"I've written myself into a corner, now, and can't think of any way to get out of writing the promised blog entry on super-senior tranches. Especially when Kevin Drum asks so nicely. So here it is. Deep breath..."
Steady on, old boy. Try explaining Godel's Proof.
"By now, you understand how a synthetic bond can behave very much like a real bond."
Let's just say it's exactly like a real bond, so we don't have to mess around with qualifiers.
"So consider the situation of a bank, which has made a bunch of loans, to 100 different companies. The companies all value their relationship with the bank, and the bank values its relationship with the companies. At the same time, however, the bank would like to free up some capital. It doesn't want to sell the loans outright -- so instead it creates a synthetic bond referencing those 100 credits, and sells that."
Free up some capital. More like avoid capital requirements or invest in things they're not supposed to, but let's humor them. They don't want to scare their customers into believing that they'll be engaging in dicey investments.
"Essentially what the bank is doing is taking the interest payments from the companies it's lent money to, and using them to make insurance payments against those companies defaulting. If the companies default, the buyers of the synthetic bond end up sending money to the bank, which will offset its loan losses. The bank has brought down its credit exposure to those companies even though it hasn't sold the actual loans. And because its credit risk has come down, its capital requirements have come down too, and the bank has more free capital to use elsewhere."
Sure, tell your customers that you've bought insurance in case they default. Okay. In this example, if I understand it, the bank created the CDSs ( Insurance against defaults ), and then sold them to some investors who are betting the CDSs don't explode. In other words, the investors are supplying insurance to the bank. So the investors must be getting a premium payment from the banks. Presumably the credit risk of the bank determines its capital requirements, which are significantly less now that they have the insurance provided by the CDSs, thereby giving them the difference between the new and old capital requirements to invest, less the premiums and cost involved in creating the CDSs. Fine. Even if this isn't Felix's example, it's why I believe that they did this.
Bank: Capital Requirement Before CDSs= $100,000
Capital Requirement After CDSs= $50,000
The bank now has $ 50,000 ( Less what I just said ) to lend out and make more revenue
"Because the loans are still on the bank's books, it needs to take mark-to-market write-downs on those loans if they fall in value but don't default. On the other hand, when that happens the value of the bank's default insurance is almost certain to rise by a very similar amount. So the bank really has managed to construct a pretty good hedge here. Not perfect: no hedge is perfect. But pretty good."
The loans are worth less, but the CDSs are worth more. A balancing or cancelling out effect, in essence. A hedge.
"So far so boring. But of course banks are never happy with simple hedges: they want to make money from all this financial high technology. (Incidentally, it's not clear that they won't: Alan Kohler had a thought-provoking column a couple of weeks ago saying that once a few more big defaults happen, "a mass transfer of money will take place from unsuspecting investors around the world into the banking system. How much? Nobody knows, but it's many trillions.")"
Come on. So I've got to read this Kohler post as well?
Let's see: A transfer from unsuspecting investors to banks. Isn't that our system?
"In any event, let's go back to the synthetic bond that the bank issued. Let's say it's structured so that each of the companies is paying an identical amount in interest every year: call it $1 million each. If the bank bundled up all those loans into a collateralized loan obligation, or CLO, then the CLO would be paying out $100 million a year, unless or until one of the companies defaulted."
The insurance equals the interest paid. That's not a great deal for the bank, is it?
Hold on. Who owns the CLO? The bank, right. But I thought that they were the ones buying insurance. So the CLO is paying out premiums for the insurance? Right?
"But rather than just sell the CLO outright, the bank would most likely split it up into tranches. Companies default, but they don't all default at once."
This is why tranches or slices work. You can use the uneven rate of defaults to organize the defaults as they occur into groups or slices of default. It's not an even rate, so you can map out the bumps, if you will, into slices.
"If the companies in question were all investment grade, you could be sure that at least 80 of them would still be making interest payments at any one time. So if you sell off the right to the first $80 million of interest payments, the ratings agencies will slap a triple-A rating on that income stream, and it can be sold at a tight spread and a pretty high price."
You're taking the least risky payers and matching them up with the least likely defaults. Well, that makes sense, since they're the same.
"Then the next $5 million might have a double-A rating, and the next $5 million a single-A rating, and the next $5 million a triple-B rating, and the last $5 million will either have a junk rating or else just be considered "equity"."
Same deal, going from least risky,to middling risky, to very risky, to hold onto your hats risky.
"Now it's possible that the bank will contrive to make a small profit here, if the sum of the value of all the tranches is greater than the amount of money that the bank lent out in the first place. But the operative word is small. "
Of course it's small. They're taking the payments and buying insurance with them. It's a miracle that they don't lose money.
"How do things change if the bank issues a synthetic bond rather than a cash CLO? Well, it can sell off the equity and the junk and the single-A and the double-A tranche, thereby protecting itself if interest payments fall by $20 million. It can then sell off a bit of the triple-A tranche, protecting itself if payments fall by $25 million. Now remember that the first $80 million of payments are rock-solid, risk-free: that's why they carry triple-A ratings. So the bank's remaining risk, after selling off that triple-A-rated synthetic tranche, has been brought down to safer-than-triple-A levels. Some of the banks referred to it as a "quadruple-A" risk, although that's not a real-world rating. But the banks were so comfortable that defaults at that level could never happen that they didn't feel any need to hedge themselves against it happening."
The banks sell the least risky stuff, figuring that they're safe, and so make some money from them.
"Janet Tavakoli, back in 2003, published a nice little table of the difference between a cash CDO and a synthetic one:
Tranche Size | % of Portfolio | |
Super Senior | N/A | |
Aaa | 439,500,000 | 87.9% |
Aa2 | 11,500,000 | 2.3% |
Baa2 | 14,000,000 | 2.8% |
Equity | 35,000,000 | 7.0% |
Total | 500,000,000 | 100.0% |
Tranche Size | % of Portfolio | |
Super Senior | 432,500,000 | 86.5% |
Aaa | 20,000,000 | 4.0% |
Aa2 | 12,500,000 | 2.5% |
Baa2 | 15,000,000 | 3.0% |
Equity | 20,000,000 | 4.0% |
Total | 500,000,000 | 100.0% |
| *Baa2 average portfolio rating. Up to 15% high yield and 10% asset backed. **Baa2 average portfolio rating. Exclusively investment-grade portfolio. ©Collateralized Debt Obligations and Structured Finance, John Wiley & Sons, 2003 by Janet Tavakoli | ||
There are nuances and differences here that we don't need to worry about too much. But the main thing to notice, in this example, is that a bank could protect itself against the first 13.5% of a group of bonds defaulting, and then declare that it was fully hedged: even the triple-A tranche had been sold off, and all that remained was a risk-free super-senior tranche.
Clearly, the cost of protecting yourself against 13.5% of a group of bonds defaulting is lower than the cost of protecting yourself against 100% of that group of bonds defaulting. Not a lot lower, since no one really imagined that more than 13.5% of the bonds could ever default. But enough lower that the bank could end up making a nice profit by selling off the credit risk associated with the bonds, and holding on to the excess income."
It looks like 1.2 %. This example is kind of funny, but let's go on. I mean, one of the benefits are the fees that get charged when you sell them, but I've dealt with that in other posts.
"Of course, the bank's loan position is not actually fully hedged. But so long as more than 86.5% of the interest payments get paid, the bank is fine. And the advantage of leaving the rest of the loan portfolio unhedged is that you don't need to use all the income from the loans to buy protection on them. There's money left over -- which can be considered interest on the quadruple-A, or super-senior, tranche that the bank retains."
So you fudge on the premiums.
"The invention of the super-senior tranche, then, was a way of letting banks have their cake and eat it too. They could take a bunch of debt onto their balance sheets, "fully" hedge it (with only that it-could-never-default tranche left over) and book all the remaining cashflow as pure profit with no credit risk."
Looks good on paper, does it? Remember, they've fudged on their insurance. There's a gap in their coverage now. Understand that.
"Now so long as you're dealing with a hundred different investment-grade corporate loans, this actually works: such things really don't all default at the same time. Banks even found a (limited) market for these super-senior tranches, by allowing their hedge-fund clients to take very leveraged bets on them -- they felt that the leverage was safe, since there was no default risk. But a huge proportion of the super-senior tranches was never sold off to hedge funds, and instead remained on the banks' balance sheets."
There's a good reason for that having to do with capital requirements, but I can't quite fit it into this example.
"And of course it wasn't long until the banks started doing the same thing with mortgage bonds. They would take a bunch of subprime-backed CDOs, and treat the interest payments from the CDOs much as they treated the interest payments from corporations."
It took a coffee break before they were ready to expand the plan to mortgages. Mortgages need that extra little jolt of energy from the caffeine.
"Oops.
In the case of CDOs, as we've all seen, the models said that there was geographical diversification in the housing market; they said that national housing prices, in aggregate, never went down. (Which was true, until it wasn't.)"
I like to think of it like insurance on your house. If a disaster occurs, fire or hurricane say, it usually occurs in one area, even if a large area, of the country, at one time. It's a contained insurance claim. Now, imagine using that model for houses. If housing prices fall, they do so in contained areas like fires and floods. That's the model.
"And somehow they said that thanks to the magic of securitization and overcollateralization, you could create not only triple-A securities from triple-B-rated subprime assets, but even quadruple-A super-senior tranches, too.
And so the banks took billions of dollars of subprime-backed mortgage securities onto their books, and "fully" hedged them while not really hedging most of them at all. When the income from those CDOs went (or was expected to go) towards zero, the banks had to write off assets which they never really considered risk assets at all. The banks thought that they had hedged all the credit risk associated with the bonds, and were left with a modest and super-safe income stream. Instead, they were left with a time bomb."
The whole point, in fact, was to lower capital requirements for lending. Let's not get fancy.
"It's worth noting here that although the bank used CDS technology in the process which ended up with these super-senior tranches, it's not the credit default swaps themselves which blew up. Remember that the bank had a lot of CDOs on its books, and the credit default swaps helped protect the bank from a lot of the losses associated with those CDOs. Just not all of them. And if you underwrite hundreds of billions of dollars' worth of CDOs, the "unfunded" portion of those CDOs can become enormous on an absolute level -- and if it gets wiped out, you can get wiped out."That's a fair point. Some of the CDSs the banks would have would pay them for the defaults. It's terribly complicated for banks to unwind these deals and see what's what. From my perspective, that's a very good reason not to do them, but I'm not a fan of complexity.
"As ever, credit default swaps, like any derivative, were and are a zero-sum game: they don't cause big losses themselves. The super-senior losses, ultimately, come from the subprime mortgage market, not from the CDS market. But without the technology of credit default swaps, banks would never have been able to retain those exposures while thinking that they had divested themselves of all the associated risk."
Now, subprime mortgages were inexcusable. Human Error. And if they wouldn't have used these investment vehicles, they would have found something else. The main objective was decreasing capital requirements for lending. However, it is possible that these vehicles were seriously more destructive than other alternatives, but we'll never know that for sure.
"Still, no amount of regulation of the CDS market would have solved the underlying problem, which really had nothing to do with the credit default swaps themselves, and everything to do with the banks' risk models. Those models said that if you take on this risk and sell that risk, you're fully hedged. They were wrong. The CDS, so far, have worked. The investors who bought the higher-risk tranches of the synthetic CDOs have been wiped out -- the banks, essentially, have taken nearly all their money. If the CDS contracts hadn't worked (if, for example, the government decided "to simply annul the credit default swaps as void", as Ben Stein has proposed), then the banks would have lost even more. "
The models were wrong, but people were conditioned to believe them by their interests and needs. Every model needs a human being to interpret it. Period. Don't blame the models. Blame the human predisposition to put faith in risky models. Please. And don't blame the investments, as they were simply filling a need. The Stein proposal made no sense, as I said on Felix's blog. Getting something is generally considered better than getting nothing.
"I'm not saying that the CDS market protected the banks from losses: without it, the banks would never have taken all those mortgage-backed CDOs onto their books in the first place. They never thought of themselves as being in the storage business; they thought they were in the moving business. But without senior management ever really realizing it, banks like Citi ended up storing hundreds of billions of dollars' worth of subprime bonds on their balance sheet, and failed to properly account for them because they erroneously thought those bonds were risk-free."
I don't believe it for a second. On this blog, there's a post, where I spent time searching the web and constructing a profile of these investment in less than two hours, as if I were in 2005. In other words, I confined my sources to 2005 and earlier. That prospectus clearly showed that these investments were very risky, even taking in to account what the creators of the models said about them. I'm not saying it predicted what happened, but nobody, nobody, can honestly say that these investment vehicles were not risky. And that's why Bob Rubin's quote in the NY Times admitting this is so important.
"Ultimately, then, the error was one of management, not of financial technology. The banks' balance sheets -- and those of their off-balance-sheet vehicles -- were expanding faster than the banks' executives and risk managers could really keep a handle on. And rather than call a halt to that which they didn't fully understand, they handed down edicts instructing the CDO desks to keep on dancing for as long as the music was playing. Most of the executives probably never even heard the term "super-senior" until those tranches started getting written down. It was their own incuriousness, rather than any CDS technology, which was really their undoing."
Then that's, at the very least, negligence. You're responsible for people's money, for God's sake. This behavior amounts to fraud or negligence or fiduciary mismanagement, and, if not criminal, there should be some way for investors to be compensated by these people for their disatrous handling of other people's money.
One thing that this blog will show, these products are not incomprehensible or unexplainable, at least as to their risk.
By the way, you should read the questions that people asked on Felix's blog. It's his model, so he should be able to answer them.
Well, he answered them.
"Super-seniors are not easy things to understand, as you'll know if you managed to trudge through my attempted explanation. I got some good questions in the comments, here's my attempt at the answers.
Eli and fresnodan both bring up the issue of counterparty risk: after the bank has bought insurance on its CDOs, how does it know that its counterparty will have the money to pay up if and when there is an event of default?
It doesn't always know for sure. But remember that synthetic bonds are structured so that the collateral payment gets invested up-front, so if the bank hedged its exposure by issuing synthetics, it's probably fine."
Truthfully, this investigation is like investigating any counterparty.
"On the other hand, as Noel notes, some banks ended up buying cheap protection on their super-senior tranches from AIG Financial Products. Which, as we've seen, was a very good deal for the banks, and a very bad idea for AIG. And, thanks to Uncle Sam, AIG is still around to pay out on those contracts."
AIG's whole reason on doing their tranches was avoiding capital requirements. All of their problems, as far as I can tell, from these types of investments come from their very reason for getting into them. On the other hand, it's a good question if investors believed that these investments were collateralized like AIG's insurance. I've no idea, but not to explain the difference to investors is, at least , negilgence.
"Matthew asks a couple of questions. Firstly:
What's the difference between this scenario than the bank just lending money to the top 86.6% of companies by creditworthiness and letting other lenders - perhaps specialists - lend to the other 13.4%? And aren't the profits the same for the bank in both cases?
The answer is that it's not the bottom 13.4% of companies by creditworthiness which always default. You don't know which companies are going to default: you just know that some but not all companies are likely to. So you lend to them all and then protect yourself against the first 13.4% of losses. It's a bit like saying "whoever the losers are, those companies, in hindsight, we'll choose not to lend to"."
Actually, I think this is better understood using other examples. He's right, but it's not obvious.
"His second question is this:
Why would the income from the CDOs go 'to zero'? This would mean all 100% of mortgage payers (in this example) default. If this is the case then the problem is massive failure to understand the riskiness of an asset- but it would have to be absolutely massive to get it 100% wrong? In fact so massive, fraudulent, instead?
I tried to explain this here, in words, and here, in pictures. But in a nutshell, these CDO weren't simple pools of mortgages. Instead, they were pools of junior tranches of mortgage-backed securities. And the junior tranche can go to zero even if quite a lot of homeowners continue to pay their mortgages in full and on time."
The lesser grades blow up first. That's the point of differing tranches and risks.
"Anon asks whether "at least one factor in the ongoing 'success' of these instruments was based on expectations of a declining USD" -- no. But he or she is quite right that the bankers
remained focused on short term profit pressures in the absence of 'new' ideas, confident both in apparent limits to their own personal liability and understanding that their firms would be too big to fail when the music stopped - and protected by bonuses and severance packages which would see them into very comfortable retirements IF proprietary knowledge of their firms did not keep them in demand for the rest of their careers."
Actually, the second part is spot on.
"And finally Kevin Drum reads me as saying that the banks were "creating a synthetic version of the subprime market that was even bigger than the original". This isn't really true: they created a synthetic version of the subprime market that was actually smaller than the original -- that was the problem, that it didn't fully hedge the subprime assets they held on their books."
That was the problem, that they didn't have enough capital. But, theoretically, at least, you could have had a larger market. But you do need to find buyers and sellers, and so there is a natural limit to this crap.
"Kevin also says that the banks kept synthetic subprime CDOs on their own books -- which happened in a few cases, notably at UBS, but was actually pretty rare. Normally they kept the real CDOs on their own books, and hedged by creating and selling the synthetics."
The CDOs allowed them to create investments of higher risk as if based on lower risk if the banks kept the CDOs on their own books.
I can't believe that I have to do more posting on this stuff today, if I can finally get around to it.
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