Credit Crisis - Academics and Analysis - 4

This blog is next in the series of blogs ‘Credit Crisis – Academics and Analysis - 3’. Please read previous blogs for a better sense of flow.

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Here I will try to analyze Risk Elements with MBS securities and attempt to build a sense of what could have gone wrong.

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Borrowers pay a rate of interest for their mortgage loans. This rate includes Risk Free Rate + Risk Premium to compensate risks associated with those loans.

• We know the bubble was created because home prices kept going upwards to a point of burst. No argument on that!
• Upward movement in prices was due to lower interest rates paid by borrowers and a larger investor base making increased supply of loan-able funds. Again no argument on that!
• Larger Investor base is what we desire and going forward, we would aim to maintain/increase that. So, there is no problem with that part of equation.
• Lower Risk Free Rates, we know were controlled by FED’s Monetary Policy. Analysts have already pointed that out as one of the strong reasons for the bubble. FED kept these rates too low for too long. Again no arguments!

Now, the remaining variable in the equation is Risk Premium added to Risk Free Rate. Let’s analyze this to see, if this premium could have been cheaply charged to borrowers.

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I will organize contents of this analysis as:

• Risks for End Investors
• Risks for MBS Issuers/Guarantors
• Total Risks Analysis as against conventional Home Loans

Risks for End Investors

• Credit Risk: Since there was Guarantor party present (i.e. Ginnie Mae, Fannie Mae, Freddie Mac), Credit Risk to Investors was quantified by creditworthiness and credit ratings of these guarantor parties.
• Interest Rate Risk: Same as with any other fixed income security. Security Prices will go down when Risk Free Interest Rates go up in the market. Its quantification is to be based on whether coupon is fixed or floating.
• Prepayment Risk: Higher when Interest Rates are going down.
• Liquidity Risk: Quite low as there was active secondary market for these securities.
• Unknown Product Risk: Since Investors are not so knowledgeable on these new complex structured securities, they should charge a premium for any associated uncertainties.
• Systematic Risk: With increased de-regulations from govt. combined with complex and relative unknown nature of these securities, did expose Investors to added systematic risk, which should have been accounted for in their premium.

Risk for MBS Guarantors/Issuers

• Credit Risk: Guarantors faced risk of defaults from actual borrowers.
• Impairment Risk: Collateral for safeguarding default was the home purchased by borrower. Any devaluation in the value of collateral should be a risk to account for.

Total Risk Analysis as against Conventional Home Loans

• Total Credit Risk: Since end borrower is still the same without any additional collateral, Total Credit Risk is same for this new Instrument.
• Total Interest Rate Risk: Is the same as with conventional loans. It is just transferred from Loaning Bank to End Investor.
• Total Prepayment Risk: For CMOs, this Risk has been reduced (or the combined premium demanded for this is lower), as the instrument has been able to create better matches of demand for prepayments.
• Total Liquidity Risk: This Risk has been reduced too. Earlier, Bank loans were pretty much illiquid, but these loan securities are much more liquid as they are traded in secondary markets.
• Total Impairment Risk: This risk was increased, because of high Loan to Value ratio. De-regulation allowed this ratio to go high, meaning borrowers could borrow with lowered down payments. Together with inflated home prices (collateral), this risk was increased. As Price to Cost ratio increases, so does the Impairment Risk. Supernormal Profits are difficult to be sustained in long run.
• Total New Product Risk: This was an additional risk component added with complex and innovative CMOs.
• Total Systematic Risk: This too had increased with increased deregulations.

So, we see, in Total Risk Premium to be charged to borrowers, there are downward factors like Prepayment Risk and Liquidity Risk and upward factors like Impairment Risk, New Product Risk and Systematic Risk.

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Questions forthcoming from this analysis are:

• Were all these risks and their premiums duly considered?
• Were Credit Rating agencies able to correctly indentify and quantify these Risks and rate these Securities accordingly?
• Did borrowers got away with paying lower interest rates with heavy costs to end Investors and Capital Markets as a whole?

On the hindsight of the Crisis, we know we can answer first 2 questions in negative and the last one in affirmative.

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To summarize, I cannot claim this analysis to be complete. But the idea is to expose more dimensions and create added inputs to your existing thought process.

Credit Crisis - Academics and Analysis - 3

This blog is third in the series of blogs ‘Credit Crisis – Academics and Analysis’. Please read previous blogs first, for a better sense of flow.

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Here I will try to build a basic understanding for another component of ‘Securitized Loans’, which is ‘Asset Backed Securities (ABS)’.

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Asset Backed Securities are similar in structure to Mortgage Backed Securities (MBS), which we discussed earlier. The differences are:

• For MBS, underlying assets are mortgage loans, whereas for ABS, underlying assets are most of other kind of loans. e.g. Credit Card Loans, Auto Loans, Home Equity Loans, Corporate Receivables, Student loans etc.
• Security Issuer is generally a Special Purpose Vehicle (SPV) for ABS, as against govt. or govt. sponsored agencies for MBS.
• ABS securities are generally shorter term securities as compared to MBS securities, so they are less prone to interest rate fluctuations and re-financing. To illustrate, Home Loans are generally for 30 years, whereas say Auto Loan would typically be for 1 to 5 years.
• When MBS is further structured into Tranches, they are known as CMOs. And when ABS is further structured into Classes/Tranches, they are known as CDOs (Collateralized Debt Obligations).

Let’s take an example of Corporate Receivables and see how ABS works for this underlying asset.

• Corporate has some Receivables. It sells them to a SPV and receives a discounted sum.
• SPV securitizes this asset and sells it to end investors.
• During the life of asset, Corporate collects receivables from its customers and pays them to SPV.
• SPV pays them back to Investors.

Motivation for Corporate

• Lower cost of credit to Corporate, as Credit Ratings of SPV are higher than the Corporate itself.
• Working Capital gets freed for further Operational Activities.

Risk Analysis

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Credit Risk to Investors

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To Investors, credit risk is based on Credit Rating of the SPV. Higher the rating, lesser would be the premium charged by investors on that security.

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Credit Risk to SPV

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SPV is exposed to Credit Risk from the Corporate itself. But, there could be Credit Enhancements agreed to by Corporate in the form of Recourse Option and Bankruptcy Remoteness. Recourse Option means, in case of any default on receivables, Corporate would be responsible. And Bankruptcy Remote option keeps these Receivable Assets away from other Creditors, in case Corporate ever files for bankruptcy. Because of such credit enhancements, Credit Ratings of SPV would always be higher than that of the Corporate itself. This reduces the cost of Credit to Corporate.

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Prepayment Risk

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Because underlying Assets in ABS have lower maturity periods (as compared to MBS), time duration of their exposure to Interest Rate fluctuations is lower. This results in lower chances of re-financing by end borrowers and hence a lower Prepayment Risk to ABS investors.

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To summarize, ABS is a structured security which enables individual and institutional investors to provide credit for various consumer and corporate loans.

Consumer and Producer Surplus

In Micro Economics, Consumer and Producer Surpluses are associated with equilibrium price of a product and efficient allocation of resources to produce that product.

I will use an example to illustrate them.

Consumer Surplus

Say, market price of a pen is 5. This is its equilibrium price derived by market factors of demand and supply. Assume, you don’t have a pen and you want to buy your first pen for writing an exam. Say, you would buy it, even if it was selling for 8. So, you are happy that you need to pay only 5 to get it. Consumer surplus for you in this transaction would be 8 - 5 = 3. However, for your 2nd pen, say you would have bought it for no more than 6. So for that transaction, your consumer surplus is 6 – 5 = 1. And say, for your 3rd pen, you wouldn’t pay more than 5. Your consumer surplus for the last purchase would be 0.

Thus, total Consumer Surplus for all consumers can be calculated from the Demand Curve as sum of [all prices above equilibrium price x Quantity demanded at those prices].

Producer Surplus

Extending the same example, let’s say Total Cost (fixed and variable) for producing that pen is 2. Producer would happily sell it for any price above 2. At market price of 3, his surplus is 1 per unit sold; at price 4, it is 2 and at price 5, his surplus is 3 per unit sold.

Thus, total Producer Surplus can be derived from the Supply Curve as sum of [all prices between total cost and equilibrium price x Quantity supplied at those prices].

Also, know that, when Equilibrium Price is determined purely by Market Factors of Demand and Supply (without any external influences like production quotas, upper/lower price limits, subsidies etc), then the SUM of BOTH, Consumer and Producer Surpluses are MAXIMIZED. That is, resources used in producing that quantity corresponding to the equilibrium price, are most efficiently allocated.

Short Selling - Debate on Uptick Rule

This financial crisis has destroyed a lot of wealth for many investors. There are many who are blaming it on Short Selling and the abolished Uptick Rule. Uptick Rule was abolished by SEC in June 2007, after being in place since 1938. Currently, SEC is encouraging a debate, if or not to put Uptick regulations back in place.

What is or rather was Uptick Rule? Uptick Rule prohibited short sale of securities, except on an uptick. Meaning, a short seller could only sell equities at a price higher than the last transaction price (higher at least by the defined uptick amount).

To me, I will take it as a market distortion rule and would support its abolition. Short Sales are important to keep markets healthy by keeping underlying prices close to their true equilibrium values. Without short sales, securities would mostly have an upward bias and be over valued. So, any regulation which discourages short sales as a correction instrument is not healthy for markets as a whole.

Having said that, it is important to understand difference between a ‘Short Sale’ and a ‘Naked Short Sale’.

In a Short Sale, seller borrows security from security owner for a short period and sells it at the market price. He is betting negatively on that company and stock, and is expecting it to be overpriced. At the end of period, seller buys it from the market (at lower prices if his bet has played correctly) and returns it back to its owner. Owner is usually an individual or institution (e.g. pension funds, ETF etc), who anyways wants to keep that security for longer term. Owner receives interest on his lending and borrower (short seller) gets to play on his bet. (If I were the owner, I would also charge premium for impairment risk on my security)

In a ‘Naked Short Sale’, seller is short selling securities without borrowing them. This is a clear distortion of market factors. He is selling something, he does not have (or no one has). His action is artificially increasing supply of that security and if the volume of this artificial supply is critical enough, it will anyways bring down the prices. This is Basic Economics; things have value, because they are scarce.

To summarize, I will take Short Selling as a healthy Correction Tool and ‘Uptick Rule’ and ‘Naked Short Selling’ as two factors distorting its correction properties. ‘Uptick Rule’ by discouraging short selling and ‘Naked Short Sales’ by abusing it.

Credit Crisis, Academics and Analysis - 2

This blog is a continuation of the previous blog ‘Credit Crisis, Academics and Analysis -1’. As mentioned there, I will try to build up an understanding for ‘Securitized Loans’, which held the biggest share in US Credit Markets up until the Credit Crunch.

Securitized Loans have been one of the greatest innovations in the recent history of Financial Markets. This Asset Class can broadly be put under 2 categories, categorized by their underlying Assets.

• Mortgage Backed Securities (MBS) – with underlying asset as Home Mortgage Loans.

- Pass Thru Securities
- Collateralized Mortgage Obligations (CMOs)

• Asset Backed Securities (ABS) – with underlying assets such as Corporate Receivables, Credit Card Receivables, Auto Loans, Student Loans, Home Equity Loans etc.

This blog, I will discuss MBS and leave ABS for next blogs.

Understanding MBS Structure

• Home Buyers are the borrowers, borrowing loans against their purchased homes.
• Banks and Financial Institutions provide them with those mortgage loans.
• Subsequently, these individual home loans are pooled together (there need to be a minimum of 300 individual loans to form one such pool) and an MBS issuer will issue securities against that pool. Once Securities have been issued and subscribed, Banks’ (Loan Issuers’) Capital is freed and they are ready to issue more loans.
• MBS issuers in the US are agencies like Ginnie Mae, Fannie Mae and Freddie Mac. These agencies also act as guarantors for their issued securities. Out of the three, Ginnie Mae is a Govt. Agency and its creditworthiness is backed by full faith of the US Govt. While, Fannie Mae and Freddie Mac are Private Agencies and their creditworthiness is rated by Credit Rating Agencies like S&P and Moody’s.
• These securities are then bought by Individual and Institutional Investors. They are similar to other coupon paying Fixed Income Securities, but could be prepaid early, and will not have any embedded options.

For Pass Thru Securities, Security Investors would get periodic Interest and any Prepaid Principal, in direct proportion to their Investment in that Mortgage Pool.

For, CMOs (Collateralized Mortgage Obligations), there are defined Tranches. That is, any prepaid Principal in the pool will first go to investors in the uppermost Tranche, till that tranche is exhausted. Investors opt for investing in specific Tranches, based on their Investment Requirements. That is, relative short term investors may prefer investing in upper tranches, whereas, long term investors like Pension Funds, Insurance Companies etc, could invest in lower tranches. Interest Payments are proportional payments to investors in all tranches, which is same as that for Pass Thru Securities.

Risk Analysis for MBS

Credit Risk

There are 2 parts to Credit Risk here.

1. Credit Risk to Investors: Credit Risk to Investors is creditworthiness of its Security Guarantor. Investors will include a premium to their asking rate, based on Credit Ratings of their Security Guarantor/Issuer. Also, understand that Credit Ratings of Guarantor may get downgraded in future. If that happens, as an investor, price of your securities will go down in secondary market.
2. Credit Risk to Guarantor: This risk to guarantor is from borrowers defaulting on their monthly payments. Since, the underlying pool is a big pool of loans (at least more than 300), cost of premium for this risk is lowered, as the risk is considered distributed over a big pool.

Prepayment Risk

For Pass Thru Security Investors, Prepayment risk will always be there, especially when Interest Rates are going down. Now, why Prepayment is considered a Risk? Because, when Interest Rates go down any prepaid amount would have to be re-invested by Investor at lower rates, thus reducing overall yield on his Security Investment.

For CMOs, however, Prepayment Risk is lower for deeper Tranches and higher for Investors in upper Tranches. For upper tranches, Prepayment Risk is higher and Credit Risk is lower. Whereas, in lower tranches, Prepayment Risk is lower at the cost of higher Credit Risk. As there is a tradeoff available between Prepayment and Credit Risk here, and there are matching requirements (demand) available among investors, combined premium for both Risks together is lowered for the Pool as a whole.

To summarize MBS:

• Home loans are financed by a wider base of investors, including individual investors. Thus more Capital is available for lending. In a conventional scenario, where a Bank lends home loan to a borrower, bank’s lending capacity is limited by Fed controlled RRR (Required Reserve Ratio).
• Financing is much more liquid, as these securities can be traded in Secondary Markets.
• Overall cost of borrowing is reduced, as risk perception is lowered for the pool as a whole.

In subsequent blogs, I will discuss ABS and analyze the crisis.

Financial and Operating Leverage - 2

In previous blog, we discussed Financial Leverage. And now, let’s talk about Operating Leverage.

Financial Leverage is to do with the Capital Structure of a firm, where as Operating Leverage is how that capital has been invested in the firm for its operations.

We know ‘Production Costs’ are broadly categorized as ‘Fixed Costs’ and ‘Variable Costs’. If a firm invests heavily in its PP&E (Property, Plant and Equipment), that is, in its fixed assets, it is increasing its ‘Fixed Costs’. Motivation for doing that is to be able to reduce ‘Variable Costs’.

Now, increase in ‘Fixed Costs’ gives firm the leverage to increase its sales and get magnified returns as compared to its competitors. Let’s see this with an example:

Example

There are 2 firms A and B. Firm A has invested heavily in its Fixed Assets and has higher Fixed Costs and lower Variable Costs as compared to another Firm B, in the same industry. Firm A has higher Operating Leverage as compared to Firm B.

Say, it is boom time and sales for both firms are 500 units each. Both have same Sales and sell at the same price. Yet, Firm A has higher Earnings than Firm B!!

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This is the magic of Operating Leverage working on Firm A’s side!!

Now the Risk Side

Again, we know higher returns are always associated with higher Risks. So what are the risks here?

Let’s go back to our example. Now, say, it is a slack time and sales for both firms have fallen to just 10 units. As seen in the figure below, Firm A with higher Operating Leverage is now making losses, whereas Form B is still showing positive earnings!
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Analysis
Other things same, with higher Operating Leverage, your point of breakeven sales would be higher as compared to a firm with lower Operating Leverage. For sales higher than the breakeven point, your gains will be higher. And for sales lower than the breakeven point your losses will be higher.

Financial And Operating Leverage - 1

In most financial reading material, you come across the term ‘leverage’ multiple limes. In this blog, I will attempt to create an understanding of what it means.

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In your early school years, you would have studied ‘levers’ in physics or mechanics. You already know, how using a lever, you can get multiplied power, which you would not have otherwise.

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In Finance it is a similar concept.

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Let me explain that with examples.

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Financial Leverage

• Let’s say you have a Business Project, which is estimated to give you a 15% return in 1 year.
• It requires an investment of $100.
• But adding up all your money, you only have $10 of your own money (equity).
• Remaining $90 (debt), you are able to borrow from the market at say 5%.
• After 1 year, as estimated, your project completed and returned $115.
• From this you pay back $90 principal plus $4.5 interest.
• Remaining amount left with you is $20.5 .
• That is, you got $20.5 on your investment of $10. Which is a hefty 105% return on your equity!
• Meaning, though your project returned only 15%, you actually got 105% return on your equity, ex all your debt obligations!!!

This is the magic of Financial Leverage. Other things same, higher your debt with respect to your equity, higher is the leverage and higher would be the return on your equity. But not so soon :)

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The Risk Side

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This higher return comes with equally higher risk. In Finance, always expect higher returns to be associated with higher risks. Let’s see how!

• Now, let’s say for your previous project, instead of 15% profit, it returned 15% loss So, after 1 year, you are left with $85.
• And you owe $94.5 to your creditors (90 + 4.5).
• You pay all of $85 you have and still owe them $9.5 .
• Your equity of $10 is all wiped out and you are filing bankruptcy as you cannot pay your remaining $9.5 obligation.

That is the Risk side of Leverage. Investors take high leverage companies as risky, so cost of their equities is higher.

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To analyze this mathematically:

• If project returns are more than the interest rate you pay on your debt, your net GAINS will be magnified by the leverage.
• But if your project returns are lower than your loan interest rate, your net LOSSES will be magnified by the leverage.

I will discuss Operating Leverage in the next blog.

Credit Crisis, Academics and Analysis – 1

This is probably going to be a series of blogs from me, so I am serializing this blog. Next, I was wondering, how and where to start and then I read an interesting blog ‘Second Engine Implosion’ by Magnus Lind and the paper from J P Morgan it refers to.

The Figure below from this paper is quite an eye opener.

Source: Federal Reserve – Flow of Funds Accounts of the United States;

Securities Industry and Financial Markets Association; Standard & Poor’s.

It shows, securitized Loans had the biggest chunk of Credit Market share.

And this is the chunk, which has been badly hit in the crisis. Or rather, this is the chunk, which has dramatically contracted and is responsible for the Credit Crunch. So, even though Bank Loans have responded positively to various stimuli, crisis in credit markets is still knee deep.

So, in next blog, I will go after these ‘Securitized Loan’ instruments and try build and understanding for them :)

G8 + G5 summit – Economics of Climate Change

World is increasingly becoming globalized and with that many of the issues are also becoming global. Climate change is one of them, which affects all humans and life irrespective of whether they are in the US or in Madagascar.

What is the problem?

Problem is rising temperature of Earth. Because of increase in greenhouse gases, more of Sun’s radiations are absorbed in the atmosphere, thus, raising overall temperatures. As global population is increasingly consuming more resources, industrial production is growing rapidly and so are these greenhouse gases. Rise of emerging BRIC economies has added to the problem created by industrialized economies. China has already overtaken US as the world’s biggest pollutant.

What is the solution?

Solution is quite simple. Just cut the level of carbon and other emissions that we throw up in the atmosphere. Good news is; there is a complete agreement on this among leaders from most countries. Bad news is; there is a lot of Contention on how this is going to be implemented. To understand these Contentions, let’s see the Economics of it.

Economists call them externalities. Markets decide the price of a good or service based on its demand and supply. At that price, both buyer and seller recognize value to themselves by doing that transaction. But what if there is a third party who is being affected by this transaction, but not involved in Price Determination?

For example, I buy a 1500W music system. Both dealer and I are happy with this deal. He makes his due profit and I get satisfaction from listening to my favorite rock at high volumes. But, does this price include irritations I cause my neighbor? Has he been compensated for that inconvenience? NO.

Similarly, I buy a car. I pay a Price that includes cost of production of that car plus various markups. But, does the price include cost of treatment to an individual’s lung cancer which is caused by emissions from my car? NO. Or does it include compensation for flood victims in Bangladesh who have suffered because of emissions from my car? NO.

So, you see, many things we buy are priced cheaper, because they don’t include cost of various externalities. And because they are priced cheaper than they should be, they are demanded and cosumed more, inflicting even more damages to external third parties.

Now, coming back to our Climate Issue; Suggested method of cutting down on greenhouse emissions is by deciding on a global limit on allowed emissions and then issuing licenses for that limited amount. Production units that throw up these emissions would have to bid for these licenses. They will have to own license for each unit of pollutant they release in atmosphere. Thus, cost of pollutants thrown up will be included in their cost of production. So, consumers will be paying more for goods and services produced by them. Cost of Externalities will thus be included in Products they are buying.

Now the Politics; Other things same, this is going to add one more factor of input to Production. At country level, this may reduce aggregate supply and hence the GDP. This is why, there is a lot of contention between developed and developing countries on who should share how much of this burden. Contention is, since it is richer people who have mostly consumed these resources in the past and have not paid their due prices, the initiative should come from rich countries without any pre-requisites.

Anyways, however way these negotiations may turn out, we as consumers should understand that nature will ultimately make us all pay the price for these externalities if we don’t start paying them in easier installments now; while that option is still available!!

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References: Essence of examples written above on externalities are from the book 'Naked Economics' by Charles Wheelan. This is an interesting book on Economics for those who do not want to get bogged down by complex equations, graphs and curves.