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Buffet on the credit crisis

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Charlie Rose interview

Skeptics will claim he is talking his own book, with the recent GS and GE investments. But I agree with most of it. Buffet says that if he could take a 1 percent stake in the bailout (investing $7 billion), he would. He thinks the bailout will make money investing in distressed mortgage securities at current market prices.

“I love to buy distressed assets… I just don’t have $700B to do it with.” (At about 13-14 minutes into the hour long interview.)

Bubble logic: “Innovators, Imitators and then the Idiots” (20 minutes)

“Confidence in markets and institutions is like oxygen… when you have it you don’t think about it… but you can’t go 5 minutes without it.” (24 minutes)

“Beware of geeks bearing formulas!” (takes a shot at quants at 27 minutes)

Upper income people should pay more taxes (basically endorses Obama’s tax plan) (42 minutes)

“It is terrible that income from investments (capital gains) should be taxed less than income from labor.” (against regressive taxes) (44 minutes)

“If AIG had to unwind their derivatives book, it would have hit every institution in the world.” (50 minutes)

“The Fed structured the AIG deal very well. They are very likely to get their money back or more.” (51 minutes)

Written by infoproc

October 3, 2008 at 2:33 am

Simple question, complex answer

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A former physicist (but non-financier) writes:

I have a question, and who better to ask than you. …something isn’t adding up.

I keep hearing that mortgage defaults are what is bringing down many financial institutions, and the the default rate in some particularly bad mortgage pools is up to 50%. Because housing prices are down about 20%, financial institutions can still regain 80% of the value of those loans, no? Actually the real value is probably a bit better, as most loans will be partially paid off. At any rate, doesn’t this imply that even in the worst loan pools, there is only a total 10% loss. And most financial institutions will have some higher quality loan pools also, and stocks, etc. So the total effect is going to be smaller than 10%, unless financial institutions were all constructing some sort of horrible options based high risk bets on housing prices, but I doubt this would happen except in some risky hedge funds.

Is this reasoning correct? If so, I don’t understand how our system can be so fragile that a few percent drop would bring everyone down. Of course everyone holding a share of these funds will have a small portfolio dip, but this happens every few years anyway.

Your calculations are reasonably correct (see comments for more detail). So why the crisis?

1) Leverage. Many I-banks had 30:1 ratios, so a small movement in value of a subcomponent of their portfolio could wipe them out. It’s like a guy who puts 10% down on his house, who can lose everything if the price goes down by 10%. Of course this only matters if he is forced to sell, or, in the bank case, if shareholders and counterparties start losing confidence. This is happening simultaneously in financial markets due to the second factor…

2) Complexity. No one knows who is holding what, who has sold insurance (credit default swaps) to other parties and is on the hook, etc. So trust is gone and credit markets are paralyzed — no muni bond issuance, no short term loans to businesses, no car loans, etc.

The efficient functioning of our economy is built on trust — I have to trust that the grocer will give me food in exchange for a dollar bill, that I can get my money out of the bank, that my employer will pay me at the end of the month, that its customers will pay it, etc.

We are nearing a dangerous point. Confidence, once destroyed, is very hard to rebuild.

Relative to the size of our economy, the amount of money involved is not that great. If we had perfect information we could solve the whole problem with about $1 trillion. (About the cost of the Iraq war; not bad for a bubble that involved housing — our most valuable asset.)

Written by infoproc

October 2, 2008 at 4:18 pm

Meltdown links

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1) Leonard Lopate interview with Economist editor Greg Ip, formerly of the WSJ. (Scroll down the page to Financial Crisis: What Happens Next?). This is the best 12 minute summary of the current situation I have yet heard. Ip is consistently good at explaining this complicated subject in an accessible manner. If you have a friend who is confused about the credit crisis, have them listen to this interview. (Avoid Terri Gross and pals on this one… 😉

I have been listening to Leonard Lopate’s show for some time and I can tell his grasp of finance has increased dramatically in the last year or so (his strength is interviewing artists, writers, etc.). It’s yet another example of high-g at work. He knew almost nothing a year ago but now asks occasional perceptive questions. (But of course it doesn’t matter how smart our next President is!)

2) Mark Thoma discusses the pros and cons of mark to market accounting. To me it’s rather obvious that M2M accounting is exacerbating this crisis. It has introduced a very significant nonlinearity, both on the upside (bubble), and now in the collapse. If the market for mortgage assets has failed it is crazy to use it as a barometer for value. More discussion at WSJ.

3) This NYTimes Op-Ed written by a former theoretical physicist discusses agent-based simulation, behavioral economics and phase transitions — yes, in an Op-Ed! (Thanks again to reader STS for the pointer.)

Written by infoproc

October 1, 2008 at 7:43 pm

Why no bailout?

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Representatives in Congress received thousands of phone calls and emails from constituents against the bailout, which some wags have characterized as “no banker left behind” 🙂

We can trace this popular reaction against CEOs and Wall St. to growing income and wealth inequality. Ordinary people no longer feel they have a stake in the system. Their reaction may be irrational (even the poorest American has a big stake in the continued functioning of the economy), but it was certainly predictable.

Next spring, unlike last year, less than half of the Harvard graduating class will take jobs in finance. I guess that signals a top in the market 8-/

Related posts:

financier pay

all about the benjamins

a reallocation of human capital

a new class war

non-residential net worth

working class millionaires

Written by infoproc

September 30, 2008 at 2:48 pm

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?

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

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