Step Up Risks for Investors - Where Are You

This article explains 7 step up risks for investors that you need to know to avoid become a prey of debt monster. I have written this topic today for the Money Grows on Hubs Contest.

Step Up Risks for Investors - Where Are You

Where do banks fit in?

For the system to work, the sole creator of money must be the sovereign state. The fiat (or creation) of money by the banks could not be permitted, period. This is a byproduct of the fact they are within the economic ecosystem and there for in the creation of money the sole purpose of the bank (to the banker) is only to make a profit and in so doing removing money from the available purchasing power in the form of interest on bank fiat money. If bank fiats are allowed, the banks can and will inflate or deflate the unit of account as best fits their goal of profit independent of the financial needs and realities of the country. Another way of view this is that an artificially created money market bearing little to no relation to the cost of the service provided by the bank is represented by interest in its current form.

Now, banks could loan money. However they would be required to do so only with money deposited for that purpose which thus could not be fiat money but had already been in existence previous to the loan. That is to say, for loans in particular, they would be required to have 100% reserve. At the same time, banks would be required to keep money intended for commercial exchange during that financial period entirely separate from money intended for loaning. So what does the consumer pay for/how does the banker earn a living? The consumer pays for check/exchange and safekeeping; however, they would earn interest on money deposited specifically for investment purposes.

Thus removing from the hands of the bankers the ability to manipulate the money supply of the country is to their own gain. The Federal Reserve Bank is not a public bank. It is a private bank, owned by bankers for bankers. Ordinary citizens cannot make deposits or withdrawals from this bank but governments and banks can. The fact that banks can currently create money with a loan by the creation of the credit/debt gap it produces can effect inflation and deflation which seems counter to the “constitutional provision giving Congress the sole right to coin and regulate the value of money”. If banks were required to lend only money which was backed by 100% deposits for the purpose of investments, the creation of money by banks would stop.

Suddenly if you put banking in a different setting, think about Flexcar. The idea is that if everyone owns a car, they spend a lot of time sitting around doing nothing but using up resources because of all the parking spaces. Flexcar rents out cars at those times when people are not using them, while they are parked. If we all did this there would be less of a need for cars and parking spaces. There is a distinction between a “car” and “use of a car”. Banks do something similar. They rent out “reserves”, the kind of money the central bank makes, to give us “use of reserves”, which is what we commonly call money. What you are proposing is that there will be no difference between reserves and use of reserves. Is this what you mean?

It would be very hard to enforce. I created a few “use of pencil” out of a single spare pencil yesterday.

All that about the Federal Reserve Bank is true. We split the monetary authority from the fiscal authority (congress). It has resulted in lower inflation than in places where the two are closely tied like in the UK. The way that works with the congressional right is that the constitution says “coin”. The US Treasury still makes the coins; the Fed takes care of the rest.

Bank Cards - Understanding Credit Cards vs Debits Cards

Credit and loan market - A small note on CDOs

They are in one underlying pool of assets, i.e., collaterals which are created through securing various assets. The pool can consist of various assets like commercial loans, mortgage back securities, retail mortgages, etc. Generally CDO'S have three level of tranching.

1. Senior 20 - 100%.
2. Subordinate 5 - 20%.
3. Equity 0 - 5%

The above percentages are nothing but the attachment and detachment points, i.e., equity tranche consists of 5% of the total notional of the pool and will face the first 5% losses after which it would get wiped off, similar logic then applies for subordinate and then senior. The reason behind higher rating of the senior is not the risk profile of the underlying pool but the level of protection offered by the lower tranches.

Now how CDO ignited the sub prime crises, such CDO'S being dependent on market value pay back the amount invested by various parties through capital appreciation but in case the value depreciates they sell off the required amount from the underlying pool (thus referred as collateral). When the meltdown started, investor demanded back there money. The CDO manager started selling the assets thus adding oil to the fire and trust me these funds are huge, you must have read about Bears & Sterns supported hedge fund collapse and best thing is that the underlying pool doesn't necessarily need to really be with the CDO, so just imagine the amount of leverage being worked on!

The illiquid mortgages seized from the defaulters did not find any buyers and so they had to write down the debt, which was backed by such mortgages.

In fact, there was one bank which was Merrill Lynch which had forfeited the mortgage from the hedge fund (Bear Stearns) and had decided "fire sale" of the assets(sale at highly discounted prices) as a result of the high rate of defaults.

Exactly. Even after Bear Stearns bought it back from Merrill, they were not able to stop the fall and this was a lucky case and in lot of other cases, hedge funds have crashed down taking the market down with them.

Banking system in India. Why banks in India are facing difficulty in getting deposits?

Are tranches of CDO rated on the underlying pool?

Banking system in India. Why banks in India are facing difficulty in getting deposits?

Tranches of CDO are not rated on the underlying pool. The underlying pool consists of tranches and different tranches from different securities are pooled together in a CDO. In a nutshell, CDO's are made up of tranches of different securities for example a CDO may be made up of a AAA rated tranch such as a leverage loan or an agency loan and a BBB rated tranch like a sub prime loan and lower-rated tranch like junk bonds, so CDO's are made up of parts of different ABS pooled together for various risk profiles.

As for ABX index, I agreed to that. Basically I did a small reading up to understand what it was made of and was precisely based on housing mortgages or not, making it something which you cud use to cover your systematic risk. I also agree that defaults were way higher than expected but the problem was not defaults, but the CDO which were based on sub prime mortgages were mainly market value structures where the payoff does not depend on the interest earned on the underlying pool but on the appreciation of the underlying pool, mortgages being very liquid are very difficult to values, mainly because you don't know what rate to use for discounting (value of the mortgage can be measured in terms of its present value for which you need a rate) with the housing market at boom a lot of people took up mortgages even when the mortgage rates were very high and much beyond there normal paying capacity hoping for significant capital gains and overall economic growth, but when suddenly the housing market crashed, the CDO's which were based on such values collapsed leading to sudden crisis.

People panicked and started looking for sell off but no buyers, and then they started defaulting and banks/lenders were left with nothing but liquid properties, could do nothing but write them down which further increased the crisis.

Debt analysis - Market based valuation of mortgages

When it comes to market-based valuation of mortgages, it mainly depends on what rate you discount it on, it is similar to a bond valuation, the housing market crash caused sudden slump in liquidity and increased defaults which led to increase in the mortgage rates leading to sudden decrease in the NPV of the mortgage which is basically its value.

When it comes to valuation of mortgages, the theory applies only initially, what if there is no market (liquidity) for the instrument? You cannot sit on the valuation you came to using the model you are talking about.

The ABX index does that precisely. It tells you the losses and gains the derivatives make and hence you are bound to downgrade the valuation. Simply a instrument has no value if it cannot be traded which is the case nowadays in CDO's containing tranches of sub prime debt and other defaulted debt instruments, so the CDO's are written down on the values but their values are not 0, for example if a CDO is worth 1000 dollars and the sub prime tranch is valued initially at 150 dollars, so a 50 percent write down in the value of the sub prime tranch would result in a reduction in the tranch's value to 75 dollars and the whole CDO's value to 1000 to 75 that is 925 dollars; however CDO's unlike this example contained contained greater proportion of the sub prime tranch in the current scenario which was as a result of greater risk taking in midst of plenty of liquidity in the US market and abroad.

The computer models valued the instruments in precisely the way you are talking about with certain weights on the liquidity and the kind of return and risk; however, the defaults or the risk anticipated by the computer model was far more than expected.

Banking system in India. Why banks in India are facing difficulty in getting deposits?

What the ABX index has shown in the credit market?

Banking system in India. Why banks in India are facing difficulty in getting deposits?

The ABX index shows the changes in the price of the derivatives, which are as a result of defaults and subsequent decrease in demand in the housing market.

Now the market value will be based on what the market is ready to pay looking at all the risks (default risk, liquidity risk) and also the kind of returns they would receive on such loans, so computer models according to market participants were unable to judge the sentiment and so the investment banks had to write down their investments.

You mentioned the rule that banks generally value their loans by the book value. This implies only until the credit rating agencies maintain the initial credit rating on these securities.

As soon as they downgrade the ratings of these securities, investment banks can either hope for a while that the market condition reverses and their is sudden demand for their debt inventory (which was piled up because of the liquidity crisis) or they have to write down the value of their debt which they hold because investors will not be willing to pay the same amount of money for the same debt with downgraded rating.

The downgraded rating (by credit rating agencies) of this kind of debt was obviously due to the defaults in the sector and fall in demand for houses.

The lag in value of these securities was probably due to the computer models, which were used by investment banks, which varied from banks to banks to value them.

Now another reason for an increase in the write downs by investment banks is cited as an increasing no of banks have moved to a more market based approach in valuing these securities (using ABX index) in the fear that they might be prosecuted on the wrongly guiding their investors (the "ENRON" factor).

Debt market analysis - Liquidity and non-banking companies

As for liquidity is concerned, I don't think there is much liquidity at least that is what is stated in lot of articles and papers. To the extent, I understand the issue it was mainly because everyone was just looking on the brighter side. A lot of non-banking companies were pooling in money for backing up mortgages. Credit checks were minimal (if any in lots of cases. Hedge funds were assisting banks in freeing up credit lines.

If the valuation part you mentioned was in reference to investment banks who are the main players when it comes to setting up of such structures (CDO, CLO, etc.) then why it is possible that they were pricing on market based indexes which are not very liquid thus creating the lag between slowing down of housing markets and its effect on the market based index (that is what liquidity does mainly) markets in such cases are not leading but lagging indicators (similar to how ratings are more of a lagging indicators - FORD, GM) but still why an ABS based index!

You are right on the front that ABS includes commercial loans etc, but the reason why the ABX index should be looked at and not the MBS index because its not only the mortgage backed securities that have suffered from the meltdown in the US housing market.

The asset backed commercial paper (short term funding for corporate) also suffered, which resulted in the AAA of the ABX index showing a decline of 20% in their values. This is the starting of a potential spillover from the mortgage market to other various asset-backed markets, so to view the cumulative effect the ABX index is the perfect one. I hope you get my point. MBS is a subset of ABS.

As far as I know, CDO by definition means pooling different kinds of debt and selling it further to suit various risk profile while such CDO are backed by debts in the various markets, so a CDO may contain tranchées of ABS and MBS. The AAA tranch would generally consist of the commercial loans and the agency loans in the US housing market, followed by Alt-A loans and sub prime loans in decreasing order of liquidity and risk.

Also there are CDO's based only of mortgages but it would not tell you as to how much impact the sub prime debts have suffered because it would also consist of tranches of other housing loans like Alt-A and agency loans (loans to borrowers with better credit histories).

Here is where valuing the mortgage securities at different stages of its life becomes difficult because of complex pooling of these securities into further complex securities.

As pointed out in the FT newspaper, the only index to view losses in the sub prime sector is to follow the BBB rating section of the ABX index which has decreased in value by about 60-80 percent, so the increasing inventory of the sub prime debts underwritten by banks initially have to be written down because of the defaults in this sector and the consequent decrease in demand for the sec backed by such mortgages.


Banking system in India. Why banks in India are facing difficulty in getting deposits?