Saturday, September 8, 2007

Cleveland, Ohio. CMOs. Toxic waste or the green fields of summer?

My impressions of Wall Street trading activity and financial reporting this summer.

Wall Street journalists described a choppy financial August for banks, lenders and sophisticated investors.

Sub-prime lenders and sub-prime paper were painted as villains and by innuendo the paper became over -valued.

Derivatives, hedge funds, real estate lenders, banks and insurance companies were described, particularly in August, as facing tough times. Some journalists even suggested some investment paper was “damaged without chance of repair.”

The holders of sub-prime paper responded by pointing fingers of blame at the sub-prime lenders.

Class action litigators were licking their lips with anticipation.

In early June someone gave me a policy discussion paper from the Cleveland Federal Reserve Bank. It had a catchy title that seemed interesting so I put the paper aside to read later. I didn’t pick it up until Labor Day weekend. The title was “Who holds the toxic waste? An investigation of CMO holdings.”

CMOs are Collateralized Mortgage Obligations. This is the very paper that, according to journalists, was roiling the August financial markets.

“Toxic waste” seems a bit edgy way to describe the financial instruments that banks, insurance companies and mutual funds were buying.

The two researchers at the Cleveland Fed described their research undertaking as using simulations to predict how the risk from Collateralized Mortgage Obligations would “manifest itself” in various interest rate environments. “Manifest itself?” “Toxic waste?” These economists began to sound like evangelical preachers or a couple Al Gores on the stump.

The researchers said they also were looking for evidence of how much of this paper was held and by whom. The researchers said that very limited public information is available except for the reports that commercial banks are required to file.

Accordingly, the researchers concentrated their efforts on the commercial banks sector.

Much of the report concerns common types of mortgage derivatives traded on Wall Street namely Z values, IO values and PO values. (Z’s are security holders who are last in line. IOs are security holders who get interest payments and POs are security holders who get principal payments.)

Obviously the researchers compute the mean reversions for each of these mortgage derivatives. Not surprisingly, they use a Monte Carlo model of stochastic interest rates and mortgage cash flows.

Their principal assumption in computations is that interest rates will follow a discretized Cox Ingersoll and Ross (1985) process with monthly shocks to annual interest rates being decribed by the Cox Ingersoll and Ross formula.

The other assumptions are pretty normal: an assumed upper interest rate boundary of thirty percent and an assumed interest rate volatility based on a fourteen year data base. (fourteen years seems a paltry number of years, but given the similar short existance of CMOs I can understand a rationale for the short span of interest rate data).

A final noteworthy assumption was based on some investment bank estimates. The researchers assumed that there is a nonlinear relationship between prepayment rates and interest rates, that is, just because interest rates rise, prepayment rates will not necessarily rise at the same rate.

From all of these assumptions and some math, the researchers offer their first conclusion: “…[W]e find that under conditions of typical interest rate volatility, the value of these derivatives is highly volatile.”

Good heavens.

It is a banal conclusion but that does sound like the Wall Street that journalists were describing in August.

The general conclusions of these researchers is consistent with their labeling CMO paper as toxic waste: “…CMO contructs can be dangerous.”

For the danger, they cite as examples the 1994 “multimillion-dollar losses” at Akin Capital Management, Piper Jaffray, the Louisiana State Retirement Fund and Yamachi Securities.

Another conclusion: “Unfortunately, the institutions that have assumed the risk in recent years are opaque and it is impossible to determine whether and where there are concentrated exposures.”

So these researchers tell us that CMOs are dangerous papers and that we don’t know who holds this toxic paper except for banks which are required to report their holdings of “toxic waste.”

In the full report, the researchers give the names of ten banks that they think held this “toxic waste” in 2005. For these ten banks, they list the amount of the CMO holdings as a percentage of assets and as percentage of capital.

All of the banks listed are owned by publicly traded financial holding companies.

The information is displayed in Table 4 in the paper.

The information is easy to find, easy to understand and it really seemed to me that the Cleveland Federal Reserve Bank was inviting investors to sell these stocks to avoid the risk of the toxic waste that these researchers said the banks held.

Name
CMOs (thousands of dollars)
Percentage of total assets
Percentage of capital

Commerce Bank, NA
$14,551,881
41.89% assets
724.96% capital

Merrill Lynch Bank
$7,930,545
13.14% assets
133.34% capital

Countrywide Bank, NA
$4,946,132
6.76% assets
92.56% capital

Merrill Lynch B&T
$4,460,239
42.47% assets
583.85% capital

Fifth Third Bank
$3,700,011
7.77% assets
75.17% capital

Charles Schwab Bank, NA
$3,424,178
50.13% assets
619.49% capital

New York Community Bank
$2,684,223
10.48% assets
132.87% capital

Branch B&T, Virginia
$2,577,437
11.45% assets
162.71% capital

HSBC Bank USA, NA
$2,339,228
1.66% assets
24.03% capital

Associated Bank, NA
$2,251,297
10.31% assets
150.99% capital


Did investors take the bait offered? Did investors dump the stocks of the banks that these two researchers said held this toxic waste? Admittedly, their list was for banks that held CMOs in 2005.

First a couple observations on Table 4. The CMOs cause noticeable distortions of financial measures for three of the banks. Commerce Bank, Merrill Lynch B&T, and Charles Schwab Bank. These three banks are in first, fourth and fifth positions as to total amount of CMOs held. They are also the top three when it comes to CMOs as a percentage of total assets and percentage of capital.

These are the kinds of distortions that catch the attention of investors and analysts. Also they are the kinds of distortions that give class action plaintiff attorneys whiffs of fresh red meat.

By these three ordinary measures, the three banks Commerce, Merrill Lynch B&T and Charles Schwab appear to be toxic waste dumps.

The Cleveland Fed policy paper is dated June, 2007. I received it sometime in July. Who knows if anyone on Wall Street received the policy paper or even read it.

I decided to make an estimate of whether the policy discussion paper might have had an effect on trading in the stocks related to the banks listed in Table 4.

I could have used trading volume in these stocks. Instead I chose approximate average closing price for the period April, 2007 through August, 2007.

The six months worth of monthly average closing price for the financial holding companies that own the banks in Table 4:

Name of bank and ticker
symbol for parent holding company Month Approximate average closing price for month, in US dollars

Commerce Bank, NA . CBC
April $33
May $34
June $36
July $38
August $37

Merrill Lynch Bank. MER
April $80
May $92
June $85
July $76
August $72

Countrywide Bank, NA. CFC
April $35
May $40
June $38
July $35
August $21

Merrill Lynch B&T. MER
April $80
May $92
June $85
July $76
August $72

Fifth Third Bank. FITB
April $38
May $41
June $43
July $37
August $36

Charles Schwab Bank, NA. SCHW
April $19
May $20
June $22
July $22
August $19

New York Community Bank. NYB April $17
May $17
June $18
July $17
August $17

Branch B&T, Virginia. BBT
April $40
May $42
June $42
July $40
August $39

HSBC Bank USA, NA. HSBC
April $86
May $93
June $93
July $90
August $90

Associated Bank, NA . ASBC
April $34
May $33
June $33
July $29
August $28

The parent of Commerce Bank begins the period with a stock price of $33 and ends the period with a stock price of $37.

Charles Schwab begins the period with a stock price of $19 and ends the period with a stock price of $19.

Merrill Lynch is the only one with a noticeable decline from $80 to $72.

Similar varieties of trading results appear for the other seven banks.

My common sense conclusion is that the Cleveland Federal Reserve report had no effect on Wall Street trading in the stocks of the parent companies of these ten banks.

Whatever happened on Wall Street during the month of August was not related to the Cleveland Federal Reserve Bank policy paper.

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