Fischer Black: "a vision of the future that came true"

This is Barnard professor Perry Mehrling on the origin of interest rate and credit derivatives in the mind of Fischer Black. I highly recommend Mehrling's biography of Black, which I discussed previously here:

Black was both an undergrad and grad student at Harvard in physics. He didn't really complete his PhD in physics, but sort of drifted into AI-related stuff(!) at MIT, under cover of math or applied math.

The bio says the only course he ever had trouble with was Schwinger's course on advanced quantum. The biographer suggests Black did poorly due to lack of interest, but I find that hard to believe given the subject matter, the lecturer, and the times ;-)

Black's point of view was clearly that of a physicist or applied mathematician. He really was a fascinating guy, and the biographer, an academic economist, can appreciate a lot of Black's thinking -- it's not an entirely superficial book despite being non-technical.

After reading the book, I don't feel so bad about questioning some of the fundamental assumptions made by academic economists. Black was asking some of the very same questions during his career.

From the book jacket:

... Although the options formula made him famous, it was only one of Black's numerous contributions to finance, including portfolio insurance, commodity futures pricing, bond swaps and interest rate futures, and global asset allocation models that have become standard in the world of finance. Amazingly, he did it all despite having no formal training in finance or economics, and despite spending the bulk of his career in business settings. Certainly the most notable non-academic theoretician of modern finance, Fischer Black was one of a kind...

For more on derivatives history, see Pricing the Future and The World is our Laboratory.

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.

AIG bailout: half trillion exposure for taxpayers

If I read this figure properly, US taxpayers could be on the hook for as much as $513 billion dollars of CDS insurance issued by its 377 person AIGFP (financial products) unit in London. Note also the compensation paid to the unit since 2001. Not bad! (Click for larger version; from NYTimes.)



Of course, half a trillion is a worst case scenario. So far, government bailout funds paid to AIG have been re-gifted as detailed below. Over $35 billion went to foreign banks. US taxpayers go the extra mile to save the financial system!

NYTimes: ...Financial companies that received multibillion-dollar payments owed by A.I.G. include Goldman Sachs ($12.9 billion), Merrill Lynch ($6.8 billion), Bank of America ($5.2 billion), Citigroup ($2.3 billion) and Wachovia ($1.5 billion).

Big foreign banks also received large sums from the rescue, including Société Générale of France and Deutsche Bank of Germany, which each received nearly $12 billion; Barclays of Britain ($8.5 billion); and UBS of Switzerland ($5 billion).

AIGFP was headed by Joseph Cassano. See earlier post Clawbacks, fake alpha and tail risk for more details. So far I nominate Cassano as the king of fake alpha.

"It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.'' -- Joseph J. Cassano, a former A.I.G. executive, August 2007

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.

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.

Complexity in the ruins of Lehman

Lehman was too connected to be allowed to fail. Now a bankruptcy court is trying to sort through 1.5 million derivatives trades with 8000 counterparties...

WSJ: Lehman Brothers Holdings Inc.'s legal and financial advisers said Thursday they plan to hire about 200 professionals to help settle the more than 1 million derivatives trades the investment bank entered into before it collapsed last month.

Lehman attorney Harvey Miller said at a court hearing that advisers are working around the clock to understand Lehman's transactions in the wake of the "chaos" that resulted from its Sept. 15 bankruptcy filing, the largest ever in U.S. history.

Much of their work will focus on wading through about 1.5 million derivatives trades involving 8,000 counterparties. Lehman's chief restructuring officer Bryan Marsal of turnaround firm Alvarez & Marsal said about 210 financial professionals will be hired to unwind those trades.

Mr. Miller credited Mr. Marsal for his work so far, saying he has "brought order to this chaos." Alvarez & Marsal has 144 employees working on the Lehman matter along with 165 Lehman employees still working at the bank.

...Mr. Miller told Judge Peck he expects it will take 45 to 60 days before Lehman can answer numerous inquiries from creditors.

Lehman CDS auction

Starts in a few minutes. Previous posts here, here and here.

The 350 participants in the auction -- meaning each of them are party to at least one CDS contract referencing (insuring) Lehman debt -- are a rogues gallery of big financial firms. Guess who has been trying to raise cash in anticipation of today, when hundreds of billions could change hands? The net payments will be much less than this notional amount, but each player has to have their cash ready -- the cancellations may be "non-local" (between multiple parties; see figure at bottom).

Bloomberg: ...Lehman's $128 billion of bonds were trading yesterday at an average of 13 cents on the dollar, indicating credit swap sellers may have to pay 87 cents.

...More than 350 banks and investors signed up to settle credit-default swaps tied to Lehman. No one knows exactly how much is at stake because there's no central exchange or system for reporting trades. It's that lack of transparency that has increased the reluctance of financial institutions to do business with each other, exacerbating the global credit crisis and prompting calls for regulation of the market.

The list of participants includes Newport Beach, California- based Pimco, manager of the world's largest bond fund, Chicago- based hedge fund manager Citadel Investment Group LLC, and American International Group Inc., the New York-based insurer taken over by the government, according to the International Swaps and Derivatives Association in New York.

...Hedge funds, insurance companies and banks typically buy and sell credit protection, which is used either to insure a bond against default or as a bet against the company's ability to pay its debt.

Settlement of Lehman contracts may lead to protection sellers paying out as much as $220 billion, assuming a 20 percent recovery on the U.S. bank's senior debt, according to Andrea Cicione, a London-based credit strategist at BNP Paribas SA. [Others estimate as high as $400B.]

``Banks can go to the Federal Reserve, or use the commercial paper market where it is still functioning'' to meet protection payments, said Cicione. ``But fund managers or hedge funds, once they've used their cash, have only one option, to sell assets.''

Web of three contracts with net value of $.1B and notional value of $3.1B. Even though, ultimately, only $.1B changes hands, each party may have had to bring $1B or more to the table. (Even if they have canceling positions, like B in the figure, there is always counterparty risk -- what if A can't pay up?)


Update: Priced out at 8.625 cents on the dollar (Bloomberg). Here's an example of the type of fund that has been selling into the markets to meet obligations.

A unit of Primus Guaranty Ltd., a Bermuda-based company that has sold more than $24 billion in credit-default swaps, said last month it guaranteed $80 million of Lehman debt. The firm sold protection on $215 million of Fannie and Freddie debt and $16.1 million on WaMu. Yesterday, it said it also had made bets of $68.2 million on Kaupthing Bank hf, which the Icelandic government seized. Primus said last week it had $820 million in cash and liquid investments to meet claims on the contracts.

Felix Salmon notes that today was just the auction and parties don't settle until October 21. A commenter there claims the contracts are collateralized daily. I don't know if that is true, but if it is then the auction doesn't do much except set the price, which we sort of knew beforehand from earlier trades.

Second update: I was told again that most CDS contracts require the party offering protection to post collateral, which adjusts according to the market value of the debt. That means that the auction itself is more an accounting event than an economic event. When the default occurs the insurers already have a rough idea of what they will owe and presumably start selling assets to cover their obligations. In this case (LEH) the auction price came out below but not that far from where the market was pricing the debt beforehand. Whether any CDS issuers won't be able to cover their obligations won't be known until October 21.

More on Lehman CDS auction

There's very little information on the web about this. Elizabeth McDonald at Fox Business:

...A key driver behind the market plunge has been the tremendous demand for cash from counterparties related to the CDS (credit default swap) payouts on these recent major credit events.

It’s all happening now.

This past Monday: An estimated $200 bn to more than $1 tn in CDS written on Fannie and Freddie’s debt, the two companies’ senior and subordinated debt, were auctioned on Monday.

Reports indicate that protection sellers on the mortgage giants’ subordinated debt won big time here, with contracts on Fannie Mae’s subordinated debt recovering 99.9% of the sum insured, and swaps on Freddie Mac’s subordinated debt recovering 98%, reports auction administrators Creditex and Markit.

However, CDSs on the senior debt got less, with Fannie Mae’s senior swaps recovering 91.5% the sum insured and Freddie Mac’s senior swaps recovering 94%. CDS sellers’ losses less than expected being felt here, because Fannie and Freddie debt have rallied since the two were placed under conservatorship;

This Friday, October 10th: When the Lehman deals get unwound. Potentially $400 bn in payouts. Lehman debt now trading between 15 cents and 19 cents on the dollar, with imputed losses of 81 cents and 85 cents on the dollar.

Felix Salmon has a nice discussion, and a news search brings up this schedule for the auction. My CDS posts here.

Salmon: ...Now there are people who made money betting against Lehman Brothers by buying default protection. And since the CDS market is a zero-sum game, there must therefore be people who lost money by selling that protection. The $400 billion question is whether they have the wherewithal to make good on their obligation. (And remember that $400 billion is a gross number: the net exposure -- the total amount that some people made and others lost -- is much smaller.)

I'm optimistic on that front: I think the answer is yes, although it might well involve selling collateral and other securities in order to come up with the cash. So there could be some nasty liquidation events on or around October 10. But I suspect that a lot of the exposure to Lehman came from synthetic bonds, CDOs of CDSs, and that kind of thing -- in other words, it resides on the buy-side, not on the sell-side.

It's always possible that some hedge fund somewhere will find itself going bust as a result of writing protection on Lehman -- but so far the big hedge-fund returns on CDS have been positive (Paulson, Lahde) and not negative. I'm holding out hope that the same will hold true on October 10.

This just up from Barry Ritholtz. Today (Thursday) looks like a very bad day for equities... suspicious. Tomorrow could be worse?

I've heard concerns from various traders and hedge fund managers over the past few weeks that the Lehamn Brothers (LEH) derivatives unwind has been what's roiling markets.

Early October, Citi (C) credit analyst Michael Hampden-Turner estimated there is $400bn of Lehman credit derivatives that will be settled on Friday.

This picture may tell all, once the dust settles. Either I am overly focused on the role of CDS, or the financial press and academic economists are totally missing one of the biggest drivers of systemic risk and current volatility. Here is a post I wrote in 2005 linking CDS strategies to equity vol. At the time, over half of all CDS volume involved hedge funds. In the end I think we're going to see some big hedge funds wiped out from selling naked or poorly hedged CDS insurance.

CDS central exchange?

The Lehman auction on October 10 is fast approaching. Previous posts on credit default swaps. In every case I've seen discussed the notional value of CDS contracts exceeds the amount of outstanding debt being insured!

WSJ: The Federal Reserve Bank of New York has summoned participants in the credit-default-swap market to another meeting Friday amid jostling by dealers, exchanges and regulators for a bigger role in this $55 trillion market, according to people familiar with the matter.

The meeting would be the second this week as regulators wrestle with rival solutions to streamline the market and reduce counterparty risk through the creation of one or more central clearinghouses.

... the fallout from unraveling billions of dollars in CDS trades following the problems of Lehman Brothers and American International Group has intensified the urgency among regulators to see major improvements in the infrastructure of this market.

CME and Citadel Investment Group this week unveiled plans to launch a CDS trading platform that would be tied to a clearinghouse, inviting banks and other users to take equity in a project slated to start in early November.

The timetable would give them first-mover advantage over another planned CDS clearinghouse being developed by Chicago-based Clearing Corp., which is owned by banks and brokers.

October CDS auctions and helicopter Ben

How do CDS contracts get settled after a credit event? We've had several recently, which means upcoming auctions (see also here). Fannie Mae and Freddie Mac auctions were October 6 (yesterday), Lehman is October 10, and Washington Mutual is scheduled for October 23.

Since Treasury is guaranteeing the GSE debt, October 6 was probably not as much of a problem as the Lehman auction will be in a few days. Many firms are scrambling for or hoarding cash and probably don't know the size of their obligation. At the auction, one has to determine the value of the bonds before deciding the value of each CDS contract. That means first an auction of Lehman debt, presumably worth only a fraction of its face value (but exactly how much?), and then a settlement of contracts. If most of the contracts are offsetting they can be canceled then and there, but the suspicion is that many CDS counterparties (perhaps, especially, hedge funds?) were writing naked contracts, which means they would have to come up with the money on the spot. For detailed discussion see here. Related post at naked capitalism.

If Treasury wants to stabilize markets and perhaps avoid more collapses, it could start on 10/10 by buying up some of Lehman's debt with its $700B war chest. Will they make an appearance? It's estimated that Lehman was involved in hundreds of billions in CDS contracts (notional). This is a very delicate moment since no one is going to want Lehman debt and therefore the market value will be very low. I can imagine a lot of smart guys who wrote CDS contracts hedged their Lehman exposure against some other (imperfectly but highly) correlated index or debt. Since those entities used in the hedge will not be simultaneously marked to market on 10/10, what was, at the time, a reasonable hedge will turn into a disaster. Note, I think the auction only covers contracts that reference Lehman -- that is, which protect one of the counterparties from a Lehman default on its debt. The auction won't resolve the problem that arises in other contracts if Lehman was actually one of the counterparties. To the extent that these exposures are canceled they would be "glued" together at the appropriate reference auction, but it's possible Lehman had some naked exposure as well.


Thinking about this more broadly, freezing of credit markets means that the effective money supply is shrinking even as central banks cut interest rates. Helicopter Ben Bernanke has always said that in an emergency the Fed had numerous tools available to inject liquidity into the markets, and today it was announced they would enter the paralyzed short term commercial paper market which is crucial to the functioning of ordinary businesses.

Helicopter speech: ...The financial distress of debtors can, in turn, increase the fragility of the nation's financial system--for example, by leading to a rapid increase in the share of bank loans that are delinquent or in default. Japan in recent years has certainly faced the problem of "debt-deflation"--the deflation-induced, ever-increasing real value of debts. Closer to home, massive financial problems, including defaults, bankruptcies, and bank failures, were endemic in America's worst encounter with deflation, in the years 1930-33--a period in which (as I mentioned) the U.S. price level fell about 10 percent per year.

Beyond its adverse effects in financial markets and on borrowers, the zero bound on the nominal interest rate raises another concern--the limitation that it places on conventional monetary policy. Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate--the overnight federal funds rate in the United States--and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target.5

Because central banks conventionally conduct monetary policy by manipulating the short-term nominal interest rate, some observers have concluded that when that key rate stands at or near zero, the central bank has "run out of ammunition"--that is, it no longer has the power to expand aggregate demand and hence economic activity. It is true that once the policy rate has been driven down to zero, a central bank can no longer use its traditional means of stimulating aggregate demand and thus will be operating in less familiar territory. ...

However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. As I will discuss, a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero.

Complexity illustrated: Lehman WAS too connected to fail

This WSJ article illustrates what I discussed more abstractly in this earlier post Notional vs net: complexity is our enemy. The story claims that by allowing Lehman to fail, Treasury and the Fed triggered the final stage of the crisis that got us to where we are today. I've included my figures from the earlier post here.

...in an age where markets, banks and investors are linked through a web of complex and opaque financial relationships, the pain of letting a large institution go has proved almost overwhelming.

In hindsight, some critics say the systemic crisis that has emerged since the Lehman collapse could have been avoided if the government had stepped in.

The Fed had been pushing Wall Street firms for months to set up a new clearinghouse for credit-default swaps. The idea was to provide a more orderly settlement of trades in this opaque, diffuse market with a staggering $55 trillion in notional value, and, among other things, make the market less vulnerable if a major dealer failed. But that hadn't gotten off the ground. As a result, nobody knew exactly which firms had made trades with Lehman and for what amounts. On Monday, those trades would be stuck in limbo. In a last-ditch effort to ease the problem, New York Fed staff worked with Lehman officials and the firm's major trading partners to figure out which firms were on opposite sides of trades with Lehman and cancel them out. If, for example, two of Lehman's trading partners had made opposite bets on the debt of General Motors Corp., they could cancel their trades with Lehman and face each other directly instead.

This figure shows three trades which almost cancel. Remove one of the counterparties and you have chaos instead of hedges. In a last ditch effort, after letting Lehman fail, Treasury tried to cancel these trades out manually -- good luck! Why did we not have a central exchange in place earlier?


Oops, there goes AIG! (Big issuer of CDS insurance.)

The reaction was most evident in the massive credit-default-swap market, where the cost of insurance against bond defaults shot up Monday in its largest one-day rise ever. In the U.S., the average cost of five-year insurance on $10 million in debt rose to $194,000 from $152,000 Friday, according to the Markit CDX index.

When the cost of default insurance rises, that generates losses for sellers of insurance, such as banks, hedge funds and insurance companies. At the same time, those sellers must put up extra cash as collateral to guarantee they will be able to make good on their obligations. On Monday alone, sellers of insurance had to find some $140 billion to make such margin calls, estimates asset-management firm Bridgewater Associates. As investors scrambled to get the cash, they were forced to sell whatever they could -- a liquidation that hit financial markets around the world. ...AIG was one of the biggest sellers in the default insurance market, with contracts outstanding on more than $400 billion in bonds.

To make matters worse, actual trading in the CDS market declined to a trickle as players tried to assess how much of their money was tied up in Lehman. The bankruptcy meant that many hedge funds and banks that were on the profitable side of a trade with Lehman were now out of luck because they couldn't collect their money.

...At around 7 a.m. Tuesday in New York, the market got its first jolt of how bad the day was going to be: In London, the British Bankers' Association reported a huge rise in the London interbank offered rate, a benchmark that is supposed to reflect banks' borrowing costs. In its sharpest spike ever, overnight dollar Libor had risen to 6.44% from 3.11%. But even at those rates, banks were balking at lending to one another.

Who was next after AIG? Time for a bailout!

...Goldman, Paulson's former employer, had up to $20B of CDS exposure to AIG. The current head of Goldman was the only Wall St. executive invited to the meetings between AIG and the government. Conflict of interest for soon to be King Henry Paulson?

Clawbacks, fake alpha and tail risk

Earlier this year I wrote a post Fake alpha, compensation and tail risk in finance:

...current banking and money management compensation schemes create incentives for taking on tail risk... and disguising it as alpha. The proposed solution: holdbacks or clawbacks of bonus money... When will shareholders smarten up and enforce this kind of compensation scheme on management at public firms?

The classic example is writing naked (unhedged) insurance policies covering rare events and pocketing the fees as alpha. You trade tail risk for cash, and hope things don't blow up until you are out the door. It's agency risk on steroids.

This NYTimes article describes, in detail, a perfect example of this phenomenon in the case of AIG. AIG, a global insurance company with over 100k employees, was brought down by a tiny unit in London that traded credit default swaps (CDS).

Once it became clear that AIG was in trouble, Treasury and the Fed had to step in because AIG was too connected to fail. In fact, the article states that Goldman, Paulson's former employer, had up to $20B of CDS exposure to AIG. The current head of Goldman was the only Wall St. executive invited to the meetings between AIG and the government. Conflict of interest for soon to be King Henry Paulson?

Joseph Cassano, the former head of AIG's London credit derivatives unit, is perhaps the first (although probably not the last) poster boy for clawbacks in the credit crisis. Total compensation for his unit of 377 employees averaged over $1 million per employee in recent years. I would guess that means Cassano took home easily in the tens and perhaps over 100 million dollars in the last few years. Will taxpayers get back any of that compensation?

“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”

— Joseph J. Cassano, a former A.I.G. executive, August 2007

NYTimes ...Although America’s housing collapse is often cited as having caused the crisis, the system was vulnerable because of intricate financial contracts known as credit derivatives, which insure debt holders against default. They are fashioned privately and beyond the ken of regulators — sometimes even beyond the understanding of executives peddling them.

Originally intended to diminish risk and spread prosperity, these inventions instead magnified the impact of bad mortgages like the ones that felled Bear Stearns and Lehman and now threaten the entire economy.

In the case of A.I.G., the virus exploded from a freewheeling little 377-person unit in London, and flourished in a climate of opulent pay, lax oversight and blind faith in financial risk models. It nearly decimated one of the world’s most admired companies, a seemingly sturdy insurer with a trillion-dollar balance sheet, 116,000 employees and operations in 130 countries.

“It is beyond shocking that this small operation could blow up the holding company,” said Robert Arvanitis, chief executive of Risk Finance Advisors in Westport, Conn. “They found a quick way to make a fast buck on derivatives based on A.I.G.’s solid credit rating and strong balance sheet. But it all got out of control.”

...The insurance giant’s London unit was known as A.I.G. Financial Products, or A.I.G.F.P. It was run with almost complete autonomy, and with an iron hand, by Joseph J. Cassano, according to current and former A.I.G. employees.

...These insurance products were known as “credit default swaps,” or C.D.S.’s in Wall Street argot, and the London unit used them to turn itself into a cash register.

The unit’s revenue rose to $3.26 billion in 2005 from $737 million in 1999. Operating income at the unit also grew, rising to 17.5 percent of A.I.G.’s overall operating income in 2005, compared with 4.2 percent in 1999.

Profit margins on the business were enormous. In 2002, operating income was 44 percent of revenue; in 2005, it reached 83 percent.

Mr. Cassano and his colleagues minted tidy fortunes during these high-cotton years. Since 2001, compensation at the small unit ranged from $423 million to $616 million each year, according to corporate filings. That meant that on average each person in the unit made more than $1 million a year.

Update: from the Pelosi bailout legislation summary -- good luck implementing this!

New restrictions on CEO and executive compensation for participating companies:

* No multi-million dollar golden parachutes
* Limits CEO compensation that encourages unnecessary risk-taking
* Recovers bonuses paid based on promised gains that later turn out to be false or inaccurate

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?