On Bank Assets
In a recent post, Patrick mentioned some proposals that have been floating around that supposedly would help the banks. One of them is to suspend “mark to market” accounting, which comes from the idea that a lot of the assets at the banks only look so bad because of overreaction. This meme has actually been around for about two years now (it first cropped up when the banks were valuing things at 90% because surely that was impossible) but most of the commentators I respect have never given it any credence. They argued that if housing prices went to historical values then default rates would be so high that the market prices were realistic.
The idea has been hard to test because the banks have refused to sell them to prevent price discovery. As long as they don’t sell then they can pretend that they are worth what they want and indeed, while the market bid price for a lot of this stuff is very low, most banks are still carrying it at rather high valuations. A few events have happened (like Lehman collapse etc) that have forced sales, but the mark to market rules allowed banks to ignore those as “distressed sales.”
Of course many of these assets have complex rules and trigger events that force liquidation once a certain percentage of the pool goes into default. The banks have no choice about this, and looking at how many pools have entered into default and the recovery rates gives a look into what they are actually worth. Apparently, not much. In fact, it’s possible that they are worth even less than the market bids, but it’s hard to tell because each one is so different.
I’ll let Hilzoy summarize how bad it is:
It’s actually hard to understand how the banks managed to do this badly: you’d think they could have done better hiring people off the street and paying them to put all those nice little loan documents into piles at random, or tossing mortgages down the stairs and bundling them based on how they landed. They certainly didn’t need to hire people with advanced math degrees and pay them seven- or eight-figure salaries to get these kinds of results.
And how about those ratings agencies? They would have done a better job using a Magic 8-Ball to rate the CDOs. (“Signs point to junk!”)
I have been hearing for years and years about how the financial services sector pays such exorbitant wages because the people who work there are so immensely talented that they are cheap at $50 million a year. I never particularly bought that line before. But I never imagined that all those Masters of the Universe would do quite this badly. If we had paid them $50 million a year to go far, far away and leave our financial system alone, it would have been a bargain.
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14 Responses to “On Bank Assets”
Empty homes still represent tangible assets.
Selling them in a panic is beyond incompetent given the current financial situation. That is precisely why the banks are holding them and I hope its why the government dont nationalize CITI and BA and then destroy them along with 100 billion in UNION PENSION funding who have as part of their Portfolio ………….BA and CITI stock.
I think you misunderstand where CDOs derive their value from. They don't represent the value of the underlying assets, they represent cash flow. When the cash flow dries up due to defaults then there is no value in the CDOs. Because the banks securitized everything acts like a derivative and that's what the balance sheets are filled up with. This is why people have advocated breaking apart all securitizations and doling out the actual mortgages based on a percentage basis.
I know what they are Mikkel.
I can only shake my head at the firesell mentality gripping some in this economy. Its no wonder Barak Obama can propose a 1.75 trillion dollar deficit with a straight face.
How is it a firesell mentality when housing still has to fall another 25-30% to get back to historical mean valuations and we have a whole GDP worth of debt larger than the previous high in the late 20s?
So, you and Hilzoy have a list of subprime pool CDO's with original issue triple A ratings to back up your rating agency comment?
And yes, of course, it is all the banks' fault…..government agencies had no pushing hand to all of this?
By 2004, even though a 2002 HUD Internal Audit Report found significant weaknesses in their Loss Mitigation Program,HUD required that FHA servicers apply loss mitigation strategies or suffer significant treble damages. Since the late 1990s, Fannie and Freddie paid servicers fees for working out the loans, and servicers had added incentives to reach accommodations through their annual bonus compensation,which was based on default and foreclosure rates. As a result, many properties that would have beenforeclosed a decade ago are not currently moved to foreclosure.
And just so I don't accuse you guys unfairly with the Monday morning quarterback label, can you direct me to your respective posts in 2005 and 2006 when you forewarned us that all these no downs, no docs, arms and negative amortizers were going to come back and bite us?
Well I've only been writing since the fall (although if you look in comments I have been commenting on TMV about this since 06 and called crazy) but I initially started being concerned about this in 2005 when the Bush administration was touting its increase in minority ownership rates and NPR was talking about the exotic mortgages. I was driving on my way to work back in Louisiana (after I graduated and moved down there to finish up my job at the Navy that I had been working at during breaks) when I heard it and just shook my head about how it didn't actually mean anything was improving but was just unsustainable. I told my parents to not take out an interest only mortgage in the spring of 2006 because there was going to be a market crash, and lost money in the stock market in the fall of '06 because I thought that what happened in '08 was going to happen in '06 since blogs like CalculatedRisk and The Big Picture were pointing out how awful all the underlying stuff was and predicting home prices to fall 30-40%…I wasn't old enough to realize how long it takes everyone else to figure that out. In the spring of '07 I told everyone that would listen that things were going to get really bad after there was that huge down day in February and convinced several of my coworkers to get out of the market when it recovered to the same spot, or around 1440. Some of them got antsy when it went up to 1540 but I told them to just wait…so no I don't have proof but I can give you references to half a dozen people that I've been talking about this stuff for several years with.
The rating agencies have downgraded tens of thousands of CDO pools across subprime, Alt-A and now prime. If you do a search for “subprime downgrade” you'll find dozens of times that they downgraded CDOs from AAA to below investment grade in one swoop.
I can't say when hilzoy first started getting worried or when she broadcast it since this was the earliest I could find and she just said she had been worried for several years.
Hum, Hilzoy is a woman…
Just letting you know.
“And yes, of course, it is all the banks' fault…..government agencies had no pushing hand to all of this?”
The standard Republican claim that has no backing. Even a conservative Governor of the Federal Reserve knows better.
Yes Mikkel what you say about mean debt in relation to historical standards is somewhat accurate but flooding the market with overvalued homes is only going to further depress and already depressed housing market.
Contrary to popular belief………..builders are still building. There is still life going on inside the United States. Realtors are still trying to sell new homes and used homes and retain some of the value.
While on paper your cdo dump might appear to have merit but there is nothing free in economics. Doing one thing has intrinsic valuations on something else. Cleaning up a bank balance sheet might help the bank but it does not help the housing market with valuations for home builders and those trying to sell in tough times.
This is what many people fail to realize when the advocate fiscal policy. Economics is not a linear equation. It depends upon a matrix of values to make up the sum of its parts.
Mikkel I do not call you crazy. I do not call you uninformed or any other names. I think you are relatively intelligent and you put forth ideas and concepts for debate.
The problem with many of your ideas is they seem to be steeped in what I choose to call the firesell mentality which is somewhat a better phrase then “the sky is falling” or “panicky” economic modeling.
Economics is much like Psychology. We know the guy is crazy. We just have to prove it. Well you cant prove it till it does something. Predicting what it will do given a set of variables is risky because the variables might change in mid stream.
This is why the markets have always been so dependent upon “Psychology” of the participants and its why the government began keeping track of how Americans feel about the economy. Its a very good indicator of what Variables are going to come into play. The continuation of the sky is falling language only encourages more negative variables and these variables then become “weighted”and this weight then changes the dynamics of the markets of a whole.
So when I seem overly critical of you. It is not calling into question your intellect or your facts. Its calling into question the certainty that you have not taken into account all the varibles that people in this business have spent a life time studying and still dont get it right 1/2 the time.
I initially started being concerned about this in 2005 when the Bush administration was touting its increase in minority ownership rates—-Ah, so, George Bush is the guy responsible! The guy who the Dems think can't even count to 3 masterminded the whole subprime/CDO marketplace?…..hmmmm. I'm not here to defend Bush, but George Bush was guilty because he was a bystander, not because he was an architect.
Sept. 22 (Bloomberg) — The financial crisis of the past year has provided a number of surprising twists and turns, and from Bear Stearns Cos. to American International Group Inc., ambiguity has been a big part of the story.
But really, it isn't. Enough cards on this table have been turned over that the story is now clear. The economic history books will describe this episode in simple and understandable terms: Fannie Mae and Freddie Mac exploded, and many bystanders were injured in the blast, some fatally.
Fannie and Freddie did this by becoming a key enabler of the mortgage crisis. They fueled Wall Street's efforts to securitize subprime loans by becoming the primary customer of all rated subprime-mortgage pools. In addition, they held an enormous portfolio of mortgages themselves.
In the times that Fannie and Freddie couldn't make the market, they became the market. Over the years, it added up to an enormous obligation. As of last June, Fannie alone owned or guaranteed more than $388 billion in high-risk mortgage investments. Their large presence created an environment within which even mortgage-backed securities assembled by others could find a ready home.
Turning Point
Take away Fannie and Freddie, or regulate them more wisely, and it's hard to imagine how these markets would ever have emerged. This whole mess would never have happened.
It is easy to identify the historical turning point that marked the beginning of the end.
Back in 2005, Fannie and Freddie were, after years of dominating Washington, on the ropes. They were enmeshed in accounting scandals that led to turnover at the top.
Then legislative momentum emerged for an attempt to create a “world-class regulator'' that would oversee the pair more like banks, imposing strict requirements on their ability to take excessive risks. Politicians who previously had associated themselves proudly with the two accounting miscreants were less eager to be associated with them. The time was ripe.
Greenspan's Warning
The clear gravity of the situation pushed the legislation forward. Some might say the current mess couldn't be foreseen, yet in 2005 Alan Greenspan told Congress how urgent it was for it to act in the clearest possible terms: If Fannie and Freddie “continue to grow, continue to have the low capital that they have, continue to engage in the dynamic hedging of their portfolios, which they need to do for interest rate risk aversion, they potentially create ever-growing potential systemic risk down the road,'' he said. “We are placing the total financial system of the future at a substantial risk.''
What happened next was extraordinary. For the first time in history, a serious Fannie and Freddie reform bill was passed by the Senate Banking Committee. The bill gave a regulator power to crack down, and would have required the companies to eliminate their investments in risky assets.
Different World
If that bill had become law, then the world today would be different. In 2005, 2006 and 2007, a blizzard of terrible mortgage paper fluttered out of the Fannie and Freddie clouds, burying many of our oldest and most venerable institutions. Without their checkbooks keeping the market liquid and buying up excess supply, the market would likely have not existed.
But the bill didn't become law, for a simple reason: Democrats opposed it on a party-line vote in the committee, signaling that this would be a partisan issue. Republicans, tied in knots by the tight Democratic opposition, couldn't even get the Senate to vote on the matter.
Oh, and there is one little footnote to the story that's worth keeping in mind while Democrats point fingers: Senator John McCain was one of the three cosponsors of S.190, the bill that would have averted this mess.
Casualobserver, Senate Bill 190 was introduced in Jan. of 2005 by Chuck Hagel when Republicans were still in the majority. McCain did not become a co-sponsor until May 2006. Republican leadership on the banking committee never brought the bill up for discussion or vote. It could of come out of committee with a simple majority of votes from Republicans on a party line vote. Do not make Republicans (or John McCain) out to be the champions of trying to divert our economic mess. It doesn't fly.
I saying you were calling me crazy. That was more in the 2006-early 2008 period where I was arguing the same thing and only the people that knew me personally listened. Everyone else said that the government would be able to stop it or said I was crazy and just talking doom and gloom that had no basis for worry.
I understand the critique about psychology and how it affects asset pricing, and feel that contributes to economic dynamics. I have always thought that the rational efficient markets hypothesis was completely wrong and was so obviously wrong I didn't understand how anyone could buy it (I mean bubbles are in something at some place at all times). However, I do believe that over time things are mean-reverting to reflect underlying value. There is very convincing evidence that if you look at 10 year returns of the stock market, you can accurately predict the returns based on P/E and dividend yield. Similarly, housing fluctuates around a couple of metrics (household income and rent ratios) that have to get to the core value of purchasing a house. The same can be said of GDP growth as it relates to debt (although that correlation isn't as strong).
So while I pay attention to psychology as it relates to the fluctuations around those metrics (both low and high) I think that blaming psychology for reversion back to historical standards is counterproductive. If housing were below historical norms right now I'd buy it and tell people to stop worrying, but it still has a long way to fall relative to incomes. The best way to prevent housing from falling is to increase incomes somehow…I don't think there is a productive way of doing this though. As it is I think we have to assume that it will revert back there, and because of the way our system is built, those reversions happen very quickly (there is a mathematical reason for this). To me panic comes from people being surprised as much as anything, and I think most people waiting to step into the market are waiting for the fundamental valuations to get better.
OK, I've pointed this out before. Are you revisionists unaware or intentionally deceptive? Bush was 100% behind these programs. Watch him fully backing them as HIS programs.
“[re: Fannie Mae and Freddie Mac]. I proposed and urged Congress to fully fund the American Dream Down Payment Act. This will use money, taxpayer money, to help low income families. One of the programs is designed to help deserving families with bad credit histories to qualify for home ownership loans. You don't have to have a lousy home for first time home buyers. The low income home buyer can have just as nice a house as anybody else.” GW Bush, 2002
YouTube again slays the revisionists.
http://www.youtube.com/watch?v=kNqQx7sjoS8&NR=1
http://www.youtube.com/watch?v=MqR15H0gNBU&feat…