Sex, Drugs and CDOs

This book is a novelization of the events surrounding the credit crisis, as viewed by a junior banker on the rise. In addition to simple introductions to securitization, CDOs, CDS, SIVs, etc. (including figures that might have been drawn on Cristal-stained cocktail napkins) there is plenty of insight into the psychology of bankers and the sometimes tawdry client-banker relationship on the sell side. Amazon: US edition , UK edition (more reviews).



Readers unfamiliar with Wall Street and The City may find the various banker shenanigans depicted surprising. Yes, client meetings really do happen at strip clubs and in the presence of call girls. But the more substantive point that readers should note is just how intense the demand was for CDO products. There are many scenes in the book in which the protagonist's main problem is dealing with incensed clients whose orders for CDO allocations have not been filled due to excess demand. As we heap blame on CDO issuers we might think a bit about the buyers of the securities and why they were so stupid.

The author, Tetsuya Ishikawa, was educated at Eton and Oxford and worked at several major banks including Goldman, where he was peripherally involved in the Abacus deal. For more, including video interviews, see his blog.

See you at the Harvard Club

If you are enamored of A.K. Barnett-Hart and/or her senior thesis on CDOs and the credit crisis, you might wish to attend the event described below, sponsored by the HBS Women's Association of New York. We wrote about Ms. Barnett-Hart previously here. Why am I not surprised she's working at Goldman now?

I couldn't come up with a good title for this post that didn't trade on Ms. Barnett-Hart's good looks, so I chose the lame one above. Chances are, I won't actually be at the event :-(

A Harvard Senior Thesis tells the Story of the Financial Market Meltdown

A.K. Barnett-Hart's senior thesis, "The Story of the CDO Market Meltdown: An Empirical Analysis" has won numerous awards. Her research on this topic was used by Michael Lewis in his recent book on the financial crisis "The Big Short".

Collateralized debt obligations (CDOs) were a leading cause of writedowns at financial institutions during the recent financial crisis, leading to the demise of Merrill Lynch and AIG. Most of the securities being marked down were initially given a rating of AAA by the rating agencies, essentially marking them as "safe" investments. The rating agencies were not alone in their mistake; indeed almost all market participants failed to question the validity of the models that were luring them into a false sense of security.

In her senior thesis, “The Story of the CDO Market Meltdown”, A.K. Barnett-Hart investigated the causes of adverse performance in CDOs backed by asset-backed securities. Join her as she presents her findings, telling the story of how deterioration in collateral, irresponsible underwriting practices, and flawed credit rating procedures allowed this arcane market to contribute to the near destruction of the global financial system.

A Harvard 2009 Magna Cum Laude graduate, Ms. Barnett-Hart’s senior thesis, “The Story of the CDO Market Meltdown: An Empirical Analysis” won numerous awards, including the Hoopes Prize, the Harris Prize for the best economics thesis, and the Dunlop Prize from the Kennedy School of Government. Her research on this topic was used by Michael Lewis in his recent book on the financial crisis, “The Big Short,” and has been used by government agencies such as the TARP and the Financial Crisis Inquiry Committee.

Ms. Barnett-Hart is also an accomplished violinist, and had studied under Itzhak Perlman at the Juilliard School of Music. She is currently an investment banker at Goldman Sachs.


Event Details:

Date: Tuesday, June 15, 2010
Time: 6:30 P.M., Registration and Cash Bar 7:00 P.M. Program
Location: The Harvard Club, 27 W. 44th Street (between 5th & 6th Avenues)
Cost: Free Event – Registration Required

Organizers: Hemali Dassani HBS ’99, The Harvard Club Programming Committee


The HBS Women's Association of Greater New York is a charitable organization established by and for alumnae of the Harvard Business School who live and/or work in the Greater New York area. Our mission is to provide education to alumnae and the broader community about women in leadership and to raise scholarship funds for a current HBS woman student. Our programs facilitate the exchange of information, experiences, tools, guidance and support to enable HBS alumnae at all stages of their lives and careers to fully realize their individual personal and professional goals.

We are always looking for great programming ideas, so if any of your readers have ideas or contacts, I'm happy to hear them. programming@hbswany.org

See you in court

The best reporting on the SEC charges against Goldman that I've found so far is by Felix Salmon at Reuters. See the post I linked to and several more he's made in the past day or two.

I still think the SEC will have a tough time with this case. In terms of public opinion (no nuance), this is definitely a black eye for Goldman. But a court of law is a different thing, one hopes.

Below are two comments from Felix's blog that sum up the issue nicely. ABN/IKB are the large European banks that were big buyers of the senior tranches of the Abacus deal in question (more correctly, ABN was an insurer of the Abacus risk). ACA is the Abacus CDO manager that collected millions of dollars in fees and put its reputation on the line. The records show that they rejected many of Paulson's suggestions for reference names to be placed in the structure.

The bottom line is that when a trade occurs the buyer and seller typically have different views on the likely future of the security. See my previous post for some color on what the world looked like when the Abacus deal was being done. If ABN/IKB had done well with their investment they might be chuckling today: "Yeah, we took a lot of money from those short chumps back in 2007. Can you believe we got 100 bps for free for AAA! Who is John Paulson?"

Somehow it's easier to blame this disaster on evil fraudsters than on plain stupidity.

Well, that’s all very nice, but what is it that ACA was supposed to have done for the fee it was paid? Just accept Paulson’s selections? Were they not supposed to be you know actually evaluating the structure and underlying assets?

When a firm gets millions of dollars to validate an investment, doesn’t it have some obligation to do some research?


*********************


I'm still at a loss to understand why sellers of credit protection would have changed their mind if they knew the buyer of the protection structured the transaction.

Do ABN/IKB assume all market participants are lazy and gullible as they are? Popeye the Sailor could have selected the collateral but it was incumbent on ABN and IKB to perform their own due diligence on the underlying assets.

Paulson/GS also had no inside or non-public information that these bonds would default. They structured the CDO based on their view that the bonds were likely to default. This information was also available to ACA, ABN, IKB.

Paulson/GS certainly didn’t force the homeowners to default on their payments or cause the bond trustee to declare the bonds in default.

If I sell you a share of Apple stock, chances are I am less optimistic than you are about the future price. However, it's also possible I'm selling it just for risk management or asset allocation reasons; maybe I have too much concentration in my portfolio so I'm selling it just to rebalance. But we usually don't require that the buyer has to know my reasons for selling the share. The SEC is more or less saying Goldman committed fraud by not letting the buyers know that Paulson really thought subprime was a bubble, and wasn't simply hedging his mortgage positions. Yes, Paulson suggested names for the structure, but ACA was there to vet all of them.

The WSJ has a nice analysis of ACA's role, and its centrality to the case, here.

This NYTimes article describes the internal dynamics at Goldman -- until very late there was no consensus that CDOs built from subprime assets would melt down.

How it looked to Paulson

Why did Paulson and Magnetar need to participate in the creation of new CDOs? Apparently Paulson had trouble finding counterparties at the time willing to take direct billion dollar bets on CDS indices. If I had had a decent way to short subprime in 2005 or 2006 I would have done it too -- see post1 and post2 from 2004!

Regarding the SEC charges against Goldman: the buyers of synthetic CDOs should have realized that there must have been short interest on the other side of the deal, and at the time Paulson wasn't a prominent figure. His short strategy was very contrarian and took enormous guts. I think this is going to be a very tricky case for the SEC.

Here's a revealing excerpt from WSJ reporter Gregory Zuckerman's book The Greatest Trade Ever. Read the whole excerpt!

WSJ: ... Mr. Paulson traveled to Boston to meet with Mark Taborsky, who helped pick hedge funds for Harvard's endowment. Mr. Taborsky was wary. Mr. Paulson's fund was willing to lose 8% a year to buy the mortgage insurance, which seemed like a lot. Mr. Taborsky also thought Mr. Paulson might be excessively gloomy about the housing market. Mr. Taborsky turned him down, too.

Even some investors who agreed with Mr. Paulson's view that housing prices would tumble doubted he would make much money because there was relatively little trading in the investments he was buying. He might have a hard time selling his investments without sending prices tumbling, shrinking any profits, they said.

"It looked like a dangerous game, taking one single bet that might be difficult to unwind," said Jack Doueck, a principal at Stillwater Capital, a New York firm that parcels out money to funds. He, too, said no to Mr. Paulson's fund.

Mr. Paulson's growing fixation on housing began to spark doubts about his business. One long-time client, big Swiss bank Union Bancaire Privée, received an urgent warning from a contact that Mr. Paulson was "straying" from his longtime focus, and that the bank should pull its money from Paulson & Co., fast. The bank stuck with Mr. Paulson but turned down his new fund.

... By the summer of 2006, Mr. Paulson had managed to raise $147 million, mostly from friends and family, to launch a fund. Soon, Josh Birnbaum, a top Goldman Sachs trader, began calling and asked to come by his office. Sitting across from Mr. Paulson, Mr. Pellegrini, and his top trader, Brad Rosenberg, Mr. Birnbaum got to the point.

Not only were Mr. Birnbaum's clients eager to buy some of the mortgages that Paulson & Co. was betting against, but Mr. Birnbaum was, too. Mr. Birnbaum and his clients expected the mortgages, packaged as securities, to hold their value. "We've done the work and we don't see them taking losses," Mr. Birnbaum said.

After Mr. Birnbaum left, Mr. Rosenberg walked into Mr. Paulson's office, a bit shaken. Mr. Paulson seemed unmoved. "Keep buying, Brad," Mr. Paulson told Mr. Rosenberg.

[Yes, in hindsight everyone knows that subprime loans were "toxic waste" -- but at the time lots of smart money didn't think so. Mr. Market needs a little help sometimes ... Steve]

Months into their new fund, Mr. Paulson and Mr. Pellegrini were eager to find more ways to bet against risky mortgages. Accumulating mortgage insurance in the market sometimes proved slow. They soon found a creative and controversial way to enlarge their trade.

They met with bankers at Bear Stearns, Deutsche Bank, Goldman Sachs, and other firms to ask if they would create securities—packages of mortgages called collateralized debt obligations, or CDOs—that Paulson & Co. could wager against.

The investment banks would sell the CDOs to clients who believed the value of the mortgages would hold up. Mr. Paulson would buy CDS insurance on the CDO mortgage investments—a bet that they would fall in value. This way, Mr. Paulson could wager against $1 billion or so of mortgage debt in one fell swoop.

Paulson & Co. wasn't doing anything new. A few other hedge funds also worked with banks to short CDOs the banks were creating. Hundreds of other CDOs were being created at the time. Other bankers, including those at Deutsche Bank and Goldman Sachs, didn't see anything wrong with Mr. Paulson's request and agreed to work with his team.

At Bear Stearns, however, Scott Eichel, a senior trader, and others met with Mr. Paulson and later turned him down. Mr. Eichel said he felt it would look improper for his firm. "On the one hand, we'd be selling the deals" to investors, without telling them that a bearish hedge fund was the impetus for the transaction, Mr. Eichel told a colleague; on the other hand, Bear Stearns would be helping Mr. Paulson wager against the deals.

Some investors later would argue that Mr. Paulson's actions indirectly led to the creation of additional dangerous CDO investments, resulting in billions of dollars of additional losses for those who owned the CDO slices.

At the time, though, Mr. Paulson still wasn't sure his trade would work. He simply was buying protection, he said. "We didn't create any securities, we never sold the securities to investors," Mr. Paulson said. "We always thought they were bad loans."

Enough Magnetar, now on to Paulson, Goldman and the SEC

See Felix Salmon for a discussion of the SEC complaint against Goldman. They allege that Goldman violated its fiducial responsibilities in marketing a synthetic CDO called ABACUS. The SEC allegations are very similar to the story told by ProPublica and This American Life, with John Paulson's fund playing the role of Magnetar.

This is being covered aggressively by the NY Times and WSJ as well.

The Magnetar trade part one, two, three.

The Magnetar trade, part 3

An MBS guy writes:

You wrote: "... there may have been motivation for Magnetar to pressure the underwriters to include particularly toxic mortgages in the CDOs they sponsored." No, I doubt it. Magnetar pressured the CDO managers (*not* the underwriter, which were the banks) to put in HIGHER YIELDING assets -- now, higher yielding assets are probably crappier, but they didn't care about the credit quality per say, only the high coupon with which they can achieve the positive carry -- i.e., getting paid while making the trade.

Furthermore, after reading that Magnetar asked Janet to provide advice, I must say, these guys aren't that sophisticated. Janet's books are great, but are NOT technical books and are horrible places for seeking trade ideas! You're better off asking the research desk of any investment bank. Please see the attached CDS primer from Lehman circa 2005, which shows you the pricing discrepancies that exist in the market, and how you can profit from it (page 10, under "valuation considerations"). They even provide a nice table (see figure 11 on page 12) on the returns given different assumptions of leverage and borrowing cost. This is just one document however, and plenty of other guides available that time will tell you how to hedge the default risk by shorting a more senior tranche - which implies that you believe correlation is high (you're long correlation -- see page 8 on the correlation trading guide from Merrill in 03 - this is for corp bond CDOs, but whatever, same concept).

So yeah, I doubt these guys knew enough to be able to figure out which loans were crappy even if they tried. If they were so good at picking out bad loans, they'd have just taken a bet (trading a view) on the crappy loans via an ABS-CDS on that crappy bond pool. Why go through all the trouble of setting up a CDO?

So in summary - these guys didn't purposefully set up crappy CDOs because

1) they frankly weren't that smart and didn't seem that knowledgeable (they made money because they were lucky - Howie Hubler blew up and lost $8 billion doing a correlation trade, and he was the smartest bond trader at Morgan Stanley), and therefore

2) couldn't have picked out which bonds were crappy even if they tried.

Here is the Lehman CDS primer (20 pages) and here is a Merrill primer on correlation trading (37 pages).

Hmm... what else could these brainy guys have been doing instead of working on "financial innovation"?

See A reallocation of human capital and The bubble algorithm for human capital allocation.








The Magnetar trade part one, two, three.

The Magnetar trade, part 2

Janet Tavakoli pointed me to this WSJ article which covered the Magnetar strategy already in 2008. Tavakoli, and another correspondent (anonymous) who works in MBS, both believe Magnetar's claim that their strategy was market neutral (in a sense; see below). It was actually a common correlation trade at the time: assuming a certain correlation between the fate of the risky equity tranche and the AAA senior tranches, one could guarantee a positive return by investing in the former and shorting the latter using a CDS contract. The strategy would make money regardless of the default rate (assuming the correlation), but it seems the upside was larger from the CDS contracts. So there may yet have been motivation for Magnetar to pressure the underwriters to include particularly toxic mortgages in the CDOs they sponsored (as alleged).

Tavakoli and my other correspondent both believe that ProPublica and This American Life have the story wrong. It may be appealing to think that a single hedge fund was capable of exacerbating the credit crisis through its participation in the creation of $30-$40 billion in CDOs, but the real story is probably more complex.

WSJ: ... CDOs are sliced based on risk, with the riskiest pieces having the highest yield but the greatest chance of losing value. Less-risky pieces have lower yields and some pieces were once considered so safe that they paid only a bit more than a U.S. Treasury bond.

Magnetar helped to spawn CDOs by buying the riskiest slices of the instruments, which paid returns of around 20% during good times, according to people familiar with its strategy. Back in 2006, when Magnetar began investing, these were the slices Wall Street found hardest to sell because they would be the first to lose money if subprime defaults rose.

For the Wall Street firms underwriting the deals, selling the riskiest pieces was "critical to getting the deals done because they were designed to act as a cushion for other investors," says Eileen Murphy, principal at Excelsior CDO Advisors LLC, a structured-finance consultancy.

Magnetar then hedged its holdings by betting against the less-risky slices of some of these same securities as well as other CDOs, according to people familiar with its strategy. While it lost money on many of the risky slices it bought, it made far more when its hedges paid off as the market collapsed in the second half of last year.

Here is Tavakoli's comment on the ProPublica story -- she was actually asked for advice by Magnetar on how to put on the trade.

Tavakoli on the missed opportunity to grill Prince and Rubin under oath on Citi's CDO activities. Was senior management negligent (understood the risks, and approved them) or incompetent (didn't understand their own CDO business)?


The Magnetar trade part one, two, three.

The Magnetar trade

Just when I thought I was out, they pull me back in...

I thought I was done discussing all of this horrible CDS, CDO, credit crisis stuff, but here we go again. Yesterday I listened to this podcast from This American Life, which details the activities of a large hedge fund called Magnetar. See here for the original reporting done by ProPublica.

The Magnetar team ("Smart. Very smart"), it is claimed, put on a very clever trade in 2006, after spending 2005 surveying the MBS market and realizing that subprime was an irrational bubble. Magnetar actually created demand for CDO structures by agreeing to fund the riskiest equity tranches. By putting up $10 million (according to the reporting) they could help initiate the construction of a $1 billion dollar security. (If the models show that the expected loss is small, and someone is willing to expose themselves to it, other investors can come in later and take the senior tranches, which could have AAA ratings.) Magnetar apparently lobbied the banks assembling the CDOs to include the riskiest subprime mortgages in the structure, because they intended to bet against the more senior tranches using CDS contracts. The underwriters and asset managers went along with this in order to book fees (also in the tens of millions of dollars) collected at completion of the transation. These transactions generated fake alpha -- short term profits for the banks, at the cost of taking on hidden tail risk. The guys who did these deals made huge bonuses. When the CDOs tanked, Magnetar made huge profits through its CDS contracts. The senior tranches were typically sold to other banks, pension funds, investors, but a large portion were actually kept on the books of the banks that underwrote them. The CEOs of these banks were often unaware of the tremendous risks (potential losses of tens of billions of dollars, hidden in the AAA senior tranches) they were taking on in order to book hundreds of millions of dollars in fees during the bubble.

Comments:

1. Cognition is bounded. Magnetar understood what it was doing. Some of the structurers at the banks understood what was going on, but their incentives were to take the short term fees and do the transaction (who cares? IBG YBG = "I'll be gone, You'll be gone"). The counterparties who bought the senior tranches didn't know what was going on, and neither (I'll bet) did the CEOs of the banks that did the structuring. Certainly the shareholders of these firms didn't understand the risks. Mr. Market priced all these deals terribly.

2. Nobody in 2006 said "Paulson / Bernanke / Obama / Geithner / ... will definitely bail us out if this gets too hairy. We're too big to fail!" Most of the MBS guys lost their jobs in the crash. But they made plenty of money while the getting was good.

3. Some people violated their fiducial responsibilities in this game. But it appears they're going to get away with it.

For more, see Naked Capitalism and Yves Smith's book Econned.

Small correction for the NPR guys: a magnetar is a neutron star (pulsar) with very high magnetic field. It's not a black hole.


Note added: In letters to ProPublica Magnetar claims it was employing a market neutral stat arb strategy, and that the CDOs they sponsored were not built to fail. See here and here. My interest in this story is not Magnetar, per se, but rather what it reveals about the MBS industry in general, leading up to the credit crisis.

Here is what Yves Smith has to say about the stat arb strategy:

... While Magnetar paid roughly 5% of the total deal value for its equity stake, it took a much bigger short position by acting as a protection buyer on some of the credit default swaps created by these same CDOs. This insurance in turn was artificially cheap because over 80% of the deal was rated AAA. Most investors did not understand what Magnetar recognized: this concentrated exposure to the very riskiest type of bond associated with risky mortgage borrowers, each of these CDOs was a binary bet. It would either work out (in which case Magnetar would still show a thin profit) or it would fail completely, giving Magnetar an enormous profit and wiping out even the AAA investors who mistakenly believed they were protected by having other investors sit below them and take losses first. Thus the AAA investors were only earning AAA returns for BBB risk.

The Magnetar trade part one, two, three.

Goldman apologia

The following appeared as a comment on my previous post discussing Paul Krugman's anti-Goldman and anti-finance column of last week. The commenter is a (very) senior quant with a PhD in physics. His knowledge of these matters is, I would guess, superior to Krugman's and certainly superior to that of any journalist.

Is Goldman entitled to keep its recently announced gigantic profits, given that they were (perhaps) saved by the government's bailout of AIG? Hear it from the horse's mouth :-)

For more background, click the AIG tag below. [If you are going to comment on this post, please read the earlier one first. Your thoughts might be addressed in the comments there!]

...on AIG - you might wanna check out this developing story.

When large derivative dealers trade with each other they typically agree to exchange margin so that on any given day neither owes anything to the other. Sometimes dealers will disagree on the value of their trades. GS has said that AIG owed them $10bio pre-bailout (in GS's opinion), and had given GS $7.5bio (AIG's opinion of the value) against this exposure. GS had purchased insurance from other large dealers for the $2.5bio balance.

AIG deals with the public too, of course, but the public pays premiums to AIG and holds no collateral. This is all "business as usual".

Now, let's look at what would happened if AIG had defaulted. For GS, the $7.5bio of collateral is "bankruptcy remote" and GS keeps it penny for penny. The insurance contracts pay off $2.5bio to GS and the right to pursue the claim against AIG passes to the counterparties. Mom and Pop who have purchased retail insurance from AIG are left with only a bankruptcy claim. So this is all very ugly, but absent further defaults, GS is left whole - no loss. But have no doubt, someone out there will be eating a big loss.

At this point in the discourse, most people have trouble understanding collateral and that it is bankruptcy remote (is this a skill? I guess so!), but let's say we have this one down. The next point people make is that letting AIG go under would have created a financial system meltdown that would have harmed GS such that GS could not collect all its $2.5bio insurance claim. Well, this is possible, but it is equivalent to saying that a large subset of JP Morgan, DeutscheBank, BNP, SocGen, Citibank, etc... all go bankrupt. However, we probably don't believe that even a full $2.5bio hit to GS would be lethal for it, so it is hard to say that a failure by AIG would have directly taken GS down.

The next point you might make is that if all these other banks went under it might have created a large enough set of other problems for GS so as to take it out. However this final claim, which is frequently made, is specific to GS in no way at all. But if you wanna say "maybe the U.S. bailed out AIG so that the entire world banking system didn't collapse", then yes, GS benefits from that just as does anyone in the economy with any exposure at all - like anyone who purchased Auto Insurance underwritten by AIG. So maybe a smart bailout avoids a situation like the depression which followed the Panic of 1837, but the beneficiaries of the bailout are likely not dominantly the banks. This is why administrations as diverse as G.W. Bush and Barry Obama have reached for identical bailout buckets.

The Kruggy regulation question should be "would compensation reforms stop the sort of loss-making trading that went on at AIG?" - and that may be, I don't know. And might it accidentally stop economically productive trading as well? Krugs sure doesn't think so.

Gillian Tett at LSE

Highly recommended: FT journalist Gillian Tett, a PhD in social anthropology, discusses her book on the financial crisis: Fool's Gold, at an LSE public lecture.

I haven't read the book yet, but it's on my list :-) Here are two nice excerpts that appeared in the FT. She does a great job of covering the birth and development of credit derivatives, CDOs, etc.

Genesis of the debt crisis

How panic gripped the world's biggest banks

Below is a discussion of correlation from the first excerpt.

The problem with correlation

Demchak was acutely aware that modelling the risks involved in credit derivatives deals had its limits. One of the trickiest problems revolved around the issue of “correlation”, or the degree to which defaults in any given pool of loans might be interconnected. Trying to predict correlation is a little like working out how many apples in a bag might go rotten. If you watch what happens to hundreds of different disconnected apples over several weeks, you might guess the chance that one apple might go rotten – or not. But what if they are sitting in a bag together? If one apple goes mouldy, will that make the others rot too? If so, how many and how fast?

Similar doubts dogged the corporate world. JP Morgan statisticians knew that company debt defaults are connected. If a car company goes into default, its suppliers may go bust, too. Conversely, if a big retailer collapses, other retail groups may benefit. Correlations could go both ways, and working out how they might develop among any basket of companies is fiendishly complex. So what the statisticians did, essentially, was to study past correlations in corporate default and equity prices and program their models to assume the same pattern in the present. This assumption wasn’t deemed particularly risky, as corporate defaults were rare, at least in the pool of companies that JP Morgan was dealing with. When Moody’s had done its own modelling of the basket of companies in the first Bistro deal, for example, it had predicted that just 0.82 per cent of the companies would default each year. If those defaults were uncorrelated, or just slightly correlated, then the chance of defaults occurring on 10 per cent of the pool – the amount that might eat up the $700m of capital raised to cover losses – was tiny. That was why JP Morgan could declare super-senior risk so safe, and why Moody’s had rated so many of these securities triple-A.

The fact was, however, that the assumption about correlation was just that: guesswork. And Demchak and his colleagues knew perfectly well that if the correlation rate ever turned out to be appreciably higher than the statisticians had assumed, serious losses might result. What if a situation transpired in which, when a few companies defaulted, numerous others followed? The number of defaults required to set off such a chain reaction was a vexing unknown. Demchak had never seen it happen, and the odds seemed extremely long, but even if there was just a minute chance of such a scenario, he didn’t want to find himself sitting on $100bn of assets that could conceivably go bust. So he decided to play it safe, and told his team to look for ways to cut their super-senior liabilities again, irrespective of what the regulators were saying.

That stance cost JP Morgan a fair amount of money, because it had to pay AIG and others to insure the super-senior risk, and those fees rose steadily as the decade wore on. In the first such deals with AIG, the fee had been just 0.02 cents for every dollar of risk insured each year. By 1999, the price was nearer 0.11 cents per dollar. But Demchak was determined that the team must be prudent.

Central limit theorem and securitization: how to build a CDO

I thought I would address the following related questions, on topics which are integral to the current financial crisis.

How does securitization work?

How can I transform a portfolio of BBB securities into a AAA security?

How does fractional reserve banking work?

How does the insurance industry work?

Before doing so, let me reprise my usual complaint against our shoddy liberal arts education system that leaves so many (including journalists, pundits, politicians and even most public intellectuals) ignorant of basic mathematical and scientific results -- in this case, probability and statistics. Many primitive peoples lack crucial, but simple, cognitive tools that are useful to understand the world around us. For example, the Amazonian Piraha have no word for the number ten. Similarly, the mathematical concepts related to the current financial crisis leave over 95 percent of our population completely baffled. If your Ivy League education didn't prepare you to understand the following, please ask for your money back.

Now on to our discussion...

Suppose you loan $1 to someone who has a probability p of default (not paying back the loan). For simplicity, assume that in event of default you lose the entire $1 (no collateral). Then, the expected loss on the loan is p dollars, and you should charge a fee (interest rate) r > p.

Will you make a profit? Well, with only a single loan you will either make a profit of r or a loss of (1-r) with probabilities (1-p) and p, respectively. There is no guarantee of profit, particularly if p is non-negligible.

But we can improve our situation by making N identical loans, assuming that the probabilities p of default in each case are uncorrelated -- i.e., truly independent of each other. The central limit theorem tells us that, as N becomes large, the probability distribution of total losses is the normal or Gaussian distribution. The expected return is (r - p) times the total amount loaned, and, importantly, the variance of returns goes to zero as 1/N. The probability of a rate of return which is substantially different from (r-p) goes to zero exponentially fast.

There is a simple analogy with coin flips. If you flip a coin a few times, the fraction of heads might be far from half. However, as the number of flips goes to infinity, the fraction of heads will approach half with certainty. The probability that the heads fraction deviates from half is governed by a Gaussian distribution with width that goes to zero as the number of flips goes to infinity. The figure below shows the narrowing of the distribution as the number of trials grows -- eventually the uncertainty in the fraction of heads goes to zero.





We see that aggregating many independent risks into a portfolio allows a reduction in uncertainty in the total outcome. An insurance company can forecast its claims payments much more accurately when the pool of insured is large. A bank has less uncertainty in the expected losses on its loan portfolio as the number of (uncorrelated) loans increases. Charging a sufficiently high interest rate r almost guarantees a profit. Banks with a large number of depositors can also forecast what fraction of deposits will be necessary to cover withdrawals each day.

Now to the magic of tranching, slicing and dicing (financial engineering). Suppose BBB loans have a large probability of default: e.g., p = .1 = 1/10. How can we assemble a less risky security from a pool of BBB loans? An aggregation of many BBB loans will still have an expected loss rate of .1, but the uncertainty in this loss rate can be made quite small if the individual default probabilities are independent of each other. The CDO repackager can create AAA tranches by artificially separating the first chunk of losses from the rest -- i.e., pay someone to take the expected loss (p times the total value of the loan pool) plus some additional cushion. Holders of the remaining AAA tranches are only responsible for losses beyond this first chunk. It is very improbable that fractional losses will significantly exceed p, so the chance of any AAA security suffering a loss is very low.

Problems: did we estimate p properly, or did we use recent bubble data? (Increasing home prices masked high default rates in subprime mortgages.) Are the default probabilities actually uncorrelated? (Not if there was a nationwide housing bubble!) See my talk on the financial crisis for related discussion.

Deeper question: why could Wall Street banks generate such large profits merely by slicing and dicing pools of loans? Is it exactly analogous to the ordinary insurance or banking business, which makes its money by taking r to be a bit higher than p? (Hint: regulation often requires entities like pension funds and banks to hold AAA securities... was there a regulatory premium on AAA securities above and beyond the risk premium?)

AIG watch

Treasury is setting up a special vehicle to buy up (face value) $70 billion in "troubled" CDOs insured by AIG CDS. At 50 cents on the dollar they intend to spend $30 billion in taxpayer dollars and $5 billion of AIG's money. This should reduce the collateral calls on AIG, although it's not clear that all the entities holding AIG CDS actually own the referenced CDO. Who at Treasury did the calculation to confirm that the ultimate value of the CDOs in question is over 50 percent of face value? If I'm holding the CDO and corresponding CDS contract, and I'm confident that the government is behind AIG, why should I sell at a 50 percent loss?

Kashkari remarks on TARP.

WSJ: ...The government's initial intervention was driven by concern that AIG's failure to meet it obligations in the credit default swap market would create a global financial meltdown. ...

Under the revised deal, AIG is expected to transfer the troubled holdings into two separate entities.

The first such vehicle is to be capitalized with $30 billion from the government and $5 billion from AIG. That money will be used to acquire the underlying securities with a face value of $70 billion that AIG agreed to insure with the credit default swaps. These securities, known as collateralized debt obligations, are thinly traded investments that include pools of loans. The vehicle will seek to acquire the securities from their trading partners on the CDS contracts for about 50 cents on the dollar.

The securities in question don't account for all of AIG's credit default swap exposure but are connected to the most troubled assets. The government may be betting that its involvement will encourage AIG's trading partners to sell the securities tied to the CDS contracts to the new entity.

Once it holds the securities, AIG could cancel the credit default swaps and take possession of the collateral it had posted to back the contracts. The total collateral at stake is about $30 billion.

It may also have some unintended consequences across the markets. For the plan to work, AIG's trading partners -- the banks and financial institutions that are on the other side of its credit-default-swap contracts -- may have to agree to any changes in the terms of their agreements with AIG.

Gary Gorton on YSM panel

Via Arnold Kling, this Yale School of Management panel (video) on the financial crisis. In the audience are YSM students and other professors.

The opening comments by Gary Gorton are good, and the last 10 minutes are excellent as well -- it ends with a debate over mark to market accounting. Note Gorton's comments at 59:55 -- 9 minutes from the end :-)

AIG killed by CDS collateral calls

As I suspected, AIG's CDS collateral obligations have eaten up the government's initial $85 billion loan commitment, which was recently boosted to $123 billion. AIG's CEO reported that they had sold over $400 billion in CDS contracts.

The WSJ piece below profiles Yale finance professor Gary Gorton, who helped Cassano's group (AIG Financial Products) build their risk models. They note that there is still a chance that the models are ok -- that in the long run losses on the securities they insured may not be large. The problem is that the CDS contracts require the insurer to post additional collateral if the market value of the security in question falls. Since all credit related products are oversold due to rampant fear, this forces collateral calls even on good securities (if there are any). I can imagine that triggers might depend on the value of various CDS indices, which have plummeted during the crisis.

If -- and it's a big if -- AIG's actual CDS payouts are limited, the government and taxpayers stand to make a lot of money over the next 3-5 years. When markets return to normal the profitable ordinary insurance parts of AIG can be liquidated to pay off the bridge loan. In that scenario the big losers are AIG shareholders -- the government, as the lender of last resort, will have bought a distressed AIG for a song. In the bad scenario we will enter a long, harsh recession and AIG will end up paying out on much of its $400 billion in obligations, perhaps exceeding even the long term liquidation value of the firm. In that case the US taxpayer will foot the bill.

WSJ: ...AIG itself has been forced to post about $50 billion in collateral to its trading partners, largely to offset sharp drops in the value of securities it insured with the credit-default swaps. These payments have continued to balloon after the bailout -- raising the specter that the government will eventually have to lend more taxpayer money to AIG.

...AIG's credit-default-swaps operation was run out of its AIG Financial Products Corp. unit, which had offices in London and Wilton, Conn. In essence, AIG sold insurance on billions of dollars of debt securities backed by everything from corporate loans to subprime mortgages to auto loans to credit-card receivables. It promised buyers of the swaps that if the debt securities defaulted, AIG would make good on them.

...The swaps expose AIG to three types of financial pain. If the debt securities default, AIG has to pay up. But there are two other financial risks as well. The buyers of the swaps -- AIG's "counterparties" or trading partners on the deals -- typically have the right to demand collateral from AIG if the securities being insured by the swaps decline in value, or if AIG's own corporate-debt rating is cut. In addition, AIG is obliged to account for the contracts on its own books based on their market values. If those values fall, AIG has to take write-downs.

...Mr. Gorton's models harnessed mounds of historical data to focus on the likelihood of default, and his work may indeed prove accurate on that front. But as AIG was aware, his models didn't attempt to measure the risk of future collateral calls or write-downs, which have devastated AIG's finances.

The problem for AIG is that it didn't apply effective models for valuing the swaps and for collateral risk until the second half of 2007, long after the swaps were sold, AIG documents and investor presentations indicate. The firm left itself exposed to potentially large collateral calls because it had agreed to insure so much debt without protecting itself adequately through hedging.

...Early on, Mr. Gorton billed AIG about $250 an hour, which likely would have netted him about $200,000 a year, says a former senior executive at the unit. Eventually, his pay was far greater; another former colleague estimates it at $1 million a year.

Mr. Gorton collected vast amounts of data and built models to forecast losses on pools of assets such as home loans and corporate bonds. Speaking to investors last December, Mr. Cassano credited Mr. Gorton with "developing the intuition" that he and another top executive had "relied on in a great deal of the modeling that we've done and the business that we've created."

...As the debt securities created by Wall Street became more complicated, so did the swaps AIG offered. Around 2004, it began selling swaps designed to provide insurance on securities called collateralized-debt obligations, or CDOs, that were backed by securities such as mortgage bonds. Merrill Lynch & Co., then a major seller of the CDOs, was a big client.

So-called multisector CDOs, in particular, were exceptionally complex, involving more than 100 securities, each backed by multiple mortgages, auto loans or credit-card receivables. Their performance depended on tens of thousands of disparate loans whose value was hard to determine and performance difficult to systematically predict. In assessing their risk, Mr. Gorton constructed worst-case scenarios that factored in the probability of defaults on the underlying securities.

In late 2005, senior executives at the unit grew worried about loosening lending standards in the subprime-mortgage market. AIG decided to stop selling credit protection on multisector CDOs, partly due to "concerns that the model was not going to be able to handle declining underwriting standards," Mr. Gorton told investors last December. But by the time it stopped, in early 2006, its exposure to multisector CDOs had ballooned to $80 billion.

Incentives and bubble logic

Question: Were bankers and risk managers and investors who got us into this credit crisis plain stupid? Or were they just responding to incentives up and down the line?

Answer: Both. For many people, it was rational to participate in the mortgage bubble even if they thought it might (would) end in tears. On the other hand, even smart people can be taken in by bubble logic if everyone around them is convinced. For example, here is a 2006 discussion from Brad DeLong's blog of a column by Paul Krugman, making the case that most of the country was not experiencing a bubble, and that zoning was the main culprit for coastal price increases (hence prices were sustainable). If you were a CDO modeler in 2006 and believed that argument, you might not have even considered that your model assumptions were way too optimistic -- even with people like Robert Shiller (and me) shouting that we were in the midst of a gigantic bubble.


Some of the best journalistic coverage I have found of the mortgage bubble is from Ira Glass and This American Life (audio, pdf transcript). They get the "local color" right from top to bottom: self-interested individual borrowers, local mortgage brokers rushing to assemble as many loans as possible, to be sold to Wall Street banks and repackaged as CDOs, rated by agencies like Moody's and S&P that were making record profits from fees, and sold to investors chasing yield in the midst of a liquidity glut caused by low interest rates. From their coverage you can see the incentives were messed up from top to bottom, and that many individuals anticipated trouble ahead, but couldn't put up a fight without risking their careers or bonuses. Some excerpts below.

borrower: ...I wouldn't have loaned me the money. And nobody that I know would have loaned me the money. I know guys who are criminals who wouldn't loan me that and they break your knee-caps. I don’t know why the bank did it. ...Nobody came and told me a lie: just close your eyes and the problem will go away. That's wasn’t the situation. I needed the money. I'm not trying to absolve myself of anything. I thought I could do this and get out of it within 6 to 9 months. The 6 to 9 month plan didn’t work so I’m stuck.


mortgage broker ...it was unbelievable. We almost couldn’t produce enough to keep the appetite of the investors happy. More people wanted bonds than we could actually produce. That was our difficult task, was trying to produce enough. They would call and ask “Do you have any more fixed rate? What have you got? What’s coming?” From our standpoint it's like, there's a guy out there with a lot of money. We gotta find a way to be his sole provider of bonds to fill his appetite. And his appetite’s massive.

...my boss was in the business for 25 years. He hated those loans. He hated them and used to rant and say, “It makes me sick to my stomach the kind of loans that we do.” He fought the owners and sales force tooth and neck about these guidelines. He got same answer. Nope, other people are offering it. We're going to offer them too. We’re going to get more market share this way. House prices are booming, everything’s gonna be good. And ... the company was just rolling in the cash. The owners and the production staff were just raking it in.


Wall St. banker ...No income no asset loans. That's a liar's loan. We are telling you to lie to us. We're hoping you don't lie. Tell us what you make, tell us what you have in the bank, but we won't verify? We’re setting you up to lie. Something about that feels very wrong. It felt wrong way back when and I wish we had never done it. Unfortunately, what happened ... we did it because everyone else was doing it.

...All the data that we had to review, to look at, on loans in production that were years old, was positive. They performed very well. All those factors, when you look at the pieces and parts. A 90% NINA loan from 3 years ago is performing amazingly well. Has a little bit of risk. Instead of defaulting 1.5% of the time it defaults at 3.5% of the time. That’s not so bad. If I’m an investor buying that, if I get a little bit of return, I’m fine.


CDO packager: ... In 2005, we had an internal debate here because there were two banks coming to us, why don’t you do a deal with us, BBB securities, you get paid a million bucks in management fees per year. Very clear, just like that, in 2005. And we declined those deals. We just don't believe those BBB RMBS assets are money-good. And we thought if we do a CDO of those, that's gonna blow up completely. We were early in '05 by not wanting to do those deals. People were laughing at us. Saying you're crazy. You’re hurting your business. Why don’t you want to make ... Per deal, you could make a million dollars a year.

CDO, CDO-squared and CDS in pictures

If you already know what a CDO is, this is too elementary, but it might be helpful for explaining to your friends...


Crisis explainer: Uncorking CDOs from Marketplace on Vimeo.


Here's one for CDS (thanks to MFA for the pointer):


Untangling credit default swaps from Marketplace on Vimeo.

CDOs, auctions and price discovery

How is Treasury going to buy up CDOs and other mortgage backed securities? What is the price discovery mechanism? I've heard discussion of a reverse auction process, in which the government offers a price and owners of the assets decide whether to accept the bid.

But this makes the problem sound much easier than it is. There are no simple or uniform categories for these securities -- no two are exactly alike. I imagine Treasury is going to have to do a lot of homework before each auction, perhaps aided by some sophisticated professionals (Bill Gross of PIMCO recently offered his team's services). Data on each security is available from ratings agencies like S&P and Moody's but presumably one would supplement this with additional information. After some initial analysis Treasury could set a conservative bound (i.e., using pessimistic estimates of future default rates and home prices) on the value of each security in units of the original face value (this one is worth at least 25 cents on the dollar, this is one, 45 cents, etc.). Then, they can publish a list of securities in a particular value category (without, of course, giving out the actual value estimate) and conduct a reverse auction covering all the assets on the list.

If they can get the assets below the value estimate, great for taxpayers like you and me. If banks (hedge funds? pension funds? foreign banks? who is really holding all this stuff?) won't sell at prices below the bound, and the auction heads above that price, Treasury should start demanding warrants or equity stakes on some sliding scale. In other words, the bid keeps getting higher, but at some point Treasury starts asking for not only the particular CDO but some additional warrants or stock. (This could also be done on a sliding scale from the beginning of the auction -- Treasury gets an additional x percent of the bid in warrants, where x increases with price.) The equity stake is compensation for the government for having to having to overpay for the security. At this price there is an (expected) flow of funds from taxpayers to recapitalize the seller, but at least we are getting equity in return. It is claimed that there is a range of values (roughly 20 percent of current market prices) over which the seller would be getting more at auction than the market is currently offering, but the government is still getting a good deal on the asset (expects to make money even under conservative assumptions).

Will it work? Who knows, but at least it may restore some confidence to credit markets.

Here are some old posts that really get into the nitty gritty of what is inside a typical CDO. You'll see that I've been covering credit securities since 2005 :-)

anatomy of a cdo

deep inside the subprime crisis

mackenzie on the credit crisis

gaussian copula and credit derivatives

Here's a recent NYTimes article that gives a peek into the complexity of structured finance.

NYTimes: ...Consider the Bear Stearns Alt-A Trust 2006-7, a $1.3 billion drop in the sea of risky loans. Here’s how it worked:

As the credit bubble grew in 2006, Bear Stearns, then one of the leading mortgage traders on Wall Street, bought 2,871 mortgages from lenders like the Countrywide Financial Corporation.

The mortgages, with an average size of about $450,000, were Alt-A loans — the kind often referred to as liar loans, because lenders made them without the usual documentation to verify borrowers’ incomes or savings. Nearly 60 percent of the loans were made in California, Florida and Arizona, where home prices rose — and subsequently fell — faster than almost anywhere else in the country.

Bear Stearns bundled the loans into 37 different kinds of bonds, ranked by varying levels of risk, for sale to investment banks, hedge funds and insurance companies.

If any of the mortgages went bad — and, it turned out, many did — the bonds at the bottom of the pecking order would suffer losses first, followed by the next lowest, and so on up the chain. By one measure, the Bear Stearns Alt-A Trust 2006-7 has performed well: It has suffered losses of about 1.6 percent. Of those loans, 778 have been paid off or moved through the foreclosure process.

But by many other measures, it’s a toxic portfolio. Of the 2,093 loans that remain, 23 percent are delinquent or in foreclosure, according to Bloomberg News data. Initially rated triple-A, the most senior of the securities were downgraded to near junk bond status last week. Valuing mortgage bonds, even the safest variety, requires guesstimates: How many homeowners will fall behind on their mortgages? If the bank forecloses, what will the homes sell for? Investments like the Bear Stearns securities are almost certain to lose value as long as home prices keep falling.

“Under the current circumstances it’s likely that you are going to take a loss on these loans,” said Chandrajit Bhattacharya, a mortgage strategist at Credit Suisse, the investment bank.

The Bear Stearns bonds are just one example of the kind of assets the government could buy, and they are by no means the most complicated of the lot. Wall Street took bonds like those of Bear Stearns and bundled and rebundled them into even trickier investments known as collateralized debt obligations, or C.D.O.’s

“No two pieces of paper are the same,” said Mr. Feltus of Pioneer Investments.

On Wall Street, many of these C.D.O.’s have been selling for pennies on the dollar, if they are selling at all. In July, Merrill Lynch, struggling to bolster its finances, sold $31 billion of tricky mortgage-linked investments for 22 cents on the dollar. Last November, Citadel, a large hedge fund in Chicago, bought $3 billion of mortgage securities and other investments for 27 cents on the dollar.

But Citigroup, the financial giant, values similar investments on its books at 61 cents on the dollar. Citigroup says its C.D.O.’s are relatively high quality because they were created before lending standards weakened in 2006.

A big challenge for Treasury officials will be deciding whether to buy the troubled investments near the values at which the banks hold them on their books. That would help minimize losses for financial institutions. Driving a hard bargain, however, would protect taxpayers.

Mortgage securities oversold by 15-25 percent

Below are some quotes which support the view that mortgage assets are currently undervalued by the market. Yes, the market is inefficient -- it overpriced the assets at the peak of the bubble (greed), and is currently underpricing them (fear). Both Buffet and ex-Merrill banker Ricciardi below think the mispricing is about 15-25 percent. That is, the "fear premium" currently demanded by the market is 15-25 percent below a conservative guess as to what the assets are really worth. This is the margin that can be used to recapitalize banks, perhaps without costing the taxpayer any money, simply by providing a rational buyer of last resort and injecting some confidence into the market. Note to traders: yes, this is obvious. Note to academic economists: this is yet another market failure -- but of an unprecedented scale and complexity.

(Actually, 15-25 percent is not bad, and just shows that credit markets are generally more rational and data driven than equities. During the Internet bubble and collapse you had mispricings of hundreds of percent, even an order of magnitude.)

Warren Buffet interview from CNBC:

Government intervention necessary to restore confidence in the market.

If I didn't think the government was going to act, I would not be doing anything this week. I might be trying to undo things this week. I am, to some extent, betting on the fact that the government will do the rational thing here and act promptly.

Mispricing is about 15-20 percent:

...all the major institutions in the world trying to deleverage. And we want them to deleverage, but they're trying to deleverage at the same time. Well, if huge institutions are trying to deleverage, you need someone in the world that's willing to leverage up. And there's no one that can leverage up except the United States government. And what they're talking about is leveraging up to the tune of 700 billion, to in effect, offset the deleveraging that's going on through all the financial institutions. And I might add, if they do it right, and I think they will do it reasonably right, they won't do it perfectly right, I think they'll make a lot of money. Because if they don't -- they shouldn't buy these debt instruments at what the institutions paid. They shouldn't buy them at what they're carrying, what the carrying value is, necessarily. They should buy them at the kind of prices that are available in the market. People who are buying these instruments in the market are expecting to make 15 to 20 percent on those instruments. If the government makes anything over its cost of borrowing, this deal will come out with a profit. And I would bet it will come out with a profit, actually.

Christopher Ricciardi, former head of Merrill's structured credit business, in an open letter to Paulson. Note his comments illustrate the role that psychology, or animal spirits (Keynes), plays in the market.

The securitization market worked exceptionally well for decades and was the financing tool of choice for large and small institutions alike. As investments, performance for securitized assets typically exceeded corporate and Treasury bond investments for decades.

Where securitization went wrong in recent years was with subprime mortgages. These securitizations performed disastrously, causing people to mistakenly question the practice of securitization itself.

Decades of historical data were ignored, with the subprime experience exclusively driving market perceptions: The entire securitization market was effectively shut down, and this explains the depth and persistence of the ongoing credit crisis.

Government purchases of illiquid mortgage assets from the system will cost taxpayers significant sums and expose them to downside risk, without addressing this fundamental issue. Billions of dollars held by all the major institutional bond managers, hedge funds and distressed funds are already available to purchase mortgage assets.

However, in the absence of a way to finance the purchase of these assets, such funds must bid at prices which represent an attractive absolute return acceptable to their investors (15% to 25% typically), resulting in typical transaction terms that have significantly impeded the sale of mortgage securities to these funds. If these funds could finance their purchases, especially under efficient financing terms, they would still require similar returns, but would be able to buy many more assets, and bid higher prices for the assets.

Our financial system needs the capital markets and the natural power of securitization to get a jumpstart from the government. I propose using the powers granted to Treasury to create “vehicles that are authorized…to purchase troubled assets and issue obligations” under currently contemplated legislation to more efficiently address the crisis and establish a program which we might call the Federal Bond Insurance Corporation (”FBIC”), as an alternative to simply having the government directly purchase assets.

Comment re: behavioral economics. The preceding housing bubble and the current crisis are very good examples of why economics is, at a fundamental level, the study of ape psychology. On the planet Vulcan, Mr. Spock and other rational, super-smart traders and investors would have cleared this market already. But we don't live on Vulcan. Anyone who wants to model the economy based on rational agents who can process infinite amounts of information without being subject to fear, bounded cognition, herd mentality, etc. is crazy.

When the conventional wisdom is that house prices never go down (people believed this just a couple years ago), you risk little of your reputation or self-image by investing in housing. When the conventional wisdom is that all mortgage backed securities are toxic, you must be extremely independent and strong willed to risk buying in, even if metrics suggest the market is oversold. This is simple psychology. Very few people can resist conventional wisdom, even when it's wrong.

The time to buy is when there is blood in the streets

As I mentioned in my previous post on the mortgage bailout, it seems clear that Bernanke and Paulson both think that mortgage backed securities are undervalued at current market prices (my scenario (1) in the previous post). Bernanke refers to the difference between "hold to maturity" and "fire sale" prices in his congressional testimony.

Many commentators are trying to wrap their heads around this difference. To understand, it helps to have seen the collapse of a financial bubble firsthand. If you haven't (as I suspect is the case with most academic economists), you are likely to cling to the idea that the market price of an asset is a good forecast of its actual value. However, this is completely wrong in the wake of a collapse. (And, certainly, the predictive power of the market price cannot hold at all times -- it is likely to be most wrong at the peak and in the aftermath of a bubble.)

The following false conundrum has been stated recently by numerous analysts, including Paul Krugman: "if Treasury wants to recapitalize banks it has to overpay for toxic assets, to the detriment of taxpayers; if it wants to pay fair prices for the assets then banks won't benefit." There is no conundrum if markets, at this instant in time, are systematically underpricing mortgage assets.

When the Internet bubble burst in the early years of this century, investors were so gun shy and under so much pressure that they would not pay even rationally justifiable prices for stakes in technology companies. Smart investors who were willing to put capital at risk bought assets at fire sale prices and made huge profits. This is nothing more than fear and herd mentality at work. If herd thinking can lead to overpricing of assets, why not underpricing immediately following a collapse?

Markets overshoot on both the up- and the down-side!

These points are obvious to any trader... it's the academics with equilibrium intuitions who are struggling to understand! Note as I mentioned in the earlier post, the "hold to maturity value" can only be modeled using probability distributions for defaults, price movements, interest rates, etc. But I've been told many times by people in the industry that current market prices imply massive default rates which are unrealistically high.

WSJ has the best summary.

Related discussion: Paul Krugman , more Krugman , Economist's View , Brad Setser.

WSJ: ...Uncertainty in housing markets and the economy are forcing financial institutions to mark mortgage securities at fire-sale prices, rather than their value if held to maturity, effectively creating a vicious circle of more write-downs that further depress asset values, Mr. Bernanke explained.

Mr. Bernanke said the Treasury plan should have taxpayers buy the assets and hold them at close to their maturity value. Removing the assets, he said, would bring liquidity back to markets, unfreeze credit markets, reduce uncertainty and allow banks to attract private capital.

...In subsequent questioning, Mr. Bernanke distinguished between, on the one hand, “fire sale prices,” the ones that prevail “when you sell into an illiquid market” and, on the other, the prices that holders think the assets are really worth, sometimes described as “fundamental” values or “hold-to-maturity” value.

“The holders have a view of what they think it’s worth. It’s hard for outsiders to know,” Mr. Bernanke said. The point of an auction is to reveal those prices. “If you have an appropriate auction mechanism… what you’ll do is restart this market,” he added.

Paulson, while seeking maximum flexibility, said the Treasury is considering doing auctions one asset class at a time. He said the aim to bring “bright people” to work on the challenge of designing market mechanisms.

Update: Krugman admits he agrees with me on this point, although he still doesn't like the plan:

Krugman NYT blog: ...Just to be fair, it’s possible, maybe even probable, that mortgage-related paper is being sold too cheaply.

I don't really like the plan either, but at least the earlier argument based on the pricing conundrum is now understood to be sloppy. I just read that Paulson will cave on the populist CEO compensation limit. As usual, bounded rationality (limited brainpower) is at work here. The taxpayers would be benifited much more by Treasury taking an equity stake or warrants in banks that are being bailed out. They should have made Paulson cave on that -- the compensation issue is just symbolic.

The devil in the details

As we all know, the devil is always in the details. The proposed legislation will put $700B in the hands of Treasury to buy distressed assets in an attempt to unfreeze credit markets. This gives the current and future Treasury Secretary incredible financial and discretionary power. Let's put aside issues of corruption and abuse of power and assume a benevolent, public spirited, intelligent person in charge. I make this assumption not because it is realistic, but in order to proceed to the question: How, exactly, will this work?

First, let's differentiate between CDOs and CMOs (Collateralized Debt / Mortgage Obligations), which are securities that entitle the holder to future cash flows from bundles or tranches of mortgages, and CDS (Credit Default Swaps) which are derivative contracts which allow two parties to bet on defaults. CDS can be used for pure speculation, or to spread out the risk associated with CDOs. I will discuss CDOs and CDS separately below, although it should be obvious that both markets are interconnected and, at this time, highly problematic. (In fact there are even synthetic CDOs which are built out of CDS, which make things yet more complicated...)


CDOs:

There are two possible world states that we have to differentiate between. Keep in mind that CDOs are currently highly illiquid, due to seizing up of markets, so in many cases there may not be any market price.

1) CDOs are oversold. In this scenario markets, due to extremely high risk premia and, well, fear, are underpricing CDOs and, effectively, overestimating future default rates on mortgages. To decide whether they believe this, Treasury must use its own models with its own forward looking projections.

IF actual future default rates turn out to be lower than implied values backed out from current market prices, then Treasury (and the US taxpayer) stand to make a lot of money by assuming the role of a rational buyer of last resort. (Which is not to say there won't be losses; there must be as home prices will end lower than in the period when most of these mortgages were written. But how much of this is in previous writedowns?) In this scenario, many banks are challenged by (short term) cash flow issues and mark to market accounting, which forces them to carry their securities on the books at the current (undervalued, oversold) market valuation, but do ultimately have positive net asset value.

(Note: cash flow insolvency is not the same as balance sheet insolvency!)

2) CDO market prices are fair. In this case many institutions will fail without massive infusions to their balance sheet. But Treasury should not buy securities at higher than fair value (if at all possible); instead they should take equity stakes in insolvent companies on behalf of the taxpayer, so that there is some upside participation. In the worst case Treasury should assume control and supervise an orderly liquidation. Note again that an institution can face short term cash flow problems (be unable to service debt) even if the long term value of their net assets is positive.


Even if we start out in case (1) we will end up in case (2) as the situation normalizes and other actors bring capital into play. There is an estimated $500B in distressed assets funds that will participate if valuations are favorable. I just heard on CNBC that Treasury may use a reverse auction model (starting at very low bids), in which case the banks themselves will get to decide whether they are desperate enough to accept a bid. Probably a good strategy.

Deciding between case (1) and (2) (ultimately, on a CDO by CDO basis) is going to depend crucially on models and future forecasts of home prices, interest rates, prepayment rates and foreclosure rates. Geeks rule!

In any event, Treasury will be acting like a giant hedge / private equity fund for the next few years. Do they have the human capital? Hopefully their returns will be good :-)


CDS:

I'm more at a loss here. Will Treasury get involved with CDS? There are going to be some huge losers (AIG?).

When Treasury tries to evaluate the (balance sheet) solvency of a particular firm, won't they have to price out that firm's entire CDS book?

Will this market automatically function properly if the CDO market becomes liquid again and counterparty confidence is restored?


Miscellaneous questions:

Do we really trust Treasury to do the right thing? Are there any checks and balances? Would those get in the way of decisive action?

What about foreign banks like Deutsche Bank, Credit-Suisse, etc.?


Naked Capitalism has a negative take on the plan. They suggest that Paulson is not being straight with the public and intends to buy assets at a high price, with the only goal of recapitalizing (his friends at big) banks. I don't necessarily agree with the reasoning given below, but it is worth thinking about.

Nakedcapitalism: ...Yet as we discussed, the plan makes no sense unless the Orwellian "fair market prices" means "above market prices." The point is not to free up illiquid assets. Illiquid assets (private equity, even the now derided CDOs were never intended to be traded, but pose no problem if they do not need to be marked at a large loss and/or the institution is not at risk of a run). Confirmation of our view came from a reader by e-mail:

I worked at [Wall Street firm you've heard of], but now I handle financial services for [a Congressman], and I was on the conference call that Paulson, Bernanke and the House Democratic Leadership held for all the members yesterday afternoon. It's supposed to be members only, but there's no way to enforce that if it's a conference call, and you may have already heard from other staff who were listening in.

Anyway, I wanted to let you know that, behind closed doors, Paulson describes the plan differently. He explicitly says that it will buy assets at above market prices (although he still claims that they are undervalued) because the holders won't sell at market prices. Anna Eshoo pressed him on how the government can compel the holders to sell, and he basically dodged the question. I think that's because he didn't want to admit that the government would just keep offering more and more.

[Paulson's statements are all internally consistent if he believes we are in state (1) described above: current market prices, due to fear and sky high risk premia, are too low and fair prices based on reasonable models of future behavior would be higher --steve]

I don't think that our leadership has been very good during this negotiation (or really, during any showdowns with this administration) at forcing the administration to own their position. If Paulson wants this plan, then he needs to sell it to the public, and if he sells a different plan to the public (the nonsense buying-at-market-price plan) then we should pass that. I'd rather see the government act as a market maker for the assets to get them transferred over to private equity firms and sovereign wealth funds and other willing holders. And if we need to recapitalize these companies, it seems like the cheapest way for the taxpayer is to go in and buy up the distressed debt and then convert that to equity.

On the other hand I've heard in other quarters that the proposed legislation allows Treasury to more or less compel firms to sell distressed assets. Which is it -- they'll have to overpay to pry the assets loose, or they've given themselves draconian powers to seize them?