Tag: howard hill
Will The GOP Turn The CBO Into A Fantasy League?

Will The GOP Turn The CBO Into A Fantasy League?

News that Doug Elmendorf will not be appointed to another term as head of the Congressional Budget Office bodes ill for future budget policy discussions.

The CBO is the official non-partisan scorekeeper for all things budgetary. The soon-to-be outgoing chief of that crucial office is held in high esteem by both parties for his fair-minded neutrality.

On occasion, Elmendorf has pleased the Democrats and frustrated the Republicans, but just as frequently the tables are turned.

The CBO’s analysis of the likely 10-year effects of the Affordable Care Act is a prime example. Democrats seized on the overall deficit savings from Obamacare that came from several cost-control measures in the Act and new taxes on “Cadillac” employer-provided insurance plans. For their part, Republicans got political talking points from the estimate that the workforce would shrink when middle-aged workers left jobs they held on to as the only way to maintain their health insurance.

No matter. The (D)s could trumpet the deficit cutting, and the (R)s could say it cost jobs.

Now, if the more aggressive members of the GOP get the kind of CBO head they want, one of the bedrock principles of CBO analyses these past several decades is likely to come to an end. The phrase we hear for the new policy is “dynamic scoring,” and it opens the door for the CBO to apply unproven — some say disproven — economic theories that favor Republican policy goals.

To be sure, even the current “rules” of CBO analyses are subject to partisan gaming. For example, when a bill increases deficits too much to be acceptable in the CBO’s standard 10-year analysis, the bills are often changed to make the expensive (but popular) aspects of the bill expire early. With a wink and a nudge, the bill’s sponsors figure that Congress will extend the popular but expensive features when they are up for expiration.

It can be so rote a change that we give names to them – like the “doc fix” for Medicare. Since 2003, the formula for Medicare spending increases has included a cut in reimbursement to doctors. And seventeen times over these past 11 years, Congress has reversed those cuts in short-term bills with the generic name “doc fix.” But the law that controls Medicare spending continues to be the law, so the CBO projects future deficits based on what is in place.

Another example was the automatic sunsetting of the tax cuts put into place in 2001 and 2003. When they were originally set to expire in 2010, the country was still suffering the after-effects of the 2008 recession, so most of the cuts stayed in place. In political speak, not extending all the cuts was labeled “raising taxes.”

The latter example is especially significant if the new head of the CBO uses the dynamic scoring that radicals like Rep. Paul Ryan (R-WI) want. According to the supply-side devotees that want the new method of scoring, tax cuts always spur additional economic growth, effectively growing our way out of the revenue shortfalls that are inevitable when tax rates are cut.

Remember the discussions before the 2001 and 2003 tax cuts became law? We were told that “deficits don’t matter,” and that the economy would grow so much that there would be huge revenue increases even at the drastically lower rates. It didn’t work out that way, and the final George W. Bush budget had a $1.3 trillion deficit even with the Afghanistan and Iraq wars “off budget,” rather than the zero deficit or surplus that supply-side economic theory had predicted.

In 2005, as the 2001 and 2003 tax cuts weren’t hitting the projected lowered deficits that their sponsors expected, some members of Congress thought they just hadn’t given the economy enough tax cut medicine. So they directed the CBO to study the effects of cutting federal income tax rates by 10 percent, and to explore what would happen if they also assumed that the tax cuts would spur additional growth, as dynamic scoring fans expect from the next director of the CBO. To be clear, they weren’t talking about lowering the 25 percent tax bracket to 15 percent; just lowering the rate by 10 percent (to 22.5 percent), lowering the 35 percent rate to 31.5 percent, and so on.

In that study, the CBO came up with estimates of additional deficits of $522 billion for the first five years, and $1,035 billion over the next five years using CBO’s conventional method of scoring. Those came from the lower tax revenues without adding in any effect of boosted growth.

To project dynamic effects they worked with external consultants at Global Insights and at Macroeconomic Advisors, who were able to give the CBO estimates of additional economic activity over a five-year horizon. Longer-term effects had to be estimated by CBO staff alone.

It’s a tough job, estimating the future, and changing the rules will make it that much tougher. The CBO decided to project multiple future paths for the economy based on how taxpayers react as their rates are lowered, how Congress deals with the revenue shortfalls created by the tax cuts, and whether capital is free to move across borders or not. Across all the scenarios, the CBO estimated that there would be incremental growth in GDP, in annual amounts varying from 0.1 percent up to nearly 1 percent.

If people simply spend and save based on how much money they have in their pockets right now (what the CBO called the “no foresight” model,) the results are not encouraging. The effect was an even higher deficit than the $1.56 trillion that conventional CBO scoring predicted.

So the CBO also imagined that taxpayers would actually change their habits based on believing that Congress would bring the budget back toward balance after 10 years through spending cuts or higher tax rates. In one set of cases, they imagined that the individual taxpayers would plan according to the effects over their entire lives. In other cases, they supposed that taxpayers would actually include the effects of their spending and saving on future generations.

Can I have a show of hands for those without professionally managed multi-generational trust funds who plan over those horizons?

Under these optimistic scenarios where people plan for at least their own lifetimes, some of the trillion and a half dollars added to the national debt by the tax cuts comes back to the Treasury by virtue of the extra growth in the economy and employment. The CBO estimated that our national debt from that relatively modest tax cut would grow by only $1.1 to $1.3 trillion with those positive feedback effects from the tax cuts.

But wait! Maybe there’s a better model, taken from reality. As Governor Sam Brownback said when he pushed Kansas to make drastic tax cuts, he was using the state as his “laboratory” — and he even hired supply-side guru Art Laffer to advise.

Kansas is bordered by four states with very similar economies. They didn’t duplicate his tax cuts. What better real-world experiment could we have?

Since the Brownback/Laffer policies were put into place, the Kansas economy grew slower and unemployment dropped less than in any of the bordering states. This year, Kansas will probably finish depleting its rainy day fund, let its roads fall apart even more, close schools all over the state, and raid specific purpose funds to give them to the general fund. That’s to plug the $279 million gap in this year’s budget that’s still left after last year’s budget cuts. And the problem being pushed into next year is already expected to be more than twice as big ($648 million). So maybe the incoming head of the CBO analysis should use this real data from the real world, where tax cuts seem to make an economy grow slower than no tax cuts.

Now that’s a plan! More unemployment, slower growth, and bigger deficits.

Watch the CBO carefully after the new boss arrives. If they don’t consider the possibility that the economy might actually shrink if taxes and spending are cut, then we know that the days of being a neutral scorekeeper are over, and fantasy sports have taken over for the real players on the field.

Howard Hill is a former investment banker who created a number of groundbreaking deal structures and analytic techniques on Wall Street, and later helped manage a $100 billion portfolio. His book Finance Monsters was recently published.

Photo: University of Michigan’s Ford School via Flickr

Weekend Reader: ‘Finance Monsters’

Weekend Reader: ‘Finance Monsters’

While the origins of the 2008 financial collapse have been well reported — the reckless repackaging of toxic mortgages, the unscrupulous lending, the lack of government oversight — author Howard B. Hill proposes a different explanation. Hill brings a unique perspective to these familiar events; as a 25-year veteran of the securitization market, Hill was on the front lines of introducing many of the analytic techniques that played a decisive role in the crisis.

In Finance Monsters, he divulges the full narrative of how these sophisticated tools were developed, incorporated, and misused by the industry. His book is an urgent, riveting chronicle of innovation that outpaced regulation, and a thrilling blow-by-blow account of how the leading institutions in the field brought about a global crash.

In the following excerpt, Hill recalls the early days of the crisis, in which panic overtook prudence with devastating results.

You can purchase the book here.

As the structured finance credit crisis unfolded, two of the most popular words used to describe it were “contagion” and “contained.” Although both these words share the Latin prefix “con,” meaning “with,” the first word was used to throw gasoline on the fire and the second word was used in an attempt to throw water on the fire that was spreading out of control.

It was common throughout 2007 to hear business leaders, our Federal Reserve Chairman, and a stream of politicians all using the word “contained.” By repeating the mantra “the subprime mortgage problem is contained,” the containment team hoped they could convince the market and the public that it was only those little subprime people who had a problem.

Arrayed against the containment team were the reporters and hedge fund bears who shouted “contagion” every chance they got.

It was enough to make you wonder if either team knew how the capital markets really work. The belief they had in common was that creditworthiness (or the lack thereof) is contagious. The analysis was presented as if they thought that sharing an elevator with a person with poor credit might make a responsible person go home and default on their obligations.

The fact is that simple exposure to subprime borrowers does not make good borrowers turn into bad borrowers. Nor does one investment turn bad just because another does. That kind of contagion is an imaginary malady, like the “humours” doctors thought caused disease before they discovered bacteria.

The containment team looked to all the other classes of debt to assure themselves that credit problems were contained, pointing out that credit card bills, prime mortgages and car loans were still being paid on time. At the same time, the contagion team looked everywhere for evidence that other classes of debt were collapsing.

Meanwhile, the real contagion both should have been worried about was taking hold. The relentless focus in both the financial press and the general press on what they liked to call “the subprime meltdown” was leading investors to do everything they could to avoid any exposure to this sector of the debt market. Some investors automatically sold the stock of banks, insurance companies, mortgage lenders or any entity that might have exposure to subprime mortgage debt, no matter how small, and regardless of whether that exposure reflected any genuine risk or not.

Fire sales took place for financial products containing no genuine risk, such as a bond with top priority for payments and a huge percentage of the structured deal subordinated to it. We sometimes saw these kinds of bonds with 70 percent or 80 percent of the deal in junior positions in a credit “waterfall.”

Let’s see what actually happens in a deal such as this when a mortgage loan in the pool is foreclosed. After the house is sold, selling expenses, legal fees, repairs, etc. are repaid to the mortgage servicer who advanced those costs. Then the proceeds from the sale are forwarded to the Trustee for the securitization. Any loss is recorded as a reduction of principal (“write off”) for the lowest priority bond in the deal structure. Finally, the money that is recovered is used to pay down principal on the highest priority bond. A bond with 80 percent of the deal subordinated underneath it could withstand having every single house in the mortgage pool foreclosed and sold at a small fraction of its former value. Where I was working, we called these bonds “bulletproof,” because they actually get paid no matter what happens, and they could be paid off even faster if there are more foreclosures.

When investors avoid bonds like these, and force them to be sold for very high spreads, they essentially force every other bond to offer the same or higher spread. This is capital markets contagion, and it has nothing to do with creditworthiness.

Billions of dollars worth of subprime debt was being sold for a song, even the bulletproof stuff. The result was that borrowing became much more expensive. This affected both prime mortgage borrowers and foreign governments. Corporate entities also had to borrow operating capital at much higher rates than they would have otherwise.

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Soon, investors who bought mining company stocks, agricultural companies or fast-growing foreign companies were disappointed by earnings that came in lower than expected. Lower earnings should have been no surprise, given the fact that the asset-backed commercial paper programs were among the biggest suppliers of trade financing used to cover the cost of metal ores or agricultural commodities until delivery.

When the market avoided buying that commercial paper, those who relied on that funding had to locate new sources of financing. Many good borrowers in the commodities business had to turn to bank loans for their short-term financing. That was already a more expensive source, but became even more expensive as the banks themselves paid higher spreads due to worries about mortgage exposure.

Selling good bonds dirt cheap and making all financing too expensive is the result of true contagion. It was a natural outgrowth of the avoidance of subprime mortgage bonds, no matter what the flavor or concentration. And it makes no more sense than wholesale slaughter of every livestock breed around the world following an outbreak of Avian Flu in chicken flocks in just one country.

One underlying cause for the eventual collapse of our debt markets was the policy reaction to the first recession of the new millennium – an extraordinary period of negative real interest rates.

We witnessed nearly unprecedented government spending increases at the same time that government revenues (taxes) decreased. The net result was huge inflation for assets that could be easily financed and exhaustion of savings to support current spending.

Trusting history, mortgage lenders believed the collateral value of the houses they lent against would not decline in any meaningful way, and certainly not nationwide. The capital markets enabled funding of mortgage loans, even subprime mortgage loans, only 30 to 50 basis points above LIBOR.

With LIBOR as low as 1.10 percent after the Fed lowered short term rates to 1%, a subprime borrower was paying a full 5 percent premium above funding costs even after taking expenses into account. Since the prior peak for loss rates on subprime mortgage loans was only 2 percent to 3 percent annually or 6 percent to 7 percent over the life of the deals, it seemed that there was plenty of cushion against losses.

Homeowners responded to this environment by taking an unprecedented amount of cash out of their homes, either by selling them, or by refinancing. By 2005, “cash out refi’s” were estimated to have added as much as $600 billion a year to the American economy. That was nearly 4 percent of the economy at the time.

The Federal Government was doing much the same, borrowing about $400 billion a year from Social Security and Medicare payroll taxes to spend on current projects, in addition to several hundred billion a year in deficit spending. As a nation and as households, we were trying to borrow our way to prosperity.

At some point, schemes that involve borrowing to support current consumption run out of assets or future income to pledge, or run out of lenders willing to lend. In the case of US housing, both effects combined to help the market “roll over” precipitously.

Effects are often compounded when two unfortunate events occur simultaneously. Virtually all the creditworthy potential home owners (as well as many who weren’t creditworthy) had acquired their first homes. At the same time, the increase in home values came to a halt and this latent source of future income to pay debt service disappeared.

This latent income had actually bailed out many of the subprime borrowers who paid their mortgages, credit cards and car loans by taking out cash through refinancings as the value of their homes increased much faster than the rate of inflation.

The open question is to what extent this latent income also made prime and near-prime borrowers appear to be able to handle their debt loads better than their earned income would allow.

The politicians and talking heads that fell into the “contained” camp spent most of 2007 focusing on the good performance numbers for credit card debt, prime mortgages, auto loans, and other debt. They concluded that the rising tide of mortgage delinquencies was limited to the typical subprime borrower, a borrower who lived as little as one or two paychecks away from defaulting on their debts. The “contagion” camp was watching the same statistics, looking for an uptick in problem credits to justify their view of worldwide credit destruction.

If you enjoyed this excerpt, purchase the full book here.

Excerpt from Finance Monsters by Howard B Hill. Copyright © 2014 by Howard Hill. Published on November 6, 2014. All rights reserved.

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How To Tell If The Next Financial Crisis Is Upon Us

How To Tell If The Next Financial Crisis Is Upon Us

In my last article, it was suggested that the rapid collapse in oil prices might have set up a repeat of the 2008 financial crisis. Before we all run for the bunkers and the freeze-dried food, we should know the conditions needed for a crisis to happen, and the signposts we’ll see if the crisis gets going.

For a sector correction to become a meltdown, and for that to turn into a global crisis, there need to be several preconditions in place.

The first condition is a serious market sector correction. Such a correction is already underway and heading toward a meltdown (the second condition), according to some participants in the market for energy company bonds and loans. Others are more sanguine.

That smaller energy companies have issued more junk-rated debt than their relative size in the economy isn’t under debate. Of a total junk bond market estimated around $1.2 trillion, about 18 percent ($216 billion, according to a Bloomberg estimate) has been issued by energy-related companies. Yet those companies represent a far smaller share of the economy or stock market capitalization among the universe of junk-rated companies.

If the beaten-down prices for junk energy bonds don’t stabilize or recover a bit, we might see the second condition: a spiral of distressed sales of bonds and loans. This could happen if junk bond mutual funds or other large holders sell into an unfriendly market at low prices, and then other holders of those bonds succumb to the pressure of fund redemptions or margin calls and sell at even lower prices.

The third condition, which we can’t determine directly, would be pressure on Credit Default Swap dealers or hedge funds to make deposits as the prices of the CDS move against them. AIG was taken down when collateral demands were made to support existing CDS agreements, and nobody knew it until they were going under. There simply isn’t a way to know whether banks or dealers are struggling until the effect is already metastasizing.

The unknown is how much of the $2.77 trillion of junk CDS on bank balance sheets on June 30 this year was energy-related. If history is any indicator, the CDS in the distressed energy sector will far outweigh its 15 percent share of the junk bond market.

But if we watch for the following three signposts, we’ll know that the crisis play is happening again:

  • Non-energy junk bonds dropping in price. That would mean large holders are exiting from all junk bonds, not just those companies affected by low oil prices.
  • Sudden drops in share prices for banks or insurance companies that hold small amounts of energy-related bonds or bank loans — a clue that some market participants think they have derivative exposure.
  • Rumors or news that the big, investment-grade energy companies (the Exxon-Mobils and Shells of the world) are having trouble renewing their commercial paper, bank loans or maturing bonds.

If we see all these signs in a matter of days or weeks, then our global financial system is being tested once again by the small community of speculators that profit from betting against industries, countries, or markets. They made a fortune betting against mortgages. Most of them didn’t retire to enjoy that wealth. They moved on to the next trade, and every day they try to repeat their investing success.

The next time their presence was really visible was the European debt crisis of 2011-2012. That didn’t take down the global financial system, but it was close. If Spain, Portugal, Italy and Ireland had followed Greece into debt restructuring, we would have had another global crisis, most likely even larger than the 2008-2009 episode. Only a major commitment from Germany kept the rest of Europe’s weaker countries from failing on their debt, too.

In March of 2012, the Greek “credit event” that triggered payment on CDS was estimated to apply to CDS that equaled 30 percent of the 300 billion Euro Greek sovereign debt market, or roughly 90 billion, (about $118 billion in U.S. dollars at the time). The “settlement price” for that CDS event was 21.5 percent. So the winners in the CDS bet took home 78.5 percent of $118 billion, or approximately $93 billion. That was nearly twice the size of the CDS payoff when Fannie Mae and Freddie Mac went into receivership. Nice trade for those who made it.

Do we need to remind ourselves that Fannie and Freddie were the Exxon-Mobil and Shell of the mortgage business? Or that no target is too big if trillions of dollars can be used to make the bets?

So where will the “next trade” be? Anywhere there might be weakness.

This month, it’s in energy companies that borrowed more than $200 billion while planning on oil prices staying over $100 a barrel, and gasoline staying over $3 a gallon.

Only time will tell whether there have been enough bets against those optimistic energy companies to make it a problem for everyone, and not just them.

Howard Hill is a former investment banker who created a number of groundbreaking deal structures and analytic techniques on Wall Street, and later helped manage a $100 billion portfolio. His book Finance Monsters was recently published.

Photo: Mathew Knott via Flickr

Are We There Yet? The Next Big Crash Might Be Around the Corner

Are We There Yet? The Next Big Crash Might Be Around the Corner

We probably aren’t at the cusp of the next financial crisis, but we can’t be sure, given the pathetic nature of the financial-market “reforms” that are already being curtailed even before taking full effect.

As we enjoy a rare market gift to the masses, the first sub-$3 gasoline in several years, we might want to temper our holiday cheer just a bit. Not because cheaper gas doesn’t help “everyman,” but because the presence of rapid price swings in one market can quickly turn into disaster for all markets.

It’s not that market volatility is in itself contagious. It’s the fact that there’s a hidden part of our financial system that works behind the scenes and takes advantage of opportunities in the market. Even if those opportunities benefit only them, and hurt the rest of us.

Remember how the last crisis went global? And how some said we should blame the banks (liberals cheer) or the bad borrowers (conservatives applaud) or even decades of government policy (libertarians blow their horns)? And everybody blamed subprime mortgage lending?

What few realize is that in September of 2008, actual realized credit losses from subprime mortgage foreclosures was a small fraction of the derivative losses sustained at just one company, AIG, which became synonymous with the word “bailout.”  And AIG wasn’t even in the subprime mortgage business.

Before the crisis, AIG was the world’s largest AAA-rated insurance company, with around $200 billion in market capitalization. AIG lost all their shareholders’ capital, and still sucked up nearly $190 billion in cash, government asset purchases and spinoffs. What did an AAA-rated insurance company have to do with mortgages, mortgage bonds or investing in mortgage bonds? Actually, nothing. Instead, AIGs connection to the mortgage crisis was a special kind of bond insurance.  It wasn’t regulated as insurance. In fact, it wasn’t regulated at all.

That insurance, called Credit Default Swaps (CDS), rightly has been addressed in the new regulations that implement the Dodd-Frank financial reforms. Delay and “pushback” on those regulations has already defanged them, but the anti-regulation crowd isn’t done yet.

Last year, the House passed a bill (designated HR-4413) to take care of the regulation problem.  Ironically titled “Customer Protection and End User Relief Act,” it made sure that anyone wanting to take speculative positions large enough to bankrupt any bank on Earth could do so without the irritating presence of examiners or capital regulations. All that was required was the assurance that they were “hedging their portfolios.”

Or they could escape scrutiny by being “end users.” When the regulations were first drafted, end users were defined as companies with less than $100 million in derivatives on their books. Above the limit would define a dealer. That limit was temporarily raised to $8 billion to give smaller banks or investment firms a chance to put systems in place. HR-4413 would make that limit permanent. The workaround for derivatives dealers in end users’ clothing couldn’t be simpler: Just put $7.9 billion in CDS bets in a number of separate companies.

What does this all have to do with cheap gas in your tank? A lot. Because the same CDS bets that nearly brought down the global economy once aren’t limited to mortgage bonds. If you’re one of the group that gambles with everyone’s future, you can do it in any sector. Like energy company bonds.

There isn’t any way to tell how big the CDS bets are in energy right now. The “reforms” have ensured that. The best we can do is look at the Office of the Comptroller of the Currency (OCC) report on derivatives after each quarter end, and find out that, as of the end of Q2, 2014, there were approximately $2.77 trillion of below-investment grade (junk) CDS outstanding in the American part of the global banking system. Almost all of it was on the books of the five largest taxpayer-insured banks.

To be fair, those banks do the best they can to pair off their CDS exposure, finding bullish investors to offset the bearish bets. Unfortunately, even the best hedges are never a perfect match. The “matched books” the banks run depend on both the bulls and the bears having enough money to pay when the time comes.

Let’s hope that time doesn’t come anytime soon.  We’re still recovering from the last crisis.

Howard Hill is a former investment banker who created a number of groundbreaking deal structures and analytic techniques on Wall Street, and later helped manage a $100 billion portfolio. His bookFinance Monsters was recently published.

Photo: Mike Peel via Wikimedia Commons