Conventional wisdom regarding the banking system is leaning again toward "zombie" banks being propped up by bailouts leading to a "lost decade". This argument is upside down, and bank earnings reports are proving it. Yet the media and "analysts" have no idea what is actually happening, content to recycle clichés and uneducated generalizations.
In the Japanese version, banking loans were priced at full value even though they were worthless - they were not receiving full (or any) principal and interest payments. The current American crisis is the opposite - syndicated loans are priced as near worthless even though they are receiving full interest and principal payments, or in the case of synthetic CDO's, full protection payments within reference portfolios.
The banks and brokerage firms were not heavy investors in the bottom rungs of credit structures. If you do some cursory research in readily available public filings the biggest source of writedowns were super senior tranches - even AIG's biggest problems are related to screwy pricing of the most senior tranches. As bad as subprime is, the loss rates and recovery rates will never be bad enough to force the senior tranches to suffer any dollar losses - yet they are typically priced below 50 cents on the dollar.
Why?
Credit default swap (CDS) illiquidity, complexity and fear coupled with screwy mathematical properties, such as the negative convexity produced by using the Gaussian copula. The fact that CDS pricing is producing insane results, like correlations above 100%, is a real indication that current valuations (the exact same valuations that the mark-to-market accounting rules forces to be "real") are not remotely predictive of cash flow reality.
The bottom line is that banks are reluctant to part with their "toxic" assets because they are, and will continue to be, money-good. The zombie bank image has been created by esoteric, nonsense CDS pricing mechanisms, but that is the reality the public has bought because of uneducated and dishonest reporting. Just because the banking system has little credibility doesn't mean it is wrong.
Rather than having a "propped-up" banking system, we really have an artificial crisis (that isn't to say there aren't real problems or even real losses, but they aren't where people think and are of an order of magnitude less). Without mark-to-market phantom/paper losses creating doubt there would never have been the commercial paper runs that took down Bear, Lehman, etc.
The gulf of perception about "toxic" assets is really a function of mathematical complexity. It is far easier to label all subprime assets as "toxic", and negative convexity simply reinforces that. But pulling apart the myth really doesn't require too much math, and even negative convexity can be explained to unsophisticated people.
In a simple example, in order for a super senior tranche to be priced at 50 cents on the dollar (Merrill Lynch sold some for 22 cents last summer) default rates would have to be 100% with a recovery rate well below 40%. Even subprime mortgages of the worst vintages (originated in the second half of 2006 or the first half of 2007) are not seeing anything close to that. At its worst, reasonable estimates are for 40% defaults with 65% recoveries. For a super senior tranche with a low attachment point of 70%, that would mean zero actual losses. In fact, that dire scenario would mean every tranche above a 14% attachment point would pay out fully (most likely all the seniors and perhaps a mezzanine).
Again, this cannot be stated more forcefully, the banks were exposed to super senior tranches. Even in synthetic CDO's (which most super seniors were) the credit structure provides more than enough protection. Didn't any "experts" wonder why nobody could come up with a price to soak up "toxic" assets? Because banks wanted full price (or near) the government worried it would look like a bailout - the difference in perceptions should have been a wakeup. Instead of decrying the insanity of bankers, the media should have been investigating exactly why banks wanted to keep "toxic" assets "experts" were convinced would ruin them. Those that think it was an attempt by Wall Street to game the government through handouts need to explain why negative convexity and 100%2B% correlations are proper and appropriate.
The vicious cycle of paper losses and inaccurate reporting was transmitted through hedging activities. Haywire spreads increased exposures, creating even more hedging activity (based on deltas). The values of the hedges continually declined as spreads widened past logical values, but accounting rules required phantom losses even though there will never be any actual dollar losses. AIG, with its naked default swap portfolio, was not brought down by actual losses - it was sunk by collateral calls created from these insane pricing methods, calls that were too big for its cash position. At that point if AIG wasn't bailed out, the unfilled collateral calls would have created even bigger phantom paper losses through mathematical delta hedging exposure changes.
While this shadow system operates outside the grasp of the media and bank analysts, the "experts" are focused on something seemingly simple - stress tests. But what they are actually measuring escapes the "experts". The true goal of the stress tests is to measure if the phantom loss repatriation will be enough to cushion against actual loan losses from non-mortgage credit. In other words, will the market value increases in super senior exposures be enough to offset recession-driven losses on credit cards and auto loans?
First quarter earnings reports from Wells Fargo, Goldman Sachs, JP Morgan and even Citigroup show that super senior valuations are, indeed, rising fast enough to offset loan loss reserve increases. But the "analysts" who cover the banks have no idea it is happening, which is why these earnings reports are a "surprise". The media is also unaware, as news articles and talking heads simply point to better results from "bond trading", when in fact no actual trading took place. Instead it is the increase in value (due to a belated realization by accounting regulators of the affects the phantom losses have produced) from credit derivatives, those pesky "toxic" assets, that is driving the banks' resurgence.
It is vitally important for investors to find a trusted source of information. Investing in the next decade is going to be almost entirely economics-driven, a period not unlike the 1970s, where the normal boom/bust cycle is interrupted by government-produced inflation and stagnation, maybe even a depression. Keeping on top of economic forces will be the key to successful investing - economic dislocations create investment opportunities for the informed.
Jeffrey P. Snider is President and Portfolio Manager for Atlantic Capital Management. You can find more information on the mark-to-market issue at http://www.client-centered.net/research.html Institutional investors can go to http://www.acminstitutional.com/research.html for more reports.
Article Source: http://EzineArticles.com/?expert=Jeffrey_P._Snider
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