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Tekið af [The Big Picture - Alternative Ideas for Rescue Plans]

September 25th 2008
Dear Sirs

In order to alleviate the current financial market problems, it is important to understand and address the root causes – not just the symptoms and peripheral issues. Topics such as executive pay, bonus schemes, mortgage application fraud, regulatory fraud, credit derivatives and investment mis-selling all need addressing in time, however the primary concern for now must be to stabilise the global financial system and have it reopen for business.

Key Problem: The unwinding of a leverage based liquidity bubble, leading to a situation where we have “Too many assets – not enough end holders”.

The fundamental problem we currently face stems from too much credit being advanced that was being financed by ever increasing leverage.

In order to fully appreciate this problem it is important to understand how the problem developed.

The Virtual Money Machine

Banks, Investment Banks, Hedge Funds and others dramatically increased their level of leverage over a number of years – the same equity base was being used to support more and more financial assets.

The recycling of deposits between institutions created a virtual money machine

• Entity A would raise $100 and buy a MBS or ABS from Lender B
• Lender B would lend $100 to the public via mortgages, credit cards etc
• The proceeds of sales would be deposited back into the Banking Industry
• The Banking Industry would lend the $100 to Entity A via a money market transaction
• Bank A would use the $100 to buy a MBS or ABS from Lender B

This recycling went on relentlessly as long as Entity A kept buying the securities and increasing its leverage.

As long as Entity A kept buying the bonds, Lender B was under pressure to lend as much money as possible via mortgages, credit cards etc because it was ‘selling’ the loans to Entity A at a profit. The current crisis was driven by the Lenders NOT the borrowers.

With excessive leverage and a timing mismatch between long term mortgage backed bonds and short term funding, the moment the music stopped Entity A was out of business: read Northern Rock, Bear Stearns, Lehman Brothers et al.

Secondary Implications

Entity B stopped performing the ‘gatekeeper’ roll of assessing the ability of the borrower to repay, as the risk was being passed onto the buyer of the bonds.

The unquenchable demand to buy securities and increase the degree to which equity was leveraged resulted in a credit boom. Borrowers were offered enormous amounts of money (this also fuelled the private equity and leveraged buyout frenzy) as the money machine turned, leading to significant asset price inflation. The ease of borrowing enabled people to pay higher and higher prices for houses and other assets.

3rd Quarter 2007

The virtual money machine stopped turning. Many institutions woke up and found they had excessive gearing, loans supported by assets of questionable value and an excessive reliance on short term funding.

Once write-downs began and the focus became de-leveraging, the virtual money machine began to operate in reverse:

• Entity A turns from buyer to seller
• The mortgages and loans cannot be ‘undone’ and the prices of the securities keep falling as Entity A is forced to liquidate.
• Without Entity A, Lender B can no longer make new loans to the public as these cannot be funded via securitisation.
• The banking industry is awash with Mortgage and Loan backed securities it is struggling to fund.
• Confidence has been lost in lending between financial institutions due to risk of losses on these securities.
• This is the liquidity squeeze.
Current Situation and Solutions

Two Distinct Problems

Problem 1: Many home owners paid too much for their houses. Time, inflation and economic growth will eventually solve this problem as long as markets are stabilised and we prevent massive forced foreclosures and liquidations.

Problem 2: Lack of liquidity in financial markets as too many assets (bonds) are looking for long term homes. There is no single solution to this problem however a number of different processes can aid in freeing up markets.

Proposed Solutions

Solution 1 : Accounting

Key Problem for Banks: Asset backed securities valuation

Valuations are not reflecting expected losses on the underlying mortgages. Banks are being forced to write down security values at a greater pace than the expected losses are increasing – These additional capital charges are putting further pressure on de-leveraging and also adding to a sense of fear in the public and loss of confidence.

Solution: Allow banks to create very tightly regulated Special Purpose Vehicles to enable holdings of specified securities to be accounted for using standard credit techniques – not securities market valuations. These SPV’s remain on balance sheet and securities transferred into them stay there. Valuation is linked to default rates and expected losses given default of the actual mortgage pool.

Role of Government/Industry
An independent body needs to be established to provide valuations of these securities and mandated loss provision requirements to the holders.

Advantage
Banks would be able to write back significant amounts of their loss provisions from these securities.

Overriding Criteria
The owner of an asset must reflect actual losses that have occurred from foreclosure and liquidation and make provisions for expected loans currently in default.

Solution 2: Liquidity in Markets

Flight to quality and loss of confidence has left banks struggling to raise short term funds and stopped banks recycling funds between themselves.

Solution: Enable the Central Banks to massively expand their intermediary role. In the case of the USA for example, issue $500 billion (or other significant amount) in 1, 3 and 6 month Treasury Notes and offer the funds raised to the banks using repurchase transactions via tender. This is the same process as existing facilities, just on a much larger scale. Such a significant increase in available funding will ease pressure on banks and LIBOR and generate a significant profit to the central banks. The borrowing will also disappear over time as the crisis eases and equity is raised to invest in MBS’s

Solution 3: Unwind Tranching

The tranching of a securitisation sounds appealing in concept, however the reality is that the different tranches simply cannot be priced in the real world. Yes it is possible to say that a senior tranch carries less risk than a junior or equity tranch, however converting this into a pricing method/formula/system is impossible without making assumptions that are unrealistic. This failure is one of the root causes of the current crisis – “Too Many Quants – Not Enough Common Sense.”

Government Role
A useful role of a government vehicle would be to facilitate the unwinding of these tranched securities.

Solution 4: Facilitate a Reduction in Foreclosures

In order to halt the spiralling lower in property prices and social disruption from foreclosures the process needs adapting. A form of the 30/20/10 proposal by Barry Ritholtz of Fusion IQ should be adapted.

In essence distressed homeowners are given the capacity to convert a portion of their mortgage into a 10 year zero interest 2nd mortgage. Please see the proposal at http://bigpicture.typepad.com for further details.

Solution 5: Funding Vehicles to buy MBS’s

In order to ease liquidity problems we need to create ‘homes’ for the pool of securities currently clogging up financial markets.

Allow the creation of tax exempt, retail and institutional closed end Exchange Traded Funds to purchase these securities with maximum allowable gearing of 3 to 1. The funds purchase these securities in the secondary market. Income and capital gains are tax free, however investors will wear the burden of any losses, which will be tax deductible.

Key Advantage: Those that have behaved prudently and saved can benefit from these investments, rather than just footing the bill from tax payer bailouts.

These will be ‘one-off’ closed end funds.

Conclusions

Losses must be taken

At the end of the day trillions of dollars worth of loans were made to people without adequate assessments being made regarding their ability to repay. Total losses from bad debts will run into hundreds of billions of dollars, however the global financial industry can absorb this if given the time to digest.

Many people that paid inflated prices for houses will live in those houses and repay the mortgage. These potentially trillions in current mark-to-market losses need never be realised if the system and economy are given the breathing space to function.

There is no single solution to this problem, however the proposals I have sketched out here will help alleviate the pressures.

Yours Sincerely

Steven A Bowles

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