Wednesday, 21 May 2008 01:00

The process and pain of reintermediation

The following excerpt amplifies the anecdotal point that I made in my recent post on commercial bank loans . In particular, the amount of securitized loans banks have created, the increasing amount they started holding for thier own account, and the abrupt disruption of the market which pretty much forced them to keep everything. Keep this chart in mind as you read through William Dudley's speech.

The primary benefit of securitization was the virtualization of the bank's balance sheet. Through securitization, banks were able to underwrite a vast amount of risk relative to their balance sheet capacity, by selling off the risk to the open markets. Despite this, banks have steadily increased the amount of risk kept on (and off, through SPEs) their books over the last 20 years, with a forced increase of this concentration in 2007 when the securitization market simply shut down - cutting off the liquidity spigot for these assets. Starting at about 2004 near the height of the securitization bubble , banks increased the pace of securitized asset retention.


Excerpt from the New York Fed web site :

May You Live in Interesting Times: The Sequel

William C. Dudley, Executive Vice President

Remarks at the Federal Reserve Bank of Chicago's 44th Annual Conference on Bank Structure and Competition, Chicago

Exhibits (slides) PDF

I gave a speech last October entitled “May You Live in Interesting Times.” In that speech I listed a number of events that I never, ever expected to see. These included AAA-rated mortgage backed securities selling at 85 to 90 cents on the dollar, asset-backed commercial paper backstopped by real assets and a full bank credit support yielding more than unsecured commercial paper issued by the same bank, and a Treasury bill auction that almost failed at a time that there was a flight to quality into Treasurys going on.

The list has gotten much longer since then. To mention just a few: AAA-rated collateralized debt obligations (CDOs) that may turn out to be worthless; monoline guarantors, some still with AAA ratings, but with credit default swap spreads higher than many non-investment grade companies and a major investment bank’s demise in a few short days in March.

The number of liquidity facilities developed and introduced by the Federal Reserve is another list that has gotten much longer. Policymakers have responded to the persistent pressures in funding markets by introducing several new liquidity tools.

Today, I want to focus on what we’ve been up to in terms of these liquidity-providing innovations. Before I begin in earnest let me underscore that my comments represent my own views and opinions and do not necessarily reflect the views of the Federal Reserve Bank of New York or of the Federal Reserve System.

Let me first define the underlying problem. The diagnosis is important both in influencing the design of the liquidity tools and in assessing how they are likely to influence market conditions.

As I see it, this period of market turmoil has been driven mainly by two developments. First, there has been significant reintermediation of financial flows back through the commercial banking system. The collapse of large parts of the structured finance market means that banks can no longer securitize many types of loans and other assets. Also, banks have found that off-balance-sheet exposures—such as structured investment vehicles (SIVs) or backstop lines of credit that are now being drawn upon—are adding to the demands on their balance sheets.

Second, deleveraging has occurred throughout the financial system, driven by two fundamental shifts in perception. On one side, actual risks—due to changes in the macroeconomic outlook, an increase in price volatility, and a reduction in liquidity—and perceptions about risks—due to the potential consequences of this risk for highly leveraged institutions and structures—have shifted. Many assets are now viewed as having more credit risk, price risk, and/or illiquidity risk than earlier anticipated. Leverage is being reduced in response to this increase in risk.

On the other side, the balance sheet pressures on banks have caused them to pull back in terms of their willingness to finance positions held by non-bank financial intermediaries. Thus, some of the deleveraging is forced, rather than voluntary.

In some instances, these two forces have been self-reinforcing: In March, the storm was at its fiercest. Banks and dealers were raising the haircuts they assess against the collateral they finance. The rise in haircuts, in turn, was causing forced selling, lower prices, and higher volatility. This feedback loop was reinforcing the momentum toward still higher haircuts. This dynamic culminated in the Bear Stearns illiquidity crisis.

During the past eight months, the financial sector as a whole has been trying to shed risk and to hold more liquid collateral. This is a very difficult task for the system to accomplish easily or quickly for two reasons. First, the financial sector, outside of the commercial banking system, is several times bigger than the banking system. So, with some hyperbole, you are, in essence, trying to pour an ocean through a thimble. Second, this process of deleveraging tends to push down asset prices for less liquid assets. The decline in asset prices generates losses for financial institutions. Capital is depleted, increasing the pressure on balance sheets.

One consequence of this reintermediation and deleveraging process has been persistent upward pressure on term funding rates. For example, the spreads between 1- and 3-month LIBOR and the comparable overnight index swap rates have widened sharply during this period. The overnight index swap rate is the expected effective federal funds rate over the stated maturity of the swap. As shown in the two exhibits on page two, this pressure on term funding rates has occurred in the United States, Euroland, and the United Kingdom. It is a global phenomenon.

In fact, the increase in LIBOR to overnight indexed swap (OIS) spreads may understate the degree of upward pressure on term funding rates. Note that after a Wall Street Journal article on April 16 questioned the veracity of some of the LIBOR respondents and the British Bankers Association threatened to expel any banks that they discovered had been less than fully honest—LIBOR spreads increased further.

The foreign exchange swap market indicates that the funding costs for many institutions may be even higher than suggested by the dollar LIBOR fixing. As shown in the next slide, the funding cost of borrowing dollars by swapping into dollars out of euros over a 3-month term is about 30 basis points higher than the 3-month LIBOR fixing.

So what explains this rise in funding pressures more precisely? Some have argued that the rise in term funding spreads reflects increased counterparty risk; others that the rise stems from a reduction in appetite of money market funds to provide term funding to banks. Over the past eight months, there is some validity to both of these arguments. But neither explanation provides a very satisfactory explanation.

Credit default swaps spreads for major commercial banks have narrowed considerably over the past two months. This indicates that counterparty risk assessments are improving—yet LIBOR-OIS spreads widened over this period. Thus, it is hard to pin this widening in LIBOR-OIS spreads on an increase in counterparty risk.

Similarly, the notion that money market mutual funds have lost their appetite for term bank debt has not been particularly compelling recently. The split of money market fund assets between Treasury-only versus prime money market funds has been relatively stable, the weighted average maturity of the funds has been increasing, and prime funds have increased their allocation to both foreign and domestic bank obligations. In contrast, when there was a flight to quality to Treasury-only money market funds last August, this was a more compelling explanation.

So what has been driving the recent widening in term funding spreads? In my view, the rise in funding pressures is mainly the consequence of increased balance sheet pressure on banks. This balance sheet pressure is an important consequence of the reintermediation process. Although banks have raised a lot of capital, this capital raising has only recently caught up with the offsetting mark-to-market losses and the increase in loan loss provisions. At the same time, the capital ratios that senior bank managements are targeting may have risen as the macroeconomic outlook has deteriorated and funding pressures have increased.

The argument that balance sheet pressure is the main driver behind the recent rise in term funding spreads is supported by what has been happening to the relationship between other asset prices—especially the comparison of yields for those assets that have to be held on the balance sheet versus those that can be easily sold or securitized. Consider, for example, the spread between jumbo fixed-rate mortgages and conforming fixed-rate mortgages, which is shown in the next slide. As can be seen, this spread has widened sharply in recent months, tracking the rise in the LIBOR/OIS spreads.

Why is this noteworthy? Jumbo mortgages can no longer be securitized, the market is closed. Thus, if banks originate such mortgages, they have to be willing to hold them on their balance sheets. In contrast, conforming mortgages can be sold to Fannie Mae or Freddie Mac. Because the credit risk of jumbo mortgages is likely to be comparable to the credit risk of conforming mortgages, the increase in the spread between these two assets is likely to mainly reflect an increase in the shadow price of bank balance sheet capacity.

If this is true, then the same balance sheet capacity issue is likely to be an important factor behind the widening in term funding spreads. After all, a bank has a choice. It can use its scarce balance sheet capacity to fund a jumbo mortgage or to make a 3-month term loan to another bank.

If balance sheet capacity is the main driver of the widening in spreads, this suggests that there are limits to what the Federal Reserve can accomplish in terms of narrowing such funding spreads. After all, the Fed’s actions cannot create bank capital or ease balance sheet constraints materially.

That said, the Fed can reduce bank funding risks by providing a safe harbor for financing less liquid collateral on bank and primary dealer balance sheets. Reducing this risk may prove helpful by lessening the risk that an inability to obtain funding would force the involuntary liquidation of assets. The ability to obtain funding from the Fed reduces the risk of a return to the dangerous dynamic of higher haircuts, lower prices, forced liquidations, and still higher haircuts that was evident in March.

In essence, the Federal Reserve’s willingness to provide liquidity against less liquid collateral allows the reintermediation and deleveraging process to proceed in an orderly way, which reduces the damage to weaker counterparties and funding structures. One can think of the Federal Reserve’s actions as smoothing and extending the adjustment process—not preventing it—so that the adjustment causes less damage to the financial system and less pernicious macroeconomic consequences.

The Federal Reserve has introduced three

Published in BoomBustBlog
Friday, 16 May 2008 01:00

Government Flip Flop

You know how I feel on this topic - Reggie Middleton says don't believe 'em ...

"In my judgment, we are closer to the end of the market turmoil than the beginning," Henry Paulson said in the text of a speech he plans to deliver in Washington. "Looking forward, I expect that financial markets will be driven less by the recent turmoil and more by broader economic conditions and, specifically, by the recovery of the housing sector."


“Frankly, things may get worse before they get better. As regulators, we continue to see a lot of distress out there,” Sheila Bair, chairman of the Federal Deposit Insurance Corp., said in the text of a speech to the Brookings Institution...“Too many unaffordable mortgages are causing a never-ending cycle — a whirlpool of falling house prices and limited refinancing options that contribute to more defaults, foreclosures and the ballooning of the housing stock,” Bair said.

Hmmm... Who do you believe???

Published in BoomBustBlog

Note: for some arcane reason, the graphs refuse to show up on this post so here is a pdf version for the blogs registered users: icon Municipal Bond Market and the Securitization Crisis (242.88 kB 2008-05-14 18:09:27)

his is a DRAFT of part 5 of Reggie Middleton on the Asset Securitization Crisis – Why using other people’s money has wrecked the banking system: a comparison to the S&L crisis of 80s and 90s. As was stated in the earlier parts, I periodically have third parties fact check my investment thesis to make sure I am on the right track. This prevents the "hubris" scenario that is prone to cause me to lose my hard earned money. I have decided to release these "fact checks" as periodic reports. This installment covers consumer finance, an aspect at risk in the banking system that is both overlooked and underestimated, in my opinion.

I urge discourse, conversation and debate on this post and the entire series. To me, it is necessary to make sure the world is as I percieve it.

The Current US Credit Crisis: What went wrong?

  1. Intro: The great housing bull run – creation of asset bubble, Declining lending standards, lax underwriting activities increased the bubble – A comparison with the same during the S&L crisis
  2. Securitization – dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble – declining home prices and rising foreclosure
  3. Counterparty risk analyses – counterparty failure will open up another Pandora’s box
  4. The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue
  5. You are here => Municipal bond market and the securitization crisis – where do we stand
  6. To be Published: An overview of my personal Regional Bank short prospects

The following municipal bond portion of the asset securitization crisis is also a tie-in to the prospects of the monoline insurance industry. The latest of my monoline analyses is the Assured Guaranty Report. You can also peruse the work I did on MBIA and Ambac starting from the inception of my short position in these companies last year.

  1. A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton
  2. Tie-in to the Halloween Story
  3. Welcome to the World of Dr. FrankenFinance!
  4. Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion
  5. Follow up to the Ambac Analysis
  6. Monolines swoon, CDOs go boom & I really wonder why the ratings agencies are given any credibili
  7. More tidbits on the monolines
  8. What does Brittany Spears, Snow White and MBIA have in Common?
  9. Moody's Affirms Ratings of Ambac and MBIA & Loses any Credibility They May Have Had Left
  10. My Analyst's Comments on MBIA/Ambac/Moody's Post
  11. As was warned in this blog, the S&P downgrade of a monoline insurer reverberated losses through c

And now, on to the Muni report...

Municipal bond market and the securitization crisis – where do we stand

As defined by the Securities Industry And Financial Markets Association (SIFMA), municipal bonds (often called munis) are debt obligations issued by states, cities, counties and other governmental entities to raise money to build schools, highways, hospitals and sewer systems, as well as many other projects for the public good. The interest income generated from these bonds is free from federal taxes, state taxes, local taxes or all the above. However, not all munis are tax-free.

Municipal bonds generally are classified as general obligations and revenue bonds. General obligation bonds (or GO bonds) are mostly backed by the credit and the ‘taxing power’ (inflow of tax revenues) of the issuing municipality. They are generally considered one of the safest investments as they have governmental support.

Revenue bonds, on the other hand, depend upon the revenue generation capability of the project in which the bond proceeds are to be invested. Hence, they are generally perceived to be riskier than the GO bonds.

Out of a total market worth US$2.62 trillion municipal bonds outstanding, mutual funds hold the maximum (35.8%), while individuals hold the second highest amount (35.0%) of the municipal bonds in the US.

Municipal bonds breakdown - outstanding and issued in 2007


Source: SIFMA

From the issuance perspective, revenue bonds have almost always attracted more investors due to their higher paying nature. Consequently, revenue bond issuance has grown at a CAGR of 8.4% in the last 12 years as compared to 6.6% for GO bonds. In 2007, the total municipal bonds issued were worth US$424.3 million, of which revenue bonds issued constituted 69.1%.

Most municipal bonds are insured by bond insurance companies. According to the S&P National Municipal Bond Index (which comprises 3,102 bonds) at the end of 2007, 48.8% of the municipal bonds were insured.

The impact of the Asset Securitization crisis on municipal bonds

The municipal bond market was severely impacted during the second half of 2007 as compared to the first half.

Property tax revenues of local and state governments severely impacted

Most local and state governments rely on taxes as their major sources of income; hence it is obvious for them to raise money through bonds based on their taxing powers. Moreover, each of the 50 states has different definitions of “property”.

There were two taxes that were primarily affected as a result of the housing market downfall – property tax as well as use tax on rents. Property tax is a primary source of income for most state and local governments in the US, states the US Treasury Department. There was a rapid decline in demand for real estate which was augmented by increasing supply of homes on account of rising foreclosures. As a result, property valuations went significantly down which affected the tax inflows of many states in the US. Moreover, with people not able to service the rents, even the income through use taxes suffered. An evidence of such a state is California. California was home to almost half of the 25 biggest US subprime lenders. According to the California Association of Realtors, the number of houses and condominiums sold in California declined approximately 30% y-o-y in January 2008 to 313,580, while the median price for an existing home slumped 22% y-o-y to US$430,370. Moreover, California had 481,392 foreclosure filings on properties last year, the most of any state, according to RealtyTrac.

As a result, the state’s Director of Finance expects the growth rate in property tax revenue to be as low as 2% y-o-y in 2008-2009 with an expectation of a 6% y-o-y fall in 2009-10. According to the California Legislative Analyst Office, a 1% y-o-y decline amounts to US$450 million of lost tax revenue (for those who don’t want to do the math, that’s approximately $2,700,000,000).

Lower income tax revenues due to economic slowdown

For the US Federal Government, income tax charges contribute most to its revenue, with personal income tax producing almost five times the revenue produced from corporate income taxes. In 2007, of the total Federal revenue collection, income taxes from individuals constituted 78.5%.

Importance of income tax revenues to the US Government

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Source: Financial statements, US Federal Reserve

With the economic hard landing in the US, income tax collections are likely to get hit, going forward. According to advance estimates from the Bureau of Economic Analysis, the US economy grew by only 0.6% y-o-y in 1Q 08 with unemployment rate having jumped from 4.5% in April 2007 to 5.0% in April 2008. With high food prices across the globe, higher fuel costs, increasing debt component pressurizing the household income and the decline in the values of houses of US citizens, there is an unavoidable pressure on personal disposable income. With rising unemployment across the country, a declining or even a marginally negative growth rate of revenues generated through income tax would severely pinch the Government’s earnings. With homeowners expecting at least as much assistance as was provided to the financial industry, tough times await the US Government.

An impact in tax revenues directly affects the credibility and capability of the government to issue any bonds based on its taxing powers – whether they be municipal or federal. This is also a major reason why the overall outlook for municipal bonds market appears grim in the near to medium term.

Bloated budgeting in the boom times

Most US state and local governments had prepared budgets based on the revenue from the (then) extant real estate boom. Hence, they continued to issue munis to fund their expansion plans; even the interest rate scenario was conducive and they could pay the investors due to a consistent inflow of taxes. However, after the housing market collapsed, property values went down and an increasing number of homeowners went for the property revaluation to cut down the property tax figures from the list of their financial obligations.

Consequently, tax inflow for these state and local governments slowed down. Due to this, payments on the long term municipal bonds became riskier than at the time of their issue. The government of California has already reduced the budgets of its police and fire departments for the coming year by approximately 20% following these developments. This, combined with private sector workforce reductions, serve to act as a reflexive mechanism that causes a feedback loop, wherein cost reductions reduce income tax revenue which exacerbated the need for further cost reductions.

Published in BoomBustBlog

In Banks, Brokers, & Bullsh1+ part 2 I forecasted Morgan Stanley having beef with their hedge fund clients and counterparties. Well, actually I claimed that they had excessive counterparty risk from these clients, which was bound to come back to bite them. In today's

Some other hedge-fund managers say they've been bullied by securities firms when they've tried to cash out on profits from such positions. When one hedge-fund manager considered selling out of a credit-default swap -- in which his fund bought protection on $10 million of bonds of Countrywide Financial Corp. -- he says there was a condition attached by two securities firms. He says the firms -- Bear Stearns Cos., which sold him the swap, and Morgan Stanley -- told him they would cash him out of his profitable position, only if he would simultaneously enter into another swap-selling insurance protection on the bonds equal to his fund's $3 million profit. Eventually, he says, his fund sold the position through Goldman Sachs Group Inc. and Lehman Brothers Holdings Inc., allowing him to book the $3 million profit. Representatives for Bear Stearns, Morgan Stanley, Goldman and Lehman declined to comment.

Published in BoomBustBlog
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