[Continued from yesterday’s Part 6 and the preceding and Part 1,  Part 2, Part 3, Part 4, and Part 5]

As 2009 opened, virtually the entire credit-crunch tidal wave had sloshed through the financial markets. 

At least we’re still here

Single-family home prices appeared to be bottoming, albeit at lower levels and with much lower volume.  Homeowners who owed more than their homes were probably worth stoically hunkered down to make the payments, waiting for recovering prices and the inevitable looming inflation to put them back into the black. 

Yet even if residential prices were slowly recovering, the globe itself was still ill, this time with a worldwide recession.

As we’ve seen, plenty of time can pass between the invisible causes and the all-too-visible effects.  While the quickest (HERA’s cornucopia of GSE powers) hit us in the lickety-split interval of under ninety days, most problems lay seemingly dormant for two to four years.  In 2009 we have two invisible causes whose damage has yet to surface, so what follows are technically not reconstructions but predictions.

I predict you will be satisfied

Even so, I’m really confident of them.

2009: California’s shameless IOU issuance

In July, the state of California did an extraordinary thing: it repudiated its debts.

Why pay debts when you can print money?  A California IOU

Instead of paying its bills with cash, the state printed paper, backed by nothing, and ordered people to accept it.

If you or I did that, we would be summarily hauled into court and our property potentially seized. 

Oh, wait – it was the court itself that was welshing.

To be sure, the state dressed up this reneging on its debts with flowery language:

1. What is a registered warrant?

A registered warrant is a “promise to pay,” or an IOU, that is issued by the State when there are not enough funds to pay all of its General Fund obligations. Registered warrants bear interest and are redeemable by the State Treasury only when the General Fund has sufficient money.

Translation: “I will pay you when I have the money – not before.”

Now make that ask at the barrel of a gun

If the Legislature and Governor fail to enact budgetary solutions that provide enough cash for the State to pay all of its bills by July 2, the Controller will begin issuing registered warrants. Assuming there is adequate cash in the Treasury, those warrants may be redeemed on October 2, 2009. 

Translation: “You may think you’ll be paid by October 2, but I may make you wait again.”

At the time I thought this utterly outrageous and nothing more than genteel extortion.  I still think so.  When a government filches money from its citizens, merely because it can, there is no bright-line distinction between that and paying the mafia protection money.  Both are obtained by use of fiat force, without law and without remedy. 

Statutes?  Statutes?  We don’ need no steenkin’ statutes!

Though I’m no Constitutional lawyer, California’s action ought to be unconstitutional under the Fourth Amendment (unreasonable seizure) and the Fifth Amendment (taking of private property for public use without due process and just compensation).  That’s little comfort now, for California has simply converted or confiscated the property.  (The state subsequently compounded its action by doubling the mandatory withholding, explaining blandly that taxpayers would recover the money some months later – without interest, of course.) 

When the history is written, California will be seen as only the first state to snatch money from its counterparties – citizens, lenders, and investors.  Dozens more will follow (New York is likely on deck.)

What do you mean we can’t afford it?

Why did California go to such extremes?  Because it is bankrupt.  As I wrote over at CAS Financial, my for-profit US consultancy [Posted December, 2009]:

Every American state, and most American municipalities, will face service cuts as the rosy asset-based revenue projections they made in prior years fall short. 

Dubai and the California will each go ’shadow bankrupt’ – a term I’ve just invented to describe slow unacknowledged insolvency. It used to be we had zombie banks; now we have zombie states.

As a thought experiment, California has already met the standard “Event of Bankruptcy” definition contained in most partnership agreements – acknowledgment in writing of inability to pay its debts via the issuance of those questionable IOUs.

“Now, California, you’ve got to ask yourself one question”

California has also started unilaterally taxing its citizens without legislation, administratively doubling employers’ required withholding of state taxes (a compulsory interest-free loan). Other states will be driven to similarly dubious measures.

“Do I feel … lucky?”

As I posted some weeks ago in the context of Dubai World, bankruptcy is an important invention, a valuable construct in a healthy financial ecosystem.  Just as death of individual creatures helps the ecosystem flourish by allowing for periodic refreshment and renewal, and survival of the fittest, bankruptcy is the unpleasant but final resolution of an unsuccessful financial creature.   When the sovereign is involved, however, the bankruptcy has to have clearly defined rules to which the sovereign adheres, otherwise failure to pay degenerates into a primitive tussle. 

If a state uses its police power to elude accountability for its own inactions, then the state is operating not under a rule of law but a rule of might and privilege.  This is one of the myriad reasons why I hate rent control – it is the state using police power to confiscate people’s economic property without compensation, and in the process to undermine urban neighborhoods.

Once the rule of law is broken, capital flees and hides, all the faster now that capital has de-materialized; see Part 2.  The foundations of global finance totter.

Dubai World’s announcement of its unilateral suspension of debt service payments of over $50 billion in Islamic-finance bonds will be a globally seismic event.

Communism fell because capital is uncoerceable; capital (and the productive people who grow an economy) must be coaxed and wooed.

Top marry a prince, miss, one must kiss a lot of frogs

The globe’s real pandemic is not H1N1 but the gross overextension of social welfare benefits (medical, retirement, unemployment, the whole safety net) beyond state’s current ability to pay.  During the next five years, hundreds if not thousands of cities, states, provinces, and countries that are now technically insolvent are going to have to reel in their spending habits.  They will choose from the following unpalatable and limited menu:

Overtly, through legislative changes announced to their citizens.

Coercively, through involuntary taxation or confiscation.

Abruptly, through default and bankruptcy.

Underhandedly, through conscious inflation.

Ruinously, through hyperinflation.

But the insolvent governments must do something.  The Law of Economic Gravity will not be denied.

Expected aftermath.  As with so many trends, California is merely the first.  Other states and nations will follow – next up, New York City and New York state. 

In the 21st century, the principal differentiator between states that prosper versus states that decline may well be how they deal with their insolvency.

Be careful out there, okay Uncle Sam?

2009, August: President Obama’s reappointment of Ben Bernanke

Last August, in the middle of an otherwise sleepy summer haze, President Obama did a startling thing.  Calling an impromptu press conference, tieless and with his tieless nominee, he pledged to appoint Federal Reserve Chairman Ben Bernanke to serve a second term:

I’m focused on continuity with Ben

The President was under no deadline pressure.  The nomination could not be formally submitted until December and Mr. Bernanke will not be reconfirmed until January.  Nor was Mr. Bernanke’s appointment inevitable: former Treasury secretary and now Obama economic advisor Larry Summers was widely believed to be interested in the job.  Chairman Bernanke had no ties to Mr. Obama: he was President Bush’s choice, you will remember, himself appointed on a platform of continuity:

“If I am confirmed to this position, my first priority will be to maintain consistency and continuity with the policies established during the Greenspan years,” Ben S. Bernanke said today.  [October 24, 2005 – Ed.]

President Obama acted when he did to calm the financial markets with the virtue of not changing horses [Posted August, 2009]:

As I’ve posted at length before, I believe that the Paulson-Bernanke-Geithner triumvirate’s aggressive actions in spring 2008, banking on value, basically staved off the Second Great Depression. It was a coup over three days, a coup both in the sense of masterstroke and that of power grasp, and it was essential, because the world was watching Washington.

Megalomaniac? Me?

Ever since then, Mr. Bernanke’s been managing against depression, and he’s been a money-supply expander.

When will he reverse?

“Now Ben, I’m showing you this courtesy, you’ll remember it, won’t you?”

If the economy recovers as anticipated, Mr. Bernanke is expected to move – probably not until next year – to raise interest rates and tighten credit to avoid inflation. History suggests that moment will arrive sooner than many elected politicians and White House advisers prefer.

Like Supreme Court justices, the Fed chairman is independent once appointed, but must be appointed. Unlike Supreme Court justices, Fed chairs serve for a fixed term (four years) that often straddles a change in presidency.

Moreover, with another four-year term in hand, he may feel he has a freer hand to take actions the White House and Congress don’t support.

Of course he will. In fact, I – and probably most of the financial markets – am counting on it.

You think I’m expanding … maybe I’m contracting

As many including the clever Tyler Cowen have pointed out (snips removed), both inflation and interest rates are suspiciously low:

It’s all about screwing my future, isn’t it?

Right now banks are earning their way back into profitability by playing the spread.  They’re paying close to zero on deposits and earning fair sums on long-term loans.  Perhaps this term structure is sustainable because people are expecting little inflation in the short run but moderate inflation in the longer run, plus there is some risk on the loans.  Here is the key point: from the bank’s point of view, what is the correct measure of the real rate of interest? 

When you’re near the bankruptcy or nationalization constraint, it’s often nominal profits that matter (relative to fixed nominal liabilities, accounting standards, capital standards, etc.), not “real profits” defined relative to the CPI.  In sum, maybe three percent expected inflation conflicts with the desire to rapidly recapitalize banks through maintaining a wide interest rate spread.  Maybe we need that zero nominal short rate, or at least the Fed thinks we do.

It means that “Main Street” is paying for “Wall Street” (forgive me the use of those awful terms) in at least two ways: high unemployment and inability to earn much on one’s savings.  If the bank mess isn’t cleaned up soon, heaven forbid.  The spread, as a means of restoring bank profitability, won’t last forever.

See those huge real interest rates 1981-85?  They’re coming back … soon

Expected aftermath.  Long, long ago, an investment professional in whom I’ve always had confidence told me, Adjusted for inflation, no government bond has ever yielded above par.  That is, no matter what rate the government pays you on its bond, the value of those future payments is less than the cash you started with.  The reason is simple – government influences the inflation rate.  So while it may pay you the stated interest, it has always deflated the value of those payments faster. 

Chairman Bernanke is way too smart and too well informed not to know this, and in fact to be quietly counting on it.  He’s lying low now – all the descriptions are affable, mild-mannered, non-confrontational – because like his predecessor Alan Greenspan, he knows the Fed chairman’s world is divided into two periods: when one is seeking appointment, and the rest of the time.  In the former, one plays nicely with the other children and does nothing to offend or call attention to oneself.  In the latter – which is most of the time – one acts as one thinks best with neither warning nor justification. 

Chairman Bernanke wants to preserve not just his job, but also its clout – meaning the Fed’s independence.  Once he has that, I believe he will set out to raise interest rates, and inflation, as the sole means of curtailing our overextended government:

Those are CBO projections, meaning non-partisan and probably a tad optimistic

Those debt projections are inflation-adjusted

For all our sakes, I hope he succeeds – in reconfirmation, in preserving the Fed’s independence, and in putting the spurs to interest rates and inflation as the essential means of protecting the dollar, the public fisc, and the US’s national economic health. 

I think he will.

Summing up.  It was an eventful decade: ten years’ events, fifteen huge invisible or underappreciated contributory causes:

It took all three hands to count the fifteen causes

We are living in interesting times.  The decade upcoming promises to be no less interesting.

Does this mean danger/ opportunity? 

With the Chinese holding $800 billion of our paper, we’re about to find out.

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[Continued from yesterday’s Part 4, and the preceding Part 1, Part 2, and Part 3.]

By 2006, asset slides had crested and were slowly sliding.  It was time for the world to zig.

We’ve got to keep values moving up

Unfortunately, late in 2006 instead of zigging, Fannie Mae zagged:

2006+: GSEs’ buying strategy shift … into subprime buying

As we saw in Part 1, under the leadership of Frank Raines, Fannie Mae had embarked on an (outwardly successful) ambitious plan to grow volume and profits, through balance sheet turbocharging.  When Mr. Raines gave way to Daniel Mudd, an executive whose principal virtue – at least to judge by the public press – was his credibility rather than his financial-engineering wizardry.  For reasons that to mean rang hollow at the time, Mr. Mudd felt impelled to continue chasing ever-higher profits, and in the environment he needed to win market share against his ‘fierce’ competition [Posted December, 2005]:

Following in Raines’s footsteps: Dan Mudd

CEO Mudd is bravely soldiering on:

“As we look at our business, we realize we have a special role to fulfill in the market,” Mudd said. “Various strategies we may consider clearly need to be examined in terms of our mission to support the market and help low- and middle-income families.” Mudd said that after the firm puts its accounting problems behind it, it will “participate in more markets with more products . . . and more flexible products for people with a credit blemish on their record and for first-time minority home buyers.”

Freddie Mac already has stepped up its investment in adjustable-rate mortgages, although about 80% of its holdings still are long-term, fixed-rate loans.

“The Press, Watson, is a most valuable institution, if you only know how to use it.” 

– Sherlock Holmes, The Adventure of the Six Napoleons, page 191

Before Messrs. Johnson, Raines, and Mudd, the GSEs had a low-risk business model.  Turbocharging the balance sheet brought them into a higher-risk business line.  Retiring Federal Reserve Chairman Alan Greenspan made this crystal clear in his last testament [Posted February, 2006]:

The GSEs are in a second business:

In contrast, once a mortgage has been securitized and sold into the public markets, Fannie’s and Freddie’s purchases of their own (or each other’s) mortgage-backed securities (MBS) for their investment portfolios creates substantial systemic risk while yielding negligible additional benefit for homeowners, renters, or mortgage originators.

“How many times must I explain these simple precepts?”

If the GSEs buy long-term loans and hold them without securitizing, how do they raise the capital to do this?  They borrow short-term.  That’s great when the yield curve is positive, because the short-term interest rates they pay (on the money they borrow) are less than the long-term rates they receive (on the loans they bought), so they have favorable spread.  But if the yield curve inverts — which it sometimes does, and quickly! — the GSEs are exposed … and hence, so are taxpayers.

Under normal circumstances, GSEs are able to easily maintain and grow their large portfolios of mortgage and non-mortgage assets without the significant market checks or balances faced by other publicly traded financial institutions. 

A private company trying this trick would be tested for its ability to cover an adverse swing.  Since the GSEs are perceived to be protected by Congress, this doesn’t happen, so the market doesn’t charge the GSEs a premium, and hence the market doesn’t check their balance sheet growth.

These large portfolios, while enriching GSE shareholders, do not meaningfully benefit homeowners and do not facilitate secondary market liquidity.  They do add systemic risk to our financial system, which normal market forces are unable to resolve.

“And risk is bad.”

But, Mr. Greenspan thinks you may say, the GSEs are very clever.  Can’t they watch the markets and react the instant there’s a flicker of a problem?

Well no, he answers, because they’re too big:

As Fannie and Freddie increase in size relative to the counterparties [The other half of any transaction. – Ed.] for their hedging transactions, their ability to quickly respond to changing market conditions and correct the inevitable misjudgments inherent in their complex hedging strategies becomes more difficult –

“You can’t hedge something this big.”

Whales move more slowly than fish (they have a much slower OODA loop).  The GSEs are so big they cannot be financially nimble.

– especially when vast reversal transactions backed by their thin capital holdings are required to rebalance portfolio risks. 

It would be one thing, Mr. Greenspan is correctly observing, if the GSEs kept so much capital on hand they could absorb this themselves.  But they’re highly levered now, so they have to match a market countermove … and they’re too slow to execute it without causing substantial disruption.

Chairman Greenspan and many others observed that, as they chased large profits along the risk curve, Fannie and Freddie were essentially gambling with taxpayers’ money.  If the bets won, the companies’ profits would rise – if they lost, we’d be implicitly on the hook to backstop their guarantees. 

Doesn’t sound like a good deal to me, baby

Moreover, shifting to riskier securities – moving up the risk curve – meant that the companies could increase their profits by increasing the risk to us taxpayers.  That’s what they did – just at the moment that many (like Angelo Mozilo; see Part 4) were dramatically reducing their exposure to subprime lending, the GSEs increased theirs. 

Where Angelos fear to tread …,

As I wrote in Who’s next? [Posted January, 2008]

Wondering who might be next in the writedown game, I hauled out a June, 2007 story from Inside Mortgage Finance that reads much more scarily now than it did back when it was first published.

Back when the only thing we had to worry about was The Bomb

Who’s next?

Yesterday we saw that the GSEs were active buyers of subprime and Alt-A mortgages in 2007.  Why were they doing this?

Certainly, the two GSEs continue a delicate balancing act between their housing mission and the need for shareholder return. At the same time, they have to respond to the changes in the marketplace while still having to contend with temporary portfolio caps from their regulator, the Office of Federal Housing Enterprise Oversight.

“While they are interested in growing their portfolios, OFHEO is not interested in letting them grow,” said Eileen Fahey, a managing director in Fitch’s financial institutions group.  “Given the market over the past two years, they are interested in changing their portfolios and assuming new risks. They’ve moved away from the management of interest rate risk as their primary method of earning money and are shifting more toward credit risk.”

Read with the benefit of hindsight, that sentence is especially frightening.

Indeed, Fannie Mae was buying what Angelo Mozilo was selling, and Mr. Mozilo and Countrywide were rapidly unloading credit risk onto the GSEs’ broad-shouldered balance sheet:

Credit risk, for those of you unfamiliar with the jargon, is the risk that borrowers will default. 

And that the collateral’s no good

Translation: To replace the yield spread they were making on mismatched maturities, the GSEs have bought higher-yielding loans from less creditworthy borrowers.

Oh, great — just the thing we want them to be doing in the first quarter of 2007!

That’s just great, really great

Mr. Mozilo, who was closest to the action, was cashing out of Countrywide and cashing Countrywide out of these loans.  Fannie Mae and Freddie Mac, who were further from the risks and from the touch on assets necessary to evaluate and manage those risks, were aggressively buying them from aggressively selling Mr. Mozilo.

Somebody had to be wrong.

They couldn’t all have been right at the same time: Johnson, Raines, and Mozilo

Aftermath.  The GSEs’ recent-year purchases are among their worst-performing vintages.  Their losses are stratospheric, so far surpassing $111 billion between the two, and likely more to come.  Much of this can be traced to those 2006-2007-2008 subprime purchases.

2007, February: The capital markets’ Minsky moment

Sometimes a chart tells a story even if you have no idea what is being charted.  Consider this exhibit presented by Doug Duncan in February, 2008:

The risk curve went haywire … in February, 2007

Those lines that resemble a seismograph of an earthquake in progress?

Something went wobbly all of a sudden

They graph the risk spreads: the amount by which riskier (lower-rated) securities had to pay interest greater than those of safer securities.

[We're using credit rating as a proxy for riskiness.  The rating agencies' connivance was a huge invisible story too … but let us not get ahead of ourselves. – Ed.]

Before February, 2007, the capital markets were contended and placid.  Not only were spreads narrow, they were extraordinarily stable; the entire world thought risk was low, continuous, and anticipatable.  That very stability of perceptions bred its own instability of reality [Posted February, 2008]:

As Duncan’s chart reveals, August, 2007 was a Minsky Moment, where an interval of protracted stability breeds its own instability.  As Nouriel Roubini, whom I’ve previously quoted, put it when it happened (!):

Hyman Minsky was an American economist who died in 1996. His main contribution to economics was a model of asset bubbles driven by credit cycles. In his view:

Minsky knew how to seize the moment

Periods of economic and financial stability lead to a lowering of investors’ risk aversion and a process of re-leveraging.

Investors start to borrow excessively and push up asset prices excessively high. In this process of re-leveraging there are three types of investors/borrowers.

The Minsky moment is like waking up in a car’s passenger seat, only to gaze horror-struck at the joyriding sixteen-year-old next to you who’s driving eighty and whooping as he does so.

Or sixteen-month old …

Once awakened from their complacency, the capital markets became progressively more spooked:

The same chart, with Duncan’s annotations

Shockingly, most of us – even those of us close to the capital markets – failed to notice this at the time.  For me enlightenment struck in October, 2007.  I was pitching a new investment-fund opportunity to a large financial institution, explaining how I thought we were so shrewd buyers we could deliver an 8% yield, only to be told that if we didn’t bring 14% or more, we shouldn’t bother to show up.

It’s one thing to be off by fifty or a hundred basis points.  When you’re 600 basis points apart, don’t even bother to show up.

Aftermath.  Setting aside the withdrawal of credit – which is concomitant with the increased risk spreads but driven by independent factors – the capital markets experienced at least eighteen months of further turmoil, and still have yet to settle down.

A reasonable proxy for ‘normal’ risk: LIBOR to Treasury bill spreads

Wider risk spreads have exacerbated and protracted the enormous dehydration of global liquidity, and been a direct cause of the global recession.

2007, May: The world becomes urban

Though many of the invisible events listed so far have worldwide implications, they have been predominantly domestic in nature.  Now for one that is principally global: on May 23, 2007, as best anyone can estimate, the world tipped from predominantly rural to predominantly urban:

The world at a glance: people moving to growing cities

Working with United Nations estimates that predict the world will be 51.3% urban by 2010, the researchers – Dr. Ron Wimberley, Distinguished Professor of Sociology at NC State; Dr. Libby Morris, director of the Institute of Higher Education at the University of Georgia; and Dr. Gregory Fulkerson, a sociologist at NC State – projected the May 23, 2007, transition day based on the average daily rural and urban population increases from 2005 to 2010. On that day, a predicted global urban population of 3,303,992,253 will exceed that of 3,303,866,404 rural people.

The shift is epochal, an event never before achieved in human existence, and never to be returned to:

Despite almost four millennia as centers of civilization, it was only fairly recently that cities attracted more than a small percentage of the global population. With hindsight, the 20th Century was the century of urbanization.

In 1900, only 14% of humanity lived in cities. By the century’s close, 47% of us did so. This change is revealed in the growth of the number of medium-sized cities. In 1950, there were 83 cities with populations exceeding one million; but by 2000, this had risen to 411.

This has special resonance for AHI because urban housing is a money good.  In rural communities, people can house themselves without money – they can settle on vacant land, then build a home with their own labor and materials.  No cash is required.

Conversely, in an urban context, housing always costs cash money, because the right to occupy urban land always has a cash price.  Further, until land occupancy’s reality and its legal conception are in alignment, urban housing is not invested in.  Hence it does not improve, and is condemned to being a slum.  Thus urbanization requires formalization, and that’s a highly complex process.

A systems-approach view of urbanization: financing the informal

Aftermath.  A planet of cities, in a century of cities, means that most of humanity’s future history will be written in cities – so to make people work, we have to make cities work, and to make cities work, we have to making housing work:

Explaining home-building plans, Durban, South Africa

Cities matter, and they’re going to matter even more in the coming decades.  As Rakesh Mohan put it when we were at Bellagio:

If the world is urbanizing, it’s because people think it’s a good idea.  Yet our urban planning as a ‘third-class carriage’ mentality: I’m inside, don’t you dare come in, you’re much better off where you are.  Most urban planners live in largest cities in the world, yet they complain that cities are too large.  This report takes the opposite view.

Our urban future: Sao Paulo, Brazil

[Continued tomorrow in Part 6.]

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[Continued from yesterday’s Part 2 and the preceding Part 1.]

By 2002, as we’ve seen in the two preceding parts, expansionary pressures on global capital were bringing forces into alignment with means, motive, and opportunity to push asset prices up. 

If we’re all rising, we’re all grounded, aren’t we?

The major expansion in capital availability, together with the technological infrastructure to move billions of dollars with a mouse click, in effect freed money from the normal de-investment constraints that reduce volatility and flexibility in capital allocations and capital investment. 

When one magnifies leverage and speed of response, the normal outcome is greater risk (measured by volatility) and greater concentration of risk.  Securitization does this.  In so doing, it distances the creation of risk (at the individual property level) from the acquisition of risk (by the holder of a structured financial instrument).  All this is fine – risk is supposed to migrate, that’s what insurance is – provided that those risk pools are visible to the capital markets, so they can evaluate the counterparty risk.

Think of risk like alcohol diluted in water, and financial structuring like distillation.  It purifies one product (the boiled-off water) and concentrates another (the Tennessee lightning). 

Y’all gotta know what yer drinkin’, that’s all

Either has its use, provided the consumer has adequate disclosure:

Yew know what yer drinkin’

That’s what made the next invisible story so significant:

2003, January: Issuance of FIN 46 (later FAS 167)

In January, 2003, seeing a problem approaching, the Financial Accounting Standards Board (FASB) issued the inelegantly named FASB Interpretation Note (FIN) 46, Consolidation of Variable Interest Entities – an interpretation of ARB No. 51.  A response to the Enron shenanigans, FIN 46 sought to prevent sponsors from playing hide the ball with risk.  The FASB created a paternity test for financial offspring, in prose so turbid as to be nearly indigestible:

Norwalk, CT, January 17, 2003—In an effort to expand upon and strengthen existing accounting guidance that addresses when a company should include in its financial statements the assets, liabilities and activities of another entity, the Financial Accounting Standards Board (FASB) has issued Interpretation No. 46, Consolidation of Variable Interest Entities.

The critical term is ‘to consolidate.’  When does a company (Parent) that has shares in another company or venture (Offspring) have to account for all its offspring’s adventures and misadventures? 

This thing of darkness I / Acknowledge mine

To use a current-day conundrum, when does Dubai have to consolidate Dubai World, and when does Abu Dhabi have to consolidate Dubai?

Before FIN 46, the test was simple: control. 

Until now, one company [Parent] generally has included another entity [Offspring] in its consolidated financial statements only if it controlled the entity through voting interests.  

That test let folks like Enron hide steaming piles of risk in special-purpose vehicles (SPVs or SPEs) that could then be shut away in nearby opaque risk garages, to which they had the only key but whose odoriferous contents they were not obligated to report.  As explained in CFO Magazine:

Early in his tenure as chairman of the Financial Accounting Standards Board, while the Enron scandal was raging, Robert Herz was confronted on Capitol Hill by a senator from the South.  As Herz tells it, imitating the lawmaker’s distinctive drawl, the senator demanded to know when FASB was going to “outlaw the use of these dummy co-poh-ray-shuns.”

Putting auditors in the driver’s seat? Robert Herz

Herz’s solution was FASB Interpretation No. 46 (FIN 46), an economic test designed to fill in when legal definitions of ownership fail. The crux of the test: who stands to gain or lose the most from an SPE whose ownership is otherwise unclear?  (Such SPEs are now dubbed variable interest entities, or VIEs.)  Whichever company proves to be the VIE’s “primary beneficiary,” said FASB, must consolidate the entity’s financial data in its own statements.

FIN 46 changed the consolidation definition from control (which could be manipulated or obfuscated) to variability (upside and downside).

Interpretation 46 changes that by requiring a variable interest entity to be consolidated by a company if that company is [a] subject to a majority of the risk of loss from the variable interest entity’s activities or [b] entitled to receive a majority of the entity’s residual returns or both. A company that consolidates a variable interest entity is called the primary beneficiary of that entity.

Basically, FIN 46 said there are no orphans: every child has one and only one father.  That father, who had to acknowledge patrimony (and hence implicit financial responsibility) was the entity with most of the upside or downside.

Yes, unfortunately, he’s mine, by George

No More Make-Believe
Before FIN 46, the orphan status of SPEs was a large part of what made them so useful. Generally speaking, SPEs are dummy corporations, created to own assets that a company doesn’t want on its own books for any of a variety of reasons. For example, for securitization purposes, an SPE increases the value of the assets as collateral by sheltering them from the company’s creditors. As long as their “sponsor” company didn’t have voting control or too large an equity stake, SPEs were considered independent.

The guidance was issued as an interpretive note rather than a standard because the FASB wanted to get it into the marketplace quickly, to prevent collapse of investor confidence in the wake of Enron’s implosion. 

En-who?

FIN 46 was later supplemented by FIN 46R, then subsumed into FAS 167.

Like many a putative safe harbor before it, FIN 46 immediately became the boundary standard for ethics.  As constructive critic Vinod Kothari put it, largely quoting S&P:

Standard and Poor’s … reported that “the majority of securitization professionals worldwide report that they are overwhelmingly frustrated, skeptical and confused by the new set of rules for off-balance-sheet financing, characterizing it as an unnecessary and costly burden on an otherwise healthy market.  Moreover, the regulation fails to adequately tackle the problem of corporate malfeasance that it was originally designed to address, market participants said.”

Along with thousands of others, I can testify how much accounting brainpower was consumed defining the maximum perimeter of entities in which the Parent had a big economic stake without the dreaded FIN 46 consolidation.  This still goes on today, consolidation being the Thing To Avoid At All Costs.

Simple, isn’t it?  Vinot Kothari’s FIN 46 flow chart

FIN 46 has all sorts of unintended consequences.  An investor limited partner in a LIHTC syndication might have 99% of the profits, losses, and cash flow, with a completely non-recourse position, yet compelled under FIN 46 to consolidate the property’s entire operating performance (including its non-recourse loans) onto the investor’s balance sheet. 

“Respondents were consistently incisive, reproachful and vehement in their criticism of FASB’s year-long process of developing and vetting FIN 46, conveying in strong, pointed language their dissatisfaction with FASB’s responsiveness to the securitization market and their disappointment with the final Interpretation, which many construe as an overly broad, ‘over-reaching’ measure which is treating a very specific abuse (inadequate and misrepresentative corporate disclosure).”

As you can imagine, this led to contortions by which entities sought to avoid having to consolidate.

A total of 470 participants from the US and Europe participated in the survey. Most also felt that the market will adapt itself with new structures which simply cosmetically re-engineer SPEs to fall out of the definitions of the Interpretation.

That was the invisible story.  FIN 46, which sought to make things more transparent, in fact made them more opaque.  While investors basked in the illusion of transparent consolidation, in reality they were absorbing ever more risk.

Aftermath.  FIN 46, now renamed as FAS 167, is now a permanent part of the landscape, but the puzzles it poses remain unsolved.  Consolidation is still a bete noire in accounting and CFO circles.

You still haven’t dealt with me

2003 onward: Explosion of unlicensed insurance: Credit Default Swaps

Dematerialized capital and massive computing power enabled the creation not just of complex securitization but also of derivative instruments – securities issued based on the performance of other securities.  As I explained at some length, credit derivatives are risk moonshine [Posted June, 2007]:

If in fact risk has migrated to those better able to manage it, then the system should be able to tolerate more risk without overloading, because the risk is distributed.

It filters through the whole system

We have seen something like this in the weakening residential home market and its followup consequence, the subprime shakeout. The housing market’s crumple zone has dispersed risk both among participants and over time, so that although it’s clearly caused localized harm, there has been no systemic or structural failure [June, 2007, oops – Ed.].

So far credit derivatives have proved a triumph of the financial sector’s ingenuity. By dividing the bond market into digestible chunks, they have increased investors’ appetite for corporate debt. That may well have lowered the cost of capital—good for the economy, since it should allow companies to invest more over the long run.

I’ll give the Economist its caution, but it seems inescapable to conclude that better risk allocation expands capitalization and contributes to a lowering of interest rates.

Everyone looks like a world-class bicyclist when pedaling downhill.

No dopes here, just athletes

What then are these unicorns, the derivatives?

Credit Default Swaps were a particularly dangerous invention, because they were essentially unlicensed insurance [Posted December, 2008]:

“I bet I’ll die soon.”

“We bet you’ll live a long time.”

– The essential bargain in life insurance

“I’ll take that bet.”

When you buy life insurance, you’re selling a risk (that you’ll die) and the insurer is buying that risk.  You’re paying the insurer to buy it. 

I who control my lifespan bet I will die, and you who have no say in it bet I won’t.  Talk about agency risk!

Because of its perverse incentives, I’ve always found the insurance among the most curious financial products humanity’s ever invented.  The insurance-craving-murderous-spouse has been a staple of noir fiction ever since Fred MacMurray in 1944’s Double Indemnity (even the title screams insurance!) and smooth Ray Milland in 1954’s Dial M for Murder.

Dial M for money?

As compared with other complex securities, credit default swaps were (and are) especially dangerous, because they introduce two new risks that the markets proved unable to appreciate.

1. Infinite replication means infinitely diluted credit-worthiness.  CDSs are side bets.  Disconnected from the direct participants’ capital, they can be written in any desired multiple of the company’s market capitalization.  We see the same effect in sports betting, where obscure events can attract wagers whose total value is many multiples of any purse for which the athletes are competing, with resulting potential for match-fixing.

$7,000,000 bet on me losing? 

2. Financial incentive to kill a company.  If enough CDSs are written where hedge funds (say) profit from a company’s demise, and the target is subject to capital requirements, then there is a serious Dial M for Murder risk: giving third parties a financial incentive to do in another.

Combine those two new risks and you can have speculators who load up, betting on the demise of a particular company, and who then conspire to make it happen (especially in concert with another hidden story, FAS 157, that I’ll profile below). 

Patience is a virtue, but killing things is so much quicker

As I put it [Unfortunately long after the fact; posted December, 2008]

We’ve already seen, in Unlicensed Insurance (Part 1, Part 2, and Part 3), that Collateral Default Swaps (CDSs) are like double-indemnity insurance, or side bets on a football game: you and I speculate on a third party’s fortunes, with me hoping they’ll lose.  If such a bet took place only in a financial private club, that would be one thing, but much like the Double Indemnity situation, a massive amount of short selling can destabilize the stock price.

The result was predictable.  CDS volume exploded:

Bets vastly in excess of collateral to cover them all

As the Economist’s chart shows, the market is repricing risk, and probably over-pricing risk.

The next shock could be the failure of a hedge fund with a big swap book, given the spike in redemptions and margin calls many funds face, thinks Pierre Pourquery of the Boston Consulting Group. Hedge funds wrote almost a third of all credit protection last year (see chart 2).

When the speculators are betting you’ll die, watch out

Selling CDSs would be like hedge funds, who are the latest generation of the ’smartest guys in the room’ – big bets, no assets required, just enormous risk tolerance and confidence.   That’s been the risk in the CDS market: not that you’d never need the protection, but that when you needed it, it wouldn’t be worth anything.

“Yes, I killed him. I killed him for money – and a woman – and I didn’t get the money and I didn’t get the woman. Pretty, isn’t it? I bet he croaks soon.”

– Walter Neff, Double Indemnity

Do I laugh now, or wait ’til it gets funny?

Hyperinflation of CDS in force created a condition of potential panic-inducing short selling – but that by itself would not have been such a problem … were it not for the decade’s next invisible story.

Aftermath.  Credit Default Swaps remain, and will do so indefinitely, but now the capital markets understand the counterparty risk (the potential “never-pay policy”). 

Kill him for me.  I’ll make it worth your while.

Issuers of CDSs will be scrutinized as never before for their credit-worthiness.

Is she credit-worthy, I wonder?

[Continued tomorrow in Part 4.]

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