Saturday, July 19, 2008

Mr. Bush, A Novice Checker Player, In A Global Petroleum Chess Tournament

Why do I constantly poke fun of Mr. Bush? Because it IS so easy, since he provides so much fodder. Fodders sufficient enough for everyone from late night comedians to staid risk managers. Once again, he does not disappoint. With mere months to go before his ignominious exit from the White House as, in Nancy Pelosi’s words, a “total failure,” Mr. Bush is again grasping at offshore oil drilling to secure some sort of a legacy.

In this vain attempt, he is now accusing the Congressional Democrats of impeding in tapping the vast offshore oil reserve. Now this is amusing to people who know since the ones who have been resisting offshore drilling for a while are Florida Republicans, led by his own brother, Jeb Bush.

Now, Jeb has been saying the right things about offshore drilling for sometime now, which is to balance the need for drilling with the need to protect the coastline. Jeb’s idea, co-sponsored and floated in 2006, is a sound idea of imposing a 100-mile buffer around the coastal states while allowing for drilling offshore. Apparently, George W. Bush doesn’t seem too concerned about the environment at all.

George W. Bush also doesn’t seem too concerned about the actual logistical implementation of offshore drilling. “The sooner Congress lifts the ban, the sooner we can get these resources from the ocean floor to the gas pump,'' Bush said today in his weekly radio address. His statement seems to imply that we can obtain oil from offshore drilling as soon as a year, once the Democrats in Congress stop dragging their feet.

Perhaps someone should remind him that just because the ban is lifted today, it does not mean that drilling can commence right away. Typically, it would take at least three to five years to ensure proper safeguards are taken for environmental and economic feasibility studies, including impact of drilling on ocean pollution, shipping lanes, and fishing. Moreover, it would take a survey ship and a drilling rig several years to identify the location of a rich enough pocket of oil. Further complicating the process is that fact that the oil appears to be located in the deeper portion of the De Soto Canyon. According to Minerals Management Service, “For the oil resources, the vast majority of this increase occurred in the deepwater areas of the Gulf of Mexico,” that, it their estimation, could be “located in waters that are water in excess of 3000 meters (10,000 feet) deep and to subsea depths in excess of 9600 meters (31,700 feet).”

What this means is that deep-sea drilling rigs are required to access the potential 17.8 billion barrels of oil. This is where Bush is a novice checkers player in a global championship chess tournament. If Bush were a chess player, he would have lined up all remaining deep-sea rigs before Brazil did. Now, with the backlog of rigs worldwide, whatever Congress decides to do will be moot.
(Source: New York Times)

Now, if Bush were a chess player, he would simply declare the Gulf of Mexico, from 200 to 500 miles off the coastal U.S. as off limits to any drilling of oil and gas and declare U.S. sovereign rights to all resources in the area, including oil, gas, and fishing. The 17.8 billion barrels of oil in the area seems mighty valuable now but it will be even more valuable 10, 20, or 30 years from now.

Now, that’s playing chess. Perhaps, Obama will play this out correctly, come the New Year.

Ed Kim
Practical Risk Manager

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Rating Agencies' Value To The Market? Nada, According To Their Disclosures

With the unraveling of the credit market, one has to wonder what value had the rating agencies actually provided to the investors. It appears quite obvious, in hindsight, that the rating agencies’ values were all perception and not reality. After all, why are financial institutions so busy marking down even “AAA” rated bonds and taking ever-increasing loss reserves against them?

If one read the typical disclosure that is on a rating agency rating letter, one would quickly realize that there is no real value. In fact, the rating agencies’ disclosures would read something like this:

Ratings are based upon information that we consider to be reliable, but neither [Rating Agency] nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. Rating agencies do not perform due diligence and assume the accuracy of the information that is provided to them by issuers and their advisors. Neither [Rating Agency] nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. This material is not intended as an offer or solicitation from the purchase or sale of any security or other financial instrument. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only correct as of the stated date of their issue.

(Note: the above is not an actual disclosure from any one rating agency; however, if one looks at S&P and Fitch Ratings, one would see where I had obtained the above language.)

The rating agencies are on the hot seat, again, for their contribution in the current financial downturn. They were here before in 2002, with their corporate credit ratings of Enron: (S&P response to SEC; Fitch Ratings response to SEC; and Moody’s response to SEC). The rating agencies’ argument now is the same as it was then: they are not in any conflict of interest and the ratings they provide is beneficial to the market and is simply an opinion protected by the first amendment and not bound by Regulation FD.

Government Is Forced To Act, Again
Again, the market has forced the government to react. Most recently, the SEC released their examination report of the rating agency and found the following issues, among others:
1. Significant Aspects of the Ratings Process Were Not Always Disclosed
2. Policies and Procedures for Rating RMBS and CDOs Can be Better Documented
3. Rating Agencies are Implementing New Practices with Respect to the Information Provided to Them
4. Rating Agencies Did Not Always Document Significant Steps in the Ratings Process
5. Rating Agencies Did Not Always Document the Rationale for Deviations From Their Models
6. Rating Agencies Did Not Always Document Significant Participants in the Ratings Process Rating
7. Rating Agencies Did Not Always Document Committee Actions and Decisions
8. Issues Identified in the Management of Conflicts of Interest

Truly no surprises here, especially to those who have been following this circus act of “slap the rating agencies on the wrist.” The Investment Company Institute (ICI), the national association of U.S. investment companies, has been lobbying the government to improve its oversight of the rating agencies for over 20 years. Here are the ICI’s comment letters to the SEC on regulation of the rating agencies: 1998 comment letter, 2002 testimony, and 2003 comment letter.

If the SEC had listen to ICI then or even listen to Senator Joe Lieberman in 2002, perhaps things may have turned out a bit better. Perhaps the combined efforts of the EU (European Union) and SEC might finally provide enough momentum in tightening up the supervision and accountability of the rating agencies. Or, perhaps not.

It may be a while before any truly innovative accountability and supervision are placed on the rating agencies. Until then, let’s not forget what we all learned in business 101: “Caveat Emptor.” After all, the rating agencies are simply stating that their ratings are simply their opinions based on information given to them that they assume is correct.

Let the rating agencies hide behind the first amendment; they have the right, just as supermarket tabloids like the National Enquirer.

Ed Kim
Practical Risk Manager

Disclosure: Ed Kim was formerly a rating analyst with Fitch Ratings in the late 1990’s, responsible for performing credit rating and due diligence on several CMBS and FASIT transactions.

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Tuesday, July 15, 2008

Risk Of Another Major Electric Blackout In The U.S.

With the news constantly streaming about various crises – the credit crisis, confidence crisis, mortgage crisis, and housing crisis, to name a few – it seems that people are forgetting about a looming risk that is just budding its head right now. That risk is the failing electric grid system in the U.S.

The potential is the need to replace the aging electric grid system in the U.S., which is so antiquated that another “cascade” failure leading to a blackout, a la 2003, is a high probability. This issue is not something new. In fact, New York Times wrote an article in August 2003 about the dangers of serious failure if the electric grid system did not receive substantial upgrade to keep up with demands.

Since 2003, our electric uses have gone up while the electric grid system has been just barely maintained. According to Energy Information Administration (EIA), our electric consumption has gone up from 3,662,029,012 KwH in 2003 to 3,891,705,491 KwH in 2007, a 6.3% increase (EIA table 8-1).

We are not slowing down in our demand for electricity. In fact, with the renewed interest in alternative fuel source, many people are turning to electric vehicles. This includes major auto manufacturers. As more electric-gas hybrid cars are sold and used, the electric consumption will trend higher than the EIA projection of 4.97 billion KwH of electricity used by 2030.
Here is an assessment from the U.S. Department of Energy’s Office of Electricity Delivery and Energy Reliability (I too am surprised that this office actually exists) on the current state of the electric grid system (as of 2005-2006 period):

“America operates about 157,000 miles of high voltage (>230kV) electric transmission lines. While electricity demand increased by about 25% since 1990, construction of transmission facilities decreased about 30%. In fact, annual investment in new transmission facilities has declined over the last 25 years. The result is grid congestion, which can mean higher electricity costs because customers cannot get access to lower-cost electricity supplies, and because of higher line losses. Transmission and distribution losses are related to how heavily the system is loaded. U.S.-wide transmission and distribution losses were about 5% in 1970, and grew to 9.5% in 2001, due to heavier utilization and more frequent congestion. Congested transmission paths, or "bottlenecks," now affect many parts of the grid across the country. In addition, it is estimated that power outages and power quality disturbances cost the economy from $25 to $180 billion annually. These costs could soar if outages or disturbances become more frequent or longer in duration. There are also operational problems in maintaining voltage levels.

America's electric transmission problems are also affected by the new structure of the increasingly competitive bulk power market. Based on a sample of the nation's transmission grid, the number of transactions have been increasing substantially recently. For example, annual transactions on the Tennessee Valley Authority's transmission system numbered less than 20,000 in 1996. They exceed 250,000 today, a volume the system was not originally designed to handle.” (Click here to view a PDF fact sheet, as of February 2006, of the electricity delivery system in North America.)

What is really shocking (excuse the pun) is that the U.S. government has not put a lot of effort into rectifying this problem. Just the fact that the Department of Energy’s most recent study of the electric transmission and delivery system is dated from February 2006 should be cause for concern. (By the way, the URL at the bottom of the fact sheet is a dead link, another sign that there isn’t a lot of effort or emphasis placed on this risk issue.)

What this means is that the risk of another catastrophic blackout can be expected in the very near future. With most people’s attention diverted by the dying “swan dance” of the financial market and the SNAFU situation in the Middle East, the real risk close to home is ignored.

Unfortunately, this is one case where ignorance is not bliss.

Ed Kim
Practical Risk Manager

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Monday, July 14, 2008

Fed’s Failures To Stabilize The Market Continues

With the Sunday announcement that the Federal Government will honor the implied guaranty of Fannie (FNMA) and Freddie (FHLMC), it would appear that many MBS bond investors may feel a bit more positive in an otherwise a negative market. So, does this mean that the MBS bonds backed by Fannie (FNMA) and Freddie (FHLMC) mortgages will stabilize?

I think not. The smart investors will be trying to unload as much MBS bonds as possible while the good news is still creating a tiny bit of uptick. This is because they know that the euphoria will be short lived. Very soon, the investment community will come to realize that the Federal Government of making Fannie and Freddie “too big to fail” will hurt the U.S. economy and the financial market.

Firstly, both Fannie and Freddie are public stock companies, not a part of the Federal Government. By explicitly posturing that the U.S. Government will support and even bail out these two firms, the government is adding more uncertainty into the market.

Uncertainty such as:

  • How will the U.S. Government ensure that Fannie and Freddie do not fail?

  • To what extent is the U.S. Government willing to support these companies that, in the recent past, have clearly demonstrated illegal accounting activities (also here)?

  • How much will it cost the taxpayers to support Fannie and Freddie?

  • What will do to our money supply and interest rate?

  • How will the U.S. Government react if China, Japan, or other large holders of the Fannie and Freddie MBS bonds decide to sell?

  • What will happen to the U.S. economy if China, Japan, or other large holders of the Fannie and Freddie MBS bonds decide to sell?

  • How will the U.S. Government convince investors to continue buying Fannie and Freddie MBS bonds when Fannie and Freddie won approval recently to raise the conforming loan limits to 125% of area’s median home prices in select areas, not to exceed $729,750? This especially, in a market that is expected to lose 10% to 20% or more in value?

  • With foreclosure rates up over 73% from April to May 2008, what how much of the MBS b-pieces and subornation be wiped out?

  • With so much financial institutions – Lehman, Citigroup, Merrill, to name a few – holding on to so much b-pieces and unsold subornated MBS paper, how much more can they lose?
With so much uncertainty, the risks are very high. Traders would think: “higher the risk, higher the reward.” However, in this case, the rewards are not sufficiently high enough to justify the risks, especially when the Federal Government is manipulating them.

I see more trouble ahead for the financial institutions well into 2009 because Fannie and Freddie MUST continue to lend to marginal borrowers (also, here) even as the market tanks. It is in their mandate, which was modified with the Financial Institutions Reform, Recovery, and Enforcement Act of 1989. So, as the housing market continues to sour, Fannie and Freddie must continue to lend and churn out MBS bonds. This is a recipe of a major disaster.

I wonder how the federal government will play this one out. Stay tuned.

Ed Kim
Practical Risk Manager

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