but the first is a club they don’t want to belong to, a la Groucho, (and traders being what they are), and typically don’t last/stay long

Many chief risk officers are former traders who have been put in the penalty box.

Brad, what other sterling assets do you think central banks have been converting their sterling forex holdings into? UK gilts, or something else?

“Short-seller Jim Chanos predicted that many student loan companies will face serious legal issues in coming months… Chanos said investigators will uncover “many tens of billions of dollars in fraud” at loan companies. “We’re short broadly speaking all of them… The real fraud they will find is the herding of middle- and lower-income kids into all kinds of degree schools, and they come out with $40,000 to $50,000 in loans…” http://www.reuters.com/article/GlobalHedgeFundandPrivateEquity07/idUSN1122964920070412

Not that Chanos is above reproach: “…Fairfax Financial… has added James Chanos to the list of defendants in its private lawsuit against short-sellers…” http://www.controlledgreed.com/2007/06/fairfax-financi.html

On the other hand, risk managers work sane hours, and there is much less volatility in risk managers income (i.e. a risk manager is less likely to get fired if things go bad). Curiously this fits into people’s personalities. People who have gambler personalities tend to be traders, and people who aren’t tend to be risk managers.

So at the end of the day, what is the loss? Is it “some rich people lose their money” bad or “blood in the streets bad”? My guess is that it will be former.

Guest: the G.Dep. was caused by never-ending withdrawal of liquidity despite the fed’s best attempts

Actually, during great depression, the fed was making the problem worse by not adding liquidity.

Personally, I don’t think it will be that bad, because some people lost a huge amount of money, but some other people made a huge amount of money off the sub-prime mess. The nice thing about derivatives is that they allow you to make bets off other people’s stupidity, and I have reason to believe that some people on Wall Street saw the mess coming, took positions that would pay off when the mess happened, and are walking to the bank with lots of money. The net result of this is that I strongly suspect that derivatives are adding stability into the financial system rather than reducing it.

“Hi FM keep up the good work - its long-winded but I’ve practically written an essay for a recent grad-friend based on CDO’s, mortgages and leverage [as a response to his question below]

“OK, there are a few sources, types of leverage:

“1) Corporates take on huge loans (issuing bonds that take their ratings lower) to buy back shares, this is not exactly a useful use of cash because co.’s should borrow for ‘real’ investment, in this sense, corporates ‘leverage up’ to increase shareholder returns but its very short-sighted in my opinion. One of the reasons they do this is hedge funds buy into companies with low levels of debt, and then force the management board to borrow money and pay extra dividends, do buybacks etc. Companies with low levels of debt do this just to avoid an LBO.

“2) Similarly… Private Equity buyers make a bid on a company (LBO)… i.e. a co. with EBITDA of $500m per year, and they pay say 10x EBITDA, i.e. $5bn. Then they put in 20% of the funds themselves (e.g. $1bn). The investment banks make them a short-term “bridge” loan for the other 80% e.g. $4bn. The idea being that they then have 18m (the normal length of a bridge loan) to issue the junk bonds from the company itself once they own it, and repay the inv. bank loan…. now think about it’s crazy, you offer to buy a company but don’t have much money, so when you own the company, the company takes an enormous loan to pay for itself, its nuts! So investment grade companies, often AA rated become B rated ‘junk’ firms overnight. The problem from here is two-fold…

“a) highly levered firms, paying 6.25% on their junk bonds (e.g. $500m over $8bn) just survive, but if rates go up to 8.25%, that company now needs $660m to pay its interest, but is doesn’t earn enough so gets into financial troubles, so companies which had LBO’s two-three years ago and now need to reissue their bonds are screwed, and a few will go bust in H2 now because they cant replace/re-issue bonds; no-one will buy them because they realise they can’t repay the interest.

“b) Investment Banks are said to hold $300bn of bridging loans on their books, now in this turgid market they can’t issue the bonds on behalf of the firms and get rid of the debt, so they’re stuck with it. This is a really inefficient use of capital for Inv. Banks, whose business is based upon churning stuff over, & now JPM et al, is a loan company to ‘junk’ bond corporates, who can’t repay their debts, suddenly it looks on slightly more shaky ground.

“… It’s interesting because investment banks only do bridging loans to win investment banking advisory fees and capital markets business, “bridges” are practically a loss-leader. After the 1930’s depression the Glass-Steagal Act prohibited investment banks from doing loans precisely to stop this sh1t from happening (yep its happened before- after all, the G.Dep. was caused by never-ending withdrawal of liquidity despite the fed’s best attempts - I don’t think they had helicopters to drop money from then!?), and investment banks were forced to separate from their lending businesses (e.g. Morgan Stanley use to be part of JPM). It was only after lobbying from Citibank in 1999ish that the G.S. Act was repealed and cross-lending allowed, now look what’s happened!!!

“So really, leveraged debt is Private Equity firms buying corporations using borrowed money, which is ultimately borrowed from the firms themselves. In theory it can work well i.e. Philip green bought BHS for £200m when he was only worth £50m. But when stock market valuations are already at their peak price/cashflow ratios it’s hard to sell the company on for more money. One of the signs the bubble was at its peak, was Leveraged firms selling companies to other leveraged firms who put more leverage into it in order to buy it!

“3) CDO’s….for example, this is when 100 companies are put into a portfolio e.g. with an average yield of 5%, and the portfolio is ‘tranched’.

“Normally, if 1 firm went bust the investors collectively would lose 1%… But with this it’s different, instead one investor would take on the first tranche, they might earn 10%yield, but if a firm goes bust they lose the whole amount… often they take the first 3 defaults, therefore 1 bust and the high risk investors lose 33% of their investment! But they are at the bottom of the structure earning 10%. the others further up are safe, losing nothing but earning lower yields, so it’s OK for them right?

“So you can model using Monte Carlo, e.g. someone who is 10 defaults up the structure earning 4% yield, statistically they might be 2 std deviations away from experiencing the 11th default etc etc. So the very high-rated investors at AA etc, …towards the top of the structure should be really safe.

“But… Who takes the first-order high-risk part? The investment banks do, because they’re the ones with the PhD’s writing the models for the CDO’s. And they say they can hedge for the first few defaults (much in the way you’d use Black-Scholes hedge-ratio for equities). In a sense it’s also a loss-leader, because they take the high-risk part in order to sell-off the other ’safer’ parts.

“Now it gets more complicated, because what are the actual entities in the portfolio? Imagine they are mortgage bonds. Now a mortgage bond works the same way, it’s tranched. So the first defaults destroy the money of the B rated investors. The next defaults destroy the money of the BB investors and so on. Now, many CDO portfolios seemed vary safe to investors who only wanted to buy the AA rated tranche, filled with AA rated mortgage bonds!… but mortgage bonds are also structured the same way as CDO’s in effect…. Suddenly, if mortgage defaults are twice what we had modelled, then those std deviation bands used for the Monte Carlo were totally wrong. What people thought was a AA mortgage bond is really a BB mortgage bond. And what people thought was a AA CDO tranche was really B (because the CDO uses leverage). Leverage in CDO’s was seen as safe because there is(was) very little mark-to-market volatility in AAA mortgage bonds, so you could take on loads of borrowed leverage and never receive a margin call - this is how Bear Stearns fund’s were caught out last month-end. This means many more things!

“a) Defaults will be much higher (exponentially) than expected/modelled for in mortgages and CDO’s

“b) Some CDO’s were a mixture of AAA mortgages and BB leveraged corporate bonds, to achieve an ‘average’ of AA etc. So lending for corporates will dry-up as the CDO’s get downgraded - as many investors never directly bought B/BB bonds they were bought indirectly through CDOs hence the fact that leverage borrowing for LBO’s got bigger and went on longer than expected. Now if a mortgage bond default causes a CDO to be liquidated, the corporate bonds also have to be sold (or in our case the CDS insurance) sending spreads wider, bearing in mind standard leverage is 8-12x in a CDO.

“c) Banks have to withdraw lending. the reason is this, AA stuff requires 20% capital (i.e. cash to be put down (and the rest is borrowed from the repo market)), but if it is BB it requires 100% (I think! Not a Basle II expert). So most (I believe) CDO investors and banks will have to sell assets to raise the cash… so there will be a global withdrawal of liquidity.

“The trigger for all of this is the fact that the 2006 ‘vintage’ of mortgage bonds was very rubbish. Mortgage brokers never bothered to check if people had jobs, so some mortgages defaulted on the 1st payment!!!

“Even worse, there are CDO’s where the entities inside them are other CDO’s!

“…. So why are stocks up this morning!! ? I think that equities don’t realise what’s happening, it is a new and complex market. At month end all the CDO firms have to revalue their portfolios, so whopping downgrades often come at the end of the month, so expect more ’shock horror’ / ‘hedge fund blows up’ stories through the next 10 days. This is definitely worse than LTCM so I’ve been told by the oldies here.

“I just thank the lord we don’t have ‘06 vintage!”

cf. http://www.housingwire.com/2007/07/10/an-inside-view-managing-a-cdo-and-why-the-rating-agencies-matter/

Admittedly, it is a few years since I was involved in wholesale financial markets, but I would be surprised if human nature had been controlled that much better since. Perhaps the fact that traders and structurers generally get paid more than risk managers reveals where investment banks’ priority lies.

The quote from the Amazon reviews of FIASCO above is selective - there were many positive reviews too. Actually, I think the book’s marketing publicity is misleading - to me, the buy side seemed to be as guilty as the sell side. Unfortunately, the mutual fund market timing scandal emerged after the book was written. I do believe that the buy side has become more sophisticated in recent years, and I doubt that they buy products that they do not qualitatively understand, but a quantitative understanding good enough to know value is a different matter, as the unfolding CDO story evinces.

A symbiotic relationship is a mutually beneficial relationship between two different species - the classic case is ants and aphids. Since I cannot remember a reference to quote, I will say that “I have read that” the structurers of credit derivatives work with the rating agencies to do just enough to get their target rating. The rating agencies get highly paid for such specialised work. It is also alleged that, as a result of this contact, the smartest rating agency quants get poached by the investment banks. The buy side is likely to get a bad deal, but note the agency problem. If an investment satisfies the plan sponsor’s rules, and yields more than the alternatives, then many fund managers will buy it without looking too closely, especially if they get 20% of the upside and none of the downside.

‘gilles/2007-07-28 17:01:46′ - if you can provide your own definition of ’strong’ and name an economy that is ’stronger’ than the U.S.? Don’t leaders of all nations generally advocate their economy’s strengths? - unless, of course, they are seeking development aid:

“Some German politicians are urging the government to halt development aid worth millions of euros to China, saying the country’s surging economy and thriving exports no longer justify the generous handouts…” http://www.dw-world.de/dw/article/0,2144,2709222,00.html

“…Whether promising to overhaul China’s regulatory regime… will be enough to tame what some view as the Wild, Wild East of capitalism is unclear… because some of the problems are so deeply rooted… 20% of its consumer goods and 14% of the truck tires made here failed safety inspections…” http://www.nytimes.com/2007/07/29/world/asia/29safety.html?hp