The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

We have a new contributor to the Big Picture Cafe — Josh Rosner.

Joshua Rosner is Managing Director at independent research consultancy Graham Fisher & Co and advises regulators and institutional investors on housing and mortgage finance issues. Previously he was the Managing Director of financial services research for Medley Global Advisors. In early 2003 Mr. Rosner was among the first analysts to identify operational and accounting problems at the Government Sponsored Enterprises, in the third quarter of 2005 Mr. Rosner identified the peak in the housing market, In October of 2006 Mr. Rosner highlighted the likely contagion from structured securities and credit markets into the real economy.

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Please refer to important disclosures at the end of this report.

Banksters in DC: “The King is Dead, Long Live the King”

Kafkaesque tragic-comedy continues to pervade Washington as sources tell us that Citi Chairman Richard Parsons met with Secretary of Treasury Geithner on Friday. Sources suggest Parson’s trip appears not to have been previously scheduled and, wile the subject of their meeting is not known, several sources advise us that his name is likely on the short list for the yet to be announced economic recovery board.

We hear Treasury, FDIC, OCC and Fed principals and staff worked together all weekend on the question of aggregator (“bad bank”) versus “insurance wrap”. It seems that positions remain fairly close to where they were before CNBC wrongly reported that the “bad bank” discussions were dead. Sources suggest those false rumors emanated from bank executives with either implicit or explicit support from Treasury.

Senior Hill sources tell us Treasury officials continue to argue the market is not correctly valuing ‘troubled’ assets and that banks current ‘marks’ continue to price these securities closer to their real underlying value. It is thus apparently Treasury favors a solution that does not require banks to recognize the current market price, a result that would be required by the sale of these assets into a “bad bank”. This seems consistent in intent, even if different in approach, with the original Paulson Treasury and Bernanke TARP testimony pitch (‘we need the taxpayers to overpay for bad assets’).

Sources inform us that Treasury continues to argue that an insurance wrap approach is preferable than a bad bank approach. They argue it would be less costly to the taxpayer. Senior regulatory and Hill sources tell us Treasury also prefers the idea of stretching losses over a long period rather than accepting the reality of an immediate recognition of losses. Their position is predicated on a belief that these securities will “recover”. That argument is more dubious and less supportable than it was in the summer of 2007 when market prices were higher, assets performing relatively better and the banks were more credible and I wrote:

“We continue to believe that many institutions will use the subjective nature of the mark to model valuation methods for illiquid securities to defer losses and obscure their true exposures. Beyond avoiding the negative impact to earnings such improper or aggressive marking of assets obscures the usefulness of investor reliance on book value…Our goal in this report is to provide analysts and portfolio managers with primary questions that investors should be asking of managements in an effort to avoid attempts at obfuscation through jargon…Although our current focus relates primarily to problems in Residential Mortgage Backed Securities (RMBS) and related Collateralized Debt Obligations (CDOs), we expect that these problems are likely to be a precursor to similar problems in other structured securities…As we have made clear since the beginning of the year, the mortgage finance problems are not isolated to subprime, subprime just had a shorter leash… Both the CMBS and CLO markets will almost certainly see rising liquidity problems. There is little doubt that beyond large future impairments there are many institutions with significant levels of embedded losses that have not yet been recognized as a result of questionable valuation…Those managements who refuse to see the significance of this tide-change, with power shifting from issuers to buyers, will find reduced access to the capital markets and a higher cost of capital.”

Apparently Treasury has, in their argument for an insurance wrap, suggested that perhaps available for sale (AFS) or trading assets could be sold to the “aggregator” bank at a potentially generous mark-to-model price while held to maturity (HTM) exposures could be wrapped also at levels that underestimate potential losses on the assets. While Treasury can try to argue that this is a less costly approach I would argue that it is a thinly veiled attempt to prevent losses from being recognized and which will result in larger levels of ultimate loss. While AFS assets are required to be market to market on a quarterly basis those exposures classified as HTM are not required to be marked. Instead, they are to be revalued only where there is an “other than temporary impairment”. Simply, such an impairment is The Weekly Spew January 2009 determined upon a realistic (potentially subjective) expectation that the asset will not repay upon originally contracted terms for change in credit conditions.

Over the past several quarters many of the large banks have moved assets from AFS to HTM, apparently to avoid marking them to market. Beyond these securities that may have been reclassified, most large whole loan exposures of banks (e.g. corporate loans, constructions loans…) are generally classified as HTM. These are precisely the loans that will increasingly be souring as the economy continues to weaken. As a result, leaving these assets on the balance sheets of troubled institutions will only result in increasing losses with little incentive, for an institution that has been provided protection by the taxpayer, to aggressively or proactively restructure or manage the exposures.

If one accepts the economy may remain flat (or even negative) for a period then it is unlikely that pushing real losses off into the future makes any more sense than it did when Japan did it. To encumber the taxpayer with insurance obligations for assets that continue to be managed, and possible overvalued, by those who have long mismanaged them is irresponsible and raises questions about either the integrity or judgment of those who would make such proposals. It makes even less sense to leave the assets on the balance sheets of these institutions so that they, and not the taxpayer, would own any future upside in the case of unanticipated recoveries. The benefit of the doubt in regard to appropriate prices to pay should accrue to the taxpayer. After all the taxpayer is being asked to shoulder the ultimate losses.

If the intent was to be respectful of the asset values of the assets of the private creditors of banks, the government could structure the purchase of troubled assets in a manner that would provide those creditors with the future upside in cash flows if those cash flows exceed the price paid for them. This would be an equitable and fair approach and could be consistent with bank management claims of a desire to hold exposures to maturity. Using such an approach would also make it clear, in the case of the worst of these institutions; the assets are for the benefit of creditors not equity holders. Drawing out the recognition of losses could lead equity holders to continue to believe they hold equity in a company that is guaranteed by the government, a view of which we would be best served by disabusing them.

The notion that “our banks are troubled and our banking system is fragile” is inaccurate and seems to have been put forward by the few large institutions that are “troubled” and “fragile” . Many of our nation’s banks will suffer a difficult time but most will draw down reserves yet remain solvent. This is because of the simple differences in their business strategies over the past several years. Small banks required less leverage to generate targeted returns on equity while large complex banks required leverage to generate comparative return rates. As a result, the large banks took advantage of a regulatory arbitrage that, on a risk based capital basis, treated leveraged residential mortgage backed securities essentially the same as they treated whole residential mortgage loans.

Just as, in good times, the leverage in these securities provided relatively larger returns than the whole loans, in bad times they generate larger losses. As a result, most of our nations banks are adequately capitalized to ride out the storm that will wipe out much or all of their reserves. This is in contrast to those large and arrogant players, we are being asked to fund the life support of, which tried to game the regulatory requirements in an effort to avoid a general recognition that they had become too big to generate returns adequate enough to support their viability.

The cost of any program, whether insurance wrap or bad bank, should be considered not by the initial cost but on the efficacy and most likely cost over the life of the program. Efficiency is not measured by the utility of dollars and effectiveness is not measured in short-term fixes. If we are to have a viable economy now is the time for our leaders to demonstrate the worth of our supposed ideals – integrity, clarity and honesty.

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Joshua Rosner
Managing Director
Graham Fisher & Co., Inc.
O – (646) 652-6207