No Kidding, Secretary Paulson

Secretary Paulson's remarks from the WSJ:

The ongoing housing correction is not ending as quickly as it might have appeared late last year.

And it now looks like it will continue to adversely impact our economy, our capital markets, and many homeowners for some time yet. Even so, I believe we have a healthy, diversified economy that will continue to grow.

OK -- a little self back-patting right now. I've been talking about housing being "nowhere near a bottom" for about a year now. Why, you may ask? Simple: the absolute number of existing homes for sale on the market is still at incredibly high levels. Excess supply = lower price and lack of demand. Secondly, there is the mortgage implosion that started at the end of last year. Then we had a second wave this summer. And there are still a ton of bad debts out there in the system right now. And things are going so swimmingly well in the mortgage market right now that the major banks are thinking of coughing up $80-$100 billion for a liquidity fund.

Of the approximately 50 million outstanding mortgages in the U.S. today, approximately 10 million are subprime loans. Many have cited the statistic that 2 million of those subprime mortgages will reset to higher rates in the next 18 months. That statistic is true, relevant, and troubling, but it is not the complete picture of the risk going forward. Many of those borrowers will be able to afford their new mortgage payment or they will be able to refinance into another more affordable mortgage. Yet, the problem today is not limited to subprime mortgages as the number of homeowners having trouble making payments on prime mortgages is also increasing. And finally, the wide geographic variation in home price trends adds to the complexity of sizing this problem with any certainty.

You'll excuse me if I find this phrase troubling "happy talk": Many of those borrowers will be able to afford their new mortgage payment or they will be able to refinance into another more affordable mortgage. The Secretary is well-aware of the credit crunch going on right now -- which has been going on since the end of last year and which the recent news indicates is nowhere near over.

Now that I'm done ranting, Paulsen has a very unenviable job. He has to bolster confidence in the economy. That's part of his job description. But at the same time, at some point that issue becomes less important than telling people that there are some serious problems out there.

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No Kidding, Secretary Paulson

Secretary Paulson's remarks from the WSJ:

The ongoing housing correction is not ending as quickly as it might have appeared late last year.

And it now looks like it will continue to adversely impact our economy, our capital markets, and many homeowners for some time yet. Even so, I believe we have a healthy, diversified economy that will continue to grow.

OK -- a little self back-patting right now. I've been talking about housing being "nowhere near a bottom" for about a year now. Why, you may ask? Simple: the absolute number of existing homes for sale on the market is still at incredibly high levels. Excess supply = lower price and lack of demand. Secondly, there is the mortgage implosion that started at the end of last year. Then we had a second wave this summer. And there are still a ton of bad debts out there in the system right now. And things are going so swimmingly well in the mortgage market right now that the major banks are thinking of coughing up $80-$100 billion for a liquidity fund.

Of the approximately 50 million outstanding mortgages in the U.S. today, approximately 10 million are subprime loans. Many have cited the statistic that 2 million of those subprime mortgages will reset to higher rates in the next 18 months. That statistic is true, relevant, and troubling, but it is not the complete picture of the risk going forward. Many of those borrowers will be able to afford their new mortgage payment or they will be able to refinance into another more affordable mortgage. Yet, the problem today is not limited to subprime mortgages as the number of homeowners having trouble making payments on prime mortgages is also increasing. And finally, the wide geographic variation in home price trends adds to the complexity of sizing this problem with any certainty.

You'll excuse me if I find this phrase troubling "happy talk": Many of those borrowers will be able to afford their new mortgage payment or they will be able to refinance into another more affordable mortgage. The Secretary is well-aware of the credit crunch going on right now -- which has been going on since the end of last year and which the recent news indicates is nowhere near over.

Now that I'm done ranting, Paulsen has a very unenviable job. He has to bolster confidence in the economy. That's part of his job description. But at the same time, at some point that issue becomes less important than telling people that there are some serious problems out there.

Read More

Citigroup Reports Big Loss

From Bloomberg:

Citigroup Inc., the biggest U.S. bank, said mortgage delinquencies and consumer lending will deteriorate for the rest of the year after earnings fell 57 percent in the third quarter.

Citigroup had its biggest drop in two months in New York trading after Chief Financial Officer Gary Crittenden said on a conference call that borrower defaults are ``accelerating.''

Chief Executive Officer Charles Prince, who has overseen a 17 percent drop in the company's stock this year, said momentum ``continues very strong'' in most of the company's businesses. Since Prince became CEO in 2003, Citigroup shares are virtually unchanged, compared with a 29 percent jump at Bank of America Corp., the second-largest U.S. bank by assets.

``They certainly had a lot of troubles and to some extent have been tripping over themselves the last couple of years,'' Jeffery Harte, an analyst at Sandler O'Neill & Partners LP in Chicago, said in an interview. Prince is ``doing the right things strategically. It's become more of an execution problem lately.''

A key to this announcement is the phrase for the rest of the year. That's a tacit admission that the fourth quarter is not going to be good. I'm not sure what other financial companies have reported for their future projections so far, but most big financial companies have reported very large losses for the 3Q, so this news shouldn't be surprising.

Another key to this release is that "borrower defaults are accelerating." Again, this shouldn't be surprising to anyone, but it's another tacit admission that the credit crunch is far from over.

However, I find it odd that this news is sending the market lower today when other companies have reported a ton of losses. The last I counted, big financial companies had reported over $20 billion in 3Q losses.

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Citigroup Reports Big Loss

From Bloomberg:

Citigroup Inc., the biggest U.S. bank, said mortgage delinquencies and consumer lending will deteriorate for the rest of the year after earnings fell 57 percent in the third quarter.

Citigroup had its biggest drop in two months in New York trading after Chief Financial Officer Gary Crittenden said on a conference call that borrower defaults are ``accelerating.''

Chief Executive Officer Charles Prince, who has overseen a 17 percent drop in the company's stock this year, said momentum ``continues very strong'' in most of the company's businesses. Since Prince became CEO in 2003, Citigroup shares are virtually unchanged, compared with a 29 percent jump at Bank of America Corp., the second-largest U.S. bank by assets.

``They certainly had a lot of troubles and to some extent have been tripping over themselves the last couple of years,'' Jeffery Harte, an analyst at Sandler O'Neill & Partners LP in Chicago, said in an interview. Prince is ``doing the right things strategically. It's become more of an execution problem lately.''

A key to this announcement is the phrase for the rest of the year. That's a tacit admission that the fourth quarter is not going to be good. I'm not sure what other financial companies have reported for their future projections so far, but most big financial companies have reported very large losses for the 3Q, so this news shouldn't be surprising.

Another key to this release is that "borrower defaults are accelerating." Again, this shouldn't be surprising to anyone, but it's another tacit admission that the credit crunch is far from over.

However, I find it odd that this news is sending the market lower today when other companies have reported a ton of losses. The last I counted, big financial companies had reported over $20 billion in 3Q losses.

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Treasury Works With Large Banks to Ease Credit Crisis

OK -- this story is a bit complicated. So let's take this piece by piece.

First what is a structured investment vehicle?

A managed investment vehicle that holds mainly highly rated asset-backed securities and funds itself using the short-term commercial paper market as well as the medium-term note (MTN) market. Because of the rolling nature of its funding, an SIV is highly dependent on maintaining the highest possible short-term and long-term credit ratings. SIVs differ from cash CDOs of asset-backed securities in that their portfolios are marked-to-market, with their ratings based on capital models agreed with the rating agencies. SIVs also have simpler capital structures than CDOs, usually comprising a junior tranche of capital notes beneath a block of senior liabilities with the same seniority. They have smaller liquidity facilities than commercial-paper conduits - which also invest in high grade ABS. SIV managers include both commercial banks such as Citigroup and Bank of Montreal, and investment managers such as Gordian Knot.

So what we're looking at here is a short-term money management fund. They pool assets and sell commercial paper, making a difference on the interest rate spread between the two products. The fund issues different types of commercial paper with different credit profiles. This all looks like a pretty standard investment situation to me.

Now, let's get some background:

Encouraging the talks that led to the creation of the fund is the latest effort by officials to help restore liquidity to credit markets, a campaign started by the Federal Reserve in August, when it cut the interest rate on direct loans from the central bank. Fed officials have said this month that while there are signs of improvement, some markets remain under stress.

``Some markets have been experiencing illiquidity,'' San Francisco Fed President Janet Yellen said in an Oct. 9 speech in Los Angeles, referring to mortgage-backed securities and asset- backed commercial paper. ``This illiquidity has become an enormous problem for companies that specialize in originating mortgages and then bundling them to sell as securities.''

As losses in securities linked to subprime mortgages started to spread in July, investors retreated from high-risk assets. SIVs that issued commercial paper to buy the securities found they could no longer roll over the debt, forcing them to sell about $75 billion of their assets.

From the WSJ:

The popularity of SIVs has boomed since two Citigroup bankers, Nicholas J. Sossidis and Stephen Partridge-Hicks, invented the strategy in London in the late 1980s. (They later left to form their own company, London-based Gordian Knot, which operates the world's largest SIV.)

Behind Treasury's concern were banks like Citigroup, whose affiliates owned $80 billion in assets backed by mortgages and other securities. The world's biggest bank, by market value, held the assets off its balance sheet and was facing the prospect of either having to unload them in a disorderly fire-sale fashion or moving them onto its books.

Either scenario would have hurt financial markets and could have damped the economy by curtailing banks' ability to make new loans to consumers and corporations. Treasury envisioned a potentially "disorderly" unwinding of assets that could worsen the credit crunch, said a person familiar with the matter.

These funds have a big problem on the horizon. They have to sell a ton of debt within the next few months. Because the credit markets still haven't fully recovered, this massive selling could lead to the following situation.

1.) A large amount of mortgage-related paper hits the market. The market is already troubled.

2.) Because a large amount of paper hits the market, prices are already going to be lower (excess supply = lower price).

3.) Because the market is already troubled, bidders are offering lower prices for the paper

4.) This leads to a downward trajectory for certain assets' prices.

In other words, a situation that previously would have been akin of a normal position situation (standard selling of securities at normal times) could in fact lead to a situation that resembles panic selling.

First -- I am personally all for this action. It is highly doubtful the big banks would get together without some type of effort from a neutral third party. Hank Paulson's prior Wall Street experience is probably a key to this situation. I have maintained a position that the Treasury Secretary should come from Wall Street, and this situation illustrates the reason why.

Some people quoted in a few articles expressed concern the Citigroup would be a primary beneficiary of this program. This is true. Citigroup is heavily invested in the SIV market and faces the possibility of some big possible losses over the next few months if this situation isn't resolved. This is one of the primary problems of having large banks at the middle of the financial world. On the good side they provide liquidity. On the bad side, the concentration of assets means that a screw-up can lead of a pseudo bail-out.

So -- will this work? I have no idea. It's good that parties are trying to find an answer to this problem. However, most solutions are going to have their own problems built in.

Read More

Treasury Works With Large Banks to Ease Credit Crisis

OK -- this story is a bit complicated. So let's take this piece by piece.

First what is a structured investment vehicle?

A managed investment vehicle that holds mainly highly rated asset-backed securities and funds itself using the short-term commercial paper market as well as the medium-term note (MTN) market. Because of the rolling nature of its funding, an SIV is highly dependent on maintaining the highest possible short-term and long-term credit ratings. SIVs differ from cash CDOs of asset-backed securities in that their portfolios are marked-to-market, with their ratings based on capital models agreed with the rating agencies. SIVs also have simpler capital structures than CDOs, usually comprising a junior tranche of capital notes beneath a block of senior liabilities with the same seniority. They have smaller liquidity facilities than commercial-paper conduits - which also invest in high grade ABS. SIV managers include both commercial banks such as Citigroup and Bank of Montreal, and investment managers such as Gordian Knot.

So what we're looking at here is a short-term money management fund. They pool assets and sell commercial paper, making a difference on the interest rate spread between the two products. The fund issues different types of commercial paper with different credit profiles. This all looks like a pretty standard investment situation to me.

Now, let's get some background:

Encouraging the talks that led to the creation of the fund is the latest effort by officials to help restore liquidity to credit markets, a campaign started by the Federal Reserve in August, when it cut the interest rate on direct loans from the central bank. Fed officials have said this month that while there are signs of improvement, some markets remain under stress.

``Some markets have been experiencing illiquidity,'' San Francisco Fed President Janet Yellen said in an Oct. 9 speech in Los Angeles, referring to mortgage-backed securities and asset- backed commercial paper. ``This illiquidity has become an enormous problem for companies that specialize in originating mortgages and then bundling them to sell as securities.''

As losses in securities linked to subprime mortgages started to spread in July, investors retreated from high-risk assets. SIVs that issued commercial paper to buy the securities found they could no longer roll over the debt, forcing them to sell about $75 billion of their assets.

From the WSJ:

The popularity of SIVs has boomed since two Citigroup bankers, Nicholas J. Sossidis and Stephen Partridge-Hicks, invented the strategy in London in the late 1980s. (They later left to form their own company, London-based Gordian Knot, which operates the world's largest SIV.)

Behind Treasury's concern were banks like Citigroup, whose affiliates owned $80 billion in assets backed by mortgages and other securities. The world's biggest bank, by market value, held the assets off its balance sheet and was facing the prospect of either having to unload them in a disorderly fire-sale fashion or moving them onto its books.

Either scenario would have hurt financial markets and could have damped the economy by curtailing banks' ability to make new loans to consumers and corporations. Treasury envisioned a potentially "disorderly" unwinding of assets that could worsen the credit crunch, said a person familiar with the matter.

These funds have a big problem on the horizon. They have to sell a ton of debt within the next few months. Because the credit markets still haven't fully recovered, this massive selling could lead to the following situation.

1.) A large amount of mortgage-related paper hits the market. The market is already troubled.

2.) Because a large amount of paper hits the market, prices are already going to be lower (excess supply = lower price).

3.) Because the market is already troubled, bidders are offering lower prices for the paper

4.) This leads to a downward trajectory for certain assets' prices.

In other words, a situation that previously would have been akin of a normal position situation (standard selling of securities at normal times) could in fact lead to a situation that resembles panic selling.

First -- I am personally all for this action. It is highly doubtful the big banks would get together without some type of effort from a neutral third party. Hank Paulson's prior Wall Street experience is probably a key to this situation. I have maintained a position that the Treasury Secretary should come from Wall Street, and this situation illustrates the reason why.

Some people quoted in a few articles expressed concern the Citigroup would be a primary beneficiary of this program. This is true. Citigroup is heavily invested in the SIV market and faces the possibility of some big possible losses over the next few months if this situation isn't resolved. This is one of the primary problems of having large banks at the middle of the financial world. On the good side they provide liquidity. On the bad side, the concentration of assets means that a screw-up can lead of a pseudo bail-out.

So -- will this work? I have no idea. It's good that parties are trying to find an answer to this problem. However, most solutions are going to have their own problems built in.

Read More

With All The Clamor For A Rate Cut -- Rates Aren't That High

There's been a lot of talk about the need for a rate cut by the Federal Reserve. However, it's important to note that interest rates aren't that high right now. Here are a few charts from the St. Louis Federal Reserve to Illustrate

The 10-Year Constantly Maturing Treasury



AAA Corporate Paper



BBB Paper



The Prime Rate



The Effective Fed Funds Rate



In addition, the short-term Treasury curve indicates that flooding the system with liquidity won't solve the problem. Just because someone has the money to lend from a liquidity injection does not mean they will use that money to make loans. Here's a chart of the short-term Treasury curve to illustrate that point.



The bottom line is this is a liquidity issue -- people don't want to make loans right now.

Read More

With All The Clamor For A Rate Cut -- Rates Aren't That High

There's been a lot of talk about the need for a rate cut by the Federal Reserve. However, it's important to note that interest rates aren't that high right now. Here are a few charts from the St. Louis Federal Reserve to Illustrate

The 10-Year Constantly Maturing Treasury



AAA Corporate Paper



BBB Paper



The Prime Rate



The Effective Fed Funds Rate



In addition, the short-term Treasury curve indicates that flooding the system with liquidity won't solve the problem. Just because someone has the money to lend from a liquidity injection does not mean they will use that money to make loans. Here's a chart of the short-term Treasury curve to illustrate that point.



The bottom line is this is a liquidity issue -- people don't want to make loans right now.

Read More