How much is enough?
$5.9 Trillion of market cap has been evaporated by toxic
mortgage debt of between $150 and $300 billion that will ultimately need to be written off.
Seem like enough?
Here's an interesting chart. GS discounted as
deeply as the Homebuilders:
And as far as what the Fed has done....
here's an interesting piece by John Hussman:
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Hardly a Bailout
John P. Hussman, Ph.D.
All rights reserved and actively enforced.
Reprint Policy
The Federal Reserve did exactly what it was supposed to do on Friday.
As I've noted before, under most conditions, the Federal Reserve is irrelevant in the sense that (since the early 1990's when reserve requirements were removed on all but demand deposits) there is no longer a link between bank reserves and the volume of lending in the banking system. However, the Fed certainly has a role to play during bank runs and other crises where the demand for the monetary base soars.
That's exactly what the Fed did on Friday. Contrary to the apparent belief of investors, the Fed did not shift its policy, nor did it “bail out” the mortgage-backed securities market by “buying” them from banks.
What actually happened is that the Federal Funds rate shot to about 6% on Friday morning, and the FOMC brought it down to its target rate by entering into 3-day repurchase agreements . The banks sold securities to the Fed on Friday, and are obligated to buy them back from the Fed on Monday at the sale price, plus interest. Such open market operations are designed to ease the immediate demand for liquidity, and to give the banks and dealers more time to find buyers in the open market for the securities they are trying to liquidate.
This was not a major policy shift. Again, it was an effort to keep the Federal Funds rate at the current target of 5.25%, in the face of demand for base money that was pushing the Fed Funds rate to 6%.
These repurchase (RP) agreements fall into three increasingly broad “tranches:” 1) Treasury securities, then 2) federal agency debt, and finally 3) mortgage backed securities issued or fully guaranteed by federal agencies. “Today's RPs were of this type,” noted The Federal Reserve Bank of New York , which conducts the Fed's open market operations. So the Fed was not taking in the toxic, leveraged, exotic stuff.
Economist Steven Cecchetti concurs, “A quick look at the history of these temporary open market operations shows that they have been taking mortgage-backed securities as collateral for repo for some time. The quantities have normally been small (between $100 mil and $2 bil) but they have been doing it. So this is not what I would call an ‘intervention in the mortgage-backed securities market.' And it is not unusual.”
Now, the size of the operation ($38 billion) was unusual, as was the scale with which the Fed allowed dealers to submit mortgage-backed securities as collateral, rather than simply Treasury and agency securities. My impression is that in doing so, the Fed had no intent of “bailing out” the mortgage backed market, or of creating a huge “moral hazard” by absorbing losses for the irresponsible behavior of lenders. Rather, the Fed had to allow submission of mortgage-backed securities because that's what the banks actually own, and it's precisely the collateral for which the banks can't find a buyer.
Look at Treasury bill yields – they're dropping sharply again because investors are scrambling for default-free securities as a safe haven. Banks and dealers have no problem selling those puppies on the open market, so there's no reason to enter a Fed repo to do it. But banks have drawers full of the mortgage-backed stuff that they can't get rid of, so the Fed bought them more time by allowing them to post those securities as collateral for 3 days. Most likely, the Fed will have to do it again on Monday, but in any event, these are not securities that are going into the “investments” column of the Fed's balance sheet. They are simply collateral taken for short-term credit extended. The Fed does not assume a risk of loss unless the bank defaults on the repurchase agreement with the Fed (whether the mortgages underlying the collateral go belly up is of secondary importance, because it is relevant only if the bank is already in default, and at that point, believe me, we've got bigger problems).
A few interesting details – in the midst of Friday morning's panic, banks would have liked to have done more. At the 8:25 AM operation, $31 billion of securities were submitted by the banks for repo, and $19 billion were accepted by the Fed. At 10:55 AM, $41 billion were submitted, and just $16 billion were accepted. But by 1:50 PM, the scramble for funds had eased somewhat - $11 billion were submitted, and $3 billion were accepted.
Given that about $1.4 trillion of interest-only adjustable-rate mortgages were issued in 2005 and 2006, and hundreds of billions in sub-prime mortgages are already delinquent, a $38 billion repurchase operation by the Fed, where the securities posted as collateral have to be bought back by the banks unless the banks default, is hardly a “rescue operation.”
The Fed has an interest in stabilizing the banking system and the real economy. It has no interest in taking the private sector's loss for the irresponsible lending practices of recent years, nor in saving overly aggressive hedge funds from the losses on their leveraged bets. Again, the Fed did exactly what it was supposed to do on Friday. There will inevitably be enormous losses taken as a result of mortgage defaults – but don't assume it will be the Fed that takes them.
Hedge funds, basis risk, and dispersion
Given the intensified focus on hedge fund losses in recent days, it's important to understand what causes a “hedge fund blowup,” and what distinguishes various approaches.
I used to tell my students at the University of Michigan that there are three factors at work in most financial debacles.
1) Mismatch: The investment position typically involves either a position that relies on a market moving only in one direction, or it involves a combination of long and short positions where there is no natural “offsetting” relationship, or that relationship is purely statistical and susceptible to breaking down under market stress.
2) Leverage: It's hard to really blow yourself up unless you're doing it big, usually with borrowed money.
3) Lack of disclosure and transparency: Generally speaking, blowups are more likely in situations where there is no regular reporting of investment positions, or where very arcane and complex instruments are being used.
A few examples. When Long-Term Capital Management blew up, they had a huge book of long and short positions in international debt securities that were “statistically” related in terms of how they typically behaved. LTCM then took that position and leveraged it up 40-to-1. In other words, for every $1 of capital, they were controlling $40 of securities. Finally, their position (as is typically the case with hedge funds) was a black box, so the hedge fund investors were operating completely on the basis of returns information, with little idea of what was driving those returns. Unfortunately, the fine-tuned “correlation matrix” between their long and short positions blew up in a global debt crisis. At 40-to-1 leverage, it only takes a 2.5% movement between your long positions and your short positions to wipe out 100% of your equity.
When Nick Leeson took down Barings Bank of England , he did it by taking a heavily bullish position in Nikkei futures. As his losses grew, he continued to add to his position, and built up massive leverage. But in order to conceal those losses, he disabled the normal reporting channels by which Barings would have been able to oversee his trading. The combination of leverage, mismatch, and lack of transparency allowed one trader to bring down one of the oldest banks in England .
When Robert Citron drove Orange County into the red, he did it by taking a large position in highly leveraged and difficult to understand “inverse floaters.” These exotic securities essentially wrapped up the three ingredients for debacle – mismatch, leverage and lack of transparency – into a single package. A lot of the more toxic CDO mortgage securities today are of this variety.
In short, when you observe the really big wipeouts, you'll notice that they tend to be in vehicles that take leveraged, mismatched positions and don't provide much disclosure.
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The thing about speculative excess is that the pendulum
always swings too far in both direction. How much further
do we have to go in re-pricing subprime paper?
We've seen an awful lot of smart money stepping into
the financial abyss - from Ken Griffin snapping up Sowood Capitals distress, to Wilbur Ross providing debtor in possession financing, to the likes of billionaires Hank Greenberg and Eli Broad putting capital in Godman's funds,
to Eddie Lampert, Warren Buffet, Carl Ichan et al buying
US Banks.
How low is the bottom?
Here's a chart on "BBB" paper:
It's now nearing .30 cents on the dollar.
Finding the bottom may be more a matter of time, than price.
SOTB |
