Thursday, February 26, 2009

Blog Calculated Risk Questions Stress Test

The blog, Calculated Risk, has become quite influential. The quality of the data and analysis as well as its accessibility has been outstanding. However, I believe they may be over reacting to possible deficiencies in the Treasury stress test. Per CR via Bloomberg:
Moody’s Investors Service said it’s reviewing all 2005, 2006 and 2007 subprime-mortgage bonds for credit-rating downgrades, covering debt with $680 billion in original balances.

The review reflects an increase in Moody’s expected losses on the underlying loan pools, the New York-based company said in a statement today. Losses for such mortgages backing 2006 securities will probably reach 28 percent to 32 percent, up from a previous projection of 22 percent, Moody’s said.

The ratings firm said that it boosted expected losses based on “the continued deterioration in home prices, rising loss severities on liquidated loans, persistent elevated default rates, and progressively diminishing prepayment rates.”
CR is concerned that the Treasury stress test may include assumptions that are even more optimistic then rating agency's base case.

A loss rate is a default rate times the loss severity of a default. For example, if you have a default rate of 50% and a loss per default of 50%, then you have an overall loss rate of .5 x .5 = .25 or 25%. To get to a loss rate of 50%, you would need an slightly worse then 70% loss rate and a 70% severity on each loss.

If you take the worst pools, this is very believable.  However, when we look back at the subprime excesses, the worst tended to be securitized.  That is, they were originated with the intention to sell to investment banks as raw material for CDO's.  Commercial banks weren't in that business, for the most part.  The originated to hold.  They may have written a lot of bad mortgages, but they know they were keeping them.

At the very least, they would have tried to keep the better loans and sell the lower quality loans.  As I have discussed before, we have two competing models of lending.  Originate to distribute/securitize and originate to hold.  The former was the provence of investment banks and the latter of commercial banks.

I wouldn't rush to judgment regarding the stress tests.  In general, all they can do is rank the banks with respect to capital strength.  They really can't do much for investment banks, due to their incredible complexity.  As far as commercial banks, they can rank them, draw a line, and take action.  That is, identify the basket cases, and sort the likely survivors by strength.

Whatever foolish decisions were made in commercial banks, they weren't creating CDO^2.   They are fundamentally different then investment banks, and the attempt to treat them the same doesn't make a lot of sense.  Unless they believe the investment banks must be kept around, and the only mechanism is to pretend they are commercial banks -- and then backstop them.  

I'm not ready to give up on Obama/Treasury yet.  

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