Monday, August 30, 2010

GSEs Prevented Private Secondary Market

"A private secondary market for prime mortgages should have been a natural market development. Why did it never develop? The answer is obvious: no private entity could compete, or can now compete, with the government-granted advantages, and now the huge explicit subsidies, of the Government Sponsored Enterprises (GSEs). There can be no evolution of a private prime mortgage loan market while the GSEs make private competition impossible.

The core issue about GSEs is this: You can be a private company, with market discipline; or you can be part of the government, with government discipline. But you can't be both."

Read more of AEI's Alex Pollock's article "To Overhaul the GSEs, Divide Them into Three Parts" here.

32 Comments:

At 8/30/2010 8:43 AM, Blogger morganovich said...

that's exactly right.

the GSE's were crummy organizations with terrible lending and investing discipline.

they got by on precisely one thing: the ability to leverage a tacit government guarantee into low cost of capital and thereby outbid everyone else.

they could always answer declining margins with more volume, and they became the whole market, not only removing discipline from the prime market, but also relegating the private guys to sub prime only, grabbing what should have been the best of the business and leaving the worst for the private sector.

in health care terms, this would be like the government covering all the health patients and leaving only the sick and complicated ones for the private carriers.

this is still getting worse. what are the GSE's now, 90% of the origination market?

 
At 8/30/2010 8:59 AM, Blogger VangelV said...

So much for free markets and the invisible hand dominating the American economy. The reality is a lot different than the claims.

 
At 8/30/2010 9:07 AM, Blogger juandos said...

"The reality is a lot different than the claims"...

That reality probably will never change if this is what passes for education...

 
At 8/30/2010 10:57 AM, Blogger bix1951 said...

question about definitions

when does a recovery become an expansion?

news still says recovery
what does it take to call it an expansion?

by the way,
my business is still in recession
I define that as falling revenues

 
At 8/30/2010 10:59 AM, Blogger Jason said...

juandos: That may be the final sign that apocalypse is upon us.

The seals, broken. The rain colored as blood. Parents paid for children's school attendence...

 
At 8/30/2010 12:25 PM, Blogger morganovich said...

bix-

these terms are often misused so expect to see bad usage in the media, but the correct definitions are as follows:

a recovery becomes an expansion when the prior peak of GDP is exceeded.

so, if gdp is 100 and drops to 90, that's recession.

growth from 90 back to 100 is recovery.

growth from 100+ is expansion.

 
At 8/30/2010 12:46 PM, Blogger bobble said...

i agree that the GSE's are a mess that should be eliminated.

additionally, the bush/paulson TARP program has established the TBTF banks as private financial institutions that have the implicit full faith and credit of the federal government behind them.

as you correctly point out; " You can be a private company, with market discipline; or you can be part of the government, with government discipline. But you can't be both."

 
At 8/30/2010 1:03 PM, Blogger morganovich said...

bobble-

a though on refining your thinking a bit on TARP.

there are 2 kinds of crises that can hit a financial institution: illiquidity and insolvency.

the former is precisely the sort of situation the fed aand fdic ought to bail out. a bank has plenty of long term assets to cover short term obligations, but they cannot be liquidated right now. an injection of funds to help alleviate a duration mismatch is fine so long as the collateral is good.

note: this is a very typical situation at a bank. deposits can be withdrawn any time, but the mortgages are 10-30 years. you can make estimates about how much money you need on hand to cover likely withdrawals, but you may not always be right. getting caught short is not a reason to take an otherwise prudent bank under.

insolvent is another issue. insolvent means your assets can't cover your debts, even if you sell them all. that's not timing, that's bankruptcy.

where TARP failed it was due to failure to discriminate between the 2. the illiquid guys like MS, GS etc all paid them back in short order. the sinkholes have been AIG and the GSE's, companies that were clearly illiquid.

of interest, this "take you profits early and let your losers run" portfolio strategy would have been avoided under the original plan for tarp.

recall that paulson's original plan was to buy up distressed assets (mbs's etc). that would inject liquidity, but not such the government into insolvency problems. it would also have allowed many issues to be redeemed at par, eliminating the massive derivative exposure overhanging many of these issue at 200:1 + leverage.

the UK did just that and it has worked well and is throwing off a big profit for the treasury.

i do not know how nancy and harry got paulson to put his tail between his legs and accept the horrid and certain to lose money TARP they demanded, but they did, and so, the taxpayer is going to get hosed.

frankly, i think it was because they knew that the GSE's were going down and could not be helped by asset purchases and didn't want to craft a bail out especially for them and make barney look bad.

you are absolutely correct that the response we made added risk to the system going forward.

the shame is how easily it could have been avoided.

 
At 8/30/2010 1:11 PM, Blogger VangelV said...

That reality probably will never change if this is what passes for education..

You don't believe that the reality will never change. You think that things will get even worse.

 
At 8/30/2010 2:18 PM, Blogger bobble said...

This comment has been removed by the author.

 
At 8/30/2010 10:36 PM, Blogger juandos said...

"You think that things will get even worse"...

Yes VangeIV the ongoing decline of public education mixed with a complete lack of discipline and bribery doesn't bode well for us...

 
At 8/30/2010 11:20 PM, Blogger Ron H. said...

juandos said:

"That reality probably will never change if this is what passes for education..."

Unbelievable. Truly sad.

I can't imagine sending my kids to a particular school because I got paid $300

 
At 8/30/2010 11:34 PM, Blogger Ron H. said...

"you can make estimates about how much money you need on hand to cover likely withdrawals, but you may not always be right. getting caught short is not a reason to take an otherwise prudent bank under."

morganovich, isn't this what overnight money is for? If the bank suffers more than a temporary oopsie, isn't a more serious problem indicated? I would think that prudent reserve management should be part of the banking game.

 
At 8/31/2010 12:12 AM, Blogger srmsoft7 said...

Building on the movement that elected President Obama by empowering communities across the country to bring about an agenda of change.clickhere to know more details about OBAMA

 
At 8/31/2010 10:25 AM, Blogger juandos said...

Hey srmsoft7, I think Alex Stuart is truly delusional but capable of spewing unsubstantiated silliness...

 
At 8/31/2010 11:37 AM, Blogger morganovich said...

ron-

it's a bit more complicated than that.

this wasn't a run on deposits.

what actually happened was that banks found themselves outside their required capital ratios due to a market crash.

if you own an MBS, that even in a horrid market will still return 90% of principal, but it's trading like that number is 50% because the market is in panic, then mark to market requirements on that (and quite possibly your whole loan book) suddenly make it look like you just lost 30-40% of assets.

if those assets are still good and the mark to market is bad, that is illiquidity. that is the sort of situation when it is good and proper for the fed or the fdic to intervene and either buy the distressed assets or allow their use as collateral for borrowing. (the other option is to not mark such assets to market, which is what was used for a long time. it does limit these sorts of crises, but it has profound effects on the transparency of balance sheets)

if those assets are really so impaired that they cannot cover liabilities, then you have an insolvent company, which is a different problem.

of course, determining which is which in the midst of a crisis can be a bit tricky...

 
At 8/31/2010 1:29 PM, Blogger Ron H. said...

"If those assets are still good and the mark to market is bad, that is illiquidity. that is the sort of situation when it is good and proper for the fed or the fdic to intervene and either buy the distressed assets or allow their use as collateral for borrowing"

morganovich, thanks for your explanation. I had forgotten that that was the original purpose of the Troubled Asset Relief Program. It seems that most of those funds got misdirected.

 
At 8/31/2010 3:22 PM, Blogger VangelV said...

Building on the movement that elected President Obama by empowering communities across the country to bring about an agenda of change.clickhere

to know more details about OBAMA


There are no details of importance. For example it would be interesting for the readers to find that Obama was the first president of the Harvard Law Review and a law professor who has never published legal papers that would clarify his legal thinking. From what I can tell his name does not appear on any piece of legal scholarship and that before he was elected to the Senate he was known far more for his political activism than he was for his legal work.

Obama is clearly a weak leader because he takes no stance that is based on principle and is willing to compromise what he believes in to make political deals that only deliver short term deals.

 
At 8/31/2010 3:34 PM, Blogger morganovich said...

the problem with using equity infusions is that they are black holes. buying troubled assets or allowing them as collateral for loans is fine because it means you need assets to participate.

preferred equity works the other way - the illiquid guys need little and pay it back quickly. then guys who are insolvent just keep needing more. they rapidly become the whole of the program as freddy, fannie, and aig have.

rule one of stock portfolios is cut your losers quickly and let your winners run.

tarp as it was implemented is the precise opposite.

it's losses will be massive, but they are all going to come from the 3-4 really bad apples.

 
At 8/31/2010 4:00 PM, Blogger VangelV said...

if you own an MBS, that even in a horrid market will still return 90% of principal, but it's trading like that number is 50% because the market is in panic, then mark to market requirements on that (and quite possibly your whole loan book) suddenly make it look like you just lost 30-40% of assets.

That is because you did lose 30-40% of assets. Market value does matter and the institutions need to use accounting that is reflective of reality.

if those assets are still good and the mark to market is bad, that is illiquidity. that is the sort of situation when it is good and proper for the fed or the fdic to intervene and either buy the distressed assets or allow their use as collateral for borrowing. (the other option is to not mark such assets to market, which is what was used for a long time. it does limit these sorts of crises, but it has profound effects on the transparency of balance sheets)

The market gets the story right far more often than the regulators. When mortgage bonds that are backed by loans to people who can't afford to pay back the lenders go south their market value should fall and should be reflected in the accounting. We can't assume that the Fed will step in and buy those bad assets at par to bail out the institution until after the Fed steps in and bails out the institution.

if those assets are really so impaired that they cannot cover liabilities, then you have an insolvent company, which is a different problem.

of course, determining which is which in the midst of a crisis can be a bit tricky...


It is not all that tricky at all. If there is value someone will step up to the plate and buy it. Even LTCM's paper had Buffet standing on the sidelines waiting to purchase it. Instead of doing what it should, the feds panicked and stepped in instead. That action helped to create the next bubble and the one after that because huge investors figured out that governments will step in and bail them out during the bad times while they could keep the profits during the good times.

 
At 8/31/2010 5:47 PM, Blogger morganovich said...

vangel-

i'm not going to argue that markets are not more accurate most of the time. they are.

but not all the time.

in a panic, they can be wildly inaccurate. MBS's were trading far below fair value. those who bought them at the end of 2008 and early 2009 have made a killing on them. (and i have first hand knowledge in this market, but look at how the UK treasury did as another example)

markets overshoot. that's not a reason to take the banks down.

the value of the cash flow stream from these instruments did not change nearly as much as their prices did.

you argument about "if there's value someone will step up and buy it" is only true in the long run. too strict an adherence to such dogma is incredibly damaging. pretending markets are always efficient doesn't make it so.

you have to understand that MBS's are not like treasuries. they don't trade much. they are not standardized. there is no listed market.

a surprisingly precise analogy would be this:

imagine that you own a house worth $1 mnillion. you put 10% down, and agree to the bank that you will put up more capital if your equity ever goes below that 10%.

you neighbor goes through a terrible divorce and has to sell his $1 million house for $700k. he's desperate, and that's that.

now, because of that transaction, the bank marks your house to "market" and you owe another $270k. it's the same house. is the "market" right? this may be the only transaction on your block for months. worse, you may not have the $270k, so now you are a really desperate seller. you have to sell your house for $600k (if you can find a buyer at all). now your other neighbor has his equity wiped out by your transaction and is margin called. repeat until crisis. realize that such a scenario does not even require a housing crash. it can just be idiosyncratic. in an actual crash, it's much, much worse.

this is the problem with thin markets in non standard products.

markets can be driven for extended periods by such series of knock on effects.

MBS's (and individual mortgages) are not like us treasuries.

you are pushing the free market ideology too far. in a liquidity crisis, such assets will always react violently, far more so than indicated by cash flows.

not taking that into account is part of what make this crisis so bad. if everyone has to mark assets to market from a few transactions, suddenly, none of the would be buyers have any money because the mark wiped out out their capital margin and they are all out of compliance too.

you don't mark individual mortgages to market, you deal with them actuarially. why should a bundle of them be different? before you answer "because there was a traded price" ask yourself, does that mean that if i sell one mortgage, the whole industry should takes it's pricing from it?

the secondary market for MBS's is minuscule. a tiny, tiny % of them ever trade. is it rational for a sub 1% portion of a market to drive the whole market? if cisco traded 100 shares twice a week, would you trust that as an accurate price signal?

 
At 8/31/2010 7:48 PM, Blogger VangelV said...

in a panic, they can be wildly inaccurate. MBS's were trading far below fair value. those who bought them at the end of 2008 and early 2009 have made a killing on them. (and i have first hand knowledge in this market, but look at how the UK treasury did as another example)

We are talking about two things. You are saying that a market can overshoot so a hedge fund or individual investor can make a pile by buying paper for less than what it may be worth.

I do not dispute your claim. What I am saying is that a bank has liabilities in the form of deposits that need to be balanced by holding marketable assets and reserves. When a bank sees the value of its holding crash it needs to mark down the assets and raise capital to have sufficient reserves to meet its obligations.

What you are implying is that it is all right for a deposit taking bank to behave as a hedge fund but pretend that it is holding safe instruments and by doing so pay low rates to its depositors that do not reflect the risk that they are taking. I believe that the banks can't have it both ways. If they take deposits they can't behave as degenerate gamblers and engage in mark to fantasy accounting games. They have to mark to market and have adequate reserves. When they don't, they should be shut down and their assets sold off.

For the record, I have little sympathy for the FDIC or for depositors. If you accept the risks you need to pay for the errors that were made.

markets overshoot. that's not a reason to take the banks down.

The European banks used 60:1 leverage. That is not being a bank but a hedge fund.

 
At 8/31/2010 7:56 PM, Blogger VangelV said...

the value of the cash flow stream from these instruments did not change nearly as much as their prices did.

Correct. The market correctly anticipated that there would be a further reduction in cash flow.

you argument about "if there's value someone will step up and buy it" is only true in the long run. too strict an adherence to such dogma is incredibly damaging. pretending markets are always efficient doesn't make it so.

First, I have never claimed that markets are efficient. I actually make a decent living because they are not.

Second, what is damaging is applying rules designed to regulate deposit taking institutions to players that use leverage like hedge funds. When banks use 60:1 leverage they should face the same consequences as hedge funds do and be forced to raise capital or be liquidated.

 
At 8/31/2010 8:03 PM, Blogger VangelV said...

you have to understand that MBS's are not like treasuries. they don't trade much. they are not standardized. there is no listed market.

I understand that. But you have to understand that MBS's are not appropriate for deposit taking institutions.

this is the problem with thin markets in non standard products.

markets can be driven for extended periods by such series of knock on effects.


A deposit taking institution should not be buying illiquid products because it needs money to satisfy depositors that want to use it. When it can't pay depositors it is insolvent no matter how you try to spin the story about possible future outcomes.

MBS's (and individual mortgages) are not like us treasuries.

you are pushing the free market ideology too far. in a liquidity crisis, such assets will always react violently, far more so than indicated by cash flows.


I am not pushing the free market ideology at all. I have assumed that there are regulations that cover banks and that the FDIC is insuring deposits that are accessible to account holders. What you are saying is that when the management gambles too much and guesses wrong it should be able to deny people access to their accounts but when times are good it should be able to keep paying very low rates that do not reflect the risk taken by the bank. That is dishonest and violates the contract between depositor and bank.

 
At 8/31/2010 8:11 PM, Blogger VangelV said...

not taking that into account is part of what make this crisis so bad. if everyone has to mark assets to market from a few transactions, suddenly, none of the would be buyers have any money because the mark wiped out out their capital margin and they are all out of compliance too.

The banks promised depositors access to their accounts. When they can't keep those promises they are insolvent. You can't deny depositors access to their own money because you bet on illiquid instruments that you hope will go back up in nominal value when governments flood enough money in the system to rob depositors of their savings.

As I wrote a number of times, there is an unregulated market in which hedge funds take lots of risks on MBS paper and their depositors get rewarded or punished based on how the funds do. Those funds have rules in which they can deny holders access to their money for a fixed amount of time. After that period is over they have to return any money that is owed to investors on the basis of market value of the holdings. The banks have no such rules and the depositors do not benefit as much when the bank managers guess right and make a pile because of the leverage that they used. The depositors took low rates in exchange for safety. That means treasuries or equivalent liquid holdings, not illiquid paper.

Here is my scenario. You are a depositor and are told that you can't get your money out because the bank is technically insolvent but that you will be paid just as soon as the market picks up, as it will. The government increases the money supply tenfold and the MBS paper is now paid off in full. You are paid by the bank but now find that your after tax holdings buy 20 times less than they used to when you made the deposit. Isn't that theft?

 
At 8/31/2010 8:16 PM, Blogger VangelV said...

you don't mark individual mortgages to market, you deal with them actuarially. why should a bundle of them be different? before you answer "because there was a traded price" ask yourself, does that mean that if i sell one mortgage, the whole industry should takes it's pricing from it?

You are missing the point. The bank needs to have liquid assets to allow depositors to take out their money as they wish. When it can't do that it is insolvent and needs to be closed down. Illiquid assets are not acceptable because they can't be sold. End of story.

the secondary market for MBS's is minuscule. a tiny, tiny % of them ever trade. is it rational for a sub 1% portion of a market to drive the whole market? if cisco traded 100 shares twice a week, would you trust that as an accurate price signal?

That is why MBS's should not be held by deposit taking institutions. Those are required to hold relatively safe and very liquid assets, which is why they pay so little in the way of interest.

 
At 9/01/2010 8:39 AM, Blogger morganovich said...

This comment has been removed by the author.

 
At 9/01/2010 9:10 AM, Blogger VangelV said...

you do not understand the difference between illiquid and insolvent.

illiquid means you have assets, you just can't sell them right now without taking a huge hit. this is the akin to the homeowner example.

insolvent means you literally cannot cover you obligations no matter what.


I understand the difference. But you ignore the obligations of deposit taking institutions.
When they fail to meet regulatory capital requirements and are unable to rectify the situation on an immediate basis they are insolvent.

To be a bank you have to have sufficient capital to meet demand of depositors. If you fail to have enough capital you need to raise more immediately. If you do not you are deemed insolvent and need to be liquidated because depositors need to be protected from further losses.

These regulations do not prohibit a bank starting up a hedge fund and looking for investors that would allow it to purchase volatile instruments. That option is available for anyone wishing to take the risk. And here is where you come into the picture. You say that it is all right for banks to take deposits, which imply safety and pay low rates, and to use those deposits to buy risky instruments that are illiquid. That it is all right for banks to pretend to be banks and pay low rates to their depositors when they are highly leveraged hedge funds who take the high profits during good times and refuse to pay depositors back when things go wrong.

i presume you agree that it is OK for a deposit taking institution to make loans?

Yes it is.

if so, then why is buying a bundle of loans any different? you claims that MBS's are inappropriate for deposit taking institutions. they are more liquid that raw loans. so what's the issue?

The issue is the need to have adequate capital. When an institution does not, it is insolvent and needs to be liquidated to protect depositors from further losses.

they are more liquid than loans.

their liquidity was the problem. it caused the marks to market based on non representative transactions which triggered cascade of margin issues (again, as in the homeowner example).


You need capital to meet the requirements. It is as simple as that. When you don't have enough capital and hold a lot of illiquid investments you go out and get more capital or get taken out by the regulators. If you want protection against illiquidity go out and start a hedge fund where you don't have to give investors their money back immediately.

sure, some bought to many, but that's like claiming there should be no pasta because some kids get eat too much and get fat.

No. When you can't comply with the regulations you have to get into compliance or go under. Period. I am not saying that there should be no MBS market. I am saying that deposit taking institutions who play the game should pay for the consequences when they are wrong.

you are arguing that banks need to manage risk better, and i agree, but a big part of their problem was driven by bad mark to market rules. few were actually insolvent, they were just caught in a liquidity mismatch.

Actually, if you look at the clear definitions that they work under it is clear that the banks were insolvent. And let us not pretend that things would have gone well if only there was more time. The only improvement came when taxpayers stepped in to buy the crappy paper from the failing banks or when governments stepped in to take the banks over or force mergers.

 
At 9/01/2010 1:18 PM, Blogger morganovich said...

v-

you are confusing illiquid and insolvent.

illiquid means you have assets, you just can't sell them right now without taking a huge hit. this is the akin to the homeowner example.

insolvent means you literally cannot cover your obligations no matter what.

i presume you agree that it is OK for a deposit taking institution to make loans?

if so, then why is buying a bundle of loans any different? you claim that MBS's are inappropriate for deposit taking institutions. they are more liquid that raw loans and can also provide significant risk reduction through geographic diversification. so what's the issue?

their liquidity was the problem. it caused the marks to market based on non representative transactions which triggered a cascade of margin issues (again, as in the homeowner example).

sure, some bought too many, but trying to ban them for that reason is like claiming there should be no pasta because some kids get eat too much and get fat.

you are arguing that banks need to manage risk better, and i agree, but a big part of their problem was driven by bad mark to market rules. few were actually insolvent, they were just caught in a liquidity mismatch.

that is precisely the sort of situation where federal assistance/intervention is needed. once a margin cascade gets momentum, it will lead to a massive blow out if something does not break the cycle.

 
At 9/01/2010 8:30 PM, Blogger VangelV said...

you are confusing illiquid and insolvent.

No I am not. The regulations define what insolvency is. A deposit taking institution is insolvent when it does not have sufficient capital and cannot raise new capital to meet its obligations.

As I wrote above, you want to apply the hedge funds rules to deposit taking institutions that hold demand accounts. But banks are not supposed to be hedge funds and certainly do not offer depositors the same returns as hedge funds. When banks cannot allow depositors that hold demand accounts to take out their money, they are insolvent. Period. End of story.

I think that you wrote a duplicate because I have already answered similar comments from you in a posting above.

 
At 9/02/2010 1:18 PM, Blogger morganovich said...

no vangle, that's not a correct definition.

duration mismatch is not insolvency.

if i owe you $100 next year, and you only have $10 right now, you are not insolvent if you have to pay $30. you have plenty of assets to cover it (as my credit is good), just not right this second.

you keep giving the definition for illiquid and calling it insolvent.

they are not the same thing, nor should they be treated the same way.

using your logic, a bank should not maker loans at all because it means that they don't have the money there is a depositor asks for it. the minute they loan even a single dollar, there is a potential problem.

even if they make no loans at all, the money has to do something. do you propose just holding it as cash with no rate of return? are you willing to pay them to hold you money?

if they buy treasuries, then OOPS there's a duration mismatch again. if they have 2 year bonds, those cannot always be sold without significant investment loss.

the standards you seem to propose would eliminate banking entirely.

a portfolio of MBS's is not functionally any different than a portfolio of loans in terms of downstream cash flow. it is superior if it provides geographic and duration diversity.

so, you never answered the question:

do you think banks should make loans?

if you say yes, then i have yet to hear you provide a single way in which buying bundled loans in an MBS is worse than making individual loans.

 
At 9/02/2010 7:10 PM, Blogger VangelV said...

no vangle, that's not a correct definition.

duration mismatch is not insolvency.


But it is insolvency when you promise people that they will get their money when they want it and you can't give it to them.

Deposit taking institutions knew exactly what the rules were but tried to cheat account holders by taking on hedge fund level leverage as they used deposits to purchase illiquid paper that paid just a bit more in interest than the safer treasuries that they should have been buying. When they could no longer meet the capital requirements they should have been liquidated and sold off to better managed institutions that did have enough capital to meet depositor demands.

if i owe you $100 next year, and you only have $10 right now, you are not insolvent if you have to pay $30. you have plenty of assets to cover it (as my credit is good), just not right this second.

It is a bad example. The banks did not have enough assets that they could sell to meet requirements because the price of what they had to sell was not high enough. They needed money to meet their demand deposit requirements, not return money to investors in a year's time when they were permitted to ask for their cash back.

As I wrote, banks managers are more than capable of opening hedge funds, which operate under different rules than deposit taking institutions. They can't have it both ways and rip off depositors by paying low interests on the understanding that they are investing in liquid assets that would give them access to their funds as promised when they are using massive leverage to purchase higher yielding illiquid instruments. By permitting the fraud to continue we would be saying that it is all right to rip off savers.

you keep giving the definition for illiquid and calling it insolvent.

It is simple. You owe me money now. You don't have it but have 'assets' that you can sell. When you try to sell them you find that they are not worth what you thought and still can't pay me now. This makes you insolvent.

 

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