Credit default swaps to follow subprime loans, CDOs, to bubbleland stage?

It does indeed seem possible that more and more economic talk will focus on the “arcane” CDSs.

Like other recently crafted financial tools, such as their somewhat kin collateralized debt obligations, or CDOs, CDSs have a few problems. First, what are CDSs?

Credit default swaps were invented by major banks in the mid-1990s as a way to offset risk in their lending or bond portfolios. At the outset, each contract was different, volume in the market was small and participants knew whom they were dealing with.

No. 1 and above all, especially in the eyes of more critical economists, is that CDSs, just like CDOs, are not “marked to market.” In other words, nobody knows if their paper value is at, or even anywhere close to, their real-world value. The reason is the same as with CDOs — they’ve never really been tested on the open market.

Major insurer AIG has already admitted some of its CDSs were mispriced.

Third, one-sixth of CDSs were created as backstops for holders of CDOs, and we know the CDO market ain’t so healthy.

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A new acronym means recession could be worse than many claim

You’ve learned about CDOs and SIVs; now, it may be time to bone up on CDSs.

John Markman claims credit default swaps by banks and other financial institutions will add extra pain to the current recession:

Nearly seven decades ago, the eight months between Germany’s invasion of Poland in 1939 and its invasion of France in 1940 was known as the “phony war” — a period of escalating anxiety, denial, appeasement, danger and death, but nothing like the murderous global train wreck soon to follow.

Likewise, we may come to look at the period between July 2007 and January 2008 as a sort of phony war in the worldwide credit crisis, because although the market has fallen 15 percent since summer, there have been no defaults of key bonds or asset-backed securities. The curious lack of real blowups has led even seasoned observers to believe that fears were exaggerated and that chaos will be averted.

In reality, however, the skirmishes we’ve seen so far might be little more than a prelude to a deeper, harsher, longer decline than most yet perceive possible. And in a very postmodern twist, it is beginning to look like unexpected consequences of an investment instrument designed to mitigate risk could turn out to be the nuclear option that bombs the globe into the financial equivalent of World War III.

Here’s why CDSs could be a problem, according to Markman:

Because we are coming out of a long period in which debt defaults have been unusually low, hundreds of little-known hedge funds, pension funds and insurers worldwide were lulled by a false sense of complacency into the practice of selling CDSs — and their ability to pay up in the event of widespread defaults amid a long, hard recession is not just in doubt but completely unlikely.

Markman lists various ways these issuers are likely to try to get off the hook. They include contract loopholes, imprecise language not crafted to a specific bond insurance need, whether or not a bond issue’s “restructure” equals a default, available collateral and hedging of CDSs, and more.

Oh, for a good summary list of financial acronyms, visit this Economist story.

[More econ news below the fold]


Housing slump worst since Depression?

For the first time since comprehensive records going back to 1968, housing prices declined for an entire year in 2007. How bad is it? Even the financial guru for the National Association of Realtors was glum:

Lawrence Yun, the Realtors’ chief economist, said it was likely that the country has not experienced a decline in housing prices for an entire year since the Great Depression of the 1930s.

In other words, neither a Fed rate cut nor a one-off stimulus package is going to make a lot of difference. The housing market is going to have to suffer through this; I hope part of the price of that suffering is a variety of new regulatory legislation, not only on the marketing of subprime loans, but the use of things such as CDOs and SIVs by financial institutions, AND…

Regulation to address the currently incestuous relationship between these institutions and ratings agencies such as Moody’s.

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Another kick in the pants for CDOs — mortgage note-holders told ‘no’ on foreclosures

Mortgage investors may not have a legal right to foreclose on property.

Judge Christopher A. Boyko of Federal District Court in Cleveland dismissed 14 foreclosure cases brought on behalf of mortgage investors, ruling that they had failed to prove that they owned the properties they were trying to seize.

You think CDOs are crap now? If lending institutions assume this ruling will be upheld on appeal, they’re going to go right in the toilet.

Writer Gretchen Morgenson notes this has been a common practice for years, letting holders of mortgage security notes foreclose, but it had never been legally challenged.

The increased slicing-and-dicing of CDOs was making mortgage securities-based foreclosures more difficult anyway.

More below the fold.


Here’s how the judge’s decision came down:

On Oct. 10, Judge Boyko, 53, ordered the lenders’ representative to file copies of loan assignments showing that the lender was indeed the owner of the note and mortgage on each property when the foreclosure was filed. But lawyers for Deutsche Bank supplied documents showing only an intent to convey the rights in the mortgages rather than proof of ownership as of the foreclosure date.

Saying that Deutsche Bank’s arguments of legal standing fell woefully short, the judge wrote: “The institutions seem to adopt the attitude that since they have been doing this for so long, unchallenged, this practice equates with legal compliance. Finally put to the test, their weak legal arguments compel the court to stop them at the gate.”

A spokesman for Deutsche Bank declined to comment on the ruling. But the inability of Deutsche Bank, as trustee for the pools, to produce proof of ownership at the time of the foreclosures will fuel borrowers’ concerns that they are being forced out of their homes by entities that may not even hold the underlying loans.

Here’s how the mortgage security process starts, without including the part of different slices, or tranches, being mixed together into CDOs, which would make the picture below even more complicated:

The process of putting together a mortgage pool begins when a home loan is originated by a bank or mortgage lender. That loan is typically sold to a Wall Street firm that pools it with thousands of others. Once a pool is packaged, it is sold to investors in different slices, based on risk. A trustee bank oversees the pool’s operations, ensuring that payments made by borrowers go to the appropriate investors.

Lawyers who represent troubled borrowers complain that trustees overseeing home loan pools often do not produce proof, usually in the form of a mortgage note, that their investors own a foreclosed property. And a recent study of 1,733 foreclosures by Katherine M. Porter, an associate professor of law at the University of Iowa, found that 40 percent of the creditors foreclosing on borrowers did not show proof of ownership.

About 40 percent? Do you hear the wheels of the foreclosure machine grinding to a halt?

And here’s why the situation exists:

When a loan goes into a securitization, the mortgage note is not sent to the trust. Instead it shows up as a data transfer with the physical note being kept at a separate document repository company. Such practices keep the process fast and cheap.

In other words, another corner gets cut. And when securities holders bitched, Boyko told them where to get off:

e plaintiff’s argument that “‘Judge, you just don’t understand how things work,’” the judge wrote, “reveals a condescending mindset and quasi-monopolistic system where financial institutions have traditionally controlled, and still control, the foreclosure process.”

The article goes on to say that the cases can be refiled in state court, whether or not a federal appeal is being pursued. But, I’m betting attornies for debtors block that, depending on where either the putative note-holders, or the actual note-holder is, on interstate commerce grounds.

I’m surprised that word of this ruling hasn’t spread more, and thus become even more of a downer on mortgage brokerages and other financial institutions.

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Govt accounting regs pushing CDO writedowns

Via Naked Capitalism, I read about two new developmental regulations essentially forcing more clarity and re-evaluation of CDOs. Combine that with marketplace changes and this is what you get:

The first is that new accounting rules gives companies far less latitude in how they value this paper. As the Financial Times explained it:

They are the “buckets” into which financial statement preparers must classify financial assets under FAS 157, a new US accounting standard for financial years beginning in November...

At the top of the bucket hierarchy is Level One, involving assets with prices quoted in active markets, such as mainstream stocks. Level Two contains less-traded securities and uses prices for assets very like the one being valued.

At the bottom lurks Level Three, assets with “un observable inputs”, meaning their value is calculated via a series of assumptions. Most collateralised debt obligations end up here.

While these categories may be familiar to many readers, what is not as widely know is that another rule, FASB 159, pushes institutions to put positions into the lowest bucket possible. Thus, no phony-baloney Level 3 valuation if there is a way to come up with a gridded or extrapolated Level 2 value.

The second development is that markeplace changes are forcing the revaluation of CDOs. Having first gone through re-rating subprime bonds, they are now tackling CDOs, and downgrades will force commercial banks, investment banks, pension funds, and other holders to recognize losses.

In other words, the first regulation allows less papering-over of hugely different credit ratings of different tranches within a collateralized debt obligation. The second fights artificial valuation.

Then, the market comes in, with CDOs now having to have more transparency, and says, “These ain’t worth shit.”

Yves Smith goes on to say that CDOs have a lot of leverage over other, tangentially connected, financial issues. In other words, “You ain’t seen nothing yet on fallout.”

The good point about the regs is they should help prevent future CDO excesses. Bad point is they should have been on the books years ago.

Bit of history from another Smith post: CDOs were created in 1987 by Drexel Burnham Lambert, home of junk-bond king Michael Milken. That alone is reason why we should have had more regulation of them years ago.

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Financial analysts should have seen the subprime bomb ticking

In fact, some did:

“All of the old-timers knew that subprime mortgages were what we called neutron loans — they killed the people and left the houses,” said Louis S. Barnes, 58, a partner at Boulder West, a mortgage banking firm in Lafayette, Colo. “The deals made in 2005 and 2006 were going to run into trouble because the credit pendulum at the time was stuck at easy.”

“I’m one guy in a research department, but many people in our mortgage team have been suggesting that there was froth within the market,” said Jack Malvey, the chief global fixed income strategist for Lehman Brothers. “This has really been progressing for quite some time.” …

“We’ve contended for a while that there was an issue in subprime debt,” said Neal Shear, global head of trading at Morgan Stanley. “A year ago, we were aware that delinquencies were going to rise.”

Meanwhile, since everybody who has followed this issue knows that the incestuous action of ratings agencies like Moody’s, touting subprime derivatives on which they stood to profit, is a fair part of the problem, the European Union is planning to investigate possible conflicts of interest. Where’s the SEC, on our side of the pond?

And, the anti-Cassandras also bear blame for being in denial still, primarily through their claim that this is a just a problem with subprime mortgages.

No, it also has affected a number of Alt-A mortgages, the next class above subprimes. Therefore, it has affected more collateralized debt obligations. It’s also caused other classes of mortgage to hike their interest rates.

And, with the peak in number of adjustable rate mortgages due to reset nearly a year off, we’re still not at the bottom of this.

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A snarky look at how the Fed caused the housing-credit bubble in the first place

It’s basically by “counterfeiting” $3 trillion of money over the past few years. This is pretty funny, but with good explanatory value:

• I use $1 trillion to buy stocks (jump starting the bull market)
• I use $1 trillion to buy U.S. Treasury bonds (thus driving bond prices higher and interest rates lower)
• I use $1 trillion to go around to every neighborhood in every major city of the U.S. and start buying houses for 10 percent higher than the listed price.

And you get all these benefits:

• This will create jobs, since lots of employees and consultants will be needed to spend $3 trillion.
• The stock market indices will soar. Everyone's 401(k) and day-trading portfolios will increase in value.
• Home prices will increase by 10% overnight.
• Interest rates will fall which will make it even cheaper for everyone to borrow money to buy new cars, upgrade into a bigger homes, and buy new gas plasma TVs every year hoping against hope of getting to watch the CUBs someday play in the World Series.
• The lifeblood of America, vastly underpaid Real Estate Agents, will get a much needed and well deserved infusion of cash.
• The economy will be humming so fine that no one will care about the loss of jobs to India and China.
• Cheap goods will continue to pour into the US and the CPI will show only a modest 2 percent rise in the price of goods.

Boy, you just can’t beat that, can you?

It does show, in addition, that, although Adam Smith was hugely wrong about his “invisible hand,” he was right on the money about human greed.

Mike Shedlock goes on to say that not just an ordinary recession, but a deflation similar to late 1980s Japan, is very possible. Bill Fleckenstein, another financial analyst who seems to have good insight, agrees.

Personally, I’ve upped my recession odds by Aug. 1, 2008 from 1-3 to 2-5. I’m leaving the Jan. 1, 2009 prediction at 1-2, but those odds will probably get adjusted upward soon.

Oh, and if your 401(k) has any such risk investments, look out.

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