Brad Setser

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I guess I am not the only one who sometimes calls CPDOs C3POs

by Brad Setser
December 29, 2006

Or for that matter, sometimes says C3DOs rather than either C3PO or CPDOs.  I used to think that no one loved acronyms more than the US government, but then the structured finance boom came along.  

I'll second Gillian Tett's comment about the accelerating pace of change

Another factor driving the trend is broader acceleration of the global financial innovation cycle. Low interest rates have left investors scrambling to find new ways to earn returns – and banks are responding by inventing products at such a furious pace, they barely have time to think up names.

Back around 2002 or 2003 I thought I had a pretty good understanding of how the market managed credit risk, though admittedly one largely derived from studying the market for dollar and euro bonds issued by emerging market sovereign borrowers.   In 2005, I struggled to understand how the market had stopped just betting on credit risk and started to be bet on the correlation between different credits (see this FT retrospective).  And in 2006, I more or less gave up trying to really understand CPDOs (let alone how CPDOs differ from ALDOs or reverse CPPIs). 

Trying to track petrodollars from secretative Gulf states and the latest gizmo dreamed up by the world's best financial engineers was more than I could handle! 

I remain convinced that there is a reason why the growth of emerging market reserves (and resulting low yields on many fixed income assets) and the growth in the stock of CDSs (credit default swaps), CDOs (collateralised debt obligations), LCDSs (loan CDSs), ABCDS (a CDS of an asset-backed securities), CLOs (collateralised loan obligations), ECOs (equity collateralised obligations), CDO2 and CDO3 (Gillian Tett: "CDOs of CDOs of CDOs") and CPDOs (constant proportion debt obligations) has been highly correlated.    


  • Posted by HZ

    Hey, not just credit products. Check out Sears Holdings, whose Chairman Eddie Lampert is billed as the next Warren Buffet. Sears uses total return swap, which is supposedly increasingly common these days (according to a recent NYT article). So now you can legally smooth earnings. Makes one wonder why Fannie Mae or Freddie Mac got so much flak for what they did.

  • Posted by Steve Waldman

    (Last month I couldn’t help but be amused that I was writing about CPDOs while writing c3p0. I like the whole Kate-Moss-thin credit spread thing. I’m quite convinced — probably by reading this blog too much! — that much of the structured credit revolution is about absorbing all of what, er, bulemic central banks seem determined to keep spewing.)

    Happy 2007 all!

  • Posted by moldbug

    If anyone has a better explanation of CPDOs than Steve, I would like to see the link! But frankly, it is not clear to me that the thing can be done. Thank you, Mr. Waldman.

    The big picture in CPDOs is that they are a classic example of government failure. Nothing like a CPDO could possibly exist in an unregulated economy. Of course, that doesn’t mean the best choice for this far-from-unregulated economy isn’t to find some way of regulating the damn things out of existence. But fortunately this is not my job.

    CPDOs exist because NRSROs exist. Rating agencies (Moody’s, S&P) are not private actors. They are granted enormous official authority. Imagining the market price of NRSRO status, sold with no questions asked – for example, to a company which could shake down its clients for ratings – is one way to conceive of the scale of this delegation of power.

    In a transparent, professional system of government such as ours, authority of this kind must never be personal and arbitrary. Old John Moody, perhaps, could tell his customers that Joe’s Railroad was a shoddy outfit run by notorious shysters, whose bonds shouldn’t be touched with a ten-foot pole no matter how many payments they’ve made. If his successors rate JRX, they have to justify their result with some serious math. Nothing else would be compatible with “nationally recognized” status.

    As Mises pointed out in the ’20s, excessive dependency on calculation is the general flaw in central planning. The planners are constantly being forced to calculate things that cannot possibly be calculated. Credit default probabilities, especially aggregate spread projections, are a classic example.

    So Moody’s can’t issue a report saying that these CPDO things just don’t smell right. It can’t call Stratfor, get a ballpark number on the chance of an Israeli-Iranian war, and factor that into the probability of a generalized credit panic. It has to do what it does – run the things through its models. Which predict, as usual, future results from past performance.

    And it’s not just that Moody’s has to do this. It’s that it can do this. Because it is effectively a government agency, it has transferred all of its risk for this behavior to the state. It is Uncle Sam that will take the hit if the models fail, and rightly so. Moody’s only existential risk is failure to comply with its own properly approved policies and procedures.

    Fortunately, Uncle Sam is perfectly capable of insuring the risk of the models. He can, after all, print more dollars. Which will then be used to buy bonds – keeping those spreads svelte. Moreover, with this same mechanism, he can stimulate the economy, keeping the people who actually have to make their payments flush.

    This is a perfect example of an expansionary ratchet. It is a political mechanism that causes immediate pain if the presses are stopped. Hyperinflation happens because the political cost of a liquidating recession exceeds the political cost of continuing around the spiral. Systems that increase sensitivity to default, like the system that the CPDO is gaming, make the spiral harder to escape.

    In other words, the more CPDOs are outstanding, the more stress the financial system will suffer in the case of a sharp credit spread widening that overpowers the “stabilizing” reaction when the CPDOs automatically react by selling protection. The CPDO machine sets up a critical point, below which it is a “stabilizing” feedback loop that causes spreads to converge (as CPDOs gear up), and above which it is a thoroughly destabilizing one, that causes them to diverge (as CPDOs max out and fail).

    It is, in other words, major “bubble skin.” The lovely old metaphor of a bubble, which really just means “disequilibrium,” can easily be extended to other materials than the usual soapy water. If your bubble is made out of latex, for example, it can get much bigger and sustain a much higher internal pressure. It is harder to pop, but it makes more noise when it does.

    With CPDOs, and ultimately with the power of the printing press, the bubble is the size of the Hindenburg, its interior could easily be mistaken for the atmosphere of Jupiter, and its walls are Kevlar and nanotubes. As Steve says, it is very hard to break.

    And it is very important to note that it is not just the personal whim of “bulimic CBs” that supports it – it itself enforces exactly that bulimia. The bubble skin is not really the critical point of the CPDOs. It is the fact that CBs cannot allow spreads to reach that critical point.

    For all the hawkish talk, they will accept any level of consumer price inflation first. It is much easier to tweak the index again (maybe it could just be the GCPI, the Game Console Price Index, measured in triangles per second per dollar) and suffer the occasional human-interest story in the Times or Post about how the man on the street thinks prices are too high, despite the fact that there is no inflation.

    So fasten your seatbelts, everyone. If I am even close to right, there are no brakes on this thing, and we are headed north in a hurry. It may be a happy 2007 indeed.

  • Posted by moldbug

    And if you care to read a retrospective description of “Kate Moss credit spreads,” rendered in lovely old 1930s prose on crumbling yellow paper, you could do a lot worse than an original edition of A Bubble That Broke The World, by Garet Garrett. I am too lazy to type it in, Dave Chiang style, but there is a bit about Brazilian railway bonds that is as resonant, poignant, and hilarious as you’ll ever get – it makes our own dear Cassandra look like Greg Ip. Financial journalism, like a lot of things, isn’t what it once was.

  • Posted by Guest

    On the remote chance you haven’t heard of Sean Egan Ranting at the Ratings Agencies:

  • Posted by Cassandra

    Thanks for setting me straight on “liquidity” confusion. As you saw, I was thinking in the broadest systemic sense, not the micro sense. Wilmott had an amusing Xmas competition thread several years ago for the best definition of the liquidty to which you were referring. Alas, I didn’t win (not even Show or Place), but there were many interesting, amusing observations by well-versed practitioners & risk-managers.

    Once again, the tapestry you’ve woven dazzles. And not that I want to argue on behalf of Darth Vader (or Bear Stearns) but one must ask the question – truthfully and unjudgementally – precisely what IS it that we really have to be frightened about in respect of financial innovation?? Is is Herstatt risk? Is it moral hazard? Is it implied leverage? Is it complexity itself? For skeptical (ok, even cynical) as I am, it seems to me that the more things issued backed by more things (as opposed to reliable but, at the end of the day, empty promises), even cleaving off the highly volatile, combustible or merely unsavoury bits for consumption by the overtly bold, certifiably insane, merely gullible, or Agent of OPM (other people’s money) Shooting-the-Moon is bona fide progress. The 151 IS in the the gritty bar, or perhaps some Trader Vic concotion, that at worst makes some unsuspecting girls panties in danger of being removed, but at least its NOT being sold in school vending machines or the corner shop. The innovation may create a logjam of cross-default risk, or back-up claims, but I as I look out at the landscape, I see risk transference that will, in the event of a large Shia trebuchet lobbing this or that over Israeli or Saudi borders, make the mess easier to clean up, the logjam easier to break, markets finding clearing prices quicker, and the certifiable idiots meeting their Darwinian (or Amaranthian) fate that much quicker. A Panglossian view perhaps, but one that The Most Sensible Man in The Fed, Tim Geithner, would probably agree with.

    In a cataclysmic event/contraction/revulsion/crash, most of the financial innovation will sting the reckless, the feckless and the marauders hardest and where it hurts most, with a large chunk broadly socialized – reasonably equitably – amongst pension funds, insurance companies, and banks or all persuasion. And call me an optimist if you must, but this is not an excessive price to pay, and economy-wide, will WILL be an improvement over the mayhem and treacle-like consequences to lending and economic activity in comparison to when it was concentrated all within – and had to be worked out by – but a few lending institutions.

  • Posted by moldbug


    My worry is moral hazard.

    It seems to me that what these instruments are doing is taking ordinary risk and moving it down the tail into Herstatt (systemic) risk. The Fed then uses its power of the press to convert Herstatt risk into dollar risk. The foreign CBs use same to convert dollar risk into euro risk, yen risk, even RMB risk. At the end of the day everything has the same risk, which means there is no risk at all – and everyone makes money.

    Or, as it were, mints it.

    What all these structured financial techniques are doing is essentially legalized counterfeiting. It is capturing the printing power of the Fed to produce notes that are, in practice, as good as dollars. It is fractional-reserve banking on steroids. The lesson of fractional reserve is that if you can underprice risk, you can turn (n) dollars into (n + m) dollars. This is now being done in a much fancier way, but the principle is the same.

    Our financial system does not actually allow you to cut a CPDO into dollar-sized units and buy coffee with them. But suppose it did. Suppose that besides the usual green bills, which are dollars due now and paying no interest, you had blue bills, which were slices of T-bill, red bills, which were slices of AAA bond, and orange bills, which were slices of CPDO. All prorated by their current dollar value, so that a $2.45 espresso was a $2.45 espresso, whatever the color of your bills.

    In a credit catastrophe, then, all the orange bills and maybe some of the red ones disappear, or at least change their face value. (Perhaps with some kind of electronic ink.) As a result, people suddenly have less money in their wallets, cash registers, etc, than before.

    Obviously, the ideal situation is that the bills are evenly mixed across the economy. Everyone has all different colors of bills. This allows the destruction to be broadly socialized.

    At maximum homogeneity, this starts to resemble an event in which all dollar bills with serial numbers divisible (for example) by 3 are destroyed. It is the reverse of Hume’s Archangel Gabriel. Perhaps the Archdemon Beelzebub.

    You could make this a completely neutral (absent psychological factors) redenomination by also redenominating debts. Then it would be no different from, for example, the replacement of 1 million old Turkish lira with 1 new TL. A proper redenomination requires the rewriting of contracts, so that if you borrowed 1 billion old TL you don’t now owe 1 billion new TL.

    But note how far we have gone from the real world of CPDOs. If money is widely destroyed, but the effect is distributed nonhomogeneously (if, indeed, broadly), and there is no formal way to calculate the transformation from pre-crash money to post-crash money, there is no formal way to, for example, impose partial debt forgiveness. If there is no debt forgiveness, you are privileging lenders over borrowers, which is politically improbable. But the lack of a Schelling point which enables sensible agreement over the proper level of debt forgiveness ensures a long period of confusion and political turmoil. Not good.

    The 151, to use your metaphor, is in the school vending machines. It has been diluted considerably. The little tykes are getting Zima, not Bacardi. But it has still spread out across the global economy and stimulated one heck of a lot of demand. An instant mass hangover is certainly not good politics, and I don’t even think it’s good policy.

    If there is anything Bernanke is an expert on, it is how dangerous and unpleasant a debt deflation scenario is. At least from an abstract intellectual perspective, it is unfair to blame him for his helicopter metaphor – what he was saying when he said that made perfect sense. But say it he did, helicopters he has, and if the alternative is mass liquidation, to the air they will take.

    My feeling is that the feckless will not suffer. The bubble will not pop. The 1929 crash will never happen. The CPDOs will not default. The political cost is too great.

    Bernanke is right in a sense. The round of liquidation that started in 1929 happened because the Mellons who encouraged it did not realize what actual liquidation meant after a decade of modern, efficient Fed credit expansion. They were used to liquidating the smaller and more private booms of the 19th century. Politically, liquidation could not have worked in the ’30s, and it probably shouldn’t even have been tried.

    And we have gone way past the roaring ’20s here. The more widespread these instruments that push risk into the CB-protected tail become, the better their protection is. Whether it wants to or not (surely not), the Fed has become the FHFIC – the Federal Hedgefund Insurance Corporation.

    This is simply lawlessness. You cannot go on letting Wall Street print money while denying that privilege to ordinary folks with their little mimeograph machines. It is incompatible with every ideal held by our political system. It is ultimately incompatible, I think, with the continued existence of that system.

    My personal view about how to return from lawlessness to law, which certainly differs from that of most libertarians, is that the only way to do it is to find a formal way to ratify past lawlessness and eliminate future lawlessness. All the land on Earth, for example, has been stolen many times over. You cannot give Massachusetts back to the Algonquins or Londinium back to the Welsh.

    This is why I feel that, rather than a deflating crash which tries to sting the “reckless, the feckless and the marauders,” the best thing for all concerned is a “flag day” solution in which everything they have managed to steal is confirmed as their formal property, and no further stealing is permitted. Which means simultaneously printing a whole heck of a lot of money, and transitioning to a post-paper financial system in which no more money can be printed.

    Think of it as the financial equivalent of “truth and reconciliation.” It is a very counterintuitive approach. Just as it goes against all our senses of justice to let the murderers of Steve Biko off the hook, it goes against all our senses to let the sharks of Wall Street keep money they have created through borrowing the Fed’s printing press. But if your priority is results rather than revenge, I think it becomes a more attractive solution.

  • Posted by 112358

    As a non-economist observer, it seems that there is a rule that actors in the game cannot find a loophole that allows them to win without the rules that allowed it to happen changing subtly. Basically, as soon as the larger system reflects the existence of the loophole, the rules enabling the loophole to exist are now changed, making it impossible to use the loophole now. I think that sort of risk is what everyone is afraid of.

    Or, to paraphrase the Hitchikers Guide to the Galaxy, as soon as you know the laws of the universe, they instantly change to become something infinitely stranger.

  • Posted by Cassandra

    At last we nail it down. And I am with you on that page (though all the teasers are plausible possibilities for concern).

    The game is certainly unfair. It’s NOT unfair from the point of view that some clever dicks have stumbled upon the more optimal solution before most. That is simply goood business. What’s “unfair” distributionally is that – at present – the umpires and arbiters are insisting its a “fair game”. That there remains high credibility to the authorities’ fiscal and monetary policies and so one is deemed potty to believe otherwise. This is why I despire Kudlow and bubblevision. This is why I condemn the Chinese and Japanese, NOT for sheer cheap manufacturing advantage or clever engineering & production efficiency (which must be disheartening for a US manufacturer in the best of times) but for not letting the interest rate market signal to particpants – particularly the masses – that the game is not true. The lie (not to mention the housing bubble) would be much more difficult to perpetuate with rates at 7% or more. The market actually would work if it were allowed and rates (both FX & IR) not so bent. Of course Congress is rather culpable here for we needn’t have run massive fiscal deficits, not coincidental to uber-loose moentary policy. In the absence of that, the lie is perpetuated, so rather than tell the people: “folks, money illusion (dilution inflation etc.) of X% p.a. is essential to continued good times, and so – in the public interest – we just thought you should know in case, like you errr ummm thinking of putting your savings in money markets, buying a US Savings Bond or Treasury Bond, or, in fact being a creditor for anything less a few days unless recompensed for the almost certain inflation that we are bound to see at some point in the future, absence the discovery of cold nuclear fusion. So folks do what you ratonally must to compensate”. After which the people can establish rational expectations based upon sound information, and not Radio Pyongyang blathher and drivel and apology after apology. This caveat is not dissimilar to the placing of photos of gruesome scarred black lung tissue upon cigarrette boxes. But at least “the people” would be on equal fotting, adjustments made, and the lie would be exposed.

    From a behavioural point of view, the game is over when everyone figures it out. The market thought they had done so with housing, but its easy to make more and so is squishy at best as a store, rather than hard. But spend and lever they will once they believe money will be worth less tomorrow. Classic wage-price spiral will be back. It will get so out of control it will implode upon itself when rates break free of their articifial tether, or need to be forcibly and brutally popped like in Serbia, SO why go there at all?

    I like the T&R analogy. BUT if it is left too long and too few folks hoover up too many chips, revolution becomes inevitable – even in couch potato land. I am not for retribution nor punitive damages per se. I am for amnesty: “Just return the stolen money, and all will be forgiven”. “Oh, and if don’t return, the people will simply take it – with interest, and maybe a pound of flesh.

  • Posted by Steve Waldman

    moldbug, like charming cassandra, i am captivated by the web ye weave, and very deeply in agreement with most of what you write. it is a great delight to read plainly written that Wall Street is making its money quite simply because its players have been permitted to print it, and that the distribution of wealth has become largely a game of cleverness or connectedness in accessing central bank printing presses, rather than a matter of conributing to the production of goods and services in the world.

    that said, i think there’s a bit of a contradiction in your flag day proposal. so long as the dudes with the printing press control the terms of mainstream debate (as they do now), there will be no flag day. they’ll just keep printing themselves money. there has to be a problem for there to be a solution. what should that problem be? a great inflation, as more people with a higher propensity to consume, get hold of a mimeograph? or a deflation, in which some of that mimeographed money just disappears, and whoever was holding it loses? something else?

    i don’t think we need to ratify anything, as all that printed money, whatever its color, is already effectively legal tender. i don’t think we need to string up anyone for their inflationary synthetic portfolios either. but i think we’ve enetered a game where 1) the accumulation of relative wealth is deeply decoupled from the production of absolute wealth, 2) the game won’t change until there is some kind of a crisis, and 3) the longer the crisis is put off, the worse the putatively ratifiable status quo will be when the crisis happens, and the greater the likelihood it ends up looking like the French Revolution rather than that 80s S&L thing.

    One way or another, we will have a great inflation or a great deflation, or both (monetary hypervolatility). I’d like to see at least some deflation, so that some of the right people get burned, but as you say, justice may be too much to hope for in this life and vengeance tends to burn indiscriminately. Whatever form the crisis takes, I just wish we’d get it over with. Only then will there be any hope of a “flag day”, or of any reasonable financial architecture that prevents this kind of thing from happening again.

    So, here’s to a crisis, early and soon. And Happy New Year!

  • Posted by bsetser

    Cassandra — very interesting set of observations at 14.40.

    Personally, I am worried by:

    a) the implied leverage … and the need to hedge in bad states of the world in ways that can augment moves.
    This is something that I think Geithner (my former boss) worries about as well — see his comments on falling margin in his last big speech on systemic issues. Less vol means bigger positions to get the same returns (or put differently, smaller spreads require taking on more leverage to generate outside returns), which is fine so long as the fall in vol is permanent and not temporary …

    b) the complexity itself … I don’t understand 1/2 the products out there, let alone how various folks hedge the nuclear bits of their portfolios, and I woudl bet I am reasonably sophisticated for someone doens’t have skin in the game. from a systemic point of view, complexity introduces more model risk (something that Waldman/ interfluidity nicely highlights in the post that moldbug links too)

    c) leveraged, correlated positions — think of all the folks who were long local EM markets (debt and equity) hedged by holding CDS (default protection) on EM $ bonds in May/ June. tHose selling the CDS protection were in a position to honor their obligations (they were big boys looking for a yield pickup) but that didn’t change the fact that the leveraged community was all basically long the same stuff (local em assets) and deleveraging meant selling. The correlation between EM local currency sell offs and EM $ debt spread widening held generally speaking, but I do wonder if this is a case where correlations that look good in a backward sense will eventually cause truoble, especially in a world were real EM $ bonds are disappearing …

    d) some concentrated positions in some key market segments. See the FT article on correlation and the CDO market. To generate the tranches that real money investors want, the I-banks of the world ended up being structurally massively long the equity tranches … which they hedged in various correlation trades (as I understand it). In the past I have called this Rajan risk … smart folks take on nuclear stuff to make money selling the less nuclear stuff thinking that they can hedge it … but that generates model risk/ complexity.

    e) is there any risk that some of the prime brokers could get into trouble in a bad state of the world? I.e. one of their clients cannot hedge/ liquidate so the prime broker has to take over the position — and say it isn’t just one client but several who all have the same trade on and cannot get out in time. then prime broker then wants to hedge, and it has touble without moving the market and so on … I am thinking things up but this strikes me as at least possible. I am not 100% that all risk has been dispersed rather than concentrated — there are only so many people who understand certain kinds of complexity and some complex positions may be very concentrated (ok that isn’t necessarily a prime broker point but it is a concern).

    f) general unease created by the fact that all this innovation has sprung up in an environment where, generally speaking, things have been very benign. Corp and EM spread have shrunk. Volatility fell across lots of assets. A massive US current account deficit has been financed at quite low rates. Macro volatility maybe hasn’t fallen (it has been fairly low for sometime) but it has certainly stayed low … and so on. Some of these features may not be a permanent feature of the global economy — and should things change, some of the models may blow up …

    Back in the 1990s, most people thought EMs should be net captial importers — many were running large CADs and most thought that they could do so for some time. It turned out that they were natural capital exporters (at least that is what the market now thinks) but getting from capital importing to capital exporting didn’t happen so smoothly in the first instance. the swing in the current account of EMs in 97/98 (reinforced in 00/01 with argentina, brazil and turkey) was rather brutal and generated a lot of collateral damage (LTCM).

    In one case the losses from default were widely spread and contagion was limited (Argentina) but in another case the losses from default were much more concentrated and there was a lot of contagion (Russia). Lots of smart sophisticated folks had models that showed that countries didn’t devalue and default on their local currency debt– and had hedging strategies that assumed that Russian banks would honor forward contracts in the event of a devaluation (somehow …). Those assumptions failed. The underlying (the GKO) and the hedge (the forward with Russian banks) both went bad. and positions were sufficiently concentrated that well, problems happened.

    Big macro transitions (if they happen) don’t necessarily play out in precisely the way expected … and many new postiions/ models haven’t been tested by any major macro trasition recently — the basic pattern of growth from 02 on has just continued with associated widening of existing imbalances rather than a shift from one kind of imbalance to another.

    enough from me — interested in your reactions

  • Posted by Guest

    re: “blue bills, which were slices of T-bill, red bills, which were slices of AAA bond, and orange bills, which were slices of CPDO…”

    how about blue, red and orange debit and credit cards – the ‘worth’ of each fluctuating with the associated ‘store of value’?

    “The 1929 crash will never happen. The CPDOs will not default. The political cost is too great.”

    Doesn’t it just come down to the fact that the system needs the rents?

    re: “everything they have managed to steal is confirmed as their formal property, and no further stealing is permitted”

    The problem with this is blow-back. The resulting uncertainty and conflict about ‘true’ and ‘fair’ ownership would collapse the valuations which have been established in the current system. If the land was raw when stolen and has since been ‘developed’, how is a fair redistribution of property established? Mass property retributions have happened – and are still happening – with disastrous consequences. Great for black markets and warlords, various political powers, PMC’s, lawyers, accountants, academics and other specialists and bankers charged with sorting out the mess – but who pays for that?

    When a corporate executive is charged with ‘corruption’ – or when a policy change aimed at correcting a policy flaw is announced – the value of all associated securities or property tanks. And the linkages are not always apparent until it happens. Complexity transfers control to those who have a lead role in cleaning up the mess. As they make a mint, the devalued assets can be picked up at a discount by insiders who then have a stake in determining how and when the risk factors will be eliminated to restore the asset values back to ‘fair valuation’.

    “…Private equity could well go into 2007 rewriting the record books yet again for buy-outs. That would be great news for Wall Street which would keep growing fat on the associated fees. (The banks would even scrape a living if the boom did turn to bust and they had to be paid to sort out the resulting mess).”

    When I sell my Picasso – hopefully before I put my elbow through it and – a huge percentage goes off the top to the auction house which has a whole lot with (re)establishing its (current) market value. Without Sotheby – how much is it worth? And how much am I paying in storage and insurance in the interim, just in case the guard dog eats it? How much of this cost is reflected in the value of the asset and how much interest or capacity do the insurers have in making sure the asset’s worth can be sufficiently preserved to generate income for themselves?

    Which also raises the question of just what exactly is a reliable store of value.

    One consequence of globalization is that mass contagion has become too expensive and perhaps has been replaced by controlled series of strategic collapses, organizational restructurings and wealth re-allocations – naming and blaming fall guys, capping and removing power from various undesirable elements in the system, buying off others charged with keeping it working, all while continuing to maintain and concentrate control.

    So perhaps as moldbug suggests (?) Without a cataclysmic ‘natural’ disaster or the uncoordinated detonation of a nuclear devise – no huge macro disaster. The only sure thing to a series of more expedient innovations, ever more strategic corrections and the continued concentration, and control, of global wealth.

    “The richest 1% of adults in the world own 40% of the planet’s wealth, according to the largest study yet of wealth distribution. The report also finds that those in financial services and the internet sectors predominate among the super rich. Europe, the US and some Asia Pacific nations account for most of the extremely wealthy. More than a third live in the US. Japan accounts for 27% of the total, the UK for 6% and France for 5%… The global study – from the World Institute for Development Economics Research of the United Nations – is the first to chart wealth distribution in every country as opposed to just income, for which more comprehensive date is available. It included all the most significant components of household wealth, including financial assets and debts, land, buildings and other tangible property. Together these total $125 trillion globally…”,,1965033,00.html

  • Posted by Cassandra


    Thank you for taking the time to both contemplate and articulate, in great detail, your concerns, their interactions, and feedback loops glossed over by Mr Geithner in his Risk Speech. With the sun now down on a wintery New Years’ eve, bubbly chilling, I will defer until tomorrow to show it proper respect.

    However lest I forget, ruminate upon this: Leverage providers like Prime Brokers are inherently “Short Puts” on the positions of the best and brightest, lets say 25 to 30% away from the current market. Many of these, you would want to own after they blow through 30% of equity. Like JPMorgans “acquisition” of Amaranths gas positions. Were they sweating bullets when they wrote the check and assumed ownership, violating all small print in their agreements? Probably not because they (or some other customers of their were probably the ones pushing the positions to what was essentially a knock-out. With THAT information, a dealer removes much of the uncertainty.

    Yes some strategies are inherently levered more, but so are their real probable volatilities (not recent historical vol) lower. They are, in a sense reinsuring the position, with more or less full transparency. I think the lines and leverage provided in all cases I’ve every seen is prudent, and well-thought out. Do they make errors occasionally? Sure, but probably not systematically. Is everyone as smart as risk managers in Bear, Morgan, Goldman, Lehman, DB, UBS etc.? Maybe some standards slip occasionally to win biz, but on the whole I would not worry here.

    The risk is that they already have some the same positions on their own books in size, with even greater leverage. The IBs have amassed enormous equity, which is not subject to call, have a privileged position in the market with respect to transparency, and so provide yet further cushions of equity and risk-capital, in adddition to much discipline about returns on equity, given their inferior credit. I would be more worried by the banks, their exposures, in addition to the mere fact that they have been the source of historical trouble, NOT the IBs. THEY are the aggregators, and it is they who will be the ones reaching for the yield, or shouldering risk with less than open eyes.

    The hedgies and their investors will get the raw end as dealers will turn-around and sell double everytime their bid is hit, when the tide turns. Hedgies despite their prowess, and capital cannot best the dealers for the dealers see most and irrespective of hallowed Chinese walls one would be naive if one didn’t believe for a second that the info is not shared covertly if not overtly through numerous back channels. This provides the market with enormous cushion for positions to move from disaggregated weak holders to concentrated stronger holders (the Put) at attractive prices whether by force of the market, or by coordinated intervention a la LTCM. More tomorrow, must don a silly party now…

    Happy New Year!

  • Posted by moldbug

    [Doh! I posted this earlier but it seems to have disappeared, and I didn’t save a copy. Tricky, these computer things. Perhaps it will be shorter this time.]

    Steve, you ask what, given that the CBs can always save the system and keep spreads Mossy by injecting more liquidity, might invoke Stein’s Law on this system.

    My answer is that, if the BWII CBs have the ammo to defeat a significant influx of First World private savings into allocated precious metals, it is not obvious to me. And if present trends continue such an influx strikes me as inevitable.

    I say “allocated” because this is an important distinction of which many casual observers of the PM markets seem unaware. The prices you see quoted for “gold” and “silver” are not really the prices of those metals. They are the prices of claims to those metals.

    To be specific, they are either New York futures prices or LBMA fixing prices. Futures prices are, of course, prices of futures, which are the commodity equivalent of a term deposit. LBMA fixing prices are prices of what is called “unallocated” metal, which is the commodity equivalent of a demand deposit.

    Both, however, are liabilities of their sellers, which are typically bullion banks. And in both cases, the general practice is to have more claims outstanding than metal to back them. This ratio is not public, but it is certainly not 1:1. Thus “fractional” might be a better word than “unallocated.”

    An influx of savings into these claims, as with commodity futures in general, does not tend to increase their price. Of course there will be some volatility, but in general, it will just result in a new supply of claims to soak up the demand.

    At least if they are rational actors, the sellers of these claims control the number of claims outstanding not by any fixed ratio of claims to metal, but by whether the price of a claim at current levels of supply and demand tends to cause an increase or a decrease in their stocks. If stockpiles are expanding, the price is too high, and more claims should be sold. If they are shrinking, the price is too low, and the number of claims outstanding needs to contract.

    Clearly, since savers – whether they are hedgefunds or mom & pop – are only interested in “exposure” to the price of the commodity, and have no need to actually take possession, their claims are unlikely to be redeemed. They are therefore unlikely to affect stockpiles. And the sellers can simply sell these buyers new claims, rather than forcing them to bid up the price of existing claims.

    This mechanism is entirely circumvented when savers buy allocated metals, in which a defined quantity of metal actually becomes their legal property, or the property of some other entity in which they own a share.

    Clearly, since a claim to X can be worth at most X, and may be worth less – if for example some actor owns Y amount of metal, but has sold 2Y claims to it – there is a rational economic reason for buying metal rather than claims to metal. And when savers buy metal proper, stockpiles diminish, and the price of both claims and metal must rise. Obviously, selling more claims cannot counteract the effect of new demand for metal. In extremis the claims will simply default.

    In the last couple of years a new set of instruments, the precious metals ETFs, have enabled savers to do just this. An PM ETF is like a modern recreation of the Bank of Amsterdam. It makes a market in which “baskets” of ETF shares can be exchanged freely for physical metal. ETF metal holdings are public – you can download the list of actual bars.

    Given that ETF shares are allocated and futures, LBMA metal, etc, are fractional, you would expect a flow of metal from the latter into the former. And in fact this has happened. ETF holdings have principally moved in one direction: up.

    The important point is that, unlike savings flow into unallocated instruments or other commodity futures, savings flow into the ETFs is a feedback loop. It tends to drive up the price of metal, which in turn attracts more savings.

    If you think about it, this is very similar to the process which originally resulted in these commodities being used as money. There was a demand for media of exchange, and the size of that demand was dominated by demand for long-term media of exchange – ie, savings. Some goods, such as oxen, were expensive to store and/or deteriorated over time. Some goods, such as axes, were not scarce, and an increase in reservation demand could not result in a sustainable increase in their price. That left the rare decorative metals, whose cost of production reached a point of diminishing returns as the quantity extracted increased. These metals developed an exchange rate relative to other goods that was far out of proportion to their actual utility, as they absorbed the savings demand of the entire economy.

    If you replace “oxen” with “dollars” and “axes” with “equities” or “real estate,” you have, I think, a fair simulacrum of this process in the modern financial market.

    Clearly, with the exchange rate between fiat and natural currencies deteriorating at 20% per annum, we are already not too far from this sort of event. What tools do the CBs have to prevent it?

    One, they have stockpiles of gold which can be sold into the market. As Alan Greenspan once pointed out, they actually prefer to lease this gold (ie, exchange it for claims to gold) rather than selling it, either because gold leasing earns them a whopping 0.1% annual return on this “investment,” or because leased gold, despite having been sold to India and turned into earrings, still appears as monetary gold on their books.

    So it is unclear how much gold remains. However, the recent price history of the market does not suggest to me that this mechanism is in perfect working order.

    Second, the CBs can increase the demand for their currency by creating less of it. In extremis, if they could permanently jettison and credibly disown their presses, demand for an alternative commodity of saving would vanish, and precious metals would not be so precious anymore. But this is deflation, and it brings us back to the CPDO discussion.

    Third, the CBs can show us what’s inside the velvet glove. Uncle Sam certainly has the legal power to confiscate, freeze, or control the price of any asset. However, this step would also imply the de facto end of globalization, and it might be at least as destructive to public prosperity as anything deflation has to offer.

    So when you ask what might prompt the “flag day,” I think it would involve an involuntary choice on the part of CBs between monetary chaos, uncontrolled deflation, and a formal termination of BWII and return to a metallic standard, probably a full-reserve standard.

    I think this is an easy decision to make. It strikes me that there are very few real defenders of 20th-century paper economics left. That is to say, I think there are few economists who, if sent to an alien planet which used a natural currency, would recommend its replacement with a fiat currency – given the sum of our historical experience here on Earth with this innovation.

    Certainly, if you look at the original political rhetoric associated with the creation of central banking, it does not seem very credible. Or at least not credible enough for anyone to repeat these days. Cries for cheap money, for instance, are few.

    What is left is the enormous difficulty and disruption that is inevitable in any effort to return to the old system. It is certainly a sufficient political cost to make the transition inconceivable simply as an opportunistic measure. But if it happens as a matter of necessity, as I suggest it will, this resistance is eliminated.

  • Posted by bsetser

    cassandra — thx for your (initial) response. I won’t be up early tomorrow either (party hats and so on), so no need to rush on the rest of the response either!

  • Posted by moldbug

    And I forgot to mention – a happy new year to all!

  • Posted by RebelEconomist

    I have recently come across this blog, and look forward to following it in the year to come.

    A couple of thoughts:

    I blame agent fund managers for the rise of spread product as much as any other financial institution. I don’t claim to understand CPDOs fully, but they seem to be a device for credit rating arbitrage. Essentially, they involve exposure to rating risk through a CDO index, but because the index gets rebased if a credit is downgraded too far, the risk of suffering an actual default is remote. In fact, CPDOs shift risk from the tail of the distribution slightly towards the centre. Presumably rating agencies give CPDOs a very high credit rating because their primary concern is with default risk. Perhaps the rating agencies share some blame for a formulaic approach to credit risk (although they might face legal challenges if they did otherwise), and maybe the investment banks are guilty of cynicism in inventing and constructing such cynical devices to exploit institutional microstructure, and but in the end, CPDOs only exist because there are end-buyers for them. No doubt a large proportion of these are agent fund managers who either do not properly understand the risks, or do, but realise that their downside risk is limited to the loss of fees, which will keep flowing if they keep ahead of the index in the meantime.

    I doubt that the macrofinancial bubble can end without the feckless and reckless being significantly hurt. A “flag day” solution would simply confirm the wisdom of their approach, and mitigate the fear that stops them and others repeating the cycle. This is the lesson of 1987, the thrifts crisis, LTCM, 9/11 etc. The new credibility problem for central banks is how to convince the financial markets that the safety net is not placed far above the ground.

    Happy New Year!

  • Posted by moldbug

    RE: a “flag day” isn’t a flag day unless it puts all the abuses in the past.

    This is the attraction of migrating to a financial system based on allocated metal. It is physically impossible to gank. There is no “punch bowl” at all.

    Otherwise, it is just more inflation, and the feckless and reckless win again – as you point out.

  • Posted by Guest

    Memories of Marc Rich and ‘Metal Men’.

    “…Money does not equate with wealth, a broader term, which includes human creativity, intellectual and social capital and ecological assets. Outside the box of conventional economics lie a wealth of creative strategies based on barter, reciprocity, mutual aid, sharing and cooperation. This hidden parallel economy is estimated at $16 trillion annually…”

  • Posted by Cassandra

    Rebel said:
    “I blame agent fund managers for the rise of spread product as much as any other financial institution.”

    The first thing Berkshire/Buffet did when they bought GenRe was to dismantle their large Swaps book, something that took onwards of five years. His view was that the interests of the “agent” – whether viewed narrowly as the traders or non-owner mgmt themselves – was different from that of the principal. He can wholly understand why a swaps trader or their mgmt would gear up the balance sheet as much as the rating agencies and regulators would deem possible, screw the tail event. As principal, one must ask: is “50bps” worth the web of default risk in the tail event?”. He categorically said “not to me”. He expressed his credit preferences by buying higher yielding paper backed by substantial assets at attractive spreads. I call the different between “Getting Rich” and “Staying Rich”. If one is trying to get rich, the rational actor will try and “shoot the moon”…

    What I cannot decide at present is whether the increasingly frenzied pace of turning levered cash to assets a sign of “competition” whereby many have now-figured the game and how to play it, OR whether it reflects a belief by those that can, that the game is imminently close to ending and they are merely trying to convert as much paper as possible – irrespective of cap rates – before it ends.

  • Posted by Joseph Wang

    moldbug: What you are saying doesn’t make sense.

    I bet you two dollars that horse A will win the Kentucky Derby. How does the government enter into this at all? How does that bet expand the money supply? If I lose all my money because I bet on horses, then it’s my problem.

    It may be that what I’m betting on has a probability that is unknowable. So what?

    And it is far from clear that CPDO’s are underpriced. They could be wildly overpriced.

    The other problem is that I think you are missing the point of von Mises and the economic calculation problem. Central planning doesn’t work because the reality is too complicated. This is why markets work because markets create the ability to evolve far more complex structures than can be manufactured by central planning. So when you rely on the market to move risk around, the result is that you end up with extremely complex structured products.

    The big problem in quantitative finance is model risk, the possibility that you have completely misunderstood the situation.

    But that’s not a problem just with quantitative finance. Suppose von Mises and Austrian economics is totally wrong about the nature of booms and busts (and in this case I think they are since I’m a monetarist on this issue). What then?

    It’s not what you don’t know that will get you, it’s what you think you know that isn’t……

  • Posted by Joseph Wang

    One other thing *nominal derivative values are meaningless*.

    If I bet $1 that the price of gold will rise to $500, the important number the $1 not the $500. The trouble with estimates on the volume of derivative transactions is that they add up the $500 and give eye-popping numbers that are totally meaningless.

  • Posted by bsetser

    JW — fair point, but the notional outstanding has gotten so big that the real exposure isn’t small either.

    Cassandra — could you spell your last subtought out in just a bit more detail …

    “that the game is imminently close to ending and they are merely trying to convert as much paper as possible – irrespective of cap rates – before it ends”

    “irrespective of cap rates” sort of lost me (embarrassing but true) … and presume convert as much paper as possible turing as much leveraged cash into paper assets as is possible .. but want to be sure. am only about 1/2 following your thinking …

  • Posted by moldbug

    JW: the problem is that the state, by implicitly insuring your bet, overvalues it. If the bet is securitized as a tradable instrument, you have credit expansion.

    Let’s adopt the horseracing example. It is very straightforward and telling. Let’s say there is a race in which there are 10 horses. The payoff for the race is $1000 – the winner gets this. The losers get squat.

    If the horse’s payoff is traded as a security, and its chance of winning is assumed to be equal to be all the others, this security will trade at $100. If the market believes the horses are not equal, its value may fluctuate.

    However, in a market economy, it is very easy to show that if you put all these shares together, their value should be exactly $1000. If this is not true, something very strange is going on.

    A loan, or a CPDO for that matter, is no different than a bet on a horse. It is a proposition that pays off in one future scenario and doesn’t in another.

    What we have in the current financial system is a situation where the total value of all liabilities due at any date D greatly exceeds the number of dollars in the world. This cannot happen unless the bets are implicitly insured by the promise of new dollars. Thus, if there was no printing, the liabilities would be overvalued by definition.

    As for derivatives, the interesting question is not the face value of the derivative, but its present market price. Or, in the aggregate, the net market capitalization of all derivatives.

    For example, if you sell an out-of-the-money option today on gold at $1000, today, that option may be worth very little. If gold gets up to $1200, suddenly it is worth a lot more. If there are a lot of these options floating around, you have an increase in the net market capitalization of derivatives. Either this is balanced by someone else’s loss – as in theory it should be – or it is inflationary.

  • Posted by Joseph Wang

    > However, in a market economy, it is very easy to
    > show that if you put all these shares together,
    > their value should be exactly $1000. If this is not
    > true, something very strange is going on.

    You will have big problems if their value doesn’t end up to be exactly $1000. The trouble is that in a market economy, there is no way that the betters have any idea that their bets have to add up to be $1 or $1,000,000 since they individually have no idea what the total payout of the race is.

    Suppose the payout is $2000? Suppose the payout is $0.5? Suppose no one has any clue what the payout is? Nothing changes in the interaction between the bettors. One way of dealing with this is to have the bettors come up with the bets. Add all the numbers together, and then match it with the payout. That’s what a central bank does.

    One of the essential parts of Austrian economics is that money has no intrinsic value and preferences are subjective.

    > What we have in the current financial system is a
    > situation where the total value of all
    > liabilities due at any date D greatly exceeds the
    > number of dollars in the world.

    1) In a derivative transaction, on date X, A gains $X and B loses $X. The net change on the money supply is zero.

    2) What matters is that on date D, the net outstanding dollars equals the amount of wealth available.

    > For example, if you sell an out-of-the-money
    > option today on gold at $1000, today, that option > may be worth very little. If gold gets up to
    > $1200, suddenly it is worth a lot more.

    So your net value decreases, and the value of the person that you sold it to, increases. Nothing wrong there.

    What *will* cause you problems is that if you issue options, and your stated net value *doesn’t* decrease. If a company issues options then it’s net value ***has*** decreased. If it is able to hide that fact, then it is printing unbacked money, and there will be hell to pay, which is what happened in 2001.

    > If there are a lot of these options floating
    > around, you have an increase in the net market
    > capitalization of derivatives. Either this is
    > balanced by someone else’s loss – as in theory it
    > should be – or it is inflationary

    When a bank issues an option, it has to record this as a liability (which it is), and make sure that it can fund the liability.

    What causes a huge amount of problem was when companies could issue options without recording them as liabilities, which basically caused the tech boom and subsequent crash. This is also the basic cause of real estate booms and busts.

  • Posted by moldbug

    > Suppose the payout is $2000? Suppose the payout is $0.5? Suppose
    > no one has any clue what the payout is?

    But there are many cases in which at least the maximum payout is precisely known. A checking deposit liability, for example. It pays the deposit sum, in case the bank is solvent on the date the deposit is redeemed. Otherwise, it pays squat – or as much as the liquidation firesale can wrangle up. Which must be less than the amount of the liability, or the bank would not be insolvent.

    > Nothing changes in the
    > interaction between the bettors. One way of dealing with this is to
    > have the bettors come up with the bets. Add all the numbers together,
    > and then match it with the payout. That’s what a central bank does.

    I am really unable to match this metaphor with any concept I have of what a central bank does. Perhaps it’s my own fault. But maybe you could clarify.

    > One of the essential parts of Austrian economics is that money
    > has no intrinsic value and preferences are subjective.

    I am quite aware of this! However, another of the essential parts is that money is a commodity, and hence can be compared to itself, providing a handy basis for calculations – of the sort performed above.

    > In a derivative transaction, on date X, A gains $X and B loses $X.
    > The net change on the money supply is zero.

    Ah. Now we get to the meat of it.

    Every contract for a future transaction is a “derivative” in a sense. No transaction can create money directly. Similarly, when a loan of sum X is paid off, the payer loses X and the payee gains X.

    But what you’re missing is the value of the outstanding contracts. If (and only if) they are backed by the power of the press, their value can exceed the underlying quantity of money. A fractional-reserve bank is a textbook case of an entity which issues more current claims to money than it has money.

    Surely you’re not arguing that fractional-reserve banks do not create money. This is not a subject of dispute between Austrians and mainstream economists.

    What I am pointing out is that the process by which central banks insure fractional-reserve banks, by promising to print money in the case of a bank run, is a general mechanism that has many other analogues in today’s financial system, some of which involve derivatives.

    Suppose A issues a liability to B. Suppose they both use the same model to mark the value of the instrument to market – a model which is trivial in the case of a checking account liability, but not in the case of a derivative. Suppose the value is X.

    A must carry the instrument as a liability at X. But B should not carry it as an asset at X. It should carry it as X * (1 – Ra), where Ra is the risk that A will default.

    When you assume that Ra is 0, you transfer counterparty risk to the central bank. The same is true if you assume that Ra is the chance that A will have a falling out with the central bank, rather than the chance that A will default irrespective of any intervention.

    Note that not even A can know this information. For example, is my bank – Wells Fargo – insolvent? If all the loans that WF owns were auctioned off, would it raise enough cash to meet WF’s current liabilities? It is hard to know.

    But, if all the other dollar banks in the US were doing this at the same time, the answer is easy. In other words – absent, again, the power of the press – if we look at all banks as a single bank, the Bank of Bank, this bank is insolvent. Without a doubt. There are not enough dollars in the world to redeem its current liabilities. It doesn’t matter what it can sell its loans, buildings, etc, for. The cash cannot be raised, because it doesn’t exist.

    If the power of the press were to lapse, the result would be an enormous run on the Bank of Bank as everyone rushed to get out first. Is this happening? I think not.

    So credit expansion is clearly a use of the central bank’s printing power, which increases the total value of current dollar equivalents. (The red notes, again.)

    If this power were to lapse, private actors would refuse to pay X for an asset that is only worth (X * (1 – Ra)). They would redeem these notes as soon as they came due, resulting in massive liquidation. It is possible that everyone would get their X back, but not very likely. Compare M0 to M1, say, sometime.

    Since the power has not lapsed and does not seem likely to, it is perfectly fine for B to value such an instrument at X, giving it no reason to redeem. For example, this is why there are no bank runs these days.

    The result is an enormous supply of bank liabilities which are as good as dollars. (In Mises’ term, “money substitutes.”) This is how credit expansion dilutes the money supply.

    And if we note that an in-the-money option and a note of current maturity are both money substitutes, in exactly the same way (an ITM option can be divided into money plus an OTM option) we see how synthetic instruments, like the CPDO, can perform the same feat.

    Granted, a CPDO’s insurance is more indirect. The CPDO is insured by the fact that credit spreads are insured – the Fed will inject liquidity if they widen, making the models revert to the mean. But the principle is the same. There is a paper asset at one end of the pipe and a printing press at the other, and if the printer disappeared the asset would evaporate almost instantaneously.

  • Posted by Guest


    What you need for your unsocialist calculation debate is a trip to London, NY or LA where the problem can be dis-solved by apply liberal quantities of that’ll “sochu” out. If that doesn’t clarify the waters, then they can be stirred by thinking generally about whose money is on the line.

  • Posted by Cassandra

    Guest – As obtuse as I can, on occasion be, I do not understand your comment.

    Brad asked ”
    regarding Cassandra — could you spell your last subtought out in just a bit more detail …

    “that the game is imminently close to ending and they are merely trying to convert as much paper as possible – irrespective of cap rates – before it ends”

    “irrespective of cap rates” sort of lost me (embarrassing but true) … and presume convert as much paper as possible turing as much leveraged cash into paper assets as is possible .. but want to be sure. am only about 1/2 following your thinking …

    I was using “Cap Rate” in the real estate sense in which it is the equivalent of the Net Earnings Yield of property or REIT based upon FFO or Net Opertating Income relative to the property’s or REITs market value. It is essentially the “earnings Yield” of the asset. Since I think in terms of all real assets, for equities this is Earnings yield or simply the inverse of the PE Ratio.

    So IF one believes increasing inflation without bond market or FX market accident (i.e. the status quo) is likely to continue, one should borrow as much as possible and lever to buy hard assets that appreciate in nominal terms. Any and all assets, which is what ADIA, Macquarie Infrastructure, Carlyle and the rest of the private equity LBO MBO MBI boys are doing. With the Petrodollars leaking to all manner of aggressive investment, competition is heating up, driving up prices, and thus driving the implied earnings yields down. This is the same expression as shrinking risk premia in credit markets. One is buying real estate at the same yield or lower than a bond because it is believed that capital values will increase by more than the negative carry – something that is likely if the status quo continues.

    My question was really pondering precisely how cynical the buyers actually are. Are they buying because they have to (i.e. “I’m in the business and have the cash so must use it to buy things irrespective of the relative value”, or “I know spreads are low, but since we expect inaction and more of the same, negative carry on assets is a small price to pay for hedging the principal risk…” or perhaps “I am an agent for someone who KNOWS if they DO NOTHING (hold USD bonds bills MBS), that they will ultimately experience large capital loss so buying something, ANYTHING, in whatever amounts I can manage at whatever “cap rates” or valuations I can, is better than twiddling thumbs or fiddling Nero-like.

    But what really intrigues me is that one year prior, the lion’s share of M&A were being done on share-for-share swaps, something that implies absolute prices are high, but relative values may still make compelling merger sense. Today, all these deals are being done not only for cash, but with borrowed funds. In a continuation of the status quo, everyone – the equity purchaser, mezzanine & junk financiers, does just fine. In a rotten stagflation, BOTH might hammered, though in a cleansing recession, the debt-holders will probably come away with their principal in-tact after workout.

  • Posted by Guest

    Hi everybody:
    I have been following this intellectual discussion on CPDO for the last few days; it’s really interesting. I have a very basic question about the mechanics of CPDO, I hope someone of you would be definately able to answer this. How the leverage(that is to be utilized)or conversly the target portfolio size is actually calculated for a ‘typical’ CPDO. I understand that the levarage is a function of the difference between the NAV and the present value of the payments (coupon, principal, admin expenses), and that leverage will be decreased with increase in NAV and vice versa; but i dont really get how exactly the target portfolio size or leverage is calculated. Say if NAV is $100, PV of payments is $200 at the start and the CPDO starts with a leverage of 15x then if the after say 6 months the NAV increases to $120 then how much will be the leverage at that time (i know it involves a lot of assumptions but i just want to know the mechanics of leverage calculation)