Thursday, December 4, 2008


US Treasury Secretary, Hank Paulson, told Congress ““We need oversight. We need protection. We need transparency. I want it. We all want it.'' - regarding the use of TARP funds. In my opinion there was transparency in Treasury announcements to anyone who looked hard enough, and yet Bloomberg filed a lawsuit to gain access to information to determine where taxpayers’ money was being applied and especially what securities were being pledged in swaps for Treasuries. The Government quite rightly witheld the names of banks applying at the Fed's window simply to protect them from being undermined unreasonably in the stock market e.g. by short-sellers. Nonetheless, what this does nothing to relieve is the panic that investors and others feel about murky toxic-smelling hidden depth of banks' footnotes to accounts regarding Off-Balance-Sheet Items (OBSIs). Investors expect to be able to do due diligence about risks and returns and current banks' share values tell us that when these fall far below book value that investors and traders are discounting heavily the quarterly and annual accounts, which they simply refuse to believe are true and fair! How important is confidence in public sector finance as much as publicly quoted private finance? Are there moral hazards involved here too? Take Citigroup for example. As it was bailed out by the government, it transferred assets from Structured Investment Vehicles back on balance sheet and into assets held for sale but price-adjusted as if to be held until maturity, after a $1.1bn negative value adjustment that would hit future p&l. But, then Government guaranteeing a fifth of Citi's assets, greatly supplemented its capital reserve ratio and proided guarantees whereby it could sell 20% of its assets (currently $1.55tn in total) at a reasonable price. What is even more opaque, however, are banks' exposure to credit and liquidity guarantees for off-balance-sheet loans and bonds in SIV/SPEs. The US top 7 banks and foreign banks such as Lloyds TSB, RBS and HSBC have together more than $300bn in such exposures. The guarantees were to solvency-remote entities when first pledged as risk insurance inducement to buyers of senior and mezzanine tranches of securitization RMBS, CNBS and other ABS bonds etc. Now, as RMBS and CMBS defaults are edging above 10%, plus credit-card delinquencies going higher, some of these standby CPs will be called on. Yet these items are not disclosed or only barely, in notes to banks' Financial Statements and insufficiently to allow readers to make informed decisions. Possibly, auditors are not informed fully clearly either? Some of these exposures are merely bundled into larger portfolios of structured finance stress test model results. The Financial Accounting Standards Board (FASB) and its proposed amendment to FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, addresses this. This proposed amendment would change what and when OBSIs would have to be consolidated into a company’s books and reported publicly, as well as eliminate the ability to create certain types of OBSIs. This should immediately impact the financial positions of many companies by bringing to light obligations previously hidden. The amendment was meant to apply to fiscal years starting after November 15, 2008. But, implementation is opposed by Citigroup Inc. and the securities industry generally and is now delayed for a year. The Securities Industry and Financial Markets Association and the American Securitization Forum complained that the changes, which could affect as much as $11tn of off-balance-sheet entities, may make companies appear short of capital to regulators and lenders. This does not help market confidence! Regulators and auditors should insure that these exposures are covered by capital reserves ratios to all risk weighted assets. Meredith Whitney, CIBC analyst, and highly influential scourge of banks' performance who has received death threats for accurately predicting bank writedowns, even she also wants to delay the introduction of accounting rule FAS 140 until 2011 or 2012. She says, “These moves to bring off-balance-sheet assets back on balance sheet for the sake of transparency are a mirage. The primary assets that will come back on to balance sheets are credit card loans. Frankly, there is more transparency in off-balance-sheet master trust data than in on-balance-sheet accrual accounting. Banks cannot afford it now and it will further constrain credit." This is the same she who wanted “banks and investment banks either to unload their problem loans and mortgage securities or to 'get real' about how they're valued”? Investors remain fearful. Banks' words are not their bonds! Government, Fed, FDIC & Treasury, have stepped in with generous modifications to loan contracts (to keep mortgage payments within 38% of household income. The UK Government is doing similar, even more generously, offering 3 year mortgage payment holidays to mortgagees who experience a sudden drop in income or have lost their jobs. These loand modifications may have a modest positive ratings impact on prime Residential Mortgage-backed Securities, and subprime, Alt-A and Option-ARM RMBS more so where over one third are defaulting and could now re-mortgage in effect during the worst of the recession - but this may not improve the prices of these bonds. Loan modifications could encourage (bring forward earlier) more delinquencies, negating pricing benefits, except if viewed in the wider roundabout context of macro-economic benefit. By placing a back-stop on delinquencies, one effect will be to dissuade vulture funds of the value of buying RMBS at say 25% of face value in expectation of a 55% minimum debt recovery from selling foreclosed properties. Standard & Poor’s Ratings Services recently quantified the potential impact of loan modifications on U.S. RMBS. The study examined four 2006-vintage transactions from each product sector that displayed average collateral characteristics and four that displayed adverse performance, subjecting them to a broad range of test scenarios. Key findings:
• Some transactions may see benefits in the form of fewer write-downs and improved ratings from successful loan modifications. However, investors should consider the potential loss in yield from the reduction in the loan interest rate and/or principal amount as a consequence of loan modifications.
• Although interest-rate reduction can potentially provide the greatest benefit as far as reducing borrowers’ monthly principal and interest (P&I) payments, we think that the most frequently used loan modification strategy will be some combination of interest-rate reduction and principal forgiveness.
• We believe that the combination strategy will be most effective because borrowers might still walk away from a mortgage, even with a lower payment, if the value of the house is less than what they owe.
• While interest-rate modifications may result in lower overall collateral losses, a reduction in interest rates may also reduce the amount of excess spread available in the transaction to protect against future losses, which may ultimately increase principal write-downs to the securities.
• Generally speaking, the senior securities for all product sectors retained greater credit support (the lower classes saw fewer write-downs) and experienced some ratings benefit from our loan modification scenarios.
• Most of the subordinate classes from the sample subprime, Alt-A, and pay option ARM classes benefited from fewer write-downs due to loan modifications, but did not experience any significant improvement from a ratings standpoint.
There are so many supposed 'moral hazard' accusations flying about, there should be no pecial reason to worry about one here; mortgagees will hold onto the debt and still be liable for the debt, even if the cost of this debt is lower in the short to medium term. It may mean mortgagees having to hold onto houses longer when prices do recover before they find themselves back in positive equity compared to others - so what?

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