Wednesday, September 5, 2007

Financial Derivatives and the Business Cycle Redux

The Dow Jones Industrial Average ended up 91 today. But if you were a banker, you didn't have such a good day.

Today, the Federal Reserve and other government agencies issued a "Statement on Loss Mitigation Strategies for Servicers of Residential Mortgages." Written in the understated parlance of financial regulation, the statement urges banks and other institutions that "service" mortgages (i.e., collect the monthly payments, transfer debt payments to the holders of the mortgages, pay out money escrowed for taxes, etc.) to try to work things out so that distressed mortgage borrowers don't lose their homes. The regulators mention various "loss mitigation" strategies, such as deferring some loan payments, rolling delinquent payments into principal (which is another way of deferring them), conversion of adjustable rate loans into fixed rate loans, and even a reduction of the principal of the loan.

Defaulting homeowners who may have been lured into adjustable rate or interest only loans they didn't fully understand may see a little light in the darkness coming from this statement. However, let's not overlook the fact that the statement focuses on "loss mitigation," meaning the reduction of loss. It's not talking about loss to the homeowner. It means loss to the bank. The statement notes that "prudent workout arrangements that are consistent with safe and sound lending practices are generally in the long-term best interest of both the financial institution and the borrower." In other words, any workout has to benefit the lender as well as the borrower, and those borrowers who are in really big trouble may not get a workout.

Why would the Fed and other regulators encourage loan workouts? Stated otherwise, what would happen if there weren't workouts? More homeowners would default, and losses on their mortgages would have to be recorded. Initially, the loss might appear to fall on the hedge funds and other investors that bought the CDO tranches that have an interest in the income stream from these mortgages. However, in many circumstances, the banks that provided the mortgages for the CDOs might have to buy back defaulting mortgages. That would mean much of the loss would fall on the banks. The banks, in turn, could try to make the mortgage brokers who initially originated the loans buy back the defaulting mortgages. But many of those mortgage brokers are now in bankruptcy proceedings, and their buyback obligations aren't worth the price of a pack of chewing gum.

So the loss on many defaulting mortgages will fall on the only remaining deep pockets--the banks. This is the loss the regulators want to mitigate, because if it gets too large, the financial system takes on the consistency of jello. And given the apparently vast amount of losses that may bubble up from the subprime morass, the threat of jello must be taken seriously.

There's more. September is also the month when banks have to begin trying to refinance several hundred billions (yes, billions, not millions) of dollars of loans for leveraged buyouts. Many of these deals have been temporarily financed by bridge loans extended by the major banks (see our blog at However, the banks don't want to be long term financiers of these deals, and would like to sell bonds and other loans to hedge funds and other institutional buyers to replace the bridge loans. That way, if the leverage buyouts fail, yogurt would fall on the investors and not the bridge-lending banks.

But it remains to be seen if the banks will be able to find long term investors for the deals. Many of those deals were priced at a time when risk was seen as a hobgoblin of little minds. Today, with the true size of the risk goblin emerging, great thinkers are paying attention. The we'll-pay-you-back-when-we-feel-like-it bonds that financed leveraged buyouts six or twelve months ago will today be about as well-received by institutional investors as carriers of hemorrhagic fever. If the banks can't find outside investors, they themselves will have to become long term financiers of the leverage buyouts, often at disadvantageous terms. That means further potential for loss.

Unfortunately for the banks, the regulators can't issue statements encouraging the private equity firms to renegotiate their financing arrangements with the banks. Those arrangements greatly favor the private equity firms, and, the LBO boys didn't get yacht-buying rich by giving money away.

So the regulators are left to use whatever moral suasion they have to urge banks to be nice, but not overly nice, to distressed mortgage borrowers. What does that tell us?

On the level of the network news, it means that the regulators sound kind of warm and fuzzy. That's nice. And it's not exactly bad p.r.

But on a systemic level, we have an admission, implicitly, by the regulators that the derivatives markets have failed in their essential promise. Going back through the last 20 years, one sees the derivatives industry promoting its products with the claim that they would disperse risk and subdue volatility. Risk would be purchased by those that wanted to bear it, and those that didn't want it would be liberated from its onerous yoke. In particular, the major banks at the heart of the financial system would transfer away the risks that could cause a systemic failure, and safety and soundness would spread far and wide in the banking system. The financial markets would bask in the copacetic glow of a new and better world.

The problem was that the alchemy of derivatives didn't alter human nature. Presented with a path that apparently led to the Seven Cities of Cibola, investment bankers, hedge fund operators, and kindred souls worldwide plunged into the derivatives market, demanding vast quantities of risky financial instruments that they could purchase for their journeys to the kingdom of Croesus. These folks were too smart to believe that the business cycle had been repealed. But they managed to outsmart themselves into believing that the risk of the business cycle, as to them, could be traded away. Thus, they boldly bought risky investments that none had dared to invest in before, and in the process caused the creation much greater aggregate risk than otherwise would have existed. Stated otherwise, they engaged in speculative excess.

Speculative excess in the financial markets has a long and venerated history. Tulip bulbs in Holland, swamp land in Florida, silver futures, and earnings-free dotcom stocks are just a few of the better known examples. The darndest thing is that even though you'd think people would move up the learning curve after each pop of the bubble, progress remains painfully slow. We now have the derivatives bubble, where people thought that the magical qualities of derivatives contracts would make the business cycle go away, at least as to them. And they invested like anyone who thought they'd never face a downturn would invest. If the markets will always be friendly, at least as to oneself, there is logically no risk that isn't worth taking.

Unfortunately, the business cycle is the product of speculative excess, and human nature assures that speculative excess--and therefore the business cycle--will always be with us. There is no vaccine, no magic bullet. Any contract or investment that can be used to hedge or transfer risk can also be used for speculative purposes. Just flip it around and a prudent hedge becomes a wild gamble.

The regulators have assiduously avoided regulating derivatives, and now their only options are treating the symptoms with monetary policy, and moral suasion. The efficacy of both is uncertain. Preventative measures haven't appeared publicly on regulatory agendas. No individual player in the derivatives market has an incentive to seriously urge reform. From the perspective of any one market participant, it's easier to just trade away one's risk and the Devil take the hindmost. Of course, as we now know, the banks at the center of the financial system can't really trade away risk. But the private sector doesn't have the ability or incentives to assess and address systemic risk. The question at hand is whether anyone else will take up the mantle.

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