How Leveraged Mortgage Monetization Created a Global Financial Meltdown & $700 Billion Bailout

Treasury Secretary Paulson has asked and Congress is considering a $700 billion bailout for financial institutions drowning in bad loans.

In the last several weeks it seems like we have entered an economic black hole. Fannie Mae and Freddie Mac are in a "conservatorship". Lehman Brothers has followed Bear Stearns and both are gone. Merrill Lynch has been bought by Bank of America, AIG has been taken over by the Federal Reserve, and Morgan Stanley (stock chart) and Goldman Sachs (stock chart) are fighting for their very existence.

The obvious question is "what happened"? Consequently,the purpose of this post is discuss how we got to the point where the Government is attemptingto prevent the economy from falling into the same black hole via a guarantee for money market accounts and an additional $700 billion bailout of U.S. financial institutions.

I. How the Market Mortgage Works & The Role of Investment Banks

Like Banks, Mortgage Bankers and brokers create, i.e. originate, mortgages by working with borrowers to obtain the funds to buy their homes. The loans made maybe kept on the books of the lender or sold to Investment bankers. Investment bankers' turn these mortgages back intomoney, that is they monetize the asset, by forming pools of mortgages that are the collateral for Mortgage Backed Securities (MBS) and Collaterialized Mortgage Obligations (CMO). These securities are sold to domestic and international money market fund, mutual fund, pension fund investors,banks and speculators as investment assets and trading vehicles.

Investment Banks, like Bear Stearns or Lehman Brothers, have a trading desk and sales force that buys and sells mortgage backed securities and collateralized mortgage obligationsfrom and to money market fund, mutual fund, and pension investors. A typical seller can call a firm and the broker will tell him what the trader will pay. If the bonds are sold to the brokerage firm they are placed in the firm's inventory and on its balance sheet until they are sold to another buyer.Brokerage firms finance their borrowings, i.e. the purchase of mortgage backed debt, through the repurchase agreement.

The "repo" allows the brokerage firm to finance its inventory by borrowing money from money market funds, mutual funds,pensions and banks for a period as short as one day and use the MBS as collateral for the loan. Lenders, however,may require a "haircut." Haircut means they will lend our example firm something less than $40.00 and rely on the $1.00 in equity as a cushion against a decline in the mortgage bond's price and thus assure full repayment payment of the loan.

The nature of the problem, long term lending via the ownership of mortgage backed bonds versus the risk of using short termfinancing to carry those bonds in inventory, is also exemplified by the use of financial commercial paper. Brokerage firms used large amounts of asset backed commercial paper to finance their holdings.

II. What Investment Bankers Did to Neutralize Leverage Risk

Investment banks support their purchases through leverage. A good example of the impact of leverage on a balance sheet comes from CNBC's Dylan Ratigan. Paraphrasing Ratigan: (1) Assume you have one dollar ($1.00). (2) assume you borrow $39.00's and with your $1.00buy a forty dollar ($40.00) mortgage backed bond. (3) Your one dollar ($1.00) is "leveraged 40 times. (5) At thispoint you have a $40 asset (the mortgage bond), a $39.00's liability, and $1.00 in equity. If the market value of the $40.00 mortgage goes down in price by 2.5% you lose $1.00 ($40.00 x .025) and the resale value of the mortgagefalls to $39.00. If you lose more than a dollar you can't repay the loan and you are bankrupt. Indeed, with leverage so high, 40 times in this example, any decrease in the value of the mortgage leaves the investment bank insolvent.
The primary exposure of the leveraged brokerage firm that holds these bonds as inventory and the investor who addsthe asset class to the investment portfolio is credit default risk. Credit default risk measures the risk that anumber of individual borrowers, in this case homeowners, will not have the financial wherewithal to repay the loan and therefore the bond.



This risk is addressed in two basic ways.First, mortgage backed bonds may be overcollaterialized to protect the bond holder from default. If the actuarial assumption is that 15% of the collateral backing the bond will default, then the bond isovercollaterialized by at least 15%. An older variant of this theme is "substitute collateral." Under this option a default on 15% of the collateralrequires the defaulting collateral be removed from the collateral pool and be replaced by mortgages in good standing.


A second way default risk is mitigated is through the credit default swap (CDS). The CDO acts as an insurance like hedge against default and can be bought and sold independently from and without the necessity of there being an underlying asset to be insured. CDO's are, however, used to reduce the default risk on actual subprime mortgage bonds.

Understanding how it is thought default risk is mitigated provides the foundation for understanding why a rating agency, such a Moody's and Standard & Poor's, assign mortgage backed bonds investment grade ratings. Both Moody's and S&P perform independent stress tests to determine the ability of a bond, be it mortgage backed, corporate, or municipal,to withstand the downward pressures associated with adverse economic and industry events. The greater that ability to with stand adverse circumstances the higher rating.

III. Why the Financial System Broke Down and Created a Global Financial Crisis

With the above in mind return to the issue of leverage and the hypothetical investment bank. The sharp increase inmortgage default rates and the resultant sharp deterioration in the value of dealer inventories at least appeared to fatally affect the firm’s ability to repay their loans. That is to say if lenders do not feel that $1.00 is sufficient to cushion their loan they may refuse to continue to finance it, demand payment and refuse to make additional loans. If the value is less than $40.00 minus any haircut or repo lenders withdraw financing because the risk is too high. Since the investment bank in unable to pay its creditors or refinance its loans, the investment bank collapses.

A similar situation exists with asset backed commercial paper. Buyers of the paper not only refused to make new purchases as older maturities matured, but they actively sold or tried to sell current positions. As the price of the holdings of commerical paper fell the money market funds broke contractually permitted values ($1, or "the buck") and caused mass withdrawals.

Credit default swaps also reflect leverage. As an example a participant may trade a $10 million swap using $1 million dollars to collateralize the trade. Thus, if a trade which moves against the participant requires it to post more collateral to cover the increase in risk. Since a credit default swap is triggered by a creditevent such as default or non-payment, the deterioration in the assets held by participants, including investment bankers, Fannie Mae & Freddie Mac, and AIG, was of such a magnitude that investors questioned the ability of such companies to meetboth potential and actual requirements to post additional collateral.

One measure of equity is the investment bank's stock price. If an investor perceives the value of the mortgage backed securities held by the investment bank is deteriorating the investor can sell the stock. When enough investors sell the stock its price falls until it more accurately reflectsthe value or liquidation risk the company. Given the leverage used by Bear and Lehman many investors and speculatorsbelieved their price was going to zero. The price of these stocks dropped quickly and sharply as a result of squeezingthrough the keyhole. Investors and speculators reached similar conclusions at similar times and were willing to and didsell them at almost any price. Conversely buyers in general and stock exchange specialists in particular, pulled theirbids in order to avoid the onslaught of selling.

And, it is this specter that lead to the recent financial meltdown. If one pictures the NYC financial industry as the hub on a wheel, the financial industries of Asia and Europe are the spokes since investors in these areas both traded in and were counterparties in the deteriorating products.

For the purpose of illustration only, hypothetically assume Tokyo companies could only meet their financial commitments to London if NYC companies could meet their commitments to Tokyo. If NYC fails then Tokyo falls, if Tokyo falls then London fails. Given the resultant panic that increasing probability evoked, everyone sold at roughlythe same time and global financial prices collapsed.

SENATOR LESNIAK SELLS PUBLIC OUT TO CORZINE FISCAL RESTRUCTURING & TOLL MONETIZATION PLAN

Senator Lesniak's betrayal of the public interest to the Corzine fiscal restructuring & toll asset monetization plan speaks for itself.

The 800% road tax was announced by Governor Corzine in his January 10, 2008 State of the State address. On January 16, 2008 Senator Raymond Lesniak told Star-Ledger Reporter Joe Donohue in an article titled Lesniak wants governor to drop toll plan for Route 440 ;

"If they want 440 in there, they will have to find someone else to sponsor it. I won't," said Lesniak, one of the earliest proponents of using the state toll roads to ease the state's financial problems."

With Senators Adler and Van Drew joining the 17 Republican Senator's in opposing the road tax,
any vote in the Senate would tally 20-20, and thus fail.

The Star-Ledger then reports that at Governor Corzine's Middlesex "Town Hall"meeting the Governor announced "Tolls on Rt. 440 'not happening,'"

On September 10, 2008 reformed sinner Lesniak turned Corzine attack dog when he posted a guest article in the Star-ledger smearing New Jersey radio station 101.5 fm [for] self-promotion and pandering because they have actively opposed the Governor's toll road tax.

Senator Raymond Lesniak's February 11, 2008 Star-Ledger post "Lets Talk About Corzine's Toll road plan" is even funnier as Senator' Lesniak's Rah-Rah speech waxes poetic about political courage during tough times and the need for all to support the Governor and reach a solution.

Is that a lesson in slick practices or what?

Corzine Letters: Asset Monetization of Sex

My Dear Brother Jon,

Plutocrat Corzine, greetings! Your continuing excellent progress as New Jersey's Minister of Public Enlightenment appears to know no bounds. Only a master of the universe could monetize sex. The coronization of birth as death and death as life. A real Triumph of the Will!

Sex has long been seen as an asset subject to monetization. In fact, the monetization of sex, i.e. the exchange of sex for money is this world's oldest profession. So too abortion is a multibillion dollar business whose act only kills an innocent and irrevocably transforms the killer. The Wretched of the Earth (Letter V, p.7) But, Governor Corzine, your asking the people for "The Permission to Destroy Life Unworthy of Life", to dissect human embryos in return for money is breathtaking in its brilliance: New Jersey's contract with the Devil.

Well done.

It is of course axiomatic that "promising life to the dying, encouraging the belief that sickness excuses every indulgence ..." is the perfect distraction. People cannot be concerned with what they do when they are thinking about what will happen to them.

And the advertising thing, the $150,000 to promote passage of the stem cell and embryo bond contract? Genius, pure Genius. There’s nothing better than frequency and reach to enforce compliance. And, they may think you so generous for it!

But remember, stick with jargon not argument. Stay with words like "hope", "save lives", and "investment". And say stem cell, but never say embryo.

Don't argue because people might think for themselves. And, if you use facts, only use selective facts because facts lead people to think. For instance don't tell them the $450 million, which is really $720 million, in bonds are to be paid from general taxes you can't collect. They might think "if this deal is so good, why not use the project's revenues to pay off its debt?" Or, "this deal must be really risky because a general tax obligation bond is the only thing investors will buy." They might think about the State being bankrupt or how it could be used for schools, childcare or bridges and the like. And, don't talk about the actual amount of money made by the project because they might ask why Rutgers projections, p. 5, show the return to state coffers ( $19.7 million in state taxes) won't begin to cover the cost.

In short keep it "real", keep it fuzzy, but don't let people think about what you mean by "real" and never clarify fuzzy.

Your Affectionate Spirit,
Mephistopheles

ASSET MONETIZATION: SUBPRIME, HEDGE FUND & PRIVATE EQUITY MELTDOWN POINTS CORZINE TO LONGTERM STRATEGY

In the lead up to the November elections one would well expect Governor Corzine's "asset monetization" to take on an increasingly negative connotation and its supporters ostracized by the electorate as advocates of an "Ivy League Ponzi scheme.”

As the mainstream press gains a greater familiarity with the problems, as calls for greater disclosure by and stricter regulation of Hedge Funds and Private Equity Funds grows, and as the availability of buyers for structured product diminishes, the aftershocks of current global financial turmoil will leave a bitter aftertaste in the economy and a new sense the "cultural of credit" has come to an end.

Despite the current financial meltdown, however, Governor Corzine has made no showing that he has abandoned his drive to use asset monetization to restructure the State's balances sheet. Indeed, if we believe what former Chief of Staff Tom Shea told NJN’s Michael Aron (On The Record) the drive to securitize future revenue is more a function of when rather than if.

The question, therefore, is what is Governor Corzine's monetization strategy, and what is a likely timetable?

Part 1. It is said that it is better to be lucky than smart. Regardless of which is the case in this instance, Governor Corzine is positioned to weather the current financial storm. The Governor has, since returning to Office, been relatively silent on the subject. During this pause, the Governor has listened to objections, made several principle adjustments, but has generally refused to engage his critics on the particulars of his plan.

Silence prevents recrimination. No on can compare his plan to the hedge funds and private equity firms currently falling by the wayside or point out the structure of his proposed financing has defects similar to the financings that set off the current round of turmoil.

Indeed, watching the turmoil develop has allowed the Governor to preempt criticism. Hedge fund and private equity firm involvement would taint the plan and thus has been removed by committing not to “sell the turnpike” to such firms, but rather to sell future revenues to the State through a “public benefit corporation.”

Furthermore, seeking to place the approval of any asset monetization on the ballot not only disengages the issue from the November election (or at least provides Democrats with cover), it kicks the can down the road until there is a settling of the market’s dust. Maybe the next budget.

Finally, with Treasury Secretary Abelow as Chief of Staff, Governor Corzine makes a surrogate expert voice available to the press and the public. This voice serves to (1) deflect criticism of the concept, (2) rehabilitate legislative and public opinion about asset monetization and restore their confidence in, or at least a necessary evil acceptance of, the concept, and (3) to do all of this in a manner consistent with new legal, political and market realities. In effect, Chief of Staff Abelow is the Investment Banker brain, the deal man driving and reshaping both the product and the ongoing public relations effort.

Part 2. Going forward, the first task of Governor Corzine and Chief of Staff Abelow will be to defend their past actions and assure the public all is well. The New Jersey track record with the hedge fund world is mixed. Although Amaranth Advisors may have cost NJ $8 million on a $25 million investment, the thirst for higher returns has not been dampened by the higher risk. And, while NJ investment types are scattered throughout various sectors of the world economy, and thus generally impacted by the global crisis and any resultant downturn, primary focus will be on the infrastructure investments. As of May 23, 2007 NJ owned 32 million shares in the private equity firms of Cintra and Macquarie Infrastructure. Both Cintra and Macquarie are managers of public goods like toll roads and bridges. Both have been mentioned as potential buyers for the Turnpike.

Part 3. Words like monitor, assess, gauge and manage, adjust and refashion are the bywords for the foreseeable future. Short term, market volatility should set the tone for any monetization strategy. At this point tactics seem reactive. Only when the markets really stabilize and the damage to economic growth better understood will the Governor be able to shift asset monetization from a defensive to offensive posture.

WHAT TOLLS? GOV CORZINE, ASSET MONETIZATION & SECURITIZATION

For whatever reason Governor Corzine and the loyal opposition are not talking about “Asset Monetization” and “Securitization”. Yet there must be some basic rules that form the foundation for any and every such program. Accordingly, the purpose of the following is to begin thinking about that discussion.

At first glance the structure would appear to be a broad balance sheet reorganization that structurally matches disparate groups of capital assets with dissimilar groups of capital liabilities.

DEFINITIONS:

ASSET MONITIZATION: Future cash receipts generated over a set time period in the future are traded for cash today, i.e. Turnpike or Parkway tolls from 01/01/08 through 01/01/18 may be sold to investors. The sale price is today’s value of that cash flow where each future flow is discounted to give the investor a current market rate of return on the investment.

Issuing debt as a means of receiving cash today with the promise to repay with toll revenues tomorrow is called SECURITIZATION. Using a bond to borrow against future toll revenues securitizes the future toll revenues.

AN IMAGINARY ILLUSTRATION TO UNDERSTAND THE COST.

The following projections are totally made up and for demonstration purposes only. And, keep in mind that the issuance of debt can take many different forms. For instance, New Jersey could sell one fixed maturity bond backed by 10 years of toll revenues and repay the total debt in year 10. Or, costs might be lowered by treating each year’s receipts as a separate bond that will be repaid when that year’s tolls are received. The theory is the shorter the time to maturity, i.e. the time until the loan is due to be paid, the lower the interest rate that will be paid. In effect the shorter pay date lessens the lenders time exposure to deterioration in the borrower’s ability to pay or that interest rates will move higher. In reality there are many more possible debt structures. All have unique costs as well as unique benefits.

If we unrealistically assume the current years revenues are $1,000,000 and those revenues grow at 2% per year, the annual income stream from tolls over the next 10 years is as follows:

TOLL REVENUE PER YEAR

2008-2009 1,020,000
2009-2010 1,040,400
2010-2011 1,061,208
2011-2012 1,082,432
2012-2013 1,104,081
2013-2014 1,126,162
2014-2015 1,148,686
2015-2016 1,171,659
2016-2017 1,195,092
2017-2018 1,218,994

TOTAL 11,168,714

If investors demand a 6% taxable return on their investment, the amount the State can borrow in 2008 is $6, 236,251. At the 6% rate $6,236,251 grows to $11,168,714 in 2018 and that total is thus the sum paid to investors as a lump sum in 2018.

This means the borrowed funds received must reduce expenses whose annual cost is greater than 6%. If used to reduce expenses or fund a project where the the cost is less than 6% the State loses money. If used to reduce expenses or fund a project that costs more than 6% the State saves money.

State, county and local government bonds are generally exempt from federal, and in certain instances State, income taxes. Because they are exempt the interest rate paid on “municipal bonds” is determined in part by an investor keeping more tax free interest than would be kept after paying taxes on a taxable bond. Ask yourself, all things being equal, would you buy a 6% bond that is taxed or a 6% bond that is tax-exempt. Logic dictates you will buy the tax exempt bond until the tax exempt interest rate is equal to the after tax interest rate you receive on taxable bonds.

The tax-free rate equivalent to 6% taxable is 4.62% for someone in the 30% tax bracket. Given a premium to induce such an investor to buy the new security the price might be 4.75% or higher. At 5.00% tax free, the present value of $11,168,714 – the amount the State of New Jersey borrow in 2008 – is $6,856,623.

SOME INITIAL THOUGHTS ABOUT ASSET – LIABILITY MATCHING

(1) The trick appears to be in the issuance of lower cost tax exempt bonds (in effect a federal subsidy) to reduce higher cost expenses or to fund higher cost projects.

Historically, this was done through what is called a pre-refunding. The borrowed funds were used to retire outstanding higher cost debt. In effect the proceeds from the sale of future toll revenues as tax exempt bonds would be reinvested in taxable bonds. As the taxable bonds pay off the proceeds are used to pay off the old debt. The higher interest earned by the State on the taxable bonds lessens the total amount which must be borrowed to retire the older, higher cost debt. The issuer saves by paying a lower interest rate on the new, substitute debt.

The problem with this structure and its distance cousins is whether the IRS allows the tax exemption to be used in this manner. Don’t count on it.

(2) Or, the proceeds from tax exempt toll revenue bonds could be used to make capital improvements, i.e. a turnpike extension. In this instance the issuance of toll revenue bonds is nothing new. A Turnpike or Parkway bond paid for by toll revenue is a typical financing. Assuming the money can be used to build new schools, however, toll revenues are a (partial?) substitute for the property tax as a new source of construction funds. In effect toll revenues are a selective, steadily increasing tax (based on the cost of living?) whose proceeds are used as an alternative to the more general property tax. In this instance the school is an asset matched with a self-liquidating liability.

Here too, one must ask if the use of toll revenues to fund non-road related capital improvements is the cheapest way to fund such projects as opposed to merely reallocating the cost via a hidden tax. Increasing the debt load of the toll roads by a substantial sale of its toll income, regardless of whether it is through a public benefit corporation or not, weakens the credit rating and increases borrowing costs while limiting future borrowing capacity. And, how does one make any reasonable estimates about spending needs without a school funding formula.

Furthermore, one has to wonder if this form of financing fatally conflicts with the Governor Corzine’s commitment to reduce greenhouse gases. On the one hand he needs to raise tolls in a manner that at least does not reduce traffic, i.e. congestion pricing in fact. On the other hand, Governor Corzine needs to reduce emissions and may therefore need to reduce auto and truck traffic. If it costs more to use the toll roads and it costs more to reduce emissions on those roads (less traffic, higher costs, or both), the diseconomies could have a rippling negative effect as the costs are passed on in the form of higher prices and / or insufficient revenues to repay the bond (more people and freight take the bus and train).

Finally, the most important question, however, is how does such a financing scheme encourage thoughtful spending rather than merely expand it. What are its political and economic boundaries and limitations and how strong are those breaks? Without such circuit breakers this form of financing is open to debilitating abuse.

(3) If the money can be used to fund earlier pension liabilities, i.e. cover the payments that were never made, the use is essentially borrowing to play the stock market. New Jersey’s been there, done that. Hopefully, never again. The more prudent alternative, if possible, might be to directly pay any increase in toll revenues directly into the pension fund.