Hello, Sam and Henry and everyone. In regards to Henry's thoughts about JPM's credit derivative exposure I came across this by "Tim Picks" and thought it might be of some interest to those six of us in the world who follow the 150 waves off Kahuna. One should not give up on this until the fifth paragraph or so ...
For Private Use only.
A few teaser leads here ....
"Enron was supposed to be The World's Greatest Company. It now seems Enron's only claim to fame can be that it was Texas' biggest innovator in creative finance since Anna Nicole Smith's groundbreaking work in pioneering the viatical marriage. (In case you're not familiar with the subject, Ms. Smith, a Playboy playmate, married an octogenarian billionaire. Though men often describe her as a woman of "ample personality," whenever I see Ms. Smith on television I immediately become concerned that I may have over-inflated my tires.)"
Or, to credit "Tim Picks" for this reference, “…I believe it was Teddy Roosevelt who said, "A man who has never been to college might steal a railroad car, but a man who has been to college might steal the whole railroad."
Was Teddy thinking of Jeff Skilling? Hey, they both went to Harvard right? Or, at least Jeff half went to Harvard and got his business MA there....
The article ....
February 14, 2002Insurance and Nakedness
By Tim Picks Market Ruminations
Before I get to the title of this piece, I'd ask you to take a short quiz -- two questions. I'll be referring back to these two items later in this article. First question:
What are the odds of someone winning the lottery?
If you're like most people, you answered something like, "they're very low." But that would be incorrect, because you answered a question that I didn't ask. The question you likely answered is the one that you're most familiar with: What are the odds that you (or another specific person, named in advance) will win the lottery?
But rather than looking at it from the point of view you're used to, look at the lottery as a whole. That's the question I asked. Someone usually does win the lottery. In fact, the point can be made even more plainly if we take the example of a charity raffle. You've probably been to one of these. Everybody buys a ticket and someone will win the prize. If the first winner isn't there, they pick another ticket out of the fishbowl. They keep doing it until someone wins. We don't know who will win in advance, but there's a 100% chance that someone will win.
Hopefully, you'll see my point later on and not think it's just a stupid question where I could say, "Fooled ya! Fooled ya!" But first, lets get to the second question which is more straightforward and rhetorical:
If a company has 90% market share of a market that is mature and is not growing, and the company isn't expanding into any other lines of business, how much more can the company grow?
Probably not much. In fact, the things that can happen are mostly bad. There's 10% more upside, but a whole lot of potential downside. A new competitor might undercut on price or on service and take away 10-15% of the market. Somebody might give away your product or service as a loss-leader to get the customer's business on something else. Another product or service might displace yours or make it obsolete, etc., etc.
The point being, there is a time when the market becomes saturated and the risk becomes greater than the reward.
Hereafter, I'll be referring to these two items as the lottery example and the 90% problem.
Is Everybody Already Into The Pool Of Available Buyers?
In a previous piece, I asked a question that I'll put to you again: name an asset that you cannot buy with 100% financing. There are very, very few. Ironically, stocks are one of the few I can think of. Cars, boats, houses, furniture, stereos, you name it -- 100% financing is available. And that's a stingy deal. Nowadays it's no down, no payments, and no interest for a year or two. Greater than 100% financing on houses is often available.
Twenty years ago, it was not like this. Even ten years ago it wasn't like this. The increase in credit availability is the reason for much of the increased demand in certain sectors of the economy.
The ability to purchase an asset on credit creates a huge additional demand for the asset because it increases the pool of available buyers. If we all had to pay cash for cars, let's say $30,000, the pool of available buyers would be small because many people have very little in the way of savings. But if the car can be purchased for a payment of several hundred dollars a month, the pool of available buyers increases dramatically. That's wonderful as the credit availability is being increased. But if it decreases, it also takes away potential buyers.
As an investor in assets, of course, you want the pool of available buyers to be small -- less competition. The time to buy real estate, for example, is when interest rates are 12-13%, no banks will lend money anyway, and nobody has cash. Nobody but you. Conversely, when lenders are offering easy credit, 125% financing, the lowest interest rates in 40 yrs, etc., this is about as big as the pool of available buyers is going to get. No one knows where the exact saturation point is, but it will come.
As discussed last time, much of the credit creation in this current bubble has taken place outside of the banking system itself. Now I'll invoke the lottery example and suggest that again we need to look at the whole -- the total amount of both money and credit available -- not just one specific part of it. Rather than looking at just the official banking numbers (M1, M2, M3, MZM, etc) for signs of an increasing money supply as we may be used to doing, we must also look at the increase in credit outside the banking system. It has exploded. Credit can affect asset prices just as much as real money. But, alas, at some point the market will get saturated with credit (whose payments still must be made), as the borrower simply cannot afford more payments given his current income. Then there are no new buyers, asset prices begin to fall, credit becomes less available, and the entire scheme goes into reverse.
Debt, Derivatives, SPEs, SPVs, and SUVs
It's quite possible that much of this credit has been effected because of a single faulty premise. If you think that's not possible, let's remember it was a very short time ago that almost the entire internet bubble was brought about by the single flawed premise that advertising would cover the costs of running a web site. Sure, you had some retailers and other businesses trying to sell stuff, but by and large everybody thought they could provide content for free, and make money from advertising. Almost everyone involved with the internet believed that faulty premise.
Where credit creation is concerned, that flawed premise may be the concept of financial insurance. Of all the "financial insurance" products, credit insurance is among the most worrisome. Think of credit insurance as being a bit like co-signing on a loan. If the borrower can't pay, you're on the hook. It would obviously be much riskier to cosign for an irresponsible teenager than for a reputable, able, qualified borrower. However, able borrowers obviously don't need a co-signer.
But Wall Street would have us believe something different. They would have us believe that you can take a bunch of sub-prime auto loans, consumer loans, or mortgage loans, etc., place them into an SPE (Special Purpose Entity) or SPV (Special Purpose Vehicle), slap a credit insurance product on them to turn them into AAA-rated paper, and the risk is somehow hedged away and just magically disappears into the system.
This is nonsense. I contend that not only is credit insurance not an insurance product, but the risks cannot be hedged away, and, in fact, the very existence of such "financial insurance" products is almost destined to bring about the very type of conditions that will expose their speciousness.
The '87 Crash Revisited
If there are two things that we should have learned from the stock market crash of 1987, they are these: (1) portfolio insurance was a flawed concept that served as nothing more than a giant stop-loss order, and (2) writing naked puts on the stock market seems like a great idea when the market is flat or going up, but you can get wiped out in a hurry when there is a large move down.
Now, in my opinion, Wall Street has combined these two great flavors to give us the new and improved concept of credit insurance. I want to make clear that when I speak of credit insurance I'm talking about the type of insurance used during the last 5-7 years (during the boom) in conjunction with the "structured finance" products: asset-backed securities, mortgage-backed securities, collateralized debt obligations, et al. This entire industry, in it's current form, is extremely young -- maybe 10 years old. It is a boom-time creation.
Credit insurance, as a concept, began by companies insuring municipal bond obligations. That, I consider to be a different and legitimate business. You're dealing with a municipality who has taxing authority and is providing a necessity to the citizenry. But then the industry began to expand into insuring other products to the point where in the last 5-7 years, I believe they are taking ridiculous risks in the structured finance area.
An insurable event must be random and mutually exclusive in order for an insurer to be able to pool a number of insureds, do the actuarial calculations, and charge an appropriate premium. Usually an insurable event is one that is mutually exclusive by geography, and/or demographics, and/or industry, and it is also not possible for the events to be contagious or interconnected, etc.
The point can be made clear with an example. An automobile insurance company, for example, may insure drivers in Dallas, Los Angeles, Denver, Omaha, etc. A car accident in Dallas is not going to cause one in Denver. Sure, accidents will happen at the same time in different cities, but it is all more-or-less random, whether happening to a 36-year-old or a 57-year-old, male or female, working in pharmaceutical sales or as a homemaker.
But now lets take that same concept and apply it to one type of financial insurance: stock portfolio insurance. None of the randomness and mutual exclusivity is there. All of your insureds are all taking part in the same event (in this case, a stock market downturn), which is cyclical rather than random. Imagine the CEO of a stock portfolio insurance company boasting, "We have a diversified insurance portfolio. Diversified geographically: we insure against stock losses in Dallas, LA, New York and Omaha. Diversified demographically: we insure people from age 28 all the way up to age 75 against stock losses. We're also diversified by industry sector, insuring against stock losses in the financial, retailing, real estate, and manufacturing sectors. We're very well diversified."
Obviously, such a portfolio is not diversified at all. The losses will come to all of your insureds in one fell swoop when the stock market heads down, regardless of their location, their age, or their industry. Attempting to write insurance for something cyclical is not insurance. It's guaranteed losses at some point, the only question is when.
Self-Fulfilling Problems
But it gets even worse than that. The very existence of financial insurance for something cyclical will almost certainly lead to a boom followed by an inevitable bust -- the very thing the "insurance company" cannot withstand. Just so that we don't over-use the stock market as our only example of "insuring" a cyclical event,
let's "insure" against a downturn in the semiconductor industry. What will happen? A boom. It's almost guaranteed. With "insurance" available, every semi manufacturer would go out and build as many new plants as possible in order to gain market share. After all, its losses are limited -- it's got "insurance." Every semi company would do the same. There would be a temporary boom. And the ultimate liabilities for the insurer would only get bigger as the boom grew. You'd get massive over-capacity that would lead to a huge bust in the industry, and huge losses for the insurer. The exist! ence of the insurance product brings about the very bust it cannot withstand.
There is no way you could charge enough for the product because every semiconductor company will have losses. Even if you knew in advance that there would be $5 million in losses for one company, you'd have to charge more than $5 million for the "insurance" policy, because all of your other insureds would have losses too. There are no offsetting "unharmed" insureds (whose premiums you get to keep) to make up for the claims you have to pay out. Everyone would be hit. Everyone would have a claim. Any attempts to hedge the risk dynamically would mean selling into a declining market and would only exacerbate the problem.
Much like insuring against a downturn in the stock market or in the semiconductor industry, the credit insurers are really insuring against a serious downturn in the economy. Loans everywhere will all go bad at the same time. And just as the semi manufacturers thought they could build with reckless abandon because they have "insurance," the purchasers of all this credit are willing to buy with abandon because the securities they are purchasing are insured. They're AAA-rated.
So it seems to me that this type of "credit insurance," can only exist for one of two reasons: (1) it is either massively under-priced and the under-pricing will be exposed during a significant downturn, or (2) it is properly priced and the buyers are stupid to buy it. Personally, I'd lean very heavily toward thinking it's number one. There is huge risk out there somewhere. As we've witnessed with recent events, these things can be hidden for some time. The credit insurers boast of very, very small losses. So small that one wonders why anyone would pay premiums for their products.
Much of the credit creation in the economy has occurred because there are ready buyers of this credit. The purchasers of these structured securities are buying them because they are AAA-rated. This is only possible because of credit insurance. If that insurance becomes too expensive or goes away because the insurers start suffering large losses or receive credit downgrades, etc., the AAA-rating would also go away, meaning the purchasers of these securities would disappear, and much of the credit creation could seize up very quickly. Thus, a significant portion of the money supply could contract, quickly. This is why I do not discount a financial accident scenario. Not to say that it will happen, only that it could.
Many of the hedge funds and leveraged speculators playing the chase-the-yield game and buying these asset-backs and mortgage-backs, et al, could go broke very quickly. Banks could be on the hook for loans to many of those hedge funds. The entire area of structured finance, in its current form, is new and untested by a
significant economic downturn. It is a chain of many weak links. Debt, derivatives, credit insurance, hedge funds, special vehicles, banks, etc., are all interconnected. The losses can be contagious. Another LTCM-type debacle is not out of the question. We seem to just keep ignoring these head-on collisions and keep speculating wildly as though nothing happened. Just hose the blood off the dashboard and let somebody new start driving the car.
The Availability Of Financial Insurance Can Disappear Quickly
Interestingly, one of the reasons Kmart cited for having to file bankruptcy when they did was the "evaporation of the surety-bond market." I heard an analyst say that the potential losses from the surety companies on Enron transactions alone (we haven't even discussed the potential for fraud, which tends to be rife during bubbles) could amount to something like 75% of all surety premiums collected by all surety companies for the year.
Many money market funds are dropping default insurance because premiums have soared. USAA, Fidelity Investments, and Putnam Investments, have all dropped insurance. Vanguard and others are considering doing so. Those funds just got a lot riskier. One has to assume they weren't blowing the shareholders' money on insurance for no reason. Now it's no big deal?
My personal belief is that the puny additional yield in money market funds is no longer worth the risk.
If there are huge losses out there, they are likely to show up without warning. Take seriously the fact that money market funds are not federally insured. I will be keeping any uninvested funds in things that are federally insured or direct obligations of the US government. Because yields are so low (another unintended consequence of cramming interest rates down), many money funds are already absorbing expenses so investors don't take losses. There's the potential for funds to take additional risk to chase yield. We should also remember that money market funds are susceptible to the equivalent of bank runs. Obviously not in the sense that there are fractional reserves like at a bank, but in the sense that too many withdrawals could force funds to go bankrupt. Just because this has rarely happened before does not mean the risk isn't there.
Mortgage insurance is another financial insurance product of dubious nature. The Japanese mortgage insurance companies are still suffering to this day, requiring further injections of capital. Many analysts say our property bubble isn't nearly as bad as Japan's. Maybe they're right . . . but maybe not. Before it crashed, we also heard the Nasdaq wasn't a bubble and wouldn't collapse like the Nikkei.
Now, the main argument used to explain that we don't have a housing bubble is that there is no oversupply. There was no oversupply of telecom equipment either. . . . until there was. Companies couldn't keep up with demand. Remember those days? Easy money produced a temporary over-demand of telecom equipment that brought about the oversupply. When the easy money disappeared, the oversupply was exposed. In housing, I believe easy credit has made for a temporary over-demand of housing. When the easy credit disappears, there will be an oversupply.
In a recent article, Joe Birbaum, an executive retiring from Mortgage Guaranty Insurance Corp, urged caution in home lending. That's good. Except we read this, "His definition of high-risk: loans exceeding 100% of a home's value or beyond 103% for low-risk borrowers rolling closing costs into the loan; and deals requiring more than 41% of borrower income for the mortgage payment." So apparently, he thinks 100% loans are not high risk. That's scary.
Structural economic problems are often not readily visible; they're not peeling paint. The building just collapses, seemingly unexpectedly, and for no visible reason. If we have a serious economic downturn, the mortgage insurers will suffer mightily.
Good Times, Loose Morals
Keep in mind, everything gets loosey-goosey when times are good. "Close enough. Let it go through. Big fees riding on this." Normally, when a company sets up an SPE or SPV they must obtain a "true sale" opinion from a law firm, indicating that this really is a sale and not some sort of sham transaction. Stop and think about that concept for a minute. You're selling to such a closely related party that you have to get a law firm to step in and say, "Yeah, this is really a sale, not just two guys pushing paper back and forth to steal money." That's not to say such a structure can't be used legitimately; it's just to point out that this is obviously a very, very close relationship.
Now the bad news. Enron had "true-sale" opinions from a highly respected law firm. We now know that these were anything but true sales. Might there be more out there? If Wall Street is good at one thing, it's making a cookie-cutter and doing the same thing over and over. Everyone's morals become a little looser when easy money is at stake. These types of structured finance transactions have yet do go through a major economic downturn. If large losses are suffered by SPVs, do you think maybe the investors from two different entities might bicker over how the deal was set up? Or might bicker over the remaining assets? Or might sue the deep pockets (the insurers)?
The other day I saw a press release stating that a company had sold a series of AAA-rated sub-prime loans. Only on Wall Street could such an oxymoron be seen as financial genius. But somehow, turning sub-prime paper into AAA-rated paper doesn't sound risk-free to me. Somebody is holding that risk. The credit insurers claim they hedge this risk away dynamically. I don't see how this is possible. Who takes the other side of that trade? They might do it once, but once they take big losses, they won't do it again. The liquidity for such a market will disappear. Many of these SPVs also have a built-in liquidation feature where if the losses get to a level that is to great, the entire thing will be liquidated. "To whom?" one might ask. Liquidity is a coward; it disappears when things get tough.
So to use a stock market analogy, I contend that the purchasers of such credit insurance products are buying something akin to portfolio insurance, and they are buying the insurance from someone who is essentially writing naked, out-of-the-money puts on the economy. Neither is a smart thing.
[And similarly, with the bankruptcies of Kmart, Enron, Global Crossing, et al, many of the large banks are discovering that those credit lines they handed out so freely during the boom, are the equivalent of writing naked, out-of-the-money LEAP puts on a given company: very small fees collected in return for the risk of huge losses in bankruptcy. Worse, they can't "buy back" these LEAP puts in the open market. They just have to sit there and take the pain |
