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Mortgage finance in pictures

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

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October 5, 2008 at 6:25 pm

Ask the expert

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Several panicked multimillionaires and financiers asked me recently if they should liquidate all their investments and go to cash.

My answer? “Beats me” :-/

Standard questions:

1) are you going to be able to time the bottom? what’s your investment timescale?

2) what kind of cash? Treasuries? Swiss Francs? Renminbi?

Generally I’m not a big believer in timing the market. On the other hand, I can think of numerous plausible scenarios for the next couple of years in which (some kind of) cash is by far the best asset. I can’t think of very many in which it’s not 😦

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September 23, 2008 at 4:27 am

The professor called the shot

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It has been clear for a while that, unless the home price bubble were to miraculously stabilize in mid collapse, the US government itself would have to socialize the entire problem in order to solve it.

It looks like Ben Bernanke (AB Harvard, PhD MIT, Professor at Princeton) made the call. Paulson is no slouch (AB Dartmouth, MBA Harvard, CEO and Chairman of Goldman Sachs), but when the biggest financial decision of our generation was made, the geeky PhD told the Harvard MBA what to do.

NYTimes: The ad hoc approach Mr. Bernanke and Mr. Paulson had been trying was no longer enough.

Talking into the speaker phone on a coffee table in his office, Mr. Bernanke told Mr. Paulson that it was time to stop treating the symptoms by bailing out distressed companies and instead start attacking the root problem with a comprehensive strategy.

Congress would have to sign off, and it would fall to Mr. Paulson, as the envoy of the executive branch, to take the lead.

Mr. Paulson understood.

…“Going back a long time, maybe a year ago, Ben, as a world-class economist, said to me, when you look at the housing bubble and the correction, if the price decline was significant enough,” the only solution might be a large-scale government intervention, Mr. Paulson said. “He talked about what had happened when there had been other situations historically. And basically he said in his view the time might ultimately come when something like this was necessary.

Mr. Paulson said he agreed but hoped it would not come to that. “I knew he was right theoretically,” he said. “But I also had, and we both did, some hope that, with all the liquidity out there from investors, that after a certain decline that we would reach a bottom.”

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September 20, 2008 at 7:10 pm

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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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!

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September 18, 2008 at 5:22 pm


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Here is a NYTimes graphic illustrating the decrease in market capitalization of financial firms. In 2007 they were 20% of the total stock market capitalization of $20 trillion dollars. By today they comprise about 17% of a $15 trillion market. (In other words, financials as a group are down about 15% relative to the market as a whole.) If you mouse over a particular company (on the Times flash version, not here) you can see how much its shares have lost over the last year.

This brings to mind a conversation I had a couple of years ago with hedge fund manager David Kane on whether “financial games” necessarily lead to more efficient allocation of economic assets in our society. I think everybody agrees now that we had (and still have — 20% to go!) a massive housing bubble in which assets were overallocated to investment in homes. The use of leverage to make these investments is what has led to the destruction of so many major financial firms. Interestingly, many people predicted a few years ago that hedge funds would be a source of systemic risk, but so far in this crisis they haven’t played a big role. Perhaps that is yet to come.

On the benevolence of financiers (December 2006)

Money talks (January 2007)

David, if you are still reading this blog, I would love to hear your thoughts on current market events! [David’s comments are here — well worth reading.]

Deep thinker John McCain was very quick to throw Wall St. and the financiers under the bus in his remarks yesterday.

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September 17, 2008 at 3:48 pm

Orders of magnitude and timescales

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As a physicist I can’t help making some comments about orders of magnitude and timescales 🙂

If home prices return to normal (historical) levels, total mortgage debt losses will be about $1 trillion. This is a staggering sum, but won’t destroy our economy. After all, our misadventure in Iraq will end up costing us about the same amount. [Insert anti-Bush diatribe here.] If necessary, we could socialize the whole loss like we’ve done with Iraq — put it on the nation’s and taxpayers’ balance sheet.

The problem is that the credit bubble losses are concentrated in financial firms, which are getting hit with a huge shock as their portfolios approach the day of mark to market reckoning. This shock is going to have to be worked through the system over a relatively short timescale if we are to avoid systemic paralysis, or worse. Once a particular entity becomes insolvent, the entire web of counterparty transactions between it and the rest of Wall St. is in jeopardy.

Dealing with that relational web is the real challenge — can we recognize the losses without impairing the functioning of our financial and banking system?

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September 16, 2008 at 2:56 am