Tuesday, 30 September 2008

The upside of $ 700 billion – and what you should be worried about

The decision of the US House of Representatives to vote against the Emergency Economic Stabilisation Plan caught me mildly by surprise. I wonder if those representatives voting against the plan have really understood what it’s about. I’ve long since given up hope that Michael Moore has.

The $ 700 billion rescue package is not a “bailout” of Wall Street banks, as widely recounted. The US Government is getting assets for its money. By purchasing mortgage-backed securities, the government is receiving the title deed to houses, and/or the homeowner cash flow that pays for them. This is a hard asset, albeit a discounted one at the current moment.

We know that the problem with these securities is that they bundle mortgages of varying value and payment condition. For instance, consider a $ 150 million mortgage-backed security comprising 1,000 mortgages with an average value of $ 150,000 each. Of these mortgages:

· perhaps 17-25% are non-performing mortgages which have been or are in the foreclosure process

· perhaps a further 13-17% have delayed payments

The remainder are functioning mortgages, providing a steady, predictable income stream.

This is what the US government will be getting: either a future income stream, or a future asset value, because it is purchasing mortgages, i.e. title deeds to houses. It’s not just giving money for free to investment banks, as some commentators apparently believe.

Now, why is this a particular problem for banks? Because of three reasons:

(a) The main reason is that by law, commercial banks need a Tier 1 and Tier 2 capital ratio of 8%. That means that for every $ 100 they’ve lent, they need $ 8 in actual assets or cash reserves. Mortgages (and mortgage securities) have been used as part of this capital, but with the fall in housing prices and the write-down in property values, they are a declining asset. The problem, however, is not so much making up the difference of capitalisation, it’s that in an environment where panic dominates in the markets, one bank will not lend to another, IPOs don’t take place, and in general all assets are under question.

(b) The second, equally important reason is that if lending does not re-start, it’s not just banks which will be affected, but ordinary people and “real economy”: businesses looking for a car loan, working capital, or any other financial transaction.

(c) The third reason is that the more banks go out of business, the greater the turbulence in the derivatives market. More on this later.

In my opinion, the US government has a strong chance of fully recovering the full $ 700 billion in securities purchases. Why? Because the housing market will eventually recover, perhaps in 18-48 months (depending on the area). Don’t forget that the US population is growing, and that recessions have tended to be short-lived in recent decades.

As the property market recovers, the government will be able to sell off the mortgages or the assets (houses) they finance. This has happened a number of times before, both with real estate as well as other asset classes, and there is no reason it will not happen with this situation.

There are definitely flaws with the current plan. Given the Bush Administration’s propensity for favouring special interests, the main open question is one of value: what value will the government buy at, and what value will it sell at. Congressional, bipartisan oversight was supposed to address this, but in my opinion this oversight often does not work in practice – as current events show us.

Now, what should the average investor (and citizen) really be worried about? This crisis has cast at least three philosophical assumptions under grave doubt:

1. Assumption # 1: Equity Investments and Retirement
The sacred cow of US politics has been the end of the defined-benefit pension and the rise of retirement assets invested in equities. The 401(k) is the typical expression of this, but there are any number of others. We should make no mistake in underestimating the gravity of this problem. Some 79 million American baby boomers are set to retire in the next 30 years. Some estimates of unfunded pension and healthcare liabilities exceed $ 200 trillion, or over 13 times US GDP.

We cannot expect a financial system in which large-scale risk of the type posed by sub-prime mortgages and highly-leveraged hedge fund trading offers enough security for a pension system based on equity investments. If this is the case, a key Republican (and Democratic) platform is rendered logically inconsistent. In turn, this means two options:

(a) Either an entirely new set of safeguards needs to be built into the system to assure that pension assets cannot be used to leverage derivatives, equities and real estate trading, or

(b) We need to build up Social Security, Medicare and Medicaid, so that they are capable of serving as the “pension of first resort” (and healthcare plan) for the growing cohort of American retirees. This will require a massive fund injection, which the US government does not currently have.

In any case, we need to stop the hypocrisy that privatising Social Security will solve the problem – recent events this past decade indicate that it won’t.

2. Assumption # 2: Self-Regulation
The principle of a self-regulating system is self-restraint. Unfortunately, this can no longer be considered natural given the large amounts of money chasing bonus opportunities for bankers and other traders. Consider that:

(a) There is someevidence to suggest that many senior investment executives or credit risk managers do not fully understand the quantitative models being deployed by the under-30 rocket scientists they employ.

(b) The fact that there is no central derivatives register makes counterparty risk impossible to quantify.

(c) Leverage ratios of between 10 - 50 are common in a number of trades and strategies. The fact that investment banks are prime brokers to hedge funds provides an immediate conflict of interest between (a) lending, and (b) risk assessment.

(d) The extensive use of Special Investment Vehicles and other off-balance sheet mechanisms makes credit rating difficult to evaluate. Given the high speed of most market trading, credit rating would have to be implemented every 2-3 hours to be accurate: this is clearly impossible.

Given that greed is a human characteristic as old as the human race, it is highly likely that the equities market, i.e. the Stock Exchange, needs to be “decoupled” from the professional investment market. This may sound like a paradox, but remember that the fundamental purpose of a corporate stock market listing is to gain capital in the form of outside shareholders. This should be a transparent, well-regulated process, particularly after the Sarbanes-Oxley Act.

What we may need to do is create a separate system of regulating and managing hedge funds, investment banks, equity funds, traders and everyone else trading primary shares for profit. Don’t forget, it’s the speculative trading side of operations that has caused nearly all the major stock market crashes in recent history, from the 1987 Savings and Loan collapse to the 1997-1998 emerging market defaults to the 2001 dot com crash to the current sub-prime collapse.

None of these crashes has anything to do with the “real economy.” In the real economy, the share valuation of the company reflects assumptions about its future cash flow and profits, as well as an evaluation of sectoral and global competitiveness. Acceptable financial ratios and indicators exist which, together with international accounting standards and financial reporting, provide a transparent basis on which investors can make decisions. In no case to short-selling or SIVs or leverage ratios of 50 or more contribute to the long-term, sustainable growth of the economy.

Similarly, the real estate / property development sector can equally be analysed from the perspective of investment valuation and risk, either at the individual or corporate level. This is not a terribly difficult process: the question is why sub-prime and Alt-A mortgages were offered (or purchased in CDOs) in the first place by institutions who should have known better. The answer is quite simple, and that brings us back to greed.

The problem is that the amounts of money in the system are simply astronomical, and many people are dining at the table: bankers, quants, politicians, realtors, foreign investors, pension fund officers – everyone. As long as the financial sector remains a main source of campaign contributions to the Democratic and Republican parties and candidates, don’t expect to see substantial change. Sarbox was supposed to deal with issues like off-balance sheet entities after Enron: now they’re back, under a different name. Can anyone explain why?

Assumption # 3: $ 700 billion is sufficient for the total debt workout
It’s not. The mess left behind by sub-prime and Alt-A mortgages is only the tip of the iceberg. Don’t forget: the total [sliding] value of US mortgages is about $ 11 trillion. Sub-prime and Alt-A in total are estimated at perhaps $ 1.2 – 1.5 trillion. Not all sub-prime and Alt-A mortgages are underwater. The financial sector has already written down at least $ 650 billion related to sub-prime loans. So the end is in sight.

The problem is not the loans themselves, but hedge fund strategies based on the loans. Quite simply:

· Sub-prime/Alt-A loan write-downs reduce bank capitalisation;

· Banks cannot get more capital; their stock market valuation falls;

· Other highly leveraged or highly valued companies start to decline (e.g Apple, Dell, General Electric, General Motors);

· Hedge fund strategies on the one hand accelerate the decline by betting against a stock (shorting it); other funds suffer because their models may not have taken such rapid falls in value.

Result? Financial chaos. With highly leveraged bets going wrong, a hedge fund with $ 7 billion under management and a 10-1 leverage ratio that makes the wrong bet and loses, doesn’t risk only the $ 7 billion in asset value, but $ 70 billion in leverage. Given that total derivate contracts are estimated at $ 62 trillion, you get an indication of the magnitude of the problem (US GDP, by contrast, is $ 14 trillion).

While $ 700 billion should be adequate for the mortgage crisis, it does not cover the remaining constellation of trades, derivatives and debt out in the market. But unless we address the mortgage issue, we can’t get to the issue of settling the other debt – we merely exacerbate it.

As Geena Davis said in “The Fly,” “Be afraid. Be very afraid.” These problems have been apparent for a long time now, but so far we have allowed ourselves to be seduced by ephemera – a rising stock market, houses that are ATM machines, high executive compensation packages, and generous campaign contributions. Yet we are living in a time of unparalleled demographic, technological and economic change.

The fundamentals of the US economy and the political system that regulates it need to change if it is to compete in this new world. I’m sorry to belabour the obvious, but I haven’t yet seen a commitment or indication from either Presidential candidate that they understand these changes and have a plan to address them. Plans like health care, withdrawing from Iraq or investing in solar power are all interesting, but in many ways these are policies that address symptoms, not root causes.

Unfortunately, with the system of legislative development, lobbying and campaign finance being what it is, I do not anticipate major changes in US foreign or domestic policy that will bring about the conditions needed for long-term success. Maybe the system will muddle through and heal itself. In my opinion, however, the chances of this decline increase with each year that educational achievement falls and complexity and national debt rise. These are clear and evident symptoms of a lasting decline, and unfortunately I don’t see a plan to reverse them.

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