bizzXceleration: Performance, Value and Profit

1. The credit crisis was created because there is a structural breakage in the incentives to each of the players. They got paid on the volume of business not on the quality of the returns.
2. Given a world awash in liqudity the overal systemic effect was to drive asset quality farther and farther down.
3. The initial breakdown occurred in mortgage-debt related instruments but could have been triggered almost anywhere.
4. We've got a long....long way to go in Housing because a) there's a lot of sub-prime resetting to do and b) we've historically overbuilt the stock of housing and paid far to high prices. And that will have to be worked off until natural demographic trends  re-balance supply and demand.
5. The structural deficiencies in the mortgage-related markets likely exist in all the other structured debt markets built using the same tools and subject to the same perverse incentives.
6. Nobody knows an overall picture of the magnitude of the problem because of a) pricing breakdowns in each of the seperate classes and individula instruments, b) nodody's talking and/or nobody's got a central picture or c) both. We think the latter is probably accurate.
   
7. Breakdowns in the mortgage markets are likely to spread directly into the non-mortgage markets because of drawdowns on assets and credit restrictions. They are likely to spread indirectly, slower and with bigger effect because of the impact of credit restrictions, housing downturns and slowing consumption on the economy.

But see for yourself if the walk-thru below supports those points or not. We've taken our best shot at it and we'd certainly be interested in hearing any expert commentary that tells us we're wrong - preferably with proof we can understand please ! :).

IMPLICATIONS & OPPORTUNITIES 

Meanwhile, so what ? Well the pressures on the banks and financial institutions will be severe for a long time to come and this will be as painful a re-working process as any from the Latin debt crisis to the S&L kaboomph to the...well you pick. Given the "technological innovation" and spread of these instruments it could convievably be worse.

Trying to cope with these problems is NOT a rate-setting problem for the central banks. It is regulatory mechanism problem; notice that unfetterred and unregulated "free" markets require enough regulation to insure that they are fair, honest and transparant. Not a giant Ponzi scheme. Otherwise, if this were an adult playground where the systemtic risks were recognized by all nobody would be opportunist enough to take advantage of this to undercut the players being careful. Right ? Now I'll tell another one.

Finally among other investment criteria that are suddenly going to come to the fore, and none too soon IMHO, is careful risk assessment and management, good credit quality and some attention to the performance (i.e. VALUE) of the asset. In other words that GE has spent a long time defending it's AAA-rating is all of a sudden going to be a major competitive weapon in their arsenal. How and why is left as an exercise for the soon to be victims of predatory competance, judgment and foresight. As well as cojones to swim against the tide.

O.K. sub-prime mortgages were bundled together as Asset Backed/Mortage Backed Securities (ABS/MBS) creating an artifical debt instrument. These (simplifying ! :) ) were then bundled into Collaterateralized Debt Obligations (CDOs) [which can be re-packaged into CDO1...CDOn themeselves]. The CDOs were/are sliced into seperate risk categories called tranches not necessarily because of inherent characteristics of the underlying assets, i.e. the sub-prime mortgages, but as a mathematical model of risk. Which presumes that the law of large numbers means that you have a large enough pool of risky assets that they can be sliced into highly guranteed/likely  to get paid slices and more risky maybe get paid downto an equity tranche that doesn't get a stream of interest payments from the mortgages but gets the value of the underlying "bonds" (the CDOs).

The parameters of the models were set by historical statistical estimation. The problem, among several, is that the history was based on a stable regime of default & payback rates. But the huge increases in liquidity flows meant the mortgage businesses had huge access to funds to originate more loans so they went after lower and lower quality homebuyers with more and more leniant terms. That resulted in the underlying assets becomeing of increasingly lower quality; i.e. the historical statistics didn't apply any longer 'cause a different universe of borrowers was being sold to.

 

Two other little details that are creating problems. Notice that the incentive of a bank to fund mortgages that they hold is to loan money to people who will pay it back, exercise careful scrutiny (otherwise due diligence) and monitor and support execution. Now when the banks originate loans but don't keep them they made their money off of their fees for orgination and servicing. There was a radical re-structuring of the incentives from emphasizing sound investment to scaling the flow as fast as possible.

 

The 2nd major structural deficiency, aside from and in addition to, the inversion of incentives was that at each link in the chain so that by the time mortages got turned into MBS they might be 30-60% or worse of the total MBS package. On the next round MBS got turned into CDOs with, say 15-30%, equity and 70% borrowed funds to leverage up the results. All of course rated AAA :) ! By the time this chain had run a few times the end might be at 70X leverage. Wheee....

 

When you see all the headlines about the "credit crisis" the deterioration of the value of the underlying asset and the resulting ripple across the chain of model-, not real market-, based structured derivatives is what they're talking about. There is another instrument the banks created called SIVs or Structured Invesment Vehicles (SIVs) which were built on similar principles. Except that the borrowed funds came from the short-term commercial paper market where things turn over once every few months.

 

This had two advantages for the Banks. First, they could borrow at 1% and then create a SIV which they sold to Hedge Funds, Norweigian city councils, Orange County, German banks, etc. etc. and got/paid much higher alleged "returns", say 8-11%. The 2nd advantage is that the little capital they put into creating these structured debt instruments didn't have to be on their books as they were seperate and subsidiary legal entities. So they could create huge lendings w/o having to face the music on raising more capital. That's why Citi is so scared of having to take this stuff back on it's books as to much where the value has to be written down from model to market could destroy their capital and make them have to seek huge outside infusions of new investment.

 

My explanations will likely strike an expert as insufficient but l strive for conceptual accuracy instead of technical precisions - in other words believe the gist of the summary is accurate but don't guarantee it. But it's my best pass to date. That said, what happens now ?

 

When sub-primes craterred starting in the Spring it cross-pollinated to the commercial paper markets and almost completely froze up worldwide s.t. credit markets. If that had happened we would have had something like the financial trigger that led into the Great Depression; no kidding or exaggeration here. Everybody though the problem was getting better this summer but the downturn in the markets in Nov was the result of spreads between low-risk s.t. instruments, e.g. US Treasuries, and riskier stuff starting to re-rise rapidly because everybody realized banks were still hoarding capital AND the mortgage market was worse than anybody thought.

 

On that by the way, especially if you read CalculatedRisk, we're going to see continued declines in sales thru the next 2-3 years and housing prices may not finish bottoming until 2010 or later. Since much of the problem is from housing values dropping and putting these mortgage borrowers underwater in the sense that they owe more than the house is worth these ARM resets are dangerous.

 

Now to add oxygen to this particular conflaguration the contagion has been spreading rapidly from sub-prime to all mortgage products which means those tails are going to wag some much bigger dogs.

 

Now let's talk about the other bonfires that are smoldering along. The underlying asset here was mortgages. Well the same mechanics were used to developed "structured debt products" for corporate buyouts - Collateralized Loan Obligations and other assets. Some of the mechanisms are different when the asset in question is a Japanese loan based on the Yen carry trade but the conceptual characterization is similar.

 

So when I talk about other asset classes it's these other major underlying assets besides houses that were put thru the same sort of sausage machine. And THAT problem is NOT getting talked about though I'm sure the Central Banks are very aware of it.