The Bald, The Beard & The Ugly (Inside Job, The Movie)

This was posted back in November 2008, and published in StarBiz as well. Well, they finally made a movie of the subprime mess. It was superbly done, I must say. Matt Damon was the narrator. I loved the many interviews, especially the ones fronting for the bad guys twitching and lying through their teeth ... Funny thing was, the bad guys are not just your usual suspects, they included many economist professors of high regard.

To watch the movie and to read my dated posting, I think I should have made the movie myself... lol.

I was watching the uncomfortable grilling by the US lawmakers on Ben Bernanke and Henry Paulson on the US rescue plan. Pity those two guys. They are trying to fix a problem which was inherited and they have to suffer the embarrassment of trying to persuade the lawmakers to approve the funds.

But who really are the culprits that brought about such a calamity? I shall try to ascribe blame to the relevant parties. But please note, it’s a highly subjective issue and everyone has a different opinion. Here’s my two cents worth (and rapidly diminishing two cents in value):

The blame game:

30% - Management of Investment Banks & Mortgage Lenders

They were greedy and overpaid. They had thrown risk management out the window. When the going is good, they pocket more than their fair share.

Paulson (left) and Bernanke could have tried to reverse the damage in their early days as they basically inherited a huge problem.– AP

The worst punishment they got was to walk out the door with nary an apology. The vast amount of liquidity in the system and the thirst for mortgages prompted them to “invent” new fangled instruments to package these loans and resell them, with little regard to the leverage effect.

Lenders kept pushing adjustable-rate and subprime mortgages, while investment banks bundled millions of risky loans and resold them to investors.

It was when these investment banks started to buy these same instruments that they really decimated their capital.

15% - Alan Greenspan

He will continue to deny it was his doing, but since 2001, he advocated lowering interest rates and continued a strong money supply growth policy.

That prompted the public to buy properties and even speculate in them. Greenspan was well known for lowering rates aggressively to counter any crisis €“ the query was that by doing that markets were never allowed to adequately correct the imbalances.

This led to the credit explosion.

He must have noticed the deterioration in the credit market back in 2003 and 2004 or was just plain blind. But he hadn’t warned lenders of using the “non traditional mortgages” now seen as a precursor to the credit crisis which unravelled as early as December of 2005, shortly before Greenspan resigned.

The excessive liquidity in the system was not just owing to the Fed’s measures. Major central banks were guilty of pumping vast amount of money supply into the system. Back in 2004, Greenspan opposed tougher regulation of financial derivatives, and actually praised adjustable-rate mortgages and refinancing for homeowners.

35% - Ratings Agencies

They are the unwitting culprits. (I am being nice here). They rated loans and bonds based on these mortgages AAA status, which caused many buyers to believe in their assurance that they were buying solid AAA papers.

The ratings agencies again acted too late to downgrade these papers €“ long after the damage is done.

They had earlier accorded high ratings and analysis which fuelled interest in these instruments to be hawked to unsuspecting investors. It is also this that led the investment banks to boldly pile up these instruments.

What kind of value-added analysis are the issuers paying these rating agencies for? It’s obvious that the analysts knew that a bulk of the packaged loans consisted of subprime.

Were the fees too enticing? Were the ratings agencies trying to curry favour with the banks? If these agencies cannot do their jobs without fear or favour, then how can investors rely on these ratings?

Maybe the US should empower the government to rate bonds, especially if the government requires certain kinds of fund managers to own only officially-rated bonds.

15% - The Regulators

The financial markets and the various instruments have their respective regulatory units.

You may include the Fed, the CFTC (Commodity Futures Trading Commission), the SEC (Securities and Exchange Commission), FDIC (Federal Deposit Insurance Corp), even the FASB (Financial Accounting Standards Board) into the fold.

They are supposed to regulate and oversee the markets and the financial instruments.

But where was the voice of reason? The last six years’ housing and subprime mortgage bubble and bust had little to do with excessive government intervention.

Instead, they had all to do with the lack of any basic sensible government regulation of the mortgage market.

They should have instituted new guidelines and rules to govern these CDOs (collateralised debt obligation), credit default swaps, and the leverage aspect of financial firms and their capital at risk.

Even now, they are mainly silent.

5% - US Treasury chief Henry Paulson & Federal Reserve chief Ben Bernanke

They could have tried to reverse the damage in their early days as they basically inherited a huge problem.

But only now, they are talking about having proper mechanisms to regulate derivatives and new instruments. Sigh.

There were institutions and people appointed to do these jobs; it’s just that they did not do their jobs properly. I am still waiting for some of the culprits to be prosecuted for what they did or didn’t do.

At the end of the day, it appears that what some of them didn’t do would be more punishable.

“But what about the American borrowers/homeowners,” you ask? Shouldn’t they too shoulder some of the blame? I left them out of the above equation for various reasons listed below:

a) I do think there should be an element of “personal responsibility” but it seems to me that they are already paying the cost of their foibles. Many have had their homes foreclosed, they have lost their deposits and payments made on these loans.

It seems to me, they are THE ONLY group that has actually “really lost” materially and has been punished.

b) The bailouts do not really bailout the end borrowers. They simply extend the life of the companies.

Maybe the bailouts will allow the companies more time to foreclose these properties in an orderly manner. Very few of those will be able to renegotiate their existing loans on decent terms to allow them to continue to fund their mortgages.

Most of the loans were priced at a time when property values were at least 30%-40% higher than now. Perhaps, it’d be better to declare bankruptcy than to continue to reconfigure the loan?

c) The public are not equipped to regulate themselves. That is why there are agencies created with “capable people” to regulate and monitor the markets.

You cannot expect the majority of borrowers to understand in detail CDOs, credit default swaps, or whether the brokers are leveraging themselves to the hilt.

You instead get assurance from top ratings agencies that brand certain papers as top notch grade. Who will really pore over hundreds of pages in a report, examine if these debt papers/bonds consist of thousands of small mortgages spread out over the country or how to value the price trends and affordability ratios of borrowers?

d) The public often acts in herd-like mentality and like most people, they are driven by the pursuit of wealth.

They see people making 50% in two years from speculating in properties and they, too, want to be part of it. Then they apply for loans, and were probably even more shocked that mortgage lenders were more than willing to lend to them.

The markets are often characterised by bouts of insanity; if you stir them up with enough incentives and carrots, people will act irresponsibly.

The regulating agencies are there to ensure an orderly market and to quell excesses. The people cannot do it themselves.

The ones who got out early will think they are very smart. The ones who got hit will think they were unfortunate victims. Both are wrong in their perception of their actions, financial decision making and brain power.

Both groups are closer to each other in every aspect than they would care to admit. It’s like a game of financial musical chairs “ the winners and losers are those who act the fastest/slowest when the music stops“ not how smart you are.

PS: In case you haven’t figured the headline out: The bald, the beard & the ugly are Paulson, Bernanke & Greenspan.

p/s photos: Ema Fujisawa (my date in Tokyo)

FASB's Move & The Aftermath

OK, we can have our disagreements over what is fair value accounting. But since its been passed and will come into effect as soon as the second quarter, lets look at the real effects on companies and markets. The first area is to look at the Credit Default Swaps for the affected banks. CDSs are basically insurance one can buy to insure against a certain company going bust. Hence if I bought Bear Stearns, and it went bust, the writer/issuer will be paying me the full sum I insured/hedged.

Now, with the new FASB ruling, the CDSs of the banks will reflect whether there was real effect or just a cosmetic effect on these banks' risk of failing following the new rules.

- Citi is in about 40 bps but is just back to where it was on Tuesday
- Bank of America is lower by 50 bps
- Wells Fargo is lower by 30 bps
- JP Morgan is lower by 15 bps, all back to one week lows
-Morgan Stanley and Goldman Sachs are each in about 30 bps

Well, the effect is only minimal at best. The ones in real danger would be Citi and Bank of America, hence the narrowing of risk would be more pronounced there. Other banks which may have a lot less toxic assets in their books, would only see a very marginal reduction in risk. That means that the new rules DOES NOT really help to put the shaky banks out of the risk of possibly going bankrupt. It was the same level of riskiness as things were a few weeks ago.

That would be a correct consequence because the treatment of the "impairment" may be changed but the substance of the impairment is still in the books - hence the risk of failing should be the same or nearly the same as before.

The difference, the really big difference as I have mentioned yesterday is in the capital adequacy side. They will not need to hold so much capital or raise much new capital. That lightens the bank's dilution danger, and eliminates the big danger of failing badly should they fail to get a truckload of new funding over the near term. The supposed new capital is to plug the hole in the toxic assets write downs, and will not actually help to fund business activities going forward. If they do not sell the toxic assets, they will not be taking the loss in effect - hence I like the amortisation rule of the losses. Thus the reduced need to raise new capital will NOT affect existing operations going forward.

Its not like the new capital will be used for expansion, it was dead money to plus a hole in the balance sheet. Another consequence will be that many of the banks that received the TARP money will be looking to repay the sums back much quicker. Again, a confidence issue will work its way to boost optimism in the eyes of investors. You cannot imagine how much liquidity still resides on the bylines. Its a confidence issue and moving market back up by 10%-20% over a few weeks is not that strange in extreme market conditions.

Will the markets rally be shortlived? I think this one's got some legs. This bear market crisis was predicated on a significant loss of confidence in the entire financial system. What has come out of the G-20 and the new FASB ruling showed a more sobering and concerted view to address the issues. We are not out of the woods in terms of real economic activity, jobs will still be lost.

However, stock markets are forward discounting models, hence in the eyes of investors, the real economy are looking brighter 1Q2010 and 2Q2010, it is with that foresight that that the Dow Jones could scale above 9,000 and try to consolidate there over the next few weeks. Will we revist the lows??? ... pretty unlikely.

p/s photo: Pace Wu Pei Ci

Brazen Commentary By BIS

The latest commentary by the highly respected Bank of International Settlements:

Overview: global financial crisis spurs unprecedented policy actions Financial stability concerns took centre stage once again over the period between end-August and end-November. In the wake of the mid-September failure of Lehman Brothers, global financial markets seized up and entered a new and deeper state of crisis. As money market funds and other investors were forced to write off their Lehman-related investments, counterparty concerns mounted in the context of large-scale redemption-driven asset sales. The ensuing sell-off affected all but the safest assets and left key parts of the global financial system dysfunctional. With credit and money markets essentially frozen and equity prices plummeting, banks and other financial firms saw their access to funding eroded and their capital base shrink, owing to accumulating mark to market losses. Credit spreads surged to record levels, equity prices saw historic declines and volatilities soared across markets, indicating extreme financial market stress. Government bond yields declined in very volatile conditions, as recession concerns and safe haven flows increasingly outweighed the impact of anticipated increases in fiscal deficits. At the same time, yield curves steepened from the front end, reflecting repeated downward adjustments in policy rates.

Emerging market assets also experienced broad-based price declines, as depressed levels of risk appetite and associated pressures in the industrialised world spilled over into emerging financial markets. With confidence in the continued viability of key parts of the international banking system collapsing, the authorities in several countries embarked on an unprecedented wave of policy initiatives to arrest the plunge in asset prices and contain systemic risks. Market developments over the period under review went through four more or less distinct stages. Stage one, which led into the Lehman bankruptcy in mid-September, was marked by the takeover of two major US housing finance agencies by the authorities in the United States. Stage two encompassed the immediate implications of the Lehman bankruptcy and the wide-spread crisis of confidence it triggered. Stage three, starting in late September, was characterised by fast-paced and increasingly broad policy actions, as responses to the crisis evolved from case by case reactions to a more international, system-wide approach. In the fourth and final stage, from mid-October, pricing patterns were increasingly dominated by recession fears, while markets continued to struggle with the uncertainties surrounding the large number of newly announced policy initiatives.

Lehman Brothers bankruptcy triggers confidence crisis In this environment of tension over the continued viability of Lehman Brothers, financial market developments entered a completely new phase. The spotlight was now being turned on the ability of key financial institutions to maintain solvency in the face of accumulating losses. The trigger for this new and intensified stage of the credit crisis came on Monday 15 September. That day, following failed attempts by the US authorities to broker a takeover by another financial institution over the weekend, Lehman Brothers Holdings Inc filed for bankruptcy protection, one of the biggest credit events in history.

p/s photos: Janet Hsieh Yi Fen

Phew! CDS, Its Just $33.6 Trillion Not $50 Trillion!!!

Dealbook: In the first of a series of weekly reports, the Depository Trust and Clearing Corporation said late Tuesday afternoon that there were a total of $33.6 trillion in credit default swaps outstanding on corporate, government and asset-backed securities. That is less than some earlier estimates of $50 trillion or more.

The company’s data provides a clearer picture of the money bet on the creditworthiness of the world’s companies and governments. The largest dollar amount of credit default swaps were written for protection against the debts of Turkey, Italy, Brazil, Russia and GMAC as of Oct. 31.

Others at the top of the D.T.C.C. list of 1,000 were Merrill Lynch, Goldman Sachs, Morgan Stanley, GE Capital and Countrywide Home Loans. In all those cases, however, the net notional values of the swaps were reduced considerably by hedging.

For example, Turkey was the leader in gross notional credit default swaps, at $188.6 billion, but its net notional exposure after hedging was $7.6 billion.

D.T.C.C.’s figures are available at Deriv/SERV on the D.T.C.C. Web site.

D.T.C.C. said that after this week the data would be shown in two sections. The first section shows the outstanding notional values at a given point in time (the end of each week). Starting next week, the second section will show data relating to the weekly confirmed trade volume, or “turnover,” with respect to the same underlying reference entities and indexes, as well as similar aggregations of such data.

The financial industry is trying to counter lawmakers, regulators and other critics who argue that the lack of transparency in the market for credit default swaps made the financial crisis worse.

“Publishing this data will provide greater transparency in a critical market,” said Tim Ryan, president and chief executive of the Securities Industry and Financial Markets Association, in a statement Tuesday. “This is an important initiative upon which the industry will continue to build.”

The collapse of Lehman Brothers contributed to a sharp drop in financial markets last month because no one knew how many credit default contracts were outstanding on the securities firm. Estimates ranged as high as $400 billion, although the actual amount turned out to be $72 billion, the DTCC said.

Comments: Well, its a very good start. Once you know the figures, its not a guessing game anymore. Then you isolate the top contracts and assess their likelihood of default. As we can see most of the trouble companies have been absorbed by other companies. There is one main danger I see, that is GE Capital, which will work its way back to General Electric. Its still a AAA company but if you were to examine its way of doing business, its a highly leveraged way, and more than 60% of profits are from the 100-200 basis points financing spread that they use to do business with clients, be it funding them or funding the transactions - e.g. consumer loans or even aircrafts (you want to buy an aircraft, let me lend you 90%).

As for country defaults, while its hyped up, only Iceland risk real default and maybe Turkey and Venezuela. The rest have to just tighten their balance sheets, get some billions from IMF and get on with it. Even Russia's demise is not exactly catastrophic, its bad no doubt, but not debilitatingly so.

Just a heads up, I am quite nervous on GE's near term prospects. Its $15 billion capital raising a few weeks back should raise alarm bells. Ratings agencies are again probably too slow to look deeply into how GE's business model is affected by the cascading impact on de-leveraging.

p/s photos: Izumi Mori