Tuesday, 08 December 2009 19:00

Financial Innovation vs Financial Fraud

I was reading a post by George Washington over at ZeroHedge that actually spurred the following rant. An excerpt reads:

The Telegraph notes:

The former US Federal Reserve chairman told an audience that included some of the world's most senior financiers that their industry's "single most important" contribution in the last 25 years has been automatic telling machines, which he said had at least proved "useful".

Echoing FSA chairman Lord Turner's comments that banks are "socially useless", Mr Volcker told delegates who had been discussing how to rebuild the financial system to "wake up". He said credit default swaps and collateralised debt obligations had taken the economy "right to the brink of disaster" and added that the economy had grown at "greater rates of speed" during the 1960s without such products.

When one stunned audience member suggested that Mr Volcker did not really mean bond markets and securitisations had contributed "nothing at all", he replied: "You can innovate as much as you like, but do it within a structure that doesn't put the whole economy at risk."

He said he agreed with George Soros, the billionaire investor, who said investment banks must stick to serving clients and "proprietary trading should be pushed out of investment banks and to hedge funds where they belong".

It is not just George Soros.

Tuesday, 08 December 2009 19:00

Financial Innovation vs Financial Fraud

I was reading a post by George Washington over at ZeroHedge that actually spurred the following rant. An excerpt reads:

The Telegraph notes:

The former US Federal Reserve chairman told an audience that included some of the world's most senior financiers that their industry's "single most important" contribution in the last 25 years has been automatic telling machines, which he said had at least proved "useful".

Echoing FSA chairman Lord Turner's comments that banks are "socially useless", Mr Volcker told delegates who had been discussing how to rebuild the financial system to "wake up". He said credit default swaps and collateralised debt obligations had taken the economy "right to the brink of disaster" and added that the economy had grown at "greater rates of speed" during the 1960s without such products.

When one stunned audience member suggested that Mr Volcker did not really mean bond markets and securitisations had contributed "nothing at all", he replied: "You can innovate as much as you like, but do it within a structure that doesn't put the whole economy at risk."

He said he agreed with George Soros, the billionaire investor, who said investment banks must stick to serving clients and "proprietary trading should be pushed out of investment banks and to hedge funds where they belong".

It is not just George Soros.

This is a corrected and extended update of my glance into the Macerich update. This post was delayed due to material data input errors which have been rectified. I've decided to offer a peak into the ongoing analysis of its property portfolio, which combined with its credit and cash flow situation brings to mind the concerns that I have had about GGP about a year before it collapsed (see "GGP and the type of investigative analysis you will not get from your brokerage house.").

In looking at the data that I am about to display, I want readers to think of MAC as an investment entity that you, yourself, would run as a real estate investor. Think of your ability to make money over time, and the viability of your entity if you would actually lose money. As a property investor, I view MAC's properties in terms of being underwater or being profitable on a capital appreciation and NOI basis. As of 11/09, many of MAC's properties are significantly underwater, the ramifications of which depend on the financing utilized, since the use of debt has literally wiped out all of the equity in some, has made others require an equity infusion to roll over the mortgage, and has simply destroyed shareholder capital in other cases.

Even those properties that are 100% equity financed represent a material loss to shareholders where they are underwater. As you will read below, this has occurred in many instances. Very few publicly disseminated REIT analyses seem to take into consideration the ramifications of REITs actually losing money on investments that don't have large loans against them. They should, though. A loss, is a loss, is a loss.  Leverage simply amplifies the loss. That being said, if I paid $30 million in cash for a property that is currently worth $20 million, I lost $10 million (less the real income derived from that property since acquisition) - no matter which way you look at it. At least with a cash purchase, I may have the option of riding it out to hope that the market returns. If I bought the property with a 70% LTV, $21 million loan), not only have I taken a 110%+ loss, but I would probably be forced to write the property off come time to refinance the loan. The leverage significantly reduces my flexibility. This is what happened to GGP.

The next question is, "Will the market come back to where it was when I made these high priced, high leverage purchases?". Reggie's assertion is, "No time in the near future!". Let's take a look at Richard Koo's chart on the Japanese asset bubble, after GDP started to ramp up...

This is a corrected and extended update of my glance into the Macerich update. This post was delayed due to material data input errors which have been rectified. I've decided to offer a peak into the ongoing analysis of its property portfolio, which combined with its credit and cash flow situation brings to mind the concerns that I have had about GGP about a year before it collapsed (see "GGP and the type of investigative analysis you will not get from your brokerage house.").

In looking at the data that I am about to display, I want readers to think of MAC as an investment entity that you, yourself, would run as a real estate investor. Think of your ability to make money over time, and the viability of your entity if you would actually lose money. As a property investor, I view MAC's properties in terms of being underwater or being profitable on a capital appreciation and NOI basis. As of 11/09, many of MAC's properties are significantly underwater, the ramifications of which depend on the financing utilized, since the use of debt has literally wiped out all of the equity in some, has made others require an equity infusion to roll over the mortgage, and has simply destroyed shareholder capital in other cases.

Even those properties that are 100% equity financed represent a material loss to shareholders where they are underwater. As you will read below, this has occurred in many instances. Very few publicly disseminated REIT analyses seem to take into consideration the ramifications of REITs actually losing money on investments that don't have large loans against them. They should, though. A loss, is a loss, is a loss.  Leverage simply amplifies the loss. That being said, if I paid $30 million in cash for a property that is currently worth $20 million, I lost $10 million (less the real income derived from that property since acquisition) - no matter which way you look at it. At least with a cash purchase, I may have the option of riding it out to hope that the market returns. If I bought the property with a 70% LTV, $21 million loan), not only have I taken a 110%+ loss, but I would probably be forced to write the property off come time to refinance the loan. The leverage significantly reduces my flexibility. This is what happened to GGP.

The next question is, "Will the market come back to where it was when I made these high priced, high leverage purchases?". Reggie's assertion is, "No time in the near future!". Let's take a look at Richard Koo's chart on the Japanese asset bubble, after GDP started to ramp up...

From the WSJ:

Credit-Rating Firms Show Independence 

Are the mice finally roaring? The credit crunch showed that ratings firms missed huge swaths of risk embedded in the economy and markets. [Risks that many independent sources such as BoomBustBlog have routinely and regularly pointed out] But, recently, Standard & Poor's, Moody's Investors Service and Fitch Ratings have produced research or made decisions that exhibit an encouraging level of independence.

From the WSJ:

Credit-Rating Firms Show Independence 

Are the mice finally roaring? The credit crunch showed that ratings firms missed huge swaths of risk embedded in the economy and markets. [Risks that many independent sources such as BoomBustBlog have routinely and regularly pointed out] But, recently, Standard & Poor's, Moody's Investors Service and Fitch Ratings have produced research or made decisions that exhibit an encouraging level of independence.

I have finally updated my Alt-A and Subprime delinquency, charge-off and loss data using FDIC, NY Fed, Corelogic, First American, and Bloomberg (among others) as sources. If you thought things looked bad last year or this spring, they are getting worse - with no reprieve for the 3rd quarter despite the extreme amounts of liquidity and capital thrown at the situation by central bankers and the US government. As soon as I started writing this piece, CNBC comes out with "US to Push Mortgage Lenders To Modify More Home Loans: The US Treasury announced plans to push lenders to modify more loans after the administration's $75 billion housing rescue plan, called Making Home Affordable, fell short and foreclosures continued rising."

Hmmm... $75 billion is a lot of money. Mayhap the problem is that the banks know how useless pushing on a string is, or mayhap $75 billion is not enough to stem $304 billion (and counting) in Alt A and subprime losses that are still in the pipeline (see graphic below). 

It gets worse though. Let's glance at the non-conforming loan losses that have already occurred in comparison to the SCAP projections that justified the return of TARP in many cases. Recovery rates had the illusion of increasing ever so slightly due to an increase in prices as illustrated by the Case Shiller index. I have expressed my doubts about this housing price recovery for several reasons, the least of which is the construction flaws in the index itself which fail to capture the nature of the transient price increases, namely the activity of short term investors and flippers (see On the Latest Housing Numbers). There are some areas that have witnessed some firming of pricing though, but that firmness is the result of the Fed and Treasury trying to blow another bubble within a bursting bubble and is more than outdone by the rampant deterioration in credit quality of loans that result in the dumping of foreclosures -> REOs -> short turnaround sales/flips (via investors, which are not captured by Case Shiller, hence the illusion of a firming market in the lower end of housing prices) all over the place.

image019.png

Subprime delinquency, charge-off and foreclosure rates are still flying through the roof - with many other categories rushing to keep up. This is as I described from the beginning (2007) through the Asset Securitization Crisis series - there was an underwriting induced crisis and never a true "subprime crisis". As such, there is a very strong chance that many other loan categories may outstrip subprime loans in terms of aggregate losses. It hasn't happened yet, but the Alt-A category is hot on subprime's heels (see below). Construction and CRE will follow up the rear with unsecured consumer (ex. credit cards) and commercial loans fighting to get into the race.

image021.png

Below, you see the loss trend as of October 2009. These are losses that have most likely NOT been claimed by the banks, and they are significant. In addition, the credit deterioration trend is climbing, not falling. If I am correct in my assumption on the validity of the Case Shiller index in capturing true inventory price depreciation across investor related sales and bank "hold outs", then prices will soon start dropping again, killing recovery rates and causing losses to spike even further.

image015.png

I have finally updated my Alt-A and Subprime delinquency, charge-off and loss data using FDIC, NY Fed, Corelogic, First American, and Bloomberg (among others) as sources. If you thought things looked bad last year or this spring, they are getting worse - with no reprieve for the 3rd quarter despite the extreme amounts of liquidity and capital thrown at the situation by central bankers and the US government. As soon as I started writing this piece, CNBC comes out with "US to Push Mortgage Lenders To Modify More Home Loans: The US Treasury announced plans to push lenders to modify more loans after the administration's $75 billion housing rescue plan, called Making Home Affordable, fell short and foreclosures continued rising."

Hmmm... $75 billion is a lot of money. Mayhap the problem is that the banks know how useless pushing on a string is, or mayhap $75 billion is not enough to stem $304 billion (and counting) in Alt A and subprime losses that are still in the pipeline (see graphic below). 

It gets worse though. Let's glance at the non-conforming loan losses that have already occurred in comparison to the SCAP projections that justified the return of TARP in many cases. Recovery rates had the illusion of increasing ever so slightly due to an increase in prices as illustrated by the Case Shiller index. I have expressed my doubts about this housing price recovery for several reasons, the least of which is the construction flaws in the index itself which fail to capture the nature of the transient price increases, namely the activity of short term investors and flippers (see On the Latest Housing Numbers). There are some areas that have witnessed some firming of pricing though, but that firmness is the result of the Fed and Treasury trying to blow another bubble within a bursting bubble and is more than outdone by the rampant deterioration in credit quality of loans that result in the dumping of foreclosures -> REOs -> short turnaround sales/flips (via investors, which are not captured by Case Shiller, hence the illusion of a firming market in the lower end of housing prices) all over the place.

image019.png

Subprime delinquency, charge-off and foreclosure rates are still flying through the roof - with many other categories rushing to keep up. This is as I described from the beginning (2007) through the Asset Securitization Crisis series - there was an underwriting induced crisis and never a true "subprime crisis". As such, there is a very strong chance that many other loan categories may outstrip subprime loans in terms of aggregate losses. It hasn't happened yet, but the Alt-A category is hot on subprime's heels (see below). Construction and CRE will follow up the rear with unsecured consumer (ex. credit cards) and commercial loans fighting to get into the race.

image021.png

Below, you see the loss trend as of October 2009. These are losses that have most likely NOT been claimed by the banks, and they are significant. In addition, the credit deterioration trend is climbing, not falling. If I am correct in my assumption on the validity of the Case Shiller index in capturing true inventory price depreciation across investor related sales and bank "hold outs", then prices will soon start dropping again, killing recovery rates and causing losses to spike even further.

image015.png

First, a quick news scan:

My regular readers should remember my warnings on the currency trade risks (Japan's Hirano can testify), and interest rate derivative concentrations (let's see what happens to the counterparty daisy chain if Dubai defaults): "The Next Step in the Bank Implosion Cycle???". As excerpted:

Even more alarming is some of the largest banks in the world, and some of the most respected (and disrespected) banks are heavily leveraged into this trade one way or the other. The alleged swap hedges that these guys allegedly have will be put to the test, and put to the test relatively soon. As I have alleged in previous posts (As the markets climb on top of one big, incestuous pool of concentrated risk... ), you cannot truly hedge multi-billion risks in a closed circle of only 4 counterparties, all of whom are in the same businesses taking the same risks.

Click to expand!

bank_ficc_derivative_trading.png

First, a quick news scan:

My regular readers should remember my warnings on the currency trade risks (Japan's Hirano can testify), and interest rate derivative concentrations (let's see what happens to the counterparty daisy chain if Dubai defaults): "The Next Step in the Bank Implosion Cycle???". As excerpted:

Even more alarming is some of the largest banks in the world, and some of the most respected (and disrespected) banks are heavily leveraged into this trade one way or the other. The alleged swap hedges that these guys allegedly have will be put to the test, and put to the test relatively soon. As I have alleged in previous posts (As the markets climb on top of one big, incestuous pool of concentrated risk... ), you cannot truly hedge multi-billion risks in a closed circle of only 4 counterparties, all of whom are in the same businesses taking the same risks.

Click to expand!

bank_ficc_derivative_trading.png