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CDOs, auctions and price discovery

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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.

Written by infoproc

September 27, 2008 at 12:06 pm

Mortgage securities oversold by 15-25 percent

with 10 comments

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.

Written by infoproc

September 26, 2008 at 5:11 pm

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

with 3 comments

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 could buy 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 is issue is just symbolic.

Written by infoproc

September 23, 2008 at 8:15 pm

The devil in the details

with 5 comments

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…)


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 🙂


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 it?

Written by infoproc

September 21, 2008 at 2:26 pm

Still no mark to market

with 2 comments

Mortgage-backed assets with face value of $30.6B were just sold by Merrill for $6.7B.

1) obviously, this reflects huge losses and perhaps forward looking expectations of a very high default rate on the underlying mortgages (can’t tell unless I know what CDO tranches are in the pool they are selling).

2) but, amazingly, this 80% loss on the securities only gives a kind of upper bound on their value: Merrill had to provide 75% of the financing to the buyer! Even with an 80% haircut Merrill might not have found a real buyer for the assets at this price.

In the final days of the technology bubble we saw the same thing: vendor financing, in which sellers would loan customers the money to buy the product, just to make their quarterly numbers.

WSJ: …Much of what Merrill is sitting on is known as collateralized debt obligations on Merrill’s books. CDOs are securities backed by pools of mortgages or other assets, which have plummeted in value during the credit crunch. In all, Merrill has written down more than $46.7 billion in exposure to such mortgage-related assets since mid-2007.

The biggest single action Merrill took Monday was the sale of mortgage assets to an affiliate of Lone Star Funds with a face value $30.6 billion which it was carrying on its books at $11.1 billion as of the end of June. The sale, at a purchase price of just $6.7 billion, which represented just 22 cents on the dollar, reduced Merrill’s holding of such assets by more than half, from $19.9 billion to $8.8 billion.

Merrill said it would finance about 75% of the value of the deal, a similar action to other banks that loaned money to firms willing to take assets off its hands.

News that Merrill was able to sell these assets, even at a steep discount, bodes well for other firms on Wall Street like Lehman Brothers Holdings Inc., which are also sitting on hard to sell assets.

Written by infoproc

July 28, 2008 at 11:14 pm

Asset-backed oversold? Paulson ready to get back in!

with 2 comments

John Paulson made $15 billion for his fund ($3.7 billion for himself!) betting against subprime securities last year. Now Bloomberg reports that he’s ready to get back in on the upside!

I’m as dismayed as anyone else about taxpayer dollars going to bail out mortgage holders, commercial banks and the GSE’s (Fannie, Freddie). I complained about Fannie back in 2004 when Franklin Raines was still CEO and the story first got out about their smoothing of earnings and use of derivatives accounting.

But, on the other hand, maybe Uncle Sam can actually generate positive return by buying oversold securities! Rumor says that current prices of subprime mortgage backed securities suggest implied default rates which are unrealistically high (e.g., like 50% !). Barring a complete economic meltdown these assets are underpriced and will generate a handsome return for an intelligent investor willing to take some risk. Is Uncle Sam smart? Let’s hope that the other Paulson negotiates some upside for us taxpayers in any bailout organized by the Treasury.

Bloomberg: John Paulson, the money manager whose wagers against the U.S. housing market helped him earn an estimated $3.7 billion last year, is now seeking to profit from Wall Street’s search for capital to offset mortgage writedowns.

Paulson plans to open a hedge fund by December that will provide capital to the world’s biggest banks and brokers as they add to the $345 billion they’ve raised in the past year, according to two people with knowledge of the matter. His Paulson & Co., which oversees $33 billion, hasn’t set a size target for the fund, said the people, who declined to be identified because the plans aren’t final.

The New York-based firm’s credit funds rose as much as sixfold last year, helped by bets that rising defaults on subprime home loans would pummel the value of mortgage-backed securities. The meltdown has forced the world’s biggest banks and securities firms to take $467 billion in asset write-offs and credit losses and led to the collapse of Bear Stearns Cos.

“Investors who are able to make money in a declining market and then rapidly turn around and profit from a rising market is highly unusual,” said Thomas Whelan, president of Greenwich, Connecticut-based Greenwich Alternative Investments, which advises clients on investing in hedge funds.

Paulson declined to comment. His 2007 earnings made him the highest-paid hedge-fund manager, according to Institutional Investor’s Alpha magazine.

Written by infoproc

July 23, 2008 at 9:22 pm

MacKenzie on the credit crisis

with 3 comments

Edinburgh sociology professor Donald MacKenzie wrote what I feel is the best history (so far) of modern finance and derivatives. In this article in the London Review of Books, he tackles the current credit crisis. Highly recommended.

On Gaussian copula (cognitive limitations restrict attention to an obviously oversimplified model; big brains were worried from the start):

Correlation is by far the trickiest issue in valuing a CDO. Indeed, it is difficult to be precise about what correlation actually means: in practice, its determination is a task of mathematical modelling. Over the past ten years, a model known as the ‘single-factor Gaussian copula’ has become standard. ‘Single-factor’ means that the degree of correlation is assumed to reflect the varying extent to which fortunes of each debt-issuer depend on a single underlying variable, which one can interpret as the health of the economy. ‘Copula’ indicates that the mathematical issue being addressed is the connectedness of default risks, and ‘Gaussian’ refers to the use of a multi-dimensional variant of the statistician’s standard bell-shaped curve to model this connectedness.

The single-factor Gaussian copula is far from perfect: even before the crisis hit, I wasn’t able to get a single insider to express complete confidence in it. Nevertheless, it became a market Esperanto, allowing people in different institutions to discuss CDO valuation in a mutually intelligible way. But having a standard model is only part of the task of understanding correlation. Historical data are much less useful here. Defaults are rare events, and producing a plausible statistical estimate of the extent of the correlation between, say, the risk of default by Ford and by General Motors is difficult or impossible. So as CDOs gained popularity in the late 1990s and early years of this decade, often the best one could do was simply to employ a uniform, standard figure such as 30 per cent correlation, or use the correlation between two corporations’ stock prices as a proxy for their default correlations.

Ratings, indices and implied correlation:

However imperfect the modelling of CDOs was, the results were regarded by the rating agencies as facts solid enough to allow them to grade CDO tranches. Indeed, the agencies made the models they used public knowledge in the credit markets: Standard & Poor’s, for example, was prepared to supply participants with copies of its ‘CDO Evaluator’ software package. A bank or hedge fund setting up a standard CDO could therefore be confident of the ratings it would achieve. Creators of CDOs liked that it was then possible to offer attractive returns to investors – which are normally banks, hedge funds, insurance companies, pension funds and the like, not private individuals – while retaining enough of the cash-flow from the asset pool to make the effort worthwhile. As markets recovered from the bursting of the dotcom and telecom bubble in 2000-2, the returns from traditional assets – including the premium for holding risky assets – fell sharply. (The effectiveness of CDOs and other credit derivatives in allowing banks to shed credit risk meant that they generally survived the end of the bubble without significant financial distress.) By early 2007, market conditions had been benign for nearly five years, and central bankers were beginning to talk of the ‘Great Stability’. In it, CDOs flourished.

Ratings aside, however, the world of CDOs remained primarily one of private facts. Each CDO is normally different from every other, and the prices at which tranches are sold to investors are not usually publicly known. So credible market prices did not exist. The problem was compounded by one of the repercussions of the Enron scandal. A trader who has done a derivatives deal wants to be able to ‘book’ the profits immediately, in other words have them recognised straightaway in his employer’s accounts and thus in the bonus that he is awarded that year. Enron and its traders had been doing this on the basis of questionable assumptions, and accounting regulators and auditors – the latter mindful of the way in which the giant auditing firm Arthur Andersen collapsed having been prosecuted for its role in the Enron episode – began to clamp down, insisting on the use of facts (observable market values) rather than mere assumptions in ‘booking’ derivatives. That credit correlation was not observable thus became much more of a problem.

From 2003 to 2004, however, the leading dealers in the credit-derivatives market set up fact-generating mechanisms that alleviated these difficulties: credit indices. These resemble CDOs, but do not involve the purchase of assets and, crucially, are standard in their construction. For example, the European and the North American investment-grade indices (the iTraxx and CDX IG) cover set lists of 125 investment-grade corporations. In the terminology of the market, you can ‘buy protection’ or ‘sell protection’ on either an index as a whole or on standard tranches of it. A protection seller receives fees from the buyer, but has to pay out if one or more defaults hit the index or tranche in question.

The fluctuating price of protection on an index as a whole, which is publicly known, provides a snapshot of market perceptions of credit conditions, while the trading of index tranches made correlation into something apparently observable and even tradeable. The Gaussian copula or a similar model can be applied ‘backwards’ to work out the level of correlation implied by the cost of protection on a tranche, which again is publicly known. That helped to satisfy auditors and to facilitate the booking of profits. A new breed of ‘correlation traders’ emerged, who trade index tranches as a way of taking a position on shifts in credit correlation.

Indices and other tranches quickly became a huge-volume, liquid market. They facilitated the creation not just of standard CDOs but of bespoke products such as CDO-like structures that consist only of mezzanine tranches (which offer combinations of returns and ratings that many investors found especially attractive). Products of this kind leave their creators heavily exposed to changes in credit-market conditions, but the index market permitted them to hedge (that is, offset) this exposure.

Quants and massive computational power (one wonders whether the mathematics and computers did nothing more than lend a spurious air of technicality to untrustworthy basic assumptions):

With problems such as the non-observability of correlation apparently adequately solved by the development of indices, the credit-derivatives market, which emerged little more than a decade ago, had grown by June 2007 to an aggregate total of outstanding contracts of $51 trillion, the equivalent of $7,700 for every person on the planet. It is perhaps the most sophisticated sector of the global financial markets, and a fertile source of employment for mathematicians, whose skills are needed to develop models better than the single-factor Gaussian copula.

The credit market is also one of the most computationally intensive activities in the modern world. An investment bank with a big presence in the market will have thousands of positions in credit default swaps, CDOs, indices and similar products. The calculations needed to understand and hedge the exposure of this portfolio to market movements are run, often overnight, on grids of several hundred interconnected computers. The banks’ modellers would love to add as many extra computers as possible to the grids, but often they can’t do so because of the limits imposed by the capacity of air-conditioning systems to remove heat from computer rooms. In the City, the strain put on electricity-supply networks can also be a problem. Those who sell computer hardware to investment banks are now sharply aware that ‘performance per watt’ is part of what they have to deliver.

Collapse of rating agency credibility:

The rating agencies are businesses, and the issuers of debt instruments pay the agencies to rate them. The potential conflict of interest has always been there, even in the days when the agencies mainly graded bonds, which generally they did quite sensibly. However, the way in which the crisis has thrust the conflict into the public eye has further threatened the credibility of ratings. ‘In today’s market, you really can’t trust any ratings,’ one money-market fund manager told Bloomberg Markets in October 2007. She was far from alone in that verdict, and the result was cognitive contagion. Most investors’ ‘knowledge’ of the properties of CDOs and other structured products had been based chiefly on ratings, and the loss of confidence in them affected all such products, not just those based on sub-prime mortgages. Since last summer, it has been just about impossible to set up a new CDO.

Illiquid assets, difficulty of mark to market:

Over recent months, banks have frequently been accused of hiding their credit losses. The truth is scarier: such losses are extremely hard to measure credibly. Marking-to-market requires that there be plausible market prices to use in valuing a portfolio. But the issuing of CDOs has effectively stopped, liquidity has dried up in large sectors of the credit default swap market, and the credibility of the cost of protection in the index market has been damaged by processes of the kind I’ve been discussing.

How, for example, can one value a portfolio of mortgage-backed securities when trading in those securities has ceased? It has become common to use a set of credit indices, the ABX-HE (Asset Backed, Home Equity), as a proxy for the underlying mortgage market, which is now too illiquid for prices in it to be credible. However, the ABX-HE is itself affected by the processes that have undermined the robustness of the apparent facts produced by other sectors of the index market; in particular, the large demand for protection and reduced supply of it may mean the indices have often painted too uniformly dire a picture of the prospects for mortgage-backed securities. One trader told the Financial Times in April that the liquidity of the indices had become very poor: ‘Trading is mostly happening on interdealer screens between eight or ten guys, and this means that prices can move wildly on very light volume.’ Yet because the level of the ABX-HE indices is used by banks’ accountants and auditors to value their multi-billion dollar portfolios of mortgage-backed securities, this esoteric market has considerable effects, since low valuations weaken banks’ balance sheets, curtailing their capacity to lend and thus damaging the wider economy.

Josef Ackermann, the head of Deutsche Bank, has caused a stir by admitting ‘I no longer believe in the market’s self-healing power.’ …

Written by infoproc

June 9, 2008 at 12:33 am