Bubble trouble
The US Department of Justice's lawsuit against Standard and Poor's is misguided, says our legal writer Lawsmith. It was the market's confidence in the ratings agencies that was at fault, not the agencies themselves.
Last week, Standard & Poor's, the rating agency, was sued by the U.S. Department of Justice (USDoJ) in a Los Angeles federal court for “knowingly and with intent to defraud, devis(ing), particpat(ing) in, and execut(ing) a scheme to defraud investors in (residential property securitisations) and CDOs, including federally insured financial institutions... and to obtain money from these investors by means of material false and fraudulent pretenses, representations, and promises and the concealment of material facts.”
Even to persons legally trained, this is weighty stuff. One of the most amusing ways I know to frighten an unschooled junior lawyer is to sit him or her down in front of a structure diagram of a securitisation, a jumbled mess of agreements, parties, cashflows, security arrangements, and hedging – and then change slides to display a CDO, a securitisation of securitisations, a stacked jumble of jumbles. (Instant fun.) Despite the visuals, however, such transactions are conceptually very simple: one takes assets that throw off a steady stream of income (such as residential mortgages), models the cashflows arising from them, and creates debt instruments which match the payments from the assets with the payments on the notes. Those notes or bonds are then sold, with the seller recouping the capital value of the assets in the present in exchange for investors' acquiring the future flows of income.
As such, securitisation is a remarkably versatile funding tool: one can quite literally put a chicken sandwich into a securitisation, and emerge on the other side with investment-grade debt. This is achieved through a process called “tranching,” where certain classes of debt receive higher payments of interest but absorb losses first, allowing the more senior pieces to be sold as relatively safer assets. So, for example, with a structure that issues £100 million in notes – £40m “B” and £60m “A” – if there is a shortfall of £30 million, the junior “B” tranche is wiped out by 75%, whereas the position of the senior debt is unaffected.
This is where rating agencies come in. Each agency appointed on a particular transaction assesses how these transactions have been structured by the banks and determines, on the basis of a pre-published (and public) set of criteria, their reasoning for arriving at their conclusions. Based on the amount and quality of credit enhancement for a given deal, they issue ratings to the more senior classes of debt which represent the rating agency's opinion as to the probability of default on a given piece – the better the rating, the lower that probability is.
USDoJ asserts that, as the sub-prime crisis began to unfold over the course of 2007, S&P rated 30 CDOs backed, in whole or in part, by non-prime (low-income borrower) RMBS collateral, and that “S&P knowingly disregarded the true extent of the credit risks associated with those non-prime RMBS tranches in issuing and/or confirming ratings for CDOs with exposure to those non-prime RMBS tranches.” One of these, the complaint points out, was “NovaStar ABS CDO I,” a $374 million transaction comprised of securities which were backed by subprime residential loans and issued in 2006 (76%), 2005 (18%), and 2007 (5%). S&P rated $277 million of the notes issued by the deal as AAA, or the lowest probability of default; however, the deal imploded. The result, as put by the Justice Department, was “near total losses to investors,” who were for the most part federally-insured banks.
This is an example of one small part of a wider evil which requires a $4bn lawsuit to be put right. The nitty-gritty of legal arguments – which does not bear repeating here – hinges on whether S&P's statements on these deals were actionable misrepresentations or protected speech under the US Constitution. The more important question, though, is this: is this a case that should have been brought in the first place?
From a jurisprudential standpoint, the only relevant consideration is that the statute upon which the claim is based has never been used before for this purpose (suggesting that this alleged social ill was not what the drafters of FIRREA 1989 had in mind).
In terms of economic substance, a slightly closer look at NovaStar shows that USDoJ falls very wide of the mark. As of late 2006, the company was a reasonably reputable originator of residential mortgage loans: as reported by the New York Times, NovaStar “boasted 430 offices in 39 states... fast becoming one of the top 20 home lenders in the country,” a “Wall Street darling” with “shares trading at $30 (in 2003), up from $9.50 in late 2002.” It would go higher, eventually soaring to $70 per share: “between 2004 and 2007, for instance, the company raised more than $400 million from investors,” eventually attaining a market value of $1.6 billion, with loan origination to sub-prime borrowers reaching $600 million per month.
The secret behind NovaStar's short-lived success was that the firm originated loans which, in hindsight, a reasonably prudent mortgage lender would not have, with low-quality security and to low-quality borowers. “One NovaStar loan on a property in Ohio totalled $77,500 even though the average sales price for the neighbourhood was $31,685, and the same house had been purchased two months earlier for $20,000,” reported the Times, and virtually anyone – “even... a corpse, the joke went” – could obtain one. NovaStar employed accounting methods that “gave the company lots of leeway in how it valued the loans held on its books,” such as one which “allowed it to record immediately all the income that a loan would generate over its life,” even if the mortgage had decades to run until maturity. As a result, virtually the entire market misapprehended NovaStar's business, including its securitisation business, until the subprime bubble was well into the throes of its (widely unexpected and spectacular) collapse.
When one considers that it is not a rating agency's mandate to perform investor due diligence, but rather to look at the stated characteristics of the income flows presented to it and “assess the likelihood, and in some situations the consequences, of default – nothing more or less,” one understands that if garbage data go in, whether by dint of fraud or endemic asset mispricing, garbage conclusions will invariably come out. It is this which should colour USDoJ's claims when being viewed by objective observers.
The credit enhancement involved in obtaining a AAA rating should, according to USDoJ, “on average, be able to withstand economic conditions similar to those of the Great Depression,” a roughly 1% probability of default. Most of the time the rating agencies get this right: the default rate of AAA-rated notes in structured finance transactions has, in the last thirty years, barely exceeded 0.5%, and even then only reached that historically unusual high in 2008.
But sub-prime RMBS was different, and this was not the fault of the rating agencies. Investors everywhere lost money as a result of the sub-prime crisis because they failed to conduct proper due diligence and were caught up in the largest speculative property mania in history – one which was US-government-fuelled at that. The U.S. federal government was left with considerable additional egg on its face after it then had to bail out these banks with these toxic assets on their books. But, if this lawsuit is to be believed, the primary responsibility for these losses should lie with S&P, which has allegedly perpetrated a massive fraud for its own material gain.
Recent rhetoric emerging from the populist left has capitalised on the suit, with financially illiterate commentators asserting that the rating agencies' giving AAA ratings to toxic assets was “tantamount to a massive betrayal of America.” This is plainly absurd. Many people and institutions made bad calls in the run-up to the great recession. It does not follow that it is appropriate to sue organisations which made a profit throughout, simply because they had no skin in the game. Nor will it do anything to protect the American taxpayer from being the guarantor of last resort, a precarious position in which the American people remain: not despite the role of their government, but because of it.
Article: Bubble trouble
Last week, Standard & Poor's, the rating agency, was sued by the U.S. Department of Justice (USDoJ) in a Los Angeles federal court for “knowingly and with intent to defraud, devis(ing), particpat(ing) in, and execut(ing) a scheme to defraud investors in (residential property securitisations) and CDOs, including federally insured financial institutions... and to obtain money from these investors by means of material false and fraudulent pretenses, representations, and promises and the concealment of material facts.”
Even to persons legally trained, this is weighty stuff. One of the most amusing ways I know to frighten an unschooled junior lawyer is to sit him or her down in front of a structure diagram of a securitisation, a jumbled mess of agreements, parties, cashflows, security arrangements, and hedging – and then change slides to display a CDO, a securitisation of securitisations, a stacked jumble of jumbles. (Instant fun.) Despite the visuals, however, such transactions are conceptually very simple: one takes assets that throw off a steady stream of income (such as residential mortgages), models the cashflows arising from them, and creates debt instruments which match the payments from the assets with the payments on the notes. Those notes or bonds are then sold, with the seller recouping the capital value of the assets in the present in exchange for investors' acquiring the future flows of income.
The 10p rate is a flawed tax cut, but a tax cut nonetheless
Robert Halfon MP’s campaign to reintroduce the 10p tax now appears to have been a success. After David Cameron’s hint that it would be introduced in the next budget and Ed Miliband’s announcement today that Labour would reintroduce it after the election, it seems inevitable that it will be a part of the next budget.
Many in the free market movement have expressed their dismay at this. The CPS’s Ryan Bourne has argued convincingly that it would be better to raise the personal allowance more instead of introducing a new band of tax, primarily on the grounds of simplicity.
I agree with him, but I am still pleased that the government is going for the 10p rate. Where I differ is that I do not see the reforms as being a case of either/or. The personal allowance will be raised to £10,000 – as I argued in my paper Just Rewards last year, it should be pegged to at least the minimum wage level – but it seems unlikely to be raised beyond that.
George Osborne is unlikely to see a raise beyond £10k as being worth the reduction in revenue – raising the personal allowance was a Lib Dem policy before the election, and it would be hard for the Conservatives to claim special credit for raising it even further. This proposal essentially allows the Conservatives to claim credit for something – taxing low-income earners less – that they should have been for all along. The effect is basically the same.
I am not really convinced that the addition of another tax band will be significantly complicating. The length of Tolley’s Tax Guide, a rough but useful guide to tax code complexity, has doubled since 1997 – not because there are extra bands (you could fit a hundred different bands on a single page) but because of the number of special exemptions and loopholes created by government to favour certain groups over others. This, it seems to me, is the real meat in the tax simplification sandwich.
I would love to see a “simple tax” proposal to scrap all the complications in income tax but preserve two different tax rates, so that the argument over tax simplification former was not bound up in the (quite different) argument over whether we should have a single band of tax or not. (Incidentally, if you’re a tax expert and you might be interested in writing this, get in touch.)
It is hard to object in principle to the idea that taxing a billionaire causes less harm to him than taxing a hospital porter at the same rate does to the porter. Indeed, anyone who believes in a tax free personal allowance and a single flat rate of tax, in effect, is acknowledging that principle as well. This isn’t to say that the practical arguments for a single rate of tax – the incentive effects and the political impetus for lower taxes created by putting all taxpayers onto the same band – aren’t very strong, just that there are good arguments in the other direction, too.
There are good arguments against the 10p rate, but most are based on an assumption that the alternative would be a further rise to the personal allowance, rather than the status quo. Alas, because of the politics, I think it’s 10p or nothing. That’s why I’ll support it – it’s a flawed tax cut, but it’s a tax cut nonetheless.
When is a potato chip not just a potato chip?
Book review: Heavens on Earth – How to Create Mass Prosperity
For those who, after five years of austerity (and rising deficit), despair about how to create growth, Heavens on Earth is indispensable bedtime and boardroom reading. In it, JP Floru investigates eight countries which have transformed their economies to create lasting high growth. In different times and places the methods used to make the switch from scarcity to plenty have been remarkably similar. At times it is surprising: who would think that there are great correlations between the Industrial Revolution in Britain, 2013 Communist China, post-World War II America and Pinochet-era Chile?
“If Julius Caesar had met George Washington in 1760, he would have found the world barely changed. He would have been served food prepared by slaves in a stately home. The average age would have been twenty-eight to thirty-five. Just 250 years later he would have heard talk of missions to Mars...” So what happened? The book brings these arguments to life throughout with such insights.
Meet “Sideline Stan”, the New Zealand Minister of Labour who systematically refused to intervene in social conflicts. Meet Hong Kong’s John Cowperthwaite, who sent statisticians arrived from Whitehall on the first plane back: statistics would only be used to interfere and harm the economy. At the same time Heavens on Earth explains the main economic concepts which are relevant today: the Laffer Curve, Austrian economics, the wisdom of Adam Smith (no coincidence: JP Floru is a Fellow of the Adam Smith Institute) and the workings of Keynesian economics (or rather: why they do not work).
Although well-known existing ideas and quotes are used, at times the book is highly original: “Regulatory Failure Spiral” is the common enough situation of governments trying to rectify failing regulations with more failing regulations. The “Holy Trinity of Profligate Government: taxing, printing and borrowing” is extensively identified and lambasted. As said before, the links between highly different economic cultures may seem surprising. Some may also be surprised to learn that concern for the poor permeates the book. Poverty is not just a state in which people exist, it has to be created: it is created by economic oppression and only free markets can free the poor.
Heaven on Earth’s sub-title: “How to Create Mass Prosperity?” is laid out in chapter 9 but I won’t give the recipe away. The book is thorough, enlightening and fun, and a must-read in times like these.
Heavens on Earth – How to Create Mass Prosperity by JP Floru is published by Biteback and available on Amazon. The official ASI launch party is in Westminster on 18 March.
Chart of the week: US trade balance
Summary: The US trade deficit for December 2012 was the narrowest since January 2010
What the chart shows: The chart shows the US trade balance – exports minus imports – in millions of dollars.
Why is the chart interesting: US exports were surprisingly strong in December, rising by 2.1% from November, while imports fell by 2.7%. The data is important, both because it shows that the recent improvement in the US foreign balance continues, if erratically; and because it is likely to lead to a revision of the Q4 economic growth data. Last month the bureau of economic analysis said that the US economy shrank by 0.1% in Q4 2012. (Note that American growth numbers are given as the seasonally adjusted annualised rate of change from the previous quarter; in Europe, where the number is usually given as the quarterly change, the US number would have been -0.025%, ie, no change.) The unexpectedly strong trade numbers probably mean that this will be revised to show a small positive figure instead.
Chart and comments provided by Stein Brothers (UK), www.steinbrothers.co.uk.
The inheritance tax of loss
The Health Secretary Jeremy Hunt plans that, from 2017, anyone with assets, including their home, worth more than £123,000 will be liable for the first £75,000 of their social care costs. They will also pay accommodation expenses of up to £12,000 a year. This, he says, will prevent people having to sell their homes when they need to move into residential care, which can be very expensive.
Meanwhile the Chancellor of the Exchequer, George Osborne, will say that the level at which inheritance tax becomes payable on estates will be frozen at £325,000 instead of being raised to £1m as the Conservatives had pledged before the election.
The care funding plans will benefit perhaps a fifth of the UK's pensioners: at present, people with much lower levels of assets are liable for their own care costs.
But then the money has to come from somewhere. Why should younger people, many of them starting out in life and trying to provide for their families on modest incomes, face higher taxes to support those who already own their homes?
After all, people in the UK see their homes as a form of saving. And it has been a much more reliable form of saving than having your money in the bank, where it is whittled down fast by inflation – inflation caused, of course, by the bad monetary policy of the authorities.
Governments have actually encouraged this form of saving too. Many of those benefiting from Jeremy Hunt's plans will have enjoyed tax relief on their mortgage interest payments for many years under the old MIRAS scheme. When they cashed in and moved up the property ladder, they would not pay the 28%-40% capital gains tax rates that have been levied on other kinds of assets like shares and bonds. Planning restrictions have ensured that house prices have kept on going. And so on.
If governments have encouraged people to save in their homes in these ways – using taxpayers' cash to fund the process – it is remarkable that they now maintain that people should not be expiated to cash in those assets when they need to. Yes, if you have to move into a residential care home it is a difficult time, but if you have saved in your home for a rainy day, it is a bit much to expect taxpayers then to hand you a very expensive umbrella so you can pass the home on to your kids.
...Who will then end up paying more inheritance tax on that asset – a 40% tax which breaks up capital (just at the time when we need capital to invest in economic recovery) and which encourages people to juggle their assets so as to avoid the tax. So big is the loss from this that the tax – though a nice earner for the government – has probably produced negative returns for the economy for the 100+ years of its history.
Why we really should cut employers national insurance
We've talked a lot around here about how the working poor should be lifted up entirely out of the income tax system. Get that personal allowance up to something like the full year, full time, minimum wage. And of course, national insurance would have to start at that point as well.
There's one bit that has been a little contentious though. I've argued that employers' national insurance must only start at that level too. The come back has been that, well, since employers pay that then why should they get a tax reduction when we want to increase the take home incomes of the working poor? Which is to ignore the whole idea of tax incidence. That employers hand over the money isn't in doubt. It's whether the workers' wages fall to account for it which is.
Fortunately we have an interesting paper to shine light on this question:
The choice between these alternatives hinges upon our views on who actually bears the tax burden. In the case of employer social contributions, they can be borne by firms (reducing their after-tax profits), they can be 'shifted backwards' to employees (reducing net wages of their workforce) or 'shifted forward' to consumers (increasing the price level of their products).
Yes, that is what we want to know. Who really pays these taxes?
The economic effects of social contributions are sensitive to both moderators representing basic economic institutions (which can be summarised in three 'models’: namely Anglo-Saxon, Continental-Mediterranean and Nordic) and the tax wedge definition – in particular, the inclusion of indirect taxes. Moreover, the impact of taxes on wages differs in the short as well as the long-term. In our preferred specification, the elasticity of wages to taxes is -0.70 in the default option, i.e. a non-Nordic economy in the long run. Therefore, workers bear 70% of taxes.
So, 70% of employers' national insurance is really paid by the workers in the form of lower wages.
Something which should give those living wage campaigners food for thought. If we now include employers' NI as well as income tax and employees NI then simply raising the personal allowance (to all three) to the full year, full time, minimum wage would give workers a larger post tax income than the living wage would.
All of which really makes me wonder why they don't in fact campaign for this. They are, after all, trying to make the working poor better off aren't they?
Certainly securitisation increased risk taking: that's the darn point of it
I thought this was an interesting little piece of research by the New York Fed.
There’s ample evidence that securitization led mortgage lenders to take more risk, thereby contributing to a large increase in mortgage delinquencies during the financial crisis. In this post, I discuss evidence from a recent research study I undertook with Vitaly Bord suggesting that securitization also led to riskier corporate lending. We show that during the boom years of securitization, corporate loans that banks securitized at loan origination underperformed similar, unsecuritized loans originated by the same banks. Additionally, we report evidence suggesting that the performance gap reflects looser underwriting standards applied by banks to loans they securitize.
However, the bit I missed in the subsequent discussion was the point that this is what securitisation is for: to allow greater risks to be taken. Not that I missed seeing what is there, I missed it because they don't mention it.
Just so that we all understand, securitisation is the idea of chopping up a loan or a pool of loans into bonds that can then be sold off to various different groups of investors. It's often associated with structuring the pool of loans: say, one group of investors takes the first 10% of losses, the next the next 20% and so on. But this structuring isn't necessary: securitisation is just the creation of the bonds that can be sold around.
And of course lending is, like any other form of provision of capital or debt to people, all about managing risk. There's the risk, after all, of absolutely any loan not being repaid. Further, there's a constraint as to how much banks can lend and to whom in the risk that is associated with any such loans. This constraint is something we'd rather like to find a way around, too.
We don't want the banks themselves to be taking more risks: but we would rather like those riskier projects to be able to find financing from somewhere. The economy would be a very boring and static place if no one did lend to anything that had any risk associated with it.
The answer thus is to make sure that these extra risks are not being carried by the banks. That they are spread out over some larger or different group of people. People who have both a greater appetite for risk and also a greater capacity to bear it. And that's exactly what securitisation does, is indeed the very purpose of it.
Finally, we find evidence that all loan investors, including banks, expect that securitized loans will perform worse. Banks appear to do so because they charge significantly higher interest rates on these loans than on the loans they don’t securitize. Institutional investors, who together with the originating bank and CLOs acquire the loans that banks securitize, follow the loan originator and choose to acquire a smaller stake in securitized loans.
And it appears that everyone was entirely aware of this greater risk: so much so that everyone took on a smaller portion of any one risk. Exactly and precisely what we desire to happen.
Our evidence that securitization led to riskier corporate lending is in line with similar findings unveiled by studies of the effects of securitization on mortgage lending. Taken together, these studies confirm an important downside of securitization.
This isn't a downside: this is the point, the very purpose. We're happy with greater risks being taken as long as those risks are distributed and laid off to those who can bear them. Which is what securitisation does.
One more thing:
While on average banks retain 26 percent of each syndicated loan they originate but don’t securitize, they retain only 9 percent of each loan they do securitize.
If the banks had held onto zero percent of the loans that they had securitised then there would have been zero financial crisis. If all of that risk had been passed on to the insurance companies, pension funds, individual investors, then we wouldn't have had highly geared banks falling over as they had to liquidate positions in bonds fast falling towards zero. And guess what the solution has been to this little point? Yup, you guessed it, laws that insist that banks must, must, hold onto a portion (usually 5%) of any securitisations that they originate. It's almost as if our rulers don't understand the world they rule. They're insisting on concentrating risk in exaclty the manner that caused the crisis instead of dispersing it in the manner that would have avoided it.