On Price, Intrinsic Value, MBS, and Mark-to-Market

[davelj]

[quote=TheBreeze][quote=davelj]

Ok, let’s give every financial institution a year to sell all its assets (as opposed to a week). Who’s going to buy them?
[/quote]

No idea. Question about the banking system: My understanding is that banks can loan out at 10:1 against deposits. Is that correct? Is there a reason for the particular leverage ratio (whatever it is)? How do U.S. banks get to the 10:1 (or whatever) leverage ratio? Who do they borrow from? Is it just private parties generally? I know they can borrow from the Federal Reserve, but that’s not the normal SOP, correct?

Now, if a bank goes under, then the FDIC is on the hook for a percentage of the deposits. Does the FDIC have preference over the failed bank’s creditors in that they can sell off assets until the depositors are paid back and then the banks’s creditors get what’s left?

If you can point me to a good source that explains all this, I would appreciate it.

Dictionary.com defines insolvency as being “unable to satisfy creditors or discharge liabilities, either because liabilities exceed assets or because of inability to pay debts as they mature.” My understanding is that most of the insolvent financial institutions are insolvent because they can’t pay their debts due to the fact that they borrowed short and lent long. That is a failed business model. Let the institutions who did that fail. Surely you would agree that if a bank can’t pay debts as they mature, that they are insolvent?

I’m not sure about the “not all at once” thing. Who’s to say that’s not a better solution? Maybe that allows the system to rebuild sooner and more efficiently? It does seem like allowing a massive cascade of failures all at once could cause problems. However, I’m not sure that over-paying for bank assets (i.e, paying more than the ‘market’ would) is the solution.

As for the ‘agrarian society’ thing, you are a finance guy so I guess you think that the finance industry is the be-all-end-all. Some are thinking that portions of the finance industry could disappear completely with no ill effects:

[/quote]

Jesus H. Christ, Breeze. I want to try to be responsive and appreciate the inquisitiveness, but for the Love of God. I just can’t distill Banking 101 into a post. I can’t do it. Just as I’m sure you can’t distill whatever it is you do for a living into a post for my benefit. But I’ll try to hit a few things here…

First problem – and I don’t mean for this to sound as demeaning as it’s going to – but your first set of questions tells me that you don’t know the first thing about banking. Not even the most basic of basics. Which then gets me wondering what other things you don’t understand. Which is one of the reasons this discussion is so difficult. I assume based on your posts that you understand some particular fundamental concept only to discover that, in fact, you do not. Now, importantly, I’m quite sure that there are MANY things that you know 1000x better than I do. But we’re not discussing those things. We happen to be discussing what I work with intimately every single day.

So, moving beyond that unfortunate introduction, if you want to learn more about banking and the banking system there are many books out there with titles like “Fundamentals of Banking,” etc. I’m sure most of them will do an adequate job of passing along the fundamentals. I would point you to the book that I wrote some five years back on banking, but that would reveal my name, firm, etc., which from this site only Rich is privy to (he may even have a copy of my book – I can’t remember), which is how I’d like to keep things.

But anyhow… deposits don’t get levered in a bank (and 10:1… I won’t even ask where that came from). Capital gets leveraged. There are a bunch of different regulatory capital ratios that any book on banking can explain that I’m not going to go into here. But, here’s what the balance sheet of a fairly typical community bank (“TCB”) looks like:

Assets
Cash and Equivalents 10%
Securities 10%
Loans 75%
Other assets 5%

Liabilities
Deposits 85%
FHLB borrowings 7%
Trust Preferred Securities 1%

Common Equity 7%

So, as you can see, the common equity is there to provide the capital foundation for the bank; the deposits are there to fund investments in loans and securities; and the cash and equivalents on the asset side are there to provide liquidity to depositors. George Bailey would be proud.

If a bank goes into receivership, the FDIC insurance fund covers all of the insured deposits. Yes, the FDIC is senior to ALL bank creditors under receivership. They only pay off the insured depositors. But here’s the problem, if the FDIC insurance fund runs out of funds – which it very wall may this time around – the govt (that’s us) will step in to bolster the fund to whatever degree is required. Then, theoretically, the govt will get paid back and the fund will be replenished by charging higher “insurance fees” on the surviving banks going forward (these fees are going up right now, and for good reason).

Your understanding of solvency is technically correct, but as you can see from the bank’s balance sheet above, not precisely applicable to banks (but not altogether non-applicable, either). An example: Let’s assume that TCB’s assets above are “good” – that is, all of the loans are current and the LTVs reasonable. Now let’s assume that all of TCB’s depositors show up at one time and want their money. TCB’s going to first go through their cash, then liquidate securities, then they’re going to have to start liquidating loans to meet depositor requests. Even a “good” loan portfolio will take months to sell because of the due diligence required by the buyer and the negotiations. The deposits would be sold also, but the value received given a day to liquidate is much different than if a couple of months is necessary. Now apply this micro example to the entire banking industry and I think you’ll see where the landmines are. It’s just like George Bailey explains in “It’s a Wonderful Life,” – everyone can’t get their money at once. But that doesn’t mean that all of the assets are bad – they’re just quite illiquid. Don’t get me wrong, a big chunk of the assets ARE bad right now, but the illiquidity is compounding the problem.

I happen NOT to think that finance is the “be-all-end-all” of things, as you surmise. But as I’m in the middle of the financial world, I recognize that The Financial System is the foundation for the whole economic machine. It’s kind of like the engine in a car. It probably only represents 5%-10% of the value of the car itself. But without it, the car doesn’t move. I don’t think many folks have a good understanding of how all the parts fit together in our economy.

Your VC example is anecdotal… but you knew that. But I agree that the financial sector needs to shrink. In some areas, considerably. We need fewer brokers, hedge fund managers, PE managers (yeah, fewer folks like me!), traders, investment bankers, etc etc… and we’ll get there in time.

But having said all that, I don’t see major flaws at the core of The System. What I see are major problems that cropped up largely due to a lack of regulation. Specifically, our biggest problems are from:

(1) Securitization: Totally out of control. Regs should have required originators to keep a specified percentage of each deal’s equity and loans on balance sheet to reduce misaligned incentives.
(2) Off-balance sheet financing and Level III assets: Please, folks. If it’s financing it should go on the balance sheet. Period. If it’s a Level III asset and its value can only be determined through “unobservable inputs” then it shouldn’t be on a bank’s balance sheet in the first place. C’mon!
(3) Credit Default Swaps: Whose idea was it that this multi multi-trillion dollar market shouldn’t be centralized on an exchange and regulated? Oh yeah, among others… Alan Greenspan. Please!
(4) Allowable loan concentrations: Banks should have limits placed on how much concentration they can have in one loan classification (such as construction and land development). This is so fundamental…
(5) Leverage at the Big Banks: I already discussed this above. (BTW, for perspective, the largest banks have twice as much leverage as the smaller ones, on average. They also have the shittiest assets outside of construction and development.)

Had these five basic issues been addressed 10 years ago, and had Greenspan and his ilk not given away money post-9/11, I guarantee you we wouldn’t be in this mess today. But when the system is levered – as it is – a few regulatory failures can cause huge problems, as we’re witnessing.

Liquidity is what ultimately kills a bank. But the liquidity problem is always driven by two issues: (1) Loan concentrations, and (2) Leverage. If you concentrate in the wrong assets, you die. And if you have too much leverage at the wrong time, you die. Combine the two, and you die first.

I apologize if I didn’t get to all of your questions, but my brain and fingers are about to melt down.

[davelj]

[quote=CA renter]Submitted by davelj on December 30, 2008 – 9:46am.

arraya wrote:
And therein lies the problem with leverage…it relies on ever-expanding leverage and debt.

Our monetary system is based on debt and compound interest, which results in an ever expanding amount of “money” chasing dwindling natural resources on our finite planet.

To put another way: All money is born of debt and all interest on debt has yet to be created and is preferably created out of more debt. Got it, infinite debt has to be possible for it to work out. Faith-based economics.

That first quote looked suspiciously canned, and indeed it can be found verbatim on many “green” websites on the internet, including this one: http://www.grassrootsnetroots.org/articl…. Next time, do the authors a favor and use quotes. Or better yet, state a position using your own words, if possible.
=======================

Actually, that was MY quote, and it’s something I’ve been saying for years (the link you’ve provided was written in 2008…perhaps they should give me credit?).

Don’t ever accuse me of plagerism unless you know what you’re talking about!!!
[/quote]

I didn’t accuse YOU of plagiarism. I was responding to ARRAYA’s post (as you can see)! (Unless you and arraya are the same person, that is… which would beg a whole host of questions.) You’re clearly confused. What planet are you on?

[davelj]

[quote=CA renter]Submitted by davelj on December 30, 2008 – 9:46am.

arraya wrote:
And therein lies the problem with leverage…it relies on ever-expanding leverage and debt.

Our monetary system is based on debt and compound interest, which results in an ever expanding amount of “money” chasing dwindling natural resources on our finite planet.

To put another way: All money is born of debt and all interest on debt has yet to be created and is preferably created out of more debt. Got it, infinite debt has to be possible for it to work out. Faith-based economics.

That first quote looked suspiciously canned, and indeed it can be found verbatim on many “green” websites on the internet, including this one: http://www.grassrootsnetroots.org/articl…. Next time, do the authors a favor and use quotes. Or better yet, state a position using your own words, if possible.
=======================

Actually, that was MY quote, and it’s something I’ve been saying for years (the link you’ve provided was written in 2008…perhaps they should give me credit?).

Don’t ever accuse me of plagerism unless you know what you’re talking about!!!
[/quote]

I didn’t accuse YOU of plagiarism. I was responding to ARRAYA’s post (as you can see)! (Unless you and arraya are the same person, that is… which would beg a whole host of questions.) You’re clearly confused. What planet are you on?

[davelj]

[quote=CA renter]Submitted by davelj on December 30, 2008 – 9:46am.

arraya wrote:
And therein lies the problem with leverage…it relies on ever-expanding leverage and debt.

Our monetary system is based on debt and compound interest, which results in an ever expanding amount of “money” chasing dwindling natural resources on our finite planet.

To put another way: All money is born of debt and all interest on debt has yet to be created and is preferably created out of more debt. Got it, infinite debt has to be possible for it to work out. Faith-based economics.

That first quote looked suspiciously canned, and indeed it can be found verbatim on many “green” websites on the internet, including this one: http://www.grassrootsnetroots.org/articl…. Next time, do the authors a favor and use quotes. Or better yet, state a position using your own words, if possible.
=======================

Actually, that was MY quote, and it’s something I’ve been saying for years (the link you’ve provided was written in 2008…perhaps they should give me credit?).

Don’t ever accuse me of plagerism unless you know what you’re talking about!!!
[/quote]

I didn’t accuse YOU of plagiarism. I was responding to ARRAYA’s post (as you can see)! (Unless you and arraya are the same person, that is… which would beg a whole host of questions.) You’re clearly confused. What planet are you on?

[davelj]

[quote=CA renter]Submitted by davelj on December 30, 2008 – 9:46am.

arraya wrote:
And therein lies the problem with leverage…it relies on ever-expanding leverage and debt.

Our monetary system is based on debt and compound interest, which results in an ever expanding amount of “money” chasing dwindling natural resources on our finite planet.

To put another way: All money is born of debt and all interest on debt has yet to be created and is preferably created out of more debt. Got it, infinite debt has to be possible for it to work out. Faith-based economics.

That first quote looked suspiciously canned, and indeed it can be found verbatim on many “green” websites on the internet, including this one: http://www.grassrootsnetroots.org/articl…. Next time, do the authors a favor and use quotes. Or better yet, state a position using your own words, if possible.
=======================

Actually, that was MY quote, and it’s something I’ve been saying for years (the link you’ve provided was written in 2008…perhaps they should give me credit?).

Don’t ever accuse me of plagerism unless you know what you’re talking about!!!
[/quote]

I didn’t accuse YOU of plagiarism. I was responding to ARRAYA’s post (as you can see)! (Unless you and arraya are the same person, that is… which would beg a whole host of questions.) You’re clearly confused. What planet are you on?

[davelj]

[quote=CA renter]Submitted by davelj on December 30, 2008 – 9:46am.

arraya wrote:
And therein lies the problem with leverage…it relies on ever-expanding leverage and debt.

Our monetary system is based on debt and compound interest, which results in an ever expanding amount of “money” chasing dwindling natural resources on our finite planet.

To put another way: All money is born of debt and all interest on debt has yet to be created and is preferably created out of more debt. Got it, infinite debt has to be possible for it to work out. Faith-based economics.

That first quote looked suspiciously canned, and indeed it can be found verbatim on many “green” websites on the internet, including this one: http://www.grassrootsnetroots.org/articl…. Next time, do the authors a favor and use quotes. Or better yet, state a position using your own words, if possible.
=======================

Actually, that was MY quote, and it’s something I’ve been saying for years (the link you’ve provided was written in 2008…perhaps they should give me credit?).

Don’t ever accuse me of plagerism unless you know what you’re talking about!!!
[/quote]

I didn’t accuse YOU of plagiarism. I was responding to ARRAYA’s post (as you can see)! (Unless you and arraya are the same person, that is… which would beg a whole host of questions.) You’re clearly confused. What planet are you on?

[TheBreeze]

[quote=davelj]

But anyhow… deposits don’t get levered in a bank (and 10:1… I won’t even ask where that came from). Capital gets leveraged. There are a bunch of different regulatory capital ratios that any book on banking can explain that I’m not going to go into here. But, here’s what the balance sheet of a fairly typical community bank (“TCB”) looks like:
[/quote]

As you can tell, I’m not a banking expert. My only knowledge of banking comes from a “Money and banking” class I took many moons ago and what I’ve picked up from reading blogs. I ‘misrembered’ what it is that banks lever against. Thanks for clearing this up. It’s now coming back to me that banks are allowed to lend out a certain percentage of their deposits and they have to maintain certain capital ratios as described here:

http://en.wikipedia.org/wiki/Capital_requirements

[quote=davelj]

Your understanding of solvency is technically correct, but as you can see from the bank’s balance sheet above, not precisely applicable to banks (but not altogether non-applicable, either). An example: Let’s assume that TCB’s assets above are “good” – that is, all of the loans are current and the LTVs reasonable. Now let’s assume that all of TCB’s depositors show up at one time and want their money. TCB’s going to first go through their cash, then liquidate securities, then they’re going to have to start liquidating loans to meet depositor requests. Even a “good” loan portfolio will take months to sell because of the due diligence required by the buyer and the negotiations. The deposits would be sold also, but the value received given a day to liquidate is much different than if a couple of months is necessary. Now apply this micro example to the entire banking industry and I think you’ll see where the landmines are. It’s just like George Bailey explains in “It’s a Wonderful Life,” – everyone can’t get their money at once. But that doesn’t mean that all of the assets are bad – they’re just quite illiquid. Don’t get me wrong, a big chunk of the assets ARE bad right now, but the illiquidity is compounding the problem.
[/quote]

I realize that you’ve simplified this example for my benefit, but this example does not at all fit what happened in this era. More loans are going bad every day. The LTVs were not reasonable when the loans were made and, to top it off, the underlying collateral is declining in value rapidly (CA median home price was down 4% from October to November: http://mrmortgage.ml-implode.com/2008/12/30/the-scariest-housing-related-chart-ever/#comments ). Further, bank runs haven’t really been a problem (except for maybe at Indymac?). The problem was that the bigger financial institutions borrowed short, lent long, and, when one day they weren’t able to roll over their short-term financing, they were toast.

In your original post in this thread, you said this:

[quote=davelj]
Now, let’s assume for the sake of the argument that these AAAs are mispriced (that is, too low). The question is: Why? The answer is simple: Liquidity.
[/quote]

Well, I don’t think the answer is so simple. How do you value an asset when the collateral underlying that asset is decreasing in value at the rate of 4% a month? Liquidity may be part of the problem, but the fact that the value of the underlying collateral is suspect (as well as the future income streams) makes these assets very hard to value.

You also said:

[quote=davelj]
In this environment, illiquidity trades at an enormous discount. Many professionals I know and trust are as highly confident as they’ve ever been that some of these MBS represent the best risk-to-reward they’ve ever seen, but outside of their personal accounts they don’t have the proper (long-term) vehicle to buy and hold the securities. So the selling continues, the prices decline, and there’s not enough long-term capital out there to reverse things. The old negative feedback loop.
[/quote]

May be the selling is continuing because the value of the underlying collateral is continuing to decline?

[quote=davelj]
I apologize if I didn’t get to all of your questions, but my brain and fingers are about to melt down.
[/quote]

No problem. Feel free to drop off this conversation at any time. I’m on vacation right now and have some time on my hands. Don’t feel like you have to respond to all my questions. This is an interesting area to me and it’s easier for me to pepper an expert with questions and see what I get back as opposed to trying to search the Web or going through a textbook for the answers.

That being said, you haven’t convinced this layperson that lack of liquidity or the banks having to engage in fire sales is the reason why the MBSs/CDOs/etc are continuing to decline in price.

[TheBreeze]

[quote=davelj]

But anyhow… deposits don’t get levered in a bank (and 10:1… I won’t even ask where that came from). Capital gets leveraged. There are a bunch of different regulatory capital ratios that any book on banking can explain that I’m not going to go into here. But, here’s what the balance sheet of a fairly typical community bank (“TCB”) looks like:
[/quote]

As you can tell, I’m not a banking expert. My only knowledge of banking comes from a “Money and banking” class I took many moons ago and what I’ve picked up from reading blogs. I ‘misrembered’ what it is that banks lever against. Thanks for clearing this up. It’s now coming back to me that banks are allowed to lend out a certain percentage of their deposits and they have to maintain certain capital ratios as described here:

http://en.wikipedia.org/wiki/Capital_requirements

[quote=davelj]

Your understanding of solvency is technically correct, but as you can see from the bank’s balance sheet above, not precisely applicable to banks (but not altogether non-applicable, either). An example: Let’s assume that TCB’s assets above are “good” – that is, all of the loans are current and the LTVs reasonable. Now let’s assume that all of TCB’s depositors show up at one time and want their money. TCB’s going to first go through their cash, then liquidate securities, then they’re going to have to start liquidating loans to meet depositor requests. Even a “good” loan portfolio will take months to sell because of the due diligence required by the buyer and the negotiations. The deposits would be sold also, but the value received given a day to liquidate is much different than if a couple of months is necessary. Now apply this micro example to the entire banking industry and I think you’ll see where the landmines are. It’s just like George Bailey explains in “It’s a Wonderful Life,” – everyone can’t get their money at once. But that doesn’t mean that all of the assets are bad – they’re just quite illiquid. Don’t get me wrong, a big chunk of the assets ARE bad right now, but the illiquidity is compounding the problem.
[/quote]

I realize that you’ve simplified this example for my benefit, but this example does not at all fit what happened in this era. More loans are going bad every day. The LTVs were not reasonable when the loans were made and, to top it off, the underlying collateral is declining in value rapidly (CA median home price was down 4% from October to November: http://mrmortgage.ml-implode.com/2008/12/30/the-scariest-housing-related-chart-ever/#comments ). Further, bank runs haven’t really been a problem (except for maybe at Indymac?). The problem was that the bigger financial institutions borrowed short, lent long, and, when one day they weren’t able to roll over their short-term financing, they were toast.

In your original post in this thread, you said this:

[quote=davelj]
Now, let’s assume for the sake of the argument that these AAAs are mispriced (that is, too low). The question is: Why? The answer is simple: Liquidity.
[/quote]

Well, I don’t think the answer is so simple. How do you value an asset when the collateral underlying that asset is decreasing in value at the rate of 4% a month? Liquidity may be part of the problem, but the fact that the value of the underlying collateral is suspect (as well as the future income streams) makes these assets very hard to value.

You also said:

[quote=davelj]
In this environment, illiquidity trades at an enormous discount. Many professionals I know and trust are as highly confident as they’ve ever been that some of these MBS represent the best risk-to-reward they’ve ever seen, but outside of their personal accounts they don’t have the proper (long-term) vehicle to buy and hold the securities. So the selling continues, the prices decline, and there’s not enough long-term capital out there to reverse things. The old negative feedback loop.
[/quote]

May be the selling is continuing because the value of the underlying collateral is continuing to decline?

[quote=davelj]
I apologize if I didn’t get to all of your questions, but my brain and fingers are about to melt down.
[/quote]

No problem. Feel free to drop off this conversation at any time. I’m on vacation right now and have some time on my hands. Don’t feel like you have to respond to all my questions. This is an interesting area to me and it’s easier for me to pepper an expert with questions and see what I get back as opposed to trying to search the Web or going through a textbook for the answers.

That being said, you haven’t convinced this layperson that lack of liquidity or the banks having to engage in fire sales is the reason why the MBSs/CDOs/etc are continuing to decline in price.

[TheBreeze]

[quote=davelj]

But anyhow… deposits don’t get levered in a bank (and 10:1… I won’t even ask where that came from). Capital gets leveraged. There are a bunch of different regulatory capital ratios that any book on banking can explain that I’m not going to go into here. But, here’s what the balance sheet of a fairly typical community bank (“TCB”) looks like:
[/quote]

As you can tell, I’m not a banking expert. My only knowledge of banking comes from a “Money and banking” class I took many moons ago and what I’ve picked up from reading blogs. I ‘misrembered’ what it is that banks lever against. Thanks for clearing this up. It’s now coming back to me that banks are allowed to lend out a certain percentage of their deposits and they have to maintain certain capital ratios as described here:

http://en.wikipedia.org/wiki/Capital_requirements

[quote=davelj]

Your understanding of solvency is technically correct, but as you can see from the bank’s balance sheet above, not precisely applicable to banks (but not altogether non-applicable, either). An example: Let’s assume that TCB’s assets above are “good” – that is, all of the loans are current and the LTVs reasonable. Now let’s assume that all of TCB’s depositors show up at one time and want their money. TCB’s going to first go through their cash, then liquidate securities, then they’re going to have to start liquidating loans to meet depositor requests. Even a “good” loan portfolio will take months to sell because of the due diligence required by the buyer and the negotiations. The deposits would be sold also, but the value received given a day to liquidate is much different than if a couple of months is necessary. Now apply this micro example to the entire banking industry and I think you’ll see where the landmines are. It’s just like George Bailey explains in “It’s a Wonderful Life,” – everyone can’t get their money at once. But that doesn’t mean that all of the assets are bad – they’re just quite illiquid. Don’t get me wrong, a big chunk of the assets ARE bad right now, but the illiquidity is compounding the problem.
[/quote]

I realize that you’ve simplified this example for my benefit, but this example does not at all fit what happened in this era. More loans are going bad every day. The LTVs were not reasonable when the loans were made and, to top it off, the underlying collateral is declining in value rapidly (CA median home price was down 4% from October to November: http://mrmortgage.ml-implode.com/2008/12/30/the-scariest-housing-related-chart-ever/#comments ). Further, bank runs haven’t really been a problem (except for maybe at Indymac?). The problem was that the bigger financial institutions borrowed short, lent long, and, when one day they weren’t able to roll over their short-term financing, they were toast.

In your original post in this thread, you said this:

[quote=davelj]
Now, let’s assume for the sake of the argument that these AAAs are mispriced (that is, too low). The question is: Why? The answer is simple: Liquidity.
[/quote]

Well, I don’t think the answer is so simple. How do you value an asset when the collateral underlying that asset is decreasing in value at the rate of 4% a month? Liquidity may be part of the problem, but the fact that the value of the underlying collateral is suspect (as well as the future income streams) makes these assets very hard to value.

You also said:

[quote=davelj]
In this environment, illiquidity trades at an enormous discount. Many professionals I know and trust are as highly confident as they’ve ever been that some of these MBS represent the best risk-to-reward they’ve ever seen, but outside of their personal accounts they don’t have the proper (long-term) vehicle to buy and hold the securities. So the selling continues, the prices decline, and there’s not enough long-term capital out there to reverse things. The old negative feedback loop.
[/quote]

May be the selling is continuing because the value of the underlying collateral is continuing to decline?

[quote=davelj]
I apologize if I didn’t get to all of your questions, but my brain and fingers are about to melt down.
[/quote]

No problem. Feel free to drop off this conversation at any time. I’m on vacation right now and have some time on my hands. Don’t feel like you have to respond to all my questions. This is an interesting area to me and it’s easier for me to pepper an expert with questions and see what I get back as opposed to trying to search the Web or going through a textbook for the answers.

That being said, you haven’t convinced this layperson that lack of liquidity or the banks having to engage in fire sales is the reason why the MBSs/CDOs/etc are continuing to decline in price.

[TheBreeze]

[quote=davelj]

But anyhow… deposits don’t get levered in a bank (and 10:1… I won’t even ask where that came from). Capital gets leveraged. There are a bunch of different regulatory capital ratios that any book on banking can explain that I’m not going to go into here. But, here’s what the balance sheet of a fairly typical community bank (“TCB”) looks like:
[/quote]

As you can tell, I’m not a banking expert. My only knowledge of banking comes from a “Money and banking” class I took many moons ago and what I’ve picked up from reading blogs. I ‘misrembered’ what it is that banks lever against. Thanks for clearing this up. It’s now coming back to me that banks are allowed to lend out a certain percentage of their deposits and they have to maintain certain capital ratios as described here:

http://en.wikipedia.org/wiki/Capital_requirements

[quote=davelj]

Your understanding of solvency is technically correct, but as you can see from the bank’s balance sheet above, not precisely applicable to banks (but not altogether non-applicable, either). An example: Let’s assume that TCB’s assets above are “good” – that is, all of the loans are current and the LTVs reasonable. Now let’s assume that all of TCB’s depositors show up at one time and want their money. TCB’s going to first go through their cash, then liquidate securities, then they’re going to have to start liquidating loans to meet depositor requests. Even a “good” loan portfolio will take months to sell because of the due diligence required by the buyer and the negotiations. The deposits would be sold also, but the value received given a day to liquidate is much different than if a couple of months is necessary. Now apply this micro example to the entire banking industry and I think you’ll see where the landmines are. It’s just like George Bailey explains in “It’s a Wonderful Life,” – everyone can’t get their money at once. But that doesn’t mean that all of the assets are bad – they’re just quite illiquid. Don’t get me wrong, a big chunk of the assets ARE bad right now, but the illiquidity is compounding the problem.
[/quote]

I realize that you’ve simplified this example for my benefit, but this example does not at all fit what happened in this era. More loans are going bad every day. The LTVs were not reasonable when the loans were made and, to top it off, the underlying collateral is declining in value rapidly (CA median home price was down 4% from October to November: http://mrmortgage.ml-implode.com/2008/12/30/the-scariest-housing-related-chart-ever/#comments ). Further, bank runs haven’t really been a problem (except for maybe at Indymac?). The problem was that the bigger financial institutions borrowed short, lent long, and, when one day they weren’t able to roll over their short-term financing, they were toast.

In your original post in this thread, you said this:

[quote=davelj]
Now, let’s assume for the sake of the argument that these AAAs are mispriced (that is, too low). The question is: Why? The answer is simple: Liquidity.
[/quote]

Well, I don’t think the answer is so simple. How do you value an asset when the collateral underlying that asset is decreasing in value at the rate of 4% a month? Liquidity may be part of the problem, but the fact that the value of the underlying collateral is suspect (as well as the future income streams) makes these assets very hard to value.

You also said:

[quote=davelj]
In this environment, illiquidity trades at an enormous discount. Many professionals I know and trust are as highly confident as they’ve ever been that some of these MBS represent the best risk-to-reward they’ve ever seen, but outside of their personal accounts they don’t have the proper (long-term) vehicle to buy and hold the securities. So the selling continues, the prices decline, and there’s not enough long-term capital out there to reverse things. The old negative feedback loop.
[/quote]

May be the selling is continuing because the value of the underlying collateral is continuing to decline?

[quote=davelj]
I apologize if I didn’t get to all of your questions, but my brain and fingers are about to melt down.
[/quote]

No problem. Feel free to drop off this conversation at any time. I’m on vacation right now and have some time on my hands. Don’t feel like you have to respond to all my questions. This is an interesting area to me and it’s easier for me to pepper an expert with questions and see what I get back as opposed to trying to search the Web or going through a textbook for the answers.

That being said, you haven’t convinced this layperson that lack of liquidity or the banks having to engage in fire sales is the reason why the MBSs/CDOs/etc are continuing to decline in price.

[TheBreeze]

[quote=davelj]

But anyhow… deposits don’t get levered in a bank (and 10:1… I won’t even ask where that came from). Capital gets leveraged. There are a bunch of different regulatory capital ratios that any book on banking can explain that I’m not going to go into here. But, here’s what the balance sheet of a fairly typical community bank (“TCB”) looks like:
[/quote]

As you can tell, I’m not a banking expert. My only knowledge of banking comes from a “Money and banking” class I took many moons ago and what I’ve picked up from reading blogs. I ‘misrembered’ what it is that banks lever against. Thanks for clearing this up. It’s now coming back to me that banks are allowed to lend out a certain percentage of their deposits and they have to maintain certain capital ratios as described here:

http://en.wikipedia.org/wiki/Capital_requirements

[quote=davelj]

Your understanding of solvency is technically correct, but as you can see from the bank’s balance sheet above, not precisely applicable to banks (but not altogether non-applicable, either). An example: Let’s assume that TCB’s assets above are “good” – that is, all of the loans are current and the LTVs reasonable. Now let’s assume that all of TCB’s depositors show up at one time and want their money. TCB’s going to first go through their cash, then liquidate securities, then they’re going to have to start liquidating loans to meet depositor requests. Even a “good” loan portfolio will take months to sell because of the due diligence required by the buyer and the negotiations. The deposits would be sold also, but the value received given a day to liquidate is much different than if a couple of months is necessary. Now apply this micro example to the entire banking industry and I think you’ll see where the landmines are. It’s just like George Bailey explains in “It’s a Wonderful Life,” – everyone can’t get their money at once. But that doesn’t mean that all of the assets are bad – they’re just quite illiquid. Don’t get me wrong, a big chunk of the assets ARE bad right now, but the illiquidity is compounding the problem.
[/quote]

I realize that you’ve simplified this example for my benefit, but this example does not at all fit what happened in this era. More loans are going bad every day. The LTVs were not reasonable when the loans were made and, to top it off, the underlying collateral is declining in value rapidly (CA median home price was down 4% from October to November: http://mrmortgage.ml-implode.com/2008/12/30/the-scariest-housing-related-chart-ever/#comments ). Further, bank runs haven’t really been a problem (except for maybe at Indymac?). The problem was that the bigger financial institutions borrowed short, lent long, and, when one day they weren’t able to roll over their short-term financing, they were toast.

In your original post in this thread, you said this:

[quote=davelj]
Now, let’s assume for the sake of the argument that these AAAs are mispriced (that is, too low). The question is: Why? The answer is simple: Liquidity.
[/quote]

Well, I don’t think the answer is so simple. How do you value an asset when the collateral underlying that asset is decreasing in value at the rate of 4% a month? Liquidity may be part of the problem, but the fact that the value of the underlying collateral is suspect (as well as the future income streams) makes these assets very hard to value.

You also said:

[quote=davelj]
In this environment, illiquidity trades at an enormous discount. Many professionals I know and trust are as highly confident as they’ve ever been that some of these MBS represent the best risk-to-reward they’ve ever seen, but outside of their personal accounts they don’t have the proper (long-term) vehicle to buy and hold the securities. So the selling continues, the prices decline, and there’s not enough long-term capital out there to reverse things. The old negative feedback loop.
[/quote]

May be the selling is continuing because the value of the underlying collateral is continuing to decline?

[quote=davelj]
I apologize if I didn’t get to all of your questions, but my brain and fingers are about to melt down.
[/quote]

No problem. Feel free to drop off this conversation at any time. I’m on vacation right now and have some time on my hands. Don’t feel like you have to respond to all my questions. This is an interesting area to me and it’s easier for me to pepper an expert with questions and see what I get back as opposed to trying to search the Web or going through a textbook for the answers.

That being said, you haven’t convinced this layperson that lack of liquidity or the banks having to engage in fire sales is the reason why the MBSs/CDOs/etc are continuing to decline in price.

[CA renter]

davelj wrote:

I didn’t accuse YOU of plagiarism. I was responding to ARRAYA’s post (as you can see)! (Unless you and arraya are the same person, that is… which would beg a whole host of questions.) You’re clearly confused. What planet are you on?

================================
Because arraya was quoting me. The first paragraph you were referring to was written by me, soley by me, using only my words. Assuming you were referring to this quote:

And therein lies the problem with leverage…it relies on ever-expanding leverage and debt.

At what point do we decide to actually make good on all our debts and bets? Is this not **exactly** what a Ponzi scheme is? Has there ever been a Ponzi scheme that didn’t implode when its upper-most limits were reached? Do we believe in “infinite upper limits,” and how would that work?
===========================

That entire quote was entirely mine. I understand how it got confusing because we were all quoting one another, so apologize if it wasn’t meant as a personal slam, but if there’s anything I don’t do, it’s lie or cheat. I just took that very personally.

[CA renter]

davelj wrote:

I didn’t accuse YOU of plagiarism. I was responding to ARRAYA’s post (as you can see)! (Unless you and arraya are the same person, that is… which would beg a whole host of questions.) You’re clearly confused. What planet are you on?

================================
Because arraya was quoting me. The first paragraph you were referring to was written by me, soley by me, using only my words. Assuming you were referring to this quote:

And therein lies the problem with leverage…it relies on ever-expanding leverage and debt.

At what point do we decide to actually make good on all our debts and bets? Is this not **exactly** what a Ponzi scheme is? Has there ever been a Ponzi scheme that didn’t implode when its upper-most limits were reached? Do we believe in “infinite upper limits,” and how would that work?
===========================

That entire quote was entirely mine. I understand how it got confusing because we were all quoting one another, so apologize if it wasn’t meant as a personal slam, but if there’s anything I don’t do, it’s lie or cheat. I just took that very personally.

[CA renter]

davelj wrote:

I didn’t accuse YOU of plagiarism. I was responding to ARRAYA’s post (as you can see)! (Unless you and arraya are the same person, that is… which would beg a whole host of questions.) You’re clearly confused. What planet are you on?

================================
Because arraya was quoting me. The first paragraph you were referring to was written by me, soley by me, using only my words. Assuming you were referring to this quote:

And therein lies the problem with leverage…it relies on ever-expanding leverage and debt.

At what point do we decide to actually make good on all our debts and bets? Is this not **exactly** what a Ponzi scheme is? Has there ever been a Ponzi scheme that didn’t implode when its upper-most limits were reached? Do we believe in “infinite upper limits,” and how would that work?
===========================

That entire quote was entirely mine. I understand how it got confusing because we were all quoting one another, so apologize if it wasn’t meant as a personal slam, but if there’s anything I don’t do, it’s lie or cheat. I just took that very personally.

[CA renter]

davelj wrote:

I didn’t accuse YOU of plagiarism. I was responding to ARRAYA’s post (as you can see)! (Unless you and arraya are the same person, that is… which would beg a whole host of questions.) You’re clearly confused. What planet are you on?

================================
Because arraya was quoting me. The first paragraph you were referring to was written by me, soley by me, using only my words. Assuming you were referring to this quote:

And therein lies the problem with leverage…it relies on ever-expanding leverage and debt.

At what point do we decide to actually make good on all our debts and bets? Is this not **exactly** what a Ponzi scheme is? Has there ever been a Ponzi scheme that didn’t implode when its upper-most limits were reached? Do we believe in “infinite upper limits,” and how would that work?
===========================

That entire quote was entirely mine. I understand how it got confusing because we were all quoting one another, so apologize if it wasn’t meant as a personal slam, but if there’s anything I don’t do, it’s lie or cheat. I just took that very personally.

[Author]

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