Cross Greeks – 2/1/2012

• Morgan Stanley  raises a middle finger at Goldman Sachs – Facebook chooses MS to lead it IPO (Bloomberg)
• January job creation numbers down from December, December numbers revised down as well. Oops (Reuters)
• Chrysler caps first profitable year since government rescue (NY Times)
• European anti-trust regulators say, “NEIN!” to proposed NYSE and Deutsch Borse merger (Deal Book)
• Eurozone factory output experiences sixth straight month of “shrinkage” in this chilly economic environment (BBC)

Banking for Dummies: Vol 2 – Mortgage Finance

Hooray!  Another installment in the Realized Volatility’s  ”Banking for Dummies” box set.  Today we dive into the compelling arena of mortgage finance.  Specifically, we are going to take an inside look at the big GSEs (Fannie, Freddie, the like).

Recently, NPR (your premier source for listening to people with interesting names say things softly during your morning commute) and ProPublica (which is a liberal fan ‘zine who are probably known for something – didn’t they win a Pulitzer or whatever?) released a spectacularly mis-informed piece on Freddie Mac.  It has been making quite the splash around the econo-blogosphere, with sides being drawn and spittle flying in all directions.

So, we at RV decided this could make a perfect topic to expand upon our already long running (ok, maybe just one volume) “Banking for Dummies” series.  Let’s get started, shall we?

The story begins with the previously mentioned NPR/ProPublica  piece, in which we discover that good ol’ Freddie has been accumulating exotic mortgage securities known as “Interest Only Reverse Floaters” on it’s books, which pay handsomely as long as the mortgages (homeowners) which underlay the security do not refinance (thus lowering the payments on their underwater homes) when rates get nice and low (like now, for instance).  Which seems a bit removed from the GSE’s stated purpose of helping out the little guy in America buy that McMansion they could never afford always wanted.  They following “everymen” are interviewed for the story:

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The Silversteins have a 30-year fixed mortgage with an interest rate of 6.875 percent, much higher than the going rate of less than 4 percent.  They have borrowed from family members and are living paycheck to paycheck. If they could refinance, they would save about $500 a month. He says the extra money would help them pay back some of their family members and visit their grandchildren more often.

The Silversteins used to live in a larger house 15 minutes from their current place, in a more upscale development. They had always planned to downsize as they approached retirement. In 2005, they made the mistake of buying their new house before selling the larger one. As the housing market plummeted, they couldn’t sell their old house, so they carried two mortgages for 2½ years, wiping out their savings and 401(k). “It just drained us,” Jay Silverstein says.

Finally, they were advised to try a short sale, in which the house is sold for less than the value of the underlying mortgage. They stopped making payments on the big house for it to go through. The sale was finally completed in 2009.

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Anyways, the NPR/ProPublica team characterize these positions as “bets” (the guy running the book on these must be making a huge Vig on this action) against these poor folks (who, by they way, seemed to have defaulted on their prior loan) and then get all liberal offended/outraged on Freddie’s ass and declare that this a huge conflict of interest and that Freddie Mac is a disgustingly greedy, baby killing monster which introduced crack into the inner cities and invented AIDS. There may have been a bit of overstatement on their part.

However, a more evenhanded look at this whole situation reveals that, just perhaps, there is nothing really that sinister going on.  To fully understand this, lets take a look at how these GSE’s operate.

Step 1.  Issue debt to raise money

Step 2.  Buy up conforming mortgages from originators (like banks and home loan companies)

Step 3. Securitize these loans into mortgage backed fixed income instruments (CMOs) and sell ‘em

They come in two flavors (both of which, by the way, are guaranteed by the GSE, thus removing all credit risk from the investors who buy this stuff).  One is a Principle Only (or PO) which is funded by the principle paid back through the loan.  The other type is Interest Only (or IO) which is funded only by the interest payments made on the loan.  The PO bits are nice and safe, with just some interest rate risk left for the investor to manage (as the credit risk was so-nicely taken by the GSE, and the prepayment risk – from the prepayment option embedded in most North American fixed rate mortgages – is held within the IO bits) and are thus easy to sell to investors.

The IO bits are a bit more complex.  These securities are funded by only the interest payments made on the loan, and are thus exposed to both interest rate risk as well as the pre-payment risk (i.e. the  volatility) embedded in the original mortgages (if the mortgages gets pre-payed, there will be no more interest cash-flows to fund the IO). These usually have a negative effective duration – which is important, remember that for later.

Now.

Not only are these IO bits exposed to more risk, they can then decomposed even further, into an IO floater and IO reverse floater pair. This makes the market for the IO bits more liquid, as the IO floater portion pays a coupon of usually LIBOR + spread (nationalized off of a larger portion of the original IO tranche), and is thus easier to manage in terms of interest rate risk.  The reverse floater (notionalized off of a smaller portion of the original IO tranche) is paid the difference of the original coupon rate on the IO and the IO floater LIBOR+Spread.  Because the reverse floater is notionalized off of a smaller portion of the original IO tranche, the coupon of the IO Reverse is then multiplied by whatever multiple the notional on the IO floater is larger than the IO reverse.

Whew.

What you end up with, after all of this witchcraft financial engineering, are three bits – a PO bit, which is simple and safe(ish), and IO floater, which does have some interest rate risk and pre-payment risk, but has a linear sensitivity to rate moves, and an IO floater, which is complex and more difficult to manage (and is usually only sold to sophisticated investors).  If you look at the formula for the coupon for the IO reverse floater ( [Original IO Coupon - Spread - LIBOR] * IO Floater Notional/IO Reverse Notional), you see that it pays off big in a low rate environment when no one pre-pays.  Just as NPR/ProPublica reported.

HOWEVER. We must then move on to Step 4 of being a GSE.

Step 4. Manage your Asset / liability mis-match.

This is a vital step to understand, because we believe it is this which is driving the GSE’s to take the actions they have, um, taken.

Remember Step 1? Where you issues some debt so you could start buying up mortgages?  Well that left you with a lump of liabilities with some average duration.  Now remember your assets?  All those mortgages and PO / IO CMO bits? They have a different duration.  And for the IOs, some level of volatility.  So you have to wade into the swap market and normalize the duration mis-match between your assets an liabilities. OR. You could hold onto some more of those IO reverse floaters (which, by the way, not a lot of people are particularly asking for these day anyways, but, you as a GSE who makes the damn things should understand pretty well and model with some level of confidence) with their negative duration and use them to help ease the asset/liability duration mis-match.  And make a bit of profit on the volatility side as well (if vol is, say, under priced at the time).  Presto! Mr. Director at the GSE’s treasury department earns his bonus this year.

Other bloggers have noted that the Freddie is probably just holding onto the scraps of the deals it can’t sell rather than actually buying up these instruments (as NPR/ProPublica contend).  But even if they were buying these things up, who cares?  It is likely a hedging strategy given the insight the politically connected GSEs naturally have into these instruments and the prevailing political environment (the headwinds facing new re-fi rules)

So there you go. Class Dismissed.

Cross Greeks – 1/31/2012

• EU Nears confrontation on Greek rescue package (Bloomberg)
• Involuntary vacations at highest level ever in Eurozone! (Reuters)
• Home prices down in December, again (NY Times)
• Banco Santander’s profits skive off for a brief siesta (Deal Book)
• Bill to ban insider trading by members of congress (wait, that is legal?) makes progress in senate (NY Times)

News from Spain…..no bueno mi amigo

With much of the world fixated upon the comedy drama unfolding in Greece as the so-called Private Sector Initiative hits headwinds (who would have thought investors may not want to voluntarily take a haircut on their assets? I, personally, love to shovel cash into my fireplace for fun) , I would like to focus on another of the southern European basket-cases. Namely, Spain.

More bad news came flowing out of the country recently, in the form of depressing economic data as well as some troubling news regarding the government’s negotiations with the country’s powerful unions.

Spain is undoubtedly diving headlong into back into a recession after a brief respite – industrial production fell by 7% y/y in November, after a 4.2% drop the prior month.  Most troubling was the fact that there was a large decrease in consumer durables (-16.3% y/y), signalling that the Spanish consumer is pulling back on the reigns, and hard.

Unemployment continues to be a huge issue for the Spanish state, with more than half of its young people out of work and unemployment rising over the final months of the year, to 22.9% of the labour force. Yes – that is correct - 22.9%. And that is merely the percentage out of work in the assuredly massaged “labour force” number.

In reaction to this poor economic data, and the rising budget deficits in the it is causing, the legislature recently passed the largest group of tax hikes and benefit cuts in recent memory – sure to negatively impact GDP and economic sentiment over the next few quarters.

In addition to this bleak economic outlook, it seems as though the government is at loggerheads with the country’s unions on the necessary economic reforms needed to get Spain back on a firm footing.  Today, the leadership four largest unions sent the Prime Minister a document demanding an equal say in the reform of the labour market in Spain, after they two sides had failed to reach an agreement on several key matters by the previous deadline, the beginning of this week.

This, as they say, will not end well.  With Spanish banks already on life support (and apparently unable to find 30B euros of the required 50B euros needed to clean up the banking system’s balance sheet), these could be the beginnings of a renewed Spanish banking crisis.  So don’t start feeling too lonely out there Greece – you might have some friends with you soon.

Cross Greeks – 01/11/2012

• Regulators may expand “Too Big to Fail” – new list apparently to include bookies, loan sharks as SIFIs. (Bloomberg)
• Romney wins N.H. Primary, goes on to South Carolina. (Reuters)
• Big Banks, not satisfied with simple mortgage fraud, now branching out in to the more exciting world of insurance fraud (NY Times)
• Europe’s pension threat loom large as economies sputters (Bloomberg)
• Fitch, wishing to be noticed by someone, makes dire warnings about the future of the Euro if more action is not taken (Reuters)

Banking for Dummies, Vol. 1

When I am bereft of ideas for posts around here, I can usually count on the New York Times to provide some kind of op-ed/news article/Paul Krugman Keynesian diatribe to get me riled up and in the mood (double entendre intended, wink wink).

Today, as usual, is no exception.

Amar Bhidé (who apparently is a professor of both law and diplomacy – wow! – and so is obviously credentialed to comment on the regulatory matters of capital markets) has recently published this piece in the NY Times titled, Bring Back Boring Banks, an exhortation to mandate that banks quit it with all the complexity and stuff, and make it easier for us “normals” to understand what it is banks exactly do.  Here, have a taste!

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Banks must therefore be restricted to those activities, like making traditional loans and simple hedging operations, that a regulator of average education and intelligence can monitor. If the average examiner can’t understand it, it shouldn’t be allowed.

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So what are these “activities” that our esteemed Professor Bhidé would like to see removed? (Also, “average intelligence”? Listen, I don’t understand with physicists get up to, but I don’t take that as an impetus to go out an lobby for nuclear power plants/high energy physics experimentation/astronomy to be banned by the feds)

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Banks should be forced to shed activities like derivatives trading that regulators cannot easily examine.

 Tighter regulation would drastically reduce the assets in money-market mutual funds…

Other, more mysterious denizens of the shadow banking world, from tender option bonds to asset-backed commercial paper…

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I’m sorry, excuse me?  Money-market mutual funds?  Asset-backed paper?  These are the opaque, complex activities that we need to abolish?  It seems like the ideal financial market being sketched out here is a few steps above the money changers that got tossed from the temple. Oh, and don’t forget about those pesky derivatives!  No derivatives (although I am unsure how the “simple hedging operations” referred to will work without derivatives, but now I’m just being nitpicky).

And now we get to the final bit of lunacy.  FDIC insurance on all deposits at the bank.  Not just those below 250k per account, I’m talkin e’rrrrrything.  What is this really supposed to solve?  I feel that anyone who really wants the comfy blankie of FDIC insurance can find a way to get it, even if they are lucky enough to break through that 250k ceiling with one bank transfer.

Mr. Amar probably would have benefited from consulting some of those Economics Ph.Ds they have floating around at Fletcher before penning his little letter to the New York Times.  Do you know he also wrote a book about this kind of shit!? I bet it’s awesome. In that same way that Snakes On A Plane was awesome.  Except you don’t get Samuel L Jackson in the book. Probably.

In The Nation’s Service

Another post by one of RV’s favorite bloggers, The Epicurean Dealmaker. A good read, laying out the reasons why we shouldn’t be all to concerned about the finance industry’s penchant for hiring large amounts of the bright, young people out of Ivy League schools.