Spero Consulting

Posts Tagged ‘CMBS’

We occa­sion­ally write about CMBS or Com­mer­cial Mortgage-​backed Secu­ri­ties and the CMBX index. For exam­ple, last Novem­ber, we wrote CMBS Is Like Lumpy MBS and That’s Not Good. We tend to get more hits on our tongue-​in-​cheek post, How to Trade CMBS? and find that a bit scary.

What should truly frighten both CMBS hold­ers and banks with large commercial-​mortgage loan port­fo­lios more than our dis­cus­sion of our page rank­ings is this arti­cle in Saturday’s edi­tion of The Wall Street Jour­nal: Hotels Deliver Some ‘Jin­gle Mail.’ The arti­cle details how hotel own­ers are walk­ing away from highly-​mortgaged prop­er­ties and how delin­quency rates for secu­ri­tized hotel loans are almost ten times higher than they were one year ago – about 4.75%.

We sus­pect that banks that were erst­while struc­tur­ers and had accu­mu­lated an inven­tory of such loans (for later bundling that has not yet mate­ri­al­ized) may face even larger problems.

Using the logic that the last loans made before the bub­ble burst are likely to be less cred­it­wor­thy than ear­lier ones, we sus­pect that the delin­quency rates for those loans that didn’t make it into a CMBS pool before the mar­ket col­lapsed could be even higher than the nearly five-​percent rate men­tioned above.

More­over, while we’d argue that any claimed diver­si­fi­ca­tion ben­e­fit of CMBS was grossly over­stated, there is absolutely no diver­si­fi­ca­tion ben­e­fit from hold­ing the entire loan. Those banks and struc­tur­ers that are stuck hold­ing those loans bear the entire risk of default. In some ways, it reminds us of a very expen­sive adap­ta­tion of the game, musi­cal chairs. (CDOs and CDOs squared, etc., are rem­i­nis­cent of “hot potato” or blind folks toss­ing raw eggs back-​and-​forth.)

Finally, we would be sur­prised if for­mer struc­tur­ers and banks with clogged pipelines didn’t report higher credit losses in the sec­ond half of this year. If they don’t, we will won­der whether reg­u­la­tors are being par­tic­u­larly loose in super­vis­ing how those banks cal­cu­late their loan reserves.(At this point, we sus­pect those loans are no longer “held-​for-​sale,” but have been reclas­si­fied into the reg­u­lar loan portfolio.)

We hope that the finan­cial cri­sis, which seems to have sub­sided, has actu­ally sub­sided. How­ever, we have a sneak­ing sus­pi­cion that it may be per­son­i­fied by Mark Twain’s famous quote about how the report of his death was greatly exag­ger­ated. This is one indi­ca­tion that it’s not over.

Our site’s sta­tis­tics pro­gram keeps track of the search terms used to arrive at our hum­ble lit­tle venue, and this morn­ing we noticed a hit from the query, “How to trade CMBS?”

That, as they say, struck us kind of funny. 

We thought: given the ongo­ing and (we would guess) accel­er­at­ing prob­lems in com­mer­cial real-​estate such a ques­tion could come from either (1) some­one com­pletely unfa­mil­iar with Com­mer­cial Mortgage-​Backed Secu­ri­ties or (2) some­one com­pletely, deeply, and des­per­ately immersed in the indus­try. (As a last-​ditch effort for mar­ket­ing help.)

In that way, we’d imag­ine that on a daily basis any num­ber of commercial-​loan con­duit man­agers, bankers, struc­tur­ers, traders, and CMBS investors all pon­der the same question: how to trade CMBS? That, after all, is a defin­ing char­ac­ter­is­tic of an illiq­uid or frozen mar­ket. Ouch.

If you’re inter­ested in the nature of CMBS, the top post here is a good place to start.

If It Is Much Ado About Noth­ing, Then It Is an Indict­ment of Congress.

Since we wrote CMBS Is Like Lumpy MBS and That’s Not Good on Wednes­day, AAA CMBX spreads have increased another 300 basis points to a level about ten times greater than where they started the year.

That means that there has been either a large increase in the num­ber of buy­ers of the insur­ance or a decrease in the num­ber of sell­ers (or both), and that could be due to panic or not.

Unfor­tu­nately, unless one is exposed (in the same pro­por­tions) to the CMBS that com­prise the index or the loans to the same under­ly­ing firms, then pur­chases of CMBX are more sledge than hedge. (See On N’edges and Sl’edges and Bil­lions Lost and On Nedges and Sledges and Paving the Road to Hell.)

With sledges it is quite pos­si­ble to lose on both legs. (It’s kind of like buy­ing fire insur­ance on another’s house when you can’t buy it on your own. It may be valu­able in a wide­spread for­est fire, but it won’t pro­vide any value if you burn down the house with a cig­a­rette ash and that causes the pre­mium on the other house to rise.)

When we see the type of panic observed this week, it makes us won­der whether CMBX buy­ers are mak­ing infer­ences based upon infor­ma­tion about oth­ers or whether they’re pro­ject­ing their own prob­lems on oth­ers. We wrote about that on Octo­ber 1^st, when we defined “finan­cial pro­jec­tion in a cri­sis” (with respect to LIBOR) as:

a bank’s deter­mi­na­tion not to lend overnight to a peer because of the sus­pi­cion that the peer’s via­bil­ity (or bal­ance sheet or asset qual­ity or future prospects) is sim­i­lar to its own.

If these recent extreme increases are anal­o­gous to our pithy and tongue-​in-​cheek def­i­n­i­tion of finan­cial pro­jec­tion, then it seems that prospec­tive losses related to com­mer­cial real-​estate will be enormous.

That con­clu­sion makes us won­der: what are the odds that banks would give res­i­den­tial mort­gages to (almost) any­one but wouldn’t do the same for com­mer­cial mort­gages? It is pos­si­ble; so, we don’t con­sider to be a rhetor­i­cal question.

If they were just as reck­less, then God help us all.

If they weren’t, and it turns out that they were far more pru­dent mak­ing com­mer­cial loans than res­i­den­tial, then that is a fur­ther and com­plete indict­ment of the sense­less and destruc­tive med­dling of Con­gress in our econ­omy (via Fan­nie and Freddie).

This is one time we’d pre­fer it to be a case of record-​breaking Con­gres­sional incompetence.

Update (01−20−09): now that Mr. Paulson’s term as Trea­sury Sec­re­tary has ended, we must admit that the small bit of opti­mism we exhib­ited in this post was sadly and unfor­tu­nately mis­placed. It was out-​of-​character for us, but we’re a hope­ful pes­imist. He quickly reverted to his behav­ior of Sep­tem­ber and Octo­ber, and for that, the mar­kets, the nation, and the world have and will con­tinue to suffer.

We hope that his ear­lier actions haven’t caused irrepara­ble dam­age, but we’re doubtful.

This is a longish post that cov­ers sev­eral aspects of the ongo­ing finan­cial cri­sis and, for the con­ve­nience of new vis­i­tors, con­tains plenty of ref­er­ence links to ear­lier posts.

In our mind, until last week, the cur­rent Trea­sury Sec­re­tary had an incred­i­bly long and unbro­ken string of wrong deci­sions and actions. Start­ing in March if not ear­lier, and through early Novem­ber, in almost every impor­tant deci­sion, when Mr. Paul­son zigged we would have zagged, and vice versa.

Well, actu­ally, we wouldn’t have zagged or zigged as that requires effort. Instead, we hope our rhetor­i­cal flour­ish illus­trates our oppo­si­tion to many of Mr. Paulson’s deci­sions. We would have done what we have advised all along, and what Mr. Paul­son finally, finally seems to be doing: nothing.

As we advised in Sep­tem­ber, par­tic­u­larly in the posts Over­re­ac­tion and Moral Haz­ard: Now That Will Be a Cri­sis and Pub­lic Bailout? Why Rush or Do It at All? among others, we rec­om­mend Mr. Paul­son to vig­or­ously do noth­ing, and advice Mr. Obama and the next Trea­sury Sec­re­tary do the same: noth­ing or more pre­cisely, noth­ing much. 

We ital­i­cize the “much” because we con­tinue to (1) offer our pri­vate, non-​governmental solu­tion to the mort­gage cri­sis, which the gov­ern­ment has yet to address since TARP become law, and (2) offer advice on the best way to mit­i­gate the big­ger and more wor­ri­some liq­uid­ity cri­sis, and that will require a bit of aggres­sive gov­ern­ment action to moti­vate remain­ing bank man­agers to act or sell. See, we don’t think that the gov­ern­ment should act (much), but we do think that banks and share­hold­ers should.

In gen­eral, we’re strongly in favor of an eco­nomic ver­sion of the Hip­po­cratic Oath: do no harm. Thus, we advise: do very lit­tle for which there will be few unin­tended con­se­quences. (Although we do have two spe­cific rec­om­men­da­tions in mind that we’ll men­tion later.)

So lit­tle time, so many mis­takes: what’s the point?

The Treasury’s ear­lier insid­i­ous approach of get­ting the government’s many, spindly, lit­tle fin­gers on all of its Vishnu-​like arms into hun­dreds of firms will likely have no end, ever. (Our pre­dic­tion: they’ll rene­go­ti­ate rates when tax­pay­ers are sup­posed to reap the ben­e­fit of rate increases.) It was so very dis­ap­point­ing – not sur­pris­ing, but so very dis­ap­point­ing – to see our fed­eral offi­cials act in such rushed and expe­di­ent manners. 

Until last week there didn’t seem to be any thought – even an after­thought – of the havoc they were wreaking. Given shal­low­ness their depth of thought, we would have been con­vinced that Mssrs Paul­son and Bush were teenagers with Prog­e­ria had text-​messaged their inter­views and press releases.

What’s the point: when we taught decision-​making to MBAs we heav­ily empha­sized (1) know­ing the deci­sion cri­te­rion – the objec­tive func­tion – and (2) iden­ti­fy­ing rel­e­vant or incre­men­tal costs and ben­e­fits across alter­na­tive courses of action.

We saw no indi­ca­tion that our government’s lead­ers oper­ated under such a frame­work, par­tic­u­larly in Sep­tem­ber and Octo­ber of this year.

In other words, it should be very clear how to account for the fed­eral government’s deci­sions and actions. One would hope that offi­cials would have some met­ric by which they mea­sure the effect of their actions, but that seems to have been beyond them.

What were Mssrs. Bush, Paul­son, and Bernanke try­ing to accom­plish? What were (or are) the costs and ben­e­fits of their fea­si­ble alter­na­tives? Which cat­e­gories of costs and ben­e­fits seemed to have the most reli­able and firm esti­mates? What deci­sions were most sen­si­tive to under­ly­ing vari­ables and assump­tions? Which deci­sions seemed the most robust across poten­tial changes in the eco­nomic environment?

Dur­ing the both the orig­i­nal mort­gage cri­sis and the larger, ensu­ing and ongo­ing liq­uid­ity cri­sis, has the reader heard any gov­ern­ment offi­cial speak in those terms? Or, until last week, when Mr. Paul­son said, “Nyet,” were their state­ments more like: “Eek! We’ve got to do some­thing! We don’t have time to think?” Yeah, it was a rhetor­i­cal question.

As reg­u­lar read­ers know, we have very seri­ous doubts about the effec­tive­ness of var­i­ous aspects of the government’s plan – although “plan” seems to be too thought­ful and orga­nized a term to describe the government’s response to the cri­sis of 2008. Like­wise, we have even greater doubts about its effi­ciency, or the ratio of ben­e­fits to costs. (Is it not approach­ing zero?) We mean that there are at least two issues to con­sider: (1) will the government’s response ulti­mately be suc­cess­ful? Will it be effec­tive? And (2) If achieved, what will that “suc­cess” cost? Will it be efficient?

Unfor­tu­nately, so far, we’ve not heard a def­i­n­i­tion of success.

However, seven weeks after the approval of TARP, the results don’t look good. In fact, unless “suc­cess” has been defined down­ward, the results look more like fail­ure. The NASDAQ Index sits at roughly half of its twelve-​month high, and has lost as much value since the pas­sage of TARP – about 700 points – as it did in the period from its high last Decem­ber to the end of Sep­tem­ber. Like­wise, the S&P 500 has gone from about 1,524 last Decem­ber to 806 today, with 366 points of that 718 point drop occur­ing since Sep­tem­ber 30. Ditto for the DJIA: down from 13,991 last Decem­ber to today’s close three points below 8,000. It stood at 10,831 on Sep­tem­ber 30. Tril­lions and tril­lions of dol­lars of value destruc­tion – both before and after TARP.

Thus, “suc­cess” how­ever defined, seems doubt­ful. More­over, any claim of suc­cess must be tem­pered by the very heavy cost bourne by tax­pay­ers and investors. So, given those results, we’re very encour­aged by Mr. Paulson’s new­found hes­ti­tancy to act. But is the too lit­tle arriv­ing too late?

Don’t just do something. Stand there.

Given its sim­i­lar­ity to our position, we very much enjoyed the recent opin­ion essay by our for­mer Wash­ing­ton Uni­vesity col­league, Rus­sell Roberts in The Wall Street Jour­nal. It was enti­tled, “Don’t Just Do Something. Stand There.” A month after our post, Out of Their Ele­ments, and weeks after related posts like Well, This Is a Fine Mess You’ve Got­ten Us into…., Mr. Roberts makes sim­i­lar points, and he draws sim­i­lar, dis­cour­ag­ing, and almost depress­ing con­clu­sions about the future. Unfor­tu­nately, that doesn’t give us even a quan­tum of solace.

For­tu­nately, how­ever, it does seem that Mr. Paul­son may have read Mr. Roberts’ col­umn dur­ing the sec­ond week­end of November, internalized it, and vowed swift inac­tion in the tur­bu­lent finan­cial markets.

Finally: doing noth­ing! But why did it take so long?

We write that because last Tues­day, Novem­ber 11, Mr. Paul­son rebuked the automak­ers and their advo­cates seek­ing TARP funds, and news reports both last week and this week note that the Trea­sury have no plans to buy trou­bled assets or imple­ment new schemes. (Last Wednes­day, in response to the news, we wrote Tak­ing the TA out of TARP, and ungra­ciously gloated over the fact that we had cor­rectly pre­dicted the law’s inef­fec­tive­ness and poten­tial harm nearly six weeks earlier.)

Last Mon­day, the day before Mr. Paul­son denied TARP funds to the auto indus­try, we wrote Patience Please! They Just Need More Time!, which noted that the car man­u­fac­tur­ers had 35 years – that’s THIRTY-​FIVE YEARS – since the first oil cri­sis to change their ways. It seems that through the entire time – almost the life expetancy of a Russ­ian male – man­age­ment, the unions, and the deal­er­ships have been locked in an inter­minable game of “chicken” with each wait­ing for the other swerve to avoid col­li­sion and death to reap the pride­ful spoils of victory. 

While in some ways, Chicken seems like an apt metaphor, it ignores the fact that over the past 35 years, with each myopic deci­sion the spoils have become smaller and smaller – and are now almost noth­ing. In that sense, the auto indus­try seems more like a black hole where a mas­sive expanse (of warm sun­shine and fren­zied activity) has shrunken to a cold, shriv­eled, and nearly non-​existent state. Yet, its mass – or more pre­cisely, the mass of its lia­bil­i­ties – seems to warp and dis­tort nearby space as it smoth­ers and destroys every­thing within reach.

Unfor­tu­nately, the self-​destruction of a once-​vital and proud indus­try is not a game or a black­hole mil­lions of ligh years away. It col­lapse is tragic and close and the col­lat­eral dam­age of the col­lec­tive, short-​sighted self­ish­ness – mea­sured in the hun­dreds of bil­lions if not tril­lions of dol­lars and in terms of lives ruined – has been all too real. More­over, the siu­ta­tion is not interminable, but it finite, and the end is near.[1. We admit to being a bit overly harsh as it seems the ill-​advised CAFE stan­dards wouldn’t per­mit the Big Three to lever their com­pete­tive advan­tages with large cars and trucks. At one time, they did make the best large cars in the world (and we still love our Suburban.)]

So, in our mind, ignor­ing GM, Ford, and Chrysler seems to be both the effi­cient and just thing do, and we admire Mr. Paul­son for admit­ting – even if only implic­itly – that his ear­lier actions were mis­takes. Clearly, we wish that he could have been a faster learner. It might have saved all of us hun­dreds of bil­lions of dol­lars of cash and tril­lions of dol­lars of equity value.

It’s our view that The Gov­ern­ment Will Save Us! Not!. Instead, we’d pre­fer that it get out of the way and pro­vide incen­tives to pri­vate enter­prise to act autonomously. In that spirit, we still pro­pose A Bet­ter Solu­tion (than a gov­ern­ment takeover), which involves tax incen­tives for buy­ers of trou­bled assets. Those incen­tives could be imple­mented as invest­ment tax cred­its or as extremely accel­er­ated depre­ci­a­tion, and would pro­vide large (30%-40%) and imme­di­ate tax sav­ings that would cush­ion the down­side risk of uncer­tain val­u­a­tions. (The things are hard to value.)

Make an example: nationalize the worst one(s).

We’re gen­er­ally almost lib­er­tar­ian in our free mar­ket approach to eco­nom­ics, but don’t get us wrong, we con­tinue to urge the gov­ern­ment to nation­al­ize the worst cap­i­tal­ized banks: the very few, not the many. We’d much pre­fer the out­right expro­pri­a­tion of the worst offend­ers both out of a sense of jus­tice and as a warn­ing to other firms to act quickly to save them­selves rather than to wait for gov­ern­ment handouts. 

Just as importantly, with com­plete own­er­ship of a few firms, it is much more likely that there would be many calls from many par­ties, espe­cially com­peti­tors and poten­tial investors, to re-​privatize the nation­al­ized insti­tu­tions ASAP. That polit­i­cal pres­sure would prove to be very ben­e­fi­cial to reduc­ing the government’s influ­ence in finan­cial intermediation.

Imag­ine if the gov­ern­ment would have nation­al­ized AIG, would the out­come have been any worse than what we’ve seen in the past two month? Would it have been any more expen­sive than it has already been? We’d argue – and have argued – that issues with col­lat­eral, includ­ing those related to AIG’s dimin­ished credit rat­ing, would have been mit­i­gated through gov­ern­ment own­er­ship and creditworthiness.

More­over, other than non-​executive employ­ees hold­ing shares, we’d argue that none – not 10% nor 20% – of the old own­er­ship struc­ture should remain. That might induce share­hold­ers in other firms to become a bit more activist and demand stronger and more knowl­edge­able rep­re­sen­ta­tion on their boards of direc­tors. (See our recent: The Fail­ure of Boards to Direct.)

We’d pre­fer the fren­zied, moti­vated efforts of bankers seek­ing cre­ative solu­tions to their most vex­ing prob­lem over the cur­rent sce­nario where hoard­ing of funds and wait­ing seem to be the pre­ferred tac­tics. In that sense we as an econ­omy, a nation, and a soci­ety are in no bet­ter posi­tion today than we were six or seven weeks ago.

We wrote about what has and con­tin­ues to occur in Even A Per­fect Bailout Will Fail and Finan­cial Pro­jec­tion in a Cri­sis among other posts.

Unfor­tu­nately, the biggest dif­fer­ence between now and the end of Sep­tem­ber is that our col­lec­tive equity hold­ings have lost about one third of their value, and new asset classes like CMBS are likely to depre­ci­ate like MBS already has. How­ever, on the upside, it seems that Mr. Paul­son is mov­ing (or more accu­rately not mov­ing) in the right direction.

In all seri­ous­ness, we do pray that our senior gov­ern­ment offi­cials take the right, rea­soned, and thought­ful actions. We hope you’ll join us. Per­haps it’s working.

(This a long post; so, there are prob­a­bly a num­ber of typos, which we’ll cor­rect dur­ing the com­ing days.)

We’ve dis­cussed Com­mer­cial Mortgage-​Backed Secu­ri­ties or CMBS in a num­ber of posts. So, it’s worth men­tion­ing that spreads on AAA CMBX (CDS) increased sub­stan­tially on Tues­day. At about 550 basis points, those spreads seem to be twice as high as the pre­vi­ous all-​time high, which was reached in the late win­ter of this year, and are seven or eight times higher than on Jan­u­ary 1.

It’s much harder to say where spreads on CMBS (bonds) are since they tend not to trade. His­tor­i­cally, they didn’t trade much, and now it is even less fre­quent. In fact, in June, we had a long post, On Nedges and Sledges and Paving the Road to Hell, on the dif­fi­cul­ties of using CMBX to hedge expo­sure to CMBS. As that post men­tioned, the now-​defunct Lehman Broth­ers was one of the firms hav­ing dif­fi­culty with things that were Some­what Like Hedges.

If the reader is unsure of the notion of CMBS, know that CMBS is very much like any other mortgage-​backed secu­rity, except: (1) the num­ber of loans in the col­lat­eral pool is smaller; (2) the dol­lar value per loan is sub­stan­tially greater (into the hun­dreds of mil­lions of dol­lar); (3) the bor­row­ers tend to be much more sophis­ti­cated and have bet­ter legal rep­re­sen­ta­tion; and (4) in our opin­ion, there is more sys­tem­atic risk, which mean less diver­si­fi­ca­tion and higher lev­els of default dur­ing eco­nomic downturns.

Like almost every­one else, we’re not sure how the loss given defaults would dif­fer res­i­den­tial mort­gages, but we doubt that it would be favor­able for com­mer­cial real estate. (By the way, read­ers look­ing for an illus­tra­tion of basic MBS should see the last part of Gos­samery Argu­ments for Trans­parency and Our Reply, in which we describe it in the sim­ple terms of a spreadsheet.)

We ask: what are the odds that the hous­ing mar­ket could crash in many parts of the coun­try, res­i­den­tial mort­gages defaults would rise, the econ­omy would seem­ingly slow down, unem­ploy­ment would increase, and the stock mar­ket would decrease sub­stan­tially AND com­mer­cial real estate would not suf­fer? Yeah, when stated pre­cisely, it seems like a silly ques­tion doesn’t it. 

So, with CMBS, we’d guess that the really bad times are just beginning.

In fact, we’d spec­u­late that pro­por­tion­ally – given the dif­fer­ent sizes of the mar­kets – the bad times may be sub­stan­tially worse for com­mer­cial mort­gages than for res­i­den­tial mortgages.

For exam­ple, in CMBS Mar­ket Begins to Show Fis­sures, two writ­ers for The Wall Street Jour­nal, describe two large –$209 mil­lion and $125 mil­lion – and recent (Decem­ber, 2007 and July, 2007, respec­tively) mort­gages that are close to default and men­tion that news was the impe­tus for spreads to increase on Tuesday.

Of course, we wouldn’t be a pedant if we didn’t men­tion that sev­eral of the fac­tors men­tioned above were start­ing to be present in July, 2007, and were cer­tainly evi­dent by Decem­ber, 2007, when those two loans were made.

In that respect, and given the ongo­ing col­lapse of the CMBS new issues mar­ket, we won­der how many other bad com­mer­cial real-​estate loans cur­rently sit in banks’ con­duits. As we under­stand it, the mar­ket for new issues has been dead for quite awhile; so, many pipelines likely con­tain similarly-​aged mort­gages (that never went into CMBS pools) and now sit in the nether world of loans avail­able for sale (although no one wants to buy them). (Kind of like pur­ga­tory, but with­out hope of heaven. In this case, inside the gates of hell.)

If J.P. Mor­gan, the orig­i­na­tor of those two loans, or other large play­ers made sim­i­lar loans in expec­ta­tion of con­tin­ued good times or a quick rebound, then one should expect larger loan-​loss reserves within the next six months or so.

In fact, (1) ithout prior large and pub­lic defaults and (2) given the mag­ni­tude of losses that many banks have incurred in their other port­fo­lios and (3) given the illiq­uid nature of the com­mer­cial mort­gage mar­ket that leads to a lack of “marks,” it seems highly unlikely that banks have already aggres­sively written-​down the value of their CMBS or their inven­tory of com­mer­cial mort­gage loans. 

In that case, one could infer that they – the banks (and their conduits) – were bet­ting that mar­kets would return to nor­mal. Unfor­tu­nately, if that was the bet, and if the above-​mentioned defaults are fol­lowed by oth­ers so spread lev­els stay high, then those banks will be forced to rec­og­nize addi­tional losses at the end the fourth quar­ter and into next year. 

We’d hate to be sit­ting on a large pile of recent, unse­cu­ri­tized, com­mer­cial mort­gages. It’s likely that they’re com­post­ing. While that might improve the prospect of growth in the future, it prob­a­bly stinks now.

It is already Thurs­day, and we’re just get­ting around to writ­ing about a few arti­cles in Wednesday’s (Octo­ber 1) edi­tion of The Wall Street Jour­nal. They are worth men­tion­ing because they are closely related to our post on Tues­day, Big­ger Is Not Nec­es­sar­ily Bet­ter, which warns about addi­tional con­cen­tra­tion risk as the largest banks con­tinue to grow larger.

One is a very small arti­cle in Deal Jour­nal, enti­tled Big-​Bank View: Get­ting Big­ger! that we can’t find online and other is At Lehman, How a Real-​Estate Star’s Rever­sal of For­tune Con­tributed to Col­lapse.¹

We’ve com­mented a few times that big­ger banks are not nec­es­sar­ily bet­ter for soci­ety or the econ­omy because mam­moth size exac­er­bates moral haz­ard prob­lems, i.e., the too-​big-​to-​fail men­tal­ity – noth­ing new there – and because it con­sol­i­dated assets and decision-​making under fewer, idio­syn­cratic (and rationally-​bounded) per­son­al­i­ties (and cul­tures). That first par­en­thet­i­cal com­ment does read bet­ter and sound nicer than the more par­si­mo­nious, “irra­tional,” but the point remains the same.

The big-​bank-​getter-​bigger phe­nom­e­non is actu­ally being encour­aged and expe­dited by expe­di­ent fed­eral reg­u­la­tors, who seem to have absolutely no long-​term plan. Those reg­u­la­tors’ recent actions and state­ments remind us of a com­ment we once over­heard in the exec­u­tive suite of a large firm: “Sorry, but we don’t have time to develop a strat­egy, we have to act.” We’re really not talk­ing about pulling some­one from a burn­ing car or house, but even in those dire, dan­ger­ous, and instan­ta­neous cir­cum­stances, one should have an aware­ness of the envi­ron­ment and a plan if one is to have a chance of success.

The other arti­cle, about Lehman’s real-​estate débâ­cle, puts most of the blame for com­mer­i­cal real-​estate losses on one man, Mark Walsh. Of course, the ulti­mate blame lays with Lehman’s lax board and senior man­age­ment, which pre­sum­ably did not have the knowl­edge or courage to prop­erly under­stand the busi­ness and man­age risk. Addi­tional blame can be placed on senior man­age­ment for improp­erly design­ing incen­tives scheme that induced exces­sive risk-​taking, which we would guess would have been exhib­ited by a “get it done how­ever you can” mentality.

We don’t know Mr. Walsh, and sus­pect that he was doing exactly what was expected of him, but that’s our point. The folks at Lehman in res­i­den­tial real-​estate were likely doing exactly what was expected of them, too, and the com­bi­na­tion was deadly for the firm.

Because of someone’s tastes, pref­er­ences, favor­able past expe­ri­ences, igno­rance, inse­cu­rity, or neglect­ful­ness, the firm suf­fered from excessively-​concentrated risks.

Now, who would think that the val­ues of com­mer­cial real estate and res­i­den­tial real estate within a city or region might be related? Actu­ally, we would guess most adults who didn’t make it past the sixth grade could fig­ure it out, and the same goes for cur­rent mid­dle school and high school students.

In fact, our own small-​sample sur­vey reveals that a high school fresh­man will likely respond with a “Duh!” when asked, “Do you think house prices and office or store prices would go up together and down together in, say, your home­town or do you think they would be unre­lated?” We didn’t ask, but we sus­pect that they would likely note that on a day-​to-​day basis they might not be related, but over longer term they will be. Oh well. What is it about col­lege that destroys that com­mon sense?

Now, the argu­men­ta­tive reader may retort that Lehman is not a good exam­ple because it was an invest­ment bank and so wasn’t scru­ti­nized by the reg­u­la­tors as much as large com­mer­cial banks are (or will be); so, such risk won’t be an issue because bank reg­u­la­tors are on the case. Though the agen­cies and per­mit­ted lever­age ratios were dif­fer­ent, we doubt that the degree of reg­u­la­tory over­sight was much dif­fer­ent across those two indus­tries, espe­cially for the larger firms. More impor­tantly, does the con­trary reader really want to make that argu­ment? (Hint: con­sider Wachovia, Wash­ing­ton Mutual, etc.) As we men­tioned on Thurs­day, reg­u­la­tors have their own incen­tive problems.

While big­ger may per­mit con­sol­i­dated oper­a­tions and cost sav­ings. Are those sav­ings large enough to jus­tify the assump­tion of addi­tional, sys­tem­atic risk or, more pre­cisely, the loss of a diver­si­fi­ca­tion ben­e­fit, caused by the cen­tral­iza­tion of allo­ca­tion deci­sions? The past year has made us very doubt­ful that the ben­e­fits exceed the increased sys­temic risks of a few busi­ness seg­ments bottoming-​out together.

in a Mark-​to-​Market Account­ing Régime.

Here’s a cou­ple of related issues that we can dis­cuss in the con­text of today’s The Wall Street Jour­nal arti­cle, Bailout Pro­posal Gets Hung Up Over Cen­tral Issue: Will It Work?

We’re deeply con­cerned about the moral haz­ard impli­ca­tions of any gov­ern­ment bailout, and we doubt that we are the only observer to har­bor such dark thoughts. How­ever, we also think that those impli­ca­tions could be real­ized imme­di­ately rather than, say, dur­ing the “next” down­turn in some far dis­tant time. Thus our pes­simism grows as does our annoy­ance with the fed­eral offi­cials who have pro­posed mas­sive snd expen­sive actions with­out suf­fi­cient lev­els of thought.

In that respect, can the reader say, “com­mer­cial real-​estate loans and CMBS?” And, does the reader know that illiq­uid CMBS – that’s redun­dant by the way-​is very dif­fi­cult to value, too? Not much dif­fer­ent than CDOs of MBS. We com­mented on some of those val­u­a­tion issues three months ago in this post: On Nedges and Sledges and Paving the Road to Hell.

We men­tion CMBS because we saw in the ref­er­enced arti­cle that many banks, not just the ail­ing ones, are try­ing to round-​up every­thing they don’t want, i.e., crappy loans and secu­ri­ties, to make it avail­able for sale to the government.

Can you, dear reader, blame the banks? We can’t. We’d cer­tainly like the feds to buy our Sub­ur­ban at its his­tor­i­cal cost, too. Mr. Paul­son are you listening? Can you help me, here?

As the arti­cle men­tions, it turns out that the banks would rather sell these items at their cur­rently marked val­ues than be forced to pos­si­bly devalue them at the end of the next report­ing period, which hap­pens to be next Tuesday.

It is prob­a­bly too late, so we doubt that it will hap­pen on Mon­day, but we could see a banker try­ing to con­vince a gov­ern­ment bureau­crat that the bank’s mark from June is still the best guess of where an item sells (if it were to sell to any­one in the mar­ket that doesn’t exist.)

We could also see the bankers’ expec­ta­tions of the sales (to the gov­ern­ment) to color their val­u­a­tions next week. As we wrote yes­ter­day in The Uncer­tain Value of Mort­gage Secu­ri­ties that expec­ta­tion will likely lead to greater adverse selec­tion prob­lems because of the pos­si­ble increase in the uncer­tainty regard­ing the value of each bank’s assets. In our view, this will exac­er­bate, not mit­i­gate, the cur­rent pan­icky behav­ior among banks as they deal with each other (until such exchanges with the gov­ern­ment actu­ally occur). How­ever, we could see it lead­ing to prob­lems after the bailout, too.

With that in mind, we ask the dear reader to guess the mul­ti­ple of $700 bil­lion that banks have iden­ti­fied as assets they’d like to sell? We’re guess­ing a mul­ti­ple of at least three – a few tril­lion dol­lars worth – with a sub­stan­tial amount of CMBS and inven­to­ried, pipelined, com­mer­cial mort­gages thrown into that mix. (Those are loans that con­duits made and planned to bun­dle into secu­ri­ties but are cur­rently stuck with because no one wants the CMBS that would be struc­tured from them.) Does the reader believe that only homes were over­built in for­mer boom towns?

So, for argument’s sake, and to be excru­ci­at­ingly pre­cise, let’s say that we are cor­rect that the bank’s col­lec­tively think that they’ll be able to sell $2.1 tril­lion worth of thin­gies to the gov­ern­ment at prices that the banks like. How will take affect next week’s third quar­ter val­u­a­tions, and what will hap­pen when they’re stuck with $1.4 tril­lion of stuff that they wish the gov­ern­ment had bought?

And that leads us to our sec­ond issue about the nature of dis­jointed and illiq­uid mar­kets and how a lit­tle infor­ma­tion can hurt a lot. You see, in social sit­u­a­tions, more infor­ma­tion is not nec­es­sar­ily better.

The fact that no one wants to buy the stuff doesn’t mean that there aren’t a lot of firms hold­ing sim­i­lar secu­ri­ties. So, let’s say that 20 firms are hold­ing a part of a par­tic­u­lar illiq­uid CDO issue or CMBS issue or what­ever it is that no one else wants.

If the thing is illiq­uid then – nowa­days – that means it’s not traded at all; so, there is no observ­able price; so, it is likely that the cur­rent marks vary across the 20 firms because they are all using slightly dif­fer­ent mod­els or all have slightly dif­fer­ent – albeit, likely inflated – expec­ta­tions of what a sale to the gov­ern­ment will bring.

All things equal, it would seem to us that the most des­per­ate firm would accept the low­est price offered by the Trea­sury. Again, all else equal, that’s usu­ally how its works; oth­er­wise, we have to add an adverse selec­tion argu­ment, too.

If that is true, then depend­ing upon how much of the issue the Trea­sury pur­chases, that low­est price is now an observ­able “mar­ket” price for the other 19 firms, and that’s not good with mark-​to-​market account­ing where a lit­tle bit of infor­ma­tion, based pos­si­bly upon one firm’s des­per­a­tion sale to the gov­ern­ment set the new (likely lower) mark for the other 19 firms. It might be infor­ma­tion and it might be the truth, but it cer­tainly wouldn’t help soci­ety. More infor­ma­tion isn’t always better.

That means addi­tional write-​downs may be forth­com­ing from, say, the other 19 firms. If that issue is part of our hypoth­e­sized $1.4 tril­lion above, then those write-​downs in the future after the gov­ern­ment pur­chase will be larger than they would have oth­er­wise been with­out the bailout. Of course, that’s based upon our argu­ment that the book val­ues of the issues would be higher than they oth­er­wise would have been (due to each bank’s antic­i­pa­tion of sell­ing to the gov­ern­ment at an inflated price). Such a sce­naroi would lengthen the dura­tion of the cri­sis and neg­a­tively influ­ence the behav­ior of the firms when they lend to each other in the near term. There will be more pan­ics that occur far­ther into the future.

Is this all idle spec­u­la­tion? Of course, we were a the­o­rist in col­lege. Are we wrong? It is quite pos­si­ble – the chair­man men­tions that it often hap­pens – but we doubt it in this case. Let us know what you think.

Or when is a “hedge” not a hedge? —when it is a nedge or a sledge or a wild*** guess, of course.

To para­phrase St. Fran­cis de Sales, the road to hell is paved with good inten­tions because exe­cu­tion mat­ters! (Else­where he scolds per­fec­tion­ism, too, and argues for a bal­ance: do not be rash, do not over-​analyze. Real­ize that it is not a sin to be imper­fect, but it is a sin to do wrong.)

Back on May 21, we posted On N’edges and Sl’edges and Bil­lions Lost in ref­er­ence to a WSJ arti­cle, “Trou­ble Hid in the Hedges.” That arti­cle cited the likely con­tin­u­a­tion of losses at large invest­ment banks to due inef­fec­tive hedges, par­tic­u­larly due to the firms using var­i­ous CMBX indices to hedge CMBS (com­mer­cial mortgage-​backed secu­rity) invest­ments. Some of those losses have now been rec­og­nized: “Lehman Talks a Rosy Talk.” A few weeks ago on June 10, we posted They’re Los­ing $Bil­lions, But Doesn’t She Have Nice Clothes and Shoes? in which we again men­tioned nedges and sledges and alluded to losses from inef­fec­tive hedges.

We define nedges as near hedges and sledges as some­what–like hedges. (Pre­sum­ably, if we were younger and hip­per, we could have thought of iHedges for inef­fec­tive hedges, but we would pre­fer that the word “hedge” not appear in it’s entirety with­out scare quotes or ital­ics, and we are not clever enough to come up with iHedge.)

We invented those terms to indi­cate that while some sta­tis­ti­cal rela­tion­ship might exist between the two items — in the com­mer­cial mort­gage case, a credit index and bonds — only a fool would believe that buy­ing one and sell­ing the other (in what­ever “optimal” proportion) would elim­i­nate the risk of loss. Unless one is buy­ing and sell­ing the same item at the same moment in time, then the com­plete elim­i­na­tion of value or return risk is not pos­si­ble either in the short run or in the long run. Moreover, it is worth noth­ing that elim­i­nat­ing mar­ket risk usu­ally comes at the cost of addi­tional counter-​party risk. That exchange of one risk for another might remind the reader of a vari­a­tion of the arcade game, whack-​a-​mole, with the pre­sumed goal to have smaller and smaller rodents pop-​up after each hit or trans­ac­tion. (Of course, one small mole can still do tremen­dous dam­age to a well-​manicured front lawn.)

In the long run, if the same trans­ac­tion could be repeated ad infini­tum, aver­age losses would likely be reduced if the rel­e­vant, return prob­a­bil­ity dis­tri­b­u­tion func­tion were well-​behaved. Unfortunately, in the real world we can never be quite sure of that fact. We can, in theory, think of nice prob­a­bil­ity func­tions that arise from, say, repeated coin flips (where one gains a dol­lar for heads or loses a dol­lar for tails on each flip). At the limit when the num­ber of flips approaches infinity, extreme losses would be rare, but avoid­ing any loss is not assured. In such an exper­i­ment, break-​even might be expected, but even there it is not guaranteed.

In the short-​run, no such asymp­totic rule comes into play, and like the CMBS exam­ple, there is the chance — in some cases quite a high chance — of los­ing on both legs of the trade.

We believe that exclud­ing fraud, the will­ful igno­rance of first prin­ci­ples is the rea­son behind many huge trad­ing losses. Such losses, while often attrib­uted to bad luck, are not usu­ally due to the lack of advanced “knowledge” or “sophis­ti­ca­tion.” So, it doesn’t take a PhD. It takes an PhD or MBA for­get­ting, ignor­ing, or never inter­nal­iz­ing the basics, espe­cially when some level of pseudo-​sophistication is com­bined with a healthy dose of hubris, pos­si­bly due to the mis­spec­i­fi­ca­tion of past good for­tune. We′ll have other posts on this issue in the near future because we find it quite annoy­ing and extremely dangerous.

In our exam­ple below, we use sim­u­lated val­ues rather than real return data so that we can con­struct it just the way we want it. We pro­vide the exam­ple as an EXCEL spread­sheet to also show the mechan­ics of a sim­ple sim­u­la­tion — as well as make our point about slopes, lin­ear cor­re­la­tions, nedges, and sledges. More­over, it would be dif­fi­cult to pro­vide an exam­ple using CMBX and CMBS rela­tion­ships because the data are so lack­ing. In fact, many such instru­ments were not marked on a daily basis until this past win­ter. Fur­ther­more, note that mark­ing val­ues on a daily basis is quite dif­fer­ent than wit­ness­ing daily trans­ac­tions and observ­ing new daily prices. Deep and liq­uid com­pet­i­tive mar­ket prices do not exist for many of these secu­ri­ties, bonds, and instru­ments; so, often it is mark-​to-​untested-​quote, rather than mark-​to-​market transaction.

Because our exam­ple is an intro­duc­tory level sta­tis­tics prob­lem, some aca­d­e­mics might con­sider it to be a straw man, i.e., a weak oppo­nent designed by us to be eas­ily defeated (by us). Fear not; we take pride in our clev­er­ness and humil­ity, but we try hard not to be devi­ous to fool oth­ers or to be so dull that we fool ourselves.

Instead, we would argue that aca­d­e­mics that would make that crit­i­cism are truly aca­d­e­mic and haven’t spent much time in firms or other orga­ni­za­tions, where it is pos­si­ble to over­hear com­ments like, “We don’t have time to think about a strat­egy. We have to do something!” Or, the equally bewildering, “We have to do some­thing, or it will look like we don’t know what we are doing!” As it turns out, with­out a sub­stan­tial degree of luck or divine inter­ven­tion, such deci­sions rarely pay-​off. As a girls bas­ket­ball coach, such com­ments remind us of closely-​contested, mid­dle school games, when the panic sets into the lead­ing team, team­mates begin to play “hot potato” with the ball (“Ouch, it burns. I don’t want it. You take it.”) and the girls for­get to breathe in their desire not to make a mis­take. (Don’t worry arbiters of sex­ism. We’ve seen it hap­pen with boys and men, too, but just we haven’t expe­ri­enced it while coach­ing them.)

In this file which we have pro­tected, we (1) gen­er­ate three cor­re­lated ran­dom vari­ables, and (2) regress two of those vari­ables, n and sl, against the other one, x. For illus­tra­tive pur­poses, we do this in a very sim­ple fash­ion to show that by design the betas, b, or line slopes should be the same due to the com­mon covari­ance that x shares with n and sl. (In a sim­u­la­tion, they may not be exactly equal.) With x as the regres­sor or inde­pen­dent vari­able, the slopes, b_n, and b_sl, are equal to cov(x, n) ÷ var(x) and cov(x, sl) ÷ var(x), respec­tively.

So, for exam­ple, when traders or risk man­agers don’t have time to think because they MUST ACT, they might select either n or sl as a suit­able hedge for x. Focus­ing only on the expected, least-​square min­i­miz­ing rela­tion­ship, they would be indif­fer­ent between the two. Moreover, such meth­ods and think­ing might allow the trader or man­ager to under­es­ti­mate or ignore the scale of the poten­tial risks that they may be inflict­ing upon the firm via their “hedg­ing activ­i­ties,” and this is where the road leads to hell. For example, if the firm owns x and uses n or sl to hedge by short-​selling either of those instru­ments, then low val­ues of x com­bined with high val­ues of n or sl would be par­tic­u­larly dam­ag­ing, and the chance and mag­ni­tude of the loss is related to the total vari­ance of n or sl—not just the covari­ance. With suit­able lever­age, it is pos­si­ble to lose big, with a nedge like n, whereas with sl it is pos­si­ble to gen­er­ate large, two-​legged loses with­out leverage.

This can be seen in the fol­low­ing graph where we have cho­sen many of the para­me­ter val­ues so that the two depen­dent vari­ables can be eas­ily distinguished. Notice, also, that as promised, both n and sl have the same slope with respect to x, and in theory, either one could be used to “hedge” x, as both would have the same expected ben­e­fit. It is just that there is a dif­fer­ence between expec­ta­tion and realization.

Now, some may argue that they are more sophis­ti­cated than our por­trayal and would not employ such a sim­plis­tic tech­nique unless no other alter­na­tives existed. How­ever, given its per­va­sive use, we find that dif­fi­cult to believe that it is a method of last resort. More impor­tantly, while there are dif­fer­ent and more com­plex hedg­ing strate­gies, unless the mar­ket risk is elim­i­nated via for­ward pur­chases or sales, all prob­a­bil­ity and statistics-​based strate­gies suf­fer from the same under­ly­ing prob­lem that we illus­trate here — there is resid­ual ran­dom­ness and the pos­si­bil­ity to lose on both legs.

With more com­pli­cated hedg­ing strate­gies it might be more dif­fi­cult to see this prob­lem and while some addi­tional vari­a­tion might be reduced, some still remains. Thus, the old adage of los­ing sight of the for­est for the trees seems par­tic­u­larly rel­e­vant here. We also note the many folks spend much time and energy ana­lyz­ing ret­ro­spec­tive rela­tion­ships to deter­mine such hedg­ing strategies, and, of course, such rela­tion­ships need not be per­sis­tent — the oft-​mentioned prob­lem of induction. Dynamic, unsta­ble rela­tion­ships will inval­i­date his­tor­i­cal analy­ses as will sta­ble rela­tion­ships with rare events and small sam­ple histories. CMBX — CMBS series have extremely small sam­ples. So, bas­ing hedg­ing strate­gies and posi­tions on his­tor­i­cal analy­ses poses addi­tional risk due to mis­spec­i­fi­ca­tion. That is why the recent and rel­a­tively long period of low volatil­ity in many mar­kets was so dam­ag­ing to those who for­got or ignored this fact — per our point of ignor­ing first principles.

In addi­tion, while CMBX offers pro­tec­tion on a bas­ket of CMBS, if either (1) your firm holds secu­ri­ties not in the CMBX bas­ket or (2) your firm holds only some secu­ri­ties in the bas­ket, your firm is likely to have sledges rather than hedges when using an index to try to off-​set a position.

Finally, a slightly more tech­ni­cal crit­i­cism is based on our obser­va­tion that some ana­lysts seem to for­get that risk-​neutral pric­ing meth­ods don′t actu­ally elim­i­nate risk; they just, in some sense, ignore it for cer­tain purposes. (Out-of-sight is often out-​of-​mind for the har­ried and/​or unwit­ting.) We won′t dwell too much on this issue here or any­where else until we pub­lish more ref­er­ence mate­r­ial, includ­ing a sim­ple expla­na­tion of risk neu­tral val­u­a­tion. How­ever, please do note that some folks do tend to believe that only expec­ta­tions mat­ter, and often these same folks tend to also for­get or repress the social and behav­ioral ele­ment of trad­ing, espe­cially if they haven’t shown a pre­vi­ous inter­est in human nature in their careers or education. Such obser­va­tions make us won­der whether their hir­ing man­agers are cyn­i­cal or naively-​ignorant? See this post, Caveat Emp­tor, for a related complaint.

P.S. As we men­tioned, the EXCEL sim­u­la­tion file is pro­tected; so, other than click­ing the link to our web site or press­ing the func­tion key, F9, to gen­er­ate a new batch of ran­dom num­bers, there is lit­tle that one can do. Inter­ested par­ties should con­tact us directly for a non-​protected version.