Wednesday, March 21, 2012

Leverage a/k/a assets owned (by certain banks) but not paid for...a $16T case of leverage

McLean, in today's Reuters, takes up the issue of whether the infamous, few have ever heard of 2004 SEC CSE program's voluntary-adoption-of-models'-leverage was the cause of the financial crisis? McLean says no, because, it was the same elevated (30 to 1 plus) level as in 1998; as for example in Professor Andrew Lo's recent paper; hence they say it did not cause or explain the 2008 financial crisis.

(CSE stands for Consolidated Supervised Entity program. Five investment banks applied to become CSE's, all five ceased to exist as CSE's by September 26, 2008 including Bear, Goldman, Lehman, Merrill, Morgan Stanley.)

However, McLean and others fail, in my view, to appreciate the alternative definition of leverage: Assets owned (controlled) but not paid for.
Example from the borrowers point of view: One guy says to his friend "I own my house and it's worth $600,000" Does the guy say that he owes $550,000? Usually not.

Banks'(and CSE's) leverage was flawed in several ways: they didn't make clear that their assets' values; hence net capital were based on models, remarkably they didn't somehow appreciate that what Gorton labeled informationally-insensitive assets would become hyper sensitive, they didn't make clear the amount of assets concealed or masked off balance sheet and they sure as you know what did not inform any individual mortgage borrowers of the above. The UCC Article 9, by the way, reminds us that mortgages evidence a "consensual interest".

As of the end of 2007, the sheer dollar amount of unpaid for “assets” (or off balance sheet, off shore exposures to assets) was $16T – correct $16T.
(For comparison purposes, I invite and welcome any so inclined to supply the dollar amount for 1998 assets owned but not paid for.)
That works out to over 97% of the “assets” on (off and or off shore) the books were NOT paid for at the end of 2007.
Banks and CSE’s assets of choice in the 2000’s were MBS and CDO’s often “enhanced” by CDS, credit default swaps.

The Fed (and its sundry support programs were undertaken in emergency, exigent circumstances).
Bloomberg estimated that such support approached $8T. The Fed did not purchase liabilities, they bought “assets”.
Why did the Fed have to buy anything? Because for years, not months, there was NO market, arms-length trading of those “assets”; had there been more trading; market participants would have been aware that $16T of MBS and or CDO's were flooding the market. More supply, especially a veritable flood of anything depresses its value.
The presence of increased leverage is a flag that banks were not TRADING – they were holding – speculating. Further it was a clear, unmistakable, flashing red, neon light they STOPPED intermediating; that’s the point. In medical terms, when banks stopped intermediating it was like the US financial system had 3 arteries 95% blocked; blood flow shrunk to a trickle but the patient had not yet had a heart attack. It was not a question of whether or not the financial system would have one, it was when and how severe it would be.

The tagline many will recall the fact upon which many swore by: for decades US house prices had NEVER gone down year over year. Remember that one?
However, behind that fact was this:
For decades borrowers were required to put down 20% that’s 4 times leverage on the underlying collateral (asset), the house.
For decades borrowers had to fully document all information on the loan application; gifts were prohibited.
Loan applications had to be reviewed by an underwriter and approved.
In the 2000’s we know that few borrowers were rejected for loans; FDIC OIG in 2006 report pointed to widespread violations and repeat violations of TILA and RESPA in 2004 and 2005.

Inherent in every MBS and CDO are thousands of individuals’ mortgages.
What was the underlying collateral in the 2000’s?
Houses on Main St. were the underlying collateral in the 2000’s.
Houses are themselves leveraged AT the point of origination.

Mixing drugs and alcohol can be lethal. Mixing bank balance sheet leverage, hiding leverage off balance sheet, borrower leverage, thong-like underwriting and using models upon derivatives (and second derivatives) to imply value and determine net capital is guaranteed systemic cancer, when-not-if global, not just US financial napalm.

Back to McLean, debunking CSE leverage is ascribed to several economists who cite leverage of approximately 30 to 1 in 2008 was about the same as in 1998. So they conclude that since leverage was the same then it didn’t explain or cause the crisis. However, no it wasn’t and it’s not anywhere near an analogue and here’s why:

1. First, 2008 was not 2007; leverage as of September 2008 would have been MUCH more pronounced, that means north of 30 or 40 to 1.

2. According to Warren Buffett’s Bloomberg interview in June 2009 30 or 40 to 1 was just what was reported at the end of the quarter, intra-quarter was, I recall the sage saying, was “much more crazy or worse” or words to that effect.

3. Accurate marks of collateral (50 cents on the dollar) in 2008 indicate effective leverage of 60 to 1 or more.

4. Leverage of 60 to 1 means if the underlying collateral declines by just 1.6% the institution, correct the institution, is insolvent.

5. Real, arms length trade, marks of 50 cents on the dollar were common, and mean that a 50% decline in value occurred, CDS aside.

6. Example, in May 2007 Goldman informed a Bear Stearns unit that their MBS were worth 50 to 60 cents on the dollar; correct May 2007.

7. Collateral in 1998 was not concentrated in MBS or CDO, leverage in 2008 was laser concentrated in MBS and or CDOs.

8. Leverage in 2008 was concealed and or hidden, off balance sheet, and or off shore. Leverage in 1998 was NOT concealed and or hidden; leverage in 1998 was likely temporarily goosed upwards due to the Fed-mandated (and supported) industry rescue of LTCM. The Lo graph clearly shows that 1998 leverage retreated south until it began to rise again after the CSE program became effective in August 2004.

9. CSE’s and certain banks’ number of on and off balance sheet and or off shore entities in the 2000's was in the hundreds, one, as I recall, had over 2,200;

10. The CSE program allowed proprietary models to imply asset values, risk and net capital.

11. The decision to apply for CSE status and use of this alternative method was voluntary; that meant the SEC did not impose the alternative (model) method ON the CSE’s; they decided to use it on their own.

12. Models were not in use to determine net capital in 1998; markets and or arm’s length trades were. In fact, a future CSE, Merrill Lynch had this to say about models in their 1998 annual report (as Roger Lowenstein wrote in his When Genuis Failed tome on LTCM, page 235):
"Merrill Lynch uses mathematical risk models to help estimate its exposure to market risk"...and "may provide a greater sense of security than warranted; therefore, reliance on these models should be limited".

13. The 2000’s we (and most of the rest of the world) had several bubbles as a result of leverage – the house price bubble, the house overbuilding bubble, the consumer spending bubble and the stock market bubble (the Dow peaked at ~14,700 in October 2007).

14. Brooksley Born, in the late 1990’s, pointed out derivates’ dangers but was disregarded – derivatives exploded in the 2000’s NOT in 1998.

15. Last, and I’m surprised economists' oversight of this: “the leverage ratio” is one of many financial ratios, called common size measurements and while generally explanatory do not account for drastic changes in either the numerator or denominator. Example: Roger Maris' single baseball season 61 home run record, eclipsed Babe Ruth’s 60 was marked with an asterisk * for decades. Why? The number of games in the season increased to 162 from 150 games.

16. The dollar amount of MBS created from 1996 to 2000 was $4T, from 2001 to 2008 was $16T.

17. And when it comes to assigning responsibility
a. No borrower approved their own loan application;
b. No borrower consented to their mortgage morphing into an MBS or CDO or something else;
c. No borrower knew at or before they signed their mortgage, to ask their lender (or loan securitizer) what leverage was or what their leverage ratio was;
d. No bank was forced by a borrower to turn their mortgage into an MBS or CDO;
e. No bank was forced to leverage an MBS or CDO;
f. No bank was forced to use models to imply value upon any MBS or CDO;
g. And no bank was forced to conceal, mask or hide leverage off balance sheet;
h. And no bank informed any borrower that the combination of the above meant that their house was effectively leveraged up to 3,000 to 1 or more.
i. And that my friends is the story of leverage in the CSE (2004 to 2008) era, not 1998 as some would lead you to believe.
j. By the way, it took the Fed until 2009/10 to figure out and draw up the schematic of the 3 banking systems we had and still have - the Traditional, Cash Shadow and Synthetic Shadow, yet the diagram (scarcely readable, and only with a magnifying glass in 2 foot by 3 foot format); explains the Traditional banking system, easily and clearly in 3 inches, the two Shadow banking systems take up 23 of 26 inches of space, nor does it capture the essential and indispensable $16T "leverage";
k. And there’s more to come.

Any and all comments, questions, reactions or corrections are welcome and appreciated.

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