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Category Archives: Banking Industry

Below is the link to the 3Q12 Economic Report I wrote for a Colorado Bank’s Board of Directors and  (reproduced with permission):

Below is the link to the 3Q12 Economic Report I wrote for a Colorado Bank’s Board of Directors and  (reproduced with permission):

I’ve temporarily had to put aside QuantumRisk, since the data pricing was raised to $800,000 p.a., and now work for a bank. The link below provides the 2Q12 Economic Report I wrote for the  bank’s Board of Directors (reproduced with permission):

Here is the March 16th 20011 CREPIG podcast interview with JW Najarian & Robert Schecter. It has been described as ‘educational’.

This interview covers many topics, the economy, residential mortgages, commercial properties, distressed property industry, and especially methodology errors.

This interview is also available at the QuantumRisk website,

I hope you find this interview informative and an enabler to executing better investment decisions.


Guan Jianzhong, Chairman of Dagong Global Credit Rating Co. Ltd

Bloomberg reports that China’s Dagong Global Credit Rating Co. reduced its credit rating for the U.S. to A+ from AA citing a deteriorating intent and ability to repay debt obligations.

Having worked on both sides of the world, I have come to associate such statements with shortsightedness. My past experience as a senior research analyst for a brokerage firm in Asia-Pacific would suggest that we are going to see problems in China by 2012.

In this blog post we take a look at how consumers could cope with the Mortgage Mess. Yes, we need strong banks otherwise the Dagong rating will be fulfilled, but this economy is 70% consumer driven. We therefore need stronger consumers, as strong consumers underpin the health of the banks, and not the other way around. Using China as an example, as China’s income per capita rises its banks and financial services companies become more confident of themselves, therefore the Dagong ratings comment above. 

I want to inform our readers that QuantumRisk’s CMBS Property Risk Analytics promotion ended September 10, 2010 per an earlier newsletter. The new pricing, valid until March 2011, is available here.

Home Prices Sag in August 2010

The State of the Housing Market
In my August 2009 blog post Have we hit the Housing Bottom? I had suggested that the house prices will bottom in 1Q 2010. Given the graph, I must say that this was a pretty good estimate of timing. 

The second question I had attempted to answer then, was home price recovery sustainable? My answer at that time was that it was more likely not.

The economic analysis presented by HiddenLevers (see picture) suggests that house prices are struggling to maintain an upward momentum. 

Why? There are two reasons. First the glut in foreclosed homes (1 in 4 for sale are foreclosed) will keep supply substantially greater than demand. Second, 1 in 6 homes in foreclosure translates into 1 in 6 homeowners who will not be able to participate in homeownership for at least 7 years or a 15% reduction in demand.

The graph shows that house prices are now hovering in the 68% to 71% range of their 2006 peak values.  From an economic cycle perspective, the housing industry collapsed before the commercial property industry. Given a 15% reduction in residential ownership capacity, it is very likely that commercial property sector will recover before the residential sector does. That is, the trough in the residential sector will be longer than that of commercials.

What is not reported in the news is the residential vacancy rates. A friend of mine who works for a utility company told me a few weeks ago, this utility is seeing 1 in 7 homes vacant. This is 50% more than reported by US Census Bureau for 2Q. That means rental incomes will not increase in the medium term. It also means that utility revenues will fall by 14%.

Some other bank just increased the difficulty of Chief Executive Officer Brian T. Moynihan 'hand to hand combat' over mortgage disputes.

The Next Big Wave: Legal Risk
Most of us are focused on market, credit & operational risks, but the next big wave will be legal risk.

I recently found out that banks are selling the second mortgage on foreclosed homes to debt collectors. Sure this maybe legally possible but lets weigh the pros & cons. The pros. Maybe banks think they can get back they principal in the second mortgage by selling the second mortgage to a debt collector. Sounds great, high fives to the managers who thought up this one. And at worst you don’t even have to write it off your balance sheet just yet. Kudos.

But wait. Does anyone really think they can get their money back from homeowners who could not even pay their first mortgage? Especially if they are unemployed? It also raises another question, what was the function and scope of collateralization?

Now the cons. What this action has done is to clarify that in the event of a foreclosure / repossession, the bank recognizes that collateralized debt survives ownership and can be put back to owner / originators. (Check with legal counsel for an informed opinion.) In the United States one cannot have one set of laws for one group of people and another set for another group of people.

Therefore, investors who bought RMBS bonds can now recognize that their securitized bonds survive any asset ownership issues, and banks are now liable for securitized bonds because they survive ownership.

I found out about a bank’s access to your personal funds some years ago. When I contacted the FDIC about it they said they could not do anything about it. Some mortgage contracts include a single sheet document that states that the bank has the right to move your funds around to keep your mortgage current. This I believe is antithetical to the securities law because securities law does not allow financial services companies to move funds around for a client for the benefit of the company.

The problem here is given such a ‘contract’ will or does the bank have the right to reach out to your 401(k) or similar funds?

Prime fixed rate foreclosures jump

How Consumers Can Protect Themselves
There are several ways consumers can protect themselves from future messy mortgage problems:

 1. House Pricing: The graph above (picture in State of the Housing Market, above) suggests that with today’s market conditions a home buyer should consider as an upper limit a purchase price of about 70% of the 2006 appraisal. If the housing situation deteriorates, this 70% number will drop. Looking at CMBS for guidance, this number can get to be as low as 54%.

 2. Appraiser Selection: Before purchasing, get an appraisal of the property by an appraiser who does not have links to banks as this minimizes banker bias.

 3. Mortgage Origination: If you are purchasing a foreclosed property, it is not recommended that you get your mortgage from the same bank that foreclosed the property. Why? At least in theory, in the event that there are ownership issues, you have a different bank behind you. 

 4. Safeguards: Given the state of the housing market, it would be prudent for the home buyer not rush into a purchase as the housing market is not likely to recover anytime soon. If you do so, you would need to have staying power. Therefore, before making a purchase, here are some points you should consider:

 4.1 Title Insurance: Don’t sign an S&P if you cannot get title insurance.

4.2 Deposit: Make your deposit conditional upon getting a clean title.

4.3 Indemnification: Require that the seller and/or the mortgage provider accepts liability for any future ownership claims in the event of the failure of the title insurance company. The lesson of 2008 was that many securitized bond credit enhancements (credit insurance) turned out to be worthless when the economy as a whole turned south.

4.4 Survival: Require that in the event of a foreclosure/repossession that all collateralized claims (1st, 2nd & 3rd liens) cannot survive the ownership.

4.5 Delinquency: Require that the mortgage provider cannot start foreclosure proceedings until the mortgage is at least 90 days past due. In the state of Colorado there are no laws to prevent a lender from foreclosing on day 2. Yes, even I was surprised by this, and know of at least one recent case where the foreclosure proceeding was started on day 50. 

4.6 Miscellaneous Contracts: Do not allow the mortgage lender have access to your other funds. Remove all such ‘subcontracts’ from your S&P agreement.

 5. Walk Away: If there are any doubts about the price, property or claims on the property, walk away. This market in not going to recover any time soon, and there will be plenty of second chances.

 There are many really good managers in banks, but as a general rule banks rotate their managers. So the great manager you see today could be replaced by a rogue manager tomorrow. Therefore do not feel ‘uncomfortable’ including these conditions in your S&P. You may even have to hire your own legal counsel to protect yourself. Remember it is wiser to walk away then to be burdened by a debt for a property you no longer own.

The real sad story is that we will eventually see 1 in 6 families homeless. To put things into perspective, James Fry, founder of Mean Street Ministry, reports that when he started this ministry about 10 years ago, there were 2 suicides per year, today there are 2 a week. We as a family have known James Fry, his family & his ministry for many years. Let us in Thanksgiving help someone in return.


Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational / educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position. Nor is this blog post to be construed as investment advice. 

Contact: Ben Solomon, Managing Principal, QuantumRisk

Real Problem versus Many Perspectives 
The perspectives reported on the Mortgage Mess varies very widely. From the political right is the Wall Street editorial “We’re not aware of a single case so far of a substantive error” to the political left Congressman Alan Grayson’s “the easiest way to make a buck is to steal it”. This one really shocked me, financial institutions and their mortgage servicing departments hired hair stylists, Walmart floor workers and people who had worked on assembly lines and installed them in “foreclosure expert” jobs with no formal training.

In my opinion these are details that subtract from the big picture. Without understanding the big picture we would not have a context in which to address this Mortgage Mess.

What is the big picture? It is, is our fiduciary responsibility to our shareholders or is our fiduciary responsibility to our customers? Correct picture but wrong perspective.

Our fiduciary responsibility is to our shareholders and that this fiduciary responsibility is derived from our fiduciary responsibility to our customers. We’ll discuss each perspective below.

Residential Mortgage Industry is Shrinking
First some context to this discussion. From the Wall Street reported data I estimate that 15.4% or about 1 in every 6 US homes are in foreclosure, and this does not include recent past foreclosures. That is a huge amount and bank troubles pale in comparison to this number. What does this number tell us?

It says that the mortgage market size will shrink by 15% as foreclosures are executed because foreclosed home owners will be barred for at least 7 years from participating in this market. The lowest estimate I was able to find was 10%. Therefore to remain profitable banks will have to lay off at least 15% of their residential mortgage staff.

Further, as reported in the New York Times, if title companies shy away from insuring foreclosed properties because they think those properties are vulnerable to claims, this will further depress the market, as investors too will shy away. 

Looking at the CMBS industry for clues, even though the reported commercial property appraisals are hovering in the 55% range, the anecdotal prices I have heard suggest purchase prices averaging between 10 to 20 cents on the dollar, and there are no reported foreclosure problems. Therefore, we can infer that the residential mortgage industry will experience similar appraisal versus selling price discrepancies and is therefore not out of the woods, yet.

Good News for Banks?
The Florida attorney general’s office says it doesn’t have the power to investigate banks but it has started an investigation into the law practices. To complicate matters, one needs to be aware that there is a difference between industry practice and actual mortgage regulation. There are also enormous variations from state to state with respect to foreclosure procedures. I found that in one state banks can start foreclosures on day 2 (1 day delinquent). This means that even though the 50 State Attorney General’s offices have launched investigations into the mortgage industry, in my opinion the banks don’t have to worry about them as these offices have no teeth. But some how this does not sound like good news, right?

First Fiduciary Responsibility
This Bloomberg article very nicely summarizes the current Mortgage Mess. That there are two fronts, “against U.S. homeowners challenging the right to foreclose and mortgage-bond investors demanding refunds that could approach $200 billion”. Of course this is an evolving situation and it is very likely many more fronts will open up.

The first fiduciary responsibility is to your customer. This is very clear in the many securities regulations since 1933. Of course banks are governed by banking regulations and in many instances are exempt from securities regulations as these exemptions are covered in the banking regulations.  Therefore I wonder if the banking regulations are any where nearly as concerned about protecting bank customers as the securities regulations require of investment advisors and broker-dealers?

Though the individual contracts appear to be in favor of the banks, investors are using every means possible to force banks to buy back bad mortgages. The final outcome, however, may play out in terms of power of buyers versus power of sellers, and not through legal means. That is investors in the future will seek assets from players who are amenable to buy backs than from those who are not.

This may be a good thing for the economy as insufficient principal protection may cause investors to seek alternative investments such as manufacturing, R&D driven technology licensing, and new materials, to name a few. Why? Because residential mortgages are no more safer than R&D.

Therefore, why did the residential mortgage market develop to the size it did? I can only conjecture that the existence of GSEs led to the mistaken belief that residential mortgages were one of the safest forms of investments.

Second Fiduciary Responsibility

The second fiduciary responsibility is to shareholders as this is a derivative of the fiduciary responsibility to customers. It is in this context that one would ask the question, how did this Mortgage Mess come to be?

In this context, given the Wall St. crash of 2008 and in the light of the Goldman Sachs hearings, the Wall Street editorial opinion that “We’re not aware of a single case so far of a substantive error” is difficult to justify as this would raise other questions.

As a general rule organizational seniority and salaries increase with fiduciary responsibility to shareholders. Therefore the questions, why did we did not have in place the systems and procedures to detect “substantive error”? Why were we paying managers so much if they did not know what was happening? What were these managers thinking?

Quite obviously operational risk and credit risk methodologies were insufficient. And may be they were ignored? A rethink of these methodologies and how risk committees are staffed and to whom they report to is in order.

Some Likely Future Outcomes

In the context of the First Fiduciary Requirement we can infer some future outcomes. 

Firstly, if there genuinely were mistakes in the foreclosure process, the second lien holder should now have a claim to the funds recovered from the sale of the property as the first lien holder did not conduct his fiduciary responsibility correctly. (Check this with your attorney as he may disagree.)

Second, title insurance fees may increase. Title insurers have two options either do not insure the title or substantially increase the fact checking required. The latter will increase title insurance fees. Assuming that Congressman Alan Grayson’s findings are correct, I believe that title insurance firms will choose not to insure as it would be more expedient to not insure than to dig up bad documents. Therefore, don’t expect title insurance for foreclosed homes unless the bank owns the title insurance firm, but this should raise questions of bias. My guess is that the title insurance problem is only going to get more complicated.

Third, future bank purchases will be structured more like an asset sale than an acquisition or merger. Why? First you don’t absorb the bad management team. Second by insisting only on asset purchases you put into place a screening process that substantially ensures that you are not purchasing a barrel of bad apples. Sure its a lot of work but that comes back to the banks’ fiduciary responsibility to its shareholders. An asset sale would allow the purchaser to include a clause that any future claims due to fraud, misstatement or omissions are the liability of the seller’s management team. Therefore one can infer that Bank of America’s purchase of Countrywide as a single company was not a good strategy, and that any subsequent M&A activity in the banking sector would require a rethink.

Fourth, further changes to securities regulation. Dodd-Frank indeed may turnout to be insufficient or in the worst case irrelevant as private action against mortgage industry participants further tighten regulation. For example if we assume that the alleged wrong doings were conducted by a handful of employees and not an issue of management culture, checks and controls, then we can expect changes to portions of the securities and banking regulations that would provide investors more time to seek recourse. For example Securities Act of 1934, Section 10(b), investors have two years from discovery of the fraud or five years from when it occurred to file their claim, while Sections 11 and 12(a)(2) claims against misstatements or omissions must be brought within one year of discovery and three years of the securities filing. These timing could be changed to 10 years or simply no statue of limitations for any fraud, misstatements or omissions.

Fifth, we would expect bond investors require,
1) A buy back clause in any future securitization, and that buy back clause is automatically transferrable to any and all future bond holders. At the very least in the event of the failure of the insurance provider.

2) That any third party providing a fee based opinion about a or soon to be securitized deal state that they have fully examined the collateral backing the deal.

This downside risk assessment of the residential mortgage industry suggest that an end to the industry turmoil is not in sight. Further, we can expect substantial private sector initiated changes to investment contracts that will provide both investors and home owners with better uniform protection.


Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational / educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position. Nor is this blog post to be construed as investment advice. 

Contact: Ben Solomon, Managing Principal, QuantumRisk

It is critical for investors & real estate professionals to know which cities to invest in and which to stay away from for the time being.

We are very pleased to announce that CoStar’s Watch List featured some of our May 2010 Analytics in their article, “Impact of CRE Distress Varies Widely Market to Market” receiving more than 10,000 reads within 24 hours. A sample report for All Properties is available at  

Our July 2010 CMBS Property Risk Analytics** (CPRA) shows that CMBS defaults & losses vary across the US by city from 0.0% to 80.0% defaults & 0.0% to 78.0% loss severities. Defaults rates continue to increase but loss severities continue to decline. How?

July 2010 CMBS Default Rates

The July CMBS Property Risk Analytics shows that the CMBS default rates continue to increase, and is at 5.79%. Note the graph is a snap shot of the CMBS pipeline as of the end of July 2010.

July 2010 CMBS Severity of Loss 

The July CMBS Property Risk Analytics shows that the CMBS severity of loss (before recovery) continues to decline and is now at 5.51%. Note, the severity of loss numbers do not include loss due to appraised value reductions. Note the graph is a snap shot of the CMBS pipeline as of the end of July 2010.

FDIC’s Mixed Report on Banks
FDIC’s list of “problem banks” reached 829 in 2Q 2010, NY Times August 31 2010. Even so, bank earnings continue to rebound posting $21.6 billion industry profits. “Across nearly every category, troubled loans started falling for the first time in more than four years. The sole exception was commercial real estate loans, which continued to show increased weakness. Still, the nation’s 7,830 banks remain under pressure.”

 New York Times / Jonathan Ernst / Reuters

“Without question, the industry still faces challenges,” Sheila Bair said in a news statement. “But the banking sector is gaining strength. Earnings have grown, and most asset quality indicators are moving in the right direction.” The agency expects a “recovery, sluggish and slow”.

The FDIC is cautioning that even though the outlook is becoming positive it may not be positive enough for a strong recoveery. On the other hand Russell Abrams of Titan Capital Group LLC, is betting the market is underestimating the likelihood of a crash (Bloomberg August 30, 2010)

So whose outcome is more likely, the FDIC’s small positive or Abrams’ second market crash leading to a double dip recession?

Will This Recession Be A Double Dip?
Our CMBS Property Risk Analytics shows that defaults are increasing but loss severities are declining. Apparently contradictory behaviors when you take into account that defaults and loss severities are usually positively correlated.

What is happening in the economy is that up to about a year ago CMBS defaults were dominated by newer loans that were backed by over priced (compared to today’s) valuations. Therefore, the large severity of losses late in the pipeline. The more recent defaults are from much older loans. Therefore smaller severity of losses early in the pipeline.

This tells us two things. First, industry losses that were primarily driven by over priced valuations have been fully absorbed by the industry – good news. Second, the industry losses has transitioned to a second stage, insufficient revenue. That is the more established older loans are defaulting due to insufficient business revenue.

It is this second stage that worries me. Our CMBS Property Risk Analytics shows that at the national level City DSCRs – a proxy for business revenue – are at 1.366 (April), 1.367 (May), 1.376 (June) and 1.397 (July). About constant between April, May, June and a 2.3% increase in July.

Could the July 2.3% increase be a one off ‘bump’ in the reported data?

Looking at the national level City Occupancies, our CMBS Property Risk Analytics show that City Occupancies were at 88.22%, 88.51%, 90.16% & 89.33% respectively. That is in the last 4 months there has been a general upward trend in CMBS City Occupancies of 0.5% increase per month – also good news – and if sustainable will reflect a general economic environment that will avert a second market crash & double dip.

Therefore, in my opinion a double dip recession is unlikely and I disagree with Russell Abrams opinion that a second market crash is likely to occur. I concur with Sheila Bair that even though a recovery is in place, at this point in time, a recovery is not likely to be as fast as we would like it to be.

Disclaimer: There is a certain amount of opacity in any business. For example the collapse of Lehman Brothers took us all by surprise. Therefore, if for example a major bank were to collapse that would alter this expected outcome.

CMBS Property Risk Analytics Pricing & Promotion
For Single Users, the CMBS Property Risk Analytics monthly reports are priced as follows:

 Item Title Monthly Price
QR CPRA Retail $135.00
QR CPRA Office $135.00
QR CPRA MultiFamily $135.00
QR CPRA Hotels/Lodgings $135.00
QR CPRA All Properties $370.00


The prices shown do not include discounted annual price, sale tax for Colorado residents/companies or Multi User pricing. For more information on pricing visit our website

The corresponding April, May, June & July reports will be provided free for all 12-month or annual subscriptions paid by September 10, 2010. For PayPal payment instructions, please contact Ben Solomon. Note, an email address is required for receipt of ftp user id, ftp password and decryption password for each monthly report.

A sample report is available at

How the CPRA Report is Generated?
Every month we analyze reported data on more than 85,000 properties backing more than 52,000 loans to identify default probability, loss severity before recovery, loan to value ratio (LTV), debt service coverage ratio (DSCR), occupancy rates & change in property appraisal value for more than 400 U.S. markets, by property type, by city, by SMSA/MSA by state across the US. Five property type reports are generated: All Properties, Lodgings/Hotels, MultiFamily, Office & Retail.

** Property Risk Analytics is the registered trademakr of QuantumRIsk LLC.


Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position. Nor is this blog post to be construed as investment advice. 

Contact: Ben Solomon, Managing Principal, QuantumRisk

QuantumRisk looks at downside risk & lessons we can learn from industry failures. We don’t provide rosy scenarios of the future, that is better left to others. We neither negate nor advocate any persons, entities, products, services or political positions. Neither are we attorneys. Nor do we profess legal opinions on any subject.
However, as much as is reasonably possible we present opinions, information and facts that can be tested and verified by & for the benefit of our readers. In so doing, we explore downside risk, their consequences and how we could avoid these future scenarios. Sometimes, the conclusions arrived at may not be desirable but many times if we don’t look an undesirable outcome straight in the eye we usually cannot find a more amenable solution. 
An ideal outcome would be the rethinking of private & public policies that lead to a more secure future for all of us.

Goldman Sachs Senate Hearings
I had originally planned to write Part 2 of Loss Containment but realized that the Goldman Sachs Senate Hearings was more pertinent in this time frame. I will get back to Loss Containment next month, if something more pertinent does not surface.

On April 27 2010 the Senate Subcommittee on Investigations held a hearing in which current & former Goldman Sachs employees (including the CEO & CFO) testified. In all fainess we need recognize that many parties by ommission or commission share the blame for this financial crisis. I watched about 7 hours of the hearings, and have several observations:

1. More Main Street
Senator Carl LevinThe goals of these hearings (Goldman Sachs hearing was one of several) are threefold:
1. To construct a public record of the facts to deepen public understanding of what happened and to try to hold some of the perpetrators accountable.
2. To inform the current legislative debate about the need for financial reform; and
3. To provide a foundation for building better defenses to protect Main Street from the excesses of Wall Street.

Sen. Levin had repeatedly brought up the need to protect Main St. and therefore I infer that future regulation will be supportive of Main St. – Wall St. engagements and discourage Wall St. – Wall St. engagements. In this light, we recognize why Glass-Steagall worked at the operational level. It ensured that a substantial portion of the financial services industry was focused on the needs of Main St, and by use of barriers protected these segments of the industry from the influences of its more glamorous kin.

2. Discourage Non-Collateral Based Instruments
Senator Claire McCaskill“It’s gambling, pure and simple raw gambling” said Sen. Claire McCaskill.  This sentiment was echoed by Sen. Carl Levin and was repeated many times by the senators, suggesting that future financial regulation would some day discourage if not curb the development and use of financial instruments that are not directly identifiable with a real physical asset. That futures-like products are acceptable but synthetic-like products are not. This is going to be tricky to do but I infer that this will be the direction of future legislation.

With respect to Mortgage Backed Securities there are two possible requirements to ensure compliance with a possible collateral-based security requirement. First, that an analyst is able to follow the cash flow from the assset to the security, and show how a specific asset default, defeasance, or prepayment would affect the cash flow to a specific security. Second that the master or even the special servicer is able to do the same.

The first requirement is usually a given for straight forward/non-exotic deals, but the second is a problem even for some ‘basic’ deals as some of the data is missing. The MLCFC 2007 9 WF or GSMS 2007 EOP WF deals are good examples where the servicer has difficulty in providing some of the data. The slicing & dicing of some of the properties in these deals has no effect on the risk characteristics of the deals but has resulted in a breakdown in the servicers’ ability to provide current information right down to the property level.

3. Strengthening of Fiduciary Responsibilities
Sen Levin and his colleagues had repeatedly asked questions relating to clients’ interests versus company’s interests. Their focus suggest that future legislation will prevent a bluring of roles with respect to client versus company interests. Therefore we should expect a compartmentalization of financial services to protect the integrity of fiduciary responsibilities

Goldman Sachs Employees Testify (Fox News/AP Photo)

4. Individual Responsibility
Seven current and former Goldman Sachs employees including Chief Executive Officer Lloyd Blankfein testified at the Senate Hearings. First a disclaimer. My comments are based on my inferences as a management consultant working with teams and not as an attorney.

The fact that the Subcommittee required both current and former employees to testify before it suggests that individual employees cannot hide behind company policy or lack of, to defend themsleves against allegations of wrong doing. Further, everybody is doing it will no longer suffice as an acceptable defense or immunity for one’s actions.

History shows that financial regulation (Securities Act of 1933, Securities Exchange Act of 1934, Trust Indenture Act of 1939, Investment Company Act of 1940, Investment Advisers Act of 1940) spawned after the crash of 1929 took 11 years to formulate and implement. Similarly we can expect to see several more new or strenghtened regulations being formulated and implemented over the next 10 years. 
Future regulation will further compartmentalize both financial services (e.g. retail banking, investment banking, trading and public-type versus private-type fund management) and financial products (e.g. basic, middle and exotic products).   
There will be stronger, clearer guidelines as to how products can be structured. For example (and this is only a suggestion) basic products can be used to structure deals where AAA accounts for up to 90% of the deal. Exoctic products cannot have more than 25% AAA, and middle products cannot have more that 60% AAA


Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position. Nor is this blog post to be construed as investment advice. 

Contact: Ben Solomon, Managing Principal, QuantumRisk

Some Thoughts on Default Methods
Summary: Asset defaults (ratio of events) are statistically different from dollar defaults (function of ratio of magnitudes).  

Multiple Distributions: I had originally thought I’d just discuss long tails, but found that some matters needed to be clarified before discussing long tails. Individual asset losses have fat and long tails; the result of default and loss severities that obey binomial, lognormal or gamma distributions.  

Default Methods: There are only 2 broad methods of determining default probabilities in the mortgage industry. The first default method is asset default Pa defined as the number of assets defaulted divided by the total number of assets in the portfolio. This is a statistic of proportion or ratio of events.  

The second is what I term dollar defaults Pd (a.k.a. structural models). A dollar default is said to have occurred when the ratio of the default boundary value to original value decreases below a specific value. I use term them dollar default because they are primarily driven by the ratio of magnitudes to estimate credit risk; severity of loss and 1 – severity of loss are examples. These are statistics of proportion or ratio of magnitude and we can term these ratios severity of loss type statistic

Industry usage: The 2 ways this is used in CMBS are: 

(1) CDR (Constant Default Rate): CDR is the ratio of outstanding balance at default (default boundary value) divided by original principal balance (original value). In CMBS deal structuring CDRs are presented as a time series of ratios a.k.a. loss vectors; severity of loss in its most basic form. There is no need to model defaults as they are assumed to have occurred (very neat!) and severity of loss is predetermined by the CDR statistic. 

(2) DSCR loss models: A default occurs when DSCR gets below 1.0. Property cash flows are reduced by 2% (or some suitable value) per annum until this default event occurs. The ratio of magnitude, the ratio of the outstanding principal balance (default boundary value) to the original principal balance (original value) is determined when DSCR drops below 1.0. To determine severity of loss, the default event is specified by a rate of deterioration of cash flows, which is itself a ratio of magnitudes


Empirical Data Confirms Biases
Summary: Empirical data confirms dollar default biases 

Empirical Confirmation: Empirical research (by others) confirm that dollar default methods (a.k.a. structural models) underestimate default probabilities. My own research on DSCR loss models concur with these results, that DSCR loss methods underestimate losses early in the life of a loan. My concern is not so much with these models’ expected values as with the shape of their tails. 

Test 1

Illustration:In a non-rigorous way we can illustrate why. Dollar defaults Pd, as a function of proportion of magnitude, have a different statistical behavior from asset defaults Pa, a proportion of events. We can see this by writing assets & dollar defaults, respectively, as some function of economic & industry factors f(x)

Asset defaults as a function of economic and industry factors:
Pa = f(x) = number of default events / total number of assets 

Dollar defaults as a function of economic, industry and asset size, s: 
Pd = g( f(x), s) = some function of ($ outstanding balance / $ original balance) 


Test 2

Using 2 portfolios to illustrate. Portfolio A consists of 2 assets of $100,000 each, and portfolio B consists of 3 assets of $100,000 each. Should one asset in each portfolio experience a loss (a good assumption if defaults are small) of $70,000, Portfolio A’s loss is 35% (70,000/200,000) & B’s is 23% (70,000/300,000). 


Different Statistics: However, Portfolio A’s asset default rate is 50% (1/2) and Portfolio B’s is 33% (1/3) but their respective severities are 35% & 23%, and being less could result in an underestimation of asset default probabilities. But wait. Should the loss have been $20,000 then Portfolio A’s & B’s losses are 1% and 7% respectively, but the asset default would still be 50% & 33% respectively. That is, for each asset default there are multiple severity of losses, and therefore, dollar and asset defaults have different underlying statistical behaviors.

The 2 figures (click on figures to enlarge) above, Test 1 & Test 2, show very different statistical distribitions that are dependent on the underlying nature of the risk drivers. It is clear from the graphs that the probability distributions of these severity of loss type statistics used to generate defaults, do not exhibit Binomial behaviors; Test 2 is not Lognormal, and Test 2’s tail is much fatter and longer than Test 1’s. 

Alternative Explanation: Researches currently believe that this consistent underestimation of default probabilities is due to missing factors such as liquidity and recovery. But including recovery will only reduce the severity of loss statistic and would further depress the dollar default estimations. My analysis, however, suggests an alternative explanation for the underestimation, that of different statistical properties. 

Undesirable Statistic: The dollar defaults statistical properties may even be undesirable. Using the form sum of (probability of default x outstanding balance at default) to estimate expected portfolio loss, we see that dollar defaults introduce asset size twice and asset defaults only once. Therefore, dollar default methodologies may not be desirable for determining default probability. 

Beta Distribution: An additional caution for those of you who model default & severity of loss. In my opinion, using the beta distribution is an assurance that your results are incorrect. Why? In my 30+ years working with large data sets, the beta distribution is the single most unstable distribution I have come across. This distribution will change shape when you are not looking! It is so unstable that small changes in its parameters can lead to significant changes in its shape. 


Reducing Impact of Loss Tails
Summary: Portfolios alter the shape of the tail for the better. 

Therefore, we drop the use of dollar default methods. Most of us use portfolio diversification to reduce risk as measured by standard deviation of returns. But portfolios have little known properties, they can reduce the effect & change the shape of long tails. 

Severity Reduction: A portfolio consists of many assets, and each asset will have default probabilities and loss severities associated with it. All other factors being equal, the impact of a portfolio’s tail loss can be reduce by increasing the number of assets in the portfolio. Using the 2 portfolios above to illustrate this; the severity of loss of Portfolio A is 35% but that of Portfolio B is 23%. The severity of loss to a portfolio is reduced by the size of the portfolio (given all other factors being equal). 

Shape Change: Taking this a step further CMBS loss severities tend to be Gamma distributions while portfolio losses ought to approach Normal distributions (but not quite). Therefore for the same mean & standard deviation, the Gamma’s tail can be 25 to 35 times longer than the Normal’s tail. Why not quite?. In lay man’s terms, the Central Limit Theorem justifies the approximation of large-sample statistics with the normal distribution, and therefore large portfolio statistics should look Normal. However, default probabilities tend to be small, in the 1 to 2% range. Therefore, there aren’t enough observations to substantially shrink the loss tail, and therefore, appear lognormal or at least skewed to the right. 

Multiple Properties: Likewise, having multiple properties (and beware of cross collaterized loans, they are usually synonymous with multi-property loans) under a single mortgage can lead to catastrophic failure if there are a few properties. The loan defaults if a single property’s loss of income causes the loan’s DSCR to drop below 1.0. In this case a multiple property mortgage magnifies the effect of a single default. To reduce this impact one needs to either reduce the number  of these assets (loans) in the deal or increase the number of properties in the mortgage. However, the latter is not a good solution as it defeats the purpose of deal structuring. 

Spatial Correlations: Another problem with multiple property mortgages is that these properties tend to be in the same MSA (Metropolitan Statistical Area), and therefore are at risk to spatial correlations (see for example Prof. Tom Thibodeau, CU Boulder) that properties in close proximity tend to rise and fall together. 

Multiple Liens: More obviously, the reverse is also true, multiple mortgages on a single property causes all loans to be in default should the property’s income fall. In this case the mortgages should be assigned to different portfolios, thereby reducing the severity of loss to a specific portfolio. 

Wrong Signals: Note that RBS has tried an approach to reduce underwriter’s risk by not closing the loans as they are pooled. Interesting. While it does not reduce investors’ risk, don’t you think this sends the wrong market signals?  


Some Lessons
Summary: Some lessons from a loss perspective. 

1. Avoid single-mortgage-multiple-property (& cross collateralized) assets (loans). 

2. Avoid CMBS deals with multiple cross collateralized assets as portfolio diversification may not be what it appears to be.  

3. Multiple-mortgages-single-property assets reduce risk for the same total principal.  

4. My experience with CMBS data suggests that CMBS deals should be in the 150+ asset range. The RBS $309.7 million, 81 property deal is small, and it should be interesting to see how a small deal at the bottom of the market fares in the future. 

5. Check your methodology. 


Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position. Nor is this blog post to be construed as investment advice. 

Contact: Ben Solomon, Managing Principal, QuantumRisk


Several news items (WSJ’s Tishman Venture Gives Up Stuyvesant Project, Control of Stuyvesant Takes Center Stage and the NYT’s Fallout Is Wide in Failed Deal for Stuyvesant Town, As Doubts Grow, U.S. Will Judge Banks’ Stability) got me thinking about stress testing.

Stress testing is an approach to evaluating how a deal or a balance sheet will behave when selected factors are changed to induce a loss. It is done to answer the question what is the downside financial risk should a bad situation occur?

Around February 2009, the Feds and the Treasury impleted stress testing of the largest banks. This illustrates that stress testing is used in both the private and public sectors. And for those who are not familiar with this methodology, it is not a Republican or Democrat issue, as we can see that Ben Bernake is a Republican and Timothy Geithner is an independent having been a Republican.

Figure 1 illustrates a single factor that is used to stress test the deal or the balance sheet. I purchased some structured finance models a few weeks ago and was reviewing them. My observations about 3 important failings of the stress tests are based partly on these models:

Figure 1: Factors Skewed Right

1. Right/Wrong Distribution: I realized that the inherent assumption behind one of the stress parameters, the loss statistic, is that it is Normally distributed, because it is based on average values. In this example the mean is the 5.0% dashed green vertical line.  Therefore, this factor should behave like the red-dashed Normal curve in Figure 1. However, losses are skewed right and fat tailed per the blue curve. The mean is still 5.0%, however, the mode is 4.6% (solid purple vertical) with a long tail extending out beyond 17.9%.

2.  Insufficient: Stress testing multiplies the loss number by 2x to 10.0% or 3x to 15.0%. In this example 15.0% is insufficient to cover 17.9% tail loss.

Figure 2: Factors Skewed Left

3. Irrelevant: In Figure 2, we see that the skew is to the left. As an example some returns distributions can be skewed to the left. Therefore, the stress test has no bearings with reality. The stress test stresses the loss statistic in a manner that can never happen because it is outside both Normal and Left Skewed distributions, and therefore, the results are irrelevant to the real world.

So take care with your stress testing.


Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position neither is it to be construed as investment advice.

Contact: Ben Solomon, Managing Principal, QuantumRisk