Don't Forget The Role of The Rating Agencies

Don't forget the role of the rating agencies in the financial crisis. In the 1975 the U.S. Congress designated the Nationally Recognized Statistical Rating Organizations (NRSRO's). When Congress passed the legislation anointing the NRSRO’s it gave this limited number of organizations oligopoly status and unique competitive advantage. At the same time, Congress appointed the Securities and Exchange Commission as regulator of the NRSRO's. 

Most investment advisors and portfolio managers use rating agency guidelines (ratings) to assist their evaluation of the quality and risk associated with the securities they purchase* and fiduciaries are restricted by law as to the minimum rating level from which they can select the investments they can purchase and manage. So, the rating agencies provide a seal of approval, so to speak, for the securities and companies they rate.

* In most cases, the ratings securities an investment advisor, or a portfolio manager will use are defined in a prospectus, offering circular, or by some other form of disclosure. 

If you would like to see a CEO of a rating agency squirm, watch and listen to, The Role of The Rating Agencies

and Too Little, Too Late 

 

 

 

 

Smoke, Mirrors and The Shadow Inventory

The Wall Street Journal “Smart Money” Will Short Sales Hit Home Prices?  By Anna Maria Andriotis - pub. August 22, 2012

 Why is there a ‘shadow inventory’ of homes?

  

In last quarter of 2008, U.S. banks and their lobbyists pushed the U.S. Congress to force the Financial Accounting Standards Board (FASB) to postpone the implementation of mark-to-market accounting (FAS #157).* The FASB eventually acquiesced.  So, after the acquiescence, banks and other collateralized mortgage obligation [CMO] investors can continue to carry these investments at origination value, rather than at the investment’s current market value.

 

But, if a bank or other mortgage investor forecloses, renegotiates the mortgage, or sells the home (the collateral) the new ‘book value’ of the investment is based upon the new selling price (or mortgage value) - as determined by the terms of the new deal (auction, renegotiation, or sale).

 

By not foreclosing, renegotiating, or formally taking back properties (REO) banks and other mortgage investors can, to some extent, manage what  their losses appear to be, and hopefully offset the losses - they recognize - against other revenue, over time.

  

Key-words-search:Congress Helped Banks Defang Key Rule” By Susan Pulliam & Tom McGinty WSJ 6/3/2009 | Professor Adam Levitin Congressional testimony “Federal Regulators Don’t Want to Know” YouTube | Zombie Banks | Japan Lost Decade (Please note that, at the beginning of Japan’s lost decade our current Treasury Secretary, Timothy Geithner was living and working in Japan as a Treasury Department attaché in the U.S. Embassy.)

 

*  See, FAS #157 [mark-to-market accounting] and scroll down to the section heading: Effect on subprime crisis and Emergency Economic Stabilization Act of 2008 , at http://en.wikipedia.org/wiki/Mark-to-market_accounting

 

Federal Regulators Don't Want To Know


Recovery, Twisting in the Wind

I find that, when discussing The Shadow Inventory, almost all real estate specialists, lawyers, regulators and many financial analysts can’t tie one very significant cause into the conversation.

The very significant cause that is missed is a rational explanation of why banks and other mortgage investors are so reluctant to liquidate (or renegotiate) bad investments.

Why do they hold significant amounts of mortgage investments which have little hope of being profitable (over the long term)? When a mortgage is in serious default, why don’t mortgage investors accept a ‘short sale’ - and why do they allow a property to go into the potentially higher loss alternative of foreclosure?

I believe the key to understanding why mortgage investors appear to be behaving irrationally, is to understand the implications of the delay in the implementation of Financial Accounting Standard #157 (mark-to-market accounting).(1)

To understand the implications of the delay in the implementation of FAS #157 read an article from the Wall Street Journal titled, Congress Helped Banks Defang Key Rule By Susan Pulliam & Tom McGinty | pub. 6/3/2009.(2)

 Then watch Georgetown University Law Professor, Adam Levitin’s Congressional testimony titled, Federal Regulators Don’t Want to Know . . . (3)

The point that I believe most commenters miss:

The postponement of the implementation of mark-to-market accounting (FAS 157) gives banks and other mortgage (product) investors the opportunity to delay recognition of their market losses until legal ownership of the property changes (foreclosure). Thus, for the investor, the hoped for offset of losses against future revenue is 'the gating factor’ for the liquidation of the shadow inventory.

Most mortgage investors are institutions. These institutions want to delay the recognition of, and the reporting reporting of, any losses to their investors - and to their regulators - for as long as possible.

As Professor Levitin explains in his Congressional testimony, these institutional investors hope to offset losses against income (fees and penalty revenue) over the next decade.

So, the shadow inventory seems to be a consequence of the rational ‘work-out’ in a world in which institutions can carry (and report) highly depreciated assets at (fantasy) origination value.

P.S. I believe in creative destruction.(4)

Footnotes:
1. See Wikipedia Mark-to-Market accounting scroll to, Effect on subprime crisis and Emergency Economic Stabilization Act of 2008, at: http://en.wikipedia.org/wiki/Mark-to-market_accounting
2. Congress Helped Banks Defang Key Rule By Susan Pulliam & Tom McGinty | pub. 6/3/2009. http://online.wsj.com/article/SB124396078596677535.html
3. Georgetown University Law Professor, Adam Levitin’s Congressional testimony titled, Federal Regulators Don’t Want to Know . . . at: http://youtu.be/ibgdgl0PoBw
4. Creative Destruction (Shumpeter) see: http://en.wikipedia.org/wiki/Creative_destruction

End Note: Even some fairly sophisticated observers can’t put the delay in the implementation of FAS 157 into its proper perspective. Why do mortgage investors prefer foreclosure over a short sale? Watch Congressman Bobby Scott (D-VA) question a panel of mortgage professionals asking, ‘Are there things in accounting principals that we need to change to get everybody to do what’s in everybody's best interests?’at:

 Then listen to Thomas Cox, of Main Attorney’s Saving Homes Project, answer Rep. Scott. Mr. Cox emphasizes a different point (the conflict of interest created by servicer fee revenue) in The Short Sale Conundrum - Misaligned Incentives of Mortgage Servicers, at: and when James Kowalski, a Florida Trial Attorney for Saving Home Project, gets his turn he moves to The MERS Mess. Mr. Kawolski explains the increase in the shadow inventory as a documentation problem rather than an accounting problem, at:

The Undisclosed Inventory of Homes

My comment on the article, Foreclosure Machines Still Running on ‘Low’  By Robbie Whelan in The Wall Street Journal [Developments Blog] – pub. July 31, 2012 at: http://blogs.wsj.com/developments/2012/07/31/foreclosure-machines-still-running-on-low/?blog_id=36&post_id=21215

The shadow inventory and the large inventory of bank ‘Real Estate Owned’ (REO’s) is a phenomenon which I believe has been caused to a significant extent by the decision to delay the implementation of FAS #157 [commonly known as ‘fair value accounting’ or ‘mark-to-market accounting’].

The delay in the implementation of mark-to-market accounting allows mortgage investors to report (on books and records) the value of their mortgage investments at the investment’s origination value rather than requiring these assets be valued at an estimate of current market value. See article, Congress Helped Banks Defang Key Rule By Susan Pulliam & Tom McGinty - pub. Wall Street Journal June 3, 2009 | at: http://online.wsj.com/article_email/SB124396078596677535-lMyQjAxMTIyNDMzMTkzNjEwWj.html?mod=wsj_valettop_email

For further insight into the implications, and one of the likely consequences of the delay of mark-to-market accounting watch a brief video-clip of a portion of Georgetown University Law Professor, Adam Levitin's U.S. Congressional testimony titled, Federal Regulators Don't Want to Know at:

The shadow inventory and bank REO's (not under current listing contracts) represent an historically significant supply of housing which in many ways is not transparent or adequately disclosed, and therefore is not fully-factored into the ‘market's pricing” of homes (supply and demand).

He Who Pays The Piper Calls the Tune

A reminder that, in real life: “He who pays the piper calls the tune”.

The mandatory implementation of fully-negotiated brokerage commissions [May Day 1975] and shortly thereafter, The U.S. Congressional approval of Section 28(e)* created an environment in which institutional ‘order flow’ became a vastly more important component in the profitability of full-service brokerage firms. [‘order flow’ = code words for undisclosed institutional soft dollar commissions]

Given the implications of fully-negotiated (retail client) commissions and 37 years of serial interpretations and uneven enforcement of Section 28(e), should anyone expect the brokerage industry to look any different than it does today?

* Section 28(e) of the Securities Exchange Act of 1934 [Also, go to linked letter requesting substantial revision or repeal of section 28(e). The letter is from past SEC Chairman Christopher Cox to former Chairman of the Senate Banking Committee, Senator Christopher Dodd, a similar letter was sent to then Chairman of the House Financial Services Committee, Barney Frank > http://www.scribd.com/doc/13752510/Cox-Requests-Legislative-Action 

Links to two related New York Times newspaper articles of interest follow:

Editorial

Not All Investors Are Equal

Published: July 17, 2012

* http://www.nytimes.com/2012/07/18/opinion/not-all-investors-are-equal.html?_r=1&nl=todaysheadlines&emc=edit_th_20120719

 

Surveys Give Big Investors an Early View From Analysts

By GRETCHEN MORGENSON
Published: July 15, 2012
* http://www.nytimes.com/2012/07/16/business/in-surveys-hedge-funds-see-early-views-of-stock-analysts.html

 

· Fair Disclosure, Regulation FD - SEC

http://www.sec.gov/answers/regfd.htm - 5k - similar pages

Aug 30, 2004 ... On August 15, 2000, the SEC adopted Regulation FD to address the selective disclosure of information by publicly traded companies and other ...

Private Equity on a Buying Binge with Other People's Money (OPM)

Bloomberg News

 

Private Equity Has Too Much Money to Spend on Homes *

By John Gittelsohn on June 13, 2012

 

From the article:


“You’ve got Warren Buffett saying he’d buy 200,000 homes if he could find the operational ability to do so,” Warren said. “The reverse of the conversation is, where the hell do you think you’re getting 200,000 properties?”

 

Gathering investment money in an artificially low interest rate environment doesn’t seem to be a major challenge. The challenge may be getting a decent rate of return after management fees, the costs of acquisition, rehabilitation, and management of the properties (I believe this is the operational ability to which Mr. Buffett is referring.

 It seems to me that traditional real estate management firms may have a better undertanding of the challenges of maintaining and managing a large number of widely dispersed single family residential rental properties.

I had to chuckle when I read, "Nobody’s ever done this on a scale before,” Michael Burns, chief executive officer of the Alaska Permanent Fund, which had $41.5 billion under management at the end of the first quarter, said in a telephone interview from Juneau, Alaska.“These people’s background is in public storage, which is about as close as we could find.”

Jingle Mail

Michael Burry, M.D. was one of the earliest investment fund managers to recognize the problems in the housing and mortgage market. Dr. Burry’s story is very well told in a chapter of the book The Big Short By Michael Lewis, and also in an article which was published in Vanity Fair Magazine titled Betting on the Blind Side, also written by Michael Lewis1 . This morning I was doing some searching and reading on the mortgage market and some of the key-players in the market. In that activity, I came upon a link to Dr. Burry’s published Scion Capital Investment Newsletters. As I was browsing through the letters, I discovered this very interesting comment (prediction) from Dr. Burry’s Second Quarter of 2003 Letter to Investors2. I thought you might like to see this comment from the Scion 2Q 2003 Letter to Investors:
When home prices begin to fall, a natural level of weak support may develop around a loan-to-value ratio of one. That is, when equity in a home approaches zero, the homeowner ought to become reluctant to sell. History suggests any such strategy should prove foolhardy. Trends in housing tend to be long and headstrong, and hence not easily resisted…The development of significantly negative home equity among the same homeowners that also comprise the world’s most voracious consumers would likely trigger several economic problems…banks would become reluctant to lend to home buyers. The effect would be to contract the credit available to would-be homeowners and therefore severely undercut the main late-cycle driver of demand…These problems would compound the worsening domestic employment situation, further reducing demand for residential housing and thereby producing the requisite positive feedback loop that historically has allowed burgeoning asset deflation to accelerate. As the real estate deflation wears on, it would not be unreasonable to expect that unemployment-induced income shocks mix in toxic fashion with the comparatively high mobility tolerance of the United States citizenry, motivating homeowners to start sending their keys to the bank in ever-increasing numbers. Many banks taking possession of increasing amounts of real estate will ultimately fail themselves. A catharsis could then take shape, and home prices would leg down yet again. After much pain both despair and disgust will settle in, and a bottom would begin to form.

-Scion 2Q 2003 Letter to Investors
Footnotes:
1. Betting on the Blind Side By Michael Lewis – published in Vanity Fare Magazine | April 2010 at> http://www.vanityfair.com/business/features/2010/04/wall-street-excerpt-201004

2. Scion Capital 2Q Letter to Investors at> http://www.scioncapital.com/PDFs/Scion%202008%201Q.pdf

A Mortgage Tornado Warning, Unheeded

BUSINESS DAY | February 05, 2012
A Mortgage Tornado Warning, Unheeded
By GRETCHEN MORGENSON
Inspired by a personal experience, a businessman began delving into the practices of the mortgage industry, including Fannie Mae. His findings have been prescient.
Ms. Morgenson:

Regarding MERS, a few months ago I read that MERS was actually conceived by Fannie Mae and the concept was described in a presentation given at a Mortgage Bankers Association convention in 1993 or 1994. The article claimed Fannie got positive feedback on the MERS concept from the mortgage bankers. The article claimed that Fannie Mae and Freddie Mac then funded the development of MERS with contributions of 2 million dollars each. After MERS was 'brought live' Fannie and Freddie invited large mortgage industry members to join MERS on a subscription basis.

I've searched again for the article(s) recently, but I haven't been able to find the articles that described the actual creation of MERS. Perhaps the articles have been "scrubbed".

What I read seems to confirm the leadership role that Fannie and Freddie had, and the ways these two GSE's influenced and led the industry, and how they shaped practices in the industry. You might find the two articles referenced below interesting:

Is FM Watch a Crusader With an Agenda? By Louis Sichelman – RealtyTimes, pub. 7/5/1999 at: http://realtytimes.com/rtpages/19990705_fmwatch.htm

New Alliance Confronts FM Watch, Champions Existing Housing Finance System By Broderick Perkins RealtyTimes, pub. 10/5/2000>  http://realtytimes.com/rtpages/20001005_fmwatch.htm

So, Who's a Lobbyist?

New York Times –Opinion | Editorial - pub. January 26, 2012

 So, Who’s a Lobbyist? *

Three step test for a duck: (1) If it walks like a duck (2) Looks like a duck (3) And, quacks like a duck.

It is, more than likely, a duck.

Inside the D. C. Beltway definition and semantics are tortured to death by people who strive to gain (or, strive not to lose) by blurring the lines of the meaning of what is . . . .

Do you remember: "I did not have sexual relations with that woman" William Jefferson Clinton – 1998
An aside: I discovered the nature of lobbying, twisted definitions, and semantic reclassification while studying the history of Section 28(e) of the Securities Exchange Act of 1934 (as amended in 1975). The amendment originally described the allowable uses of investment advisors’ clients’ ‘brokerage commissions paid-up above the fully-negotiated costs of brokerage transaction execution’ (soft dollars). When passed, this amendment never mentioned any difference in the treatment institutional agency brokerage commissions arrangements, as compared to institutional full-service bundled undisclosed brokerage commission arrangements.

The Means of Production

On the subject of capital investment, and the taxation of capital gains, it seems to me that almost all of the media has missed an important point, and several lesser points that flow from that central point.

The Central Point: 

Capital investment pays for (or finances) what Karl Marx called “the means of production”.

  

Other Points:

In a free capitalistic market individual investors decide where they want to invest their money, how much risk to take with their money, and whether they are going to invest in, for instance, the manufacture of cell phones or the activities of grocery stores. Or, they can decide if they want to invest in solar panel manufacturers (like, Solendra?).

If individual investors are not incented to invest their capital in “the means of production” it seems the alternative is for government to use taxpayer funds for investment and use some form of ‘central planning’ to decide in which enterprises the taxpayers taxes will be invested.

It’s been pointed out by several in the media that capital investment actually produces taxable revenue when the enterprise must pay a tax on revenue. And, it’s been mentioned that the investor then pays another tax (the capital gains tax) - if the investor is fortunate, or smart, enough to make a capital gain.

However, I’ve not seen any media (or reporters) mention that there is usually another source of taxable revenue which flows from capital investment. Capital investment generally contributes to job creation. Most of the people who are employed in the investors’ enterprise will have an income – some of which is taxed. And another point, which also seems subtle to the press, the part of those workers’ income which is not taxed can be used by the workers to consume, save, or invest. These worker activities (consumption, saving and investing) all add value to the economy, and they produce jobs and more (downstream) revenues which are taxed.

I believe myriad individuals participating in a relatively free market, and making judgments about products to be offered while making judgments about demand levels for those products, and evaluating risk-and-reward payoffs, is a far more efficient, objective, and practical way to finance ‘the means of production’ than any central planning scheme.