This week in The Institutional Risk Analyst we feature an essay by Jack Sustman, Managing Director of the Institute for Enterprise Finance, on why the vortex is a better model for market crises than bubbles. We've always favored entropy over bubble-talk as a conceptual framework for describing market behavior, so we found Jack's discussion of the vortex as a metaphor for risk events compelling.

BTW, this Wednesday, November 18th, IRA co-founder Chris Whalen is the featured speaker in a webinar hosted by Professional Risk Managers International Association. The topic is "Bank Counter Party Risk" and will include a basic discussion of the methodology used for monitoring bank counterparties. For more information, please click here: http://prmia.org/events/view_events.php?eventID=3752

Before we go to our feature, we could not let pass the silly commentary last week in the Big Media regarding the fiscal situation of the Federal Housing Administration, the Federal Home Loan Banks and the other GSEs. The head of the FHA, Commissioner David Stevens, says that the agency is solvent and will have more than sufficient reserves to meet its obligations, primarily guarantees on 37 million first lien mortgages. We disagree.

Last week, in the IRA Advisory Service, we described how Wells Fargo & Co. (NYSE:WFC), in its most recent 10-Q, discloses that it need not bring on balance sheet ANY of the $1.1 trillion in conforming residential OBS exposures that are the subject of the new FASB rule eliminating the "Qualified Special Purpose Entity" designation. Why? Because the loans inside these securitization vehicles are insured by FHA, so goes the thinking of WFC and its auditor, thus the bank has no liability to these entities or the securities they have issued to investors. Pretty neat trick, eh?

Call us provincial, but we have a hard time understanding how WFC can take the position that none of the securitizations issued by Wachovia and WFC are properly reflected on balance sheet. Does WFC really believe that none of the loans underlying these securities will be rejected by FHA? At a minimum, we believe that WFC should show the likely portion of these securitizations that will be rejected by FHA as a liability, especially since the expense of curing such violations of the reps and warranties made at the time of the sale is a cash expense. Maybe our friends at the FASB can add this issue to the list for future study.

More, given the past industry practice of substitution of collateral and cash advances to the OBS vehicles followed by WFC and all of the other major players in the industry, we have an equally hard time understanding how any bank can, as a practical matter, still pretend that these vehicles are not de facto controlled by the sponsors. Eventually the courts and/or the Congress will deal with this issue, but for now the children's hour continues.

But it gets better. If you take the "real," economic rate of default inside the WFC loan portfolio, say 2x the reported 2.5% annualized defaults at Q3 2009, and attribute it across the $1.1 trillion of conforming RES OBS exposures of WFC alone, we are talking about over $60 billion in realized losses. If you take the standard industry posture that OBS exposures typically underperform the loss rate experience of retained portfolios, the number is more like $100 billion in realized losses from the conforming residential exposures alone.

The loss rate experience from WFC's OBS exposures wipes out FHA reserves two times over -- and we are not even talking about Bank of America (NYSE:BAC) and its Countrywide zombie love queen, which has a pile of OBS vehicles around the same order of magnitude as does WFC. And there are thousands of other banks that originate and sometimes sell FHA guaranteed paper.

Now FHA argues that the flow of fees from new guarantees will allow the agency to meet the rising tide of guarantee losses and eventually repay any deficit. OK. What do FHA officials think total realized losses across the 37 million first lien mortgages will be in 2010? Since the FHA has an unlimited ability to borrow from the US Treasury above and beyond any statutory surplus accumulated from guarantee fees, this number could become significant to the bond markets. Or to quote Lita Epstein, writing in Daily Finance: "The FHA's reserve fund could be a black hole for U.S. taxpayers."

Josh Rosner of Graham Fisher in New York thinks that the irony in the situation with FHA is that the banks, which have pulled future originations into the present in order to boost current revenue, are now arguably taking greater care of the taxpayer than the FHA is itself. "The realtors are delighted by the strong volumes of new loans written by the banking industry," Rosner tells The IRA, but adds that the mortgage bankers and even commercial banks are increasingly uncomfortable with what they see in the channel in terms of poor FHA underwriting and risk management standards.

As with low interest rates, debt guarantees and repurchase agreements, the subsidies provided by FHA enable the banks to generate income today, but at a cost to the taxpayer and even the banks tomorrow. And does this mean that WFC, BAC et al are getting away clean on the loans due to the FHA guarantee? Noooo. To our earlier point about the rejection of collateral guaranteed by the FHA, we suspect that the estimated loss rates to FHA illustrated above also will be the minimum hit to the securitization sponsors through the cycle, something that we'll be addressing in detail in the IRA Advisory Service in coming weeks. Maybe that's why in all of the disclosure to date from large sponsors such as WFC, BAC the filers indicate that they are still "studying" the matter.

Of note, last week the Federal Deposit Insurance Corporation adopted a proposed Interim Final Rule amending 12 C.F.R. § 360.6 to provide a transitional safe harbor effective immediately for all participations and securitizations in compliance with that rule as originally adopted in 2000. The Interim Final Rule confirms that participations and securitizations completed or currently in process on or before March 31, 2010 in reliance on the FDIC's existing regulation will be 'grandfathered' and continue to be protected by the safe harbor provisions of Section 360.6 despite changes to generally accepted accounting principles adopted by the Financial Accounting Standards Board. GAAP and RAAP remain two different worlds. Stay tuned.

Now to our feature. We met Jack Sustman at the Chicago Fed's banking conference. His research interests include the physics of economics, the interactions between financial stability and the real economy, the logical foundations of probability theory, and microcredit regulatory policy. He was review editor of Banking in Transition Economies (Edward Elgar, 1998). Jack was educated at the University of Illinois at Urbana and DePaul University in Chicago, and lives in Austin, Texas. The essay is republished with the permission of the author.

VORTEX HYPOTHESIS OF ASSET PRICES
By Jack Sustman

The last thirty years or so have brought numerous episodes of what many economists have long called market or economic "bubbles", in which the prices of various kinds of assets seem to rise out of all proportion to their intrinsic value, at least in retrospect. The huge rise and subsequent fall in the prices of equities, bonds, currencies, commodities, or real estate during various "bubble" periods have greatly magnified the potential risks and final costs of these boom-bust cycles to taxpayers and citizens in both developed and developing countries.

Interestingly, the appearance of asset-price "bubbles" in many countries and regions since about 1980 coincided with the dampening of consumer inflation. Since asset prices can skyrocket with or without consumer price buildups, the exact relationship between the two remains obscure, even though both kinds of inflationary distortions seem to feature too much money chasing too few goods or valuables. Until relatively recently, soaring asset prices based on healthy demand and high liquidity were seen as a good thing as long as consumer inflation appeared to be under control. Indeed for many years it seemed that the hard-won independence of monetary authorities, along with governmental discipline in fiscal outlays, had succeeded in slaying the inflationary dragon. Only in the late 1980s did financial instability and systemic risk, in the form of unsustainable asset-price booms and busts, begin to challenge the primacy of central banks' inflation-fighting mandates.

Given the unacceptably high cost of recent financial crashes and subsequent economic slumps, much research has been undertaken to examine why asset prices soar and plummet. At international policy conferences held at the Federal Reserve Bank of Chicago, presentations and discussions have raised nagging questions as to whether asset-price booms should be called "bubbles" at all. The traditional description of a "bubble" - which builds, broadens, and then bursts - is vivid indeed. But the "bubble" analogy suggests nothing specific about the structural characteristics of these asset-price distortions and nothing at all about how to prevent their occurrence or clean up in the aftermath.

A more helpful comparison might liken asset-price buildups and breakdowns to the emergence and dissipation of nature's whirlwinds, such as hurricanes, cyclones, and tornadoes, which are formally known as "vortices". A vortex occurs when rotations of liquid or gas fluids accelerate in conditions characterized by low external pressure known as the doldrums. Vortices can acquire great speed, mobility, and height, feeding on themselves as well as on their environments, drawing immense amounts of energy into their domains. A deceptive calm prevails at the very center, in the so-called "eye of the storm", while elements caught up in the action are subjected to sustained, if tenuous, vertical displacement. Because their extreme volatility and strength make models and measurements extraordinarily complex and error-prone, vortices have proven difficult to test reliably and accurately. What we do know is that vortices can uproot, damage, and destroy almost everything that gets in their way. Eventually vortices "play out", breaking down when more balanced conditions reassert themselves.

It is proposed here that asset "bubbles", in which market prices ascend to dizzying heights amid frenetic activity, can more properly be seen as "vortices". This extended analogy is based upon the first two laws of classical thermodynamics as modified by quantum physics. The first law, which states that total energy is constant, allows for thermal equilibrium to be expressed in the formula PV = T. The second law, which states that entropy strives toward a maximum, recognises that quantum "fluctuations" can reduce or reverse this tendency.

Together, the two laws suggest that in economics, as in physics, even a small-scale disturbance can eventually give rise to a giant, chaotic fluctuation called a vortex. In the economic version of vortex formation, each of three components in classical thermodynamics - pressure, volume, and temperature - corresponds to a market variable, however roughly defined at present. For example, physical pressure (P) seems comparable in an economic sense to buying and selling pressures in various asset markets. Similarly, the volume (V) of a physical system can be seen to represent the pool of available investments, in global or even local markets. Likewise, the temperature (T) of any phenomenon, which actually measures the velocity with which particles move, seems analogous to the speed with which money changes hands in an economy.

When a physical system is disturbed, the three thermodynamic components - pressure, volume, and temperature - adjust as the system struggles to retain equilibrium. These changes can be compared, in the economic case, to variances in net buying pressure (P), the abundance of market opportunities (V), and the ease with which funds flow (T).

When a boom begins, buying pressures build, market infrastructures expand, and money moves about vigorously. This market situation would correspond to the physical case in which P, V, and T - buying pressures, market sizes, and monetary velocity - all increase. More investors are drawn into the fray; prices get whipped up as heat is a by-product of work. Contravening the usual tendency of entropy to strive towards a maximum, a vortex is created.

Other forces come into play as the vortex builds, further boosting asset prices. Buying pressures (P) respond to the reinvestment of profits as well as to central banks' monetary policies. New market opportunities (V) are created as successful institutions expand and new ones are created. In addition, rapid vorticity - the curl of velocity - creates centrifugal forces that literally bend space and time, dissuading gravitation toward the horizontal and weakening its vertical pull as measured locally. This might account for the sense of lightheadedness, even euphoria, felt by many investors as the whirl of transactions activity (T) intensifies. As a result of the changes in economic weather during these periods, statistics often appear to be warped or skewed, departing from long-term averages or familiar patterns. As the economy appears to achieve an adjusted equilibrium, analysts are sometimes tempted to conclude that conventional or historical standards no longer apply in the new circumstances.

As the boom enters its critical phase, the high prices of some investments can no longer be justified. The pool of affordable market opportunities (V) thus diminishes in size. Despite these early warnings, market bullishness is not tamed so easily, however; as the frenzied trading action (T) continues in the wider market, a disproportionate increase in relative buying pressure (P) is needed in order to maintain the PV = T equilibrium in the economy as a whole. Prices in ever-more-narrow market segments thus rise to ever-more-stratospheric levels; and these wild swings, combined with adjustment lags, produce far-from-equilibrium market conditions. It is during this turbulent period that gross overvaluations and associated systemic risks should become identifiable, with financial-stability implications for both market participants and economic policymakers.

The denouement of the vortex story occurs relatively suddenly as a reduced number of bids relative to asks (P), a dearth of attractive investments (V), or a lapse in the pace of market activity (T) cause the phenomenon to fail, investors to exit, and prices to plummet. Buying pressure dissipates, markets vanish, and receivables suffer; in physical terms the three thermodynamic variables - pressure, volume, and temperature - all decrease. Fixed investments, previously justified by expectations of robust cash flows, no longer adequately service associated debts. As the market gropes for a new equilibrium, a post-"vortex" slump takes shape as hollowed-out economies struggle along, often resisting cheap money, fiscal largesse, and financial restructuring, attendant upon the return of business confidence.

The vortex hypothesis of asset prices: Asset prices, normally subject to human volition on a microeconomic scale, take leave of macroeconomic equilibrium during boom-bust periods as work inefficiencies produce heat and trading activity dissuades gravitation.

Much more work remains to be done on this "vortex hypothesis of asset prices", which is presently more a phenomenological description than a testable theory. The stylised description of asset-price behaviors described herein, featuring market manifestations of physical variables, can be modeled and analyzed using the same kinds of partial differential equations commonly used in the study of thermal equilibrium and its associated dynamics. Further research into market vortices will need to incorporate economic variables representing a structured core in the center of the vortex; gradients at some distance from the center; velocity along each of the gradients; and vorticity as upward curl of the phenomenon, all within some market space.

The market analogs of the physical variables proposed here, and their interactions during boom-bust periods, might help to explain the complex and chaotic episodes that have historically been called "bubbles". Indeed, this approach might be able to describe many other kinds of macroeconomic activity, with available investment funds (P), institutional market spaces (V), and ease of monetary exchange (T) providing new variables for use in general and partial equilibrium theory. In any case the vortex approach will most likely stop short of providing precise predictive power over asset prices. What does appear evident, however, is that the temporary duration of most of nature's vortices seems analogous to the unsustainability of asset-price overvaluations.