Tuesday, October 21, 2008

judging the government's solutions

summary:
my plan of buying corporate and asset-backed bonds would do a better job of fixing the financial market than our current approach. in the last 10 years, banks have become less important as lenders in our economy, and the "capital markets" have become a larger source of money. over that time, all kinds of loans -- home mortgages, credit card balances, mortgages on office buildings, car dealer inventories -- have been funded by selling bonds. they are packaged into trusts, which then issue debt in the capital market. this is the new way our economy funds itself, and there are many benefits despite some real problems. fortunately, my plan would call for an overhaul of the credit-rating agencies -- major enablers of the binge.

my plan would embrace the new capital-market dominated reality. instead of trying to fix the banks, which long embraced these trusts, I think policymakers should look to the structuring technology as the solution. that means restoring the market for asset-backed securities -- especially those tied to credit cards and home mortgages. bank balance sheets and deposit bases are now much less important the economy. and, banks are private companies with their own shareholders to answer to. giving them free money and free guarantees, and then expecting them to effectively deploy the capital into the economy is naive. what's the incentive, other than the scorn of hank paulson, who'll be out of office in a few months? why should any bank put that money to work now?

paulson's "TARP" (troubled asset relief program) wanted to simply buy up distressed assets. some of his logic made sense because right now, some securities are TRULY MISPRICED and have very low risks of default under even the worst situations... the problem is that the market is frozen and no one wants to be the first one to buy.

that's why we need the government as a buyer... if the Treasury were to decree that AAA asset-backed paper should have a spread of 50 basis points over Treasuries, it would trigger a massive rally in securities that are now trading at areas around +500bp-600bp. because their default risks are so low, these are real instances of the market "going too far." many of these bonds were purchased by entities such as structured investment vehicles (SIVs), which got the money by borrowing short term in the "commercial paper" market. but now the commerical-paper market is crashing the SIVs have to pay back their debts, forcing them to sell longer-term asset-backed securities ...


a liquidity drain this size will inevitably reverberate throughout the economy. between aug 8 2007 and feb. 6 2008, the asset-backed CP market shrank by $378bln, or some 2.7% of GDP.

the market then more or less stabilized, as asset-backed CP levels remained close to $800bln from december through late july. it then fell 9% over the next five weeks.... then lehman brothers magicallly collapsed. (while it's hard to draw actual lines of connection, when you're dealing with large leveraged bets like this, it doesn't really matter how things work because everything winds up interconnected anyway.)

with less liquidity from ABCP, there was less money available to buy longer-term asset-backed (structured) securities, so issuance plunged:with less demand for these kinds of asset-backed securities, it's harder for credit card companies to securitize account balances. that means tighter standards, smaller credit lines and higher interest rates ... even businesses that have no exposure to housing will encounter tighter conditions as vendors demand earlier payments, etc. it will mean less money for ordinary people and small businesses... in other words, the exact thing the government wants to prevent.

this is a classic financial contagion scenario, where weakness in one area harms other areas. but this time, the problem is occurring in the capital market much more than the interbank market. we mustn't forget that the first indications of the credit crisis were visible in the asset-backed commercial paper chart above... it started falling in August 2007... while stocks went on to make new highs, the die was cast. by the end of the year, the sp-500 began a sharp bear market... by march, bear stearns was gone...

IDENTIFYING THE PROBLEM

this housing boom and bust cycle was created in that capital market. that's where we have to solve it.

I believe the efforts so far will largely fail because they inject money into the wrong place. instead of rewarding banks with cheap subsidized capital, we should use that money to revive the market for long-term bonds. in this new modern system, the CAPITAL MARKETS, NOT THE BANKS, ARE THE SOURCE OF LENDING. investors are already on the sidelines with plenty of cash. they are afraid to buy now and recognize losses, but if the government were to establish official prices, they would rush back to the market.

such a solution would get money more quickly to the parts of the economy that need it. instead, we're trying to cobble together some kind of solution based on precedents established in other countries. we're giving the money to banks, which are bleeding out of every limb, and ASKING THEM to pass it along. this seems like plain wishful thinking to me. maybe hank paulson is just too close to wall street to know any better.

pursuing a capital-markets solution such as mine will also guarantee taxpayer upside. after all, bonds are priced relative to Treasuries. if they just took the average spreads over the last 10-15 years, it would allow to buy AAA at about +50bp, AA at +80bp, etc.

CRACKING THE WHIP

this would put a lot of onus on the credit-rating agencies. after all, the government would use their ratings to determine borrowing costs across the entire economy. that would require a major overhaul of the industry. for years, moody's and S&P have existed in a nebulous, murky realm. they take a cut of all issuance, which makes them resemble the investment banks that manage debt offerings. but unlike the banks, they cannot easily be sued. that's because they have the legal standing of journalists... this places them in a very priviledged place... they profit from surging debt issuance, but can't get in trouble when something goes wrong. heads they win, tails you lose.

we need to fix this situation. the rating agencies were at the very center of the credit collapse. (they're already ensconced in regulatory regimes around world involving pensions, insurance, banking, etc.) we cannot allow them to just slip into the woodwork. that's another benefit of my capital-markets solution... it would necessarily cast moody's and S&P into the political spotlight, where they belong.

as for-profit organizations, they inevitably seek growth first and foremost. in their case, they found that growth in structured products:

it appears Moody's and S&P made much more money rating complex debt securities than old-fashioned stuff like plain vanilla corporates and soveriegns. furthermore, those same issuers had less debt to sell. so the rating agencies turned to the most obvious growth opportunity: structured debt, most of which was tied to consumers rather than companies or countries.

on Feb. 4, 2004, Moody's acknowledged that the traditional corporate business would slow, but then assured investors with these words:

We also expect good growth in consumer spending in 2004. As a result, we expect that revenue from rating asset-backed securitizations, together with moderate growth in the commercial mortgage securitization and credit derivatives segments of the business, will substantially offset an important decline in revenue from rating residential mortgage-backed securities as the very strong refinancing activity of the past two years declines. In the public finance ratings business we expect approximately 20% revenue decline in 2004, reflecting projected slowing of issuance related to both refinancings and "new money" borrowings.

now, I am not sure why they said residential mortgage backed securities would decline. I don't believe that happened. but, we do see that Moody's was viewing structured finance as a growth area, which it was.

here's something from Moody's 2002's 10-K annual report:

Operating income of $538.1 million in 2002 was up 35.0% from $398.5 million in 2001. Moody’s operating margin for 2002 was 52.6%, up from 50.0% in 2001. The strong operating income growth in 2002 principally reflected the Company’s high revenue growth without a proportional increase in expenses.

again in 2003, the magically language appears:

Moody’s operating margin for 2003 was 53.2% compared to 52.6% in 2002. The increase reflected the strong growth in revenue in the Moody’s Investors Service business without a proportional increase in expenses.

in essence, these guys' were bringing in more revenue, but their costs didn't go up. everything was pure margin... why? because they were the gatekeepers sitting a top hundreds of trillions in debt issuance, and took bigger cuts when a deal was structured. all they had to do was hire a few more analysts and put in a few more computers... peanuts compared with the amount of revenue coming in. (this phenomenon is called "operating leverage.".. unlike making physical products with raw-material costs, the rating agencies just collect revenue when bonds are sold. if strong demand allows issuance to increase from $100mln to $150mln, the agencies get 50% more money for doing 0% more work... that makes the commission on $50mln pure profit.

and, the rating agencies' fees were almost certainly higher on these newer products. (I should emphasize there is no really definitive way to PROVE this, but it's a reasonable assumption given the chart above showing that the company's profit margin expanded when its product mix turned in favor of structured products.... furhermore, in any environment when something is new, with high growth potential, margins are ALMOST ALWAYS wider than a sector like sovereign debt, which has existed for centuries.)

and, of course, Moody's and S&P don't disclose their fees publicly.

this collapse of overall issuance, led by structured products, has been accompanied by a collpase of the share prices at both moody's and S&P parent McGraw-Hill this year.

even Fitch Ratings discussed how the weak structured-product market at its rival S&P could hurt McGraw hill's credit profile (which happens to be a plain vanilla corporate issuer in its own right, and the owner of S&P):

Rating concerns include dramatic slowdown in structured finance rating fee revenues, and the declining issuance of commercial mortgage-backed securities (CMBS), collateralized debt obligations (CDOs) and residential mortgage-backed securities (RMBS).

finally, as public companies serving shareholders, Moody's and S&P have no incentive to look at the macro economic/financial picture. no one stopped and said: debt in the overall economy is growing too fast-- make it stop. they continued giving the nod to individual securities without any sort of concern for the bigger system. they remind me of careless fishermen who overexploit an area just to make money, only to destroy a population's long-term viability. these rating agencies have eaten at the trough of the american financial system long enough. while they can produce a million excuses for why they misrated subprime debt, they can offer no explanation for allowing our household sector to take on so much debt except "it wasn't our problem." in truth, it wasn't their problem ... their only responsibility is to make money for shareholders. this renders them incapable of thinking about the broader financial system.

if we're going to give Moody's and S&P such an important role in the economy, maybe we should expect something more from them. maybe their mission should be brought into line with the needs of the country.

it's clear the rating agencies were at the center of this mess... and it's also clear that the mess began as early as August 2007 when asset-backed commercial paper came unglued and longer-dated issuance collapsed. that is what killed the bid for credit and unleashed the cascade of price declines, which subsequently caused bank writedowns. the problem began in the capital market, and that's where it needs to be fixed.

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