We the Cared For

Rating Agencies on the Hot Seat

The ratings agencies were the latest attendees in the congressional parade of shame today so I thought I would provide readers with some background on why these ratings are so important and the role they play in the markets.

The following is a lift from my upcoming book "From Your Wallets to Their Pockets"...

Why are Ratings Downgrades a Problem?

The problem with ratings downgrades is that they have a tremendous rippling effect throughout the financial, public, and private sectors. Ratings downgrades reflect the fact that the security is riskier than the initial rating suggested and the current market value is lower. This means the initial return expectation is now lower and the possibility exists of loss of the investor’s principal and interest.

The broad spectrum of investors in these securities includes employee pension funds, insurance companies, other banks and financial institutions, municipalities (such the county in which you live and work), private investors, major corporations, other governments, and other governments’ financial institutions, to name a few.

Investors

Investors in these now-riskier securities face two issues. First, they were expecting a profit on their investment. Second, the current value of those investments is reflected in their financial statements on their balance sheets.

With regard to the expectation of profit on the investment, the investor relied on the initial risk/reward analysis, which has now proven to be flawed. Now the investor is receiving a rate of return far lower than another investment of similar (or perhaps now more or less) risk would pay.

Loss of the investment means more than just the bonds becoming worthless. Those who invested in them have lost not only the profit they expected to earn but also the money (the principal amount) they used to purchase the investment.

Then there’s the matter of the balance sheet. As these securities decline in value, they must be marked-to-market, or written down to their current value in the market. Not only does this write-down lower the value of the company that made this bad investment but, in many cases, these changes are so significant that the company cannot stay in compliance with its own operating charters or regulatory requirements.

Consider, for example, Bank XYZ. Bank XYZ has invested $1 billion in these securities and has an adequate capital ratio as required to stay in business. The securities in which they invested are then downgraded and the marked-to-market value is now only $500 million. This $500 million loss in value reduces Bank XYZ’s capital level to an inadequately capitalized condition that must be rectified immediately. Bank XYZ has a few options to raise this additional required capital:

• sell more stock, which raises equity capital and dilutes the existing shareholders’ equity;

• borrow the money, which involves paying interest at a higher rate, since the loan to the bank is now to a “riskier” organization;

• sell part of the business, losing more control and diluting current owners’ equity;

• sell off other higher-performing assets to get the balances down to the bank’s new level of capital; or

• sell the downgraded securities at a significant loss… if there are any buyers!

All of these options are extremely costly and sometimes making decisions like these put companies out of business.

Public municipalities can find themselves in similar predicaments. I happen to reside in Orange County, California, so even if I weren’t in this business, I can honestly say I have firsthand knowledge of how this works. My fellow taxpayers (and my family and I) in Orange County are still paying for the county’s bankruptcy due to a different financial debacle in December 1994.

Let’s say that, as part of investment plan for cash on the balance sheet, Orange County purchased subprime mortgage-backed bonds or CDOs and that these bonds defaulted or were downgraded. This would effect the county in two ways. First, the county would have lost taxpayer dollars from its operating budget and, unless cash was in abundance, it would have to make up the loss from somewhere else. Second, if the amount of the loss was significant enough, it would result in the county’s own credit rating being downgraded. Since the county borrows money in the form of bonds, its ratings downgrade would require it (readers are encouraged to interpret that “it” as “we taxpayers”) to pay higher rates of interest for that borrowed money.

The recent, unprecedented actions by the Federal Reserve Bank have this same effect. The bailout of Bear Stearns included the Fed taking almost $30 billion of these types of securities (funded and managed securities) onto its books. Bear Sterns is not a member of the Federal Reserve System and any further loss (and, as the Fed kindly points out, “profits”) will be at the taxpayers’ expense or gain. JPMorgan Chase picked up a competitor and its good business assets at an astoundingly low price at the Fed’s behest, and the Fed took on the worst of it to make the deal happen.

The Fed’s new Term Auction Facility expands, for the first time, the collateral that may be used to borrow money from the Fed. Now, the Fed allows poorer performing security, including mortgage-backed securities, to be used as collateral. No need to give us your Mercedes as collateral; we’ll be happy with that beat-up old Pinto. Another shining example of privatizing profits and socializing losses.

Government Bailout: Not Giving Credit, Where Credit is Due

The reason the banks aren’t starting to lend yet is because they are now risk averse, regardless of how much money is being pumped into the system.

The U.S. taxpayer is propping up bank balance sheets through the Federal Reserve and we’ll be taking bad assets out soon with the bailout money.

Yet the credit isn’t flowing…

While you were sold in the weeks leading up to the approval that credit for Main Street was what this is all about, the fact is that it just props up the system and the players and does not increase credit availability.

Credit is extended through the use of underwriting criteria. The basics are intent and ability and in the case of asset based lending (mortgages, commercial property etc.) aspects of the asset itself. Does the borrower show the intent to pay (credit history), the ability to pay (income, cash-flow) and if an asset is involved; does the asset represent the right type of security, at an appropriate value, on which to make the loan.

We are now in a situation where all three of these evaluations are suspect but for the highest tier of credit quality and borrowers with significant assets. Declining asset values, business contraction, restrictive credit and higher unemployment all serve to increase the risk in making loans to the lower tiers even though they may be good credit risks.  

Until the banks are forced to lend, through mandated underwriting guidelines or regulatory force and assessment, the money will not make its way through to borrowers.

How is that for a conundrum?

Since the government has intervened and the American tax payer is being forced to hand over a trillion dollars (in this first installment),  the only way to get it back to the purported people who need it,” Main Street”, is for government to force the banks to do it. 

This is a vicious circle.

The Federal Reserves Balance Sheet

Before the bailouts “TARP” program has even been implemented, the Federal Reserve Bank has been pumping money into the system to very little effect for borrowers. The Fed has almost doubled the size of its balance sheet since January of this year:

 

The Fed does this by selling U.S. Treasury Bills (taxpayer debt). The newly borrowed money is then put into the banking system. The idea here is that the banks, now gorged with new capital, will circulate this money back into the economy through lending and other banking activities.

It hasn’t worked yet. It’s not going to work while the banks are still trying to boost their capital levels from massive overleveraging and also deal with unquantifiable levels of default in every area of lending.  

Credit will not flow by just pushing the money into the banks and hoping the system goes back to business as usual. Our government made the case that the tax payer has no choice in the matter and that unless we spend this money, “Main Street” won’t get credit. “Main Street” isn’t going to get that credit unless they force the system to do it.

Now that we’ve socialized our financial system in the name of “Main Street”, these same leaders should finish the job and force the system to get the money out to “Main Street”.

So there you have it. If you want credit to return to previous levels, the government is going to have to make them do it, with tax payer money, which will result in government controlling each of the individual banks risks and profitability. These are the same folks who did such a fine job before we had to nationalize everything.

Or we could stop now and understand that if they don’t force the banks to lend, credit will have to reach a lower, more rational level and it will be quite painful for some time to come. It's going to happen anyway.

Who was it our leaders told us we were helping again?

A Crisis in Capital for Free Market Capitalism

The two primary issues at hand for policy makers are to deal with the current crisis and to change the system moving forward to avoid repeating the problems.

In my ongoing efforts to come at this from different angles to explain why, even as the government(s) pump trillions of dollars into the system and nationalize everything, the stock market and the economy are still in for a very painful time.

The fundamental factors in all of these problems are that excess credit availability, fueled by government policy and private market greed, has over inflated the value of everything. During this period we did not put away enough money in the system (adequately reserving and capitalizing) for the increased risk (over leveraged).

In the 7 year period between 2001 and 2007, $19 trillion dollars in mortgage loans were originated. In the prior 10 year period, between 1990 and 2000, approximately $10 trillion in mortgage loans were originated. In the last 7 years we financed twice the amount of mortgages as we did in the previous decade.

 

During this same period private mortgage backed securitizations accelerated from virtually nothing to approximately $1 trillion dollars in 2006 and 2007…

 

And Fannie Mae and Freddie Mac doubled their retained and mortgage backed securities from over $2 trillion in 2001 to $4.9 trillion in 2007…

 

These mortgage backed securities were then leveraged up again as Wall Street firms created synthetic products from the underlying MBS, or collateralized debt obligations (CDO). This can be complicated so for simplification you can think of it as; the same collateral that made up one MBS was used to make another investment instrument… it was used twice. When the one loan or tranche goes bad, two different sets of investors lose their money.

On top of all of this is the additional leveraging up through the use of Credit Default Swaps (CDS) which are used for hedging purposes and significantly now, for speculation.

So what is the significance of this?

Prior to the advent of aggressive securitization by the GSEs (Fannie and Freddie), and the private Mortgage Backed Securities market, these loans had to be accounted for on lenders balance sheets. This required the banks to adequately capitalize themselves to support these balances and set aside cash reserves for the potential losses from these loans.

In the securitization model this doesn’t exist to a great extent because these loans are moved “off balance sheet” if they are treated as a “sale”. The accounting rules for these transactions are complex and contained primarily in FASB 140.

Derivatives; Credit Default Swaps (CDS)

To keep this simplified, a CDS is where one party makes insurance payments to another party (counterparties) to pay-off the credit extended in the case of default (non-payment, bankruptcy). If I am the premium paying party (Buyer) I will be paid off by the insurer (Seller) if the third party (Reference Entity) doesn’t pay off the loan, bond etc.

Basically banks and speculators are buying and selling credit insurance to each other for the performance of the bonds and companies. The problem is they are also speculating by trading in the CDS even if they don’t own or have an interest in the collateral.

The OCC’s Quarterly Report on Bank Trading and Derivatives Activities for Second Quarter puts this number at $15.5 trillion for U.S. Commercial banks. Credit Default Swaps are 99% of this number. 

The bottom line is this; we completely refinanced existing mortgages that were “on balance sheet” and adequately capitalized and reserved for in the system, with new mortgages that were primarily put into private or public securitizations, many treated “off balance sheet” in the trillions of dollars. Then we created synthetic securities on top of those. Since the same loans are used as “collateral” or are the “underlying collateral” for the synthetics, when the loans go bad multiple investments go bad, and many more investors lose their shirts.

A Simplified Example

Let’s take an over-simplified example of one mortgage loan made $200,000. The person that loaned the money, sold the loan to an investor and took their fees. The investor is now responsible for the loss. This loan is again used to sell to another investor in a derivative Wall Street product, so now there is $400,000 invested in this same $200,000 loan.

Both of these investors are concerned that the loan may go bad so they buy a credit default swap.

Other speculators wanting to make money on this loan buy credit default swaps on the loan as well betting on one side it will pay and on the other it will default. Now let’s say there is over $1.5 million invested  and bet on this one $200,000 loan and only one or two people reserved a little money to cover any loss… and it stops paying. We have a credit crisis and a crisis of capital.

The GSEs

Fannie Mae and Freddie Macs share of these mortgages may seem somewhat inconsequential on a percentage basis, in 1995 it was 35.7% and in 2007 it reached 41.4%, however in dollar terms it meant that Fannie and Freddie, meaning the U.S. tax payer  (now obvious to everyone at this point) stood behind an additional $3.6 Trillion dollars in mortgage loans. As far back as December 2004 OFHEO, Fannies regulator, rated Fannie Mae as “significantly undercapitalized”.

The table below is a combination of FDIC Statistics on Institutions and the Federal Reserves statistical release“Flows and Outstandings Second Quarter 2008” .

Observable in this data is that from the period of December 2005 to December 2007, residential mortgage loans (1-4 and multi-family) outstanding increased in total (inside the FDIC Bank group plus outside the banking system) over $8 trillion dollars. The FDIC banks loss reserves which are the reserve for all loans including credit card, auto etc. went up a mere $42 billion during the same period.

 

What can also be observed here is that although Tier 1 Core Capital also went up in the system by $589 billion, when you add the mortgages outside the system together with the leveraged synthetic products plus inadequately capitalized GSE’s and investment banks, you have a significant gap in loss reserves and capital in the entire system. $8 trillion dollars in additional mortgage balances and multiples of risk in the derivatives market including CDO^2 and $15 trillion in Credit Default Swaps.

Where-oh-where is the capital to support this leveraged up risk?

It's in the U.S. Treasury.

The fees to each of the participants were large, the government was pushing hard for over 20 years to democratize credit, not enough capital is set aside capital for the risk and good loans are made and bad loans are made. House prices are pumped up, businesses are expanded, jobs are added, and up we go.

Since the fix to the moral and the future financial hazard is to force adequate capitalization for risk, the availability and velocity of credit will have to return to its pre-2000 levels… and down will come everything with it until the asset prices meet the investment and spending level represented by this responsibly adjusted amount of credit in the market.

The government is trying to stem the tide through massive infusions of tax payer dollars, but if we put the appropriate safeguards in the system moving forward, it will be an artificial floor with artificial values that will meet their maker some day when there isn’t enough taxpayer dollars to make up for the difference between rational, and irrational credit availability.

It’s really not a “new” reality. It’s the reality that was always there, we’ve just run our tax paying heads smack into it as we were blown out of Alice in Wonderlands rabbit hole.

The Real Reason You are about to Bailout Wall Street

After last night’s vote on the Government’s Wall Street Bailout (a.k.a., “The Economic Rescue Plan”), I am compelled to now take the conversation to a different level. I am going to attempt to explain why this bill will make no difference in credit availability to Main Street, regardless of the repositioned marketing efforts designed to sell you otherwise.

The old way lending worked was that the bank or financial institution that made the borrower the loan, owned the loan. If you made a mortgage application to Bank of America, they analyzed your credit, approved the loan and kept the loan on their books (on balance sheet).

These were the days when you got your billing statement from the same bank that gave you the loan. The bank billed the customer, collected payments and most importantly collected on the delinquent loans. Collections include calling delinquent customers, foreclosing when they weren’t paid, selling the property and (this is key) writing off any losses (charge-off).

Since the bank owned the loan and had to take any losses from the loans they made, they had to set aside money to pay for those losses. This money that had to be set aside for losses is called “loss reserves”. These reserves had to stay in reserve and could not be used for any other purpose. The money couldn’t be used to make more loans (i.e., pay operating expenses, more loans). It was set aside to pay for potential losses.

This changed in the 1980s, as a Wall Street tool called securitizations came into play. I’m not going to go into detail on this, you can find it in my upcoming book, but the end result was that the bank that made the loan could sell the loan to private investors. The investors were now the people responsible for the losses.

As an example, let’s say a bank made five $200,000 loans for a total of $1 million dollars (5x$200,000) and their anticipated loss rate was1%. The bank would then have to set aside $10,000 ($1,000,000 x 1%) to cover those losses.

Once the loan is sold, the bank is paid for the loan and is no longer responsible for the losses. Since the bank is no longer responsible for the losses, they didn’t need to keep loss reserves for the loans they made. Using the same example, the bank makes $1 million in loans, sells the loans, collects their money from the sale and never puts anything in loss reserve.

This very fundamental difference in lending is the primary reason we are where we are today and why credit is going to be severely restricted in comparison to the last 10 years.

Let me explain.

The first issue is credit underwriting, which is the criteria the lender applies to say who gets a loan and who doesn’t. The reason so many loans were made to people who couldn’t afford them is because the lender, making the credit decision, is no longer responsible for the losses. The more loans they make and sell, the more money they collect (more profit).  It is important to note again, this model does not require the lending institution to set aside money for losses.

The game then becomes to make as many loans as possible, good or bad, which is exactly what happened. In the period between 2001–2007, $19 Trillion in mortgage loans were originated. For those that pay attention to the numbers, the reason this amount exceeds the current mortgage loans outstanding of approximately $14 trillion, is pay-downs and the large numbers of refinanced mortgages in the $19 trillion.

The second issue is that these loans are made and the loss reserves that are supposed to be set aside in the banking system do not exist. This is what the now roughly $1.5 trillion in tax payer bailout (if this ridiculous bailout bill goes through) is paying for.

The reason all of this spin telling you the “bailout” has to be approved or you, Main Street, won’t be able to get loans is completely misleading is because credit is going to be severely restrictive moving forward in comparison to the past 10-20 years, regardless of this bailout.

The only way to keep our system safe from these problems moving forward is to require lenders to set aside the appropriate loss reserves for the loans they make. The lender must be responsible for their losses. This has to happen and must be the primary demand of the public to our regulators or the problems we have now, will just continue. If the lender is again responsible for those losses, they will make better (read tighter) credit decisions. This resolves the massive moral hazard we have built into the game.

If these loss reserves have to be set aside by the lender, it means less money to lend to borrowers; less money to lend because they own the results of their decisions, and less money to lend due to loss reserves.

There are other conversations about vehicles to help resolve the problem, such as covered bonds, but none of them can get around these banking basics.

If you want to go along with the bailout of Wall Street, go ahead and line Warren Buffett and other’s pockets who are taking advantage of this situation, that’s certainly your prerogative. Don’t do it because you think it will change your ability to get credit now or in the future or actually solve the issue at hand.

A Massive Government Bailout by any Other Name

Are you convinced about the bailout yet?

Are you feeling the pressure? Have you noticed the shift in the conversation by Wall Street, the media and the supporters of this bailout?

It is now all about “Main Street”

• The government bailout is now called the “Rescue Package”

• The stock market will collapse and the equity lost will be lost by everyone including Main Street

• The problems are spreading to small business which is going to cripple the country

This is spin marketing in its most unethical form. They couldn’t sell this pig to the American people, so now it’s being repositioned to tell you if you don’t buy the pig, you won’t be able to buy the bacon and ham at the grocery store either.

The “Rescue Package”

Still an unprecedented, massive government bailout and expansion of government that is attempting to socialize the losses of the private markets. It will be the first installment of many more to come. Even the spinners admit that this won’t fix the problem.

The Stock Market Collapse and Main Street

The markets didn’t collapse when Paulson and Bernanke tried to scare us into acting two weeks ago. Nor did it collapse when we all woke up Tuesday after the initial rush to a bad solution was appropriately leveled in Congress. The stock market is going to decline whether this bailout happens or not. It is is over inflated due to too much credit in the system for years and has to readjust to reflect reality.

The Problems are Spreading to Small Business

This is the most dishonest and deleterious message in the new spin. I heard the same story about the guy that couldn't meet his payroll because of these problems, from five different politicians and commentators on three different news shows. The latest (second story plucked from millions of small businesses) is the lady that can’t get access to a $1 million to expand her business.

First of all, if I spent some time at it, I could go find you stories of small businesses that are getting credit and loans right this very minute.

Second, this “guy” must be running his business on a shoe string if he needs to borrow money to make payroll and will probably be out of business soon regardless of the bailout.

Third these people may not get access to the loans they need anyway. Credit has tightened and rightfully so. Banks don’t want to make loans they don’t think will be paid back anymore (novel concept).

Don’t listen to the fear mongers who want your money to pay for the problems. Demand a private market solution that may have to contain a temporary, tax payer bridge loan, to get the best solution in place.

Let’s work this problem hard, for whatever time it takes, with the right people. The market can certainly hold its collective breath until it's done.