Spero Consulting

Posts Tagged ‘increased uncertainty’

If you haven’t read it, For the Vix, 40 Looks Like It’s the New 20 in today’s The Wall Street Jour­nal please know that is a decent column.

We par­tic­u­larly like the paragraph:

“Volatil­ity may not return to its highs, but it isn’t clear when it will get back to nor­mal, either. Volatil­ity breeds fear, which breeds more volatil­ity. There is still too much uncer­tainty about the losses lurk­ing on bank bal­ance sheets and about the depth and breadth of the cur­rent reces­sion to inspire much calm.”

Now, the first sen­tence is true but says absolutely noth­ing. We’re not try­ing to ridicule Mark Gon­gloff the writer of the Ahead of the Tape column; instead, we empathize with the dif­fi­culty he faces writ­ing about mar­kets and uncertainty.

The notion of uncer­tainty about uncer­tainty–and the inabil­ity to mea­sure it in a sim­ple man­ner – tends to make state­ments about the topic either sound overly-​complex and overly-​qualified (by all of the nec­es­sary descrip­tive qual­i­fi­ca­tions to the state­ment) or makes them sound trite. Some­times that’s the writer’s fault, but often it is the reader’s fault, too, espe­cially when the reader incor­rectly pos­sess no uncer­tainty about their own “knowledge.”)

Now, we espe­cially like Mr. Gongloff’s fol­low­ing sen­tences because that’s almost exactly what we’ve writ­ten dur­ing the past sev­eral months – almost three months now.

The mort­gage cri­sis that cre­ated the con­fi­dence and liq­uid­ity cri­sis and the result­ing equity mar­ket volatil­ity all con­tin­ued unabated. Last Wednes­day, in The Mort­gage Cri­sis: Why Not Incen­tivize the Pri­vate Sec­tor? we wrote: “By the way, folks who think this Thanks­giv­ing week’s mini-​rally sig­ni­fies that the worst is over are likely to be sadly mis­taken. We do hope that we’re wrong, but doubt it.” 

While we try not to make much of one-​day changes, even when they are as large as today’s drop of 680 points in the DJIA and the nearly 9% decreases in the S&P 500 and NASDAQ indices, we do believe both the con­tin­u­ing volatil­ity and losses pro­vide evi­dence that the government’s actions to date have not helped instill con­fi­dence. In all like­li­hood have hin­dered econ­omy and finan­cial activ­i­ties by not allow­ing any res­o­lu­tion of the uncer­tainty of the value and via­bil­ity of large finan­cial intermediaries.

We wrote about that in Could a “Bailout” Pro­long the Finan­cial Cri­sis? and The Uncer­tain Value of Mort­gage Secu­ri­ties (among other posts) in late Sep­tem­ber. How­ever, the government’s exe­cu­tion and lack of plan­ning has been even worse than we could have imag­ined, and we had extremely low expec­ta­tions to begin with. 

As we have been men­tion­ing since that time, we wish fed­eral gov­ern­ment would pro­vide tax incen­tives – say, mort­gage invest­ment tax cred­its – to moti­vate pri­vate pur­chases of trou­bled assets. 

We also wish the gov­ern­ment would expro­pri­ate the worst offend­ers – the most poorly cap­i­tal­ized large banks. We know that the Trea­sury can’t run banks any bet­ter than the exist­ing man­age­ments, but that’s not one of our reasons. A main rea­son is to moti­vate other health­ier insti­tu­tions to act. Hav­ing ready buy­ers – moti­vated by such tax cred­its – would cer­tainly help those banks exchange assets for cash, and that lack of trade keeps the analy­ses of each bank’s finan­cial con­di­tional need­lessly opaque, and that’s (by def­i­n­i­tion) no way to resolve uncertainty.

We’re not sure when dur­ing the day, Mr. Paul­son spoke of new pro­grams (Paul­son Says Trea­sury Actively Mulling New Res­cue Pro­grams), but we doubt if that stemmed the (ebbing) tide of sharply decreas­ing equity val­ues. Unfor­tu­nately, there is no rea­son to expect any pos­i­tive news any time soon.

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.