Noland: Don't Get Hopeful About Fed Interest in Asset Bubbles

There has been a raft of articles about the Federal Reserve's new found interest in the question of asset bubbles, suggesting that the Fed might be ready to shift policy and exhibit more willingness to rein them in. Yesterday, a page one Wall Street Journal story discussed at length research central bank chairman Bernanke has sponsored at Princeton, and noted:

The Fed is giving the activist approach some thought. In a speech scheduled for delivery Thursday night, Fed Governor Frederic Mishkin suggested that while it was inappropriate to use the blunt instrument of interest-rate increases to prick bubbles, if too-easy credit appeared to be fueling a mania, policy makers might craft a regulatory response that could "help reduce the magnitude of the bubble."

Doug Noland at Prudent Bear takes issue with the view that the Fed might be changing its approach and gives a close reading of the Mishkin speech:

The conclusions from Professor Mishkin’s paper differ only subtly from previous doctrine:

First, not all asset price bubbles are alike. Asset price bubbles that are associated with credit booms present particular challenges....Second, monetary policy should not try to prick possible asset price bubbles...Instead, monetary policy should react to asset price bubbles by looking to the effects of asset prices on employment and inflation, then adjusting policy as required to achieve maximum sustainable employment and price stability… Third, because asset price bubbles can arise from market failures that lead to credit booms, regulation can help prevent feedback loops between asset price bubbles and credit provision. Our regulatory framework should be structured to address failures in information or market incentives that contribute to credit-driven bubbles.

Mishkin suggest regulatory remedies might help prevent unhealthy booms, but even the ideas he presents as possible solutions are minimal. Information failures? The research described in the Journal article essentially said that investors get overly excited about a broad scale innovation and start bidding up prices of related investment opportunities beyond realistic levels. Those with more cautious views step aside, unwilling to get killed, until the bulls exhaust themselves. Pray what information failure can you point to in that? The negative information is out there, just as it was during the housing bubble. But it was ignored. Mishkin is pointing to instrument-specific misunderstandings, as with investors buying MBS and CDOs, they really didn't understand. But what information failure was there in the dot-com era? It was clear to all that the vast majority of companies had no realistic prospect of turning a profit, yet ownership of "eyeballs" became the new version of tulip mania.

Back to Noland:

I’ll posit this evening that the entire issue of “central bankers vs. asset Bubbles” has become little more than A Red Herring. While it is as of yet too early in the unfolding financial and economic crisis for “consensus opinion” to have reached a similar conclusion, in reality contemporary monetary management can already be proclaimed an unmitigated failure. Cloaked in ideology and a flawed conceptual framework, the Greenspan/Bernanke Fed sat idly by as history’s greatest Credit inflation and myriad resulting Bubbles irreparably damaged the underlying structure of the U.S. Credit system and real economy (before going global). And while the Fed executes its latest round of post-asset Bubble “mop up,” precarious Credit Bubble dynamics are left to run similar roughshod through global financial and economic systems. Better to downplay the asset Bubble issue for now, as we contemplate the nature of what will be a much altered post-Global Credit approach to central banking.

From Mishkin:

The ultimate purpose of a central bank should be to promote the public good through policies that foster economic prosperity. Research in monetary economics describes this objective in terms of stabilizing both inflation and economic activity. Indeed, these objectives are exactly what is embodied in the dual mandate that the Congress has given the Federal Reserve.

In no way do I believe “the ultimate purpose of a central bank” is to “foster economic prosperity,” and I certainly don’t expect any such grandiose mandates to survive in the post-Bubble environment. On many levels the notion that central bank policies are instrumental in creating prosperous economic conditions is problematic. For one, it grossly over promises in regard to the long-term benefits derived from government manipulation of interest-rates. Secondly, it virtually guarantees an accommodative policy regime and, inevitably, a strong inflationist bias. Thirdly, such a nebulous objective invites overly discretionary policymaking, along with an activist and experimental approach to monetary management. Fourthly, such an approach ensures that policymaking errors beget greater and compounding errors.

Noland is correct to point to the dangers of continued Fed mission creep. Noland again returns to quoting Miskin:

From Mishkin:

After a bubble bursts and the outlook for economic activity deteriorates, policy should become more accommodative. …If monetary policy responds immediately to the decline in asset prices, the negative effects from a bursting asset price bubble to economic activity arising from the decline in wealth and increase in the cost of capital to firms and households are likely to be small. More generally, monetary policy should react to asset price bubbles by looking to the effects of such bubbles on employment and inflation, then adjusting policy as required to achieve maximum sustainable employment and price stability.

This passage, in particular, goes right to the heart of several key failings of current doctrine...The problem with post-asset Bubble “accommodation” is that it specifically accommodates the very Credit infrastructure and related Monetary Processes that financed the preceding boom. It works to validate the present course of financial innovation (think “Wall Street securitizations,” “CDOs” and “carry trades”), while emboldening those at the cutting edge of risk-taking (think “leveraged speculating community”).....

Moreover, a commitment to aggressively cut rates in response to faltering asset Bubbles openly courts leveraged bond market speculation – a market dynamic that engenders artificially low market yields and exacerbates liquidity excess during the late-stage of asset bubbles (think bond market “conundrum”). The last thing a central bank should encourage is an entire industry dedicated to placing leveraged bets on the direction of Federal Reserve policy responses...

The overriding flaw in the Greenspan/Bernanke approach has been to openly disregard Credit Bubble dynamics, in particular the increasingly profound role being played by Wall Street-backed finance in fueling Credit, market liquidity and speculative excesses. I believe The Ultimate Objective of a Central Bank is to Foster Monetary Stability in the broadest sense. In this regard, asset Bubbles should be viewed primarily as important indicators of some type of underlying Monetary Disorder. The key analytical focus must be on the underlying Credit and speculative dynamics fueling the asset price distortions – to better understand and rectify the source of “disorder” – and the earlier, the better.

The most dangerous policy approach is to further incentivize a system that has already demonstrated a proclivity for Credit and speculative excess – employment, output and “deflation” concerns notwithstanding....

Greenspan, Bernanke, Mishkin and others repeatedly stress the inability of policymakers to recognize the existence of a Bubble until after it pops. It is my view that the entire notion of asset prices dictating monetary policy is flawed. The focus should instead be on the underlying sources of monetary fuel – the Credit growth and financial flows underpinning asset inflation and economic boom....

Central bankers can and should avoid being in the difficult position of having to respond directly to inflating asset markets. Instead, there must be carefully fashioned, communicated and administered “rules of the game”. To begin with, it is incumbent upon the Fed to clearly articulate to the public (and their elected officials) the overwhelming benefits of stable Credit and financial conditions. It must be conveyed that Credit and speculative excesses are destabilizing, fostering boom and bust dynamics and structural impairment. The public must come to appreciate that the effects of destabilizing Credit inflation come in many forms, including asset price inflation and Bubbles, Current Account Deficits, currency debasement, traditional consumer price inflation, and various distortions to underlying Financial and Economic Structures.

Volcker could carry this off, as possibly could have earlier former non-academic Fed chairmen (ie, not Arthur Burns). But it seems the Fed has been badly, hopelessly captured by the industry, which is the converse of what is desirable. Unless a new President is able to find and slowly restock the Fed with men and women with some good old fashioned probity, the instability and propensity to financial excess will only get worse.

Quelle Surprise! Banks May Be Gaming ECB Liquidity Facility

The ECB has uncovered gambling in Casablanca. The central bank is shocked to learn that banks appear to be originating crappy assets solely for the purpose of dumping them in a liquidity facility intended to help them through a rough patch, not to provide an ongoing subsidy.

Regulators should know better. Indulgent parents generally wind up with spoiled kids who posses a sense of entitlement and react particularly badly when restrictions are imposed. In this case, the ECB took it as a point of pride that it accepted a broader range of collateral than other central banks, but its liberalmindedness appears to be working against it. Financial firms are first and foremost loyal to their own wallets. Any program that can be used to generate profit or other competitive advantage can and will be exploited.

From the Financial Times:

The European Central Bank yesterday voiced its "high concern" at growing evidence that banks are exploiting its efforts to unblock the frozen funding markets by using its liquidity scheme to offload more risky assets than it envisaged.

Yves Mersch, a governing council member, said the ECB was now "looking very hard at whether there is not a specific deterioration of collateral" which the central bank is accepting in return for funds.

He was speaking amid signs of some banks creating low-rated assets specifically so they can be traded for treasuries at the European Central Bank.....

Mr Mersch said the type of collateral now being accepted was: "A matter of high concern."....

Investment bankers who work in securitisation say that their main business is structuring bonds that are eligible for ECB liquidity operations. Some analysts have concerns about whether the bonds being created will ever be saleable if markets recover.

"There is moral hazard . . . and we are not in the business of taking over the market," Mr Mersch said. "That means there must be an exit strategy."

This shows the danger of the idea of the central bank as market maker of the last resort. It's too easy for it to become market maker of the only resort.

Floyd Norris: Candidate for Worst Mortgage Securitization, Ever

I'm sure readers know of other super turkeys, but Floyd Norris in the New York Times did find a prime example of crappy paper. Note that he limited himself to securities, so CDOs were not candidates for this Hall of Shame award.

The Merrill deal was a pool of seconds ("piggybacks"). Moody's noted that this type of loan was typically written off after serious delinquency, since they had little or no equity from the outset. Key terms of the Merrill deal per Norris:

Fewer than 30 percent of the loans were made to borrowers who provided full documentation of their income and assets. Many of the other borrowers probably lied about their income. Nearly all had borrowed the full appraised value of the home, either for the purchase or for refinancing, and it is possible that some appraisals were unreasonably high even before home prices began to fall.

One hates to say it, but so far, this sounds only-somewhat-worse-than-usual late subprime practice. But they we get to the doozy:

...the mortgages had rates averaging 11.2 percent. Yet investors who put up most of the money were willing to accept a floating rate of just 30 basis points — three-tenths of one percentage point — over the London interbank offered rate.

And this paper was sold institutionally....or at least some of it was. Remember, Merrill would up retaining the super senior tranches on later deals because it couldn't find enough suckers takers. And yes, super senior means AAA.

Moody's still rates this dreck as investment grade (barely), while Standard & Poor's cut it to junk, and has now ceased publishing ratings on this and similar instruments.

The amazing thing about an issue like this is at a large institution, you can't blame a deal like this on a rogue investment banker. A lot of people are involved in underwritings: the investment banking department, bond salesmen, traders, sometimes research. Pricing is a formal process. So this means a bunch of supposed professionals either got very high together or were subject to collective delusion.

Blackstone Chief Calls Credit Recovery "Eye of the Hurricane"

Blackstone President Tony James said it may be premature to label the credit crisis over, although he did point to improving conditions in the market for LBO-related debt.

However, one also has to wonder whether this call is to lower expectations for Blackstone's performance, given the firm's dreadful first quarter results. Oddly, Bloomberg reports the the alternative investment shop lost $66.5 million in the first quarter, and cited a company statement. Yet the 8-K filing today, which includes a detailed discussion of first quarter results, says:

Economic Net Income for the First Quarter 2008 was a Loss of $(93.6) million reflecting a reduction in carrying value of investments.

GAAP Net Loss of $(246.7) million reflecting transaction related (including non-cash charges of $940.0 million) costs of $952.5 million offset by Non-Controlling Interests of $799.4 million.

Looking through the statement, nowhere do a see either a $66.5 million figure for losses, nor do I see the 12 cents a share deficit that the article cited (the release shows (page 6 and elsewhere):

Net Loss Per Common Unit, Basic and Diluted $ (0.97 )

What gives?
From Bloomberg:

Blackstone Group LP President Tony James said banks are mistaken if they think credit markets have begun a sustained recovery.

``It's not clear to me if it's a permanent upswing as I think many of the banks are saying or the eye of the hurricane,'' James told reporters on a conference call today.

High-yield, high-risk loan prices have climbed from a low of 86.3 cents on the dollar in February to 92.42 cents after banks whittled down a backlog of buyout debt to less than $100 billion from more than $300 billion last year, James said. Banks still must find a way to sell loans and bonds backing the takeovers of telephone company BCE Inc. and Clear Channel Communications Inc.

Private equity firms Bain Capital LLC and Thomas H. Lee Partners LP, which are buying Clear Channel, had sued Citigroup Inc. and five other banks for trying to back out of financing the deal. San Antonio-based Clear Channel, the largest U.S. radio broadcaster, said this week it settled the legal fight by agreeing to a reduced buyout price of $17.9 billion, 8.2 percent less than the Boston-based buyout firms agreed to pay last year.

``The Clear Channel deal moving forward was a blow to the banks,'' James said on the call, noting credit prices have moved down two or three points since the legal fight ended. ``The next big event will be BCE, which is even bigger than Clear Channel.''...

Banks are willing to lend for acquisitions, though ``I would not call it aggressive but they are open for business,'' James said. ``It's got materially better,'' he said.

Doubts About Credit Market Recovery

In keeping with Bernanke's cautionary remarks about the unsettled state of the markets, some debt market participants worry that the recovery will prove short lived. While few are forecasting a return to the near paralysis of early in the year, the combination of continued caution among lenders and a deteriorating economy could make debt dearer and more difficult to come by.

The Wall Street Journal, in "Is Debt Thaw on Borrowed Time?" while recounting various signs of improvement in the corporate loan market, also warns of the potential for credit tightening:

"There's no question the tone in the market is getting better," says Jim Casey, co-head of leveraged finance at J.P. Morgan Chase.

He adds, however, that "there is some concern that this might be a short-term window of opportunity for issuers, since investors are still very focused on default rates and the potential severity of a recession."

Banks and debt investors are treading carefully. While they are more open to financing deals where one corporation buys another, many are still somewhat reluctant to fund leveraged buyouts by private-equity firms.....

Investment banks, which incurred big losses after selling a lot of buyout debt at heavily discounted prices, are committing only to deals they can underwrite at a profit. And investors don't want to be caught wrong-footed if corporate defaults spike.

"Risk tolerance is still pretty low," says Daniel Toscano, a managing director of leveraged and acquisition finance at HSBC Securities in New York.

In "Is It Really Different This Time?" in Barron's, Randall Forsyth notes that fixed income markets often price in a recovery after a round of monetary easing, but then resume their trajectory as the economy continues to flag:

There's been a hiccup in every decline in the two-year Treasury note yield in the four major cycles since the mid-1980s. (The two-year T-note is the most actively traded security on the planet and reflects expectations about the Fed's next move. [Robert] Kessler [of Kessler Investment Advisors] oncentrates on this portion of the yield curve and adjusts the effective duration of the portfolio by adding or subtracting leverage.)

But, after those temporary blips, the two-year note yield fell again, and onto new lows for the cycle....

The recurring script seems to be that after the initial phase of the financial squeeze that leads to the first cuts in interest rates, Wall Street essentially thinks that this monetary easing has cured all ills. But, while that addresses the problems of the financial markets, the economic woes in the real economy take longer to cure. That realization leads to the final downleg in rates, Kessler says.

That's still to come, he continues. "Phase Two will be worse than Phase One," he says. It will come when consumers pull up to the gas pumps and then have nothing left to spend on anything else. Combined with the impact from soaring food costs, that point isn't far away...

As for inflation, Kessler also observes that it's curious that with crude oil hitting $126 a barrel, gold hasn't made net headway in three months. Tuesday, June gold futures lost $15.30 to $869.60 an ounce even as crude futures set a new mark.

While the charts of the current cycle looks almost like those of its three predecessors, Kessler fingers an important difference.

Then, the Fed could fuel a recovery by dropping interest rates. Housing, especially, would respond forcefully and lead the rest of the economy to recovery. But in past cycles, the mortgage market could readily provide credit to prospective buyers; not so any more. Credit this time is tighter, not by the Fed's doing, but mortgage originators, which play an integral role in the process.

Consumers, Kessler continues, came out of the 1980s with high savings rates and liquid assets. Now, they're tapped out because of a lack of savings in the past few years. And to sustain spending in excess of poor income growth, Americans used credit to keep spending. The limits on that are becoming apparent.

All in all, it really is different this time, Kessler says, invoking the mantra used by blinkered bulls for years. It is worse, he asserts, given the little response he sees in the real economy from the rate cuts that have taken place.

Stocks have rallied coming out of past credit cycles, but you have to be brave to expect the same this time, he contends. Treasury yields, however, are likely to fall to new lows once this inflation scare blows over, Kessler concludes.

Volcker Calls for Regulation, Questions Loyalties of GSEs

Former Fed Chair Paul Volcker reiterated some of his concerns about the Fed's recent moves and the evolution of the financial system in prepared remarks before the Joint Economic Committee of Congress. From the WSJEconomicsBlog:

“Whatever claims might be made about the uniqueness of current circumstances, it seems inevitable that the nature of the Fed’s response will be taken into account and be anticipated, by officials and market participants alike, in similar future circumstances,” Volcker said ....

The Fed, he said, “felt it necessary to extend that safety net” to systemically important institutions by “providing direct support for one important investment bank experiencing a devastating run, and then potentially extending such support to other investment banks that appeared vulnerable [to] speculative attack,” Volcker said.

“Hence, the natural corollary is that systemically important investment banks should be regulated and supervised along at least the basic lines appropriate for commercial banks that they closely resemble in key respects,” he said...

He said heavily “engineered” financial markets, using sophisticated mathematical models, led to “enormous complexity” and “opaqueness” in markets.

“In the process, close examination of particular credits with respect to risk has too often been lost; the subprime mortgage is only the leading case at point,” Volcker said. “This new system has failed the test of the marketplace.”

Volcker said the Fed’s role in banking and financial supervision “should be recognized more clearly than in present law.”

“Specifically, direct and clear administrative responsibility should lie with a senior official, designated by law” Volcker said, and more staffing at the Fed will be needed.

Given the global nature of markets, Volcker said reform can’t proceed in a vacuum and urged cooperation with the European Union and Japan, citing past successes in developing bank capital requirements, accounting standards and settlement procedures...

He also warned that initiatives by the Fed and other central banks to boost liquidity in mortgage-backed securities markets raise public policy questions. Central banks, he said, have become “supporters of the mortgage market.”

And he questioned the role of government-sponsored enterprises such as Fannie Mae and Freddie Mac during the recent turmoil in mortgage markets. “Where were Fannie Mae and Freddie Mac?” Volcker said.

“What kind of system do we have” when agencies charged with the public interest in housing are instead “out serving the interests of their shareholders?” he added.

Some Informative Credit, Housing, and Mortgage Charts

Reader AK sent me a bit of Christmas in May: three hot-off-the presses reports, one from Morgan Stanley on the credit standing of US and European broker dealers, a Moody's report on RMBS, and a UBS report on the subprime crisis.

The Morgan Stanley report, although the shortest, was in some ways the most informative, since it provided a table that shows the marks that dealers are using for various types of securities. The paper argues that the gap between US (based on a universe of 7) and European (universe of 15) broker dealers has narrowed considerably, so the perception that European dealers were in worse shape than they appear to be is dated (note Knight Vinke disagrees vehemently as far as HSBC is concerned).

Morgan Stanley is suitably mysterious about its methodology, but claims it is +/-2% for those marks that have later been disclosed. Their approach no doubt includes sexual favors and the liberal use of alcohol.

Note this research does not necessarily contradict what my buddy with high level sources said about European banks sitting on a lot of undisclosed losses. The bulk of the lousy 2006 RMBS and CDOs were sold abroad, often to smaller institutions. So their could be trouble brewing in the next-tier institutions.

The Morgan Stanley chart (click to enlarge):



Note that these marks are generally higher than the haircuts required by the Fed per its collateral table, with the notable exception of CDOs. Of course, these marks are averages, and one would have to assume adverse selection in whatever was fobbed off on the central bank.

The report argued that broker/dealers are two thirds of the way through their write-downs, but warned that there was still the potential for trouble via basis risk and counterparty risk in hedges (code for possible CDS woes). And its other main caveat:

But as our equity analysts in the US and Europe have highlighted repeatedly, the looming concern is that of more traditional loss provisioning by commercial banks. Rising provisions and further deleveraging will make the earnings environment challenging for years to come, although with tail risk also reduced, we be believe this will be a greater headwind to financial equities than to credit.

I thought I'd lift the charts I found most interesting from the two other presentations (150+ pages in total, so forgive the arbitrary selection). From UBS (click to enlarge):





From Moody's (click to enlarge):

Moody's: "Elevated" Concern About MBIA, Ambac Aaas

Moody's issued the weakest warning it could about the two big monolines. Most observers did not expect the bond insurers' last round of fundraising to carry them very far, and that view appears to be playing out on schedule. We may be moving towards a repeat the January-February drama, with the rating agencies saber rattling until the bond guarantors raise enough money to tide them over for another bit.

From Bloomberg:

MBIA Inc. and Ambac Financial Group Inc. had ``meaningfully'' higher losses on home-equity loans and collateralized debt obligations than anticipated, raising concern about their Aaa status, Moody's Investors Service said.

The losses elevate ``existing concerns about capitalization levels relative to the Aaa benchmark,'' Moody's said in a statement today. MBIA and Ambac tumbled in New York Stock Exchange composite trading.

Satyajit Das on Nuclear De-Leveraging

It's one thing when journalists and analysts offer worrisome forecasts about the markets, quite another when someone with good inside knowledge sounds an alarm. Satyajit Das, an expert in derivatives and risk management, best known as the author of Traders, Guns & Money, looks over the financial landscape and does not like what he sees.

Reader CR sent me a copy of Das' latest piece on nuclear de-leveraging, which he also posted at Eurointelligence. Das works thought an example of how deleveraging feeds on itself and discusses how it will progress:

The first phase of de-leveraging is focused on financial markets. Banks have suffered losses in excess of US$200 billion (with more possible). Approximately US$1 trillion of assets have returned onto bank balance sheets.... An additional unknown amount of assets will return onto bank balance sheets as hedge funds gradually de-leverage.

Banks require funding and capital to cover losses and returning assets (christened IAG (involuntary asset growth). High inter-bank rates and the deceleration in bank lending reflect, in part, banks husbanding their cash resources to accommodate the involuntary increase in assets.

They have been raising money both via “helpful” central banks and in the market. Major financial institutions have issued substantial volumes of term debt at very high credit spreads....

Banks will also need substantial new capital to cover losses and the regulatory capital required against returning assets as follows:

Losses: US$ 200 to 400 billion

Additional Capital: US$ 100 to 300 billion (calculated as 10% (the Basel minimum is 8% but few banks operate at that level) of returning assets)

For bank’s operating under Basel 2, probabilities of default in credit models will increase resulting in regulatory capital increases....The capital required is around 15-25% of total global bank capital....

It is not clear how this capital requirement will be meet. Initially new capital was supplied by sovereign wealth funds (“SWFs”) and Chinese banks. Given that most investors have (sometimes) significant losses on their investment, this source of capital is less likely to be available in the near term. Banks have resorted to “hybrid” capital issues such as perpetual preference shares. The major attraction for investors has been the high income. Investors, especially retail investors, may not understand the equity risk in these structures. Rating agencies have expressed concern about the increasing level of hybrid securities in the capital structure of many banks.

Other sources of capital include asset sales. The current state of asset markets makes this problematic. Asset sales will put further pressure on available liquidity and prices.

One bright spot is investment in emerging market banks; for example, investments in Chinese State banks....Many banks see disposition of these shareholdings as an attractive source of capital....

The new capital noted above will merely restore bank balance sheets. Growth in lending and assets will require additional capital. The banking system’s ability to supply credit is significantly impaired and will remain so for the foreseeable future. Credit is clearly being rationed in the global financial system. If the banks are not able to re-capitalise, then the contraction in credit supply will be sharper.

In recent years, off-balance sheet vehicles – ABS CP conduits, SIVs, CDOs and hedge funds (collectively known as the “shadow banking” system) – provided additional leverage. These vehicles relied extensively on bank funding or support. The withdrawal of this support means that these vehicles are also de-leveraging rapidly.

ABS CP conduits, SIVs and CDOs are being gradually dismantled and the assets returning onto bank balance sheets. Hedge funds have been forced to reduce leverage by between a third and a half times. Prime brokers and banks have significantly tightened credit, increasing the level of collateral needed even against high quality assets. Each 1 times leverage reduction in hedge fund leverage represents in excess of US$2 trillion of assets. This accelerates the de-leveraging process.

The next phase of de-leveraging will focus on the real economy....

High quality corporations with maturing debt face face higher borrowing costs. For companies with less than stellar business outlook and credit quality, refinancing may prove difficult. Some US$150 billion + of leveraged loans comes due in 2008. A similar amount also must be refinanced in 2009.

Non-investment grade bond issuance over the last few years was concentrated in the weaker credit categories and is vulnerable to deterioration in economic conditions. Standard & Poor’s rating agency estimates that Two-thirds of non-financial debt issuing companies are junk-rated currently, compared with 50 per cent 10-years ago and 40 per cent 20 years ago. In recent years, around half of all high yield bonds issues were rated B- or below. These borrowers will face refinancing challenges.

Personal balance sheets will also de-leverage. Consumers in the USA and to a lesser degree in the UK, Ireland, Australia and New Zealand have used borrowings (against inflated real estate values) to offset a reduction in real incomes. Falling real estate prices and the reduced availability of “easy” credit will force de-leveraging.

Inflation is also a factor in the de-leveraging in personal balance sheets. Higher prices for the necessities of life reduce cash flow available to support debt....

An economic slowdown will exacerbate the de-leveraging.....In the US economy, the household, housing and financial sectors constitute over half of all economic activity. A (perhaps protracted) slowdown may be difficult to avoid. US demand is a significant driver of global activity. Recent reductions in global growth forecasts reflect these concerns....

There has been a systemic “financialisation” of corporate balance sheets. Changes in financial markets will have a significant impact on many companies that now rely on “financial engineering” rather than “real engineering”. The problems of GE may not be isolated.

For personal borrowers reduced personal income and unemployment will sharply accelerate the de-leveraging. Uncertainty about the future and market volatility will also accelerate the de-leveraging as companies and consumers reduce debt and aggressively save.

De-leveraging in the real economy may result in increasing defaults. Firms and individuals with unsustainable borrowings will fail. This will result in further losses to financial institutions setting off negative feedback loops as both asset prices and the level of aggregate leverage adjusts.

Central banks and governments actions have been directed at maintaining liquidity and (increasingly) directly supporting the financial sector. In the US and Spain, direct fiscal stimulus is already being administered.

These actions are designed to prevent a catastrophic collapse in the financial sector. They are also designed to help maintain a normal supply of credit to creditworthy business and individuals. These actions are designed to help the real economy from slowing down to a degree that the de-leveraging accelerates further. At best, these actions will smooth the inevitable de-leveraging and adjustment to financial asset prices.

MBIA Reports $2.4 Billion 1Q Loss, Downstreams Cash to Sub

The news on MBIA reveals a bit of revisionist reporting.

The Armonk based bond insurer posted a first quarter loss of $2.4 billion. The Financial Times says that that red ink was twice what analysts expected; the initial story at Bloomberg (hat tip Andrew Clavell) apparently made similar comments.

But the stock is up, and what does the Bloomberg headline now say? "MBIA Rises After Loss Is Narrower Than Some Estimates." That piece now conforms to the new reality;

MBIA Inc., the ailing bond insurer, rose in New York Stock Exchange trading after saying it will pump $900 million into its insurance unit and reporting a first-quarter loss that was narrower than some analysts' estimates.

MBIA, whose market value has slumped 87 percent in the past year, gained as much as 9.8 percent as the company reported a net loss of $2.4 billion and an operating loss of $3.01 a share. Bank of America analyst Tamara Kravec yesterday revised her estimate to a loss of $5.02 a share, from 99 cents.....

``Anything less than catastrophic is deemed to be good in this market,'' Greg Peters, director of credit strategy at Morgan Stanley in New York said in an interview.

Further reporting from the Financial Times:

MBIA, the world’s largest bond insurer, on Monday reported a $2.4bn loss for the first quarter as it took billions of dollars of writedowns on derivatives contracts amid ongoing credit market deterioration.

The loss was more than twice analysts’ estimates, equating to $13.03 a share for the quarter, compared with profits of $198.6m, or $1.46 a share, for the first quarter of 2007.

MBIA was forced to reduce the value of securities it has insured through derivatives trades by $3.6bn in the first quarter as credit markets tumbled. Unlike traditional insurance on corporate or municipal bonds, the value of derivatives contracts called credit default swaps must be priced at the end of each quarter at current market value.

However, while MBIA acknowledged that the mark-to-market adjustment was “attention-getting”, it did not believe the writedown was representative of actual losses on the insured securities.

Bottom Testing in Mortgage Land

The Financial Times has a long analysis, "Value to Unlock," on how various financial players are starting to pick and choose among distressed mortgage assets. This may prove to be premature (recall how Wall Street firms eagerly bought subprime brokers through January 2007) and the housing market itself appears unlikely to hit its floor before 2010, but even at this stage, there may be pockets that are so cheap that the downside is (or appears) modest.

Note this seems to be a theme du jour: Calculated Risk also saw signs of buying in some distressed markets, and too is cautious about reaching conclusions.

The set up is that the Mortgage Bankers Association, a sober and sparsely attended affair this year, is galvanized by the report that a BlackRock fund will buy $15 billion of UBS's subprime debt for 75% of face (UBS is a minority investor in the fund; query whether there was more than meets the eye here).

The piece comments on various players buying servicers allegedly to gain expertise. Maybe I am talking to the wrong people, and Tanta et al will correct me, but my sources tell me servicers are factories, and don't have skills that are relevant to evaluating mortgage pools. Remember, the credit decision was made long before the securitized mortgage got in the hands of the servicer (and in the recent environment, calling them "credit decisions" is generous. More accurate might be "handing out cash to anyone who had a pulse and could fill out a form"). I'm a little perplexed that this factoid, while narrowly accurate, keeps being bandied about uncritically.

From the Financial Times:

Policymakers, bankers and investors all want more buyers like BlackRock to emerge for mortgage securities and other risky assets, to provide a tipping point that ends the credit crisis. Yet thus far there has been only patchy evidence that this healing wave of purchases is under way.

Certainly, the market for corporate debt has shown some positive signs. The $23bn buy-out of Wrigley by Mars, agreed two weeks ago, involved more than $10bn of debt - although less than $6bn of that debt came from investors, with the rest provided by Warren Buffet's Berkshire Hathaway.

The debt capital markets, which last year made possible deals that were twice that size, still have a long way to go before they recover fully.....Banks are so desperate to rid their balance sheets of these loans that they are offering their best clients sizeable discounts and lots of leverage to sweeten the sales....

Investor fear of buying distressed assets too soon and catching the "falling knife" is even more intense in the mortgage market, where premature buyers have been badly burnt by plummeting asset prices...

Nevertheless, BlackRock's deal with UBS represents one of the more significant examples of a small but growing number of contrarian bets on distressed mortgage assets by opportunistic buyers. Goldman Sachs, TPG and other investment banks, private equity firms and hedge funds have also started looking to buy portfolios of mortgages - in some cases reversing bearish bets made last year.

Indeed, in the past 10 months more than 80 funds have begun raising money to buy bad mortgage debt on the cheap, including Marathon Asset Management, GSC Group, Pimco and Fortress Investment Group. Goldman is trying to deploy around $4.5bn to invest in mortgage assets...

Placing values on distressed mortgage assets remain an enormous problem for both buyers and sellers, in part because it is hard to predict the full extent of the continuing slide in US home prices and the accompanying level of mortgage defaults and foreclosures.

Part of the difficulty is that faith has been lost in the measures of probable losses on which lenders used to rely, such as credit ratings and historical data. For pools of subprime mortgages, guides such as loan-to-value ratios, used to compare the size of a loan against the value of the property on which it is secured, have proved unreliable.

Mark Fleming, director of economics at First American CoreLogic, a research provider, says that while reported loan-to-value ratios for many subprime mortgage pools had been around 100 per cent, the existence of unreported "piggyback" loans meant that in some instances the ratio could be as high as 160 per cent.

"The problem is that while market-based pricing is not necessarily commensurate with the true risk, it's still hard to measure the mismatch between pricing models, rational pricing opinions and prices driven by fear," says Mr Fleming.

The valuation problem is worse for more complex instruments, for which there are still no buyers, particularly if these fall under fair-value accounting rules that require securities to be "marked to market" - priced on the books at no more than what is achievable. Susanna Kondraki, vice-president at Risk Span, an advisory firm, says one client spent $250,000 on valuation services for a $1bn portfolio of collateralised debt obligations backed by mortgages, only to discover that the portfolio had to be valued at zero.

James Fratangelo, head of whole loans sales and acquisition at Bayview Financial, says snags like this are why many parts of the mortgage market are yet to establish clearing prices. "There is plenty of liquidity for distressed assets but there is still a huge gap between where buyers want to buy and where sellers want to sell," he adds - with the gulf between bids and offers remaining as wide as 20 cents on the dollar for many assets.

Robert Gaither, head of the secondary marketing group for mortgage securities at Bank of America, illustrated this problem at last week's conference. He described receiving bids for a portfolio of so-called "Alt-A" mortgages, between prime and subprime, that the bank had marked down to 91 cents on the dollar. After a series of bids from prospective buyers at 50 cents, he finally received one at 86.5 cents. Yet the bank's pricing model said the mortgages should be priced in the mid-90s.

The bank decided to hold on to the portfolio, even though it was forced by mark-to-market accounting rules to write down the mortgages to match that 86.5 cent bid.

Many European banks are also refusing to sell at prices that they consider to be artificially depressed....

She says European banks' belief that such asset prices have fallen too far has been bolstered by a recent Bank of England report suggesting that triple-A tranches in particular were mispriced......

Still, there are signs - including UBS's sale of loans to BlackRock - that some higher quality assets are beginning to move...Traders say the scale of buying generally remains small, however. In the European markets, buyers are placing orders of just €20m (£16m, $31m), far below the €500m orders that were normal before the crisis broke.

Many funds say they remain constrained in the volume of deals they can do by the sheer difficulty of raising finance. Others fear this means there is too little capacity to absorb the volume of distressed assets in the market.

"What worries some people is that you have seen a few people fill up but it's not clear whether there will be more buyers after that - it could just be one or two groups that are ready to buy," says one London-based hedge fund official. "The market is so thin and prices are so volatile that if they stop buying, we could go back down again."....

One of the biggest problems facing prospective buyers of distressed mortgage assets is that US house prices continue to fall and the flood of late mortgage payments and foreclosures shows few signs of abating. Unless the rising tide of losses in the housing market can be stemmed, establishing a floor under asset values may be difficult, writes Saskia Scholtes.

Mark Kiesel, a portfolio manager at Pimco, the big US bond investor, says: "We may need housing prices to bottom for this entire process to trough and for most markets to rebound."

Downtown LA Package for Sale at 35 Cent on the Dollar

Bloomberg reports that the company that is the biggest property owner in downtown LA, with concentrated holdngs in the Little Tokyo section of Los Angeles is trading at a deep discount to book value minus borrowings. The reason? The company may not be able to refinance debt coming due.

Now one may legitimately take book value with a handful of salt, and my dim recollection of LA is that Little Tokyo is adjacent to rather than in the business district. Another factor is that this stock probably trades by appointment: market cap of $142 million, with 45% held by the CEO. Nevertheless, this is yet another manifestation of the credit crunch.

From Bloomberg:

A package of Los Angeles real estate on sale for 35 cents on the dollar is attracting investors to the depressed shares of Meruelo Maddux Properties Inc., the biggest private landowner in the city's four-square-mile downtown.

The stock has plummeted 85 percent since an initial public offering 15 months ago as the global credit crisis threatens to disrupt refinancing of $200 million in mortgage debt coming due in the next 12 months, as well as completion of the city's tallest downtown residential tower.

Meruelo Maddux owns or controls 80 acres including the Little Tokyo Shopping Center, home of the country's largest Japanese supermarket, as well as warehouses and buildings used in Tom Cruise's action film ``Mission Impossible III.''

``It sure looks like a cheap way to play the downtown L.A. market,'' said Mike McGarr, a portfolio manager at $2.4 billion Becker Capital Management in Portland, Oregon, which has added shares this year and owns 1.55 million. ``You're not hanging your hat on a few properties. You've got about 50 properties in various states of development or redevelopment.''....

Loan payments and maintenance consume $500,000 a month more than the company takes in, eroding the developer's $13.5 million in cash.

Brady Bonds Redux as Credit Crisis Remedy?

At VoxEU, Luigi Spaventa makes a forceful case that the remedies to the credit crisis are provisional at best and more work needs to be done:

The global financial system may be caught in a downward spiral as market and funding illiquidity reinforce each other...

Prolonged financial distress, which has now lasted for almost a year, is debilitating the financial system and risking a full-fledged crisis. Central bank interventions have thus far prevented worst-case outcomes, but they have alleviated symptoms rather than the underlying causes. Financial intermediaries are still in the process of shrinking their balance sheets, thus activating a channel of transmission of financial distress to the real economy...

The immediate problem is a spiral of forced deleveraging and illiquidity, as the link between market and funding illiquidity strains balance sheets. Proposed remedies are either insufficient or unsatisfactory...

The immediate problem is the disorderly reaction to the unprecedented growth of the financial system’s leverage and its exposure to risk. As demand for asset-backed securities has disappeared, prices have collapsed without finding a floor. Banks are reporting losses that strain their capital positions. The loss of market liquidity affecting all classes of debt securities directly or indirectly owned by intermediaries has translated into a sharp decline of funding liquidity, the more so because short-term debt issued on wholesale markets has become a major component of banks’ funding. The forced adjustment of banks' balance sheets could, in the worst case, result in a credit crunch with painful consequences on the real economy.

Can we break the link between the illiquidity of banks’ securitised assets, which prevents their orderly liquidation, and the shortage of funding liquidity, which is the driving force of the negative feedback originating from the process of deleveraging?
For funding liquidity, emergency liquidity support from central banks has helped lower the temperature in the worst moments, but it is not a long-term solution....Capital increases are also insufficient to break the spiral, as injections of capital may prove inadequate only a few weeks after their announcement.

For market liquidity, suggested remedies are equally inadequate. Mandated full disclosure of losses might reduce uncertainty, but unless market liquidity is instantly restored, full disclosure of the situation at time t offers no guarantee that it will be the same at time t+1. Similarly, retreating from marking financial products to market or model during this time of crisis would face a number of difficulties.

The feedback between market and funding liquidity problems demands more radical pre-emptive solutions. As long as “there is no immediate prospect that markets in mortgage-backed securities will operate normally”, “the situation will improve only if the overhang of illiquid assets on the banks’ balance sheets is dealt with” (Bank of England 2008). In creating its Special Liquidity Scheme, the Bank of England has moved to serve as the “market maker of last resort.”

The scheme allows banks and building societies to swap some of their illiquid assets, including debt securities rated no less than triple A, for specially issued Treasury Bills for up to three years. Eligible securities will be valued at market prices, if available, or, if not, at a price calculated by the Bank, with haircuts for private debt securities. Changes in market prices or in valuations will require re-margining. The credit risk will remain with the banks, so that there will be a loss for the lender only if the borrower defaults and the value of the collateral falls below that of the bills originally acquired in the operation.

Is the initiative bold enough? The scheme does not set a floor for assets’ market prices and uses market prices to value collateral, despite the fact that during a negative bubble they do not reflect fundamentals. Downward instability may moreover occur if haircut discounted collateral values trigger a convergence process for market prices requiring repeated re-margining.

In CEPR Policy Insight 22, I recommend the creation of a publicly sponsored entity that could issue guaranteed bonds to banks in exchange for illiquid assets, drawing on US Treasury Secretary Nicholas Brady’s solution to the Latin American sovereign debt crisis in 1989. This new entity, preferably multilateral, would value assets based on discounted cash flows and default probabilities rather than crisis-condition market prices.

As a firm floor is set to valuation and illiquid assets otherwise running to waste are replaced by eminently liquid Brady-style bonds, funding difficulties and, at the same time, the market liquidity problems besetting the banks’ balance sheets would be removed. Shielding the banks’ assets from the vagaries of disorderly markets is a necessary condition to dispel the uncertainty that prevents a proper working of credit markets.

I'm curious to get reader reactions, but I suspect that this model breaks down under further examination. First, a fair bit of paper that banks hold is sufficiently arcane that valuing it for the purposes of going into this entity is problematic. How do you value a CDO (I'm not suggesting they can't be valued, but I suspect that valuation ranges using reasonable assumptions would be very wide). Does this mean going back to the repudiated credit models of the rating agencies?

And even if you exclude the more complex structures, coming up with a cash-flow-based value when there is still a high deal of uncertainty in the trajectory of the housing market (particularly in markets like Florida with massive inventory) involves a great deal of artwork. Moreover, the sovereign loans that were restructured in the early 1980s were pretty homogeneous, as far as terms were concerned. The mortgage assets are far more diverse, and the underlying collateral is very heterogeneous, which makes for a difficult valuation process.

As I understand it, the original Brady bond process arrived at structure and pricing via negotiation, not via one side putting out an offer based on its valuation (which seems to be the process here) and seeing who shows up to submit colllateral is asking for adverse selection: you'll get offered paper when you are offering too much.

Nevertheless, this is an interesting idea, and if there was a better finesse for the valuation issue, this could be a useful remedy.

So Why Did MBIA Raise $1.1 Billion? To Pay Executives, Apparently

MBIA has brazenly advanced its own interests at the expense of investors and policyholders. A partial list:

Issuing a disappointing earnings release in the middle of the night in the hopes that it would garner less attention that way

Asserting it needed no more capital while the Dinallo-led "save the monolines" effort was still underway. CEO Gary Dunton's claim was so patently bogus that it stirred the normally circumspect S&P to issue a swift rebuke

Telling the one major rating agency that has the guts to give the bond insurer the less-than-AAA it deserves to take a hike (fortunately, Fitch is ignoring that directive)

Admittedly, some of these unsavory actions took place on ousted CEO Gary Dunton's watch; we now have Jay Brown in charge. However, old habits die hard.

The latest stunner is that the money raised in MBIA's last, hugely dilutive equity sale is being held at the parent company. For those who have not followed the monoline saga, that's scandalous.

The whole purpose of the fundraising was for the parent to then downstream the proceeds to the insurance subsidiaries. That's where the insurance is written, that's where the capital shortfall is.

So why is MBIA hoarding cash at the parent level? Well, executives (along with other corporate charges) are paid out of the parent company's books. The subsidiaries can dividend cash up only if the are profitable OR get permission from their regulator.

The big bond guarantors have been notably loss-making of late. Eric Dinallo says that both MBIA and Ambac may need to raise more capital. The monolines' business model is toast. The structured finance business involves bona-fide risk transfer, and the bond guarantors' capital bases (equity is less than 1% of assets) is far too thin to allow for that, particularly when an AAA rating is essential for conducting business; the nearly risk free ratings arbitrage in the muni finance business is going the way of the dodo bird (and with local government budgets under stress, even that old supposedly cosmetic credit enhancement may wind up leading to some unanticipated losses).

So how does the hoarding of cash fit into this picture? Well, Bill Ackman, the hedge fund manager who was leading the campaign against the monolines, argued that they should be put in runoff mode, with the investors at the parent level sacrificed to preserve the claims-paying ability of the subs. That's a course of action the regulators would almost certainly arrive at on their own if they thought the bond insurers were in peril.

So what does the holding of so much cash at the parent level mean? Aside from being a shameless case of duplicity, it says one of two things, neither pretty. First, they expect losses for the foreseeable future, and expect the regulators to prohibit dividend payments too. But withholding the entire $1.1 billion is an admission of how bad they expect things to get. Or second, they expect the regulators to put MBIA into runoff mode, and are keeping their cash to support the parent level empire that would otherwise be starved out of existence. But if so, the representations made by management about the soundness of the company are false.

No matter how you slice it, the sequestering of funds is wildly inconsistent with management's position that MBIA has a good future, or indeed any future at all.

From Bloomberg:

MBIA Inc. has yet to pass on $1.1 billion of capital to its insurance subsidiary, three months after raising the money to defend the unit's AAA credit rating.

The cash, raised in a February stock sale, is being held at the parent company while Armonk, New York-based MBIA develops a plan for the company's legal and operating structure, MBIA Chief Executive Officer Jay Brown said in a letter to shareholders released yesterday.

``Given the more than adequate liquidity in both our insurance and asset management businesses, there is no compelling reason to move this cash at this point,'' Brown said.

MBIA was criticized by Fitch Ratings, which said on April 4 the decision raised the risk that the cash may not end up as capital for the insurance unit as MBIA had promised. While Fitch downgraded MBIA to AA from AAA, Moody's Investors Service and Standard & Poor's cited the capital raising as a reason for keeping the insurance unit at AAA.

Regulators are waiting for MBIA to contribute the funds, according to New York State Insurance Department Deputy Superintendent for Property and Capital Markets Michael Moriarty.

``It was never our expectation that the funds raised would go anywhere other than to the insurance subsidiary,'' Moriarty said. MBIA spokesman Jim McCarthy declined to comment.....

``S&P and Moody's are being a bit disingenuous by affirming the AAA on the insurance company based on their ability to raise capital, even though the capital isn't there,'' said Joshua Rosner, managing director at New York-based research firm Graham Fisher & Co. ``The rating seems unjustifiable.''

MBIA said in a February statement that it would ``contribute most of the proceeds of the offering to the surplus of its subsidiary, MBIA Insurance Corporation, to support its business plan.''

Moody's assigned a negative outlook to MBIA's rating in part because the money wasn't transferred to the insurance unit, Stanislas Rouyer, an analyst in Moody's financial guarantor group, said in an e-mailed statement.

``The proceeds from the capital raise remaining at the holding company is one of the factors considered in our negative outlook,'' Rouyer said.

Fitch, a unit of Paris-based Fimalac, said MBIA's insurance unit needs $3.8 billion, in addition to capital already raised, to warrant a AAA. MBIA in March asked Fitch to stop rating its debt because of disagreements over the model Fitch uses to estimate losses. Fitch relies on other ratings companies for data and its analysis is limited, MBIA said.

``Since a significant portion of the capital that was recently raised by MBIA Inc. still resides at the holding company level, the insurance company's capital position could become pressured in the future by possible liquidity demands at the holding company,'' Fitch analyst Thomas Abruzzo said in a report.

Note that S&P, unlike Fitch ad Moody's, is not upset that the cash has not been downstreamed.

Is "The Credit Crunch is Over" Talk Premature?

Even though there has been a lot of whistling-in-the-dark talk that the credit crisis is past, the evidence is far from conclusive. On the one hand, BlackRock bought $15 billion of subprime debt at a mere 25% discount to face. In March, UBS was rumored to have sold $24 billion of Alt-A for 70 cents on the dollar. Has the market really gotten that much better or were sexual favors exchanged?

I had dinner last night with a very senior Japanese buddy fresh off the plane from Tokyo. He mentioned in passing several Japanese banks' writedowns of subprime paper, and in all cases, they marked it down to ten cents on the dollar. That isn't to say the Japanese are right, merely that different institutions have very different views of what conservative pricing amounts to. But the seeming consistency says regulators pushed for deep haircuts.

The issue is that the credit crisis being behind us is not the same as the credit crunch being over (and note I am not convinced we won't have a resumption of worries about systemic risk, given the possibility of an eventual GSE bailout, a CDS meltodown, and a downgrade of MBIA and/or Ambac, any of which would create turmoil). In the do-com bust, the economic recovery preceded an improvement in credit spreads by nearly a year. And unlike the last downturn, this time credit officers have been badly burned, and they tend to remain overly cautious long after the worst is past.

The fear factor is alive and well, and keeping bank lending in the US at bay, as reported in the Financial Times:

US banks tightened lending standards in the early months of this year in near-record numbers, a Federal Reserve report indicated on Monday, suggesting that the credit squeeze in the economy continued to intensify.

The senior loan officers’ survey reported that the fraction of banks tightening lending standards was “close to or above historical highs for nearly all loan categories” – including corporate loans, commercial real estate, mortgages, credit cards and other consumer loans....