Reverse engineering financial engineering
The process that turned subprime mortgages into triple AAA rated securities is, by now, pretty well known. Rich Bookstaber (his blog is here) describes the process nicely.
Here's the recipe for a CDO: you package a bunch of low-rated debt like subprime mortgages and then break the package into pieces, called tranches. Then, you pay to play. Some of the pieces are the first in line to get hit by any defaults, so they offer relatively high yields; others are last to get hit, with correspondingly lower yields. The alchemy begins when rating agencies such as Standard & Poor's and Fitch Ratings wave their magic wand over these top tranches and declare them to be a golden AAA rated. Top shelf. If you want to own AAA debt, CDOs have been about the only place to go; hardly any corporation can muster the credit worthiness to garner an AAA rating anymore. Here's where the potion gets its poison potential. Some individual parts of CDOs are about as base as bonds can be — some are not even investment grade. The assumption has been that even if the toxic waste bonds really stink, the quality tranches can keep the CDO above water. And life goes on.
The problem is that CDOs were untested; there was not much history to suggest CDOs would behave the same way as AAA corporate bonds.
Nouriel is characteristically more blunt. He concludes a recent post on the securitization of subprime lending by noting:
That “toxic waste” of unpriceable and uncertain junk and zombie corpses is now emerging in the most unlikely places in the financial markets.
One of those unlikely places is the money market. Perhaps not directly — but it sure seems like a lot of financial firms issued commercial paper to finance what look like mini-credit hedge funds. Blogger RIIP:
Banks, investment banks, hedge funds, and PE firms have been issuing commercial paper as funding for carry trades. They put in capital of $100, borrow $2,000 in CP, and invest the proceeds in higher yielding stuff: CDOs, MBS (including sub-prime) and other ABS. So, sports fans, this is why we are all rushing to call our Schwab brokers and blowing out our cash sweep accounts and other money market funds as though they were leveraged Egyptian equity funds. The (ex-)masters of the universe were using the commercial paper market – formerly a way for quaint old fashioned “companies” to get short term funding – as financing for leveraged carry trades. Now some of these conduits (also known as SIVs, structured investment vehicles) may be related to the bank’s operations (e.g., a bank makes mortgage loans and then sells them to the off-balance sheet conduit) but .. a lot of these vehicles … look suspiciously like off-balance sheet credit hedge funds.
Money market funds effectively financed highly leveraged financial structures that bought higher-yielding, but illiquid CDOs — and in come cases in commercial paper issued directly by a CDO.
Right now, though, no one wants to own this debt. Maturing commercial paper isn't consistently being rolled over. Various investment vehicles — most recently Sachsen's Ormond quay – have had to turn to their parent banks for funding and Sachsen's case, it in turn had to turn to a consortium of German banks for funding. Other funds are looking to raise cash as well.
The money market funds don't want to buy the paper of the conduits, and no increasingly investors don't want money market funds either. The result: Treasury bill yields have absolutely collapsed, and the 3m bill-3m libor spread has truely blown out in both the US and Europe. Bloomberg.
“I've never seen it like this before,'' said Jim Galluzzo, who began trading short-maturity Treasuries 20 years ago and now trades bills at RBS Greenwich Capital in Greenwich, Connecticut. “Bills right now are trading like dot-coms.''
“We had clients asking to be pulled out of money market funds and wanting to get into Treasuries,'' said Henley Smith, fixed-income manager in New York at Castleton Partners, which oversees about $150 million in bonds. “People are buying T-bills because you know exactly what's in it.'' (Emphasis added)
Call it the downside of complex financial engineering. That engineering took some risks off the banks balance sheet (literally in some cases), but it also means that no one quite knows where the subprime losses are. And there is a suspicion that some of those losses are hiding in funds that haven't offered adequate compensation for the risk.
A few months ago a lot of subprime debt could be packaged into a security that was worth more than the sum of its parts (with a bit of help from the credit rating agencies. And this process was widely lauded.
The IMF argued that the United States unique skill at creating innovative fixed income “product” was pulling in the capital needed to finance the US current account deficit.
The Fed argued that financial innovation allowed the banks to sell risks that they previously might have held on their balance sheet — though it is also worth noting that the banks themselves were big buyers of MBS as well. Risks were divided and then sold to those best able to manage them.
There were, of course, notes of caution from the Fed. Some warned that many new instruments had not been tested by a real downturn – and hinted that credit spreads might not be commensurate with the risks. But I think it Fed and certainly Greenspan generally applauded these shifts, even if — as the prescient Gillian Tett noted — this new financial technology helped make the markets more opaque.
But apparently the Fed's thinking is starting to shift.
Splicing and dicing turned a lot of illiquid loans into a lot of illiquid securities. Some CDOs now seem to be as illiquid as a portfolio of plain mortgages would have been in the pre-securitization days.
More importantly, the Fed now seems to think that the wide dispersion of subprime risk – and the fact that it is now embedded in a broad swath of “structures” – is one reason why the market is now so illiquid. Krishna Guha and Eoin Callan of the FT report:
They [policy makers] believe that markets are paralysed by lack of information as to the ultimate size and distribution of losses – which has contributed to a sudden drying up of liquidity in the three-month interbank and commercial paper markets.
The information problem has two components. First, investors do not know where the losses from subprime – which Ben Bernanke, the US Federal Reserve chairman, suggested last month could be up to $100bn – lie.
Second, they have lost confidence in their ability to value complex structured credit products that include some exposure to subprime bundled up with exposure to other underlying assets. …
In principle at least, investors can overcome the problem of not knowing where subprime losses lie by investing in a diversified pool of credits. A few of these investments may turn sour, but the portfolio as a whole should not.
However, the uncertainty over where losses lie may be compounded by what economists call information asymmetries and adverse selection. Banks or other entities sitting on large losses may seek funding even at unattractive rates in current market conditions. Those in better shape may hold back, hoping for better times.
If this is the case, it would be unwise to lend to even a broad range of institutions now coming to market.
In other words, no one wants to buy what others want to sell out of fear that those who are selling are selling for a good reason. The lemon problem in the used car market also seems to apply to the creation of the rocket scientsists. No one wants to pay for prime and get a bit of subprime …
While putting a lot of different loans together previously created something that could be sold for more than the sum of its parts, now that structure is likely worth less than the sum of its parts.
The Fed’s solution?
Take the cash flows from CDOS that contain a bit of subprime, which previously had been mixed together with a bunch of other cash flows in order to try to reduce the correlation between the various cash flows, and repackage them yet again – so all the subprime cash flows are once again bundled together.
"If investors do not know how to value a security, the classic “price discovery” process by which sellers and buyers settle on a new equilibrium price may not function. Markets – for instance for complex structured derivatives and some asset-backed securities – could remain closed for some time.
Ultimately the complexity problem too is solvable.
The financial institutions that created these products in the first place will break up the products into separate income streams investors can understand and can price: subprime, non-subprime mortgages, auto loans, and credit card receipts. " Emphasis added
If the income streams that were bundled together in an effort to reduce correlation and, as a result, created higher rated debt are broken apart, those who want to bet that subprime is trading at too big a discount would be able to do so – and those who don’t want to buy subprime wouldn’t run the risk of inadvertenly buying a structure that includes subprime debt. At least that seems to be the Fed's current thinking.
But I cannot but note the irony of trying to use a new round of financial engineering to reverse the outcome of the past round of financial engineering …
Maybe it would have been easier just to have sold a bunch of subprime mortgages packaged together as a (probably not terribly highly rated) security from the start. And if there wasn’t enough demand for subprime backed mortgage backed securities in their pure form, well, maybe a bit less credit would have been extended.
Do read last week's Guha and Callan piece.
It hints at a potentially important shift in how the Fed is thinking about financial engineering — as well as the Fed's thinking about how rate cuts would work. The Fed recognizes that rate cuts won't solve information problems. But they could help insulate the economy from the fallout from the financial sector's current difficulties …
it’s not so much the probability of default that ratings agencies got wrong as the _expected loss_ which is a lot higher in CDOs, whereas recoveries are much higher in ‘regular’ paper. they should have never used the same letter/# scheme for a completely different type of ’security’…
“no one wants to own this debt”
the new york fed does; and where the new york fed goes, distressed debt funds follow…
re: “I cannot but note the irony of trying to use a new round of financial engineering to reverse the outcome of the past round of financial engineering …”
per Ip: “Securitization, long common in conventional mortgages, had been supercharged in the early 1990s when the federal Resolution Trust Corp. took over S&Ls that held more than $400 billion of assets. Though some thought it would take the RTC a century to unload them, it took only a few years. The agency successfully securitized new classes of assets, such as delinquent home loans or commercial loans.” http://online.wsj.com/article/SB118643226865289581.html
First, we do have an idea of the total losses. Subprime was a $3 trillion market. Put in your guess for the total likely loss, and that gives you your number.
Second, we do have an idea of where the mines and corpses are. None of the places that have gone belly up are particularly unexpected.
I don’t think we are going to end up with a hard landing. What has happened so far is that a lot of circuit breakers got tripped. It makes a huge number of sparks, but the that keeps the damage from spreading.
So is this the reason coupled with the legacy of low s-term rates that the mortgage spreads did not rise till now?
Markets are supposed to be good at pricing risk, and it doesn’t look like they’re doing that particularly well; Twofish insists this is all part of the “normal” functioning of financial/credit markets, but guess what? Twofish gets paid to price risk (of opaque, illiquid instruments) — so what happens when those instruments go away? Do you sense a conflict of interest here?
There aren’t ant CDOs buying debt pools anymore because people — Twofish excepted — have no idea (like Bill Poole) what they’re worth. The “smartest guys in the room” would tell you, but that would reveal them as complete hucksters. They make it, but you don’t see them eating it.
“…The two largest monolines, MBIA and Ambac, both started out in the 1970s as insurers of municipal bonds. In recent years, much of their growth has come in structured products, such as asset-backed bonds and the now infamous [CDOs]. The total outstanding amount of paper insured by monolines reached $3.3 trillion last year. André Cappon of CBM Group… describes monolines as “rating agencies that put their money where their mouth is.” Arguably the keenest of credit-market observers, they extend their gold-plated credit ratings to paper they deem worthy of their protection, in return for a premium… Mr Ackman has spent the last five years, no less, telling anyone who will listen that the monolines are doomed, with MBIA particularly vulnerable. He points to their massive leverage: outstanding guarantees amount to 150 times capital. He also questions MBIA’s “aggressive” accounting techniques. Earlier this year the company paid $75m to settle allegations that it used reinsurance contracts to conceal losses… Monolines may be highly geared compared with traditional insurers. But… they are highly conservative in other ways… To wipe out the monolines’ capital cushion, it would take a loss twenty times bigger than the hit they took last year. Even in today’s febrile markets that is hard to imagine… The monolines may lose business as investors turn their back on CDOs and other structured products… the general confusion over credit risk may even help them, as more debt issuers seek comfort in guarantees…” http://www.economist.com/finance/displaystory.cfm?story_id=9552987
Calculated Risk wrote in April 28, 2007:
Ranieri on the MBS Market: It’s Broke
Our friend Brian sent me a Bloomberg transcript (no link yet) of comments made by Lewis Ranieri at the recent Milkin Institute Conference on financial innovation, subprime lending, and the housing market. Lewis Ranieri, if you don’t know, is generally given a large part of the credit for creating the private MBS market, and would have to be considered, by anyone’s standards, a highly-informed participant in the mortgage credit markets.
Ranieri trnascript is worth reading: http://calculatedrisk.blogspot.com/2007/04/ranieri-on-mbs-market-its-broke.html
CR conclusions:
“So let’s consider Ranieri’s question: is the system “broke”?
There is a credible estimate that as much as half of recent subprime production could have qualified for a GSE-style loan at a much lower interest rate. That means, among other things, that the “risk premium” these borrowers are paying is likely causing their defaults; if they weren’t subprime the day they got the loan, they are now. The theorists of “perfect” pricing of credit risk have some explaining to do. It is not unlikely that they will have the opportunity to explain that in court, as I for one can think of few more likely class actions than a group of borrowers who qualified for a prime or near-prime loan and got steered to some subprime exploding ARM.
Someone who is considered “the father of MBS” did not anticipate the difficulties of modifying securitized loans, given the constraints of the true-sale requirement (which means that the sponsor/servicer cannot “control” the collateral, and you’d have to get 400 bond holders in the Coliseum to vote on a loan modification). This is to say that a mortgage financing mechanism intended to mitigate risk is less able to respond quickly enough and efficiently enough to stave off losses than an unsecuritized portfolio or a simple agency pass-through.
Bondholders who may well understand that it is in their best interest to allow modifications of loans will discover what it will cost in legal and accounting fees to do that, costs that are there only because these loans are securitized; a similar restructure of a portfolio would not have those costs. Risk “dispersion” means never being able to get all your risk holders into the same room to hammer out a plan.
Some senior bondholder is going to sue some issuer for SFAS 140 violations (modifications, with or without a 1099) that were intended to cut the losses for the subordinate holders, but which would have the effect of maintaining some credit support for the senior notes, too. Besides the simple extraction of legal fees here, you have a situation in which losses will simply continue to mount while each tranche and the sponsor argue in court about whose interest is or is not being served. Meanwhile, borrowers get further behind.
There is always, of course, the option of foreclosing rather than working out, but bondholders are likely to get paid less for that, even if they don’t happen to care about the homeowner or the macro effects of that much foreclosed property. Securitization of loans did not, actually, eliminate the risks inherent in property markets; it seems to be capable, in fact, of magnifying those risks.
I’d go for “broke.”
So, it seem that reverse engineering will be mucch harder that just financial engineering.
Thanks
The holy grail would be reverse engineering the gunk out of the system. It wouldn’t even need to be all of it, but just primarily the ABS and CDOs backed by subprime mortgages put out in 2005 and 2006, since these are the ones that really saw the laxest lending standards and big delinquency increases.
But when Chinese manufacturers allow lead paint to get into the Buzz Lightyear action figure, you can put out a recall. How would that work in this case? So many people don’t even really know what they’ve got. CDO2’s mean alot of the subprime debt has been sliced and diced multiple times. Some is in plain-vanilla CDOs, some in commercial paper, some in inflation-indexed bond funds, etc. Can you recall it all? Better question, WHO can recall it?
And who gets left holding the subprime gunk you take out? Do you just see a universal haircut to these products equivalent to the subprime contingent and write it all off? Or would it just be easier to stop putting more in now and just wait for these things to mature.
Geez, we just about got rid of Brady bonds and now we’re gonna have to issue Paulson bonds. Oh, the horror.
2fish — no surprises? wow. i certainly wouldn’t have pegged KKR financial and a bunch of landesbank conduits as subprime victims a few weeks ago, but then again i had no clue about the ABCP paper a few weeks ago? where, would you guess, are the remaining problems (noting that the stock of subprime and perhaps some alt-a puts an upper limit on losses, but the scale of losses is still unknown)?
RiSK — brilliant comment. love the thought of Paulson bonds as the successor to Brady bonds. Your points on the difficulties of reverse engineering - and the concentration of problems in recent vintages — are both important.
In your opinion is it actually getting to the point to where one should move money from a brokerage money market account to an FDIC-insured savings account??? Thanks for your thoughts.
i try not give investment advice for a host of reasons, not the least of which is that i do not have the credentials to do so.
but if a fully insured savings account pays more than a “safe” money market account - i.e. one that just owns t-bills — i would assume that money would migrate to the banks. that is one reason why 3% probably isn’t a sustainable long-term price for t-bills with a 5.25% fed funds rate …
but then again most money market accounts didn’t buy or sell t-bills today. and if a money market fund bought a 3m t-bill rather than ABCP a month ago and sold it today and found someplace else to park the funds, the money market fund is sitting on a (small) capital gain.
Thanks, Brad. Insightful points. I guess it’s a question of what your money market invests in (and hope it’s not a lot of ABCP…)
Guest: Twofish insists this is all part of the “normal” functioning of financial/credit markets
That probably over simplifies my point of view. You can separate recent financial crises into two groups, things like the 1987 crash and LTCM, and things like the bursting of the dot-com bubble, the Asian flu. The former is dramatic and scary, but had very little impact on peoples daily lives. The latter did have a lot of impact on people’s daily lives.
The subprime mess looks like the former rather than the latter to me. These sorts of panics are “normal” in the sense that major earthquakes in California are “normal” or Gulf hurricanes are “normal.”
Guest: but guess what? Twofish gets paid to price risk (of opaque, illiquid instruments) — so what happens when those instruments go away?
I go into risk management. If finance all blows up, then I go into medical imaging, nanotechnology or whatever the job of the day is.
Guest: Do you sense a conflict of interest here?
If the doomsayers are right and the subprime mess is the start of a general collapse of the US economy, then nothing I say here will matter. Incidentally, that’s why my managers and the SEC will let me talk, because nothing I say about CDO’s will move the markets to any great degree, and because I don’t really have much more information than anyone else has.
There *is* a interesting quirk in that you can hand me a paper with twenty pages of equations about CDO pricing, and I can make some sense out of it. This means that I’m not running around panicking since I can see the parts move. Now maybe that makes me overconfident. Or maybe not. We shall see.
bsetser: where, would you guess, are the remaining problems (noting that the stock of subprime and perhaps some alt-a puts an upper limit on losses, but the scale of losses is still unknown)?
It’s a lot like reading a good mystery novel. It’s hard to guess ahead of time “whodunit” but once you get to the last page, it makes sense. I couldn’t have told you a few weeks ago everyone that would have gotten burned, but once the identities are revealed, they turn out not to be too shocking.
Right now, my belief is that the total losses from this mess are in the $200-$3000 billion range. As long as this is the case, then I’m not too worried. We can split up the losses, but it isn’t too enough to cause harm to the “real economy.”
What would have me worried is if that limits seems to be breached. The thing to note right now is that some not-so subprime mortgage firms have gone out of business, but there is no reason to believe right now that the underlying mortgages for these companies are bad.
My thoughts on this is that if things get bad enough so that brokerage money market accounts are no longer safe (and things aren’t nearly that bad), then you should really start questioning whether or not FDIC will hold up.
Speaking of commercial paper, Jeffrey Inmelt owes Bill Gross a lot of money. I remember that a few years ago Gross complained that GE was rolling over huge amounts of commercial paper to fund GE Capital, subjecting itself to high risk. Sure, back in the days of 1% rates that risk seemed almost null. As far as I can recall, GE was shaken by those comments and promised to change. But it does make me wonder how many others didn’t change their ways.
Twofish:
1. It’s not about subprime. It’s about adjustable rate mortgages. They will all default at rates thought to be statistically impossible.
2. It’s about the leverage on those mortgages via derivatives.
It’s much much bigger than 200-300 billion. Please refute. I don’t think you can.
Is reverse engineering of CDOs really possible? As I understand it the real problem with CDOs is that each security is tied to a specific set of mortgages that will over time reveal itself to have risk characteristics that may be very different from the general pool of mortgages. (Am I missing something here?) Like the classic case of selling a used car, each individual CDO is more or less likely to involve high costs. As soon as someone names a price for a particular class of CDOs, the sellers who will find the price attractive are those who are most concerned that one they own is worth less than that price. The sellers who have reason to believe that theirs is worth more than the price offered will hold on to it.
In short it seems to me that it is entirely possible that the reason that markets in CDOs have collapsed is that they were unstable to begin with. As soon as owners of CDOs began to get information about which of these securities were likely to be profitable and which were likely to be losers, the market became one in which economic theory tells us that there is no market clearing price.
Basically I’m wondering whether the process of securitization itself solves the adverse selection problem only the point of initial sale, not for subsequent trades especially when people know there is bad news out there somewhere — ergo an extremely illiquid market. On the other hand, maybe I just don’t know what I’m talking about. If you know why I’m wrong, please inform.
TWOFISH: The subprime mess looks like the former rather than the latter to me. These sorts of panics are “normal” in the sense that major earthquakes in California are “normal” or Gulf hurricanes are “normal.”
Saying it is normal makes it appear like an act of nature and therefore denies culpability on the part of Wall Street. Financial bubbles are no more “normal” than a gang war is “normal”. In both cases, anti-social behavior and profiteering on the part of the few puts the safety and well-being of the many at risk. In both cases, better government action and enforcement can help a great deal. But above all, a sense of responsibility and restraint on the part of market participants can make the problem go away to a great extent.
Can you explain what exactly is “normal” or justifiable about the obscene profits in the financial sector last year? In many ways money stolen then is what is causing problems now.
Information asymmetry is the oldest concept in banking.
Where did you get the idea that ‘reverse engineering’ is ‘the Fed’s solution’ or is part of ‘the Fed’s thinking’? What’s the source for that?
Brad:
Could you give us a list of all the CDO tranche rated AAA that have defaulted.
I am ready to bet you won’t even find one.
“…Somehow, the quants must model the “herding” effects when their peers pile into the same trades. They must build in the fact that their own actions will move the market - and may even be more likely to move parts of the market that are relatively inefficient in the first place…” http://www.ft.com/cms/s/0/22278cc4-4f7e-11dc-b485-0000779fd2ac.html
again it’s not so much the probability of default (altho they got that wrong too) but the _loss upon default_; ‘AAA’ is a misnomer, because the speed of the downgrades as tranches are burned thru can be breathtaking — instead of a linear progression from AA+ –> AA –> AA- they can go to AA+ to BBB in rapid succession — like the ‘mad scientist‘ analogy it’s not classical physics we’re dealing with but quantum mechanics (spooky action at a distance that no one quite knows how to interpret).
“Is reverse engineering of CDOs really possible?”
it’s hard(er), which is another difference…
“…[G7] industrialized nations have spent the last few weeks making sure their banks, unable to borrow from one another because of a bout of risk aversion, don’t run out of cash. The [PBoC], meanwhile, is still grappling with the opposite problem of reining in surplus cash…” http://www.bloomberg.com/apps/news?pid=20601039&sid=aO9FKy.kSoes&refer=home
“…Inflation has outstripped returns on bank savings. That has encouraged households to switch money to stock and property markets…” http://www.bloomberg.com/apps/news?pid=20601087&sid=ar8uC9E7ui_E&refer=home
“…These markets are still not fully fungible because foreigners can’t invest directly in the Chinese market and there is no mechanism for shorting stocks…, but these new rules are a big step towards that goal…” http://www.ft.com/cms/s/f724fcee-4f48-11dc-b485-0000779fd2ac.html
“…With the steep rise in the Shanghai stock market over the last two years, essentially identical shares in mainland companies now sell for considerably more in Shanghai than in Hong Kong, and some mainland Chinese investors may now choose to buy the less expensive shares in Hong Kong… If this produces a drop in the Shanghai market, the Hong Kong market could also fall because it has been dragged up by high valuations in Shanghai… The new policy comes as China struggles to prevent the value of its currency, the yuan, from rising…” http://www.nytimes.com/2007/08/21/business/worldbusiness/21yuan.html?ref=business
“…Today’s boom has its roots in China’s financial history. Even before 2004, the amount of money sloshing around China’s economy (and stored under beds) was massive relative to the scale of goods and services produced. By 2004 the ratio of M2, the broad indicator of money supply, to gross domestic product had reached 160 per cent, much higher than in most other economies. China had got to this point by stimulating its economy in slow times, by either massive bank lending or budgetary stimulus packages. In recent years, more liquidity has been imported via huge trade surpluses… plus foreign investment and “hot” money inflows… As China’s wealth globalises, the relative price of assets bought by private China is going to rise. Residential land in Hong Kong and Vancouver, farmland in Africa and natural resources in Asia will bear the first brunt of these outflows…” http://www.ft.com/cms/s/0/7c8e472a-4f7e-11dc-b485-0000779fd2ac.html
“In an August financial crisis, Masters of the Universe must use their BlackBerries from the beach. They are constantly in touch with the data, but out of physical contact with their colleagues. The contrast with 1929 is complete. Then, investors were in contact with each other, but not the data…” http://www.ft.com/cms/s/0/b1b3c164-4f7e-11dc-b485-0000779fd2ac.html
“Where did you get the idea that ‘reverse engineering’ is ‘the Fed’s solution’ or is part of ‘the Fed’s thinking’? What’s the source for that? ”
It is my interpretation of the reporting of Guha and Callan — Guha replaced Andrew Balls as the FT’s fed watcher. I could have it wrong — the article describes the fed’s thinking about the role information assymetries are playing in the current crisis.
as for actual defaults on AAA CDO, i am not the right person to ask. my sense is that the problem is that the risk of such a default has gone up, both b/c of a higher than expected default rate (which itself is still rising) on the underlying mortgages and b/c of a higher than expected correlation among the different MBS tranches that went into some CDOs, but don’t take my word on this — find a real expert (hint: the folks at Calculated risk in blogosphere).
certainly it seems (from reading the financial press) like triple AAA CDOs are kind of hard to trade, and thus would have to be dumped at a lower price than say MBS to raise cash if a financial firm cannot roll over its commercial paper. and that is a non-negligible risk right now.
“…Coventree’s offerings still carry top ratings from debt rating agencies. “You can be right as rain on your investments, but if everyone in the market is betting against you, you’re going to lose money…” http://www.globeinvestor.com/servlet/story/GAM.20070818.RCOVENTREE18/GIStory/
Brad:
No AAA CDO has defaulted, it takes a huge hit for those tranches to be impaired.Take a look at the waterfall structure in my post:
http://www.aleablog.com/2007/08/06/misleading-index-of-the-year-abxhe/
More than 20% loss has to be realized before the lowest AAA tranche is impaired, this counting reserve,overcollateral and excess spreads.No BBB- has defaulted either although they are obviously more at risk.
The issue is leverage, not the credit.You can lose your shirt obn treasuries at *40 leverage and that does mean the US is going to default.
” It is my interpretation of the reporting of Guha and Callan — Guha replaced Andrew Balls as the FT’s fed watcher. I could have it wrong — the article describes the fed’s thinking about the role information assymetries are playing in the current crisis.”
I read that article, which is where I was looking for the inference, which I didn’t find. As far as the Fed’s role in reverse engineering of financial system excesses - forget it. They may by sympathetic to the idea of vulture-like second-generation hedge funds that pick up and rescue the pieces from this debacle, but they won’t touch the problem directly with a 10-foot pole. They’ll use their own tools such as the discount rate and the funds rate. The closest the Fed will come to direct involvement and embracing the idea of ‘reverse engineering’ will be it’s regulatory input on future mortgage lending practices and any government involvement in rescuing existing mortgagors - but not as it applies to extracting bad assets from hedge funds or other reckless investors.
“…In the midst of a global credit squeeze, hedge funds have been cutting many of their bets on gas and oil… “Fundamentals suggest natural gas and oil prices should be moving just in the opposite direction that they are moving right now: oil should go up and natural gas down.” The price changes have also sent shock waves to a number of quantitative commodities hedge fund, whose mathematical models have failed to grasp the latest change in directions”…” http://www.ft.com/cms/s/0/7e133c3c-4f55-11dc-b485-0000779fd2ac.html
The line that caught my attention in the Guha/ callan piece was:
“The financial institutions that created these products in the first place will break up the products into separate income streams investors can understand and can price: subprime, non-subprime mortgages, auto loans, and credit card receipts.”
I also highlighted in the post. The title of the post was my own tho — my sense is that the fed now sees a reduction in the complexity of financial instruments as a potential way of overcoming some information problems.
but i certainly didn’t intend to imply that the Fed is about to do anything directly; i generally agree with your broad point. the fed is now intellectually sympathetic to unbundling, but that doesn’t mean that they intend to go out and do it. hence the the point that the “financial institutions” themselves would do the reverse engineering needed to create products that can be understood and priced by a broad range of folks (Brady bonds are a good example here. They weren’t the easiest to trade b/c of the guarantees, but they were a lot easier to trade than the original loans — and right now a lot of CDOs with subprime seem kind of like the original LDC loans. ok, that goes a bit too far, but you get my point, i think)
jck — true, leverage matters. see the on the run v. off the run bet, which really does not have any credit risk, but still can cause problems if you cannot wait the market out. But leverage times credit risk is where you often get the biggest problems — and I do think there is a “fundamental” reason why some CDO credit spreads have widened. And if spreads widen — even if risks are never realized and the instrument performs over time - and you have a lot of leverage, well, you can become a forced seller even with wider spreads (i.e. more compensation for the risks you are taking).
“…The short-term picture is cloudy and cannot be resolved without the passage of time and/or central bank action…” http://www.ft.com/cms/s/0/065de002-4f1e-11dc-b485-0000779fd2ac.html
“…rumours have floated through the markets that some banks will pull financing, or even agree to pay break fees to end takeovers, rather than having to advance loans at rates set before the credit crunch. But given that most of the deals pending have committed financing from banks, that risk is relatively remote because banks are unlikely to risk long-term damage to their reputations…” http://www.globeinvestor.com/servlet/story/GAM.20070821.RARBS21/GIStory/
This is the second time in recent history that ’sophisticated’ investors have blown their brains out by a “25 standard deviation” or “1 in 10,000 year” event. The last was LTCM. The problem is the complete intellectual failure of the risk management industry, which has become a bubble unto itself, staffed by fortresses of charlatan statisticians who don’t have the imagination to understand that ’standard deviation’ is itself a measure that is subject to considerable risk. This hasn’t been helped by the defined Knightian distinction between risk and uncertainty, nor the original Markowitz number crunching exercise using historical statistics. ‘Quant funds’ are only characterized by degree insofar as this is concerned - the same malaise contaminates the entire ‘value at risk’ industry. Of course, examining longer-term history would relieve some of statistical disease, but the real answer is more imagination, judgment, and common sense - over robotic quantification and extrapolation of recent history. Buffet comes to mind as an outlier, but I’m sure there are others - Michael Price once said that risk is not the same thing as volatility.
“…Risk aversion? There is no easy Mandarin translation…” http://www.ft.com/cms/s/0/7c8e472a-4f7e-11dc-b485-0000779fd2ac.html
Guest: It’s not about subprime. It’s about adjustable rate mortgages. They will all default at rates thought to be statistically impossible.
We’ll see about that. So far I don’t know of any reason why one should expect that to happen.
Guest: It’s about the leverage on those mortgages via derivatives.
True, but what has happened so far is that leverage via mortgages has caused hedge funds to blow up before doing more damage to the rest of the economy. That limits the size of the losses.
The problem with CDO’s weren’t that the models on default rates were inaccurate. A CDO was rated AAA, because the likelihood of that CDO defaulting in the lifetime of the loan was considered the same as a AAA corporation, and there is nothing thus far to suggest that those numbers were wrong.
The problem is that if you have a lot of defaults on the low tranches, the chance of a default in the high tranches increases, and then the AAA CDO suddenly gets its credit downgraded. If you have a basket of 100 names, you own defaults 70 to 100, and 0 to 20 have just defaulted, your chance of default increases, even if those defaults were expected.
This means that a AAA CDO has a much larger chance of losing a AAA rating than a AAA corporate bond. If you have a fund that is legally required to hold a certain level of securities, you then have to sell those securities quickly.
Guest: This is the second time in recent history that ’sophisticated’ investors have blown their brains out by a “25 standard deviation” or “1 in 10,000 year” event. The last was LTCM.
(Actually the dot-com fiasco and Enron were more recent examples.)
Most people in the industry understand this very well. It’s the people who don’t understand it that make the news.
Twofish on 2007-08-21 12:27:35
Dot-com and Enron had nothing to do with statistical risk modeling. Dot-com was a moronic new economy paradigm, and Enron was a fraud. Most of the people in the industry understand this about as well as they understand gamma, apparently.
Brad what do you think about this article
http://www.asahi.com/english/Herald-asahi/TKY200708130308.html
India and Japan have signed a fx sharing pact
Speaking of Enron, anyone know or care to guess what the sum total of these assets are worth today? “Principal Assets: At the time of bankruptcy, Enron owned all or interests in the following major assets” http://en.wikipedia.org/wiki/Enron
“In the meantime…. we’ll do the limbo” said traders.
“…Because of the defaults of Enron, Argentina, WorldCom and others, investors in the market have made large payouts on credit derivatives recently… The credit derivatives market has continued to grow. I can only conclude that the majority of investors must have understood the risks and been willing and able to bear them. What should financial policymakers do in response to the rapid growth in the credit derivatives market?…” http://www.federalreserve.gov/boardDocs/Speeches/2002/20021120/default.htm
“Its not even the number of deviations any more”, said one trader, “its that the deviations aren’t standard”
well, both india and japan have lots of reserves to share — not sure it means much. sharing reserves with philippines or indonesia would mean more ..
it does potentially give india a non-imf non-pboc lifeline if it should need one.
but i would need to look at the details to see if india really could draw on the money easily or if it is just for show — and the real negotiations only start once one party actually wants the $ (or yen).
“Or the conga!”, said another. “Lets all do the fat tail! Lets all do the fat tail! ….La! La! La! La!, La! La! La! La!
re: “Most people in the industry understand this very well…”
“…I recently spent some time with a senior executive in the structured product marketing group (Collateralized Debt Obligations, Collateralized Loan Obligations, Etc.) of one of the largest brokerage firms in the world… He told me that the “real money” (US insurance companies, pension funds, etc) accounts had stopped purchasing mezzanine tranches of US Subprime debt in late 2003 and that they needed a mechanism that could enable them to “mark up” these loans, package them opaquely, and EXPORT THE NEWLY PACKAGED RISK TO UNWITTING BUYERS IN ASIA AND CENTRAL EUROPE!!!! He told me with a straight face that these CDOs were the only way to get rid of the riskiest tranches of Subprime debt. Interestingly enough, these buyers (mainland Chinese Banks, the Chinese Government, Taiwanese banks, Korean banks, German banks, French banks, UK banks) possess the “excess” pools of liquidity around the globe…”
re: “More than 20% loss has to be realized before the lowest AAA tranche is impaired…”
“…If you plug in 15% depreciation in housing prices and 50% loss severities into our Subprime model, the capital structure is wiped out all the way to the “AA” tranches…” http://ftalphaville.ft.com/blog/2007/08/21/6727/the-full-subprime-letter-from-haymans-kyle-bass/
I hear the words and propaganda of so called Smart Money
The Smart Money created this mess and now the Smart Money wants to give advice. the stock market has a huge infrastructure that would like to invest there if at all possible. True, the stock market can go up even if the streets are burning. Nevertheless would that be enough to restart the consumer binge? That is what everybody is worried about: CONSUMER CONFIDENCE. Get your butt over to the mall and whip out your credit cards now that the FED cut the discount rate PRONTO.
Guest:
Bad math, I can show a 18 month pool with 43% loss severity and
cumulative net loss is 0.70%
here if you care to check:
http://www.cdcixis-na.com/abs/collateral/2005-HE4-072507.html
I can show a worst one with 79.64% loss severity
cumulative net loss is 2.05%
here it is:
http://www.cdcixis-na.com/abs/collateral/2003-HE1-072507.html
It is a very long way to 20% loss…
then how come no one’s buying it…
“…Its monetary policy may have been loose too long. The regulators may also have been asleep. But neither point is the heart of the matter. Assume that the US remains a huge net importer of capital. Assume, too, that US business sees no reason to invest more than its retained profits. Assume, finally, that the government pursues a modestly prudent fiscal policy. Then US households must spend more than their incomes. If they fail to do so, the economy will plunge into recession unless something else changes elsewhere… This is why the Fed is sure to cut interest rates if today’s crisis seems likely to reduce the supply of credit (as surely it will). Would that work or might the Fed find itself “pushing on a string”, as the Bank of Japan did so painfully in the 1990s and early 2000s? A good guess is that the policy would work. But if it did not, there would be only two ways out: a huge fiscal expansion in the US or a huge reduction in the US current account deficit. The former looks undesirable and the latter inconceivable… Today’s credit crisis, then, is far more than a symptom of a defective financial system. It is also a symptom of an unbalanced global economy. The world economy may no longer be able to depend on the willingness of US households to spend more than they earn. Who will take their place?” http://www.ft.com/cms/s/0/a3beaa64-5001-11dc-a6b0-0000779fd2ac.html
“…This view is particularly strong at the Financial Times, where its well regarded economics editor Martin Wolf…” http://www.nakedcapitalism.com/2007/08/on-what-fed-hath-wrought-so-far.html
An Indian businessman who is in the steel industry said India is pointing towards its domestic market of 2 billion plus people. China also has a population of billions of people. These population are enough to substitute the U.S. in theory at least. Even though there is no consumer like the American lavish consumer. India and China are trying focusing on greater internal domestic consumption. Would L.A. port and Wal Mart survive without China is another story?
Guest:
Yesterday, Thornburg sold $20bn of AAA…there are few real money buyers and a lot of levered players forced to get out.At price you can deal in anything, and the price with forced sellers has nothing to do with the underlying credit issue.
re: “Thornburg sold $20bn of AAA…” - but not AAA CDOs
“…Thornburg also said it plans to begin funding loans, including jumbo ARMS, within the next two weeks….” http://www.housingwire.com/2007/08/20/thornburg-sells-21-billion-of-mortgage-assets-at-a-loss/
Guest:
My point is that if you are a distressed seller, somebody out there will accommodate you, at a price.For a market that’s supposedly frozen $20bn looks like a big trade to me.You are it’s not AAA CDOs (didn’t say it was…) but same kind of “junk” by today’s new standard.
that’s the point; it’s a different kind of “junk” that the fed feels has to be decomposed (reverse engineered) to bring in distressed-debt buyers. while the models you and twofish use to value CDOs may be sound and blessed by the ratings agencies, no one believes them — obviously they are not trading… why is that? are they (markets/investors) just stupid and not as smart as you? are they running different models (operating on different assumptions)? do they/you have privileged (asymmetric) information?
lots of debt has been absorbed into CDO/CLO/ABS structures allowing banks not only to offload risk, but stay profitable in a flat yield curve (conundrum/savings glut) environment. but the securitisation machine, at least at the margin for structured products, has shut down removing at least some access to credit. compounding the problem was 2005/2006 vintage lending was done under some extremely lax underwriting standards as desire for what wilmot characterises as the ‘Missing Asset’ — high yielding, but relatively safe bonds of very long duration — was insatiable.
this was arguably at least the partial intent of the fed to reduce imprudent lending, but then what do you do with unconventional/exotic/imprudent/toxic loans/commitments that either exist in complex/opaque/illiquid structures or are warehoused/hidden somewhere on the B/S? you insist they are fine and someone — some well-capitalised and kindly soul — will eventually come in (at the right price) and take over what others do not understand. and that appears to be the working fed/treasury assumption at this point… isn’t that as it ever was?
i guess bringing it back to the larger point of this blog is whether the US — which has been very good at producing debt (its ‘comparative advantage’) — has reached some kind of limit or is its capacity to spin gold from straw infinite… and who ultimately decides that? it would appear, by accident or design, to be the US’ major creditors… do they want to keep on lending into the aforementioned situation? an economy that ’structures’ products rather than makes them? where the incentive is for someone like twofish to devote his time marking CDOs to market rather than working on “medical imaging, nanotechnology or whatever the job of the day is?”
so, to end, lemme posit a proposition, if not a solution: i’ll submit that there would be more high yielding, but relatively safe bonds of very long duration if more people spent their time and energy into real ‘engineering’ (tradeable goods) and institutions would incentivise and put more resources behind that effort instead of financial engineering ‘assets’ that are anything but.
Schwab closed their Treasury Money Market Fund to new investors yesterday. You can still get your funds out of their non-govi MMF. Whew!!
While listening all day to the rumors about Warren Buffett buying Countrywide, I couldn’t help but recall the large share of Moodys that St. Warren owns. This is the same Moodys that, along with S&P and Fitch, gave AAA ratings to the same toxic waste that brought Countrywide Financial stock prices down to a level that a risk averse take-over artist might find appealing. Is it ironic that a man like Buffett allowed a company, Moodys, in which he had a powerful controlling interest, to grossly over-rate CDO tranches that later would lead to the downfall of a company like Countrywide, a company that can now be acquired at a greatly discounted price? No way could it have been a calculated move. After all, ethical Warren can do no wrong. If you don’t believe that, ask the workers at See’s Candies.
re: “so, to end, lemme posit a proposition, if not a solution”
again - and the question is what the financial policymakers should do: “….The credit derivatives market has continued to grow. I can only conclude that the majority of investors must have understood the risks and been willing and able to bear them. What should financial policymakers do in response to the rapid growth in the credit derivatives market?…” http://www.federalreserve.gov/boardDocs/Speeches/2002/20021120/default.htm
and controlling shareholders of Fitch, McGraw-Hill and DBRS are?
“Sentinel Management Group’s decision to sell some of its choice assets to life-preserver Citadel Investment Group has brokers and investors seething. The Chicago Tribune reports that Citadel is paying some $500 million for what Jeffrey Barclay, an attorney for brokers, says is Sentinel’s “best portfolio” - and at a discount, 85-90 cents on the dollar. “Many brokers are angry because they will be receiving less than the full value of the securities that are being sold to Citadel.” That just adds to their ire that has been building since last week when Sentinel froze all withdrawals. The attorney says this means war, as brokers try to protect the interests of their clients, whose money via brokers is caught in the freeze and in the fire sale to Citadel. “There are lawyers all over Chicago drafting lawsuits as we speak,” Barclay told the Tribune. And elsewhere, too. San Jose, Calif.-based futures broker Farr-Financial is already one step ahead…” http://www.institutionalinvestor.com/Article.aspx?ArticleID=1403688&LS=EMS138226
“…Mr Lipsky said that the market crisis had three main components: first, a repricing of credit risk; second, a testing of the newer parts of the asset-backed securities market - in particular [CDOs] and [CLOs]…; third, increased fear of counterparty risk, caused by inadequate transparency on the part of banks… .while many market participants appeared to have lost confidence in their counterparties… the risk transfer mechanism through bilateral derivative contracts seemed to be working so far…. one big difference between the current episode and the financial crisis in 1998 was that, in 1998, the risk transfer mechanisms that came under strain had been designed to transfer interest-rate risk, whereas the mechanisms being tested now were designed to transfer credit risk. Mr Lipsky said it was not the IMF’s job to judge whether credit rating agencies had done their job well… “in the end, professional investors bear the ultimate responsibility for risk assessment and management in a securitised market…” http://www.ft.com/cms/s/58aa3200-503d-11dc-a6b0-0000779fd2ac.html
“…In the past Harvard has disclosed the gains of every asset group, but it is a sign of the growing competition in the market that it no longer gives out those numbers. Mr. El-Erian wrote that one of his goals was to emphasize risk management at a time where markets and investment strategies seem so interdependent that diversity may not always provide the protection in a downturn. For example… “when we entered the new fiscal year, we had hedges against the credit markets and the equity market. When the market sold off, we made money on the hedges…” http://www.nytimes.com/2007/08/21/business/21cnd-harvard.html?_r=1&ref=business&oref=slogin
Speaking of engineering….
No Capiche. Can someone help reconcile this apparent contraction in the low bid to cover rate with the dismal yield. The seemingly “overwhelming” WANT for T-bills yesterday is NOT CONSISTENT with the Treasury barely being able to get enough bids to carry out a 4 week T-bill auction today. The bills were sold at a high discount rate of 4.75 percent. The yields on one-month bills fell as low as 1.272 percent yesterday, and were trading at about 2.6 percent prior to the auction. In a sign of weak demand, the government received bids for the bills equal to 1.11 times the amount sold, the lowest since at least July 2001. The “low” bid-to-cover ratio on the Treasury’s 4 week T-bill auction is COMPLETELY inconsistent with what was observed in the open [inter-bank] market yesterday - with 4 week T-bills trading as low in yield as 1.25 % and 3 month T-bills rallying over 100 basis points at one point during the day. I also posted this question on N. Roubini as this doesn’t seem possible to me.
re: “the rumors about Warren Buffett” - I’ll spread one… he directed Moody’s to misrate paper to encourage excessive borrowing thereby engineering a crash, whereby only he’d be left to pick up the pieces.
re: ‘rumors about Buffett’ - what about Fitch et al?
“…”You had a situation where one rating agency was willing to assign a rating, and other agencies were saying, ‘Not a chance…’ …DBRS had one point of view, S&P and Moody’s had a very different point of view on issues such as liquidity.”…As competition in the non-bank ABCP market heated up, more risks were taken… “On the credit side, yes, we were comfortable with the ratings,…Although, as these things slide, those are subject to change.”…” http://www.globeinvestor.com/servlet/story/GAM.20070822.RDBRS22/GIStory/
and other very wealthy (not just ‘US”), presumably informed market participants: “in the end, professional investors bear the ultimate responsibility for risk assessment and management in a securitised market…”
“…”We are going to be in subprime, it is a valid business. There is nothing wrong with lending subprime…” …His views mirror those of Warren Buffett who recently said that the current market conditions, with falling company valuations and tighter credit, would make it easier to deploy a $50bn cash pile. Unlike Mr Buffett, Mr Ross is looking to expand outside the US, especially in Germany where some small and medium-sized companies might be in need of capital.” http://www.ft.com/cms/s/0/852bb9b6-5047-11dc-a6b0-0000779fd2ac.html
“…JP Morgan’s conservative estimate is that at least $100bn of the country’s $2,300bn in individual savings will leave China over the next year, with outflows increasing to $500bn within three years… “The timing of this to coincide with the global market turmoil of the last few weeks is probably no accident - Beijing wants domestic investors to capitalise on relatively cheap valuations,”…” http://www.ft.com/cms/s/0/0ef22c64-5013-11dc-a6b0-0000779fd2ac.html
re: “That “toxic waste” of unpriceable and uncertain junk and zombie corpses is now emerging in the most unlikely places in the financial markets.”
blunt adj., blunt·er, blunt·est. - “Slow to understand or perceive; dull.”
rhetorical, hysterical, obscure and therefore potentially misleading and unhelpful to those seeking meaningful insight - ‘intelligent thinking’ in your view?
Jeffrey Lacker’s speech yesterday -
http://www.richmondfed.org/news_and_speeches/presidents_speeches/index.cfm/id=102
As usual, the Fed is the exclusive source of reasoned articulation and adult supervision in a time of lemming market panic. The equity market has swallowed the discount rate pill with the glee of a child on a lollipop. There’s little change in the Fed’s outlook for the real economy as of yesterday. A fed funds rate cut is becoming increasingly ‘uncertain’ in the mind of ‘Mr. Market’, whose brain was destroyed by the volatility of perceived ‘certainty’ a long time ago.
I was trying to do some rough calculations. I wondered what the price tag would be if we all realized everybodies house was overvalued by $50K and it got up and disappeared like Galbrieth’s lap.
I multiplied 20 million by 50K and came up with 1e+12. Can anyone tell me what 1e+12 means??
interesting point on low bid to cover ratio — agree it seems at odds with monday’s story of massive demand for bills (tuesday was a different story, bills sold off a bit). any ideas what may be going on
the core of the bubble.
beautifully clear diagrams in time magazine show or nearly show how B junkfood investment slices get rated AAA.
we are coming close to the core of the bubble. if the time magazine reader knows that there is nothing there - there is nothing there. financial complexity requires time and study to understand, but recognition of an empty bubble is both simple and instantaneous. it is also tends to be self fulfilling.
so i am buying into nouriel roubini’s compelling imagery -
indeed, you don’t know who has been swimming naked until you meet zombie corpses floating in toxic waste.
“interesting point on low bid to cover ratio — agree it seems at odds with monday’s story of massive demand for bills (tuesday was a different story, bills sold off a bit). any ideas what may be going on ”
Don’t know. Who could be a source of demand, yet not considered a direct or indirect buyer?
Guest: while the models you and twofish use to value CDOs may be sound and blessed by the ratings agencies, no one believes them — obviously they are not trading…
Because you are in the middle of a classic bank run. People run for the exits, so everyone runs for the exits. Right now, I’m looking a little foolish because I’m standing here saying that there isn’t major to worry about while everyone else running past me.
The Time magazine article didn’t mention why junk gets rated as AAA. What happens is that you have lots of junk, that junk gets split into the really bad parts, but if you take out the really bad parts, then the rest of the stuff is not so bad.
I believe that the credit rating expresses the probability of default, with maybe some weighting for loss given default…..or am I mistaken? But risk is more than default, so you can make a risky security AAA.
Does anyone have a sense as to the amount or percentage of CDO/Synthetic CDO/ABS/RMBS/CMBS liquidations that are triggered by pre-default actions including: rating agency downgrades, delinquencies, mark-to-market levels, rate resets, covenant violations and/or minimum excess spread thresholds breached? My belief is that merely the prediction of default is enough to enable it to become self-fulfilling. Thanks.
enquire within…
http://jobs.kedrosky.com/job/7af8574128a220c5b25f574659a605ec/?d=1