Who Would Bail Out Switzerland’s Banks?

Posted on November 11, 2008 by Felix

Richard Baldwin of VoxEU gives us a sneak preview of a new article by Jon Danielsson:

In this crisis, the strength of a bank’s balance sheet is of little consequence. What matters is the explicit or implicit guarantee provided by the state to the banks to back up their assets and provide liquidity. Therefore, the size of the state relative to the size of the banks becomes the crucial factor. If the banks become too big to save, their failure becomes a self-fulfilling prophecy.

This seems right to me. And also very scary, because of one country: Switzerland.

UBS has a $2 trillion balance sheet; Credit Suisse has another trillion on top of that. Call it $3 trillion between the two of them, which is about ten times Switzerland’s GDP of $300 billion or so. Now that’s what I call too big to save. Oh, and did I mention? At the end of 2007, Credit Suisse was levered by more than 40 times; UBS was levered by more than 64 times. A 16% fall in UBS’s assets would wipe out not only all of its equity but 100% of Swiss GDP on top.

This could be the first make-or-break economic issue to face Barack Obama: if it came to it, would Treasury bail out UBS? I’m sure it would try to get European governments to pitch in too, and the Swiss, of course, to the extent that they can. But I’m sure I’m not the only person praying that UBS never comes close enough to the edge that we have to find out.

Posted in bailouts, banking | Comments Off on Who Would Bail Out Switzerland’s Banks?

Contrarian Investing

Posted on November 11, 2008 by Felix

Baruch has a corker of a post over at Ultimi Barbarorum on hedge funds, and why it is that they’ve unravelled so spectacularly this year despite largely escaping the bursting of the dot-com bubble unscathed. Go read the whole thing, but here’s a tiny taster:

The hedgies are hanging onto the winners of the Great Moderation, and instead of selling them when they go wrong, their first impulse is to defend, manipulate, and hang on.

Baruch also talks about how difficult it is to go short a stock or asset class which everybody else is long:

This is harder than you think. It means going against everything everyone in Wall Street tells you to do… It is lonely being short QCOM with no friendly sell siders to hold your hand and tell you it will be OK in the end.

I was reminded of Michael Lewis’s article in the last issue of Portfolio magazine, which spends a lot of time on a fund manager named Steve Eisman who was similarly bearish among a crowd of bulls:

There’s a long list of people who now say they saw it coming all along but a far shorter one of people who actually did. Of those, even fewer had the nerve to bet on their vision. It’s not easy to stand apart from mass hysteria–to believe that most of what’s in the financial news is wrong or distorted, to believe that most important financial people are either lying or deluded–without actually being insane…

Zelman alienated clients with her pessimism, but she couldn’t pretend everything was good. “It wasn’t that hard in hindsight to see it,” she says. “It was very hard to know when it would stop.” Zelman spoke occasionally with Eisman and always left these conversations feeling better about her views and worse about the world. “You needed the occasional assurance that you weren’t nuts,” she says…

There was only one thing that bothered Eisman, and it continued to trouble him as late as May 2007. “The thing we couldn’t figure out is: It’s so obvious. Why hasn’t everyone else figured out that the machine is done?” Eisman had long subscribed to Grant’s Interest Rate Observer, a newsletter famous in Wall Street circles and obscure outside them. Jim Grant, its editor, had been prophesying doom ever since the great debt cycle began, in the mid-1980s. In late 2006, he decided to investigate these things called C.D.O.’s. Or rather, he had asked his young assistant, Dan Gertner, a chemical engineer with an M.B.A., to see if he could understand them. Gertner went off with the documents that purported to explain C.D.O.’s to potential investors and for several days sweated and groaned and heaved and suffered. “Then he came back,” says Grant, “and said, ‘I can’t figure this thing out.’ And I said, ‘I think we have our story.’ßø”

Eisman read Grant’s piece as independent confirmation of what he knew in his bones about the C.D.O.’s he had shorted. “When I read it, I thought, Oh my God. This is like owning a gold mine. When I read that, I was the only guy in the equity world who almost had an orgasm.”

The thing to note is that for all Eisman’s self-confidence and ability to make his own decisions, he’s still human: he surrounded himself with like-minded professionals at his hedge fund, and would hugely value confirmations and affirmations of his investment thesis from the likes of Zelman and Grant.

Eisman would also badger the bulls, asking them question after obnoxious question. He obviously wasn’t trying to persuade them that he was right and they were wrong — but he was trying to persuade himself. So long as other smart people couldn’t give him simple answers to simple questions, he reckoned, he was much more likely to be on to something.

This is the human element of investing. It’s always easier to be long than to be short; it’s always easier to do what everybody else is doing than to do the opposite. Certainly all responsible investment advice says pretty much the same thing to pretty much all people: buy index funds, rebalance occasionally, don’t trade, don’t try to time the market (beyond rebalancing), over the long term stocks will outperform. Is that, now, a crowded trade? The only reason that so many people are doing it is that it has generally worked in the past. But as we’re reminded daily, everything works until it doesn’t.

Posted in hedge funds, investing | Comments Off on Contrarian Investing

The Underwhelming Frannie Loan-Mod Plan

Posted on November 11, 2008 by Felix

The Frannie loan-mod plan has arrived, and it’s not particularly exciting. Among the more obvious problems:

  • It applies only to mortgages owned by Frannie, which means, by definition, that it doesn’t include subprime mortgages. FHFA is trying to apply moral suasion — but no cash — to persuade other mortgage holders to adopt the same plan. Good luck with that.
  • It doesn’t even begin to address the problem of mortgages which have been securitized, rather than being held by a single bank.
  • It’s based on the idea that servicers "have dedicated personnel who are experienced in working with borrowers

    who are struggling with finances, but who are eager to keep their homes". Not nearly enough of them they don’t.

  • It requires borrowers to be 90 days delinquent — and therefore gives many borrowers with mortgages over 38% of their gross monthly income a massive incentive to cease making any mortgage payments now.
  • The onus is on the borrower to initiate proceedings, providing a package including "monthly gross

    household income, association dues and fees, and a hardship statement". For $800 per mod, servicers aren’t going to be proactive about helping get this kind of thing done, especially given how overworked they are already.

In a quite extraordinary turn of events, FHFA director James Lockhart said in his statement that "we have drawn on the FDIC’s experience and

assistance, and have greatly benefited from the FDIC’s input", yet the FDIC’s Sheila Bair then turned around and released her own statement, saying that the plan "falls short of what is needed to achieve widescale modifications of distressed mortgages".

Clearly this is not going to be the last word when it comes to government attempts to help stabilize the housing market. It’s probably going to be the last word until January 20, though; after that, Bair might find Treasury and the White House more amenable to her ideas.

Posted in housing | Comments Off on The Underwhelming Frannie Loan-Mod Plan

Sheldon Adelson’s Surprising Capital Raise

Posted on November 11, 2008 by Felix

Never count Sheldon Adelson out. I don’t know how many other people could manage to raise $1.62 billion in a public stock offering after their company’s shares had fallen 94%. Yes, it helps that Adelson’s putting in another $1 billion of his own money, between the $475 million he announced at the end of September and the extra $525 million he’s putting in today.

But still: well done, in this market, and well done too to Goldman Sachs, which is the sole managing underwriter and bookrunner of the offering. Assuming, that is, that Goldman genuinely sold all those shares, and isn’t just sitting on them in the hope that they’ll be able to sell them at some point in the future.

Posted in stocks | Comments Off on Sheldon Adelson’s Surprising Capital Raise

Why Buying Default Protection Isn’t Naked Shorting

Posted on November 11, 2008 by Felix

Commenter "cds_till_i_die" asks:

Can you explain to me the conceptual differences(if there are any) between buying CDS protection on a bond you don’t own and naked short selling…I think I get it but some clarification would be useful.

Happy to oblige. There are two big conceptual differences between buying CDS protection and naked shorting, beyond the simple fact that the former is common and legal, while the latter is uncommon and illegal.

Firstly, the fact that naked shorting is even possible in the first place is due only to the way that settlement conventions work. When you sell shares in the stock market, you don’t deliver those shares immediately, but often only after three days. So an unscrupulous trader can enter into a deal to sell shares without even having the shares to sell; he then has three days to either close out the position or find a borrow.

If naked shorting were legal, it would be possible for traders to overwhelm the market with sell orders, and just keep on selling unlimited amounts of stock until all buyers were exhausted and the stock plunged — until, of course, the mother of all short-covering rallies began, with the short-sellers trying to buy back more stock than actually existed. Basically, naked shorting is a very bad idea and no one thinks it should be legal. It’s equal and opposite to something equally illegal: going out and buying stocks even though you have no money, hoping to sell them quickly at a profit before you have to come up with any cash.

In the CDS market, there’s no such shenanigans. There’s no taking advantage of settlement conventions: instead, you’re just agreeing to a swap, where one person will make a regular stream of payments to the other, in return for getting a highly irregular single payment in the future, should a certain reference entity default.

Now selling default protection, like buying a bond, is a way of taking on credit risk. Similarly, buying default protection, like selling a bond, is a way of reducing credit risk. So in that sense, buying CDS protection on a bond you don’t own is a bit like shorting a bond. Not naked-shorting, mind, just regular, common-or-garden shorting, where you borrow the bond from someone who has no intention of selling it, and then you sell it in the market. Once you’ve sold the bond, you can invest the proceeds in something that you think is going to go up; meanwhile, you hope that the price of the bond is going to go down, so that when you buy it back you make a profit on both legs of the transaction.

But in fact buying a CDS is more benign than shorting a bond. When you short, you’re borrowing from someone who might be long, but isn’t actively buying. But then you sell into what might be quite an illiquid market — which can in and of itself drive down the market price of the bond. In the CDS market, by contrast, when you buy protection you’re buying from someone who is actively selling credit protection, and the cash market might not be affected at all.

In that sense, buying default protection isn’t like shorting a bond: instead, it’s much closer to buying a put option on that bond. It’s a zero-sum derivatives transaction, and in the vast majority of such transactions, cash-market prices are unaffected. Just look at the volume of puts and calls being traded on individual stocks every day: that options market very rarely affects the underlying stock market.

Now the corporate-bond market, being more illiquid than the stock market, is easier to move, and a bit of delta-hedging by the sellers of default protection might be all that’s needed to move it. But still, buying default protection is a pretty roundabout way of trying to move a market, and is in fact the choice you would make if you wanted to protect yourself from downside while running as little risk as possible of driving the market down by doing so.

Buying CDS, then, is much closer to buying puts than it is to shorting, and it’s much closer to shorting than it is to naked shorting: it’s at least two steps removed from the kind of manipulative and illegal activity that naked-shorting bans were devised to prevent. It is a fundamentally bearish thing to do, and any bearish market activity has the ability to move markets down. But in the demonology of bears, CDS buyers don’t belong anywhere near naked shorters.

Posted in derivatives | Comments Off on Why Buying Default Protection Isn’t Naked Shorting

Mortgage Repayment Datapoint of the Day

Posted on November 11, 2008 by Felix

As we await Frannie’s latest mortgage-mod plan, David Streitfeld has news of the dire mortgage situation in Mountain House, California — a new town where all the houses were bought since 2003 and as a result 90% are now underwater.

The Martinezes bought their house in early 2005 for $630,000. It is now worth about $420,000. They have an interest-only mortgage, a popular loan during the boom that allows owners to forgo principal payments for a time.

But these loans eventually become unmanageable. In 2015, Mr. Martinez said, his monthly payments will be $12,000 a month. He laughed and shook his head at the absurdity of it.

That’s beyond absurd — in fact, I don’t even see how it’s possible. If the Martinezes are just paying their interest payments every month and don’t have a negative-amortization mortgage, then the total amount they owe won’t rise above $630,000, even assuming they took out a 100% mortgage. Paying $12,000 a month on a $630,000 debt is the kind of interest rate normally associated with credit cards, not mortgages: there’s something very funny going on here.

Even if they do have a neg-am mortgage, such loans don’t allow you to capitalize interest payments for a full decade. So if somebody can show me a mortgage product which would result in a $12,000 monthly payment on a $630,000 loan, I’d be very interested to see how it was structured. And to see who on earth would sell such a thing.

Still, there are moments of comedy even in articles such as this:

Kenny Rogers, a data security specialist, moved into Mountain House last year, buying a foreclosed property on Prosperity Street for $380,000. But the decline in values has been so fierce that he too is underwater.

He has cut his DVD buying from 50 a month to perhaps one, and is waiting until the Christmas sales to buy a high-definition television.

Waiting until the Christmas sales to buy a high-definition television — now there’s hardship for you.

Update: BirdDog, in the comments, says he can get there with a 10/20 interest-only mortgage at 8%. I can’t. Putting a $630,000 principal amount at 8% into my mortgage calculator generates monthly interest payments of $4,200. Then, after ten years, you pay down the principal in 120 equal monthly installments of $5,250. Add a $4,200 interest payment onto that, and you still only get to $9,450.

Posted in housing | Comments Off on Mortgage Repayment Datapoint of the Day

ProPublica’s Goldman Sachs Hatchet Job

Posted on November 11, 2008 by Felix

ProPublica is a non-profit investigative-journalism shop founded by Paul Steiger, the former managing editor of The Wall Street Journal. So you’d expect that when it moves into the world of finance, during a credit crisis which has thrown up its fair share of scandals, it would produce something really good.

Instead, it’s produced something really bad: a non-story about Goldman’s sell-side research on munis, larded generously with ridiculous overreach and, naturally, a generous pinch of CDS demonization. Today, the story leads in the LA Times.

The only really investigative bit of the story is that ProPublica’s Sharona Coutts has managed to get her hands on some sell-side research. Unfortunately, instead of simply phoning up Goldman’s press office and asking for it, she clearly got it through other channels — and as a result, her copy of the research has a "Proprietary and Confidential" stamp on it. Which is obviously all she and Steiger needed to conclude that there was scandal afoot.

The research in question recommended that Goldman’s buy-side clients buy credit protection on California’s bonds. As the article details, Goldman is in the process of trying to build up the municipal CDS market, and so it’s putting out research on it. I’m sure no one at Goldman thought for a minute that whenever that research suggested buying protection rather than selling it, they were risking a major exposé.

But Coutts has worked out the chain of causality: let’s assume that Goldman’s clients acted on its research. Then the price of credit protection on California might go up, and that could get people worried about California’s credit, and that in turn could show up in higher prices for new bond issues. Therefore, "the Wall Street titan’s activities could have harmed taxpayers".

Of course, the Wall Street titan’s activities could have helped taxpayers, too: by creating a liquid market in muni default swaps, investors could rest reassured that they would always be able to insure their bond holdings against default, even if the monolines all went bust. As a result, they might, at the margin, be less likely to avoid the muni market altogether.

The article, naturally, never goes there. Instead, we get this:

Some experts said the investment bank’s actions, while not illegal, might be inappropriate. "That’s not a good way to do business," said Geoffrey M. Heal, professor of public policy and business responsibility at Columbia University. "They’ve got a conflict of interest and they’re acting against the interest of their customers. . . . You act in the interests of your clients. You don’t screw them, to put it bluntly."

This is just silly. Banks are intermediaries: investors are just as much their clients as issuers are. Issuers want their banks to have this kind of conflict of interest, because it means those banks have good relationships with the investors who buy their bonds. It’s true that Goldman shouldn’t actively screw California, but I don’t think that putting out a CDS research product goes nearly that far.

Oh, and did I mention? The research hardly singled out California for shorting. Instead, California was just part of a much more general trade putting on a globally-bearish macro view:

The firm advised "shorting" — that is, betting on a price decline — in markets for corporate junk bonds, European banks, the euro and British pound currencies, and U.S. municipal bonds.

This constitutes "proposing a way for investment clients to profit from California’s deepening financial misery"? Come on. Investors want to buy in good markets and sell in bad markets. There’s no scandal there.

But of course, whenever CDS is involved, there must be scandal:

The swaps could be beneficial to the market, encouraging risk-averse investors to buy more municipal bonds. But like derivative securities in general, they can be dangerous to hold. That’s because they are often highly leveraged. A small investment can buy coverage on bonds worth much more. If defaults rise to unexpected levels, the swap sellers could be hard-pressed to make good on their promises.

The perils of the credit default swap market were brought home this year, when they were instrumental in the collapse of Lehman Bros. Holdings, American International Group and Bear Stearns. Lehman and AIG were rumored to owe far more than they could pay on swaps they had sold.

The more you look at this, the less it makes sense. "A small investment can buy coverage on bonds worth much more"? Um yes, that’s how insurance works. If you had to pay the full value of your house to insure your house, I doubt there would be many takers. As for the brief lesson in counterparty risk, it would be more convincing if Coutts didn’t go on to imply that Lehman Brothers was, like AIG, a net seller of protection: that’s simply not true.

And coming after 18 months of unprecedented upheavals in the financial markets, where thousands of previously-inconceivable events ended up happening, this is just plain funny:

What some traders found perplexing about the push for a market in municipal credit default swaps was that muni defaults almost never happen.

But when it comes to baseless speculation, it’s hard to compete with this:

The company may have hoped to parlay the swaps market into more activity in municipal bond trading, which is traditionally light because muni investors tend to hold the bonds to maturity.

Theoretically, the swaps index could lure speculators into the muni market, a development that would create much more fluctuation in daily prices, which in turn would generate revenue for trading desks at Goldman and other investment firms.

No one’s cited as source for this garbage: it seems to have come straight out of the feverish imaginations of the writers. It’s hard to know where to start — the bit about luring speculators into the muni market, for all the world as though Goldman’s some kind of Pied Piper and buy-side investors are guileless children; the very idea of the muni market as being a potential arena for speculative activity; the idea that such activity is bound to be profitable for the desks taking the other side of the trade — all of it tends to fall apart on a moment’s reflection.

Everything Goldman does in this article comes tinged with ulterior motives:

Goldman had "regularly urged" California to trade in the municipal swaps itself, ostensibly to hedge the state’s risks as a bond issuer.

Ostensibly? If California bought default protection on munis, that would quite genuinely protect the state against a rise in municipal borrowing costs. Municipal issuers regularly buy bond insurance from monolines when they issue; there’s no reason in principle why they shouldn’t save money by buying insurance in the CDS market before they issue, especially when many the monolines have disappeared from the market.

Naturally, the article ends with talk of Californian cutbacks in education and social services, linked by the most tenuous of speculative threads to that single Goldman Sachs research report. This isn’t responsible impartial journalism, it’s a gratuitous hatchet-job. And I’m frankly shocked that Steiger’s ProPublica would go there.

Update: Dick Tofel of ProPublica says in the comments that readers of this blog "should be aware of" two quotes from the story which I didn’t quote. Here they are:

"The giant investment firm did not inform the office of California Treasurer Bill Lockyer that it was proposing a way for investment clients to profit from California’s deepening financial misery. In Sacramento, officials said they were concerned that Goldman’s strategy could raise the interest rate the state would have to pay to borrow money, thus harming taxpayers.

"’It could exaggerate people’s worries about our credit,’ said Paul Rosenstiel, head of the public finance division of the treasurer’s office."

"Goldman ‘as a firm’ [is] no longer giving the trading advice to clients, [Goldman said]."

No one likes being the subject of investment-bank research which puts any kind of sell rating on a credit or stock, and California’s treasurer is no exception. But Goldman should be allowed to put out its research without fear or favor, and had no obligation to inform California in advance.

As for Goldman no longer giving the trading advice to clients, I’m pretty sure that’s a function of cutbacks in Goldman’s research department: those analysts, like Bill Tanona, no longer work at the firm. If Tofel wants to imply that they got fired because putting out this research was in any way unethical, he should come out and say so.

Posted in banking, journalism | 8 Comments

Even Harvard’s Feeling the Pinch

Posted on November 11, 2008 by Felix

Harvard president Drew Faust is worried about the university’s endowment:

As a result of strong returns and the generosity of our alumni and friends, endowment income has come to fund more than a third of the University’s annual operating budget. Our investments have often outperformed familiar market indexes, thanks to skillful management and broad diversification across asset classes. But given the breadth and the depth of the present downturn, even well-diversified portfolios are experiencing major losses. Moody’s, a leading financial research and ratings service, recently projected a 30 percent decline in the value of college and university endowments in the current fiscal year. While we can hope that markets will improve, we need to be prepared to absorb unprecedented endowment losses and plan for a period of greater financial constraint.

Isn’t the whole point of an endowment that it goes up so much in good times that it can see you through lean times? In a worst-case scenario Harvard will still have a substantial eleven-figure endowment to its name, whose annual changes in value, both up and down, are significantly larger than the university’s funding needs through the rest of this recession. The Harvard endowment has been a first-rate investor; it would be sad indeed not to take advantage of that fact when times are tough.

But the wealth effect works two ways: a first-order "I’m wealthy, I can spend money", and a second-order "I’ve made money, I can now spend it". Faust is clearly being hit by second-order effects: since the endowment probably hasn’t made money this year, she feels shy about spending as much of it as she has in the past. If I were Jack Meyer, who made the endowment so large that she never needed to worry about such things, I’m not sure how I’d be feeling right now, on reading her speech.

On the other hand, it’s entirely possible that Faust is using endowment losses as an excuse for making cuts she’s been wanting to make for a while but found politically difficult to announce, much as governments take advantage of crises to push through necessary-but-unpopular legislation.

I’m also interested in why Faust is going off of some Moody’s report on college endowments generally, rather than the performance of the Harvard endowment in particular. Is she incapable of picking up the phone and seeing how it’s doing? Is there any good reason why she should keep that information confidential? The endowment does release its returns on a regular basis; there might be some reason why its managers don’t want her to jump the gun at all, but I can’t off the top of my head think of a good one.

Posted in education | Comments Off on Even Harvard’s Feeling the Pinch

Extra Credit, Monday Edition

Posted on November 11, 2008 by Felix

The End: Michael Lewis on the death of Wall Street.

The Hedge Fund Collapse: Jesse Eisinger on the death of the hedge funds.

R.I.P. Franklin Bank: Lew Ranieri faces up to the death of his most recent creation.

Posted in remainders | Comments Off on Extra Credit, Monday Edition

New Yorker Blind Item Watch

Posted on November 10, 2008 by Felix

Nick Paumgarten attended an election-night party with various hedgies:

One hedge-fund trader, a Democrat, said that he’d recently reread (several times) John Kenneth Galbraith’s classic history “The Great Crash, 1929.” He quoted two passages from memory: “The singular feature of the Great Crash of 1929 was that the worst continued to worsen”; and “The autumn of 1929 was, perhaps, the first occasion when men succeeded on a large scale in swindling themselves.” He reckoned that the autumn of 2008 was the second. His boss, looking on, seemed irritated by this display, until it became clear that he was preoccupied by the news that another man at the party had made an investor five billion dollars that year–five yards, in the vulgate. The presence of superior performance stung him.

So, there’s a hedge fund manager who made an investor $5 billion this year. The question then becomes: which fund manager, and which investor?

I suspect that the answer here is John Paulson, who started the year with $28 billion and is up to $35 billion at this point. Which means his investors, plural, have made $5 billion, assuming zero inflows — but no single investor has made that much.

But it does raise the question: what’s the largest amount of money that any one investor (not principal) has ever made from a single hedge-fund investment? My best guess is one of Julian Robertson’s investments in his tiger cubs, but any concrete datapoints would be welcome.

Posted in hedge funds | Comments Off on New Yorker Blind Item Watch

Where are the TIPS Strips?

Posted on November 10, 2008 by Felix

Let’s say you’re a risk-averse investor with a nest egg you want to save for retirement. You’re not greedy; you’d rather take absolute safety over an extra point or two in annual returns. You could just keep your money in cash, but then you run the risk that it will be eroded by inflation: while that might not be a huge worry right now, your time horizon is decades long. And so you look to TIPS instead.

The problem with TIPS is the interest payments: if inflation is high, your coupon will be high as well, but it comes to you in rapidly-depreciating cash. Buying the TIP ETF, as Dave Neubert recommends, has the same problem: it, too, dividends out the coupon, leaving it to the investor to try to reinvest that coupon as best he can. The real yield on TIPS might be great right now (about 3%), but it probably won’t be that high when you try to reinvest your coupons.

Fortunately, there’s a solution. TIPS are strippable, which means that you can buy a 20-year zero-coupon TIPS — just the final payment, with none of the coupons along the way. It’s a risk-free way of getting a guaranteed real return over as many years as you like, and since you can pick which principal or coupon payment you want to buy, you can orchestrate things so that your bond matures on pretty much the very day you want: just when, say, you’re set to retire.

One would imagine, then, that TIPS strips would be very popular investments right now. And one would be wrong. In fact, TIPS strips are so unpopular that one broker told me he suspected they don’t actually exist. While TIPS are indeed strippable, the strips don’t seem to be traded in any kind of a liquid market, and finding them in the wild is decidedly non-trivial.

I’ve spent a bit of time googling things like "tips strips cusip" without a lot of luck, so maybe my readers can help me out. How easy or difficult is it for an individual investor to buy TIPS strips? What’s the bid-offer spread on such things? And why aren’t they more popular?

Update: pwm76, in the comments, did some serious looking and came up empty-handed:

I asked several major brokers to look for stripped principal TIPS for me, and for large lots. No luck. I doubt they exist (at a good price, that is).

Odd.

Posted in bonds and loans | Comments Off on Where are the TIPS Strips?

Goldman Sachs: Back in the Crosshairs

Posted on November 10, 2008 by Felix

What is going on over at Goldman Sachs, whose shares are down 10% or so today at $70 apiece? John Carney says that the market fears Goldman might be lining up yet another secondary equity offering — after raising $10 billion in September.

That would explain the share price falling on a day when the news of AIG’s second bailout would seem to be supportive for Goldman — after all, Goldman is by all accounts AIG’s biggest CDS counterparty, which means it’s probably holding a good number of those CDOs which AIG wants to buy at an inflated 50 cents on the dollar. On the other hand, maybe the markets are worried that Goldman will have much less money to play with if it loses all the collateral that it’s forced AIG to put up.

More generally, it seems to me that Goldman is pretty much impossible to value. The bulk of its earnings have historically come from proprietary trading operations, and it’s not clear how much latitude Goldman will have to continue on that road now that it’s a bank operating under the aegis of New York State regulators. Meanwhile, its investment-banking deal pipeline has got to be looking pretty barren these days.

A quarterly loss when Goldman reports its fourth-quarter earnings might at this point be priced in to the stock, and it’s astonishing how little time it’s taken to reach the point at which Evan Newmark can say that Goldman trading below book value is "unsurprising". (It was trading at $169 in early September; its book value is about $100.)

I’m actually more constructive about Morgan Stanley than I am about Goldman Sachs right now. Yes, Morgan Stanley has a higher probability of being wiped out entirely — but Treasury has made it clear it won’t let that happen. But it’s also easier to see Morgan Stanley functioning as a bank than it is to see Goldman changing its spots. Both of them are going to have to shrink dramatically, but I get the feeling that John Mack, who has looked into the abyss and survived to tell the tale, is more likely to embrace that destiny than anybody at Goldman Sachs, which for most of this crisis looked as though it was escaping largely unscathed. Given that Morgan Stanley is trading at a market capitalization of just $15 billion, compared to Goldman’s $27 billion, it might be the better buy of the two.

Posted in banking | Comments Off on Goldman Sachs: Back in the Crosshairs

Why the Detroit Bailout Should Include Bankruptcy

Posted on November 10, 2008 by Felix

With Deutsche Bank saying that GM is worthless, and some kind of government bailout of Detroit now a certainty, the battle lines are being drawn: is bankruptcy an option? Justin Hyde says it isn’t, and he might well be right, politically. But it certainly should be an option, and Joseph White has an excellent column today explaining why.

If there is to be a government bailout of Detroit, a large sum should go towards funding the union retiree health obligations set up by the three big automakers in 2007. There should also be a scheme to backstop the automakers’ warranties, so that consumers don’t balk at buying a new GM car for fear the automaker won’t be around any more to make good on its obligations. But I see no reason why GM in particular, and US automakers in general, shouldn’t take advantage of the perfectly-good bankruptcy system if they’re insolvent. Yes, the government might be the entity extending the debtor-in-possession financing. But GM bondholders should absolutely share in the pain here.

Posted in Portfolio | Comments Off on Why the Detroit Bailout Should Include Bankruptcy

The FT.com Redesign

Posted on November 10, 2008 by Felix

The FT.com redesign isn’t live yet, but you can get a preview here. It has a lot more white (or, rather, pink) space than before, and places a huge onus on the front-page editors to get the story mix exactly right. It also, at least according to the preview, has the grand total of one ad unit on the whole page. I can’t imagine that will last long.

The most depressing part of the relaunch, though, is that the FT hasn’t taken advantage of the opportunity to throw out its idiotic business model. Indeed, it’s been tightened up, and you now need to ration yourself to just 20 articles per month if you don’t want to subscribe — guaranteeing that no non-subscribers will be able to explore what the site has to offer.

Incidentally, the technology behind that business model still isn’t working properly, a year after it was introduced: despite being a full-access subscriber, I regularly run into the subcription firewall when I follow a link to the site from elsewhere, even though the site recognizes me as being logged in. Maybe that, at least, will be fixed with the redesign, although I doubt it.

When it comes to business models, I’m beginning to think that there’s some kind of Sotheby’s-Christie’s style duopolistic cartel action going on between the FT and the WSJ. If one of them went free, the other would have to go free as well, and so they’ve got some kind of implicit understanding that so long as neither of them makes the first move, they might be able to save themselves some subcription revenue through this recession. (Is it germane that the editor of the WSJ ran the US edition of the FT for four years? I don’t know.)

As for the substance of the redesign, are drop-down menus at the top of the page really better than a left-hand navbar? I hate drop-down menus, because they tend to drop down when you don’t want them to, and because you’re never entirely sure how to get to where you want to go. But designers love them, because they mean much less clutter on the page.

If the FT was serious about its website, the home page — and the rest of the site — would be a constant work in progress, instead of being stuck in aspic for five years and then undergoing a major rehaul. But that’s probably too much to hope for. Instead, I’ll just be happy if they manage to fix their RSS feeds. Not that I’m holding my breath.

Posted in Media | Comments Off on The FT.com Redesign

Against Summers

Posted on November 10, 2008 by Felix

Brad DeLong is pushing Larry Summers as Treasury Secretary. His argument, in a nutshell, is that "we want really smart people" running things, that Larry Summers is a really smart person, and that if you have the intelligence, self-confidence, and communication skills to persuade Summers that you’re on top of your brief, he’ll have your back and "give you more responsibility than you thought you could handle".

Brad DeLong, of course, is a really smart person in much the same mold as Summers: great on the analytics, not so great on people skills or subtext. Such people tend to be justifiably proud of their intelligence. But even if great intelligence is a necessary condition for being Barack Obama’s Treasury Secretary, it’s not remotely a sufficient one. And as Hank Paulson (no intellectual slouch himself) has shown, right now a large number of the skills needed at Treasury are political, not technocratic.

Bill Clinton, first with Rubin and then with Summers, built a model whereby the president would take the political lead on economic initiatives, while letting the policy wonks at Treasury work out the details. That was fine, then. But the job is bigger, now, and includes persuading both Congress and the public that the government is doing the right thing — that’s something which no self-respecting Treasury secretary should leave to the president. And Summers, like Paulson, is really bad when he has to talk to people he doesn’t respect.

What’s more, in order to be able to work well with Summers, you need all three prerequisites: intelligence, yes, but also the self-confidence to stand up to Larry (and that’s a lot of self-confidence), and the communication skills necessary to be able to persuade him in the space of a few minutes that you know exactly what you’re talking about (more than he does) and are on top of your brief. Many very able public servants don’t fit that exacting bill, and installing Summers at Treasury would mean that they would largely go to waste.

Summers has surely learned a lot about staying on-message over the past decade. But Obama’s Treasury secretary should do more than simply stay on-message: he or she should be able to respond dynamically and persuasively to the public’s concerns, and should be able to talk clearly and directly to all Americans, not only pointy-heads with college degrees. Now more than ever, America — and not just the president — needs to trust the person signing their dollar bills. Which means that Summers, for all his qualifications, is not the best man for the job.

Posted in Politics | Comments Off on Against Summers

Have the Democrats moved to the left?

Posted on November 10, 2008 by Felix

Brad DeLong:

One way in which 2009 is different from 1993 is that the Democratic Party is far to the left of where it was back then–let alone back in 1977.

Is the Democratic party the only major left-wing party which has moved to the left over the pat 30 years? Or is Brad being a bit contentious/disingenuous here?

Posted in Not economics | 1 Comment

Couldn’t the New AIG Bailout Have Waited Until January?

Posted on November 10, 2008 by Felix

Last night I asked why AIG was getting a second bailout. I think the answer came this morning: AIG lost $24.5 billion in the third quarter.

Under the terms of the first bailout, AIG could effectively borrow that $24.5 billion from Treasury, and try to pay it back out of operating profits (ha!) at Libor +850bp. But at that point AIG would be so deep in the hole, and its interest payments would be so large, the US government might end up with a monster insurer dangling off the edge of its balance sheet for decades to come.

Yves Smith is justifiably furious at this deal. The mechanism for buying up CDOs is particularly opaque and unfair: if you’re lucky enough to own a CDO insured by AIG, then you will probably be able to sell it to them for the high price of 50 cents on the dollar. On the other hand, if your CDO is not insured by AIG, you’ll have to fall back onto the increasingly-forlorn hope that TARP will find some money to do what it was originally intended to do.

There’s certainly no doubt that communication surrounding the deal has been atrocious. How is it possible that every commentator thinks it’s a Really Bad Thing? Isn’t there a single contrarian out there willing to take the government’s side? Some very smart people put this deal together, how come their logic simply hasn’t been communicated to the press or to anybody else?

The most uncharitable explanation of what just happened is that the government balked at outright nationalization for ideological reasons, and structured this deal so as to have the best hope of being able to sell its equity stake in AIG with in a few years and put this whole episode behind it. My feeling is that it’s a bit of that, combined with a bit of hands-tied syndrome: Paulson has promised the nation that there won’t be any major financial-sector bankruptcies between now and January 20, and so he felt he had to bail out AIG. Again.

But AIG could have muddled through, under the terms of the first bailout, for another three months, when a new Treasury secretary would have arrived with a new big-picture economic plan. Why Paulson felt the need to meddle now is still very unclear.

Posted in bailouts, insurance | 1 Comment

Extra Credit, Sunday Edition

Posted on November 9, 2008 by Felix

NBER’s Hall Sees `Conclusive’ Evidence of Recession: "’The evidence is more than compelling,’ Robert Hall, the Stanford University economist who leads the National Bureau of Economic Research’s business cycle dating committee, said in an interview. ‘It’s conclusive, in my personal opinion.’"

The IMF should guarantee emerging market debt: Mario Blejer attempts to destroy the International Monetary Fund after being cuckolded by its managing director.

Jump Risk and Dangers of CDS: "Moving to an exchange will put the burden of handling margining into a central party with visibility of all contracts, and with the benefit of hindsight will set collateral and leverage requirements with the understanding that these will jump in a correlated fashion." I’ll believe it when I see it.

Posted in remainders | Comments Off on Extra Credit, Sunday Edition

AIG Bailout 2: Why?

Posted on November 9, 2008 by Felix

The WSJ has details of AIG Bailout II:

Under the terms being finalized on Sunday night, the government would replace its original $85 billion loan with a two-year duration with a $60 billion loan with a five-year duration. Interest on the loan would drop from 8.5% plus three-month Libor interest-rate benchmark to 3% plus Libor. (Libor, the London interbank offered rate, is a common short-term benchmark.)

In addition, the government would tap the $700 billion Troubled Asset Relief Program to inject $40 billion into AIG in return for preferred shares. Those shares would carry 10% annual interest payments.

Let’s do a quick back-of-the-envelope calculation here. Libor is now at 2.29%, so $85 billion at Libor +850bp works out at $9.17 billion per year. Meanwhile, $60 billion at Libor +300bp works out at $3.17 billion per year, and the 10% coupon on $40 billion of preferred shares is of course $4 billion per year, for total interest payments under the new plan of $7.17 billion. That’s a savings of $2 billion a year for AIG. Against that, AIG has to put $6 billion in cash into two new special-purpose vehicles, designed to help sort out many of the problems at the insurer’s CDS and securities-lending business.

The article does shed some light on just how spectacularly incompetent AIG has been when it comes to securities lending:

A second vehicle would be set up to solve the liquidity problems in AIG’s securities lending business. The business involves lending out securities to short sellers or others and investing the collateral for gains. The strategy for many has lately backfired as once-reliable credit investments have seized up…

Under the new plan, the government would inject about $20 billion into the securities lending vehicle and AIG would put in $1 billion. The vehicle would then buy the illiquid securities the AIG unit holds, known as residential mortgage-backed securities, for about 50 cents on the dollar.

Securities lending is meant to be a no-risk operation. In a repo operation, the long-term owner of a stock — in this case, AIG — will sell it to someone who wants to short it, and charge them interest. They then subsequently buy back the stock at the price they sold it for; the interest is pure profit.

AIG, however, seems to have gotten spectacularly greedy. It took the proceeds from the stock sales, and instead of putting it somewhere safe, invested it in RMBS. Which are now worth 50 cents on the dollar.

This is in a way worse than AIG’s misadventures in the CDS market. When AIG Financial Products wrote credit protection, it thought the chances of default were minimal. But investing $42 billion of repo collateral in RMBS? There’s no good reason to do that: it’s not your money, you can’t afford to lose it, so you put it somewhere safe.

The silliest bit of this plan, however, is the idea that AIG will be able to cancel out its CDS exposure by buying the underlying securities. The WSJ explains how improbable this scheme is:

The government may be betting that federal involvement will encourage the counterparties to sell the assets to the AIG vehicle.

Once it holds the securities, AIG could cancel the credit default swaps and take possession of the collateral it had posted back the contracts…

However, the agreements may be difficult to work out. Some banks that face AIG in credit-default swaps don’t actually hold the physical securities on which they purchased protection. Merrill Lynch & Co., for example, previously sold many mortgage CDOs it underwrote to European and Canadian banks. Through a complex set of transactions, Merrill took back the credit risk of some of those assets and hedged that risk by buying credit-default swaps from AIG. When the securities fell in value, the European and Canadian banks demanded collateral from Merrill which in turn demanded collateral from AIG.

None of this makes sense to me. If AIG wants to unwind its CDS exposure, all it needs to do is negotiate with its counterparties to pay them an up-front sum in return for their tearing up the contract. CDS are derivatives: you don’t need to do anything with the underlying securities in order to cancel them out.

But of course if AIG simply made those kind of payments and took its losses, the government wouldn’t end up with any assets, and wouldn’t be able to tell the public that it was still possible that AIG might make a profit on the deal.

So this looks like an exercise in face-saving to me, rather than something with any real economic logic behind it. But at least the Troubled Asset Relief Program finally gets to buy itself some Troubled Assets, even if there isn’t a reverse auction involved. Maybe that’s why Treasury’s going along with this plan; I can’t think of any other reason. Here’s how the WSJ parses the logic:

The revised structure is designed to improve both AIG’s ability to sell assets for a decent price and the taxpayer’s ability to recoup the money that has been pumped into the insurer. It also transfers to the government many of the risks once absorbed by AIG, potentially exposing the government to billions of dollars in future losses.

How does transferring billions of dollars of contingent liabilities from AIG to Treasury in any way help the taxpayer’s ability to recoup the money that has been pumped into the insurer? I don’t get it. And I don’t see the systemic risk which this plan is meant to head off. Without that systemic risk, I see no reason why AIG should get any bailout at all.

Posted in bailouts, fiscal and monetary policy, insurance | Comments Off on AIG Bailout 2: Why?

Two Investment Bank Post-Mortems

Posted on November 9, 2008 by Felix

Jennifer Hughes deserves some kind of medal for her magnificent article on Lehman Europe’s insolvency in this weekend’s FT.

Hughes’s piece clears up a large number of questions about UK law, the $8 billion taken from Lehman Europe by Lehman US, and the $40 billion of assets held by Lehman Europe’s prime brokerage operation. It paints the PricewaterhouseCoopers team now running Lehman as surprisingly competent — even after you make allowances for the fact that they’re the main sources for the article. And it’s written in prose of such clarity and internal coherence that you’re left in no doubt Hughes knows exactly what she’s talking about.

The contrast with Gretchen Morgenson’s similarly-ambitious piece on Merrill Lynch in the NYT is instructive.

Morgenson is a dab hand with her metaphors, especially when it comes to credit derivatives: Merrill was "trafficking" in them, she writes, in an "often inscrutable financial dance" which "transformed a financial brush fire into a conflagration" — and then on top there’s "wreckage" and "carnage" and risk becoming "viral". But it’s all telling and no showing: Morgenson never begins to quantify the losses associated with the synthetic CDOs she’s writing about.

Yves Smith reckons Morgenson’s statement that Merrill "dove into the C.D.O. market — primarily synthetics" means that "Merrill was writing more synthetic CDOs than the kind with underlying assets". That reading is fair enough, but the absence of any hard numbers in the article indicates to me that Morgenson simply doesn’t know for sure, and that a lot of her piece is simply conjecture.

What’s more, all of Morgenson’s Merrill sources are anonymous "former executives who requested anonymity to avoid alienating colleagues at Merrill" — a particularly weak construction. Is that reason really good enough for the New York Times to grant anonymity? Were any of these executives responsible for synthetic CDOs, or even the mortgage group more generally? Or are they just fired executives from other arms of the bank who are upset about Merrill’s fate and who are looking to point fingers? Answers, of course, come there none.

For me, the difference betwen the Hughes and Morgenson pieces is simple: the Hughes piece is genuinely informative, while the Morgenson piece is more of an exercise in bias confirmation. If, like Barry Ritholtz, you’re already inclined to believe Morgenson’s story, it’ll be grist to your mill. But if you’re looking for substantive new information in order to make up your mind, your efforts will be in vain.

(Thanks to Don for the link to the Hughes article. And if anyone can explain to me why the URL name of the Morgenson piece is 09magic.html, I’d be much obliged.)

Posted in banking, journalism | 5 Comments

The Wealth Effects of House Price Declines

Posted on November 9, 2008 by Felix

Dean Baker reckons that wealth effects alone would be sufficient to cause a massive recession, even absent any kind of financial crisis:

Homeowners have lost more than $5 trillion in housing wealth. There is a very well established wealth effect whereby $1 of housing wealth is estimated as leading to 5 to 6 cents of annual consumption. This implies that the loss of wealth to date would cause consumption to fall by $250 billion to $300 billion annually (1.7 percent to 2.0 percent of GDP). If you add in the loss of around $6 trillion in stock wealth, with an estimated wealth effect of 3-4 cents on the dollar, then you get an additional decline of $180 billion to $240 billion in annual consumption (1.2 percent to 1.6 percent of GDP).

Alex Tabarrok agrees, and I have quite a lot of time for this position myself. But it’s worth pointing out what Baker doesn’t mention here: that his $5 trillion number is speculative, and doesn’t come from any official statistics.

Baker explained to me that in order to arrive at $5 trillion, he started with the Fed’s valuation of America’s housing stock as of end-2006: $21.8 trillion. If US residential houses were worth about $20 trillion a couple of years ago, and if they’ve fallen by 20% in nominal terms since then, it’s not hard to come up with a total loss of $5 trillion in real terms. Baker got the 20% figure from the Case-Shiller house price index.

Note that using Baker’s real-money math, if you had a $100 bill in your wallet for the past two years, he’d say that you’ve lost $7 over that time, thanks to inflation. Does that kind of loss show up in wealth effects? I’m not sure. But even if you ignore the inflation adjustment, 20% of $21.8 trillion is still a loss of $4.4 trillion: more than enough to cause a big drop in consumption.

The problem is that the most recent figures from the Fed peg the value of America’s housing stock at… $21.8 trillion, exactly the same as it was two years ago. In order to buy Baker’s calculation, you have to believe that the Fed has miscalculated to the tune of more than $4 trillion over the past two years.

Is that possible? Yes. As Baker explained to me:

For [house price] movements the Fed uses the OFHEO index which has shown a much lower rate of decline. The main reason is that OFHEO excludes subprime and jumbo loans. In the bubble markets, the median house price is close to the conformable limit, so the OFHEO index is missing much of the price decline in the bubble markets (it also missed much of the increase).

The Fed does rebase using the Census of Housing, but there is a 2-3 year lag for this.

It’s certainly possible that the Case-Shiller index overstates the decline somewhat because it overweights the bubble areas, but the Case-Shiller data is likely to be much closer than the OFHEO index, since it doesn’t exclude such a large portion of the market with the most movement. The Fed measure also includes new construction and improvements, which would have been around $1 trillion over the last two years.

This is all entirely reasonable, and if you buy Baker’s reasoning here then his estimate of housing-related wealth effects could be quite accurate. Indeed, it could be an underestimate: after all, housing wealth is a function not of home values but rather of home equity. And if home values have fallen by 20%, home equity has surely fallen much more than that. If during normal times a marginal drop in home equity has a 5% wealth effect, it’s easy to imagine that the wealth effect associated with an outright eradication of home equity could be substantially greater.

Update: Ryan Avent weighs in. "Household consumption was a positive contributor to GDP, right up until the last quarter. Surely that says something about the action of the wealth effect, no?"

Posted in housing | Comments Off on The Wealth Effects of House Price Declines

Ben Stein Watch: November 8, 2008

Posted on November 9, 2008 by Felix

Just how much does Ben Stein love his "mighty Cadillac STS-V"? So much, it seems, that he considers its survival a matter of national security. Srsly:

The national security considerations make saving General Motors, Ford and Chrysler a life-or-death matter.

I wish I were making this up. I’m not:

We’ll want a G.M. or a Chrysler when it’s time to make tanks and Humvees.

I guess we were all kidding ourselves about China being any kind of military force so long as it didn’t have "a large automobile and truck industry". And of course Detroit doesn’t make tanks: for that kind of thing you’d probably be better off looking to General Dynamics. As for the Humvee, it’s built by a company called AM General, which was smart enough to sell the Hummer brand name to GM.

But Ben Stein, of course, never lets facts get in the way of a nice piece of alarmism: if we don’t bail out Detroit, we’re all going to die!

Stein also casts his entire column as advice for "a new leader of the United States" and "a Democratic president" — not only can’t he bring himself to use the name "Obama", but he can’t even use the definite article. Although he has no problem using the word "herewith" — he’s never been lacking in pompousness.

The greatest bit of bensteinery in the column, however, comes when he starts talking about "relocation assistance" as an alternative to job retraining:

I am endlessly amazed that I have to pay about $60 an hour to hang a mirror in Rancho Mirage, Calif., and that there is a shortage of reliable handymen there. This has implications for hard-working machinists being laid off in Detroit. Maybe there is some merit to a fund that would take workers where they want to go and are needed.

Doesn’t your heart just bleed? It’s so hard to find good staff these days. And there’s something to be said for uprooting skilled workers from Detroit and put them to work hanging mirrors for Ben Stein in Palm Springs. After all, a little bit more reflection in his life would surely do Stein a world of good.

Update: Commenter "icandoitdon" makes a good point over at Seeking Alpha:

If you want to argue that the survival of the American car manufacturers is important to national security you must also argue that free trade agreements, which have led to the flight of American manufacturing for years, are generally contrary to our national security interests.

I wonder whether Stein is willing to go there.

Posted in ben stein watch | Comments Off on Ben Stein Watch: November 8, 2008

CDS: An IM Exchange

Posted on November 8, 2008 by Felix

Many thanks to Robert Waldmann, who allowed himself to be roped into an IM conversation with me about the CDS market, after he left a couple of skeptical comments on the subject here and at Kevin Drum’s. Here, then, is my (partially successful) attempt to persuade him that it’s not as bad/dangerous as all that. And, as a bonus, if you make it all the way through to the end, you’ll be treated to an indelible image involving Larry Summers.

So, wonks away:

Robert Waldmann:

Thanks for the invitation. I am flattered. However, I am also fairly ignorant about developments in financial markets in the past 20 years, so please bear with me.

Felix Salmon: Bilateral derivatives have been around for much longer than that, so there’s nothing in the CDS market which is really rocket science

In fact, CDS are much easier to price than options

Robert Waldmann:

I’ve been learning about them fairly quickly, but just creating gaps of knowledge in my ignorance. I won’t bother you with further warnings.

Felix Salmon:

My feeling is that they grew out of big problems in the corporate bond market.

It was always very illiquid

I remember when I started at Euromoney in the mid-90s, bond traders would make an absolute fortune, thanks to bid-offer spreads you could land a 747 in

You can just imagine what would have happened to credit markets at a time like this, then, if it wasn’t for CDS.

Robert Waldmann:

Well that gets you as far as bilateral trades instead of submitting huge market orders and driving prices against yourself.

The legal form of derivatives has to have (I think) a lot to do with capital requirements.

Felix Salmon:

The clever thing about the CDS market is that precisely because it’s unregulated and bilateral, it has developed its own form of capital requirements, in the form of the seller of protection having to post collateral when prices move against it

This has actually worked extremely well, and the only problems in the CDS market so far have been in that small handful of writers of credit protection who had AAA ratings and managed to exempt themselves from having to post collateral.

Robert Waldmann:

OK but the variable collateral can cause, uhm, cash flow problems for sellers having to get their hands on tens of billions given how fast and much prices can move.

Felix Salmon:

only if they’re stubborn enough not to unwind their positions in the face of prices moving against them. The good thing about the CDS market is that it’s liquid enough that that is actually possible.

Robert Waldmann:

A question. I read somewhere that AIG has had to post collateral now that (credit ratings of insured credit declined and/or its credit rating has uhm changed a bit and/or market prices of CDS it wrote changed).

Felix Salmon:

Yes, the minute you lose your AAA, you have to start posting collateral.

Hence the gazillions of dollars in collateral which AIG has to borrow from Treasury at Libor +850bp.

Robert Waldmann:

OK so it was their personal corporate rating that did it. Also the money will go back to AIG if when the crisis is over they get back to AAA and the insured credit in question hasn’t defaulted (I understand not much has yet so relatively little paid to settle CDS contracts).

Felix Salmon:

The money certainly goes back to AIG when the contract expires. I don’t know enough about the language in AIG’s contracts to be able to tell you whether the collateral requirement goes back down to zero in the event AIG regains its AAA.

That said, Berkshire Hathaway says in its most recent quarterly report that it hasn’t put up a penny of collateral against the CDS it has written, despite taking over a billion dollars of losses on CDS and equity puts in the third quarter alone.

I don’t like that. I think everybody should put up collateral, and compete on an even playing field.

Robert Waldmann:

Seems to me that the complexity of CDS due to complete flexibility in writing the contracts makes them very hard to price.

Felix Salmon:

That was more of a problem in the early days of CDS, but nowadays substantially all of them conform to standard ISDA boilerplate.

Robert Waldmann:

ah hah. Where can I find standard ISDA boilerplate

(googling ISDA at their web page)

they seem to have a good bit of traffic right now oh it’s a pdf

LCDS protocol published July 24 … damn I’m being paid too little (0) to read this stuff.

Felix Salmon:

The important thing is that everyone’s using the same protocols. Which means that so long as you’ve dealt with counterparty risk, you can close out a position with a perfect hedge.

Felix Salmon:

And it’s definitely possible to deal with most counterparty risk, through a combination of CCDS and collateral requirements, as explained here.

Robert Waldmann:

Yeah thought came to me that a cds on the counterparty would do it (so my thought was wrong because I didn’t think collateral was relevant)

Felix Salmon:

It’s definitely kludgier than a CDS exchange, but it has actually proved surprisingly robust.

But I’m interested in a comment you left on my blog:

"Now as to CDS abuse, tell me a non abuse involving way in which the notional value of CDS is so much greater than the value of all insured D? If something like that happened with another kind of insurance, wouldn’t you consider it abuse?"

I think I can answer that quite easily: I enter into a position, and then I unwind it by entering into an equal and opposite position

And since I’m a trader, I do that many times a day.

Pretty soon, notional is through the roof, even with no net exposure at all.

Robert Waldmann:

Yes that seems to be an answer (and indeed quite easy).

Felix Salmon:

And the data which DTCC is finally giving out would seem to indicate that net exposures are only ever a tiny fraction of nominal notional exposures.

Where was the DTCC a year ago, that’s what I want to know, it might have saved us a lot of worry.

Robert Waldmann:

That’s for sure.

Felix Salmon:

It’s like they waited for the moment of absolute maximum panic, following the Lehman default, before sauntering in a nonchalant manner onto the scene and saying "everyone chill the fuck out, I got this"

Robert Waldmann:

Well so long as they got this, fine by me.

Felix Salmon:

So, have I brought you around to the idea that CDS really aren’t a major cause of the current crisis?

As you know, Kevin Drum calls me "disturbingly persuasive"

Robert Waldmann:

Ah well that is ambitious. You have convinced me that there is a perfectly legitimate reason which can explain why face value is so huge. As to the cause of the crisis, I remain confused. Stupid CDS tricks could have done it. So could stupid CDO tricks and what all.

Felix Salmon:

I will concede that there were indeed stupid CDS tricks

Robert Waldmann:

I mean the situtation is I don’t understand the new financial instruments and it sure looks like the trader types didn’t understand them as well as they thought.

Felix Salmon:

But the stupidity was in understanding credit risk, not in understanding CDS.

Basically the banks thought they were moving all the credit risk off their books, but they weren’t, because they kept those "super-senior" tranches.

They could easily have moved the super-senior credit risk off their books too, but that would have made their CDO deals unprofitable, so they didn’t.

That’s not a problem with CDS technology, it’s a problem with credit-risk modelling.

Robert Waldmann:

Yours is a plausible hypotheis. As far as I know (and I don’t know much) another is that they placed huge bets against each other and don’t know yet who won big and who is insolvent (that is each is still sure they won big and the others are insulvent).

My sense is that it has to be something which is very different for different firms or the general equity injection for preferred shares (and promise of more) would have pushed the TED spread back to normal.

Felix Salmon:

Bank prop desks certainly had the ability to make big bets using CDS. But those are the kinds of bets you mark to market daily.

Robert Waldmann:

Yeah but CDS markets can not move not move not move JUMP. Historical data can be very misleading if distributions have fat tails and if history so far is not very long.

Felix Salmon:

There are basically three kinds of institutions which wrote a lot of CDS protection on a net basis.

There’s AIG, there’s the monolines, and there’s the synthetic CDOs bought by institutional investors.

Given the zero-sum nature of any derivatives market, that means that everybody else, on net, was a buyer of credit protection.

As I say, it’s possible that someone who sold credit protection could find themselves losing a lot of money one day when the CDS spreads gapped out

But that would show up in a bank’s daily P&L, and in its quarterly earnings.

And generally the CDS desks at banks were so profitable just as brokers, taking no or very small net positions, that it seems improbable they would have tried to reinvent themselves as insurance companies and write a lot of protection on a net basis

Robert Waldmann:

Some people (hedge funds mostly I’d guess) decided to bet on CDS misspricing by taking large not quite matched long and short CDS positions. They would be having uhm cash flow problems, if it weren’t for AIG’s credit facility at the FED.

Felix Salmon:

You’re quite right that the failure of AIG could have been catastrophic for the CDS market — with any luck, we’ll never know.

Robert Waldmann:

The consequences of those cash flow problems have to do with CDS trading and I would count what would have happened without public intervention.

Felix Salmon:

My point is that AIG is a unique case, thanks to the way it abused its AAA rating.

Robert Waldmann:

I have been arguing with you in my mind usually remembering not to talk to myself out loud (makes people nervous). My argument was that just because things are OK with $90 billion in 27 days for liquidity assistance (most could go back to AIG) doesn’t mean that the market behaved as a market should be allowed to behave.

OK a reform proposal. CDS must come with collateral even if you find a sucker willing to buy one without collateral (this is a regulatory restriction).

Felix Salmon:

Yes yes yes.

That’s why I’m so astonished Berkshire Hathaway is STILL writing CDS without collateral requirements.

But a move to an exchange would have the same effect.

Robert Waldmann:

I know I remembered your BH complaint so I guessed you would say yes (didn’t guess the 2nd and 3rd yes).

Felix Salmon:

Interestingly the US govt, which is undoubtedly safer than BRK, is posting collateral on the protection written by AIG.

Robert Waldmann:

Well the US government has a long tradition of not exploiting its credit rating to the max. Without it, the USA would be the Union of soviet socialist republics of America.

Felix Salmon:

it’s also interesting though that when the US govt does try to exploit its credit rating, by backstopping Frannie’s debt, it doesn’t seem to work!

The market reckons that if the govt can guarantee Frannie debt, it can unguarantee it too.

Robert Waldmann:

Well that was a wink wink nudge nudge semi maybe guarantee made by people who have left office to be replaced by people who hate Fannie and Freddie so not really a shocker.

Felix Salmon:

Yeah, didn’t Summers at one point propose a plan which would bail out Frannie’s senior bondholders but do a debt-for-equity swap when it came to the sub debt?

Robert Waldmann:

I don’t know

Felix Salmon:

Found it

"The government should use its new receivership power to protect taxpayers and the financial system. In the process, payments to stock holders, holders of preferred stock and probably subordinated debt holders would be wiped out, conserving cash for the benefit of taxpayers."

Robert Waldmann:

Ouch

Felix Salmon:

This is the man who will probably be treasury secretary come Jan 20

At least according to Intrade

Robert Waldmann:

Yeah but last time he was treasury secretary they managed to teach him to not shoot off his mouth. I don’t know how (I think a cattle prod was involved).

It’s dinner time over here (I live in Rome you know).

Felix Salmon:

I think the vision of Michele Davis wielding a cattle prod is a great place to end this, then

Robert Waldmann:

OK thanks for the chat. Real fun. Bye for now

Posted in derivatives | Comments Off on CDS: An IM Exchange

The WSJ Breaks the External-Link Taboo

Posted on November 8, 2008 by Felix

Many congratulations to the Wall Street Journal! Here’s a little bit of today’s WSJ.com front page — you can click on the picture for a big screencap of the full front page.

The important thing here is the second link, to the third-quarter report: it’s an external link, to the SEC’s website. I don’t know whether the WSJ has done this before, but it’s the first time I’ve ever seen an external link on the home page of any mainstream news organization website. May there be many more!

Posted in Media, publishing | Comments Off on The WSJ Breaks the External-Link Taboo

Extra Credit, Friday Edition

Posted on November 7, 2008 by Felix

Berkshire Hathaway Profit Falls 77% to $1.06 Billion: Oof. And the reinsurances losses attributable to hurricanes Ike and Gustav, along with some other natural catastrophes, added up to only $186 million. There were much bigger losses attributable to the fact that Berkshire’s been writing credit protection on junk bonds.

Wall Street Lays Another Egg: The best 10,000-word popular history of the financial bubble that you’re likely to read.

A Dreadful Jobs Report Recalls the 1980s

Why Larry Summers could be a good Treasury Secretary: John Gapper. Dean Baker begs to differ.

Geithner and Lehman Brothers: Did he really oppose letting Lehman fail?

Fed Stonewalling on Giving Details About Collateral Accepted for Loans

October’s budget deficit bigger than the deficit for all of 2007

Posted in remainders | Comments Off on Extra Credit, Friday Edition