I'm not an expert on this stuff, so this might be a stupid question - but given that the loans are backed by buildings and have real value, why can't banks find buyers at anything more than pennies to the dollar? It seems like a really cheap way to acquire land.
I want to clarify one thing again. Like I said in my last post, only the senior (Class A certificates) are rated AAA's, even those range from AAA's to A's. The mezzanine and subordinate certificates are not. If those are rated as AAA's, I'd be the first one to have problems with it. Mezz (M-1 to maybe M-9) are typically rated BBB's to B's, and investors who bought those are rewarded for their risks. MBS certificates are usually floaters. So for example, the A-1 class will have a coupon of One-month LIBOR (as is typical) + a spread of say, 0.24% (0.48 after stepdown, but that's another issue), the M-9 would probably have One-month LIBOR + 3.75%. So wherever you read that even the most risky and volatile tranches are rated AAA's, that's simply not true. What most likely happened is the media (which typically doesn't know what's going on) and hedge funds that screwed up (many also don't know what's going on) tried to cover their screw up. The thing is, unlike the media tried to portray it (and unlike the stock market, where it actually is an issue), disclosure never was really an issue with sub-prime MBS. If you should have any problems you should have with over-disclosure. For each deal you' have easily 300 pages in the prospectus. If you read that, you just wasted your time. The meat (modeling assumptions) is in the prospectus supplements, which also easily run 250 pages. In it you'll find prepayment assumptions, loss assumptions as detailed breakdown of the loans by things like state of the property, credit score, loan-to-value percentage, etc, among other things. Does it need to be 250 pages? No. You see, a long time ago, investment banks were in a bind. If they tell people the level of risk that surround the later M and B classes are, nobody would ever buy them. But their lawyers wouldn't let them not disclose (for liability purposes of course). So a smart young broker (his name is slipping my mind right now) came up with the idea of "disclose everything." For example, do you know in the section of "risk factors," every new deal now has a section for Hurricane Katrina? That's good, cuz if Katrina ever happens again, you'd know what to expect with your bonds. As for conflict of interest, well my friend, that's unavoidable in the business world. Investment banks typically don't trade in deals they underwrote themselves either. And yes, the Fed is trying to prevent trouble at Bear from spreading. Keep in mind that $33 billion is not all Bear's assets, it's Bear's risky positions. It has other assets engaged in transactions with counterparties. But should Bear fail because of those risky positions, it wouldn't be able to honour other transactions either. That is due to subordination which I stated in my last post. Whatever amount you recover is applied to the senior certificates first. So let's say you have a deal of $10,000 backed by $12,500 in mortgage ($2,500 OC amount). Of that $7,500 foreclosed, $5,000 foreclosure after wiping out OC. You recover $2,000 (realized loss of $3,000). Each bond is backed by specific mortgages, so that $3,000 is first applied to A's if any (most likely not, due to OC and excess interest generated by it is likely to cover this amount even before realized losses). Then M-1, M-2... So if that $2,000 you recovered runs out at M-6 and you are the poor dude that bought M-7, well, you get whatever backing M-7 that hasn't failed, which just may be pennis on the dollar. Of course, there is also the issue of speculation. A lot of traders don't hold them to maturity. So when sub-prime occurred, a lot sold, even those that haven't failed.
Can't edit post. Not $3,000 applied to A's first. The $2,000 recovery is applied to A's first. Or alternate way of looking at it, $3,000 is losses is applied to subs first.
Thanks for the summary MFW...I agree with a lot of what you're saying...My thought would be let the market work, meaning no bailout, but understand why it happened... JP must have some pull to get a great deal like this...granted there is some inherent risk, but in general, they will make out like bandits...
You're welcome. My pleasure. Usually, I'm all for letting people pay for their own mistakes. But in this case, I think without the bailout, it would be disastrous. However, I agree a lot with what you are saying as well. I'm afraid that with the recent round of rescues, we are preventing the bubble from bursting now and creating a bigger one in the future.
Again, I appreciate your insights in the financial industry, MFW. I've been reading more into this, and I misread and misinterpreted the articles. It was 25% of the $900 billion in sub-prime mortgages issued over the past two years that were given top AAA and not the tranches itself. I can't directly recall other ratings tomfoolery, but not many news articles have been positive about Moody’s, S&P and Fitch. That sounds awfully dangerous (but clever) because the buyer would probably take the dealer's word over spending resources to read it over, especially in a boom time. Terms like SIVS, CDOs, CDS, and the shadow banking market make my head hurt. What is your outlook on those instruments? Bear's estimated positions on derivatives were around 13.7 trillion dollars. Will they ever be brought into the light? If so, more transparency through enforced plain English terms? These wildly abstract values shatter my piggy bank mentality. I believe in regulation. I can only hope that it isn't politically meddled for expediency, and it has the overall national interest in mind. Reading this out of pure personal interest is really depressing me.
You're welcome. I must say I am also very impressed that you read every word. It's a very complicated (and in many cases, boring) subject. I don't expect them to, see below. Dangerous? Absolutely. But I think the investors themselves are not blameless. Both sides are at fault. To start, let me say that if you read a prospectus from late 2006 and 2007, compare it to one from say, 2004 or 2005, one thing you'd notice is an improvement over the structuring assumptions. For example, remember when I said prepayment is one of the most significant risks to MBS? In a 2004/2005 deal you'd probably see a structuring assumption of 30% Constant Prepayment Rate (CPR), it's a mathematical curve model on how mortgages get prepaid, very important to a buyer in calculate his yield. Now, if you look at history, 30% CPR has never occurred and likely will never occur. It was just used because it was simple and quick to structure a deal with it (after all, the underwriters need to calculate their own returns). After troubles started, 2007 deals let's say, have far more robust prepayment assumptions. Obviously it can't be completely right because you are predicting the future, but more robust. So you might say the underwriters were lazy and shirked on their duty. But then you look at the other side of the picture, investors were buying sub-primes left and right. As soon as it's out, it's bought. The investment banks couldn't get them out fast enough (hence the laziness). Who's fault is it? Larger companies either have their only analytical tools for the sub-primes, or could buy so software (very very expensive) from somebody else. They saw everybody else making money and decided to take more risks. Smaller funds (hedge funds for example) probably don't. They just saw everybody else making money and decided to get in on the action, so they bought on rating. That's why they are blaming the rating agencies right now. I think the underwriters should be held accountable for their laziness (it won't happen), but an argument in their favour, only in a small minority of cases have they went about to purposely defraud investors. Lehman was in the penalty box for a long time for that (they really took advantage of that 500 page prospectus). But the buyers themselves took more risks than is good for that, a lot of them didn't even understand what's going on. They should bear significant blame for their own loss as well. I'm a pessimist, so I'll tell you, regulations don't really work. Would be great if they did, but past histories suggest otherwise. You see, in order to effectively enforce, regulation agencies have to have some teeth. But we all know that the teeth lies with Congress, which doesn't understand such complicated issues but understand very much donations from interest groups. The SEC, toothless. FASB, toothless. PCAOB, toothless. The list goes on and on. These organizations lack both the political backing and resources to effectively regulate. The FASB is probably the one that comes under attack more than any. And I won't even go into the SEC's Form 8-K debacle.
As for Bear Stearns, I think they'll recover some value. They probably won't find any buyers to take the securities off their hands, but they can wait until they mature. But $13.7 trillion, are you sure? As for using plain English terms, it's not that simple. Sure they can straighten out the language by quite a bit, but other parts you just can't, because you can't tell an underwriter how to structure a deal, in many cases, complicated is in their favour. So you can't really say "the investors are getting confused, simplify the deal." To do such a deal, it also requires specialized knowledge. To see how complicated it is, even in plain English, here's a Bear deal, it's actually a pretty short prospectus: Bear Stearns Asset Backed Securities I Trust 2005-HE10 http://www.sec.gov/Archives/edgar/data/1283557/000088237705003153/d387614_all.htm Here is an excerpt on OC target: "“Overcollateralization Target Amount” with respect to any distribution date (a) prior to the Stepdown Date, approximately 2.30% of the aggregate Stated Principal Balance of the mortgage loans as of the cut-off date, (b) on or after the Stepdown Date and if a Trigger Event is not in effect, the greater of (i) the lesser of (1) approximately 2.30% of the aggregate Stated Principal Balance of the mortgage loans as of the cut-off date and (2) approximately 4.60% of the then current aggregate Stated Principal Balance of the mortgage loans as of the last day of the related Due Period (after giving effect to scheduled payments of principal due during the related Due Period, to the extent received or advanced, and unscheduled collections of principal received during the related Prepayment Period, and after reduction for Realized Losses incurred during the related Due Period) and (ii) approximately $4,923,867 (c) on or after the Stepdown Date and if a Trigger Event is in effect, the Overcollateralization Target Amount for the immediately preceding distribution date." I'll tell ya, I do love the later of the earlier of... and the lesser of the greater of... types. It confuses the hell out of people. In that case you have to keep real good track of the (1)'s and (2)'s and the (i)'s and (ii)'s and (a)'s and (b)'s. Don't know what it's saying? Of course not, it's because you don't know what the Stepdown Date, Due Period, Trigger Event, etc are. Those are in there too. Here is the line on Stepdown Date: “Stepdown Date” means the later to occur of: (x) the distribution date occurring in November 2008 and (y) the first distribution date for which the Class A Specified Enhancement Percentage (calculated for this purpose only, prior to distributions on the certificates but following distributions on the mortgage loans for the related Due Period (after giving effect to scheduled payments of principal due during the related Due Period, to the extent received or advanced, and unscheduled collections of principal received during the related Prepayment Period, and after reduction for Realized Losses incurred during the related Due Period)) is greater than or equal to approximately One thing you probably noticed right away is you just have more specialized terms you have to look up. So yeah, simplifying won't help that much.
Reading doesn't necessarily mean understanding. Geez... I don't know what to say. I understand the appeal to deregulation, but letting the inmates run the asylum won't allow me to sleep soundly at night. What about keeping banks, financial institutions, underwriters, etc... split similar to what Glass-Steagal used to do? I remember what you wrote about how the banks nominally did not double dip transactions from within, but with the advent of Too Big To Fail, isn't this an encouragement for the financial industry to merge into a handful of companies? Sounds like a wide loophole against Moral Hazard to me. And I do notice the irony since it was Congress and Clinton who repealed the Glass-Steagal Act, and to some extent, it was the regulations in place that caused companies to find ways in circumventing it. Under the current circumstances, it's time to take another deep breath and honestly reevalute the system and all of its new fangled innovations that half centuries old regulations and lobby oriented legislatures have failed to keep up with. J.P. Morgan Adds to Derivatives Muscle Bear's Collapse Risked Weakening Big Market For Spreading Out Risk By SERENA NG and DAVID REILLY March 19, 2008; Page C2 With J.P. Morgan Chase & Co.'s rescue of Bear Stearns Cos., a behemoth in the complex world of derivatives trading has become even bigger, and the business is now more concentrated. J.P. Morgan has a derivatives portfolio that is the largest by far among U.S. commercial banks. At the end of last year, its portfolio hit $77 trillion in "notional value," which is the value of the assets underlying these contracts, according to its regulatory filings. • The Issue: J.P. Morgan, already one of the biggest players in derivatives, is even bigger after taking on Bear Stearns's trading obligations. • Background: In rescuing Bear, J.P. Morgan had an interest in helping to prevent a broader market meltdown that could have hurt other firms it trades derivatives with. • What It Means: As financial institutions merge, the risks that derivatives are meant to disperse could become more concentrated among fewer players. The company's positions were more than twice as large as those of Citigroup Inc. and Bank of America Corp., according to data from the Office of the Comptroller of the Currency. They run the range from straightforward stock futures contracts to interest-rate swaps and more complex agreements with individual trading partners. Analysts say J.P. Morgan's large position in the derivatives markets meant it had an interest in seeing Bear Stearns's problems sorted in an orderly way, because Bear is another big derivatives player. Bear's failure might have weakened the entire market. Now, the planned acquisition of Bear means the risks that derivatives are meant to disperse may be getting more concentrated among fewer players. J.P. Morgan's influence in the market has risen because it is now standing behind Bear's derivatives book. "'Many pathways through this maze of derivatives lead back to J.P. Morgan," said Martin Weiss, president of Weiss Research, an investment-research firm in Jupiter, Fla. "The domino effect of a major firm like Bear defaulting on its derivative transactions may have hurt other counterparties in the marketplace, many of which trade with J.P. Morgan." According to its regulatory filings, Bear had derivatives covering notional amounts of $13.4 trillion at the end of November. Around $1.85 trillion of these were in futures and options contracts that trade on exchanges. Nearly $11 trillion were more complex agreements with individual parties. In the fast-growing credit derivatives market, the 10 biggest players were parties to nearly 90% of the volume of contracts traded in 2006, according to a survey last year by Fitch Ratings. J.P. Morgan was ranked third. Bear was ranked No. 9. While most investors are more familiar with stock and bond markets, the world of derivatives linked to debt, interest rates and currencies is far larger and more opaque. Some derivatives, such as popular futures and options contracts, trade on organized markets such as the Chicago Mercantile Exchange. The vast majority trade directly between big banks and financial institutions in the over-the-counter market. Customers in that market, which can range from companies looking to protect against swings in currencies to banks betting on the direction of interest rates, deal either directly with each other, or through intermediaries called interdealer brokers. The market is vital to the functioning of companies and the financial system. The total amount of interest-rate, currency and credit derivatives outstanding at the end of 2007 was about a notional $400 trillion, the International Swaps and Derivatives Association says. Eye-popping notional amounts can be somewhat deceptive. They represent the total value of the underlying securities affected by a contract, although actual contract values could be a fraction of that. J.P. Morgan, for example, said in its regulatory filings that while its total derivative notional amounts were $77 trillion, what it is owed on these contracts is 0.1% of that, or $77 billion. Kristin Lemkau, a J.P. Morgan spokeswoman, said the bank didn't feel overly exposed to Bear before the deal. "We are comfortable with the risks we are taking in acquiring Bear at the price we paid," she said. Policy makers are deeply worried about the threat of a big player in these markets failing, which could cause problems for many of its trading partners. Sunday night, in unveiling its acquisition of Bear, J.P. Morgan said it would immediately guarantee the Wall Street firm's trading obligations and its counterparty risk. "J.P Morgan Chase stands behind Bear Stearns," the bank's chief executive, James Dimon, said in a statement. J.P. Morgan's guarantees effectively provided a backstop for Bear, whose credit ratings were cut Friday by the major rating services to the low-investment-grade rung of triple-B from single-A because of the firm's funding problems. Those downgrades could have forced Bear to fork over significant amounts of cash or collateral to some of its swap counterparties, demands that could have bankrupted the firm. The backing of J.P. Morgan, with its stronger credit rating, prevented that from happening. "The immediate counterparty problem we tried to avert is tabled for now," said Carlos Mendez, a senior managing director at Institutional Credit Partners, a boutique investment firm in New York. "However, widespread credit problems persist, and no solutions are on the table." That pop and fizzle you heard is the sound of my mind processing that stuff. I've read that derivatives are much much more convoluted and difficult to understand than ABS.
It's the effort that counts. Besides, if you understood even just a part of it, you're ahead of the curve compared to most people. Let me clarify by saying that I consider myself central right. I don't believe in over-regulation, but I'm also not one of those that call for an elimination of them altogether. The unfortunate truth is, we may be at a stage where regulation would not do us too much good. I think we're in a Catch 22 situation. Here's why Glass-Steagall won't work. Let's say you're a bank, your traditional income (I say traditional, because fees are getting to the sate they may one day become number one, sad) is returns generated by loans. The problem with loans is that, they mature in 10/15/30/etc years. In the meantime, your bank is stagnant. You already loaned out your money and the principal won't be coming in anytime soon. Quite frankly, that means not only a stagnant bank, but also a stagnant economy, which depends highly on the ability to raise capital for new projects. That's the reason the original MBS got started. You loan out say $300 million, it won't come back soon, but you can sell it to say a retirement fund that is willing to hold it 30 years (because the retirees may come in 30 years). If it's a 6% coupon mortgage, you charge 0.5% servicing fee and pay 5.5% on the bonds. 0.5% of $300 million is a lot of money. The banks make money, which it can use to make new loans and the retirement funds get its relatively "safe" investment. Everybody's happy (until now). The problem with separating banks from underwriters is that, remember, those large banks are the only ones with the resources to package/underwrite those deals. They are also the only ones with the credibility (sounds like an oxymoron, I know) to back it. My regional bank can never do it. If they packaged a deal, nobody would buy it. And quite frankly, there aren't too many large investment banks out there. Those large institutions are also the one of the largest buyers of such securities. So telling the top 6 Wall Street investment banks, OK, you 3 underwrite and you other 3 buy won't work. Oh OK, scared me for a second. Thought I missed some news. That $13 trillion or so is notional amount. So let's say Bear has $1 trillion futures, it doesn't mean Bear paid/owes $1 trillion. They may have paid maybe $10 billion for the right to purchase in the future. Of that $13 trillion, there would also be contracts to hedge themselves. As a matter of fact, I doubt all of the contracts would be exercised. So to answer your question, they'll never get back the contract prices, however many billions of dollars they bought them with, but they should be able to extract some nominal amount if they bet right. In general, yes, but it depends on the deal. ABS deals often have simple derivatives built in too. Namely an interest swap contract, an interest cap contract, maybe both.
