After replying to a post by Rebellion regarding the mortgage meltdown and the subsequent semi-bail out, I decided to due some further research.

Having many ties to the academic community allowed me the opportunity to discuss (it was actually a one way lecture, with a few questions by me thrown in) the situation with the Chief Economist of a Federal Reserve District Bank.

I am calling this a Political Forum exclusive, because I can find no mention what so ever on some information that was revealed to me. It may be out there, but I can not find it. Read on further. I am going to go into great detail. Divided between an explanation, followed by an explanation for the layperson, with a hypothetical example.

1) Sub-prime Mortgages are not the problem. The problem is alternative mortgages. Including (2/28's, ARM, No downs, Home Equity Line of Credit, and other mortgage finance creations/innovations)

The default rate of Sub and non prime FIXED rate mortgages are actually doing quite fine, and comprable to Prime FIXED rate mortgages.

The default rate for PRIME ARM and other variation Mortgages are extremely High.

2) The ARM type mortgages in and of their selves is actually not a big deal at all. Had it not been for its relation to the real problem, it would be a blimp, that would quickly correct itself.

3) The Federal Government is already re writing and going to enforce new regulations. (The guy I spoke with called them "guildlines" and would not committ to regulation, but would not dismiss the term)
Mostly the new regulations are that applicants must qualify for the life of the mortgage not just the first few years.

4) THE REAL PROBLEM.

In a nut shell: Asset Backed Commercial Paper Conduits, of which the banking industy is acting (for a fee) as both the Credit Enhancment Provider as well as the Liquidity Provider.

The problem is that the ABCP Conduits are using Alternative mortgages as their collateral to sell commerical paper. I am going to explain this in moderate detail, followed by in laymans terms. Jump ahead if you need too.

So, as the assets are devalued (due to defaults and depriciation in home values ((mainly the 2 coasts))) 2 things happen.
1) ABCP Investors which is basically everybody from Hedge Funds with the largest risk exposure, to retirement and pension funds, with the lowest, depending on their Tranch level, are not rolling over their cash, and instead asking pulling their money.

This causes, the Banks to risk federal intervention as their capital to asset ratios, which are CLOSELY monitored, risk imbalancing. So they are seeing severe capital problems, one solution of which was to get outside investment. (Middle East and foreign Banks). This also causes problems for other major sellers whose assets are tied up in ABCP conduit loans.

2) The Banks are doubly exposed because they are contractually obligated to pay credit enhancement as well as liquidity provision. As the ABCP Conduit assets are devalued, the banks have to pay either the difference, or provide total liquidity, in which case they are stuck with devalued assets.

Again, this causes a severe problem in their capital to asset ratio.

For the Layman:
Commercial paper is a very short loan, supervized, but not issued by a bank, to a group of investors for a %interest rate. Most loans mature in 1-4 weeks, with investors rolling over the money to the next loan. Businesses do this to raise capital prior to the selling of asset, and Commerical Paper is offered at a lower rate than an actual commerical bank loan. So a company can save .5-2% points on a loan.

Investors, for some companies require that actual assets are put up as collateral. A new vehical is created, seperate from the company books, into which the assets are put. So if they company defaults, the investors get the assets.

Many of these assets were long term alternative mortgages.

Then factor in that any company can buy long term alternative mortgages.
These companies can choose their risk and reward exposure in levels called tranchs. From AAA to BBB or Equity level.

Hedge Funds buy in at Equity level, which means high risk but high reward.

Pension funds buy in at AAA for what was supposed to be NO risk, and moderate rewards.

An example:

Best Buy (not a real example) buys 300million worth of AAA alternative mortgages.
Then Best Buy uses this asset as its collateral to sell commerical paper. To fund every day business operations, at a cost lower than what a bank would charge.
The Alternative Mortgages are seeing defaults in the 20% range. Meaning that the Equity level owners all the way up to the AAA investors are stuck with losses and devaluation.
So Best Buys mortgage assets once valued at 300 million, is now only worth 150 million.

But Best Buy was very clever. They basically bought insurance on the investment from a major bank. CitiGroup promised Best Buy two things.

1) If the asset decreases in value, we will pay the difference.
2) If you need to liquidate the asset, we will buy it.

Best Buy makes them live up to the contract.

So CitiGroup now has to buy 150million worth of assets for 300 million, in addition to paying Best Buy the difference in value from its original to it current.

A MAJOR blow to CitiGroup.
When you factor in that they were providing this service to virtually all Asset Backed Commerical Paper sellers, and many of them are using long term alternative mortgages as their collaterol, you see a VERY MAJOR problem.

The blow is soo big, that the banks risk being taken over by the Federal government or sold off to other banks. Unless they can see an imediate influx of cash. This is why the banks are taking middle eastern and other foreign money.


NOW for the pol. Forum Exclusive (at least I think) Information.

1) All American banks togeather have a total exposure to this problem equal to 40% of their value. Meaning, if a solution is not found, they stand to experience a 40% lose in total capital.

2) If you count just the top 20 Banks.
They have a total exposure of 80%.

3) The two banks worst off are :CitiGroup and WaMu.
Followed by JPMorgan and Bank of America.

4) I don't want to get into default swap indexes but: The finance sector exposed to the ABCP conduits problems, have seen over a 100% increase in Investment Grade Basis Points.

5) If you are not investment or economically savvy. No worries. The FED is doing a lot to curtail this problem. Mainly reducing i rates and flooding the industry with cash (This helps keep the banks solvent through capital/asset ratio problems.)


I assume this is going to sound like a lot of Greek to most, but I would like to hear what Stekim and Rebellion make of all this. (I am assuming they are both familiar CP markets, SIV's, and Credit Default swapping)


Ixtellor

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George W. Bush "I don't think our troops ought to be used for what's called nation-building"

Blasphemy is a victimless crime.

You lost me at "subsequent semi-bail out."

I only have a intermediate understanding of how consumer mortgages work, but am familiar and was aware of the above as it is similar to what happens in commercial lending as well. It certainly all makes sense and I'll just add a few things. One thing I never thought of was the impact of this on federal ratios. It's obvious, but I guess I was one of many who didn't think of it. Certainly the ratios should be adjusted to include any potential exposure as a result of ABS.

I can address 4 as our rates have been hit as a result. We also package up our loans and sell maybe 3/4 of them in the same fashion backed by our AAA credit rating. It's also worth noting that in some instances these pools are backed by letters of credit instead of a company's credit rating. So if I'm ABC company with a BB rating which would result in 300 point spread I can secure the transaction with a letter of credit from AA Citibank that would provide spread of maybe 125.

Spreads for investment grade credits have essentially doubled. The reason is that companies like ours who get a lot of their liquidity by selling these securitized loans are unable to sell. That's because they don't trust the rating agencies. So in order to sell we have to increase the return to the investor (which of course means our rates to customers increase). Of course there is nothing nefarious to putting these assets into special purpose entities, it's just a way to provide liquidity. In commercial lending the exposure is no different than if they had held the loans on their own portfolio. In consumer mortgages it's different because when they're forced to foreclose they'll do so at a time when property values are likely low. So there is additional risk there.

In your Best Buy example you said if the value declines they make up the difference. If it works the same way as it does with commercial lending then the only time the difference is made up is if the entity that was sold to investors was secured by a letter of credit as I noted above. There are generally no provisions requiring us to buy back the investments, this must be either a characteristic of that industry or something Citi and others foolishly did in order to get business. SPE's should work just like any investment where the risk lies with the investor. So no buy back requirements.

I didn't realize exposure levels, I find the BofA one difficult to believe based upon my knowledge of them. The biggest harm in them going under is not so much loss of capital or a government bailout, they should be able to survive by being bought. The bigger risk is that they are going to have to increase rates dramatically to consumers which can have a significant impact on the economy, no matter what the Fed does. I mean if BofA usually charges a 200 point spread on an average consumer loan, the fed cuts rates 50 points, but now BofA has to charge 300 points, that means the net effect to the consumer is a 50 point increase despite a Fed cut. Economically that is very bad.

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All you need to know about the energy crisis:
ANWR Exploration Republicans: 91% Supported. Democrats: 86% Opposed.
Coal-to-liquid R's: 90% YES. D's: 78% NO.
Oil Shale Exploration R's: 90% YES. D's: 86% NO.
Outer Continental Shelf Exploration R's: 81% YES. D's: 83% NO.
Increased Refinery Capacity R's: 97% YES. D's: 96% NO

SUMMARY: 91% of House Republicans have historically voted to increase the production of America’s own oil and gas. 86% of House Democrats have historically voted against.

for that outline of the problem. I don't really follow all of it but for me it still boils down to this: be angry. The Feds are supposed to be watching over the financial system. What happened? Why did Greenspan allow another giant bubble formation? Why didn't anyone blow the whistle on the rating agencies who passed off junk mortgages with AAA ratings? Who advertised skim milk as rich cream? Who allowed the age old wisdom (caution and 20% down) about loaning money to be thrown out the window? Because, if matters progress in the typical fashion, a lot of homeowners will be hurt and the taxpayer will once again be asked to pay for the the childish greed and poor judgment of these banks-and just as recession looms!

There is definitely going to be a "Frontline" made on this one.

The Fed doesn't supervise the lending industry so there isn't anything they could have done to prevent it. Short of cutting money supply (and possibly harming the economy). There is nothing magic about 20% down. Better to have more home owners and allow something less IF they can afford the payments. And I don't think there was anything to blow the whistle on. I think it's like saying why didn't anyone blow the whistle on people who bought stock in Lycos at $250/share. People (naively so apparently) thought the market had changed. Though I'm sure there will be instances of lack of due diligence as well.

__________________
All you need to know about the energy crisis:
ANWR Exploration Republicans: 91% Supported. Democrats: 86% Opposed.
Coal-to-liquid R's: 90% YES. D's: 78% NO.
Oil Shale Exploration R's: 90% YES. D's: 86% NO.
Outer Continental Shelf Exploration R's: 81% YES. D's: 83% NO.
Increased Refinery Capacity R's: 97% YES. D's: 96% NO

SUMMARY: 91% of House Republicans have historically voted to increase the production of America’s own oil and gas. 86% of House Democrats have historically voted against.

I think the problem here was this: the mortgage companies packaged some riskier loans in with safer loans, in a ratio such that the overall package qualified for a AAA rating. Even if some of the loans defaulted, it was unlikely the whole package would be in trouble.

Except they forgot to account for the fact that if the housing market cooled off, all those bad loans would go bad pretty much at once, overwhelming the market's ability to absorb them.

One can opine that they *should* have foreseen that, but the history of the banking industry is pretty much entirely made up of banks being overly optimistic in rising markets, helping fuel bubbles, then getting badly burned and turning ultraconservative when the market falls. Then when the market turns up again....

Which is one reason I thought it was a bad idea to let the regulatory wall between banking and brokerage collapse. Because now banks have the ability to take down *two* industries, one of which they don't really understand.

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Man up.

My understanding is the banks, with investor and borrower encourgament, were providing basically two forms of "insurance" outside and beyond the SIV assets.

It was the liquidity provider aspect that was most damaging. As the banks are contractually obligated, for a fee, to either A) Take over the loan, or B) Buy the assets. I do not know for certain which one the banks are doing. I assumed it was a mixture.


I am going to link a fed website that will fulfill two functions.
1) That the Fed in an intragency agreement, did regulate the liquidity providers.
2) Flesh out more about liquidity providers work. If you read the background section, it explains it in layman terms why and how of liquidity providers and their need and role.

I am going to quote some relevent portions.

http://www.federalreserve.gov/boardd...5/SR0513a1.pdf


Ixtellor

P.S. It seems to me there is a way to make money off the Sub Prime ARM finance packages. The perception out there is that they are crap, but in reality, they are safer than Prime ARM's.

I would guess that one could buy cheaply into the Residential mortgage-backed securities not issued by the GSE's. I suspect investors are running away and might be willing to take a hit. I would be curious to see how the lowest tranche or equity level investors fared, I suspect they were wiped bout, but maybe a level A or AA tranche CDO would suffer no losses and be available at a discount.

Food for thought.

P.P.S. If I had the time, energy, and money, one might be able to find venture capital to invest in the misperception. For a fee... MUHAHAHA!

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George W. Bush "I don't think our troops ought to be used for what's called nation-building"

Blasphemy is a victimless crime.

So Goldman has done very well betting against products it was selling? Do I read this correctly? From CNN:


While the short sale allowed Goldman to show outstandingly strong earnings in the quarter, it may actually cause problems for the bank in other ways. First, investors in Goldman's two large poorly performing hedge funds will want to know why the savvy deployed in trading for Goldman's own account was not deployed in their funds. If a strategic decision to be short certain bonds was made high up, why didn't this end up helping the Global Alpha hedge fund and the Global Equity Opportunities fund, which were down 30% and 20%, respectively, in the third quarter alone?
Subprime: Let the finger-pointing begin!

Goldman spokesman Lucas van Praag responds: "We're always disappointed when we don't meet our clients' expectations. We're working hard to adjust our strategies to reflect the lessons we learned in August." In addition, the large gains from the mortgage trade will also deepen investors' desires to get a better handle on how brokerages like Goldman make money.

One of the figures that didn't seem to make sense in Goldman's earnings was a number that estimates the market risk on a broker's balance sheet. This indicator, called Value at Risk, or VaR, moved up only 5% in the third quarter from the second. If Goldman was placing big bets in volatile markets - like the short trade in mortgages - VaR might be expected to move up by more.

In other words, Goldman seems implausibly immune from the general rule in investing that higher returns almost always carry higher levels of risk. Van Praag responds that VaR didn't go up by much because Goldman reduced positions as volatility in the markets went up."

From a layman's point of view it is hard NOT to suspect that there is skullduggery afoot. Both Robert Reich and Paul Krugman place blame squarely at the feet of Greenspan for doing nothing to contain the bubble but there seems plenty of blame to go around.

Gosh, call me old -fashioned but it seems crazy to loan money to someone who has little or no money invested in the transaction and no incentive NOT to walk away from the debt when the going gets tough.

Bottom line is that America is no longer about manufacturing; its all about finance.-so I thought. If we can't even be trusted and competent in this dept. what does that say about our credibility?

1) Actually all of this banking crisis can be solved by selling the banks. It is only a problem if you think major banks should be owned by Americans. If you have no problem with China some other wealthy investor buying and controling our banking industry, then all these problems are easily solved.

2) Well the loans were not really risky for a long time.
People would enter into 2/28 ARM's knowing there was no way they could make the payments after 2 years, but because the homes have been consistantly appreciating at high rates, they could just sell the home and keep the equity. It was a win for the buyer and the bank.

So banks making loans to people without the ability to pay over the life of the loan was not a large risk, as the equity growth would more than compensate.


Ixtellor

__________________
_______________________________________
George W. Bush "I don't think our troops ought to be used for what's called nation-building"

Blasphemy is a victimless crime.

then how crazy is it for professional investors to clamor for more asset based offerings to invest in recognizing those investments consisted - to some degree - of those very risky mortgages

the only thing i can say in their defense was that the rating companies may have misled them to believe the securities were less risky than was actually the case. but caveat emptor!

one invests to seek reward but there is RISK. allow them to lose because of the risks they took. do not mitigate their losses at taxpayer expense

amazing to me that we believe in a capitalistic market but when these bubbles implode we want government, rather than the marketplace, to intervene and "fix" things. no government intervention should be found as the best government intervention

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Quote:

"I like to watch the news, because I don't like people very much and when you watch the news ... if you ever had an idea that people were really terrible, you could watch the news and know that you're right."

Frank Zappa