Obama’s 'Maginot-Line' Regulation Will Kill Any Recovery - Time to Fix MBS

Includes: FMCC, FNMA, KME
by: Andrew Butter

I finally figured it out. By virtue of a one in a hundred million chance random interaction of a diverse gene pool, President Obama is French.

Proof of that is irrefutable. He has good clothes sense, he looks after himself, he is family orientated; his kids are charming, well mannered and very well behaved, and he’s tough to pin down. Also he smokes (very French). But that is just superficial, what really reveals his true French psyche is his determination (a) to make people PAY for their “crimes” and (b) to fight yesterday’s wars.

That’s uniquely French.

How do I know? Simple, I’m married to one.

This is what Wikipedia says about the Treaty of Versailles signed after the First World War:

While both American and British leaders wanted to come to a fair and reasonable deal, France's interests were much more aggressive and demanding as many of the battles had been fought on French soil. After the treaty was signed, many world leaders agreed that some of France's demands were far too harsh and unsympathetic.

Ring any bells?

After tying-down Germany to reparations that they could not possibly afford, which led directly to the hyper-inflation and economic collapse in 1923 which in turn laid the foundation for the rise of Hitler, France proceeded to build the Maginot Line. So that if what happened before happened again they would be impregnable.

The main point I would like to make is that it didn’t work.

When Secretary Geithner first presented his “Plan” in March 2009 he was on a roll. He had shrugged off the little matter of cheating on his taxes; at that time no one knew of his little “affair” with Goldman Sachs (NYSE:GS), and he was confident and word-perfect. In answer to a question about having the Fed as the systemic risk regulator, he said:

You can’t fight a fire with a committee.

That of course is (broadly) true; but that’s not the point. What needs to happen in America right now and soon is that someone has to START a fire out of the ashes of the financial system that burnt down and are inundated with the water that was poured onto it fighting the fire.

The Fed and TARP and whatever have pumped trillions of dollars of “fuel” into the US financial system in a classical “Keynesian” response.

But it’s not getting out into the economy. Without a “match” that’s like pumping the gas-peddle when your automatic choke is jammed on a winter’s day, it gets you nowhere.

Breaking it down:

When you fix a problem, you need to know what the problem is. If there are two then you need to fix the big one first, and then the second biggest; then the third biggest, etc; prioritization is the key.

The last thing you want to do is forget about the core problem, and focus on the symptoms, and the very last thing you want to do is start off with blaming people and taking revenge on the people who might (and might not) have caused the problem in the first place.

The BIG problem that occurred in the US financial system was that securitised debt blew up. So if in January 2008 you held a AAA security that you could easily sell for $100 (i.e. it was “liquid”), by September 2008 you found out that you could only sell it for $50 if you were lucky and on top of that it wasn’t “liquid”, i.e. it was hard, sometimes impossible to sell, at any price.

That was THE problem. Everything else was secondary, either a symptom of the first problem or a direct consequence.

For example:

1: Credit Default Swaps had been written insuring that debt against a default or even a loss of value, but the people who had written those could not pay up.

2: That problem was compounded by the fact that the regulators had allowed the underwriters to in effect allow insurance to be sold to people without an insurable interest, and to metaphorically sell ten policies that would pay up if some poor jerk’s house burnt down.

3: Non-regulated banks had borrowed short-term to buy longer dated securitized debt to make a turn on the difference in yield. When the value of what they had bought came into question, they couldn’t roll over the short-term debt.

Then when it became obvious that the securitised debt (I’ll call that MBS for short, although that includes RMBS, CMBS, CDO and CDO Squared), when there was a realization that stuff was not worth anything like what it had been previously valued on the balance sheets (and off the balance sheets) of the concerned parties, well everything stopped, DEAD.

Why it was not valued properly in the first place is of course another story, but that’s in the past.

Then government, the regulators, the Fed, the Treasury, and all-the King’s Horses and all-the King’s Men reacted (after a bit of a delay).

Discount windows were opened wide, money was pumped in directly to banks via TARP, Fannie (FNM) and Freddie (FRE) were nationalized so that they could run up unfunded liabilities guaranteed by the government, and banks were “allowed” to “value” the MBS that they could not sell, well broadly for what they had paid for them, when they were reporting their capital adequacy (and solvency) to regulators.

And well, the “fire” was put out, although no one is quite sure if it isn’t smoldering, and the contagion spreading or not. For example, to direct loans to commercial property which are all coming due for rollover, except that the mark-to-market valuations today are about half what they were two years ago, and the FDIC is busy allowing those loans to be brushed under the carpet for now.

Plus the mortgage market has collapsed. Last September reportedly over 95% of all new loans for single-family homes in the U.S. were made with federal assistance, either through Fannie Mae and the implied guarantee, or Freddie Mac, or through the FHA.

A good account of that can be found here.

Efforts were made to somehow “re-start” the dead-donkey that was the market for securitized debt. First via TARP (that failed because no one could figure out how to value an MBS without the expediency of taking away the cost of a CDS from an equivalent Treasury), then there was talk of PPIP which sank without a trace. And more recently the Fed has been “buying” that stuff, although no one knows what price the Fed paid or how the assets on their balance sheet are valued, although it would appear that there is a new valuation standard in use these days, called the “Trust Us” Valuation Standards (TUVS).

And well, the “market” hasn’t re-started.

So that’s “Mission Accomplished” in the terminology used by President Bush when he paraded himself in front of the troops after the “conquest” of Iraq, in May 2003.

Now President Obama has started to throw his toys out of the pan (very French), but the credit crunch was not caused by greed, it wasn’t even due to “reckless” risk-taking.

When you buy a AAA security paying 4.5% and borrow 100% of the money to finance that purchase using a short-term facility at 2.3% and pay 0.7% for a CDS to cover your “risk”, and make 1% out of thin-air, that’s not “reckless”. Sure it was stupid in retrospect, but I’m not sure it was reckless.

When you package up a MBS, get it rated, and get it ready to sell you bought the underlying mortgages, so you have exposure there, but you “know” that you are going to make great money selling them. And then there is a crisis and you can’t sell any, and if you had financed all that with short term debt, well, you are screwed.

But that’s no more reckless than retailers who stocked up on Victoria Secret underwear, and borrowed money to finance that in anticipation of making a good margin, only to find that this year all the gals decided to wear sack-cloth and cover themselves with ashes.

And if you were a pension fund or an insurance company that was required under the Law to hold so many AAA securities, and you bought some AAA MBS yielding 5.5% when an equivalent US Treasury would have given you 4.8% and you bought a CDS to cover your risk, was that “reckless”?

Too-Big-to-Fail, OK, the fact the institutions that got into trouble managed to borrow so much, contributed to the problem; but that’s not about being BIG, it’s about regulation. And also in that situation, where the losses on all those sure-thing bets were so huge, the capital adequacy is meaningless. What went wrong was that the MBS were not valued properly, everyone assumed that if it had AAA stamped on it and you could buy a CDS for peanuts to cover the highly unlikely possibility that the MBS would explode, it was safe with a capital “S”.

But the focus of Geither & Co and more recently the tirades by President Obama is that bankers were greedy, reckless, got paid too much, didn’t have enough capital adequacy, and basically were a bunch of crooks who made a pot load of money and strutted around like they were Gods, is sadly not helpful. If the bankers broke the law, put them in jail. If they did not don’t try and get at them by some underhand tactic. It might make everyone feel good, but in the meantime, in case no one noticed, America is dying.

What should happen?

What should happen is that the FIRST problem, the core of the problem should be fixed first. What that is, is that no one knew and even now no one knows how to value a Mortgaged Backed Security (MBS) or a CDO or a CMBS or a RMBS…etc.

The rating agencies didn’t know, evidently. But coming down on them is pointless, all they did was apply a bunch of “rules” and tick a bunch of boxes, that were required so that the regulators would allow them to put a AAA stamp on the box.

That’s all it was, “This MBS conforms to all of the criteria that allows it to be called a AAA security, so a pension fund or an insurance company can own it instead of a AAA US Treasury”, period. They said explicitly on the box that the buyer should do his own due diligence to work out if it was a decent investment or not, so did the investment bank that packaged the thing up, it was assumed that the buyers were not incompetent morons, and that they knew what they were doing, and if they made a mistake well that was their problem, that’s how it worked.

Think of it like this, your doctor prescribes a drug, it is approved by the FDA…you die, who do you sue? Not the FDA, not the doctor either, they have caveats as thick as your wrist written by the smartest lawyers in the world. You would go after the manufacturer, or if he had covered himself, just die quietly.

The problem that needs to be fixed:

The Achilles heel of all that was that the buyers stupidly thought that if they could buy a CDS to cover themselves, and if the could see a similar “benchmark” MBS trading on a “market”, they were covered.

Markets are great things to discover value, but you need at least ONE person who is not following the crowd.

And the fact of the matter is, it is IMPOSSIBLE to value a MBS, because sufficient market data on the line-by-line details of each and every loan is not available to the potential buyers.

That’s locked up, here and there, to value a RMBS now you need basically to know about every loan that it is based on.

AND you need to have enough data on similar loans to be able to work out the inputs into your valuation model (% pre-payment, % default, value of collateral, and you need to know the loan details, the salary declared, whether each borrower owns a dog, and optimally whether it is a Labrador or a Rottwieler; then and only then can you start to do multivariate regression analysis and produce a valuation that is reliable.

Without that information you can do ZIP. I know, that’s what I do.

What President Obama and his sidekicks needs to do is to mandate that ALL of that information (minus names) is made public domain. Then investors will be able to have enough information to do a valuation, and ONLY THEN will the market, re-boot.

It’s that simple, right now there is about $13 trillion of securitised debt clogged in the gullet of the US financial system. TARP failed to deal with it, PPIP failed to deal with it, and it looks like the Fed has swallowed as much as it can handle, and I’m sure those guys either don’t know. Or if they do know, don’t have the information to value it properly.

Until that stuff starts to move, America is strangled, and the only option is for the Fed and the Treasury to borrow money to drip feed it into the economy to keep it on life support.

And that can only go on for so long until there is permanent damage.

Disclosure: "No positions"