R&R Consulting » Federal Reserve Bank

R&R’s Ann Rutledge on Public Purchase of Bad Assets

admin — Tue, 23 Sep 2008 21:01:00 +0000

Federal Reserve Chairman Ben S. Bernanke signaled that the government should buy devalued assets at above-market values to make its proposed $700 billion rescue package most effective in combating the financial crisis…. Analysts said Bernanke is essentially advocating that government use a pricing model that assumes that the debt will be paid in full over a long period of time. That is different from the mark-to-market model used by investment banks that prices assets at what they are worth on a given day.

The risk is that the model does not provide transparent pricing of the assets taxpayers are taking on, said Ann Rutledge, partner at R&R Consulting in New York, a firm that specializes in structured finance. Many of the securities “are not going to pay at maturity,” Rutledge said.

- Craig Torres and Kathleen Hays, “Bernanke Signals U.S. Should Pay More for Bad Debt,” Bloomberg, September 23, 2008

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.

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!