Subprime and the Panic of 2008

(a.k.a. "Collateral is the Contagion")

Why the Fed & Treasury have failed to stop the contagion
By Jack R. Buchmiller

October 5, 2008

While the subprime meltdown of 2007 triggered the Panic of 2008 they are separate phenomena requiring different solutions. Subprime was old-fashioned dumb lending, differing little from commercial real estate, savings & loans (S&L), and real estate investment trusts (REIT) fiascoes in preceding decades. That is why traditional solutions worked for Countrywide, IndyMac, Washington Mutual, and Wachovia but not for Bear Stearns, Lehman Brothers, and AIG. The Panic of 2008 is one of contagion, a pandemic driven by defects in FAS-157 combined with the market practice of bilateral collateralization of derivatives.

The problem is finite but variable in size. Subprime and HELOC debt outstanding peaked at $2.3 trillion in 2006.[1] Subprime has tainted an additional $10 trillion of other mortgages by depressing home prices and refinancing opportunities. Globally, banks have reported $588 billion in write-downs and losses.[2] Insurers and other investors have also racked-up substantial[3] figures. The problem has expanded far beyond mortgages: NYSE and NASDAQ composites have lost a combined $5 trillion in value since July 2007.[4] But it should not be ignored that for a few years American homeowners enjoyed a flexibility and access to global capital rivaling any corporate CFO.

FAS-157: Marking to what market?
Mark-to-market (“MTM”) is a necessary discipline for financial institutions and disclosures of MTM by levels one, two, or three were a wonderful addition to transparency. However, FAS-157 is unrealistic as it requires MTM where & when markets don’t exist.

As Warren Buffett’s mentors put it, “The stock market is a voting machine rather than a weighing machine.”[5] If level 1 market prices are a ‘vote’, then level 2 is an opinion poll and level 3 a sound-bite. Investors are entitled to “weighed” 2nd or 3rd opinions when there is no reliable market. A security’s price reflects a market consensus of the present-value (PV) of its risk-adjusted future cashflows but also of its liquidity -- supply versus demand for that type of security and issuer’s name. But liquidity is neither an inherent nor intrinsic property of a security; it is a property of markets. When there is no liquidity cashflow discounting should applied, a process of ‘weighing’ risk and return. By all means disclose MTM, but also economic ‘weight’.

Those who structured subprime mortgage-backed securities (MBS) had valid models for underwriting various credit risk factors individually (e.g., low FICO scores, high loan-to-value, low documentation, etc.) but they had no data or experience on how these factors would interact once combined (no old-school lenders were dumb enough to try that). So they made assumptions. They thought they understood the risks; as did rating agencies and investors.

When performance data (experience) emerged on subprime and other new-school securitizations they all learned their mistake: 2005-07 MBS and ABS originations are defaulting at multiples of prior years. Collateralized debt obligations repackaging those securities (ABS-CDO), and eventually even prime mortgages and HELOC, faltered as home prices declined nationally, creating uncertainties about the banks, investment banks, and insurers exposed to these securities.

So far, this was only an old-fashioned real estate bust, with MBS, ABS, CDO, and SIVs as amplified analogs of the 1970’s REITs.

Risk versus Uncertainty:
Markets are very efficient at pricing risk but inefficient at pricing uncertainty. “Risk” is when you believe you understand the distribution of possible outcomes, for example a “bell curve”. Uncertainty ranges from a ‘not sure of the distribution’s parameters’ to ‘is there any distribution or is it chaos?’ Think of a game of blackjack where the dealer has one deck of cards: that’s risk. When the dealer’s ‘shoe’ may hold from one to a thousand decks: uncertainty. When pinochle, tarot, and Old Maid cards appear the market rushes to convert “blue chips” to cash (or Goldman Sachs to a bank): “panic”.

A security’s value is the present-value of its risk-adjusted cashflows. Its price or MTM is the market’s consensus value. As uncertainty increases the market begins “hair-cutting” value, an inherently arbitrary process given the uncertainties. As players quit the game illiquidity increases and markets are less able to find a consensus, creating more uncertainty and more hair-cuts, becoming a self-fulfilling act or “death-spiral”. This was seen in 2007-08’s cycle of restatements by banks, broker/dealers, and others.

Despite FAS-157’s obvious (and multiple) defects it wasn’t until September 30, 2008, after hundreds of billions of dollars of damage has been irreversibly incurred, that the SEC and FASB issued a press release to relax the insistence (now demurred) on MTM for level 3 assets.[6]

But this spiral has a companion.

Collateral is the Contagion!
Derivatives created efficiencies in investment and risk management that previously did not exist. To limit risk, market participants collateralize net MTM counterparty exposures on a reciprocal basis, typically via a “Credit Support Annex” to an ISDA agreement. This was and is a perfectly sound method to limit bilateral exposures, and regulatory capital, but one that created systemic risk.

$531 trillion of derivatives have been written on interest rate, equity & equity index, currency, commodity, and other risks, including $54.6 trillion of credit derivatives.[7] The problem with credit default swaps or “CDS” is they are not really ‘swaps’ but options as they have asymmetrical pay-offs, which means ISDA collateral asymmetry. Optionality makes perceived or “market-implied” volatility (a statistical quantification of risk) a significant component of MTM.

In the asymmetrical context of CDS, delivering cash collateral is just like prepaying the loss today (except that as MTM changes either you get collateral back or send more). But MTM of CDS is driven by the risk and uncertainty not just on the underlying MBS, ABS, or CDO discussed above but also by CDS counterparty credit-worthiness. Thus collateral calls will always be in excess of expected loss as they embed a risk component. Even if loss expectations don't change increased volatility will produce collateral calls.

Markets can price their own uncertainty and liquidity, but they cannot collateralize their own uncertainty and liquidity. Efforts to do so create contagion, a second spiral. Unlike an old-school credit crisis worked-out over time, this one demands immediate prepayment.

TARP … or Trampoline?
The Federal Reserve and Treasury Department first tried to contagion by throwing their balance sheets at ‘deals’ – Bear Stearns and AIG. But not at Lehman, creating both anxiety and confusion as Lehman was ‘too-bigger-to-fail’ than Bear.

Balance sheets are not the problem, FAS-157 and CSA collateralization spirals are. Nor has the federal government the balance sheet: it’s already mortgaged. The “Troubled Asset Relief Program” (TARP) might succeed by creating liquidity and a rational ‘weighing’ of value. But other than by that indirect means, it does not prevent further contagion. It just throws a bigger balance sheet.

One way to break the collateralization spiral would be for the Fed to step in as the CSA provider, as surety, among regulated financial institutions. Instead of scrambling for eligible collateral, everyone takes the Fed's name; no further collateral (cash) changes hands. Realized losses would remain for the financial institution’s own account until regulatory capital is depleted. Markets are no longer trying to prepay losses and collateralize uncertainty and illiquidity. The Fed's risk is that banks & brokers have mismatched books or asymmetric losses, but that is just an old-fashioned work-out.

If uninsured liabilities must be picked-up too, then perhaps federal regulators will finally grasp the folly unleashed with Continental Illinois and “too big to fail”. Free markets require freedom to fail.

JRB

Opinions expressed are solely those of the author and not those of his employer.
Copyright 2008 by Jack R. Buchmiller

[1] Source: LoanPerformance, part of First American CoreLogic, Inc.
[2] Per Bloomberg, as-of 10/3/08.
[3] Still fact-checking.
[4] Using Bloomberg’s TRA or total return function on NYA & CCMP indices from 7/31/07 – 10/3/08 and market cap’s from DES: NYSE fell 20.7395% to $16.39 trln, CCMP -20.2443% to $3.14 trln.
[5] From “Securities Analysis” by Graham & Dodd, 1934 edition, page 452, via google.com -- http://books.google.com/books?id=wXlrnZ1uqK0C&pg=PA452&lpg=PA452&dq=%E2%80%9Cvoting+machine%22+and+%22weighing+machine%22+and+Graham+and+Dodd&source=web&ots=kUrqmbzYSm&sig=PHdrucNTyugvcIhvdIQ7ph3WXHo&hl=en&sa=X&oi=book_result&resnum=4&ct=result
[6] SEC Office of the Chief Accountant and FASB Staff Clarifications on Fair Value Accounting: 2008-234 (http://www.sec.gov/news/press/2008/2008-234.htm) ‘I think these gentlemen doth protest too much.’
[7] ISDA’s mid-year 2008 market survey dated 9/24/08 (www.isda.org).

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The genesis of this essay dates back to April or May. I was visiting a certain federal regulator on another matter (right place, wrong people) and posed the rhetorical question: As all Bear Stearns counterparties were collateralized [ISDA Master and CSA's] why would their failure have been 'systemic? Why did no one see it coming, the contagion of collateral, if not the ensuing Panic? (Although I saw the collateral problem, I never thought it would be anything like this.) Given that Lehman was far 'too bigger to fail' than Bear, how could they not see the cataclysm LEH would cause? And then to rescue AIG a day later?

JRB

12/9/08