Origins
Problems
Solutions
Opportunities
Debt Markets and Toxic Paper: What Happens pp Next? Prepared for Global Interdependence Center Annual Monetary and Trade Conference April 18, 2008
Dr. Joseph R Dr R. Mason Drexel University, the Wharton School, and Criterion Economics LLC
Contact information: joseph.r.mason@gmail.com, (202) 683-8909 office. Copyright Joseph R. Mason, 2008. All rights reserved.
Origins
Problems
Solutions
Opportunities
Natural Recession
20 months 8 months 20 months 9 months 8 months 6 months 12 months 6 months
855 years and oveer
75 to 84 yearrs
65 to 74 yearrs
60 to 64 yearrs
55 to 59 yearrs
50 to 54 yearrs
Solutions
45 to 49 yearrs
40 to 44 yearrs
35 to 39 yearrs
Problems
30 to 34 yearrs
25 to 29 yearrs
20 to 24 yearrs
15 to 19 yearrs
10 to 14 yearrs
5 to 9 yearrs
Under 5 yearrs
Thousan nds
Origins Opportunities
The Demographic Problem
25,000
20,000
15,000
10,000
5,000
0
Origins
Problems
Solutions
Opportunities
Structure Risk is the Enemy • • • •
Credit Enhancement Granularity, Homogeneity, and History Th P The Predictability-Simplicity di bili Si li i Tradeoff T d ff Resecuritization
Origins
Problems
Solutions
Opportunities
Engineering/Credit Enhancement • Sequential claims form a “waterfall” of CE – Size of senior and subordinate classes may be altered to affect repayment probability for senior securities. – Underlying pieces are a form of credit enhancement, or guarantee, for g pieces. p higher
AAA
AAA
A
A BBB
BBB 5
Origins
Problems
Solutions
Opportunities
Granularity, Homogeneity, and History • Predictability based on law of large numbers: statistics. • Probability of exogenous shock affecting pool performance greater with small number of observations (or large exposures) exposures).
Origins
Problems
Solutions
Opportunities
The Predictability Predictability-Simplicity Simplicity Tradeoff • Not riskiness of underlying collateral, collateral but predictability AAA
A BBB
Origins
Problems
Solutions
Opportunities
Resecuritization Compounds Structure Risk
Source: The next “subprime”? Quantifying expected losses from CRE, Alt-A, HELOCs, Option ARMs, Goldman Sachs, Global: Financial Services, February 1, 2008.
Origins
Problems
Solutions
Opportunities
Structure Risk is the Enemy • • • •
Credit Enhancement Granularity, Homogeneity, and History Th P The Predictability-Simplicity di bili Si li i Tradeoff T d ff Resecuritization
Origins
Problems
Solutions
Opportunities
Problems • Repeated Games • Information • Financial Fi i l Markets M k andd Economic E i P Performance f
Origins
Problems
Solutions
Opportunities
Securitization is a Repeated Game
Origins
Problems
Solutions
Opportunities
Information Problems and Lemons Discounts
“We Have Limited Exposure to Subprime Mortgages” “Our Exposures are Highly Rated”
? “Our Process ? for?Marking ? Exposures is Rigorous” “W H “We Have H Hedges d that h Off Offset our E Exposures””
?
?
?
+
Origins
Problems
Solutions
Opportunities
Recession? Credit problems will not cause a recession recession. If a recession occurs in the presence of credit problems, however, that recession will be deeper p and longer g than otherwise.
Origins
Problems
Solutions
Opportunities
Monetary Policy • Point of monetary policy is to create inflation pressure. – Inflation pressure will not cure credit ills, ills nor the information problems that plague markets today.
• Monetary policy impotent with credit market difficulties (300 bp?) – Credit Cr dit SSupply ppl – Credit Demand
Capital Policy
Origins
Problems
Solutions
Opportunities
More Bailouts? • • • • •
Bond and Mortgage Ins Insurers rers GSE’s Pension Funds Insurance Companies Credit Cards Cards, Student Loans, Loans CRE
Origins
Problems
Solutions
Opportunities
Functional Regulation
Source: Saunders, Financial Institutions Management, McGraw-Hill, 2007
Origins
Problems
Solutions
Opportunities
Other Regulatory Ideas • Mayy get g Scaryy – More bankruptcy reform – Foreclosure moratoria
• President President’ss Working Group – Hope Now – Regulatory Reform – Credit rating agency reforms: not SEC, IOSCO
• FASB, SEC, Bank Regulators – Credit Rating Agencies – Loan-loss Reserves – Capital
Origins
Problems
Solutions
Opportunities
Winners and Losers • Beneficiaries of the Bailouts – Look to those that can argue social necessity • Monolines-crucial to muni markets (Buffet called Dinallo’s bluff) • Mortgage Insurers-crucial to consumer borrowing • GSEs-crucial to mortgage borrowing • Pension Funds and Insurance Insurance-crucial crucial to boomer retirements
– Outside financials, look for exposures in short-term treasury operations • Bristol Bristol-Meyers Meyers Squibb $275m is a template on the private side. side • ABCP, SIVs, TOBs, VRDOs: used to boost short-term AAA yield
Origins
Problems
Solutions
Opportunities
Other Opportunities • Litigation t gat o (securitizations (sec t at o s of o probable p obab e settlements) sett e e ts) – – – –
Ratings Agencies Underwriters of Loans and Securitizations Servicers and Managers of SF Sarbanes-Oxley violations (unlike SEC, PCAOB is h hungry) )
• Legislation and Public Relations – Assistance/Bailouts – New Regulatory Arbitrage Products and Legal Services – Information Products
Origins
Problems
Solutions
Opportunities
Debt Markets and Toxic Paper: What Happens pp Next? Prepared for Global Interdependence Center Annual Monetary and Trade Conference April 18, 2008
Dr. Joseph R Dr R. Mason Drexel University, the Wharton School, and Criterion Economics LLC
Contact information: joseph.r.mason@gmail.com, (202) 683-8909 office. Copyright Joseph R. Mason, 2008. All rights reserved.