R&R Consulting » Curmudgeon

The Market: Cornerstone or Stumbling Block?

Ann Rutledge — Thu, 12 Jun 2008 21:16:00 +0000

There are markets, and there is the Market. Markets are networks of people who come together to exchange one thing for another. The Market is the cornerstone of a belief system whose biggest proponent has been the University of Chicago. Chicago: Hog Butcher for the World, according to Carl Sandburg in 1912, whose economy was revitalized in the 1970s by the City’s commodity exchanges and their esoteric flacks in Hyde Park.

Market value theory is to economics what “universal grammar” is to Chomskian linguistics: a hypothesis that the human brain wants to trade in organized markets, where the syntax of our behavior generates a fair valuation of the resources and goods that we are trading, which we call “price.”

This view has considerable romantic appeal, but it does not explain an inalienable dimension of market behavior: cheating. The stunning barrage of evidence that the Market is being willfully and systematically dismantled—the rigging of mutual fund pricing, credit ratings and now LIBOR—is positive if it causes us to reflect critically on our false belief in the power of the Market to protect us from ourselves.

Rope-A-Dope Securitization Economics: Part 2

Ann Rutledge — Sat, 05 Apr 2008 14:49:00 +0000

In Rope-A-Dope 101, we said there are five ways to mask the credit quality of a structured bond, that it is done by manipulating an “invisible” boundary where the consequences of being on one side or the other are not symmetrical, and that the boundary is only invisible to the investor. In Rope-A-Dope 201-205, we will go through each of the five in more detail to show how the cheating takes place, beginning with: Recognize a bad (credit) event late.

Default and delinquency are bad credit events. The meaning of delinquency is strictly financial. It represents the point in time when the borrower’s payments begin to lag the contractually due amounts. Default on the other hand is a political event. It signifies that the lender has lost faith that the borrower will repay and starts proceedings to try to recover the capital. The right time to declare a default is a judgment call, made in light of the borrower, the loan purpose, the type of collateral and the due amount. Give the borrower too little time and he will not be able to repay you. Give the borrower too much time and he will not want to repay you but will divert funds originally intended for you to other uses. Despite the judgmental aspect of when to set the cutoff, however, good credit policies always have an arm’s-length cutoff, which good credit managers consistently enforce.

The simplest game is to securitize receivables whose credit and investment (C&I) policy doesn’t define default in days-delinquent terms. Information about loan status disappears upon sale or transfer, because the clock is reset to “zero days delinquent.”

What happens? If the cutoff is not in the definition of default for purposes of setting eligibility criteria, the receivable will always be “current” even after it stops paying. That loophole allows it to be securitized again, and again as if it still had full value, because the buyer can never discover what the seller knows, namely that the receivable is worthless.

Is it legal? The Uniform Retail Credit Classification and Account Management Policy has clear cutoffs for consumer loans. The default definition for wholesale lending under the U.S. Basel NPR (September 2006) is well-intended but has no teeth. It is also out-of-synch with regulatory guidelines elsewhere that have a clear cutoff.

Another common game, mainly in ABCP conduits, makes use of a double-standard: the original cutoff for the transferor, and a more lenient cutoff for the SPE.

What happens? Say the cutoff of the original receivable is 90 days and the cutoff for the conduit that buys the receivable is 120 days. An 89-day delinquent receivable may be sold out of portfolio and funded in the conduit for another 119 days. And new notes can be issued against it, even though it is still unpaid at 208 days, because it is still “current.” (For a thorough discussion of calendar tricks, see Sam Pilcer’s Understanding Structured Liquidity Facilities in Asset-Backed Commercial Paper Programs, ABCP Commercial Paper Market Review, First Quarter 1997.)

Is it legal? Calendar tricks are acceptable in fully-supported conduits, where the conduit administrator provides a credit backstop. By rating agency and market custom, they are not permissible in partially-supported conduits where receivables should be funded at fair value. However, since loan-level information is never disclosed in ABCP conduits, this trick is utterly beyond the capacity of investors to discover, unless or until it is too late.

A third game is to “fix” the delinquency clock so the cutoff is never reached. The most common version of this trick is to keep track of delinquencies using recency rather than contractual accounting.

What happens? With recency, the clock is reset to zero and the borrower is deemed current, regardless of whether or not the contractual amount has been paid. The consequences are the same as above: only the seller can see that the loan is not worth what the buyer pays for it.

Is it legal? Bank regulators frown upon and discourage it. Under the Revised Uniform Retail Credit Classification and Account Management Policy in 2000, the FFIEC highlighted the abuses of the recency method and articulated a preference for the contractual method. The revision imposed a limit on institutions using the contractual method, who would not be allowed automatically to change to recency without seeking and obtaining permission.

Finally, Market Value games are based on the use of traded price as a proxy for fair value when price formation becomes disconnected from valuation. Market value games are the rationale for Market Value CDOs. They also led to the August 2007 U.S. ABCP liquidity crisis.

What happened? Demand for prime mortgages in the late 1990s was strong. It was common for delinquent loans to be bid at par in dealer markets. That is why rating agencies came to accept market value swaps (MVS) in extendible notes (SLNs) issued by single-seller mortgage conduits. MVSs came to be viewed, incorrectly, as a credit protection. Their role in these extendibles continued long after the original rationale was forgotten and the mortgage collateral was no longer prime.

Is it legal? So long as the swap is documented and the counterparties are not proscribed in their own rules from making the trade, it is perfectly legal. But it is not credit protection.

Rope-a-Dope Securitization Economics: Part I

Ann Rutledge — Sat, 15 Mar 2008 17:47:00 +0000

The high road of securitization is forward-looking. It promotes economic growth and rewards superior asset quality. Securitization is alive and doing well in grass-roots economies. But maybe you have not come to our blog to read about the high road of securitization. Maybe you have come looking for a map to lead you off the low road of securitization because it’s a dead end, and you’re out of a job.

Your first step is to take a good long look at the pot-holed reality of the low road you’ve been on. All the signs of fast money and questionable business practices were in public view for five or ten years. (The annual conference in Las Vegas—what did you think that was? WYSIWYG) But, this blog is not meant as a litany of cheap shots. It’s meant to be a guide to what needs to be confronted and changed. You see, the low road of securitization is actually much worse than people imagine.

The low road of securitization is a series of pseudo-processes embedded in a special market where anything goes so long as it can be vetted by one or more rating agencies. Call them de facto regulators of a rogue financial system placed effectively beyond the control of the SEC, the Fed and Congress, and below the radar screen of FASB. Call these pseudo-processes Rope-A-Dope 101. Call the American public - you, and me too - who are being handed a sentence of lifetime of debt service for the financial system’s five year credit orgy, the dopes.

In Rope-A-Dope 101, there are five preferred (often inter-related) ways to mask the true credit condition of a structured bond. Each entails the manipulation of an “invisible” boundary where the consequences of being on one side or the other are asymmetrical. The boundary is not really invisible; it is transparent to the rating agency MDs and certain parties inside the arranging banks who know how to play. But most of the market does not, and in some cases, cannot see it. That’s the beauty of Rope-A-Dope.

Here are the rules:

(1) Recognize a bad event late. In credit, the “bad event” is generally taken to mean default, but delinquency numbers can also be jiggered.

(2) Recognize a good event early. Receipt of cash flows is a “good event,” hence recoveries are good although they result from defaults. To minimize the optical loss, delay the recognition of defaults and accelerate the recognition of recoveries. Push the envelope as far as it will go.

(3) Hide a particularly toxic loan or security inside a portfolio and publish only aggregated (which is to say average) risk measures that paint an unduly rosy picture of risk-adjusted returns. This is a favorite Rope-A-Dope tactic in ABCP conduits and CDOs, where collateral is generally heterogeneous.

(4) Massage the capital structure until the security in question (part of the capital structure) is on the right side of a rating boundary. The classic maneuver is to make the security a very weak BBB-/Baa3 and not a very strong BB+/Ba1, because of the pricing or capital regulatory impact of carrying a NIG (non-investment grade) rather than an IG (investment grade) risk.

(5) Stuff the pool with small portions of ineligible or non-existent collateral. If the transaction pays anyway, make the portions bigger the next time.

The Moody’s Blues

Sylvain Raynes — Mon, 10 Mar 2008 16:40:00 +0000

The last entry in this journal was rather pessimistic. In it, we recounted what was likely to happen from the Fed’s irresponsible attitude towards cutting interest rates without a workable plan in mind about what to do next. Our verdict was that nothing good was to come out of it. However, that still left open the possibility that nothing bad would come out of it either. We were dead wrong, for the credit markets are now in an even bigger mess than they were 30 days ago.

This mid-life crisis of confidence is not going away any time soon, and politicians are now busy looking for whipping boys with names like Prince and Mozilo. As if these guys are single-handedly responsible for the excesses of an entire nation. These people, and their friends, were acting self-interestedly, and most of us would do the same if we had the chance. Who knows, maybe we will soon?

Besides, it’s a little late to look for culpability on Wall Street. You might as well hand out speeding tickets at the Indy 500. As things now stand, the people actually responsible for this mega-disaster have never truly been called to account. And who is that? How about the rating agencies?

The logic is simple and unavoidable. If there are a slew of bank robberies in New York, Mayor Bloomberg is not going to visit the headquarters of the NY Bank Robber Association and ask its management: what have you been doing, you busy, busy little bees? He will visit the NYPD’s headquarters and ask the Police Commissioner why he is not stopping those same robberies. It is not the fault of Wall Street when excesses take place. People working there are behaving totally consistently and rationally, as they have for 100 years by the way, in trying to make an honest and, alas too often, dishonest buck. It is that of those who claimed to act as the policemen for the credit markets, and who, in fact, were doing a fine job not too long ago. Those who could have stopped them, who should have stopped them, even assuming they ever knew how, were themselves playing the other side in encouraging the behavior they were sworn to prevent. It was not difficult to do in any event. You had to have been completely unconscious to ignore the warning signs, some as big as a managing director’s bonus check.

This crisis took years to unfold and it will take years to go away, until the next one that is. Unless Value in structured finance is conceptualized properly, which really means conceptualized at all, this crisis will teach us nothing, except that finance still remains in its infancy, somewhat like aerodynamics in the 19th century. Price and Value are incommensurate and can never be equated as a matter of definition. One is linear (Price) while the other is non-linear (Value). To define them as identical amounts to a quadrature of the circle, something that has eluded mankind since time immemorial. The problem is not so much that quadrature has yet to be discovered, for that will never and can never happen. The problem, rather, is the naïve belief in the outer possibility of Value.

The fault, dear brethren, lies not in our deals but in our selves.

Sylvain Raynes

Pseudo-Fed: Bury your Head in the Sand

admin — Mon, 28 Jan 2008 14:57:00 +0000

Just a few days ago, the Board of Governors of the Federal Reserve pumped enough cash into the US economy to lower interest rates by 75 basis points. For the average American citizen, who would be hard pressed to define what a basis point means, this most recent Fed action is at best meaningless. To the vast majority of bankers on and around Wall Street, the very same people who brought us to the edge of the abyss like cattle to a slaughterhouse, chances are this move will be interpreted as what it is not: a lifeline. It’s a line alright, but one coiled into a noose sufficiently large to accommodate the neck of the American people.

One basis point may be small, but multiplied by $13 Trillion (the current size of the US economy), it can add up to significant figures. A billion bucks is not something that can easily be conceived. If you gave an infant a billion in $100 bills, he would not live long enough to count them. $100 billion is not something one can even imagine, let alone count. As one US Senator once said “a billion here, a billion there, pretty soon you’re talking real money.”

It’s not so much that Chairman Bernanke’s bold but reckless move will be misunderstood, for to misunderstand something, you first have to understand it. Besides being mismanagement on a monumental scale, it is a step in the wrong direction, a faux-pas Alan Greenspan would never have taken. How do we know that? Simply because the Russian debt crisis, nowhere near as large as this one but quite similar in its import and breadth of culpability, was handled with brio and aplomb and was nipped in the bud long before it snowballed into a crisis. This rate cut is nothing but one more bottle of Jack Daniels given to an alcoholic upon the promise that this would be ‘the last one’. Ladies and gentlemen, the party hasn’t even started yet; we’re just buying the booze.

This crisis is not a liquidity crisis, whereby Value is mysteriously locked up in healthy but illiquid structures, and someone simply needs to enable such pre-established Value to be ‘liberated’ via cash infusion. For if that were the case the Federal Reserve, the liquidity management tool par excellence for the United States banking system, could indeed deliver us from evil in the name of irresponsibility. In other words, if this amounted to a transitory pricing aberration, all would be well once the normal insanity subsided. There is no such thing as a liquidity crisis, for that is impossible. There is a valuation crisis. This is not finance 101; this is finance 001.

Thanks to the Fed’s move, for the foreseeable future American finance is burying its head in the sand, hoping that some day a genie in a bottle of gin will save us from ourselves. Speaking of head in the sand, we would like to introduce a very appropriate game, entitled “The Ostrich Syndrome”. It was created by Peik Looi Ong, a former Baruch College Masters student in the Program in Applied Finance under the adroit leadership of Professor Dan Stefanica. Peik Looi developed this game as a model of infectious corporate greed in highly correlated environments. We hope you will agree that the results are impressive and revealing.

Some of you may know that ostriches have the strange and nasty tendency to commit suicide upon encountering a dead ostrich on their path. This phenomenon is also the way cancer grows inside human bodies, i.e. one cell at a time. We believe this to be an apt analogy given the current Zeitgeist. We hope you enjoy watching this tragedy unfold in real time; and you can even choose your own parameter-set to make this game more to your liking.

Regardless of what the Fed’s mignons might believe, this mess has nothing to do with liquidity but with an obvious inability to conceptualize Value in the primary, not the secondary structured markets. Our predicament has nothing to do with Price, but everything to do with Value and the two, by the way, are incommensurate. Cash moves for Value, not the other way around. Until this is understood, American finance will wallow in an ocean of denial and wander aimlessly in a metaphysical waste land characterized by fear, which is where we are today. Everybody wants to go to heaven, but nobody wants to die.

Only a God can save us now!