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September 20, 2007
Foreclosure at Default or Why Ratings Are Not the Problem
Below is the latest issue of The Institutional Risk Analyst, which we wrote in preparation for tonight's meeting of the New York Chapter of Professional Risk Managers International Association. The event is entitled "The Subprime Crisis: Scofflaws & Scapegoats."
Foreclosure at Default or Why Ratings Are Not the Problem
The Institutional Risk Analyst
September 17, 2007
"When capital is devalued such that returns do not take into account risk, it becomes a commodity, rather than a prized possession. When capital becomes a commodity, it is burnt."
Michael Dawson
FT, Letters, 9/06/07
When we saw that Rep. Paul E. Kanjorski (D-PA), Chairman of the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, announced a September 27, 2007 hearing on the role of credit rating agencies in the structured finance market, we could not help but reflect that the rating agencies are getting too much credit for the subprime fiasco. Like the Sell Side dealers who create new assets, the ratings agencies were simply following their issuer clients into the structured asset swamp.
To us, the real moved-mover of the subprime debacle is former Federal Reserve Board Chairman Alan Greenspan, who last week took chutzpah to new levels by predicting a double-digit decline in US housing prices. The easy-money policies of Greenspan-led FOMC in the early part of the decade certainly fueled the mortgage bubble, but more important in structural terms was the advocacy by the Federal Reserve Board of OTC derivatives dealing by the major US banks.
During Greenspan's two decade tenure in Washington, OTC derivatives went from a novelty to the largest portion of earnings for some of the largest US banks. Just look at the fact that the new Basel II accord is almost entirely dependent upon VaR models and you'll understand the pro-derivative mindset of the academic economists who dominate the Fed's internal workings.
Without the wonders of structured finance, there would have been no "demand pull" surge for mortgage paper starting in the 2003 period, when Buy Side investors began to clamor -- no, scream -- for higher risk adjusted returns. The easy money policy by the Greenspan-led FOMC is the obvious explanation for the subprime bubble, but was it not the fact of regulatory support for structured finance by the Fed, OCC et al. which allowed the Sell Side banks to respond to this demand with products like collateralized debt obligations or CDOs?
There is nothing you can do to "fix" a CDO, to make it liquid, other than to standardize the terms and trade it on an exchange. The liquidity gridlock prevailing in the secondary market for CDOs is the normal situation for such unique and entirely opaque instruments, whereas the past illusion of liquidity was abnormal, a byproduct of the "irrational exuberance" described by Greenspan himself. Buy Side investors accepted the fallacy of liquidity -- until they asked the Sell Side dealers to bid on the paper. That's when the current trouble really began.
From a bank analytics perspective, the net effect of the Greenspan years was to first hand the US banking industry an extraordinary earnings windfall in the mortgage boom, but then leave that same industry trapped between shrinking net interest margins and rapidly rising credit default rates -- more rapidly than during any previous credit contraction since the Great Depression.
As a number of observers have noted in recent weeks, the increase in non-performing loans in US banks is growing at a rate far higher than in previous credit adjustments, this even though current default rates remain low. Some analysts -- and we agree with them -- worry that the adjustment in bank asset quality over the next couple of quarters will be so rapid that banks will sustain significant reductions in Tier One capital, putting the US economy into a tailspin.
"This time it may be different," writes Robert Matthews in the FT (Letters, 09/13/07) regarding impact of CDOs and the like on bank earnings and capital levels. "If the clearers' accounting rules force them to mark to market their 'off-balance sheet' mistakes immediately as third-party investors bail out and force the value of these vehicles lower, much of the worldwide surplus Tier 1 could be wiped out. Composite Tier 1 is 'super money'. If it drops below the 4-5 per cent set minimum, all expansion in credit, worldwide, must come to an end."
Consider that JPMorgan Chase (NYSE:JPM) had 6.18% Tier One capital at the end of June 2007 vs. 7.63% for the 68 other banks in the peer group defined by the Fed. That is not very much capital compared to the huge banking and trading book risks that JPM and other large institutions face. In the first six months of 2007, JPM's credit losses of 94bp were covered by earnings just 8.5x vs 24x for the peer group.
After you recall that the above measure of JPM's credit losses relates only to on-balance sheet risks, then factor in the point made by Matthews and others that, this time round, US banks may not be able to spread out losses over four or five years. The prospect of a surge in loan and securities losses raises the possibility of a sudden, systemic decline in bank capital below levels where credit expansion is possible.
Watching Chairman Greenspan comment on his handiwork in speeches and in his memoirs, and rake in the six-digit speaking fees all the while, we can't help but ponder the victims of the subprime debacles, especially outside Wall Street. Like the individual US home owner who was unlucky enough to get a subprime loan (which ended up inside some hideous CDO) and now faces foreclosure. Or the shareholders of UK mortgage bank Northern Rock, which was rescued by the Bank of England over the weekend and is likely to be sold. Or the investors in dozens of other mortgage companies which have failed in the past six months.
In suburban New York, the local Journal News reported on Saturday that court clerks in Westchester, Putnam and Rockland counties are seeing triple-digit increases in foreclosures compared with a year ago. One locksmith we know, call him Joe, had not performed a lock-out for a creditor in a foreclosure in almost four years through the end of Q1 2007, but since then has done almost two dozen such jobs.
Now you may ask, what's a lockout?
Well, when a home "owner" defaults on a mortgage loan and goes beyond 90-days in arrears on payments, the creditor files foreclosure papers with the local court and gives the debtor notice to vacate the premises. Sometimes, though, the debtor refuses to leave the home.
That's when the creditor gets the sheriff deputies, a moving company and Joe to meet at the home. The sheriffs enter the home and ask the debtor to leave. If the occupants still refuse to vacate, then the sheriffs handcuff the people and lead them out of the house. The moving company then empties the house, leaving the debtor's possessions in the street. And then Joe changes the locks on the house and secures the premises, while the sheriffs wait outside.
When Chairman Kanjorski convenes his subcommittee's hearings on the role of credit rating agencies in the structured finance market, we hope that someone on the panel or on the subcommittee will ask whether the proliferation of derivative assets such as CDOs, a phenomenon actively encouraged by the Federal Reserve Board, has not created the circumstances for a credit meltdown in the US financial system.
Whether the FOMC decides this week to drop interest rates or not is irrelevant if the wave of credit defaults looming ahead leaves US banks decapitalized come 2008. That's what is meant by the phrase, "pushing on a string."
Posted by whalenc at September 20, 2007 07:37 AM
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