Class: 10-31-08 What are CDOs?

A collateralized debt obligations (CDO) is an asset-backed security. CDOs are backed by pools of bonds, bank loans, or other assets. A CDO may contain corporate bonds, commercial loans, asset-backed securities, residential mortgage-backed securities, commercial mortgage-backed securities, emerging market debt, etc.

A good analogy is that different types of rocks represent corporate bonds, commercial loans, asset-backed securities, residential mortgage-backed securities and, commercial mortgage-backed securities.

Then the rock strata is comparable to tranche different credit ratings (cheap to expensive rocks): senior tranches (rated AAA), mezzanine tranches (AA to BB), and possibly equity tranches (unrated).

Rocks as Different Underlying Assets

Strata as Tranches

Since 1987, CDOs have become an important funding vehicle for fixed-income assets, especially mortgages.

Now for an excellent and simple explanation of a CDO, watch and listen to David Harper here.

Class: 10-31-09 Myth: Alaska’s Permanent Fund Loses 10 B

First, for those not from Alaska, what is the Permanent Fund?

The following is taken from the Alaska Permanent Fund Corporation website which can be found here.

A dedicated fund owned by the State of Alaska

In 1976, as the Alaska pipeline construction neared completion, Alaska voters approved a constitutional amendment to establish a dedicated fund: the Alaska Permanent Fund.

“At least 25 percent of all mineral lease rentals, royalties, royalty sales proceeds, federal mineral revenue-sharing payments and bonuses received by the state be placed in a permanent fund, the principal of which may only be used for income-producing investments.”

Used for both savings and spending

The Legislature may spend realized Fund investment earnings. Realized earnings consist of stock dividends, bond interest, real estate rent and the income made or lost by the sale of any of these investment assets. Unrealized earnings – those resulting from the change in market value of assets that are held – cannot be spent. Most spending from the Fund has been for dividends to qualified Alaska residents. The Permanent Fund Dividend Division (a separate entity from the APFC) operates the PFD program, which the Legislature established in 1980.

Managed by a state-owned corporation

In 1982, the Legislature established the Alaska Permanent Fund Corporation to manage Fund investments.

Now the headlines from the Anchorage Daily News. Read here.

The fund did not lose $10 billion dollars over the last year as the headlines suggest. The value of the fund dropped 10 billion dollars over the last year – a tidy sum. If one is not liquidating or closing the fund, the 10 billion ($10,000,000,000) is an “unrealized” loss. Now, could the fund have “lost” some money – of course – in all likelihood, a fund this size owns most of the S&P 500 firms where some companies have gone bankrupt like Lehmans, AIG (which is in the process of liquidation), and others.

What if tomorrow the market doubled in value (it is possible, though not likely), then the Permanent Fund would in all likelihood increase in value to 60 billion dollars ($60,000,000,000) so in less than a month we made some “cool cash” or “cold cash” in Alaska. But it is an “unrealized” gain, not a true gain unless someone in the fund actually sells part of the fund and puts the proceeds in the cash drawer.

An we have an excellent CEO of the Permanent Fund in Mike Burns. Newspapers like to make “news” worse or better. It helps sell more copies – economists call it wealth maximization. Note what Mike told the Anchorage Daily News below:

Despite the pounding from the stock market, the fund should make a profit for the fiscal year that ends next June, said Michael Burns, chief executive of the Alaska Permanent Fund Corp. That should prop up next fall’s annual Permanent Fund dividend paid to Alaskans. The dividend is based on profits averaged over five years. The fund’s profits this fiscal year would need to hit about $1.5 billion to result in a dividend about the size of this year’s $2,069.

“With our cash stream from real estate rent and other sources, we expect to end the fiscal year with a positive balance for statutory net income,” Burns said. But he noted that one-fourth into that fiscal year the fund was showing a $137 million loss, not a profit.

“These certainly aren’t easy times, but our advantage is right there in our name – Permanent,” said Michael Burns, chief executive of the Alaska Permanent Fund Corp. “Our board sets an allocation for the long term, and accepts that volatility will come in the short term. Our job now is to hold to our long-term plans, and not be tempted to change course in the middle of the storm.”

TARP: 10-31-08 MoneyMill

Check out the blog here. The blog is call MoneyMill – I am not sure of the author but this is what he/she says about himself/herself.

“I have been a participant in the financial markets for seven years, dealing in commodities, stocks, and forex at different times. Since 2003 I’ve been growing more and more pessimistic about the mortgage market, and since August 2007 my anticipation has been for a global recession. I believe today’s crisis still has a long way to go, and expect it to peak during some sort of geopolitical development.

I don’t live in the US, as my expectations for the next decade are a bit too pessimistic to allow me to enjoy a peaceful life there. Still, my heart remains in America, as I believe that the American model, with all its failures, is the most powerful and inspirational in today’s world.

I’m married, with no children – yet.”

While I don’t agree with all of the analysis, it is one of the first publications, blogs or news reports that writes about TARP’s possible ill effects and focuses more on the free market rather than constant government intervention. The article is long, but here is an excerpt. I would suggest it for your reading pleasure!

But this is deeply flawed reasoning. As I have stated here many times before, what the financial sector needs, and in fact, in an indirect way, demands, is bankruptcies. It’s very easy to gain a general idea on the status of many banks in the US by examining the FDIC’s statistics, or easier still, by visiting the FED’s website. What we see in the former is that banks have no money to cover their bad loans, and that this is a general phenomenon. The cover ratio of non current loans on banks’ balance sheets is only 70 percent at this stage, which is by far the lowest on record, and the situation is almost certain to deteriorate further from here. And on the Federal Reserve’s website one can see that they have been lending more than 100 billion dollars to commercial banks for the last two weeks, and although a bit crude as a measure, this serves well to demonstrate the difficulty in obtaining funding from other channels.

And so, why is the TARP counter-productive? Because it is funding institutions that have only one use for the funds they receive: patching up their books, covering their losses, and sustaining themselves. But what is the purpose of a bank, from the point of view of the public? It is to expand credit to the real economy and consumers. If the numerous banks that the TARP and the Fed are funding cannot expand credit, and are using the funds which they receive only for continuing their existence, isn’t the TARP prolonging and perpetuating the crisis, by helping those institutions that cannot, will not, and should not survive in the first place? If the program succeeds, and the complete mess of a system that we have now survives, will the financial system be in a better form where it is led and directed by players who exist as parasites on government subsidies, and whose only purpose is continued existence through government help? With the balance sheets that they have, and the managements that have brought them to where they are, can the American financial system have any hope of recovery if it expects the recovery to be financed by credit from institutions which are, for all intents and purposes, bankrupt, and which only exist at the mercy of the FDIC, and the federal government?

The TARP is a mistake, but given the way that the government has been reacting to each crisis, it’s not a surprising mistake.

Class: 10-30-08 Ballmer’s Email

I found this email from Steve Ballmer on TechCrunch. I believe it is worthwhile for all of my students to read. You can find the article here.

I decided to include all of the email below. My thanks to TechCrunch, one of the best Tech Sites on the Web.

—–Original Message—–
From: Steve Ballmer
Sent: Tuesday, October 28, 2008 2:37 PM
To:
Subject: A Platform for the Next Technology Revolution

During the past decade, a dramatic transformation in the world of information technology has been taking shape. It’s a transformation that will change the way we experience the world and share our experiences with others. It’s a transformation in which the barriers between technologies will fall away so we can connect to people and information no matter where we are. It’s a transformation where new innovations will shorten the path from inspiration to accomplishment.

Many of the components of this transformation are already in place. Some have received a great deal of attention. “Cloud computing” that connects people to vast amounts of storage and computing power in massive datacenters is one example. Social networking sites that have changed the way people connect with family and friends is another.

Other components are so much a part of the inevitable march of progress that we take them for granted as soon as we start to use them: cell phones that double as digital cameras, large flat-screen PC monitors and HD TV screens, and hands-free digital car entertainment and navigation systems, to name just a few.

What’s missing is the ability to connect these components in a seamless continuum of information, communication, and computing that isn’t bounded by device or location. Today, some things that our intuition says should be simple still remain difficult, if not impossible. Why can’t we easily access the documents we create at work on our home PCs? Why isn’t all of the information that customers share with us available instantly in a single application? Why can’t we create calendars that automatically merge our schedules at work and home?

This week at the Professional Developers Conference (PDC) in Los Angeles, we shared news with software developers about a new set of platform technologies that will help transcend these limits. Because you are a subscriber to Executive Emails from Microsoft, I wanted to share my thoughts about the impact that these technologies will have as developers begin to use them to create a new generation of experiences that extend uninterrupted from the desktop to the mobile phone, media player, car, and beyond-to places where we never thought information and communications would be available to us.

A NEW PLATFORM FOR CLOUD COMPUTING

At PDC, we announced the availability of an early preview release of a new technology called Windows Azure. Windows Azure will enable developers to build applications that extend from the cloud to the enterprise datacenter and span the PC, the Web, and the mobile phone. For the first time, we shared pre-beta code for Windows 7 and for Windows Server 2008 R2. Windows 7, which is the next version of the Windows desktop operating system, will take advantage of software and hardware advances to help eliminate the boundaries between information, people, and devices.

We also previewed Office Web applications, which are light-weight versions of Word, Excel, PowerPoint, and OneNote that are designed to be accessed through a browser. Office Web applications will be part of the next version of Office and will enable people to view, edit, and share information and collaborate on documents on the desktop, the phone, and in a Web browser in a way that is consistent and familiar.

Windows Azure is part of the Azure Services Platform, a comprehensive set of storage, computing, and networking infrastructure services that reside in Microsoft’s network of datacenters. Using the Azure Services Platform, developers will be able to build applications that run in the cloud and extend existing applications to take advantage of cloud-based capabilities. The Azure Services Platform provides the foundation for business and consumer applications that deliver a consistent way for people to store and share information easily and securely in the cloud, and access it on any device from any location.

Windows Azure is not software that companies will run on their own servers. It’s something new: a service that runs in Microsoft’s growing network of datacenters and provides the platform that helps companies respond to the realities of today’s business environment, and tomorrow’s. Windows Azure technologies are already finding their way into products such as Windows Server 2008 and System Center Virtual Machine Manager, enabling organizations and Microsoft partners to create their own cloud infrastructure.

Windows Azure will enable organizations to respond to realities such as the need to use the Web to provide customers with comprehensive information and to interact with an audience that has the potential to expand exponentially overnight; to integrate operations with partners-and sometimes even competitors-to meet customer needs; to add new capabilities quickly to respond to new opportunities; and to enable employees to work efficiently and effectively no matter where they are. These realities apply not just to businesses, but to organizations of all kinds: schools, governments, community groups, and more.

Traditional approaches to building technology infrastructure and delivering computing capabilities make it difficult and expensive to adjust to these realities. You need systems with enough capacity to meet the highest possible demand-capacity that includes servers and buildings to house them, the power to run them, and the people to manage them. You have to spread that capacity across locations so there’s a backup if one part fails. You have to solve issues like access for different types of users and compliance with tax regulations in all countries where your customers reside.

Designed specifically to meet the global scale that today’s organizations require, the Azure Services Platform will provide fundamentally new ways to deploy services and capabilities. It gives businesses the option to take advantage of the capacity available in the cloud as it is needed, reducing the need to make large upfront investments in infrastructure simply to be ready when demand spikes. It will enable developers to create applications that run in the cloud and provide the features, information, and interactivity that employees, partners, and customers expect-no matter how many of them there are, where they are in the world, or what device they have at hand.

SOFTWARE PLUS SERVICES AND THE POWER OF CHOICE

The Azure Services Platform reflects our belief that choice is critical for developers, companies, and consumers. It is also based on our belief that the key to delivering value today and in the future lies in combining the best aspects of software running on PCs, servers, and devices with the best aspects of services running on the Web-an approach we call “software plus services.”

Our software plus services approach lets people take full advantage of the incredible power of today’s devices. While there are undeniable benefits to being able to tap into the wealth of information and services that can be accessed over the Web through a browser, the interactive experiences that people expect on their PC, mobile phone, and media player depend on sophisticated software running on powerful processors.

The richness of these experiences will only increase as multicore processors expand the computing capabilities of our devices and new programming languages open the door to a new generation of applications that let us use more natural ways to interact with digital technology such as voice, touch, and gestures.

Software plus services also recognizes that for most companies, the ideal way to build IT infrastructure is to find the right balance of applications that are run and managed within the organization and applications that are run and managed in the cloud.

This balance varies by company. A financial services company may choose to maintain customer records within its own datacenter to provide the extra layers of protection that it feels are needed to safeguard the privacy of personal information. It may outsource IT systems that provide basic capabilities such as email.

This balance will change over time within an organization, as well. A company may run its own online transaction system most of the year, but outsource for added capacity to meet extra demand during the holiday season. With software plus services, an organization can move applications back and forth between its own servers and the cloud quickly and smoothly.

Today, companies around the world are implementing Microsoft technologies to take advantage of the best combination of on-premise software and cloud-based services. Using Microsoft Online Services, businesses including Coca-Cola Enterprises, Blockbuster, and Energizer access and manage Microsoft Exchange, SharePoint, Office Communications Server, and Live Meeting over the Web through a single, secure infrastructure. In addition, 1 million people rely on Office Live Workspace for sharing and collaborating with friends, family, and colleagues.

EXPANDING THE DEFINITION OF PERSONAL COMPUTING

Ultimately, the reason to create a cloud services platform is to continue to enhance the value that computing delivers, whether it’s by improving productivity, making it easier to communicate with colleagues, or simplifying the way we access information and respond to changing business conditions.

In the world of software plus services and cloud computing, this means extending the definition of personal computing beyond the PC to include the Web and an ever-growing array of devices. Our goal is to make the combination of PCs, mobile devices, and the Web something that is significantly than more the sum of its parts.

The starting point is to recognize the unique value of each part. The value of the PC lies in its computing power, its storage capacity, and its ability to help us be more productive and create and consume rich and complex documents and content.

For the Web, it’s the ability to bring together people, information, and services so we can connect, communicate, share, and transact with anyone, anywhere, at any time.

With the mobile phone and other devices, it’s the ability to take action spontaneously-to make a call, take a picture, or send a text message in the flow of our activities.

Through Live Mesh-a service from Microsoft that we announced earlier this year and about which we shared new information week-we’re beginning to bridge the PC, phone, and Web and create this next generation of connected experiences. Built on the Azure Services Platform, Live Mesh enables you to use programs and information stored on your work computer from your home PC, and vice versa. With Live Mesh, you can share folders and ensure that the information is automatically synchronized across your devices.

Live Mesh hints at how our lives will be transformed as the barriers between devices disappear and the option to connect instantly to people, devices, programs, and information becomes a reality.

We’re not quite there yet. Today, the Azure Services Platform is available only as a limited technology preview release. But as developers begin to combine the capabilities of this new platform with the amazing ongoing hardware and software innovations that we are seeing from companies across the industry, it will bring us significantly closer to the time when information, communication, and computing flows along with us seamlessly as we move through our day-to-day activities.

You can learn more about these technologies and the progress we are making by visiting the Microsoft Software + Services Web site at http://www.microsoft.com/softwareplusservices/.

I look forward to sharing more information with you about these new technologies in the near future.

Steve Ballmer

Credit Facilities: 10-30-08 AMLF & MMIFF

We have two additional credit facilities – These include Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) and Money Market Investor Funding Facility (MMIFF). These facilities are targeted at money market funds (MMFs) and helping them meet increasing redemption requests.

Mike Hammill and Andrew Flowers from the Federal Reserve Bank of Atlanta’s Research Department provide an excellent explanation of these credit market instruments. You may read it here.

Credit Facility: 10-30-08 Term Securities Lending Facility

The Federal Reserve announced on October 11, 2008 an expansion of its securities lending program. Under this new Term Securities Lending Facility (TSLF), the Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS.

Short Video (relatively technical) about the TSLF

The TSLF is intended to promote liquidity in the financial markets.

Class: 10-30-08 Bailout not acceptable, change organizational structure!

People are rational – a major assumption in economics. In an earlier post, I argued that “when governments begat regulation, the natural proclivity of man and one can argue an institution is to maximize their expected utility – in others word – do what is best for them.

Well, here is another example of a “rational” corporation [I know, I know, only people make decisions.] or of rational individuals making themselves better off by changing organizational structure.

Read the article here or see below. Again, you gotta love em’.

GMAC Financial Services says it’s holding discussions with federal regulators about becoming a bank holding company. The move could help it access government funding.

GMAC said in a statement Thursday it plans to refinance its debt and is in discussions with the Treasury Department, the Federal Deposit Insurance Corp. and other federal regulators.

The Treasury Department has outlined plans to use at least $250 billion of the $700 billion bailout of the financial sector to give banks access to capital.

GMAC is the financing arm of General Motors Corp (GM, Fortune 500)., which owns 49% of the company. Cerberus Capital Management LP owns 51% of GMAC.

Cerberus is the majority owner of Chrysler LLC, which is in talks with GM about a potential merger.

Class: 10-30-08 AIG ‘plays with’ a new government program

I was taught at an early age that water flows downhill. Now I know that that this only applies when one makes the assumption that gravity exists. Economists make models which provide insight into individuals’ behavior which provide simple but powerful insights.

One such model is that “individuals will maximize expected utility”. Put simply, people do what is best for them. It takes another model and a few other assumption to explain or harmonize when an individual would make optimal decisions for a firm – for example, incentive compensation.

Well, it doesn’t take a lot of logic to see the “beauty” in AIG paying down their initial borrowing of 85 billion from the United States government. The good news is that AIG is beginning to pay their debt down. The bad news is that they are using another government program which is discussed below – The Commercial Paper Funding Facility. And it’s all consistent with economic theory!

To read the article, go here. The basics of the operation are below.

The struggling insurance giant now is allowed to issue up to $20.9 billion of short-term debt, known as commercial paper, under a new Federal Reserve Bank of New York program, according to a federal filing posted Thursday. The Commercial Paper Funding Facility, which began this week, is designed to provide short-term financing to companies suffering from the credit crunch.

But the interest rate AIG pays under the commercial paper program is less than 4%, while the $85 billion federal loan it received in September carries a rate of nearly 11.7%. The rates fluctuate daily.

“It appears we’re giving away more money,” said Bill Bergman, senior equity analyst at Morningstar. “The Fed terms are getting less, not more tight.”

AIG also has access to a $37.8 billion lending facility from the Fed arranged in early October after its securities lending division ran into trouble.

Again, the private sector wins by using the markets competitively, even those markets that our “dear regulators” create.

Islamic Banking: 10-30-08 and the Treasury

Read here.

“U.S. Deputy Treasury Secretary Robert M. Kimmet, visiting Jiddah, said experts at his agency have been learning the features of Islamic banking. “

Interestingly, derivatives are banned.

Credit Facility: 10-30-09 A Commercial Paper Funding Facility

One of the newest program and just tapped by American Express is a new program to help cash-strapped companies meet their short-term borrowing needs.

What is A Commercial Paper Funding Facility? (CPFF}

Quoting the article which can be found here.

The Fed’s Commercial Paper Funding Facility (CPFF, again, let’s keep adding acronyms – my comment) allows companies that have registered to sell commercial paper, or short-term debt, for day-to-day needs ranging from paying rent to stocking inventory. In exchange, corporate borrowers have to pay a fee in addition to a borrowing rate that is set daily. The aim of the facility, announced Oct. 7, is to thaw the credit freeze, bring down rates and lure investors back into the market. The Fed began buying commercial paper from companies Monday.

Read here to see that Chrysler Financial, which finances Chrysler LLC vehicles has qualified (they have not yet tapped the program); additionally Ford Motor Credit and GMAC, the lending arms of Ford Motor Co. and General Motors Corp., respectively, also have access to the CPFF.

Mike Hammill and Andrew Flowers of the Federal Reserve Bank of Atlanta’s Research Department provide a good description of the CPFF here. The material which Mike and Andrew write about is technically complex, but two items are worthy. There are two types of Commercial Paper – see the material below from FED of Atlanta – traditional commercial paper (CP) and now asset-back commercial paper (ABCP)

1. Traditionally, companies use CP to finance day-to-day operations, borrowing cash they need to meet payroll or buy materials. Borrowing short-term money gives a company more flexibility to meet short-term needs, and is usually cheaper than issuing long-term debt. Companies can, and often do, roll over their CP as it matures, which effectively turns short-term debt into long-term debt, but at short-term interest rates.

In the past few years the commercial-paper market has grown dramatically, increasing by about 56 percent from 2005 until its peak in August 2007. Much of this growth has been in asset-backed commercial paper (ABCP), which jumped 76 percent over the same period.[GRAPH DELETED] In contrast to unsecured CP, which is backed by the name and assets of an entire company, ABCP is backed by a pool of specific assets, such as credit card debt, car loans, and/or mortgages.

Continuing on…

In the CPFF, the New York Fed will lend to a Special Purpose Vehicle (SPV) which will purchase eligible highly-rated (A-1, P-1, F-1) 3-month CP and ABCP from U.S. issuers. According to the New York Fed, the rate charged on unsecured commercial paper will be the three-month overnight index swap (OIS) rate plus 100 basis points per annum, and the rate for ABCP will be three-month OIS plus 300 basis points per annum. Additionally, for unsecured commercial paper, the New York Fed said “a 100 basis points per annum unsecured credit surcharge must be paid on each trade execution date.” Looking back before September, three-month CP rates typically traded very close to three-month OIS rates. The jump in CP rates in September led them to trade much wider than the SPV spread.

Now for the final part of their article. The reason for the development of the program for Commercial Paper.

Short-term debt markets have been under considerable strain in recent weeks as money market mutual funds and other investors have had difficulty selling assets to satisfy redemption requests and meet portfolio rebalancing needs. The CPFF is intended to support the issuers of CP by providing liquidity and supporting term lending in the CP markets. On Oct. 21, the Fed announced the creation of the Money Market Investor Funding Facility, which supplements the previously announced Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, to free balance sheets at money market funds and to encourage them to resume their traditional role in securities lending and participation in other financing markets.