It looks like we were all wrong.

The current worldwide financial meltdown is all because a small bank in San Diego, California wrote a $500,000 mortgage to a housekeeper making $20,000 per year.

She should have known better.

I can’t believe the stupidity of some people.

Now we all have to suffer.

I also agree that the people who participated in fraud need to suffer some pain. I think that a fair conclusion can be accomplished by:
1. Criminally prosecuting the worst cases
2. Providing aid only for owner-occupied primary residences
3. Limiting aid to no more than the amount of mortgage resets
4. Conditioning debt relief on borrower and issuer sharing any pain
5. Unbundling CDOs into individual mortgages to restore transparency

I think that an annual expenditure of about fifty billion for five years, delivered as a mortgage guarantee, would serve. That will work its way through the system to reduce the deleveraging.

Any good solution must leave everyone unhappy… but, except for the outright crooks, solvent.

–Charles of MercuryRising
http://www.phoenixwoman.wordpress.com

Well, if by “trust” means consider their analysis as one factor in making an investment, I should hope so. On the other hand, any one who depends exclusively on their ratings should have their minds examined; and laws that are based on their ratings should be changed.

And of course I have no sympathy for investors who knew they were getting a deal that was too-good-to-be-true (AAA rating with a yield much higher than Treasuries) and are now blaming the ratings agencies for their own greed.

Now, it seems like the major banks themselves are writing off huge sums of money which as reported currently amounts to at least 45 billion dollars. I have a few questions if anyone knows:

Which were the largest write offs in history in terms of overall economic impact?

How do they compare to the $45 billion in write offs the banks have already acknowledged the past few weeks?

Thanks for your comment. I agree if there was some way to attenuate the deleveraging, it would be vastly better for all parties concerned. But there are a lot of losses out there that will eventually be recognized.

And then we have the prevailing belief in the “let the market clear” construct. For big but not overwhelming overvalued asset classes, that is probably the best, or more accurately, the less bad, solution (even though it damages innocents, the alternative, of shoring up the market, means the same perps will do it again on a bigger scale and create even more collateral damage down the road).

The powers that be like to hold up the Resolution Trust Corporation, which sold off the assets of brain dead S&Ls, as a great success, but they forget a few things. First, the S&Ls had failed. That’s why the government had to deal with the assets. Um, do we want financial institutions to fail here? No one would say that, but it is implicit in the model.

Second, the RTC was very controversial at the time, and its reputation has been burnished after the fact. It sold a lot of assets for much less than it could have gotten, partly due to inexperience (this was a vast new undertaking) and partly due to time pressure (Congress did not like the cash drain of funding RTC working capital).

Third, the recovery of the economy was due largely to Greenspan driving short-term rates very low. The steep yield curve that resulted was a massive subsidy to the banking system.

That’s a long-winded way of saying I agree with your general point, but even independent of the ideological obstacles, I don’t see a neat way of ameliorating the situation. And I haven’t seen any great or even good proposals either. The best ideas are on the regulatory reform front, but while desperately needed, that does not address the immediate crisis.

I assure you that I am not missing this, Yves. I am saying that the cost of preventing deleveraging is substantially less than the cost of allowing it. If, for the want of a nail the battle is lost, then the battle can be won for the price of a nail.

I also understand that there are other categories of loans bundled into CDOs. Without doing book length posts, it’s hard to deal with all the details, but the subprime issue is emblematic. Mortgages don’t get paid either because the borrower didn’t have the money to begin with (fraud) or because rates adjust up and the borrower’s income doesn’t or because something changes in the borrower’s life to make it impossible to pay (illness, unemployment, etc.)

The supply/demand imbalance due to difficulty of valuation that you describe is characteristic of panics from time immemorial. The federal government can step in, guarantee that the players get enough time to do the valuation, and the panic is over.

It probably won’t happen, because there is no leadership in Washington. But this disaster does not have to happen.
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H stated that “To assume, as you (Yves Smith] did in this post, that the total outstanding on CDOs (whatever the size may be), could suffer a 25% loss, is just ridiculous.”

Actually it’s not. It’s essentially identical with the assumption that 25% of recent mortgages default, which is more or less what the actual performance numbers are looking like. Yves is perfectly correct that if nothing is done, this will turn into a giant problem.

–Charles of MercuryRising
http://www.phoenixwoman.wordpress.com

“Loss” means “reduction in market value.” Since most buyers were using now repudiated credit models for pricing, and there is no standard pricing model for this stuff, price is the eye of the beholders. And the beholders now realize they bought stuff that is too arcane for their taste.

You give the impression that these are simple mutual funds of heterogeneous assets, and completely ignore the role of having a significant portion of CDO assets be the weaker tranches of structured credits, which already have embedded leverage (their value will go to zero while their is still value in the senior tranches, that’s the whole point of the subordination) into another structured CDOs have high embedded leverage, yet you ignore this fundamental feature.

A example in the October Bank of England Stability Report work through how quickly BBB- tranches erode. An increase in the five year default rate from 25% (assumed in the deal’s design) to 35% reduced the value by 36%. If in addition to that, the loss upon foreclosure increased from 20% (assumed level) to 30%, the value of the BBB- tranche fell by 60%.

Even though CDOs do not consist primarily of subprime, the point of that illustration is that material deterioration below the deal’s assumed loss/default rates has a dramatic effect on the value of BBB and BBB- tranches.

Remember, Alt-As and option ARMs were also included in these deals. They are showing much higher default rates than anticipated too. And most important, the mortgage recovery rates these days are terrible. 70% used to be a good working assumption; I have read estimates of 50% and below. Mortgages were made with little to no equity and the fall in housing prices has been dramatic.

Moreover, it is certain that whether the monolines are downgraded or not, the market (CDS swap prices) says they are no longer AAA. So any CDOs that received credit enhancement via them will be worth considerably less. This is an effect independent of the value of the underlying assets.

And that doesn’t even get into the lack of demand issue. Even if this stuff on some theoretical basis is worth 85 cents on the dollar, if no one will pay more than 60 cents, the loss will be 40%.

Merrill marked down its AAA rated CDO portfolio by 30% or more. While most of the value of CDO paper is in the AAA tranches, a significant portion is not. That will be even more impaired. Tell me why readers should believe that Merrill’s CDO paper was vastly worse than other CDOs in the market. And if other investment banks mark down their “super senior” tranches that much or more, assuming they still even are rated AAA by year end.

These writedowns are very public and are an official statement of what their market value is deemed to be. It will most certainly affect how others holding CDOs will view and mark their positions.

These clowns are a moral hazard all by themselves

CDOs only repackage already existing securities

Yes, but they also use the “credit enhancement” rackets to “promote”, for example, BBB and BBB- ABS toxic sludge to AAA ratings. So they end up with people who have no appetite for the risk they are taking. Or, maybe the high rating allows them to be used as collateral for other “investments”, increasing the leverage and therefore the damage done. Either way, the phoney rating is an economic distortion, if not outright fraud.

Finally, after seeing this crap at AAA, will anybody ever again trust S&P, Moody or Fitch? I sure won’t.

To assume, as you did in this post, that the total outstanding on CDOs (whatever the size may be), could suffer a 25% loss, is just ridiculous, considering that most of these assets are indeed very sound and performing. A 25% loss, whether realized or implied by mkt prices, means that 50% of the underlying credits would default (assuming a 50% average recovery value), compared to the current default rate of below 2%. It is clear, however, that the current mkt dislocation, driven mainly by a supply overhang, as too few people want to step in front of this train (yet), has driven prices significantly lower, but let’s try to keep our hair on.