Uncertainty now in the box
By Daniel M. Ryan
If the market averages are any gauge, the Obama Administration's stimulus and assorted credit-reflation plans aren't going to have the hoped-for effect. When Commerce Secretary Timothy Geithner announced the new framework for bank rescue, both the financials and market averages tumbled. The passage of the stimulus bill itself hasn't been received all that well either, although I have not heard anyone pining for the good old days under the waning Bush Administration.
If President Barack Obama wanted a rescue plan that would treat Wall Street harshly, as a responsibility of the aid, then he's gotten his desire. More than a few troubled-bank stocks are presently lower than they were at the November plunge. The only group of financials that have seen the clouds lifted from them are the big brokerages. If policies are judged by effects, then the Paulson plan has succeeded in rescuing the big brokers (except for Lehman Brothers, of course.)
Despite the continuing awful news in the economy, there are hints of recovery coming: the most recent was unexpectedly strong consumer spending in January. This strength could be attributed to the stimulus plan, or it could be taken as supporting Larry Kudlow's mustard-seed hypothesis. Either way, there are signs that the stimulus bill's enactment will accompany an economic recovery. Come 2010, Democrats will likely be bragging that the "Obama Plan" had turned things around, regardless of the true cause-and-effect sequence.
The likely consequence of the Obama Administration's attempts to rescue the banking system will be an unexpected one, as was the Bush Administration's. Despite the awful drop in home prices so far, the current iteration of the All-Banks All-Rescue initiative should put the residential real estate bear to sleep. Leaps in mortgage refinancings and surprisingly large foreclosure sales will be amplified by the foreclosure-relief part of the plan, and spill over into a troughing in home prices. Despite it being promoted as the be-all and final installment of Bailout Nation, though, it's unlikely to restore full confidence. That's because there's a crucial element missing, one that explains why private capital has not been that bold in buying up so-called toxic assets.
Most of these are mortgage-based securitizations, such as CDOs. The reason for the general gun-shyness is because no-one knows what's in them. This point was made last Thursday evening on CNBC, where Thomas Patrick presented a plan to take the performing mortgages out of CDOs and SIVs at par. It was shot down by CNBC reporter Charlie Gasparino on the grounds that performing mortgages may not perform at all in the future. Because no-one knows what's in those securitizations, they're not really buyable. This impression explains why mortgage-rooted CDOs and SIVs are selling way below what their present cash flow indicates, a disparity that Mr. Patrick's plan depends on.
In less fearful times, an exact inventory of the mortgages therein was considered superfluous. All that any buyer needed to know was the cash flow and performance ratio if the rating didn't suffice. The securitization was supposed to take care of any idiosyncrasies, and make any deviations predictable by the laws of statistics. It's easy to see that anyone who insisted upon an inventory of the underlying mortgages was dismissed as old-fashioned. It's ironic that such stodginess may very well be the only rescue plan that'll succeed.
There is a definite bottleneck, as evinced by the above-noted disparity between CDO price and its underlying cash flow. Had statistical structuring sufficed, those stricken CDOs would have been picked up by now. Someone who expects, say, seventy cents on the dollar would be glad to buy at, say, sixty cents. This process isn't happening, whether it's caused by fear or rational prudence. It's a stark demonstration that statistical carefulness isn't enough for the rough times.
Maybe the above point is somewhat reactionary, but the evidence is plain. The current financial crisis could be called a case of Murphy's Revenge.
There may not be any need for further regulation to make sure this mess doesn't come about again, although it's likely that such regulation will be broached. The free market has a solution, like the ratings firms in their days of inception, even if said solution has yet to make an appearance. What the mortgage-based CDO and SIV market needs is a set of firms that will inventory the underlying instruments, right down to the individual contracts.
This function has traditionally been done in-house, but most financial houses tend to treat this work as a much-disdained cost center. A strong and effective inventory-verification department is too at odds with present Wall Street culture to be treated any differently. With outsourcing, though, that culture clash will disappear. Careful checkers will be dominant in a firm that sells thoroughness and probity.
The most likely customers for such a firm would be just like the first customers of the ratings agencies…the institutional buyers. As the lawsuits drift into the courts, it will become plain that due diligence firms will find a ready market.
Get weekly updates about new issues of ESR!