The Daily Double: Martin Mayer on CDS; Nouriel Roubini on the Banks
Once upon a time you dressed so fine You threw the bums a dime in your prime, didn't you? People'd call, say, "Beware doll, you're bound to fall" You thought they were all kiddin' you You used to laugh about Everybody that was hangin' out Now you don't talk so loud Now you don't seem so proud
How does it feel How does it feel To be without a home Like a complete unknown Like a rolling stone?
Bob Dylan "Like a Rolling Stone" (1965)
As we were preparing our remarks for the session today at American Enterprise Institute on credit default swaps, "Everything You Wanted to Know about Credit Default Swaps," our thoughts turned to the interview we did last year with Martin Mayer ('The Vigorish of OTC: Interview with Martin Mayer', June 12, 2008')
All of sudden, through the window came an unsolicited manuscript from Mayer, who is the author of numerous books and articles about banking and finance, and a Guest Scholar of The Brookings Institution. His comments follow below:
Pricing CDS and Other Illiquid Assets
By Martin Mayer
"Price theory," the UCLA economist Jack Hirshleifer wrote, "is the heart of economics and the key to its application in the world of affairs." It is also highly susceptible of mathematical analysis, both in the ivory tower and in the real world. In its primitive form, it insists on a price tag, a "law of one price" the same for everybody at each moment in time, which means that people can make fortunes on arbitrage. In sophisticated form, price theory gives us computers programmed so that the 140 passengers in the airplane are paying thirty different prices to get from the same place to the same place at the same time.
Working on our horrendous banking crisis, unfortunately, we seem to be stuck with the primitive approach. We cannot get the "troubled" assets off the books of our "troubled" banks because we don't know the correct "price."
Actually, there is a large and growing cottage industry of experienced and wannabe vulture funds eager to get in the business of pricing and selling this stuff. Lone Star Funds, which paid Merrill Lynch 23 cents on the dollar for some billions of mortgage debt and business loans, has been around for thirteen years, and the Bass family members who helped start it had been big players in the Resolution Trust Corp. auctions that closed out the savings-and-loan mess in 1990-91.
Twenty years ago, Michael Milken of Drexel Burnham and a staff of razor-sharp Wall Street kids set up a hugely successful half-billion-dollar "bad bank" to rid Mellon Bank of its doubtful assets and distribute them to investors without any government support. The deal had a terrible press when new, but Mellon, Milken and the buyers of the stuff all did great.
This well-understood process has not been available in the current crisis, mostly because some $30 trillion of credit-default swaps stand between the owners of the "troubled" loan and debt obligations and anyone's assessment of what they are "worth." Each of these hundreds of thousands of swaps is a sort of stand-alone bastardized insurance policy against the prospect that some loan will not be repaid. Anyone can and anyone does write these individual loan guarantees; anyone can a nd anyone does reinsure them.
Whether these contracts will in fact pay off if there is a default, nobody knows. Some no doubt will, and some won't. They reside off the balance sheet. There is no government regulator or exchange to list them, and no reporting system to drag them out from behind closed doors.
Credit-default swaps were always a bad idea, because they rest on the false premise that statistical sampling from historical evidence can replace knowledge of the borrowers in the creation of bank loan portfolios. Among the lessons taught but not yet learned in the ongoing horror story at the banks is that the insurance of financial instruments is an activity that can be safely conducted only by governments.
In the meantime, these derivatives severely complicate the necessary task of creating a market where private bidders (with some government help) can price the paper that now clogs the plumbing of finance. Separating debt securities from the swaps that were written theoretically to protect them will take ingenuity and persistence (and ruthless exploitation of well-known defects in the systems that trade derivatives), but it doesn't have to be done all at once. No plan to recapitalize the banks can work unless it lifts the fog of uncertainty from the credit-default swaps.
Now What for the Big Banks?: Interview with Nouriel Roubini
Next we turn to our friend Nouriel Roubini, Professor of Economics at the Stern School of Business, New York University and Co-Founder and Chairman of Roubini Global Economics LLC.
The IRA: First, thank you Nouriel for telling people that we are the top bank analysis shop on the planet. All of us at IRA appreciate the praise. Before we talk about the banks, let's get some context on the US economy. If you go back several years, even decades, most economists were predicting that our downfall would come as a result of an external shock due to trade and financial flow imbalances. Yet now it seems that the shock has instead come from the financial sector, leveraged to the sky due to derivatives and poor prudential regulation. How do you reconcile the fact that you and many other economists were focused on the trade and current account and did not see the "innovation" coming from Wall Street, the City of London, Paris as a threat?
Roubini: Well, the things we were explicitly worrying about before, like external deficit and trade flows, played a role in how things developed in the financial sector. The immediate causes of the crisis were a series of policy mistakes. The Fed pushed down the Fed funds rate down too low for too long and normalized the rates too slowly. There was poor supervision of the financial sector. There was greed and excessive risk taking within the financial institutions. And there was the poor behavior and conflicts of the rating agencies, who were the enablers of the structure finance bubble.
The IRA: Speaking of monetary policy as a driver of financial excess, there is a really great staff paper entitled "Money, Liquidity, and Monetary Policy," that was circulated in draft form in January by two FRBNY staffers, Tobias Adrian and Hyun Song Shin. The last paragraph states: "Balance sheet dynamics imply a role for monetary policy in ensuring financial stability. The waxing and waning of balance sheets have both a monetary policy dimension in terms of regulating aggregate demand, but it has the crucial dimension of ensuring the stability of the financial system. Contrary to the common view that monetary policy and policies toward financial stability should be seen separately, they are inseparable. At the very least, there is a strong case for better coordination of monetary policy and policies toward financial stability."
Roubini: Precisely. If you ask yourself, how were the global excesses able to occur? In my view the imbalances are a big part of the story, the excess savings from China, Russia, other parts of the world, enabled the US to finance itself cheaply. That build up of the leverage, the excesses, was facilitated by the flows of savings from abroad.
The IRA: So how much of GDP on a global basis and in the US do you think was illusory? That is, how much of the "growth" which we think occurred in the US over the past several years was simply a function of financing proceeds instead of true wealth creation? The losses in financials suggest that we were actually destroying wealth over this period?
Roubini: Certainly the availability of financing from foreign savers to fund American borrowers allowed the excesses to become bigger and last longer. This was a big contributor to the size of the damage in the financial sector. If the US had been a developing country, by 2004 with the twin deficits, you would have had a financial crisis and the bubble would have been deflated sooner. But the fact that the US is not a developing economy, that there was all of this financial innovation, the rest of the world was willing to finance further excess in the US because the had their own surpluses to invest.
The IRA: So the need of foreigners to invest the paper dollars we print in such great supply fuels our financial collapse? Meanwhile gold is trading over $1,000 per ounce.
Roubini: Look, the fact of the cash from abroad allowed long rates to creep in even after the Fed normalized the Fed funds rate. The bond market conundrum that Alan Greenspan referred to was when short rates were being pushed up but long rates were falling. So easy money, easy credit was facilitated by the global financial flows. There is a growing consensus that the Fed by cutting rates from 6 ½ to 1 percent was a mistake and that the normalization process, again, was too long. Even when we get out of this serious recession we're in now, when the Fed does start to normalize rates, it should happen not over 24 or 36 months but rather over a very short period of time. Otherwise you risk to create another bubble.
The IRA: But let's take a step back for a moment. We had a conversation with a very experienced loan officer from one of the big banks last week. He described how Sarbanes-Oxley, not the adoption of the mark-to-market accounting rule in 2008, actually was the start of the process of marking down the assets of the US financial system by 25%. M2M reflects the price = value thesis of the Chicago School. But in the US, we were adopting all of these rules to "add transparency" in the post-Enron world, even as the quality of earnings from banks and other financials was going down the toilet. We were arguing about fair value accounting even as the fundamentals of the US economy were being so badly compromised by financial innovation that accounting just barely matters.
Roubini: Absolutely right. We had fair value accounting and increased transparency at one level. In the meantime you had the process of securitization adding opacity, where you could take a mortgage and sell it to somebody else with no accountability. And then you convert it into an MBS and you slice it and dice it. And then you covert it into a tranches of a CDO of a CDO or a CDO. And then you end up with food chain that produces ever more exotic, non-standardized, illiquid, mark-to-model assets and you end up with a market where there is no transparency. And yes, all the while you hear the politicians talking about increased transparency.
The IRA: Right, so responsibility ultimately rests with the Congress and an unwillingness to govern. When we hear our friends in Europe or Asia ask whether Americans have all lost out minds, you can understand why.
Roubini: We have created a monster. You cannot convert a bunch of doggy "BBB" mortgages using voodoo financing into broadly "AAA" securities because eventually people will panic. That is precisely what we have now. Nobody knows who holds it or how much toxic assets or where, so we have created a monster.
The IRA: But here is the question regarding political economy: Were efforts such as Sarbanes-Oxley and M2M accounting driven by guilt? Did we know, at least passively, that the policies of encouraging regulatory arbitrage via OTC market structures and "innovation" were bad choices, but we still allowed them to continue out of greed? The market economies constantly seem to create our own problems, then over react to them. Maybe that is the way free markets must operate. We seem to teeter from one expedient to the next, without ever addressing the underlying causes. Does this bother you?
Roubini: Yes it does -- especially because I support the calls for stronger supervision and regulation. But I also am painfully aware that the opportunities for regulatory arbitrage are many.
The IRA: Maybe we need to make regulation dynamic instead of giving the industry groups and lobbyists a static target?
Roubini: There are three problems: First, those who innovate are always quicker than those who regulate. As you said, this is a free market. Second there is jurisdictional arbitrage across countries which makes regulation much less effective. And finally there is regulatory capture, where the regulators become advocates for the industry instead of supervisors. In each case, we need incentive-compatible regulation to make it work.
The IRA: To move to the banks, isn't the silence regarding Basel II deafening? Thirty years of research in financial economics and regulation has been flushed in 24 months. I am still getting comments about our discussion last year with our mutual friend Bill Janeway('New Hope for Financial Economics: Interview with Bill Janeway', November 17, 2008), where he basically said that a new path must be created where we explicitly calculate risk exposures based on real data, not quant shortcuts and guesses using bastard methodology stolen from the physical sciences.
Roubini: Well, many of the major dealers who helped to develop the final Basel II rule have failed before the rule was event fully implemented, so yes you could certainly call that a repudiation. Basel II did not work in the real world of irrational exuberance and regulatory arbitrage.
The IRA: How would you feel about imposing formal professional limits on economists and investment analysts? Any model that is used for either monetary policy or pricing a security must be published and subject to peer and regulatory review. That is part of several proposals to fix the ratings mess, make them publish their models, put forward by people like Josh Rosner and Sylvain Raynes.
Roubini: Well, the more basic issue is can you model these risks at all? The internal risk management models upon which Basel II was supposed to be based clearly did not work. You also have seen significant corporate governance problems within financial institutions, as you have written in The IRA regarding Robert Rubin and Citigroup. The compensation system on Wall Street encourages risk taking and, again, reliance on the rating agencies to make asset allocation decisions was clearly another source of instability. And the capital adequacy standards are pro-cyclical as we all know, so every pillar of Basel II has been a failure. I am not sure that simply publishing the models is a sufficient solution. The IRA: Agreed. So, to switch gears, what is your assessment of Obama so far? Roubini: Well, on the one hand I think you have to give them credit for in less than a month they've done three things, however imperfect: they passed a large stimulus package that I large. I am critical of many aspects of the stimulus, but in the absence of a large fiscal package, I think the economy will contract more.
The IRA: So you believe the stimulus package will slow the decline in aggregate demand? The internal assumptions for transactions like Wells Fargo (NYSE:WFC) and Wachovia having a happy ending depends upon stabilizing the economy by Q3 2009.
Roubini: Precisely. The second this Obama has done is the mortgage plan. In my view, you must eventually have to reduce the face amount of the mortgages, not merely extend the maturities…
The IRA: Yeah, as suggested by Jim Crammer on CNBC on Friday, who wants to refinance everyone into 40-year fixed but w/o a principal reduction. Cramer and the other inhabitants of Bubble Land just cannot get their arms around the notion that the valuations of these securities and the underlying collateral cannot be fixed. The 25% asset haircut for the banking industry that our channel source referred to before equates to a $3-4 trillion loss vs. $13 trillion in total assets and that may not be enough for C, BAC, etc.
Roubini: That's right and this is why I believe we must see a markdown across the board, for securities holders and mortgagees. And third, on the Geithner plan for the banks, it is true that it was not really a plan and many aspects of it were very disappointing. The market reacted negatively to it not only because it was vague but also because the Administration essentially signaled that we are not going to throw trillions of dollars of good money after bad to bail out the shareholders of the big banks. The market was expecting a bailout and instead they got a stress test. That aspect of the plan, at least, is positive.
The IRA: Thank you. We have been telling people that the word "nationalization" is inappropriate and that the word "restructuring" is more apt. The OCC and the FDIC are going to support these institutions and sell assets for a while, but eventually the bond holders are going to take a haircut. Do you agree? What do we do with the bond holders of the big banks?
Roubini: That is a tough one. In my view, if you don't treat the bond holders as secured creditors the fiscal costs are huge. If you treat them as traditional creditors, then you run the risk in the minds of some people of further systemic damage a la Lehman Brothers. But my view is that now that the Fed is in the market as counterparty, we are not going to see the fear and panic that existed when Lehman failed. We have to treat the bond holder as a secured creditor and give them a haircut in my view, possibly event convert the creditors explicitly into equity claims. If you take over all of the major banks all at once and restructure them, as you and others have been proposing, I think we minimize the risk of a "creeping" problem going from one bank to the next and therefore we can eliminate a lot of uncertainty. At some point you need to take a decision to deal with all of the insolvent institutions at once and make clear that the institutions that are not resolved are fine and can be saved and made stronger with fresh injections of capital.
The IRA: And thereby give investors finality. Again, we keep reminding people that a happy outcome for WFC, BAC and many other banks depends on arresting the increase in NCLs.
Roubini: Yes. Citi and Bank of America are obviously insolvent today, in my view, especially if you factor in the structured finance exposures. How things turn out for the rest of the industry depends on whether we can slow the decline.
The IRA: The difference between BAC and WFC, and JPM on the other hand, is that Jamie Dimon, who we like more and more, bought WaMu for three cents on the dollar of assets. WFC bought Wachovia whole, without a resolution. So JPM does not have to soft-pedal on foreclosures, despite what you read in the newspaper, and they don't have to write anything down. WFC and BAC are choking on their acquisitions because they were not restructured first.
Roubini: The same analogy you draw applies to auto loans and whole mortgages and many other asset classes. The way to get these markets moving again is to mark the prices down, take the losses and sell these assets into private hands.
The IRA: Ditto. Thanks Nouriel
Originally published at The Institutional Risk Analytics and reproduced here with the author's permission.