Friday, January 29, 2010

Resolving fake homeownership

Mike Konkzal has a new post on the homeowner crisis. In it, he describes the current phenomenon of homeowners being offered mortgages, which they can’t afford once rates are reset after a teaser period, then being left with an uncertain future as banks defer on foreclosure after they‘ve gone delinquent. He gives this a term, “Fake homeownership”, which is probably a very apt term for what the arrangement essentially amounts to. He has given vivid illustrations of what is actually going on in the ground, and like many, is reasonably perplexed at how banks could have let people come this far into trouble. Not being in the US, many of the things he says are new to me, but having once been in a bank, I will put my comments and clarifications on key passages of his post, to try to put more light on some of the reasons why they are what they are, so that Mike (who’s doing an admirable work of trying to get to a deeper understanding) can give us more nuanced recommendations.

Here’s what fake homeownership looks like on the way up: a subprime loan’s “teaser rate”, the initial rate, was much higher than the prime rate. It was often in the 8-9% range. So the teaser is set at the maximum level a borrower could pay, and there’s an interest rate jump at the 2 or 3 year mark. It is highly unlikely the borrower can make the jump payment, so they must refinance it. In fact, you see something like 80% of subprime mortgages refinanced by the 3 year mark. I see the logic of subprime having a higher rate than prime, simply because it is subprime. But I do not see the logic of why a mortgage whose teaser rate was already at the maximum that a borrower can pay, was still offered. Of course, this can only result in a default once the teaser rates expire. This is absolute insanity, and admittedly, US banks were greedy and probably either relied too much on constantly rising home prices, or more likely, on the risk diversification provided by securitization.

What is often not discussed is that over 70% of subprime loans have a prepayment penalty. The prepayment penalty is quoted in terms of months of interest (BS like that is reason alone to have vanilla contracts), and a rule of thumb is something like 6 months interest which at the 2nd or 3rd year is somewhere about 4% of the principal. Now the subprime borrower probably doesn’t have 4% of the principal laying around, so it is rolled into the new principal of the refinanced loan. From my experience, prepayment penalties are there to compensate the bank from any loss it will incur from losing a loan account that may have already been matched with a funding of similar maturity, ex. A mortgage that earned 8% that resets after 3 years was probably matched with funding (most likely by attracting long-term deposit or issuing CDs) that matched that duration, and provided the bank with an economic spread. Losing that income stream before the bank was able to pay out its funding in full results in a loss for the bank, and the bank usually capitalized this loss in the prepayment penalty. Of course, assuming that a subprime borrower would have 4% lying around upon rate reset is obtuse, and likely, the intention was really to include the penalty into the principal all along.

This is influenced by the binomial approach Yale economist Gary Gorton takes in his The Panic of 2007 paper (see around page 15 if you are a finance geek). Note that this contract is rational only if housing prices are expected to appreciate faster than the fees, and on average analysts thought housing prices would go up about 5% a year. So the endless recycling of these loans generates fees that eat up a large chunk of the house price appreciation. No wonder all these homes are underwater! Analysts who projected 5% house price increases were probably making assumptions that you and I do not use or are aware of. Whatever, it is obvious now in hindsight, that this was stupidity of the superlative order. More likely, they were just looking at the fees, and justifying them by assuming the 5% increase.

What Gorton puts weight on in his model is that banks can choose not to refinance, and the homeowner will likely have to sell the house – so there’s an option embedded for a foreclosure after two years by the bank (he argues that refinancing with other institutions is difficult because of the adverse selection issue). So from a financial engineering point of view, the bank has hired someone to sit in a house for them, and they are each getting paid by splitting the home equity. The borrowers need to be of poor quality else they’d just gamble on HPA with a prime mortgage. This makes sense, and illustrates how the entire housing crisis was (deliberately or unwittingly) engineered by the banks looking to cash in on the perpetual fees coming from “perpetually” refinancing mortgages, and obviously, only people who never accumulate sufficient equity in a house will fit this criterion. Perhaps it’s true that banks also saw the positive option value of a foreclosure, once they have accumulated enough fees from said ‘house sitter’.

This is a widespread phenomenon – the rate of prime loans failing is doubling at all times. One solution would be large principal reductions. Another would be to allow for mortgage cramdowns, to make negoiations more credible. Another would be to subsidize short sales. Another would be to have the government purchase a huge chunk of these mortgages at a cheap price and sit through whatever profit can be made – Roosevelt’s efforts to do this in the Great Depression made a profit. Now I see why principal reductions are very necessary. The reduction should be of an amount at least equal to the fees already ‘robbed’ by the guilty banks over the years, that should have otherwise accumulated as equity for the ‘house sitter’ by this time.

But it is fascinating to think of what is happening with the people who can’t make their mortgage payments but haven’t been foreclosed on. The bank in this case is exercising an option to defer foreclosure – an option I never thought would be used on such a wide-scale. How does that option work? And what kind of ‘ownership’ do people in these situation experience? Is it a kind of mini-vacation, where you get to live in a nicer house than you could ever afford? Is it a perpetual sense of anxiety, where someone could come to remove you within a week? Is it just a sense of resignation at being a widget that the largest banks are using to pretend second-liens assets are worth something other than a penny on the dollar – their home as juking some financial statistics? I’d love to read more about that. In all likelihood, the banks are not foreclosing because the positive option value of foreclosure is no longer there, i.e., if they foreclose, to whom can they sell at the previously assumed value? And for as long as the market for housing has not stablized, foreclosures will likely be deferred. This is absolutely the kind of ‘fake home ownership’ that Mike has termed. And second liens will definitely be worth pennies if not zero, hence, you won’t see them initiating any of the foreclosure proceedings. I don’t know if this deferment has been to juke any statistics (they're nonperforming assets either way), it is probably more the reality that the costs of foreclosure far outweigh any tangible benefit it accrues for the banks. Benefits of foreclosing will only become more tangible once prices have stabilized, and ironically, that will likely only come once more mortgage cramdowns are effected.

Wednesday, January 27, 2010

On the possible reason why mortgage modifications have so far failed, and some modest solutions to improve results

Mike Konkzal writes a post that sheds a bad light on the mortgage banking industry, and gives a good reason why many people are angry and are considering strategic default. He says that many people who have gone to their banks asking for modification end up getting one, but one that makes the debt burden worse for the borrower.

From Analysis of Mortgage Servicing Performance, more than 70% of the modifications resulted in an increase in the loan balance. Not staying the same, and certainly not decreasing, but piling on more principal for the loan. I’ve seen a lot of bad things during this financial crisis, but this is the most disgusting thing I’ve seen so far. At a time when one out of four homeowners are underwater, banks are using a mortgage modification program to pile on more debt on these loans. They do this even when it’s well known the correlation between the level of being underwater and default.

How? From the report: “Servicers routinely capitalize delinquent interest, corporate advances, escrow advances and attorney fees and other foreclosure-related fees and expenses into the loan balance when completing a loan modification.” So fees allow them to make it look like they are doing their clients a favor, while all they are really doing is running them in a big circle.


He points out that it is ironically the people who asked for a modification from their bank, with the intent of enabling themselves to continue their payments instead of letting themselves end up in default, who end up with larger principals.

These are people who, instead of walking away from their responsibilities, are burning time, money and energy to credible signal to the bank: “I’m in over my head with this mortgage but I want to do right by it because it’s an obligation I made to you. Instead of simply walking away or trying to short sell, is there any way we can work this out so I can still pay you whatever I can? I gave you my word and that means something to me.” And the bank uses their signal that they want to do the right thing to fuck these borrowers the hardest, piling on as much debt as possible on these guys as they can get away with.

So the people who really want to meet their obligations are the ones you screw with as much principal as possible, and the ones who threaten to walk away are the ones you have to take seriously.


This is the dark other side of the strategic default issue - bankers who don’t have a clue, or don’t care, what is happening with their borrowers, and what the ramifications of not helping them are. Firstly, banks have always capitalized any penalties, accrued interest, (and sometimes even any modification fees) into the principal outstanding of any loan. This is how it’s always been done, because these are all the real costs involved in the modification. If payments had been missed, there was a cost of money that the bank had incurred, and that had to be earned back somehow.

But this stance can only be the norm when everything else in the economy is humming along as they always have. It is not so this time. This time around, the options they have are: do what you can to ensure the return of your money, or squeeze the borrower hard, so that you earn as much return on your money as you can.

We are obviously past the point of banks earning their originally projected profit from the accounts, and way past the point where banks can assume that they can expect to earn fees for giving borrowers the privilege of modification. This time around, the obvious objective of the banks should be: do what you can to ensure that the principal that was put at risk in the first place is returned as completely as possible.

And this time around, because of the unsustainable housing bubble that they allowed themselves to be instruments of, house prices have gone down, and in many cases, way below the loan value of their borrowers’ mortgage. And because many mortgages were structured so as to increase rates if the borrower doesn’t increase his equity in the house after a specified period, the recent fall in house prices ensured that many borrowers will not meet that equity requirement, and end up with the increased rates.

This leads to a negative feedback loop where the increased rates has led to more defaults, putting more pressure on house prices, thereby putting more borrowers underwater. Admittedly, this is an explosive combination that can only lead to higher risks with regard to the principal that was put at risk by the banks.

Banks have a fiduciary duty, whether to their depositors, who put their money in the bank on good faith, or to investors, who bought asset-backed securities from them, on the belief that the bankers put in the necessary work of validating the creditworthiness on their accounts, and in structuring their accounts in a way that leads to a stable stream of fixed income until the entire principal on each account is paid off.

Because of this fiduciary duty, banks cannot just declare a mass principal forgiveness on all borrowers currently underwater. This mass forgiveness often cannot help due to several reasons, and I can think of 2 now:
1. This will lead to massive losses, not just to the bank itself and/or its funders, but by extension, to its depositors, and/or the market funds that bought mortgage-backed securities from them.
2. Principal forgiveness will lead to massive writedowns which could provide a negative feedback loop into the real estate market anyway, if it happens that any of their affected funders have to unload properties in response to their investment writedowns.

However, the alternative of no action by banks is way much worse. Borrowers who cannot pay anymore will default. Eventually, borrowers who can still afford, but are pissed because banks don’t seem to care, will strategically default. This will lead to way, way more credit writedowns. In this way, bankers will have failed in their duty to their depositors, funders, investors, and equity holders.

By facing up to their choices, banks will have to admit to themselves that losses have to be recognized, and have to be contained, so that they do not lead to bigger losses later on. Extend and pretend is not the best way forward.

There will be losses because there are borrowers who have lost their jobs, and will not be able to pay no matter what. Banks should do the right thing and foreclose now rather than give the borrower any false hope with a modification that he cannot meet. And there will be losses because there are people who have decreased income now than they had previously, and will only be able to pay with principal forgiveness and/or a much longer term. But the losses that will have to be eaten, though they will be large, will not be as monstrous as with the alternative.

There will be banks that will likely fail, and close, when they face up to their options. But what are they hoping for anyway? Better times? If they know now that they are capital-constrained to afford modifications at the rate and extent necessary, they might as well fail now than fail later.

Government needs to do its part to help. Perhaps more tax incentives to banks that have to eat more losses than they have capital for, will make it easier for their funders and owners to bite the bullet and do what is right.

Depositors need to be reassured more that their deposits will be returned as much as possible if and when their bank is one of those who have to bite the bullet and fail. In this case, stronger banks will have to given the incentives to assume the deposits and liabilities of the failing banks. And in the case of the money market accounts that invested heavily in mortgage-backed securities, well, their investors invested in them with open eyes, knowing that they provided higher returns because they are not insured by the government.

These are not easy solutions, and many people will suffer. But again, the alternative is worse. If there are any of you wondering why there are banks that have so far seemed to promise a fair modification, but whose actions show a completely different intent, James Kwak and his commenters are on to the right reason: Banks perhaps have not communicated a clear change of objectives to the people who are supposed to execute their policies.

Therefore, at the modification level, the banks are still pursuing a return on your money policy, rather than a return of your money. If CEOs and/or owners have not had the stomach or courage to communicate this change, despite promises made, then we can coerce them with a slight variation of the best idea I heard today, from Steve Waldman: take away FDIC deposit coverage. We can take this away from banks that do not follow through on the necessary actions.

Americans, take these as modest advise from one of your neighbours up north of the border. We also have an interest in seeing you succeed in your recovery. After all, if you bring your system down, you take us along with you.

Monday, January 25, 2010

More on why individuals are not like corporations, and shouldn't strategically default

Felix Salmon is finally toning down on his call for mass strategic defaults. In his post, The Corporate Conscience, he quotes Justin Fox: The individuals who make up the electorate in the United States are, as Friedman described, beings of many facets — their actions and their views shaped by pecuniary self interest but also by values, beliefs, and loyalties that might conflict with that self interest. The ideal for-profit corporation, on the other hand, is out to do nothing but make as much money as it can “within the rules of the game.” It is supposed to behave in a fashion that for an individual would probably be described as psychopathic. And if corporations are allowed to play a decisive role in shaping the “rules of the game,” we have effectively put the inmates in control of the asylum…

If corporations are persons, they are — if they behave as Milton Friedman wanted them to — persons with mental and emotional impairments so severe that any decent judge would feel entirely justified in declaring them incompetent.


Felix adds: There’s a connection, here, to the increasingly conventional-wisdom argument that walking away from a mortgage is perfectly fine since the banks who lent the money in the first place wouldn’t hesitate to behave in exactly the same way. But if Justin is right, we’d have to be psychopaths to treat corporations as our role models in such matters.

Absolutely! So no more public calls for actions that don’t solve the problem, and only make it worse.

And a long as we’re talking about how individuals are different from corporations, I want to add this one more thing, which I believe is important to remember, especially for those individuals who may be thinking of doing a strategic default, and justifying themselves by pointing out how corporations do it all the time. And here it is-

Corporations have a distinct and separate existence of their own, BUT their credit is very much determined by the character and integrity of the people who run them.

I believe this explains, partly but not fully, why corporations are sometimes able to get away with strategic defaults. When a corporation does so, its standing with the over-all credit community takes a nosedive, and its chances of taking out loans in the future, let alone at favourable rates, drops drastically. An individual who does the same will experience much the same consequences.

However, the individual running the corporation often does not stay long enough to reap these consequences. Sometimes they retire with their golden parachutes, sometimes they’re pirated by other corporations looking for the deadbeat CEO to replicate his astounding returns to their own shareholders. Sometimes they’re appointed Treasury Secretaries, or sometimes they merely bow out after falling from grace. The corporation, in the meantime, gets a new CEO, or is bought out by Warren Buffet, Steve Jobs, or some other angel investor who is trusted by the market. Because of this new individual, the company may be able to get new credit again.

Meanwhile, Joe Deadbeat, who’s already blacklisted by the market because of his default, remains Joe Deadbeat, 10, 20 years from now, and the memory of what he did will remain on the banks’ records. He will likely never get credit on favourable terms ever again. And this is particularly true, if his default was a STRATEGIC DEFAULT.

So, what proves disastrous economically collectively will also prove economically ruinous individually. Now stop for a moment and let that stick.

Related:

The mainstreaming of strategic defaults is the best thing to happen to deadbeat speculators since liar loans

2010 tough luck year for anyone connected with the US economy

Gillian Tett brings new understanding to why the Fed will continue with monetary loosening

Why strategic defaults will be good for loan sharks

On 'extend and pretend' and 'walking away on your mortgage'

Why are we even encouraging strategic defaults?

UPDATE: I hoist this from comments, because this is a common sentiment for a lot of people. I want to post my answer here.

Humbug! The US banks wont have anyone to lend to if they shut out defaulters, that is until the job market recovers. Can anyone with a brain see how a long term self sustaining recovery can ever be achieved by government spending? It will never happen. People like that douchebag Robert Reich say that government spending is the answer. Face it-property values are going to fall so much and interest rates rise so much that no one will want to buy.

the only way your argument makes sense is if 10 million homes are destroyed AND a 10 yr moratorium on residential construction is done. Then, real estate would actually have value for owners to sweat to keep, and for banks to actually lend on. in 5 years, 200K homes 'might' fetch 40k, cash, cause thats what theyre really worth. Houses are simply a proxy for bonds and as interest rise, home values will crash. Banks will be happy to lend to defaulters cause at least they might be INTERESTED in buying!

My answer: You have strategic default confused with mortgage forgiveness. No bank will grant loans to any buyer who has already defaulted. But they may be coerced into providing renegotiation and/or principal forgiveness, to minimize the value destruction that you’re talking about. I had put forward other possible approaches in the previous posts that I listed (read them, that’s why I put the links here). Nonetheless, for the sake of those who don't click, here they are in verbatim.

• If the banks already see a default down the line, they should just take their losses and foreclose now (and eat their losses) rather than trying to squeeze every last penny from borrowers who have already lost their jobs.
• In the case of borrowers having no ability to pay the adjusted rates on their ARMM mortgages, but still have paying jobs, banks will need to be coerced to renegotiate. Here, nationalization seems to be the solution. A better way would probably be to impose a restructuring along the lines of rent-to-own, and there have been good discussions on this so far in other blogs.
• In the case of borrowers who have the ability to pay their mortgage and only want to walk away, or do a renegotiation, because they are now underwater, the stance should still be ‘a deal is a deal’.

What would happen to the financial system once everyone no longer has shame of default? More defaults leading to more underwater mortgages leading to more defaults, all the way down to financial armageddon. If defaults become at all common, it won’t be long before we forever say good-bye to any notion of providing credit to anyone. And not paying debts because banks didn’t do their jobs properly could be just one step away from not paying taxes because the government isn’t spending your tax money correctly. Is that next?

And if you’re doing this to spite the bankers, remember that they are made up of more people than those who sold and structured toxic mortgages. Most likely, those most culpable have already taken out most of their equity (via corporate tax-deductible bonuses) and are likely to even profit from something such as this happening (they can short all finance-related futures indexes, bringing down all institutions that are in some way inter-connected with the prime culprits.)

Don’t cut off your nose to spite your face. In this scenario you talk about ,the biggest losers are depositors (that may be you!) and other borrowers who have faithfully paid their loans. The solution is stronger bank regulation, not Armageddon.

Saturday, January 23, 2010

The new Volcker rule and the future of finance

The news of the day is the announcement of an impending White House proposal to reform the US financial markets, much of which will follow the now so-called “Volcker Rule”. There are 2 main guidelines of this rule:

Limit the Scope - The President and his economic team will work with Congress to ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit.

Does this help in limiting risk in the market? Ok, to simplify this, let’s go back to the steel company analogy from my last post (I know this is beating up on shaky analogy, but still, if you haven’t already read the post, you should, to understand what my point here is.)

11. So it turns out that the steel company, aside from making a ton of money selling overvalued steel, also happens to have a small purchasing office that had been purchasing hand fans and rubber tires, also purely for its resale value, and it also happened to lend some money to other buyers with the same objectives. Their activities have inflated the price of hand fans so much that people of more meagre means were now sweating like pigs in the summer heat.

12. With the new Volcker rule, it will have to shut down that purchasing office. Oh well, the steel company will just need to content itself with profits from flooding the market with toxic steel.

Limit the Size - The President also announced a new proposal to limit the consolidation of our financial sector. The President’s proposal will place broader limits on the excessive growth of the market share of liabilities at the largest financial firms, to supplement existing caps on the market share of deposits.

13. But wait, with the new Volcker rule, too, the steel company will now have to limit its use of iron ore. That should limit the number of steel going out into the market, right? So now who are those people getting out of the steel plant? That’s right, they’re existing employees out to start their own steel plant. No sense letting all this good ore go to waste, don’t you think?

Tuesday, January 19, 2010

What is the best way to abstract what finance is all about?

I got to thinking about this because of Nick Rowe’s question - Does the "industry" of Finance actually *create* short, safe, liquid, simple assets out of long, risky, illiquid, complex assets (in the same way that the steel industry creates steel out of iron ore). Or does it just redistribute those properties so that the people most/least willing to hold assets of a particular length, safety, liquidity, complexity get to hold most/least of what they want?

In other words, does finance fit into this mold of an economic enterprise that takes inputs and turn them into outputs.

In a way, yes. But likening it to the steel industry does not really give us a fully accurate view. And you need to model finance properly if you want to be able to analyze its effects on the overall economy.

I’m pretty sure that even if you ask finance insiders, they will find it very difficult, if not practically impossible, to pigeonhole it with a comparable category in the real economy. To illustrate my point, here are several ways that finance is different from enterprises that turn inputs into outputs. But to make it fun, let’s continue with the steelmaker analogy.

1. So the steelmaker turns iron ore into steel, but no supplier will actually demand to get back his iron ore, and no one is going to destroy steel just to return someone's iron ore.

2. In this finance aka steel company, its buyers do not buy the steel for the utility they get from it. They buy it as a store of value, but more importantly, they buy it with the full intention of selling it again, and with the expectation that they will sell it a higher price than they bought it for.

Now here is where it gets interesting…..
3. Profits that buyers make from selling higher priced steel can go into buying more steel, an activity which in itself makes the price of steel go higher.

4. Because the price of steel is getting higher, more buyers are lured to buy it, again with the expectation of selling it to the market at some point, always at a higher price than they bought it for.

5. But as more steel is bought, and the higher its price, the more steel is being made, to sell to even more buyers who want to unload it to still more buyers.

6. Because the intent of all steel buyers is to sell to other buyers, nobody wants to be the last one buying steel. This sentiment in itself should ensure that at some point the price of steel will stabilize, and in fact start going down.

7. So all buyers are now fully preoccupied with trying to outwit everybody. Because the steel market will crash once buyers start thinking it is now selling at the peak price, no existing holder wants to be seen selling steel. One way that sellers do this discreetly is to pool steel with rubber tires, plates, hand fans, or what have you, and sell the entire thing as a bundle (Hey, maybe tires, plates and hand fans are still being expected to go up in price).

8. As a consequence, when the shit hits the fan, buyers who thought they were buying hand fans are surprised to find themselves holding steel.

9. Because of this dynamic, the steelmakers are rewarded not for making the best steel, but for managing to sell the most steel, even when every other buyer wants to be sellers themselves.

10. Because buyers caught holding steel need to make up for their loss (maybe they borrowed to finance the purchase) they unload whatever they can. This means hand fans, rubber tires, plates….their prices also hit the fan (not the figurative hand fan).

So where am I going with this? I really don’t know. I have yet to find the appropriate analogy. I told you, once you try to abstract finance with the intention of understanding how it works, you end up getting lost in endless thought streams that somehow melt into each another. So now pls. excuse me, I think I just poked my eye with my pencil.

Friday, January 15, 2010

Interest rates, regulation, trust, and finance's intermediary role

This post adds points to Mark Thoma’s post, where he said that both low interest rates and regulatory failure were responsible to the credit crisis. In response to the question of whether the Fed's low interest rate policy is responsible for the bubble, most respondents point instead to regulatory failures of one type or another. Ben Bernanke has also made this argument. However, I don't think it was one or the other, I think it was both. That is, first you need something to fuel the fire, and low interest rates provided fuel by injecting liquidity into the system. And second, you need a failure of those responsible for preventing fires from starting along with a failure to have systems in place to limit the damage if they do start.

….Once the fuel was present, something had to allow the bubble to inflate and then do widespread damage, and that's where the regulatory failure comes in. But I don't think the regulatory failure matters much without a large amount of liquidity within the system, and I don't think the large amount of cash in the system is problematic without the regulatory failures.

I agree with Mark that Ben Bernanke cannot deny the low interest environment’s role in creating the crisis. In fact, in my view, interest rate’s role is even more emphasized than lax regulation (though I’m certainly not excusing lax regulation either).

To explain this point, let me start with Nick Rowe’s musings on finance. I can't get over the feeling that Finance is magic….By "Finance" I mean the whole industry that intermediates between ultimate borrowers and ultimate lenders. And that means not just banks, insurance companies and mutual funds, but also financial markets for stocks and bonds.

Like any other industry, Finance converts inputs into outputs. Ultimate borrowers want to borrow to finance assets that are: long, illiquid, risky, and complicated. Ultimate lenders want to hold assets that are: short, liquid, safe, and simple. Finance is an industry that coverts the raw materials of the former into the finished output of the latter. And it just can't be done. It's an illusion, a confidence trick; it's magic.

..... what surprises me is how far it has come along that road. It's surprising that Finance exists at all. Theoretically, Finance doesn't seem possible. It's just too far-fetched to expect it to work in practice. It's just a confidence trick; it all depends on trust.

Leading from Nick’s thoughts, here’s a summary of my thoughts on finance’s role and importance to society. Finance exists because its practitioners know who, in a given population, are willing to exchange liquidity for yield. They also know, on average, how much that yield should be, given how much everybody is willing to part with his liquidity. This is true for all kinds of intermediaries - bankers, insurance people, and fund managers.

Finance does the job mostly successfully because, in a given population, people have varying preferences for liquidity. They have different durations whereby they sacrifice liquidity. Finance, if it deals with a large enough segment of the population, manages its liquidity by matching funds with uses that have the same duration. Anytime that one person (or entity) decides he needs his liquidity back, he trusts that he will get it, because finance can replace that lost fund with funds from another person (or entity) who doesn’t need his liquidity at that moment.

For as long as the market’s preference for liquidity is the determinant of yield in constructing finance’s output, everything is okay. However, we occasionally see cases when people are chasing after yield, while maintaining the fa├žade that liquidity is not being sacrificed. (This is what happened in the run-up to the crisis.)

Now this gets to the point I want to make. The biggest reason the market was chasing after yield was because the prevailing interest rates were too low. The need for yield is more acute the more the market consists of money market funds and insurance funds, who have an obligation toward their investors to consistently provide positive returns.

This need for yield necessitated that they go after what would normally be considered riskier investments, or investments that sacrificed more of liquidity. Without the impetus coming from low interest rates, finance would not have found the need to chase after yield at the expense of liquidity.

Now this also came at a time when regulations were also getting lax. In this environment, it became easier for investment bankers, the ultimate intermediary to other intermediaries, to come up with products and structures that effectively clouded the true extent to which liquidity was being sacrificed for yield. In this way, finance (investment bankers) compromised much of the trust from the market (the fund providers) that enabled it to do its job.

Finance is an activity that needs pro-active regulation because it is so easy for its emphasis to shift from using the market’s preference for liquidity as the determinant of yield, to using the market’s demand for yield as the basis for creating its outputs, without full consideration to high yield’s ramifications for liquidity. When people realize that liquidity has been compromised in way that they never anticipated, it will be a mad scramble for the exits as people demand more liquidity, even at the cost of negative yield. (This is where we found ourselves in the fall of 2008).

Now, whether we have lax regulations or not, low interest rates will always lead to markets chasing after yield. Because we had lax regulations, more people were victimized by Wall Street’s unscrupulous practices that fudged the real extent that the artificially high yield was being achieved at the cost of liquidity. Going forward, the Fed should be more sensitive at the adverse effects created by low rates and lax regulations.

Tuesday, January 12, 2010

The mainstreaming of strategic defaults is the best thing to happen to deadbeat speculators since liar loans

I say this because strategic defaults, taken with liar loans (or in other words, the lowering of mortgage underwriting standards) has largely democratized what has always been a Wall Street playground - asset speculation.

Taken in context, what this has done is to enable the unwashed masses to buy what is essentially a put option on the housing market. With minimal down payment ( and at leverage ratios that would that would make Gordon Gekko proud) they gained the rights to all potential gains from an appreciating market, but retain the right to return the keys to the creditors in the event of a fall in market price. Thus, with the current housing price collapse, their option to sell property is largely ‘out of the money ‘ and while they still have the right but no obligation to exercise it, the ‘rational thing’ to do is to, in effect, let the option expire (by walking away).

Then, the current play will be to short the creditor banks, the bond funds heavily invested in mortgages, Fannie, Freddie, the Fed……...Anybody and everybody mortgage assets-heavy, and liable to get just pennies on the dollar, if at all, will be fair game.

After this, what do you think will be the best, most ‘rational ‘ move of these deadbeat speculators? At least those who do walk away with still some money left with them? That’s right, taking after the example of Wall Street, they will now come to realize that they have created the condition whereby they can cherry pick the market for the bargains of their lifetime. Meantime, the last person holding on to his existing mortgage while the market escalates towards Armageddon will be the biggest schmuck.

So if you were unfortunate enough not to have been one of those who sold early while the market bubble was still inflated, you will still have your chance to reap wild gains. Take heed, the seeds of strategic default are now being planted by the most respected academics and thinkers. So come drink the cup of Kool Aid with them, and go ahead, just walk away from your mortgage.

Roger Lowenstein: No one says defaulting on a contract is pretty or that, in a perfectly functioning society, defaults would be the rule. But to put the onus for restraint on ordinary homeowners seems rather strange.

Henry Blodget: One advantage of this move, aside from saving underwater homeowners from pouring money down a rat hole, is that it will help fix the housing market faster. If underwater homeowners walk away, the banks will be forced to take a writedown on the bad loan instead of pretending that it's worth what they say it's worth.

Felix Salmon: If there’s less shame attached to default, we will end up with exactly what we want — less badly-underwritten credit, a more solvent society, and much less tail risk. We went far too many years believing without really analyzing the proposition that credit is nearly always a Good Thing.

Friday, January 8, 2010

2010 tough luck year for anyone connected with the US economy

1. US-based homeowners – tough luck, a wave of strategic defaults are coming, your house will lose even much more value
2. Savers in US banks – tough luck, a wave of strategic defaults are coming, you bank could be next to fall.
3. Investors in US Treasuries – tough luck, the US plans to inflate away its debt, your investment will probably have a negative real return
4. Holders of US currency – tough luck, the US plans to inflate away its debt, your currency will be less valuable when buying other currencies and foreign goods
5. US-based consumers – tough luck, the US plans to inflate away its debt, everything will cost more in your debased currency
6. Investors in US-based small businesses – tough luck, see here
7. Investors in US stocks – tough luck, a new wave of US Armageddon is coming, see all of the above and this.

Gillian Tett brings new understanding to why the Fed will continue with monetary loosening

Felix Salmon links to Gillian Tett, who: has an interesting column today on the degree to which “social cohesion” determines whether or not a country in fiscal difficulties will end up defaulting on its debts. The Japanese, she says, are used to the idea of sharing the pain, and would probably not tear themselves apart should the country have to make painful fiscal cuts in order to remain current on its obligations. (Besides, given that 95% of Japanese government bonds are held domestically, a default would probably cause even more pain among the population as a whole.)

On the other hand, says Tett: the US is used to growing its way out of problems: In the US, the government has less experience of dividing up a shrinking pool of resources. Instead, in a land built by pioneers, Americans prefer to spend time thinking about how to make the pie bigger – or to find fresh frontiers – than about making shared sacrifices.


This could be telling as to what is the preferred course of action for the US. In order to grow the economy, a strategic default of some kind on old debt is in order. Of the various options, the most strategic seems to be to inflate away the debt. No politically painful budget cuts or tax increases. Just pure unadulterated GDP growth, via hyper-inflation. And as to strategic default, it has lately been growing as an acceptable and viable option, not just for businesses, but for individuals and governments as well. If businesses do it all the time, why not others, and I am starting to be more open-minded about this. Now pass the kool-aid

Thursday, January 7, 2010

Why strategic defaults will be good for loans sharks

Felix Salmon asks: Does predatory lending rise when other forms of credit contract. …I’m not at all convinced that tightening rules on credit has that effect. Indeed, it seems to me that payday lenders and the like positively thrived during the credit boom — much as India’s moneylenders have thrived and grown even as microfinance institutions in the country have done likewise.

So is there less predatory lending now, from loan sharks and payday lenders and the like, than there was in Damon Runyon’s day?


Firstly, I think predatory lenders thrive because there are bad credit people. People who go to predatory lenders are people shunned by banks, whether the economy is in credit expansion or contraction.

A credit contractionary environment isn’t necessarily what it takes to make them thrive (although in this environment, when many people are becoming worse credits, predatory lenders will thrive even more.)

Very usually, in a bad economy, people who otherwise may not need money, will find a need to borrow money because cash is running low (maybe they lost a job, or their livelihood is doing badly). Because people in this condition are now considered higher risk (whereas in a good economy, they may have had stable sources of income), people who absolutely need the money will go to alternative lenders. There are pawnshops and other various lenders who lend money on pawned collateral. They are not necessarily predatory lenders.

The worst credit people, however, the ones without collateral to pledge at all, are the ones who go to predatory lenders, the ones who charge loan shark rates. Loan sharks exist because they often are the only resort for people who have no other lifeline left.

That is why I am perplexed that Felix seems to be encouraging the notion of strategic defaults. If defaults become at all more common, it makes a whole bigger swathe of the population bad credit. The logical consequence will be that it won’t be long before we forever say good-bye to any notion of regular banks providing credit to anyone. This will be a bonanza for predatory lenders.

Those who do not have any assets, and absolutely need the money, will have no other choice but them. And if the notion of strategic defaults gathers steam, we will likely see a scenario of more defaults leading to more underwater mortgages leading to more defaults, which means more people needing money who have no assets of any value.

So I see a disjoint between him encouraging strategic defaults, and then wondering why we have a lot of loan sharks. A better way to fix the mess here.

Wednesday, January 6, 2010

Can high-frequency trading cause the next market crisis?

Put another way, do they heighten the risk of an imbalance in the market, such that a meltdown is inevitable? This is the latest article on high-frequency trading titled “Trading Shares in Milliseconds” published by Technology Review. (HT Tyler Cowen).

Just five years ago, automated trades made up about 30 percent of the market, and few of those moved as quickly as today's trades do. Since then, however, automated trading has become much more widespread, and much quicker. ….estimates that high-frequency automated trading now accounts for 61 percent of the more than 10 billion shares traded daily across the numerous exchanges that make up the U.S. market…With the rise of automation, the bulk of U.S. stock trading has moved from the once-crowded floor of Manhattan's New York Stock Exchange (NYSE) to silent server farms run by exchanges and broker-dealers across the country.

We see two sides of the argument in the article. One side says they mostly engage in ‘market-neutral’ strategies. This means their positions are always balanced, and that they mostly act as hyper-efficient intermediaries who are better than human traders at finding, and revealing, the lowest selling price of sellers and the highest buying price of buyers.

Funds running quantitative strategies are mostly market neutral. When we take a position, we're always balanced somewhere else, and when we unwind, it doesn't affect the market either." By this he means that forced selling by quant funds may be painful for the funds themselves, but that pain is barely reflected in the market, because the funds' long and short positions--positive and negative bets on the direction of given securities--cancel one another out. "We don't take from the retail guy," he says. "We make the market more efficient. Things are better for the retail investor because of high-frequency trading."

…….high-frequency traders are making money by delivering a service: liquidity. In today's highly decentralized market, defenders say, their systems are simply the most efficient way to match buyers and sellers. And because they can capitalize on small differences between the prices at which a seller is willing to sell and a buyer is willing to buy, those differences stay small.

……"There is risk, definitely, but quant funds like us take it all," he says. "If a quant meltdown happens, it won't affect the retail investor."


On the other side of the argument, experts say that high-frequency trading increases the volatility of the market , particularly if there are numerous competing high-frequency programs employing the same strategies, acting on the same triggers, and doubling up on the same positions.

The increasing dominance of algorithmic trading and the growing speed of execution….could cause tiny price changes to snowball, rolling down the hill at exponentially increasing speed--either because the machines are trading too fast or because too many funds are trading in the same style.

….regularly see algorithms executing more than 1,000 orders a second. At that rate, one algorithm trading the wrong way could execute 120,000 orders in two minutes. At 1,000 shares per order and an average price of, say, $20 a share, that's $2.4 billion in unintended trades. In his letter, Jacobs warned of "the potential for trading-induced multiple domino bankruptcies."

……Many now blame that crash on simple automated "portfolio insurance" systems, which were meant to keep a fund's holdings from losing more than a preset amount of value by automatically selling shares when the price dropped by a certain amount. They had their roots in a practice used by floor traders: the "stop loss" order, which initiates the sale of a given share if it falls below a given price. But the herd of computers issuing stop-loss orders created a stampede that pushed the then-dominant floor traders to sell as well. Donefer worries that if such a sell-off happened now, it would happen many times faster.


So where do we stand? In my opinion, it depends on whether you follow the “Efficient Market Hypothesis” or you follow George Soros’ “Theory of Reflexivity”.

Here are the quick wikipedia definitions. Efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient", or that prices on traded assets (e.g., stocks, bonds, or property) already reflect all known information, and instantly change to reflect new information. Therefore, according to theory, it is impossible to consistently outperform the market by using any information that the market already knows, except through luck. Information or news in the EMH is defined as anything that may affect prices that is unknowable in the present and thus appears randomly in the future.

Reflexivity asserts that prices do in fact influence the fundamentals and that these newly-influenced set of fundamentals then proceed to change expectations, thus influencing prices; the process continues in a self-reinforcing pattern. Because the pattern is self-reinforcing, markets tend towards disequilibrium. Sooner or later they reach a point where the sentiment is reversed and negative expectations become self-reinforcing in the downward direction, thereby explaining the familiar pattern of boom and bust cycles

A current example of reflexivity in modern financial markets is that of the debt and equity of housing markets. Lenders began to make more money available to more people in the 1990s to buy houses. More people bought houses with this larger amount of money, thus increasing the prices of these houses. Lenders looked at their balance sheets which not only showed that they had made more loans, but that their equity backing the loans—the value of the houses, had gone up (because more money was chasing the same amount of housing, relatively). Thus they lent out more money because their balance sheets looked good, and prices went up more, and they lent more.


Throughout the rise in the use of derivatives, the finance engineers who dreamed up ever more complicated structures claimed that their creations were eliminating risk from their financial transactions. Because the complicated structures usually incorporated the hedging of particular risks with what they believed were securities with offsetting risk characteristics, they sincerely believed, and preached, that their endless innovations were responsible for increased market efficiency and the great moderation in economic volatility. Now we know what they did was just transferring the risk somewhere else. And because of the added ingredient of leverage, the risks they thought they were eliminating were actually being magnified.

We could see the same pattern of events developing with high-frequency trading. While many first movers have heavily employed ‘market neutral’ strategies, which improve market efficiency, the entry of more competitors ensures that declining returns on the original market neutral strategies will drive more players into open-ended and speculative positions - those that stand to gain from the market’s movement in one particular direction. You can be sure of what happens next when it turns out that many of them have been piling onto the same strategies and positions. Just as the magic of growing leverage increased the havoc wrought by derivatives, so too, in my opinion, the magic of increasing speed will heighten the havoc to be wrought by high-frequency trading.

If you’re one of the little guys, and are still heavily invested in the stock market, get out now.

Saturday, January 2, 2010

Global demographic rebalancing could be the chief focus of the decade

It is the start of a new year, and many other blogs are lining up their forecasts for the new year. Since we are embarking on a new decade, I would like to make my forecast for the following decade (In many ways, it is much easier to project what is longer-term than what is just around the corner, because you do not have to be as accurate in timing or detail).

Let me start off by describing a framework conjured by Italian economist Franco Modigliani, termed as the life cycle savings theory (hat tip Edward Hugh, who has been basing much of his analyses and projections on the life cycle theory). The theory divides people into various age groups:

0 – 20 yrs – childhood. Life characterized by pure consumption, dependency to elders.
20 -50 yrs – the bulk working years. Characterized by high investments and high spending. This is the time when people start saving, buy a home, start a family, educate young children, buy new things for a growing family.
50 – 65 yrs – the pre-retirement years. Characterized by much higher savings and liquid investment. No longer supporting or educating children, no more mortgages to pay, and people have acquired most stuff they should ever want. They arestarting to plan and save for retirement yrs.
65 yrs onwards – retirement years. No longer earning. Using up existing savings to fund for retirement expenses.

Countries that have a big bulk of its population in the 0-20 yrs and the 20-50 yrs have high growth economies. Most people are spending for housing, education, acquiring things, buying a car, etc. Businesses are expanding, both as a result, and in anticipation, of this. The US for the most part of most part of its history is in this group.

Countries that have a big bulk of its population in the 50-65 years have a high savings rate. The economy is no longer growing quickly, but there is a high surplus savings that people are looking for assets to put into. The US is entering this stage, as well as Canada, Australia, Germany, Sweden.

Countries that have a big bulk of population in the 65 yrs upwards will be in a perennial deflation. People are no longer investing to start new businesses, there is a shortage of productive workers for those few businesses left, retirees living on fixed pensions are happy that deflation is causing consumer prices to go down even though it is also destroying the savings of those who still have high savings. Japan is entering this stage.

The reason greying countries like Japan, Germany and Sweden are relying on large exports to boost their GDP is that their domestic consumption is no longer high enough, given that most of their elderly population is in the savings stage of life, not investing or massive spending stage. Without exports, their economies will stagnate. Hence, the current economic environment is going to be dangerous for them unless the government does drastic things to artificially prop up the economy. The US is now doing what Japan has been doing since the 1990s. It is acting as the spender of last resort and resorting to yearly deficits. In the long run, this will result in high government debt.

Here in Canada, many Canadians are already getting into cash and staying in cash. These could largely be the people who are nearing retirement, and do not want, and don’t have the time frame, to get into speculative investments. They want to be liquid so that they will have money when they need it in retirement.

Japan, which is entering the last stage, is now trying to keep its mostly elderly population from becoming impoverished by supporting a strong yen. The strong yen contributes to deflation locally, and it makes goods cheaper for people on pensions. The government has also been supporting their pensions, despite more than a decade of economic stagnation, by constant deficits. The government has previously been able to finance its deficits by being a net exporter, but not anymore.

So how will the world look like as we get further along in the next decade? All developed nations, who mostly have older populations, will experience much slower growth, some like Japan, will decline even further. The big growth in the world economy will have to come from the emerging economies. They will be the ones who can support growing businesses, and this will attract investments from countries that are now experiencing high surplus savings (provided that these emerging economies are able to develop a thriving consumer class capable of replicating that of the developed countries.)

Australia and Canada may have largely avoided stagnation because of the constant arrival of new immigrants. These people are, on the whole, almost identical substitutes for people in the 20-50 year age group, who are characterized by high investments and high spending, who are still buying homes, starting families, educating young children, buying new things for growing families.

Germany and Japan, which have more homogeneous societies and do not encourage immigration, have relied more on surplus exports, and in the case of Japan, has been having a stagnant economy for the last 15 years. Younger people in Japan are mostly working in temp jobs, as most business can no longer afford regular employees in this economy. They are now caught in a vicious spiral of a declining economy, which leads to conditions that decline the economy further.

Businesses expect to thrive best in economies with young and growing populations, who have enough growing incomes to support more growing businesses . Emerging economies, as I have mentioned, could fit this bill, but their domestic consumer economy will need a strong jumpstart if they are to realize their potential. A potent growth strategy for them will be to focus energies on improving infrastructure, so that they can attract the demographic who are pure consumers, and who may be looking for low cost substitutes to retirement in a developed country.