Dad used to tell me there is no accounting for standards when looking
at something that seemed odd. Today, we have faulty standards for
accounting that are ripping apart the fabric of the world's economy.
How can a security that has a high probability of full repayment be
downgraded from AA to junk levels? What we will explore today tell us a
lot about why we are in the crisis state of affairs. Since I wrote you
last Friday, the financial landscape of the world has changed even
more. And what will happen this weekend will change it even more. And
our kids will be paying for it for a long, long time. At the end I
offer a few thoughts on the events, and if there is time my thoughts on
the new short covering rules. All in all, it should make for an
instructive and interesting letter. We'll jump right in with no "but
I was invited to an invitation only presentation to a
room of chief executives of a number of small Texas banks made by Rich
Berg of Performance Trust Capital Partners this week (http://ptcp.performancetrust.com).
He graciously gave me permission to go over the main points of his
presentation. I think you will find it eye-opening to say the least.
You probably have seen Rich, as he is all over the media lately.
jump back 18 months. I spent several letters going over how subprime
mortgages were sold and then securitized. Let's quickly review. Huge
Investment Bank (HIB) would encourage mortgage banks all over the
country to make home loans, often providing the capital, and then HIB
would purchase these loans and package them into large securities
called Residential Mortgage Backed Securities or RMBS. They would take
loans from different mortgage banks and different regions. They
generally grouped the loans together as to their initial quality as in
prime mortgages, ALT-A and the now infamous subprime mortgages. They
also grouped together second lien loans, which were the loans generally
made to get 100% financing or cash-out financing as home owners
borrowed against the equity in their homes.
Typically, a RMBS
would be sliced into anywhere from 5 to 15 different pieces called
tranches. They would go to the ratings agencies, who would give them a
series of ratings on the various tranches, and who actually had a hand
in saying what the size of each tranche could be. The top or senior
level tranche had the rights to get paid back first in the event there
was a problem with some of the underlying loans. That tranche was
typically rated AAA. Then the next tranche would be rated AA and so on
down to junk level. The lowest level was called the equity level, and
this lowest level would take the first losses. For that risk, they also
got any residual funds if everyone paid. The lower levels paid very
high yields for the risk they took.
Then, since it was hard to
sell some of the lower levels of these securities, HIB would take a lot
of the lower level tranches and put them into another security called a
Collateralized Debt Obligation or CDO. And yes, they sliced them up
into tranches and went to the rating agencies and got them rated. The
highest tranche was typically again AAA. Through the alchemy of
finance, HIB took subprime mortgages and turned 96% (give or take a few
points depending on the CDO) of them into AAA bonds. At the time, I
compared it with taking nuclear waste and turning it into gold. Clever
trick when you can do it, and everyone, from mortgage broker to
investment bankers was paid handsomely to dance at the party.
we ever forget Charlie Prince's line, the CEO of Citigroup, saying that
"As long as they are playing music, you have to get up and dance?" just
a few weeks before the market imploded? Apart from having his rhythm
being proven totally horrendous and overseeing an implosion which cost
Citigroup tens of billions, it was a great statement of the zeitgeist
of the financial world at the time.
The key word here is model.
The ratings agencies used data supplied by the investment banks on what
the likely default rates would be. It was something like taking an open
book test where you get to write the questions. And since home values
had only gone up, default rates were low. And of course, the data was
from an ear when bankers lent money actually expecting to get paid back.
Inside a RMBS
look at a RMBS. As Berg points out, when you are buying a mortgage
backed security, there are really only three questions you need to know
the answers to:
- How many mortgages will default?
- How much will I get back on a defaulted loan?
- How much credit enhancement is there in the security?
set the table by looking at a few terms and definitions. Using his
example, let's take a mortgage where the home was originally appraised
for $400,000 and there is a $300,000 mortgage on the home. Let's assume
a default and the bank takes back the home. If they sell the home and
recover $240,000 that means they lose $60,000. This is called a 20%
severity. If they sold and recovered $150,000 it would be said to have
a 50% severity.
Next, let's look at how the rating agencies come
up with the AAA rating. First they model the expected losses, with
emphasis on the word model. If they figure that worst case that 8% of
the loans default at a severity of 50%, then the security would lose 4%
of its value. To get an AAA rating you have to have at least two times
the coverage of the "modeled" loss. In this illustration, that means
that 92% of the loans would be put into the AAA tranche. An A rating
assumes a coverage of more than 1 times but less than 2. B means you
expect to get your money back and if they model that you will get below
100% back then the rating would be at junk levels.
Now, this next
fact is important. All ratings assume a par value of 100. The rating of
these bonds has nothing to do with price. After the presentation, Rich
sat down with me and pulled up an actual mortgage backed security that
was being offered that day on his screen. It was once a AAA rated Alt-A
security. If I remember correctly it was a 2006 vintage security.
of the latest reporting, a little over 5% of the mortgages were over 60
days past due or in foreclosure. In this security, there are no toxic
option ARMS. The numbers of mortgages in this security that are in
trouble are rising. S&P has downgraded that AAA tranche to BBB,
which of course means its value is going down.
And sure enough,
the offered price of the security is 70 cents on the dollar, or 70% of
the original par value. Now remember, this particular AAA bond will
only start to lose money after the lower tranches take up the first 8%
of losses. Thus, this bond can be said to have an 8% credit enhancement.
Pricing in Financial Armageddon
let's stress test that loan. For the AAA portion of the loan to lose
money, that would mean that 16% of the loans would have to default with
a severity of 50% losses. Could that happen? Sure.
But let's look
at what buying that loan at 70 cents on the dollar does for the new
owner. First, you are getting a much higher yield (interest rate)
because you are buying the security at a lower valuation. But something
else even more interesting happens.
Even though the security sold
at 70 cents, it still gets all of the first of the proceeds of the home
owners who pay their mortgages, up to 92% of the original value in the
security. How many loans would have to default in order to make the
buyer at 70 cents lose money? Remember, we already had credit
enhancement of 8%. But at 70 cents, we just "bought" or priced in
another 30%. Let's think Armageddon and that 50% of the mortgages
default and they only recover 50% of the loans. That would only be a
total loss of 25% to the entire collateral of the deal, but it would
mean that the new investor still get all of my 70 cents plus another
13% back! The proud new owner could get up to 92% of the monies paid.
Even in a pretty bad scenario, you get more than you paid for the
Let's walk through the math. Let's say the original
security was $100 million (which would be a very small RMBS). The AAA
tranche would have cost $92 billion. If you have it at 70 cents on the
dollar you paid approximately $64 billion. In my Armageddon scenario
above, the security loses 25% or $250 million. The lower rated tranches
are completely wiped out losing $8 billion. Your tranche loses the
remaining $17 billion which means you get $75 billion and you only paid
So, how bad would things have to get to lose money
on this security? If I am doing the math right, 72% of the loans would
have to default with a severity of 50% before your investment of $64
billion was impaired by even so much as 1 dollar. If that happened, it
would be Armageddon.
So, why is it rated BBB? Because the rating
is over the entire tranche and it is made at a par price of 100. The
rating is not affected by the current price. As of today, assuming that
even double the number of mortgages currently delinquent default with a
50% severity, your returns over the life of the security would be well
over 12%. You would get back $92 million for your $64 billion dollar
investment along with interest payments.
The reason this
presentation was being made to banks and institutions? Because if you
are a bank, you can generally only get prime plus 2% on a loan you
make. But if you buy this security with your capital, you can make
prime plus 6%. That is a large difference to a bank. Performance Trust
has sold billions of this type of paper to banks and institutions.
this is such a good deal, then why isn't everyone hitting the bid?
Because these securities are very difficult to analyze. It is time
consuming. You need to analyze every loan and develop your own
valuations. You simply can't trust the ratings, as they are measuring
something completely different.
And the real truth is that many
of the various RMBS securities will in fact be totally wiped out or
lose a great deal. Many are seeing default rates of 30% or more. You
have to be very careful when you walk through this minefield. And in a
time of crisis, it is not clear what the new rules will be. What if the
government forces lenders to re-set mortgages at some loss level? What
if the housing crisis gets worse? On the other hand, what if the
government comes in and buys up all the bad mortgages in an attempt to
stop the erosion in the home markets. The level of uncertainty in these
times makes people a lot more cautious.
There are Alt-A RMBS like
the one mentioned above that are probably not worth even 70 cents on
the dollar. These things are marked to a market that is frozen.
Everything gets lumped into the same basket and it all has to be marked
to market by the new accounting rules called FASB 157. The institution
selling the above mentioned security is being forced to do so, either
because they are in financial trouble or they are not allowed to hold
BBB securities in their portfolios and by law are required to sell. And
in times of crisis, the selling price is not that of normal times.
Ratings to Collateral to Ratings: A Vicious Cycle
a recipe for a perfect financial storm? Let's make a massive amount of
bad loans and get them on the books of most of the major financial
institutions because they are rated investment grade. Then let's have
the loans start to go bad. Throw in some general panic as everyone
tries to sell the loans. No one is buying.
Let's make a new rule
that you have to mark your illiquid securities to the last price paid
by someone desperate to sell. That means that many institutions now
have to mark their capital down and that means those pesky rating
agencies must by their own rules mark down the ratings of the
institutions which of course means that it costs them more to raise
capital at a time when they can't get it which means they get lower
ratings and so on. It becomes a vicious cycle.
In the early 80's,
every major US bank was bankrupt because they had loaned Latin American
countries far more than their capital they had on their books. The
Latin American countries defaulted. If the US banks had been forced to
mark to market, they would have all gone down taking the US economy
along with them. So, the Fed simply allowed them to carry the loans at
book value, offering liquidity and allowing the banks to buy time to
make enough money to eventually write off the loans.
mark to market rule, while nice in theory, works in normal times. But
it has the unintended consequence of making things worse in crisis
times. Why should an institution have to write down a security which
over time is going to pay back the lion's share or more of its value
just because a severely stressed institution was forced to sell that
security at a very low price in a time of crisis?
needs to be transparency and we as investors need to know what is on
the books of the companies that we invest in. But it is somewhat like
my bank asking me to mark to market my home and pricing my loan daily
based on that new price. If my neighbor loses his job and sells his
home at auction, does that mean my home is now worth less two years
from now. Maybe an even better analogy, if I am renting that home to a
very good tenant, does my neighbor's price impair my income?
was, and am, a fan of mark to market pricing. But we need to think
through what a market price is. Not all things can be easily marked to
market. This is doubly true when "market price" is a nebulous index of
mortgage securities which may or not have a fundamental relationship
with an illiquid security on the books of an institution which has no
intention of selling, especially in a time of credit crisis.
is one thing to require that you mark your stocks or bonds to market
values. It is another thing entirely to require all mortgage backed
securities, which are extremely complex things, can be very different
one from another and which require a lot of time and effort to value,
to be priced as though they are all the same.
FASB 157 needs to
be amended this week. If Congress can create a new Resolution Trust
Corp in a week, the surely the accounting board, with the suggestion of
Treasury, can figure out a better way to price illiquid securities.
This Too Shall Pass
know that you probably are reeling from all that has happened the past
few months and especially the past two weeks. Lehman and Mother Merrill
gone? We the people own AIG? Fannie and Freddie? A new housing bailout
which will cost hundreds of billions? The Fed creating whole new
programs to provide liquidity? Did you notice they loaned some $250
billion this last week to banks all over the world? Stopping short
Want to see in graph form how bad it got and what
spooked Paulson, Bernanke and company to act so quickly? Look at these
graphs from my friends at Casey Research (http://www.caseyresearch.com/crpmkt/crpSolo.php?id=119&ppref=JMD119ED0908A).
30 day commercial paper went to 5% from 3% a week ago. The market was
literally freezing. And the amount of paper issued is in free fall.
Commercial paper is the life blood of the financial and business world.
Without it commerce will soon grind to a halt.
simply takes your breathe away. As President Bush said today, it does
not help to find who is at fault today, we have to figure out how to
get out of this mess. It is going to cost the taxpayers a lot of money.
While I think the losses on AIG will be rather minor in the grand
scheme of things, if you add up Fannie and Freddie and a new RTC,
coupled with the stimulus package, you can easily get to $500 billion,
and that is probably a low number.
For such a price, we had
better get a new regulatory scheme which requires reduced leverage.
Want to get really mad? Up until 2003, all investment banks were
allowed only 12 to 1 leverage. Then in 2004, the SEC basically gave
five banks (and only five banks) the ability to lever up 30 or even 40
to 1. Bet you can guess the five banks. Bear, Lehman, Merrill, Morgan
and Goldman. Three down.
As Barry Ritholtz wrote: "So while the SEC runs around reinstating short selling rules, and clueless pension fund managers mindlessly point to the wrong issue, we learn that it was the SEC who was in large part responsible for the reckless leverage that led to the current crisis."
(Don't get me started on blaming the short sellers. Let's not blame the
people who leveraged up their companies 40 to 1 with bad investments.)
absolutely must move credit default swaps to a regulated exchange, no
matter how much investment banks and hedge funds scream. Must be done.
Do it now. Real rules about writing mortgages, although now that losses
are in the hundreds of billions, underwriting rules are already
becoming quite restrictive.
And while we are at it, a thorough
revamping of the rating agencies and the rules they use should be at
the top of someone's list.
South Africa, Boulder and Stand Up to Cancer
is time to hit the send button. Chuck Butler of Everbank and Thomas
Fischer of Jyske Bank just walked into the office to watch the Texas
Rangers play Anaheim from my balcony (which is inside the Ballpark
where the Rangers play). That would be baseball to those not from the
states. Chuck is a huge baseball fan and when I heard he was going to
be in town I had to have him come, even on a writing day.
is known for letting clients open CDs denominated in scores of
different currencies. If you are interested in diversifying away from
the dollar, you can go to Everbank.com. Or call EverBank at 800-926-4922.
has had some very serious cancer, and has been going through lots of
chemo. He just told me that his latest scan shows him 100% cancer free,
and he is going off the chemo. Sometimes good things do happen to good
And speaking of cancer, Stand Up to Cancer is a charity
formed to raise money to find cures for cancer and fund innovative new
therapies and research. SU2C is going to make a difference in how
cancer research is conducted over the next five years, with its focus
on targeted treatments that interrupt the mechanisms of uncontrolled
cell growth. This is the kind of emphasis that can make cancer into a
disease patients live with, rather than one they die from (sort of like
AIDS has become for most of its victims in developed countries). You
can and should see the program broadcast live a few weeks ago on most
major networks. And then send money. Their web site, with tons of
information is http://www.standup2cancer.org/ and the TV show is at http://www.nbc.com/Movies_Specials_More/Stand_Up_To_Cancer/video/episodes/.
leave for Cape Town in South Africa tomorrow morning. I will be
speaking at the ABSIP (Association for Black Securities &
Investment Professionals) Annual Conference in Cape Town on September
23. Then that evening I fly to London for meetings with my partners and
clients there and fly back to Dallas on Thursday. I hope to be able to
keep up with what is going on and write the letter next Friday. And
then Sunday I fly to Boulder to meet with Dr. Bart Stuck and learn
about a company called InPhase which is making holographic memory.
Pretty cutting edge stuff.
I mention this because it is companies
like InPhase, and a thousand more like them, which will power the next
big wave of change. The crisis on Wall Street will pass and the world
will continue to change. I think it is going to change for the better
for most people.
The game ahs started, so I think I am going to
find an adult beverage and really, truly celebrate with Chuck, who was
on the road when he got the news. I know he will be celebrating with
his family when he gets home.
Your not looking forward to a 15 hour flight analyst,
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