Tuesday, May 22, 2012

It's Still About Leverage

This post by Dr. Manhattan arguing that Mortgage-backed Securities should be abolished caught FLG's eye.

FLG has long been on record that real estate is a uniquely problematic asset with regards to financial crises because it both simultaneously highly leveraged and illiquid.

Here's part of a passage that Dr. Manhattan quoted:
As a groundbreaking modeler in the mortgage departments at First Boston and Drexel, he had come to see that all of mortgage trading was just a way to make money until the next unanticipated blow up. Time after time, the same thing happened: rates changed and entire trading desks, whole fixed income divisions were blown out of the water because of one or two mortgage trading positions. Savage had a litany of reasons why: hedges -- if they were even available -- always underperformed because the securities were too leveraged to interest rates. In turn, brokers and hedge funds, trying to squeeze every last dime of profit out of a trade, used too much leverage in positioning the bonds, so when the market reversed, they were always forced to sell in a panic.
FLG isn't sure that this proves that MBS's ought to be abolished.  The issue is the amount of leverage, not MBS's.   FLG might be able to get behind the idea that MBS's present leverage that is inherently unregulatable, but he's not there yet.

As FLG has said before, much of the financial crisis response has been more about hobby horses than effective proposals to mitigate and regulate systematic risk. 

Look, almost everybody who calls for Glass-Steagall to be brought back (and FLG would argue most people who support the Volcker Rule) predicates that recommendation on the moral stance that financial markets are no more than gambling.  The trouble is that the lines between investment and commercial banking have blurred for a variety of financial and technological reasons and it isn't desirable or probably even possible to truly put that genie back in the bottle, regardless of how much people would like it to be so.  And don't get FLG started on how the Consumer Financial Protection Bureau has fuck all to do with systematic risk and is all about therapeutic moralism.  

FLG isn't arguing that financial markets aren't risky.  Nor is he arguing that prop trading is super-socially useful.  This isn't the issue when it comes to systematic risk; the issue was, is, and will be leverage.

A bank wants to bet a bunch on the Kentucky Derby trifecta?  Great.  FLG doesn't care.  He only cares about how big the bet is relative to the bank's balance sheet.  Well, that's not quite true.  It's pretty damn stupid thing for a bank to do.  But the point is that what he does care about is whether the amount of money they are putting towards that wager represents a risk to the soundness of the bank.

That's pretty much how FLG views JP Morgan's $2 billion loss.  Sure, $2 billion is a lot of money.  But in comparison to $90 billion in revenue, $20 billion in net income, and more than $180 billion in equity, who gives a shit?    Mistakes were made.  People lost their jobs.  $2 billion ain't chump change, but it's not like JP Morgan was or is anywhere near going under because of a $2 billion loss.  It sure doesn't represent anything like a systematic risk to the banking system.

As far as FLG can tell, the hoopla is motivated by a combination of schadenfreude at Jamie Dimon's predicament (understandable), fears that if $2 billion was lost then who is to say they couldn't have lost $200 billion and sunk the bank and the entire financial system (unreasonable), and finally the same moral stance as above (unhelpful).

UPDATE:  Not two minutes after FLG published this post, he read that the loss could be as much as $7 billion.


The Ancient said...

Just for fun -- What do you think the downside would be in abolishing mortgage-backed securities? (Not necessarily all of them, mind you, just certain types.)

FLG said...

Well, the end result of that is going to hit home buyers. The obvious one would be the probable death of the 30 year fixed mortgage.

Rather than focusing on MBS's though, the best thing to do if you are worried about the real estate market in particular, at least in my opinion, is to, again, focus on the leverage actual buyers are taking on. So, mandate larger down payments or something.

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