Sunday, October 28, 2007

Dirty Little Secrets of Subprime

I was reading through various blogs today when I stumbled upon Paul Krugman’s summary of the Report and Recommendations by the Majority Staff of the Joint Economic Committee (the “Report”) by Senator Charles Schumer, Chairman, and Rep Carolyn B. Maloney, Vice Chair. You can find the Report here: Since I have been writing on this drama for the past few weeks, I decided to get the Report and take a look under the hood. I found quite a few oil leaks. Unfortunately I believe this report to be another expenditure of taxpayer funds by Mr. Schumer to pull the wool over the eyes of the public and protect his wealthy constituents on Wall Street. By diverting attention away from those who profited from this adventure the Report attempts to back door a taxpayer bailout of the financial industry. Here are some of my issues with the Report:

1. The Report is stunning in the questions it does not answer. One such question is who is responsible? Of course, that would be investment banks, Wall Street attorneys, accountants, rating agencies, and mortgage servicers who collectively made a market for these mortgages that, from history, they knew (or should have known) were junk. None of these players in the game of wealth redistribution are mentioned in the Report. Instead, the blame falls to the state chartered mortgage bankers and the mortgage brokers. This is like concluding that the reason we have made so little progress in Iraq is because of the soldiers’ ineptitude rather than the generals or the administration. It’s like concluding the drug problem lies with the small time pusher but the cartels have nothing to do with it. The mortgage bankers did exactly what Wall Street wanted them to do – sell loans to feed the securitization machine. To now blame the foot soldiers and state regulatory failures for this mess is a disgrace. I would like the report to address where all of those HUD-1 statements executed at all of these home mortgage closings ended up? Mr. Jackson, please?

2. Another failure of the Report is it never asks the question “who profited from this disaster?” According to the Report, there are approximately $1.5 trillion in outstanding subprime mortgages. Of those, between 50% and 80% were securitized depending on the year in question from 2001 through 2006. If we assume 70%, the total of these loans that were securitized would be $1.05 trillion. Now, I don’t know how much profit is in these securitizations, but I assume that between attorneys, accountants, rating agencies, sponsors, etc., there has to be around 3% coming off of the top (probably multiples if we include servicing fees). That would be (1,050,000,000,000 x .03 = $31,500,000,000) $31.5 billion. It’s party time! It disgusts me that none of this is in this Report. How can it include worthy recommendations when it ignores the facts? If my percentages are off, it’s only because these numbers have not been made available in the Report. This is not to say that the mortgage bankers did not also profit from these transactions. I have seen many profit handsomely from them. The problem is where does that profit come from? It trickles down from the profits up the food chain on securitizing these mortgages. There has been a massive redistribution of wealth and, based on the recommendations of the Report (see below), Senator Schumer believes the taxpayers should pay the tab.

3. The report fails to observe some of the most obvious conclusions that can be reached from the data it presents. Here is one example: according to the Report, “As can be seen in Figure 10, between 2001 and 2006 adjustable rate mortgages (ARMs) as a share of total subprime loans originated increased from about 73 percent to more than 91 percent. The share of loans originated for borrowers unable to verify information about employment, income or other credit-related information (“low-documentation” or “no documentation ” loans) jumped from more than 28 percent to more than 50 percent.

“The share of ARM originations on which borrowers paid interest only, with nothing going to repay principal, increased from zero to more than 22 percent. Over this period the share of subprime ARMs that were originated as “hybrids” increased dramatically. The share of 2- and 3-year hybrid ARM’s accounted for more than 72 percent of all subprime ARM’s originated in 2005 (See Figure 12 in Appendix).”

At the same time, the Report discloses that these subprime ARM loans went to borrowers with, on average, lower FICO scores (624) than any other type of loan. Subprime fixed FICO scores were 636, near prime ARM 711, and near prime fixed 717. Why are the adjustable rate borrowers in these lower FICO scores? Because that’s how you get them to qualify for a loan, by basing their payment on the initial teaser rate or interest only payment. These were the loans being made toward the end of this debacle, and over 80% of them by dollar value were securitized in 2005 and 2006. All of this makes it painfully obvious that the mortgage machine was working its way down the food chain from qualified to unqualified borrowers, while all of the regulators did nothing but brag about how home ownership rates where going up and Wall Street collected fees. In my opinion, heads should roll. The Report does give this point lip service with the following “full” coverage of this topic:

“Because mortgage companies sell many of the loans they underwrite to the secondary market, they have an interest in underwriting loans that are desired by the secondary market investors.51 This observation has special weight because of developments in nonmortgage financial markets. In recent years, as hedge funds have proliferated and the market for structured financial products has expanded, there has been significant demand for highyield assets that can underlie collateralized debt obligations (CDOs) and other financial derivatives. Subprime mortgages have, until recently, been considered terrific assets to include in CDO structures. Hence subprime lenders have had a strong incentive to underwrite high-yielding subprime mortgages, whether or not these loans were best interests of the borrowers.” Yup, that’s it. The fault lands at the feet of the subprime lenders and no further up the food chain. Lets not examine what accounted for the strong incentive lenders had to originate these mortgages.

4. The Report shows a clear relationship between the rate of subprime mortgages and the rise in overall housing prices, yet it never actually makes this connection. In other words, the $1.5 trillion artificial increase in housing demand from subprime borrowers resulted in rising prices that kept subprime default rates artificially low until lenders got far enough down the food chain. Then the house fell down. What device enabled this run-up in subprime and housing prices and now defaults (subprime went from 2.6% of outstanding mortgages in 2001 to 14.0% in 2Q 2007)? The CDO and securitization machine that was making money from it.

5. The Report ignores the role of the rating agencies in this mess. In order to make these loans, they had to be securitized because nobody wanted to hold them in their portfolio. Apparently it was well known that these loans were highly risky. Well known to everyone except the rating agencies who rated tranches too aggressively and are now in the process of downgrading them rapidly. This should come as no surprise. As the Report shows, subprime default rates have always been high with the exception of the period of time when home prices were appreciating at unsustainable levels. This is painfully obvious from the statistics presented in the Report. But the next logical question is how did the rating agencies get this so wrong? Did they actually assume that home prices would continue to appreciate at levels we have only seen in the past for a short period following WW II? Here is what the Report has to say about this:

“Since underwriting deteriorated from 2001 to 2005, and the accelerating housing price boom was giving subprime borrowers important help (see Part II), a cautious analyst might have questioned whether the improvements in subprime performance could be sustained. The financial intermediaries who expanded the supply of these loans were apparently not troubled by this issue. The reasons for their lack of curiosity may lie in the strong incentives they had for expanding the subprime market.”

Who are these “analysts” and what were their strong incentives to expand the subprime market? Other than the mortgage bankers supplying food for the CDO market we have no idea from this Report. So, it is some unidentified “analyst” who is to blame for this massive screw up. Not the CDO wiz kid quants or the rating agencies, but some “analyst”. Please stop insulting our intelligence. Regarding the rating agencies, these issues are not new, and they are now coming to the forefront. The Connecticut AG has issued subpoenas to get answers to questions that many scholars have been asking for a decade regarding rating agency independence and the pseudo regulatory role they play. If you are interested in this issue a good place to start would be with Frank Partnoy’s research paper HOW AND WHY CREDIT RATING AGENCIES ARE NOT LIKE OTHER GATEKEEPERS. This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection: You can also review my piece on the pseudo regulatory role, and the resulting house of cards, that rating agencies play in our banking system here:

6. Where is the SEC? One of the striking issues about this whole mess is that nobody seems to know exactly where all of these CDOs are. This gets us back to the SIVs and M-LEC that have been discussed at length in the media, and I will not re-hash all of my issues with that here. You can read my previous posts on that topic here: and here: It seems to me that there are some people who actually know the answer to that question, whereas most of us do not. Doesn’t this create asymmetry in the markets? Can’t those who are in the know be putting on positions right now to their advantage based on this information? Think now is a good time to be in the markets? This shoe will drop in the woods, and none will hear it.

I could go on, but I think I have made my point that this Report is biased, and I for one am again angry at this snow job that appears to me intended to deflect attention from where the responsibility (and the profits) lie. Of course that's just my opinion.

Now to the recommendations. Total losses to homeowners could be as high as $164 billion (based on the assumption that the inflated real estate values are the real values). Of course, the recommendations do not include any mention of those on Wall Street. Instead, the first thing we should do is “increase FHA’s ability to refinance by passing the Federal Administration’s (FHA) Modernization Act of 2007, which would increase FHA’s capacity and flexibility to insure subprime mortgages that can be refinanced.” In other words, we should push the problem to the taxpayers. Are you ready for the $1.5 trillion bailout? Here it comes! Next, we should expand the capabilities of the GSEs Fannie and Freddie to help subprime borrowers through refinancing. Wait, isn’t that the same as recommendation 1? Taxpayer bailout. There are other recommendations such as educating borrowers, amending the bankruptcy laws, and so on. The bottom line – and I must give credit to a Newsvine friend for this quote – privatize the profits, socialize the costs.

All in all this Report is, in my opinion, another expenditure of taxpayer funds by Mr. Schumer to pull the wool over the eyes of the public and protect his wealthy constituents on Wall Street. By diverting attention away from those who profited from this debacle the Report attempts to back door a taxpayer bailout of the financial industry. This is the same financial industry that benefits from favorable and unjustifiable tax preferences, and represents the largest share of the top 1% income earners in the country. Unfortunately there is nothing new here. For another glaring example see my piece on another Schumer sponsored report here: . Shell games at the highest levels of government.

Finally, there is a case in front of the Supreme Court right now that could have an impact on the ability of anyone to hold any third party responsible in this mess. The case, Stoneridge, deals with concepts of third party liability for investor harm. It is not exactly on point, but it is not far from it. Should the Court, as expected, rule in favor of no third party liability, good luck ever getting anyone responsible for this mortgage debacle to pay. You can get my take on Stoneridge here:

Looks like all the lose ends are getting tied up nicely.

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Thursday, October 25, 2007

Subprime Socialization

I was responding to a post in The Informed Reader section of The WSJ Online Edition (here: regarding His Honor Richard Posner’s discussion of third party liability. The question is whether a bartender or host should be liable for another person who drinks too much, gets in their car, and then causes a seriously unfortunate accident.

Because I have been following this whole subprime mortgage debacle I decided to take the opportunity for an analogy. Here is what I wrote:

“I wonder what His Honor would think about holding the Wall Street securitization players (banks, bankers, rating agencies, etc.) liable for the devastation caused in the mortgage, commercial paper, and real estate markets. That’s where a lot of the profits went, but it looks like much of the cost will ultimately fall to the taxpayers, the note holders, and the homeowners. I suppose one important question would be whether they are third parties or conspirators. If they are third parties, perhaps we could apply a Grokster inspired logic and find them contributorily liable: “When a widely shared product [MBS, SIV, ABCP Conduit, etc.] is used to commit infringement [fraud by mortgage bankers and clients], it may be impossible to enforce rights in the protected work [prevent the fraud] effectively against all direct infringers [fraudsters (mortgage bankers, etc.)], so that the only practical alternative is to go against the device’s distributor [Wall Street et. al.] for secondary liability on a theory of contributory or vicarious infringement [fraud]. One infringes [commits fraud] contributorily by intentionally inducing or encouraging direct infringement [fraud], and infringes vicariously by profiting from direct infringement [fraud] while declining to exercise the right to stop or limit it.” (From the Grokster syllabus here:, pg. 2.) Hum, it definitely needs some work and it sounds a lot like conspiracy, but it’s not too much of a stretch. I guess I am assuming that people in the securitization stream had actual knowledge that these mortgages were not what they were supposed to be, and I do not really know that for sure. It could just be a massive case of due diligence failure or, if the loans are actually what they were supposed to be, stupidity.

“In any event, it seems to this admittedly smaller legal mind that the moral hazard of a social solution is far worse than the financial losses of those who profited from this misadventure. Of course, that’s just my opinion, and I already hear Mr. Becker speaking up about the social costs of a major credit de-leveraging throughout the economy should we let the liability fall to these parties through whichever legal theory you like. In the interim, I really hope someone is checking the documentation on those loans Countrywide is transferring to FHA loans because I have a guess about just how good the due diligence has been there lately and I, for one taxpayer, do not feel the need to pick up the tab for this one.”

This issue of third party liability comes up a lot, and there is a current third party liability case in front of the Supreme Court now, STONERIDGE INVESTMENT V. SCIENTIFIC-ATLANTA, INC. ET AL. The issue in this case:

Plain language version:
Company A enters into transactions with Company B that have no real business purpose, but which allow Company A to report more earnings than it really had using hocus-poke-us accounting. Company A publishes its financial reports and its stock goes up. People buy the stock. Then the hocus-poke-us stuff is revealed, and the stock tanks. Now the stockholders want Company B to pay because without its participation in the scheme the fraud would not have happened (so they claim).

The way lawyers do it:
The issue presented is whether shareholders of a company that committed fraud resulting in losses to those shareholders can recover damages for deceptive conduct from a third party company that engaged in transactions with the public corporation with no legitimate business or economic purpose except to inflate artificially the public corporation’s financial statements, but where the third party themselves made no public statements concerning those transactions. (Butchered from the court records)

Well, this raises all kinds of questions. If you allow Company B to get away with this, investors will be unprotected and invest less. This dries up available capital and slows the economy. On the other hand, the Banks (often third parties in these misadventures) argue that if they are held to account for the sins of their clients, they will stop lending (and/or it will cost more) and that could dry up capital and hurt the economy. Oh yes, there is also the usual lawyer bashing with claims that it’s the lawyers pushing for liability because they want to be able to bring law suits against all of those third party companies (probably some truth to that too).

Decision due out soon. I have my money on no liability for third parties here. My reason is simple; the banks are on that side and it seems to me that the banks have been getting whatever the banks want these days.

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Tuesday, October 23, 2007


Unless you are very young, you remember the now infamous declaration by President Bill Clinton “I did not have sex with that woman.” Then there was the stained dress, and everyone said “but you did!” His reply was that “sex”, where he was from, meant intercourse and he did not have sex with that woman. The public was outraged! Liar! Liar! Impeach!

Today we find ourselves arguing over another definition, although framing the argument seems to be difficult because there is so much that is not known (even though we are talking about entities that can profoundly impact our economy). The definition in question is “value.” How much are the assets in those SIV things worth. This is a critical issue because if they are worth say 50, then the owner SIV would have to sell them. If they are worth 95, then they do not need to sell them or, if they do, they can sell them to this “super-siv” or M-LEC thing you’ve been hearing about ($80 billion bank fund) without any really bad repercussions for the banks. Rather than get into the details about what happens if the value is on the low side, lets just say it could cause the banks and, unfortunately, our economy some significant pain because it could trigger a massive de-leveraging. (Of course there will be some who are impacted little by this, and you can find a really good piece about that written by Ben Stein here: Such an event could easily lead to a pretty bad recession.

So what do we do about this? We morph the definition of value. Now, the people in charge of determining the value of these assets in question are not just people off the street. These are exceptionally smart people who have developed these SIV things using all kinds of mathematical models based on quantitative methods and such. I believe they know exactly what the assets are worth if they tried to sell them today, and accepting that value could trigger a very destructive de-leveraging. But they argue that value can be defined differently. What if we define value as what these assets may be worth if we wait for a really long time by selling them to a big daddy SIV (at, oh, lets say a value of 98), bring down interest rates (which causes the value of interest-bearing securities to rise – here is our inflation problem too), and hope that these assets pay out over time more than they are worth today? Hey, I like that definition! 98 it is! Who wants a recession anyway? “I did not hide the value of that SIV!” (Liar! Liar!)

In the words of William Poole, president of the Federal Reserve Bank of St. Louis:

“I think the big uncertainty right now has to do with the subprime paper: the extent to which there are owners that are potentially really stressed and are going to be forced to sell, how strong are their positions, to what extent can they gain financing from other sources so that they don’t have to dump assets,” Mr. Poole said. “They may be convinced that this paper is worth 60 cents on the dollar and they don’t want to be forced to sell it at 30 cents on the dollar. I really don’t know very much about that, and I suspect that a lot of the people even who run these funds, whose businesses run these funds, don’t know exactly where they stand on that and are out there trying to figure out what to do.”
From The Wall Street Journal Online Edition here: .

Sounds like a lot of confusion for the President of one of our Federal Reserve Banks, especially when you consider that this all gets back to the sufficiency of bank capital in our financial system. Those "people even who run these funds," aren't those the major financial institutions regulated by the FED?

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Saturday, October 20, 2007

Public and Private Bank Regulators

Revised - see excerpts added at end.
Revised 10/23 - see joint press release regarding capital adequacy rules for conduits at end.

I am not an expert on banks and banking, although I have been a banker and I have read a few books on the subject. Because of that, consider this an opinion piece based on some observations that I would like to share regarding the current credit crises. If you plan to use any of this information for anything important please remember to verify.

My conclusion is that too much of our financial system is currently regulated by rating agencies. This is accomplished by (get ready for this one) - using the market distortion of bank regulation to avoid bank regulation. Now this is not a rant against rating agencies. In fact I like rating agencies and they play a very important role in our economy. But I believe they have been making too many decisions that impact us all in what has effectively become a dual system of public and private regulation. Here is my reasoning:

On one hand, the banking industry is structured to take excessive risk because of all the safeguards built in by regulators. We don’t want banks to fail. The results are bad – people lose money, fewer loans are available and that slows the economy, etc. So, to protect us from that, banks get certain privileges. First, they have a lender of last resort – the FED. Banks, assuming they are not insolvent, can pledge collateral to the FED and borrow from it if they run into a liquidity problem. If they have no assets the FED is willing to take and not enough liquidity to meet withdrawal demands, then they are most likely insolvent. But even then, there is the “Too Big To Fail” doctrine that, we all know from history, is true. The impact of a large bank failure on the economy would be big and bad, so we don’t believe the government would let that happen. Finally, the FDIC insures deposit accounts (within limits) so even if a bank does fail, the depositors get their money back. Look at all the bail out built into the system. This limits the downside risk of lending because in the worst case, who gets hurt really? So, banks have a built-in incentive to go for the gold (make risky high interest loans).

In order to ensure that banks don’t just swing for the fences, there is the flip side called bank regulation. Banks are prohibited from owning certain types of risky assets like stocks and junk bonds. They are also required to hold a certain level of equity capital that is based, in part, on the risk level of the assets they own (the securities, loans, etc.) to provide a cushion against insolvency. If the value of their assets declines, there must be enough equity to absorb it. They also must keep a certain percentage of the deposits they owe to depositors in reserves to help ensure liquidity. These regulations are enforced by regulators and are in place to counter balance the protections we offer banks and prevent them from focusing on volume instead of quality of loans. These checks and balances result in a profitable banking system that is less likely to fail, and that results in better credit ratings for banks. So, all of the regulation helps banks maintain good credit ratings.

Once you take away these regulations, or more precisely, figure out how to avoid them, you take away the check on the imbalance toward too much risk. I believe this is one of the major issues with off-balance sheet vehicles such as SIVs and ABCP Conduits. As noted above, banks are required to have risk-based capital that is calculated based on the risk of the assets they hold. This is the implementation of one of the checks against all of the protections banks are afforded. When it comes to ABCP Conduits, however (including the now infamous SIVs), banks calculate the amount of risk-based capital required by multiplying the line of credit used to enhance the conduit by 10% (the regulations allow them to do this). So, they escape 90% of the risk-based capital requirement. Shouldn’t this lower their credit rating? (Now, I believe these numbers are generally correct, but as I said I am not an expert on this and I do not have access to a law library at this time. I did find some support for these numbers here:

Now we see why banks love this structure. They take the interest rate differential between the assets funded by the conduit and the liabilities funding the conduit and earn a fee from it while only using up 10% of the risk based capital they would be required to maintain if they did this on their balance sheet. This jacks up return on equity by, in effect, getting around the capital requirements.

Let’s look at an example, a make believe bank named PLUS 90 Bank. It has lines backing conduits of approximately $77 billion. Lets be very generous and assume that the assets would be risk-weighted at 20% if they were on the balance sheet, so the bank would be required to keep $1.232 billion dollars in capital to support these assets ($77 x .2 x .08). But, because they are not on the balance sheet, the bank needs only $123.2 million in capital ($77 x .2 x .08 x .1). This $1.1 billion dollar difference is why the banks love this structure. They can avoid the capital requirement and enhance the return on equity. Lets do a simplified example:

Suppose a bank acquired assets with $77 billion and funded that purchase with time deposits. They would earn an interest spread on the investment. Since we are using a risk-weight of 20%, these would be pretty good assets and the interest spread would be on the low side. Assume it is 1.5%. What is the return on equity before expenses?

($77,000,000,000 x .015) / 1,232,000,000 = 0.9375, or 93.75%. Leverage!

What happens if the bank takes this whole thing and moves it off-balance sheet?

($77,000,000,000 x .015) / 123,200,000 = 9.375, or 937.5%! Even if the bank makes a 1% fee from the off-balance sheet entity, that’s still ($77,000,000,000 x .01) / 123,200,000 = 6.26, or 626.00%.

Looked at another way, with a 10% capital requirement, the bank can provide 10 times as much credit off-balance sheet as it could on-balance sheet (in fact, they can probably leverage it even more if they can avoid the 10% bank line; is this why there are troubles afoot with the SIV structure?). See what I mean about the regulations? This structure makes a mockery of the basic idea of limiting bank exposure through the regulatory framework. So what, then, does limit bank exposure? Well, the limit is really the market for commercial paper. This market is driven, in large part, by the perceived quality of commercial paper and that is where the rating agencies come in.

Rating agencies examine the structure of conduits and the quality of the assets they hold. They also look at the credit lines from the banks that provide liquidity to the conduit should there be a problem, so in part the rating assigned a conduit depends on the rating of the bank. See, the rating of the bank that is in part determined through the regulatory structure is then used to backstop a conduit, which is used to avoid those very same regulations. Eureka! (For more learning on how rating agencies rate conduits you can go here where you will find Moody's Update on Bank-Sponsored ABCP Programs: A Review of Credit and Liquidity Issues from September 2007.) (See below for some excerpts.)

As long as rating agencies opine on a particular conduit, the money flows. If there were a problem and the bank had to actually fund the credit lines that could impact the rating of the bank and in turn the rating of the conduit. Sounds like circular reasoning to me, sort of like making a loan to the CEO of a company and using her stock as collateral. We know how those work out when there’s trouble afoot. In any event, this structure leverages up the amount that can be loaned given any level of total bank capital as long as the rating agencies opine, hence they are regulating the banking system. This would not be a concern if there were no bank lines behind these structures because then bank solvency would not be an issue. Unfortunately, when they are backed by bank lines bank insolvency can become an issue, and how big of an issue is regulated not by the bank regulators but by the rating agencies.

Here are some details from the Moody’s report referenced above. Note the asset classes that are financed through conduit structures. Sounds like traditional bank lending assets to me. (I do not know if these include SIVs.)

“In the United States, Moody’s rates 113 bank-sponsored programs, with total ABCP outstanding of US$522 billion as of June 30, 2007. Of these, 62 are multiseller programs, with US$461 billion outstanding, 22 are securities arbitrage, with US$67 billion outstanding, and 10 are hybrids with US$32 billion outstanding. Looking at the multisellers, we note that these are highly diversified programs. On average, these programs fund 62 different transactions among 10 different asset types. The largest asset types by outstanding amounts are credit cards at 15%, trade receivables at 13%, commercial loans at 11%, auto loans at 10% and securities at 9%. Mortgages also make up 9% of the total, mostly in the form of warehousing lines that fund newly originated mortgages for short periods of time. Highly rated CDOs comprise about 3% of the assets. Note that US multiseller programs typically have 8% to 10% program credit enhancement, nearly covering any single one of these asset classes.” And,

“Securities arbitrage programs are similarly diversified, averaging 126 different individual securities among 7 different asset types. The concentrations by dollar par amount reflect more the term securities market, with CDOs comprising 35%, commercial mortgage loans 17%, residential mortgage loans 13%, home equity loans 12% and student loans 5%. Of these securities, 89% have Aaa ratings from Moody’s, and another 6% have Aa ratings. An additional 5% are rated Aaa by rating agencies other than Moody’s. This leaves less than 1% rated below Aa.”

Regarding the link between ABCP Conduits and their sponsoring banks:

“As we have noted, all three types of bank-sponsored programs – multisellers, securities arbitrage and hybrids – rely on liquidity and credit enhancement provided by Prime-1 rated entities. For most of these programs, most of this support is provided by the sponsoring bank. Therefore the credit rating of these programs is also linked to the rating of the sponsoring bank. Should a liquidity or credit support provider be downgraded below Prime-1, Moody’s would review the ABCP conduit rating and might downgrade the conduit’s rating.” And,

“Moody’s includes a review of the sponsor and the support providers when assigning a rating to an ABCP program. As a result, we believe that those parties are able and willing to perform according to the terms of the agreements supporting ABCP programs in general, and bank-sponsored conduits in particular.”

I welcome all comments and additional learning on this topic. Please feel free to leave your thoughts and point out any faults in my fact base or logic.

For posts I have done on the SIV issue you can scroll down or click on the link to your right. There are two additional posts from the past week.

Update: Here is the announcement of the rule for bank capital in connection with conduits, which can be found here:

"For Immediate Release
July 20, 2004
Agencies Issue Final Rule on Capital Requirements for Asset-Backed Commercial Paper Programs

The federal banking and thrift regulatory agencies today issued a final rule (393 KB PDF) amending their risk-based capital standards. The rule permits sponsoring banks, bank holding companies, and thrifts (banking organizations) to continue to exclude from their risk-weighted asset base for purposes of calculating the risk-based capital ratios asset-backed commercial paper (ABCP) program assets that are consolidated onto sponsoring banking organizations' balance sheets as a result of Financial Accounting Standards Board Interpretation No. 46, Consolidation of Variable Interest Entities, as revised (FIN 46-R). This provision of the final rule will make permanent an existing interim final rule.

The final rule also requires banking organizations to hold risk-based capital against eligible ABCP liquidity facilities with an original maturity of one year or less that provide liquidity support to ABCP by imposing a 10 percent credit conversion factor on such facilities. Eligible ABCP liquidity facilities with an original maturity exceeding one year remain subject to the current 50 percent credit conversion factor. Ineligible liquidity facilities are treated as direct credit substitutes or recourse obligations and are subject to a 100 percent credit conversion factor. The resulting credit equivalent amount is then risk weighted according to the underlying assets, after consideration of any collateral, guarantees, or external ratings, if applicable. All liquidity facilities that provide liquidity support to ABCP will be treated as eligible liquidity facilities for a one-year transition period.

The rule, which will be published shortly in the Federal Register, will become effective on September 30, 2004. "

For the rule and a good description of ABCP Conduits here is the link to the FED's publication:

Check out this piece from the FED from the link referenced above:

"The resulting credit equivalent amount would then be risk-weighted according to the underlying assets or the obligor, after considering any collateral or guarantees, or external credit ratings, if applicable. For example, if an eligible short-term liquidity facility providing liquidity support to ABCP covered an asset-backed security (ABS) externally rated AAA, then the notional amount of the liquidity facility would be converted at 10 percent to an on-balance sheet credit equivalent amount and assigned to the 20 percent risk weight category appropriate for AAA-rated ABS."

So, the rating agencies determination of the risk in the conduit is used to determine the amount of capital the bank must keep which in part determines the rating on the Bank which in part determines the rating on the conduit. I' dizzy!

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Friday, October 19, 2007

Maybe Stalling Is Viable (The Master SIV) 10/22 update

Revised again - see the end. I have added a quote from a New York Times article on this topic.

I was going to revise this entire post (it was very dramatic and some people were offended by the Shamco reference – I was poking fun) but decided that an explanatory preface would suffice. So here goes:

The SIV structure is different from the ABCP Conduit structure on which this post was originally based. As details have emerged, it appears the SIV structure has less in the way of direct recourse to the sponsoring bank, although there is some [some more recent commentary suggests the recourse is only for reputational issues - "On SIVs, Citi is a manager of roughly $80 billion in SIVs. While they do not have liquidity backstops to their SIVs, they will lend at arms-length, exposing Citi to potential losses. Given that there is no disclosure on these loans, it is hard to estimate the magnitude of these potential losses, but we do bake in deteriorating corporate credit in the investment bank" From FT here:, citing Mrogan Stanley comments]. These entities use a different capital funding structure than other conduits. Because information has been so slow to come out on these, reports (including mine) based analysis on the ABCP Conduit with traditional liquidity and credit enhancement lines from the banks. I assume that the reason the current problem is more pronounced in SIVs is in part because they do not have as much support from the bank sponsors as the traditional ABCP Conduit and the structures are weaker given the impact of current market conditions.

Either way, I believe the accounting issues discussed below remain relevant to any restructuring of these off-balance sheet entities and their sponsors whether they are SIVs or not. In the end, if the CP market that funds these structures were to dry up, bank liquidity would be negatively impacted and the resulting lack of credit availability could cause major economic damage. The extent of the direct hit to the sponsoring banks depends, in part, on the level of support they provide, and I have not found any definitive source of information regarding the level of support or the sponsors’ liability with respect to SIVs (which is probably one reason why the reporting has been based on the more widely understood conduit structure).

ABCP Conduits are also off-balance sheet entities that use liquidity lines directly from the sponsoring bank (often a group of banks) to deal with liquidity risk, and these lines could be called upon to fund if the market for commercial paper issued by these entities evaporates. The potential cascading effect should not escape us. If bank quality deteriorates because of depreciation of assets both on and off the balance sheet, which could be sparked by the SIV issue, the risk of the ABCP Conduits will also increase and should reduce the demand for their commercial paper as well. This could ripple through the market, especially if forced liquidation of assets occurs further depressing asset values on the balance sheets of banks and in both SIVs and ABCP Conduits.

According to a September 12, 2007 Moody’s Investors Service Report, “Bank-sponsored ABCP conduits are the oldest and largest segment of the asset-backed commercial paper market. As of June 30, 2007, there were over 200 such conduits worldwide, with approximately US$900 billion of ABCP outstanding, comprising two-thirds of the outstanding ABCP rated by Moody’s.” There are three types of these conduits, and “all three types of bank-sponsored programs – multi sellers, securities arbitrage and hybrids – rely on liquidity and credit enhancement provided by Prime-1 rated entities. For most of these programs, most of this support is provided by the sponsoring bank. Therefore the credit rating of these programs is also linked to the rating of the sponsoring bank. Should a liquidity or credit support provider be downgraded below Prime-1, Moody’s would review the ABCP conduit rating and might downgrade the conduit’s rating.” In other words, if the banks that sponsor the Conduits are downgraded, so goes the commercial paper they issue. You can find this report here: . As it turns out, according the The WSJ Online edition, Citibank "has nearly $160 billion in SIVs and conduits, but its shareholders wouldn't get a clear view of this from reading the bank's balance sheet. Instead, footnotes only disclose that the bank provides 'liquidity facilities' to conduits that had, as of June 30, $77 billion in assets and liabilities." This article can be found here: [Subsequently I have reviewed the financials myself, and I believe the $77 billion number relates to multi-seller programs only.]

So, if you decide to read the original post, simply replace SIV with ABCP Conduit. If the SIV problem escalates into a larger problem, we could be looking at the same situation there anyway. And, the accounting issues remain relevant in any event. And, if anyone can give me (and others) some specific guidance on SIV sponsor liability, I would be grateful.

With that lengthy but necessary introduction, here is the original post:

Updated 10/18 - see below.

I just don’t get it. Everyone knows what this is about – stalling. It’s about using financial reporting flimflam to protect the banks from major problems. Here’s what this is about, as far as I can tell, in kind of simple terms (it’s not really simple). I am making assumptions about the structure for lack of details in the reported information. I did, however, hear from an under-secretary (I think that was his title) of the Treasury on Nightly Business Report tonight who said this beast would be funded by the banks and by commercial paper investors, so I have an idea what they plan to do. Here is the latest from The WSJ Online Edition as of this writing:

Banks (it seems Citi is the name that keeps popping up) have structured investment vehicles. What are these? Well, lets say you want to borrow some money to invest in mortgage-backed securities, but you don’t want the loan on your credit report. So instead you form a company called Shamco, and Shamco borrows the money. Of course Shamco has no credit history so you end up guaranteeing the loan that is also secured by the mortgage-backed securities you plan to purchase. The money from the loan comes in and Shamco uses it to purchase mortgage-backed securities that pay 6.5% interest, while borrowing at 3.5% interest. Borrow short term at 3.5%, lend long term at 6.5%, and go home with more money! What allows this to happen is your personal guarantee and the fact that some analysts at the rating agencies opined that there was very little risk in lending to Shamco in part because you will pay up if there is a problem. The loan is not on your credit report (or balance sheet). (Welcome to financial engineering.)

Everything is fine for a long time. Then, one day, it turns out that the investments Shamco purchased are bad. The mortgages aren’t getting paid, so the value of the mortgage-backed securities Shamco purchased for say $100 are only worth $80. Well the lender finds out about this and says, “Pay me back.” Here is the problem. You can’t really pay the loan back because Shamco has no cash (it used it all to buy the mortgage-backed securities) and you don’t have enough cash reserves to make good on your guaranty. Shamco can’t sell the mortgage-backed securities because it’s no secrete that they are bad investments and nobody wants them. But you guaranteed the loans, so if push comes to shove, you are on the hook. You would have to buy the investments for the amount you owe even though they are not worth that much, or sell the investments and chip in the rest. This could cause you major problems, including ginormous losses.

I give you the SIV. This is what the banks have done. The SIV is the new company, and it issues commercial paper (which is very short term stuff). The commercial paper is purchased by money market mutual funds (and such) at very low rates because S&P and Moody’s have given the commercial paper high ratings for safety. The SIV uses the proceeds of the commercial paper loans to purchase assets, like mortgage-backed securities (and lots of other stuff). The bank guarantees the commercial paper investors that if there is a problem, the bank will come in and pay them. None of this debt or assets is on the bank’s balance sheet. (There is a footnote somewhere that tells investors the bank is the guarantor on these loans.) The bank charges the SIV a fee, and that goes right into fee income for the bank.

Well, Houston we have a problem. There is a lot of commercial paper coming due in November and the banks don’t think investors are going to be interested in taking new commercial paper for old commercial paper when the collateral stinks. They will want to get paid. Oh sh$&%^t.

Bring in the M-LEC! What is this M-LEC (master liquidity enhancing conduit) thing? Well, it’s like a Daddy SIV. The major banks will put some cash into Daddy’s account, and that pool of cash, together with new commercial paper issued by Daddy, will be used to purchase the bad investments that the SIVs cannot finance. Now, the investments haven’t gotten any better, they still stink. But, instead of accepting that the investments are worth $80 and recognizing the loss, they are sold to Daddy who is willing to pay $95 instead of $80. Daddy gets $15 from the banks (the cash they gave Daddy) and $80 by issuing new commercial paper. The commercial paper lenders are OK with this (everyone hopes) because the banks will take the first loss if the investments end up not paying off.

Wait a minute, something is missing. Oh yes, those darned accounting rules. I wonder how the investment will get valued when it is sold to Daddy. Now, in reality, it is only worth $80 and I would think it should be sold for its market value. Anyone want to make a wager that these assets will move from the SIVs to Daddy at something higher than that? Lets say at $95. The “loss” to the bank that guaranteed the selling SIV is only $5, and not $20! The hope, I suppose, is that in time investors will be less scared about the value of the investments and the investments may rise in value again. Lets say they go back to $100. Everyone gets their money back! If not, the losses will occur over time, giving the banks a chance to fund reserves for the losses.

Lets review. My guess is that according to accounting rules, these assets should be “sold” from the SIV to the M-LEC at market price, a price of $80 and not more. This would result in a loss to the bank guaranteeing the selling SIV of $20. Instead, a much smaller loss is reported because Daddy purchases the investment for $95 instead of its true value of $80. Where did the other $15 go? Probably something like “Investment in Daddy” on the bank’s balance sheet. Hocus Pocus!So, what is going on here? Are the banks, with the help of Treasury, inflating the value of their assets? By the way, at the same time they are deflating the value of their liabilities. If you want to know about that, click here: So, inflate the assets, deflate the liabilities. This of course increases the equity capital and makes the banks look much better. Problem solved! (I wonder how are they calculating the deposit insurance fees to the FDIC? Isn’t that supposed to change with capital inadequacy? “Good” banks may be upset with all of this.)

Please, someone tell me this is not the plan! If it is, then this is the highest level of financial flimflam, right up there with Raptor III (Enron). In fact, it’s worse because it is being done out in the open (sort of) and with the blessing of the United States Treasury. If this is the plan, we know there are real problems out there. Even so, this sort of magical mystery accounting tour should never be contemplated by those entrusted with our financial survival. How can regulators ever fault a company for this sort of accounting engineering if they are party to it? My guess is that if this is the plan then fear (and in some cases greed) will keep everyone who can stop it from doing so. If this is the plan, it is a sad day in the world of business.

PS: What if this were H-P and Dell withholding inventory from the market because they overproduced? Think collusion.The Latest from David Reilly at The WSJ Online Edition here:

"Changes enacted after Enron Corp.'s collapse were supposed to prevent companies from burying risks in off-balance-sheet vehicles. One lesson of Enron was that the idea that companies could make profits without taking any risk proved to be as ridiculous as it sounds."

David Reilly again on accounting:

Response to ongoing questions: I have had a couple of people ask questions about this post. I want to clarify the link between the off-balance sheet piece and the need for help. If these entities were on balance sheet, banks would have had to hold reserves for possible losses. [Banks hold minimal reserves for off-balance sheet entities like these. For more information on this you can see my post on Bank Regulators]. Then we would not have this problem because the banks would have adequate liquidity to deal with it. Sure, there may have been less money available for mortgage and other financing if they had to hold reserves, but looking back, would that have been such a bad thing? The fact that they did not have to hold reserves is, in part, why we are in this mess to begin with. There is no free lunch - when will we learn this? I hammed this one up a bit, I know that. But I get aggravated when the same thing happens over again - we don't learn.

Good post on this at

Update - good article in today's WSJ on this structure. Note the "junior notes." These are what I referred to above as "Investment in Daddy." From the article, SIVs "didn't require banks to cover fully the fund's debts if the commercial-paper market dried up." Details Please!!!! Here is the URL:

Revision - 10/22

I was reading an article by Ben Stein today published in The New York Times yesterday here and I thought it was very well done (I love it when the pros do it). He has a different slant on the whole MLEC issue, although he comes to the same basic conclusions that I do (here and in my other post about Citi). Here is an excerpt from his article, but I encourage you to read it all at The Times. It is free, although registration is required.

"THE deal, as far as I can tell, is that they buy the most secure levels of debt that Citigroup and others own, get large fees and allow Citigroup and the others to keep the debts off their balance sheets. But there are at least two giant issues here.

"One is that it’s a bit too predictable that Mr. Paulson would basically pooh-pooh the subprime problems until major Wall Street powers got in trouble and then — presto! — swing into action. It might have been inspiring had he stepped up to the plate when smaller players like home buyers were getting burned, but that’s not really his style.

"The other is that it’s hard to see what good the maneuver would do. Suppose Citigroup or some other lender has a perfectly good loan to sell. Why does Citigroup need a big Treasury-sponsored organization to sell it? They can sell it to anyone right now. The problem is with the questionable loans. And they seemingly are not part of the plan from the Treasury.

"The Treasury plan is either just plain foolish (an explanation not to be sneered at) or it’s the thin edge of the wedge: what may follow is to have a government fund to buy the slightly less fragrant parts of the portfolio. Indeed, that would seem inevitable to me, and I’ll tell you why.
The goal is to keep Citigroup and others from taking large losses on bad loans. If the loans are sold to supershrewd buyers of debt like Leon Black or David Tepper or our resident megagenius, Warren E. Buffett, those buyers will demand a big haircut on the deal. Losses will have to be taken. The only buyers who might step in to pay full price are — drumroll, please — you and I, the taxpaying suckers.

"I could easily be wrong, but I suspect that at the end of the day, you and I will be bailing out the hundred-million-a-year finance titans who messed this up in the first place. This is what happened with the savings-and-loan disaster. The S.& L. chieftains — very often connected with Michael R. Milken and Drexel’s junk-bond world — became multimillionaires and billionaires by wheeling and dealing with government-insured money. When the loans went bad, you and I picked up the bill while the bankers went shopping for their Bentleys."

PS - can anyone help me with formatting this stuff? I can't seem to carry it over from Word.

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Sunday, October 14, 2007

The Road To Poverty (Free Trade)

I was reading the WSJ today, as I do most every day, and I found a couple of very interesting articles that really compliment one another. This happens a lot, and when it does it makes for good blog fodder. The articles I am referring to are “Why The US Job Market Is Sagging In The Middle” which can be found here:, and “The Burma Connection” which can be found here:

I must say that I found both articles to be very interesting and well done. The first article was in the Career Journal section, and it addresses the loss of good paying middle class jobs. These jobs are being replaced by personal service jobs, the demand for which is growing as those at the top demand more things like nannies, security guards, and so on. These are things that cannot be done anywhere else, so you can’t ship the jobs to another location to take advantage of lower wages or replace them with technology (not yet anyway). A bastion of safety from globalization and technology (unless, of course, you simply import the workers – some food for thought).

David Wessel, the author of this article, points to one possible solution to the widening wage discrepancy – unionize the service jobs to provide better wages thereby replacing the traditional middle-class factory workers with a new middle-class of service providers. I thought that was very interesting, and something the labor unions should grab on to (I’m sure this has not escaped them). They certainly are not winning many battles in their traditional strongholds such as the auto industry. Other possible avenues include further obfuscation of the tax code and trade restrictions, although Mr. Wessel correctly points out that many economists warn taking trade action would be costly to consumers (I assume here that he is referring to the increase in prices that would accompany a more restrictive trade policy). What I want to work through in this post is the globalization/trade restriction issue. This comes up a lot these days, including in the article about Myanmar, f/k/a Burma.

In the Burma article, author Andrew Higgins describes the tragic consequences for many residents of a planned economy, dictatorial regime, and economic sanctions. In particular, he explains the ordeal that many women go through each day crossing the Moei River into Thailand to work in factories for $4.30 per day (these are apparently the fortunate ones). This is the other side of the changing nature of the US work force and an important part, in my view, of the trade issue. These women living in abject poverty are working in textile mills making things such as braziers. The products ultimately end up on the shelves in our stores. Now, regardless of your political leaning, this is one of those facts that just cannot be reconciled with a national conscience grounded in freedom and fairness. OK, these are not people of our country, but so what? Something that results in these working conditions for these people and a product that we use is wrong and there should be a way to make it better, period. I am not claiming to know how.

We had circumstances in this country during the industrialization of our economy that left many workers in poverty. Now, I’m no expert on this point in history, but I have consulted someone who has read quite a bit about it. (I would like for him to do a piece on it, actually, and if I can convince him to there will be many more details to come). The very short upshot is that dreadful labor conditions led to revolt in the form of both violent and non-violent acts against industry and the political structure. Socialists, anarchists, and communists all gained popularity as workers were forced to endure these working conditions or go hungry. Ultimately, we altered the accepted rules of our society that had held labor could not bargain collectively. Originally (and today in many cases) collective bargaining was seen as collusion and inconsistent with a market based economy. Of course, with the deterioration of working conditions to the point of revolt, change was necessary. In this case laws were passed to allow workers the right to organize, thereby reducing the power of the business organization (yes, I use that term intentionally here) over that of the individual worker. If we had not done that, we may not have survived and thrived as we did. In fact, advancing workers’ wages turned out to be a good thing as we developed a strong middle class consumer population with a big appetite for goods and services. How did this happen?

I think it goes right back to basic economics. If the price of an input is dirt cheap, you will use that input over others. If the price of that input goes up, you will substitute another input for it. Now, there may be no absolute substitute for the labor of an individual, but if that labor gets more expensive, business figures out ways to compensate by innovating. This is the same argument for a minimum wage. It lifts people out of abject poverty (into just poverty) and it forces business to innovate. The innovation creates new job opportunities for those who are innovated out of a job, and the cycle continues. But if the cost of labor remains dirt cheap, there is no incentive to innovate around labor. It simply remains the low cost way to operate and workers suffer. This is also the argument for an increase in taxes on fuel.

Now connect the dots. What is happening in the US is certainly connected to what is happening in Myanmar. Business seeks out the lowest cost anywhere on the globe today. Don’t blame business, it is supposed to do that and it is good for us that it does. The issue here is the set of rules that business must play by once they leave the US. There are lots of rules, and we keep hearing these days that those rules are why US businesses are losing competitiveness around the world (too much regulation, too many law suits, etc.).

OK, time for a thought experiment. What if, instead of exporting jobs to places like Thailand, we exported our rules? What if we said to other countries that we will not trade with them unless they protect their workers and pay them at least a living wage (defining “living” as something greater than survival)? Lets throw in a little environmental protection while we’re at it. Well sure, the cost of labor would stay higher, but does that mean that in the long run the prices of everything will go up? I for one am not convinced that this is the only logical long-run result. Didn’t the price of a car in this country steadily decline while labor gained much higher wages during the 20th century? And labor is a large part of automobile manufacturing. Oh, that’s right, it’s less so today. Why? Maybe it has something to do with manufacturers substituting technology for labor due to labor’s high cost.

As long as we export the jobs without exporting the rules, we are in fact importing the rules through the back door in the form of lower wages to the middle class. We begin living by the standards of other nations rather than our own. We may also be losing our advantage in innovation if we simply lower costs by moving from one area of cheap labor to another. Any change will likely cause short term pain making it politically difficult, but in the long run no change could be a lot worse. In the mean time, can we please figure out a way to help people like those women in Myanmar? If we don’t, we may be looking at our future.

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Friday, October 12, 2007

I Hate Greed! (The Carried Interest)

That’s right, I hate greed. Don’t get me wrong, I do believe in the profit motive and free markets and all of that. I believe in profiting by providing a valuable service to members of society. I believe that if we all do that, whether through our labor, capital, or both, we as a society will prosper more than in any currently available alternative form of social organization. I do not, however, believe in finding creative ways to game the system to gain wealth at the expense of others. So can you believe in the profit motive and free markets, but still hate greed? Absolutely. And when people tell you that those two principals are in conflict, they are involved in something else I hate – spin.

You couldn’t escape the news today that the top 1% earners in the United States raked in a higher percentage of total earnings in 2005 than in previous years. As reported by The Wall Street Journal on Page A2 today, and here in the Online Edition:, the percentage that went to the top 1% is 21.2%. That’s right, the top 1% earned 21.2 % of all the income. According to the article, the data also suggest that many of the top earners are from Wall Street. Not surprising in light of the volume of mortgage backed security activity and private equity deals over the past few years. One tidbit that really stands out is that the top 25 hedge-fund managers earned more in 2004 than the chief executives of all the companies in the S&P 500 index combined. How much income do you need to get into the top 1%? In 2005 the bottom was $364,657.00 while the average was $1,591,711.00. I don’t know what the top was, but there had to be at least 8 figures if not 9 (before the decimal place). I didn’t make it to the top 1%, but that’s not why I’m angry. I do not begrudge anyone who makes a lot of money playing by the same set of rules that apply to everyone.

I am angry because of the fact that those top 25 hedge-fund managers walked away with a 15% tax rate on much of their income, while I paid a higher percentage of mine. Not only that, but all of those lousy mortgage loans they were packaging through the system are now the topic of various taxpayer bailout plans, so I will likely get stuck picking up some of the pieces they left behind while they were accumulating massive wealth.

Now, get ready for all of the statistical spin-babble you will hear over the next few days. For example “the top earners pay most of the taxes.” That’s true. In fact according to the IRS Statistics the top 1% paid 39.38% of all the income taxes, but earned (only) 21.2% of all the income. What was the tax rate? 23.13%. (That’s the lowest rate since 1986, which is as far back as the statistics go.)

OK, but if you were to insure a $10,000,000.00 property, wouldn’t you expect to pay more than someone insuring a $250,000.00 property? I certainly would (unless one of those companies I took private was a property insurer). Want the system to keep running so you can continue making so much money that you are among the most privileged souls to ever live? Then you have to be prepared to support that system that makes that possible, even if it means you will pay for more of it than those who get less out of it. Those who are doing all that other stuff like teaching, laboring, and so on, need to live too. Without them there aren’t any mortgages or student loans to package and sell. And what they make, after income taxes, payroll taxes (which applies to all of their income, not just the first month’s paycheck), property taxes, and sales tax (which is applied to almost all of their disposable income because they need to spend it all to live) doesn’t leave much extra to cover the tab. In fact, if you add up all of the taxes paid by the average earner and then take that as a percentage of their income, it’s a lot more taxes than the numbers suggest. On top of that remember that the average worker is also supposed to be saving for retirement because there isn’t enough money to pay for that (or health care) in “the system.”

My point is that we are all in this together and it’s only fair that we all play by the same set of rules. Those in the top income brackets pay more of the income tax because they can afford to, and without all of those “others” who can’t afford to pay it, the top earners wouldn’t be earning what they are. If I jump the income spectrum, I should have to pay the higher taxes (which I have had the displeasure of experiencing in the past).

Somehow, there are a privileged few who escape the rules of fair play and get more than they deserve. The system has been gamed. Those in power have managed to rig it in their favor. The “carried interest” rate of 15% is a sham against everyone, and those taking advantage of it, especially while we are at war, should feel a bit greasy. Of course, that’s just my opinion.

Update: For some background on carried interest (including some info in conflict with some of the above) go here:

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The Rich Get Richer - for now

News out today about growth in income inequality tells us that through 2005, the wealthiest among us got even wealthier. The rich got richer, the poor poorer, the middle closer to the bottom. Actually, that’s not really what the data show. The true message is that a higher percentage of the total of all incomes went to the top 1% of the earners. Whether they kept any of that income is not in the data, so they may or may not be “wealthy.” If you want the details, you can find them all over the wires, including on this blog: .

The income data explain why the middle class is uneasy about the economic outlook while others feel everything is just fine. The share of the national profits that went to high earners grew (for them, everything is fine), which means the share that went to everyone else fell (things are not so good). Some argue this is because those with high-level skills can gain scale economies from these skills through the globalization of the economy (the argument from the right). Maybe. Or maybe the political machine has been used to benefit high earners more than low earners (the argument from the left). I think some of both, plus some other factors that someone should research (and I am sure someone will).

As I began analyzing this news, my mind went off in so many different directions that I have a scratchpad of notes that could provide blog fodder for a week. Issues include tax policy, executive compensation, national competitiveness, social fairness, immigration, and so on. I decided that I should focus on one discrete issue at a time, and picked the economies of scale argument as a starting point. (Maybe I’ll come back to some of the others in another post.) Here goes.

Truth be told, I kind of like the economies of scale argument. It makes some intuitive sense to me and relates to other issues I have written about lately. If your skills are suddenly in demand from many more customers (the world is flat!) and nobody else has learned to do what you do (or has the required resources at their command), according to the laws of supply and demand your skills should be worth more. If this is the reason for the higher share of income going to the wealthy, then the top earners better watch out! You know what happens in a global free market? Price (the high price of your skills) signals profitable demand and, as a result, people allocate resources to learning to do what you do. Supply goes up, price (the value of your skills) goes down. Right now you may be very valuable, but as those millions of students in China and India learn to do what you do, you may become less valuable.

It seems to me that this trend is already evident. Skills that take less time to learn, such as manufacturing and programming, have already moved to other markets. Just ask the UAW about this. I believe the same trend is happening in some areas of the high-earner industries, although many are in denial. It may just be that it has taken longer for global competition in high earner industries to develop due to lags in education or financial infrastructure.

Lets take Wall Street as an example, where high earners abound. There is concern on Wall Street that the United States is becoming less competitive in the business of underwriting. Our market share is in decline. What could be wrong? Well, Wall Street rallied the politicians who commissioned studies to determine why we are losing market share. They concluded that there are lots of reasons why, but THE FACT THAT WALL STREET CHARGES ABOUT TWICE THE FEES AS CHARGED IN OTHER MARKETS has nothing to do with it (they are in denial). I have written on this before, and if you would like the full commentary you can find it here: I suspect someone who writes full time will fully research this issue at some point, and I look forward to the result.

Wall Street is used to charging high fees because for decades they have had the only game in Globaltown. The global market for financial resources has, however, begun to mature and Wall Street is no longer the bouncer at the only club in town. If you don’t like the cover charge you can go down the street (or across the pond). As capital accumulates in other markets, financial talent follows it. These markets will naturally compete with our markets, and more competition leads to lower prices. Supply and demand - remember that’s why Wall Street salaries are high to begin with. So why is Wall Street losing market share? Because Wall Street charges too much given its loss of the monopoly it has had for so long. Does this sound like Xerox? Yup.

To stay competitive Wall Street will likely need to lower its price and this means less money for the high earners on Wall Street. So it appears to me that Wall Street may just be a few years behind Main Street. For other professionals such as corporate executives who reap huge benefits from running concentrations of shareholder investment, it will probably take longer to suffer any competitive impact. They are, to some extent, insulated from competition for their positions because they have some control over the process (that argument from the other side). Likewise, attorneys (another high earner group) still have barriers to entry as against global competitors because attorneys must be admitted to practice in the United States. But if Wall Street lowers prices, they may put pressure on their lawyers to follow suit. I am beginning to feel some pain.

Since Wall Street makes up a large portion of those top earners, the latest trend in earnings may soon reverse course. The reported data is from 2005, and I wonder what it will look like for 2008.

Back to the scratchpad. Maybe I’ll wait and try to decipher some of the (other) inevitable babble that will follow this news.
(c) Mark Palermo, 2007

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Tuesday, October 9, 2007

You Know What They Say About Opinions (Laffer Curve)

One thing I really enjoy about writing opinion pieces is that you don’t always need to do a lot of research. I know this because I do it – note the warning on your right!

That said opinion pieces are ripe for controversy for just that reason. For example, I was reading one today published in The Wall Street Journal Online Edition here (pg A16 in the print edition) that really caught my attention. In it, someone (no author noted) is opining on the shrinking deficit, noting that faster growth, not taxes, is the way out of deficits. Unfortunately, the piece goes on to say, this will be short lived because congress has its eye on lots of spending.

Well, I agree that Congress should spend less. I also like lower taxes, especially mine (see what I mean about opinion pieces?). In fact, if Congress could spend a lot less and lower my taxes by a lot, I think that would be great! Unfortunately, that doesn’t save this opinion piece. What gets lost is the connection between lower taxes and growth.

You know, I can earn less income and spend more. That would produce a really nice result, for a while. Things would be great, and for a time, I may even be able to spend more than I borrow. The numbers may even look good, at that point. That’s why the author of this article can point to a shrinking deficit and claim victory that tax cuts create growth, and the growth produces even more tax revenue. Hooray!

Maybe. But lets look at some of the facts here (darn those things). From the end of 2000 (the beginning of the Bush policies) to the end of 2006, GDP (current dollars) increased at a compound annual growth rate of 5.1% (I got my numbers here Not Bad. What happened to the national debt over that time period? Well, from January 31, 2001 to January 31, 2007, the national debt grew at an annual compound rate of 7.3% (these numbers come from here So, the shrinking deficits? These numbers do not appear to support the hypothesis that the writer claims. OK, so what if we look at just the past year? Well, GDP increased 6.12% while the national debt increased 6.24% (2005-2006, and January 2006 to January 2007, respectively). Better, but still not supportive of the writer’s conclusion. Now add the fact that Congress changed hands last year and the lower deficit numbers come into context. Is it possible that less is being spent this year because the Democratic Congress is limited by the Republican administration? Wouldn’t that be a surprise? I think the hypothesis needs a little more testing. Perhaps a good statistical analysis is in order. When the WSJ is ready, I think I know someone named Tom who can do that. Give me a call.

UPDATE: I found this link today at Paul Krugman's blog. Be sure to scroll down to the second table of numbers! Link to Paul's blog on your right.

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Monday, October 8, 2007

Wash & Spin (Commentary on Forbes Commentary)

Nothing gets me more fired up than a politically skewed description of a problem, especially when the spin is so clearly evident (and when it spins away from my point of view). I ran across one of these today when reading an article in Forbes Magazine (found here authored by Mr. Forbes himself. I planned to take the day off, but I just could not resist this one.

In the commentary under “Too Bad We Can’t Tax Economic Idiocy” Mr. Forbes sounds the tired old cry that the Democrats (and some Republicans) want to tax you, and if this happens we will have devastation in the form of recession and crashing financial markets. Let’s examine some of the logic used in this argument. First of all, expiration of the Bush tax cuts is referred to as tax increases. The real truth is that the Bush tax cuts are temporary because congress could not have passed them if they made them permanent. So they used a congressional rule to pass tax cuts that they try to extend whenever they can. Mind you this was done when the Republicans controlled Congress and the White House. He then argues that if these “tax increases” go through, it will devastate small business because most are Subchapter S Corporations paying the individual tax rates. Because small business creates jobs, any tax rate increase will destroy job creation.

Well, this devastation did not occur all throughout the 1990s before the Bush tax CUTS were passed by THE REPUBLICANS, so I would like to see the evidence for his conjecture. In fact, I think there were a few pretty good small business venture success stories in that decade. Another question I have about this is why it is assumed that small business must be organized as pass through tax entities? They do not, and any small business owner is free to use the C form over the S form. Looks like we can avert that disaster too. In addition, I want to point out that the Republican Congress passed The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. This act makes it more difficult for individuals to file a Chapter 7 bankruptcy proceeding and wipe the slate clean (note the title of the act vs. its actual purpose). Talk about discouraging entrepreneurship in this country! We know that many, if not most, entrepreneurs fail at least once. They then settle their affairs (which often includes credit card debt used as seed capital), pick themselves up, and try again. If instead they are strapped to payments over a long period of time, they are much less likely to garner the resources necessary to try again. Talk about damaging the job creation process. Oh, by the way, who was behind this act to protect the consumers? If you think credit card issuers and their benefactors you will get there.

Mr. Forbes then goes on to make the link between taxing the income of hedge fund managers at normal rates (the ones you and I pay) to pension funds. This argument cannot stand up to even the most common-sensical analysis. This argument is that if hedge fund managers are forced to pay the same tax rates that you and I pay, they will stop what they are doing and pension funds of (yes, here we go again) teachers and firemen (not Mr. Forbes’ words in this comment, but the words of others making the same argument) will be negatively impacted by the loss of these great investment vehicles. First of all, I have never seen the research behind this claim. How much MORE have pensioners earned because of the existence of hedge funds? In addition, if hedge fund managers have their multi-million dollar annual incomes taxed at normal rates, they will stop doing this and go where to earn more? Oh yes, the argument that if you tax this more you will get less of it, and that’s bad. Well, if that’s how we should look at it, then let’s just tax the teachers and firemen less. Why not go directly to the source?

The last point in Mr. Forbes’ commentary is that we need to cut corporate tax rates. So, we need to keep the current tax cuts, cut taxes on corporations, and he also mentions we should eliminate the estate tax (referred to by the Republicans as the “death tax,” another tired ploy). He points out that the rest of the world is cutting taxes, even Old Europe! Well, cutting taxes from what to what? Where are the numbers? Even if the numbers show (after a careful analysis including all of the corporate welfare) that our corporate tax rates are high, what can we do about it? Just cut taxes so we can compete? Well, unfortunatley those thrifty Republicans have gotten us bogged down in Iraq, and that costs a few dollars to support. Old Europe doesn’t have to worry about that. Those thrifty Republicans have also dug us deep into the largest deficit in our history just when we should be saving for future entitlement outlays (like my social security that I have paid into for over 20 years and at a much higher percentage of my compensation than Mr. Forbes). So, the reality is, we cannot afford to simply cut taxes because we need the revenue because the Republicans have created a huge national debt and ongoing deficit. Those darn Democrats are at it again!

OK, to be fair, Mr. Forbes does say that “a number of GOPers” are also thinking wrong on these issues. But I challenge anyone to read the commentary and then tell me it is not meant to bash the Democrats. His conclusion is that if Republicans make low taxes the major issue in the upcoming campaign, a Republican can win the election notwithstanding the Republican Party’s unpopularity. I hope this is a vast underestimation of the American electorate.

Finally, I must say that I agree with Mr. Forbes on the issue of new taxes from areas such as real estate. This is not the time to be looking there. An expansive example of his point is occuring in Long Island, with the proposed Brookhaven Community Preservation Fund. Talk about spin, the advertising for this “transfer fee” of 2% of the sale price of real property in excess of the first $250,000.00 “will not affect sales taxes or your property taxes” (the quoted portions in this paragraph come from the advertising flyer from The Town of Brookhaven). This is not a tax, it is a “real estate transfer fee that most residents will never pay.” Why will most residents never pay it? Because the purchaser of the property pays it. Does that mean there is no cost to current homeowners? If you read up to this point, you already know the answer. By the way, spin is bi-partisan.

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Sunday, October 7, 2007

Sub-Prime Commentary - updated 10/11

I have been talking a lot about the sub-prime mortgage mess, as have many other people. One thing that I find striking is the sub-prime nature of some of this commentary coming from unexpected places. Who would have thought that the Chairperson of the FDIC would make a statement suggesting that mortgage servicers simply keep adjustable rates on sub-prime mortgages low to avoid problems? I will discuss many of the issues raised by this in a minute. I also heard a HUD representative commenting on the news one evening, I think it was The Nightly Business Report. The representative, who I believe was HUD Secretary Alfonso Jackson (it was pretty late and I was on may way to slumberland), said they want to help the teachers and firemen, but not those yuppies who just wanted to have a bigger house with more stuff – I couldn’t believe my ears (yes, he used the words yuppies, teachers, and firemen in this context). In Congress, your tax dollars are hard at work passing legislation that takes away the taxes that would be due if your lender decided to give you a gift and reduce the amount you owe on your mortgage or decided not to sue you for the balance if they sold the house but didn’t collect enough to pay themselves back (something I am sure many people who lost their homes in the past only to find out they owed income tax for the privilege are simply giddy about). This Congressional action is the set-up, I believe, for the next round of bail out action.

All of this is simply sub-prime. What are people in the highest levels of our government thinking? Lets look at some of the implications.

As reported in an article in the October 5 WSJ Online Edition that can be found here (or on page A12 in the print edition), FDIC Chairperson Sheila Bair has urged loan servicers to convert those sub-prime variable rate loans that are about to adjust to fixed rate loans. She would like the rates to stay at the initial teaser rates. This would apply to all of those who are current on their payments and occupying the home in question, but not to others. In other words, bail out the people who used financing trickery to purchase a home they really could not afford or maybe they could but wanted the really low rate up front. Ms. Bair is very concerned because there are approximately $600 billion in sub-prime mortgages that are about to rate-adjust and many may fall into default when they do. Forget about those who have already lost their home. Too late for you.

Well, here we go again messing around with the economic fundamentals. Of course, when you do this there are always winners and losers. At first blush, it would appear that the winners are overstretched homeowners who could use a break and the losers are those yuppies and the big Wall Street financial firms we read about. Just who the heck are those “servicers” anyway? But is this really the end of the story? I think not.

First of all, I am not convinced that all of the people who took a sub-prime mortgage are in need of a bail out, and this would be like handing them a holiday present for no reason. Many sub-prime borrowers are placed in the sub-prime category because they do not report their income (they get paid in (or collect from their customers in) cash). Do we really want to bail those people out? If we want to bail out the less fortunate, shouldn’t we first make sure they are?

If we do bail out those people who collectively owe close to $600 billion by resetting their interest rates (in effect renegotiating their mortgages for better terms) I see other indirect effects that are not pretty. For example, who actually pays for this bail out? If we just let the borrowers keep their low interest rates, then nobody really loses, right? Wrong – someone purchased those mortgages based on the contractual obligations of the borrowers to pay the higher interest rates. If all of those borrowers are handed a windfall gain of lower rates, then the value of the mortgages goes down and those who purchased them lose. Who purchased them? Well, in this day of securitization, we don’t really know. However, don’t be at all surprised if your pension fund owns some of them, because that would be part of its normal operations. As a result, Ms. Bair’s recommendation shifts the burden of this problem from homeowners and the lenders who made the loans to those who purchased the loans. Shouldn’t we at least analyze who owns those loans now before we do that? After all, it could be the pensions of teachers and firemen! Now, Ms. Bair may argue that the losses from doing nothing will be greater than the losses created by reformation of all of those loans, but I haven’t seen that analysis, nor have I heard any commentators discuss it.

In addition to shifting the losses and bailing out many who don’t need it, there are other losers. Those who are struggling, working several jobs and foregoing all luxury to make their mortgage payments will be very upset. I know some of these people. Some purchased a home to accommodate a growing family just at the peak, and got stuck on the sale side because the buyer walked or the financing fell through. What about them? They may not have a sub-prime mortgage, but they are in a mess created by the same set of forces and at no fault of their own. Many of these people are teachers or firemen, and some are even yuppies! How do these people feel about bailing out the people responsible for this mess in the first place? I’ll tell you from my observational experience – angry. In their eyes people took a risk buying homes they could not afford on the bet that prices would continue to rise and they could profit. That bet turned out to be a loser, and in a free market system they should lose. Even worse, why should they get bailed out but not those otherwise stuck holding the bag from this mess? People with sub-prime mortgages took a risk and lost, simple as that. They were told their rates and payments would go up and they knew what they were doing. If not, then the companies (and the people) that loaned them the money should suffer for not making lawful disclosures, period. If those disclosures were not being made, then I would like to know where Ms. Bair and Mr. Jackson have been for the past few years.

In the short term, a bail-out provides an incentive for those who can pay their sub-prime mortgage to default so they can benefit from the bail-out. In the long term this also creates a huge moral hazard. What do we tell people who buy more than they can afford only to get bailed out from the debt they incur? What happened to all of those arguments I heard when the financial industry was pushing for bankruptcy reform about those who cause the system to suffer should be the ones who pay? The system needs reform because the current system creates a moral hazard? How different the spin when it is the financial industry trying to “reform” the bankruptcy laws so they can make more profit as opposed to trying to get bailed out of its own mess. Maybe I’ll do a little research on this point if I have some time. If anyone can add to it please do.

There is another, less obvious victim of a sub-prime mortgage bailout. Since labels are getting applied to people here, I will use one. The good people. Those who knew they could not afford a house without first saving for a down payment. Those who deferred their consumption until they could afford it. They are also victims of any bail out. If people who cannot really afford the homes they are in are bailed out of their mortgages by giving them below market interest rates, then the prices of homes will be artificially inflated because there will be less supply on the market. At the same time interest rates are now moving up because of the risk in this market caused by bad lending practices. So, Mr. and Ms. America who waited to purchase a home until they could afford one? They are now locked out of the market altogether. Prices will remain higher than they should and their interest rate and payment will be more than they can afford.

Where have all the free market pundits gone? Gone to hide from everyone. As expressed by a friend, privatize the profits, socialize the costs (thanks for that one).

Update: Check out the statistics from The WSJ about who these sub-prime borrowers are by going to Page one and reading the article "The United States of SubPrime", online here: Also rising to the surface today, and in The WSJ, is a story about Beezer Homes and some funny business with mortgage applications. That article is available on the online edition at Finally, follow the drumbeat for the public bailout by going here:

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Saturday, October 6, 2007

And Justice For All?

I often hear comments from non-lawyers about decisions by courts, including The Supreme Court, such as “that result is so unfair, how could they do that?” and “what do they know about business anyway, they aren’t business people?” I find that, behind this question, there lurks a misconception about the nature of the issues The Supreme Court actually decides. I decided to address this question by making up a hypothetical case that will address some issues that may not be obvious at the onset to illustrate why judicial decisions sometimes seem at odds with carrying out our traditional notions of justice.

Imagine that you make loans for a living, and a friend asks you for a loan. Your friend tells you that he cannot borrow the money from other sources because they would condition a loan on his disclosing his plans to them, and he wants his plans to remain confidential. He does not want to tell you what he needs the money for. You decide to lend the money, but because you have no idea what it will be used for you will only do it if your friend agrees to pay you an exorbitant rate of interest, say two times the going rate. Your friend agrees and you lend him the money. You have no idea what he intends to use it for and your friend has never been in any legal trouble.

As it turns out your friend’s business idea was a pump-and-dump scheme, and he is very successful at defrauding investors. Unfortunately, he gets caught and sent to jail. The money he stole from investors is gone, having been spent on fast cars and expensive parties (many of which you attended). One day a large man greets you at your door and hands you a package of legal documents. You go directly to your lawyer (now also your best friend), who tells you that you are being sued by all of those investors who lost money on your friend’s scheme because they believe that if you had not loaned him the money they never would have been harmed. They claim you either knew, or should have known, that your friend was going to use the money to set up an illegal scheme, so you should be held to account. They also claim you did this because you profited from the scheme by charging such a high rate of interest. They are asking the court to award them damages equal to their losses of $100,000,000.

This case makes it all the way up to the Supreme Court. Both the Securities Exchange Commission (the “SEC”) and the Justice Department (“Justice”) file briefs with the Court letting the Court know how they feel about the case. The SEC is against you on this, but Justice believes you should not be held to account. (The following positions of these entities are HYPOTHETICAL!) What issues are raised that get you all the way to the Supreme Court and get the attention of the SEC and Justice?

The SEC has sided with the defrauded investors against you. Their position is that if you are not held to account, investors will be much more likely to be defrauded in the future because people like you will enable wrongdoers to operate. The cost to society of people being harmed in this way, they argue, goes way beyond the losses incurred by you if you are found liable for the investors' losses. The larger issue is that if this behavior continues, fewer people will invest in business and that will chill overall economic growth of the country because businesses will not be able to raise money in the capital markets. This far outweighs the cost to lenders of having to be more careful in making loans. They also argue that the cost to lenders of being more careful would be inconsequential. They point to the fact that this loan was very unusual in that the rate of interest was extremely high and almost all other lenders would have wanted to know what the proceeds of the loan were to be used for. The harm was due to the fact that you turned a blind eye and made a loan you shouldn’t have.

Justice, on the other hand, takes the position that if you are found liable for the illegal activity of your borrowers, nobody will be willing to make loans because they will be worried about the costs of such liability. At the least, investigating the use of funds you lend and taking other protective measures will increase the cost of operating and, therefore, raise the cost of borrowing. The lack of loans and/or higher cost of them would have a chilling effect on the economy because it would be more difficult for businesses to raise capital (sound familiar). Their position is that you cannot push the responsibility for wrongful acts to parties beyond the actor itself, and whatever resulting losses occur for people such as the defrauded investors in this case are more than offset by the benefit we get as a society from a smooth and unhampered banking system allocating funds to business investment.

As you can see, the implications go way beyond whether the investors in this case get some of their money back. There is a balancing act to be done among major issues affecting all of society. The reason these larger issues arise is that once the Court makes a decision in this case, it will become precedent (the law of the land) and will apply to all other cases like it that arise.

So what is the balancing act that the Court must do in my hypothetical? On the one hand, investors should be protected from the fraudulent acts of business participants even if it means businesses must be more careful. If investors are not protected, they will be unwilling to invest in businesses and that will hamper economic growth. This issue of investor protection was prevalent during the Great Depression and was the driving force behind the establishment of the SEC in the first place. On the other hand, if duties are imposed on businesses that relate to the acts of other businesses they interact with, it would cost more to do business because new procedures would be required and the cost of insurance, litigation, and damage awards to plaintiffs would rise (not to mention the cost to taxpayers of all of the additional lawsuits tying up the courts). This cost issue has many implications for society, including a chill on economic activity and our competitiveness as a country in this time of globalization. Is this the time to take another step toward investor protection or should we wait until the other major global economies begin imposing additional costs on their businesses to protect investors (or labor or the environment)?

If you think the Justices on the Supreme Court have an easy job, think again. This type of balancing act occurs all the time. For many of these questions there is no “right” answer, and getting “justice” for the harmed investors may not be the issue at all.

© October 6, 2007, Mark Palermo

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