Sunday, January 31, 2010

Money talks

In an earlier post 100 cents on the dollar I discussed the controversial AIG bailout, summarizing a WSJ narrative as follows:

IF AIG (credit rating) Downgrade,
THEN collateral provisions trigger in derivatives (CDS) contracts,
THEN AIG bankruptcy,
THEN systemic meltdown.

So the AIG counterparties played chicken with the Fed and got 100 cents on the dollar for $60 billion in derivatives contracts. Paid for by you and me and our kids :-/

If I have any of this wrong, experts please correct me -- I'm just trying to understand how the world works.

A reader with considerable expertise weighs in with the following analysis of the events of late 2008. While this person has more expertise on this matter than anyone I know, he may not be completely unbiased, considering his employer ;-)

Steve - I do think you have it wrong. The plot line is false, but it is also imbued with plenty of facts - so explanation is difficult.

Quick summary: An AIG bankruptcy filing did not hinge on the resolution of these contracts, thus there could not have been a game of chicken.

Details (greatly simplied but still quite wordy): This story is set in November of 2008, but to understand it we have to go back two months earlier - to September. In September 2008 the clearing price of mortgage-backed securities implied a high rate of mortgage default with low recovery on foreclosed property - a decline in real estate values such as never seen before. Observers were still debating whether prices were correctly forecasting widespread defaults or whether prices were merely depressed due to illiquidity. For institutions levered to real estate the distinction was very important because it meant the difference between short-term liquidity problems and long run insolvency which would force bankruptcy.

To understand liquidity problems, we need to understand collateral. In order to minimize credit risk to each other, financial institutions ask for collateral from each other. As trades slowly move up or down in value, cash and securities flow between institutions so that everyone owes each other approximately nothing and the effects of a sudden bankruptcy are much smaller than they otherwise would be. Having collateral in hand means not having to worry about why your counterparty's trades are marking down so low - you are 100% insured by the collateral and if prices rebound you'll just give it back. And if your counterparty goes bankrupt you won't take a loss. Lehman was long real estate and, due to falling prices and having to post collateral, come September they ran out of cash. Regulators shopped them to other banks whose traders pored over Lehman's books and concluded "the company is insolvent, not just illiquid" so "goodnight Lehman Bros".

AIG was in the same boat as Lehman however AIG is an insurance company - this opened up three problems. (1) Banks are usually regulated by federal entities like the Fed and the SEC, so they all fit into similar frameworks nationwide. However insurance companies are only regulated by states. States are not particularly great at regulating because they are small and every state does things differently. (As a side note for fans of health care reform, regulating insurance companies at the federal level and creating national competition is the single most important reform needed. Lack of this in the so-called reform bills is proof that the legislation is all about creating health care entitlement without any real reform.) You can't just call in JP Morgan or Goldman Sachs to tell you what to do here because a bank can't really analyze an insurance company over a weekend. (2) Next, the ratings agencies had assigned AIG their highest rating, AAA, meaning that people who didn't want to do a lot of their own credit analysis, but didn't want to take any risk of default, were the sort of people who bought AIG bonds - that is to say, AIG bonds were largely being held in accounts that were presumed to be taking no risk by their owners. If you go back to news stories from September 2008 you will find many shrill voices invoking the spectre of systemic melt-down, but those voices tend to come from holders of AIG bonds, not random investors worried about "the system". (3) As an insurance company the general public was very broadly exposed to AIG in pensions, annuities, home insurance, etc... and these people aren't holding any collateral at all, but would account for a lot of votes at the polls come November. So, because of these three complications, the same politicians who let Lehman go under decided, at about the same time, to bail out AIG.

Now, there are lots of ways to do a bailout. This very same month, the largest financial entities in the world, Fannie and Freddie, were bailed out - and basically by the federal government saying "we simply guarantee all the debts and obligations of Fannie and Freddie". (Note that, in the end, the agency bailout is where the "taxpayer" will take almost all his lumps. But the politicians don't talk about this too much because Washington spent decades exempting Fannie and Freddie from any meaningful regulation and encouraging them, via various acts of congress, to facilitate mortgage loans to people who probably couldn't afford homes, but would make U.S. home ownership "more diverse".) In the case of AIG the bailout took the form of an $85 billion loan. It is important to remember at this point the debate over whether real estate securities were down because a bunch of mortage defaults were coming or just because nobody wanted to own the bonds. The politicians were still hoping for the latter and hoping that a loan would tide AIG through its illiquid period and into a time when the securities recovered. The TARP legislation was debated this same month, and the original intent of TARP was to buy these securities, thus creating a market for them, and a recovery in their prices. (In the end, however, TARP was not used in this way. It was used to invest in banks, for which no legislation was required anyway, and auto companies - which was probably illegal.) The TARP debate informs us that in September the politicians were not believing the market-implied rate of mortgage default. So, AIG used its bailout money to keep collateral flowing on its real estate positions. The thinking on this was that it stopped the counterparties from closing out the trades and thus "locking in the loss".

Now let's move forward to November 2008, the subject of this post. By November those debating that real estate securities were down due to illiquidity rather than coming defaults had given up their argument. A wave of defaults was coming and everyone finally realized that a lot of people who took out sub-prime mortgages always had the intention of defaulting because they didn't want to own a home so much as speculate on real estate going up. Back at AIG, their positions had continued to go against them and it became pretty obvious that AIG was insolvent, not just illiquid, and a more aggressive bailout was going to be needed if they were not to declare bankruptcy. But now if AIG goes bankrupt the government is in for a loss too since it has made all these loans. So "in for a penny in for a pound" the feds decide to up the bailout. Among many issues to be sorted out in the fresh bailout is that AIG still has all these real estate positions which keep bleeding money and, since AIG made the wrong calls on this all along, the feds decide to close out all of these positions.

At this point, the "unlimited bailout" decision has been made, and the discussion over mopping up these positions is a sidebar, not super important at the time (but it will become very politically sensitive a year later). The feds would like to save a few bucks by negotiating the close-out on these trades with the banks. However, because all the banks are holding lots of collateral, and some of them are even insured against AIG defaulting, they expect to be paid in full just like everyone else exposed to AIG. The feds aren't calling PIMCO and asking them to take 80 cents for their AIG bonds, they are calling retirees and asking them to take 80 cents for their pension annuities, and the aren't calling up auto insurance holders and asking them to take 80 cents for fender-bender repairs. Further, the insured banks wouldn't take a loss even if AIG went bankrupt unless you buy the end-of-the-world systemic melt-down scenario. But, even if you believe that, why aren't all of AIG's creditors being asked to contribute? Indeed, why not everyone in the world, since all benefit from there being no global melt-down. The banks are not the primary beneficiaries of the bailout, the bondholders are - bondholders have no collateral. In essence, there is nothing for the fed to negotiate, so they abandon the effort.

So, back to Steve's question. AIG was going to go bankrupt without a bailout, and negotiating 80 cents on the dollar for its real estate positions would not have changed that either way - so no game of chicken. For political reasons, the decision was made to bail them out. The banks were not asked to pay a disproportionate amount towards that bailout, and intelligent minds can debate whether or not they should have, but the case is far from clear. Lastly, I will add that I am unconvinced that letting AIG go bankrupt would have created a systemic meltdown, but it is clear why those involved in the bailout would say that. It is human nature that when you make a convenient but unpopular choice, your first defense is likely to be that you didn't really have a choice. The choice to bailout AIG was convenient and unpopular, but I don't agree that it would have led to systemic meltdown, and the historical arguments on my side are quite strong. Panics happen every 10 to 20 years and it is never the end of the world.


rp said...

Thanks for this - helpful to someone who's followed this with amateur interest, thanks. A few remaining oddities for me that keep me confused and support lingering doubt. On the one hand the RE price decline devastation flowed through structured products and into balance sheets over months as you say (I'd peg the clear start earlier, say July when the Bear hedge funds got hammered) which meant AIG had to be throwing up collateral throughout the summer and fall on the AIGFP products and should have made impending disaster evident, particularly when it had to be the AIG insurance assets covering the FP losses, and no way that I can see did AIG have the kind of B/S valuation flexibility that a hedge fund would have to string things along for months given the insurance regulation i assume they were/are under. So why did AIG seems to tank so suddenly, or at least so suddenly require the bailout when all things finance hit the wall in Sept/Oct? This is where it is odd the press reports on the one hand suggest a sudden blow up where AIG seemingly all of a sudden was on the hook for the counterparty payments (supporting the idea that government money flowed directly to counterparties) but your explanation contradicts that. Quick googling supports your view - the press reports I've read on this seem to talk about the $$ that flowed AIG-to-GS over the months leading up to the bailout, not in Oct/Nov.

On MBS pricing default rates - even in early/mid '09 totally unprecedented mortgage default rates were (still are?) baked into everyone's assumptions. ie the IMF report projecting 2.7T global loss, the Roubini 3.4T loss report both put cumulative mortgage loss rates in the US at 15-20%+ vs historical numbers never exceeding 1% or so. Assume 50% recovery, then one out of every three mortgages in the US is going to default??? Seemed crazy. And if this was the baked in assumption, why didn't they highlight that eye-catching fact? I don't understand why all of this has to be so convoluted in its reporting. For instance, as best I could tell the IMF report was actually more pessimistic than the Roubini one (shocking) because Roubini was projecting cumulative losses through the entire 'event' (roughly through end of '11) while IMF was projecting through the peak loss/bottom ie '10 - ie the 2.7 and 3.4 people kept comparing were not comparable (there was also a geographic discrepancy that escapes me - I have not looked at this in months).

And to keep rambling, another part of this that struck me as counterintuitive. The fact that the US system had roughly 50% of outstanding debt securitized vs on bank balance sheets as loans actually seems to have helped us work through this quickly vs how Japan went. The value of the securitized assets tanked quickly, forcing banks to admit half the issue and deal with it, while still trying to string out the possible losses on the loans on the books - ie they simultaneouly carried securitized assets with 50%+ losses while valuing loans on their books covering essentially the same things at much higher rates because they don't have to write loans off until the losses are closer to being recognized. Put everything on the books (vs securitized) and we'd have seen little of the writeoffs that occured and we'd still be hearing stories about how the banks are 'fine' as loan losses gradually built. just like japan.

Also - was there money to be made in scooping up the securitized loans that were so underpriced in late '08 and had baked in these crazy default/loss rates that don't seem to have happened? On the one hand mortgage defaults don't seem to have done anything near the rates people were projecting in early/mid '09, on the other hand i haven't heard about huge hedge fund gains on anyone who bought distressed securitized loans then. Another scnadal that if the govt had bought those assets as tarp was supposed to do we the public would have made out quite well?

Steve Hsu said...

RP: I hope LY posts some additional comments here that address the points you raise.

Overall, his story hangs together but I also have some questions which, after more reflection, I'd like to pose. (I'm thinking about other stuff at the moment and would have to go back and re-think a lot of stuff from back in 2008 to recall how I saw it at the time, or even in light of subsequent coverage ...)

Did any of the recent congressional testimony by Blankfein et al., or even Geithner or Bernanke, produce a narrative as clear as LY's? If so I missed it.

rp said...

Yeah, this stuff is really interesting although I say again it seems like the stuff that is unclear isn't unclear because it's all that complex. Are journalists just not that good? The questions/inconsistencies seem obvious to highlight even if one doesn't understand them enough to explain them. Or are the scientist/finance people I talk (science background, finance learned on the job) too uneducated broady in finance and simplifying things too much in asking these sorts of questions - eg Steve's blog post and comments? (ie it's not just that these answers don't seem clear from press reports, its that these questions arent even being asked and i don't know why)? I like to think we are getting to the root of the matter but I'd love to hear LY or another true finance expert respond to that. One edit to what I said above - the IMF report in early '09 projected 4T of gloabl losses with 2.7T in the US (by US entities I think, as opposed to the other definition of 'US losses' - losses on US assets). Roubini's approach was a little less clear (at least the data I saw) as to how he measured 'US' - losses on loans against assets in the US or losses by US entities - but the differences roughly offset (loans on non-US assets held by US entities vs loans on US assets held by non-US entities, both around $4T?? of the $24T in total US loans/securitized loans), so i don't think it is a huge deal, and the 3.4T Roubini would be roughly geographically comparable to the 2.7 IMF except then for the very different time period issue I mentioned. Anyway I mention these reports because they (and all others I've seen, including the IB analyst reports on the banks as potential investments) had roughly the same eye-popping mortgage losses built into them that underlies a lot of this.

LondonYoung said...

I will try to answer what I can:

Why did AIG seem to melt down so suddenly in late 2008? As I've said, there was a binary debate over the value of these securities. Previously on Steve's blog, I have referenced this post:
Now, a bit of fine detail on collateral - as I've said, collateral flows between counterparties as the valuation on their trades slowly moves. Ah - but who determines what that valuation is? As you see in this link, in November 2007 MER was pricing a trade at 95 cents on the dollar that GS was claiming was only worth 75. Reading this AIG memo, it is clear that they were hoping the MER price was right and probably not coughing up collateral to the GS levels. By the fall of 2008 everyone came to understand MER was wrong and GS was right, and this was a sore blow to AIG.
So AIG bled collateral continuously up to the fall of 2008 and then more rapidly as people gave up on the "housing is about to bounce back" argument.

Overall implied defaults rates - I am unfamiliar with the details of Roubini's or the IMF's analyses, but the data on calculatedriskblog is usually pretty good. I think Roubini and the IMF include things like HELOC losses, most of which don't hit mark-to-market positions. I think conforming mortgages, the best kind, are defaulting at a 1 in 20 rate (and climbing) and lower quality mortgages are up there in the "Tony Soprano HUD mortgage" category - a near complete loss. 1 in 3 defaulting sounds high, but 1 in 6, say, would not sound high. If you are the sort of person who doesn't know many people earning less than the median family wage while still carrying a mortgage, then beware of developing an opinion based on what you anecdotally see among your friends.

On the U.S. vs. Japan. The U.S. tends to bounce back quicker because we are more willing to put the insolvent into bankruptcy. In Japan, the govt will tend to support the insolvent by providing liquidity hoping that they will earn their way out of insolvency. When this works it is slow, and when it doesn't it is slow and painful.

Have hedge funds made money scooping up these assets at depressed prices? Some have made, some have lost. The asset space is incredibly rich here, and every security is different. I would have to go on for pages on which assets have bounced back and which have continued downward.

Ian Smith said...

LY's long response means he wants to toss your salad Steve.

rp said...

OK, pricing uncertainty adds another layer to the mix. But still missing something essential. How are all of the following true: pricing uncertainty leaving AIGFP obligations unclear, FP counterparties were fully collateralized even once the worst case pricing scenario becomes clear, and sudden bankruptcty of the overall AIG business with little warning? If they were paying the counterparties over time, they can't have valued their balance sheet using a more optimistic pricing scenario than implied by their collateral payments, right? on the other hand if they had fully collateralized their counterparties when everything finally hit the fan they must have been collateralizing under a fairly pessimistic pricing scenario, right? and if they were using a pessimistic pricing scenario overall, why did it not become clear months earlier where this was all going?

i can see how a hedge fund could string this along for a while. i don't see how aig could gradually transfer many billions to fully collateralize FP counterparties by taking reserves covering insurance obligations without some kind of intervention from somewhere, particularly if the counterparty payments were gradually putting them a hundred billion+ in the hole against their other obligations. maybe a complicating factor is that other parts of their balance sheet were taking hits as global asset prices dropped in late '08, but i assume this was a small factor. are you saying AIG senior management was making the collateral payments, realizing they were bankrupt if those payments held, but hoping the RE market would recover so they could get back the collateral payments? Pretty sure that's not the case either.

Complicated thoughts on the possible discrepancies between huge bank write-offs on securitized mortgages vs bad but not titanically bad default rates so far - I still see an unexplained gap here even with 1 out of 20 default rates (cumulative, right?) so far, and 1 out of 5 on the riskier stuff.

LondonYoung said...

rp - I love your questions, let me paraphrase: "nice narrative LY, but do the numbers foot?"
I don't know, I would love to see someone disciplined try to work it out. It's easy for me to bloviate about generalities, but opening excel and collecting info on the net is beyond me for today. I hope the following helps:

I don't think AIG's fall was "sudden" when you view it in context. The stock market *as a whole* fell 30 to 40% around October, but many stocks are low risk! That AIG should deteriorate much than the market seems unsurprising. September and November were world's away from each other.

Next, I'm sorry to report that nothing requires an insurance company to value its positions at the same price to which they are margined. I don't know what you mean by a pessimistic pricing scenario, but as I said: in September lots of people were thinking the market was coming back, but not so come November. I will also add that I don't mean to imply that all of their counterparties were fully collateralized to their own prices. Many of their counterparites held lots of collateral, and some were even insured against AIG defaulting. This makes the counterparties much better off than bondholders - who hold no collateral. A bailout benefits the uncollateralized vastly more than the collateralized.

How much did AIG lose on these positions? I dunno, but $100 bio sounds high, I am not sure. I think some docs are coming out of the congressional inquiry, do they say? Also, I think you are using the word "bankrupt" when you mean "insolvent". Would AIG keep paying out collateral if they thought they were insolvent? I think this is illegal, so I bet not. But even now, there is debate over what the ultimate value of these positions will be - so there is room for disagreement over solvency.

And, following up on this last - how do implied default rates from fall of 2008 compare to what we have seen since? I think your loss rates look a tad low, and are clearly low for the riskier stuff. But these were complicated positions. Maybe AIG was insuring "first to default" tranches of subprime? Also, beware of comparing the whole market to any given set of mortgages. I think there might be adverse selection in which mortgages get securitized vs which the originators choose to keep themselves? I though this graph of MONTHLY default rates looked interesting:

Xiaoding said...

60 billion dollars? You are upset about 60 billion dollars? Are you serious?

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