Thursday, December 1, 2011

More on Financial Models: "The Fed Is Actually Bailing Out Itself"

Or is it 'moron' financial models.*
From RealClearMarkets:

In December 2006, a small, relatively unknown financial firm called First Marblehead completed a $1 billion student loan securitization. At the close of the deal the company expected to receive up-front "structural advisory" fees of about $89.6 million, or 12.4% of the total balance. In addition, First Marblehead modeled and discounted additional advisory fees of $8.8 million and "residual revenue" of $48.7 million. The "blended" yield on the transaction was more than 20% of the total balance of expected student loans (the loans had yet to be acquired).

Because of the gain-on-sale accounting rules as they pertained to securitizations, First Marblehead booked those massive earnings of "expected" cash flows at the deal's inception, right up front. The company was a small operator in the overall picture of loan securitization, but it represents a very good, unfiltered window into the world of modern high finance. What they were doing in student loans, the big banks were doing in mortgages on a much greater scale.

It is easy to see why these deals were so attractive to financial firms. They would book so much revenue and income up front, meaning the larger the deals, the sweeter the internal assumptions in their discounting models, the more profits would flow to the firm up front. Given the credit system's evolution into one based on the accounting notion of equity capital, these booked profits flowed directly into the firm's retained earnings, and therefore greatly increased their ability to create even more credit (and phantom, expected profits). It was a self-feeding, narrowly construed cycle....MUCH MORE
...The failure of MF Global in November maddeningly followed this same exact path, right down to the gain-on-sale accounting and incremental charges to net income as fear in the marketplace forced a change in assumptions. The banking system is not currently constituted to function outside of a narrow window of assumptions.

So far, all the monetary solutions offered have been to change the world to fit into that narrow window - rather than change the banking system to reflect the world. The Federal Reserve, in particular, offers endless money to keep the banking system afloat, a life raft to the expected better days ahead. To ensure those better days actually appear, central banks all over the world alter the interest rate structure, directly hurting the responsible savers and investors that might actually lead a real recovery, while further manipulating prices everywhere and causing widespread consternation and uncertainty....
*See also: This morning's "Book Review: "Models.Behaving.Badly: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life ""