This theory is quickly debunked by considering the glowing counterexample of Bear Stearns.

From Derivative Dribble:

"The Art Of The Banking Controversy In Uncategorized on April 20, 2009 at 7:21 am

Also published on the Atlantic Monthly’s Business Channel.

Now that we are well into the depths of a recession, banker-bashing is all the rage. In addition to being fashionable, these “arguments” have an air of credibility about them, given the dire context in which they are made. As a result, the debate over regulating the financial sector is being recontextualized by portraying Wall Street as little more than a vacuous pig-pen. This view is informed by a grand equivocation, which lumps together all of finance under one roof, somewhere on Wall Street, where bankers convene and discuss how they can further redirect the world’s resources towards their pockets. And the shapeless anger that follows from this view has consumed not only the main stream media, but bloggers as well.

Brad Delong takes the view that both compensation and profits in the financial sector are wholly unjustified. Matthew Yglesias agrees. Another even more dubious theory, also espoused by Matthew Yglesias, is that those in finance are morally inept. (You can find Conor Clarke’s response to Yglesias here). Together, Delong and Yglesias employ straw men, false dichotomies, equivocation, conflate coincidence and causation, and in general treat a complex subject with glib answers that suggest the authors have no concern with getting it right, or have just finished reading Schopenhauer’s, “The Art of Controversy.”

Summary Judgment

In a sparsely worded opinion, Justice Delong condemns all of finance, finding the Economist’s piece on the likely pitfalls of blaming the wealthy for the current downturn an unconvincing defense to the charges. In structuring his opinion, Delong provides us with only two avenues through which we may prove our worth:

The rise in [financial sector] profits [as a share of domestic American corporate profits] from 20% to 40% would have been justified had finance produced (a) better corporate governance and thus better management, or (b) more successful diversification and thus a lowered risk-adjusted cost of and a higher risk-adjusted return to capital.

To say that profits can be justified only by satisfying exogenous factors strikes me as bizarre, especially coming from an economist. To say that there are only two such factors is simply ridiculous. There is no mandate which financial institutions must satisfy, other than the law, in order to prove their worth. The fact that Mr. Delong would like to see more emphasis on corporate governance and diversification does not create the presumption that profits earned at financial firms were somehow unjustified. Investors and clients are not in the business of making charitable contributions to financial institutions. If they paid financial institutions for services or products, they believed that they were getting good value in return at the time.

One sensible explanation for the rise in financial sector profits is that investor appetite was voracious during the relevant period. This was due at least in part to an influx of capital available for investment from the Middle East and elsewhere, which was itself due to record commodity prices, and a period of seemingly unbounded asset appreciation, each of which skewed the market’s appreciation for risk. Note that this explanation would not satisfy Delong’s demand for the justification of such profits. That is, Delong suggests that the mere existence of lawfully earned profits which the market elects to create through the demand for goods and services is insufficient. After all that happens, he, or some other economic Tsar, gets to determine which are justifiable and which are not.

Similarly, Yglesias writes:

Could it really be the case that so many people were naive enough to trust their monies to institutions that were only claiming to have brilliant investment models? Well, it seems to me that it could.

If we assume that financial institutions were merely feigning the existence of “brilliant investment models,” whatever that means, are we to simultaneously believe that these institutions were unaware of their inadequacy? After all, to accept Yglesias’ argument is to believe that Wall Street was not drinking its own Kool-Aid, but only selling it to others. This theory is quickly debunked by considering the glowing counterexample of Bear Stearns. Employees up and down the spine of corporate governance were married to Bear in the form equity. When Bear’s equity got wiped out, so did its employees, who held approximately one third of the company’s stock.

Despite Delong’s and Yglesias’ pronouncements to the contrary, the goings-on of Wall Street are not an elaborate ruse fashioned by the well-connected to deplete the world’s “precious bodily fluids.” That said, something has gone disastrously wrong. But indulging in argumentation that amounts to little more than hand waving will not help anyone to understand what happened, and more importantly, what policies should be implemented to prevent it from occurring again."

Me:

“After all, to accept Yglesias’ argument is to believe that Wall Street was not drinking its own Kool-Aid, but only selling it to others. This theory is quickly debunked by considering the glowing counterexample of Bear Stearns. Employees up and down the spine of corporate governance were married to Bear in the form equity. When Bear’s equity got wiped out, so did its employees, who held approximately one third of the company’s stock.”

The above doesn’t follow:

“What responsibility does he take, as chief executive officer, for the failure of Enron?

“I have to take responsibility for anything that happened within its businesses,” says Lay. “But I can’t take responsibility for criminal conduct of somebody inside the company.”

“This is what I call the Elmer Fudd defense — that I went to work every day and was paid $6 million a year and had a Ph.D. in economics — and somehow, despite all of this, I didn’t know anything that was going on. It’s laughable,” says Bill Lerach, a lawyer who sued to stop document shredding by Enron’s accountants. Now, he’s leading an investor lawsuit against the company, its bankers, its accountants and Lay.

“What was he doing every day in his office? Reading comic books? This man was the CEO of the company,” says Lerach. “He had an obligation to be informed about what was going on in that business every day in every way. And he utterly failed to do it.”

And:

“Prosecutors have tacitly conceded the effectiveness of Lay’s use of what is known in legal circles as the “idiot” or “ostrich” defense. The indictment handed down against him was narrowly drawn, consisting of seven counts of fraud and conspiracy, compared with the 35 counts leveled against Skilling and the 98 against former Chief Financial Officer Andrew Fastow, who is set to testify against Lay and Skilling under a plea bargain that limits his prison term to 10 years. Confined almost entirely to Lay’s actions during the last few months of 2001, the indictment accuses him of misrepresenting Enron’s condition as it careered toward insolvency.”

Of course, he was convicted.

As for Bear:

“The disintegration of the funds cost investors $1.6 billion and set in motion a series of cascading collapses, resulting in the write-down of more than $350 billion in losses and the demise of Bear Stearns itself.

“Perhaps the greatest irony yesterday was that these most networked of men, who were tuned into their Blackberries day and night, are being prosecuted through their own incriminating emails to one another.

In its indictment, the government uses email messages confiscated from both their home and work accounts to make the case that Cioffi and Tannin knowingly misled investors about the funds’ impending crackup to save their own jobs and reputations – in Cioffi’s case, going so far as to withdraw $2 million of his money from one of the funds, even as he reassured investors.

“If I can’t [turn the funds around] I’ve effectively washed a 30-year career down the drain,” Cioffi says in a June 9, 2007 email with the collapse imminent, according to the indictment.

The two are the first traders to face criminal charges in connection with the sub-prime mortgage crisis in a case that is likely to be a bellwether of the government’s ability to prosecute those who used highly complex financial transactions. ”

And:

“SEATTLE, April 8, 2008 /PRNewswire/ — Hagens Berman Sobol Shapiro filed a
third complaint today against Bear Stearns (NYSE: BSC) on behalf of current
and former employees, claiming the company violated ERISA laws concerning the
management of the Employee Stock Ownership Plan (ESOP).
Today’s lawsuit, filed in U.S. District Court in New York by plan
participant Rita Rusin, seeks to represent all employees that invested in the
ESOP from December 14, 2006 until the present.
The lawsuit claims the company’s failure to adequately manage the plan and
its investments resulted in the depletion of hundreds of millions of dollars
in retirement savings and anticipated retirement income for plan participants.
“We’ve received calls from employees looking for help,” said Hagens Berman
managing partner and lead attorney Steve Berman. “They are upset that Bear
Stearns didn’t warn them that the company stock might be in trouble.”
Berman also noted that the firm has received calls from current Bear
Stearns employees, afraid the company could retaliate against them if they
participate in the legal action. “I urge any employee who wants to speak up to
do so without fear,” Berman noted. “There are very strong laws that protect
employees when they come forward on cases such as this.”
Hagens Berman filed its first suit against Bear Stearns on March 24, 2008
after the company announced JPMorgan Chase & Co. was purchasing Bear Stearns
for $2 per share, 90 percent less than the company’s market value the week
prior.”

I don’t accept the Kool-Aid or Stupidity Defense, but all I’m asking for are through investigations into allegations of Fraud, Collusion, Negligence, and Fiduciary Mismanagement. Is that so much to ask for?

donthelibertariandemocrat 21 April 2009

it appears Hernando De Soto has joined the ranks of economists who demonstrate a complete lack of understanding of the subject area

TO BE NOTED: From Derivative Dribble:

"How To Speak “Structured Finance” In Uncategorized on March 31, 2009 at 7:20 am

Also published on the Atlantic Monthly’s Business Channel.

With all the accusations of excessive speculation on Wall Street, the media has certainly done its fair share of speculation as to what goes on in the structured finance market. And given all the public outrage, this is information the press should should get straight before they report.

Like every trade, the world of structured finance has developed its own little language describing the things that people in the market do. The first step to understanding that language is building a vocabulary. I would say that most folks in the media have developed to the point where they can identify, point at, and grunt towards objects in the structured finance space. But it’s not just the media that doesn’t understand structured finance. It’s economists, pundits, and perhaps most ironic, financiers! Even that giant of finance, George Soros has loused up explanations of how credit default swaps work. I’ve called out economists in the past for their mumblings on credit default swaps and the like, and so has Megan McArdle. This is a serious problem because economists, finance giants, and the like command a level of authority that my local TV news anchor does not.

Continuing in the tradition of misinformation, it appears Hernando De Soto has joined the ranks of economists who demonstrate a complete lack of understanding of the subject area. But rather than devote an entire article to bashing an intelligent man, I’ve decided to use the errors in his opinion piece in The Wall Street Journal as the first step in exploring the world of structured finance for those (lucky) folks who have hitherto had little exposure to the area.

Speaking Structured Finance

Speaking “Structured Finance” is not as hard as those around you suggest. Sure, these are not ideas and terms you’ve grown up around. But with a bit of reading and thinking, you’ll be the star of your next wine and cheese night. In this article, I provide topical treatment of a wide range of subjects, but provide links for those brave souls who really want to dive in and impress their cheese-eating friends.

First, Mortgage Backed Securities are not derivatives. To my fellow finance wonks, this may be a trivial observation. But apparently Mr. De Soto was not aware of this distinction:

[A]ggressive financiers have manufactured what the Bank for International Settlements estimates to be $1 quadrillion worth of new derivatives (mortgage-backed securities, collateralized debt obligations, and credit default swaps) that have flooded the market.

A Mortgage Backed Security (MBS) is just that, a security and not a derivative. Investors that own MBSs receive regular income from these securities. What distinguishes them from traditional securities, such as corporate bonds, is that the MBS is backed by a pool of mortgages. That is, investors buy MBSs, and as a result, they have a right to the cash flows produced by that pool of mortgages. As the homeowners whose mortgages are in the pool pay off their mortgages, the money gets funneled to and split up among the MBS holders. In effect, MBSs offer investors the opportunity to finance a portion of each mortgage in the pool and receive a portion of the returns on the pool. For more on MBS, go here.

Similarly, a Collateralized Debt Obligation (CDO) is not a derivative, but a security. It is similar in concept to an MBS, except the pool is not made up of mortgages, but rather various debt instruments, such as corporate bonds. The pool underlying the CDO could be made up of loans, in which case it’s referred to as a Collateralized Loan Obligation (CLO). In general, a CDO has a pool of assets that generate cash. As that cash is generated, it gets funneled to and split up among the investors. For more on CDOs, go here and here.

A Credit Default Swap (CDS) is a derivative. So De Soto got 1 out of 3. Well then, what’s a derivative? A “derivative” is a bilateral contract where the value of the contract is derived from some other security, derivative, index, or measurable event. For example, a call option to buy common stock is a fairly well known and common derivative. A call option grants the option holder the right (they can do it) but not the obligation to buy common stock at a predetermined price. The person who sold the option has the obligation (they must do it) and not the right to sell common stock at that predetermined price. So the value of a call option that entitles the holder to buy 100 shares of ABC Co. at $10 per share would depend on the current price of ABC’s stock. If ABC is trading above $10, it would be worth something to the holder, a.k.a., “in the money.” If it’s trading below $10, it would be “out of the money.”

So what are OTC Derivatives? The term “OTC” means “over the counter.” The spirit of the term comes from the fact that OTC Derivatives are not traded on an exchange, but entered into directly between the two parties. “Swaps” are a type of OTC Derivative. And the Interest Rate Swap market is by far the largest corner of the OTC Swap market, despite media protestations as to the size of the CDS market. For more an Interest Rate Swaps, go here.

Despite the fact that the Interest Rate Swap market is an order of magnitude larger than the CDS market, we will succumb to media pressure and skip right past Interest Rate Swaps and onto the most senselessly notorious OTC Derivative of all: the Credit Default Swap.

What Did You Just Agree To?

Under a typical CDS, the protection buyer, B, agrees to make regular payments, usually quarterly, to the protection seller, D. The amount of the quarterly payments, called the swap fee, will be a percentage of the notional amount of their agreement. The term notional amount is simply a label for an amount agreed upon by the parties, the significance of which will become clear as we move on. So what does B get in return for his generosity? That depends on the type of CDS, but for now we will assume that we are dealing with what is called physical delivery. Under physical delivery, if the reference entity defaults, D agrees to (i) accept delivery of certain bonds issued by the reference entity named in the CDS and (ii) pay the notional amount in cash to B. After a default, the agreement terminates and no one makes any more payments. If default never occurs, the agreement terminates on some scheduled date. The reference entity could be any entity that has debt obligations.

Now let’s fill in some concrete facts to make things less abstract. Let’s assume the reference entity is ABC. And let’s assume that the notional amount is $100 million and that the swap fee is at a rate of 8% per annum, or $2,000,000 per quarter. Finally, assume that B and D executed their agreement on January 1, 2009 and that B made its first payment on April 1, 2009. When July 1, 2009 rolls along, B will make another $2,000,000 payment. This will go on and on for the life of the agreement, unless ABC triggers a default under the CDS. While there are a myriad of ways to trigger a default under a CDS, we consider only the most basic scenario in which a default occurs: ABC fails to make a payment on one of its bonds. If that happens, we switch into D’s obligations under the CDS. As mentioned above, D has to accept delivery of certain bonds issued by ABC (exactly which bonds are acceptable will be determined by the agreement) and in exchange D must pay B $100 million.

Why Would You Do Such A Thing?

To answer that, we must first observe that there are two possibilities for B’s state of affairs before ABC’s default: he either (i) owned ABC issued bonds or (ii) he did not. I know, very Zen. Let’s assume that B owned $100 million worth of ABC’s bonds. If ABC defaults, B gives D his bonds and receives his $100 million in principal (the notional amount). If ABC doesn’t default, B pays $2,000,000 per quarter over the life of the agreement and collects his $100 million in principal from the bonds when the bonds mature. So in either case, B gets his principal. As a result, he has fully hedged his principal. So, for anyone who owns the underlying bond, a CDS will allow them to protect the principal on that bond in exchange for sacrificing some of the yield on that bond.

Now let’s assume that B didn’t own the bond. If ABC defaults, B has to go out and buy $100 million par value of ABC bonds. Because ABC just defaulted, that’s going to cost a lot less than $100 million. Let’s say it costs B $50 million to buy ABC issued bonds with a par value of $100 million. B is going to deliver these bonds to D and receive $100 million. That leaves B with a profit of $50 million. Outstanding. But what if ABC doesn’t default? In that case, B has to pay out $2,000,000 per quarter for the life of the agreement and receives nothing. So, a CDS allows someone who doesn’t own the underlying bond to short the bond.

So why would D enter into a CDS? Most of the big swap dealers buy and sell protection and pocket the difference. But, D doesn’t have to be a dealer. D could sell protection without entering into an offsetting transaction. In that case, he has gone long on the underlying bond. That is, he has almost the same cash flows as someone who owns the bond. So a CDS allows someone who doesn’t own the bond to gain bond-like credit exposure to the reference entity.

I will follow this article up with another elaborating further on why derivatives are used and why they are your friends."

Why is anyone surprised that AIG made substantial payments to large financial institutions?

TO BE NOTED: From Derivative Dribble:

"The Non-Event That Is AIG’s Counterparty List In Uncategorized on March 20, 2009 at 6:47 am

Why is anyone surprised that AIG made substantial payments to large financial institutions? Wasn’t the entire purpose of bailing out AIG to prevent the collapse of the financial system? Such a purpose would imply that without a bailout, the financial system would collapse. Therefore, we should expect the result of any bailout made with that purpose to result in substantial payments into the financial system. Since large financial institutions are at the heart of the financial system, we should expect such a bailout to result in substantial payments to large financial institutions. Is the world so devoid of news that such a trifling and obvious result warrants extensive coverage?

Without the report, we could not have known exactly who had received funds. But, we could have used information that was already available and apply categorical logic (or common sense if you prefer) to infer what sector was on the receiving end, as I have demonstrated above. But then again, it appears logic, common sense, and facts have nothing to do with public policy or debate on this crisis. Rather, populist rage, childish blame, and jealousy are firmly in the lead."

Thus, the existence of CDSs operates as a safety valve on the issuance of MBSs.

From Derivative Dribble, now on the Atlantic Business Channel:

"Jan 29 2009, 10:15 am by Charles Davi

Demon credit default swaps: the case of the synthetic security

An essay on mortgage backed securities. See also The Demand For Risk And A Macroeconomic Theory of Credit Default Swaps

Mortgage backed securities allow investors to gain exposure to the housing market by taking on credit risk linked to a pool of mortgages. Although the underlying mortgages are originated by banks, the existence of investor demand for MBSs allows the originators to effectively pass the mortgages off to the investors and pocket a fee. Thus, the greater the demand for MBSs, the greater the total value of mortgages that originators will issue and ultimately pass off to investors. So, the originators might front the money for the mortgages in many cases, but the effective path of funds is from the investors, to the originators, and onto the borrower. As a result, investors in MBSs are the effective lenders in this arrangement, since they bear the credit risk of the mortgages.

This market structure also has an effect on the interest rates charged on the underlying mortgages. As investor demand for MBSs increases, the amount of cash available for mortgages will increase, pushing the interest rates charged on the underlying mortgages down as originators compete for borrowers.

Loss In The Context Of Derivatives And Mortgages

I often note that derivatives cannot create net losses in the system. That is, they simply transfer money between two parties. If one party loses X, the other gains X, so the net loss between the two parties is zero. (For more on this, go here.)

This is not the case with a mortgage. The lender gives money to the borrower, who then spends this money on a home. Say a lender and borrower entered into a mortgage and that before it's paid off, the value of the home falls, prompting the borrower to default on their mortgage. Generally at this point the lender forecloses on the property, selling it at a loss. Since the buyer receives none of the foreclosure proceeds, the buyer can be viewed as either neutral or incurring a loss, since at least some of the borrower's mortgage payments went towards equity ownership and not just occupancy. It follows that there is a loss to the lender and either no change in or a loss to the borrower and therefore a net loss. (If the mortgage encouraged builders to spend too much building houses no one wants, there's a net loss to the economy as a whole.) This demonstrates what we have all recently learned: poorly underwritten mortgages can create net losses.

Net Losses And Efficiency

You can argue that even in the case that both parties to an agreement incur losses, the net loss to the economy is zero, since the cash transferred under the agreement was not destroyed but merely moved through the economy to market participants that are not a party to the agreement. That is, if you expand the number of parties to a sufficient degree, all transactions will net to zero. While this must be the case, it misses an essential point: I am using net losses to bilateral agreements as a proxy for inefficient allocation of capital.

Both parties to the mortgage expected to benefit from the agreement, yet both lost money, which implies that neither benefited from the agreement. For example, in the case of a mortgage, the borrower expects to pay off the mortgage but benefit from the use and eventual ownership or sale of the home. The lender expects to profit from the interest paid on the mortgage. When both of these expectations fail, I take this as implying that the initial agreement was an inefficient allocation of capital. This might not always be the case, and of course it depends on how you define efficiency. But as a general rule, it is my opinion that net losses to a bilateral agreement are a reasonable proxy for inefficient allocation of capital.

Expectations Of Lender/Borrower vs. Protection Seller/Buyer

As mentioned above, under a mortgage, the lender expects to benefit from the interest paid on the mortgage, while the borrower expects to benefit from the use and eventual ownership or sale of the home. Both parties assume that the mortgage will be repaid.

An economist would say that the lender is long on the mortgage, which is to say, the lender gains if the mortgage is fully repaid. Although application of the concepts of long and short to the borrower's position is awkward at best, the borrower is certainly not short on the mortgage--they do not gain if they fail to repay the mortgage. They might mitigate their losses by defaulting and declaring bankruptcy, but that's not really an improvement on their position before they bought the house. Both only really benefit if, as they both expect, the mortgage is fully repaid.

If we consider only lenders and borrowers, then, there are no participants with a true short position in the market. Thus, price, which in this case is an interest rate, will be determined by participants with similar positive expectations and incentives. Anyone with a negative view of the market has no role to play and therefore no effect on price.

This is not the case with credit default swaps (CDSs) referencing MBSs. In such a CDS, the protection seller is long on the MBS and therefore long on the underlying mortgages, and the protection buyer is short. That is, if the MBS pays out, the protection seller gains on the swap; and if the MBS defaults, the protection buyer gains on the swap. The two parties are expressing, through the CDS, their opposing expectations of the performance of the underlying security. Thus, the CDS market provides an opportunity to express a negative view of mortgage default risk.

The Effect Of Synthetic Instruments On "Real" Instruments

As mentioned above, the CDS market provides a method of shorting MBSs. But how does that effect the price of MBSs and ultimately interest rates?

As I've previously described, the cash flows of any bond, including MBSs, can be synthesized using Treasuries and CDSs. Using this technique, a fully funded synthetic bond consists of the long end of a CDS, and a Treasury. The spread that the synthetic instrument pays over the risk free rate is determined by the price of protection that the CDS pays the investor (who in this case is the protection seller).

One consequence of this is that there are opportunities for arbitrage between the market for real bonds and CDSs if the two markets don't reach an equilibrium. Because this opportunity for arbitrage is rather obvious, we assume that it will be quickly traded away. As the price of protection on MBSs increases, the spread over the risk free rate paid by MBSs should widen, and visa versa. Thus, as the demand for protection on MBSs increases, we would expect the interest rates paid by MBSs to increase, thereby increasing the interest rates on mortgages. So those with a negative view of MBS default risk raise the cost of mortgage funds by buying protection through CDSs on MBSs, thereby inadvertently "correcting" what they view as underpriced default risk.

In addition to the no-obvious-arbitrage argument outlined above, we can consider how the existence of synthetic MBSs affects the supply of comparable investments, and thereby interest rates. As mentioned above, any MBS can be synthesized using CDSs and Treasuries (when the synthetic MBS is unfunded or partially funded, it consists of CDSs and other investments, not just Treasuries). Thus, investors will have a choice between investing in real MBSs or synthetic MBSs. And as explained above, the price of each should come to an equilibrium that excludes any opportunity for obvious arbitrage between the two investments. We'd expect at least some investors to be indifferent between the two.



Depending on whether the synthetics are fully funded or not, the principal investment will go to the Treasuries market or back into the capital markets respectively. Note that synthetic MBSs can exist only when there is a protection buyer for the CDS that comprises part of the synthetic. Only when interest rates on MBSs drop low enough, along with the price of protection on MBSs, will protection buyers enter CDS contracts. So when protection buyers think that interest rates on MBSs are too low to reflect the actual probability of default, their desire to profit from this will spur the issuance of synthetic MBSs, thereby diverting cash from the mortgage market and into either Treasuries or other areas of the capital markets. Thus, the existence of CDSs operates as a safety valve on the issuance of MBSs. When interest rates sink too low, synthetics will be issued, diverting cash away from the mortgage market.

Permalink :: Comments (4) :: TrackBacks (0) :: Share This"

And me:

Previewing your Comment

Charles, Congratulations.I think I posed that gambling question in October. Underlying it, I argued, was a moral notion of unproductive investment. Here's my current view:

You are absolutely correct. CDSs can help in the following ways:
1) Mirror Bonds
2) As insurance
3) Counterbalance other investments
4) Provide price information in a calcified market
5) Provide investments with less capital requirements
All of these are valid uses. Only misuse renders them a problem. Any such misuse is either a crime or financial malpractice. Could someone refer to a post that actually details how CDSs caused these problems? The last post I went to, on RGE Monitor, had more hedges in it than a hedge fund.

Real people misused these instruments. Those people need to be held to account. The arguments I'm hearing are more moral than economic:
a) They bet on things going bad
b) They bet against the government bailout
c) They don't produce anything real
Then don't buy them.

This legislation is as silly and short-sighted as short selling bans. Welcome to the world of blaming inanimate objects for human failings. Don't we all feel better?

My own view's on our current crisis follow Irving Fisher's classic paper on Debt-Deflation. In my view, the trigger for this crisis were the poor loans that began a foreclosure tsunami, the eventual end of which will be a major loss in the value of homes. That loss in home value is the real problem, and it has a number of serious problems associated with it.
1) A negative wealth effect
2) Loss of property taxes
3) Shell shocked lenders ( I notice that Meredith Whitney supports this view )
4) Triggering insurance payments on CDSs
5) Triggering calls on other investments to make up for the losses in mortgages and insurance
Notice that the CDSs figure in on 4 and 5.In other words, the loss of wealth in homes and on mortgages caused the Calling Run, not the other way around. I have yet to see any evidence that shows that CDSs clearly caused the problem. In order to understand what has happened, you have to explain why a Calling Run occurred. Why did people demand up front money, and not just on CDSs? For example, why did AIG need to raise money immediately? The reason is that there was a general panic about how many home foreclosures that there would be, and how low home prices would fall. In that uncertainty, investors made calls on cash with anyone who had anything to do with mortgages. That was the problem. To the extent that there were problems with CDSs, it has to do with not expecting a Calling Run or Debt-Deflation to occur. If this seems odd, remember that this is exactly how our banking system works. Theoretically, Bank Runs can occur. That's why we have FDIC insurance on deposits. To forestall a Bank Run. Had insurance been in place, as Ricardo Caballero has argued, the Calling Run might well not have occurred, and these assets would have been exchanged in an orderly manner, although with large losses because of the foreclosure tsunami. There was no way to escape that.

Posted by: Don the libertarian Democrat | January 30, 2009 3:55 PM | Reply

Previewing your Comment

One more point: Strictly speaking, the AIG problem was caused by a ratings downgrade which triggered capital requirements, but the downgrade was caused by a fear of AIG not being able to weather a Calling Run.

Posted by: Don the libertarian Democrat | January 30, 2009 4:04 PM | Reply

"The firm’s failure is caused by that firm’s own poor risk management."

A new post from Derivative Dribble:

"The Demand For Risk And A Macroeconomic Theory of Credit Default Swaps: Part 2 In Politicized Economy, Systemic Counterparty Confusion on January 10, 2009 at 8:43 pm

Redux And Reduction

In the previous article, we defined a highly abstract framework that considered the subjective expected payout of both sides of a fixed fee derivative. In this article, we will apply that model to the context of credit default swaps and will show that the presence of credit default swaps and synthetic bonds should be expected to reduce the demand for “real” bonds (as opposed to synthetic bonds) and thereby reduce the net exposure of an economy to credit risk( WOW ).

The Demand For Credit Default Swaps

In the previous article, we plotted the expected payout of each party to a credit default swap as a function of the fee and each party’s subjective valuation of the probability that a default will occur. The simple observation gleaned from that chart was that if we fix the subjective ( YES )probabilities of default, protection sellers expect to earn more as the price of protection increases and protection buyers expect to earn more as the price of protection decreases. Thus, as the the price of protection increases, we would expect protection seller side “demand” to increase and expect protection buyer side “demand” to decrease. But how can demand be expressed in the context of a credit derivative? The general idea is to assume that holding all other variables constant, the size of the desired notional amount of the CDS will vary with price. So in the case of protection sellers, the greater the price of protection, the greater the notional amount desired by any protection seller.

In order to further formalize this concept, we should consider each reference entity as defining a unique demand curve for each market participant. We should also distinguish between demand for buying protection and demand for selling protection. For convenience’s sake, we will refer to the demand for selling protection as the supply of credit protection and demand for buying credit protection as the demand for credit protection. For example, consider protection seller X’s supply curve and protection buyer Y’s demand curve for CDSs naming ABC as a reference entity. The following chart expresses the total notional amount of all CDSs desired by X and Y as a function of the price of protection.

As the price of protection approaches zero, Y’s desired notional amount should approach infinity, since at zero, Y is getting free protection and should desire an unbounded “quantity” of credit protection. The same is true for X as the price of protection approaches infinity.

Synthetic Bonds As Competing Goods With “Real” Bonds

Imagine a world without credit derivatives and therefore without synthetic bonds. In that world, there will be a demand curve for real ABC bonds as a function of the spread the bonds pay over the risk free rate, holding all over variables constant. Now imagine that credit default swaps were introduced to this world. We know that the cash flows of any bond can be synthesized using Treasuries and credit default swaps( TRUE ). For example, assume we have synthesized the cash flows of ABC’s bonds using the method described here. We would expect at least some investors to be indifferent between real ABC bonds and synthetic ABC bonds, since they both produce the same cash flows( TRUE ). Thus, the two are competing products in the sense that investors in real ABC bonds should be potential investors in synthetic ABC bonds. So because some investors will be indifferent between synthetic ABC bonds and real ABC bonds, synthetic ABC bonds will siphon some of the cash that would have otherwise gone to real ABC bonds( TRUE ). Thus, in a world with credit derivatives, we would expect there to be less demand for real bonds than would be present without credit derivatives. In the following chart we express the macroeconomic demand for real ABC bonds in terms of the spread over the risk free rate and the total par value desired by the market.

Thus, the demand for credit derivatives diminishes the demand for real bonds. Although we cannot know exactly what the effect on the demand curve for real bonds will be, we can safely assume that it will be diminished at all levels of return, since at each level, at least some investors will be indifferent to real bonds and synthetic bonds, since each offers the same return( OK ).

Real Cash Losses Versus Wealth Transfers Through Derivatives

Economics already has a term to describe payouts under credit default swaps: wealth transfers. Although ordinarily used to describe the cash flows of tax regimes, the term applies equally to the payments under a credit default swap. As described in the previous article, there are no net cash losses under a credit default swap. There is a payment of money from one party to another, the net effect of which is a wealth transfer. That is, credit default swaps, like all derivatives, simply rearrange the current allocation of cash in the financial system, and nothing is lost in process (ignoring transaction costs, which are not relevant to this discussion)( TRUE ).

When a real bond defaults, a net cash loss occurs. The borrower has taken the money lent to it by investors, lost it, and the investors are not fully paid back. Therefore, both the borrower and the investors incur a cash loss, creating a net cash loss to the economy. So, in the case of a synthetic ABC bond, upon the default of one of ABC’s bonds, a wealth transfer occurs from the protection seller to the protection buyer and the net effect is null. In the case of a real ABC bond, upon the default of that bond, the investors will lose some of their principle and ABC has already lost some of the money it was lent, the net effect of which is a loss to the economy.( OK )

So every dollar siphoned away from real bonds by synthetic bonds is a dollar that will not be lost in the economy upon the occurrence of a credit event. If there were no credit derivatives, then that dollar would have been invested in real bonds and thereby lost upon the occurrence of a credit event. Therefore, the net losses to the economy upon the occurrence of a credit event is less with credit derivatives than without. In the following diagram, the two circles of each transaction represent the parties to that transaction. In the case of real bonds, one of the parties is ABC and the other is an investor. In the case of synthetic bonds, one is the protection seller and the other is the protection buyer of the credit default swap underlying the synthetic bond.

This diagram simply demonstrates what was described above. Namely, that with credit derivatives, some investors will choose synthetic bonds rather than real bonds, thereby reducing the amount of cash exposed to credit risk. Thus, rather than increase the impact of credit risk, credit default swaps actually decrease the impact of credit risk by placating the demand for exposure to credit risk with synthetic instruments that are incapable of producing net losses. However, there may be consequences arising from credit default swaps that cause actual cash losses to an economy, such as a firm failing because of its obligations under credit default swaps. But the failure is not caused by the instrument itself. The nature of the instrument is to reduce the impact of credit risk. The firm’s failure is caused by that firm’s own poor risk management( I AGREE. BY HUMAN ERROR. )."

While I find this persuasive, I also can imagine one objection: Namely, that a corporate bond is a loan to a company to fund its business, and that business can help the economy grow. In other words, the risk of actual loss is higher, but the value to the economy is also a lot more on the upside. Buying a Bond can be productive, while buying a CDS can not.

I would also argue that, since the CDS doesn't involve an actual asset, the collateral should be higher than bonds, not less, since the ability to pay up in cash is the essence of the CDS contract. In a mortage or corporate bond, you might well be able to claim assets in a default. The probablity of payment is a part of the risk, as well as the risk in the CDS.

"This process repeats itself and eventually market prices will develop."

Derivative Dribble with another excellent post:

"A Higher Plane

In this article, I will return to the ideas proposed in my article entitled, “A Conceptual Framework For Analyzing Systemic Risk,” and once again take a macro view of the role that derivatives play in the financial system and the broader economy. In that article, I said the following:

“Practically speaking, there is a limit to the amount of risk that can be created using derivatives. This limit exists for a very simple reason: the contracts are voluntary, and so if no one is willing to be exposed to a particular risk, it will not be created and assigned through a derivative. Like most market participants, derivatives traders are not in engaged in an altruistic endeavor. As a result, we should not expect them to engage in activities that they don’t expect to be profitable. Therefore, we can be reasonably certain that the derivatives market will create only as much risk as its participants expect to be profitable.” ( VERY TRUE )

The idea implicit in the above paragraph is that there is a level of demand for exposure to risk ( TRUE ). By further formalizing this concept, I will show that if we treat exposure to risk as a good, subject to the observed law of supply and demand, then credit default swaps should not create any more exposure to risk in an economy than would be present otherwise and that credit default swaps should be expected to reduce the net amount of exposure to risk ( TRUE ). This first article is devoted to formalizing the concept of the price for exposure to risk and the expected payout of a derivative as a function of that price. ( A GOOD IDEA )

Derivatives And Symmetrical Exposure To Risk

As stated here, my own view is that risk is a concept that has two components: (i) the occurrence of an event and (ii) a magnitude associated with that event. This allows us to ask two questions: ( 1 )What is the probability of the event occurring? ( 2 ) And if it occurs, what is the expected value of its associated magnitude? We say that P is exposed to a given risk if P expects to incur a gain/loss if the risk-event occurs. We say that P has positive exposure if P expects to incur a gain if the risk-event occurs; and that P has negative exposure if P expects to incur a loss if the risk-event occurs.

Exposure to any risk assigned through a derivative contract will create positive exposure to that risk for one party and negative exposure for the other ( THIS IS WHAT I SAID WAS A LOSS FOR ONE AND A GAIN FOR THE OTHER ). Moreover the magnitudes of each party’s exposure will be equal in absolute value ( THEY WILL BALANCE OUT ). This is a consequence of the fact that derivatives contracts cause payments to be made by one party to the other upon the occurrence of predefined events ( TRUE ). Thus, if one party gains X, the other loses X( I SAID THAT ABOVE. I AGREE ). And so exposure under the derivative is perfectly symmetrical ( TRUE ). Note that this is true even if a counterparty fails to pay as promised ( TRUE ). This is because there is no initial principle “investment” in a derivative. So if one party defaults on a payment under a derivative, there is no cash “loss” to the non-defaulting party ( TRUE ). That said, there could be substantial reliance losses ( TRUE ). For example, you expect to receive a $100 million credit default swap payment from XYZ, and as a result, you go out and buy $1,000 alligator skin boots, only to find that XYZ is bankrupt and unable to pay as promised. So, while there would be no cash loss, you could have relied on the payments and planned around them, causing you to incur obligations you can no longer afford ( TRUE ). Additionally, you could have reported the income in an accounting statement, and when the cash fails to appear, you would be forced to “write-down” the amount and take a paper loss ( TRUE ). However, the derivatives market is full of very bright people who have already considered counterparty risk, and the matter is dealt with through the dynamic posting of collateral over the life of the agreement, which limits each party’s ability to simply cut and run ( TRUE ). As a result, we will consider only cash losses and gains for the remainder of this article.

The Price Of Exposure To Risk

Although parties to a derivative contract do not “buy” anything in the traditional sense of exchanging cash for goods or services, they are expressing a desire to be exposed to certain risks ( THAT'S IT ). Since the exposure of each party to a derivative is equal in magnitude but opposite in sign, one party is expressing a desire for exposure to the occurrence of an event while the other is expressing a desire for exposure to the non-occurrence of that event ( TRUE ). There will be a price for exposure. That is, in order to convince someone to pay you $1 upon the occurrence of event E, that other person will ask for some percentage of $1, which we will call the fee ( PREMIUM ). Note that as expressed, the fee is fixed. So we are considering only those derivatives for which the contingent payout amounts are fixed at the outset of the transaction. For example, a credit default swap that calls for physical delivery fits into this category. As this fee increases, the payout shrinks for the party with positive exposure to the event ( TRUE ). For example, if the fee is $1 for every dollar of positive exposure, then even if the event occurs, the party with positive exposure’s payments will net to zero ( TRUE ).

This method of analysis makes it difficult to think in terms of a fee for positive exposure to the event not occurring (the other side of the trade) ( YOU KEEP THE FEES ). We reconcile this by assuming that only one payment is made under every contract, upon termination ( THAT'S IT ). For example, assume that A is positively exposed to E occurring and that B is negatively exposed to E occurring. Upon termination, either E occurred prior to termination or it did not. ( OKAY )

If E did occur, then B would pay to A, where F is the fee and N is the total amount of A’s exposure, which in the case of a swap would be the notional amount of the contract":

Under a typical CDS, the protection buyer, B, agrees to make regular payments (let’s say monthly) to the protection seller, D. The amount of the monthly payments, called the swap fee, will be a percentage of the notional amount of their agreement. The term notional amount is simply a label for an amount agreed upon by the parties, the significance of which will become clear as we move on. So what does B get in return for his generosity? That depends on the type of CDS, but for now we will assume that we are dealing with what is called physical delivery. Under physical delivery, if the reference entity defaults, D agrees to (i) accept delivery of certain bonds issued by the reference entity named in the CDS and (ii) pay the notional amount in cash to B. After a default, the agreement terminates and no one makes anymore payments. If default never occurs, the agreement terminates on some scheduled date. The reference entity could be any entity that has debt obligations, like AIG.

"If E did not occur, then A would pay . If E is the event “ABC defaults on its bonds,” then A and B have entered into a credit default swap where A is short ( DEFAULT ) on ABC bonds and B is long ( NO DEFAULT ). Thus, we can think in terms of a unified price for both sides of the trade and consider how the expected payout for each side of the trade changes as that price changes ( BASED UPON THE CHANCE OF DEFAULT ).

Expected Payout As A Function Of Price

As mentioned above, the contingent payouts to the parties are a function of the fee. This fee is in turn a function of each party’s subjective valuation of the probability that E will actually occur( IN THIS IT'S LIKE INSURANCE ACTUARIAL TABLES ). For example, if A thinks that E will occur with a probability of , then A will accept any fee less than .5 since A’s subjective expected payout under that assumption is . If B thinks that E will occur with a probability of , then B will accept any fee greater than .25 since his expected payout is . Thus, A and B have a bargaining range between .25 and .5. And because each perceives the trade to have a positive payout upon termination within that bargaining range, they will transact ( THEY BASE THEIR ACTUAL INVESTMENT ON THE PROBABILITY OF THE EVENT OCCURING IN THEIR OPINION ). Unfortunately for one of them, only one of them is correct ( THIS IS WHERE PEOPLE FEEL IT'S LIKE GAMBLING AND NOT LIKE INSURANCE ). After many such transactions occur, market participants might choose to report the fees at which they transact ( ON AN INDEX ). This allows C and D to reference the fee at which the A-B transaction occurred. This process repeats itself and eventually market prices will develop ( FORMING AN INDEX, AND, POSSIBLY, AN EXCHANGE ).

Assume that A and B think the probability of E occurring is and respectively. If A has positive exposure and B has negative, then in general the subjective expected payouts for A and B are and respectively. If we plot the expected payout as a function of F, we get the following:

The red line indicates the bargaining range. Thus, we can describe each participant’s expected payout in terms of the fee charged for exposure( TRUE ). This will allow us to compare the returns on fixed fee derivatives to other financial assets, and ultimately plot a demand curve for fixed fee derivatives as a function of their price ( TRUE )."

It is important to understand each point as he goes along, so that you can see that the investment has defined terms, and is thus Priceable and Saleable.

Why do I believe that this is so important? Because I do not believe that these investments are that complex. I believe that it is very easy to explain the purpose and risk of these investments, even to people who do not have the ability to understand how the CHANCE OR POSSIBILITY OF THE RISK is determined, which is where the real complexity is located.

Hence, I believe that Fraud, Negligence, Fiduciary Mismanagement, and Collusion, are the main problems associated with these investments in the real world. For example, the iffy nature of the models used to determine the Chance or Possibility of the Risk were known, and all that needed to be explained to a buyer is just that. The methods are iffy.

Stop looking at the investments for the cause of this crisis. It's a charade.

"Tranche is a French word that means slice.": I Use It When Asking For A Piece Of Pie

The great Derivative Dribble with a new post on Tranches:

"What Is A Tranche?

Tranche is a French word that means slice. Every investment will convey certain rights in the cash flows produced by the investment to the investors. A tranche is a slice of those rights. Quite literally, each tranche represents a unique piece of the investment pie. So the term tranche connotes a fairly accurate indication of how the term is used in finance. And after all, its easier to tell investors that they’re buying tranches as opposed to “pits” or “buckets.”

I'd like them to use:

1) Slice of the pie

2) Levels: Called Riskier, Riskiest, Least Risky but riskier than, etc.

"Payment Waterfalls

A payment waterfall determines who gets paid what and when. That is, each dollar produced by an investment will be “pushed through” a payment waterfall and allocated according to the rules in the payment waterfall. For example, assume that there are 3 investors, A, B and C. They collectively invest in venture X. The payment waterfall for X is defined as follows: on the first of each month, A will be paid the lesser of (i) $100 and (ii) all of the cash flows produced by X in the previous month; B will be paid the lesser of (i) $100 and (ii) all of the cash flows produced by X in the previous month less any amounts paid to A; and C will be paid the lesser of (i) $100 and (ii) all of the cash flows produced by X in the previous month less any amounts paid to A and B."

I think that "waterfall" is an unfortunate choice of terminology, since a waterfall can, and often does, denote continuous flow. I prefer "cascade":

a series of shallow or steplike waterfalls, either natural or artificial.

One could also use "laddered".

In essence, the first one gets paid before the others. The second gets paid, etc.

"Assume that in month 1, X produced $300 in cash. On the first day of month 2, the $300 will be pushed through the waterfall. So A will get $100; B will get $100; and C will get $100. Note that in the case of C, the two choices will produce equal amounts, so the term “lessor of” isn’t technically accurate. But assume that when the choice is between equal amounts, we simply pay that amount. Now assume that X produced $150 in month 1. On the first day of month 2, the $150 will be pushed through the waterfall. So A will get $100; B will get $50; and C will get $0. Because A is “first” to get paid, so long as X produces $100 per month, A is fully paid. B is fully paid so long as X produces $200 per month and C at $300 per month. So in this case, A’s tranche is said to be the least risky of the 3 tranches, with B and C being more risky in that order. Note that I am not using my technical definition of risk."

DD also prefers "waterfall".

"What Is Risk? There are a number of competing definitions depending on the context. My own personal view is that risk has two components: (i) the occurrence of an event and (ii) a magnitude associated with that event. This allows us to ask two questions: What is the probability of the event occurring? And if it occurs, what is the expected value of its associated magnitude? "

Let's continue:

"So why would C agree to be last in the pecking order? Well, one simple explanation is that C paid the least for his tranche. In another example we could have given C the right to any amounts left over each month after all other tranches are paid. This type of right is called a residual right. It is basically an equity stake. So in that case C would bear the risk that X’s cash flows will fall short in exchange for the right to acquire any excess cash flows produced by X. As is evident, the terms of the waterfall can be anything that the parties agree to. As such, we can cater the payment priorities to meet the specific desires of investors and distribute risks accordingly."

He could have paid less, or the payments could be more as you go down the ladder. However, strictly speaking, this is structured like a contract, so it could be arranged on whatever terms the parties agree to. This is one reason you often hear calls for standardizing these products, so that their dimensions can be limited and more strictly and narrowly confined for ease of understanding.

"Mortgage Backed Securities And Prepayment Risk

Securitization is a fairly simple process to grasp in the abstract. In reality, turning millions of mortgages into interest bearing notes is not a simple process."

Just think of the complexity for yourself if you had a bundle of ten bonds, all with differing rates of interest and maturity dates and conditions. You bundle them, and then, somehow, divvy them up. I'm already not playing this game, and we're on the baby level, where, quite frankly, I spend most of my time anyway.

"However, we can at least begin to understand the process by considering how a payment waterfall can be used to streamline the payments to investors. Viewed as a bond, a mortgage is a bond where the borrower, in this case the mortgagor, has a right to call the bond at any point in time. That is, at any point in time, a mortgagor can simply repay the full amount owed and terminate the lending agreement. Additionally, even if the mortgagor doesn’t pay the full amount owed, it is free to pay more than the amount obligated under the mortgage and allocate any additional amounts to the outstanding principle on the mortgage. For example, if A has a mortgage where A is obligated to make monthly payments of $100, A could pay $150 in a particular month, and request that the lender allocate the additional $50 to reduce the outstanding principle on the mortgage."

This is what I did. I paid my mortgage off in half the time by paying more each month than was called for and paying extra principal when I refinanced. I find that most people intuitively understand this.

"The typical practice for a mortgage is to require the mortgagor to make fixed payments over the life of the mortgage. So each payment will consist of an interest portion and a principle portion. The amount allocated to principle is predetermined and said to amortize over the life of the mortgage. And as mentioned above, any amount over the fixed amount can be allocated to principle at the option of the mortgagor. The risk that any given loan will pay an amount above the required fixed payment is called prepayment risk."

If you want to get people to pay more each month, show them how much money their house will cost if they pay it all as scheduled. It's usually a shock. It worked for me. Let's just make up numbers:

House A: Paid As Scheduled: House $100,000 + Interest $200,000
House B: Paid In Half Time: House $100,000 + Interest $100,000

You, the borrower in House B, have just saved $100,000, while the lender, has, in effect, lost $100,000. That's the lenders Prepayment Risk.

"While getting your money back is usually a good thing, investors prefer to defer repayment to some future date in exchange for receiving more money than they invested. So getting all of their principle back today is not the most preferred outcome. They prefer to get their principle at maturity plus interest over the life of the agreement. For example, if all of the mortgages in a pool of mortgages that have been securitized prepay the full amount before the anticipated maturity date of the notes, then the investors will presumably be repaid, but will not receive the remaining interest payments over the anticipated life of the notes. If this prepayment en masse occurs on the second day of the life of the notes, it would defeat the purpose of the investment."

Not necessarily. If you give me my money back early, depending on the current rate of interest and the mortgage market, I could make more money. Of course, the opposite is true as well. The reason I say this is that I'd personally rather be paid off early, but that's why I don't do this. You know who, funnily enough, loved fiddling around with this kind of thing, was Marx.

"Prepayment Risk And Payment Waterfalls

We can use payment waterfalls to distribute prepayment risk into different tranches. In reality, this can become a mind numbingly complex endeavor. We propose one simple example to demonstrate how tranches can be used to redistribute complex risks."

I love the phrase "mind numbingly". So, we're going to slice this cake up into pieces of risk. Let's say that each piece varies in rancidity.

"Assume that our mortgage pool consists of mortgages; the remaining principle on each mortgage is ; and the total remaining principle on the pool is . Because each mortgage payment consists of some interest and some principle, each month, there will be a scheduled reduction in the outstanding total principle on the pool."

Forget the math. I always do if it includes variables. I simply can't abide the lack of specificity involved. It reeks of imprecision, as does all higher math.

You have a bundle of mortgages. A pool suggests that they're undifferentiated. Each month, each borrower will send in his payment which might well include this damned nuisance to our accounting of extra principal payments. The overpayment needs to figure into our distribution.

"Let denote the scheduled reduction of . That is, is the sum of all of the principle portions of the fixed payments to be made in the pool. If there are any prepayments in the underlying mortgages, the actual reduction in will exceed the scheduled reduction. Let denote the actual reduction in . The question now becomes, what do we do with ? "

Let NL denote "not likely". Where does the extra cash from the prepayment go?

"That is, how do we distribute the amount by which the actual reduction in total principle exceeds the scheduled reduction?"

To whom on our ladder does it go? Which rung? Notice how I deftly shift images to aid in my own understanding. You're probably following the damned math.

"The simple answer, and the one considered here, is to push the entire prepayment amount onto one tranche, and reduce the outstanding principle on that tranche by that same amount."

Pay it all to one guy. That is the simplest thing to do.

"For example, assume that a mortgage pool contains mortgages with a total $100 million principle outstanding and that $100 million worth of notes were issued against that pool. Further, assume that there are two tranches of notes: the A series and B series, with $50 million face value of each outstanding. For simplicity’s sake, assume the notes pay interest monthly. On any interest payment date, we could pay the B series the entire prepayment amount and reduce the face value on the B series notes by . For example, if on the first interest payment date, $10 million, then we would pay the $10 million to the B series note holders and reduce the face value on the B series to $40 million. Thus, any prepayment amount less than or equal to $50 million will be completely absorbed by the B series note holders. So the net effect is to cushion the A series against a certain amount of prepayment risk. The B series note holders will likely demand something in return for bearing this risk."

This is the kind of brilliant, lucid, explanation, that you get when the explanation comes from a fan of Paul Erdos. Mine is the kind of explanation you get from a fan of Groucho Marx.

Anyway, the guy lower on our ladder gets screwed by having all the prepayment assigned to him, so he'll want something in return. I'd give him/her a copy of "Memoirs Of A Mangy Lover", but that's just me.

Now you know all about Tranches. Be careful which slice of the pie you take in future.

"Credit-recovery swaps are trading on the debt of about 70 companies"

I don't know why this strikes me as funny, except that the ingenuity of investors astonishes someone like me who has no such skills. From Bloomberg:

"Nov. 25 (Bloomberg) -- Goldman Sachs Group Inc., Citigroup Inc. and JPMorgan Chase & Co., which helped turn bets on company defaults into a $47 trillion market, are among banks offering wagers on the amount investors may recover from bonds after borrowers go bankrupt. "

First of all, notice the use of the word "wager". Yep, Derivative Dribble isn't going to like that. It sounds a bit like me. Anyway, we now have, are you ready, DRSs, i.e., Default-Recovery Swaps.

Now, given the wonderful explanations on Derivative Dribble, and so knowing that anything on earth that can go up or down and be measured can become a Derivative, I should have expected this.

So, we now have a Derivative on CDSs. Hello.

"Credit-recovery swaps are trading on the debt of about 70 companies, including automaker General Motors Corp. and bond- insurer MBIA Inc. That’s up from 40 during the summer, according to Mikhail Foux, a strategist at Citigroup in New York.

The contracts, barely traded in 2006, are now worth about $10 billion as more companies fail to repay debts, Foux said. Also known as recovery locks, the agreements are bought as insurance by sellers of credit-default swaps, such as banks, hedge funds and insurers."

So, DRSs=Recovery Locks. They are an insurance policy on CDSs, which are an insurance policy on mortgage defaults. So, I assume, if your CDS doesn't pay, or defaults, then you get paid. I'm getting dizzy.

How long will it take to have insurance on DRSs?

“The market definitely has potential to grow,” Foux said. “As we see more defaults -- and there’s no doubt we’re going to see more defaults -- you’re going to see more recovery swaps trading.”

Try and control your glee, for God's sake. Hey, how can they figure odds on defaults of CDSs, when no one else can? Wouldn't they need to know that to write insurance on them? And how can they trade? That means they're priced. How can you price them without some idea of how many CDSs are going to default?

"Goldman Sachs and JPMorgan officials declined to discuss their role in the market. '

Yeh, some people earlier lost money on these derivatives you're writing derivatives on. It's in the news. Give it a read. And, no, we don't want to be seen profiting on this distress. Can you say "Bad publicity"?

"Securities and Exchange Commission Chairman Christopher Cox blames speculation in credit-default swaps for contributing to almost $1 trillion in global financial losses. Some sellers of the contracts buy recovery locks to protect what they may get back on bonds when companies default. "

How do they know what they might get back?

"Holders of recovery swaps agree to exchange a preset fixed rate for the actual amount received by bondholders after a default. The investor getting the fixed amount will benefit if the payment they get is lower than the rate agreed. "

How are they figuring these things?

"The Oct. 10 derivative industry auction on bankrupt Lehman Brothers Holdings Inc.’s credit-default swaps set a value of 8.625 cents on the dollar for the New York investment bank’s debt, according to Creditfixings.com. '

Okay. You got nine cents on the dollar. Yikes.

"A credit-default derivative seller could have bought a recovery lock to ensure a 20 percent recovery rate on Lehman debt three days before the firm’s Sept. 15 bankruptcy, Foux said. The seller would thus have received 11.375 cents on the dollar from the recovery contract."

That sounds like a better deal, less the premiums and fees. Yep, an extra 11 cents. Good work, if you did that.

"MBIA, of Armonk, New York, trades at a recovery value of about 26.5 cents on the dollar, down from 40 cents at the beginning of the year, Foux said. Detroit-based GM, the largest U.S. automaker, is valued for a recovery of about 15 cents, about half what it was on Jan. 1. "

I'm shocked that they had these things at the beginning of the year. And they were betting on getting back only 40%? At the beginning of this year? And it's only declined 15 cents?

"Many credit-default contracts written early this year assumed a 40 percent recovery rate in pricing deals, Foux said.

MBIA spokesman Jim McCarthy and GM spokeswoman Julie Gibson each declined comment."

No ever comments on these things from the company being "wagered on". I guess if you figure something's going to default, you're not going to bet on getting a lot back.

"Recovery locks for Tribune, the newspaper publisher and broadcaster taken private by billionaire Sam Zell, are trading at about 7 cents on the dollar, down from about 14 cents in September, Foux said. Contracts for MGM Mirage, the biggest casino operator in Las Vegas, are trading at about 27 cents, compared with about 37 cents in September. "

No TARP money, maybe, explains this drop. Or just the general downturn? Can we write Derivatives on government bailouts? Calling Derivative Dribble.

"Tribune spokesman Gary Weitman declined to comment. MGM Mirage spokesman Alan Feldman didn’t immediately return a call seeking comment. "

Do any of these people ever answer their phones?

"Seventy U.S. companies have defaulted through Nov. 11, more than four times as many as in all of last year, according to a Nov. 17 Standard & Poor’s report. "

No Frank Sinatra songs for this year.

“One would expect much lower recovery rates as default rates soar,” Diane Vazza, head of S&P’s global fixed income research group, said in an e-mail. '

Hey, somebody answered an e-mail. I guess the likelihood of default helps determine the recovery rate. Less money to go around when these things settle.

"S&P cited an “inverse correlation” between defaults and investor recoveries in a February 2007 report. "

That's interesting.

"When default rates are less than 2 percent, more than half of defaulted debt recovers more than 70 percent of face value, according to the rating company.

When defaults are greater than 8 percent, more than half such debt recovers less than 40 percent, S&P estimated."

I can only figure that the pool of money to settle is smaller if there are more defaults. Any other explanation?

"Investors use credit-default swaps to protect themselves or speculate on the value of company debt. The market grew 100-fold to more than $62 trillion between 2001 and the end of 2007."

In other words, CDSs can be:
1) Actual insurance
2) A bet on the likelihood of default

It's 2 that troubles the average person. It certainly can be used to determine risk, since that's what 2 is based upon, but most people, I'll wager, see it as a side bet.

"In case of a default, swap sellers must pay buyers the difference between the amount being protected and the value of the defaulted bond, as determined by an industry auction."

In that sense, it's like insurance.

"Specifics about recovery-lock contracts aren’t generally available because they are made privately and don’t trade on an exchange. The contracts date back to 2005, when a Fitch Ratings report said investors were starting to use them to lock in returns after defaults. "

So, this all was beginning in 2005. I wonder if they'll have to be on an exchange going forward?

"The International Swaps and Derivatives Association established standard documents for deals in 2006. The New York- based trade group doesn’t keep records on the size of the market.

“There has not yet been member demand for us to track recovery swaps,” said spokeswoman Cesaltine Gregorio.

“Nobody thought about hedging the recovery rate” when default rates were low and recoveries stable, said Philip Gisdakis, a Munich-based credit strategist at UniCredit SpA."

Wouldn't the demand be to see how they're doing, so that I could invest in them? No average investors need apply. How about just doing it because it interests me?

“Typically, investors thought recovery rates for financial companies should be in the range of 80 to 85 percent,” Gisdakis said. “With Lehman below 10 percent and with other financials at very low recovery rates, that’s something that is completely new.”

Well, yeh, which is why I thought those 40% rates at the beginning of the year were scary.

"Recovery swaps aren’t traded heavily because bid-offer spreads “remain wide,” Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California said in an e-mail. That means it’s hard to find a price that satisfies traders on both sides of a deal. "

I'm surprised that they can be priced at all, with so little information to go on, unless you can correlate these things with other, more definable, numbers.

“It is definitely more of a buy-and-hold security than a traded security in this environment,” Backshall said. "

In other words, it's more insurance than speculation.

"The bid-ask spread for MBIA and GM debt is about 6 percentage points, according to Foux. By comparison, the companies’ credit-default swap bid-ask spreads are about 2 percentage points, according to CMA Datavision prices. "

Now, that interests me. You have an idea about one number, which you base the second on, but the second is iffier. It makes sense, but the spread seems too wide. Oh well.

Have I convinced anyone to buy DRSs?

"Rather, the spectacular, outrage, and irrational blame have been the big winners lately"

The great Derivative Dribble on Credit Default Swaps:

"Systemic Speculation

Pundits from all corners have been chiming in on the debate over derivatives. And much like the discourse that has dominated the rest of human history, reason, temperance, and facts play no role in the debate. Rather, the spectacular, outrage, and irrational blame have been the big winners lately. As a consequence, credit default swaps have been singled out as particularly dangerous to the financial system. Why credit default swaps have been targeted as opposed to other derivatives is not entirely clear to me, although I do have some theories. In this article I debunk many of the common myths about credit default swaps that are circulating in the popular press. For an explanation of how credit default swaps work, see this article."

Please read the whole post. Here was my comment:

“To call the latter gambling is to call all of investing gambling. For there is no difference between the latter and buying stock, buying bonds, investing in the college education of your children, etc.”

Wow. Another great post. You got right to my question.

Investing involves looking at a business, say, and getting a return for how the business does.When you buy a stock or a bond, you are either purchasing part of the company or loaning it money, but your analysis is based upon and tied to how the business does.

If you bet on sports, say, you have knowledge of the game which you use to determine your wager, but you are betting on an event. You’re not investing in the teams. Now, your knowledge might well lead to predicting which teams are good or bad, but you are still betting on a particular outcome.

CDS’s seem more akin to sports wagering than investment as I’ve just defined them. Both involve money and risk, but they seem to have different qualities and objectives.

I have always thought that investors, as opposed to traders, say, were seen to be different types of creatures. Traders do look more like gamblers than investors.So clearly stocks, bonds, all financial products can involve investment that looks more like gambling.

To the extent that CDS’s were more or less insurance, they seemed to make sense. I’m kind of proud of myself that your post help me get to my question on the same day that article on gambling came out.

http://don-thelibertariandemocrat.blogspot.com/2008/10/it-is-commonly-said-that-derivatives.html

My point was not what the WSJ was saying. I agree that such CDS’s can make sense and even be useful as you describe them, but my fear was that they were being marketed as safe investments, and the risks were not well understood by some of the buyers.

However, until you said this:

“But why should someone profit from ABC’s failure? Because if B’s belief in ABC’s impending failure is shared by others, their collective selfish desire to profit will push the price of protection on ABC’s bonds up, which will signal to the market-at-large that the CDS market believes that there will be an event of default on ABC issued debt. That is, a market full of people who specialize in recognizing financial disasters will inadvertently share their expertise with the world.”

I did not clearly understand the benefits. I had thought that the benefit was hedging your bet or positions by buying a CDS for one direction of movement, and some other form of financial asset for the opposite movement. In other words, it was a way of seeming to minimize risk, but that was really more risky than it seemed.

I hope I have explained my confusion, and thanks again for the explanation. Please don’t post this if it makes no sense. I’m hoping it does, but I’m not sure.

Here's the response:

"Hi Don,

I’m glad I can help you better understand things. These are complicated issues and it’s not always clear who’s right. One of strange things about a lot of human behavior is that selfish actions can have effects that are beneficial for everyone. I’m not saying this is always the case, but it is quite common. So, look past the greed and ask what is the effect of the greed."

So, in the end, I don't fault the investments themselves. I would tend to stay with what I termed investments, but that has to do more with my level of understanding and competence.

After reading Derivative Dribble, I find that these investments should have been able to be clearly explainable and better managed. I'm wondering how much of the problem is fraud and negligence on the part of the sellers of these products, and wishful thinking on the part of the buyers. But I subscribe to what I call the Human Agency explanation of this crisis. What were the factors used in deciding to take such poor risks and make such poor judgments. I'm not crediting complexity as much as others, nor mechanistic explanations of the movement or flow of financial instruments. I suppose that this is a philosophical difference as well.

Securitization Reconsidered

Okay. Big news. Derivative Dribble explains securitization. Let's go back to the Bloomberg article:

"The bundling of consumer loans and home mortgages into packages of securities -- a process known as securitization -- was the biggest U.S. export business of the 21st century. More than $27 trillion of these securities have been sold since 2001, according to the Securities Industry Financial Markets Association, an industry trade group. That's almost twice last year's U.S. gross domestic product of $13.8 trillion. "

Okay. Claims about securitization:
1) bundles loans and mortgages into securities
2) more than $27 trillion of these securities have been sold since 2001
3) that makes these securities the largest U.S. export since 2000

So what? That hardly seems a bother other than the figure being quite large, but, then, good for the U.S.

So now banks outside the U.S. start doing this:
Result: $667 billion in losses: $260 billion or so outside of U.S.: about $400 billion in the U.S.

Okay. These securities lost this money? How?

"Securitization is a shadow banking system that funds most of the world's credit cards, car purchases, leveraged buyouts and, for a while, subprime mortgages. The system, which pools loans and slices up the risk of default, made borrowing cheaper for everyone, creating a debt culture that put credit cards in wallets from Seoul to Sao Paolo and enabled people to buy luxury cars and homes. It also pumped out record profits for banks, accounting for as much as one-fifth of their revenue over the last decade."

Okay, here, I'm lost.

These securities fund:
A. Credit cards
B.Car purchases
C. Leveraged buyouts
D. Subprime mortgages

The "system"
A. Pools loans
B. Spreads risk
C. Makes borrowing cheaper

Voila: A Debt Culture
Does all lowering of interest rates lead to a Debt Culture?

There's $4.2 trillion in money market funds ( deposits paying interest )
Banks made money with the mm funds by funding subprime mortgages and cutting costs
The cutting costs sounds like a good thing, the subprime loans don't

"Before the invention of securitization, banks loaned money, received payments and profited from the difference between what the borrower paid and the bank's funding cost."

The banks took in deposits, paid interest on the deposits to the depositors, and loaned the money out to borrowers at a higher rate of interest than they were paying depositors or charged fees. This example doesn't make that clear.

Now, after securitization:

"During the mid-1980s, mortgage-bond traders at Salomon Brothers devised a method of lending without using capital, a technique at the heart of securitization. It works by taking anything that has regular payments -- mortgages, car loans, aircraft leases, music royalties -- and channeling the money to a trust that pays bondholders principal and interest."

How do the banks make money in this? If it's lending, do they get interest, fees, what?

"Securitization's biggest innovation was off-balance-sheet accounting. If a bank couldn't sell a bond or didn't want to, the asset could be sold to a trust within a so-called special- purpose entity, incorporated in a place such as the Cayman Islands or Dublin, and shifted off the books. Lending expanded, and banks still booked profits.

With this new technology, a bank could originate $100 million in loans, sell off some to investors, transfer the rest to a special-purpose entity and not have to hold any capital. The profit could be as much as 1.25 percentage points of the amount loaned, or $1.25 million for every $100 million issued.

``The banks could turn a low return-on-equity business into one that doesn't use any equity, which was the motivation for this,'' said Brad Hintz, a Sanford C. Bernstein & Co. analyst and former chief financial officer at Lehman. ``It becomes almost like a fee business because it requires no capital.''

It is a fee business if there's no capital. That's why I asked how the banks make money on these securities. How does the bank originate a loan without capital?

"As securitization caught on, borrowing increased. U.S. consumer debt tripled in the two decades after 1988 to $2.6 trillion, according to the Federal Reserve. Foreign banks used the new technology to expand lending, seeking borrowers on their home turf. ``One of the things the United States exported overseas was a debt culture,'' Haley said."

So, because of these securities, consumer debt tripled in the U.S., and, since we seem to be rich, other nations did the same thing.

I've already gotten a headache, and we're just coming to CDO's.

"Starting around 2005, securitization began to rely more on short-term money-market funds for financing. This was especially true for securities made by pooling other bonds, known as collateralized debt obligations, or CDOs. Investors were loath to buy long-term debt of issuers that didn't have a track record, so new issuers sold asset-backed commercial paper that matured in less than a year. While money markets are the cheapest way to finance, they can also be the most dangerous for borrowers because they can mature as soon as the next day."

Okay. CDO's use short term debt which is cheap but comes due fast.

"SIVs, banks and CDOs sold trillions of dollars of asset- backed commercial paper between 2005 and 2007 in maturities ranging from nine months to overnight. In the U.S., the amount outstanding marched higher almost every week beginning in April 2005, peaking at $1.2 trillion for the week ending Aug. 8, 2007"."

And:

"Once money-market funds began to be tapped for financing, Ocampo said, ``it created a huge appetite for high-yield assets, far more than could be originated on a sound basis.''

To accommodate the demand, banks funded more subprime mortgages, with an average life of seven years, replacing car loans with an average life of three years and credit-card bonds paid off within 18 months."

And:

``Most of the terrible things happening now are because of the presence of money-market assets, taking what used to be long-term funding and making it short-term,'' Bruce Bent, 71, who started the first money-market fund in 1970, said in an interview in July"

Okay. Short term lending is the problem.

"Yet asset-backed securities weren't Bent's undoing. His fund also owned $785 million in Lehman debt, bought before the firm filed for bankruptcy Sept. 15. In the two days following the bankruptcy, Reserve clients asked to pull about $40 billion from the $62.5 billion fund, and its net asset value fell to 97 cents. It was the first time that a money fund ``broke the buck,'' or fell below $1, in 14 years. The fund is now being liquidated, and Bent hasn't given an interview since."

Only it's not. It looks here like lack of collateral.

We've come a long way. Derivative Dribble asked if I was fair to securitization in the first post I did? No, I wasn't. It looks like the culprits are:

A: Lack of capital
B. Poor loans

A poor loan is a poor loan.

Here's Derivative Dribble:

"So What Does That Accomplish?

B wanted to enter the local mortgage market but was struggling to do so because it couldn’t lend at the same rates as national banks. This was due to B’s inferior credit standing relative to large national banks. But the securitization process above allows B to isolate the credit quality of the mortgages it issues from its own credit quality as an institution. Thus, the rate paid on the notes issued by the SPV will be determined by examining the credit quality of the mortgages themselves, with no reference to B. Since the rate on the notes is determined only by the quality of the mortgages, the rate on any individual mortgage will be determined by the quality of that mortgage. As such, B will be able to issue mortgages to its local community at the market rate and profit from this by servicing the mortgages for a fee."

So remember where I said the banks are making money through fees? Banks are making money on these securities, mortgages through fees.

Of course, whether there is enough capital in a bank, or whether a loan or mortgage is sound, are completely separate questions. So until I hear otherwise from Derivative Dribble, it seems to me that, just like CDS's, the problems are lack of collateral and unwise loans, not the investments themselves.

Can people have been deluded?

See my post about coming up about PRDC's in Japan.