"Sunday, March 22, 2009
Robert Waldmann
I think the reason the CDO market is frozen is that CDO owners are not willing to sell at the market clearing price, because they would then have to mark their remaining holdings to market. This is one hypothesis.
(after the jump I will re-review others and explain why I find them unconvincing)
I'd say that people are convinced that something else must be going on, because of an earlier example of market freezing. I say frozen markets are a sign that people care a lot about the latest price and will not sell an asset at a price higher than their perception of its hold to maturity value, because they don't want the transaction to be recorded in the market to which they mark.
So, why would broker-dealers have done such a thing say the last time markets froze ?
That would be during the Long Term Capital Management meltdown/Freeze up metaphor mixer.
Why lo and behold, it is alleged that markets froze because all broker dealers were manipulating the mark to market value in this book I read "Inventing Money. subtitle includes "long term capital management" or "LTCM""
The assets were long maturity calls on European stock indices. LTCM was massively short these options. The market price of the options became absurdly huge and trading volume fell to roughly zero. LTCM collapsed. Now given the absense of actual trading, the price to which they were marked was the list price as listed by broker/dealers. All major broker dealers were LTCM counter parties. LTCM had REPO accounts so if the mark to market value LTCM's holdings at a bank fell to zero, the bank could seize the holdings including a short position on a grossly overpriced option.
So long as all broker/dealers refused to sell the options for less and no one wanted to buy them for that absurd price, they could seize a valuable LTCM position.
It was rumored that broker/dealers were secretly trading the options at lower prices.
So, it is alleged, that the market freeze up then was pure fraud.
I just know what I read in this book. I don't know if it is true. However, I think the allegation makes it unwise to use the case to prove that market's freeze up for reasons other than dishonesty about the true value of assets.
Here I argue against three other explanations of the current freeze.
Another would be adverse selection. Only the worst of the CDOs are for sale so the market price is the price of the worst of the worst. This can happen if sellers know more about the value of assets than buyers (check) and buyers have to bid on assets and let sellers accept some of the bids and reject others (huh). The second condition doesn't hold. As I've argued repeatedly below, if I had the money I could offer to buy x% of a bank's CDO book at a y% discount but only if they sold me equal proportions of the book. Adverse selection problem largely solved.
Another would be that everyone is panicked (except Geithner, Paulson and Summers). or that everyone has to deleverage. This would really have to be everyone. With frozen markets willingness to buy even a small amount of the assets at a high price would be enough that the latest market price wouldn't be the latest fire sale price.
Another would be that everyone has to deleverage. Again *everyone*.
Commenting on Drum again in one day
Drum argues that the US public will have to eat the toxic assets in any case and that Bank shares are basically worthless so who cares.Now, it's true that if we nationalize we'd wipe out the shareholders of the bad banks. But although that's the right thing to do, it's also pretty small potatoes since stock prices have dropped so far that shareholders in bad banks have virtually no equity left at this point. (Sweden didn't even bother trying to wipe out shareholders when they nationalized Nordbanken in 1992, for example. They just bought out the minority shareholders at the highly depressed market price.) What's more, a lot of those shareholders are mutual funds and pension funds anyway. The amount of bankster wealth that would be wiped out in a nationalization is probably pretty small.
Look the aim is not to keep the banks going with worthless shares forever OK.
Shares are worth nothing now, but, if the Geithner plan works, they will be worth a lot. So will shares in nationalized banks. But if we nationalize the value shares which are actually worth something will go into the Treasury. Geithner's plan is not to keep zombie banks staggering around forever. If shareholders are not wiped out and if the plan works as promised, they will end up with a huge amount of money given to them out of your tax dollars.
Also, I know this is so totally 2 days ago, but remember that little dust up about AIG bonuses ? The issue is not the shareholders; they lost long ago. It is the managers. Will they be able to pay themselves £11 million a year (and claim it is $1 million ?). Will they be masters of the universe or subordinates of the subordinates of Geithner ?
CEO compensation is a tiny amount of money, even in banking. Total compensation over $250,000/yr for all employees is not. That's the money Atrios is after.
Managers at banks don't want banks to be nationalized. Geithner is willing to give hedge fund managers tens of billions of US dollars to protect the sacred power of the Bank managers who messed up.
Commenting on Drum
update: Oh wow. Drum linked to this post. A Political animal stampede. I want to stress that, while I tend to use a confident tone, I really don't know anything about finance.
kevin Drum discusses Valuing the Toxic WasteAfter all, if markets can overvalue assets on the way up — and obviously they can — then they can also undervalue them on the way down. There's a pretty good chance that the toxic waste in question really is worth more than the market is currently willing to pay for it.
It is hard for markets to freeze at a price far from subjective effective hold to maturity value. It is easy for markets to flow (opposite of freeze) at such prices.
The current situation is not just that many people are willing to buy Toxic Waste at a huge discount and some owners are willing to sell it. It is also necessary that no one is willing to pay a higher price for toxic waste which happens not be available in a fire sale. Someone should be willing to buy at least a little bit of an asset at say 90% of that persons expectation of its hold to maturity present value. That would be enough to give a market price which isn't absurdly low.
In contrast back during the bubble one could sell short a huge amount of toxic waste at its huge price without affecting that price. People were willing to buy a huge amount at that price. Current owners are just not selling huge amounts of toxic waste at huge discounts (the market is frozen remember). That's the difference. It really has to be that no one wants it except at a huge discount and that really means no one not fewer people than want to sell it at a higher price (so long as they won't sell it at the huge discount because they would have to mark down the identical assets that they still own).a lazy shorthand that a lot of us have fallen into: namely the notion that the value of mortgage-backed securities is certain to keep plummeting because home prices themselves still have another 20-30% to fall. But these securities aren't backed by the value of the homes they represent. They're backed by mortgage payments. Home prices could fall by half, but the value of the securities wouldn't drop by a dime if homeowners kept making their monthly payments. Their value only drops if default rates go up.
So what causes default rates to rise? Falling home prices are certainly a factor, since it's more tempting to mail in the keys when your loan is way underwater. Rising unemployment is an even bigger factor: if you lose your job, you're more likely to stop paying the mortgage. And the crappy lending practices at the height of the bubble produced a surplus of buyers who have always been more likely to default than average.
I comment
You understate the effect of home prices on the value of mortgage based assets for two reasons. First the value of the assets is not just based on default rates, it is also based on cents on the dollar recovered through foreclosure. That clearly falls when home prices fall. Also, if a homeowners have positive equity I'd guess that even if they have say zero income, they can fend off foreclosure by taking out a second mortgage to pay the first (even if this debt is junior it is covered by the equity in the home). So default rates are higher for under the water mortgages for a reason different from mailing in the keys.Obviously, then, there's tremendous uncertainty about future default rates. But the market appears to be valuing most mortgage-backed securities these days at something like 30 cents on the dollar. That's crazy. When you factor in recovery rates, it assumes that over three-quarters of all homeowners will default on their loans. That might be true of the absolute worst of the toxic waste, and it's certainly true of the equity tranches of even the better stuff, but on average? No way. 30 cents on the dollar simply doesn't represent a reasonable long-term value for most of this stuff.
But everyone is scared, and when there are no buyers prices get unreasonable.
Your argument rests entirely on the figure 30% which does sound low. In fact, it seems that it would be low even if we could be absolutely sure that all mortgage debtors will never make another payment. Recovery after foreclosure should be worth more than 30% of face value on average.
You assume that the figure 30% applies to all mortgages or, at least, to all securitized mortgages. Whatever gave you that idea ? What if the figure comes from mezzanine tranches of CDOs of by liars loan only MBSs ? There are some assets which no one will buy for more than 30% of face value. They are called toxic sludge. Are they representative mortgages ? I think that's unlikely.
A key point is that there are patient, brave deep pocketed investors still out there. Warren Buffet is one and he controls enough money that there doesn't have to be another one. If the current market price is so absurdly low, why isn't he buying? If he is worried about adverse selection and counterparties with more information picking lemons to sell him and keeping the cherries, then why not offer to buy say 1% of a banks total MBS and CDO of MBS book ?
I think the fact that this isn't happening shows that the prices banks demand for their toxic sludge are higher than justified by a sober patient valuation by an agent with a huge capacity to bear risk.
To get a market price of 30 cents on the dollar it has to be that no one is willing to buy even a small amount of the asset for more. Banks would be delighted to sell a little of an asset for a high price so they could mark the rest to that high price.
The claim that everyone is scared must be literally true. Everyone. Warren Buffet has to be terrified of maybe losing a billion while probably making many billions.
How likely is that ?
Attempted DeLong smackdown meets It's a Dirty Rotten Job But Someone's Got to Do It.
Brad DeLong attempts to defend the Geithner plan. I consider this a good sign for the USA and a bad sign for Berkeley economics department economic history teaching. He is brilliant as always and almost convincing. I post some of his argument and all of my comment
Q: What is the Geithner Plan?
A: The Geithner Plan is a trillion-dollar operation by which the U.S. acts as the world's largest hedge fund investor, committing its money to funds to buy up risky and distressed but probably fundamentally undervalued assets and, as patient capital, holding them either until maturity or until markets recover so that risk discounts are normal and it can sell them off--in either case at an immense profit.
[snip]
Q: Why isn't this just a massive giveaway to yet another set of financiers?
A: The private managers put in $30 billion, but the Treasury puts in $150 billion--and so has 5/6 of the equity. When the private managers make $1, the Treasury makes $5. If we were investing in a normal hedge fund, we would have to pay the managers 2% of the capital and 20% of the profits every year; the Treasury is only paying 0% of the capital value and 17% of the profits every year.
We own the FDIC too so we are bearing 97% of the downside risk. Hedge fund investors can't end up with less than zero if the manager ends up with zero. This makes the analogy clearly false.
Second, the fact that hedge fund investors do it does not mean that it isn't essentially giving lots of money to already rich people in exchange for a chance to bear a lot of risk. You do not, in general, assume that investors are rational. You can't turn the efficient markets hypothesis on and off at will.
Finally, no one is willing to invest in someone's second hedge fund (well maybe someone is but it is dumb). If I have one hedge fund that is generating me income of 10 million a year and another one where I have limited risk, I might just take huge gambles with the second, to, you know, maximize the value of my option. If all my income comes from one fund, I won't be so casual about it becoming worthless. I think that hedge fund managers typically keep a lot of their wealth in their one fund too. The one example I know of LTCM was like that except for one manager who put more than all of his wealth in LTCM by borrowing to super duper leverage.
Investors can tell how much fund managers have taken out. I don't know anyone who invests in a hedge fund, but, I suspect, that if the manager takes a lot of money out of it, they switch funds.
The fact is that the Geithner deal will have highly positive expected returns for the private partners even if the expected returns on the investment are negative. Loss limited to 3% of the investment and gain equal to 17% of the gain is an extremely valuable Geithner put. This means that, if the private partners really are experts and know what assets are worth in expected value, they will pay more and the US government will have large expected losses.
If Geithner didn't want the USA to lose money, he could design the program so that hedge fund managers put of 3% of the capital and get, say, a 4% share. That way they would be willing to buy assets at 4/3 of their expected hold to maturity value *if* they were risk neutral, less since they are risk averse. This way I'd guess that they are willing to pay double their estimate of the expected hold to maturity value, because of the value of the Geithner put.
I admit that my guess has nothing to do with any calculation of the value of the option. I'm guessing that Geithner wants to buy toxic sludge at twice its hold to maturity value, because that is the only price at which banks are solvent -- that he wants to give banks the value of their toxic sludge but wants to pretend that he didn't do it on purpose. I am using the current market price as my estimate of the hold to maturity value. OK so I'm switching the efficient markets hypothesis off and on, but its the only estimate we have. I'd say there is a lot of wealth in the world and selling pressure can't keep assets undervalued for months.
The fact that CDOs are not being bought and sold doesn't mean that there is no one able to buy them because everyone is deleveraging. It has more to do with the fact that they are on balance sheets at values much higher than anyone is willing to pay. Current owners won't sell at the current market price, because they are not marking to the current market price not because they can't find buyers at the current market price.
Oh and adverse selection my ass. If I had a billion dollars, I could go to Goldman Sachs and say I want to buy 0.1% of your CDO proportional to your current portfolio. If you want to sell me some of them and not all of them, you can go to Geithner -- he's the one who wants to give you money. Doesn't seem to be happening does it ?
update: pulled back from comments
"The fact that CDOs are not being bought and sold doesn't mean that there is no one able to buy them because everyone is deleveraging. It has more to do with the fact that they are on balance sheets at values much higher than anyone is willing to pay. Current owners won't sell at the current market price, because they are not marking to the current market price not because they can't find buyers at the current market price."
You offer zero evidence for this proposition. You spend an enormous time on this blog arguing that markets are not efficient, but here insist on using the "market" price as a reasonable estimate of the net present value of the assets, even though there is no liquid market in these assets. You can offer hypotheses about why that is, but what we know is that the market doesn't exist right now. The vast majority of the "prices" that are being used for markdowns are fire-sale prices. It's absurd to think that the prices that distressed institutions are willing to sell at are real prices.
I'm glad you called this an "attempted smackdown," because it certainly doesn't succeed.
1:35 PM
Delete
Blogger Robert said...
I admitted to the inconsistency in my turning the efficient markets hypothesis on and off (and after accusing Brad of doing that).
On the substantive contested claim it is just not true that *everyone* is deleveraging. This is a fact, and I have evidence. Warren Buffet, for example, decided to pick up more exposure to Goldman Sachs. I don't need another example.
Brad's analysis is aggregate (he is a macroeconomist).
Now it has been alleged that no one is buying CDOs because the seller knows more about the CDO than the buyer so there is an adverse selection problem and there is an equilibrium of no trading except for fire sales.
I think this argument is based on an absurd assumption that all sales must be via market orders on double auction markets. There is no need for me to allow the seller to pick the lemons to sell me and keep the cherries. If I had the money, I could offer to buy 1% of a banks CDO book for, say 60% of face value. That is demand an equal fraction of all of their CDO's.
No one has done this. Banks are very eager to deleverage. Warren Buffet is buying -- something -- but not a part of any banks current CDO book. I think my explanation, for which you claim I present no evidence, is the only explanation which fits that fact, which I call evidence.
"
Posts
No comments:
Post a Comment