First, the quiet cheer: regulators seem to be moving on shadow banking. For one, the SEC is talking about a floating net asset value for mutual funds and thicker capital buffers, which has predictably set off a howl of protest from the industry.
And Reuters wrote:
Watchdogs to Drag Shadow Banks Into the Light
Then, the prediction:
There will be something in the fine print of the as-yet undetailed giant mortgage settlement that will elicit a chorus of "we let the banks off the hook for that -- what the hell?"
Sunday, February 12, 2012
Saturday, February 4, 2012
NYT's DealBook Gets It All Wrong on CLOs
This was a painful piece to read at the New York Times DealBook: "A Debt Market's Slow Recovery Is Burdened by New Regulation."
Steven Davidoff whips out his violin, tucks it under his chin, and plays a mournful lament for the market for collateralized loan obligations, which is under threat by none other than the act that the bankers have all flicked out their switchblades for: Dodd-Frank. Specifically, Dodd-Frank meanies want CLO originators to retain 5 percent of their funds, to prevent them from stuffing the investments with, er, crap.
The Times should have top-notch journalists who know more about CLOs and junk debt than Davidoff appears to here. Because, honestly, in this piece I can't tell sometimes if he is playing the fiddle or he is being played by someone else like a fiddle.
Here are five problems I have:
1. "CLOs are largely made up of loans that are at much lower risk of default than the risky high-yield, or "junk," bonds that also finance private equity buyouts."
He's trying to make these loans seem safer. But let's take the buyout for the old TXU, which as Davidoff notes, was made possible by leveraged loans and bonds. Right now TXU (renamed Energy Future Holdings) is rated CCC, deep into junk territory, only four levels from D (which, for non-credit junkies, means "D" for default).
If Energy Future goes belly up, the loans and bonds should both default. The loans will probably enjoy a better recovery rate, because they're higher on the capital structure and secured, but they will default. I'm not sure where Davidoff gets this idea that the default risk is "much lower" for leveraged loans than bonds. When a company is rated Total Junk, the default risk will be high for both.
2. "CLOs had a default rate of less than 1 percent even as the loans underlying them had a default rate of about 6.5 percent."
So? Davidoff seems to imply that CLO structurers have somehow transmogrified straw into gold by using this numerical comparison. Look! The default rate is much lower! But it's disingenuous and incomplete.
The CLO is the loans, in aggregate. Structuring doesn't magically conjure up a new income stream out of thin air. Those 6.5 percent of loans that defaulted -- they defaulted whether they're in the CLO, out of the CLO, or wrapped in something called a super duper wonderbar GCLO (giant CLO).
In fact, thought experiment: let's say you create that GCLO that almost never defaults, even when a mess of underlying loans do. Let's say the default rate is 6.5 percent for the loans, 0.8 percent for the CLO, and 0.001 percent for the GCO.
But let's say when the GCLO defaults, because it's so huge, there's a good chance the entire financial system will implode. So if I tell you that 6.5 percent of the loans have defaulted, but the GCLO has never defaulted, is that a good thing (by Davidoff's logic, it would seem to be)?
Or is it bad that when that GCLO explodes it's probably taking down the financial system, so you'd be better off having the loans outside of that only ostensibly super-safe structure -- out where they'll do less harm? (Note: if you've been thinking a lot about the financial crisis, you'll realize this is not an accidental sort of thought experiment.)
(3) "So new CLOs are crucial to support the corporate loan market. Without them, banks will be hampered from originating credit since they will be unable to sell these loans off their balance sheet."
Well, for decades preceding the invention of the CLO, the financial system seemed to bumble along just fine. In fact, banks were regarded as being safer because they kept loans on their balance sheet, because that meant they were more circumspect about what lending they did. Here, Davidoff is mourning an end to the easy money that securitization threw open the spigots to. But he doesn't really seem to reflect on whether being awash in easy money was a bad or a good thing.
(4) "Most managers do not actually originate the loans underlying these financial instruments [CLOs]. Instead, the manager buys these loans from originating banks."
So he claims that leads to a "secondary-market check" that "may be lacking with other structured products."
Davidoff says this to argue that CLOs are unlike the mortgage-backed securities that crashed and burned, and thus deserve to be exempt from a rule about securitization originators retaining 5 percent of the deal. But wait a minute -- check out this post about "Why Structured Finance?" -- because the securitization model for mortgages doesn't require that a structurer originate the debt either.
In fact, before the crisis there were plenty of Wall Street banks bundling mortgages that they never originated. So Davidoff's "secondary-market check" looks like a rather weak safeguard.
(5) "And of course, private equity would also be hurt if the CLO market dried up."
Ah, private equity. You know, Mike at Rortybomb just showed us that much private equity activity occurs because of our screwball tax code -- not because it makes sense, business-wise, and James Surowiecki at the New Yorker had a good bash on the subject too, revealing that these raw-meat capitalists actually get a lot of hidden supports that make them look more like welfare queens.
Davidoff never pauses to consider that it might be a good thing if private equity buccaneering was curtailed.
Of course Davidoff misses the really big story about the CLO market: mathematically, these things just don't make much sense. With all the fees that they suck out, they should collapse under their own weight.
Before the financial crisis, they were priced close to real AAA, as investors were fooled by the complexity into thinking they really were AAA safe. Today, investors aren't that dumb: they're onto the game and demanding higher, non-AAA yields for debt that's graded AAA.
But why would investors play along with such shenanigans? Check out:
The Ratings Charade Continues: A CLO Investigation (Part I)
The Ratings Charade Continues: A CLO Investigation (Part II)
Steven Davidoff whips out his violin, tucks it under his chin, and plays a mournful lament for the market for collateralized loan obligations, which is under threat by none other than the act that the bankers have all flicked out their switchblades for: Dodd-Frank. Specifically, Dodd-Frank meanies want CLO originators to retain 5 percent of their funds, to prevent them from stuffing the investments with, er, crap.
The Times should have top-notch journalists who know more about CLOs and junk debt than Davidoff appears to here. Because, honestly, in this piece I can't tell sometimes if he is playing the fiddle or he is being played by someone else like a fiddle.
Here are five problems I have:
1. "CLOs are largely made up of loans that are at much lower risk of default than the risky high-yield, or "junk," bonds that also finance private equity buyouts."
He's trying to make these loans seem safer. But let's take the buyout for the old TXU, which as Davidoff notes, was made possible by leveraged loans and bonds. Right now TXU (renamed Energy Future Holdings) is rated CCC, deep into junk territory, only four levels from D (which, for non-credit junkies, means "D" for default).
If Energy Future goes belly up, the loans and bonds should both default. The loans will probably enjoy a better recovery rate, because they're higher on the capital structure and secured, but they will default. I'm not sure where Davidoff gets this idea that the default risk is "much lower" for leveraged loans than bonds. When a company is rated Total Junk, the default risk will be high for both.
2. "CLOs had a default rate of less than 1 percent even as the loans underlying them had a default rate of about 6.5 percent."
So? Davidoff seems to imply that CLO structurers have somehow transmogrified straw into gold by using this numerical comparison. Look! The default rate is much lower! But it's disingenuous and incomplete.
The CLO is the loans, in aggregate. Structuring doesn't magically conjure up a new income stream out of thin air. Those 6.5 percent of loans that defaulted -- they defaulted whether they're in the CLO, out of the CLO, or wrapped in something called a super duper wonderbar GCLO (giant CLO).
In fact, thought experiment: let's say you create that GCLO that almost never defaults, even when a mess of underlying loans do. Let's say the default rate is 6.5 percent for the loans, 0.8 percent for the CLO, and 0.001 percent for the GCO.
But let's say when the GCLO defaults, because it's so huge, there's a good chance the entire financial system will implode. So if I tell you that 6.5 percent of the loans have defaulted, but the GCLO has never defaulted, is that a good thing (by Davidoff's logic, it would seem to be)?
Or is it bad that when that GCLO explodes it's probably taking down the financial system, so you'd be better off having the loans outside of that only ostensibly super-safe structure -- out where they'll do less harm? (Note: if you've been thinking a lot about the financial crisis, you'll realize this is not an accidental sort of thought experiment.)
(3) "So new CLOs are crucial to support the corporate loan market. Without them, banks will be hampered from originating credit since they will be unable to sell these loans off their balance sheet."
Well, for decades preceding the invention of the CLO, the financial system seemed to bumble along just fine. In fact, banks were regarded as being safer because they kept loans on their balance sheet, because that meant they were more circumspect about what lending they did. Here, Davidoff is mourning an end to the easy money that securitization threw open the spigots to. But he doesn't really seem to reflect on whether being awash in easy money was a bad or a good thing.
(4) "Most managers do not actually originate the loans underlying these financial instruments [CLOs]. Instead, the manager buys these loans from originating banks."
So he claims that leads to a "secondary-market check" that "may be lacking with other structured products."
Davidoff says this to argue that CLOs are unlike the mortgage-backed securities that crashed and burned, and thus deserve to be exempt from a rule about securitization originators retaining 5 percent of the deal. But wait a minute -- check out this post about "Why Structured Finance?" -- because the securitization model for mortgages doesn't require that a structurer originate the debt either.
In fact, before the crisis there were plenty of Wall Street banks bundling mortgages that they never originated. So Davidoff's "secondary-market check" looks like a rather weak safeguard.
(5) "And of course, private equity would also be hurt if the CLO market dried up."
Ah, private equity. You know, Mike at Rortybomb just showed us that much private equity activity occurs because of our screwball tax code -- not because it makes sense, business-wise, and James Surowiecki at the New Yorker had a good bash on the subject too, revealing that these raw-meat capitalists actually get a lot of hidden supports that make them look more like welfare queens.
Davidoff never pauses to consider that it might be a good thing if private equity buccaneering was curtailed.
Of course Davidoff misses the really big story about the CLO market: mathematically, these things just don't make much sense. With all the fees that they suck out, they should collapse under their own weight.
Before the financial crisis, they were priced close to real AAA, as investors were fooled by the complexity into thinking they really were AAA safe. Today, investors aren't that dumb: they're onto the game and demanding higher, non-AAA yields for debt that's graded AAA.
But why would investors play along with such shenanigans? Check out:
The Ratings Charade Continues: A CLO Investigation (Part I)
The Ratings Charade Continues: A CLO Investigation (Part II)
Friday, January 20, 2012
Is Being an Ideologue a Contributor to Stupidity?
A gratuitously provocative question?
Maybe not.
Consider the following equation:
TA * TR = TB.
Let's say TB represents some "financial obligation" among a group of people. Further, let's say that at some point in time, the group has a TB of 40. And then, almost 30 years later, TB equals 55.
Now, if you don't know the values of TA and TR, what would be logical to conclude about how they must have changed over that period?
This one is so simple, it couldn't stump an eighth grader who wastes most of math class staring out the window. For TB to increase on the right side of the equation, one of the two variables on the left side of the equation must have increased -- or perhaps both did, in some combination.
But what if you're an ideologue? And what if your ideology leads you to think a "TB" of 40 for this particular group is already high? And what's more, you vehemently insist that TR should be as low as possible, and that a lot of economic problems result from a high TR?
So what happens when you see:
TA * TR = 40
Jump to:
TA * TR = 55
It's clear to you what the problem is. TR! Because TR is always the problem! You don't spend a lot of time mulling over what may be going on here. You fixate on TR, because that's what you always fixate on.
In which case, your name might be Ari Fleischer.
Because this equation is really: "Taxable Amount (taxable income of the top 10% of the population) times the Tax Rate (tax rate of the top 10% of the population) = Tax Burden (the percentage of overall federal taxes paid by the top 10% of the population)".
Fleischer, President Bush's former press secretary, recently tweeted that the "Tax Burden" of the richest 10 percent soared from 40 percent in 1979 to 55 percent in 2007. The implication: the TR (Tax Rate) on this group is already high enough, and this group is carrying more than its fair share of the TB (Tax Burden).
But ideology -- his visceral dislike of taxation, and the welfare state, and wealth redistribution -- has made him too dumb to see how a simple equation works.
Because consider this thought experiment: if in 20 years, the income of the top 10 percent explodes and the other 90 percent of the population become their slaves and earn no income (and meanwhile the Tax Rate doesn't change at all), the top 10 percent will pay 100 percent of taxes (up from 55 percent). But what does that show? That they're being taxed too much?
Of course not. It shows that we've regressed to something akin to a feudal society.
There are two variables on the left side of this equation, TA * TR = TB. If you're an ideologue you tend to miss stuff like that. (See Mark Thoma proving here that, yes, the answer to the mystery of what happened with the Tax Burden does lie with "TA," as the richest scored the biggest income gains over the last three decades.)
But ideologues don't do nuance well. They also abhor cognitive dissonance.
This is why I think Peter Wallison has become a sort of trivial hand puppet for the right, a useless one-note screech owl in his vehemence that it was Fannie and Freddie that caused the financial crisis (and he apportions no blame at all to Wall Street's securitization machine). He can't see beyond his ideological blinders.
P.S. For those of you thinking that Fleischer's "tax burden" is a percent, not a straight-up number like 40, yes, I've simplified. But the argument isn't impaired by this simplification. The ratio just introduces a second layer of complexity. If you understand math, you know what I mean. If you don't, I can write it all out ...
Maybe not.
Consider the following equation:
TA * TR = TB.
Let's say TB represents some "financial obligation" among a group of people. Further, let's say that at some point in time, the group has a TB of 40. And then, almost 30 years later, TB equals 55.
Now, if you don't know the values of TA and TR, what would be logical to conclude about how they must have changed over that period?
This one is so simple, it couldn't stump an eighth grader who wastes most of math class staring out the window. For TB to increase on the right side of the equation, one of the two variables on the left side of the equation must have increased -- or perhaps both did, in some combination.
But what if you're an ideologue? And what if your ideology leads you to think a "TB" of 40 for this particular group is already high? And what's more, you vehemently insist that TR should be as low as possible, and that a lot of economic problems result from a high TR?
So what happens when you see:
TA * TR = 40
Jump to:
TA * TR = 55
It's clear to you what the problem is. TR! Because TR is always the problem! You don't spend a lot of time mulling over what may be going on here. You fixate on TR, because that's what you always fixate on.
In which case, your name might be Ari Fleischer.
Because this equation is really: "Taxable Amount (taxable income of the top 10% of the population) times the Tax Rate (tax rate of the top 10% of the population) = Tax Burden (the percentage of overall federal taxes paid by the top 10% of the population)".
Fleischer, President Bush's former press secretary, recently tweeted that the "Tax Burden" of the richest 10 percent soared from 40 percent in 1979 to 55 percent in 2007. The implication: the TR (Tax Rate) on this group is already high enough, and this group is carrying more than its fair share of the TB (Tax Burden).
But ideology -- his visceral dislike of taxation, and the welfare state, and wealth redistribution -- has made him too dumb to see how a simple equation works.
Because consider this thought experiment: if in 20 years, the income of the top 10 percent explodes and the other 90 percent of the population become their slaves and earn no income (and meanwhile the Tax Rate doesn't change at all), the top 10 percent will pay 100 percent of taxes (up from 55 percent). But what does that show? That they're being taxed too much?
Of course not. It shows that we've regressed to something akin to a feudal society.
There are two variables on the left side of this equation, TA * TR = TB. If you're an ideologue you tend to miss stuff like that. (See Mark Thoma proving here that, yes, the answer to the mystery of what happened with the Tax Burden does lie with "TA," as the richest scored the biggest income gains over the last three decades.)
But ideologues don't do nuance well. They also abhor cognitive dissonance.
This is why I think Peter Wallison has become a sort of trivial hand puppet for the right, a useless one-note screech owl in his vehemence that it was Fannie and Freddie that caused the financial crisis (and he apportions no blame at all to Wall Street's securitization machine). He can't see beyond his ideological blinders.
P.S. For those of you thinking that Fleischer's "tax burden" is a percent, not a straight-up number like 40, yes, I've simplified. But the argument isn't impaired by this simplification. The ratio just introduces a second layer of complexity. If you understand math, you know what I mean. If you don't, I can write it all out ...
Friday, December 30, 2011
Bill Black Takes on the "Fannie and Freddie Did It" Meme
I really enjoyed this piece for its knowledgeable, historical analysis. Black doesn't exactly side with the "It Wasn't Fannie and Freddie" crowd, but he's more unsparing in his criticism of ideologue Peter Wallison, whose position "It Was All Fannie and Freddie" is laughable (and Black shows us even more reasons why).
I'm willing to move up Fannie and Freddie on my list of causes of the crisis to, say, number 6 or 7 from number 11. ;)
Black frames the problem well, I think. What caused problems wasn't Fannie and Freddie's mandate to help the poor -- in other words, all those do-good liberals trying to put welfare Moms in houses they couldn't afford. It was, plain and simple, accounting fraud to lavish bonuses on the top echelon of executives -- the same problem found at investment banks that were more direct causes of the crisis.
I'm willing to move up Fannie and Freddie on my list of causes of the crisis to, say, number 6 or 7 from number 11. ;)
Black frames the problem well, I think. What caused problems wasn't Fannie and Freddie's mandate to help the poor -- in other words, all those do-good liberals trying to put welfare Moms in houses they couldn't afford. It was, plain and simple, accounting fraud to lavish bonuses on the top echelon of executives -- the same problem found at investment banks that were more direct causes of the crisis.
Monday, December 26, 2011
Joe Nocera Takes on the Big Lie
I've often thought you could make a case for Fannie Mae's and Freddie Mac's culpability in the financial crisis: a very, very small case.
So, if you started listing reasons for the crisis, they might come in, say, number 11 or thereabouts.
What amazes me is the persistence of the simple-minded Republican narrative that they were the cause of the financial crisis. Not a cause. But the cause. (And the hard-core faithful don't want any other causes entered into the record, as when the four Republicans on the FCIC voted to ban the words "shadow banking" and "deregulation" from the final report!)
This viewpoint is so ignorant and ill-informed, so contrary to "the truth on the ground" that we know from how this crisis developed and what it looked like as it unfolded, that it strains credulity. Is Peter Wallison so ideologically blinkered that he can't even process a set of historical facts in a logical way?
Joe Nocera had a good recent column about this, The Big Lie.
What I enjoyed best though was the second comment that appeared afterward. Excerpts:
Earth to Peter Wallison: Are you listening?
So, if you started listing reasons for the crisis, they might come in, say, number 11 or thereabouts.
What amazes me is the persistence of the simple-minded Republican narrative that they were the cause of the financial crisis. Not a cause. But the cause. (And the hard-core faithful don't want any other causes entered into the record, as when the four Republicans on the FCIC voted to ban the words "shadow banking" and "deregulation" from the final report!)
This viewpoint is so ignorant and ill-informed, so contrary to "the truth on the ground" that we know from how this crisis developed and what it looked like as it unfolded, that it strains credulity. Is Peter Wallison so ideologically blinkered that he can't even process a set of historical facts in a logical way?
Joe Nocera had a good recent column about this, The Big Lie.
What I enjoyed best though was the second comment that appeared afterward. Excerpts:
I was a mortgage broker during the housing bubble. I can tell you that a "conforming" loan -- one that was run through Fannie or Freddie's "desktop underwriting" software -- always made us nervous. We got rejected for approval regularly whereas if we sold a subprime loan with a higher interest rate we got approved more easily and made much more on the loan ... rather than blame what was in essence a good government program for the housing collapse I say a lot of it deserves to go to the lenders and brokers who hustled these loans.Exactly, and a flaw I noted in the securitization model (and I'm far from the first person to make the observation) almost two years ago.
Once mortgages became securitized and the lenders had no skin in the game the whole system went to hell.
Earth to Peter Wallison: Are you listening?
Saturday, December 10, 2011
Keep an Eye on That Shadow Banking, Folks
Because it's starting to rear its ugly head again.
Turns out that what may be at the heart of MF Global's gaping hole on its (off) balance sheet: collateral that may have been shifted over to its U.K. unit to permit rehypothecation.
"Rehypothecation" is one of those mouth-filling words that basically says you can repledge the same piece of collateral (a useful trick in the shadow banking world of repo).
In the U.K., the collateral can be endlessly rehypothecated, again and again and again, creating long, unstable, dangerous chains -- and the interesting concomitant, lots of liquidity (which tends to act like a stimulant -- call it cocaine for the financial system -- and we know how hard it is to break a drug habit). Reuter's Christopher Elias:
This is a powder keg waiting for a spark.
For more, check out Alphaville's "Shadow Banking and the Seven Collateral Miners."
Turns out that what may be at the heart of MF Global's gaping hole on its (off) balance sheet: collateral that may have been shifted over to its U.K. unit to permit rehypothecation.
"Rehypothecation" is one of those mouth-filling words that basically says you can repledge the same piece of collateral (a useful trick in the shadow banking world of repo).
In the U.K., the collateral can be endlessly rehypothecated, again and again and again, creating long, unstable, dangerous chains -- and the interesting concomitant, lots of liquidity (which tends to act like a stimulant -- call it cocaine for the financial system -- and we know how hard it is to break a drug habit). Reuter's Christopher Elias:
This churning of collateral means that re-hypothecation transactions have been creating enormous amounts of liquidity, much of which has no real asset backing.Ladies and gentlemen, this is h-u-g-e. Too few people have wrapped their brains around this. We have central banks that greatly influence money supply/liquidity through their open market operations. Then we have a massive, off-balance sheet system of shadow banking that does the same with no oversight, in complex ways we barely comprehend.
This is a powder keg waiting for a spark.
For more, check out Alphaville's "Shadow Banking and the Seven Collateral Miners."
Wednesday, November 30, 2011
Europe's Bailout Fund -- Seriously, WTF Is This Thing?
I tried to figure out the EFSF again (the European Financial Stability Facility) and, once again, my brain exploded.
I can't figure out if this Rube Goldbergian mother of all securitization schemes is:
(a) a way to secretly print a whole bunch of euros behind door #24 while everyone is distracted by the elephant and monkey show in Exhibition Room C.
(b) a clever new way of shunting tail-risk into a vehicle that, when it fails, will send fireworks high into the night sky as the eurozone spectacularly implodes.
(c) a way of handing out 1,000 gold-plated pigs when there are only 10 gold-plated pigs in the warehouse, vague promises of 990 more gold-plated pigs, and a whole lot of securitization in between.
(d) a full-employment act for structured finance professionals on the continent.
(e) some combination of the above.
Or add your own speculation below. Because, in this Brave New World of Structured Finance, we're obviously beyond the point where an entity (say the IMF) simply extends a loan to some country (or countries) in fiscal straits.
Here's some more commentary on this bewildering high-finance thingamabobby:
More European Financial Chicanery
I can't figure out if this Rube Goldbergian mother of all securitization schemes is:
(a) a way to secretly print a whole bunch of euros behind door #24 while everyone is distracted by the elephant and monkey show in Exhibition Room C.
(b) a clever new way of shunting tail-risk into a vehicle that, when it fails, will send fireworks high into the night sky as the eurozone spectacularly implodes.
(c) a way of handing out 1,000 gold-plated pigs when there are only 10 gold-plated pigs in the warehouse, vague promises of 990 more gold-plated pigs, and a whole lot of securitization in between.
(d) a full-employment act for structured finance professionals on the continent.
(e) some combination of the above.
Or add your own speculation below. Because, in this Brave New World of Structured Finance, we're obviously beyond the point where an entity (say the IMF) simply extends a loan to some country (or countries) in fiscal straits.
Here's some more commentary on this bewildering high-finance thingamabobby:
More European Financial Chicanery
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