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.

Janet Tavakoli interview

This was recommended by a commenter on my previous post. It's definitely worth watching if you have an interest in the financial crisis.



Here's a recommendation for her book:

"[T]he book’s real strength is the sub-plot that emerges as Tavakoli tugs vigorously at the seemingly disparate threads of the current financial crisis, naming names, citing cases and leaving no schmuck — whether investment bank, credit rating agency, monoline insurer, mortgage brokers, regulators and their ilk — unspared. Based on more than 20 years in the derivatives arena, and having served time at Salomon Bros, Bear Stearns and Goldman Sachs, she knows that of what and who she speaks. Should anyone ever display the slightest interest in criminalizing the criminals who led us down this path, a prosecutor could do worse than ordering up copies for the grand jury."

Here's a nice figure from her web site:

Toxic assets anyone?

You can be a vulture too :-)

Free leverage from Uncle Sam! What's not to like?

WSJ: ... New York-based fund giant BlackRock is launching a closed-end mutual fund aimed at allowing ordinary investors to put their money into the kind of toxic mortgage-backed securities that nearly brought down the financial system a few months ago. Shares are expected to go on sale in about a month.

The BlackRock Legacy Securities Public-Private Trust, which may raise up to about $1 billion, will be sold through brokers and advisers. It will try to buy mortgage-backed securities at distressed prices from banks looking to shore up their battered balance sheets. The fund will invest alongside the U.S. Treasury as part of the Public-Private Investment Partnership, or PPIP, launched earlier this year. BlackRock is among a small group of firms picked to take part in PPIP.

... The fund will also benefit from helpful financial engineering courtesy of the U.S. government. PPIP was set up to encourage private investors to help bail out the financial system. So for every dollar invested, Uncle Sam will provide another $2—$1 in equity and $1 in debt. The debt’s cheap, too: about two percentage points over the LIBOR interbank rate. That should boost returns.

Sources are hoping that, when you factor in the financial engineering, the fund will be able to earn maybe 10-12% annually over its ten-year life.

... “For now, the bulk of toxic assets are not going to be in play,” Harvard law professor Lucian Bebchuk, one of the intellectual architects of PPIP, told me. Changes to accounting rules and government stress tests, have taken off some of the pressure off banks, so Professor Bebchuk says banks are not as motivated to sell their toxic assets as they were when PPIP was set up in March. “For many types of toxic assets, even if the banks can get a price that’s fair, if it’s at a discount to face value they don’t have an incentive to do it,” he says.

Furthermore, thanks to the stock market rally the banks are feeling more confident—and have a lot more access to capital.

... Meanwhile, the fundamentals of MBS continue to worsen. Fitch Ratings says 6.8% of (non-agency) prime mortgages are now delinquent—twice as many as were delinquent six months ago. The figures for Alt-A are 21%, and for sub-prime, 40%. They’re still getting worse. Fitch director Grant Bailey says mortgage delinquency rates won’t stabilize until house prices and unemployment rates do.

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?)

Bay area housing market has cracked

To all my friends in the bay area: I told you so, I told you so, I told you so... :-/

SF Chronicle:

“Twenty percent of Bay Area homeowners owe more on their mortgages than their homes are worth, according to a study being released today. This dubious distinction has entered the American lexicon as an all-too-familiar term - being underwater.

As home values continue to plunge, the real estate valuation service Zillow.com said that 20.76 percent of all homes in the nine-county Bay Area are underwater. The rate is much higher than the national average of 1 in 7 homes, or 14.3 percent. That’s because the Bay Area - like most of California - was a classic bubble market, where buyers in recent years paid overinflated prices for homes that now are rapidly losing value in the market downturn.”

(Via Barry Ritholtz.)

Michael Lewis on the subprime bubble

Michael Lewis nails it in this long Portfolio article. It's the single best piece I've read on the subject.

...In the two decades since then, I had been waiting for the end of Wall Street. The outrageous bonuses, the slender returns to shareholders, the never-ending scandals, the bursting of the internet bubble, the crisis following the collapse of Long-Term Capital Management: Over and over again, the big Wall Street investment banks would be, in some narrow way, discredited. Yet they just kept on growing, along with the sums of money that they doled out to 26-year-olds to perform tasks of no obvious social utility. The rebellion by American youth against the money culture never happened. Why bother to overturn your parents’ world when you can buy it, slice it up into tranches, and sell off the pieces?

At some point, I gave up waiting for the end. There was no scandal or reversal, I assumed, that could sink the system.

...Enter Greg Lippman, a mortgage-bond trader at Deutsche Bank. He arrived at FrontPoint bearing a 66-page presentation that described a better way for the fund to put its view of both Wall Street and the U.S. housing market into action. The smart trade, Lippman argued, was to sell short not New Century’s stock but its bonds that were backed by the subprime loans it had made. Eisman hadn’t known this was even possible—because until recently, it hadn’t been. But Lippman, along with traders at other Wall Street investment banks, had created a way to short the subprime bond market with precision.

Here’s where financial technology became suddenly, urgently relevant. The typical mortgage bond was still structured in much the same way it had been when I worked at Salomon Brothers. The loans went into a trust that was designed to pay off its investors not all at once but according to their rankings. The investors in the top tranche, rated AAA, received the first payment from the trust and, because their investment was the least risky, received the lowest interest rate on their money. The investors who held the trusts’ BBB tranche got the last payments—and bore the brunt of the first defaults. Because they were taking the most risk, they received the highest return. Eisman wanted to bet that some subprime borrowers would default, causing the trust to suffer losses. The way to express this view was to short the BBB tranche. The trouble was that the BBB tranche was only a tiny slice of the deal.

But the scarcity of truly crappy subprime-mortgage bonds no longer mattered. The big Wall Street firms had just made it possible to short even the tiniest and most obscure subprime-mortgage-backed bond by creating, in effect, a market of side bets. Instead of shorting the actual BBB bond, you could now enter into an agreement for a credit-default swap with Deutsche Bank or Goldman Sachs. It cost money to make this side bet, but nothing like what it cost to short the stocks, and the upside was far greater.

...But he couldn’t figure out exactly how the rating agencies justified turning BBB loans into AAA-rated bonds. “I didn’t understand how they were turning all this garbage into gold,” he says. He brought some of the bond people from Goldman Sachs, Lehman Brothers, and UBS over for a visit. “We always asked the same question,” says Eisman. “Where are the rating agencies in all of this? And I’d always get the same reaction. It was a smirk.” He called Standard & Poor’s and asked what would happen to default rates if real estate prices fell. The man at S&P couldn’t say; its model for home prices had no ability to accept a negative number. “They were just assuming home prices would keep going up,” Eisman says.

As an investor, Eisman was allowed on the quarterly conference calls held by Moody’s but not allowed to ask questions. The people at Moody’s were polite about their brush-off, however. The C.E.O. even invited Eisman and his team to his office for a visit in June 2007. By then, Eisman was so certain that the world had been turned upside down that he just assumed this guy must know it too. “But we’re sitting there,” Daniel recalls, “and he says to us, like he actually means it, ‘I truly believe that our rating will prove accurate.’ And Steve shoots up in his chair and asks, ‘What did you just say?’ as if the guy had just uttered the most preposterous statement in the history of finance. He repeated it. And Eisman just laughed at him.”

“With all due respect, sir,” Daniel told the C.E.O. deferentially as they left the meeting, “you’re delusional.”
This wasn’t Fitch or even S&P. This was Moody’s, the aristocrats of the rating business, 20 percent owned by Warren Buffett. And the company’s C.E.O. was being told he was either a fool or a crook by one Vincent Daniel, from Queens.

...That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all.

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.

The subprime primer

In case you haven't seen this, it's pretty funny (strong language warning).

Special bonus: The Making of Goldman Sachs. Leonard Lopate interviews Charles Ellis, the author of The Partnership.

Double plus good: the Times goes after Greenspan and those weapons of mass destruction, derivatives.

Mortgage finance in pictures

This graphic is from TheDeal.com (via Paul Kedrosky). Note they give the notional to net ratio for CDS as $62 to $2 trillion, or 30 to 1. That ratio is a good proxy for the complexity of the network of contracts and how difficult it will be to disentangle.

Don't blame the quants: Fannie edition

This article in the Times gives some details about the collapse of Fannie Mae. It's pretty clear that the quants at Fannie knew they were undercharging for risky loans, and that senior management knowingly pushed the firm into dangerous territory.

Fannie's business: repackaging mortgages into collateralized securities. But it operated under political pressure to help low-income buyers achieve home ownership and under financial pressure to compete with investment banks getting aggressively into the mortgage securitization business.

NYTimes: ...When Mr. Mudd arrived at Fannie eight years ago, it was beginning a dramatic expansion that, at its peak, had it buying 40 percent of all domestic mortgages.

...So Fannie constructed a vast network of computer programs and mathematical formulas that analyzed its millions of daily transactions and ranked borrowers according to their risk.

Those computer programs seemingly turned Fannie into a divining rod, capable of separating pools of similar-seeming borrowers into safe and risky bets. The riskier the loan, the more Fannie charged to handle it. In theory, those high fees would offset any losses.

With that self-assurance, the company announced in 2000 that it would buy $2 trillion in loans from low-income, minority and risky borrowers by 2010.

All this helped supercharge Fannie’s stock price and rewarded top executives with tens of millions of dollars. Mr. Raines received about $90 million between 1998 and 2004, while Mr. Howard was paid about $30.8 million, according to regulators. Mr. Mudd collected more than $10 million in his first four years at Fannie.

Take aggressive risks, or "get out of the company":

...But Fannie’s computer systems could not fully analyze many of the risky loans that customers, investors and lawmakers wanted Mr. Mudd to buy. Many of them — like balloon-rate mortgages or mortgages that did not require paperwork — were so new that dangerous bets could not be identified, according to company executives.

Even so, Fannie began buying huge numbers of riskier loans.

In one meeting, according to two people present, Mr. Mudd told employees to “get aggressive on risk-taking, or get out of the company.”

In the interview, Mr. Mudd said he did not recall that conversation and that he always stressed taking only prudent risks.

Employees, however, say they got a different message.

“Everybody understood that we were now buying loans that we would have previously rejected, and that the models were telling us that we were charging way too little,” said a former senior Fannie executive. “But our mandate was to stay relevant and to serve low-income borrowers. So that’s what we did.”

I complained about Frankin Raines, who embroiled Fannie in a derivatives accounting scandal, back in 2004-5.

Mr. Raines and Mr. Howard, who kept most of their millions, are living well. Mr. Raines has improved his golf game. Mr. Howard divides his time between large homes outside Washington and Cancun, Mexico, where his staff is learning how to cook American meals.

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

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.