Posts Tagged ‘illiquidity’
Financial Reporting Transparency and Regulation
There are two related essays in the editorial section of today’s (March 30) edition of The Wall Street Journal regarding government oversight and regulation that are worth mentioning: Welcome, Businessmen, to Government Oversight and Transparency Is More Powerful Than Regulation. We’ll mention the suffocating nature of regulations and then discuss the more interesting topic last, including our own work of using XML-based systems and tags for (internal) management information systems, which relates to the discussion of XBRL systems in the second column.
Suffocating Regulations and Bureaucracy
Is there any other kind? Well, yes. As we see it, regulation is either suffocating or ineffective, and the former often has a crushing feel about it. Like modern digital television sets, government regulators seem to have no “fine-tuning” dial; it’s generally one extreme or the other: either there’s “NO EXCEPTIONS” or “it’s all good, do what you want.”
Victoria Toensing discusses that overbearing weight of the government in Welcome, Businessmen, to Government Oversight in which she highlights, among other indignities, the silliness of government offices unable to accept small gifts like cherry pies. Our guess is that she has spent most of her life in public service and doesn’t appreciate how similarly bureaucratic large corporations can be, but that’s besides the point because much – although not all – of that corporate bureaucracy is induced by government regulation.
We’ve discussed both negative aspects of regulation in numerous posts although we tend to highlight ineffectiveness because it has been very obvious in the current financial crisis and the mortgage débâcle that preceded (and which continues to coincide with) it. For example, on Saturday we wrote The Cure is Worse than the Disease, which criticizes Mr. Geithner’s proposed financial system regulations.1 We fear the suffocation to come.
Generally, we favor decentralized government and much prefer decentralized working environments, i.e, light regulation with the policing authority’s option to crush, i.e., heavily penalize for indiscretions. We take that from the Bible and the Parable of the Good (and Bad) Servants, which covers both moral hazard and ignorance, and that’s why we’re strong proponents of nationalizing the weakest of the large banks. (Not because we think the government will manage them better but because we think shareholders and current managements have forsaken the right to control those assets.)
Suffocating regulations and bureaucracy usually provide no benefit to society and are inhumane and demeaning. If “effective,” they usually end up killing the thing they are trying to protect. (Nationalized health-care anyone?) In short, that’s why we’re against Mr. Geithner’s plan.
Transparency Anyone?
The other column worth mentioning is L. Gordon Crovitz’s Transparency Is More Powerful Than Regulation in which he focuses his attention on a substitute for extensive regulatory oversight: more reporting transparency. For support of his position, he mentions former Supreme Court Justice Louis Brandeis’s point that “sunlight is the best disinfectant,” which we often cite, but is irrelevant here.
While we tend to agree with many of his points, we think, that in the end, Mr. Crovitz draws the wrong conclusions because (1) in general, in social settings more transparency isn’t necessarily better (doesn’t necessarily improve social welfare and can decrease it), and (2) in the special case of securitizations of pooled assets, additional transparency won’t solve the problem of flawed pricing models because the models’ owners have lost confidence in them.
Is More Information Always Better?
It depends. In single person games – i.e., natural science experiments and games against nature, more information is better. Roughly, that means it leads to higher expected satisfaction for the participant.2 Clearly, record-keeping is necessary for several reasons, but often those records don’t necessarily provide marginal benefit for decision-makers in all decisions, i.e., the records might not identify additional relevant or differential costs or benefits among the possible alternatives for the decision. Alternatively, because they are not perfectly rational, decision-makers may not be able to categorize and synthesize or relate the new information that is present, or they might misuse it.
In a seeming contradiction to that view, last week, in Separating the Mortgage Débâcle from the Liquidity Crisis, we agreed with Hernando de Soto’s recommendation that more details about contingent claims and securitization contracts should be made public, and Mr. Crovitz explains how this is technically feasible through the XBRL initiative.
As we see it, such details are informative about certain aspects of the contracts, but not what Mr. Crovitz thinks. For example, it might help creditors better understand particularly low outcomes associated with certain securities; so, we think that the details are worth reporting, BUT the additional details may not help with pricing claims on the pooled assets. Thus, we don’t see how transparency will induce liquidity. In fact, markets often fail because there is “too much” transparency to sustain transactions, i.e., no one wants the clearly-identifiable crap – the lemons.
As we’ve written in the past, one of the problems with these pricing models for pooled assets is that their owners have lost confidence in them. They’ve lost confidence because they view the models as no longer applicable, and they view them as no longer applicable because they have failed empirically.
They failed because they did not capture the relationships and inter-relations among the assets, particularly among residential mortgages. (In other words, the traders and analysts vastly under-estimated the joint dependencies among cash flows and collateral values, which those folks may express as having a poor estimate of the correlations, but which is likely more complicated and far less calculable than that.) We’ve written about that on several occasions, including here: Trading, Incentives, Organizational Structure and Risk Management, where we explain it as a contagion. (We also discuss it in Well, This Is a Fine Mess You’ve Gotten Us into…. along with other still pertinent issues.)
The problem is that there are few mathematically tractable ways to specify how these assets are related; so, solvable – but nondescriptive and misspecified – methods were employed. In stable times and with a bit of good luck, that misspecification didn’t seem to matter. Unfortunately, luck changed, and did and it does now.
So, we don’t see how transparency will induce trading, but that doesn’t mean that trading cannot occur. (Mr. Crovitz has a good solution, but to a different problem, i.e., Mr. de Soto’s problem.)
Our Solution
Since September we’ve recommended changes in tax policies – via mortgage investment tax credits or immediate write-offs of purchase prices – as a way to induce trade and create liquidity in these security markets. Providing a 30 – 40% cushion in the purchase price, will induce trading even if buyers aren’t completely confident of their calculations. Imagine if the same tax incentives were available to new car buyers? (See “The Good Cop” section of Poor Mr. Geithner: No Forest, No Trees, Just Lost for a recent overview of our plan.)
What Does This Have to Do with MIS?
The same types of system that XBRL is based upon are available very cheaply for internal decision-makers. We’re designing and implementing similar robust, tagged systems for our clients. They are easily searchable systems – both informally (ad hoc) and formally (routine reports); they’re easy to update and edit; they’re secure; and they’re relatively inexpensive. The benefits of technology can now be realized by any size firm or organization. Contact us for more information.
As always, we might update this post after we re-read it.
Copyright © 2009 Spero Consulting.
Footnotes:
- That post provides links to a few of our earlier ones, too. ↩
- We’re being very general, here, and not specifying what either “more information” or “expected satisfaction” mean, but is a very well-studied area in statistics and decision-making.
In multi-person games – i.e., in social settings – there are any number of reasons and cases where more information is harmful to overall societal welfare. Those reasons generally involve risk-sharing and/or incentives. Our own (joint) contribution to the field is Kanodia, Singh, and Spero (JAR 2005), which studies a social setting with a manager and investors in which two important variables are unknown.
One might think that if one variable can never be perfectly known, then (costlessly) learning as much as possible about the other one would be beneficial. We show that’s not the case because of the way that more precise information distorts incentives (and costless effort): depending upon the specification assumptions, either gross underinvestment or gross over-investment results.
Will More Details (More Transparency) Help?
It depends.
Details or facts are not necessarily information, and that relates to our second criticism.[3. Interested parties can read our essay on the topic: Details Are Not Information. ↩
How to Trade CMBS?
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.
CMBS Is Like Lumpy MBS and That’s Not Good
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.
Principles Lost and More
Or – to seriously mix our metaphors – falling head-over-heels for the wolves’ claims that the “sky is falling.”
Our favorite line from the play and movie, A Man for All Seasons, is Saint Thomas More’s statement at his trial in which he gently belittles one of his perjuring accusers, Richie Rich:
“Why Richard, it profits a man nothing to give his soul for the whole world…Ahh, but for Wales?”
Mr. Rich received an appointment from Henry VIII in Wales for his efforts.
After performing a short and cursory search of the web, we’re not sure – and it seems that no one else is, either – as to whether the martyred Saint actually made that statement, or whether it is an apocryphally placed by the playwright, Robert Bolt.
Nonetheless, it so beautifully expresses the wry, amused, and considered insight of a thoughtful, yet condemned, man, who by quoting scripture (Mark, 8:36), makes clears Rich’s Faustian bargain, and for what?
The Scared: We have been reminded of that 16th century, courtroom scene several times during the past several weeks, including today when we read Kim Strassel’s poorly-reasoned, column on in today’s WSJ, What Leadership Looks Like, and yesterday, when we read The Wall Street Journal’s editorial, entitled, “Free AIG.”
Yesterday, the Journal’s the editorial staff seemed to regain – at least temporarily – their free-market principles long enough to criticize the Federal Reserve’s seizure of AIG in mid-September. Unfortunately, the editors have failed to take that same logic and apply it to the larger financial crisis, as does Ms. Strassel and her subject, Congressman Paul Ryan.
Indeed, while claiming to be for “free markets and free people,” they seemed awfully willing to forsake it for a smidgen of a promise of security and stability.
Regular readers know that we’re morally opposed to the plan for several reasons, including that trade-off of freedom for security and our doubts that it is necessary despite the many, many pleas of exigent circumstances, falling skies, and wolves.
Furthermore, as we have written extensively during the past two weeks, we believe that there are harmful immediate and long-term implications of the bailout and that it will fail.
So, the promised security and stability will be illusory – a mirage, perhaps – as all such promises have been since at least the takeover of Bear Stearns in the early Spring. See any of these recent posts: The Financial Bailout, Reverse Auctions and Marking to “Market”; Moral Hazard and Another Problem with Illiquid Assets; If ‘If’s and ‘But’s Were Candy and Nuts…(#2); Bigger Is Not Necessarily Better; OMG! OMG! OMG! Largest US Bank Failure Ever!; The Crisis and Free Market Critics; The Uncertain Value of Mortgage Securities; Sorry Mr. Bush, We Respectfully Disagree; Could a “Bailout” Prolong the Financial Crisis?; Idiosyncratic and Concentration Risk, Again.; and Public Bailout? Why Rush or Do It at All?. (Actually most everything we’ve written during the past two weeks.)
In that regard, we have proposed our own privately-oriented, market-based plan, A Better Solution (than a government takeover), that requires only a few small changes in the tax laws to implement. It is similar to allowing accelerated – well, immediate – depreciation of the cost or an investment tax credit to the prospective purchasers of certain mortgages and MBS and CDS issues. (Note: the current bill provides investment tax credits for risky R&D but not risky mortgages. Does that make any sense?)
The Scary: in addition, we ask the dear reader to consider this: if the current plan fails to alleviate the panics, can he or she imagine how far the government will further overstep its authority to solve what will then be a prolonged crisis REQUIRING additional governmental intervention, or have supporters not considered that prospect?
The Sorry: the illusory nature of many such bargains and trade-offs induced us wonder about the individuals – executives, regulators, and employees – who “cut corners,” turned a “blind eye,” or just went along with something in which they didn’t believe… in hopes of gaining the world or perhaps just a small bit, say, a little corner of Wales or Long Island.
In the process, not only did they bear high personal costs, but in many cases, the gains, e.g., the value of their stock grants or their new titles, turned out to be illusory. (Cromwell was guillotined a few years after More’s trial, too.)
We sympathize with them – not the amoral ones; they don’t care and would only mock our sympathy. No, we mean the folks with consciences, who knew right from wrong, but couldn’t resist and traded their decency (and in many cases their self-worth) for the lure of a few dollars more or a little less aggravation. That near-universal weakness is the reason that we and many others admire Sir Thomas, even if we can’t always emulate him.
The Final Irony: All such sacrifices (and government directives) are designed to lead one or one’s people to Utopia. By the way, who wrote that book?
Moral Hazard and Another Problem with Illiquid Assets
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.
