A Review of Treasury Secretary Paulson's Challenging Week
He Comes out looking pretty good
By blackhedd Posted in Economy — Comments (14) / Email this page » / Leave a comment »
Last week, I wrote here and here about two major challenges faced by SecTreas Henry Paulson. He was sharply criticized for helping to foster a complex and creative plan to stabilize credit markets. He also came in for serious pressure to increase the value of the dollar from visiting foreign central bankers and finance ministers.
I sensed that, opaque as it was, the flap about "Structured Investment Vehicles" was important, which is why I brought it to your attention. To my surprise, it turned out to be among the week's big stories. Even Alan Greenspan weighed in. So it's worth a followup.
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Secretary Paulson hosted a big sitdown of the G7 finance ministers and central bankers in Washington last week. (The "Group of Seven" are the US, the UK, France, Germany, Japan, Canada and Italy. Together, they account for two-thirds of global GDP.) Before the meeting, everyone but us was setting expectations that they were planning to kick Paulson's behind for letting the value of the dollar slide.
For his part, Paulson has stuck to free-market, non-interventionist principles in handling the currency markets. (The US has never once intervened in currency markets during the Bush Administration. Japan threw in the towel on such interventions back in 2003, and the Bank of England has been gun-shy ever since George Soros raped them 15 years ago.)
Paulson won last week. The joint communique from the G7 conference had some nonspecific happy talk about currency "volatility" that didn't mention the dollar. France's impressive new Finance Minister, Christine Lagarde, reinforced the non-emphasis on the dollar in her statements to reporters after the conference.
Instead, the G7 expressed serious concern about China's undervaluation of the yuan against the dollar, euro, and yen. This is another big win for Paulson because he's staked huge political capital on getting the Chinese to revalue. His efforts have been unsuccessful so far, but you can expect him to start drawing quickly on the new credibility that the G7 has given him on this issue.
China's currency undervaluation is perhaps the biggest issue in the financial world (after the ongoing credit crisis). It's the reason China has a huge and rising trade surplus with Europe and with us. It causes economic illiterates in the US Congress (like Chuck Schumer and Hillary Clinton) to seriously propose protectionist legislation against Chinese imports. And it's creating serious stress in China's domestic economy (as I explained here.)
On the arcane subject of "Structured Investment Vehicles," Paulson's press was much less good. I'm going to skip a full rehash of this story, but see my earlier RedState pieces linked above.
It's clear to most people that, as I pointed out, the "M-LEC" vehicle fostered by Treasury Undersecretary Robert Steel and funded by Citigroup and others, is not a government bailout of the mortgage-financing industry.
But many people, including Warren Buffett, Bill Gross (the boss of Pimco Funds, the country's largest bond investor) and no less than former Fed Chairman Alan Greenspan, have come out with skeptical words for the M-LEC plan.
In addition, the whole subject got very, very hot toward the end of last week, as two European-based SIVs defaulted on about $7 billion of commercial paper because of asset-value impairment in their portfolio of mortgage-backed securities. This is the kind of default that the M-LEC (when fully functional late this year) should help to prevent.
What was the essence of the criticism from Greenspan, et al?
There were two points. First, having an investment vehicle created with the blessing of the US Treasury may create moral hazard by giving market participants the impression that they won't have to suffer the full consequences of their mistakes. This is a red herring because no public money appears in the M-LEC fund. It's all being contributed by Citigroup, Bank of America and JP Morgan Chase.
Second, there was concern that free-markets were not being allowed to function by letting mortgage-backed securities crash and find their true valuation in the market. The word people threw around was "transparency," meaning confidence that the prices discovered by the market were accurate. This never made any sense to me, even as Chairman Greenspan and others were saying it.
I remember the crisis of 1998, in which large classes of perfectly-valuable securities faced the prospect of disastrous de-valuations because of highly-unusual breakdowns in the risk-covariance matrices that portfolio managers use to construct hedging strategies. I think a similar situation applies here. There's nothing fundamentally distorting about providing a syndicate (namely, the M-LEC) that can backstop asset values for mortgage-backed securities. There's nothing artificial about the money that Citigroup are providing to this market.
Greenspan's reaction to this point was that the current crisis is far larger than 1998, and involves many more players. I'm still not buying it.
What really made me smell something funny was the names of the people who were advocating, quite straightforwardly, that a large class of fixed-income securities be allowed to crash down to serious undervaluation, so they can be picked up by other investors at screaming bargain prices.
Hasn't that been both Warren Buffett's and Bill Gross's strategy through the decades? These two guys have something to gain from seeing the mortgage-backed securities market crash.
What about Greenspan? Well, now that he's no longer running the Federal Reserve, he's gone back to his original job of high-priced consulting for private companies. Who's one of his most prestigious clients? Bill Gross's Pimco Funds.
I still think that Paulson and Steel did the right thing. We'll see next year.
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Without being too revealing, I was at a conference recently where the Europeans, et al where throwing rocks at us for hurting their mortgage backed securities. They whined about how instruments like Cedulas' and Pfanbriefs have been around for centuries without such ridiculous, speculative volatility. The overall thought was that people just heard "mortgage backed", related it so US subprime and dumped without respect to the rating. Now besides needing a history lesson and better understanding of their investors sophistication level, I would disagree this can be solely blamed on the US.
Most global mortgage backed instruments have enjoyed a nice long run I believe was way ahead of the fundamentals. Yet when it crashes back to earth, everyone cries and points the finger.
The general agreement was mortgage backed instruments will be devoid of any decent activity until this shakes out and confidence is restored. Perhaps that will just take time or confidence building measures such M-LEC which I believe in theory appears to be a good idea. However, I would like to understand the FI consortium angle. Should I favor them over Buffet-Gross speculation or are they just trying to protect their underlying business' (not necessarily a bad thing for investors); food for thought.
"Dulce et decorum est pro patria mori"
Contributor to The Minority Report
...the securities they own, which are backed by American mortgages? Or were they complaining that they can no longer issue securities backed by European mortgages?
The former, I've heard also. And I think a lot of people were surprised when many of the investors who supplied floods of money to lend to subprime American homebuyers, turned out to be based in Europe.
If it's the latter, that would surprise me quite a lot. I was unaware that Europe had any kind of functioning market for subprime mortgages.
and their prime market is completely different as well. For instance, most of their loans are ARMs but they don't adjust the rate, they adjust the term so the payment stays the same.
Frankly, if we had done that with out ARMs a big chunk of our "problems" would be nonexistant.
____
CongressCritter™: Never have so few felt like they were owed so much by so many for so little.
They are basically saying that mortgage is a dirty word period and that entire class of instruments themselves now carries a stigma; thanks Yanks!
Numbers for some Euro based instruments and related spreads have taken a hit since our subprime downturn. However, I don't believe that is directly due to a US subprime stigma. Like you, I feel it's an illogical market comparison and they need to get over it.
To me it is more a phenomena of global liquidity, demand, etc. That is a much more arguable set of dynamics to explain overall negativity in the market. I thought it would be nice if they were a little more introspective beyond "you suck, it's your fault".
Overall, bottom line consensus from the US players was stay away from the market and only selectively play until 08'. They are also looking at instruments from across the pond due to both what they forsee is more favorable market and regulatory conditions.
"Dulce et decorum est pro patria mori"
Contributor to The Minority Report
We suck. It's terrible that our subprime problems unfairly made your securities unmarketable... Sorry about that.... I'll give you 5 cents on the dollar for them so you can get them off your books.
Socialism doesn't work. It looks nice on paper, but it's been tried and it's failed miserably every time (usually accompanied by widespread death and suffering).
Proud member of the V.R.W.C.
why volume in the secondary market has not really been hurt.
"Dulce et decorum est pro patria mori"
Contributor to The Minority Report
Whadya sell some of that paper backed with AZ mortgages to Franz?
"Dulce et decorum est pro patria mori"
Contributor to The Minority Report
BIG TIME with this one.
Franz is a three points a week personal loan kinda guy. And you don't even want to think about being late with a payment. You'd be auditioning for the "fat lady" parts at the Met.
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CongressCritter™: Never have so few felt like they were owed so much by so many for so little.
that US mortgage companies bundled mortgages together and then sold them to Wall Street Mortgage Funds that had overseas investors money in them. The mortgage funds that now own the bundled mortgages are losing their butts and all of the overseas investors money...
I'm sure I'm off a little on the details here. Anyone else understand it a little more in depth?
There's a whole supply chain at work here.
Traditionally, mortgages were originated by banks and sold to companies that would service them. (Becker can probably clean up my details on the front-end of the chain.)
There are inherent limits to the amount of money you can make available to the consumer channel this way. But mortgages as a class are of considerably higher credit quality that many other kinds of assets, so there has always been a tremendous appetite on the part of nontraditional lenders to get into the act.
Wall Street has been working on this problem for pretty close to 20 years now. Mortgages turn out to be incredibly difficult to analyze, mostly because the risk that the homeowner will prepay the mortgage at his discretion.
Banks, S&Ls and other traditional mortgage lenders don't have a problem with this. They deal with it the old-fashioned way, using a labor-intensive process.
Wall Street can't do that, because there's no leverage. The usual way to deal with this problem is to deal with it stochastically. You "bundle" together a big pile of mortgages with similar characteristics (there are devils in the details, of course), and throw off the income stream as a coupon payment, making the package look like a good old fixed-income security. The "pooling" is supposed to make it easier to attach a value to the thing by applying statistical models rather than guesswork.
Voila, you now have a highly-rated fixed-income security that you can sell to someone that knows how to properly hedge such a thing. And all of a sudden, floods of money from nontraditional investors started pouring into the front end of the channel. (A small number of specialized engineering firms do the "bundling" and the securitization. Wall Street's "buy side" are the buyers, although there were exceptions, like the hedge funds operated by several sell-side firms, including Merrill, Bear Stearns, and Goldman.)
That's when the standards started to relax. It was a case of a technological innovation reducing the price of a product (namely money) below the point at which the supply of buyers remained of a high quality. When that happened, the crash was inevitable.
"Losing their butts" is an interesting term of art to apply to the situation. A great many companies lost huge dollars in the debacle that ultimately started with mortgages, but it wasn't because their securities lost value. Rather, their values became uncertain, because there was no way to trade them. The mortgage-backed securities market is illiquid.
When the bubble popped, it was clear that mortgage-backed securities were worth less, but the market had no way to figure out how much less. That's precisely the situation that causes panic.
All of a sudden, last August you saw a situation in which investors (many of them in Europe) started selling assets in unrelated classes just because they had to get liquid, somehow, anyhow.
Most investors are fiduciaries, and they're required by law, regulation, and covenants with their bankers and their limited partners, to maintain strict hedges against their "value at risk." That's what set off the stampede, and the failures.
Does that help?
Nice story on Paulson here:
Translation: China, you'd better get your heads out of your behinds, or else I won't be able to keep the idiots in the Democratic Party from protecting against you and wrecking your economy as well as ours.