Turning lemons into lemonade
Or perhaps – with a bit of reverse financial engineering – into “apples, pears, strawberries and all the rest.”
Martin Wolf is the latest observer to note that the US has created a lot of financial lemons that left a sour taste in the mouths of investors around the world. Lemons that have prompted policy makers around the world to seek a bit more say in how the US regulates its financial markets.
And lemons in the economic sense as well.
Buyers of used cars have to worry that the original owner is selling the car because the seller knows that the car has problems – and since the seller knows more about the car than the buyer, the risk that the seller is trying to pass on a lemon inhibits transactions. Buyers of used securities apparently have similar concerns about a lot of complex financial products. Martin Wolf writes:
What is driving this is “asymmetric information”: buyers believe sellers know more about the quality of what they are selling than they themselves do. This seems to be precisely what has now happened to trading in certain classes of security. The crisis is focused in markets in structured credits and associated derivatives. The cause seems to be rampant uncertainty. Investors have learnt from what happened to US subprime mortgages that these securities may be “weapons of financial mass destruction”, as Warren Buffett warned. With the suckers fled, the markets have frozen. The people who created this kind of stuff distrust both the instruments and their counterparties.
That distrust is one reason why the stock of outstanding money market instruments has shrunk by close to $250b — an amazing number — over the past three weeks.
I suspect – and I am certainly not an expert on this, only an interested observer – that a lot of this complexity is central to a certain part of the securitization process.
After all, the idea behind a CDO is that by combining a whole bunch of different – and hopefully uncorrelated – payment streams, you can create a new security that is less risky than the original securities. All the payments go into a common pot, and someone – the holder of the equity tranche – agrees to take all of the losses.
The holder of the equity tranche is betting that nothing much will default. If all goes well, they win big. They want correlated good performance. But their losses are also capped in the event of highly correlated poor performance. The equity tranche can only be wiped out once. If a lot of different payments streams going into the CDO go bad at once, some of the tranches protected by the equity tranche are at risk. Consequently, those holding the higher rated tranches are effectively betting that the payment streams are not correlated. Credit magazine — drawing on JP Morgan — explained it this way:
"JPMorgan explains default correlation trading as analogous to a cat walking blindfolded through a room filled with mousetraps. If the cat has only one life, he would prefer the traps to be located in clusters. The cat will lose his life whether he hits a single trap or a cluster. At least with the traps in clusters, there will be paths between them. The same is true of a lower-rated tranche of a CDO: the holder of such a tranche would prefer high correlation, or clustered traps.
If the cat is a more traditional cartoon cat, one with nine lives, he is happy for the traps to be scattered evenly round the room. He can afford to hit a few traps, but does not want to hit a large cluster which would wipe out all his nine lives. Likewise investors with senior tranches prefer low correlation."
Avoiding correlation means bringing different things together. Subject, of course, to the constraint that freshly minted CDOS will be composed, in aggregate, out of the debt that the economy is creating. If households are borrowing a lot, well, some CDOs likely will have a lot of household debt.
Back to lemons. The initial theory was that combining different payment streams together produced an ensemble that was worth more than its constituent parts (presumably because there was more demand for higher rated paper than lower rated paper, so creating a big set of highly rated tranches maximized value). But if investors lose faith in the technology that created the jumbled set of payment streams – and start to worry, for example, that even a combination of mortgages and leveraged corporate loans could prove to be correlated because of a broad decline in lending standards– well, you have a mess. Gillian Tett:
"all this complexity is coming back to bite us with a vengeance. For as policy makers scramble to shore up confidence in the money markets, they face two crucial challenges.
One is the fact that nobody quite knows exactly where the subprime losses truly lie, since these credits have been sliced into millions – if not billions – of securities and scattered between all these modern investment vehicles. Hence the Bank's baffling diagram.
But the second problem is that nobody knows the real value of these instruments either. For many have never been traded, but simply stuffed into these vehicles and left there, seemingly unnoticed – until now, when investors are panicking about potential losses."
Each CDO is in some sense unique, as it is composed of a unique set of payment streams. But many unique securities also seem to contain some exposure to subprime – or to the debt issued to finance the recent leveraged buy out boom – so many unique securities share exposure to a common set of risks.
Those who might be tempted to buy worry that they sellers are selling the true duds – the pools with the worst combination of underlying instruments. They don’t want to overbid for a security that could turn out not to work as well as expected. On the other side, those holding pools that they like are reluctant to sell what they still think is a good asset at the distressed price they can get in the market.
The result: Nothing moves. That is a particular problem for those who borrowed to buy these securities. They need to raise cash to assure their creditors that their creditors won’t be stuck with the lemons. And that either means taking a big loss on the potential lemon – and selling at below firesale prices – or selling other, higher-quality, securities.
Gillian Tett reports that parts of the official sector think the solution is to unpackage existing pools.
"More specifically, some policymakers now suspect that one key to rebuilding confidence would be to find ways of ripping apart some of these fiendishly complex structures, so that the constituent components can be clarified and traded again. Structured products, in other words, may need to be restructured into less . . . er . . . structured formats."
But Yves Smith has noted that unpackaging the payment streams of existing CDO likely will prove bloody difficult.
… [Y]ou have different holders with different economic interests in this entity. To unwind it, you have to pay them out, either in cash or collateral, or perhaps via paper in a new entity. To do that you have to make a determination as to what those classes are worth relative to each other. That means you have to value them, at least on a relative basis.
But the whole problem that we were trying to solve to begin with was that no one is certain to value this paper. But unwinding it presupposes some sort of valuation. [emphasis in original]
In all probability, prices need to fall a lot more – meaning more people need to be forced to sell at almost any price – before it becomes profitable to buy up the tranches of a bunch of different lemons (or all the tranches of a single lemon) and try to assembly the tranches of those lemons into something that is easier to understand, easier to value and thus easier to trade.
Taking apart what has already been joined together and creating a simpler, cleaner, more standard product sounds hard.
Not joining different payment streams together initially seems a lot easier. Rather than turning apples and pears into lemons, it probably is now easier just to take the apples and pears directly to market.
That raises another issue.
There may not be a lot of demand out there for certain “used securities” initially assembled out of what has turned out to be quite risky housing debt. But there also isn’t much demand out there for newly minted subprime debt that is fresh off the mortgage broker to investment banker MBS assembly line.
Two problems intersect. The first is the information asymmetries that now dominate the secondary market for complicated financial “products.” The second is that the US securitization assembly line was churning out of freshly made clunkers for much of the past two years – but that problem was masked (to really mix metaphors) by demand for clunkers from folks who thought they had figured out how to buy a lot of different clunkers, mix them together and somehow create a smooth (financial) ride …
Those billions of synthetic securities waiting on the sidelines can gather a whole lot of dust. As a matter of fact those underwriting firms should review the Due Diligence of these securities and uphold Rule 405 Customer Suitability. Certain BIG clients of BIG brokers have already forced those firms to absorb the losses of those securities or lose their business. That process should continue.
Sounds like they were making “smoothies” out of lemons!
More Lemonade spiked with grain alcohol to come
http://www.washingtontimes.com/apps/pbcs.dll/article?AID=/20070830/BUSINESS/108300076/1001&template=nextpage
Mortgage analysts say the bad news is far from over. Major dislocations continue in the credit markets that finance home loans, including a near freeze on purchases of commercial paper from mortgage companies that specialize in nonconventional loans — which has been the main reason such mortgages are so much harder to get.
“Headlines from financial markets will get uglier,” said Kornelius Purps, a fixed-income strategist at Unicredit Markets.
Yesterday, the credit markets were roiled by news that a major London hedge fund was selling assets to avert collapse because it can no longer access funding in the commercial paper market.
Cheyne Capital Management Ltd., whose Queen’s Walk mortgage bond fund reported losses in June, said that it has been selling investments and has enough cash to repay commercial paper due through November. Standard & Poor’s Corp. slashed the company’s debt rating Tuesday.
Companies that depend on commercial paper — corporate debt due in 270 days or less — are facing funding shortages because buyers, including most money market funds, have grown wary of further losses on mortgage-backed securities. The average yield on the highest-rated asset-backed commercial paper with one-day maturity — a typical debt offering by a mortgage company — has risen 73 basis points this month to 6.04 percent as investors exited the market and dived into safe-haven Treasury bills.
Further turmoil may lie ahead. The Times of London reported that Boston-based State Street Corp., one of the largest U.S. money managers, has major exposure to losses in the asset-backed commercial paper market.
re: “making smoothies out of lemons.” that is an absolutely brilliant metaphor.
Twofish,
In my personal opinion, the Clinton Administration was perhaps the most corrupt in US history. Please read my earlier comments relating to Clinton’s pardon of criminal fugitive Marc Rich. The amount of money we are talking about maybe trival in New York City, but the impact from the Hedge Fund currency speculators was completely destructive to the developing nation of 200 million Indonesian people. The ultimate foreign policy objective of the Clinton Administration wasn’t the deliberate impoverishment of the Indonesian people, but the restructing of Asian economies to the laizze-faire Neo-liberalism model. Robert Rubin could personally care less one way or another about the Indonesian people. The high growth economies of the Asian tigers were viewed by Clinton Administration policymakers as the primary strategic threat to US global economic hegemony. The Asian Economic Crisis represented a deliberate attempt to destroy the Asian developmental economic model, originated by Japan but emulated in slightly different versions across the Asian region. Of course, the strategy ultimately backfired with the Japanese refusal to cooperate with the Clinton Administration in any of their foreign policy objectives. At one point, the Japanese Finance Minister even threatened to dump US Treasury bonds in retaliation. At the Malaysian APEC summit, the normally very polite, Japanese Foreign Ministry blasted the Clinton Administration as incompetent and corrupt for its role in the Indonesian fiasco.
dc — your post on marc rich here is entirely off topic and a distraction to the discussion of credit market lemons and smoothies.
Brad,
The reason we have the $300 billion and counting “lemon” mortgage problem is due to the lack of proper financial regulation and oversight that started with the Clinton-Rubin Administration. The accounting conventions in this nation have devolved to the point where financial statements for financial institutions are worse than useless. Allowing this nonsense to pass for an honest assessment of reality has created the credit fiasco we’re in now. The accounting and bond rating issues that began with Enron and Worldcom have never been addressed.
Bloomberg News on Creative Accounting at Wells Fargo Bank
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aY8m0nta94GA
Aug. 22 (Bloomberg) — Last quarter Wells Fargo reported record net income of $2.28 billion, up 9 percent from a year earlier. Read the footnotes to its latest quarterly report, though, and you will see a new term in accounting lingo called “Level 3” gains. Without these, the financial-services company’s earnings would have declined.
So what are Level 3 gains? Pretty much whatever companies want them to be. For San Francisco-based Wells Fargo, whose stock is up 5 percent this year at $37.37, last quarter was a veritable mark- to-make-believe feast. In other words, it’s a safe bet the losses were real, while the gains had all the substance of a prayer.
There are too many trees being discussed and not enough wood for my liking. Sure, these structured investments are difficult to value, and sure, the faults coming to light now happen to arise from sub-prime lending, but these risks have been widely known for several years. Anyway, as I recall, Akerlof was explaining why used cars are hard to sell to the point that a market may not exist at all. Yet this structured garbage sold well. Why?
(1) Because investment banks make a lot of money out of manufacturing and pushing it.
(2) Because the incentive structures for investment agents (eg two and twenty) favour taking tail risk, whether the agent properly understands it or not.
(3) Because monetary policy has been too loose for too long, depressing the return on investments (other than transitory capital gains) so that investors were eventually willing to accept more risk to boost their returns.
(4) Because risk-takers have been bailed out so many times by easing during financial crises that they became complacent about risk.
For now, a crash should be allowed to take its course at least until it begins to have a substantial effect on real economic activity, and then the aid should be fiscal. Some kind of restorative tax should be imposed on investment bankers and investment agents like hedge funds who made so much out of the cynical exploitation of the system. And hopefully, investors learn from the losses to investigate their investments more thoroughly in future.
Thereafter, central banks should stop trying to set interest rates and monetise a wider range of assets.
Foreign oversight of U.S. financial markets demanded
Wednesday August 29, 7:22 am ET
http://biz.yahoo.com/cnnm/070829/082907_foreigners_us_markets.html?.v=2
Investors outside the United States are calling for greater foreign oversight of American markets, banks and credit agencies, according to a report Wednesday.
They argue that the U.S. exports its financial products to international investors, but isn’t adequately monitoring and regulating the securities, as evidenced by the substantial losses related to the subprime mortgage scare, said the New York Times.
“We need an international approach, and the United States needs to be part of it,” Peter Bofinger, a member of the German government’s economics advisory board, told the Times.
Major international banks suffered losses after buying mortgage-backed bonds based in the United States, the report said.
In the past, Washington has emphasized that it does not want foreign oversight. But analysts say Europe and Asia have more leverage now, because they own so much U.S. debt, the Times said.
Rebel
And hopefully, investors learn from the losses to investigate their investments more thoroughly in future.
A view back through history suggests that investors do not learn from their losses; perhaps something inherent about human behavior.
Whether it is smoothies or lemonade being made out of lemons, the more fundamental problem is the tree producing the lemons. From my perspective it is not the bad sub-prime mortgages per se, but rather the slippery valuation models and their gratutitous assumptions which established asset spurious valuations. The issue now is that these valuations have all of a sudden become suspect. Hence, their is diminishing confidence in tranche valuations. The spread to CDO’s is a natural extension of this valuation process. Overall it is an appropriate loss of confidence in a house of cards.
Current circumstances really highlight the real nature of a politicized global financial system where manipulations serve political interests rather than being responsive to fundamental economic factors. It is not really much more than a legitimized confidence game.
Smoothies and lemonade aye! Sounds good cuz I just had a “Mango & Coconut” smoothie for lunch today — you guys should try it sometime!
Brad – what are you announcing to the world…. This idea might get passed along to the US governments’ “suggestion box” that we approve an “unwanted” market “bail-out” thereby increasing even more the probability that the Fed will surely cut the fed fund rate soon and casting the “moral hazard” shadow. And guess who’s going to pay for it — us the parents of those little kids sipping the smoothies.
RE – if the there’s a US bail-out, what’s a contingency plan you can think of that would not cost us taxpayers a $3-$4 smoothie?
Since when do mousetraps kill cats?
Scratchy
Rebel E –
the lemon analogy sort of works. remember, the problem comes in the used car market, not the new car market. and right now there are problems with “used” securities — i.e. there are concerns that sellers might know something that the buyers don’t know but should know.
but you are right to note that this problem developed recently and suddenly, right when concerns about the quality of both the new and used product developed. up until then, the conventional wisdom was the more financial engineering the better. the market knew what it was doing — and new credit technology was allowing risks to be placed with those best able to bear them. and so on.
the swing in regulators views over the past 6 weeks (judging from tett’s reporting, along with guha’s) has been rather big, almost as big as the swing in the market. it is big enough that i suspect some harbored doubts previously but thought it was prudent not to criticize market practice when everything seemed to be working.
one question? just how bad is the market right now? and what do the insiders think the mostly likely outcome will be?
I am curious. my guess is that a lot of those holding certain cdos tranches still believe in the technology and the value of the underlying instrument and thus don’t want to sell at anything close to current prices. but they also are not in a position to be big buyers in a liquidity constrained market. but that is a pure, pure guess.
The summary doesn’t quite explain what went wrong, and I haven’t seen a good explanation of the problem so here goes…..
You have a CDO that’s divided into three tranches. Let’s call them high risk, medium risk, and low risk. Everyone knows that the high risk CDO will lose money, the question is how much. You do the calculation and it shows that the low risk tranche has a 2% chance of losing money.
So hedge fund manager comes along and asking, got anything for me to buy. Bank says sure, here are some risky CDO’s, I’m selling these cheap, be careful with them. Hedge manager says “no problem, we are all adults here, I like risk.” Manager buys CDO’s. Bank collects commission.
Now a pension fund or overseas bank comes along and asks got anything for me? Bank says sure, I got these great low-risk CDO’s, I did the calculation and they say that you only have a 2% chance of losing money on them. Pension fund says, I don’t understand 2% risk what that means, can you translate for me? Goes to rating agency. Rating agency says “according to our calculations, a AAA corporation has a 2% chance of going bust, so that 2% means that the CDO is equivalent to a AAA bond.” Pension manager says great, I can buy AAA stuff. Goes to bank. Bank gets a small fee for selling these things.
Now time passes. Mortgages default as people expected. The in fact default exactly according to calculation. Hedge fund blows up, but that’s not a big problem, since everyone knows that Mr. Daredevil the hedge fund manager had to coming. No problem so far…..
Here is the problem…..
Now that the high risk CDO went bust, the mid-risk CDO is next in line to go bust and then becomes high-risk. The low-risk CDO now becomes mid-risk. That AAA CDO now has a risk that is the same as a AA.
At this point the pension manager gets angry. You *told me that this was AAA*. Bank says, it was. We did the calculations, the calculations were correct, and it was AAA. Pension manager says, but AAA corporate bonds never get reranked unless something bad happens, and here I am, and my AAA CDO’s just got reset to AA even though I didn’t do anything. Just who do you think I am, a hedge fund manager???? Listen, I’ve had enough of this crazy stuff, I’m just going to sell my CDO’s to whoever will buy them and just and buy nice safe treasuries.
Note that at no time here was any lying to anyone else, and also note that nothing in the low-risk tranche has actually defaulted, nor has anything happen concerning defaults that were not predicted by the models.
The information asymmetry argument just doesn’t wash. It’s not mom and pop average consumer that was buying these derivative instruments, it was well-paid professional investment managers. There’s nothing hidden about the payouts and the risks of these securities. There is no information that the seller of the securities has that the buyer does not. The lawyers on both sides make sure of that.
True, you might need people with physics and mathematics Ph.D.’s to understand the models and the equations, and explain the risks and dangers in language that even an MBA can understand, but you can hire physics and mathematics Ph.D.’s and this sort of work is good for encouraging kids to learn math and science.
Hi David Chian,
I missed you for a couple of weeks in troubled waters, and I’m very happy you are back again. Dissident voices are always welcome and healthy.
But, please, stop ranting about Rubin and Clinton. Everybody in this blog knows your opinions and feelings about it.
Two-fish is a very practical financial guy, and you won’t impress him. He should have some roots somewhere, but it seems they are financial. So, let it be.
Brad,
The lemon analogy is very good as far as old rotten lemons spread worldwide don’t weight more than the new ones.
The problem is that the famous sub-prime MBS products are hidden in lots of other derivatives, and big part of them are still to blossom in the middle of any financial operation…
And being the situation so, would you embrace new derivatives?
MM says that yields hunger might make miracles,
I don’t think so.
Let’s see and wait until Olympic games in China and a new democracy in USA.
In between, lots of noise.
Not new inventions, but Frak Zappa & The Mother of Invention.
Best Regards
RebelEconomist:
(1) Because investment banks make a lot of money out of manufacturing and pushing it.
This is true….
(2) Because the incentive structures for investment agents (eg two and twenty) favour taking tail risk, whether the agent properly understands it or not.
This isn’t. Most hedge fund managers are compensated against a high water mark. This means that if you have a lucky year, and then the market tanks, you don’t get a penny until the fund hits the high water mark. Since LTCM, people have thought a lot about incentive structures.
bsetser: one question? just how bad is the market right now? and what do the insiders think the mostly likely outcome will be?
IHMO, big thing is that it hasn’t really hit the real economy yet, and the higher tranche subprimes haven’t defaulted and neither have prime mortgages to any large extent. Also long as that is the case, then the senior CDO’s are worth something, even if no one is buying them.
bsetser: I am curious. my guess is that a lot of those holding certain cdos tranches still believe in the technology and the value of the underlying instrument and thus don’t want to sell at anything close to current prices. but they also are not in a position to be big buyers in a liquidity constrained market. but that is a pure, pure guess.
If you hold a senior CDO outright and assuming the default situation doesn’t worsen, then you can hold them to maturity. The trouble is that if you borrowed money to buy the CDO’s or if you for some other reason need cash right now, you have a cooked goose.
Part of the dynamics is this…. You have a fund of some sort, and you hold senior CDO’s that will be worth something if you hold to maturity. Unfortunately, you need cash now, perhaps because some of your clients want out. Since you can’t sell the CDO’s for what you think they are worth, you have to find something else to sell, short term commercial paper for example or treasuries. Multiple this by a lot of other funds that are in the same position, and you see the effects on other markets.
I question whether it was ever appropriate to apply the types of ratings applied to corporate credit CDOs. As I understand traditional bond ratings, they were supposed to represent not the probability of loss, but the probability of default. But if an AAA corporation defaults, unless it is completely fraudulent, there should still be assets available to make the bondholders whole, and further the corporation has the ability to see business conditions and adjust to avoid bankruptcy.
But if it looks like an AAA CDO is going to run into trouble, there is nothing that can be done to change the terms of the underlying credits. It is on autopilot. And of course the underlying “equity” tranches will have already been wiped out, so there won’t any assets left below–the risk of default would seem to be very similar to the risk of loss.
Since these assets don’t really have very similar characteristics, it doesn’t seem sensible to rate them on the same scale.
Analogies are dangerous because they might be wrong. Part of the reason we got into this mess was that people said, here is a CDO with an X% percent of default which is just like this corporate bond with the same chance of default.
I do suspect that financial engineering will come out of this looking better than one might think right now. The question one will need to ask a year from now is “who got hurt” and “who should have gotten hurt”
As far as regulation goes, the problem is that if the basic issue is complexity, than adding regulation just adds a layer of complexity, which might not be what you want.
2fish — thanks for your comments. i was kind of hoping you would answer my questions.
but i am still a bit confused by your first comment. you claim that the hedge fund manager has blown up even tho the lowest rated tranche is still whole, and all payments have been made … if that is the case, why isn’t the daredevil still whole? b/c the expected value has fallen b/c of expected defaults in the future and a need for liquidity?
and similarly, if the equity tranche is whole, why have the top tranches been downgraded?
i accept that some level of loss is built into the calculations that go into the structure, and that perhaps that level of actual loss hasn’t been realized …
but at the same time, it does seem like a higher than anticipated level of defualts is now expected in a range of structures with subprime and perhaps other kinds of exposure, so the structure itself is probably going to perform a bit outside initial expectations — meaning that the lowest rated tranche will blow up faster, and the middle tranche may take some losses and the top tranche isn’t as secure as those buying it initially thought.
at least that is my perception –
either that or the whole problem comes b/c those buying the thing didn’t really trust the structure to protect them and weren’t anticipating any losses, and now those at the bottom are getting into trouble, they are just getting scared in the face of an event that those constructuring the structure fully expected, which sort of seems your story.
p.s. i don’t quite buy the argument high water marks deter risk seeking behavior. if you are just starting out (no high water mark yet) don’t you have an incentive to try to do well enough to get noticed and thus attract more funds? 2% of a bigger base is always interesting, as it 20% of the returns of a bigger fund even if returns decline a bit with size. and in any case, in your story, it was the daredevil — not the conservative pension fund/ asian bank — that bought the equity tranche, presumably for a reason …
U.S. government may no longer have the true power over its finances as it is dependent on foreigners for cash flow.
But it still has power over something: information fed to the populace.
Government members are sometimes quoted as calling the economy as “resilient”. And boy is it resilient! But not in the way the public may think.
The U.S. economy is “resilient” in the sense that economical problems do not show up in the statistics measuring the situation on the “main street”. This does not mean that problems do not exist; it only means that they do not show up. Take for example how numbers such as unemployment, wages, and inflation are calculated. Chapter 2 (”What Uncle Sam, the Wall Street, and Mass Media Don’t Want You to Know”) in Peter Schiff’s book “Crash Proof” shows how misleading some of these are.
I can see a couple of reasons for this “information hiding” although there are perhaps many. The first being that the value of the USD (just as other currencies) is ultimately based on perception. The second is that inflation (loss of that value) can become a self-fulfilling prophecy. If the service and retail industries perceived the dollar as having less value the next month they would be likely to increase their prices; this sort of increases would propagate through the system and actually bring down the value (since the value is based on perception anyway).
Nevertheless the “information hiding” brings to fore another issue: the claim that the U.S. capitalistic “system” is run in a way that provides a positive investment environment. This is of course a lie but what would you expect from a government that is not honest with the statistics that should provide a true picture of economic fundamentals?
How is it possible to invest into a country when a countrys true situation cannot be assessed?
This problem is compounded by the behaviour of accounting firms and rating agencies. The former do not just value companies according to “marking to model” or “marking to market” but also “marking to myth”. See Warren Buffetts take on this at: money.cnn.com/galleries/2007/fortune/0708/gallery.crisiscounsel.fortune/
The issues with the rating agencies and their “opinions” have of course been mentioned before.
Some commentators have brought up the possibility of U.S. attacking Iran in an attempt to redirect the focus from the economical situation. Another reason for why U.S. would like to do so (as there is more than one anyway) is to create an excuse for the economical situation (”the crisis is because of the war and not because of how this country was run”).
Others have stated that U.S. would not attack as China would pull out their investments from the U.S.
The best option would be (considering the lack of trust in U.S. investments) for foreign investors not to act after other countries have been attacked. They should pull their investments out of the U.S. as soon as possible, not just to protect their own interests but also to help avoid further bloodshed.
Brad,
As a former junk bond fund manager and credit analyst, I would strongly presume that the problem is not assymetric information – it is, quite frankly ZERO information. That’s right, ZERO. I strongly doubt anyone knows what these things are worth.
Let’s think of what a CDO is: An amalgam, of pieces of, say, 30 RMBS, then sliced into the by now well-known structure of tranches ranked by seniority. And what is in those RMBS? If the each RMBS averaged out at $200 million total issuance, let us say that each one averages out at 1,000 underlying loans.
Now, under the last two years’ underwriting standards, what happened? No one did due diligence for many of the loan originators. So no one — originator, issuer of the paper, or the bond buyer — can evaluate the likelihood that the underlying borrowers will pay. That’s what a liar loan is — no information about the borrower’s ability to pay.
Nota bene: in my scenario there are pieces of 30 THOUSAND loans underlying our single CDO. Since no one did due diligence in the first place, the only way to get a line on what they are worth is to start getting loan files from the originators or loan servicers, start looking at what they have, and verify. Not bloody likely — loan files are normally confidential. But even if you can, it would be one large task. Very different from the credit analysis I used to do, where I would read SEC filings and then interview bond issuers.
What else can you do? Build big databases and start trying to sample, how well the loans have done by each of the several originators? Good luck. We need several years to see how well they can be predicted to do; we are running that experiment in realtime, right now, with no controls.
I have heard that some people say that a team of credit analysts can evaluate a single CDO in a weekend. Given that so little seems to be known about the underlying product, I would like to know how they do it, because I have trouble figuring it out.
Note number two: Fannie and Freddie spent lots of time in the 70s, running loan experience through the computers, and on that basis figured the rules for conforming loans. The kind of product that one can buy without fear. You know, 20% down, 28% of income for debt service, those familiar rules of thumb and many others. And Fannie and Freddie as a two player monopsony (okay, there are also GNMA and FHA but you get the idea) can and do force originators to hold to the rules — or else. That’s why (beside the implicit Federal guarantee) people still believe in Fannie Mae and Freddie Mac passthroughs.
But the private MBS market threw out the rules of prudent underwriting and so all private RMBS paper is rightly presumed worthless until proven otherwise. It is that simple. No modeling about economics, prepayment speeds, interest rates is going to mean anything if you don’t know who can pay, who can’t, and why. The underlying is random garbage and I am at a loss to value it. Put garbage like that into any model, how do you get something other than garbage out? Maybe you or another commenter knows more, I would love to hear.
Sunlight
Twofish et al.
The asymmetric information line explains both the initial sale and a later collapse if buyers and rating agencies (and presumably sellers — though one does wonder) viewed the each RMBS as representative of a certain class of mortgages. That is they were most likely being treated as something close to a random sample within a given set of mortgages.
The problem is that the RMBSs were not random samples, the process that built them almost certainly created biases in each security. So you end up with assets that rating agencies were treating as equivalent within a given class, when in fact they are very, very different products. Now that people are getting information about where the defaults are, owners of this paper are finding out whether or not what they have is a lemon. That’s why the problem popped up now, not earlier.
Good to hear from Sunlight that passthrough RMBS can be done right. I suspect that the market will only start to work right once norms (or legal requirements) of clear and coherent disclosure on the underlying loans are established.
If I may throw in my two cents…
The basic, structural problem with all “structured” products is that they contain assumptions: about mortgage default and pre-payment rates, about the value of underlying collateral, about the default and seizure process and many, many more. The engineers have to make educated guesses about them in order to construct the various products, so they use historical data and model around them.
Now, if you look at things from another perspective, these products are designed to fail catastrophically, past a given point. That’s in the very nature of their cascade structure. If defaults rise significantly past the engineer’s assumption then not only does the equity tranche get wiped out, but so does the mezzanine tranche and then the AAA tranche starts getting hit and does not go from AAA to AA but acts like a CCC.
In finance negative events “cluster”: when you have rising defaults you also get lower collateral values and longer periods until the collateral is seized and auctioned, plus higher legal and admin costs, plus the government may step in and create problems…in other words what previously looked like uncorrelated assumptions now hit all at once.
Obviously the financial engineers do not create products based on worst-case or even adverse scenaria, otherwise they could never turn CCC pools into cascaded tranches consisting of 90% AAA, 7% BBB and 3% equity. They take the approach that allows them to manufacture as much of the readily salable AAA product as possible right now and thus keep a fatter slice of the spread as imbedded fees.
In the used car analogy, the salesman throws a couple of handfuls of sawdust in the transmission so it runs quietly for a while and then…caveat emptor.
Hi just an excerpt of the comment I posted on the last thread and that relates here in fact.
Brad I have been amazed by this last post. I would suggest turning lemons (individual lemons) into Acid rain ( something that falls from the indivisible sky of the market).
See below :
Just look at ROubini s blog. WHat does he discuss : fiscal and monetary policies … He does not even adress regulation ones. Yet anyway you look at it the main problems origin not in fiscal or monetary imbalances … THey origin in the deregulation of the finance industry that has allowed all this foolish lending business with each lender passing the risk to the market hoping that the pollution created would never fall back on its head. I mean instead of turning lemons into lemonade, I would have called it, turning lemons into acid rain. Basically that s what has happened, before people were afraid to buy lemons, now they have been made unaware that all the citric acid has been sent into the sky up above and is just waiting to fall in disastrous acid rains.
THe problem is not asymetry of information its stupid deregulation of the finance industry. WE ve been through all these all those innovations had been banned in the 30’s, we were supposed to have learned why. BUt it seems men like to play with fire…
In case you never heard about acid rain
http://en.wikipedia.org/wiki/Acid_rain
and let me sum up, financial deregulation and ensuing innovations have turned lemons (hard to trade) into sugar (easy to trade) and acid rain (that falls from the sky of the market on all traders).
Lemon trade is riddled with information asymetry, between traders.
Acid raid is a problem more related to lack of information altogether, disentropy, its a collective phenomenon.
I finally wrote this http://revolution2006.blogspot.com/
on lemons and acid rain. Nothing really different from my comments above. If you have links ideas about this shif from individual uncertainty (seen from the collective, the individual risk is an uncertainty) to collective risk (there s no way to slice the market into parts, pool them and sell them on a market, if there were, this market of markets would then be subject to risk, that is an uncertainty on which no probability can be made. Just as Hellasious wrote, this is not an asymetry of information between traders problem with uncertainty, this is a market problem with risk.
bsetser: but i am still a bit confused by your first comment. you claim that the hedge fund manager has blown up even tho the lowest rated tranche is still whole, and all payments have been made …
Because the hedge fund manager may have borrowed money to buy the CDO’s, and if the value of the CDO goes done, the fund may well be underwater. Even if the fund isn’t insolvent, the investors for the fund may want to pull out their money, and the banks that are lending the hedge fund money are also likely to be pulling their credit lines.
bsetser: and similarly, if the equity tranche is whole, why have the top tranches been downgraded?
Because even if the defaults are being absorbed by the lower tranches, the risk that the upper tranches may be affected increases. Credit ratings are based not on whether you default or not. If you default its too late, they are based on the possibility that you might default. And if there are defaults in the lower tranches, then the chances that the upper traches *might* default increases.
This points out a very important fact which is that things might blow up even if the underlying mortgages are still mostly good.
Sunlight: I have heard that some people say that a team of credit analysts can evaluate a single CDO in a weekend. Given that so little seems to be known about the underlying product, I would like to know how they do it, because I have trouble figuring it out.
It depends on what you mean by “credit analysis”. Given a model of defaults and coorelations, you can figure out the credit value of a CDO in a weekend. If those inputs are bogus, the outputs are going to also be bogus. In the case of subprime mortgages, yes you are correct in doubting the inputs. However, “CDO technology” is used in other areas where the default structures are much better established (corporate bonds for example).
Hellasious: Now, if you look at things from another perspective, these products are designed to fail catastrophically, past a given point.
Not necessarily. One other thing that gets added into these CDO’s is that an investment bank will often put up some money saying that it will absorb some fraction of the defaults. This is to put some buffer into the structure.
The issue here is that the credit ratings in the upper tranches will decline long before the defaults hit them. It should be noted that the defaults thus far haven’t come anywhere close to hitting the upper tranches.
The other thing is that it is simply not the case that people were not taking correlations into account. The CDO market basically got created after 2001, when David Li introduced a fast way of calculating CDO values taking into account coorelation effects. Relating this all back to China, the math and physics Ph.D.’s who run and develop these models tend to be from China, India or Eastern Europe.
Brad is right not to buy the argument that high water marks do not deter risk seeking behaviour. In fact, high water marks make tail risk even more attractive to fund managers. If the loss event is so large that you would have been shut down anyway, the high water mark makes no difference to the agent’s payoff.
If there has been asymmetric information, it was not between the dealers and the fund managers, but between the fund managers and their clients, like pension funds. Any compensation for the losers in this game should come from a tax on the individuals who have done so well out of it. Give them a Gross (tax) Bill!
Here, I do agree with Twofish. As I said in the previous thread, this is a liquidity-involvency crisis. The CDOs in SIVs are not necessarily impaired much, but investors are no longer willing to buy commercial paper secured on them at rates that make the SIVs viable. The reason that these investors accepted a low yield on their commercial paper is that it gave them the liquidity to withdraw, and that is exactly what they are doing. In short, the SIV business model no longer works, so they have to be wound up, either as the commercial paper matures and cannot be refinanced, or later if a bank line can substitute for the commercial paper for a while. Depending on the price that the CDOs can be sold for, the SIV may or may not be insolvent, but their game is certainly up.
Re: cash as buffers and catastrophic failures.
The cash buffer is just that – a buffer. What I meant by “catastrophic” failure past a point is this: unlike a regular corporate bond that gets paid in full (barring bankruptcy, of course) a CDO or other such tranched product will start taking partial hits on interest and principal even if 80% of the underlying loans never experience a problem. Does this mean it goes from AAA to AA – of course not. Such a security is almost by definition a CCC, also because unlike a corporation you cannot look at the balance sheet or meet the CFO to ask hard questions.
And going from AAA to CCC has dire consequences for the market price of such securities Ii.e. catastrophe). The market has already figured that out, by the way…
hellasious — i think i see your point. ratings are designed to measure the risk of any default event — not recovery once there is a default. and a lot cdo structures may turn out to have a much higher than expected probability of a default — i.e. some fraction of the payments not being made in full and on time — even if they probably will continue to deliver some payments. i.e. the ratings ultimately is about a binary event — paid in full or not. and cdos probably have a higher risk of “not quite being paid in full” because there aren’t quite enough buffers or lower rated tranches in the structure than corporate bonds, where you end up with fairly binary outcomes (paid in full, or restructuring)
i also think your point about correlations emerging from a general easing of lending standards (i.e liar loans) as home values rose past the point of broad affordability is an important one.
df — i am actually interested in regulatory solutions, tho i would note that regulation that raises standards won’t solve the problems in the market for loans that already have been issued, and right now, there isn’t a problem with loose lending standards so much as a problem of no lending in parts of the market. Excess was replaced by stasis.
Dude, Where’s My Bailout Check?
http://www.businessweek.com/magazine/content/07_37/b4049050.htm
An open letter to Fed Chairman Ben Bernanke, Treasury Secretary Henry Paulson, and Senate Banking Committee Chairman Chris Dodd
Honorable Public Servants: As you know, the conflagration in the subprime mortgage market is beginning to singe the very fabric of the American dream, by which I mean life, liberty, and the pursuit of home equity. I was elated to hear everyone from bond guru Bill Gross to Democratic Presidential hopefuls endorsing the idea of a government bailout of homeowners facing foreclosure as the payments on their zero-money-down mortgages soar.
Bad credit? No credit? No problem! Uncle Sam has your back.
I don’t have a mortgage, much less one that’s about to blow up. But I have no shortage of other losses, some of them quite painful, from the many well-considered investments I’ve made over the years. Therefore, under the equal protection clause of the U.S. Constitution, I’m entitled to a bailout as well.
Please remit my $74,400 by check, money order, or PayPal (EBAY ). Rest assured that I will cycle the dollars back into economically vital investments. I hear some hedge funds are slashing their minimum buy-ins to $10,000, and that half-finished condos in Miami can be gotten for pennies on the original dollar. In any case, my efforts to bolster the U.S. gross domestic product could surely be strengthened by a series of interest rate cuts, so please see to those, too. After all, gentlemen, while intrepid investors like me crank the engine of American capitalism, times like these call for all of us to pitch in.
Twofish -
I gather that the market (incorrectly) treated them as instruments that would have a fixed rating and priced them accordingly.
Except that this is a product *designed* to have a rating that declines over time? Presumably, this fact was present at the creation – did the rating agencies neglect to factor it in or mention it, or did the buyers and sellers ignore/overlook it?
If the CDOs have a standard declining ratings curve, couldn’t you further cut-n-paste them into re-packaged securities so as to aggregate and smooth that curve? Could that product reclaim the higher rating – and would that rating be fixed in time?
These Banking Bad-loan bailouts by the Federal Reserve have to stop. The bailout of Countrywide mortgage finance, aiming to save rotting MBS financial paper and derivatives contracts, does damage the real economy. Nearly half a trillion dollars of extraordinary central-bank injections of funds into banks have been provided in just three weeks. Despite the pious claims by the Federal Reserve that “it is only intervening to prevent the financial crisis from harming the economy,” its interventions have precisely the purpose of saving the toxic-to-radioactive MBS and their derivatives, which have blown the whole international banking system into an unsalvageable bubble. These interventions do not save hedge funds and bank funds for more than a few days or weeks; they do harm the real economy, and if kept up, they will accelerate into a disastrous hyperinflation of the US money supply. European Central Bank head Jean-Claude Trichet in a statement on Aug. 17, blasted Fed chairman Ben Bernanke, stating that the, “15% increase in money supply to get any claimed GDP growth has gone mad.”
If press reports of what Bush will say today are to believed, the US is about to take another step on the Road to Argentina. It will only be just if the first act of the more objective credit rating agencies that some politicians are calling for is to downgrade US sovereign debt.
There is no real difference in the rating concept between CDOs and corporate debt. Both risk analyses are binary. Both are subject to the risk of future downgrade. Both reflect the priority of capital claims according to a defined capital structure. Both reflect a degree of asymmetry in availability of information and transparency of risk. Both derive their risk attributes from a portfolio of underlying assets. CDOs are one or more steps removed in their derivation, making issues around the awareness of risk similarly more removed and complex. But there’s nothing fundamentally different here.
http://atimes.com/atimes/Global_Economy/IH24Dj02.html
Federal Reserve flow of funds data shows outstanding home mortgages in Q1 2007 to be at $10.4 trillion. About $1 trillion in mortgages are due for a reset by the end of 2007 alone. A 4% reset of interest rates on $1 trillion of mortgages would require addition payments of $40 billion. Agency-and GSE-backed mortgage asset amounts to $3.9 trillion. Issuers of asset-backed securities home mortgages asset amounts to $1.9 trillion. The numbers are further magnified hundred of folds by structured finance with high leverage which magnifies the cash flow caused by even the slightest interest rate volatility. Liquidity problem associated with counterparty default could quickly run up to trillions of dollars. What does the Fed hope to accomplish with injecting a mere $50 or 100 billion in the banking system, except to show its impotence? The Fed can keep the banks from failing, but it cannot prevent the harsh reckoning of the debt bubble economy.
Twofish:
“It depends on what you mean by “credit analysis”. Given a model of defaults and coorelations, you can figure out the credit value of a CDO in a weekend. If those inputs are bogus, the outputs are going to also be bogus. In the case of subprime mortgages, yes you are correct in doubting the inputs.
You’re quite right, it does depend upon what you mean by “credit analysis”. The corollary which follows is that the CDO valuation is also soft, fuzzy, and lends itself to self serving subjective determinations. As long as there is mutual complicity and among the players, we have a workable system. When the fear quotient rises and one or more players are left, or fear being left holding the bag, the system breaks down.
Also, while “the “CDO technology” is used in other areas where the default structures are much better established (corporate bonds for example).”, the framework for this technology does not give adequate consideration to adverse cluster events from which arise structural systemic changes which may create cascading alterations in the valuation environment.
In the academic world it is more affordable to delve into and flush out “improbable” conceptual nuances which impact a valuation model. In the world of commerce, however, the major driver becomes competitive model profitablilty, preferably in the near term. An analogy would be a CPA firm performing theoretically correct textbook model audit, or getting in completing the engagement and moving on to the next job. Until a problem arises, it is good enough.
http://atimes.com/atimes/Global_Economy/IH24Dj02.html
The Federal Reserve is pumping in money to help banks from failing, while families are evicted from their homes is very bad politics in a election year. The central banks are giving financial institutions whose credit rating and cashflow are not much better than family with subprime mortgages, free credit cards with a subsidised interest rate and no spending limit for as long as needed, while these very same institutions are foreclosing on the homes of their customers. This crisis will likely build to a crescendo just before the November presidential election. Its going to be a very interesting election. Will the credit crisis of 2007 usher in an age of popularism in US politics?
Guest on 2007-08-31 11:38:09
“usher in an age of popularism in US politics”? Don’t you watch the news? It is here, and has been for years. And it has spread to the Fed. That is what caused this mess in the first place.
“…resources have been misallocated because of the cheapness of credit in both stock and credit markets. So, you’re not going to solve the problem by making money cheaper again. ”
- Al Friedberg, March 23, 2001
EthanJ: did the rating agencies neglect to factor it in or mention it, or did the buyers and sellers ignore/overlook it?
My guess is that the sellers and the rating agencies figured that this element of subprime CDO’s was too “obvious to mention”, and the buyers of senior CDO’s (although not junior ones) didn’t have the in-house expertise to notice this aspect of CDO’s.
The people that work for the sellers of CDO’s tend to come out of math and physics departments and speak partial differential equations. The people that work for the buyers of senior CDO’s tend to come from economics and finance departments and speak statistics.
As far as how to rate CDO’s. This is what a lot of the screaming is about, but I doubt it is going to be a very important issue for a while. People who get burned by one rating system aren’t going to be in a mood to agree to another one for a while.
There are two things that would very much worry me:
1) If CDO’s behaved in a way that were different from the way the models said they would. Right now, everything that I’m seeing suggests that CDO’s are behaving exactly the way that the model predicts.
2) If mortgage defaults rates were much higher than they seem right now. If the total loss ends up in the $300-$500 billion range, then this is something that can be absorbed.
The reason for I’m looking at these two things is that *IF* mortgage default rates are more or less what we’ve seen and *IF* the CDO’s behave according to model *THEN* we don’t have a big problem. In particular, the thing that I’m worried about is a feedback loop in which you have defaults triggering defaults. The Fed has intervened to stop the most obvious feedback.
To Guest: Tell your letter writer that he can get your bailout check at any bank. Go to your local bank, take out a loan on something. The rebate will be in the form of paying less in interest than he otherwise would.
DC: These interventions do not save hedge funds and bank funds for more than a few days or weeks;
Correct. That is why they are not such a bad idea. The fed’s interventions will not save any hedge funds or boost investment bank profits. If they did, then you run into the problem that you aren’t punishing the people that got us in this mess.
DC: they do harm the real economy, and if kept up, they will accelerate into a disastrous hyperinflation of the US money supply.
My current view of reality says that we are not in a von Mises credit boom/bust and so injections of liquidity will not trigger inflation. If I’m wrong, then the damage by the liquidity injection isn’t going to be great.
Ryan: You’re quite right, it does depend upon what you mean by “credit analysis”. The corollary which follows is that the CDO valuation is also soft, fuzzy, and lends itself to self serving subjective determinations.
It actually doesn’t. The important number is how many defaults there will be over the lifetime of the CDO. It’s an unknown number, but it isn’t a subjective one.
Ryan: As long as there is mutual complicity and among the players, we have a workable system.
No. You want the players to be at each others throats. You have one player, let’s call him the buyer, that wants to make the CDO as cheap as he can. You have another player, let’s call her the seller, that wants to make the CDO as expensive as they can. Put them in a room, and they’ll scream at each other until you have a price, which will reflect that they think the hidden number is.
Ryan: the framework for this technology does not give adequate consideration to adverse cluster events from which arise structural systemic changes which may create cascading alterations in the valuation environment.
Yes it does. The whole point of a CDO model is to model clusters of events. When one company goes belly up, other’s are likely to do so, and vice versa. The connection between one company goes belly up and others is called a copula.
Ryan: In the world of commerce, however, the major driver becomes competitive model profitablilty, preferably in the near term.
And you aren’t modeling correlations correctly, you will run into big, big problems. One reason banks like to hire physics/math/engineering majors more than finance majors to do this type of work, is that physics majors tend to be more hard-headed about matching models to reality.
2fish –
re: if the ” total loss ends up in the $300-$500 billion range” it can be absorbed.
two questions.
first, $300-500b is a bit higher than the estimates that seem to be floating around fedland (tho perhaps those numbers are now dated). didn’t Bernanke estimate something more like $100-200b not-so-lonmg ago (I haven’t actually checked/ am working off fuzzy memory, which is risky). have the consensus estimates inside the math/ physics if we weren’t building derivatives we would be building rockets and nukes world increased over the past couple of weeks?
second, care to speculate on how $300-500b (which sounds like a big number to me) would be absorbed? i.e. what are the losses on pure MBS which have been bundled into a structure? and what are the losses on structured products (CDOs) that contain various mortgage backed securities?
and then (if you are really bold), who would you guess holds the instruments that will take the loss (apart from the BOC and SAFE, which presumably hold up to $40b, depending on the size of SAFE’s portfolio of this stuff … and the implied $30b here is my current high end estimate)
Guest: The numbers are further magnified hundred of folds by structured finance with high leverage.
No. What happens when someone highly levered makes a mistake is that they go bust. What I think is going on is that the hedge funds and the mortgage companies are like circuit breakers. When the situation goes bad, they break, and this prevents more damage to the rest of the system.
Hedge funds are heavily leveraged. Outside of proprietary trading, the big banks are not. The Federal Reserve won’t let them do that.
Guest: Liquidity problem associated with counterparty default could quickly run up to trillions of dollars.
No. What happens is that the moment there is a problem, the big banks pull credit, and the hedge funds and mortgage companies with heavily leveraged positions go bust. That keeps the problem from getting too large.
Guest: What does the Fed hope to accomplish with injecting a mere $50 or 100 billion in the banking system, except to show its impotence?
The danger is not that the hedge funds and mortgage companies will go bust. The danger is a feedback cycle that includes the whole economy. Default -> loss of liquidity -> rising interest rates / job losses -> more default.
Guest: The Fed can keep the banks from failing, but it cannot prevent the harsh reckoning of the debt bubble economy.
The two contradict themselves. If there is a “harsh reckoning of the debt bubble economy” then the Fed can’t keep the banks from failing.
The question that gets asked a lot in the banks especially among risk managers is “suppose you are wrong about the way the world works…. then what….”
2fish –
i am not quite sure how the circuit breakers work. sure, wiping out hedge fund capital before the hedge funds’ creditors assume their (losing) positions = a bit of a buffer, but if funds sell elsewhere to cover losses/ or as part of an orderly unwind — or if SIVs sell to raise funds to cover maturing commercial paper — you also have a mechanism for ampliying moves.
in general, if a losing position is held by a real money account, i see how the loss gets absorbed without further transmission. but when losses are in leveraged players, there seems to be an inbuilt mechanism for amplification/ transmission — i.e. you have a volatiltiy machine rather than a shock absorber, to use a phrase from michael pettis.
It seems like there are two points of view running through this blog:
(1) the securitization process was fundamentally flawed
(2) the process wasn’t flawed, but buyers weren’t prepared for predictable downgrades.
Twofish: “You have a CDO that’s divided into three tranches. Let’s call them high risk, medium risk, and low risk. Everyone knows that the high risk CDO will lose money, the question is how much. You do the calculation and it shows that the low risk tranche has a 2% chance of losing money.”
But the latter sentence is a prediction about the future. This prediction is based on assumptions (e.g. x percent of the underlying loans will behave like this population of loans on which we have historical data). The models only address correlations between the different cash flows to the degree that their assumptions about the behavior of the underlying mortgages are correct. The problem is times change, behavior changes. It’s hard for some of us to believe that models that process historical data can hope to give reliable predictions about future events.
If the models are only a little wrong – and the modelers would have taken this into account – you have a good CDO. If the models are a lot wrong, you have a lemon.
I seems that the people who believe (1) think that the models are likely to be wildly off the mark, while the people who believe (2) think the models are basically sound.
The problem I have with (2) is this: If in fact the process by which CDOs were created is fundamentally sound, why aren’t people in the know making a killing buying CDOs up right now?
Isn’t the fact that the market is completely illiquid the evidence that at least one of the two things Twofish is worried about (”1. If CDO’s behaved in a way that were different from the way the models said they would … 2. If mortgage defaults rates were much higher than they seem right now.”) must be going on.
The only other possible explanation I can see for what is going on is that all these CDO based funds were caught completely unprepared for the mark down in CDO value and their leverage is certain to take a whole lot of them crashing down so everyone’s steering clear of a genuine liquidity crisis. But how can sophisticated financial players have completely missed an event that Twofish (”My guess is that the sellers and the rating agencies figured that this element of subprime CDO’s was too “obvious to mention”.”) for example believes was entirely predictable?
Excellent post and some very good responses.
Twofish -
Next question:
If CDOs are behaving as expected, and we simply see that rating agencies and buyers were not successfully communicating with each other, that suggests that CDO holders overpaid for them initially, thinking they were getting a permanently-rated AAA asset, instead of one whose rating would decline predictably over time.
So is the problem that the CDO holders are facing portfolio restructuring pressures all at once? I.e., since their assets are downgraded, they hold too many AA securities and not enough AAA?
Or is it that everybody is suddenly realizing that they overpaid for this stuff, and nobody wants to buy it until prices drop a bunch? Because if CDOs are behaving as expected (by their creators), how come nobody wants to buy them? Now that the price has fallen, aren’t they a “bargain”? Where are the deep pockets to snap up all these cut-rate revenue streams?
Another Question: This rude awakening looks like it was inevitable, regardless of the *default rate* of the underlying mortgages. That is, if buyers were fundamentally mistaken about the predictable long-term behavior (and credit ratings) of these instruments, and overpaid as a result, well… we’ve learned too often over the last ten years that the only “Bigger Fool” is the one who believes that Theory. The initial over-valuation had to come out on the balance sheets eventually.
It just so happens that the reported sudden upsurges in subprime defaults and foreclosures made everybody nervous enough to look a little more closely at CDOs – at which point the unpleasant truth was discovered, laying dormant these years.
Is that largely correct?
That also suggests that all the talk about excessive foreclosures, improper loans, and poor oversight is overblown. Rather, the real damage to house prices will not come from foreclosure-driven excess supply, but rather liquidity-driven interest rates rises that wipe out demand.
Guest and I had exactly the same thought… maybe I need to type faster.
“asymmetric information”
Is that a politically correct wording for deceit and corruption?
The only place to discuss these issues will be in front of judges. Alas.
A bloody-disappointed foreigner
all of this complexity is not lemons, but mill machinery. the cogwheels are arranged so that a small turn on the big millwheel turns lighter wheels up in the mill much faster. the mortgage backed machinery did dazzling things with gears and stuff, to the extent that the traders on the top floor began to forget about the big mill wheel and the big river of debt turning the whole set up, far below.
all the sums made sense while the river flowed, but that river was a river made up of borrowers all hoping – and led by recent history to expect – to get something for nothing. whatever you paid for property was a one way bet. a game of snakes and ladders with no snakes in sight. impossible to make a bad call in a rising market.
but the river is occasionally tidal. no one said that the wheel could turn backwards. but it can. now all the lighter but geared up wheels turn backwards at high speed.
there are no solutions on the upper floors except disconnection from the system. the fed makes a show of pissing in the river to restore the flow. it’s only a show. when the tide turns the river of borrowers dries up.
the whole machinery is geared to getting a cut of that original ’something for nothing’, but when the flow of eager buyers goes into reverse, you are into nothing for something, or negative equity.
there is no lack of information – just a forgetfulness of what it is that turns the wheels. the most distant wheels have perfectly good mathematical relationships with the intermediate wheels. the moral is – you have to look out the window at the flow of the river. you can’t expect AAA torque from a B flow going in an upstream direction. you must keep your eye on the bigger picture.
Mr. Twofish, thank you for your comments. May I ask, in regard to counterparty risk, what exposure MBIA and Ambac, Fannie, Freddie, and Ginnie, have to the rising incidence of default across all mortgage types ? Freddie just announced 320 million more in loss reserve, and there are some rumblings about the insurers.
Twofish:
“One reason banks like to hire physics/math/engineering majors more than finance majors to do this type of work, is that physics majors tend to be more hard-headed about matching models to reality.”
1. Apparently banks have made a serious miscalculation in this regard, given current circumstances, although given modern finance, I’m don’t believe the finance majors would do much better.
“No. You want the players to be at each others throats.”
That may indeed be what is most desirable for an efficient market. The reality, however, appears to be somewhat more complex with strategic alliances and tacit mutual back scratching for mutual benefit.
The important number is how many defaults there will be over the lifetime of the CDO. It’s an unknown number, but it isn’t a subjective one.”
It may be an objective number after the fact. Prior to that being established assumprtions need to be made as to what the default rate will be. You can couch this in quasi-objective terms by reference to historical data, assumed normal distributions, etc. However, when there is a systemic event(s) outside the range of normal probabilities, this is a soft a fuzzy assumption, and is self serving to the extent it pumps up asset valuations.
“The whole point of a CDO model is to model clusters of events. When one company goes belly up, other’s are likely to do so, and vice versa.”
Work by people such as Mandelbrot, and more recently Shiller, and Bookstaber, born out by recent events, suggest to me that if this is being done, it is beong done inadequately.
perhaps we need new terminology -
when debt is resold as securities, are these ‘fiat securities’ ?
when borrowers blame lenders and lenders blame borrowers, we need to remember that every transaction is an agreed deal – we could call them all ‘blenders’ ?
- and when debt is marketed as assets, we need a new word – ‘debtass’ ?
sample headline : ‘GREENSPAN SAYS EXCESS BLENDING MAY LEAD TO SHAKY DEBTASS.’
.
re: “Relating this all back to China, the math and physics Ph.D.’s who run and develop these models tend to be from China, India or Eastern Europe”
if you could be convinced to expand on this, as the references to ‘American financial engineering’ have always struck me as unobservant and misleading.
too much information, and processing lags have to be part of the problem
along with too many metaphors and witty slang at the expense of balanced, genuinely informed commentary
“Commodities prices were higher on Thursday as firm fundamentals began to outweigh fears about the credit turmoil…” http://www.ft.com/cms/s/0/69497f8e-56e7-11dc-9a3a-0000779fd2ac.html
The Federal Reserve’s relentless liquidity infusion of cash into the banking system won’t revive the debt bloated US Economy.
http://www.financialsense.com/fsu/editorials/yu/2007/0831.html
From David Yu,
Since the housing market top in the 2nd half of 2005, the 52-week ROC (Rate of Change), or the year-over-year change, of M1 had started to dipped into the negative territory. And, since the beginning of this year, the ROC had begun to fall below minus 2%. Past recessions had correlated closely with the descend of the M1 52-week ROC into the negative territory. When the public has no money to consume, 70% of our economy have no place to go but down. Incidentally, the public also used to be known as the Citizens but is now better known as American Consumers.
What’s more of a mystery is that this is happening right in the face of the Fed’s relentless liquidity infusion. Other than a brief pause in the summer of 2006, the 52-week ROC of M2 has been in a strong uptrend (Chart 3). I’ve shown you before that the correlation coefficient between M2 and M3 is 0.9999, which simply means that tracking the movement of M2 is just as good and as reliable as tracking the movement of M3, the aggregate money supply.
One thing the dichotomy of M1 and M2 tells us is that the liquidity increase has almost nothing to do with the public’s input. Another thing is that the liquidity injection hasn’t put any more money into the hands of the public. But that wasn’t the Banking Cartel’s intent anyway; the intent was merely to bail out Wall Street. The problem is that all the monetary manipulations may ultimately make the condition even worse for the public. And, that’s the real problem even the Fed’s rate cut won’t solve.
“…China, in particular, urgently needs to list more companies to mop up excess liquidity. Some bankers say that Beijing will simply not allow a market downturn before the Olympics in 2008… Hedge funds in the US have been a key driver of Asian listings in recent months, often forming up to a third of the investor base of newly-listed Chinese companies… It should not be forgotten many Asian economies are dependent on exports, and a prolonged US economic downturn will eventually make waves at home…” http://www.ft.com/cms/s/0/6dd1114c-5823-11dc-8c65-0000779fd2ac.html
“…The test would implicate some of the most basic questions of what law is. In 1881, Justice Oliver Wendell Holmes created the idea of legal positivism by announcing: “The life of the law has not been logic; it has been experience.” For him, the law was nothing more than “a prediction of what judges in fact will do”. He rejected the view of Harvard’s dean at the time, Christopher Columbus Langdell, who said that “law is a science, and… all the available materials of that science are contained in printed books”.
Many insiders watched with interest as the contest played out during the course of the Court’s term; both the computer’s and the experts’ predictions were posted publicly on a website before the decision was announced, so people could see the results as opinion after opinion was handed down.
The experts lost. For every argued case during the 2002 term, the model predicted 75 per cent of the court’s affirm/reverse results correctly, while the legal experts collectively got only 59.1 per cent right. The computer was particularly effective at predicting the crucial swing votes of Justices O’Connor and Anthony Kennedy. The model predicted O’Connor’s vote correctly 70 per cent of the time while the experts’ success rate was only 61 per cent.
How can it be that an incredibly stripped-down statistical model outpredicted legal experts with access to detailed information about the cases? Is this result just some statistical anomaly? Does it have to do with idiosyncrasies or the arrogance of the legal profession? The short answer is that Ruger’s test is representative of a much wider phenomenon. Since the 1950s, social scientists have been comparing the predictive accuracies of number crunchers and traditional experts – and finding that statistical models consistently outpredict experts. But now that revelation has become a revolution in which companies, investors and policymakers use analysis of huge datasets to discover empirical correlations between seemingly unrelated things. Want to hedge a large purchase of euros? Turns out you should sell a carefully balanced portfolio of 26 other stocks and commodities that might include some shares in Wal-Mart…”
http://www.ft.com/cms/s/0/44f39c1c-5824-11dc-8c65-0000779fd2ac.html
df — i am actually interested in regulatory solutions, tho i would note that regulation that raises standards won’t solve the problems in the market for loans that already have been issued, and right now, there isn’t a problem with loose lending standards so much as a problem of no lending in parts of the market. Excess was replaced by stasis.
Brad we don t seem to have the same time horizon.
RIght now there is still a problem with loose lending standard. Proof : the debt/GDP ratio is still rising. Derivatives are still allowed. Besides, if the Fed were to lower rates at 0% lending would resume.
You know my position pretty well. We need to roll back all or 90% of the innovations made since th 80’s because they are inherently bubbly and dangerous.
Of course this will widen the problem short term. THat’s why I m saying we do not have the same time horizon. I guess there will have to be massive defaults on derivatives and mutual funds before they get so regulated that they get practically banned.
My Solution to the short term problem is massive injection of liquidity by the FED, if possible a FED that would have been nationalized. If possible it would be great that lending standards be reinforced so that the newly printed money does not lead to new debt emissions, but only enables those in debt to repay, but hopefully the change in mood of lenders and borrowers will help do that (see Japan). What we need is restore the state monopolly of money emission (Give the state a bigger share of the money emission business).
And of course this must be helped by public deficits that will help throw this newly printed money into the debtors hands.
We need inflation and as little as possible deflation to erase debts.
But all this won t solve the long term bubbly nature of the economy untill we strictly regulate the private money emission business. On this I m on a team with austrians. THey favor a strict interdiction of the money emission business wether public or private. I favor a strict regulation of this business under public authorities and according to a managing of the debt/Gdp ratio variation.
In europe we have the Maastricth criterions. THose say governments should not go deeper than 60% in debt/GDP. Well I ask why don’t we have the same criterions for businesses and households. HOuseholds should not be allowed to go further than 60% in debt relative to GDP. And neither should businesses. May be they should not be allowed to go below 4o% either. ANd of course you get me right, the 60 or 40% are not important in themselves and I ve no idea if it should be 50 or 70. What is important is reducing the magnitude of the variations, and the speed of the variation.
“DEBTASS FIAT ISSUANCE OVERWHELMS BLENDERS”
“BLENDERS’ DEBTASS FIAT INFLATED BUBBLE”
“BLENDERS’ SAY DEBTASS AND FIAT UNCORRELATED
“HE WHO SMELT IT DEALT IT”
Guest on 2007-09-01 06:00:19
“Since the 1950s, social scientists have been comparing the predictive accuracies of number crunchers and traditional experts – and finding that statistical models consistently outpredict experts.”
This is somewhat of a no brainer as the number crunching models generally only formalize the existing paradigm which shapes expert perspective. Experts, as well as the number crunching models, are probably overrated in the context of a changing paradigm unless they are able to somehow see with fresh eyes as well as with their body of assimilated experiences. Very few seem to have this capacity.
What I think is going on is that the hedge funds and the mortgage companies are like circuit breakers. When the situation goes bad, they break, and this prevents more damage to the rest of the system.
Is this a bypass around some “circuit breakers”?
Fed bends rules to help two big banks
If the Federal Reserve is waiving a fundamental principle in banking regulation, the credit crunch must still be sapping the strength of America’s biggest banks. Fortune’s Peter Eavis documents an unusual Fed move.
http://money.cnn.com/2007/08/24/magazines/fortune/eavis_citigroup.fortune/?postversion=2007082416
can an individual predict a market ? an individual dealer or an individual computer ? i am not sure they can, because the market is the prediction – it is the sum total of many individual human or computer predictions.
it is pity the person who said ‘lemons into smoothies’ did not give us a name – even a pseudonym. it’s not to know who you are, just to know whether a series of posts signed ‘guest’ or ‘anonymous’ are from the same contributor. a name can link several contributions and gives them more weight as a result.
.
“Investment Technology Group… has unveiled a new type of trading algorithm that reacts to real-time market events in fulfilling the user’s performance criteria…” http://www.hedgeweek.com/articles/detail.jsp?content_id=164775&livehome=true
“…Clearly, China’s day traders aren’t getting much respect. But they might actually be superior market players than many of their North American counterparts (read: folks who held stakes in Enron or Nortel long after their best-before dates)… Then again, it was trust in “future opportunities” that lost a lot of people money on dot-com plays, and even after a week of trading in negative territory, the P/E ratio for the SHSZ300 sat at 38.45. And that is based on earnings reported in a regulatory environment not known for strict adherence to the fine art of accurate bookkeeping.
The truth of the matter is that even sophisticated institutional shareholders should be wary of mainland China, where even investors who get dressed don’t put much faith in market information… “On the off chance that you happen to buy a China stock that appreciates 10- or 100-fold,” says one expert on market bubbles, “you’ll probably sell too early and miss the gains, or hang on too long and end up where you started. Or you will also buy a dozen China dogs that go to zero and, between these losses, trading commissions, taxes, lost wages and stress-induced therapy bills, you’ll eventually conclude that you could have done better selling insurance in Toledo…” http://www.canadianbusiness.com/markets/stocks/article.jsp?content=20070312_85357_85357
I live in a neighborhood near Boston that has witnessed the tearing down of small one and two story “cape” homes, which have been replaced by larger, but poorly constructed “McMansions” — many listed at over $1 million. In my 50 years in the U.S., I have never witnessed such a horrific misallocation of productive capital. The world has fed us credit to invest in unsustainable consumption, like this manic, frenzied home construction. Perhaps Helicopter Ben can sustain this with more irrational infusions of fiat cash, while Bush-the-compassionate makes noises about getting U.S. homeowners off the foreclosure hook. But the party is over. The credit bubble should be allowed to collapse. Perhaps then we in America will go back to the basics of saving and investing in productive assets.
http://www.globalresearch.ca/index.php?context=va&aid=6639On
Within the U.S., the government is hiding the severity of the crisis in order to prevent a collapse of consumer confidence. Rather the problem, as with the Great Depression, is that purchasing power at the consumer level is lacking. In the U.S., purchasing power, as measured by M1, is already in a recession-level decline. The causes are the high level of consumer debt, high cumulative levels of taxation on the dwindling middle class, and the tragic erosion of wages and salaries from job outsourcing.
In the absence of purchasing power, the Federal Reserve has chosen the strategy of trying to outrun collapse by creating inflation. This is the meaning of the bail-outs that are going on. It’s an attempt to devalue debt at the macro level. It’s a hidden tax on everyone but the super-rich. Everyone else is poorer today than they were yesterday.
How long this can go on is unpredictable. It’s another bubble following on the housing and asset bubbles that are already bursting on a daily basis before our eyes. The only real solution is a new world financial system based on the concept of credit as a public utility. This is what should be implemented to replace the present system of institutionalized usury.
What Has Happened to Free Markets?
http://biz.yahoo.com/tm/070831/16247.html?.v=1
Our Fedhead…no all the Fedheads have been out no less than several hundred times over the past year to tell us everything WAS A-OK. Don’t worry about this, that or the other thing. Why can’t they keep their mouths shut? Why do they have to interfere with the markets?
Why did Bernanke lower the discount rate the day of options expiration instead of a day that did not mean as much? Why is he interfering with the markets? And in a laugher, Bernanke was quoted just this morning as saying” It is not the Fed’s responsibility to protect lenders and investors from consequences of their decisions!” Who is he trying to kid? Dropping $250 billion on a problem is exactly that. Let me rephrase that…that’s one quarter TRILLION.
Whatever happened to RISK IS RISK? You take stupid risks, you pay the piper. Whatever happened to that? Why are the hedge fund managers who went 15-1 margin bailed out? Why are lenders who lent money to people without asking for income statements…without asking for net worth statements…without asking for anything…bailed out? Why are private equity idiots who are sitting with over $300 billion in unfunded buyouts?
I know free markets. Free markets are a friend of mine. These are no free markets. Our markets are now being constantly interfered with in order to save the so-called “masters of the universe” and I have to tell you, it is downright depressing. If markets want to go to the moon, I am all for it. If markets wanted to go into a bear market, I am all for that. I just want free markets.
Much of our national financial well being depends on our lemonade sales. Our credibility has been materially damaged and we are now known for selling tainted goods, deliberately selling tainted goods. That’s important. One has to expect sales to materially drop off. Tough times lie ahead.
re: “free markets”, messy, complex, “tainted goods”
- relative to what?
“…China has a complex stock market. There are several classes of shares, and some of them are available to certain investors and not to others…” http://www.indexuniverse.com/index.php?option=com_content&view=article&id=2956&Itemid=28
re: “the market is the prediction – it is the sum total of many individual human or computer predictions” – with some having a greater capacity to fulfill the prediciton
“…the Chinese market remains dominated by lumbering state-owned companies – not the private sector enterprises that are the real engine of economic growth, or many of the global companies that dominate exports. Although the official market capitalization is $1.3-trillion, most of this amount is in shares that cannot legally be traded until 2008 or 2009 because of rules imposed when they were converted to A-shares… Only about $400-billion worth of shares can be legally traded now… and of this amount, only about $160-billion are held by retail or institutional investors. This means that 60% of tradable shares are controlled by state corporations, government agencies, the police, the army, or large private investors with dubious legal status. Despite the reforms of recent years, the Chinese market is still riddled with manipulation and insider trading, and it will take at least another 10 years before it reaches any level of maturity… “The market prices aren’t set by any transparent process… The prices of the stocks are unrelated to their value. Nobody really knows who owns the stocks…” http://www.chinatownconnection.com/china-market-myth.htm
product or system? – if its minimum speed is 400km/hr on roads built to accomodate 100-180km, there are bound to be crack-ups and casualties until the infrastructure adapts…
“…For a start, there is no relatively simple and well-understood single model of default correlation like the Black-Scholes model, which is used in the interest rate and equity option markets. Bankers admit that in the world of credit derivatives, the market is only just beginning to settle on a standardised model of correlation, while Black-Scholes has been around for two decades. These models of correlation are not only inherently flawed because the historical data is insubstantial and often untrustworthy, but they are also likely to make assumptions about the market that do not capture anything like its full dynamic and complexity. This, of course, is the nature of models. Any model of a concept as complex as correlation that is structured to take full account of market complexity is likely to be too cumbersome to be used effectively in a front-office environment. Decisions about pricing a deal have to be made in seconds, or at least minutes, but very rarely can they be allowed to take hours. Even using the standard one-factor copula, pricing a bespoke CDO tranche can be a very time-consuming business…” http://www.creditmag.com/public/showPage.html?page=168572
“…Harry Markowitz’s modern portfolio theory, introduced in 1952, is no longer fully adapted to today’s financial environment, and it’s time for portfolio construction theory to move on…” http://www.hedgeweek.com/articles/detail.jsp?content_id=165352
Generally you can’t split up correlation products on n underlyings into m underlyings (m < n). The value of the product depends on an n x n matrix, which can’t be decomposed into smaller matrices.
http://www.prudentbear.com/index.php?option=com_content&view=article&id=4735&Itemid=53
The spread of securitization and derivatives has enabled more bad deals to be done, confidence to be raised to a higher and more irrational level and the asset bubble to be prolonged. By increasing the opacity of the market, these new techniques have weakened its ability to price risk appropriately.
Needless to say, when confidence finally disappears, the market outcome will be very bloody indeed. We have already seen this, in a blip in the inter-bank market similar to the darkest days of 1974, in which banks have been forced to pay more for simple overnight funding because counterparties did not trust what hideous losses might be hidden in their dealing rooms. This first time around, injections of cash from the Fed and the ECB prevented the panic from worsening. However panic will return, and at some point the world’s central banks will be unable to dampen it down. In the end, when all becomes opaque, all becomes uncertain and market confidence dies. Roll on that day, for ending the wave of overconfidence is a necessary corrective; the longer it is delayed, the more expensive the denouement will be.
At that point, market participants will doubtless wish that a healthy suspicion of new apparently painless ways of making money had been maintained throughout.
gillies,
Wonderful extended mill metaphor. “A Fool’s Progress”?
a
if the n by n matrix is no longer worth more than the n underlying instruments, how would you recommend proceeding? or is a ‘correlation product” once created something that has to be effecively held til either a) maturity or b) the return of liquidity to that segment of the market?
one of the things that amazes me is that a process orginally intended (in part) to create “liquidity” in the mortgage market (i.e. securitization) managed to create a set of complicated “correlation” products that now seem almost as illiquid as mortgages were in the pre-securitization days.
stuart. I agree in broad terms. not sure about “deliberately tainted” goods. but sheen is off of American securitization/ financial “sophistication.” and it is hard to argue against the notion that the us has been in the business of exporting lemonade (and a lot of plain vanilla treasuries and agencies) over the past few years.
the potential savings grace is that the underlying demand for agencies (with the us keeping the credit risk and foreigners just buying int. rate risk and currency risk) remains strong, in part b/c central banks as a matter of policy buy the currency risk despite the expected loss.
Guest on 2007-09-02 07:48:22 – in other words, http://www.prudentbearfunds.com/ thinks, of course, that everyone should buy its’ products now – but you might want to read the risk profiles first: http://www.prudentbearfunds.com/index.php?option=com_content&view=article&id=16&Itemid=78
and check out relative performance, recently and since inception: “The Prudent Bear Fund returned -1.20% during the quarter ending June 30, 2007, while the S&P 500 returned 6.28%…” http://www.prudentbearfunds.com/index.php?option=com_pbfunds&module=&task=bearFundManager&Itemid=27
and speaking of transparency, if anyone knows PB products well enough to find a current, detailed description of the assets held in these funds, I’ve clicked on the most obvious links, but nothing yet…
re: “process orginally intended (in part) to create [or facilitate?] “liquidity”"
if process is the key word – like resevoirs that go dry in a drought.
“…First State Investments, based in Singapore, has cut its holdings in all Asian financial firms in recent weeks. At this point “it doesn’t really matter what their exposure is” to subprime products through derivatives… “What concerns us is the sentiment” in the market…”
http://www.iht.com/articles/2007/08/30/business/derivatives.php?page=2
re: poorly constructed manic, frenzied home construction
sorry, but seems to be a global trend, even in ‘emerging mortgage market’ regions
“…Mortgages account for just 1% of gross domestic product in Russia, compared with 5% in Kazakhstan, and about 40-50% in the West…” http://www.moscowtimes.ru/stories/2007/08/30/041.html
with the ‘productivity’ of investment and quality of construction having little, if anything, to do with credit markets:
“…Transparency International (TI) singles out the global construction industry… as the most corrupt segment of the world economy… more than just wasted money. Corruption can lead to shoddy workmanship, which in turn can damage the environment and even cost lives…” http://www.rferl.org/featuresarticle/2005/03/cf4e62f0-006d-4d20-a131-fd18dfed99c3.html
“…WHY has the impact of the subprime meltdown been so much more severe in communities like Maple Heights than in other parts of the country? Mr. Rokakis suggests that it is a combination of Cleveland’s underlying economic problems and a [resulting] lack of the steadily appreciating housing prices that other areas enjoyed…” http://www.nytimes.com/2007/09/02/business/yourmoney/02village.html?pagewanted=4&_r=1&ref=business
“…if Northeast Ohio doesn’t learn how to innovate again, if it doesn’t start finding new ways to attract more of the world’s money, “we’re in trouble,” Hill said. “The slow bleed will continue.”… innovative, growing, knowledge-rich regions like… the fabled corridor around Boston’s Route 128 that attract and produce lots of smart people, usually with the help of a world-class university or two… “Cleveland has no critical mass on which to build,”… That lack of critical mass is why high-tech spinoff companies have not materialized here in the hoped-for numbers, despite what Fogarty described as substantial investments in science and technology. And it’s why the standard of living – as measured by per-capita income – continues to slide here relative to the rest of the nation. Fixing the problem will take far more research than is now being done into how to create those critical linkups of university-industry R&D…” http://www.cleveland.com/quietcrisis/index.ssf?/quietcrisis/more/997613701159100.html
Stormy, Gillies,
When I heard Friday’s reports of Bush’s bailout plan and Mishkin’s Jackson Hole speech, it was Hogarth’s “Rakes Progress” that came to my mind as a metaphor for the US economy.
GDP grew 4%..proof that you doomsdayers are wrong.
The US economy always prevails.
Guest on 2007-09-02 16:17:40
“GDP grew 4%..proof that you doomsdayers are wrong.”
What a moron!
Guest and anon posting should be discouraged.
Guest and anon posting should be discouraged.
I concur.
Stormy, Gillies and RebelEconomist,
Do you remember that the Economist was talking about a “soft landing of US housing” a year ago?
Today they released a long paper about the US housing hard landing, the credit crunch, and so on.
Although premium content, it is here:
http://a330.g.akamai.net/7/330/25828/20070831144222/graphics.eiu.com/upload/Heading%20for%20the%20rocks.pdf
A little resume:
The tremors in financial markets have gone far beyond their beginnings in the US sub-prime mortgage sector, and indeed far beyond the borders of the US. The full impact on the markets, and the repercussions on the global economy, remain unclear, but we can sketch out three broad scenarios:
- Scenario 1. The Economist Intelligence Unit’s central forecast, to which we attach a probability of 60%, sees the impact being contained by timely monetary policy action, with only a modest effect on the global economy.
- Scenario 2. Our main risk scenario, with a 30% probability, envisages the US falling into recession, with substantial fallout in the rest of the world.
- Scenario 3. Should the US enter recession, another, darker scenario arises: that corrective action fails, and severe economic repercussions cascade from the US into the world economy with devastating effect. We attach only a 10% probability to this outcome, but the potential impact is so severe that it warrants careful consideration.
Since scenario 1 informs about regular output and Scenario 3 has a low probability, the bulk of the report focuses on scenario 2.
It’s funny to note that they are giving explanations of Scenario 2 in the 60% of the report, when they say that the chance of this scenario is 30%. 2 + 3 make 40% of a bad future… Hummmmm!
Might that mean that they are sure of scenario 2 and doubting about scenario 3?
Brad, we’ve realized that you are more bear than bull lately, and not precisely by Roubini’s influence… and if things go this way, you’ll take your hat off to Roubini, with a Chinese smiling.
But, don’t worry, he will be very happy of having you with him, because you’re the only hope of fundamental economics working in that dammed globe!
MBS and CDOs apart,
you’ll work will shine sooner than later!
The best teacher!
Best Regards to you all!
Koteli,
I rarely read the Economist……you have to draw the line somewhere!…..but they are famous for bold predictions which sometimes are made at precisely the wrong moment. Macro Man did a post on their most embarrassing cover stories a while ago.
I have no doubt that without easing of some kind, there will be hard times ahead, but I also have no doubt that there will be easing. For me, the interesting question is whether there should be, and whether it would be better to allow a recession to take its natural course now than hit something even worse later. It seems to me that most commentators who opine on monetary policy do not consider how it works, but they have been told that it is like a car accelerator, and if the car slows down, then the pedal should be pushed harder. The trouble is that this view is mistaken – an interest rate is a market price, like anything else, and if it is fixed, distortion can be expected.
“…The United States makes more manufactured goods today than at any time in history, as measured by the dollar value of production adjusted for inflation… With less than 5% of the world’s population, the United States is responsible for almost one-fourth of global manufacturing, a share that has changed little in decades. The United States is the largest manufacturing economy by far. Japan, the only serious rival for that title, has been losing ground. China has been growing but represents only about one-tenth of world manufacturing…” http://www.washingtonpost.com/wp-dyn/content/article/2007/09/02/AR2007090201189.html?hpid=topnews
Correlation products: sell it back to the original client (not possible in this case, if I understand correctly), find another buyer, or hold it to maturity.
“…the credit market for small businesses is “thriving.”… But some analysts said banks that rely on deposits to make loans will generally not have to charge their business customers more to borrow. “The banks are pretty immune from the type of problems the finance companies have had because they are not dependent on the money markets, commercial paper markets and other market-driven sources of liquidity…” http://www.washingtonpost.com/wp-dyn/content/article/2007/09/02/AR2007090200966_2.html
beyond the fruits, bulls and bears have never been adequate categorizations for market participants and sentiment, and certainly are not in the age of more complex markets. i’ve never met a knowledgeable investor who is consistently, blindly optimistic. successful ‘bears’ are very ‘bullish’ about anything that is clearly undervalued and has good long term potential.
assume the chicken littles work for the insurance industry, are serial short sellers – or government economists hoping that market failures may create opportunities to build a powerbase and their own income potential as administers of social assistance to those affected.
really effective shortsellers may be deserving of bloomberg’s ‘hitmen’ metaphor – not sure how that translates in the animal world – perhaps attack trained dobermans and pitbulls.
the dinosaurs must work for the dredges of dying industries or may have obligations to protect various outdated academic theories and territories – or laziness at the prospect of having to endure the hard work and competition involved producing something better which actually captures change – better to fear and slander anything new, keep dwelling in the past and hope all change is temporary phenomena that will implode leaving one’s own prehistoric pet theories to prevail.
endangered species representing sectors, regions and ideas worth saving, like the environment and proven approaches to its management.
ostriches perhaps belonging to the family of political animals that selectively isolate and spin facts for the sole purpose of slandering the opposition, and regain or hold their own powerbase while attempting to suppress and distract from unpleasant truths about their own party’s failings.
i’m sure the farm is much bigger then that – whether haphazard cross-breeding and genetic engineering is generating replacements for possible losses in dinosaur and endangered species categories – and without getting into the mapping of more favourable habitats for each. just a start
“…[vulture] funds are now said to be circling over an estimated $300bn of loans that the big banks cannot sell on because of market uncertainty. Typically, vulture funds try to buy [dead meat] at levels well below par… They generally shy away from the word “vulture” and prefer to call themselves “special situations” investors… Citadel… is an expert at so-called bottom fishing.” http://www.ft.com/cms/s/0/62f204c4-51da-11dc-8779-0000779fd2ac.html
bear: “…One of the most successful investors to bet on a credit crunch was Jim Melcher, who has run Balestra Capital, a small New York hedge fund… It has doubled so far this year. He did this by exploiting the complex new debt instruments that are now exploding in the faces of their inventors. For example, he bought… (CDSs) against a range of 30… (CDOs) that were rated AA. Translated into English, he bought insurance against default by packages of loans that were not the highest quality, but were not junk either… He sold short the ABX index of subprime mortgage bonds, a manoeuvre that made money when the price of these bonds shot down. He also sold short high-yield, or “junk” bonds while buying Treasury bonds. That paid off when there was a sharp increase in the extra yield that junk companies had to pay. And he bought the Japanese yen, which has risen during the market mayhem. The risk was that someone on the other side of the transactions had to pay up. These counterparties are usually investment banks and Mr Melcher thought some might go under. As insurance he bought “put” options – giving the right to sell stock for a given price – in investment banks. These were cheap because they were “out of the money” – meaning that they conferred the right to sell for a price far below the price at which the companies were trading. That trade also proved lucrative, as the fall in investment banks’ share prices has pushed up the price of the options. Even his insurance policy is making money. The true bargains, then, were when the credit market was at its peak. There will be chances to pick up undervalued securities when this crisis has played itself out. But for now, the discouraging news is that value investors remain on the sidelines – while Mr Melcher is still betting on things to get worse.” http://www.ft.com/cms/s/0/c8ceb270-5823-11dc-8c65-0000779fd2ac.html
“…Like horses that rear up at the sight of a rattlesnake, investors who financed commercial lending have become spooked… “The reason there isn’t a market for these credits is that people don’t know what price they should be trading at,” …One official compared the load of maturing debt to a pig in a python: a bulge that would be take time to digest… Much of the digesting will be by big banks [pythons?]…” http://www.nytimes.com/2007/09/03/business/03fed.html?ref=business
“One of the most successful investors to bet on a credit crunch was Jim Melcher”
if i follow this man’s manoeuvres correctly, he made a lot of money entirely out of people like himself. in the market menagerie he counts as a cannibal trout.
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Written by bsetser on 2007-09-02 09:12:24:
” One of the things that amazes me is that a process originally intended (in part) to create “liquidity” in the mortgage market (i.e. securitization) managed to create a set of complicated “correlation” products that now seem almost as illiquid as mortgages were in the pre-securitization days.”
I think there’s a distinction to be made between the idea of funding liquidity capacity of the originating institutions and the market liquidity of mortgages as instruments. The original motivation for securitization was to expand the outlet for mortgages beyond bank portfolios. Banks viewed securitization as an alternative funding source. Moving mortgages off balance sheet liberated bank-funding capacity for other purposes. Beyond liquidity, the broader risk purpose was freeing up bank capital. Banks could improve ROE by moving mortgages off balance sheet while retaining origination and/or servicing fees. Other balance sheet benefits such as a reduction in asset concentration and interest rate risk fell under the broad umbrella of more efficient capital utilization.
This worked fairly well for the commercial banks. But the risk motivation of bank CFOs is not the same as the risk motivation of investment bankers and traders. The machine for securitization went to overdrive on aggressive risk sourcing and overly complex risk transformation. Increasing complexity in non-bank portfolios resulted in deteriorating non-bank credit and liquidity risk, until we are where we are today.
The secular improvement in bank liquidity has actually been a success – notwithstanding the recent larger-scale discount window borrowing (largely staged and symbolic), in an environment of broad credit and liquidity turmoil. Much commercial bank risk has been transferred to others. The money center banks with broadly diversified risk profiles should weather the storm relatively well in comparison to stand-alone investment banks (e.g. Bear, Lehman) and non-banks.
The buildup of risk in the latter is the center of the systemic failure this time around. This was aided and abetted by risk analysis that promoted backward looking correlation as a (risk) free lunch. Unfortunately, the risk management industry has supported risk taking with great quantitative sophistication, but absent a counterbalance of good judgment.
“…James Grant: “The legacy of a boom is excess in all forms…” http://www.pbs.org/newshour/bb/business/jan-june02/ethics_6-27.html
“…the focus on ownership has seen the dual objectives blur, and the emphasis move from rehabilitation and construction of public housing towards moving more Americans onto the home-loan ladder. “One administration after another – particularly during the Clinton years – has pointed to the increase in ownership. It seems we overdid it.”…” http://www.ft.com/cms/s/0/aa9ea90a-57dc-11dc-8c65-0000779fd2ac.html
Guest: Why are the hedge fund managers who went 15-1 margin bailed out?
The weren’t.
Guest: Why are lenders who lent money to people without asking for income statements…without asking for net worth statements…without asking for anything…bailed out?
Also no bailout. Now FHA is extending some credit to the borrowers who are on the edge of losing their homes, and that can be justified since there was a lot of selling of mortgages that were clearly unsuited for the customer.
Guest: Why are private equity idiots who are sitting with over $300 billion in unfunded buyouts?
Because they had nothing to do with investing in subprimes.