Excellent story in the Guardian about sub-prime lending, CDOs, etc.

Travelling out to Bethlehem, today. The upside is that I get to sit and read the Guardian (with internet I feel guilty spending the money on the International edition); downside is no internet. Also the Guardian today was predictably full of Alistair bloody Cambell and his diaries.

Redeemingly, the paper carried some worthwhile stories, including this one:

Many repackaged the mortgage debt and sold it to other institutions as part of complex financial instruments. Banks pool the debts they buy, grade them according to their risk profile, and package them as so-called collateralised debt obligations (CDOs) to sell on to other banks and institutions. The problem is that these instruments are traded between banks which gives them a value, but no official market. Their value is based on a model contrived by the investment banks who sell them. Until one of the banks begins selling these CDOs in the open market no one really knows what they are worth. If banks are forced to sell their CDO holdings or mark down their value, it could result in a wholesale re-pricing across the sector, leaving some institutions with a large hole in their finances.

“It’s back to game theory. It is in everyone’s interests to sell, but the danger is that you spark a collapse that means you lose more on the debt you retain than the debt you sell. The alternative is to sit on it and hope for better times. It’s almost a conspiracy of silence. But no one can think of a better idea,” said one analyst.

Last week the US investment bank Goldman Sachs gave some indication of how the value of these instruments can change when it began a revaluation of its portfolio of mortgage-backed debt securities. Goldman cut the value by almost 30%, wiping $1.5bn (£750m) off the value of its assets.

Regulators in the US are ignoring the problem, say critics, because they also realise that adopting a hard line and forcing a market price on these packages of debt, will flush out catastrophic losses. The increased use of CDOs, often referred to as debt derivatives, created a web of holdings by banks which bought and sold from each other. To the US central bank the web was so wide it spread the risk and allowed banks to extend lending to poorer households.

It means that many banks now harbour debt portfolios that are difficult to value and which could turn out to be worth a lot less than expected.

To the banks it is not just a paper money problem; many of the empty homes they have repossessed are now sitting directly on their books. There are districts in Orange County, across Florida and many other parts of the US where they own hundreds of homes. Congress is beginning to ask if keeping these homes empty is the best policy. Shouldn’t they be sold and families move in? If that happened, the very real losses on selling homes would again leave large holes in the banks’ accounts. Worse, it might cause a collapse in confidence in the housing market, with all the implications that flow from falling prices and negative equity.

This latter mention of the empty houses is a great one. Banks, if and as they repossess houses, have two options (not including burning them down for the insurance money, renting them for use as props in monster truck derbies, or such things): keep the house, and keep the mortgage on their books as the asset value of that house, or sell the house, and determine the true value of that asset. In a housing market characterised more and more by distressed sales and falling prices, odds are the banks’ balance sheets do not accurately reflect the market value of their assets – but we never need to find out, as long as the market is never asked to value the house.

This is precisely the problem with CDOs, CMOs, etc., which also are not traded on a market. When Merril Lynch planned on taking Bear Stearns’ bonds built on these assets – all the way down to the sub-prime mortgages that made up the riskiest slice of the CDOs – a market, and a market value, would slowly have come about. Odds were that value would be significantly less than the value posted on balance sheets, both in Bear Stearns’ two funds, as well as hedge funds all over the land. Hence the conspiracy of silence, with periodic sensible behaviour such as the write-down at Goldman Sachs

Very relevantly – and this we do not hear often at all, and certainly not often enough:

Some critics say the Federal Reserve and Alan Greenspan, its former chief, take a good part of the blame. In a series of speeches he encouraged innovation in the credit markets that would allow banks to price the risk of lending to low-income households and those with poor credit histories. As late as 2005 he was making speeches encouraging banks to develop this market.

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1 comment so far

  1. I read this article and wondered if we could connect our blogs somehow – share traffic or links and content. I have written 490 articles on hedge funds and continue to blog within this niche. Let me know if you have any ideas on how I could help you.


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