point they already knew what was going to happen in the rest of the week, the said $400B. So why bring in JP Morgan?

Seemingly, there are two choices. Either the cost to bail out Bear Sterns exceeded $400B or Bear is just the beginning and the FED is doing it's own version of "matchmaking".

Two other interesting points.
1) The FED's goal is to free up some space on the banks balance sheets to get the credit markets moving again. Right now, everything is just stuck.

2) The Carlyle Group wasn't invested in SubPrime debt, they were invested in agency debt (Fannie Mae, Freddie Mac etc.) They had bought the "good stuff."

You know, this is way beyond my ability to comprehend. It makes for some great conversations and speculation.

Anyways, it's 10 PM on Saturday night, I just got back from a St Patty's day party where I was drinking water because I have a long night's work in front of me. Nothing quite a fun as a small software company starting to show some signs of life.

Hopefully this adds something interesting to the discussion. I'll leave with one final quote which either comes from Ben Graham or from his time talking about panics (later renamed depressions later renamed recessions...):

"When the police raid the whorehouse, they arrest all the girls."

I would bet large sums of money that Bear Sterns is not the last banking house to go down. Certainly the CDS (Credit Default Swap) market doesn't think so.

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