Brad Setser

Brad Setser: Follow the Money

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Not all that sophisticated

by Brad Setser
April 21, 2008

Back in 2005, Ragu Rajan warned that the banks were taking on the hard-to-sell leftovers from the securitization process. As a result, he argued that the banks were becoming less liquid – and that the process of risk transfer was incomplete. I assumed that this meant that the banks were holding small amounts of the most risky tranches that emerged from bundling a lot of different loans and securities together. That assumption seems to have been off. The risky bits carried high yields, and seem to have been easy to move. Instead the banks were holdings large quantities of the safest (and lowest yielding) securities – the “super-senior” tranches.

Gillian Tett:

The concept of super-senior debt was essentially invented by creative bankers about four years ago to refer to the chunk of debt that sits at the very top of the capital structure of a collateralised debt obligation. It is the bit that gets paid off first, before other investors, if the CDO ever defaults. In theory, it makes this debt super-safe; indeed, so secure that rating agencies have been happy to give super-senior CDO debt a triple-A tag, irrespective of what lay inside the CDO.

When I first heard about this asset class a couple of years ago I initially assumed this stuff might appeal to risk-averse institutions such as pension funds. But nothing could be further from the truth. In fact, key buyers for super-senior in recent years have been banks such as Merrill Lynch and UBS. Most notably, as these banks have pumped out CDOs, they have been selling the other tranches of debt to outside investors – while retaining the super-senior piece on their books. Sometimes they did this simply to keep the CDO machine running. But there was another, far more important, incentive: regulatory arbitrage.

Most notably, because super-senior debt carried the triple-A tag, banks were only required to post a wafer-thin sliver of capital against these assets – even though this debt has typically offered a spread of about 10 basis points over risk-free funds. Thus, banks such as UBS and Merrill have been cramming their books with tens of billions of super-senior debt – and then booking the spread as a seemingly never-ending source of easy profit. It is not just the CDO desks that have been playing this game; treasury departments have been playing along. So have many hedge funds, including those financed by . . . er . . . the major investment banks

It turns out that the super-senior tranches carried a lot more risk than many thought – Combing a bunch of CDOs composed of subprime securities into a new security didn’t make the underlying risk go away. Plus these instruments were illiquid and thus hard to sell.

I never thought that (formerly) highly-rated US securities would trade at the same price as Argentine bonds just after Argentina’s default. The ultimate recovery on those bonds may end up being higher as well.

Moreover, as Gillian Tett reports, the banks themselves weren’t only holding these securities to make the securitization process work. They also liked the extra yield that they could get on something that was rated triple-A.

So there you have it: in the last resort, a key reason for these record-beating losses is not a failure of ultra-complex financial strategies or esoteric models; instead it arose from a humongous, misplaced bet on a carry trade that was so simple that even a first-year economics student (or Financial Times journalist) could understand it. It is a shocking failure of common sense and risk management. So the moral, in a sense, is also a simple one: if someone offers you seemingly free money, in seemingly infinite quantities, with a soothing new name, you really ought to smell a rat. Even – or especially – if you are in the position of running a supposedly sophisticated investment bank.

It took a huge amount of sophistication – or at least computing power – to produce a lot of the securities that have caused so much trouble. But sophistication doesn’t explain why so many banks were holding something with risks that they didn’t fully understand to pick up a few basis points.

And it wasn’t just pure regulatory arbitrage either . Unregulated institutions seem to have been doing much the same thing — UBS’s in-house hedge fund for example.

My guess is that a bunch of unsophisticated reserve managers ended up doing a lot better over the past few years than a lot of sophisticated bank treasurers. They didn’t take on as much credit risk, so they didn’t get as much yield during the good times. But they also didn’t take on the risk of large losses for a few extra basis points.

Of course, the bank treasurers who took on too much “holding complex securities that you cannot sell when you need to risk” generally avoided taking on much currency risk. Central banks generally avoided credit risk, but took on a ton of currency risk. The investment banks held the super-senior tranches no one else wanted; central banks have been holding the dollars no one else wants.

References:

The FT on the sources of UBS’s subprime exposure

The Wall Street Journal’s explanation of why Merrill ended up with so much subprime related exposure on its balance sheet (they kept their factory going even as demand for the product faded … ), and a story illustrating how Merrill created a CDO composed largely of credit default swaps on “triple B” mortgage backed securities and bits and bits of other Merrill CDOs. Merrill didn’t confirm that it ended up holding the super-senior tranche, but, well, you can draw your own inferences.

Yves Smith’s examination of Merrill’s initial round of CDO-related losses.

Fortune’s write-up of UBS’s internal report. UBS’s internal hedge fund seems to have loaded up on subprime — and banks’ own desk was adding to its positions even in q2 2007.

Felix’s analysis. UBS wasn’t just holding the unwanted output of its own securitization. It bought a lot of other banks CDOs. And its hedging methodology effectively left it unhedged — and created incentives for its internal fund managers/ prop desks to take advantage of UBS’s low cost of funds to load up on CDOs and pocket the carry.

The actual UBS report.

Internal Citi presentation (lifted from the comments)

Alea’s table showing CDO issuance

67 Comments

  • Posted by NICOLAS

    If the rating agencies did not understand what they were rating why did they give a rating at all to these CDO’s etc. Regardless of what responsibility the FRB has in this mess. How could the rating agencies make these products acceptable?

    This mess is a massive failure of competence and is not just a matter of more regulations which is what the blind incompetents of Washington want. This seems a matter of corruption.

  • Posted by bsetser

    p.s. if a reader has a good link or two on the origins of citi’s big exposure (liquidity puts and the like), I’d be all ears. I did this post in part to warehouse some links on the truoble the banks got into warehousing CDOs …

  • Posted by DC

    And the Fed’s balance sheet is rapidly filling up with the same garbage loans. From Bloomberg,

    " Wall Street firms may be bundling high-yield, high-risk corporate loans into securities to use as collateral to borrow from the U.S. government, according to a report by Morgan Stanley analysts. Securities firms can borrow against collateralized loan obligations at the Federal Reserve’s Primary Dealer Credit Facility, the analysts said. The Fed set up the facility last month, its first extension of credit to non-banks since the Great Depression.

    Lehman Brothers Holdings Inc., the fourth-largest U.S. securities firm, last month created the $2.8 billion Freedom CLO, the largest this year, out of loans that couldn’t be readily sold to investors, such as for buyouts of payment processor First Data Corp. and power producer TXU Corp. JPMorgan Chase & Co., Deutsche Bank AG and Barclays Plc also underwrote CLOs in March, according to data compiled by Bloomberg. "

    http://www.bloomberg.com/apps/news?pid=newsarchive&sid=alBrRvnzgSaM

    Now we see CLOs being created for the express purpose of swapping to the Fed. The reason the CLOs are being created is there is no market for the underlying loans. Yet supposedly Moody’s, Fitch, and the S&P are supposed to rate this garbage investment grade so that it can be swapped with the Fed. Absolutely corrupt!

  • Posted by Guest

    Remember when we were told that there was "good" debt (mortgages) and "bad" debt (credit cards)? The idea was that if debt could be used to create greater wealth, then it was good debt. Since we can no longer borrow to create greater wealth (real estate prices continue to drop and the stockmarket is rigged), there must be no such thing as good debt, anymore. Somehow, this good debt looks a lot like "enhanced", SIV-driven money markets. Those enhanced instruments turned out to be really bad debt.

    Our creative money managers are really working hard to generate their commissions. Wouldn’t it be great if they worked hard to protect the solvency of their investors’ funds, and maybe, at the same time, worked to generate, for those investors and pensioners, some tangible yields?

  • Posted by Guest

    Not all that sophisticated? The sad part is the Federal Government agencies who should have provided oversight to keep the crooks from tearing down the financial system were staffed with bigger crooks………Greenspan, Paulson, Bernanke, come to mind.

  • Posted by bsetser

    there is a difference between being driven by ideology and being a crook. I wouldn’t lump Bernanke with Greenspan either — Bernanke strikes me as much less doctrinaire on the question of regulation and I suspect (in part b/c of the events early in his tenure) much less of a cheerleader for financial innovation.

  • Posted by somalia

    What ARE the SIGNS that the US is losing its top position in the world?

    Many!!

    One of them is the EXCESSIVE propaganda by the contrived US media leveling at China. Why? Because China is apparently EXPANDING RAPIDLY its "sphere of TRADE." The West had a thing they called their "Sphere of Influence."

    There you have it. China has a policy that favors TRADE. While the West has a policy that calls for INFLUENCING OTHERS!!!!!!

    No one in this world today wants to be influenced in any way by the corrupt, war-like US. We, in AFRICA, like China’s sphere of trade because the chinese seek to INFLUENCE NO ONE and steals NO one’s resources by military force!!!!!

    And that’s why the West will FALL and China will RISE, RISE, RISE, until it soars above the West. That day is coming sooon!!!!!!!!

  • Posted by RebelEconomist

    Interesting……I am also surprised to hear that the investment banks were keeping the more highly rated tranches. I struggle to believe though that even super-senior structured product only yielded 10bps more than "risk-free funds". Investment banks cannot be that stupid.

  • Posted by Anonymous

    To make it more obscene, super-senior tranches are generally attached to synthetic CDOs, which are constructed from credit default swaps. Its not even real money to begin with – just a pure bet on credit risk.

    Citi held a mountain of super-senior CDOs on its books. If you want an interesting education on this stuff, listen to their 3rd quarter conference call last year.

  • Posted by SGC

    See this link for Citi and super-senior exposure: http://ftalphaville.ft.com/blog/2008/01/03/9880/citis-19bn-cdo-writedown/

    Note that Citi’s problem was less warehousing, than backstopping commercial paper conduits (i.e. liquidity puts). When the asset backed commercial paper conduits failed, Citi ended up with piles of super senior exposure on their books.

  • Posted by satish

    Somalia-

    I completely agree with you. Chinese economy is currently the largest economy in the world. CIA factbook few months ago had chinese percapita income at 8100 for 2007. So this year it will over 9000 dollars due to devaluation of dollar. But that will put chinese economy the largest in the world. So they convieniently changed to 6700 dollars(PPP). This tells US is still in a colonial era.

  • Posted by mheck82

    satish,

    Not that it would matter, but you are wrong. The change was made because the PPP was outdated and there was a complete survey for the first time. And of course devaluation of the dollar does not improve PPP GDB in the same way as nominal GDP: Local services in the US have become cheaper in CNY.

    PPP is irrelevant with regard to most international issues. Nominal quantities count, for example if you want to buy raw materials or equaty or food or whatever in another country…

  • Posted by Anonymous

    Tett’s article isn’t really correct as to the why.

    Yves has it right:

    "So what happened to Merrill? It was enamored of the CDO underwriting fees (managers also get to take "management" fees). But the market was backing up and Merrill was having trouble placing paper. (note despite the discussion of guarantors, Merrill did not step in to provide credit enhancement. It didn’t have the AAA rating to enable it to do that. The financial guarantor business was added either out of confusion or to illustrate that guarantors as well as investors were abandoning the paper). The fact that Merrill was holding AAA paper means it was already structured and rated, not inventory waiting to be securitized (although a related story suggests Merrill was stuck with some of that too). So Merrill kept doing these deals so it could continue to book the new issue profits, but wound up keeping some of each deal on its balance sheet because it COULDN’T SELL IT."

    The same thing happened at Citi. Equivalent in concept to a massive failed underwriting.

  • Posted by Guest

    RGE alum Felix Salmon could help you out…

    http://www.portfolio.com/search/results?txtSearch=liquidity+put

  • Posted by bsetser

    I get the sense that Citi’s SIVs could be viewed as a form of warehousing, just sort off balance sheet. And perhaps that citi increased its placements with various vehicles when demand started to erode for the fees. The liquidity puts were part of the process that was required to move the paper off-balance sheet. That though could be off — and I clearly do not know.

  • Posted by bsetser

    Somalia. I am quite aware of the fall in the United States global standing, its political influence and its economic impact — the rise in commodity prices even as the US slowed is a sign that things have changed. traveling to europe with the dollar at 1.60 is a wake-up call. I also realize that rising commodity prices have been quite good for much of Africa. That said, I would be surprised if china has no desire to exercise influence — once china makes a large investment, it presumably will want enough influence to assure that its investment isn’t threatened by a change in government.

  • Posted by Qingdao

    Another clear explanation at; Remarks of John C. Dugan Comptroller of the Currency before the Global Association of Risk Professionals, NY NY, Feb. 27, 2008. (sorry, no web site)

  • Posted by Guest

    "…there’s a strong case to be made that the super-senior tranches of CDOs were never worth what the banks booked them at, not even before the market crashed. Here’s the bit of the story that Tett only hints at… no one was interested in the "super-senior" tranches which yielded only 10bp over… If the banks had sold the super-senior debt at a market yield – if they’d bumped up the coupons on the super-senior tranches to the point at which some investor would have been willing to buy them – then the magic profits of securitization would have been eradicated, and the efficient markets hypothesis would have held: you can’t make a pie bigger by slicing it laterally rather than radially. But the bankers’ bonuses were all tied to the idea that you could make a pie bigger…

    Think about it this way. I buy the ingredients for an apple pie: apples, sugar, flour, that sort of thing. Add them all up, and they come to $10. I then cut the pie into four unequal slices. I sell one for $1, another for $3, and a third for $5. The fourth slice I price at $2, but I can’t find any takers… Now in theory, if I could sell that fourth slice for $2, then I’d have a nice little business going. But I can’t, so instead I keep a hold of that fourth slice myself, telling everybody that it’s worth $2, and booking my $1 profit. Then, one day, the game stops, people start asking awkward questions about how much that slice is really worth, and it turns out that when I test the market, no one’s willing to pay even $1 for it, let alone $2. And that’s when I write down the value of my slice and take a big loss for the quarter… But hey, at least I got nice big bonuses so long as the game was going…" http://www.portfolio.com/views/blogs/market-movers/2008/04/21/how-to-make-fake-profits-in-the-cdo-game

  • Posted by bsetser

    glad to see felix’s skepticism toward financial engineering has gone up; there was a time when he really was convinced that CPDOs could deliver LIBER + 200 bp with no real additional risk :)

  • Posted by Guest

    Your right Brad and every time they created a new fund to move the bad money to they got $ for themselves, they house be dammed. It’s along way from being over I can see that from were I live as close to the ground and as far away from this group as possible.

    jo6pac

  • Posted by Anonymous

    Brad,

    `Super senior’ can refer to tranches with widely (and wildly) varying characteristics. Citi got into trouble with _unfunded_ super-seniors, which are total return swaps and looked like a free lunch.

  • Posted by bsetser

    anonymous — i am going to need a bit more help to get the full significance of your point. could you spell out the difference between a funded and unfunded super senior tranche to help me out? thanks.

  • Posted by Anonymous

    Brad,

    An unfunded super-senior is essentially a CDS that protects the next-lower tranches in the deal. The structure pays the super-senior for protection, and, as in a CDS transaction, the super-senior (protection writer) has no upfront outlay. The idea, of course, is that the lower tranches wouldn’t breach, and Citi would book the protection payments. Didn’t work out that way… The confusion is thinking that a tranche is a bond rather than a CDS.

  • Posted by bsetser

    Now I am really confused. If the super-senior tranche (unfunded) is providing protection to junior tranches, it isn’t in any meaningful sense super-senior best I can tell (and I cann’t tell all that much). Rather than being protected by the lower-rated tranches in the credit structure, it is providing the protection …

    Am i missing something?

    I get the idea that Citi got into trouble selling insurance too cheaply (b/c it wanted the profit from selling insurance) and sold too much insurance v its capital b/c that seemed like an easy way to boost earnings. But I don’t get how a seller of insurance is "senior" to the insured bits of the structure.

  • Posted by Anonymous

    No, you’re not confused. The super-senior is termed such because it is first in the payment waterfall (it gets paid before any other tranche, unless there is a breach. If there _is_ a breach, then the super-senior holder is obligated to inject cash into the structure per whatever the structure’s indenture requires.). So it’s a payment stream with a huge liability in the tail. Note that this is a _cash_ liability, so it’s not a paper write-down. Citi actually discussed this in its first conference call with Pandit, but it seems to have escaped the attention of analysts and journalists.

  • Posted by Anonymous

    Also, providing the super-senior protection may have had more to do with monoline unwillingness than the desire for a 10bp spread…and, I believe, some of the super-senior wound up in SIV / CP conduits and subsequently flowed back onto the balance sheet when Citi backstopped that paper. Citi’s off-balance sheet was a three ring circus.

  • Posted by anonGuest

    "An unfunded super-senior is essentially a CDS that protects the next-lower tranches in the deal …If there _is_ a breach, then the super-senior holder is obligated to inject cash into the structure per whatever the structure’s indenture requires."

    This is not correct. It doesn’t protect the lower tranches.

    The super-senior provides credit protection via a CDS type structure, and pays if credit losses exceed the lower-tranche loss absorption. Citi got nailed due to write-downs on super-senior.

  • Posted by anonGuest

    The liquidity protection for the SIV is separate.

    Citi took CP onto its books that was exposed to super-senior via the SIV.

  • Posted by anonGuest

    The following from Felix, which corresponds to above:

    "the banks which created these structures, like Citigroup, promised that they would step up and buy the ABCP if no one else would. That is the famous liquidity put.

    After the super-senior tranches of mortgage-backed securities started plunging in value, the owners of those tranches found themselves having to roll over their ABCP, repaying their original lenders and finding new lenders to fund their positions. At that point, there were no takers for that kind of paper at any price – there was no liquidity in the ABCP market. And so the liquidity put was triggered, and Citigroup was forced to buy the ABCP itself.

    Now the ABCP is asset-backed, so Citi could and presumably did take possession of the super-senior paper which was held by the LSS vehicle. The original investors in the LSS will have been wiped out, left with nothing. But the value of that super-senior paper as now fallen so far that it’s worth much less than Citigroup paid for the ABCP"

  • Posted by anonGuest

    And the "liquidity put" as an aspect of securitization structures is 20 years old, for God’s sake.

    It’s central to everything that’s going on, because it points to the issue of whether the risk has really been transferred from the bank to the vehicle, and therefore whether the bank can get capital relief. It’s turned out to be the fundamental flaw in securitization economics, but it was recognized as controversial and contentious at the dawn of securitization itself. Capital relief for the bank asset providers turned out to be smoke and mirrors. On this issue, the blame clearly rests with bank regulators who assessed the risk and still allowed capital relief for the banks. This isn’t really capital "arbitrage" as you refer to it, anymore than any other capital adequacy assessment, because the capital rules were in place. It’s just bad risk and capital adequacy analysis by the regulators.

  • Posted by anonGuest

    The liquidity put refers to the CP, which is backed by super-senior.

    It doesn’t refer directly to the super-senior, which itself is synthetic.

  • Posted by anonGuest

    And, from Felix again:

    "Or, rather, the liquidity put is that CDO-backed ABCP, and it’s making billions of dollars of Citigroup’s capital softly and silently vanish away.

    A liquidity put is really nothing more than a CP backstop."

  • Posted by Judy Yeo

    Brad

    When the crisis hit hard, Yves did entire weeks of coverage on the mess, pretty extensive.

    the complicity of ratings agencies and banks was also well documented by Yves. The entire alphabet soup be it CDOs squared or VIEs have been dragged out but apparently dismissed by the equity players? Optimism or just no where else to park funds?

    As for recovery, erm, not so optimistic; partly ‘cos initially people thought that should the worst happen, it would merely impact the lower rated tranches and that the super senior tranches would be protected i.e. the triple A ratings guaranteed safety, unfortunately, the surfacing of correlation meant almost all tranches were affected, going from bad to worse from August to December 2007. Recovery almost vertainly depends on the underlying assets which are ultimately tied to mortgages, maybe next year there’ll be a recovery of sorts but highly unlikely in the next few months. Eventual recovery also involves the viability and existence of those underlying assets; even the foreclosure processes are messy right now, so who knows?!

  • Posted by Twofish

    Nicolas: If the rating agencies did not understand what they were rating why did they give a rating at all to these CDO’s etc.

    Most of the people who did the actual ratings did understand the complexity of the stuff. However, what happens is that people want to reduce all of the risks to a single set of letters, and what you do that, a lot of information gets lost.

    The basic problem with super-seniors is the tower problem. If you are on 50th floor of a building, it’s highly unlikely that the waves will hit you, and the AAA rating basically consisted of the correct belief that the waves will not hit the 50th floor.

    Trouble is that, that with CDO’s unlike corporate bonds, if the first floor goes, then it will take down the 50th floor.

  • Posted by Twofish

    Guest: The sad part is the Federal Government agencies who should have provided oversight to keep the crooks from tearing down the financial system were staffed with bigger crooks………Greenspan, Paulson, Bernanke, come to mind.

    Don’t think that this is the problem. The trouble is that regulatory oversight is not free. In order to do effective regulation you need thousands of highly paid bureaucrats, and at which point people start complaining that their tax money is being wasted.

    What should have Paulson or Bernanke done that was different? If you just issue a regulation banning X, then you have lots of lawyers and clever people doing something that does the same thing as X without doing X. So you have to have very skilled lawyers and financial people on your staff that can figure out what to do, but at that point people start complaining about "Washington bureaucrats" again.

    Blaming individual politicians is fun because it is cheap, but if you replace person X with person Y and don’t give them the staff and money (and we are talking large amounts of staff and money), then there are going to be limited on what they can do.

  • Posted by Twofish

    To give you an idea of the scope of the problem, to do due diligence of a major investment bank took hundreds of people, and to monitor trades takes thousands. The Fed just doesn’t have the staff to do this sort of detailed oversight on one bank, let alone thousands. So the oversight that they do has to be very general.

  • Posted by Twofish

    DC: Now we see CLOs being created for the express purpose of swapping to the Fed. The reason the CLOs are being created is there is no market for the underlying loans. Yet supposedly Moody’s, Fitch, and the S&P are supposed to rate this garbage investment grade so that it can be swapped with the Fed. Absolutely corrupt!

    Not really. The analogy here is that you could be standing at a pay phone with a dump truck full of gold bricks and you can’t make a phone call. A lot depends on how much the underlying loans are worth, and whether you have gold bricks that you can’t sell or dirt that you can’t sell.

    It gets even more complex because the value of the loans depends on current decisions. Whether you have gold bricks or dirt depends on the fraction of companies go bust in 2015 is fundamentally unknowable because any decisions you make today will affect who many companies go bust in 2015.

    The value of your loans today depends on the future, but what happens in the future is influenced by the value of your loans today.

    One problem is that markets are a bit too magical for most people. To find a "price" of a stock, you look it up on google, and this leads to a belief that everything just has a number tagged to it, and people don’t realize how complex markets are.

    Something to think about. Suppose I have a ton of gold bricks, some huge flawless diamonds, but I’m trapped in the middle of a desert, and my only line of communication is a payphone and I don’t have a quarter with me. How much are those gold bricks worth? Central banks are intended so that people don’t get themselves in that situation.

  • Posted by Twofish

    It actually gets worse….

    What happened in late-2007 was that once banks lost money, they had to sell some of their derivatives to meet reserve requirements. You sell some of your derivatives, price goes down, you mark-to-market, you have balance sheet problems, you sell some more of your derivatives, price goes down, you mark-to-market, you have balance sheet problems. And before you know it everything falls apart……

    I think Bernanke is going to turn out to be a hero in all of this, because I really believe he prevented a recession from turning into something much, much worse (Great Depression bad).

  • Posted by bsetser

    Guest and anonguest — thanks for the discussion.

    Anonguest — i’ll take your word that liquidity puts aren’t new, and what was new was the size of the assets that citi ended up taking back on its balance sheet. I agree that the regulators allowed the banks to move things off-balance sheet (And thus not count against capital) a bit too easily. Tho bank management also has to take responsibility for exposing the banks’ equity owners to a lot more risk than they should have.

    If I am interpreting the discussion above correctly, some of the super-senior stuff in citi’s SIVs was a synethetic CDO i.e. a CDO created out of the premiums from selling credit protection rather than holding the actual securities. The super-senior bit of the capital structure is the bit that has to pay out on the insurance if the losses exceed what the junior tranches paid out. And, well, the structure had to pay a lot, which dramatically reduced its value.

    this sounds fairly similar to the structures that Merrill was creating (see the link above about Norma). CDOs composed from selling protection on a diverse set of BBB mortgage backed securities have proved nuclear — as in the top rated bits have taken big losses (i.e. in 2fish’s analogy, the top floor was nearly as high above the flood as expected).

    judy — I agree that no one did a better job of covering this last summers than Yves.

  • Posted by Guest

    "Moody’s walks Roger Lowenstein (writing for the Times Sunday magazine) through the construction, rating and demise of a pool of subprime mortgage securities. Some readers may have thought the IMF was exaggerating when it forecast up to $1 trillion in future losses from the credit bubble. After reading the following you will see that it’s not an implausible number, and it will be clear why the system is paralyzed…

    You may have thought the internet bubble, with irrational investors buying shares of pet food e-commerce companies, was crazy. Read the excerpts below and you’ll see that our recent housing boom was even crazier and at an unimaginably larger scale…" http://infoproc.blogspot.com/2008/04/deep-inside-subprime-crisis.html

  • Posted by anonGuest

    I don’t know who coined the stupid term “liquidity puts”. They are simply liquidity backstop facilities, which I suppose stretching the terminology of options reflects the obvious fact that there is short put option risk inherent in the idea of a backstop.

    As I said, they’ve been around since the start of securitization. Moreover, CP funding for securitization vehicles has been around just as long. As have special purpose entities, or conduits, or vehicles, or whatever you want to call them. They’re all designed to house assets that have been transferred /originated from banks.

    Again, the issue of capital rules and capital adequacy with respect to these arrangements is just as old, and the debates were just as fierce at the start.

    The remarkable thing is that it’s taken 20 years for this issue to explode into an actual risk crisis.

    The only thing that’s new here is the increasingly complex nature of the assets that were securitized, including not only cash CDOs, but synthetic CDOs, as well as the use of extreme leverage and the compounding of intermediation risk through such structures as CDO squared, etc.

    This was not a new idea, but rather an old one that was taken to its extreme via leverage and derivatives.

    It is almost funny that so much attention at the end was paid to CP funding of such entities, an apparently later stage development, given that CP funding has been a mainstay of mainstream securitization for so long.

  • Posted by anonGuest

    This issue of capital requirements and “liquidity puts” is actually a Basle regulatory counterpart to the failure of the rating agencies in the case of CDOs, etc. It is the Basle regime that allowed banks to set up these liquidity lines without being charged (sufficient) capital for them.

    In general, the relative absence of criticism of the Basle regime while the rating agencies have been pummelled is somewhat puzzling. Moreover, handing the problem of capital requirements back over to Basle after such obvious failure reminds one of the criticisms against handing the Fed even more power to regulate the US financial system.

  • Posted by DC

    "I think Bernanke is going to turn out to be a hero in all of this, because I really believe he prevented a recession from turning into something much, much worse (Great Depression bad)."

    Oh please, Bernanke’s monetary agenda to devalue the US Dollar into toilet paper in order to bailout politically-connected Wall Street banks will destroy the wealth and retirement savings of the entire American middle class. Yesterday the President of OPEC cartel stated, "the high oil prices are a function of the declining US Dollar. For every percent the US Dollar falls, the OPEC oil price will rise $4 per barrel." How simple is that? OPEC’s President de facto admits that the global Oil price is now pegged to the Euro. And as former Chairman Volcker writes, "it is none of the Federal Reserve’s business to bailout Wall Street Investment banks". Period. Bernanke should tender his resignation.

  • Posted by DC

    US Global Hegemony: RIP

    http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a_SLF9qd.W0E

    April 21 (Bloomberg) — To hear Kevin Phillips tell it, the U.S. is a world power on the skids, an overstretched empire slumping toward the fate of Hapsburg Spain, the maritime Dutch Republic and imperial Britain. The culprits: Wall Street and Washington.

    The former Republican strategist lays out his harsh case in “Bad Money,” an update of his 2006 bestseller, “American Theocracy,” which warned that the U.S. was dangerously dependent on debt and oil.

    “Far more worrisome is the possibility that neither Washington nor Wall Street is willing to confront the deeper problem — the ascendancy of finance in national policymaking (as well as in the gross domestic product), and the complicity of politicians who really don’t want to talk about it,” he says.

    In Phillips’s view, U.S. politicians have made the fatal error of betting the nation’s future on finance. In 1950, manufacturing represented 29.3 percent of U.S. GDP, while financial services accounted for 10.9 percent, he shows. By 2005, the roles had reversed, with financial services accounting for 20.4 percent and manufacturing for 12 percent.

    Like the Spanish, Dutch and British hegemonies before it, the U.S. has let itself “luxuriate in finance at the expense of harvesting, manufacturing, or transporting things,” he writes. “Doing so has marked each nation’s global decline.”

  • Posted by RebelEconomist

    Since people commenting here seem to know, I would like to ask whether any/many of the AAA rated tranches have actually defaulted (or whatever event the rating indicates), or do the reported losses arise from markdowns representing a lower market value? It is probably a naive question, but how much blame the rating agencies deserve depends on the answer.

  • Posted by Guest

    another way to put (no pun intended) it is, can they default if they are now effectively backstopped by the fed?

  • Posted by Twofish

    RebelEconomist: Since people commenting here seem to know, I would like to ask whether any/many of the AAA rated tranches have actually defaulted (or whatever event the rating indicates), or do the reported losses arise from markdowns representing a lower market value?

    As far as I’m aware the loans in most of the AAA rated tranches are still paying, and there have been very few defaults in them. The trouble is that it doesn’t matter if the loans are good. If you have a AAA CDO that you think has good loans but has a low market value, then theoretically you can hold the CDO for 30 years and sit and wait for the money to come in.

    However, if you’ve bought the AAA with short term borrowed money (from commercial paper) and that money runs out, then you have a big, big problem. You have to dump the CDO at the same time everyone else is dumping their CDO’s.

    DC: In Phillips’s view, U.S. politicians have made the fatal error of betting the nation’s future on finance. In 1950, manufacturing represented 29.3 percent of U.S. GDP, while financial services accounted for 10.9 percent, he shows. By 2005, the roles had reversed, with financial services accounting for 20.4 percent and manufacturing for 12 percent.

    And in 1850, 80% of the people in the US were in agriculture whereas in 2008, the number is 3%. I’m not sure that see what the point of the statistics is. Yes, if we uninvented the tractor, and had people plow fields with hoes, then we’d need more people in agriculture, and we can have more people employed in manufacturing if we made that more inefficient.

  • Posted by Twofish

    Guest: another way to put (no pun intended) it is, can they default if they are now effectively backstopped by the fed?

    Sure. The fed is exchanging illiquid loans and securities for cash. If the loans go bad then the bank is still on the hook for the loan. What the fed is doing with the discount window is not going to change anything if the underlying loans are bad. It will only help if the underlying loans are good, but are unsaleable because of market conditions.

    The fed has only issued one non-recourse loan in all of this and that was to JPMorgan to take over Bear’s assets.

  • Posted by anonGuest

    Don’t know the numerics on it, but you can safely assume that defaults on AAA tranches so far are very minimal.

    By far, the bulk of the losses so far reflect lower market value, mostly still on the books, some sold.

    This is the basis on which some predict "mark-ups" down the road. Although this represents wishful thinking, if one takes into account forecasts such as Roubini’s, which may be quite realistic.

    How does this affect your rating agency blame assessment?

  • Posted by Twofish

    DC: Oh please, Bernanke’s monetary agenda to devalue the US Dollar into toilet paper in order to bailout politically-connected Wall Street banks will destroy the wealth and retirement savings of the entire American middle class.

    Please explain how destroying people’s wealth and retirement savings will help people who are running a bank make money.

    I might be stupid about this, but is seems like if you are a bank, you want people to be rich, because rich people have money and when people have money, it needs to be managed, and when money is managed, money managers get a cut of it.

  • Posted by DC

    " then we’d need more people in agriculture, and we can have more people employed in manufacturing if we made that more inefficient. " – Twofish

    That is the deceptive BS argument used by both Greenspan and Rubin to justify the deindustrialization agenda. Everyday we consume enormous amounts of energy, food, and manufactured products. And right now, the US is in a deficit position in energy, manufactured products, and believe it or not, even food. A financial service based economy maybe ok for a niche economy like England, but not for any large continental economy like the US.

    "Please explain how destroying people’s wealth and retirement savings will help people who are running a bank make money. " – Twofish

    On my 401K retirement savings of over $300K, I receive a measly 2.6% interest rate that is well below the real inflation rate. If I were permitted to, I would of course dump every last US Dollar into sound money currencies, foreign energy stocks, and precious metals. I am indirectly subsidizing the enormous financial losses by the Wall Street banksters. Is Bernanke or anyone offering me a bailout check to cover my financial losses on my 401K?

  • Posted by DC

    “Financial mercantilism” describes how Washington and Wall Street have collaborated “to minimize certain unwanted marketplace forces.”

    Hence the long, sad history — from the Latin American debt crisis and the S&L bailout to the subprime mortgage meltdown — of the U.S. government and Federal Reserve rescuing our failed financial wizards. He gives a name for what happens when taxpayers rescue profligate bankers: “Wall Street socialism.”

    Like a prosecutor, Phillips speaks with a finely honed indignation and calls expert witnesses to challenge the “myth” that financial markets are “a rational and safe underpinning for public well-being and the stewardship of a leading world economic power.”

    http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a_SLF9qd.W0E

  • Posted by RebelEconomist

    Twofish and anonGuest,

    Thanks for your replies…….I thought it would have been reported in the media if there had been defaults on AAA tranches.

    In that case, I have more sympathy for the rating agencies and less for the holders of these instruments. The rating agencies make it clear that they assess default risk, and not market risk, and so far it seems that the ratings do, as we say in Britain, exactly what it says on the tin!

    The trouble is that there have been plan sponsors, fund managers and even investment bankers who ignorantly, lazily or cynically used agency ratings as a measure of general risk. As I wrote here over a year ago, it seemed to me that some of the structures (CPDOs in particular) were deliberately designed to exploit this misunderstanding.

  • Posted by bsetser

    my sense is that there are a small number of AAA tranches that have taken real as opposed to expected losses … but most of the write down is mark to market. that said, i am very far from being on the ground …

  • Posted by Guest

    The fed has only issued one non-recourse loan in all of this…

    exactly

  • Posted by Twofish

    DC: Is Bernanke or anyone offering me a bailout check to cover my financial losses on my 401K?

    Yup. Go to your nearest bank and take out a home equity loan or line of credit.

  • Posted by SGC

    AnonGuest: I have to differ with you on this " the blame clearly rests with bank regulators who assessed the risk and still allowed capital relief for the banks"

    The regulators are completely hobbled by operating in a rule based environment where their charges demonstrate no interest whatsoever in helping them maintain the stability of the financial system. Post-Enron the regulators made a serious effort to put an end to "liquidity puts" that also served to provide credit enhancement to off balance sheet entities (http://www.phil.frb.org/publicaffairs/circulars/attachment5631.pdf) and thereby allowed asset backed commercial paper conduits to get AAA ratings while incurring a tiny capital charge. (The credit enhancement required by rating agencies to issue a AAA to off balance sheet entities carries a 100% capital charge and always has.) Citi’s liquidity puts were either a direct violation of this rule or the rating agencies "conspired" with the banks to circumvent the intent of the rule.

  • Posted by anonGuest

    SGC:

    I see your point in part, but the fundamental issue has always been the answer to the question, “Has the credit risk effectively been transferred from the bank to the vehicle?” If the answer is yes, the bank frees up its capital while collecting a fee. Credit enhancement is separate and is charged capital. The liquidity backstop lines were structured in such a way as to create the impression that credit risk had been transferred. The problem is that the liquidity scenario had never been thought through to the point of the total breakdown of the securitization system itself, and the collapse of normal funding availability. When funding reverts to the bank permanently, it effectively assumes the credit risk permanently. This is yet another permutation of the classic bank run. These were ‘normal’ liquidity backstops. This did not require circumvention of rules. It was just a rule that didn’t contemplate the worst case. This points to another very fundamental problem with Basle and risk management in general. In general, there is no capital charge for liquidity risk. The macro categories for capital charges are credit risk, market risk, and operational risk. Liquidity risk is managed under separate guidelines, which are somewhat fluffy in substance. These events hopefully will cause Basle to rethink the approach to liquidity risk.

  • Posted by anonGuest

    Perhaps there’s a loose analogy between the morphing of these liquidity backstop lines into full credit exposure, and the Fed’s decision to move beyond its normal liquidity provision role by assuming longer term credit risk (particularly with the Bear Stearns loan).

  • Posted by SGC

    I think the question is whether the rating agencies deliberately held off on downgrading the super senior CDOs in order to protect the money markets and force the banks to treat the liquidity backstops as credit enhancement. Contractually the loss should have been taken by the commercial paper holders, since liquidity backstops exclude any assets that are impaired — and by the time that Citi, for example, took the assets on it was clear that they were already impaired, whether or not they had a AAA rating.

    While some very short-sighted people might see this protection of the money markets as a good thing because the public would have been frightened, it seems to me that it just allows a fundamentally unstable and contradictory market to continue to operate. (You can’t have investors believing that money market accounts will never break the buck while also requiring them to sign on to the fact that they could lose money. The product is nonsensical on its face.) In short, it seems that the money markets have been protected at the expense of the banking system, when the reverse would have put us on the road to a more stable and sensible investment environment.

  • Posted by SGC

    "force the banks to treat the liquidity backstops …" maybe that should be "enable the banks to treat the liquidity backstops …"

  • Posted by anonGuest

    SGC – interesting point on rating agency strategy. I have no view on it except that it was an incredibly stupid product in terms of the risk gymnastics required for some paltry yield pick up. Probably a lot of brokers at fault for pushing it like some boiler room stock scam.

  • Posted by Twofish

    SGC: Contractually the loss should have been taken by the commercial paper holders, since liquidity backstops exclude any assets that are impaired — and by the time that Citi, for example, took the assets on it was clear that they were already impaired, whether or not they had a AAA rating.

    The trouble was that the AAA rating referred to credit risk not liquidity risk, and even though the values of the securities dropped because they became illiquid the default risk of those assets didn’t markedly increase, thereby giving the credit rating agencies little reason to reevaluate the rating of the security.

    I think the basic problem is that a AAA rating didn’t mean what a lot of people thought it meant. (And to be far, there were some huge financial incentives not to think too hard about this.)

  • Posted by Twofish

    SGC: You can’t have investors believing that money market accounts will never break the buck while also requiring them to sign on to the fact that they could lose money. The product is nonsensical on its face.

    No more nonsensical then having people base their investment decisions on credit ratings given by an agencies that explicitly tell people not to use rely on those ratings to make investment decisions…….

  • Posted by SGC

    Twofish 15:56:02: Most of the CDOs backing Citi’s asset backed commercial paper conduits were ABS CDOs (i.e. securitizations of securitizations, see http://www.citigroup.com/citigroup/fin/data/qer081.pdf, page 11). Since it is usually the lower quality ABS that is put into CDOs, it’s hard to believe that the drop in value was due only to illiquidity and not credit risk. Citi took a 17% writedown on these at the end of December (and the write-downs continue).

    In fact I ran into this http://www.soa.org/files/pdf/2008-ny-kalotay-r2.pdf by a Citi analyst. See page 3 for an estimate of 75% losses for ABS CDOs. If the super senior tranche is 70% of the CDO, this implies over 60% losses on the super senior tranche.

    That there was significant credit risk for securitizations of securitizations must have been obvious in the fall to the credit rating agencies — which afterall understood the structure of these creatures.

    Twofish 16:00:27: Touché.

  • Posted by bsetser

    I appreciated the quality of this discussion, and the various links that were posted. I will archive many of them in the references section of the post over the weekend. Many thanks.

  • Posted by JB

    I’ve got some issues with this commentary. Triple A rated tranches in CDO’s are not as risky an investment as the lower tranches. While I will agree that the risk element was seriously underestimated by the rating agencies. I’m not going to join the banter that Wall Street has zero brains and anyone could have seen this crisis coming. If all of you fellas had seen it, why are you chatting away on an economics discussion forum rather than enjoying your new yacht on the islands. Some elements, were visible, and should have been anticipated by the banks. But, not all of it was visible. The speed and transition of the pension fund investor out of Asset Backed Securities was really quite impressive. Similarly, I think some of the sharpest risk experts will tell you that the triple AAA rated tranches are undervalued. After Wall Street got their liquidity back this tranche has started to rally on some of the recent rolls.

    In regard to whether or not the rating agencies played a conspiratorial role? Ofcourse they did, at the request of Spitzer and the Federal Reserve. They were holding their downgrades on the big banks and monolines until the last minute. How would you like to be the head of a quasi-public agencies that threaded the needle for massive economic recession?