The Money Supply And The Credit Crisis

I have been reading about monetarism around the web lately and find the topic interesting. Most of the writings I have seen look to money supply measures as an indicator of whether we should expect inflation and discuss the monetary aggregates, M1 and M2. Some commentators are stressing that M3 and MZM are better indicators of the true money supply as they include institutional money market funds ("IMMFs"). I agree with this position, but I think it misses some issues of the current economic situation. I think of it this way: Under the traditional model of monetary expansion the Federal Reserve injects reserves into the banking system which then uses the reserves to make a loan. The proceeds of the loan are then deposited into a bank and this is new money! The bank receiving the deposit can use a portion of this new deposit to make a loan, and the proceeds of that loan will be deposited into another bank – more new money. This process continues expanding the money supply and debt, limited by the portion of each new deposit that must be kept in reserve rather than loaned out and the fact that in order to make a new loan, banks need capital. But what if debt could expand without expansion of the money supply or bank capital? There would be a decoupling of the relationship between the money supply and debt creation. This decoupling has happened as debt that is originated by banks is often removed from the balance sheets of the banks through securitization, and this process converts the money supply from M2 to M3 or even out of M3 completely. To see how this happens requires a rather lengthy diversion into an example, so here goes:


To see how an everyday transaction ends up converting M2 to M3, I have drawn the diagram above. Beginning with the asterisk in Bank Reserves and assuming the Fed has injected $100 in new reserves, the Bank would want to make a loan for $100. Assume the Bank makes a loan of $100 to Home Buyer to purchase a house from Home Builder. Home Buyer takes out the loan and the cash goes to Home Builder. Home Builder now takes the cash and deposits it into the Bank. (These transactions are the black lines.) This is a new deposit and it represents growth in all the monetary aggregates. But in today’s financial markets (at least before the current meltdown) the Bank is likely to sell the loan to remove it from its balance sheet. If it does so by selling the loan (either directly or through a securitization first) to a commercial paper conduit, then the blue lines would represent the transfer of the loan in exchange for cash. But where did this cash come from? Let’s assume Investor took $100 out of its account at the Bank to purchase a share in IMMF (institutional money market fund) (the red lines). IMMF used this new cash to purchase commercial paper from the Conduit, which is where the Conduit got the cash to purchase the loan (the green lines). At the end of this series of transactions, there has been no net change in bank deposits because $100 went in from Home Builder and $100 came out from Investor (no change in M1 or M2). The original $100 of reserves injected into the bank by the Fed has been replaced by the proceeds from the $100 loan purchase by the Conduit. The money supply has grown, but it is what used to be M3 that increased through an increase in IMMF balances. The Bank is now free to lend the entire $100 again, effectively eliminating the reserve requirement and bank capital as a limitation on money supply (M3) growth from the initial reserves. Because of this off-balance sheet financing of loans by banks it can be M3 that increases as loans are made and sold rather than M1 or M2. Also note that this financing structure is speculative, funding long-term assets with short-term debt. Since the funding source (commercial paper) is not generally guaranteed (as are bank deposits) it is prone to a run. If the bank simply securitized the loans and sold them directly to investors without a commercial paper conduit we could diagram the same result with respect to M2 without an increase in M3 or MZM, but it would not necessarily be speculative. In any event, we have already created the money underlying the loan, but we have converted it to something that is not measured by M2 and sometimes not measured by M3. Because of these conversions of money from one form to another the traditional concepts of money supply and monetary expansion have been altered. As debt creation escapes the bounds of the monetary system around which traditional debt expansion occurred we should monitor debt outside banks as well as M2 or M3.


To see the change in the relationship between deposit expansion and debt creation I compared M2 to non-federal-government debt (“NFGD”) using the first graph above. (NFGD is all debt less federal government debt.) NFGD has increased from a multiple of approximately two times M2 in 1980 to over 3.2 times in 2007. Historically, as debt increased through the banking system there would be a concurrent increase in M2 as the fractional reserve system of banking would multiply the monetary base through deposit expansion. Today, however, deposit expansion and debt expansion have become decoupled as banks sell loans to third parties. In addition to decoupling deposit expansion from debt expansion, the latter is no longer constrained by bank capital since the banks are no longer accumulating loans that require capital. This can create a monetary base outside of the traditional measures of money.


We have also seen a decoupling of the relationship between incomes and debt creation. In its simplest form this is the relationship between debt and GDP. The second graph shows NFGD as a percent of GDP and M2 as a percent of GDP. The divergence is striking, and I think gets to the heart of our economic crisis – the breakdown of the relationships between money supply and debt and between debt and income. With debt ballooning to new highs relative to income, the cash flow implication for consumers is less consumption and more saving – a recession. But what supports this balloon of debt in the first place? In part it is like any other bubble - the rising prices of the assets being financed by the debt provides collateral for more debt. The difference with this bubble, however, is that we have gone from a game where the ultimate size of the monetary bubble is regulated by the Fed through banking reserves, deposit multipliers, and bank capital to a system where any bubble can create its own monetary supply to support itself using securitization to multiply bank reserves in a virtually unlimited manner. At the same time we should be monitoring broader measures of monetary expansion because of financial innovation the Fed has stopped publishing M3 in the belief that it adds nothing to what M2 tells us.

So, other than restructuring how we monitor the financial system for the future, what should be done? Lets start by recognizing that doing nothing is unacceptable as the risk of a deflationary spiral is too great and the results too dire to chance. Once consumers are overburdened with debt service we should expect a recession because not only will consumers save to pay down debt, they will stop borrowing while they do so which will further reduce consumption. Reduced consumption could lead to falling incomes and prices, in which case relative debt burden increases making things worse. Assuming savings also decline through falling asset prices (stocks, home values, etc.) there would be no reason to expect an increase in consumption (save the increase in the value of cash net of the value of liquidity, if any, in such circumstances) or investment, and we could get stuck in a long-term underemployment of great proportions. If the true driver of the current financial crisis is the creation of too much consumer debt, then the only way we exit the crisis is by reducing the burden of the debt on consumers through some proactive means. There are several ways to go about reducing the burden of debt-service on consumers (other than simply using public funds to repay private debt). (1) We can try to inflate our way out of the impending cycle of deflation and recession by adding reserves to the banking system, but this assumes more reserves will result in more borrowing, investment, and consumption. Will companies borrow to invest when the economic outlook is dreadful because consumers are overburdened with debt? Will consumers borrow to consume when they are already overburdened with debt? In short, will traditional efforts to expand the money supply expand the money supply? The evidence is not in yet on this front. (2) We can make every effort to lower interest rates thereby supporting asset prices and reducing debt service payments. This would help to reduce the debt-service in the debt-service/income ratio and provide more income for consumption. The Fed’s efforts to reduce both short and long term interest rates should have some positive impact on reducing the debt burden by lowering rates and, therefore, debt-service payments and should, in turn, support asset prices. Note this is related to the inflation scenario in that monetary policy easing means lowering interest rates on the short end. The Fed has now gone to purchasing long-term securities in an effort to reduce long-term rates that have not responded to the short-term rate reductions. We can also attempt to restructure debt obligations so as to reduce the current payment obligations of consumers by, for example, extending the term of a loan. (3) We can have a major fiscal stimulus that creates employment to increase incomes relative to legacy debt-service. By increasing incomes the debt-service/income ratio would decline. The stimulus would, in effect, replace private debt with public debt, freeing up income for consumption. Based on recent reports, a major fiscal stimulus plan is probably in the works by the new administration.

While we wait to see if our efforts are successful, we can utilize the Fed and Treasury to (i) pump public money into bank capital so the banks have enough capital to make new loans when they hold excess reserves, and (ii) lend to ever increasing elements of the financial system to prevent major systemic collapse as speculative financing evaporates. None of this is news.

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Is M3 Important?

There is interesting discussion on Paul Krugman’s NYT blog today regarding monetary expansion and the Great Depression. For the current crisis, I think you need to look at the divergence of M2 and M3. As institutional money market investors fund commercial paper that funds asset sales by originators, M2 is converted to M3. The money multiplier becomes unlimited as the original reserves used to fund loans are returned in full to the banking system with no new net increase in deposit liabilities. What’s happening right now is the reverse – M3 is liquidating and the monetary base is expanding to, in part, accommodate the conversion. If you look at Institutional Money Market Funds on Z.1 you will see the reductions in this (and, I believe other) components of M3 relating to credit expansion in the modern financial system. I have been waiting for the next Z.1 to confirm these movements.

I believe M3 is important, notwithstanding the Fed’s decision to stop publishing it. I have not concluded that the M3 expansion is the cause of the bubble, but it certainly shows how monetary expansion and, in particular credit expansion, contributed. I plan to post more on this after the holiday weekend.

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Bailout Testimony

Chairman Bernanke’s testimony today was astounding to me for two reasons. First, he stated that by using public funds to purchase toxic assets from financial institutions we would gain a better understanding of the hold-to-maturity prices of these assets. In effect, he is saying that the market doesn’t work and only government intervention will provide a price discovery mechanism. I take exception to this conclusion because it is based on internally flawed logic. Creating a market with public funds does not provide price discovery, it provides a new market that is not based on “market” prices at all. Rather it is based on availability of funds from taxpayers and it is ripe for abuse.

Second, Mr. Bernanke said that punitive measures should not be used against institutions that participate in sales to the government because it would limit participation. The only reason this could be true is that the government will not allow these institutions to fail so, rather than participating in this plan financial institutions could blackmail taxpayers for another rescue plan. If the government made it clear that they either participate or fail they would participate. I, for one, am tired of being held hostage by financial institutions.

Treasury Secretary Paulson addressed the lack of oversight provisions in his bailout proposal by explaining that he did not intend there be no oversight in his proposed plan. Rather, he felt it should be up to Congress to figure out how to monitor this program. I figured that to be the case, but I have an exception to this. If the oversight was to be determined by Congress, then why put the following provision into the proposal?:

Sec. 8. Review.
Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

Finally, I ask again, where is the presentation?!? All I am hearing is “this is my opinion as Fed Chairman” and as Treasury Secretary. Taxpayers deserve better than this.

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Shock And Awe

I feel like I did just before we attacked Iraq. I feel as though we are being frightened into doing things that in the long run are very bad ideas, but only those in power know all of the details. It's Paulson's way or else. I think we need debate on how to approach this crisis, and I would love to hear plans that focus on supporting market function while allowing bankrupt entities to fail. One problem is that those working on fixing the problems are the same people who created it and their view is strongly biased toward Wall Street. I have a bad feeling about this.

So far, the steps being taken don’t seem to be working while at the same time are creating the dangers of the next financial crisis. For example, I think there is real subterfuge going on with the IBanks. First, the Fed relaxed rules on using FDIC insured deposits to fund IBank operations (that happened the day Merrill & BOA merged). In effect, this is a taxpayer guaranty for Merrill without any congressional review and could be the seeds of the next disaster. This rule is only effective until the end of January 2009, but if the Ibanks are relying on depositor funds at that time what will happen – they will magically find an alternative source of funds? With Goldman and Morgan converting into national bank holding companies they will benefit from the same rule relaxation as Merrill and perhaps use more favorable accounting treatment to value their assets. If I get some time I want to look into that and I welcome all comments on it. Also, today the Fed relaxed rules on private ownership of financial institutions - another move that could contribute to the next disaster as private equity groups that control all types of businesses purchase controlling interests in taxpayer backstopped institutions. All of these moves have, in my opinion, negative implications for the future of our financial system.

What is missing from this entire debate is a clear description of what exactly we are afraid of. Now, I understand the implications of a complete meltdown of the financial system and I think we should be doing something to address the issues. But I have not heard from Paulson or anyone else a clear description of what happens if we do nothing and what the alternative actions may be. Where is the slide show? Where is the full and complete analysis? How does this flow of funds from the US Taxpayer to privately owned financial institutions that continue to pay dividends to their investors fix the problem? Why are these institutions still paying dividends? Shouldn’t there be a prohibition on dividends until taxpayers are made whole through recourse guarantees or some fund created through dividends that would have been paid to investors? Is there a way to fix this problem from the bottom up rather than the top down? Shouldn’t there be some executive compensation limitations? Etc., etc., etc. Rather than all of these issues being addressed we are getting shock and awe. Congressional hearings are beginning – let’s hope our representatives in government step up to the plate. They have certainly heard from me, and you can express your views by going here and contacting your Senator.

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What Caused The Credit Crisis?

I have been following and writing about the credit crises for some time. Watching the stock prices of the financial companies plummet over the past few months has been painful if you own any of them. As I wrote in March I have been expecting this decline, but its acceleration in recent weeks has been breathtaking.

I have been reading a lot of commentary about what caused the credit crisis. Most recently I read the first section of “The First Global Financial Crisis of the 21st Century” published by VoxEU.org. This is a collection of articles written by renowned economists addressing the credit crisis, and part one deals with the causes. Unless otherwise noted my references in this article to other writers refers to their article in this collection. There is a rather long list of suspects, but in my opinion the cause of the credit crisis was a failure of the regulators of the financial system to adequately protect it from systemic risks that they should have seen at the time. Determining why they failed under such circumstances should be the primary path of inquiry. This involves uncovering the reasons why, in the face of compelling evidence of a major financial storm in the making, financial regulators did nothing. The same can be said for Congress.

I believe there is plenty of blame to go around and there were many bad actors involved in generating loans that should never have been made. In one of my early articles I pointed the finger at many of these actors. But it is the job of regulators to monitor the financial system and prevent excessive, systemic credit problems and they failed to do so. When banks are lending people 100% of the value of a home, waiving income verification, and basing the borrowers ability to pay on a loan payment that is based on a temporary teaser rate there is abject foolishness in the market. This condition existed for at least two years while bank regulators and Congress looked on and did nothing. As if this wasn’t enough, at the same time there was obvious chicanery in the credit markets relating to housing we experienced a housing bubble of massive proportions. Regulators and Congress still did nothing, except that Congress and the President began to brag about home ownership rates.

Some commentators (see Tito Boeri and Luigi Guiso, pg 37) (see also Theodore Forstmann, “The Credit Crisis Is Going To Get Worse”, The Wall Street Journal Online Edition, July 5 2008) argue it was classic supply-push in the credit markets caused by excessive monetary easing from 2001 – 2004 that caused the stupidity that led to this crisis. I tend to agree that monetary policy has been too accommodative and is one of the root causes of the current crisis. However, we have always known that monetary policy easing increases risk taking so to blame this as the cause of the crisis misses the point.

Some argue that new innovations, such as CDOs, where not fully understood (see Guido Tabellini, pg 45). I find humor in this though I am not happy with the result. If we take a lot of crappy assets and put them together, will the resulting “diversified” pool of crappy assets have less risk? Well, when all the assets are correlated to the housing market and are the most sensitive to any price changes (subprime) then obviously all you have done is made a bigger pool of crap. Add to this the fact that history exists in the subprime lending world and it is not good. Where the assumptions came from underlying the ratings on CDOs is a mystery to anyone who has seen subprime lenders crash and burn. To say this was a failure of the statistical models is a nice way of saying the assumptions were wrong and upon further inspection this should have been obvious. Statistical complexity aside, what happened to common sense? Isn’t this where the regulators are supposed to come in? When the market is doing things that are clearly high risk and in large magnitude? Where were they?

Some argue it was the rating agency conflicts that enabled this debacle to occur. I agree this was a contributing factor, but Congress and the regulators knew this problem existed since, at the latest, 2002 when it was presented to Congress in testimony relating to the Enron bankruptcy by Frank Partnoy (see part II. D). There were very clear and explicit warnings that this type of crisis was waiting to happen yet Congress and the regulators turned a blind eye.

Some argue that it is the over reliance on statistical modeling that led to this crisis (see Jon Danielsson pg. 13). The lack of backtesting data for those once in 100 years events meant that the science was flawed. In addition, the correlations are all wrong when everyone acts the same way at the same time (the heard). I buy this argument, but what I don’t buy is the argument that the regulators were fooled by all of this. This was clearly a movement to allow financial institutions to self regulate using their own internally developed models. Whether this was politically driven or truly a belief among regulators that this was a better way I do not know, but it takes a lot of the burden off regulators to monitor and regulate! Now regulators are calling for additional powers. I ask, where were they when this crisis developed?


I actually know part of the answer to my last question. One thing the regulators were working on was providing the financial system with large amounts of leverage that would ultimately be at the root of the liquidity part of this crisis. In 2004 regulators codified banks’ use of off balance sheet entities, those SIVs and asset-backed commercial paper conduits that leapt onto the front pages last Fall, with minimal regulatory capital requirements. At the same time there were regulatory changes for the investment banks that have been referred to as the “Bear Stearns Future Insolvency Act of 2004”. With respect to the banks, the result is easily discernible from the graph above. Asset-backed commercial paper outstanding skyrocketed as banks utilized their newly codified leverage structure to take on the CDOs and other securities where the true risk of all this absurd lending was being hidden. Especially notable here is the absence of the SEC. These securities that were being rated and issued were, apparently, not understood by anyone. By extension, they were not understood by the SEC – isn’t that part of its job? Unfortunately, when investors discovered that there was excessive risk in these vehicles they stopped purchasing the commercial paper that funded them. The result was a severe liquidity crisis as the banks had to honor lines of credit they provided to these entities securing the repayment of commercial paper under just these circumstances. The Federal Reserve has received great admiration for its creative tonics when this crisis broke out, but I believe that is like honoring a firefighter for extinguishing a very dangerous fire that the firefighter ignited in the first place. I can’t finish this part of my rant without pointing out a couple of issues here. First, a crisis in the commercial paper market would certainly present a systemic risk to the financial system if all the banks had credit lines backing their $1.2 trillion in asset-backed commercial paper. Given this fact, together with the knowledge from Enron that off balance sheet treatment does not eliminate risk but increases risk taking, how did the bank regulators determine that is was 10 times safer to fund assets this way than the traditional method of holding them on a bank’s balance sheet? This seems like an extraordinary conclusion, extraordinarily wrong headed.

Of course the current crisis is well beyond a mere liquidity event. The off balance sheet leverage combined with excessive monetary easing provided much too much liquidity to the markets, and the resulting stupidity in the credit world will ultimately cost institutions their solvency. As of this writing Bear Stearns no longer exists (although the taxpayers now own $29 billion (and falling) of mortgage-backed securities that Chase didn’t want while the shareholders walked with cash) and the FDIC has seized IndyMac, a large bank with extensive mortgage operations. I don’t believe this will be the last, and taxpayers will be paying for this debacle for years to come.

So what caused this crisis? Those responsible for ensuring a sound financial system failed, plain and simple. Regulators and Congress are to blame as they were well aware of the risks of rating agency conflicts, off balance sheet financing and excessive leverage yet they turned a blind eye when it came to the financial sector. The fact that rating agency conflicts and other abuses by Wall Street and others played a role does not change the fact that those responsible for regulating these activities failed. In fact, these issues should have made the regulators even more watchful in light of the fact that they were warned of rating agency conflicts that go to the heart of the regulatory system they set up.

In hindsight all of this looks obvious, and what is obvious in hindsight is not always so clear at the time. Perhaps it was not so obvious to regulators or Congress at the time. But why didn’t they figure it out? These are the best and brightest in the field and it is their job to figure this out and monitor and protect the financial system. What forces were at play such that this set of events could be set in motion and play out without any reaction from the Fed or Congress? Perhaps there is something structurally wrong with having the Fed involved in bank regulation at the same time it is responsible for monetary policy. Perhaps there is an issue with the appointment of regulators such that a given administration’s policies become too pervasive. Perhaps too many key people in the regulatory authorities come from the very institutions they are there to regulate or get jobs at those institutions when they leave. Perhaps the financial industry has too much influence in Congress and it is the broken political system where money buys influence that caused the credit crisis. In my opinion these are the fundamental issues raised by the credit crisis and I believe they should get more attention than they are getting now. I also believe that these very same regulators should not be setting the agenda for the new regulatory regime that will follow this crisis, but as of now they are.

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Sheriff John Green

I was reading this article in today’s Wall Street Journal, Online Edition and was struck by some of the conflicting messages it highlights for many. I am a student of financial markets and to some extend the Federal Reserve (the “Fed”), so I have a certain perspective on the whole subprime mortgage debacle that is no secret to anyone reading my column. I object to bailouts, whether it be for homeowners or Wall Street, and I have been writing that opinion since last October when I first started publishing my blog. But this article got me thinking about these Philadelphia residents who are being evicted from their homes because they can’t pay their mortgages. Circumstances have now changed, and they have changed because the Fed, no doubt with the blessing of Treasury, has bailed out Wall Street. (For more on this there is another article in today’s Wall Street Journal Online expressing one Federal Reserve Bank President’s concerns about the Fed’s recent actions and the market distortions that can be expected as a result.)

Admittedly bailing out Wall Street is good, in some ways, for everyone as it lessens the risk of a major economic blowup. But tell that to a resident in Philadelphia being evicted from their home who can understandably be thinking “they can bail out those Wall Street executives and their customers but they can’t help me?” Enter the Sheriff, John Green:

Sheriff John Green has spent 37 years in law enforcement. But these days he's best known around town for the law he won't enforce.

With the economy soft and thousands of Philadelphians delinquent on their mortgages, Sheriff Green this spring refused to hold a court-ordered foreclosure auction. His move raised eyebrows on the bench and dropped jaws among lenders and their attorneys, who accuse him of shirking his duty to enforce legal contracts….

Mortgage lenders, servicers and their attorneys thought Mr. Green was acting more Robin Hood than sheriff. "It's not his job to postpone things in favor of certain people," says Michael VanBuskirk, a Philadelphia attorney, who describes the city as a "legal free-fire zone." The city, he says, is "less attractive to business if you can't be certain that the sheriff won't invalidate a contract."

Fed policies to help rescue Wall Street firms have created distortions that have hurt many innocent bystanders in this debacle as savings rates plummet and inflation increases. In fact, the inflation in food and energy prices caused in large measure by negative real interest rates is likely a direct cause of many of the foreclosures as those consumers most at risk can no longer afford to pay all of their bills. So in keeping real interest rates negative to rescue the financial industry Fed policies are hurting many of those who would be hurt in a larger financial collapse anyway and the impact is falling disproportionately to the most vulnerable among us. To hear mortgage lenders now object to the Sheriff’s actions because they favor one group over another is, in my opinion, entertaining at best. In my view, looking to the public policy issues behind this story presents a very different picture than a simple issue of contract law.

I believe we are witnessing the spread of the bailout mentality that has been established by the Fed (and sanctioned by the Administration) in favor of Wall Street. Regardless of the ultimate consequences of allowing major Wall Street firms to fail, the general public will understandably view these actions as favoring those on Wall Street as opposed to them. Let’s do a thought experiment. The first part is to ask: “Why is it good for the Fed to bail out these Wall Street firms by providing credit at taxpayer risk?” The answer, of course, is that to do so will help avoid an economic collapse that would hurt everyone. The second part is to ask: “Why should the Sheriff refuse to sell foreclosed homes at auction?” The answer, of course, is that doing so helps avoid an economic collapse of the neighborhoods involved that would hurt everyone. So, is the Sheriff acting like Robin Hood or following the example set by the Fed? In the eyes of those on the ground I think taking the latter view is easily comprehensible.

The distortions caused by the Fed’s bailout of years of negligent lending activities by Wall Street and all of its subsidiary tentacles has set the stage for redistribution fights such as this one, and I don’t know how you put this genie back in the bottle. So at the end of this piece I have an unanswered question: Is the creativity demonstrated by Mr. Bernanke, with the certain blessings of Mr. Paulson, good for our society in the long run or just another example of how being too creative (ever heard of a CDO squared?) can really mess things up?

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Subprime and the Bush Administration

What did the Bush Administration have to do with the credit crisis? I keep hearing people say that a president does not have very much influence on the economy and they are given too much of the credit or blame when the economy fluctuates. I disagree for two reasons. The first is that fiscal policies can have a rather dramatic and immediate impact on economic activity as the President is making clear today by touting the fiscal stimulus plan. Tax cuts and government spending certainly impact the economy in a direct and timely way. The other reason is the general regulatory oversight that each administration is responsible for. For example, who heads the SEC and what are the priorities given it by the administration? What about the Treasury Department? I believe these policies have a direct impact on economic activity and are responsible for a lot of the fluctuation in the economy as well as income distribution from one administration to another. Here is an example.

As hedge fund investor David Einhorn laid out in his recent remarks, ”Private Profits and Socialized Risk” the SEC, under the Bush Administration, altered the capital requirements for broker-dealers. Einhorn concludes that the result was a lower capital requirement leading to higher leverage. The higher leverage, as we know, leads to higher risk and that higher risk culminated with the failure of Bear Stearns. So, is this why we have the credit crisis? Wait, there’s more.

The SEC regulations applied to the broker-dealer world. What about the commercial banks? What have they got to do with all of this? Well, as I wrote about last October, the rules regarding commercial bank capital requirements were also altered back in 2004 through rules promulgated by the Federal Reserve and Treasury as regulators of the commercial banking system. In effect, these rules said to banks they could move loans and other assets from their balance sheets to off-balance sheet conduits and reduce their capital requirements. Banks love this because it allows them to – guess what – leverage! They set up something called a conduit that purchases assets from the bank and/or a bank customer. The conduit gets the money for the purchase by issuing securities, like commercial paper. The rating agencies rate the commercial paper based, in part, on the fact that the bank typically provides a line of credit to the conduit so that if the commercial paper market dries up the conduit can borrow to repay maturing commercial paper. This is a very general description and these structures can get very complex, but this is the basic idea. So how does this increase leverage? The rules promulgated in 2004 established that under this structure banks could provide these credit lines to back these conduits but hold only 10% of the risk based capital they would hold against the same assets if they were on the bank’s balance sheet. You can find the announcement of the rules here. So, using this structure, banks can leverage their capital in multiples. Eureka – a way to get around the sound banking principals established by the regulatory framework over the past 90 years! The regulators behind these rules included the Office of the Comptroller of the Currency (Treasury), The Federal Reserve System, The Office of Thrift Supervision (Treasury), and The Federal Deposit Insurance Corporation.

Lets review. According to Mr. Einhorn, in 2004 the SEC relaxed capital rules for broker dealers, placing more of the regulatory requirements in the hands of the banks and allowing them to use more leverage than before. In the very same year the Federal Reserve and Treasury codified the rules that permitted commercial banks to leverage through off-balance sheet entities. (In case you were wondering, Congress had hearings on many of these issues as well.) All of this turned out to be extremely profitable for the banks, brokers, and rating agencies.

Suddenly, there is an incredible credit bubble that begins with loans and ends up as securities in the portfolios of, among others, the investment banks, banks, and off-balance sheet bank sponsored conduits. I wonder if there is a link between these events? Now, to be fair, the credit bubble began a little before these regulatory changes. But these changes must have accommodated a huge demand that was unsustainable. The graph accompanying this post illustrates the credit bubble I am referring to.

What really caps all of this off is the cries from many of these agency heads now about what should be done to fix this mess. For example, Sheila Bair, head of The Federal Deposit Insurance Corporation, has been calling for months for a bailout of subprime borrowers. First, back in October, she called for a freeze on interest rates for those who had adjustable rate subprime mortgages. She is now lobbying for loan modifications to reduce principal for those subprime borrowers whose mortgages exceed their property values. From her recent comments before Congress

Permanently forgiving part of the principal amount can provide a better financial result for investors than foreclosure by creating long-term, sustainable solutions that will allow borrowers to stay in their homes. This approach also has the added benefit of limiting the overall adverse affect of declining property values on communities.

In closing, Ms. Bair states

Congress, the SEC, the Treasury Department, as well as federal bank regulators have expended considerable time and effort to assure that the industry has authority under tax and accounting rules to modify loans proactively. The industry needs to demonstrate greater commitment to using those authorities.

They should be expending all the time they possibly can and they should never mention it because these agencies are collectively, in my opinion, among the most culpable groups in this entire debacle.

To be fair to Ms. Bair, she was appointed to head the FDIC in 2006, after these regulatory changes. She was, however, on the FDIC’s Advisory Committee on Banking Policy. Donald Powell was FDIC Chairman in 2004, John Snow was Secretary of the Treasury, William Donaldson was Chairman of the SEC, and our old friend Alan Greenspan was Chairman of the Board of Governors of the Federal Reserve System. Who appointed these people?

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Fear or Greed (today)?

This is a very non-analytical discussion of how I have been feeling about the markets. Sometimes I sit down and do research. You know, go and get actual numbers from reliable sources and analyze what they say. Other times I just think about the general news and events and work to a conclusion based on the “how it feels” method. I have had some successes and failures using both methods. This piece is about the current state of my “how it feels” method. This can change with one news story because fear and greed are very powerful impulses.

Most professionals will tell you to pick good companies and invest for the long term. That’s probably great advice, but I don’t want to see my net worth collapse with the market, even if it is temporary. So I try to keep up with what’s going on in the markets and react accordingly. I find it exciting to watch the financial news each day as the stock market gyrates between hope (greed) and fear. Up 400 on the DOW one day, down 300 the next. Listening to the traders on money shows is interesting as they banter about their proposals for moneymaking trades. Take this position today, then get out and take that one next week. I wonder how many non-professional stock traders, common folk like me, actually trade like this? When watching CNBC one needs to remember whether one is a trader or an investor. Fast Money, Mad Money, buybuybuy – sellsellsell. “Start buying the financials because they haven’t been this cheep in decades”. I have been hearing that for months while they continue to decline. If I had a share of JPM for every time I heard that…. It seems no one wants to think about the lost revenue sources for the financials. All they talk about is write-downs – when will the write-downs be over. But when the write-downs are over, then what? How much of that precious fee income from the originate-and-distribute model will be coming back on line in the near future? How can they replace it with net interest income if they are short capital from the write-downs? What about fees from off-balance sheet commercial paper entities? What about the smaller regional banks that financed local real estate developers? Is now really the time to be buying financials with all of these unanswered questions? Not in my book, but I am a very nervous type of investor. I thought it was time to buy the financials in 2002 or thereabout when I purchased some JPM. I did pretty well with it and sold it in February 2007 because I got nervous. Sometimes it’s good to be nervous. I think there will be a time to get back in, especially JPM and perhaps BAC, but for me there are too many questions right now. In fact, there are so many questions that I went, and still am, short the financials in general. I may get burned, but I think it is a better play right now than going long financials. So far gains from this position have offset losses from long positions I have, so taking this position helps to hedge my little portfolio.

What is going on in the commodity markets? “The commodity play is real, it’s all caused by skyrocketing demand for global resources.” China, India, billions of new consumers. This skyrocketing demand suddenly happened over the past nine months? What about the past 5 years of global prosperity – wasn’t demand skyrocketing then? I don’t know, and I haven’t crunched the numbers, but if you step back and look at this objectively I think there is a lot of risk in those markets. Stocks down, treasuries and commodities up, and this is because of global demand? If that were the case then why are global stocks down and treasuries up at the same time? Wouldn’t global stock markets be up because of all of this global demand? Perhaps this is just the latest place for the “fast money” to park while the credit markets work out the current turmoil. Using the “how it feels” methodology I am afraid of commodities right now because it is possible that this is the next asset bubble to burst. That’s easy for me to say because I am not a big commodity investor anyway (in fact, I am not a big investor period). I’m sure there is some validity to the global demand story and, in fact, there have been articles in the press lately questioning whether a Malthusian catastrophe is in the works. So commodity prices should probably be on the rise, but the sudden skyrocketing of prices seems a bit overdone to this amateur, especially on the heels of what appears to be some serious economic weakness. Commodity prices are also being pressured by the falling dollar, but how much more does that have to go (better hope not much)? Of course, had I invested more in commodities I would have made more money, assuming I would know when to get out.

If you are living on a fixed income right now you are likely to be worried (unless of course it is a very large fixed income). Treasury and CD rates are very low and anything else in the credit markets is too scary right now, so how do you get income without risking your nest egg? This is one of the prices being paid for the orgy of debt we had over the past seven years. It seems counter intuitive at first that interest rates should be low (perhaps even negative in real terms) after we had a debt binge, but this is because the Federal Reserve has been flooding the markets with liquidity in the hopes of avoiding a major financial collapse while investors are bidding up the prices of treasury securities as they run for cover from riskier investments. So while it is not easy to get credit right now if you are looking to borrow, at the same time the typical safe investments for retirees and others on a fixed income are paying less and less interest. Perhaps some Fannie or Freddie securities or municipals make sense, although the tax advantage of municipals to investors on a fixed income may not be worth the low yields.

Oh yes, and there is inflation. I really don’t care what the CPI, PCE, PIG or SHI! say, filling up the car, the cupboard, and the heating oil tank have taken a much bigger bite out of my income on a percentage basis this year than any other in memory. That is inflation no matter what you call it. I was at the bagel store the other day and there was a sign up saying that due to the rise in the cost of flour bagel prices have been increased – a lot. The last time I started to see this kind of thing on a regular basis was back in the days of double-digit inflation. Not that we are having double-digit inflation now, but the memory is disturbing. Even if price increases slow down, they have already increased a lot.

So what do I do? I wish I had the “right” answer. I am still very nervous about where this whole credit crisis thing ends up. I did some reflecting and I decided that I needed to deal with the fear and greed issue. I thought about all of the credit market news and the financial bailouts, the falling real estate prices (sales were up some 2.7% in February – “maybe we are seeing a bottom!”), soft employment numbers (my most important indicator), and weak capital spending, and I decided that there is a lot of risk in all of the markets right now. Of course, when things are really bad is when you are supposed to have courage and get in, and countering all of the bad news is the totality of all of the Federal Reserve and federal government actions being taken to avoid a financial disaster. But when was the last time I though there was a real possibility of a financial disaster???? That’s enough for me – fear it is, today. The gains I may give up by sitting this one out are easily outweighed by the potential losses. So I have hedged my portfolio by reducing exposure to equities and going short on some general and selective indexes so that when the market goes up I don’t, but when the market goes down I don’t. I may also do a little gorilla trading here and there to try to juice returns as I can. The rest has been reallocated to those lousy-return safe investments like treasuries and FDIC insured CDs for now. As they mature I will be on the prowl for better returns, but with caution. Perhaps some high dividend yield stocks hedged with shorts on a lower yielding equity index. If I miss a big upswing in the stock market I will be less well off than had I been more aggressive and motivated by greed. If I miss a big drop I’ll feel really smart and then start buying. In the meantime I will keep watching all of those economic indicators, including the general tone and gyrations of the CNBC talking heads, as my “how it feels” indicator evolves.

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A Long Article about the Credit Markets

OK, here is my take on the current goings on in the financial markets. I want to preface this with the fact that this is not investment advise and it is my opinion. I do not have the time to provide backup for all of the numbers but they are readily available from current news sources. Where I don’t know the exact number I tried to be conservative. It is very difficult to try to boil this down to any reasonable length so a lot is left unsaid and what is said is meant to stress the risks we currently face. Many if not most professional economists believe we will have a mild recession and return to growth in the second half of 2008. That said, here goes:

1. The US has relied on foreign capital to support a large and long-term trade deficit. As we consume more than we produce, the net difference is imported from overseas. At the same time we export dollars to pay for these things we import. Those dollars often find their way back here in the form of investors looking for return. With all of these dollars looking for investments added to the normal amount of available investment capital, the markets work their way down the food chain. First they make good investments until those run out, then they make mediocre investments until they run out, then they make bad investments until the cracks begin to show as with the subprime mortgage meltdown. While this is going on the economy is booming because people are buying things, in fact, spending even more than they are making. Once investors realize they have made some very bad investments, however, they do exactly the opposite and run from these investments. Foreign investors take their money out of the US and bring it home or invest it elsewhere. This causes the value of the dollar to fall as everyone is trying to sell it in exchange for their own currency, and it reduces the amount of financing available to support asset prices and economic activity in the US.

2. As foreign investors pull their money out of the US and domestic investors run from financial assets prices of financial assets in the US fall because there is less demand for them. This is especially true when investors realize that the assets they invested in are not of the quality they expected. Mortgage backed securities, private equity buyout loans, and so on are all worth less than they were last year, not just because of defaults but because there is just less money around looking to buy these assets. This is referred to as re-pricing of risk. This flight to quality is seen in the dramatically low interest rates on Treasury securities that fall as demand for these safe investments increases – investors are selling riskier assets and purchasing safer ones. They are also purchasing hard assets as seen in the recent explosion of commodity prices.

3. As asset prices fall and capital flows out of the country and out of certain financial assets, banks begin to feel pressure. They need to raise funds to meet the demands of deposit withdrawals and to fund loans to customers who can no longer raise money in other markets such as the commercial paper market (again because the flow of money has reversed from in to out). Normally banks will borrow from other banks or depositors, and/or sell assets to raise the liquidity necessary to meet these demands. Today, however, they cannot do enough of either because they are all in the same boat and because there is a lack of demand for their assets – remember the capital is going out, not coming in. In order to sell assets and raise liquid funds the banks would be forced to take big losses on their assets, and that would reduce bank capital. The more they have to sell the lower the price they will get and the more bank capital is reduced. This could ultimately lead to insolvency of the banks, which is worse than illiquidity because it means that even if the banks had liquidity, they could not make any loans. No loans, investment plummets and employment follows. Of course, if this happens the loans on the banks’ balance sheets get even worse because as employment falls loan defaults increase in this downward spiral.

4. The Fed is using all kinds of tools, new and old, to prevent the system from collapsing under the weight of this de-leveraging (the term for when investors who provide capital leave the markets). First, it is lowering interest rates rapidly, with the federal funds target rate down from 5.25% in September to 3.0% now and another cut expected on Tuesday. Lowering interest rates is targeted at two things: lower rates in general means the rates on investments should go down and the re-pricing of assets should be less severe; and lower rates should support additional investment and consumption assuming those rates make it to the borrowers. The problem is that the lower rates are not making it to the borrowers and so the intended effect is not yet being felt. One reason this is happening could be that the banks are, in fact, insolvent based on current asset prices so they cannot make loans even if they have the liquidity. The other reason this could be happening is that the liquidity crisis is so severe that the banks are simply keeping up with their own balance sheet changes without making many new loans. Either way this is very troubling.

5. In addition to lowering interest rates, the Fed normally acts as lender of last resort to commercial banks. If a bank has a liquidity problem it can pledge collateral to the Fed and the Fed will then make a short-term loan to the bank through the discount window. This has also run into to trouble, however, because none of the banks want to borrow from the Fed this way. They are worried that if they do it will signal a problem and everyone will withdraw their funds from the bank – a classic run-on-the-bank scenario. To deal with this, the Fed created a new program called the Term Auction Facility, or TAF. Under this $100 billion facility the banks bid for loans from the Fed, and if they win they pledge collateral and get a loan for 28 days. The Fed has opened up the collateral pool to include basically anything the banks have to pledge (they can pledge anything they could have pledged for a discount window loan). The names of borrowing banks are not made public, and there is no schedule of the collateral the Fed takes to secure these loans released to the public.

6. The TAF was a very good idea, except it did not provide liquidity directly to the investment banks because they cannot borrow from the Fed without drastic action. In order to address this issue, last week the Fed announced a new $200 billion swap facility called the Term Securities Lending Facility. Under this facility an investment bank can give the Fed mortgage backed securities and other collateral and the Fed will give the bank Treasury securities from its own portfolio. The investment bank can then sell the Treasury securities for cash to get liquidity, and 28 days later it reverses the transaction by returning the Treasury securities for the collateral. Unfortunately this facility is not yet operational so it was too late for Bear Stearns. Bear experienced a run-on-the-bank Thursday and Friday of last week, and the Fed took that drastic action to lend directly to Bear Stearns through JP Morgan Chase. The Fed has not done this since the Great Depression.

So between lowering interest rates (the cost of funds to banks) and providing a source of liquidity (the loans and swaps) for the banks’ assets that are re-pricing, the Fed is hoping to avoid a major collapse of the system that could include runs on many institutions such as the one experienced by Bear Stearns last week. If the banks cannot raise liquid funds then they cannot meet the demands of depositors and borrowers and once this is known, there is a run on the bank. All told, the Fed has announced at least $400 billion in new facilities to provide liquidity to the banking system, which is about 44% of its entire balance sheet. Unfortunately interest rates to borrowers are still not declining signaling an even deeper liquidity crisis or an insolvency crisis. The falling dollar confirms the exodus of capital from the US markets and no one knows how far this will go. In the interim, the economy looks worse as banks do not extend credit for investment or consumption in large enough quantities to support economic growth. The very interesting and as yet unanswered question is what happens if the banks cannot repay the loans from the Fed and the pledged collateral ends up being worth less than the loan?

7. The Fed has a dilemma on its hands and there may be no solution available to it. On the one hand interest rates must be low to stimulate the economy by promoting borrowing and investment/consumption. If interest rates are high businesses will not invest and consumers will postpone purchases, so low rates traditionally help spur the economy. This is the standard policy response to a declining economy, and we are in a declining economy. On the other hand, however, low rates drive more capital out of the markets as it seeks better returns elsewhere. Witness the current boom in commodities, surely the next asset class to bubble over, and the continuing decline in the dollar. These trends are also leading to higher inflation as witnessed at the pump. So lower rates help to spur the economy and hopefully place some floor under the assets being re-priced, but at the same time chase away much needed capital (perhaps worsening the re-pricing because of lack of purchasers) and create a higher inflation risk. If the capital stays away because of the lower rates banks will not lend and we could have a severe economic downturn. Raising rates may help attract the much-needed capital, but it will slow the economy at a time when it is already vulnerable possibly resulting in a severe economic downturn. Therein lies the dilemma. It is very possible the Fed does not have a solution to the current problems.

8. Remember from number 1 above that this cycle of asset pricing and re-pricing was at least in part created by the unsustainable trade deficit of the US. The trade deficit reflects the fact that we have been consuming more than we have been producing, and paying for the difference by borrowing (and, in some cases, selling our assets). We have simply blown our credit beginning with the subprime mortgage meltdown, and it is now time to pay down some of the debt because our lenders are cutting off the flow of funds. That means a combination of selling our assets (as in Citigroup equity sold to foreign sovereign wealth funds) and saving. Saving is the opposite of consuming, so the more we need to save the less we can consume. The less we consume the lower the GDP, unless of course we cut all spending only on imports which is impossible, especially with our dependence on foreign oil. So I predict a fairly substantial slowdown in our immediate future as all of this works its way through the economy. If the flight of liquidity is severe enough we could also witness even more stress in our financial system, without which our economy comes to a halt. Because of this don’t be surprised if there is a large Federal bailout of the banking system on the horizon, regardless of what noise comes out of the White House about free markets and the like. If Bear Stearns is too big to fail so are all of the other major banks, both commercial and investment.

9. A taxpayer bailout of any magnitude is the last thing we need right now, especially with rising budget deficits, two wars, and ever increasing health care commitments. Tax increases may be unavoidable, even if they do further depress economic activity (though there is debate over whether this would be the case under these circumstances). The flight to commodities and resulting price pressure may or may not be sustained, depending in part on how long and how deep the economic downturn turns out to be. If the economy falls into a very deep recession, and especially if the global economy follows, we could see a reversal of the commodity price boom and, potentially, a period of deflation as all asset prices fall (this would be a worst case scenario).

10. How big of a crisis do we have on our hands? We can look at what the Fed and the Federal Government have done so far. At least $400 billion of liquidity facilities have been announced beginning in December and this does not include whatever loans have been made to Bear Stearns. Approximately $200 billion of mortgages have been funded by The Federal Home Loan Banks, an extraordinary increase on a historical basis. The FHA is in the process of refinancing defaulted subprime loans, and there are proposals in Congress to increase the total amount they can refinance to $300 billion. Congress and The President have passed an economic stimulus package estimated to cost approximately $160 billion. All the foregoing is taxpayer backed in one form or another. On the private side, banks have so far written off approximately $150 billion in losses on their assets and many expect another $135 billion to follow. Are we over $1.3 trillion yet? I think so. This sounds like a big problem.

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A History of The Great Economic Collapse of 2008

Looking back several decades at the economic downturn in the United States that began in the third quarter of 2007 and lasted for the better part of a decade, the causes seem predictable and inevitable. The United States had been consuming more than it produced for many years, running massive trade deficits. At the same time consumers were borrowing from international sources of capital to finance consumption, the United States Government was also running budget deficits, financing its expenditures largely from foreign investors and the retirement funds of the baby boom population – some 75 million Americans. Some of this over-consumption was funded through asset sales, especially after the initial decline in the dollar, as foreign investors thought they were getting bargains purchasing US assets.

The cracks in the system began showing up in earnest in 2007 with the great Subprime Mortgage Meltdown. This crisis in the subprime real estate market ultimately spread to the rest of the market and triggered an exodus of capital from the financial system as investors realized they had been taking on too much risk for the promised returns. Notwithstanding valiant attempts by the Federal Reserve to provide liquidity to the banking system, the risk re-pricing forced historic write-downs of assets on the books of the major banks, both commercial and investment, resulting in capital shortfalls at the major institutions. The first bank to experience a run was the 83-year old investment bank Bear Stearns, which was temporarily kept afloat through emergency loans from the Federal Reserve. This marked the first time such a loan was made since the Great Depression of the prior century. The resulting lack of financing into the economy drove investment to levels not seen in decades and unemployment soared. At the same time as the employment picture soured, many in the baby boom generation were retiring. Unfortunately the insolvency of the Federal Government resulting from tax cuts for the wealthiest Americans and deficit spending required massive cuts in health care and social security as well as large tax increases, further depressing the economy. A massive portion of the population retired into poverty.

In an attempt to fight both the re-pricing of assets and the lack of financing in the economy the Federal Reserve lowered interest rates dramatically, from 5.25% to 1%, at the same time inflation was running up. The interest rate targeted by the Federal Reserve at the time, the Federal Funds Rate, was negative in real terms for the second time in a decade. Unfortunately, these lower rates did not pass through to borrowers because the banks’ lack of capital prevented them from making loans regardless of how low their cost of funds was, and the fear of insolvency prevented banks from lending to one another which was how the system worked at the time. In fact, the monetary easing resulted in a further flight of capital as investors sold dollars to invest elsewhere where returns were better. The resulting fall of the dollar was also historic in nature as it hit all time lows against a basket of currencies week after week. This would have been a bright spot due to its impact on net exports, except that the decline in the US economy spread to the rest of the developed and developing nations reducing demand for exports.

Ultimately the Federal Government had to step in and bail out the financial system that had profited so handsomely for many years prior to the meltdown. The size of the bailout dwarfed the S&L bailout that was still visible in the rear view mirror, enraging much of the population. At the same time, those who had amassed fortunes during the boom years were able to acquire vast holdings of productive assets thereby widening the already large gap between the wealthy and the poor. Despite passing law after law and amending regulation after regulation in favor of the banking lobby for two decades, Congress professed shock at the actions taken by some of the major financial institutions during the ensuing hearings. The conflicts of interest of the rating agencies, the off-balance sheet accounting, the lax capital requirements, and several other issues resurfaced in the public view. Once the population at large learned that all of these issues had been brought to the attention of Congress years before, but ignored at the behest of the finance industry, there was a near revolt in the streets. This resulted in what we now refer to as the Great Political Restructuring.

Between the devaluation of the dollar and the massive infusion of funds to rescue the financial system inflation raged out of control for some time until the collapse progressed, after which deflation took hold as the world economy followed suit and demand for everything fell off globally. The lessons of this era remained strong and bank regulation was revised and strengthened. However, due to advances in technology and other systemic changes, the banking industry is now lobbying Parliament for additional powers such as combining their commercial and investment banking operations and allowing them to export interest rates from their home state to other states. They are also seeking reform to the bankruptcy laws and a declaration of Federal Preemption for protection from state regulators. Some argue that we should honor the lessons of the past and deny these powers to the banks, especially since the banks are ultimately backed by the taxpayers as lender of last resort. The neo-neo-conservatives, however, argue that the free markets will provide better competitive results for all consumers and the bankers, notwithstanding their incentives to take excessive risk, will adequately manage any potential risks to a systemic crisis. Paul Krugman, the sage economist now in his 98th year, declared such proposals outrageous and claimed they will lead the economy on a path to great divergence of wealth and the rebirth of the poverty population. Larry Kudlow, the underground talk show pundit whose age none can ascertain, pronounced this to be a great day for America, the likes of which he has not seen since the Great Political Restructuring. Time will tell which of these elder statesmen is still connected to the political economy and which is simply disconnected.

[Of course, I hope none of this is true and we see a rebound in the second half of 2008 as many predict. I just could not help having a bit of fun with this. I may do a serious analysis if time permits.]

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The F-LEF, or the Federal Reserve Liquidity Enhancing Facility

The Federal Government is in full swing on the current crisis in the financial markets. We have the FHA refinancing subprime loans and financing purchases with no money down (they claim 3% is required but this can be satisfied with a Seller’s Concession for closing costs, and we all know that’s code for raise the price to cover the concession); we have the Federal Home Loan Banks lending hundreds of billions of dollars to the banks on mortgage collateral; we have pressure on the GSEs Freddie and Fannie to step up their participation in the mortgage markets at a time when they are experiencing large losses themselves; we have the fiscal stimulus package (that, in part, increases the amount FHA and the GSEs can lend against homes from the high 300ks/low 400ks to $729k in many markets); and we have the Federal Reserve not only lowering interest rates but also providing $100 billion in liquidity for the banks through the new Term Auction Facility, or TAF. Wow! I have written on all of the foregoing steps taken to blunt the impact of the financial crisis that started with subprime mortgages except the TAF. You can find these articles by clicking on the “bailout” keyword on the list of keywords below. Today I want to look at this TAF.

Several months ago many commentators, including me, where writing about the Treasury plan to create a master liquidity enhancement conduit, or M-LEC. The purpose of this conduit was to be a buyer for assets that struggling SIVs, or structured investment vehicles, needed to liquidate. SIVs, at their core, take advantage of short-term financing at low rates to invest in longer-term assets that pay higher rates making a profit on the spread. When the short term funding dried up because of concern over the value of the assets held by SIVs they were forced to look elsewhere for funding or sell their assets. The problem was that the SIVs could not sell many of their assets into an unfavorable market without suffering losses on those assets. If they were sold at losses investors would suffer and the market could be permanently harmed. Enter the M-LEC that could purchase and hold these assets until the markets returned to “normal” and then sell them or simply hold them until maturity, thereby eliminating the need to sell them at a loss. Of course this raised accounting issues, among others, because if the market value of these assets was below the amount they were sold for the accounting really didn’t work. In the end the M-LEC was never formed. Instead, some banks that sponsored these SIVs ended up taking the SIV assets onto their balance sheets in order to avoid very embarrassing and reputation devastating results of SIV failures. Others were restructured into longer-term debt or liquidated at a hair cut to investors. (There were also liquidity lines from banks to these SIVs at stake, although the reporting on these was and is very confusing.) So in the end, the assets that caused the trouble ended up sold or on the balance sheet of the sponsoring banks.

Now enter TAF, or the Federal Reserve’s Term Auction Facility. This was introduced in December, around the time the M-LEC was originally to be finalized. The TAF is a loan facility from the Federal Reserve to banks. The Federal Reserve has been increasing the amount of the TAF facility in the aggregate from an original $30 billion to $60 billion, and last week to $100 billion. Here is what it does. Bank A needs liquidity to meet deposit withdrawals and/or loan commitments. It can try to get more deposits if it can, but apparently the banks can’t. It can borrow from other banks, but apparently the banks don’t want to lend enough to each other right now either. It can sell an asset on its books to raise liquidity, although this would reduce its profits by shrinking its balance sheet. Or, perhaps it can’t sell an asset on its books to raise the needed liquidity because the market value of the assets is below the carrying value and Bank A would take a loss. Hum, food for thought.

Enter the TAF, where Bank A can pledge assets to the Federal Reserve in exchange for a loan as long as 28 days in duration. Problem solved, Bank A has the liquidity it needs and the markets are not flooded with assets no one wants to purchase. All of this has me wondering – has the Federal Reserve become the Master Liquidity Enhancing Conduit that the banks and Treasury could not work out? The amount, about $100 billion, seems about right. The timing seems about right. It walks and talks like a duck, so maybe it is. I call it the F-LEF, or the Federal Liquidity Enhancing Facility.

The next question that follows is what assets is the Federal Reserve taking against these $100 billion in loans to the banks? Are they those same assets that moved from SIVs and perhaps other asset backed commercial paper conduits sponsored by the banks to the balance sheets of the banks? Seems like a very logical sequence of events viewed this way, so I decided to try to verify whether this was in fact the case. (The banks can pledge collateral that includes mortgage-backed securities, even ones that may contain subprime mortgages). Unfortunately, the Federal Reserve has not, to my knowledge, published a schedule of the collateral it has taken for these loans. So, the usually transparent Federal Reserve has hit a wall of opacity. It is not publicizing which banks are borrowing and it is not disclosing what assets are being pledged against those loans.

I, for one, would like to know what collateral the Federal Reserve is accepting and how it is being valued. Until these facts are made public, I will assume that the Federal Reserve has done what the M-LEC failed to do by creating the F-LEF through which the banks are delaying sales of assets that have been negatively impacted by the changing markets in order to preserve liquidity (or is it the appearance of solvency?). At the same time the banks are being openly encouraged to raise additional capital. So just how solvent are the banks?

Some very interesting questions and issues have been raised by this TAF. On the one hand, some commentators believe it could be the first step to nationalizing the banks (see this article by Steve Randy Waldman). If there are margin calls on the collateral that the banks cannot meet, what is the Federal Reserve to do? Convert the loan to equity? Interesting point. One colleague of mine suggested the Federal Reserve could simply forgive a portion of the debt, or “write it down”, just like the Federal Reserve Chairman Ben Bernanke is suggesting lenders should do with mortgage loans that are more than the property values securing them. That would raise a lot of very interesting issues. Others have said this is just a more effective way to provide needed liquidity to the banking system and should be well down the list of current concerns (see this article by Caroline Baum in Bloomberg).

Stay tuned – I have a feeling this isn’t over yet.

(Ordinarily banks that are solvent can borrow from the Federal Reserve using the Discount Window. The TAF is different in several ways. First, the Federal Reserve will not publish the names of the banks that win the auctions so we just don’t know which ones they are. These loans are also much longer in duration at 28 days and the Federal Reserve has assured the markets that it will provide these lines of credit for at least six months unless market conditions clearly show they are no longer needed and will increase the size if necessary. In the Federal Reserve’s words:

First, the amounts outstanding in the Term Auction Facility (TAF) will be increased to $100 billion. The auctions on March 10 and March 24 each will be increased to $50 billion--an increase of $20 billion from the amounts that were announced for these auctions on February 29. The Federal Reserve will increase these auction sizes further if conditions warrant. To provide increased certainty to market participants, the Federal Reserve will continue to conduct TAF auctions for at least the next six months unless evolving market conditions clearly indicate that such auctions are no longer necessary.)

For more details about the TAF visit the Federal Reserve's website.

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Proposals for Taxpayer Bailout of Banks

I was reading this article in The Wall Street Journal Online Edition titled Worried Bankers Seek to Shift Risk to Uncle Sam about proposals being shopped around DC to move defaulted subprime loans to FHA. According to the article:

The banking industry, struggling to contain the fallout from the mortgage debacle, is urgently shopping proposals to Congress and the Bush administration that could shift some of the risk for troubled loans to the federal government.

One proposal, advanced by officials at Credit Suisse Group, would expand the scope of loans guaranteed by the Federal Housing Administration. The proposal would let the FHA guarantee mortgage refinancings by some delinquent borrowers.

This will almost certainly lead to a taxpayer bailout in my opinion. I have been writing about this for months and the fact that it is being considered in DC is truly troubling. Congress has been warned about the consequences of this in 2006 testimony before the Committee on Banking, Housing and Urban Affairs. You can read that testimony here. If you would like my article on this issue you can find it here. The ideas discussed in the WSJ article referenced above go beyond what I wrote about back in December.

If you object to taxpayers bailing out the banking industry, again, I urge you to write to your congressional representatives.

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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: http://www.chapman.com/media/news/media.485.pdf.)

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 http://americansecuritization.com/uploadedFiles/Moodys_ABCP.pdf 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: http://www.federalreserve.gov/boarddocs/press/bcreg/2004/20040720/default.htm

"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: http://www.federalreserve.gov/boarddocs/press/bcreg/2004/20040720/attachment.pdf

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

10/22
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: http://ftalphaville.ft.com/blog/2007/11/01/8559/consumer-contagion-coming-says-morgan-stanley/, 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: http://americansecuritization.com/uploadedFiles/Moodys_ABCP.pdf . 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: http://online.wsj.com/article/SB119249738008460181.html?mod=todays_us_money_and_investing [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: http://online.wsj.com/article/SB119245287618859154.html?mod=hps_us_whats_news

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: http://polecolaw.blogspot.com/2007/10/hocus-poke-us.html. 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:http://online.wsj.com/article/SB119249738008460181.html?mod=todays_us_money_and_investing

"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:http://online.wsj.com/article/SB119257816857761266.html?mod=hps_us_whats_news

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 http://www.financialarmageddon.com/2007/10/the-crowding-ou.html

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:http://online.wsj.com/article/SB119266856453862839.html?mod=hps_us_pageone

Revision - 10/22

I was reading an article by Ben Stein today published in The New York Times yesterday here http://www.nytimes.com/2007/10/21/business/21every.html?ex=1350619200&en=bfe48f041e1a9aaf&ei=5124&partner=permalink&exprod=permalink 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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