Can we know what regulations were appropriate pre-credit crisis?

September 23, 2008 at 4:26 pm | Posted in credit, Housing, regulations | Leave a comment
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I don’t believe in much regulation, but we need some framework. And what isn’t regulated (just a little bit) could (and often does) need rescuing.
Its easy to figure what should have been done after the fact. The challenge in doing it right before the fact is two fold –

First – For a variety of reasons, the US thinks home ownership is good and must be encouraged. Therefore there is a reluctance to tighten the screws too much if that means undermining the home ownership objective. So, good luck trying to tighten regulations when lobbyists (and, unfortunately many in the government) would be very vocal about how Congress is denying the American Dream. Yes, Mr. Greenspan, I mean you.

Second – If you come to me to borrow money, and I am willing to lend it to you, without too much inquiry into whether you could pay it back, or what your resources and income are, arguably, that is my lookout. Government has no business legislating caution or prudence or intelligence or even basic common sense on my part. Survival of the fittest will basically take me out of the business pretty quickly.

I do think things were overly lax. But I’m not sure just where the regulation should have come in. I mean, yes, Lehman was overleveraged, true, but some of that excessive leverage is actually a result of asset write-downs destroying equity, so it is an outcome of the credit crisis, not a cause. But the leverage was public knowledge. Equity investors should have known this was a risk, as should creditors.

You can regulate disclosure. You cannot regulate intelligent responses to that disclosure.

So the best that could have been done would have been to have tougher lending standards. Perhaps more responsibility for consequences on the part of the rating agencies would have ensured a more rigorous examination of their models. Perhaps tighter capital norms. There are a few things that could have contained this problem (more on this later).

But ultimately, if a few firms went bankrupt, and others stopped trusting S&P and Moody’s, the taxpayers may have had a few laughs about Wall Street’s follies and hoped that the bankers learned a lesson.

It is only because, after the fact, we realize that the system is at risk that we want to rescue the system, and care about what it would cost us to rescue it.

Is it a rescue if you don’t overpay?

September 23, 2008 at 6:24 am | Posted in credit, economics, Housing | 1 Comment
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There are various rescue proposals out there. The Paulson plan has run into some serious opposition, with Congressional Democrats offering alternative suggestions. I believe whatever solution is implemented, it must overpay for the assets acquired, and thus, there will be losses in the $700B (or whatever) real estate fund. The question is – how bad will the losses be?

But the fundamental question is- Is this credit crisis a liquidity crisis, or a solvency crisis? I think it is increasingly obvious this is a solvency crisis.

Say you put in $10, borrowed $90, and invested the whole $100. But a couple of investments went bad, and the $100 is now worth just $80. What do you do? You have assets worth just $80, and owe $90. Borrowing more won’t help – If you borrowed $10, you would have $90, but would owe $100. You could sell some of the assets, but if you sold half and used the money to pay off your creditors, you would have assets of $40 left, and still owe $50.

How does one get out of this solvency crisis? Well, either the current owners of the firm put in new money to meet the shortfall, or we get new owners to come in. Or we get a “rescue”. The current owners may not have enough money to meet the shortfall. The current or potential new/ additional owners may not want to put in new money, because they know that the new money will not be invested in something productive that may generate a profit – It will be used to meet the shortfall in what we owe our creditors.

It seems pretty clear that we are in a solvency crisis. Lending money to troubled institutions will, in many cases, only postpone the day of reckoning.

When the US government (or anyone else, for that matter) “rescues” an institution, they are the last-resort savior. So, clearly, they are the highest bidder – they are willing to pay more than anyone else was – for the firm, for parts of the firm, or for some of the assets of the firm, or as a guarantor of some of the assets. They may even be the only bidder.

The government is paying more than anyone else thinks it is worth. But, as we saw, what others think it is worth (the firm or its assets), is less than the debts – thats why we have a solvency problem.

The only way a rescue could work is if the rescuer paid whatever was necessary to solve the problem. In this case, enough above what others think it is worth to close the asset-liability gap.

If the market said the assets were worth $80, and the firm owed $90, we saw there was a solvency problem. The rescuer can solve this problem by basically being willing to pay $90 or more for the assets, allowing the firm to pay off its liabilities and stay solvent. Here, $10 of every $90 the US government spent is a dead loss – unless, eventually, it turns out the market was wrong in valuing the asset at $80; it was really worth more. The rescuer is could buy the asset for $80, but is choosing to pay $90 for the asset as a favor to the institution.

Whatever the final rescue package looks like, whatever securities the rescue fund buys, or invests in equity, or whatever else; whether the fund buys mortgages, or mortgage backed securities, or derivatives, or whatever else – It will all be distressed.

Since the government is only going to buy the junkiest of junk – the stuff that absolutely needs rescuing, the only way a rescue works is if the government pays much more than the market price.

Wall Street is now Bank Street

September 22, 2008 at 11:07 am | Posted in credit, regulations, Stock market | Leave a comment
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Goldman and Morgan Stanley – the last remaining independent investment banks – have now requested they be treated like traditional banks, with all the regulations, oversight and capital requirements. While this is voluntary, it acknowledges the risk in the traditional model, and brings to a close the era of investment banks (created by the Glass Steagall Act after the Depression). Glass Steagall was slowly dismantled in the 1990s, but now, it is completely rolled back.

NYTimes has the story here –

Goldman Sachs and Morgan Stanley, the last big independent investment banks on Wall Street, will transform themselves into bank holding companies subject to far greater regulation, the Federal Reserve said Sunday night, a move that fundamentally reshapes an era of high finance that defined the modern Gilded Age.

…

As bank holding companies, the two banks, whose shares have lost about half their value this year, will have to reduce the amount of money they can borrow relative to their capital.

That will make them more financially sound but will also significantly limit their profits. Today, Goldman Sachs has $1 of capital for every $22 of assets; Morgan Stanley has $1 for every $30. By contrast, Bank of America’s has less than $11 for every $1 of capital.

So how would this work? If MS has to go from $1 capital for $30 assets to a more bank-like $10-11 assets per dollar of capital, one of two things have to happen – Either MS sells $20 worth of assets (2/3rds of what it has), and returns the proceeds to debt holders, or raises $2 more of capital.

The first would be disruptive to the markets, bringing a lot of selling pressure while every intervention is aimed at relieving the selling pressure. The second would be dilutive to existing shareholders – The share of existing shareholders would drop by 2/3rds. This is obviously bad for the stock, but, at least the losses are private and limited to shareholders, who kind of took on the risk in the first place.

So they will need time to adjust their balance sheets. Given enough time to get to the required capital ratios through a combination of asset sales and capital raising, and using additional classes of capital (such as preferreds and convertibles), they should be able to emerge as stronger institutions. And they can now buy a commercial bank to help get to the target ratios.

Own-to-rent?

September 21, 2008 at 5:30 pm | Posted in credit, Housing, regulations | 2 Comments
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Here’s an idea. How about, the government acquire toxic mortgages and modify the foreclosure process. Maybe the title transfers over to the government. The government then transfers it over into what is, essentially, an apartment REIT, and appoints a property manager to manage its rental portfolio.

The erstwhile homeowner is now a tenant of the property. They’ve lost equity – if they ever had any- but not the roof over their head. They now owe rent instead of the monthly mortgage payment, and perhaps the rent can be modified to the interest payment on the outstanding balance at a reasonable interest rate (Perhaps the current average 30-year fixed rate), rather than either a low teaser rate or a too-high post-reset ARM rate.

The tenant is basically locked in to a 2-year lease, so they have to pay rent for two years. If they fail to do so, they have a foreclosure on their credit report; if they do make the payments, they walk away with no equity, but also no dings to their credit. The foreclosed home stays occupied, so there isn’t a flood of bank-owned real estate boosting supply and depressing prices. The neighborhood doesn’t start emptying out, and foreclosed homes don’t drag down values – or boost crime in vacant homes.

Perhaps the government could in turn sell these rental REITs to investors – They buy into the rental cash flows + the value of the property. We know that the government will lose on this – The REIT cannot be valued at what the government paid for the assets in the REIT, but at least this will provide liquidity to both the financial markets as well as support the real estate market, helping borrowers in trouble.

I think this might be a workable idea, although it needs developing further.

Regulators – absentee parents

September 20, 2008 at 7:03 pm | Posted in credit, economics, Housing, regulations | Leave a comment
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I think regulations and regulatory agencies failed to create an adequate framework for the credit markets.

In essence, while lenders invented 5% down, even the 0% down, no documentation, stated-income loans with down payment assistance, regulations allowed lenders and investors to get away with similar low equity / high leverage balance sheets. Lehman, for example, had a debt-equity of 30-40x (admittedly boosted by prior write-downs of its assets).

This is just like parents raising kids – Some parents regulate kids more than others (I think less- but not too much less- is better, generally), but if you fail to regulate them, sooner or later, they are going to need rescuing – whether you rescue them or want to teach the kids a lesson.

Crisis of risk aversion

September 20, 2008 at 6:55 pm | Posted in credit, economics, Housing | Leave a comment
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I think, and some people wiser than me think, that this whole crisis was created, not by too much risk taking, but by too little. Investors had money to invest, and tons of potential investments. They could invest in startups, or corporate debt, or in biotech R&D ventures, or in retail – They had the option of investing in just about any area of our economy.

But they invested disproportionately in two areas – First, in treasuries – safe paper. The other area they invested in was also supposed to be just as safe, but could let them eke out a few extra points of interest – mortgage securities of all stripes. They were very complex, and a single security contained as many as tens of thousands of underlying mortgages. This was too much data to handle, in terms of the quality of each underlying mortgage, and the derivatives on this became ever more complex. The investors did not have the time, the data or the ability to understand them fully.

But the credit rating agencies said that they had studied these mortgages, and their models predicted that the losses in the portfolio would be modest, so the investors piled in. The problem was, the models were wrong. The models assumed that house prices would always keep going up, and thus, that refinancing would never be a problem. Wrong on both counts.

All it takes is a close look at the economy – where have all the record profits of the past 5 years gone? Where is the big spending? Where is the corporate expansion? Where is the massive R&D? The investments?

It all got crowded out by the least risky option – Not by someone swinging for the fences with their investments, but by someone hoping to approximate the safety of a treasury with 27 extra basis points of return.

High noise-to-signal in SEC actions

September 20, 2008 at 1:20 pm | Posted in regulations, Stock market | Leave a comment
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This NYTimes article discusses the market reaction to the SEC rules banning short sales. A number of trades in the market were involuntary, forced on by the new regulations. As such, I doubt the strength in the market is sustainable. Nothing fundamental has changed; just a few rules changed, which made some people make transactions in the market in order to comply with the new rules, and made others make transactions in response to the market response. There is not much other information in the response, other than the fact that one can expect the government to continue to rescue and to regulate and market participants have to figure out where the heavy hand will fall next.

The pendulum swung far away from regulation during the “Bush expansion”, now, it is going to swing even further in the other direction.

We already know this. I think the SEC is saying that things are not as bad as they seem (as I said previously here), but then, is that what the SEC really believes, or is this just empty reassurance?

I guess, looking ahead and trying to decide what to do in the markets, this last week was mostly noise and  little signal.

Short selling – why it helps

September 20, 2008 at 12:57 pm | Posted in regulations, Stock market | Leave a comment
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First: Short selling means selling shares you don’t actually own. Traditional investors use their cash to buy shares, and at some later point, sell the shares back into cash, hopefully at a higher price for a profit. There are two transactions – first, they convert cash (which they have or borrow) into shares. Later, they convert the shares back into cash, and use the cash to pay off any money they borrowed to finance the transaction. A short seller basically reverses this order. First, they borrow shares they do not own, and sell them, converting into cash. Later, they use the cash to buy the shares back, and return the shares to the lender.

Say you were convinced that stock A will fall from $50, where it is currently trading. If you own the stock, you can sell your holding, and, suppose the stock did fall to $30, you could feel good that you avoided the $20 / share loss. But what if you don’t own the shares? How do you profit from your convictions? Well, you borrow a few shares, and sell them at $50. Later, when the stock falls to $30 you can buy them back, return the borrowed shares to the lender, and pocket the $20 difference (ignoring transaction costs, cost of borrowing the shares and taxes). That is basically what a short seller does.

The market combines tens of thousands of trades to arrive at a stock price. In other words, todays price reflects the combination of the information and beliefs that every participant in the market has about the stock. Some people are selling the stock – their views suggest they expect the stock to fall. Others are buying (for every sale, there is a buyer), and they expect the price to rise. Today’s price is just the momentary equilibrium between the forces propping the stock up and those pushing it down.

Banning short sales forces the market to ignore the information that the short sellers are bringing to the market. The supply of shares for sale will now come only from those who own the stock and are willing to sell. So the supply has fallen. Nothing prevents potential buyers from buying, so the demand curve remains the same, and the price equilibrium is artificially high because of less supply. So you have got rid of a good chunk of the sellers in the market, and a bunch of buyers who think the stock would have been cheap at $30 but wouldn’t touch it at $50 are also left out of the market. In the meantime, short sellers who have already sold the stock (who may or may not have wanted to sell more) know that the new equilibrium price is going to be higher than they expected, and the stock won’t fall as much as they had expected. So they try and buy back the stock to return the borrowed shares, pushing the stock up quickly (and temporarily). As the price rises, any one who is short the stock is losing money, so they all head for the exit, buying up shares to close their positions (so they can return the borrowed shares and square things off).

The rush of short sellers to close their positions is called a short squeeze, and it causes the stock price to overshoot. But then, once it is done, you have fewer sellers, and fewer buyers. Liquidity falls, and pricing becomes less efficient.

Suppose the short seller was right – The $50 stock is really worth $30. (We don’t really ever know what a stock is worth, but if the share price does reach $30 some day, then the market agrees, at least for that moment, that the stock is really worth $30). Eventually, that information will spread in the market, so, eventually you should see the price get to $50. But short selling helps you get there quicker. It can also cause the stock price to overshoot, and fall too low before recovering. But, generally, all this plays out relatively quickly. If the price overshoots, some of the short sellers will come in to buy and return the borrowed stock, locking in their profits. Other investors will find a price they cannot resist and will also buy in, bringing the stock back up.

All this is not perfect. But a fast-falling stock does not entice as many people as it falls, than one which gets from $50 to $30 over months instead of days. So, without short sales, more people will come in on the way down, get burnt, and stay away from the stock for months after it has bottomed. With, they come in later in the fall, hopefully find a great entry point if the stock has overshot, and feel reassured by the bounce back from the low to the more natural equilibrium point, providing better buying interest over time.

I do favor setting some limits on short sales – For example, what percentage of total shares can be lent out to short sellers. I am not sure what those limits are, but I would like to protect against an over-reaction. But over-reacting is better than not reacting enough – I would err on the side of the short sellers.

With short sellers, the market moves faster – but it also moves truer.

Do not yell “FIRE”! It is not that bad!

September 20, 2008 at 12:43 pm | Posted in economics | 1 Comment
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So the SEC banned short selling in financials, and the markets took off. Is that good? What is the signal the SEC is sending us? I think the signal is that things are not as bad as they seem. The SEC is trying to prevent people from yelling “FIRE” in a crowded cinema hall full of smoke. Maybe the fire is relatively minor, and an orderly evacuation is better than a rush for the doors.

I don’t know if things are better than appearances – I remain bearish, but now the SEC will make it all play out in slow motion, so it may take longer before I know if my continuing fears are justified.

Do markets work?

September 19, 2008 at 1:25 pm | Posted in economics, regulations | Leave a comment
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The centerpiece of right-wing dogma is that markets work. Left wing dogma, at least in the US, is that markets work most of the time.

I think markets do work, but they often need a framework within which to operate. To those who want to cut back on regulation (including libertarians), I ask – would you want to live in a town of any reasonable size without regulations for stop lights?

Markets need to be tempered by regulations, particularly to account for two factors – externalities (which affect other people) and information asymmetry (where the different parties to the transaction don’t have the same information).

An example of an externality dictating regulations is a noise ordinance – I don’t care how late my neighbors let their kids stay up – there is no real externality that affects me, but I do care how late they let them party at home. I don’t care if someone enjoys a few drinks. But I do care if they drive after that. And I cannot affect these outcomes directly – only by supporting the regulation of these activities.

An example of an information asymmetry can be found in lead paint, or tobacco, or pharmaceuticals. The seller of the product sells a ton of these things. Whether or not they have studied the side effects (pharma, yes, lead paint, perhaps the manufacturer has not), they become aware of the issues from customer feedback over a period of time. But they have no incentive to share information about the product that may hurt their sales. Especially if there is a long time lag between purchasing a product and seeing the negative side effects, traditional information sources such as news articles or customer forums may not work, so the only way to mitigate this is through regulations requiring disclosure. Insider trading is another example.

I would love to hear thoughts for and against regulations, and how regulations can mitigate externalities and information asymmetry. Would you support regulations even where these issues do not exist? Or would you oppose regulations where such considerations do apply? And, perhaps toughest of all, how does one create a framework to determine when regulations are appropriate?

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