Sunday, September 28, 2008

$700 Billion Don't Buy What it Used to. Part I.

This will probably be my most ambitious post. In what could be termed the greatest triumph of mediocrity, I'm going to try and explain the mechanisms by which we find ourselves in this current economic state of affairs with Uncle Sam pumping $700 Billion into the economy and explain how the plan (TARP, Troubled Asset Relief Program) will work. My analysis will be, at best, imperfect in predicting its long term impact (and anyone else who professes to know anything should probably confess the same) on the U.S. and global economies, and, at the very worst, a disturbing reminder of the agony of a mediocre mind. This is part I.

First, A Quick Review of the Mortgage Mess

I'll refer everyone to my prior two posts, found below, on the "credit crunch" and birth of the mortgage back security. As a quick reminder, subprime mortgages were packaged into portfolios of Prime and Alt-A (between prime and subprime) mortgages and inappropriately rated 'AAA'. These portfolios were sold to other financial institutions (both public and private). Since there was no historical mechanism by which to price these assets (I'm referring here to the "securitized", or packaged product, obviously not mortgages themselves) it should come as no surprise that they were mis-priced. Now, hold that thought. Here, one needs to understand a basic accounting principle called mark-to-market.

What is all this Mark-to-Market and Fair Market Value jazz?

GAAP (Generally Accepted Accounting Principles) requires that assets (including portfolios of mortgages) should be reviewed (usually quarterly, or earlier if necessary) and priced at Fair Market Value. FMV requires you to 'mark' the asset as if you had to sell it in the market today, so you 'mark' your asset according to the 'market' price (mark-to-market). This is all in the name of greater transparency for the shareholder so that any quarterly statement accurately reflects the economic viability of that institution at that point in time. So we have hundreds of financial institutions that are having to mark-to-market their portfolios of troubled mortgages. Okay, let me address the "market" and why I don't think it's efficient (meaning, it can not be relied on to deliver accurate pricing).

Efficient Market Theory

Efficient Market Theory was the product of Harry Markowitz in 1952 and is widely held today as the paradigm explaining market prices. I've already written about EMT as well in a previous post on investing, but I will revisit it here.

Basically, EMT claims that markets are able to correctly price any asset at any point in time. In other words, markets are completely 'rational.' When news regarding a certain company or event is 'known' the market automatically correctly, and 'efficiently', prices the news. However, this assumption has been tested. In fact, a theorem coming out of Stanford asserts that technical fundamentals, based on EMT, only account for about 20% of stock price volatility. Investors as a whole are simply incorrect in their assumptions of future events. This is the classic difference between "Experience" and "Exposure." Where experience looks to the past, exposure considers the likelihood, and risk, of an event that history may not reveal. I think most investors are currently wrong about 1) their ability to forecast future events and 2) their ability to correctly price the news. And those are two fundamental assumptions one needs if EMT is to hold true.

Is There Any Pride in Being the Last Lemming off the Cliff? The Wisdom of Crowds.

What we're seeing is a fundamental shift in belief-structures. Mordecai Kurz's theorem on belief structures indicates that the other 80% of stock price volatility is the result of shifting belief structures. Again, this is a theorem, not an opinion. Belief Structures represent the proportion of all investors at a given point in time that hold below average/above average expectations of returns. Logically, a constant, or diminishing rate of good or bad news, can create a growing proportion of optimists or pessimists. EMT holds true, most of the time, in a heterogeneous population. However, when heterogeneity (or diversity) is lost, markets perform poorly as herding sets in and immitation becomes a substitute for reason. I think this accurately describes today's environment. Belief Structures work independant of fundamentals. Many economists think that, based on fundamentals, we should only see a 30% drop in these mortgage backed securities and we've seen 80% decreases. As I mentioned in my previous post, the presence of severe uncertainty exacerbates the problem. For nobody knows how high-is-high or how low-is-low. Last year, Alan Greenspan stood up at a conference, and, holding a mortgage back security, waved it around and said, 'Can anybody tell me what this thing is worth?" Note, this was after the news about subprime mortgages hit the fan. This alone should severely question anyone's allegience to EMT and rational markets.

Back to Fair Market Value

So I ask, "Why are companies forced to price their securities according to market prices when the market is probably not accurate?" It's this inaccuracy that is creating the balance of the economic crisis. Follow the logic below:

Institution 'A' must write value of security down (based on markets pessimistic belief structure and mass uncertainty) - Institution becomes insolvent (more liabilities than assets as a result of the new asset "price") - Institution must sell asset quickly or risk bankrupcy - Institution sells assets at fire sale price (thus setting the new "market price") - Institution B must write down value of security based on 'A's' price - Cycle Repeated

What results is a self perpetuating downward spiral that can only be stopped by external influences (unless you allow for widespread systematic failure).

The Fed's Bailout

Is it a good idea or not? Time will tell. But I have to strongly disagree with the position of many politicians and friends who assume that Wall Street gets all the upside while the tax-payer is stuck with the bill. This opinion incorrectly assumes Wall Street and Main Street operate on separate planes, which couldn't be further from the truth. Anyone who has ever received a business loan, or a mortgage, or purchased stocks, mutual funds, or ETF's illustrates that Wall Street and Main Street are unseperable. At the same time, there are bad actors on both sides. We should not only be pointing fingers at Wall Street. Clearly, there were nefarious actors who made a ton of money and disreputable credit agencies that acted out of greed. But, at the same time, there were thousands of consumers who lied on mortgage applications (granted, some were tricked) and that bought more house than they knew they could afford. I think blame should go both ways and that politicians should quit pandering to us like we're Harry Potter's fat spoiled cousin Dudley Dursley (although that may not be too far from the truth).

Anyway, if you would like to read the entire 110pg bill that's being debated this week, you can do so by clicking here:

I would simply like to make a few points about the proposed plan.

1) The Fed will be buying direct mortgages and mortgage portfolios from institutions requesting aid.

2) It's a "principles" based bill as opposed to "rules" based. In other words, Hank Paulson's mandate is to act in a manner that is in the best interest of the country and the tax-payer, maximizing profits and reducing costs. Granted, there are plenty of rules, but Paulson's authority is fairly broad in the bill.

3) Executive aren't making out like bandits. First, all the executives are getting canned, and, according to the bill, if any institution wishes to participate in the $700 billion, the executive must reimburse the company any bonus received which is deemed to have been previously paid for inappropriate self-enrichment. Also, they are doing away with any 'golden' parachutes. And no investor that watched their stock go from $70/share to .20 cents/share is going to think they are getting bailed out. And what about tax-payers? I think we already made our money. Most of us wouldn't be in our houses if not for Wall Street's innovation. Not to mention Real GDP grew to almost 4% (historical average of 3.5%) which translates in to trillions of dollars that came to most of us in the form of rental homes, new tools, xbox 360's, cars, and flat screen T.V.'s.

4) The Fed is buying these mortgages using Net Present Value. Essentially that is above market price (putting the cab-bosh on the downward spiral) but below what the company paid for them. They will buy most of the mortgages in a reverse auction, where banks basically compete for the Fed (lowest price wins). The fed will then service the loans and cut deals with individual borrowers by extending terms, reducing principle amounts, or deferring payments.

5) Some of the money will come back. The Government isn't going to simply spend the money. As I stated above, many, if not the majority, of the mortgages will get worked out and the Fed will make money (For example, your loan is for 100k, the Fed buys it from XYZ corp for 10k, turn around and cut a deal with you, the borrower, for 70k). Win-Win-Win. And the Fed is able to take equity (but non voting) stakes in a company that is a participant in the program, thus giving the tax-payer potential upside.

6) The language is interesting on the total amount borrowed. The program allows for more than $700 billion. It simply says the Fed cannot have more than $700 billion outstanding at any one time. In other words, it will function like a line of credit in that they could have $300 billion, sell it, buy $400 billion, sell it, buy $250 billion, sell it, buy $400 billion, etc. etc.

Although I support the plan, the touted ramifications should Congress not act sounds eerily like George Bush's threats of Armageddon should we not invade Iraq. Anyway, that's it for now. I'm going to follow up in a couple of days after I get some sleep and do more research.

Friday, September 19, 2008

Useful Sites

You'll notice to the right that I posted some of the financial websites I check on a regular basis. I clearly did not list all of them, but most of the ones I thought were helpful. In addition to the ones posted, I would also like to recommend reading commentaries and whitepapers posted on the sites of the various Federal Reserve Banks across the country. I didn't list their links because there are 12 of them, but you can get to them from here:

You'll also notice underneath the "Useful Websites" list that I have a short list of "Interesting" websites. These sites are owned by prominent venture firms (the same ones that started Google, Yahoo, Amazon, eBay, Apple, 3Com, etc.). There's no shared theme, other than they are all owned by venture capitalists and could be the next big thing.

You can also click on the map to the right for local news on any country in the world.

Wednesday, September 17, 2008

Indeed, the other shoe has dropped

The current environment demands and explanation. So let me first reiterate the impact of uncertainty and then share one perspective on the recent news of Merrill, Lehman, and AIG.

"Uncertainty" is different than "Risk." In risk, the underlying probabilities of a certain event are known, as well as the effects (i.e. you are able to quantify the payoff) those events will have. Thus, roulette is a game of risk (all probabilities and payoffs are known). War is an uncertainty, in that the effects of the same can't be accurately quantified. As I stated in a previous post, when you are unable to quantify the problem, the more likely you are to follow the herd. And the herd will demonstrate a tremendous amount of overshoot (up, if the news is good, down, if the news is bad). And the less one is able to identify the "high" and the "low," the less likely the trend will end anytime soon. The presence of magnificent leverage, or debt, exposes both institutions AND individuals to extraordinary financial risk amidst uncertainty. So I think we're in for a long ride. Unfortunately, the overshoot and uncertainty is so great, and the leverage all too common, that it has produced multiple victims (seen in high profile bankruptcies on the corporate side, and massive foreclosures on the consumer side).

Now, on to the hemorrhaging on Wall St. Merrill was sold to Bank of America (not a big deal, although alarming), Lehman declared bankruptcy and will sell off various divisions, and AIG was bailed out by the government. I don't think I will address the actual remedies of Merrill Lynch, Lehman Brothers, and AIG. Those have been treated in great detail by others more qualified than me. Perhaps the question you may be asking is, "Why was one sold, one bailed out, and one not? And what does that say about our financial system?"

Merrill Lynch was wise and found a potential buyer before things got really ugly. They realized they were going to run out of money. But unlike many of their competitors that kept the news quiet until the last moments, Merrill's CEO was forthright and honest about the current state (probably because he was only hired in November and is still in the honeymoon stage with the Board). In the words of beloved JPMorgan CEO Jamie Dimon, "It's one thing to buy a house (referring to BoA's acquisition of Merrill), it's an entirely different matter to buy a house on fire." Merrill bailed while the flames were beginning to torch the grass but have not yet reached the home.

Before discussing AIG and Lehman, let me interject here that I've been pleased with the coordination between Bernake's Fed and Paulson's Treasury (the Fed is responsible for monetary policy while the Treasury is responsible for fiscal policy, or, how the government spends money). They've both approached this disaster with very innovative ideas, which I think are in the best long term interest of the U.S. economy. The biggest problem most people have, rather, what I hear people complain about most frequently is the doctrine that government should not undertake bailouts because it creates a type of "moral hazard." Although the government is stepping in to help AIG, average taxpayers face a higher standard of living over the long run from utilizing a taxpayer-funded "bailout" to re-establish growth than they do by permitting a collapse of the global financial system. Furthermore, management and shareholders often pay a heavy price under such circumstances (which is not the case in other countries where governments have stepped in and protected shareholders).

So why save AIG and not Lehman (who filed for chapter 11)? Although Lehman is huge, AIG is the hub of a spoke and wheel network whose wheel is the global economy. Their integrity must be protected. One economist we work with said, "what we are seeing is a certain level of experimentation and sampling. The financial system has never really been stress-tested and is evolving." No one really knows how it will end up. That makes it difficult to say "bailouts" are either good or bad. Apparently, the risks of testing the system by letting a huge global giant like AIG go bankrupt are too high to assume until we have experimented with smaller companies, like Lehman. I believe we are seeing a testing-while-protecting strategy from the Treasury and the Fed, and, I think on the balance, they are doing a good job.

Again I'll end with an ominous prediction. Whose next? Wall Street seems to think Morgan Stanley and Goldman Sachs are next (based on credit default spreads, which gauge risk). I would not be surprised to see a partnership between the two. I would be surprised, if twelve months from now, those two organizations still stand independant.