Bowie Bonds: Risk, Bonds and Fannie Mae

Dan Denning explains Bowie Bonds and where they came from, and goes from there into a discussion of the risks and rewards of securitized assets, specifically going into Fannie Mae and Freddie Mac.

THE PRINCIPLE BEHIND the Bowie Bonds is straightforward, albeit derivative. You are buying a stake in the future income of David Bowie.

The problem, from a risk-assessment point of view, is how much dare you assume about the present value of David Bowie’s future income? Music is a fickle business. Assessing David Bowie’s current value is hard enough. What kind of metric would you use to measure how much you should pay today for what David Bowie’s future worth?

You could start with known-knowns, as the current Secretary of Defense might say. By the way, jumping ahead, if Rumsfeld were an investment, he’d be a very contrarian buy right now. We know that Bowie’s hit songs like “Changes,” “Let’s Dance,” “Young Americans,” and “Heroes” will be popular with the classic rock demographic. There will be some depreciation in their value, though, as the Americans who liked Bowie in their youth change and become cynical.

But Bowie has some staying power. First, is his voice. No matter what happens so say, his hair, which may thin and go gray, his voice is the real value of Bowie. Getting older and looking it diminishes the visual power of the Bowie franchise. But if Elvis could go from hip-thrusting heartthrob to fat Vegas showman and pull it off, a change in image doesn’t have to mean a net loss in marketability, or future royalties.

Besides, “Ground Control to Major Tom” has appeal to all demographics. And at this time of year, one is reminded of the brilliant pairing of Bowie and Bing Crosby in 1977. The duet’s performed and unforgettable version of “Little Drummer Boy” on Crosby’s 42nd annual Christmas Special.

The song only spent sixteen weeks on the charts. Ironically, it lasted longer than Crosby. Bing was never able to cash in on the jarring image of icons from two different eras. He died six weeks later. The special aired anyway. It’s become staple footage on VH1 and MTV as one of the oddest Christmas videos on record.

For as long as their will be Christmas music specials, there will be David Bowie and Bing Crosby parump-a-pum-pumming. But coming back to our Bowie Bonds, how does one value this? On a discounted cash flow basis? Net present value?

Maybe the best person to ask is David Pullman, who invented the idea of Bowie Bonds in the first place. The biography on Pullman’s website tells us that he “is the Founder, Chairman & CEO of The Pullman Group, LLC in New York City, where he heads all debt, structured finance and asset backed securitization arenas for the firm.”

Pullman has experience securitizing and selling assets that are not traditionally traded. His bio continues, “David has over a decade of experience on Wall Street, starting as a mortgaged-backed securities trader and working at primary dealers. David has traded, securitized and executed asset sales with an aggregate value in the billions of dollars.”

Pullman’s work at the Wharton Graduate School of Finance must have uniquely prepared him for a career securitizing the intangible assets of rock stars. The Bowie Bond issue in 1997 raised $55 million for the ageing icon. Other musicians soon followed. Ashford and Simpson signed a deal. You remember them. Their big hit was, “Ain’t Nothing Like the Real Thing Baby.”

Bowie Bonds: Soul Futures

Even the “Godfather of Soul” got in on the act. Pullman securitized an asset worth the $30 million for James Brown in December 1999. It was just in time for Christmas, and not all coincidental. The asset in question was the “James Brown Christmas for the Millennium and Forever” album. It includes such hits as “Slay Ride [sic],” “Christmas is for Everyone,” and “Funky Christmas Millennium.”

Your editor does not know how much of the securitization actually went to the Godfather. Nor do I know how the early-December announcement that the hardest working man in show business has prostate cancer will affect his future income-earning power. But we wish him a very funky Christmas all the same, and a speedy recovery.

Yet how to value James Brown’s career as an asset (securitized by his Christmas album) remains an incalculable risk. The very question only scratches the surface of a whole new financial order. Pullman was on to something. If real assets like a house or office equipment can be securitized and sold as a kind of bond, why not intellectual property?

On his website, Pullman lists any number of intangible assets that one could commodify, securitize, and sell today. Author’s royalties, software license streams, pharmaceutical license streams, patents, trademarks, sports players contracts, future ticket sales for say, the Stanley Cup or the Super Bowl, or, at the individual level, future receivables. After all, what is the future income from your career other than a receivable on the asset side of your personal balance sheet?

Pullman is not alone in trying to broaden the definition of tradable assets. He starts with what is not obviously tangible and attempts to quantify it in a way that allows investors to make a calculated assessment of the risk, and then come to a price they’re willing to pay.

Coming at it from another angle is Robert Shiller. Shiller is justly famous for his book, “Irrational Exuberance,” which highlighted the absurd valuations of the technology bubble. He is less famous for his tome “The New Financial Order.”

Your editor confesses to not making it through each and every chapter of Shiller’s interesting and challenging book. But allow me to convey some of the basic principles:

First, that technology makes the democratization of finance possible. For example, electronic markets make the pricing of a thing-anything-more efficient.

Next, the greatest risks facing the world in the coming decades are the personal and political strife that results from income inequality. So Shiller says. We face risks which we have no way of reducing through current financial tools. Insurance isn’t enough, when you can’t insure your income.

Bowie Bonds: Spreading the Wealth of Risk

What’s needed, Shiller suggests, is a way to diversify and pool risks so they are distributed throughout the global financial system. What’s needed, in essence, is a bigger market for risk, where all sorts of risk, from the loss of your future income to the re-nationalization of the Russian economy can be traded in an efficient market.

The conceit behind such a market is one that Alan Greenspan might share. Namely, there is always a counter party to any kind of trade you want to take on. So, if you want to securitize your future income and sell it as an asset, there’s someone, somewhere out there, who wants to buy it. They may not even know you, or much about what you do .

But why bother? It’s the yield the investor is looking for. And judging the quality of your assets becomes less problematic if you’re income is pooled together, with say, the incomes of your co-workers, and traded as a whole.

After all, the same thing is done with mortgages, why can’t it be done with the union dues, the collective wages of the electricians of Boston, or all the accountants in Arkansas?

The only real limit to the kinds of securitized assets you could buy is the imagination of those who can dream them up. And in this respect, Wall Street performs a valuable service, as the increasing complexity of collateralized debt obligations clearly shows.

But even assuming there is a counter party to every trade in every kind of securitized asset or collateralized debt, you still have the nagging problem of how to assess the risk itself. In the Greenspan/Shiller model, the wide dispersion of risk in millions of little chunks makes the enterprise of owning someone else’s promise to pay or intangible asset…less risky. At least that’s the theory. Is it true?

Bowie Bonds: Heart Attacks and Derivatives of Death

For example, securitizing the future revenues from Merck’s Vioxx probably would have seemed like a great idea in 1999. The drug went on to make the company billions worldwide–until recently. The FDA revealed Vioxx can lead to heart attacks. Further the FDA concluded that 27,000 patients taking Vioxx would not have suffered fatal heart attacks had they been taking Celebrex, the rival drug made by Pfizer.

Merck lost $27 billion in market capitalization in one day. Not so good for current shareholders. Probably less good for any theoretical investor who owned a strip of Merck’s Vioxx-related revenue.

Ironically, Celebrex itself has come under fire. The same Cox-2 inhibitors that appeared to increase the likelihood of a heart attack in Vioxx are in Celebrex. Pfizer sold $2.3 billion of Celebrex in the first nine months of this year, fully 6% of its revenue. It has since stopped marketing the drug, although it has not withdrawn it from the market.

It’s clear buying a piece of a securitized asset or a collateralized debt has its own unique risk. You are buying a liability, or at the very least, banking on the value of the securitized assets (a mortgage, the NHL, or James Brown) not falling. But the rewards of creating these new instruments outweigh the risks, according to Shiller.

Shiller suggests that two kinds of risk insurance would greatly improve individual decision making. In the aggregate, society would benefit too. My risk antennae always go up when someone starts writing about doing things, “for the good of society,” as if the collective will of individuals is not already apparent in the society we have. But Shiller is a smart man, so we owe him the benefit of the doubt.

He says that if we could find a way to reduce the risk of loss of future income and the risk of a decline in the value of our home we would be less conservative and more entrepreneurial.

Freed from the specter of no income and no home (because those sources of wealth are fully securitized and insured through efficient global markets in risk dispersion) we are free to get on the business with of our lives, namely, earning said income and paying off the mortgage on said home.

Shiller even suggests that GDP bonds (another innovation of the New Financial Order) are one way for you to be “short” your country, while still earning your living in it. Call it a geographic hedge, or a government hedge, or some way of protecting yourself against the self-destructive financial practices of your government (pick a government, any government.) I love the idea. It’s genius.

But the problem, again, is determining the value of the asset to be insured/securitized/sold. For example, typical homeowner’s insurance covers the replacement cost of the assets destroyed by fire or some other calamity. If the asset is a plasma screen T.V., the replacement value is easy enough to determine. Just go to Circuit City or Best Buy.

And if the asset is the structure itself, this too is tangible. Raw materials costs are variable. But it’s not impossible to determine what it would cost to replace a four bedroom, two bathroom home, with an unfinished basement. Lumber, cement, carpet, furniture. All these items can be valued as tangible goods. That is not the problem.

Shiller, if I understand him correctly, suggests that the kind of insurance needed is insurance on the market value of the home, not the replacement cost of the tangible assets that go into building it. Here is where the notion of insuring against risk through securitization of tangible and intangible assets goes from the bizarre to the systematically dangerous.

You cannot insure the value of anything. Not David Bowie’s lips nor James Brown’s hair nor future issues of Whiskey & Gunpowder. You CAN insure against the future loss of income produced from an asset-as long as someone is willing to agree with you today on what that value is. Perhaps Jennifer Lopez has a policy with Lloyd’s on her derriere.

Yet it’s doubtful that Lloyd’s would be willing to insure or guarantee the future value of J-Lo’s asset will be the same as it is today. As the incomparable moral philosopher Frederic Bastiat points out, value is determined only through exchange, not in your subjective conception of the intrinsic worth of the asset.

In “Selected Essays on Political Economy,” Bastiat writes, “I call value only that portion of utility that labor imparts or adds to things, so that two things have value when those who have labored over them exchange them freely for one another.” As long as I’m willing to trade my income (which itself derives from you trading your income for my investment ideas) for Ashford and Simpson’s greatest hits, all three of us (Ashford, Simpson, and myself) find some value in the exchange.

This is all free and fair and transparent, which is, after all, the virtue of a free market. The prices for goods and services, all other things being equal, are determined by the unhindered exchange between supply and demand. People stop buying things when they find them too expensive (not enough value for the price.) Producers produce things when they realize they will earn more than the sum total of all the costs of production (labor, raw materials, energy.) They produce to make a profit.

There is an element of risk to all of this that can’t be eliminated. Indeed, it ought not be. To try and insure the value of things (rather than their simple replacement cost) is to take the element of risk altogether out of the exchange. This ultimately leads to much bad risk taking and dire consequences.

Bowie Bonds: Buy the Wrong Stock and Go Right to the Slammer

After all, there is such a thing as “risk premium.” That is, you get rewarded for investing in a risky venture by earning a higher return on it that the safer alternatives. If you’re good at assessing risk, you get paid for it. If you’re not, you get thrown in jail. That’s the way it used to be.

Two years ago I suggested as much to my colleague Eric Fry at the Fairmont Hotel in San Francisco. We were there for an investment conference. And I’d just warned about the growing bubble in mortgage debt. I said to Eric” You know what would help people to become much better investors?…If they imagined that they were on the hook personally for a company’s losses, and not just in line to share in its prosperity.”

“Hmmm…nice idea,” Eric replied..

About that topic, Shiller writes, “Before the passage of this law, investors could in principle lose their homes, life savings, and everything else, and even conceivably end up in debtors’ prison, simply by owning a few shares in a company that later fails.”

The idea of a limited liability corporation, of course, is to remove individual corporate officers from personal responsibility should the enterprise fail. Without any personal risk, the officers of the corporation can better serve the shareholders and take intelligent risks without jeopardizing the viability of the business or squandering the quality of the underlying assets that capitalize it.

Which brings us, as you might have guessed by now, to Fannie Mae and the government sponsored enterprises (GSEs).

In Fannie Mae we have the convergence of the idea of collective risk being bundled up and sold as an asset. We also have a case study in why pseudo-private corporations with implied backing by the U.S. government, run by pseudo-public servants, are an idea vehicle for defrauding the American people and putting the entire system of government subsidized mortgage financing at (ahem) risk.

The Fannie story is now vogue. It has all the elements of good public scandal. We already know that Fannie improperly accounted for revenues in 1998 in order to trigger executive compensation bonuses in the millions of dollars.

And today, the news for ousted former Fannie CEO Franklin Raines is even worse. Fannie’s regulator, the Office of Federal Housing Enterprise Oversight (OFHEO) is reviewing the severance and bonus packages of Raines and fired CFO Timothy Howard. It’s not chump change at stake either. A $1 million yearly pension and $30 million in stock and options are in question for Raines and $13 million in stock and options for Howard, plus an $559k annual pension.

Those are big numbers for you and me. But they are small numbers in the inflated asset world of Fannie Mae. The company has over $900 billion in assets. These assets are the mortgages Fannie buys from primary lenders (banks) and turns into mortgage-backed securities (MBS). They also include the MBS Fannie buys from other lenders.

At stake for the U.S. financial system in the current OFHEO, SEC, and Justice Department investigations of Fannie is how Fannie has accounted for the derivatives it uses to hedge its risk from rising interest rates. It’s a critical issue to the viability of Fannie’s entire enterprise.

Derivatives help Fannie hedge against a decline in its assets. That’s extremely important when you have a lot of liabilities (as Fannie does) and very little real capital matched up against them. If all you have is future promises to pay, your asset quality is a slender reed to lean on. But don’t take my word for it. Listen to the President of the Federal Reserve Bank of St. Louis, William Poole, who addressed the issue in a May speech this year.

I’ll quote certain passages from Poole’s speech. He clearly outlines what’s at stake for the GSEs and the American taxpayer. Poole says:

Some crises, such as the one that brought down Enron, are well contained and do not spread to other firms. Others, such as Long Term Capital Management, have wider effects. There is no question but that a crisis affecting either Fannie Mae or Freddie Mac would have widespread effects because these firms are so large…

I want to emphasize that, on the basis of information I have, no crisis is at hand in the market for GSE obligations. However, it does seem to me that investors have priced these obligations under the assumption that there are no possible risks that might strain GSE capital positions. In my opinion, GSE capital positions are undesirably thin and leave these firms unnecessarily vulnerable to surprise shocks. There is no way to predict what kind of shock might shake market confidence, but the reason a shock could have serious adverse effects is that Fannie and Freddie pursue a strategy of borrowing short and lending long, with a thin capital margin…

It has long been a canon of sound finance that a firm should not borrow short to finance long-term assets. There are two reasons for this principle. First, a financial firm exposes itself to interest-rate risk when the duration of assets and liabilities does not match. Second, a firm must continuously roll over short-term liabilities that are used to finance long-term assets…

It is not difficult to make a back-of-the-envelope calculation of exposure to basis risk. At the end of 2003, Fannie Mae had approximately $335 billion of short-term debt swapped into fixed-rate long-term debt. Currently, 6-month agency paper trades about 10 basis points above U.S. Treasury 6-month obligations. However, that spread reached 50 to 70 basis points in the period from 1998 to 2001. Should the current spread rise from 10 basis points to 60 basis points for a sustained period, the extra 50 basis points would cost Fannie Mae about $1.7 billion in extra interest expense per year, which would reduce annual earnings by about 21 percent based on 2003 net income…

A 21 percent reduction in net income would not be enough to shake the firm; clearly, though, a larger increase in the spread would be a matter of serious concern. Such an increase could occur should the market come to distrust the creditworthiness of either Fannie Mae or Freddie Mac…

Poole was visionary. Today, Jenny Wiggins at the Financial Times reports that the credit rating on Fannie Mae’s preferred stock were lowered by Fitch, one of the three big ratings agencies. The downgrade only affects about $4 billion on stock.

But it makes it more expensive for Fannie to borrow. And that means Fannie can’t grow the balance sheet, it cannot bring in new short-term capital to balance against the long-term liabilities it has entered into.

If Fannie cannot “roll over” short term liabilities to finance long-term assets, it finds itself with diminished capital, the same liabilities, and assets whose value can change.

What the situation exposes, in essence, is that Fannie has too little real capital and too many liabilities. The quality of Fannie’s assets may soon come into question as well. We learned yesterday that new home sales fell 12% in November. Not only that, but the median price on homes fell from $224,700 to $206,300.

Even with the fall in median home prices, foreclosure rates are up, especially in places like Colorado where low-cost financing made its way into a demographic ill-prepared for buying an expensive home with lots of leverage, just as the low-interest rate cycle bottomed out.

As rates go up, we will find out how well Fannie and her little brother Freddie Mac have managed their interest rate risk. We will also find out what happens to the balance sheet if and when the value of the assets (the mortgage pools) begins to decline because of higher defaults and foreclosures nationwide.

As Fannie must devote more income to borrowing costs, we’ll also find out what slower growth in the balance sheet does to Fannie’s capital.

Bowie Bonds: Greenspan on GSEs

It’s an issue that even has the attention of Chairman Greenspan. He spoke on the subject earlier this year. He connected the GSEs implied government guarantee with the growth in their respective balance sheets, and the outlined why it was in the best interests of all involved to see more measured growth in said balance sheet:

The GSEs’ special advantage arises because, despite the explicit statement on the prospectus to GSE debentures that they are not backed by the full faith and credit of the U.S. government, most investors have apparently concluded that during a crisis the federal government will prevent the GSEs from defaulting on their debt. An implicit guarantee is thus created not by the Congress but by the willingness of investors to accept a lower rate of interest on GSE debt than they would otherwise require in the absence of federal sponsorship.

Because Fannie and Freddie can borrow at a subsidized rate, they have been able to pay higher prices to originators for their mortgages than can potential competitors and to gradually but inexorably take over the market for conforming mortgages. This process has provided Fannie and Freddie with a powerful vehicle and incentive for achieving extremely rapid growth of their balance sheets. The resultant scale gives Fannie and Freddie additional advantages that potential private-sector competitors cannot overcome. Importantly, the scale itself has reinforced investors’ perceptions that, in the event of a crisis involving Fannie and Freddie, policymakers would have little alternative than to have the taxpayers explicitly stand behind the GSE debt. This view is widespread in the marketplace despite the privatization of Fannie and Freddie and their control by private shareholders, because these institutions continue to have government missions, a line of credit with the Treasury, and other government benefits, which confer upon them a special status in the eyes of many investors.

The part of Fannie’s and Freddie’s purchases from mortgage originators that they do not fund themselves, but instead securitize, guarantee, and sell into the market, is a somewhat different business. The value of the guarantee is a function of the expectation that Fannie and Freddie will not be allowed to fail. While the rate of return reflects the implicit subsidy, a smaller amount of Fannie’s and Freddie’s overall profit comes from securitizing and selling mortgage-backed securities (MBS)….

The Federal Reserve is concerned about the growth and the scale of the GSEs’ mortgage portfolios, which concentrate interest rate and prepayment risks at these two institutions. Unlike many well-capitalized savings and loans and commercial banks, Fannie and Freddie have chosen not to manage that risk by holding greater capital. Instead, they have chosen heightened leverage, which raises interest rate risk but enables them to multiply the profitability of subsidized debt in direct proportion to their degree of leverage. Without the expectation of government support in a crisis, such leverage would not be possible without a significantly higher cost of debt.

As always, concerns about systemic risk are appropriately focused on large, highly leveraged financial institutions such as the GSEs that play substantial roles in the functioning of financial markets. I should emphasize that Fannie and Freddie, to date, appear to have managed these risks well and that we see nothing on the immediate horizon that is likely to create a systemic problem. But to fend off possible future systemic difficulties, which we assess as likely if GSE expansion continues unabated, preventive actions are required sooner rather than later….

The Chairman was remarkably lucid on the subject. You can presume he hoped preventative action would come sooner. But it may already be too late. It’s not just the credit risk and the Fitch ratings, the Chairman says, but changes in interest rates, which you suspect he might know something about (at least their magnitude and timing):

Interest rate risk associated with fixed-rate mortgages, unless supported by substantial capital, however, can be of even greater concern than the credit risk. Interest rate volatility combined with the ability of homeowners to prepay their mortgages without penalty means that the cash flows associated with the holding of mortgage debt directly or through mortgage-backed securities are highly uncertain, even if the probability of default is low….

We come back to where we started, then. What is capital? What is an asset? Is it a Bowie Bond? Or is it capital? In “A History of Money,” Glyn Davies tells us that the English words capital, chattels, and cattle all have a common root. Hen then shows that at one time, before mortgage-backed securities, cattle were considered a form of capital, of money. They were, like oxen, a real, tangible, if somewhat cumbersome form of wealth. And they even threw off extra streams of income, milk – and fertilizer!

Today however, the wealth of the nation is concentrated in assets of much less tangible value. The GSEs are the repositories of much of the nation’s household wealth, the mortgages that count as assets to millions of Americans. Yet we are beginning to find out that in the process of encouraging home ownership, the GSEs have taken their implied government guarantee and used it as a get-out-of-risk-free card. They are badly undercapitalized. And we may not know-until it’s too late-just what the consequences are.

Despite public declarations to the contrary-the U.S. government will not sit idly buy if the $7 trillion GSE bond market begins to unravel. The unthinkable solution is a monetization of all the GSE debt. That is, the Federal Reserve simply buys Fannie and Freddie’s assets.

But is it even possible to monetize $7 trillion in debt and not destabilize the nation’s financial system? Perhaps we’ll find out, dear reader.

In the meantime, those Bowie Bonds don’t sound so bad after all.

Parumpapumpum and Merry Christmas from London. Happy Holidays and Happy New Year too!

For Whiskey & Gunpowder,
Dan Denning
December 24, 2004