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Phil Gramm, McCain and the CDS meltdown

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In my last post I tried to illustrate why certain entities like AIG might be too connected (not just too BIG) to fail. I didn’t mean politically connected — I meant too connected in the web of unregulated credit default swap contracts. So connected that if, for example, AIG were to fail, the entire financial system would collapse. The now $60 trillion CDS market is a tangle of unknown and unregulated contracts whose value depends sensitively on the behavior of underlying securities such as bundles of mortgages.

The “too connected to fail” problem could have been averted with some simple regulatory steps; ideally in the future we should have a central exchange for these contracts with collateral requirements. I’ve discussed the incredible growth of the CDS market several times on this blog. But I always wondered why it was’t more carefully regulated.

Economist: (2006) OVER a year ago, a whiff of something nasty filled the nostrils of the world’s financial regulators. It came, appropriately, from the back end of the credit-derivatives market, an unregulated asset class that was growing so fast that banks and hedge funds that dabbled in it had lost track of their trades.

In other markets where trading is private (rather than on an exchange), the problem might have seemed minor, involving thankless back-office tasks with monotonous names like matching and confirmation. But this time regulators saw a threat to the stability of banks, because of the popularity of credit-default swaps (CDSs), instruments that disperse lending risk around the financial system.

…Last month Alan Greenspan, former chairman of the Federal Reserve, startled bond traders at a dinner in New York with both a friendly pat and a slap on the wrist. Credit derivatives, he gushed, were “becoming the most important instruments I’ve seen in decades.” But he then went on to say how appalled he was at the “19th-century technology” used to trade credit-default swaps, with deals done over the phone and on scraps of paper.

The answer, apparently, is in a bill sponsored by McCain economic advisor Phil Gramm — the Commodity Futures Modernization Act, passed in 2000, which exempts swaps from regulation! [Thanks to reader STS for making me aware of this.]

Did McCain know about this earlier in the week when, after first pretending there was no crisis in financial markets, he ranted about the betrayal of the noble American worker by the greed and corruption of Wall Street?

MotherJones: …But Gramm’s most cunning coup on behalf of his friends in the financial services industry—friends who gave him millions over his 24-year congressional career—came on December 15, 2000. It was an especially tense time in Washington. Only two days earlier, the Supreme Court had issued its decision on Bush v. Gore. President Bill Clinton and the Republican-controlled Congress were locked in a budget showdown. It was the perfect moment for a wily senator to game the system. As Congress and the White House were hurriedly hammering out a $384-billion omnibus spending bill, Gramm slipped in a 262-page measure called the Commodity Futures Modernization Act. Written with the help of financial industry lobbyists and cosponsored by Senator Richard Lugar (R-Ind.), the chairman of the agriculture committee, the measure had been considered dead—even by Gramm. Few lawmakers had either the opportunity or inclination to read the version of the bill Gramm inserted. “Nobody in either chamber had any knowledge of what was going on or what was in it,” says a congressional aide familiar with the bill’s history.

It’s not exactly like Gramm hid his handiwork—far from it. The balding and bespectacled Texan strode onto the Senate floor to hail the act’s inclusion into the must-pass budget package. But only an expert, or a lobbyist, could have followed what Gramm was saying. The act, he declared, would ensure that neither the SEC nor the Commodity Futures Trading Commission (CFTC) got into the business of regulating newfangled financial products called swaps—and would thus “protect financial institutions from overregulation” and “position our financial services industries to be world leaders into the new century.”

…But the Enron loophole was small potatoes compared to the devastation that unregulated swaps would unleash. Credit default swaps are essentially insurance policies covering the losses on securities in the event of a default. Financial institutions buy them to protect themselves if an investment they hold goes south. It’s like bookies trading bets, with banks and hedge funds gambling on whether an investment (say, a pile of subprime mortgages bundled into a security) will succeed or fail. Because of the swap-related provisions of Gramm’s bill—which were supported by Fed chairman Alan Greenspan and Treasury secretary Larry Summers—a $62 trillion market (nearly four times the size of the entire US stock market) remained utterly unregulated, meaning no one made sure the banks and hedge funds had the assets to cover the losses they guaranteed.

In essence, Wall Street’s biggest players (which, thanks to Gramm’s earlier banking deregulation efforts, now incorporated everything from your checking account to your pension fund) ran a secret casino.

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Written by infoproc

September 19, 2008 at 1:31 am

Notional vs net: complexity is our enemy

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The credit default swap (CDS) market, where AIG played, had notional outstanding value of about $45 trillion at the end of 2007 (about $60 trillion now). Of course many of these contracts are partially canceling, so the net value of contracts in the market is much smaller than the notional value.

Unfortunately, the network diagram (network of contracts) probably looks something like this:

Imagine removing — due to insolvency, lack of counterparty confidence, lack of shareholder confidence, etc. — one of the nodes in the middle of the graph with lots of connections. What does that do to the detailed cancelations that reduce the notional value of $45 trillion to something more manageable? Suddenly, perfectly healthy nodes in the system have uncanceled liabilities or unhedged positions to deal with, and the net value of contracts skyrockets. This is why some entities are too connected to fail, as opposed to too BIG to fail. Systemic risk is all about complexity.

Here’s a simple example of a network of contracts whose notional value is much larger than its net value. Suppose A = AIG, B = Barclays and C = Citigroup have traded CDS contracts related to a particular pool mortgages. If defaults in the pool exceed some threshold, A must pay B $1 billion, but will receive $1.1 billion from C. Now suppose there is a third contract in which B pays $1 billion to C if defaults exceed the threshold. The notional value of all contracts is $3.1 billion, but the net value that changes hands is only $.1 billion. So notional value is 31 times net.

B’s position is completely neutral and A and C only have $.1 billion at risk. This may sound contrived, but it’s actually not unrealistic.

Everything is fine until, say, A has a problem. Suppose A becomes insolvent and *poof* disappears. B and C are left with a naked $1 billion bet on mortgages. Suddenly the notional value, which wasn’t previously very representative of the amount at risk, due to the cancelations, isn’t far off from the amount at risk ($3.1 vs 1 billion).

Now scale this little example up to, say, $45 trillion in notional value, thousands of bets and dozens of firms, and you’ve got systemic risk!

Written by infoproc

September 18, 2008 at 5:22 pm

MacKenzie on the credit crisis

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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.’ …

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June 9, 2008 at 12:33 am

Deep inside the subprime crisis

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Moody’s walks Roger Lowenstein (writing for the Times Sunday magazine) through the construction, rating and demise of a pool of subprime mortgage securities. Some readers may have thought the IMF was exaggerating when it forecast up to $1 trillion in future losses from the credit bubble. After reading the following you will see that it’s not an implausible number, and it will be clear why the system is paralyzed in dealing with (marking to market) the complicated securities (CDOs, etc.) that are contaminating the balance sheets of banks, investment banks, hedge funds, pension funds, sovereign wealth funds, etc. around the world.

Here’s a quick physicist’s calculation: roughly 10 million houses sold per year, assume that 10% of these mortgages are bad and will cost the issuer $100k to foreclose and settle. That means $100B per year in losses. Over the whole bubble, perhaps $300-500B in losses, which is more or less what the IMF estimates as the residential component of credit bubble losses (the rest of the trillion comes from commercial and corporate lending and consumer credit).

The internet bubble, with irrational investors buying shares of pet food e-commerce companies, was crazy. Read the excerpts below and you’ll see that our recent housing boom was even crazier and at an unimaginably larger scale. (Note similar bubbles in the UK, Spain and in China.)

The best predictor, going forward, of mortgage default rates (not just subprime, but even prime mortgages) in a particular region will likely be the decline in home prices in that region. The incentive for a borrower to default on his or her mortgage is the amount by which they are “upside down” on the loan — the amount by which their indebtedness exceeds the value of the home. Since we can’t forecast price declines very well — indeed, it’s a nonlinear problem, with more defaults leading to more price declines, leading to more defaults — we can’t price the derivative securities built from those mortgages.

Efficient markets! 😉

The figure above compares Case-Shiller data on the current bust (magenta) to the bust of the 80s-90s (blue). (Click for larger version.) You can see we have some way to go before all the fun ends.

Wall Street (Oliver Stone):

Gekko: Greed, for lack of a better word, is good. Greed is right. Greed works. Greed clarifies and cuts through and captures the essence of evolutionary spirit. Greed in all of its forms, greed for life, for money, for love, knowledge has marked the upward surge of mankind. And greed, you mark my words, will not only save Teldar Paper, but that other malfunctioning corporation called the USA.

Gekko: The richest one percent of this country owns half our country’s wealth, five trillion dollars. One third of that comes from hard work, two thirds comes from inheritance, interest on interest accumulating to widows and idiot sons and what I do, stock and real estate speculation. It’s bullshit. You got ninety percent of the American public out there with little or no net worth. I create nothing. I own.

Carl Fox: Stop going for the easy buck and start producing something with your life. Create, instead of living off the buying and selling of others.

NYTimes: …The business of assigning a rating to a mortgage security is a complicated affair, and Moody’s recently was willing to walk me through an actual mortgage-backed security step by step. I was led down a carpeted hallway to a well-appointed conference room to meet with three specialists in mortgage-backed paper. Moody’s was fair-minded in choosing an example; the case they showed me, which they masked with the name “Subprime XYZ,” was a pool of 2,393 mortgages with a total face value of $430 million.

Subprime XYZ typified the exuberance of the age. All the mortgages in the pool were subprime — that is, they had been extended to borrowers with checkered credit histories. In an earlier era, such people would have been restricted from borrowing more than 75 percent or so of the value of their homes, but during the great bubble, no such limits applied.

Moody’s did not have access to the individual loan files, much less did it communicate with the borrowers or try to verify the information they provided in their loan applications. “We aren’t loan officers,” Claire Robinson, a 20-year veteran who is in charge of asset-backed finance for Moody’s, told me. “Our expertise is as statisticians on an aggregate basis. We want to know, of 1,000 individuals, based on historical performance, what percent will pay their loans?”

The loans in Subprime XYZ were issued in early spring 2006 — what would turn out to be the peak of the boom. They were originated by a West Coast company that Moody’s identified as a “nonbank lender.” Traditionally, people have gotten their mortgages from banks, but in recent years, new types of lenders peddling sexier products grabbed an increasing share of the market. This particular lender took the loans it made to a New York investment bank; the bank designed an investment vehicle and brought the package to Moody’s.

Moody’s assigned an analyst to evaluate the package, subject to review by a committee. The investment bank provided an enormous spreadsheet chock with data on the borrowers’ credit histories and much else that might, at very least, have given Moody’s pause. Three-quarters of the borrowers had adjustable-rate mortgages, or ARMs — “teaser” loans on which the interest rate could be raised in short order. Since subprime borrowers cannot afford higher rates, they would need to refinance soon. This is a classic sign of a bubble — lending on the belief, or the hope, that new money will bail out the old.

Moody’s learned that almost half of these borrowers — 43 percent — did not provide written verification of their incomes. The data also showed that 12 percent of the mortgages were for properties in Southern California, including a half-percent in a single ZIP code, in Riverside. That suggested a risky degree of concentration.

On the plus side, Moody’s noted, 94 percent of those borrowers with adjustable-rate loans said their mortgages were for primary residences. “That was a comfort feeling,” Robinson said. Historically, people have been slow to abandon their primary homes. When you get into a crunch, she added, “You’ll give up your ski chalet first.”

Another factor giving Moody’s comfort was that all of the ARM loans in the pool were first mortgages (as distinct from, say, home-equity loans). Nearly half of the borrowers, however, took out a simultaneous second loan. Most often, their two loans added up to all of their property’s presumed resale value, which meant the borrowers had not a cent of equity.

In the frenetic, deal-happy climate of 2006, the Moody’s analyst had only a single day to process the credit data from the bank. The analyst wasn’t evaluating the mortgages but, rather, the bonds issued by the investment vehicle created to house them. A so-called special-purpose vehicle — a ghost corporation with no people or furniture and no assets either until the deal was struck — would purchase the mortgages. Thereafter, monthly payments from the homeowners would go to the S.P.V. The S.P.V. would finance itself by selling bonds. The question for Moody’s was whether the inflow of mortgage checks would cover the outgoing payments to bondholders. From the investment bank’s point of view, the key to the deal was obtaining a triple-A rating — without which the deal wouldn’t be profitable. That a vehicle backed by subprime mortgages could borrow at triple-A rates seems like a trick of finance. “People say, ‘How can you create triple-A out of B-rated paper?’ ” notes Arturo Cifuentes, a former Moody’s credit analyst who now designs credit instruments. It may seem like a scam, but it’s not.

The secret sauce is that the S.P.V. would float 12 classes of bonds, from triple-A to a lowly Ba1. The highest-rated bonds would have first priority on the cash received from mortgage holders until they were fully paid, then the next tier of bonds, then the next and so on. The bonds at the bottom of the pile got the highest interest rate, but if homeowners defaulted, they would absorb the first losses.

It was this segregation of payments that protected the bonds at the top of the structure and enabled Moody’s to classify them as triple-A. Imagine a seaside condo beset by flooding: just as the penthouse will not get wet until the lower floors are thoroughly soaked, so the triple-A bonds would not lose a dime unless the lower credits were wiped out.

Structured finance, of which this deal is typical, is both clever and useful; in the housing industry it has greatly expanded the pool of credit. But in extreme conditions, it can fail. The old-fashioned corner banker used his instincts, as well as his pencil, to apportion credit; modern finance is formulaic. However elegant its models, forecasting the behavior of 2,393 mortgage holders is an uncertain business. “Everyone assumed the credit agencies knew what they were doing,” says Joseph Mason, a credit expert at Drexel University. “A structural engineer can predict what load a steel support will bear; in financial engineering we can’t predict as well.”

Mortgage-backed securities like those in Subprime XYZ were not the terminus of the great mortgage machine. They were, in fact, building blocks for even more esoteric vehicles known as collateralized debt obligations, or C.D.O.’s. C.D.O.’s were financed with similar ladders of bonds, from triple-A on down, and the credit-rating agencies’ role was just as central. The difference is that XYZ was a first-order derivative — its assets included real mortgages owned by actual homeowners. C.D.O.’s were a step removed — instead of buying mortgages, they bought bonds that were backed by mortgages, like the bonds issued by Subprime XYZ. (It is painful to consider, but there were also third-order instruments, known as C.D.O.’s squared, which bought bonds issued by other C.D.O.’s.)

Miscalculations that were damaging at the level of Subprime XYZ were devastating at the C.D.O. level. Just as bad weather will cause more serious delays to travelers with multiple flights, so, if the underlying mortgage bonds were misrated, the trouble was compounded in the case of the C.D.O.’s that purchased them.

Moody’s used statistical models to assess C.D.O.’s; it relied on historical patterns of default. This assumed that the past would remain relevant in an era in which the mortgage industry was morphing into a wildly speculative business. The complexity of C.D.O.’s undermined the process as well. Jamie Dimon, the chief executive of JPMorgan Chase, which recently scooped up the mortally wounded Bear Stearns, says, “There was a large failure of common sense” by rating agencies and also by banks like his. “Very complex securities shouldn’t have been rated as if they were easy-to-value bonds.”

…The challenge to investment banks is to design securities that just meet the rating agencies’ tests. Risky mortgages serve their purpose; since the interest rate on them is higher, more money comes into the pool and is available for paying bond interest. But if the mortgages are too risky, Moody’s will object. Banks are adroit at working the system, and pools like Subprime XYZ are intentionally designed to include a layer of Baa bonds, or those just over the border. “Every agency has a model available to bankers that allows them to run the numbers until they get something they like and send it in for a rating,” a former Moody’s expert in securitization says. In other words, banks were gaming the system; according to Chris Flanagan, the subprime analyst at JPMorgan, “Gaming is the whole thing.”

When a bank proposes a rating structure on a pool of debt, the rating agency will insist on a cushion of extra capital, known as an “enhancement.” The bank inevitably lobbies for a thin cushion (the thinner the capitalization, the fatter the bank’s profits). It’s up to the agency to make sure that the cushion is big enough to safeguard the bonds. The process involves extended consultations between the agency and its client. In short, obtaining a rating is a collaborative process.

The evidence on whether rating agencies bend to the bankers’ will is mixed. The agencies do not deny that a conflict exists, but they assert that they are keen to the dangers and minimize them. For instance, they do not reward analysts on the basis of whether they approve deals. No smoking gun, no conspiratorial e-mail message, has surfaced to suggest that they are lying. But in structured finance, the agencies face pressures that did not exist when John Moody was rating railroads. On the traditional side of the business, Moody’s has thousands of clients (virtually every corporation and municipality that sells bonds). No one of them has much clout. But in structured finance, a handful of banks return again and again, paying much bigger fees. A deal the size of XYZ can bring Moody’s $200,000 and more for complicated deals. And the banks pay only if Moody’s delivers the desired rating. Tom McGuire, the Jesuit theologian who ran Moody’s through the mid-’90s, says this arrangement is unhealthy. If Moody’s and a client bank don’t see eye to eye, the bank can either tweak the numbers or try its luck with a competitor like S.&P., a process known as “ratings shopping.”

…From 2002 to 2006, Moody’s profits nearly tripled, mostly thanks to the high margins the agencies charged in structured finance. In 2006, Moody’s reported net income of $750 million. Raymond W. McDaniel Jr., its chief executive, gloated in the annual report for that year, “I firmly believe that Moody’s business stands on the ‘right side of history’ in terms of the alignment of our role and function with advancements in global capital markets.”

…Moody’s was aware that mortgage standards had been deteriorating, and it had been demanding more of a cushion in such pools. Nonetheless, its credit-rating model continued to envision rising home values. Largely for that reason, the analyst forecast losses for XYZ at only 4.9 percent of the underlying mortgage pool. Since even the lowest-rated bonds in XYZ would be covered up to a loss level of 7.25 percent, the bonds seemed safe.

XYZ now became the responsibility of a Moody’s team that monitors securities and changes the ratings if need be (the analyst moved on to rate a new deal). Almost immediately, the team noticed a problem. Usually, people who finance a home stay current on their payments for at least a while. But a sliver of folks in XYZ fell behind within 90 days of signing their papers. After six months, an alarming 6 percent of the mortgages were seriously delinquent. (Historically, it is rare for more than 1 percent of mortgages at that stage to be delinquent.)

Moody’s monitors began to make inquiries with the lender and were shocked by what they heard. Some properties lacked sod or landscaping, and keys remained in the mailbox; the buyers had never moved in. The implication was that people had bought homes on spec: as the housing market turned, the buyers walked.

By the spring of 2007, 13 percent of Subprime XYZ was delinquent — and it was worsening by the month. XYZ was hardly atypical; the entire class of 2006 was performing terribly. (The class of 2007 would turn out to be even worse.)

In April 2007, Moody’s announced it was revising the model it used to evaluate subprime mortgages. It noted that the model “was first introduced in 2002. Since then, the mortgage market has evolved considerably.” This was a rather stunning admission; its model had been based on a world that no longer existed.

Poring over the data, Moody’s discovered that the size of people’s first mortgages was no longer a good predictor of whether they would default; rather, it was the size of their first and second loans — that is, their total debt — combined. This was rather intuitive; Moody’s simply hadn’t reckoned on it. Similarly, credit scores, long a mainstay of its analyses, had not proved to be a “strong predictor” of defaults this time. Translation: even people with good credit scores were defaulting. Amy Tobey, leader of the team that monitored XYZ, told me, “It seems there was a shift in mentality; people are treating homes as investment assets.” Indeed. And homeowners without equity were making what economists call a rational choice; they were abandoning properties rather than make payments on them. Homeowners’ equity had never been as high as believed because appraisals had been inflated.

Over the summer and fall of 2007, Moody’s and the other agencies repeatedly tightened their methodology for rating mortgage securities, but it was too late. They had to downgrade tens of billions of dollars of securities. By early this year, when I met with Moody’s, an astonishing 27 percent of the mortgage holders in Subprime XYZ were delinquent. Losses on the pool were now estimated at 14 percent to 16 percent — three times the original estimate. Seemingly high-quality bonds rated A3 by Moody’s had been downgraded five notches to Ba2, as had the other bonds in the pool aside from its triple-A’s.

The pain didn’t stop there. Many of the lower-rated bonds issued by XYZ, and by mortgage pools like it, were purchased by C.D.O.’s, the second-order mortgage vehicles, which were eager to buy lower-rated mortgage paper because it paid a higher yield. As the agencies endowed C.D.O. securities with triple-A ratings, demand for them was red hot. Much of it was from global investors who knew nothing about the U.S. mortgage market. In 2006 and 2007, the banks created more than $200 billion of C.D.O.’s backed by lower-rated mortgage paper. Moody’s assigned a different team to rate C.D.O.’s. This team knew far less about the underlying mortgages than did the committee that evaluated Subprime XYZ. In fact, Moody’s rated C.D.O.’s without knowing which bonds the pool would buy.

A C.D.O. operates like a mutual fund; it can buy or sell mortgage bonds and frequently does so. Thus, the agencies rate pools with assets that are perpetually shifting. They base their ratings on an extensive set of guidelines or covenants that limit the C.D.O. manager’s discretion.

Late in 2006, Moody’s rated a C.D.O. with $750 million worth of securities. The covenants, which act as a template, restricted the C.D.O. to, at most, an 80 percent exposure to subprime assets, and many other such conditions. “We’re structure experts,” Yuri Yoshizawa, the head of Moody’s’ derivative group, explained. “We’re not underlying-asset experts.” They were checking the math, not the mortgages. But no C.D.O. can be better than its collateral.

Moody’s rated three-quarters of this C.D.O.’s bonds triple-A. The ratings were derived using a mathematical construct known as a Monte Carlo simulation — as if each of the underlying bonds would perform like cards drawn at random from a deck of mortgage bonds in the past. There were two problems with this approach. First, the bonds weren’t like those in the past; the mortgage market had changed. As Mark Adelson, a former managing director in Moody’s structured-finance division, remarks, it was “like observing 100 years of weather in Antarctica to forecast the weather in Hawaii.” And second, the bonds weren’t random. Moody’s had underestimated the extent to which underwriting standards had weakened everywhere. When one mortgage bond failed, the odds were that others would, too.

Moody’s estimated that this C.D.O. could potentially incur losses of 2 percent. It has since revised its estimate to 27 percent. The bonds it rated have been decimated, their market value having plunged by half or more. A triple-A layer of bonds has been downgraded 16 notches, all the way to B. Hundreds of C.D.O.’s have suffered similar fates (most of Wall Street’s losses have been on C.D.O.’s). For Moody’s and the other rating agencies, it has been an extraordinary rout.

…The agencies have blamed the large incidence of fraud, but then they could have demanded verification of the mortgage data or refused to rate securities where the data were not provided. That was, after all, their mandate. This is what they pledge for the future. Moody’s, S.&P. and Fitch say that they are tightening procedures — they will demand more data and more verification and will subject their analysts to more outside checks. None of this, however, will remove the conflict of interest in the issuer-pays model. Though some have proposed requiring that agencies with official recognition charge investors, rather than issuers, a more practical reform may be for the government to stop certifying agencies altogether. …

Written by infoproc

April 22, 2008 at 11:09 am

Credit crisis for pedestrians

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Here is a 40 minute discussion of the credit crisis on NPR’s Fresh Air. The “expert” is a law professor with a tenuous grasp of finance, a love of regulation and an axe to grind against Wall St. and former Senator Phil Gramm. Terri Gross, ordinarily an astute interviewer, can’t seem to get beyond concepts like big bets at a big casino by unregulated fat cats. 8-/

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April 4, 2008 at 2:07 pm

Privatizing gains, socializing losses

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Roger Lowenstein, author of When Genius Failed: the rise and fall of Long Term Capital Management, writes cogently about the credit crisis and government intervention in the Times Magazine.

I’d like to hear a believer in efficient markets try to tell the story of Bear Stearns’ demise. One week it was OK for them to be levered 30 to 1, the next week it wasn’t? When the stock was at 65 people were comfortable with their exposure to mortgages, but then suddenly they weren’t? Come on. When the stock was at 65, what was the implied probability of a total collapse, based on out of the money puts? Zero.

Markets are complex dynamical systems that undergo phase transitions. Even sophisticated institutional investors are mostly just following the herd. Prices can disconnect wildly from real value for long periods of time, until suddenly they jump, often overshooting in the other direction. Huge risks, which in hindsight are obvious, build up in plain view while escaping notice from all but a few Cassandras. Robert Rubin, the Chairman of Citigroup, former co-head of Goldman, former Treasury Secretary, doesn’t know what a SIV is until after the crisis has hit. Tens of trillions of dollars in off the books credit default swaps are traded (often recorded on scraps of paper!) before Wall St. CEOs, central bankers and regulators realize the instabilities involved.

More from James Surowiecki in the New Yorker. (I love this month’s cover 🙂

NYTimes: …Government interventions always bring disruptions, but when Washington meddles in financial markets, the potential for the sort of distortion that obscures proper incentives is especially large, due to our markets’ complexities. Even Robert Rubin, the Citigroup executive and former Treasury secretary, has admitted he had never heard of a type of contract responsible for major problems at Citi.

Bear is a far smaller company, and, it would seem, far simpler. But consider that as recently as three weeks ago, it was valued at $65 a share. Then, as it became clear that Bear faced the modern equivalent of a bank run, JPMorgan Chase negotiated a merger with the figure of $10 a share in mind. Alas, at the 11th hour, Morgan’s bankers realized they couldn’t get a handle on what Bear owned — or owed — and got cold feet. Under heavy pressure from the Fed and the Treasury, a deal was struck at the price of a subway ride — $2 a share.

It is safe to say that neither Jamie Dimon, Morgan’s chief executive, nor Ben Bernanke, the Fed chairman who pushed for the deal, know what Bear is really worth. For the record, Bear’s book value per share is $84. As Meredith Whitney, who follows Wall Street for Oppenheimer, remarked, “It’s hard to get a linear progression from 84 to 2.”

Capitalism isn’t supposed to work like this, and before the advent of modern finance, it usually didn’t. Market values fluctuate, but — in the absence of fraud — billion-dollar companies do not evaporate. Yet it’s worth noting that Lehman Brothers’ stock also fell by half and then recovered within a 24-hour span. Once, investors could get a read on financial firms’ assets and risks from their balance sheets; those days are history.

Firms now do much of their business off the balance sheet. The swashbuckling Bear Stearns was a party to $2.5 trillion — no typo — of a derivative instrument known as a credit default swap. Such swaps are off-the-books agreements with third parties to exchange sums of cash according to a motley assortment of other credit indicators. In truth, no outsider could understand what Bear (or Citi, or Lehman) was committed to. The thought that Bear’s counterparties (the firms on the other side of that $2.5 trillion) would call in their chits — and then cancel their trades with Lehman, perhaps with Merrill Lynch and so forth — sent Wall Street into panic mode. Had Bear collapsed, or so asserted a veteran employee, “it would have been the end: pandemonium and global meltdown.”

Perhaps. Or perhaps, after some bad weeks or months, Wall Street would have recovered. What is scary is the degree to which the Fed assimilated the alarmism on the Street: “These guys are so afraid of an economic cycle,” a hedge-fund manager remarked. And without public airing or debate, it stretched the implicit federal safety net under Wall Street.

To question intervention is not to dispute that markets need rules. But for nearly two decades, Washington has trimmed its regulatory sails. The repeal of Glass-Steagall, which once separated banks from securities firms, and the evolution of new instruments that circumvent disclosure rules have loosened the market’s moorings. Huge pools of capital have been permitted to operate virtually unregulated. Mortgages have been written to the flimsiest of credits. Swelling derivative books have made a mockery of disclosure.

The relaxation of oversight has implied an unholy bargain: let markets operate unfettered in good times, confident that the feds will come to the rescue in bad. In 1998, the Fed intervened to cushion the collapsing hedge fund Long-Term Capital Management; dot-com stocks immediately began their dubious ascent. Then, when the tech meltdown led to a recession and the Fed cut rates to 1 percent, adjustable-rate mortgages became as hot as the iPod. One rescue begets the next excess.

It is true that Bear’s shareholders have suffered steep losses. But the Fed went much further than in previous episodes to calm the waters. Notably, it announced it would accept mortgage securities as collateral for loans — enlarging its role as lender of last resort. (Wall Street jesters had it that the Fed would also be accepting “cereal box-tops.”) Then the Fed extended a backstop line of credit to JPMorgan to tide Bear over; finally, it agreed to absorb the ugliest $30 billion of Bear’s assets.

Written by infoproc

March 30, 2008 at 12:56 am

What Created This Monster?

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The mainstream media is finally starting to catch on to the nature of the current credit crisis. One of the key points is that very few of the top people — CEOs, central bankers, regulators — really understood what was going on. Some are even starting to admit it.

See this article in the Sunday Times, and dozens of posts on this blog over the last 3 years… Here’s a post from 2004 in which I noted that Fannie Mae CEO Franklin Raines didn’t seem to understand derivatives accounting.

NYTimes: …LIKE Noah building his ark as thunderheads gathered, Bill Gross has spent the last two years anticipating the flood that swamped Bear Stearns about 10 days ago. As manager of the world’s biggest bond fund and custodian of nearly a trillion dollars in assets, Mr. Gross amassed a cash hoard of $50 billion in case trading partners suddenly demanded payment from his firm, Pimco.

And every day for the last three weeks he has convened meetings in a war room in Pimco’s headquarters in Newport Beach, Calif., “to make sure the ark doesn’t have any leaks,” Mr. Gross said. “We come in every day at 3:30 a.m. and leave at 6 p.m. I’m not used to setting my alarm for 2:45 a.m., but these are extraordinary times.”

Even though Mr. Gross, 63, is a market veteran who has lived through the collapse of other banks and brokerage firms, the 1987 stock market crash, and the near meltdown of the Long-Term Capital Management hedge fund a decade ago, he says the current crisis feels different — in both size and significance.

The Federal Reserve not only taken has action unprecedented since the Great Depression — by lending money directly to major investment banks — but also has put taxpayers on the hook for billions of dollars in questionable trades these same bankers made when the good times were rolling.

“Bear Stearns has made it obvious that things have gone too far,” says Mr. Gross, who plans to use some of his cash to bargain-shop. “The investment community has morphed into something beyond banks and something beyond regulation. We call it the shadow banking system.”

It is the private trading of complex instruments that lurk in the financial shadows that worries regulators and Wall Street and that have created stresses in the broader economy. Economic downturns and panics have occurred before, of course. Few, however, have posed such a serious threat to the entire financial system that regulators have responded as if they were confronting a potential epidemic.

As Congress and Republican and Democratic presidential administrations pushed for financial deregulation over the last decade, the biggest banks and brokerage firms created a dizzying array of innovative products that experts now acknowledge are hard to understand and even harder to value.

On Wall Street, of course, what you don’t see can hurt you. In the past decade, there has been an explosion in complex derivative instruments, such as collateralized debt obligations and credit default swaps, which were intended primarily to transfer risk.

These products are virtually hidden from investors, analysts and regulators, even though they have emerged as one of Wall Street’s most outsized profit engines. They don’t trade openly on public exchanges, and financial services firms disclose few details about them.

…TWO months before he resigned as chief executive of Citigroup last year amid nearly $20 billion in write-downs, Charles O. Prince III sat down in Washington with Representative Barney Frank, the chairman of the House Financial Services Committee. Among the topics they discussed were investment vehicles that allowed Citigroup and other banks to keep billions of dollars in potential liabilities off of their balance sheets — and away from the scrutiny of investors and analysts.

“Why aren’t they on your balance sheet?” asked Mr. Frank, Democrat of Massachusetts. The congressman recalled that Mr. Prince said doing so would have put Citigroup at a disadvantage with Wall Street investment banks that were more loosely regulated and were allowed to take far greater risks. (A spokeswoman for Mr. Prince confirmed the conversation.)

It was at that moment, Mr. Frank says, that he first realized just how much freedom Wall Street firms had, and how lightly regulated they were in comparison with commercial banks, which have to answer to an alphabet soup of government agencies like the Federal Reserve and the comptroller of the currency.

…Wall Street firms rushed into the new frontier of lucrative financial products like derivatives. Students with doctorates in physics and other mathematical disciplines were hired directly out of graduate school to design them, and Wall Street firms increasingly made big bets on derivatives linked to mortgages and other products.

…ONE of the fastest-growing and most lucrative businesses on Wall Street in the past decade has been in derivatives — a sector that boomed after the near collapse of Long-Term Capital.

It is a stealth market that relies on trades conducted by phone between Wall Street dealer desks, away from open securities exchanges. How much changes hands or who holds what is ultimately unknown to analysts, investors and regulators.

Credit rating agencies, which banks paid to grade some of the new products, slapped high ratings on many of them, despite having only a loose familiarity with the quality of the assets behind these instruments.

Even the people running Wall Street firms didn’t really understand what they were buying and selling, says Byron Wien, a 40-year veteran of the stock market who is now the chief investment strategist of Pequot Capital, a hedge fund.

“These are ordinary folks who know a spreadsheet, but they are not steeped in the sophistication of these kind of models,” Mr. Wien says. “You put a lot of equations in front of them with little Greek letters on their sides, and they won’t know what they’re looking at.”

Mr. Blinder, the former Fed vice chairman, holds a doctorate in economics from M.I.T. but says he has only a “modest understanding” of complex derivatives. “I know the basic understanding of how they work,” he said, “but if you presented me with one and asked me to put a market value on it, I’d be guessing.”

…Timothy F. Geithner, a career civil servant who took over as president of the New York Fed in 2003, was trying to solve a variety of global crises while at the Treasury Department. As a Fed president, he tried to get a handle on hedge fund activities and the use of leverage on Wall Street, and he zeroed in on the credit derivatives market.

Mr. Geithner brought together leaders of Wall Street firms in a series of meetings in 2005 and 2006 to discuss credit derivatives, and he pushed many of them to clear and settle derivatives trading electronically, hoping to eliminate a large paper backlog that had clogged the system.

Even so, Mr. Geithner had one hand tied behind his back. While the Fed regulated large commercial banks like Citigroup and JPMorgan, it had no oversight on activities of the investment banks, hedge funds and other participants in the burgeoning derivatives market. And the industry and sympathetic politicians in Washington fought attempts to regulate the products, arguing that it would force the lucrative business overseas.

“Tim has been learning on the job, and he has my sympathy,” said Christopher Whalen, a managing partner of Institutional Risk Analytics, a risk management firm in Torrance, Calif. “But I don’t think he’s enough of a real practitioner to go mano-a-mano with these bankers.”

…In the meantime, analysts say, a broader reconsideration of derivatives and the shadow banking system is also in order. “Not all innovation is good,” says Mr. Whalen of Institutional Risk Analytics. “If it is too complicated for most of us to understand in 10 to 15 minutes, then we probably shouldn’t be doing it.”

Written by infoproc

March 23, 2008 at 9:34 pm