Deal of the week

On Wednesday HBOS closed the first UK RMBS deal since August 2007 (that we know about, anyway). Libor + 85 for AAA bonds with a 160% OC. Yep, the deal is £500M and there is £800M of collateral. 800. Just pause a moment and think about that OC. The deal can suffer 35% delinquencies with zero recovery and still be money good. That is truly an astonishing level of safety for the market to demand in return for something as rich as 85bps. Remember AAA prime UK RMBS used to trade at low teens of bps: 85 was BBB territory. Verily the Crunch is a harsh mistress.

For the curious, there are more details here and here.

Bye bye Bear

From Bloomberg:

JPMorgan Chase & Co. won approval of its purchase of Bear Stearns Cos., shuttering an 85-year-old firm whose collapse ranks along with Drexel Burnham Lambert as one of the biggest in Wall Street history...Bear Stearns shareholders endorsed the sale during a 10- minute meeting today

Don't say a prayer for me now, save it 'til the quarter after... Apart from the Bear's employees, I don't see many tears being shed about this one.

Quantitative finance ideas in decision making

Suppose you have a decision to make and you know some quantitative finance. How can you use what you know to help in your decision?

First you construct a outcome metric. This is just a function that expresses whether one distribution of outcomes is better or worse than another. Next you deduce the distribution of outcomes for various choices, often by building a model of how the initial conditions determine the outcome, then determining the distribution of initial conditions and putting that through the model*. Apply the metric and make the decision.

Now here's where it gets interesting. Being a quantitative person, you know that there is model risk. Specifically here three kinds of model risk:

• Your outcome metric might be wrong. One common way this can happen is that there is something that you have neglected entirely - unexpected consequences.
• The distribution of outcomes is wrong because the model is wrong.
• The distribution of outcomes is wrong because the future does not behave like the past.

So, knowing this, we need to continue monitoring the decision, updating both our outcome metric and our model, to ensure that with new information our decision remains correct.

Two things stimulated me to write this account: one was the shameful mess that is UK energy policy mentioned earlier in the week; the other was hearing an item on a new book Mistakes Were Made (But Not by Me) on the Today programme. The book discusses how, when faced with evidence that our decisions are bad, rather than recant and change our minds, we engage in self justification. I will let the authors take over at this point:

The engine that drives self-justification ... [is] cognitive dissonance. Cognitive dissonance is a state of tension that occurs whenever a person holds two cognitions (ideas, attitudes, beliefs, opinions) that are psychologically inconsistent, such as "Smoking is a dumb thing to do because it could kill me" and "I smoke two packs a day." Dissonance produces mental discomfort, ranging from minor pangs to deep anguish; people don't rest easy until they find a way to reduce it. In this example, the most direct way for a smoker to reduce dissonance is by quitting. But if she has tried to quit and failed, now she must reduce dissonance by convincing herself that smoking isn't really so harmful, or that smoking is worth the risk because it helps her relax or prevents her from gaining weight (and after all, obesity is a health risk, too), and so on. Most smokers manage to reduce dissonance in many such ingenious, if self-deluding, ways.

One of the most obvious examples is of course Blair and the Iraq war, but there are many many more.

The quantitative way of thinking - acknowledging up front that we do not have all the relevant information (and might never have) so that we need to review the decision regularly - is a good way of depersonalising matters. We do not need to engage in self-justification because it is not our decision: it is the result of some modelling. If it goes wrong, we fix the model. Our course there may very well be opinions that go into the model, but by explicitly including the monitoring step we acknowledge before we make the decision that it might be wrong. That must be helpful.

* This is a stylised version of what any kind of economic capital model such as VAR does. The outcome metric in finance is sometimes obvious - it's expected return, with more being better - and one of the many things that makes non-financial decisions harder is that such an obvious metric is not easy to find. In particular away from the risk neutral measure, how much compensation should you require for uncertainty in outcomes? (Oh, and if there are any mathematicians reading, it does not need to be a metric in the technical sense: a well-founded total order with all GLBs and LUBs will do.)

Minsky, Ponzi and Procyclicality

More on my reading backlog: I've been tackling Minsky's Cushions of Safety: Systemic Risk and the Crisis in the U.S. Subprime Mortgage Market which compares the old-style model of financial system fragility with the happenings in the subprime crisis. What I had not realised is that Minsky's notion of fragility is just a form of procyclicality:

Central to Minsky’s analysis of financial fragility was the concept of a cushion of safety...The “cushion” covers the margin of error in anticipated returns from an investment project...For example, the margin of safety for a banker lending to a businessman for a particular project would be determined by the difference between the amount loaned and the amount required to finance the project...The idea of increasing financial fragility is built around the slow and imperceptible erosion of margins of safety during conditions of relative stability.

A good example is credit risk modeling: calibration of credit risk models to recent historical default rates during quiet conditions slowly erodes cushions of safety, leaving institutions more leveraged when a crisis hits. Minsky might have been one of the first to identify procyclicality via the lending decision, but there are plenty more examples of the phenomenon in modern banking. I don't think it is fair, as some commentators do, to call this a Ponzi scheme: rather I think it is a calibration error, but one firms and their regulators need to be aware of.

Uncertainty and strategy

A key issue in strategy is uncertainty in the outcome. Unlike financial return distributions, where we at least have some data to go on, and some models (albeit ones which struggle with autocorrelation, fat tails, and regime changes) there isn't much data on corporate strategy because each situation is different. I can't try the same acquisition a hundred times over to get a sense of the distribution of returns or, as Keynes said:

Our knowledge of the factors which govern the yield of an investment some years hence is usually very slight and often negligible

Usually people don't let that worry them too much not least because the downside is bounded at zero: often you cannot lose more than you put in. But there is one area where is glaringly obvious that a consideration of uncertainty is important because the returns are so volatile and possibly highly negative - nuclear power. Today we heard, entirely predictably, that:

[The] cost of cleaning up the UK's ageing nuclear facilities, including some described as "dangerous", looks set to rise above £73bn

In fact we have no reason to believe that nuclear fission has net positive value. The costs of building it, running it and cleaning it up may well exceed, perhaps by an order of magnitude, the value of the power generated. As France's nuclear safety watchdog has ordered EDF to halt work temporarily at its flagship new generation nuclear power station and half a million people were hit by unscheduled power cuts after seven power stations, including Sizewell B in Suffolk, unexpectedly stopped working within hours of each other perhaps the policy makers might like to reconsider their push for a new generation of nuclear power stations.

Update. WTF? Gordon Brown has said the UK needs to increase its nuclear power capacity - raising the prospect of plants being built in new locations. As Sting didn't write, every little thing he does is hurried, ill-advised, and foolish.

How long before things are back to normal?

I have belated managed to read the OECD document The Subprime Crisis: Size, Deleveraging and Some Policy Options. It's a little scary.

It could take 6-12 months for banks to offset losses via earnings alone

And that is based on $350B or so of total losses. If the uber-bears are right and it is a trillion, presumably it will take three times longer.

Whither US financials?

I am convinced that there will be a good buying opportunity for financials at some point in the Crunch. Has it arrived? It would be a brave person who was certain it had, and events of the last few weeks are curious. Consider (courtesy of Bloomberg) first two of the hardest hit large broker/dealers, Merrill and Lehman:This underperformance contrasts with the broker/dealers who seem to have higher market confidence - Morgan Stanley and Goldman - and the Bank who ate the Bear, JPM. Even Citi has not been as hard hit recently as MER and LEH:This strikes me as odd. Thain had every incentive to kitchen sink the Merrill write down, and we could easily see write ups in coming months if Merrill's prices predict lower default rates than are actually experienced. Lehman has skillfully negotiated a crisis of confidence and shown itself to be better managed than the Bear. I'm not sure I'm ready to be outright long US financial yet. But one could be tempted to consider a long in the harder hit broker/dealers vs. a short in the other two.

Educated readers

Of financial statements that is. The IIF has recently pleaded for more laxity in applying fair value accounting in disrupted markets. Specifically they want banks to be permitted to use book value where it suits them, but not to be locked into hold to maturity if they do that. As Lex says:

However diplomatically couched, the proposals are unedifying. After precipitating a crisis and then borrowing large amounts of public money, it takes an audacious industry to cast accounting as a villain...The IIF wants “stable valuations” that “increase market confidence”. This is not the purpose of accounting standards. Even if market prices have overshot ... relying on banks’ interpretations is worse.

Exactly right. Nothing forces users of financial statements to act based on the earnings disclosed. But now that, for the first time, these readers are seeing the real volatility of earnings, rather than the smoothed version produced by accural, they are bidding down financial shares. They are better educated and hence able to make more informed decisions. The IFF wants to take that information away - somehow I don't think the readers will stand for it.

I still prefer 157, but 163 is a good one too...

From the FASB:

Statement 163 requires that an insurance enterprise recognize a claim liability prior to an event of default (insured event) when there is evidence that credit deterioration has occurred in an insured financial obligation.

Specifically, from the standard itself:

The recognition approach for a claim liability relating to a financial guarantee insurance contract requires that an insurance enterprise recognize a claim liability when the insurance enterprise expects, based on the present value of expected net cash outflows to be paid under the insurance contract discounted using a risk-free rate, that a claim loss will exceed the unearned premium revenue.

For the monolines, of course, that means a realistic assessment of eventual credit losses. Now that isn't an easy thing to do, and there is still a lot of wriggle room in how that standard is applied, but at least sticking their heads in the sand is no longer a sanctioned accounting standard.

Trichet on asset price bubbles

Jean-Claude Trichet made a speech in 2005 on Asset Price Bubbles and Monetary Policy. The full text is here. A few points leap out at me. Firstly Trichet raises the question as to whether there is such a thing as an asset price bubble:

I believe the NASDAQ valuation of the late 1990s was not excessive... [I] tend to believe that occasionally we observe behavioural patterns in financial markets, which can even be perfectly compatible with rationality from an individual investor’s perspective, but nevertheless lead to possibly large and increasing deviations of asset prices from their fundamental values, until the fragile edifice crumbles.

`Excessive' is a difficult word and I can see why Trichet is cautious about using it. But certainly the fair value of debt securities is the result of many phenomena including funding premiums and liquidity premiums as well as long term default rates. Their spread can tighten leading to asset price growth if funding is cheap and liquidity is plentiful without this necessarily being irrational.

The problem knowing how much is too much means that Trichet is cautious about the possibility of identifying an asset price bubble:

I would argue that, yes, bubbles do exist, but that it is very hard to identify them with certainty and almost impossible to reach a consensus about whether a particular asset price boom period should be considered a bubble or not.

He suggests one definition of a bubble:

[There is] a warning signal when both the credit-to-income ratio and real aggregate asset prices simultaneously deviate from their trends by 4 percentage points and 40% respectively.

I agree, but I would have thought that liquidity and/or funding premiums and the availability of credit would also provide helpful warning signals. As Trichet says:

A bubble is more likely to develop when investors can leverage their positions by investing borrowed funds.

Interestingly (for 2005) Trichet points out the positive feedback in a bubble pricking of collateral:

A negative shock is likely to have a larger effect than a positive one. The reasons are that credit constraints can depend on the value of collateral and that in case of a financial crisis the whole financial intermediation process can in the worst case completely fail.

After those insights the conclusions are depressing:

With regard to the optimal monetary policy response to asset price bubbles, I would argue that its informational requirements and its possible – and difficult to assess – side-effects are in reality very onerous. Empirical evidence confirms the link between money and credit developments and asset price booms. Thus, a comprehensive monetary analysis will detect those risks to medium and long-run price stability...

I fully advocate the transparency of a central bank’s assessment of risks to financial stability and of its strategic thinking on asset price bubbles and monetary policy. The fact that our monetary analysis uses a comprehensive assessment of the liquidity situation that may, under certain circumstances, provide early information on developing financial instability is an important element in this endeavour.

In other words we will try to tell you when a bubble is inflating but, beyond targeting inflation, there is little we are going to do about it. And M. Trichet did indeed keep to the second part of that promise.

The US housing market in pictures

Continuing our occasional series, more pictures of retail housing gloom. First from Big Picture, house pricesAnd unsold inventoryCalculated Risk likes to look at Sales vs. Inventory normalised by the number of owner occupied units. This gives a sense of the percentage of unsold inventory and the percentage turnover:They argue that since turnover is still above the historic average, the volume of home sales could have further to fall.

About that model risk

On Monday I said:

The combination of leverage and complexity is a massive concentrator of model risk

By Wednesday we find in the FT:

Moody’s awarded incorrect triple-A ratings to billions of dollars worth of a type of complex debt product due to a bug in its computer models...after a computer coding error was corrected, their ratings should have been up to four notches lower.

The product was CPDOs. But that doesn't matter. This kind of thing will happen with leverage and complexity. A bug in the ratings model for French yoghurt companies might change the rating of Danone by one notch. But for structured stuff, it's likely to be a much bigger error.

Freddie and Fannie have a new guvner...

...apparently. According to Reuters:

The two top members of the U.S. Senate Banking Committee announced on Monday that they have a deal that will create a multi-billion dollar mortgage rescue fund and a new regulator for Fannie Mae and Freddie Mac.

Reflecting Trichet

A speech by Jean-Claude Trichet at the International Capital Market Association’s Annual Conference has received considerable comment - see here for instance for Alea. I'd like to focus on just two aspects in a long speech. First, leverage:

The challenge lies in preventing the system from feeding on itself through a spiralling process of leveraging...

Abundant liquidity, financial complexity [and] financial players’ incentive structures contrived a convergence of mechanisms that resulted in the upward spiralling of asset prices, further leveraging, increasing complexity and shrinking transparency.

The combination of leverage and complexity is a massive concentrator of model risk. Simple leverage is easy to spot: my broker won't let me buy stock on margin with a 1% haircut. But a tranche of a CDO-squared financed via repo could have a much higher leverage than 100:1. Complexity, then, can hide leverage and it can make modeling the true return distribution difficult or impossible: just because you can structure something does not mean that you should, as Bankers' Trust found out with Gibson's Greetings and Libor-squared swaps.

Second, ECB open market operations:

The first response of the Eurosystem during the turmoil was to try to keep very short-term money market rates near policy rates through more active liquidity management. With this objective in mind, the ECB adjusted the distribution of liquidity supply over the course of a maintenance period, by increasing the supply at the beginning of the period and reducing it later in the period (the so-called frontloading). The average supply of liquidity remained unchanged over the whole reserve maintenance period, in line with the Eurosystem’s aim to provide to the banking system over each maintenance period the exact amount of total liquidity it needs to fulfil its liquidity deficit. The average size of the Eurosystem’s refinancing operations for the maintenance periods since August 2007 remained at around €450 billion, as in the first semester of 2007.

This is remarkable -- and it makes the point beautifully that is is not the supply of cash that has been important in central bank financing operations, but rather guaranteed funding for illiquid assets. The ECB has indeed been remarkably liberal (by the standards of other central banks pre Crunch) in the collateral it permits at the window, and so it did not need to explicitly manipulate liquidity premiums the way the FED did.

The ECB and The Scorpion

In the fable of the scorpion and the frog, the frog is surprised that the scorpion's nature comes out in the dealings between them. The ECB is similarly surprised the banks have arbitraged their rules, despite arbitraging rules being in the very nature of banks. From the FT:

The European Central Bank on Thursday voiced its “high concern” at growing evidence that banks are exploiting its efforts to unblock the frozen funding markets by using its liquidity scheme to offload more risky assets than it envisaged.

Yves Mersch, a governing council member, said the ECB was now “looking very hard at whether there is not a specific deterioration of collateral” which the central bank is accepting in return for funds.

He was speaking amid signs of some banks creating low-rated assets specifically so they can be traded for treasuries at the European Central Bank.

You mean banks are chucking assets into SPVs, issueing paper, never trading it but claiming it is worth par, getting the blessing of their reliable friends the rating agencies, repoing it with the ECB, and smiling all the way to their Treasuries? Surely not. That wouldn't be in the spirit of the rules...

When I talked about this in February I thought the ECB knew what was going on and at least tacitly approved. It seems not. And now banks are creating euro tranches in dollar deals specifically to appeal to buyers with access to the ECB window. That makes sense - these deals presumably trade tight because of the certain funding. This is irritating the ECB, who are now looking for `an exit strategy' from this mess. But presumably one that doesn't send liquidity crashing down in the Eurozone. That will be interesting.

Volcker vs. Fannie and Freddie

Paul Volcker has cottoned on to the bizarre and currently unhelpful nature of the GSEs I discussed a few days ago -- the epitome of privatised gains and socialised losses. From WSJEconBlog via Naked Capitalism:

...he questioned the role of government-sponsored enterprises such as Fannie Mae and Freddie Mac during the recent turmoil in mortgage markets. “Where were Fannie Mae and Freddie Mac?” Volcker said.

“What kind of system do we have” when agencies charged with the public interest in housing are instead “out serving the interests of their shareholders?” he added.

What kind of system indeed. As always, the rules determine the behaviours observed.

Horst and £17M Sue

Two contrasting news headlines drew my attention this morning. Horst Köhler – a former head of the International Monetary Fund – singled out excessive executive pay ... as a factor in the subprime crisis and accused bankers of acting irresponsibly according to the FT. And over in New York a Lucien Freud portrait of Sue Tilly set a record Tuesday night for the most money paid for any work by a living artist. The 1995 life-size painting -- "Benefits Supervisor Sleeping" -- fetched $33.6 million during bidding at Christie's auction house in New York according to CNN. (That's $10M more than the previous record, by the way.)

Whatever you think of the desirability of having one of his paintings on your wall, Lucien Freud is one of the greatest artists of his generation, perhaps of all time. His unflinching cruelty, the visceral brushstrokes, the shock of seeing the reality of the body as he portrays it: no one since Goya has been as brutal about what people are. His output is of staggeringly high quality as anyone who saw his only major retrospective (the Hayward in 1988 - why hasn't he had one since?) can attest. Yet despite the new record price, Stan O'Neil could buy four paintings at this price and still have enough left to build a gallery to put them in and staff it for life with his payoff for leaving Merrill -- leaving it with enormous losses. Chuck Prince could manage three with his payoff for failure at Citi. When you see that, you realise that perhaps Horst has a point.

Cheap jibes

This should be below me. But it isn't. So I'll point out that hiring a guy called Jerker after you have writen-off $37B seems like an odd move...

On Tragedy

A frequent correspondent who I respect highly has just given me two new pieces of vocabulary: anagnorisis and hamartia. Wikipedia's entries can be summarised thus:

• Anagnorisis (ἀναγνώρισις), also known as discovery, originally meant recognition in its Greek context, not only of a person but also of what that person stood for, what he or she represented; it was the hero's suddenly becoming aware of a real situation and therefore the realisation of things as they stood; and finally it was a perception that resulted in an insight the hero had into his relationship with often antagonistic characters.
  
• Hamartia (ἁμαρτία) can be seen as a character’s flaw or error. The word is rooted in the notion of missing the mark and covers a broad spectrum that includes accident and mistake, wrongdoing, error, or sin. In Aristotle's Nicomachean Ethics (didn't you always want to write that clause in your blog?) hamartia is described as one of the three kinds of injuries that a person can commit against another person. Hamartia is an injury committed in ignorance (when the person affected or the results are not what the agent supposed they were).

The credit crunch is a tragedy. A tragedy for those that have lost their jobs while blameless (I'm not thinking of Jimmy Cayne here); a tragedy for those that were conned into a mortgage they cannot afford; perhaps even a tragedy for investors who lost a fortune because they believed ratings agency due diligence. There's lots of Hamartia: a belief in the robustness of risk transfer via securitisation and conduits; a belief that you know what the CDRs will be on mortgage pools; various kind of mis-selling and representations that were either knowingly or unknowingly false.

Then we had a series of moments of Anagnorisis: the initial falls in the prices of mezz then AAA ABS; the wave of announcements of write-downs; the distress of the monolines and the implications of that for the muni markets; conduit and SIV failures; Libor spikes and central bank interventions; rising delinquencies.

Let us take a moment then to mourn a tragedy,-for that is not too extravagant a word,-to hope that at least lessons can be learnt, lives mended, a better equilibrium attained.

Not dead (just)

Bloomberg reports MBIA had a substantial first quarter loss yet the stock went up:

MBIA Inc., the ailing bond insurer, rose in New York Stock Exchange trading after saying it will pump $900 million into its insurance unit and reporting a first-quarter loss that was narrower than some analysts' estimates.

(The $900M is a downstreaming of cash from the parent into the insurer. That money cannot now be dividended to shareholders unless regulators are comfortable with the capital adequacy of the insurer: the funds came from a $1.1B capital raising in February.)

MBIA, whose market value has slumped 87 percent in the past year, gained as much as 9.8 percent as the company reported a net loss of $2.4 billion and an operating loss of $3.01 a share.

It seems that anything less than a cataclysm is a cause for celebration with the monolines at the moment.

Update. Bloomberg now reports:

MBIA Inc. and Ambac Financial Group Inc. had ``meaningfully'' higher losses on home-equity loans and collateralized debt obligations than anticipated, raising concern about their Aaa status, Moody's Investors Service said.

The losses elevate ``existing concerns about capitalization levels relative to the Aaa benchmark,'' Moody's said in a statement today.

So instead of being, say, $10B short of AAA they are now $12 1/2 ? Big deal. Sabre rattling won't make up for the downgrade that should have come months ago.

Plunging rating

What should you do when confidence is being lost, when people are starting not to believe you? Gordon has this problem, and for him it is hard to see a way out. He looks inept after the would-he wouldn't-he election, the climbdown on 10p, and so on. And he hasn't closed down the obvious vulnerabilities: ID cards, 42 day detention, the war.

At times like this it is important to be clear what you stand for, what people can expect, and what they can't. Trying to be all things to everyone is a recipe for disaster. So is failing to understand why people are upset. Stand back, admit to what you think are mistakes and apologise for them, present a clear vision for the future, be clear on where you think the ethical lines are, and wait.

All Inflation's Little Parts

A wonderful graphic from the NYT illustrates the US inflation basket. The original interactive version is here: the static version is below.
(Click for a larger version.)

Seven Habits

Martin Wolf's blog has some suggestions for improving financial regulation. As usual, quote plus comment:

First, coverage. Perhaps the most obvious lesson is the dangers of regulatory arbitrage: if the rules required certain capital requirements, institutions shifted activities into off-balance-sheet vehicles; if rules operated restrictively in one jurisdiction, activities were shifted elsewhere; and if certain institutions were more tightly regulated, then activities shifted to others. Regulatory coverage must be complete. All leveraged institutions above a certain size must be inside the net.

OK, but this is a colossal task and one laden with systemic risk. It covers the regulation of banks, broker dealers, hedge funds and insurance companies globally. Do we really think it is realistic to work towards common regulatory standards for all of these? And if we do, we run enormous regulatory risk: set the wrong standards for *everyone* and *everyone* will do the wrong thing. At least at the moment regulatory diversity ensures that different players have different incentive structures.

Second, cushions. Equity capital is the most important cushion in the financial system. Also helpful is subordinated debt.

I might quibble with that last sentence to some degree but certainly leveraged players need capital. This is motherhood and apple pie.

Third, commitment. The originate-and-distribute model has, it is now clear, a huge drawback: originators do not care sufficiently about the quality of loans they plan to offload on to others. They do not, in Warren Buffett’s phrase, have “skin in the game”. That makes for sloppy, if not irresponsible or even fraudulent lending. Originators should be required, therefore, to hold equity portions of securitised loans.

Or at least some of the equity portion. And, in order to stop people selling very thin equity tranches then leaving the real risk in the mezz, 'equity tranche' should be defined to at least include the capital required for the whole tower calculated at a reasonable confidence interval and with conservative default correlation assumptions.

Fourth, cyclicality. Existing rules are pro-cyclical. Capital evaporates in bad times, as a result of write-offs, thereby forcing contraction of lending, worsening the economic slowdown and further impairing assets. Mark-to-market accounting, though inherently desirable, has a similar effect.

Agreed. We need a mechanism to make net capital requirements anti-cyclical, and to counteract the unpleasantly procyclical combination of constant leverage and mark to market.

Fifth, clarity. Lack of information, asymmetric information and uncertainty are inherent in financial activities.

I doubt the efficacy of information simply because I believe in the power of lazyness. The real contents of subprime ABS were not hard to discover. Investors didn't buy on a rating because they couldn't do their own due diligence: they bought on a rating because they couldn't be bothered to do their own due diligence. More disclosure is good but I don't expect it to make much difference.

Sixth, complexity. Excessive complexity is a significant source of lack of clarity. It is particularly damaging, as we have seen, to the originate-and-distribute model, because markets in complex securitised products may, at times, seize up, forcing central banks to become “market makers of last resort”, with all the difficulties this entails. One possibility then is to insist that all derivatives be traded on exchanges.

Arrant nonsense. Complexity is not necessarily bad and neither do exchanges necessarily provide either price transparency or a guarantee of liquidity.

Seventh, compensation. On this I can do no better than quote Mr Volcker: “In the name of properly aligning incentives, there are enormous rewards for successful trades and for loan originators. The mantra of aligning incentives seems to be lost in the failure to impose symmetrical losses – or frequently any loss at all – when failures ensue.” Whether regulators can do anything effective is unclear. That this is a challenge is not.

The incentives in favour of the first institution to figure out how to break the spirit of any regulation here are so huge that I doubt we will see at best short term and ineffectual change.

Awake the harp

The broker dealers still have laughably generous capital requirements and access to the FED window. But in a step that suggests more of a snore than being full awake to the issues, the SEC is going to make Wall Street investment banks disclose their capital and liquidity levels according to Bloomberg. Not yet of course, but soon. Really.

In favour of the narrow bank model?

Naked Capitalism has an insightful commentator. I'm not sure if I agree with all of this, but it is certainly a helpful perspective:

Perhaps a lesson to be learned here is that liquidity acts as an efficient conductor of risk. It doesn't make risk go away, but moves it more quickly from one investment sector to another.

From a complex systems theory standpoint, this is exactly what you would do if you wanted to take a stable system and destabilize it.

One of the things that helps to enable non-linear behavior in a complex system is promiscuity of information (i.e., feedback loops but in a more generalized sense) across a wide scope of the system.

One way you can attempt to stabilize a complex system through suppressing its non-linear behavior is to divide it up into little boxes and use them to compartmentalize information so signals cannot easily propagate quickly across the entire system.

This principle has been recognized in the design of software systems for several decades now, and is also a design principle recognizable in many other systems both natural and artificial (c.f. biology, architecture) which are very robust with regard to exogenous shocks. Stable systems tend to be built from structural heirarchies which do not share much information across structural boundaries, either laterally or vertically. That is why you don't die from a heart attack when you stub your toe, your house doesn't collapse when you break a window, and if your computer crashes it doesn't take down the entire internet with it.

Glass-Steagall is a good example of this idea put into practice. If you use regulatory firewalls to define distinct investment sectors and impose significant transaction costs at their boundary that will help to reduce the speed and amplitude of signals which will propagate from one sector to another, so a collapse in one of them will be less likely casue severe problems in the others.

It worries me that we’ve torn down most of these barriers in the last several decades in the name of arbitrage, forgetting that the price we paid for them in inefficiency was a form of insurance against the risk of systemic collapse. This is exactly what I would do if I wanted to take a more or less stable, semi-complex system and drive it in the direction of greater non-linearity.

US Residential Mortgage Delinquencies in Pictures

Ben Bernanke gave some insight into the pattern of mortgage delinquencies and foreclosures in a recent talk. To begin, here is where the problems have been - the hot spots indicate areas with the biggest changes in delinquencies.
Ben suggests three contributing factors. Firstly increasing financial stress on mortgage holders, decreasing the ability to pay. The employment rate is a proxy for this:
Clearly that does not explain that much. So how about negative equity? When prices are falling that effects the incentive to pay. Here we have:
That gives us a better explanation for Florida, California, Nevada, Michigan, and parts of New Mexico and Colorado.

Finally non homeowner purchases, aka Buy to rent, gives an idea of speculative buying:
This is insightful but I'd prefer to see a map of new home construction. My suspicion is that that would line up pretty well with speculative construction accounting for many of the hotspots in delinquencies.

One should also mention in this context mortgage types. The dynamic maps at the NY FED allow one to analyse the distribution of ARMs and ARMs resetting this year, and that may provide some insight into future delinquency distribution.

Does this make sense?

Bloomberg reports a miserable quarter for Fannie Mae:

Fannie Mae, the largest U.S. mortgage- finance company, reported a wider loss than analysts estimated, cut its dividend and said it will raise $6 billion in capital

The $2.19B, while eye catching, isn't the real story. For that let us turn to the New York Times:

As home prices continue their free fall and banks shy away from lending, Washington officials have increasingly relied on two giant mortgage companies — Fannie Mae and Freddie Mac — to keep the housing market afloat.

But with mortgage defaults and foreclosures rising, Bush administration officials, regulators and lawmakers are nervously asking whether these two companies, would-be saviors of the housing market, will soon need saving themselves.

Remember Fannie and Freddie are not regulated as banks. They would be capitally inadequate if they were as their leverage is frightening: a combined $83B of capital vs. $5T of debt according to the NYT. Instead they have the Office of Federal Housing Enterprise Oversight, which has consistently acted as their cheerleader. With losses rising politicians are beginning to worry:

“They are on real thin ice financially,” said Senator Richard C. Shelby of Alabama, the senior Republican on the Banking Committee. “And the way the law is written right now, there is very little we can do to correct that.”

The real issue is how these entities came to be in the first place. Their debt is viewed as government guaranteed (although that is not explicit). Yet they have shareholders. In addition to not bearing the weight of Basel, they have preferential tax status and are exempt from many SEC securities regulations. But they are hardly government pawns:

“We have to bow and scrape and haggle each time we need help,” said a senior Republican Senate assistant who spoke only on the condition of anonymity [...]

In a March meeting, Freddie Mac’s chairman, Richard F. Syron, bolstered those fears by saying the company would put shareholders’ interests first.

This is clearly bizarre. Either regulate them as banks and let the shareholders keep their stakes or nationalise them and have them act in the interest of the state. Privatised gains and socialised losses is not a good compromise.

Update. Talk about putting out the fire with gasoline. The Office of Federal Housing Enterprise Oversight has just said that it will lower requirements for surplus capital at the agencies to 15% from 20%, allowing the agencies to increase their leverage yet further. This might help the mortgage market in the short term but the US tax payer will be left holding the baby. S&P already thinks this is a trillion dollar problem. In the immortal words of Homer Simpson, shimatta-baka-ni.

Further Update. The FT reports that Fannie is planning a $5.5B capital raising. Too little, too late.

The Warren of Wrapped Wraps

Warren Buffett's new monoline is doing well, partly through writing wraps on already wrapped paper. From the FT:

Berkshire Hathaway’s fledging bond insurer generated $400m in premiums during the first quarter, outstripping all the established, but troubled, operators in the so-called US monoline insurance market.

Many of the 278 contracts the unit wrote were for clients who already held policies from other triple-A rated insurers, Berkshire’s Warren Buffett said at the annual shareholder meeting in Omaha on Saturday. “They’re paying us a [higher] fee to write insurance that will only be paid if the principal [insured party] and insurer didn’t pay,” Mr Buffett said. “It tells you something about the meaning of triple-A in the bond-insurance field.”

I guess if you need a real AAA BHAC is one of the few places you can go. The interesting question is why people want that degree of credit protection on muni risk given the low underlying default probability.

ABS in the TAF

The TAF is getting bigger and AAA ABS will be eligible. From the FED:

The Federal Reserve announced today an increase in the amounts auctioned to eligible depository institutions under its biweekly Term Auction Facility (TAF) from $50 billion to $75 billion, beginning with the auction on May 5. This increase will bring the amounts outstanding under the TAF to $150 billion [...]

In addition, the Federal Open Market Committee authorized an expansion of the collateral that can be pledged in the Federal Reserve's Schedule 2 Term Securities Lending Facility (TSLF) auctions. Primary dealers may now pledge AAA/Aaa-rated asset-backed securities

That they did not take this second step earlier beggars belief.

Off off B/S : good optics

From the often amusing Long or Short Capital:

The latest credit product is the new OFF-off-balance sheet provided by Private Equity Shop Y and Hedge Fund X. In exchange for below market financing, loose structural terms, and a 10-20% down payment, the off-off-balance sheet structure is designed to take an undiversified smorgasborg of the bank’s very own hung deals fresh from the bank’s books.

Recommendation: Being that off-off is a double negative, we think that maybe, just maybe, that selling loan assets to highly leveraged entities to which you provide the financing is more of a shell game than a credible solution.

Which is not to say that in terms of the optics, the accounting, and the regulatory capital it doesn't work really well. It's just the actual risk transfer part that's the issue.

Stung by apple pie and ice cream

Avinash Persaud has a thought-provoking article The inappropriateness of financial regulation on VOX. I will return to the detail of his proposals tomorrow - they deserve a wide debate - but for now here is a stinging comment on the responses to financial crises:

In each crisis I have observed a “cycle” in the response to the crisis. In the middle of a crisis, when circumstances look dire and chunks of the financial system are falling off, proposals get radical. [...] But a few months after each crisis is over, these radical plans are tidied away and we are left with three things. And they are always the same three things: better disclosure, prudential controls and risk management.

These measures are the regulatory version of apple pie and ice cream. Who would say no? The thing is – we have been investing heavily in these areas for the past twenty years and do not have much to show for it in terms of financial stability.

Ouch, that hurts. But you have to say that he has a reasonable point.

Will inflation be targeted?

Central banks have over the last few years been either rather successful at inflation targeting or rather lucky that inflation has remained low (but positive). FT alphaville cites some research from Morgan Stanley questioning whether this happy state will persist.

For me there are two parts to this question. Does inflation targeting work? And if it does, will central banks actually practice it?

On the first certainly when inflation has been rising in the major economies recently raising rates seems to have reined in inflation. However we have not really seriously flirted with a deflationary environment so the evidence concerning raising a too-low inflation rate is scanty. But that was definitely an issue in Japan: with rates close to zero they had nowhere to go if the only policy tool is control of the short rate. The efficacy of targeting therefore gets a 'not proven' from me.

The second point is more problematic. The FED, for instance, seems to have abandoned inflation targeting entirely in order to protect the financial system. When you consider the manipulation of the inflation index in the US (the official inflation figure is now known to some as 'inflation ex-inflation' - see here for an independent calculation) this response becomes even more troubling. So it seems that central banks will target inflation only if there is not something more important they need to use short rates for.

On my street

On the day of the London mayoral and assembly elections, and with upcoming vote on 42 day detention, this seems apposite.