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In our previous
discussions about how banks work, we noted that the presence or quantity of
impaired loans on banks' balance sheets tends to get way more attention than
it deserves. The problem is generally not loans that have already had issues,
but rather the flow of new bad loans, in other words the continuing
deterioration of credit conditions, which typically reflects broader economic
factors that banks themselves can't do much about. Thus, rather than having
bankers do something about their bad loans, it is best for politicians to do
something about the economy.
February 24, 2008: How Banks Work
4: Banks and the Economy
February 17,
2008: How Banks Work 3: More Elephant Poop
February 10,
2008: How Banks Work 2: Shitting Like an Elephant
February 3, 2008:
How Banks Work
This can help even those
loans that have already had issues, as an improving economy can increase
recoveries for loans, or allow borrowers to become current on their payments,
thus reducing banks' losses.
Usually there is a pretty
clear economic impairment -- very often high or rising taxes, or monetary
instability -- which can be solved by a policy change. The present situation
is somewhat different. There have always been credit busts, but the present
one is rather special both in its extremity and extent around the world. (I
have heard that, to some extent, the US housing boom in 2001-2002 was
centrally engineered to compensate for the recession of that time -- and I'm
not talking about the Fed funds rate target alone.) Thus, the present
situation is a bit of an exception to the general rules I'm presenting here.
The government should do what it can to promote economic health, via a better
tax system or monetary stability, or at the very least not make things worse.
However, to the extent that the present situation does not reflect broader
economic issues (high or rising taxes, or monetary instability), then the
sloppy lenders and the sloppy borrowers have to take their losses. There is a
responsibility for the government to keep this process from getting too far
out of hand, which is why I focused on bank recapitalization a few weeks ago.
January 27, 2008: Crisis
Management
We're now hearing that
our little adventure in Iraq may end up costing the US taxpayer in the
neighborhood of $2.4 trillion, or more (probably).
Thus, the government has more than enough resources to take care of the
banking system, if necessary, if it wasn't expending those resources to blow
stuff up and kill people in the desert.
Typically, as bad loans
at banks pile up, there is a suggestion that they "solve the bad loan
problem" by selling the loans. This doesn't make the bad loans
disappear, of course, it merely transfers their ownership. As far as the
broader economy is concerned, it generally matters little who owns the loan.
(These days, most borrowers probably don't even know who owns their loan.) As
loan losses mount, banks' capital bases become strained. There are two
immediate ways to deal with this: get more capital, or shrink the balance
sheet, possibly by selling loans. But, a bank could just as well sell
performing loans rather than non-performing. What difference does it make?
Indeed, a bank might be better off selling some "good" loans for
$1.02, when the bank thinks there might be problems that will make their
ultimate value more like $0.96, instead of selling some "bad" loans
for $0.20, when their ultimate value might be $0.65. Indeed, to sell
"bad" loans for a deep discount can create more losses for a bank.
If a loan is on the books at $0.65, and this is a reasonable figure for
ultimate value, but the bank sells it for $0.20, then the bank has to take an
additional $0.45 loss on the loan, which means more
capital impairment.
If a bank can sell good
loans to others, then it can continue to make loans, and thus we see that the
bank's capital base is not really a restraint on lending. Indeed, banks have
been getting more and more into this business model over the past twenty
years, packaging loans and passing them along to other investors in the form
of asset-backed securities, etc.
We can also see that, if
there is a buyer for a loan (good or bad), then in effect more capital comes
into the banking system. It may not be on banks' balance sheets, but
effectively there is some entity willing to make loans, and that entity has
capital.
Typically, banks
recognize that in an environment where there is lots of supply of impaired
loans, but not very many buyers, they are better off holding the $0.65 loan
and getting $0.65 for it eventually, or even $0.50, rather than selling it
off for $0.20 and taking another $0.45 loss. That's when you start to hear
the economists of the big brokerages start to make all sorts of arguments
that banks need to "take care of the bad loan problem" by selling
off their bad loans en masse. Of course the journalists pick up on it, and
the politicians start to hear this from everywhere that "banks could
take care of the bad loan problem, but they are being stubborn and holding on
to them."
This is often driven by
the fact that it is quite a wonderful business to buy a $0.65 loan for $0.20.
So, the bad-loan vulture investors start to have private conversations with
the politicians, about how they could Do Wonderful Things for the National
Economy if the stubborn banks would Just Solve the Bad Loan Problem by
selling off their bad loans. Often, the politicians relent and actually force
banks, through legislation if necessary, to liquidate their inventories of
bad loans. Since all the banks are then selling all at once, as mandated by
the government, the supply of loans is extreme, and there are not very many
buyers, certainly very few domestic buyers, but only the foreign vulture-type
investors who have been quietly encouraging this whole process. The banks
thus sell the $0.65 loans to the vulture types for $0.20, or $0.10 or $0.02
or whatever. This causes catastrophic losses to the banking industry, at
which point the banks themselves are then bought out by other foreign vulture
investors, including the big banks of the U.S. or Europe. Thus, the process
of economic colonization continues.
Now, selling a loan
simply changes ownership. It doesn't make the bad loan disappear. The loan
still needs to be "worked out" in some way, which can take several
years. The original bank might have been very careful about this process.
They have a multi-year relationship with the borrower. They understand the
business, the possibilities, the markets, and so forth. They make careful plans
to get the $0.65 value out of the loan, or maybe more than $0.65. The new
foreign vulture investor is often a lot sloppier about this process. If they
bought the loan for $0.10, it doesn't really matter if they get $0.20 or
$0.30 for it. Either one is a huge profit. They like to do thinks quick and
sloppy, book the profits, collect their bonuses, and buy another house in Sun
Valley. This liquidation itself often has rather poor economic consequences.
The foreign vulture
investor types probably haven't really thought all this out. Maybe some of
them have. Most probably believe the myth that "taking care of the bad
loan problem" is the path to economic recovery. They would rather not
think about it too much. That could be inconvenient. In the end, they'll say
anything, and believe anything, if it helps them buy a $0.65 loan for $0.02.
* * *
One concept that is
blowing up in people's faces right now is that of "mark to market."
Experienced investors know that, often, "market" prices diverge to
an extreme extent from underlying value. They assume that the market is wrong all
the time.
The only questions are: is the market wrong enough to be useful to me, and
can I come to a reasonable determination of how wrong it is? Often, markets
are very wrong, but it is difficult to tell how they are wrong. For example,
the market price of Google is probably grossly different than its actual
economic value over the next thirty years. However, it may be hard to say
just how wrong the market is, or even the direction in which it is wrong! It
takes experience in investing to become an experienced investor. Most people,
as they do for any topic that comes their way, look for the consensus. A
market price appears to be a consensus, although that may not actually be the
case at all. Maybe the reason that security A is falling in price is due to
the selling of Fund X. Maybe the selling in Fund X is due to redemptions from
investors, caused by Fund X's losses in security B. It may have nothing at
all to do with security A. In any case, the fact that most people consider a
market price to be a consensus creates a consensus that the market price is a
consensus.
WSJ: Mark to Meltdown?
Hedge funds and the like
are in the mark-to-market business. It's the game they play. If they buy WMT
at $15 and it goes to $10, then they deal with that on that basis, even if
WMT stock is really worth $80.
That's why we see, for
example, that it is very difficult to use lots of leverage in stocks
(excepting some hedged strategies), because of the daily volatility of stock
markets. Just try to buy-and-hold the S&P 500 at 3x leverage. You would
be liquidated on the first 15% decline. However, private-equity firms
regularly use 4x or 5x leverage, because they are subject to the underlying
business, and its cashflows, rather than the silly market.And these are individual companies. The S&P
500, as a whole, due to diversification, has much more stable operating
characteristics than virtually all individual companies.
However, there are more
and more companies, which are really operating companies rather than
investment funds, that are being treated like investment funds. This is
getting dangerous. Take the strange example of Thornburg Mortgage. This is
basically a mortgage bank, which makes loans to upper-income homebuyers.
Their clientele is gold-plated. Here is the average borrower:
47 years old
$435,000 annual income
High FICO
$656,000 mortgage
LTV 67%
Thornburg has had total,
cumulative credit losses of $174,000 in the last ten years -- on a $30
billion book! At present, only 78 of 38,000 loans (0.2%) are 60 days
delinquent. It made $286 million in 2006. Thus, it could take a loss of $286
million, and still be in reasonably good shape. If it took a total loss on
all 78 of its delinquent loans (not likely as they are well collateralized),
that would cost about $50m. Operationally, Thornburg looks fine.
However, Thornburg has
become a victim of the "mark to market" mentality. The
"market" has said that loans like Thornburg's are worth perhaps
$0.95. These "losses" made Thornburg's balance sheet look iffy.
Some of Thornburg's lenders demanded that Thornburg sell some of its loans to
reduce leverage. Thornburg was thus forced to sell $22 billion of its
mortgages for about $0.95, resulting in a realized $1.1 billion loss. Instead
of just sitting on the mortgages, all of which were paid in full, and maybe,
perhaps, experiencing such a disaster that it recovered only $0.95 on its
mortgages, Thornburg ended up taking an actual cash loss in the market! And,
because of the selling of Thornburg and others like them, the market price
fell further! Producing even more problems for Thornburg!
Let's think about what
would have to happen for Thornburg to actually take a 5% loss on its loan
portfolio. Let's assume that the price of the houses that serves as
collateral for Thornburg falls by a whopping 50%. Remember, the LTV is 67%.
So, if the house was originally appraised at $1m, then there would be about a
$670,000 mortgage on it. (Which is just about in line with the actual
figures.) Then, if the market value of the house fell by 50%, the house could
be sold for $500,000. Remember, this is an average, not just the single worst
house in the bunch. Thus, Thornburg would have a $670,000 mortgage and a
$500,000 house, for a loss of $170,000. That would be about a 25% loss on a
$670,000 mortgage. Now, people don't just stop paying their mortgages just
because their house is worth less than before. Certainly not people making
$435,000 a year. But let's say there is mass job loss among these borrowers.
20% of them lose their jobs and are unable to pay their mortgage. 20% -- that
is a huge figure. That's 6,707 mortgages -- compared to 78 presently. And,
none of these 20% has any other assets that could be used to pay off the
mortgage. (Remember, these people are making $435,000 a year.) It's just a
total disaster -- which doesn't really happen in real life. Some of the
borrowers pay the mortgage by selling their yacht, or their vacation house,
or some stocks, or their third and fourth cars, or whatever. Or the loan
terms are changed so the monthly payments are less, so the borrower keeps
paying and there is only a partial loss. Or maybe they get another job. But
if all these terrible things happened, the loss would be about 25% * 20%, or
5%. Or $1.1 billion. And, that would be spread out over a couple years, so
that the losses could be matched against income from performing debts. You
can see why Thornburg has had so few realized losses over the years. It takes
absolute Armageddon for them to suffer a 5% loss.
And what happened to the
people who bought mortgages from Thornburg? After all, if the mortgages
were basically OK, then they should have done well, right? No -- they blew up
too!
Peloton Partners Asset Sale
These were smart guys --
and they bought best-quality mortgages, like those of Thornburg. They bought
with only 5x leverage, which is about half that of a normal bank. However,
with all the other sellers hitting the market -- Thornburg-like entities --
prices collapsed further in February. Now Peloton has to sell, into the
collapsing market, causing -- you guessed it -- more problems for Thornburg.
Thornburg is now in
default. It may go bankrupt and be liquidated.
Operationally, everything
is fine. People are paying their mortgages on time. However, due to today's
rather extreme allegiance to the "mark to market" concept, entities
are blowing up right and left.
* * *
This is wonderful. Video of Richard Nixon announcing
the end of the gold standard in 1971. Be sure to listen for all
the goofy rationalizations.
Nathan
Lewis
Nathan Lewis was formerly the chief international economist
of a leading economic forecasting firm. He now works in asset management.
Lewis has written for the Financial Times, the Wall Street Journal Asia, the
Japan Times, Pravda, and other publications. He has appeared on financial
television in the United States,
Japan, and the Middle East. About the Book: Gold: The Once and Future
Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is available at
bookstores nationwide, from all major online booksellers, and direct from the
publisher at www.wileyfinance.com or 800-225-5945. In Canada,
call 800-567-4797.
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