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Complexity illustrated: Lehman WAS too connected to fail

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

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

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

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

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


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

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

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

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

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

Who was next after AIG? Time for a bailout!

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

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Written by infoproc

September 29, 2008 at 3:17 pm

Clawbacks, fake alpha and tail risk

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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

Written by infoproc

September 27, 2008 at 7:57 pm

The devil in the details

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

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

CDOs:

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

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

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

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

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

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

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

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

CDS:

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

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

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

Miscellaneous questions:

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

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

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

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

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

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

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

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

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

Written by infoproc

September 21, 2008 at 2:26 pm