The Root Cause of Today's Market Turmoil?: It's a Matter of Trust

Trust in our government. Trust in our financial institutions. Trust in those who play the role of "trusted adviser," regardless of whether or not they are considered fiduciaries by law. After taking a big step back and asking the question "Why are the markets trading so poorly, and why are financial institutions in particular getting crushed?" the answer boiled down to one word: trust. Or the lack thereof, as seems to be the case today.

The last few days the buzz has been about Merrill Lynch, and the possibility that they've been trying to engage in cosmetic balance sheet transactions to make things look better than they really are. From today's Wall Street Journal:

Merrill Lynch & Co., in a bid to slash its exposure to risky mortgage-backed securities, has engaged in deals with hedge funds that may have been designed to delay the day of reckoning on losses, people close to the situation said.

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In one deal, a hedge fund bought $1 billion in commercial paper issued by a Merrill-related entity containing mortgages, a person close to the situation said. In exchange, the hedge fund had the right to sell back the commercial paper to Merrill itself after one year for a guaranteed minimum return, this person said.

While the Merrill-related entity's assets and liabilities weren't on Merrill's own balance sheet, Merrill might have been required to take a write-down if the entity was unable to sell the commercial paper to other investors and suffered losses, the person said. The deal delayed that risk for a year, the person said.

In a statement, a Merrill Lynch spokeswoman said, "We don't comment on specific transactions and we are confident in the appropriateness of our marks."

Whoa. Now as one who has trafficked in the world of structured transactions for the bulk of my career, I can tell you that this type of "creative balance sheet management" has been going on for decades. No joke. And in the wake of Enron, things were supposed to have changed, where "sham" transactions (those without true economic substance, or where the transfer of risk didn't truly take place) were supposed to go the way of the buggy whip. Well think again, friends. There is a fine line between risk retention and true risk reduction, and if what's described in the WSJ is true, these deals are all about balance sheet presentation and have nothing to do with risk reduction. And FYI, Merrill Lynch shareholders, your firm is paying money, your money, to effect this optical illusion. So not only is there a breach of trust, you are paying for it, too.

And then consider the rating agencies, those who put their imprimatur on instruments of all stripes in order to give investors a level of comfort about the risks they are assuming. Could there be a more important trust relationship in the multi-trillion dollar debt market? Well if it's not number one, it is certainly way up there. Well, there are many that feel that rating agencies let them down, not just because of shoddy work but because of embedded conflicts of interest between those want to sell bonds (i.e., banks) and those who want to rate bonds (Moody's, S&P, Fitch, you know the ones). Where does this leave the investor? Good question. From the WSJ, 09/27/2007:

The Securities and Exchange Commission is investigating whether credit-rating firms such as Moody's Corp. and McGraw-Hill Cos. unit Standard & Poor's followed their procedures to manage conflicts and remain impartial when rating mortgage-backed securities, SEC Chairman Christopher Cox told the Senate Banking Committee.

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"Some specific ratings were wrong, and the subsequent downgrading actions by the ratings agencies have had a serious impact on a significant sector of our financial system," said Sen. Richard Shelby (R., Ala.) the committee's ranking Republican.

Mr. Cox said the SEC's probe is focusing on whether rating firms were influenced improperly by issuers and underwriters of such securities to publish high ratings. The examination also is looking into whether the credit raters followed their stated ways of managing conflicts of interest.

Not good. And this is an investigation that is only going to pick up steam. Given the nature of who is paying whom and who benefits from high ratings, the risk of conflict is extremely high. So I hope those in the rating agencies have been keeping copious records and have world-class policies and procedures for addressing the conflicts issue, because once the SEC gets in there their fact-finding will be relentless and, quite likely, quite damning. Regardless of the outcome, there is the perception of a breach of trust by the rating agencies towards investors, and this does not bode well for enhancing liquidity in a locked-up credit market.

And what about one of the most exciting new cases on the block, the State of New York's case against mortgage appraisers and a subsidiary of Washington Mutual for artificially boosting the value of homes in order to support more and bigger loans? This has the possibility to be the grandaddy of them all, ensnaring every big bank with a mortgage origination arm (like, say, JP Morgan Chase?) in a multi-billion class-action case of epic proportions. The breakdown of trust is laid so bare it is hard to comprehend. I recently spoke about this on NPR and wrote about this as well, flaws at the very beginning of the mortgage chain. From my post on 10/23/2007:

So if you were to draw a picture of the problem with arrows and a big SIV in the middle, you've got loans in on the left, some good, some bad, into the SIV, and then CDO paper out. Retail investors need better protection on the left, in my opinion via know-your-customer and product appropriateness standards. CDO investors, many of whom relied on ratings agencies to make their purchases, need the confidence to be able to trust the integrity of the agencies and the quality of their analytical work. Right now, both issues are in question. That said, investors need to do their homework, over and above an implicit "seal of approval" from the rating agencies. And none of this addresses the accounting rules, which still enable off-balance sheet structures that defy both economics and logic.

This case is all about screwing the retail buyer, but it has ripple effects throughout the loan origination to loan packaging to debt rating to CDO selling process. From the New York Times 11/02/2007:

The New York attorney general, Andrew M. Cuomo, accused an appraisal company yesterday of inflating the value of homes under pressure from Washington Mutual, one of the nation’s largest mortgage lenders.

The case, filed in New York Supreme Court in Manhattan, accuses a subsidiary of the First American Corporation of defrauding homeowners and investors who bought securities backed by loans that were underwritten with the appraisals it conducted.

The case centers on a central tenet of mortgage lending — determining the value of homes that secure loans. It is an area that many housing specialists have said was rife with abuse and conflicts of interest. The lawsuit also signals that Mr. Cuomo, who was secretary of Housing and Urban Development in the Clinton administration, intends to move as aggressively against the mortgage industry as he has done with college loan providers.

Careers are made out of cases like this, and I am sure it will be an interesting few years as suits initiated by states get picked up by high-priced class-action plaintiff's counsel and the mortgage industry and their banking brethren get a lower GI in full public view. And if the lawyers are successful in finding the conflicts they are alleging, this breach of trust will cost shareholders in these financial firms tens of billions of dollars in market cap. Easy.

Without getting too academic and preachy, I was quoted in the latest issue of New York magazine (aptly titled the Dirty Money issue), the elements of which get at the heart of what I'm talking about:

Roger Ehrenberg, an ex–Wall Streeter and author of the financial blog Information Arbitrage, forecasts extreme financial pain. “You’ve got a weaker dollar, declining economic fundamentals, and a debt-strapped consumer—I’d call that a bad fact set,” he says. “Lay on top of that the mortgage problem and declining home values, and you can paint a pretty ugly picture.”

The government has breached our trust by running up trillion-dollar deficits that make the US a debtor to the world. The mortgage industry and banks may well have breached our trust via conflicts of interest, sowing the seeds of the mortgage meltdown. They may well have been supported in their efforts by the ratings agencies, eager to get more business and getting paid by those who directly benefited from high ratings. And because Wall Street was so spectacularly successful in selling CDO paper, when the fundamental mortgage credit problems came to light it had a chilling effect on credit markets across the globe. This then caused the Fed to lower rates at a time when economic fundamental didn't really warrant an easing, placing further downward pressure on the dollar that has already been battered by an excess of US Government debt and a spending binge that shows no sign of abating. Now this lower dollar, along with high energy prices (together contributing to inflation) and slowing growth, could put us in that really bad place we discovered in the 1970's: stagflation. Now while I am generally labeled a pragmatist, in this particular article I was quoted in a section called The Catastrophist View. No kidding. I'm not saying this will happen, I'm simply making the case that today's environment is pretty unpleasant. And it didn't need to be this way. And it really pisses me off.

So what we're left with is a really bad economic and financial markets back-drop and a slew of broken promises. What if those in a position of trust had done their jobs, and simply upheld the trust that was afforded them? We'd be in a far better position than the one in which we find ourselves today. Wishful thinking, I guess.

Comments

[Chris]

This was a great article and you nailed it. This is syptomatic of "bubbles" in that during those times, most participants become less questioning of the course of events. But recent events now show the trust has been misplaced. The reason to be pissed, even if it doesn't affect us directly, is that our children will have to live with the consequences. Lets see how much trust is afforded if gold gets to $1,000.

[Michael]

Oh my, I have been waiting sooo long to use this:

Now for a bit of satire, providing great insight on why we are where we are:

http://lostpeopleofmountainvillage.com/joomla/index.php

[Michael]

Re: "Why are the markets trading so poorly"

I hope they'll trade this way forever :) This volatility is exactly why I began coding an ats in 1999. Momentum is an awesome force of Nature.

Sshorting is sooo easy, algo waves are the size of tsunami's, with hedge funds exiting their positions in one fell swoop. Showing our cards? Who cares?

Trust for Wallstreet? Trust for Corp America? Trust for Politicians? Roger. The Great American Dream is a pyramid scheme. The worker bees just finished the build out and the Climate changed before they began.

Adaptation in small tribes is another awesome force in Nature, and the root of Life :)

ps: the news on WM was known by at least four "investors" before the story became public.

[Agoracom]

Roger, great article. We need people like you to keep hammering this point home.

The problem is that people in a position of trust do not put themselves there in order to exercise that trust. They put themselves there in order to exercise greed.

The financial markets are too big and too sophisticated for watchdogs to manage. Smart (but evil) people know that and are taking advantage of the system as fast as they can.

As a result, there is a good chance the US economy will collapse for both fundamental and trust reasons. By the time they figure it out, most of the culprits will be long gone.

The masses will get killed. Those in our position will protect ourselves - because we're smart enough to know the system can not.

Regards,
George

[Dominic]

Roger,

I always seem to stumble across your blog when you're at your best.

This is one of your best. But then I'm probably just biased because I'm pissed off, too.

I wouldn't put so much faith in the SEC though. That agency is starting to look more and more like one of those crisis PR firms that gets called in when things go wrong. They do some grandstanding and say nice, calming things, but they never actually fix the underlying rot that caused the problem in the first place.

"Investors need to do their homework." Period.

Thanks.