Analysts Converse on CDS Issue

Yesterday, several analysts from Zacks.com and Zacks Equity Research had a lively discussion in reaction to Dirk van Djik's blog post explaining credit default swaps [CDS]:

Jason Napodano, CFA, senior drug industry analyst: A guy on CNBC referred to buying a firm's CDS and then shorting the stock as buying a life insurance policy on your neighbor and then running them over with your car. I'm usually for free-markets and little government regulation, but how in the world was that allowed to go on for so long?

Steve Reitmeister, Editor at Large: I read a good analysis that said that each of these firms had risk management in place. But their risk management models didn't account for the fact that most of the other firms had similar risk management models, and that they would all come to the market at the same time to sell their failing securities -- and thus no buyers and thus no fair pricing for securities and thus the mess we are in. I.e., they had risk management, just that it was terrible risk management.

Charles Rotblut, CFA, Senior Market Analyst: The interesting thing about Long-Term Capital Management is that they thought they had Value At Risk figured out. Except their models didn't account for the odd wrench being thrown into the system.

The sad part about this current ordeal is that by merely running average household income data against housing prices, many would have figured out a long-time ago that the ARMs were a potential minefield. That would have told far more than a complex Monte Carlo simulation.

Ann Northrop, CFA, senior media and restaurant industry analyst: Out here on the West Coast it was abundantly clear 3-4 years ago that we were in a real estate bubble. Bank of America (BAC) told me they'd lend me whatever I wanted, that it was up to me to know how much I could afford to pay back! True conversation, circa 2006.

Everyone I talked to was getting neg-am [negative amortization] loans. A former neighbor bought a $500K house with an interest-only mortgage in 2000 and sold it in 2005 for $1.5M, then bought a $4.5M house that now must be worth $3M -- oops, his theory that LA real estate prices never decline was flawed.

In 2006, the 20-something girl that works at the tanning booth had just bought a $850K condo with her boyfriend and said she didn't know how they were going to pay the neg-am mortgage when it refinanced.

The sad thing is that responsible people who didn't buy homes they couldn't afford or use their houses as ATMs to buy $150K cars, are now subsidizing those that did.

Eric Rothmann, senior finance and insurance industry analyst: Some did make the case, but few if any wanted to listen - "this time its different."

Once the effects of the dot.com Kool-Aid trip ended "Laissez Les Bon Temps Roulez" for home values, as housing prices continued to escalate at such a rate, it appeared that everyone got caught up in the new and improved Kool-Aid.

It's amazing that everyone can relate the story of tulip bulb crazy but few remember what happened as a result of HLTs and LDCs, or what caused the RTC to come into existence.

Dirk van Dijk, CFA, Director of Zacks Equity Research: Yes, that and the relationship between the price to buy a house versus renting a similar house which told the same story as the house price versus income ratios.

Ken Nagy, CFA, senior semiconductor industry analyst: Maybe 6 months ago Rob Plaza [CFA, senior retail industry analyst] recommended "Demons of our own Design," a great book about a Quant on Wall Street in the middle of the '87 Crash and The LTCM crash. "When Genius Failed" was also a good read. The one string going through them is when everyone is a seller you cannot be a seller and the models break down.

Ann Northrop: The catalysts for the housing bubble appear to be:

1997) Congress approves of a capital gains exemption for homes ($250K individual, $500K for joint filers). Market begins heading up.

2000-2001) The stock market tanks, beginning with Internet stocks in 2000 and spreading to most sectors in 2001. This sends investors, speculators to R/E market, seeking shelter.

2000-2007) Greenspan fuels the fire with cheap money.

2003-2006) Average homeowners join the party, buying in over their heads,
hoping to cash in on the appreciation bonanza.

2005) Housing becomes too expensive for most people -- even with negative
amortization, no-money-down loans.

2005) Real estate plateaus.

2007 to present) ARMs expire and must be refinanced, but equity stops increasing as prices stall. Borrowers default.

2007 to present) Housing prices drop.

2008) Congress engages in futile effort to prop up inflated home values (while asking prices in West LA remain 75% above sales prices in 2005!!).

It's fascinating to look at an inflation-adjusted price chart of U.S. real estate dating back to the late 1800's. Relative to 2000-2006, it looks pretty smooth, even with recession dip. Then the angle heads up like a roller coaster.

Dirk van Dijk: I would also add in the growth of the securitization model for financing mortgages, particularly private label, non-GSE [government-sposored enterprise] paper. The severing the relationship between the people who make the loan from the people who are on the hook if the loan goes bad was also key to the whole process.

Ann Northrop: True, but the main point I was trying to make is that the first and perhaps the biggest catalyst for the bubble was not the market crash of 2001, but rather the elimination of cap gains on the majority of real estate sales. I doubt we will hear either McCain or Obama cite this as it was passed by a Republican-controlled congress and a Democratic President.

I'd imagine Greenspan will be the scape goat tarred and feathered somewhere down the line.

Jason Napodano: If not, then I do really think the SEC dropped the ball on the "CDS and shorting issue." If the life insurance industry can police itself so that you can't take advantage of taking a life insurance policy out on someone and then killing them, the SEC should be able to do the same. If you buy a CDS you should also have a vested interest in that company.

Dirk van Dijk: Same is true of the repeal of Glass Steagal, although that had more to do with some of the current mess than the housing bubble itself. Brain-child of the GOP and Clinton went along with it, so sort of a bipartisan screw up.

Rob Plaza: There is a catalyst missing:
http://www.sec.gov/rules/final/34-49830.htm

That SEC rule allowed Bear Stearns, Goldman Sachs (GS), Lehman Brothers, Merrill Lynch (MER), and Morgan Stanley (MS) to lever up their balance sheets well beyond prudent levels. That expansion of credit helped fuel much of the irresponsible lending.

Dirk van Dijk: Yup, and that is just the on-balance-sheet leverage. Add in the off-balance-sheet SIVs [structured investment vehicles] that the regulators ignored, and leverage got really scary.

Charles Rotblut: There was also the lack of adequate SEC staffing. It's easy to have deregulation when too few people are enforcing the rules.

Eric Rothmann: Did not Arthur Levitt complain that he was not given the tools to do the job while he was SEC Chairman under Clinton?

Read the full analyst report on BAC

Read the full analyst report on MER

Read the full analyst report on MS

Read the full analyst report on GS