Joseph_Mason's_Comments_GIC-LeBow_AMT_Conference

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.