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!)

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

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.

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.

Because it’s not true.

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.”

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.

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.