Decision Quality Blog

You probably didn’t hear about it and don’t know who he is, but David Einhorn’s speech last year at the Helbrunn Center for Graham & Dodd Investing ranks as a must read if you want some clear and concise analysis of the current credit mess. The PDF text of the full  presentation is at Naked Shorts. Here’s the lead . .

What strikes me the most about the recent credit market crisis is how fast the world is trying to go back to business as usual.  In my view, the crisis wasn’t an accident.  We didn’t get unlucky.  The crisis came because there have been a lot of bad practices and a lot of bad ideas. Securitization is a mediocre idea.  Re-securitization of already securitized assets into a CDO is a bad idea. Re-securitization of CDOs into CDO-squared is a really bad idea.  So is funding a pool of long-term illiquid assets with very short-term funding in the so called asset backed commercial paper market. And as I will get to in a moment, it is a horrendous idea to delegate most of the responsibility for assessing credit risk to a group of credit rating agencies, paid for by the issuers rather than the buyers of bonds.

This crisis came for exactly the right reason.  There is a big flaw in the structure of our credit markets.  The bad structure induced lenders to take imprudent risks and make imprudent loans, which, of course led to losses.  What is unique about this crisis compared to others is that the losses are in illiquid, opaque structures scattered around the world.  Why should anyone be surprised?  We got what we deserved.

Last Saturday’s Wall Street Journal reported that the big fear that the US Treasury department is working to avoid is, “the danger that dozens of huge bank-affiliated funds will be forced to unload billions of dollars in mortgage-backed securities and other assets, driving down their prices in a fire sale. That could force big write-offs by banks, brokerages and hedge funds that own similar investments and would have to mark them down to the new, lower market prices.”   So the fear is that the new prices are actually disclosed.  This is the “don’t ask-don’t tell” method of security valuation.

In my view, the credit issues aren’t just about subprime.  Subprime is what the media says.  Subprime is what parts of our financial establishment say.  Subprime is about them – those people and the people who made foolish loans to them.  The word “Subprime” is pejorative.  Subprime is not about us, for we are not subprime.  How convenient to be able to pass the blame.

There has been much talk from politicians and pundits about predatory lending – that is making loans at high rates to people who couldn’t reasonably be expected to pay them back.  They are right, that is a bad practice, but that is not what’s shaking the markets.  At issue today is that lenders of all sorts have lent too much money and did not demand enough interest to compensate them for the risks they took.  There has been a colossal undercharging for credit across the board. 

It goes on like that, calling a spade a spade. The naked truth is that the captains of finance took unreasonable risks, spurred on by non-existent oversight and no real personal downside if they busted the pinata (which they did). In a sign of rushing backwards from change, the mortgage business is mounting a full scale assault on the latest round of attempts to introduce some transparency and standards into what has become a game of liars poker. See this from the NYT . . .

The plan presented by the Fed was proposed by its chairman, Ben S. Bernanke, and Randall S. Kroszner, a former White House economist in the Bush administration who is now a Fed governor and leads the Fed’s consumer and community affairs committee.

The plan would not cover existing mortgages but would apply only to new ones. It would force mortgage companies to show that customers can realistically afford their mortgages. It would require lenders to disclose the hidden fees often rolled into interest payments. And it would prohibit certain types of advertising considered misleading.

The Fed is expected to issue final rules this summer.

Earlier this month, as the comment period was about to close, the Fed was deluged with more than 5,000 comments, mostly from lenders who said the proposals could affect loans that have not presented problems. Some bankers and brokers also said the rules would discourage them from lending to some creditworthy borrowers.

I can remember what it was like to get my first mortgage a couple of decades ago. It was a lot of work. It was a lot of paper. EVERYTHING had to be explained. But it got done. I can promise you with 99.99999% certainty, the contention that "the rules would discourage them from lending to some creditworthy borrowers" is a complete crock. People will still want to buy and finance homes. It’s a very, very big business. Someone will meet the need.

As to the part about cost rising, they should. I realize that’s profoundly anti-consumer, but I can’t think of a single good reason why risk shouldn’t be properly priced. Governments distort the price of things all the time for all sorts of reasons. Exhibit one is the cost of gasoline at the pump in the US . . . it’s not even close to what it should be given the huge bill the Chinese and Gulf States finance every year so that our vast military can make the Gulf safe for the flow of oil. Sorry, I digress.

Nothing about the debt markets for the past five years has been properly priced. As obnoxious as lenders find the various regulators, they clearly were AOL. So whatever the compliance costs, they were, in retrospect, too low. Same with the ratings firms, whose negligence borders on the criminal. It’s not that the money shape-shifters weren’t taking their vig every time something was transmuted into something else. But none of that drag was staying home in the form of capital. And yes missy, at the end of the day, the mess would be less messy if the firms had spent less energy trying to leverage their capital to the nth degree in service and more energy running sound businesses.

As Ben Stein points out . . .

Tags: BenStein, David Einhorn, Helbrunn Center for Graham & Dodd Investing, CDO, Securitization, Sub Prime, Decision Making