Summarizing my three year old thesis

March 13, 2009 at 12:54 pm | Posted in economics, Housing | Leave a comment
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I’m back after a long break from writing. I’ve been thinking about how psychology plays into the recession – in fact, most of my direst predictions of the past three years have played out, often worse than I expected, mostly because I think I got consumer actions right.

My thesis can be summarized as follows: The US economy is 70% consumer spending. Much of business spending is in anticipation of future consumer spending ( or anticipation of other businesses anticipating consumer spending). With the savings rate near 0% and housing slowing down, there was no wealth effect or accumulated assets to drive spending, so any correction in house prices must necessarily slow down consumer spending and thus the economy as consumer’s try and fix their balance sheets and their income statements (expenses and savings % equivalent to net income margin for business). Businesses would respond accordingly, and, while exports could help, a lot of global income – especially emerging markets like China, is dependent directly or indirectly on US consumer demand. The bottom had to fall out of the market, and the banking system was going to be part of that because of housing and consumer exposure (Credit cards are yet another shoe waiting to drop). Oil prices didn’t help but were not central to the argument.

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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.

Liquidity vs. solvency

September 23, 2008 at 5:41 am | Posted in credit, Housing | Leave a comment
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I think the response to the credit crisis has to be dictated by a determination of whether the crisis is principally one of liquidity or of solvency. So here is a basic attempt to clarify what this means.

A liquidity crisis basically means that firms have enough assets, but they cannot be easily converted to cash in time. This is a temporary problem and can be tided over relatively easily. An example of a liquidity crisis for an individual could be – You have $50,000 in a bank CD or savings account, $500 in your checking account, and your car needs major repairs over the weekend. You have the money to cover the repairs, but not right now. You need credit – Of course, you could put it on your card. But suppose you couldn’t? Or didn’t have a card. You would need to borrow from a friend or family member – Just for 2-3 days, till you can get your own money into cash.

A solvency crisis means you just do not have the money or other assets to meet your liabilities – your borrowings and your other obligations (taxes, condo fees etc). Borrowing from someone won’t help you much. Say what you owe on the house and car and cards etc. all came to $400k, but the value of the house and car and furniture and savings all add up to $350k. Maybe you still keep making your payments, but if those debts needed paying (say you had to sell your house to move for a new job), you would come up short, and borrowing from somewhere else will still leave you just as short.

In the financial institution context: The FI has borrowed some money (direct borrowing or securities issued or public deposits), has put in its own money as well, and invested the whole amount, buying shares and/or lending money to various borrowers. Say some of the depositors want their money back, and the FI doesn’t have that much cash handy. They would either need to borrow from someone else to pay off the first guys, or sell some of the investments to get the cash. But what if the investments are hard to sell, like an individual mortgage or individual loan to a small business owner? Or, what if they can be sold, but selling too much all at once can cause the price to drop, forcing the firm to take a loss? This is a classic “Its a wonderful life” scenario, and borrowing from someone for a few days or months until some of the investments come due is a ready (though not always easy solution) to the liquidity problem.

With a solvency problem, the assets / investments may have gone bad, and so are now worth a lot less than the firm paid for them. Some borrowers may be out of business, others are struggling, and their assets, which were offered as security when they borrowed the money, may not be worth as much as you thought they were (housing is a prime example).

There is no easy way out of a solvency problem.

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.

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.

AIG bailout – Necessary, unfortunately

September 17, 2008 at 7:53 am | Posted in credit, Housing | 1 Comment
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So the US government is deeper into the business of being in business. This NYTimes article
http://www.nytimes.com/2008/09/17/business/17insure.html
talks about the Fed’s $85 billion loan to AIG.

Fearing a financial crisis worldwide, the Federal Reserve reversed course on Tuesday and agreed to an $85 billion bailout that would give the government control of the troubled insurance giant American International Group.

The decision, only two weeks after the Treasury took over the federally chartered mortgage finance companies Fannie Mae and Freddie Mac, is the most radical intervention in private business in the central bank’s history.

Financial institutions need a certain amount of capital to remain solvent – basically, when they borrow money, they need to be able to pay it back, or go bankrupt. So they need enough of their own money -equity – to cover any losses they make, so that they are still able to pay off the debt.

Here’s an example of this works – Say I borrowed $80, and put in $20 from my pocket. I then lent the $100 out to borrowers – some borrowers want to borrow to buy a house, others, to buy products for sale in their store, others, to build a plant or buy a shop – whatever. The people I borrowed from don’t really care where I lend the money – they only care that they can get back their money. So let’s say that a storekeeper went bankrupt and couldn’t return the $10 he borrowed from me. I still have the other $90 lent to other people – I owe my lenders $80, and have basically lost $10 of the $20 I put in. Now, if a homeowner went bankrupt and I lost $20 more, I’m in trouble, because my assets (the stuff I own) are now just $70, but I owe my lenders $80. Either I put in another $10 from my pocket (this won’t be enough, because then I have $80, and owe $80, and if another of my borrowers goes under, I will again need to add more from my pocket), or I go bankrupt too. But like I could go bankrupt because somebody who borrowed from me went bankrupt, so could somebody who lent me the money go bankrupt if I cannot pay them back. And this could cascade through the system. That’s why the government had to step in – They don’t really want to save any one company – but if each bankruptcy or other, less serious event were to trigger another such event, the entire system can get into a lot of trouble.

That’s why the government had to step in as the last resort, to prevent the system from collapsing. I think better regulation can help protect the taxpayers from some of the consequences. I don’t think regulation has all the answers – we can’t anticipate everything that can go wrong, or how things can go wrong, but we can certainly assume that something will go wrong, and regulate risk norms accordingly. That wouldn’t fix everything, and we must be careful not to over-regulate, but what we did have is not enough.

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