Why The Banks’ Legacy Securities Aren’t Illiquid

I don’t know much about Linda Lowell who writes occasionally for HousingWire but she sure does a good job of cutting through the fluff on issues. For the past month or so she’s put out some of the best work I’ve seen on mark-to-market accounting (thanks for the education, Linda) and today has a great piece on the myth that RMBS are illiquid.

Ms. Lowell starts her article with a nice wrap up of the implications of FASB’s announcements today and then dives into the RMBS issue.

I didn’t come here to praise FASB, however, but to bury the notion that the devalued and disgraced RMBS securities on banks balance sheets are illiquid. Nor should the observable market prices be described as “fire sale” or “distressed sales.”

Not that there have not been fire sales. There were some very large and visible fire sales last year as the biggest “sinners” in structured products (a blanket term that includes fairly vanilla non-agency RMBS and CMBS as well as CDO, CDO’s backed by CDS, CDS and so on) shed assets on their way to bankruptcy or acquisition (Merrill’s infamous 22-cents-on-the-dollar sale will come instantly to mind for many).

That those fire sales took place has provided a smoke screen, as it were, for banks and their enablers in Congress, free-enterprise, free-market “think tanks” and industry groups, and the media, to claim these markets are inactive.

The other mythos this crew hides behind is the notion that these riskier-than-first-thought assets are too complex to easily value (please notice that I am not going to say “troubled,” “toxic” or, no not never, “legacy” with regard to this batch of soiled laundry).

First, there is plenty of pricing information on triple-A private RMBS and CMBS. They may not trade where banks holding lots of this paper at a loss wish they traded, but they do trade. Let’s get something clear, too — they NEVER traded with the kind of depth or frequency that Treasury, agency debt or Ginnie, Fannie and Freddie MBS do. Each bond is unique enough that it has to be manually evaluated — anything from a simple cash flow calculator that uses market conventions for prepayments and defaults – or elaborate option pricing models that take into account hundreds of different interest rate, credit performance and prepayment scenarios. The cash flow calculators are ubiquitous — the sophisticated tools are available at a market price.

They trade less frequently because significant sources of demand have been eliminated. Except for the big trading books at the big banks, banks have eliminated themselves as potential buyers on the re-trade. They also cannot sell held-to-maturity triple-As unless they are downgraded, they can’t realize much in the way of losses on available-for-sale triple-As. Ditto for insurance companies, though the rising tide may let them wriggle out of some clunkers.

What’s left is the subset of investors who are marked-to-market. Ergo they have experienced their losses. This would include money managers of various kinds of funds (mutual to pension) using what we call “real money” and leveraged investors — the hedge funds and private equity managers. This segment of the market can and does trade this paper. It has been slow, but their activity has been significant enough for trading desks on both sides of the trade to track market levels, make offers and attempt to buy paper from known holders.

Most pertinently, sources on trading desks tell me they make “on the market” bids to banks for their paper and banks won’t sell. These same sources will explain that hedge funds are still the buyer on the margin, and prices have adjusted to reflect the hedge funds’ required yield –- typically 25 percent.

However, hedge funds used to achieve that yield by leveraging securities that traded at much higher prices, back when triple-A was assumed to mean risk-free (not a waiting game or playing chicken with a falling housing market). Now hedge funds’ traditional sources of leverage are gone. Security pricing has adjusted to reflect this loss of leverage.

Ms. Lowell points out that the announcement of PPIP caused a stir among investors that resulted in a tightening in spreads, position building by speculative investors and signigicant research and modeling among the players likely to be involved.

I recommend the entire article to you. My take on it is that the banks and buyers under PPIP are not going to do a lot of deals for the RMBS portion of their portfolios. PPIP as it applies to securities does not have much built in leverage, so based on her analysis, that would seem to say that the prices are unlikely to rise to a level the banks will consider acceptable particularly since some heat has been taken off of them in terms of marking the securities.

That opens the door to other questions. If the banks opt to sit on the securities what does that do to their lending capacity? Are we creating an environment that creates zombie banks? If we’ve learned anything along the way here, it is that this gigantic complex financial system reacts in strange ways every time that we think we have a fix. I suspect that there will be an unanticipated surprise or two as these new wrinkles work their way through.


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