You are under the unfortunate delusion that simply because you run away
from danger, you have no courage. You're confusing courage with wisdom. - From The
Wizard of Oz.
For a moderately overweight and
decidedly non-fitness focused person like me, summer tends to be a time of
worry as female acquaintances near and far swoon over the wonderful "abs" of
bronzed swimmers and surfers in all the beach counties. At any sight of such
"abs", I swear to myself that a trick of lighting is upon my eyes for what
stands before me is simply a flabby man with cleverly painted lines on his
torso to give an appearance of muscles where there are (and cannot be) none.
In any event, the warm days of summer are behind us (I reason), and a man needs
a bit of fat to sustain himself through the cold
winter months - let's see those bronzed freaks from Bondi Beach do that!
Right, with that little bit of steam blown away, let us look away from morons
on beaches to morons in markets and especially at the archaic world of
asset-backed securities (ABS); that financial juggernaut which constitutes the
largest category of debt in the world. Right from the emergence of the
turbo-charged ABS in the late 1980s and early '90, one particular question has
always gnawed at my insides - what exactly is an ABS when the collateral
underpinning it actually proves non-existent?
[Readers note - I have referred to these securities as asset-backed securities,
which is the umbrella term for residential mortgage-backed securities (RMBS),
commercial mortgage-backed securities (CMBS) and so on; most of the actual
assets referred to in this article are RMBS. Plus I couldn't think of any
wicked puns with the useless abbreviation RMBS].
The answer, dear readers, is that the security becomes an unsecured (or
non-collateralized) obligation of the issuer. So as a creditor you effectively
go from the chap who has a charge on specific assets to being the muppet who
stands in the same queue as all the other creditors of the issuer. You thought
you were better placed because there was no "credit" risk from the issuer, ie
you didn't have to worry about whether the issuer of the security was safe or
not - what really mattered was that you had strong financial collateral with
which to recover the value of your investment if ever the payments stopped
coming. If the collateral is exposed as a lie you of course become the same as
everyone else.
Tickle me Elmo, what can I say.
To be sure, my initial questions back in those days pertained mainly to the
issue of ABS that were backed by homes in, say, hurricane-prone Florida and
what happens when the physical collateral simply disappeared in a mighty gust
of wind. In the kernel of that question though, lay a deeper quandary, namely
the possibility that documentation and legal problems could always undermine
the actual quality of an ABS.
Interestingly, the notion of disappearing collateral was the reason the ABS
market virtually never took route in "emerging" markets - "Pah!" they said. "No
one can trust these Chinese and Indian guys to document their collateral
properly; and we can never enforce on the actual assets anyway." Thus it was
that the ABS market remained firmly rooted in the "developed" countries such as
the United States, United Kingdom, France and Spain.
So to summarize, developed markets could create and sell ABS because of two
reasons:
a. The rule of law allowed creditors to seize collateral whenever payments were
stopped;
b. Documentation was straightforward and clear; with layers of checks and
balances to prevent errors of commission and omission.
Alright Dorothy, stand by to witness the Wizard.
The two basic assumptions underpinning the quality of ABS have now become
questionable. Firstly, there is the foreclosure crisis that has been sweeping
its way through the US financial system over the past month or so and which has
severely dented the ability of creditors to proceed against borrowers based on
their non-payment of mortgage dues.
This is but the tip of the iceberg, as a number of banks have stopped,
restarted and then stopped their foreclosure processes due to the significant
failures of underlying collateral. There are multiple issues on the political
front, as American taxpayers consider the actions of banks that were (largely)
bailed out by the US government in the past few years and now appear to be
shirking their implied social responsibilities.
(It is entirely another matter here that I never expected banks or anyone else
being bailed out by governments to show their gratitude by altering their
profit motives or doing things differently; that is not an appropriate
discussion for this particular topic).
Even as the problems with actually laying your hands on the collateral exploded
on to the television screens, along came the second problem - namely the
documentation issue. It appears that the practice of "selling" the same
mortgage into multiple securitization vehicles was not particularly uncommon.
Or to put it in a phrase that is more straightforward, "everyone did it".
The notion of the same mortgage sitting in multiple asset pools from which
securities were issued (and then purchased by mortgage investors globally) is
of course anathema to the very existence of the industry. Suppose there were
two securities' pools that counted the mortgages of three people, namely A, B
and C. Suppose further that person A defaulted on his mortgage. You would then
have the spectacle of two custodians going after the mortgage - and indeed a
number of websites and blogs have cited exactly the same issue, ie that more
than one bank attempted to foreclose on the same property in the past two
years.
That is however not the biggest problem here. Suppose further that persons B
and C are still paying their mortgage. Which of the two pools is actually
collecting their checks?
Enter, stage left, the business of servicers, who are usually the folk
responsible for monitoring all the payments coming into every mortgage pool and
then paying out on the other side to investors of those pools after adjusting
for the losses (which would be borne by "junior" or equity investors in these
pools).
The trouble is, servicers are usually owned by banks or, at the very least,
rely heavily on the banks to track specific payments. So it is a simple act of
financial legerdemain for banks to essentially pay out on mortgage pools where
they KNOW that the assets are fraudulent, that is, for banks to pay out of
their pockets pretending to be the mortgage borrowers (for one of the pools).
Why would they do that - well, simply because the laws of economics are
wonderful. Or put simply, because borrowing with collateral is a whole lot
cheaper than borrowing without. When you are talking a few billion (let alone a
few hundred billion), the difference of 0.5% can be pretty gargantuan.
What choice do investors in such ABS have - well, they can go after the
original "sponsors" which are usually the banks originating the mortgages to
buy back the fraudulent securities. This is precisely what some of the world's
largest fixed-income funds such as PIMCO and Blackrock did last week when they
pushed for billions of shoddy ABS to be re-purchased by the giant Bank of
America (BAC).
The "funny" thing was that the New York Federal Reserve joined in the action
against BAC because it too was holding some of the shoddy assets due to the US
government's rescue of AIG in 2008. And thus the circle came fully around to
the starting point.
Stock market reaction for BAC has not been kind, as the chart above from Yahoo!
Finance makes abundantly clear. What puzzles me though is the general
out-performance up until now of the other bank in the chart namely JP Morgan;
which given its purchase of Bear Stearns in 2008 is probably also in a similar
boat. Still, I am not a CNBC analyst so it doesn't matter to me to express an
opinion on every odd detail out there.
In effect, what I am getting to here is that the ramifications of these actions
for US banks could be bigger than anything else; some analysts have bandies
about a figure of a $200 billion in mortgage-backed securities that would need
to be repurchased or downgraded as a result of the latest disclosures. If banks
such as BAC and JPMorgan Chase were forced to repurchase these, they would need
to flood credit markets with hundreds of billions in "straight" bonds - those
that are backed by nothing other than their good names. That in turn could
cause rapid series of adjustments to borrowing rates; and from there to the
rest of the economy.
China angle
A curious development for last week was China's decision to increase interest
rates, a clear signal if any was ever needed that further currency reform (or
float) has been completely ruled out in the Middle Kingdom. If the Chinese
government was going to cut domestic demand through internal monetary policy
adjustments, it stood to reason that externally oriented adjustments
(tightening) through a float that would push the yuan higher against the US
dollar was simply not on the cards.
There was also the little matter of the Chinese and American delegations
appearing to agree on most things during the Group of 20 meetings of finance
ministers in Seoul last weekend, which produced a damp squib resolution on
controlling trade deficits. Much fodder for comedians, but precious nothing for
anyone else.
All things considered, my theory (and that is it is for now) is that the US and
China have entered into a "mutually beneficial" arrangement wherein China will
continue to purchase fraudulent ABS issued by US agencies and banks (alongside
vast quantities of sovereign debt) and in return the US will continue to buy
Chinese goods - and that little matter of what some rude folks term "currency
manipulation" will not be mentioned.
Seeing the potential scale of the problems about to erupt in the archaic world
of US ABS, it seems like a bargain deal to me.
References
This article could not have been written without the excellent work showed in
various sites, as listed below:
a. The Institutional Risk Analyst bank rating service at
http://us1.irabankratings.com
b. www.washingtonsblog.com
c. www.nakedcapitalism.com
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