White House Rallies Markets - For How Long?
By Karl Denninger
Yesterday afternoon there were two pieces of "news" that between them caused quite a ramp job in the markets off the lows - lows that threatened to
cascade into a crash (gee, where have we seen this movie before?)
The first was that The Fed held a conference call in which they apparently confirmed that they will be granting 90% non-recourse financing for
purchasers of debt via the TALF. Yours truly was not invited, of course (big surprise - not!) but this was the widely reported result from people who
were on the call. I have identified my problem with this program before; it is effectively an appropriation of $900 billion (the $1 trillion less the
10%) because any losses beyond the "cash in" component from investors will be taken by The Fed and thus the taxpayer, although there has been no
appropriation in The House to authorize it. The Constitution prohibits such nonsense and what's worse is that Bernanke will almost certainly
"create new bank reserves" (that is, devalue our currency!) to cover any losses.
This program will not restart securitization of stupid loans, so they say. Or will it? It may clear some of the trash off a few balance sheets and
dump the loss on the people instead of on the guilty parties. Nice, if you can pull it off.
The real problem with TALF is that as noted above it is not in comportment with The Federal Reserve Act, which requires that The Fed lend against good
collateral, not take ownership stakes in things. Irrespective of whether you think securitization markets for things like credit cards and auto loans
should be restarted the fact remains that allowing our central bank to do this amounts to allowing them to transfer any bad debts that consumers take
on to the taxpayer balance sheet without oversight or review by Congress or anyone else.
This power is restricted to Congress for a very good reason; we allegedly live in a Constitutional Republic, and Constitutional Republics demand that
you have representation to go along with your taxation. 230 years ago we had a little war over this issue, if you remember your history. Today we
are throwing that basic principle out the window under the rubric of "exigent circumstances", even though The Congress at the time of The Fed's
creation did not give them this power even under those circumstances because the power to tax, handed to one person or group of people meeting behind
closed doors with zero public accountability, is the essence of crowning someone a Sovereign - that is, KING.
CONgress, being unable to parse beyond "spending money is good", refused to address this when Bernanke was on the hill a couple of days ago. This
is no big surprise, but ultimately this is also an issue that one way or another must be faced and dealt with. While some people think that Bernanke
is "the right person" to guide us through these perilous times, that is simply not the point, nor is it material to the discussion. The fact
remains that so-called "AAA" securities have been proved to be toilet paper and so-called "eight sigma events", which are supposed to happen once
in the history of the universe, have been popping up every couple of days.
What is clear to this commentator is that someone's confidence bands are set incorrectly and so are that same person's assumptions. Since I do not
believe that such events come about purely as a result of random chance, but rather are mostly the consequence of acts of either omission or
commission in our "power agencies" in the United States, I therefore reject out of hand the idea that we can "safely" stretch the boundaries of
The second, however, is the real reason for this note - that's the following reported by MSNBC among others:
"The White House is considering a proposal to head off potentially millions more home foreclosures by using federal funds to buy up at-risk loans
and then refinance them with more affordable terms.
Treasury Secretary Timothy Geithner and other Obama administration officials met Wednesday with a group of top bankers, community groups and
financial industry representatives to discuss the plan.
Under the proposal, the government would draw on $50 billion in funds already approved for the financial bailout to buy up millions of mortgages
at a discount. A $300,000 mortgage on a house now worth $200,000, for example, might be bought at a 30 percent discount.
The homeowner then would be able to refinance the smaller mortgage with lower monthly payments. The government could then sell the loan back to
investors, freeing money to buy more loans. "
While this sounds constructive, there are two immediate problems:
1. $50 billion isn't much money. If that's all that's really involved, it will do little or nothing in fact. I suspect The Fed intends to
"fan" the money much as they are with TALF funding, effectively treating the $50 billion as new bank reserves and then running the restructured
loans through Fannie and Freddie which they then purchase. This sort of convoluted structure would turn that $50 billion into $500 billion, but once
again, it would be blatantly illegal if done this way without enabling legislation. That hasn't bothered The Fed up until now and I don't believe
it will this time either if they decide to chase this particular path.
2. The bigger issue, however, is an obscure little clause in a bunch of securitizations. See, a good number of them - especially ALT-A and HELOC
paper - have a nasty little clause in them that a modification that involves reduction of the balance (which this plan does) is not taken "up the
securitization chain", as is done for ordinary losses, but is instead spread evenly over the entire structure.
This latter "feature" is a major problem. See, structured finance depends on the "lower" capital elements taking "first loss" and protecting
the higher ones.
For instance, you might have a structure that looks like this:
The Super-Senior and "Senior" tranches of this debt might make up some 60-70% of the total. The way the contractual documents are drawn up
(hundreds of pages in most cases) losses that are due to lack of performance (Joe can't pay his loan) get taken first by Equity, then when that is
wiped out by the Mezzanine, then by Subordinated, and finally into the Senior and Super-Senior.
Only when the tranches below are wiped out does the next one up the line take loss. This is how these things manage to get "AAA" ratings - it is
this protection afforded by the lower tranches (which, incidentally, pay a higher coupon - that is, for the extra risk you get more interest) that
makes the "magic" possible.
But this nasty little clause means that instead of the loss being absorbed by the lower elements in the structure first in the event of a
mass-modification movement - which is outside of the control of the securitization owners or the servicers - everyone up and down the line will take
the hit equally - that is, pro-rata - across the entire structure!
This will almost certainly cause all of the securitizations with such a clause in them to lose their "AAA" ratings instantaneously (since nobody has
a way to know which ones MIGHT get hit, but all are at RISK of getting hit), and not by a few grades either. In most cases it would result in a
downgrade to "A" at best, and in some cases to "unrated" (or worse, "D" or "default" if actual losses are recognized.)
What makes it worse is that in many cases these structures are already damaged from defaults - that is, the lower-rated tranches may have already been
either impaired or in some cases totally wiped out. Spread a loss over a smaller number of suckers, er, holders, and each takes a bigger hit.
This will wind up causing massive forced sales and panic among those who hold this paper. In fact, if the denied meeting at Goldman really took
place, I'll bet my last nickel this is what it was really about.
It will also totally screw with securitization going forward. If I buy something that I believe is protected by the holders of inferior tranches under
me, and I am getting paid a lower coupon in exchange for that protection, if you rip that protection away from me I will never make that mistake
See, the buyer thought that the entire instrument had to take a 40% loss before he was impacted. That, of course, is unlikely - even if half the
people default on their mortgages and the houses are only worth half the purchase price, you still don't get to a 40% loss in aggregate (with rehab
and resale expenses.) This is why the super-senior tranches were considered safe - short of global thermonuclear war it was believed there was no way
you would lose.
Now consider where that "AAA" paper is and what happens if it takes a 20% haircut, or even if it just loses all but 10% of its "support" - that
is, only ten percent in further loss now causes me to lose money.
Some of that formerly-presumed "safe" paper might be in places like.... oh..... money market funds.....
Full article here
edit to fix headline
[edit on 2/13/09 by redhatty]