Eugene Linden
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Imagining a Post Pandemic World

How might a post-pandemic world look and feel? Let’s imagine a creative team at a New York City advertising agency pitching a campaign in 2050 for a new perfume (more than most products, perfumes are sold by attaching to the dreams and aspirations of their times).  The Big Apple, ...

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THE ECOLOGY OF TOXIC MORTGAGES


Saturday October 27, 2007

EUGENE LINDEN
[This musing ran in July on Huffington Post, but it's quite relevant today as the credit crisis continues to spread]
I lead two lives. Three days a week, I'm employed as chief investment strategist for a hedge fund that specializes in distressed and bankrupt situations. The rest of my time, I do what I've done for decades, which is to write about nature and the environment. There is virtually no overlap between these two worlds -- with one exception. At a metaphorical level, there are irresistible parallels between a profound flaw in early models of how to deal with pollution, and an almost exactly analogous flaw in financial models for how to deal with the financial universe's own version of toxics: risk. My role at the fund is to look at the macro situation, and to help the portfolio managers interpret how larger trends in the economy will interact to the benefit or detriment of our investments and prospective opportunities. In that capacity, I've been looking at the unfolding debacle in subprime lending, a slow motion, far-reaching toxic poisoning, whose reach and impacts have been obvious for at least eighteen months to anyone not involved in making money off the origination, sale, and securitization of these subprime loans. Unfortunately for investors, that aforementioned conflicted group includes virtually everybody in finance, including the mortgage brokers, subprime lenders, Wall Street firms that securitize the loans into mortgage-backed securities, Wall Street firms that then resecuritize slices of these bonds into collateralized debt obligations, and the rating agencies that, for a price, enable all these securitizations and re-securitizations, by blessing these teetering structures with ratings that imply far less risk than is turning out to be the case. There has been a good deal written about the ecology of finance in recent years, but reading about theoretical parallels between the worlds of nature and finance pales in comparison to the thrill of watching a toxics crisis in finance unfold before your eyes almost exactly as it does in the environment. For all our vaunted foresight, it's interesting to see that when greed and self-interest come into play, collectively we're no smarter than fruit flies. In this case, the flawed environmental model for dealing with risk might be summed up by the cute phrase, "dilution is the solution to pollution." For a number of years, we freely poured toxics into the water and skies under the assumption that pollutants would disperse and become harmless in these vast receptacles. Instead, what we discovered is that these toxics re-accumulate as creatures eat each other and are eaten, a process repeated on up the food chain until the toxics reach deadly concentrations in the top predators and big animals. I remember years ago reading that dead whales washed up in the Saint Lawrence seaway contained such high concentrations of heavy metals and other toxics that in the U.S., they would be declared superfund sites. That also could be said for some of the big investment banks, hedge funds, and Wall Street firms at the moment. The toxics in this case would be portfolios of various forms of securitization of subprime, alt-a and other loans that, amazingly enough, aren't performing according to models developed during the greatest run-up of home prices in American history. (I recall attending one conference on securitizations of home equity loans in early 2006 where the quants showed us supposedly reassuring "stress" tests of these bonds under various scenarios of home price appreciation. The most "stress" they envisioned was 3% appreciation, and not the negative price movements we are seeing just a year later). The practical logic behind packaging these risky loans was that most of them were money good, and that so long as defaults did not exceed expectations -- say 4-5% of the loans being packaged -- the great preponderance of the securitization could be treated as investment grade. And, the philosophy behind this whole process was that risk could be reduced if it was sliced up and efficiently dispersed in the investor ocean. But, in an exact analogy, to the environmental example, risk did not stay dispersed. Rather it re-aggregated in the whales (hedge funds, investment banks, and pension funds) of the investment community. And now these top dogs are discovering that risk is just as toxic if it's sliced up and reformulated as if it never was broken up in the first place. The analogy does break down ultimately, because in the investment universe version we have an accelerant to the toxicity of risk in the form of leverage. Because so many of these repackaged subprime loans were rated investment grade, the whales could gorge on the stuff using borrowed money. The embedded leverage is astonishing. While each deal is different, and this unregulated market remains opaque to non-participants, an idealized example illustrates this point: Take a billion dollars in subprime mortgages and package them into a new security. Typically, a model security would rate about 95% of the slices in this new bond as investment grade. Under these high-rated slices are what are called mezzanine tranches, the lowest piece of the investment grade slices, and the lowest of these would be rated BBB-, or just above junk status. Typically, these mezzanine tranches will amount to about 4% of the$1 billion total value. Below the mezz pieces would be the lowest rated tranches, including the equity which absorbs the first losses if borrowers default. In this idealized securitization, the BBB- tranches might represent 1% of the total value of the bond and be buffered from losses by about 5% of equity and junk (which represents a computer model's estimate of the outer limit of realized losses). So in this case, those buying the BBB- tranche are betting that losses for the entire billion dollars in loans never rise above $50 million over the life of the bond. Fair enough, but if they do rise higher, those holding this tranche lose money in a hurry. Let's say, losses rise to 8% (some predictions are even higher). In that case, the value of the BBB- tranche would be worthless, and losses would take out all of the BBB tranche and half the BBB+ tranche as well. That's the price of leverage. But it gets worse. Given the risks of subprime loans, many lenders could not afford to make large volumes of loans if they were forced to keep the loans on their own books since they would tie up too much capital. So they finance the loans with short term borrowing and then sell the mortgages into securitizations. The buyer -- the securitizer -- then puts together his MBS. To do this, the buyer has to sell the mezzanine tranches (many securitizers keep the equity themselves). These tranches buffer the whole structure from losses, and once they have been sold, it's easy to sell the higher rated stuff. In recent years, the money funding these mezzanine tranches has come from a subset of another securitization called collateralized debt obligation or CDO. To form a CDO that invests in subprime mortgages, a securitizer will buy up mezzanine tranches from perhaps 100 different mortgage-backed securities, and then package them in different tranches similar to the way a mortgage backed security was packaged in the first place. Thus, some CDO's can consist entirely of BBB- tranches of subprime mortgage MBS, but still have 95% of their value rated investment grade. Here is where leverage is the true killer. While an increase in realized losses from 5% to 8% will wreck havoc on a $1 billion MBS, even a smaller increase from say 5% to 6% losses could utterly destroy a CDO based on BBB- tranches where the leverage is over 100 to one. That additional one percent in losses will not only wipe out the bottom tranches of the CDO, but it will eat through most of the investment-grade slices as well. Bearing in mind that many hedge funds also used leverage (meaning that they borrowed most of the funds to buy a CDO tranche), it becomes obvious that even minor variations from the expected performance of subprime loans can have a huge impact on results. This is why we are beginning to see some very sick whales, and what happens to them affects us all. Since $1 invested in a CDO ultimately funds $100 in subprime lending, this poisoning will reduce subprime lending (as much as 50% this year alone) sending further ripples through the housing market. Moreover, most Americans have exposure to this mess since pension funds accounted for 18% of purchases of the riskiest tranches of CDOs, and insurers and pension funds were investors in the investment-grade tranches as well. So, given the stakes and leverage, why haven't we seen more blow-ups such as what happened to the Bear Stearns funds? Just wait. The system has built in lags in recognizing losses since the rating agencies don't have to downgrade until losses are actually realized, and that can take 18 months or more. Moreover, markets for these bonds are highly illiquid, and without trades, holders can maintain the illusion nothing bad has happened. That's a dangerous game, however, because, investors don't have to wait for downgrades or price adjustments before pulling out of exposed hedge funds or otherwise dumping suspect investments. If a fund wants to take advantage of the illiquidity and lags in the system to maintain the illusion of good performance, it runs the risk of having to pay investors more than market value if they withdraw at the end of the quarter. That's probably why we've seen a number of funds halt withdrawals from investors in the past few weeks. This sets up an interesting dynamic for the coming months. Typically, an investor gives 90 days notice before withdrawing money from a hedge fund, and the price for the redemption will be marked to the next quarter's performance. Clearly that puts some pressure on hedge funds to come clean in their accounting of performance in the quarter that just ended, but, because alarm about this market has soared in the past month, it puts even greater pressure on funds to accurately price for the third quarter ending in September. What's likely to happen is that unlevered funds will mark down their investments in this now-toxic stuff and pay off those who want to redeem. Is there a way to avoid this day of reckoning? CDOs are actively managed, and in theory the manager can swap out badly performing investments for better stuff. The bad stuff has to be sold, however, and given the illiquidity of this market such sales could hasten the repricing of many billions of similar toxics sitting in portfolios. Also, subprime accounted for over 50% of the collateral for CDO's in 2006, and an asset class that disproportionately represented is not easy to swap out even in the best of times. More likely, this toxics crises will play out in finance just as it does in nature -- with a mass die-off.

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Short Take

Relaxing COVID-19 Restrictions will Kill, not Save, the Economy


 

[This is a more developed version of the previous Short Take}

Those who want to relax mandates on self-isolation and social distancing to save the economy have got it exactly backwards. Reopen society too soon, and we risk destroying the economy as well as public order and our shaky democratic institutions. The reason comes down to two words: supply lines.

 Supply lines for necessities such as food are already under stress. Those going to grocery stories encounter random instances of empty shelves and vegetable bins. Smithfield Farms shut down a South Dakota plant that supplies roughly 4% of the pork in the nation after over 500 of its workers tested positive for the coronavirus. Other giant meat processors such as Tyson have also shut down plants for similar reasons. Farmers in the West are having trouble finding workers to harvest the crops now reaching maturity in the fields. And even if they manage to get the crops picked, farmers are out of luck if the truckers fail to show up, or the flow of packaging for their products get interrupted. 

Right now, these disruptions are episodic, but that should be concerning because we haven’t even seen the end of the first wave. What we have seen is that vital front-line workers such as nurses, doctors, EMT’s, and other first responders have had trouble finding protective equipment and maintaining morale. Some have staged walkouts over the dangerous conditions, and these are workers with a sense of mission.

By contrast, for most of the hourly-paid workers who keep supplies made, distributed, and sold, their work is a job that pays the bills. It would be appropriate if society recognized that they played a vital role, but mostly these workers encounter demanding bosses, monotony, and surly customers. If sick, they are not going to work – nor would we want them too. And they are not likely to risk their lives if going to work exposes them to contagion.

Disruption of one link, e.g. the trucker that delivers food the last mile, could halt a supply chain. COVID-19 is a threat to every link. Should a second wave hit before there is a readily available, cheap and effective treatment, it’s a very high probability that many supply lines will be disrupted and filling the gaps could easily overwhelm the nation’s businesses. 

Even today, on the evening news, we see images of vast caravans of cars lined up to get supplies from food banks. Imagine two weeks of empty shelves in the stores that feed our cities. How likely is it that civil order could be maintained in that situation? Will people suffer in silence if they realize that they can’t buy food for their kids because our leaders reopened the economy before a treatment was available because they wanted to prop up the stock market (which is how it will be portrayed)? If we want to look analogues for what life is like once supply chains break down, they’re readily available today in cities like Mogadishu, Kinshasa, and Port au Prince. 

 Thus far, the Trump administration’s response to the pandemic seems to be a mélange of Boss Tweed, Don Corleone and Inspector Clouseau. For the next act, the administration has a choice: Churchill, who bolstered British morale during the London Blitz, or Pol Pot, who sacrificed millions of his countrymen for a bad idea. Let’s hope those around Trump can convince him that the cure for the disease is the cure for the economy.
 



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