Great interviews in finance

Sorry - YouTube has mangled the video and the sound is stuffed.  I can't seem to fix.  

Mish alerted me that Land America had filed bankruptcy.  Its a company I used to follow - but I never shorted.  

This is a gem - an interview from only 18 months ago.

The money quote: "the United States real estate economy is the envy of the world... the ability to create value out of real estate by taking mortgages and securitising them..."

And this was the seemingly boring business of title insurance!

Goodbye Tanta - I will miss you...

Doris Dungey (Tanta) - a really competent blogger in the mortgage area has died at an unfortunately young age.  

I am not much into obits...  I would rather praise the living when they can enjoy it.

But I will give you one blog post - an absolute gem which shows the quality of the woman:

http://calculatedrisk.blogspot.com/2007/03/unwinding-fraud-for-bubbles.html

John Hempton

Weekend edition: surf lifesaving as a spectator sport

I am a volunteer surf lifesaver at Bronte Beach.  I used to be at North Bondi (one of the softest but most crowded Sydney beaches) but moved my allegiance when I moved to Bronte.  It scares me though because Bronte Beach, whilst having a reputation as a family beach – and a multi-cultural hang-out – is actually quite dangerous.  A large amount of water comes in (usually on the north end of the beach) and cycles out in a fierce rip.  [For the uninitiated a rip is a current going straight out to sea.]  The rip is a “Kieren Perkins rip” because on days like today you would need to be Kieren Perkins to swim in against it.

Anyway I had a patrol on Saturday afternoon.  It was quiet – very quiet because it rained in the morning and rain was predicted in the afternoon.  I spent my time chatting to a lifesaver who I had never previously met – but who was a lot fitter than me.  (He rowed for Australia at the Beijing Olympics.)  

Sunday afternoon was different.  The beach was crowded, the surf was up and the rip was strong.  

I said Bronte had a reputation as a family beach – and so it does – but for two main reasons:

1. there is a large grassed area where large family groups (extended newer-Australian families, drunk groups of younger Anglo-Saxons) have barbeques, play cricket or kick soccer balls, and
   
   
2. propped against the southern edge of the beach is a big rock hole which is very child-friendly at low tide.  Bulldozers have dragged the rocks out of the centre – and left a beautiful and calm sandy swimming hole – known ubiquitously as the “bogey hole”.  You can see a picture of it in calm conditions here.  
   

I was down the beach with my son (aged 8), a friend of similar age and the neighbourhood six year old.  The surf was up so we were playing in the bogey hole.  The kids were playing with some other 8 year olds who had come with an extended group of Muslim Australians.  I wound up chatting with one of the dads.  The Muslim group was racially mixed but highly identifiable because the women were wearing head-clothes.  Even then there was a range of hijab – black African muslims in form fitting jeans but loose (and hence obscuring) upper-body clothing and fairly full hijab, and a European Muslim (probably Bosnian) wearing a scarf loosely over her shoulders but not obscuring any of her hair.  The men told me they had come from Belmore – a suburb of Sydney with a large mosque and a double-digit percentage of Arabic speakers.

The boys would have fitted neatly in anywhere.  They were wearing board shorts, playing a little loudly and splashing water on each other - and they spoke in English and Arabic.  Some of the women were throwing sand at them as they played in the bogey hole.  

Two of the fathers climbed through the rocks that sheltered the bogey hole from the wild surf (the waves had 8-10 foot faces).  The tide was rising and the dads enjoyed the water splashing around them.  At least they enjoyed it until they didn’t – as the waves were getting just a little rough.

I wasn’t the only person that noticed.  Two lifesavers (clubbies) were also watching from the shore.  They tried climbing around the rocks to talk to the men – but they thought better of it and snuck back to the beach.  

I should explain "clubbies".  The beaches of Sydney mostly have amateur surf-lifesaving clubs.  However the amateurs only patrol the beaches on weekends and public holidays.  They also have professional life-guards.  The clubbies wear red-and-yellow.  The life-guards (almost all former clubbies) wear blue.  The lifeguards are all amazingly fit and competent.  The lifesavers (clubbies) vary – from overweight middle-aged finance executives (me) to super-fit amateurs (the Olympic rower I was chatting with on Saturday).  

Anyway the two clubbies were on it – as the obvious happened.

The two blokes – now getting quite uncomfortable as bigger surf washed them against the rocks – decided to swim for it.  They swam out to sea.

The only problem was that they wound up immediately in a very strong rip – and it was obvious within seconds that they were going to need rescuing.  There were two lifesavers.  They immediately radioed back to the tent what was happening and one clubby got into the surf on a yellow rescue board.  The other stayed on the shore watching.  By this stage I was watching – along with twenty others – quite enjoying the spectacle.  I tapped the wife of one the victims on the shoulder – a woman of indeterminate Middle Eastern origin in a fairly formal hijab.  I pointed out her husband needed rescuing.  She didn’t believe I was talking about her husband – and ignored me.  She apologised later – when she was getting over her utter panic.  

Anyway a lifeguard (blue shirt – blue rescue board) ran in (he heard the radio) and got out in maybe 20 seconds.  Some surfers had also managed to get to our hapless victims.  The clubby cheered me up by proving my inadequate surf-rescue board skills were not alone.  Clubby number 1 lost the board as he was trying to get victim number 2 onto the board.  The lifeguard came in with victim number 1.  [It turns out later than number 2 was a competent swimmer who did not understand rips and would have drowned eventually, number 1 could barely swim and would have drowned rapidly without rescue.  Victim 2 held onto the clubby 1 whilst they both awaited something that looked like rescue.]

The rescue board washed up on the beach – and I was sprinting down the beach ready to grab it and do some heroics of my own.  Another clubby beat me to it – and as he was on patrol and in uniform it really was his turn.  He went out.  I grabbed a rescue tube (just some floatation) and decided if clubby number 2 was going to have troubles that I would jump into the rip and ride the same current out as they had.  I was not needed (for which I was grateful).  

Only about this time did the Muslim women realise that their men-folk were in mortal danger.  There must have been 50 people watching this as the best entertainment all day before the women realised there was a problem.  But once the Muslim women realised there was a problem there was plenty of commotion.

The two blokes were ferried into shore.  The lifeguard (who had gone out again in case he was needed) surfed in gracefully on his knees on a very large wave.  He made me feel inadequate as to my rescue board skills all over again.  

I chatted freely to the woman in the formal hijab.  She was shocked – and told me how common drowning was in her home country.  I explained to her that the clubby that rescued her husband was a volunteer – she had no idea.  She was amazed that volunteers would “risk their lives” like that.  For a competent lifesaver there isn’t that much risk – but the action is still of volunteers savings lives.

The last I saw the whole group of Muslim families – maybe 20 people in all – walked up to the lifesavers’ tent to say thank you.  

A few years ago there were race riots at Cronulla beach with drunken Anglo louts beating up on Maronite and Muslim Lebanese Australians.  The proximate cause was a Lebanese lout assaulting a lifesaver after the lifesaver had told the man not to play soccer on the beach (which was crowded with passive sunbathers).  The lifesaving clubs however didn’t cover themselves in glory either – with one racist younger lifesaver having written on his body the line “we crew here – they flew here”.  

But today made me proud.  It made me proud of my surf club and made me proud of Australia.  It also made it patently clear that there are ways that we can coexist – that Muslim/Western relations do not have to be all bad.  And that us Westerners would risk our lives for a couple of wayward Muslim blokes just as we would for each other.

John

Even Krugman doesn't get how plainly irrationally bad it is out there

I used to think that if the government only made the GSE obligations full faith and credit (FFC) obligations the remaining problems in the conventional mortgage market would go away.  Paul Krugman still thinks it:

The Fed is confusing me

OK, so the Fed is planning to buy obligations of the GSEs — as well as securities guaranteed by the GSEs. This is in an effort to lower spreads. The Fed will in effect pay for these purchases by having the Treasury issue U.S. government debt.

But the GSEs have been nationalized. Their obligations are already U.S. government debt. What’s going on here?

It’s true, as the Fed’s statement says, that

Spreads of rates on GSE debt and on GSE-guaranteed mortgages have widened appreciably of late.

But that’s presumably because the Bush administration, weirdly, has refused to declare that GSE debt is backed by the full faith and credit of the US government. Why not just make that declaration, turning GSE debt into Treasury obligations, rather than stuff the obligations onto the balance sheet of the Federal Reserve?

Is this some kind of strange political game? Is there something else going on here? Inquiring minds want to know.

He is of course wrong.  The Goldman Sachs obligation is full faith and credit of the US Treasury - and trades at an irrationally wide spread.  Nobody has given a plausible explanation (except lack of trust in the government) as to why the spread on FDIC paper issued by Goldies but backed by the full faith and credit of the US Treasury is 200 bps.

For once the world is even stranger than Paul Krugman thought and stranger than his models.

Now there is an implication here - which is if the market will not believe that something is full faith and credit of the US Government then the government should buy it, issue treasuries and make an arbitrage profit.  There is a free lunch here.  Of course this mucks government accounting around (the debts wind up on balance sheet of the government rather than just contingent).  However it does not change the economics from the government perspective.

And in the process we go from the government buying the troubled assets of financial institutions to the government buying the guaranteed liabilities of financial institutions.

John Hempton

Proof we are not in Kansas any more

Brad Delong thinks that the failure of Citigroup is about “risk premium”.  I think it is about trust – and I guess in some sense these are the same thing.  However it is about trust then no plausible amount of capital solves the problem – whereas in the Brad DeLong model there is a reasonably estimable and plausible quantum of capital that is sufficient.

Anyway today was a deal that proved to me just how strange these markets are. 

 

Goldman Sachs got to issue some FDIC bonds.  These bonds are guaranteed by the FDIC and are hence full faith and credit of the US government.  They were issued at over 200bps of spread.  The spread traded to about 200bps.

That spread makes no sense whatsoever unless you really believe that there is a chance that the US government is going to selectively default.

Once upon a time Long Term Capital Management traded “on-the-run” versus “off-the-run” Treasury bonds, noting that a 29 year bond (which was off the run) had a different yield to the current 30 year bond (which was the reference bond and hence more liquid).  If you went long the illiquid bond and short the liquid bond you might make 16-20bps.  Lever that 100 times and you get quite a nice return on equity.  However if the spread between them (call it a liquidity premium) blows out you can get into some trouble.  

Now we have an FDIC bond with a spread of 200bps or more.  No need to lever 100 times – ten times will make you a super-profitable hedge fund.  And you are leveraging 10 times to term matched US Government obligations which should be less risky than the slightly term mismatched positions taken by LTCM.  

Of course it is a little harder these days to borrow the government securities needed to pull the LTCM stunt.  (There has been a problem with fails in the Treasury market.)  But the margin leaves me gob-smacked.  

If anyone has an explanation other than trust (a belief the US government might default on full faith and credit obligations) or liquidity let me know.  If Brad Delong is right – and it is about capital then this should be able to be levered 5 times as there should be little capital risk.  

But I don’t think it is about capital – it is about something else – something altogether darker and harder to solve.

In the Wizard of Oz all you needed to do was click your red shoes together.  

I have been trying all day!

John Hempton

Arguably the best proxy disclosure of the year

I had never heard of Schulman until today – but then Footnoted led me to  a proxy disclosure.  I won’t adorn this:

During fiscal 2008, the Compensation Committee determined that maintaining a lease on a private airplane was no longer a cost-effective method for providing business-related transportation to our Named Executive Officers and Directors. The airplane was used only for business-related travel, and personal use was not permitted. With the termination of the lease on the airplane, it also became increasingly difficult and cost prohibitive to access our Canadian fish camp. Consequently, the fish camp, which was only used for business entertainment purposes, was offered for sale during 2008. The only offer to purchase the fish camp came from Terry L. Haines, our former Chief Executive Officer and President. Ultimately we negotiated with Mr. Haines to sell the fish camp for a purchase price of $55,000 and the transaction closed during fiscal year 2009.

Reaction to the bailout

The consensus is that the Citigroup bailout was bad - see Mark Thoma.

I am going to differ here.  The bailout was well designed...

except

1).  The Government should have taken a much larger fee - at least 20 percent ownership of Citigroup - and arguably more.  Shareholders should be punished.

2).  The attachment point of the excess of loss policy is too low.   If the attachment point had been 80 billion Citigroup would survive.  There was no need for a 40 billion dollar attachment point.  

The problem with the bailout was not the design - it was the amount extracted from Citigroup shareholders.  The government took too much risk for too little reward.

I am surprised that the shareholders were not effectively wiped out as per Fannie, Freddie, AIG.

Not displeased - but somewhere I wish the government would get a happy medium somewhere - rather than one rule Citigroup and one rule for Fannie.

John Hempton

The Brad DeLong question - and how to design a bailout that works

Brad DeLong asks a question which seems obvious enough to me – but seems to elude him.  

Le Citi Toujours Dormer...

Why oh why can't we have a better press corps? Eric Dash and Julie Creswell write that:

• Citigroup had poor risk controls.

• As a result, the bank owned $43 billion of mortgage-related assets that it incorrectly thought were safe.

• They weren't.

• And so as a result the market value of Citi has collapsed by a factor of ten: from $200 billion to $20 billion.

To which the only appropriate response is: "Huh?" How can losses out of $43 billion of optimistically overvalued asserts eliminate $224 billion of value? Eric Dash and Julie Creswell don't answer that question. They don't even seem to recognize that it is a question that they should be interested in. That they were given this story to write, and that no editors said "wait a minute! this doesn't add up!" is yet another signal that the New York Times is in its death spiral: not the place to go to learn anything about an issue.

I think he is a little rough to criticise the NYT for that – or for that matter any other paper – because at the moment the Treasury and the FDIC are also acting (at least until now) as if they do not know the answer.

The answer is that the crisis is not about the amount of losses yet realised or yet to be realised, and it is not about capital adequacy of the banks and it is not about their level of leverage.  It is simply about the question “do we trust them to repay their debts”.  You might think is about capital or losses or leverage – but even if the bank has adequate capital and losses come are relatively small if we believe collectively that they can’t repay then they can’t repay.  Sure more capital would produce more trust – but the level of distrust at the moment is so high that nobody can tell you how much capital is needed.  All estimates are a shot in the dark.  In reality all that is needed is more trust.

The short answer to the Brad deLong question is that due to the losses and the lack of risk control people stopped believing in Citigroup – and hence Citigroup dies without a bailout.  It was however pretty easy to stop believing in Citigroup because nobody (at least nobody normal) can understand their accounts.  I can not understand them and I am a pretty sophisticated bank analyst.  I know people I think are better than me – and they can’t understand Citigroup either.  So Citigroup was always a “trust us” thing and now we do not trust.  

The long answer has to be a replay of the various themes of this blog.  So lets do it in pieces.

1).  The losses in the banking system in America are not unmanageably large.  Anyone that tells you otherwise just hasn’t done the maths (and that is most people).  I have written this idea uphere…  and nobody yet has an adequate response though Mark Thoma has tried and even Kevin Drum on the Mother Jones blog has commented on it.

One offender not doing the maths is (very surprisingly) Paul Krugman - although his last post in which he blamed lack of capital for the crisis was March  - so maybe he has done some maths since.  Krugman usually does the maths and is spot-on in his analysis of Fannie and Freddie.   I am usually an unabashed fan of the Shrill Professor – so his various diagonoses  leave me perplexed.

2).  The problem with the banking system is that it is structurally short of stable funding.  America has a loan to deposit ratio that is collectively well above 100.  So does the UK, Iceland, the Baltics and most of Eastern Europe, Australia and New Zealand.  This means that collectively the banks need an awful lot of wholesale funding.

Japanese banks fizzle, they make no profit – but they do not collapse.  Why?  Because they are structurally long finance.  Agricultural Bank of China (the notorious ABC) is deeply desperately insolvent – but it is still here.  Why?  Because it is long funding.  Generally it is banks in current account deficit countries that are vulnerable.  The main German bank that collapsed (Hypo Realestate) had two large businesses with no deposit base.  It was the bank in a current account surplus country that collapsed – the exception that proved the rule.  [There is an issue with banks with life insurance subsidiaries in current account surplus countries.  They are vulnerable but for completely different reasons – the subject of another blog post – a long time into the future...]

3).  The crisis will end when people are convinced to roll the wholesale funding.  Government policy that brings us closer to that point is probably effective.  Government policy that does not bring us closer to that point is almost certainly ineffective.  Policy that takes us further from that point is counter-productive.  My case examples of counter-productive policies are the confiscation of the rights of the debt holders of Washington Mutual, and the pointed refusal to issue government guarantees even when it is utterly obvious that the government is on the line (as in Fannie Mae and Feddie Mac).  The confiscation of Washington Mutual convinced bond holders that their positions would be compromised by government fiat and with little notice.  As I have posted many times I thought that was reckless and that Sheila Bair should resign.  The refusal to guarantee Fannie Mae and Freddie Mac at this point looks like sheer stubbornness but I think is driven as much as anything by government accounting concerns – a full guarantee means the assets and (more importantly) liabilities get bought onto the government balance sheet.  

The cause of the crisis

This is a wholesale funding crisis and the cause of the crisis is plain.  It is lies told by financial institutions.  Financial institutions sold AAA rated paper which they almost certainly – deep in their bowels – knew was crap.  They sold it to people who provide wholesale funding.  

Now they need to roll their own debt.  The people who would normally wholesale fund them are the same people who have had a large dose of defaulting AAAs.  They no longer believe.  It is “fool me once, shame on me, fool me twice, shame on you”.  As I have put it the lies that destroyed Bear Stearns were not told by short sellers.  They were told by Bear Stearns.

Now the problem is that no matter how many times Pandit says that Citigroup is well capitalised nobody will believe him.  In answer to the Brad DeLong question – the company told lies about its mortgage book – which compounded the lies about the dodgy CDO product they sold.  The lies about the mortgage book totalled $20 billion on say $43 billion of optimistically valued assets – and those lies reduced the value of Citigroup by $200 billion because they removed the trust in Citigroup.

It is one of those ironic things that when financial institutions lied in 2006 the market seemed to believe them.  When they tell the truth now, nobody will listen.  

Robert Rubin racks his brain about how he would have done things differently.  Well one thing he would have done differently is get Citigroup to remove the culture of obfuscation – the culture that allowed it to be perceived as if it were lying even when it was telling the truth.  The problem is that even Robert Rubin doesn’t have enough uncashed integrity to save Citigroup.  Even Robert Rubin.  In a world where Berkshire credit default swaps are going skyward because people do not believe that Warren Buffett has no collateral requirement Robert Rubin’s reputation ain’t going to count for much.  

Anyway given that the crisis is a wholesale funding crisis we need to do something to make the people who provide wholesale funds happy.  

What of course would make the people who provide the funding happy is a plausible government guarantee.  Iceland couldn’t provide one because its banking sector was ten times GDP.  But the US probably could. 

The most extreme (and probably effective) solution would be a full guarantee of all sorts of bank debt.  The problem of course is that is hugely risky for the taxpayer.  My view – and I think the only way in which such a guarantee is viable – would be that if the taxpayer takes the risk they should also get the upside.  That is full nationalisation.  The advantage of full nationalisation is that since the system is actually solvent (but illiquid) the government will make a profit out of it.  That is fine.  Take the risk – make a profit – it’s the capitalist way.  Incidentally the Sheila Bair approach of confiscation from the equity holders and subordinate debt holders works fine in this scenario.  Indeed the sub-debt holders should wear it – but they will still be willing to lend again because they will be lending again to the government.  In a full nationalisation I see no reason for Sheila Bair to resign.  (Her tenure in that position would not threaten the financial system.)  

I suspect that wholesale nationalisation is the cheapest (and most sure) way to end the financial crisis.  But it would be difficult to find a Deputy Secretary of the Treasury for Citigroup (and Bank of America, JPM etc).  Still as I think the system is eventually solvent if the government nationalised pretty well the whole system as it failed then the government would make a shocking profit.  It would not be the first time – Norway made such a profit.

But I am not sure that the American politic is ready for a wholesale nationalisation of the financial system.  Indeed they are determined it seems not to control financial institutions.  If you are not convinced of that see the Deal Professor’s wonderful piece on who controls AIG.

A cost effective TARP

What however is required is something that convinces the funders that the banks are solvent at the least possible cost to the Treasury.  Now my view is that if the treasury guarantees (and hence takes the risk) it should own.  That is a view in favour of nationalisation, but as that is not on the table let’s do the next best thing.  Suppose the Treasury takes the “fat tail only”.  Then the banks are solvent.  Imagine for instance if the treasury agreed to capture the losses at Citigroup above say $90billion.  Why did I chose 90 billion – well – it is the stated capital of Citigroup.  

As Citigroup has at least its net worth guaranteed then Citgroup is solvent.  Funding should come back.  

Note that excess of loss insurance policies are almost certainly the cheapest way in which to guarantee banks.  The reason of course is that you take on only the losses you need to take on.  However you leave the upside with the banks.  

The Federal Government should logically charge for the excess of loss policy.  There will be some banks with very big losses that will claim on it – and so there will be losses recognised even if the system is solvent.  My rule – which is a little arbitrary – the government should take 20% of the equity of all institutions that want to buy an excess of loss policy.  I figure in five years time selling the equity should pay most government losses.

To be precise the excess of loss policies should not be for 100% of losses beyond an attachment.  In reality the government should guarantee only 90% of the losses beyond the attachment.  The reason for that is when the attachment point is hit you want the bank in question to have an incentive (be it 10% of recoveries) to actively mitigate the losses.  A better incentive is also to have the losses covered by the government – but with the government receiving equity in the institution dollar for dollar for the losses covered.  This will still mean that institutions are nationalised – precisely those with the biggest losses.  [The equity grant to the government for covering the losses will punish institutions that have to claim and will help mitigate government losses from the scheme…]

Mr Paulson seems however to be wanting to give government money inefficiently to financial way too cheap.  The bailout of Citigroup is a case in point.  They gave a capital injection (subordinated debt) for which they charged the princely sum of 8 percent.  Hey – that was what bank preferred stock yielded in 2006 – and way below the fair value of such money now.  Then they just guarantee 300 billion of assets – admittedly subject to an excess of loss rule (above 40 billion).  This excess of loss threshhold is way too low.  It could be 80 billion and Citigroup would remain solvent.  Then the government also did not take anything like a large enough equity stake in Citigroup even though Citigroup would have willingly handed one over.  Why not?  Because they play fast-and-loose with taxpayer resources.  

That said – the excess of loss policy is the right idea and for that (and for once) I applaud Mr Paulson.  This is the first bailout I have seen with a decent design.

Now as for Sheila Bair.  Her takeover of Washington Mutual and the subsequent collapse in Wachovia is perhaps the most glaring example of abusing the bank intermediate creditors this cycle.  She should resign for it – and the intermediate creditors will not be comfortable until she takes the fall.  But, and you will sense me relenting a little here, if the deal is that the government writes excess of loss policies on a grand scale her continued tenure in the job doesn’t actually threaten the financial system.  But until then she is the symbol of the risks faced by the providers of intermediate finance.  Absent a comprehensive solution as outlined here she should resign.  With a comprehensive solution her position is neutered – and she can stay in it without risk.  If she is driver for a comprehensive solution then I will forgive her staying around - but at the moment she seems far more concerned with modifying mortgage terms - that is about first loss.  An efficient comprehensive solution is about excess of loss - and she isn't playing that ballgame.  

John Hempton

I risk being detained by the Latvian secret police

It appears that a Latvian academic was detained by the secret police for spreading rumours about the possible devaluation of the Latvian currency.  (Hat tip to the Latvian economy blog.)  

I think I did that first.  

Do you think they can be bothered coming to Australia?

John

Tax benefits, Wells and Wachovia

The most repeated argument against my line that Sheila Bair erred badly when gifting Wachovia to Citigroup is that Wells could only make the alternative work because of tax benefits.

Lets dismiss that for once and for all.

The tax benefits would also have been available to Citigroup.  

John