Give me yield, give me leverage, give me return
“Give me yield, give me leverage, give me return” perfectly sums up how Wall Street bought itself close to financial ruin. JP Morgan’s William Winters didn’t just create help to create CDOs. He seems to have a way with words.
During the past few years, the Street bet – and bet big – on two theories in its quest for higher returns.
The first was that housing prices never fell. At least not on a nation-wide basis. That meant that lending against a diversified pool of housing collateral wasn’t that risky, no matter how risky the individual borrower might be.
The second was that macroeconomic – and financial – volatility had been vanquished. That, in effect, meant it was OK to try to improve returns through the use of borrowed money.
Neither assumption proved true.
As the crisis has unfolded, the different ways different institutions had bet on a low-volatility-home-prices-only-rise world gradually became clear. Gretchen Morgenson – in her big Sunday New York Times article– delves into how Merrill Lynch in particular got caught up in the excesses of the boom.
Her article — which included the Winters quote — didn’t just look at Merrill though. She noted that Wall Street was a big buyer of mortgages for its “private label” mortgage backed securities at the peak of the housing boom. Morgenson reports that the Street issued $178 billion of mortgage and asset backed CDOS in 2005 – and an incredible $316 billion in 2006. 2006 was when the quest for yield was at its most intense. Short-term interest rates had been raised. That should have squeezed profits. The fact that it didn’t should have been a warning sign.
It turns out that the rapid growth in CDOs stuffed with exposure to risky mortgages — including “synthetic” exposure from writing credit default swaps on bonds backed by subprime debt* — was facilitated by the broker-dealers willingness to hold more credit risk on their own balance sheets. If you have any doubts, read Gillian Tett’s reporting from over a year ago.
There were clues that this was happening in the Federal Reserves’ flow of funds data. Working off an earlier tip, I added the assets of the “funding companies” to the assets of the broker dealers (see the note in the update; I am not convinced that I consolidated the balance sheets of the broker dealers and funding companies correctly — I have consequently updated the graphs to show the broker dealers on their own as well as to do a better job of netting out obvious cross investment) The Fed data indicates that the broker-dealers (the big investment banks) increased the size of their aggregate balance sheet from around $1.5 trillion in mid 2002 to around $3.2 trillion in mid 2007 – with close to $800 billion of the increase coming from mid-2006 to mid 2007. That growth corresponds well with the increase in the outstanding stock of asset-backed securities – which increased from $0.8 trillion in mid 2002 to $3 trillion in mid 2007. Roughly $550 billion of the increase in the outstanding stock of asset-backed securities also came late in the cycle, from mid 2006 to mid 2007. To illustrate the correlation, I plotted the increase in the outstanding of the broker dealers and the increase in the outstanding stock of ABS from mid 2002 on.
Correlation doesn’t imply causation, but in this case we have discovered that at least some of the broker dealers were holding a lot of asset-backed securities on their balance sheets — so there was at least a bit of direct causation.
Hints of a relationship between the expanding balance sheets of the broker dealers and the growth in asset backed securities also show up in a plot comparing the 4q increase in the assets of the broker dealers with the 4q increase in the outstanding stock of asset backed securities.
Why does this matter? Accrued Interest – in a recommended post — explains:
In the period leading up to this recession, we had a overinvestment in housing. Even if nothing else had happened, the adjustment in housing probably would have resulted in a recession. Loans were made that shouldn’t have been made. Houses were built that shouldn’t have been built. We need to clear the excess investment (houses).
However, we also had a financial economy which had become reliant on low volatility and continuous access to liquidity. After the failure of Bear Stearns, Wall Street was forced to decrease their leverage positions. … This added to the already painful economic adjustment underway.
Then came September.
One last point:
At the peak of the mortgage boom (q2 2006), the fed’s flow of funds data indicates that the growth in the mortgages held by issuers of asset-backed securities, not by growth in the stock of mortgages held by the Agencies, drove the overall growth in mortgage lending.
Agency demand increased in early 2007 — and then increased even more after last August.
Absent a second source of demand for mortgages, the collapse of the private label securitization business would have led to an even bigger downturn than we have seen to date. However, it also left the US in a position where it was relying heavily on the Agencies to support the mortgage market. Over the last four quarters, the growth in the Agencies mortgage portfolio accounts for the full increase (through q2) in the outstanding stock of mortgages. That is why the willingness (or right now, the unwillingness) of central banks to buy Agency debt matters: it feeds directly into the cost of borrowing to buy a home. That in turn, feeds into home prices – and ultimately the losses the financial sector will take on the risky mortgages that were extended during the boom …
UPDATE. Based on the discussion the comments, I lost confidence in my initial methodology for aggregating the assets of the funding corporations and the assets of the broker-dealers. I adjusted the methodology to do a better job of netting out cross-holdings, but I am still not sure that I got it right. To compensate, I also plotted the growth in the reported assets of the broker dealers alone. The basic story doesn’t really change.
* Yves Smith is skeptical that Merrill was as interested in synthetic CDOs as Morgenson claims. I am not as skeptical – largely because Morgensen’s story matches up with earlier reporting by the Wall Street Journal (see their reporting on “Norma”) and the Financial Times.
Synthetic CDOs were composed out of CDS rather than actual bonds. Selling insurance against default on a bond has many of the same characteristics as actually owning the bond. Both are bets that pay off if nothing goes bad. If you own the bond, you get paid back in full with interest. If you sell insurance you collect the insurance premium and never have to pay out. Clever financial engineers substituted one for the other, as for a while, there was more demand for subprime exposure than actual subprime loans from investors eager for big returns (helped along by investment banks willing to take the parts of the structure that investors didn’t want on their own balance sheets) …
The Wall Street Journal wasn’t sure whether the “protection” v default on subprime bonds that Merrill sold to Norma (the CDO) was kept on its balance sheet or sold to other investors. The Journal (Mollenkamp and Ng) wrote:
For Norma, N.I.R. assembled $1.5 billion in investments. Most were not actual securities, but derivatives linked to triple-B-rated mortgage securities. Called credit default swaps, these derivatives worked like insurance policies on subprime residential mortgage-backed securities or on the CDOs that held them. Norma, acting as the insurer, would receive a regular premium payment, which it would pass on to its investors. The buyer of protection, which was initially Merrill Lynch, would receive payouts from Norma if the insured securities were hurt by losses. It is unclear whether Merrill retained the insurance, or resold it to other investors who were hedging their subprime exposure or betting on a meltdown.
Many investment banks favored CDOs that contained these credit-default swaps, because they didn’t require the purchase of securities, a process that typically took months. With credit-default swaps, a billion-dollar CDO could be assembled in weeks.
With the benefit of hindsight, it is pretty clear that Merrill resold the insurance it sold to its CDO machine to other investors — and that it also bought a lot of the tranches of the CDOs like Norma. The overall result was that Merrill ended up holding a lot of subprime exposure …
The more I read about this mess, the more it seems that JP Morgan Chase (and Goldman Sachs, as well) has been the chief culprit, right at the epicenter of this financial disaster in all its most corrupt aspects. There was a great article in November’s Conde Nast portfolio, about how JPM basically invented the CDO and CDS market, at least in the form it’s taken on. JPM, of course, has also been at the forefront of the whole predatory-lending industry– it was JPM that began the practice of introducing these utterly outrageous interest rates into their loans for not only mortgages, but also car loans, even various forms of educational and other loans, using the slightest excuse they could find. (They then lobbied corrupt politicians from both parties to push these provisions into law.)
Couple this with JPM’s major support for offshoring US tech jobs, as lots of people have been pointing out, and one has to wonder if JPM may not be the single worst-behaved company in terms of bringing the USA to the brink of financial ruin.
(And forget about this AAA rating for US debt on the part of Fitch, Moody’s and the other bootlickers– it just shows that the ratings agencies are just as corrupt and untrustworthy as Enron became prior to its collapse in 2004.)
It just makes it even more reprehensible, then, that JP Morgan Chase is receiving hundreds of billions of dollars in taxpayer money for the Bear Stearns gift, for WaMu and for whatever else they’ll be embezzling in bailout money– has there ever been such naked corruption in US financial history before, at least since the US Grant administration?
For that matter, Goldman Sachs has also been in on the whole national-scale racketeering scheme– made all that much easier since they have “their guy,” none other than Hank Paulson himself, on the inside. Paulson, of course, made absolutely sure to selectively ensure the failure of Goldman’s chief rival, Lehman– despite the fact that such selective bailouts all but guaranteed the loss of confidence and the collapse of our financial system– for the sake of bailing out his old company, in which has has many billions worth of assets vested.
I’m not saying that JPM and Goldman Sachs are the only culprits here– Wells Fargo, Countrywide and Citi, not to mention overseas banks like Westpac, Barclay’s and even HSBC lately, have their own dirty hands in this mess.
But nobody exceeds JP Morgan Chase and Goldman Sachs in the sheer extent of their greed and corruption.
Or, for that matter, in their exposure to toxic waste:
JPM is mired even deeper in the toxic sludge than Lehman and Bear Stearns were, even before they stepped into even deeper quicksand with WaMu (the part that isn’t being covered). It’s unsurprising, since JPM basically invented the CDO’s and other toxic debt divviers in the first place, to help spread out the unserviceable leveraging that came with their extraordinary advances in predatory lending.
Only Goldman Sachs could even remotely rival JPM in their exposure, with GS escaping greater scrutiny only by virtue of the Paulson Protection team, and GS’s greater skill than Lehman at Enronizing their toxic schmutz off the balance sheet. They won’t have that protection for more than a couple months, and since GS doesn’t even have insurance (the self-insure all their liabilities), they’ll be falling even harder than Bear Stearns, Lehman and AIG all have.
The top brass there know it, which is why they’re skimming off whatever they can before GS itself goes underwater, probably by February or so. You better believe that Paulson and the other schmucks at Treasury are getting their own ducks lined up while they still can. The Grand Larceny of America is still chugging very much ahead.
If the top marginal tax rates were 70% or more, as they were in pre-Reagan, none of this would have ever happened.
Maimonidazzler:“probably by February or so”
…with the swaps, courtesy of the Europe. And then the EMs crunch. And then some more swaps from our allies. And now some more AIG rescue for this month, ’till next one. All to settle and clear and settle and clear and settle and clear and settle and clear and settle and clear. All the stuff.
Even if it takes 1,2 “worlds” to settle-it through.
But ultimately it’s the CIC who’s not getting-it still. Not buying our Agencies. Ha. Who do they think they are? In spite of the numerous invitations from This site. J
Just goes to show PBoC not understanding how not being an accomplice to all this can ever be viewed as anti-US? It won’t – at the end. If there is one.
And lastly, it is the “peasant” in China that’s ultimately protecting the US “elite”. The latter too busy unloading all of their stuff onto …
… the FEDs balance sheet (to settle and clear-it some more and to follow Chinese) now (e.g. too outright stupid), to see this at all.
It’s the P in the PBoC that must be inflated, so now we unleash our Universities, to search for “those people”, on ground. It’s re-education time for some of the people of People’s Republic of China.
Might this world be shrinking too fast for this settlement’s progress? Nah, we just need another zero point two of another one.
If your investments are leveraged 20 to 1, a 5% price change can either double your profits or completely wipe you out. Now Bear Sterns and Lehman were leveraged from between 30 and 40 to 1. As the multiple interlocking bubbles expanded across the US Economy, Wall Street banks reaped enormous profits from their high leverage, but it was only a matter of time before the banking profits imploded. Over the past couple decades, capital was massively misallocated by Wall Street finance capitalism into McMansions and luxury condos. Since the entire US Economy was the mortgage finance bubble, there is not much”real” wealth industrial production left to stimulate.
Brad,
In your research could you ascertain how synthetic CDOs showed up on published balance sheets? Synthetics were probably an increasing proportion of new CDOs as the boom approached its crisis point – but I don’t see how synthetic notional amounts would show up on balance sheets in the same way as cash CDO notional amounts.
My impression is that the overall balance sheet effect was the financial crisis version of an inventory build-up followed by the mother of all financial inventory corrections (i.e. deleveraging) – e.g. Merrill steadily positioning new CDO product generated by their massive CDO assembly line because they couldn’t sell them and they couldn’t shut down the assembly line quickly enough (i.e. didn’t want to).
I’m still puzzled by the role of the broker-dealer/funding corp combination in this ABS mess. I’m the tipster, and when I added these two together in the Fed’s flow of funds, I crossed out the links between their two balance sheets, which are “investment in broker dealers” for funding corps, and securities loaned by broker dealers to funding corps. When you do this, you get asset growth from roughly $1.6 trillion to $2.7 tril, from 2003 to mid 2007. (I haven’t bothered to download the zip files you need to look at the earlier years quarterly.) And this growth is scattered across items. Only about $150 bil. is in holdings of corporate bonds, which is where this asset backed stuff is supposed to be. The rest of the growth is $300B to cash and near cash, minus 100 to govt. related paper, 100 to equities, 150 to security credit, 150 to foreign office investment. And then 300 to 400 to “unidentified”. Maybe a bunch of ABS/MBS stuff is there.
In any event, I know they got themselves into trouble. At these numbers, though, I don’t see why it’s such a big deal. I’m thinking most of the real losses are in commercial banks (perhaps in direct mortgage lending) and in mutual and pension funds that hold this stuff, rather than in investment banks and their so-called counterparties.
Ostrich.
I want to get the calculation right and it sounds like i am double counting … i can try to adjust my spreadsheet for those lines. My immediate reaction was that $2.7 trillion tho seems a bit too small for the collective balance sheet of the broker dealers. i thought Goldman, Morgan Stanley and Merrill all had balance sheets in the $1 trillion range. But then guess some of that could be outside the US.
Help here would be most appreciated!
“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.”
So, how come, when I keep saying this is on blogs, I keep getting the response that:
1) It’s the complexity of the investments
2) It’s too easy credit
3) It’s too much incentive
The answer is just as described. My only point is to try and understand how much implicit and explicit government guarantees went into these decisions, and to what extent the selling of these products was either fraud, negligence, or fiduciary incompetence.
But thank you for linking to that post. I’ve finally found someone I basically agree with.
I thought the New York Times article was wonderful…
Maimonidazzler responds: There was a great article in November’s Conde Nast portfolio, about how JPM basically invented the CDO and CDS market, at least in the form it’s taken on.
Alfred Nobel started his Peace Prize after inventing dynamite and then feeling guilty about what his invention was used for. CDO’s and CDS’s are like dynamite, machine guns, and morphine, extremely powerful, potentially useful, and extremely dangerous in the wrong hands. The important thing about powerful but deadly things is that you just have to have a lot of common sense in using them. What’s interesting about deadly tools is that they are far more dangerous in the hands of people without common sense than they are in the hands of the evil and corrupt.
Maimonidazzler responds: But nobody exceeds JP Morgan Chase and Goldman Sachs in the sheer extent of their greed and corruption.
The hardest part about fighting fires is dealing with the crowds outside that are throwing rocks at you while you are doing it.
Don: 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.
There’s the other adage about “don’t invest in things that you don’t understand.” People that are supposedly “sophisticated” can get themselves into a lot of trouble if they thing that they understand more than they actually do. At some point, you just have to turn off the computer and talk to people.
Don: My only point is to try and understand how much implicit and explicit government guarantees went into these decisions, and to what extent the selling of these products was either fraud, negligence, or fiduciary incompetence.
Not much. The problems of the markets I think come from vast underregulation rather than overregulation. The reason I’m not a Libertarian is that I’ve seen markets work up close and I really don’t see how they can work without a large amount of regulation. It just has to be the right type of regulation that enhances the market rather than destroys it.
Having said that you have to be very careful how you regulate. You can drive on the left side of the road. You can drive on the right side of the road. If you drive on both sides of the road you have a mess. In particular some parts of the economy had a combination of government regulation and non-regulation that gave you the worst of both worlds. In particular, if you have a government regulated low interest market connected to an unregulated high interest market, there is going to be a lot of “regulatory arbitrage” going on as money from the low interest market ends up in the high interest market so that you end up having something that is controlled by *neither* administrative decrees or market action.
You know, I don’t really know much about this stuff, and I’ve never looked at the financials for the investment banks. I just went to the Fed report, and figured that all the shadow bank stuff they pull into their data is pretty much in the ABS pool statement, the broker dealer statement and the funding corp statement. My consolidation of the latter two is simple. Look at the statement for 2007Q2. Funding corp assets “investment in broker dealers” of 636.6 comes out of the broker dealer liability “due to affiliates”. You can see this in the miscellaneous asset/liability pages toward the end of the funds flow report. And funding corp liability “securities loaned” of 1436.5 comes out of broker dealer asset “miscellaneous assets”. If we’re not capturing all the relevant money here, it must be something to do with what the Fed reports.
Just one note. I’m not a disinterested and unbiased bystander in all of this. I do work in the financial industry, and much of the reason that I post in blogs is so that people can ask questions of someone that is sitting in the middle of the action. It’s also to get rid of a lot of stereotypes.
One is that most that work in finance are super-millionaires with yachts. Compensation in finance is extremely skewed, which is why Obama’s message of “share the wealth” gets a good hearing on Wall Street. Also, you’d think from the stereotypes that people on Wall Street are jumping up and down and swimming in the money that they cheated from good honest working taxpayers. In fact, everyone is worried about their job.
It wasn’t a bailout, it was a clean up.
The other stereotype is that people in finance are generally amoral bastards plotting the destruction of society so that people can make a few extra dollars. THINK. Even if you are an amoral bastard, you’d hardly end up making more money by sinking the ship that you are on. It’s not the amoral bastards that do the worst damage, it’s the well meaning idiots. Morally people in finance tend to be no better or worse than people in any other field, although I do think that people in finance tend to be a little more honest than most people about what their real motivations are.
Personally I got into finance because it was the only real job in which a physics Ph.D. could have some realistic shot of making it into the upper middle/lower upper class.
“The reason I’m not a Libertarian is that I’ve seen markets work up close and I really don’t see how they can work without a large amount of regulation. It just has to be the right type of regulation that enhances the market rather than destroys it.
Having said that you have to be very careful how you regulate. You can drive on the left side of the road. You can drive on the right side of the road. If you drive on both sides of the road you have a mess. In particular some parts of the economy had a combination of government regulation and non-regulation that gave you the worst of both worlds. In particular, if you have a government regulated low interest market connected to an unregulated high interest market, there is going to be a lot of “regulatory arbitrage” going on as money from the low interest market ends up in the high interest market so that you end up having something that is controlled by *neither* administrative decrees or market action.”
Twofish, Thanks for the comments. They’re good. Because I’m a libertarian Democrat, I actually agree with everything that you just said.
But note this:
“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”
Now this is just plain risky. I actually mentioned this point about trying to invest in products with less capital/collateralization as being the motive for the investment, so that blaming the investment created to fill the need is silly. If not this product, it would have been something else give:
1) A taste for risk ( It’s there, we just need to explain it )
2) A taste for lower capital/collateralization requirements
And this:
Tuesday, November 4, 2008
“He calls for a regulatory system based on “principles” rather than “rules.”
Via Deal Book on the NY Times we get “Stephen Schwarzman’s Seven-Step Program”:
“In an opinion piece in The Wall Street Journal’s Nov. 4 issue, Mr. Schwarzman maps out seven principles he believes should guide any regulation of the financial system. In many of them, he uses the opportunity to criticize the current regulatory framework in the United States, describing a “hodgepodge” of fragmented agencies and laws that make a “fetish of compliance with complex regulations.” He expresses concern that the latest debacle on Wall Street will inspire a thicket of new rules that choke off innovation.”
Here’s my comment:
“He calls for a regulatory system based on “principles” rather than “rules.” He writes:
If we are to sweep a vast array of financial institutions into the net of a single regulator, then that regulator has to be able to regulate not by promulgating a blizzard of ever more complex rules, but by enunciating a set of guiding principles. If these principles are coupled with strong disclosure and oversight, they will give the regulator the flexibility needed to cope with an ever-changing financial landscape, and to provide a clear direction for the regulated institutions.”
I agree with this:
This is the real problem with regulation. These investors can be very clever people, and are adept at shifting the terrain. That’s why regulation always seems to be correcting the last problem.
The solution is either to regulate or supervise risk, especially any investment that shifts risk to a third party or magnifies risk. In other words, broad principles.
However, have you ever noticed that some of these recommendations being bandied about are as simple disclosure and transparency, traits one would think a decent human being would try and exemplify as a matter of course.
— Posted by Don the libertarian Democrat
That’s my basic position. Again, thanks.
For clarification, the funds flow tables I’m working with are L129 and L130. The miscellaneous assets and liabilities shown there get sorted out in L229-231. L126 shows that the Fed classifies all liabilities of ABS pools that aren’t commercial paper as corporate bonds.
Ostrich responds: In any event, I know they got themselves into trouble. At these numbers, though, I don’t see why it’s such a big deal.
The problem isn’t the absolute losses, but rather the leverage. When you are leveraged 30:1, then any loss becomes a big deal, since even relatively small losses can wipe out your capital.
Ostrich responds: I’m thinking most of the real losses are in commercial banks (perhaps in direct mortgage lending) and in mutual and pension funds that hold this stuff, rather than in investment banks and their so-called counterparties.
Yes. The difference is how the institution reacts to the loss. If you have a highly leveraged investment bank lose money, then you have a crisis and lots of headlines in CNBC. If you have a pension fund lose $10 billion then its a lot quieter and less dramatic.
We’ve finished the “dramatic phase” of the crisis, and right now we are in the “slow aching” part of the bust. In some ways it’s more depressing because while you are in a crisis, at least you have excitement and adrenalin pumping through you can you can focus on the disaster. It’s after the drama has ended that you start feeling miserable as you look around you.
CDOs present an interesting problem. They were priced based on models (models that use some pretty hairy maths). But unlike Black-Scholes, for example, the models and the derivative came packaged as one. So the models couldn’t be validated against reality.
Now that it’s obvious that the models were based on faulty assumptions there is no easy or obvious way to price the things. Even if there was an exchange on which to openly trade CDOs, could it be that their complexity precludes market participants being able to look at them and say “it’s worth $X”? The end result seems to be that they are effectively priced at $0.
Twofish,
I think I get what you are saying. My question is: why not just wipe out the hedge fund activities of the investment banks, let their capital holders, bondholders, and if necessary, other “counterparties” take the appropriate losses, and move on. If this means there is no capital left for the legitimate broker/dealer market making activities, then deal with that. What I’m not getting is, why is there so much “systemic risk” attached? (or at least that’s what we’re being told by our keepers at the Fed, Treasury etc.)
Don: But there was another, far more important, incentive: regulatory arbitrage.
This was a big, big problem. Another problem was just the lack of regulators. The regulators had to rely on the rating agencies and the banks for lots of things, because they didn’t have the people or the skills to do their own evaluations.
Don: If we are to sweep a vast array of financial institutions into the net of a single regulator, then that regulator has to be able to regulate not by promulgating a blizzard of ever more complex rules, but by enunciating a set of guiding principles. If these principles are coupled with strong disclosure and oversight, they will give the regulator the flexibility needed to cope with an ever-changing financial landscape, and to provide a clear direction for the regulated institutions.
One problem here in order for a principle-based regulatory system to work, you have to hire lots and lots of highly paid regulators to apply general principles to specific cases. If you just state some general principles and don’t pay lots of money for people to interpret and apply them, then those principles are useless. The basic issue here is that financial systems are *inherently* complex, and if you reduce complexity in one area, you increase it in another.
One difficult part about principle based systems is that people disagree about what the principle’s should be. It’s very easy to sit down with a group of people that have the same outlook on how the world should work and hammer out a set of principles. However, in the real world, you have to work with people that just want different things than you do and see the world in very different ways. Often things come down to agreeing on a rule rather than on a principle, because people are just not going to agree on the principles, but they can agree on a rule that everyone things will get them what they want.
People also suddenly go against principle based systems when people they don’t like or don’t trust are writing the principles.
Don: This is the real problem with regulation. These investors can be very clever people, and are adept at shifting the terrain. That’s why regulation always seems to be correcting the last problem.
It’s also a function of the fact that regulators don’t get paid has much and don’t have as high status as the people they regulate. If you pay regulators more money, you end up with more clever regulators.
Don: However, have you ever noticed that some of these recommendations being bandied about are as simple disclosure and transparency, traits one would think a decent human being would try and exemplify as a matter of course.
Disclosure and transparency are things that are easy to say, but really hard to do. For example, suppose I give you all of the transactions that an investment bank did yesterday. It would probably be ten thousand pages. Ultimately disclosure, but useless disclosure since you have no way of analyzing that information.
Also there are things that you *don’t* want to make transparency. In an world of ultimate transparency, everyone would be able to see everyone else’s bank accounts and account numbers. I don’t think most people would like that.
Also I really don’t think that disclosure and transparency was or is the real problem. It’s not as if we woke up one morning and realized that *gasp* investment banks had been investing in real estate, and *gasp* lending money to subprime borrowers. There is very little that we know now about what financial institutions that we didn’t know in 2005. The trouble is that you know that banks are being stupid, now what?
Ostrich writes: My question is: why not just wipe out the hedge fund activities of the investment banks, let their capital holders, bondholders, and if necessary, other “counterparties” take the appropriate losses, and move on.
That’s exactly what is going on right now. It’s a very messy process. It’s also extremely labor intensive.
Ostrich writes: If this means there is no capital left for the legitimate broker/dealer market making activities, then deal with that.
Which is what people are doing right now.
Ostrich writes: What I’m not getting is, why is there so much “systemic risk” attached? (or at least that’s what we’re being told by our keepers at the Fed, Treasury etc.)
1) Because things don’t happen by magic. In order to wind down the bubble and write off everything and figure out who gets what takes a lot of people doing certain things, and if you get yourself in a situation where people can’t do the things that they need to to wind down the system, then you have a big problem.
2) You get all sorts of domino effects that happen if you aren’t careful. One way of thinking about it, is a pebble looks pretty harmless and you look at how big a pebble is and how big an adult human being is, and you can’t imagine the pebble killing the human being. However, if you get a pebble stuck in someone’s throat they could choke to death.
There’s something similar at work in the financial system. It’s not that the losses that we are looking at are huge, but if you get those losses in the wrong place at the wrong time, the system can choke itself to death. Something like the tree branch that caused the entire northeast power grid to go out a few years back.
Patrick says: CDOs present an interesting problem. They were priced based on models (models that use some pretty hairy maths).
Be very careful when people start talking lots of math. If someone can’t explain a model except by writing lots of greek letters, then chances are that they don’t understand it themselves. Basically how much money you can make from a CDO depends on two things. Correlation: If one company goes under, what is the likelihood that another company will go under. Recovery: If a company goes under, how much money am I going to get back.
If you have a manager that just wants to sell CDO’s to collect their yearly bonus, you can put in whatever bogus numbers they want to get whatever answer they want. If you have a manager that wants to know the truth, then you can put in realistic numbers and get out realistic results, and if you come up with realistic results, these tell you that you shouldn’t be very heavily invested in mortgage CDO’s because if lots of houses go bust and you can’t recover money then those CDO’s are going to be worthless.
Patrick: Now that it’s obvious that the models were based on faulty assumptions there is no easy or obvious way to price the things.
Actually there are easy and obvious ways to price CDO’s. If you tell me how correlated defaults are and how much recovery you think you will get, I can get a clever high school student to work through the math and tell you how much those are worth.
The real problem is that the easy and obvious ways to price CDO’s weren’t giving the numbers that people wanted. If you use an easy and obvious way to price CDO’s then it becomes obvious that holding CDO’s for subprime mortgages was stupid because 1) if one subprime borrower can’t pay, then it’s likely that they all can’t pay and 2) if a subprime borrower can’t pay then you probably are not going to get much money from them. If you don’t like that answer, then you can bury it with lots of complex math.
At that point you go to the manager and tell them this, and what happens next depends on 1) if the manager looks at the numbers and says “good job!!!” I’ll tell my bosses not to invest in subprime CDO’s or 2) if the manager looks at the numbers and says “I don’t like them” run the model again.
The good news about this is that firms that haven’t fallen apart due to CDO’s are probably not going to have many “hidden bodies” since the thing that kept them from buying CDO’s was a good firm culture and common sense.
Ostrich — if you net out securities loaned, the combined balance sheet of funding cos and broker dealers is smaller than the balance sheet of broker dealers alone. that may be right, but i would like some confirmation! the $636.6b is clearly double counting … and i am going to adjust my graphs accordingly
Brad,
Beats me. Why doesn’t somebody with some contacts call up somebody at the Fed and ask them how they put these numbers together?
Brad-
Another interesting question is where the Broker/Dealers and Funding Corporations got their money from.
Looking at the Z1, Brokers/Dealers main Liability increases where from Security RPs and Security credit, while Funding Corporations money mainly came from Securities loaned and FDI.
Is there anyway to figure out who these funding sources were?
Brad,
More seriously, I can’t fathom just who is represented in these two entities (bd and funding corp) and how they are connected. And what would the funding corps do with a trillion and a half $ of borrowed securities?
Brad,
I have a broader problem with this stuff. In my fumbling way, I’ve been trying to reach an explanation that actually incorporates numbers of what all this financial system mess is about, especially how much it really affects the non-financial economy. International finance is over my head, and I’ll leave that to you. But it does seem to me that a half-bright citizen with some numbers skills should be able to piece together some insight as to the U.S. picture.
But all we get from the U. S. government is a lot of bs that’s supposed to sound like an explanation, but isn’t (and that includes Bernanke, from whom I’d hoped for more). Read his speeches, and those of Fed Governers. Blah, blah, blah.
Ostrich: I’ve been trying to reach an explanation that actually incorporates numbers of what all this financial system mess is about, especially how much it really affects the non-financial economy.
Boiled down. People acted as if you had houses that were worth lots of money. They weren’t, and now we are scrambling trying to deal with the aftermath of this. Also, you aren’t going to be able to understand the mess if you look only at statistics. The statistic records a house as being worth $500,000, that doesn’t tell you if the house is actually worth $500,000. Getting numbers is part of the story, but it’s only one part.
Ostrich: But it does seem to me that a half-bright citizen with some numbers skills should be able to piece together some insight as to the U.S. picture.
If you want to understand some of the issues, I find that it is easier not to look at this aggregate statistics, but rather look at the behavior and numbers that concern you and people that you know. Instead of looking at aggregate total savings, look at your own bank account and spending patterns and try to understand those numbers first.
Ostrich: But all we get from the U. S. government is a lot of bs that’s supposed to sound like an explanation, but isn’t (and that includes Bernanke, from whom I’d hoped for more). Read his speeches, and those of Fed Governers. Blah, blah, blah.
People still get into some heated discussions about what caused the Great Depression and World War I and World War II, so don’t expect any consensus on what exactly happened. The thing that people have been mainly concerned about is how to fix what happend, and you can put out a fire without knowing exactly what caused it.
Twofish: I will admit to not being an expert, though I am pretty good at math. When I see papers like these:
CDO Pricing with Nested Archimedean Copulas
On Copulas and their Application to CDO Pricing
I really wonder if a clever grad student could handle the math, never mind a clever high school student. But, I’ll admit that I might be missing something.
And my talk about starting with bank accounts and balance sheets for households was to try to put the numbers in some context. If you look at the numbers without connection to real world actions, you aren’t going to get anywhere, so one way of connecting those numbers with reality is by focusing on one’s immediate surroundings. You start with your own checking account and mortgage, and figure out where in the charts those numbers end up, and you think about what you did between 2003 and 2007 and try to figure out how that affected the capital flows.
ostrich — insults of long-term contributors are inappropriate; indeed any comment direct at a person rather than the argument is inappropriate …
Ok, Brad, and OK, twofish. I take your points and apologize. I thought I was getting patted on the head pretty good here, and got kind of tired of it.
Brad, I don’t think I know how to consolidate these two entities we’ve been discussing. I’ve been treating them as if funding corps owned broker dealers, which they clearly do in part. But I don’t know what to do with the loaned securities. If I borrow cash from you, I have a liability, and an asset –cash. But what’s the asset of the funding corps that corresponds to the liability “securities loaned”? And where would that asset be in the Feds balance sheet for funding corps? It’s a big number. Maybe its where all those junk securities are, and the shadow banks” holdings of this stuff are a lot bigger than I think they are.
A funding corporation is a firm that provides short term cash in exchange for buying up things like accounts receivables.
Ostrich: I’ve been treating them as if funding corps owned broker dealers, which they clearly do in part.
I don’t think that they do. The investents in broker-dealers look like money that the funding corporations have on deposit with investment banks. They aren’t ownership stakes as far as I’m aware of.
Ostrich: But what’s the asset of the funding corps that corresponds to the liability “securities loaned”?
My guess is that they are repurchase agreements. I have some extra cash, so I call my friendly neighborhood investment bank, I give them some spare cash, they loan me some US treasuries, and in a week or so, we reverse the deal.
Ostrich: Maybe its where all those junk securities are, and the shadow banks” holdings of this stuff are a lot bigger than I think they are.
I don’t think so. Funding corporations specialize in short term funding, and I just don’t see them holding lots of junk, since they don’t hold securities for very long.
Also the “shadow banking” system sounds more sinister than it actually is. There is an entire system of banking that doesn’t go through commercial banks. If you go to your typical manufacturing plant, and ask them where they get their working capital, it doesn’t go through a commercial bank, but rather through a funding corporation that buys their account receivables and gives them cash.
The flaw in the system is that the funding corporations have to work very tightly with the investment banks so if something unrelated hits the investment banks, then things get transmitted *very* quickly to the manufacturing corporations, which is why things were very scary a month and a half ago.
Michael Lewis does a a good job in finally explaining how credit default swaps were used to juice the earnings of the Banks and Investment Banks during 2005-2006, the last two years of the housing boom and proves again how hard it is for a man to accept a fact when it is his or her interest to pretend it does not exist.
Patrick writes: (CDO papers) I really wonder if a clever grad student could handle the math, never mind a clever high school student. But, I’ll admit that I might be missing something.
The basic question that a CDO model tries to answer is “assuming one company defaults, what is the likelihood that a lot of them defaults.” So all those models ask “given this sort of corrrelation between defaults and given this recovery rate how much money is this CDO worth?”
That’s it. If I assume that people won’t default and I can get lots of money from them when they do, CDO’s are worth a lot. If I assume that when one subprime borrower goes bad, they all will, and that I won’t be able to get any money from them, then CDO’s aren’t worth very much.
The silly thing about these papers is that if you go to page 8 of the paper on nested Archimedian couplas, you see “In what follows we assume an identical deterministic recovery rate R for all companies…”
On page 12 “The constant recovery rate is chosen as R=40% for all firms, a commonly accepted assumption.”
So what you build into the model is the assumption that you can get R back if a company goes under. Suppose R is 40%, this means that with this model, you will never lose money on a super senior CDO. If you assume that you are guaranteed to get back 40%, then it’s perfectly safe to hold CDO’s that are funded by the first 10% of the money that you are getting, because you’ve assumed that you will never lose more than 40%.
At this point you may ask the important question “what happens if I can’t get back 40%?” and the even more important question “do I lose my job if I ask that question?”
Rickstersherpa responds: how hard it is for a man to accept a fact when it is his or her interest to pretend it does not exist.
It’s actually pretty easy for individuals to accept facts, the hard part is trying to figure out what to do about things.
Put yourself in the role of someone in 2005 that figures out that CDO models are bogus. What do you do? If you have a well run bank with competent senior management then you point this out and the bank doesn’t invest in CDO’s. Suppose you will get a much smaller bonus for asking questions?
What do you do? Go to the regulators, who believed in 2005 that markets can do no wrong? What about the media? Yeah right. Pointing out that the real estate bubble is a bubble isn’t going to make you popular with *anyone*.
You probably do what most people will do, stop asking questions and maybe start looking for another job.
Twofish: I guess an obvious question that only just occurred to me is: what do the models say if one plugs in recovery and default correlation that reflect observed reality? I’m wondering if, under certain conditions it’s possible that the CDO is worth less than the unsecuritized mortgages would be.
Brad,
Nice work. I wonder how hard it qwould have ben for a decent regulator to spot this (and much earlier of course) and what that regulator would have done with it. If you look at this and the crazy story of the Icelandic banks, for instance, my instincts tell me that this situation (also given reasonably smart people pushing the buttons) has little to do with beliefs about markets, but rather with beliefs about regulators: that they will not intervene (for many reasons), about shareholders in financial firms (that they are stupid) and about people who manage pensionfunds etc (that they are either fall guys or have very good lawyers).
These apparent beliefs that you think may have led all kinds of experienced finance people into this mess could be a plausible explanation if the drivers of this process were all plating with their own money. OK, some of these people lost a lot (the bunch that was taking the public for a ride was playing an internal game as well, musical chairs) but I would guess that the rally smart ones were long gone when the bubble they helped create, burts, and busy making money on the way down.
I am still wondering whether the various bailouts (entirely predictable for someone highly familiar with history and anatomy of the various bubbles) are going to reward or punish the bubble-makers. But I am sure no one has the forensic resources to look into that question and probably the bubble-makers can buy all the justice they need, at least via the political process. And, of course, lots of ordinary people who were lucky enough to have sold stocks and houses at the right time, benefited from all this mischief.
When there’re losses in CDOs or in CDS, for banks, broker dealers, etc someone else has to be the gainer.
I’m still wondering why this is so complicated and difficult for people to understand?
Will it take a PhD in stochastic differential equations to figure this out?
Chidambaram:
Could you expand a little? For a CDS, I see your point so long as the buyer actually owns the referenced financial instrument and the seller isn’t bankrupted by the credit event.
But for a CDO, I’m not seeing who gains when the underlying assets fail to perform. My understanding is that the losses trickle up the tranches in reverse order of seniority.
To be fair the the assumptions for CDO models aren’t totally insane if you apply them to corporate bonds. Saying I don’t know what the recovery rate is but 40% sounds good, doesn’t give you absurd numbers if you are talking about corporations. Subprime mortgages on the other hand…..
Patrick: Twofish: I guess an obvious question that only just occurred to me is: what do the models say if one plugs in recovery and default correlation that reflect observed reality?
Depends. Subprime recovery rates and default correlations for 2005 or for 2007? For 2005, CDO’s are worth a lot. For 2007, they aren’t. However, the curious thing is that the price for CDO’s right now assume default rates and recoveries that are far worse than what people have been getting.
In principle someone with cash should be able to buy the CDO’s and assuming we don’t have another great depression, they should make some money. Trouble is 1) anyone with cash right now is keeping it 2) we don’t know that we won’t have another great depression and 3) some people have already tried this assuming things couldn’t get much worse and lost their shirts when they did.
Patrick: I’m wondering if, under certain conditions it’s possible that the CDO is worth less than the unsecuritized mortgages would be.
Yes. When people are spooked they run away from anything complex. One thing is that you can have a model that says something is worth $X, but to get $X you need someone that is willing to give you $X in cash money. Most of the financial models didn’t take into account “fear and panic.”
Chidam: When there’re losses in CDOs or in CDS, for banks, broker dealers, etc someone else has to be the gainer. I’m still wondering why this is so complicated and difficult for people to understand?
Because it’s not true.
Brad,
Back to broker dealers and funding corporations. Reading the footnotes to L130, funding corps include, among other things, nonbank financial holding companies. I think that would include, for example, Goldman Sachs Group, at least up to the point where it converted itself to a bank holding company. In their case, if you deconsolidate their statement, the holding company would have an asset “investment in broker dealer”. Apparently other entities are lumped into the funding corp category, but I think to get a numerical sense of the investment bank world there are grounds for consolidating funding corps and broker dealers in the flow of funds report.
As to “loaned securities”, a very large number, which shows up as an asset for broker dealers and a liability for funding corps: This is just a guess, but I think this may be securities borrowed by investment banks for their own securities lending operations (to short sellers and the like). They might be borrowed from customers or institutional money managers. If this is so, why the accounting in the funds flow statement puts the asset in one category and the liability in the other — that beats me. Anyhow, if this is right (a big if), I would think these numbers should be netted out of a statement that tries to get at the possible ABS holdings of investment banks.
Ostrich: I think that would include, for example, Goldman Sachs Group, at least up to the point where it converted itself to a bank holding company.
I don’t think so. Bank holding companies and financial holding companies are very different things.
Loan securities sounds very much like a repurchase agreement, and that market is huge.
If you have $1000 in cash, you put it into a savings account. If you have a $250 million in cash, you sign a repurchase agreement with an investment bank. You buy $250 million in treasury bonds or other high grade collateral, with the agreement that in a week, you get to resell it back to the bank for $250 million + interest.
2fish & don — perhaps someone @ the FED/FDIC/OCC was reading your discussion (excellent btw) yesterday?
from today’s joint press release:
Structuring compensation
Poorly-designed management compensation policies can create perverse incentives that can ultimately jeopardize the health of the banking organization. Management compensation policies should be aligned with the long-term prudential interests of the institution, should provide appropriate incentives for safe and sound behavior, and should structure compensation to prevent short-term payments for transactions with long-term horizons. Management compensation practices should balance the ongoing earnings capacity and financial resources of the banking organization, such as capital levels and reserves, with the need to retain and provide proper incentives for strong management. Further, it is important for banking organizations to have independent risk management and control functions.
The agencies expect banking organizations to regularly review their management compensation policies to ensure they are consistent with the longer-run objectives of the organization and sound lending and risk management practices.
The agencies will continue to take steps to promote programs that foster financial stability and mitigate procyclical effects of the current market conditions. However, regardless of their participation in particular programs, all banking organizations are expected to adhere to the principles in this statement. We will work with banking organizations to facilitate their active participation in those programs, consistent with safe and sound banking practices, and thus to support their central role in providing credit to support the health of the U.S. economy.”
http://www.federalreserve.gov/newsevents/press/bcreg/20081112a.htm
Brad,
Check Michael Lewis article on Portfolio regarding the importance on synthetic CDOs in increasing this mess.
Funny, informed, and the best was left for last (page 9, a classic!)
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