lend support to government measures aimed at taking troubled assets off banks’ balance sheets—such as the US Troubled Asset Relief Program (TARP)

TO BE NOTED: From Shopyield:

"The pricing of subprime mortgage risk in good times and bad: evidence from the ABX.HE indices

The pricing of subprime mortgage risk

Ingo Fender (BIS)* and Martin Scheicher (ECB)**

Abstract

This paper investigates the market pricing of subprime mortgage risk on the basis of data for the ABX.HE family of indices, which have become a key barometer of mortgage market conditions during the recent financial crisis. After an introduction into ABX index mechanics and a discussion of historical pricing patterns, we use regression analysis to establish the relationship between observed index returns and macroeconomic news as well as market-based proxies of default risk, interest rates, liquidity and risk appetite. The results imply that declining risk appetite and heightened concerns about market illiquidity—likely due in part to significant short positioning activity—have provided a sizeable contribution to the observed collapse in ABX prices since the summer of 2007. In particular, while fundamental factors, such as indicators of housing market activity, have continued to exert an important influence on the subordinated ABX indices, those backed by AA and AAA exposures have tended to react more to the general deterioration of the financial market environment. This provides further support for the inappropriateness of pricing models that do not sufficiently account for factors such as risk appetite and liquidity risk, particularly in periods of heightened market pressure. In addition, as related risk premia can be captured by unconstrained investors, ABX pricing patterns appear to lend support to government measures aimed at taking troubled assets off banks’ balance sheets—such as the US Troubled Asset Relief Program (TARP). ( NB DON )

Keywords: ABX index, mortgage-backed securities, pricing, risk premia.
JEL classification numbers: E43, G12, G13, G14.
*

BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The views expressed in them are those of their authors and not necessarily the views of the BIS.

Copies of publications are available from:

Bank for International Settlements

Press & Communications

CH-4002 Basel, Switzerland

E-mail: publications@bis.org

Fax: +41 61 280 9100 and +41 61 280 8100

This publication is available on the BIS website (www.bis.org).

This was written by cate. Posted on Saturday, April 4, 2009, at 2:14 pm. Filed under Open engines, Pricing, Trading, Transparency. Tagged Liquidity, risk, subprime. Bookmark the permalink. Follow comments here with the RSS feed. Post a comment or leave a trackback."

"A better approach is to design legislation that better aligns the incentives of bankers with the public interest."

Here's an analysis that centers on incentives which, while they don't force people to do things, can be effective in making people adjust their actions and dispositions. From Jonathan B. Berk in the FT:

"In any financial crisis, it is possible with 20/20 hindsight to identify the specific proximal causes. Armed with this knowledge, legislators are invariably tempted to outlaw specific activities."

Attempting to focus in on specific problems is a mistake.

"After all, if these activities had been illegal before the crisis, surely the crisis would have been avoided. The flaw with this seemingly plausible logic is that it ignores the incentives that affect people’s behaviour. A better approach is to design legislation that better aligns the incentives of bankers with the public interest."

Okay. Let's see where he goes with this.

"Bankers are incentivised to make money. Inevitably, their actions expose the economy to the kind of breakdown we saw in October. With new regulations on their behaviour, future crises will no doubt look different, but they will not be eliminated."

I don't like inevitably, but more than likely is fine.

''The only way to avert crises is to treat banking in the same way we treat polluters: Create an environment that internalises the negative externalities that banking activity generates. That is, we should give bankers incentives so that they do not want to engage in the kind of risk-taking that exposes the whole economy to a meltdown.'

This makes it sound like bankers are invariably thieves or insane risk takers. Don't we have laws already on the books? Why don't we see if they apply first?

"To address this, we need to examine the effect of leverage. When investors invest borrowed resources, a problem known to financial economists as “asset substitution” is created: If the investment goes bad, the investor can declare bankruptcy and leave the debt holders bearing the costs.

Because of this downside protection, risk takers have an incentive to take on more risk than they would if there was no leverage. Most debt holders are well aware of these incentives, and ordinarily they monitor the behaviour of the risk takers with policies like margin requirements."

I thought that collateral had to do with how much money you needed to deal with losses that occurred in tough circumstances, not to protect against insane lending.

"By doing so, they avoid exposing themselves to unduly large losses and lessen the likelihood of a larger financial meltdown. But when the government implicitly insures debt holders by bailing them out in bad times, the incentive to monitor borrowers is reduced. The inevitable consequence will be much larger and more costly crises in the future."

Well, this I completely agree with. However, this assumes that the bankers believe that their risk is covered by the government, not that they can just walk away from responsibility. His approach makes it sound as if the bank's clients become lax in their observation of the bank's behavior. So, we agree on the cause, but not on who's acting on the implicit and explicit government guarantees.

"Government action might well be required to address this problem. But it would be a big mistake for legislators to focus on regulating leverage, the activity perceived to have caused the current crisis. Instead, they need to concentrate on undoing the perverse incentives to take on risk that results from the perceived willingness of the government to bail out large risk takers."

The incentives are the guarantees themselves.

"As matters stand right now, it is clear that once investment banks (or whatever these risk-taking entities will call themselves in the future) reach a certain size, they become too big to fail, and thus the entities that hold their liabilities know they can implicitly count on a government guarantee."

That's correct.

"Competitive debt markets will internalize the implications of this guarantee, and the result is that large investment banks will find that they can borrow at artificially low costs of capital, providing yet an additional incentive to take on more risk."

That's correct.

"Because smaller banks will not have this implicit guarantee, they will be at a competitive disadvantage in this highly competitive environment. The likely result is further consolidation of the industry and a compounding of the problem."

They are more likely to be allowed to fail, yes. That's what has happened this year.

"To avoid the mistakes of the past, legislators should begin by taking as given the incentives investment bankers and their lenders face. It is naïve to believe that it is possible to control these incentives by passing tough new laws regulating specific activity such as the amount of leverage."

I don't see why. Doesn't it work for insurance?

"Such regulation would soon become archaic as investment bankers invent new financial products that could achieve the same results without running afoul of the regulations. Instead, legislators should consider reorganising the industry to better align its incentives with the public interest."

It is true that they will try and innovate in order to leverage without running afoul of regulations. Yes.

"Although a full analysis of how this can be achieved will require time and data, there are two policies that I believe are worth considering."

What are they?

"The first, which I have alluded to already, is curbing the size of investment banks. By keeping them small, failures can be allowed in times of crisis without endangering the entire economy. Consequently, government can credibly commit to not bail out these institutions. Debt holders will then have incentive to aggressively monitor these institutions, greatly reducing the likelihood of future financial crises."

This is a very good idea. It would deal with moral hazard by allowing the closure of insolvent banks quickly and effectively.

"A second approach would be to align incentives by reconsidering the corporate structure of investment banking. Less than 10 years ago Goldman Sachs was a partnership. If Goldman was still a partnership today, its partners would be personally liable for all of Goldman’s losses. That is, it would not just be their current bonuses that would be on the line, but their entire personal wealth.

Faced with the potential of personal financial devastation, it is extremely unlikely that the partners would have allowed the firm to get into its current financial straits. By reorganising investment banks into partnerships, the likelihood of another financial meltdown would be reduced far more than, for example, through restrictive regulation on their borrowing and lending activities.

One might argue that reorganising investment banks as partnerships would reduce their incentives to take on risk and thereby hobble their ability to grease the wheels of capitalism.

But it is worth pointing out that for 130 years Goldman Sachs operated as a highly successful and very profitable partnership. If those enormous profits are indicative of the value created in those years, one would be hard pressed to argue that the partnership structure handicapped Goldman’s ability to take on risk or otherwise serve as a valuable middleman."

This seems like overkill, but I do like the point about personal responsibility, so maybe I'll come around to it.

"I believe it is naïve to believe that we can protect ourselves from future crises by simply passing tougher regulations. The political will to make structural changes will likely evaporate once the crisis passes. So although the window of opportunity to make structural changes is short, it would be a mistake to rush to legislative action. Congress should carefully consider how to align the incentives of risk takers before taking legislative action."

I agree that there are problems that cannot be addresses by specific regulations, but I believe that the solution is to divide the financial industry into government guaranteed and not government guaranteed, and then set up an oversight organization that takes a look at financial products by throwing a very wide net, especially for investments that:
1) Transfer risk
2) Magnify risk

Although I believe that individuals are responsible for this crisis, both in terms of responding to the implicit and explicit government guarantees, and committing fraud, negligence, fiduciary mismanagement, and collusion, we don't need to assume that financial people are an especially unethical and greedy group of humans. Rather, we need to focus on the types of incentives and disincentives that motivate and deter most humans.

Smaller banks is a great idea, and personal responsibility is as well, but it might not take the measure of mandating partnerships. Having been in one, I wouldn't be that interested in being in one ever again, even though I can assure you that I'm not going to risk my own money crazily, let alone the money of someone else. But this post was an interesting contribution.

"I've written myself into a corner, now, and can't think of any way to get out of writing the promised blog entry on super-senior tranches"

Felix Salmon considers Super-Senior Tranches:

"I've written myself into a corner, now, and can't think of any way to get out of writing the promised blog entry on super-senior tranches. Especially when Kevin Drum asks so nicely. So here it is. Deep breath..."

Steady on, old boy. Try explaining Godel's Proof.

"By now, you understand how a synthetic bond can behave very much like a real bond."

Let's just say it's exactly like a real bond, so we don't have to mess around with qualifiers.

"So consider the situation of a bank, which has made a bunch of loans, to 100 different companies. The companies all value their relationship with the bank, and the bank values its relationship with the companies. At the same time, however, the bank would like to free up some capital. It doesn't want to sell the loans outright -- so instead it creates a synthetic bond referencing those 100 credits, and sells that."

Free up some capital. More like avoid capital requirements or invest in things they're not supposed to, but let's humor them. They don't want to scare their customers into believing that they'll be engaging in dicey investments.

"Essentially what the bank is doing is taking the interest payments from the companies it's lent money to, and using them to make insurance payments against those companies defaulting. If the companies default, the buyers of the synthetic bond end up sending money to the bank, which will offset its loan losses. The bank has brought down its credit exposure to those companies even though it hasn't sold the actual loans. And because its credit risk has come down, its capital requirements have come down too, and the bank has more free capital to use elsewhere."

Sure, tell your customers that you've bought insurance in case they default. Okay. In this example, if I understand it, the bank created the CDSs ( Insurance against defaults ), and then sold them to some investors who are betting the CDSs don't explode. In other words, the investors are supplying insurance to the bank. So the investors must be getting a premium payment from the banks. Presumably the credit risk of the bank determines its capital requirements, which are significantly less now that they have the insurance provided by the CDSs, thereby giving them the difference between the new and old capital requirements to invest, less the premiums and cost involved in creating the CDSs. Fine. Even if this isn't Felix's example, it's why I believe that they did this.

Bank: Capital Requirement Before CDSs= $100,000
Capital Requirement After CDSs= $50,000
The bank now has $ 50,000 ( Less what I just said ) to lend out and make more revenue

"Because the loans are still on the bank's books, it needs to take mark-to-market write-downs on those loans if they fall in value but don't default. On the other hand, when that happens the value of the bank's default insurance is almost certain to rise by a very similar amount. So the bank really has managed to construct a pretty good hedge here. Not perfect: no hedge is perfect. But pretty good."

The loans are worth less, but the CDSs are worth more. A balancing or cancelling out effect, in essence. A hedge.

"So far so boring. But of course banks are never happy with simple hedges: they want to make money from all this financial high technology. (Incidentally, it's not clear that they won't: Alan Kohler had a thought-provoking column a couple of weeks ago saying that once a few more big defaults happen, "a mass transfer of money will take place from unsuspecting investors around the world into the banking system. How much? Nobody knows, but it's many trillions.")"

Come on. So I've got to read this Kohler post as well?

Let's see: A transfer from unsuspecting investors to banks. Isn't that our system?

"In any event, let's go back to the synthetic bond that the bank issued. Let's say it's structured so that each of the companies is paying an identical amount in interest every year: call it $1 million each. If the bank bundled up all those loans into a collateralized loan obligation, or CLO, then the CLO would be paying out $100 million a year, unless or until one of the companies defaulted."

The insurance equals the interest paid. That's not a great deal for the bank, is it?

Hold on. Who owns the CLO? The bank, right. But I thought that they were the ones buying insurance. So the CLO is paying out premiums for the insurance? Right?

"But rather than just sell the CLO outright, the bank would most likely split it up into tranches. Companies default, but they don't all default at once."

This is why tranches or slices work. You can use the uneven rate of defaults to organize the defaults as they occur into groups or slices of default. It's not an even rate, so you can map out the bumps, if you will, into slices.

"If the companies in question were all investment grade, you could be sure that at least 80 of them would still be making interest payments at any one time. So if you sell off the right to the first $80 million of interest payments, the ratings agencies will slap a triple-A rating on that income stream, and it can be sold at a tight spread and a pretty high price."

You're taking the least risky payers and matching them up with the least likely defaults. Well, that makes sense, since they're the same.

"Then the next $5 million might have a double-A rating, and the next $5 million a single-A rating, and the next $5 million a triple-B rating, and the last $5 million will either have a junk rating or else just be considered "equity"."

Same deal, going from least risky,to middling risky, to very risky, to hold onto your hats risky.

"Now it's possible that the bank will contrive to make a small profit here, if the sum of the value of all the tranches is greater than the amount of money that the bank lent out in the first place. But the operative word is small. "

Of course it's small. They're taking the payments and buying insurance with them. It's a miracle that they don't lose money.

"How do things change if the bank issues a synthetic bond rather than a cash CLO? Well, it can sell off the equity and the junk and the single-A and the double-A tranche, thereby protecting itself if interest payments fall by $20 million. It can then sell off a bit of the triple-A tranche, protecting itself if payments fall by $25 million. Now remember that the first $80 million of payments are rock-solid, risk-free: that's why they carry triple-A ratings. So the bank's remaining risk, after selling off that triple-A-rated synthetic tranche, has been brought down to safer-than-triple-A levels. Some of the banks referred to it as a "quadruple-A" risk, although that's not a real-world rating. But the banks were so comfortable that defaults at that level could never happen that they didn't feel any need to hedge themselves against it happening."

The banks sell the least risky stuff, figuring that they're safe, and so make some money from them.

"Janet Tavakoli, back in 2003, published a nice little table of the difference between a cash CDO and a synthetic one:

	Cash CDO*
	Tranche Size	% of Portfolio
Super Senior	N/A
Aaa	439,500,000	87.9%
Aa2	11,500,000	2.3%
Baa2	14,000,000	2.8%
Equity	35,000,000	7.0%
Total	500,000,000	100.0%
	Synthetic CDO**
	Tranche Size	% of Portfolio
Super Senior	432,500,000	86.5%
Aaa	20,000,000	4.0%
Aa2	12,500,000	2.5%
Baa2	15,000,000	3.0%
Equity	20,000,000	4.0%
Total	500,000,000	100.0%
*Baa2 average portfolio rating. Up to 15% high yield and 10% asset backed. **Baa2 average portfolio rating. Exclusively investment-grade portfolio. ©Collateralized Debt Obligations and Structured Finance, John Wiley & Sons, 2003 by Janet Tavakoli

There are nuances and differences here that we don't need to worry about too much. But the main thing to notice, in this example, is that a bank could protect itself against the first 13.5% of a group of bonds defaulting, and then declare that it was fully hedged: even the triple-A tranche had been sold off, and all that remained was a risk-free super-senior tranche.

Clearly, the cost of protecting yourself against 13.5% of a group of bonds defaulting is lower than the cost of protecting yourself against 100% of that group of bonds defaulting. Not a lot lower, since no one really imagined that more than 13.5% of the bonds could ever default. But enough lower that the bank could end up making a nice profit by selling off the credit risk associated with the bonds, and holding on to the excess income."

It looks like 1.2 %. This example is kind of funny, but let's go on. I mean, one of the benefits are the fees that get charged when you sell them, but I've dealt with that in other posts.

"Of course, the bank's loan position is not actually fully hedged. But so long as more than 86.5% of the interest payments get paid, the bank is fine. And the advantage of leaving the rest of the loan portfolio unhedged is that you don't need to use all the income from the loans to buy protection on them. There's money left over -- which can be considered interest on the quadruple-A, or super-senior, tranche that the bank retains."

So you fudge on the premiums.

"The invention of the super-senior tranche, then, was a way of letting banks have their cake and eat it too. They could take a bunch of debt onto their balance sheets, "fully" hedge it (with only that it-could-never-default tranche left over) and book all the remaining cashflow as pure profit with no credit risk."

Looks good on paper, does it? Remember, they've fudged on their insurance. There's a gap in their coverage now. Understand that.

"Now so long as you're dealing with a hundred different investment-grade corporate loans, this actually works: such things really don't all default at the same time. Banks even found a (limited) market for these super-senior tranches, by allowing their hedge-fund clients to take very leveraged bets on them -- they felt that the leverage was safe, since there was no default risk. But a huge proportion of the super-senior tranches was never sold off to hedge funds, and instead remained on the banks' balance sheets."

There's a good reason for that having to do with capital requirements, but I can't quite fit it into this example.

"And of course it wasn't long until the banks started doing the same thing with mortgage bonds. They would take a bunch of subprime-backed CDOs, and treat the interest payments from the CDOs much as they treated the interest payments from corporations."

It took a coffee break before they were ready to expand the plan to mortgages. Mortgages need that extra little jolt of energy from the caffeine.

"Oops.

In the case of CDOs, as we've all seen, the models said that there was geographical diversification in the housing market; they said that national housing prices, in aggregate, never went down. (Which was true, until it wasn't.)"

I like to think of it like insurance on your house. If a disaster occurs, fire or hurricane say, it usually occurs in one area, even if a large area, of the country, at one time. It's a contained insurance claim. Now, imagine using that model for houses. If housing prices fall, they do so in contained areas like fires and floods. That's the model.

"And somehow they said that thanks to the magic of securitization and overcollateralization, you could create not only triple-A securities from triple-B-rated subprime assets, but even quadruple-A super-senior tranches, too.

And so the banks took billions of dollars of subprime-backed mortgage securities onto their books, and "fully" hedged them while not really hedging most of them at all. When the income from those CDOs went (or was expected to go) towards zero, the banks had to write off assets which they never really considered risk assets at all. The banks thought that they had hedged all the credit risk associated with the bonds, and were left with a modest and super-safe income stream. Instead, they were left with a time bomb."

The whole point, in fact, was to lower capital requirements for lending. Let's not get fancy.

"It's worth noting here that although the bank used CDS technology in the process which ended up with these super-senior tranches, it's not the credit default swaps themselves which blew up. Remember that the bank had a lot of CDOs on its books, and the credit default swaps helped protect the bank from a lot of the losses associated with those CDOs. Just not all of them. And if you underwrite hundreds of billions of dollars' worth of CDOs, the "unfunded" portion of those CDOs can become enormous on an absolute level -- and if it gets wiped out, you can get wiped out."

That's a fair point. Some of the CDSs the banks would have would pay them for the defaults. It's terribly complicated for banks to unwind these deals and see what's what. From my perspective, that's a very good reason not to do them, but I'm not a fan of complexity.

"As ever, credit default swaps, like any derivative, were and are a zero-sum game: they don't cause big losses themselves. The super-senior losses, ultimately, come from the subprime mortgage market, not from the CDS market. But without the technology of credit default swaps, banks would never have been able to retain those exposures while thinking that they had divested themselves of all the associated risk."

Now, subprime mortgages were inexcusable. Human Error. And if they wouldn't have used these investment vehicles, they would have found something else. The main objective was decreasing capital requirements for lending. However, it is possible that these vehicles were seriously more destructive than other alternatives, but we'll never know that for sure.

"Still, no amount of regulation of the CDS market would have solved the underlying problem, which really had nothing to do with the credit default swaps themselves, and everything to do with the banks' risk models. Those models said that if you take on this risk and sell that risk, you're fully hedged. They were wrong. The CDS, so far, have worked. The investors who bought the higher-risk tranches of the synthetic CDOs have been wiped out -- the banks, essentially, have taken nearly all their money. If the CDS contracts hadn't worked (if, for example, the government decided "to simply annul the credit default swaps as void", as Ben Stein has proposed), then the banks would have lost even more. "

The models were wrong, but people were conditioned to believe them by their interests and needs. Every model needs a human being to interpret it. Period. Don't blame the models. Blame the human predisposition to put faith in risky models. Please. And don't blame the investments, as they were simply filling a need. The Stein proposal made no sense, as I said on Felix's blog. Getting something is generally considered better than getting nothing.

"I'm not saying that the CDS market protected the banks from losses: without it, the banks would never have taken all those mortgage-backed CDOs onto their books in the first place. They never thought of themselves as being in the storage business; they thought they were in the moving business. But without senior management ever really realizing it, banks like Citi ended up storing hundreds of billions of dollars' worth of subprime bonds on their balance sheet, and failed to properly account for them because they erroneously thought those bonds were risk-free."

I don't believe it for a second. On this blog, there's a post, where I spent time searching the web and constructing a profile of these investment in less than two hours, as if I were in 2005. In other words, I confined my sources to 2005 and earlier. That prospectus clearly showed that these investments were very risky, even taking in to account what the creators of the models said about them. I'm not saying it predicted what happened, but nobody, nobody, can honestly say that these investment vehicles were not risky. And that's why Bob Rubin's quote in the NY Times admitting this is so important.

"Ultimately, then, the error was one of management, not of financial technology. The banks' balance sheets -- and those of their off-balance-sheet vehicles -- were expanding faster than the banks' executives and risk managers could really keep a handle on. And rather than call a halt to that which they didn't fully understand, they handed down edicts instructing the CDO desks to keep on dancing for as long as the music was playing. Most of the executives probably never even heard the term "super-senior" until those tranches started getting written down. It was their own incuriousness, rather than any CDS technology, which was really their undoing."

Then that's, at the very least, negligence. You're responsible for people's money, for God's sake. This behavior amounts to fraud or negligence or fiduciary mismanagement, and, if not criminal, there should be some way for investors to be compensated by these people for their disatrous handling of other people's money.

One thing that this blog will show, these products are not incomprehensible or unexplainable, at least as to their risk.

By the way, you should read the questions that people asked on Felix's blog. It's his model, so he should be able to answer them.

Well, he answered them.

"Super-seniors are not easy things to understand, as you'll know if you managed to trudge through my attempted explanation. I got some good questions in the comments, here's my attempt at the answers.

Eli and fresnodan both bring up the issue of counterparty risk: after the bank has bought insurance on its CDOs, how does it know that its counterparty will have the money to pay up if and when there is an event of default?

It doesn't always know for sure. But remember that synthetic bonds are structured so that the collateral payment gets invested up-front, so if the bank hedged its exposure by issuing synthetics, it's probably fine."

Truthfully, this investigation is like investigating any counterparty.

"On the other hand, as Noel notes, some banks ended up buying cheap protection on their super-senior tranches from AIG Financial Products. Which, as we've seen, was a very good deal for the banks, and a very bad idea for AIG. And, thanks to Uncle Sam, AIG is still around to pay out on those contracts."

AIG's whole reason on doing their tranches was avoiding capital requirements. All of their problems, as far as I can tell, from these types of investments come from their very reason for getting into them. On the other hand, it's a good question if investors believed that these investments were collateralized like AIG's insurance. I've no idea, but not to explain the difference to investors is, at least , negilgence.

"Matthew asks a couple of questions. Firstly:

What's the difference between this scenario than the bank just lending money to the top 86.6% of companies by creditworthiness and letting other lenders - perhaps specialists - lend to the other 13.4%? And aren't the profits the same for the bank in both cases?

The answer is that it's not the bottom 13.4% of companies by creditworthiness which always default. You don't know which companies are going to default: you just know that some but not all companies are likely to. So you lend to them all and then protect yourself against the first 13.4% of losses. It's a bit like saying "whoever the losers are, those companies, in hindsight, we'll choose not to lend to"."

Actually, I think this is better understood using other examples. He's right, but it's not obvious.

"His second question is this:

Why would the income from the CDOs go 'to zero'? This would mean all 100% of mortgage payers (in this example) default. If this is the case then the problem is massive failure to understand the riskiness of an asset- but it would have to be absolutely massive to get it 100% wrong? In fact so massive, fraudulent, instead?

I tried to explain this here, in words, and here, in pictures. But in a nutshell, these CDO weren't simple pools of mortgages. Instead, they were pools of junior tranches of mortgage-backed securities. And the junior tranche can go to zero even if quite a lot of homeowners continue to pay their mortgages in full and on time."

The lesser grades blow up first. That's the point of differing tranches and risks.

"Anon asks whether "at least one factor in the ongoing 'success' of these instruments was based on expectations of a declining USD" -- no. But he or she is quite right that the bankers

remained focused on short term profit pressures in the absence of 'new' ideas, confident both in apparent limits to their own personal liability and understanding that their firms would be too big to fail when the music stopped - and protected by bonuses and severance packages which would see them into very comfortable retirements IF proprietary knowledge of their firms did not keep them in demand for the rest of their careers."

Actually, the second part is spot on.

"And finally Kevin Drum reads me as saying that the banks were "creating a synthetic version of the subprime market that was even bigger than the original". This isn't really true: they created a synthetic version of the subprime market that was actually smaller than the original -- that was the problem, that it didn't fully hedge the subprime assets they held on their books."

That was the problem, that they didn't have enough capital. But, theoretically, at least, you could have had a larger market. But you do need to find buyers and sellers, and so there is a natural limit to this crap.

"Kevin also says that the banks kept synthetic subprime CDOs on their own books -- which happened in a few cases, notably at UBS, but was actually pretty rare. Normally they kept the real CDOs on their own books, and hedged by creating and selling the synthetics."

The CDOs allowed them to create investments of higher risk as if based on lower risk if the banks kept the CDOs on their own books.

I can't believe that I have to do more posting on this stuff today, if I can finally get around to it.

"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.

“The time has come that we consider what sort of limitations we should be placing on the Fed"

Here's a Bloomberg article I like, so I'm going to scan a fair bit of it even though it moves around quite a bit ( Kind of like TARP ):

"The U.S. government is prepared to provide more than $7.76 trillion on behalf of American taxpayers after guaranteeing $306 billion of Citigroup Inc. debt yesterday. The pledges, amounting to half the value of everything produced in the nation last year, are intended to rescue the financial system after the credit markets seized up 15 months ago.

The unprecedented pledge of funds includes $3.18 trillion already tapped by financial institutions in the biggest response to an economic emergency since the New Deal of the 1930s, according to data compiled by Bloomberg. The commitment dwarfs the plan approved by lawmakers, the Treasury Department’s $700 billion Troubled Asset Relief Program. Federal Reserve lending last week was 1,900 times the weekly average for the three years before the crisis."

I'm not sure what to say about this. In a way, I understand it. At some point, you just bet the whole ball of wax, and feel the wind in your hair, and the trade winds behind you. Do any of those work for you?

Pledging half of what we produced last year seems to validate the enormity of the undertaking. We're not fooling around here. We like our messes to be enormous. Given the situation, I have to admit to agreeing with this Bagehot on steroids approach. It somehow makes him more modern, more relevant to me.

"When Congress approved the TARP on Oct. 3, Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson acknowledged the need for transparency and oversight. Now, as regulators commit far more money while refusing to disclose loan recipients or reveal the collateral they are taking in return, some Congress members are calling for the Fed to be reined in."

There's a need, but not the means or will to fulfill it. But we acknowledge the need.

“Whether it’s lending or spending, it’s tax dollars that are going out the window and we end up holding collateral we don’t know anything about,” said Congressman Scott Garrett, a New Jersey Republican who serves on the House Financial Services Committee. “The time has come that we consider what sort of limitations we should be placing on the Fed so that authority returns to elected officials as opposed to appointed ones.”

It's good to know that you're on the case Congressman " A day late and a dollar short".

"Bloomberg News tabulated data from the Fed, Treasury and Federal Deposit Insurance Corp. and interviewed regulatory officials, economists and academic researchers to gauge the full extent of the government’s rescue effort. "

Peculiarly, because no one else would.

"The bailout includes a Fed program to buy as much as $2.4 trillion in short-term notes, called commercial paper, that companies use to pay bills, begun Oct. 27, and $1.4 trillion from the FDIC to guarantee bank-to-bank loans, started Oct. 14. "

Don't worry about this.

"William Poole, former president of the Federal Reserve Bank of St. Louis, said the two programs are unlikely to lose money. The bigger risk comes from rescuing companies perceived as “too big to fail,” he said. "

How reassuring. I love the use of "perceived", implying an illusion of some sort. Apparently, Mr.Poole, if that is his real name, doesn't believe that they are. Otherwise, there was no need to qualify the expression "rescuing companies too big to fail".

"The government committed $29 billion to help engineer the takeover in March of Bear Stearns Cos. by New York-based JPMorgan Chase & Co. and $122.8 billion in addition to TARP allocations to bail out New York-based American International Group Inc., once the world’s largest insurer.

Citigroup received $306 billion of government guarantees for troubled mortgages and toxic assets. The Treasury Department also will inject $20 billion into the bank after its stock fell 60 percent last week.

“No question there is some credit risk there,” Poole said."

Poole again. First he's very forceful, using "No question". Then he's back to qualifying himself again with "some risk", meaning, what? There's a hell of a lot, but I don't want to say so, and freak everybody out? There's a little, but not enough to worry about? What does Mr. Poole do for a living exactly, that his speech is so terribly careful.

"Congressman Darrell Issa, a California Republican on the Oversight and Government Reform Committee, said risk is lurking in the programs that Poole thinks are safe.'

Can risk "lurk"? The only meaning that I could find that didn't imply agency, and work, is the following:to exist unperceived or unsuspected. But if you know it's there, it's not lurking. It's of unknown quantity, but you know it's there.

“The thing that people don’t understand is it’s not how likely that the exposure becomes a reality, but what if it does?” Issa said. “There’s no transparency to it so who’s to say they’re right?”

Okay. It's not how likely, but what if it does? If I knew what is was, why couldn't I know what happen if it does, or at least have an idea. After all, I even have an idea about Heaven. There's no transparency. Meaning you can't see it. So who's to say they're right? Them, obviously. What's the problem, unless you don't trust them? If that's the case, just come out and say so.

"The worst financial crisis in two generations has erased $23 trillion, or 38 percent, of the value of the world’s companies and brought down three of the biggest Wall Street firms. "

I'm sorry, but every time I hear generations I begin singing "L'dor vador".

"Regulators hope the rescue will contain the damage and keep banks providing the credit that is the lifeblood of the U.S. economy. "

At least they're using organic terms, and not engineering terms.

"The money that’s been pledged is equivalent to $24,000 for every man, woman and child in the country. It’s nine times what the U.S. has spent so far on wars in Iraq and Afghanistan, according to Congressional Budget Office figures. It could pay off more than half the country’s mortgages."

It's a little more that than the $24,000, because I refuse to take responsibility for this. When you start thinking about what it could buy, your brain has an aneurysm. If I were Bloomberg, I'd be worried about lawsuits.

“It’s unprecedented,” said Bob Eisenbeis, chief monetary economist at Vineland, New Jersey-based Cumberland Advisors Inc. and an economist for the Atlanta Fed for 10 years until January. “The backlash has begun already. Congress is taking a lot of hits from their constituents because they got snookered on the TARP big time. There’s a lot of supposedly smart people who look to be totally incompetent and it’s all going to fall on the taxpayer.”

That's why they're supposedly smart.

“This is the worst capital markets crisis in modern history,” Harris said. “So you have the biggest intervention in modern history.”

This is why, if you're for smaller government, you have to have a real world plan to avert these crises. Otherwise, you might as well believe in Zeus.

"Bloomberg has requested details of Fed lending under the U.S. Freedom of Information Act and filed a federal lawsuit against the central bank Nov. 7 seeking to force disclosure of borrower banks and their collateral."

Thanks.

"Collateral is an asset pledged to a lender in the event a loan payment isn’t made."

I like this definition.

“Some have asked us to reveal the names of the banks that are borrowing, how much they are borrowing, what collateral they are posting,” Bernanke said Nov. 18 to the House Financial Services Committee. “We think that’s counterproductive.”

Huh.

"The Fed should account for the collateral it takes in exchange for loans to banks, said Paul Kasriel, chief economist at Chicago-based Northern Trust Corp. and a former research economist at the Federal Reserve Bank of Chicago.

“There is a lack of transparency here and, given that the Fed is taking on a huge amount of credit risk now, it would seem to me as a taxpayer there should be more transparency,” Kasriel said."

Does "counterproductive" here mean "it would piss people off "?

"In the three years before the crisis, such average weekly borrowing by banks was $48 million, according to the central bank. Last week it was $91.5 billion. "

I can't even compute that increase.

“Money markets seized up after Lehman failed,” said Neal Soss, chief economist at Credit Suisse Group in New York and a former aide to Fed chief Paul Volcker. “Lehman failing made a lot of subsequent actions necessary.”

I find this obvious, but some remain unconvinced. Go figure.

"Most of the federal guarantees reduce interest rates on loans to banks and securities firms, which would create a subsidy of at least $6.6 billion annually for the financial industry, according to data compiled by Bloomberg comparing rates charged by the Fed against market interest currently paid by banks.

Not included in the calculation of pledged funds is an FDIC proposal to prevent foreclosures by guaranteeing modifications on $444 billion in mortgages at an expected cost of $24.4 billion to be paid from the TARP, according to FDIC spokesman David Barr. The Treasury Department hasn’t approved the program.

Bernanke and Paulson, former chief executive officer of Goldman Sachs, have also promised as much as $200 billion to shore up nationalized mortgage finance companies Fannie Mae and Freddie Mac, a pledge that hasn’t been allocated to any agency. The FDIC arranged for $139 billion in loan guarantees for General Electric Co.’s finance unit."

They've guaranteed a hell of a lot more than that.

"Paulson told the House Financial Services Committee Nov. 18 that the $250 billion already allocated to banks through the TARP is an investment, not an expenditure.

“I think it would be extraordinarily unusual if the government did not get that money back and more,” Paulson said."

"Extraordinarily unusual" means " so unusual that you can't blame me if it happens".

"In his Nov. 18 testimony, Bernanke told the House Financial Services Committee that the central bank wouldn’t lose money.

“We take collateral, we haircut it, it is a short-term loan, it is very safe, we have never lost a penny in these various lending programs,” he said."

Oddly, he and Paulson are bald like me.

"A haircut refers to the practice of lending less money than the collateral’s current market value."

A nice definition.

"Requiring the Fed to disclose loan recipients might set off panic, said David Tobin, principal of New York-based loan-sale consultants and investment bank Mission Capital Advisors LLC.'

Earth to David Tobin, "We're in one".

“If you mark to market today, the banking system is bankrupt,” Tobin said. “So what do you do? You try to keep it going as best you can.”

You don't mark it. That was easy.

“Mark to market” means adjusting the value of an asset, such as a mortgage-backed security, to reflect current prices."

Another good definition.

"Some of the bailout assistance could come from tax breaks in the future. The Treasury Department changed the tax code on Sept. 30 to allow banks to expand the deductions on the losses banks they were buying, according to Robert Willens, a former Lehman Brothers tax and accounting analyst who teaches at Columbia University Business School in New York.

Wells Fargo & Co., which is buying Charlotte, North Carolina-based Wachovia Corp., will be able to deduct $22 billion, Willens said. Adding in other banks, the code change will cost $29 billion, he said.

“The rule is now popularly known among tax lawyers as the ‘Wells Fargo Notice,’” Willens said.

The regulation was changed to make it easier for healthy banks to buy troubled ones, said Treasury Department spokesman Andrew DeSouza."

This was the Paulson move that many just discovered. It was intended to facilitate mergers.

"House Financial Services Committee Chairman Barney Frank said he was angry that banks used the money for acquisitions.

“The only purpose for this money is to lend,” said Frank, a Massachusetts Democrat. “It’s not for dividends, it’s not for purchases of new banks, it’s not for bonuses. There better be a showing of increased lending roughly in the amount of the capital infusions” or Congress may not approve the second half of the TARP money."

Strictly speaking, Rep. Frank is correct, although the tax breaks were obviously intended to facilitate private mergers to keep the government from having to recapitalize them. Remember, originally, TARP was not going to give money to the banks, but to buy toxic assets. These tax subsidies were meant to deal with the problem of recapitalization of banks through mergers, such as the failed Citi/Wachovia deal, and the successful Wells/Wachovia deal.

He would say, ‘You have to take more risk if you want to earn more.’ ”

From an article in the NY Times I came to via Dean Baker by Eric Dash and Julie Creswell:

"C.D.O.’s were complex, and even experienced managers like Mr. Maheras and Mr. Barker underestimated the risks they posed, according to people with direct knowledge of Citigroup’s business. Because of that, they put blind faith in the passing grades that major credit-rating agencies bestowed on the debt.

While the sheer size of Citigroup’s C.D.O. position caused concern among some around the trading desk, most say they kept their concerns to themselves.

“I just think senior managers got addicted to the revenues and arrogant about the risks they were running,” said one person who worked in the C.D.O. group. “As long as you could grow revenues, you could keep your bonus growing.”

To make matters worse, Citigroup’s risk models never accounted for the possibility of a national housing downturn, this person said, and the prospect that millions of homeowners could default on their mortgages. Such a downturn did come, of course, with disastrous consequences for Citigroup and its rivals on Wall Street.

Even as the first shock waves of the subprime mortgage crisis hit Bear Stearns in June 2007, Citigroup’s top executives expressed few concerns about their bank’s exposure to mortgage-linked securities.

In fact, when examiners from the Securities and Exchange Commission began scrutinizing Citigroup’s subprime mortgage holdings after Bear Stearns’s problems surfaced, the bank told them that the probability of those mortgages defaulting was so tiny that they excluded them from their risk analysis, according to a person briefed on the discussion who would speak only without being named."

Here's my problem. I don't find CDOs or CDSs that hard to understand. What's more, I don't think that it's hard to see that they're risky. As Rubin says at the end of the next quote:

"Because C.D.O.’s included so many forms of bundled debt, gauging their risk was particularly tricky; some parts of the bundle could be sound, while others were vulnerable to default.

“Chuck Prince going down to the corporate investment bank in late 2002 was the start of that process,” a former Citigroup executive said of the bank’s big C.D.O. push. “Chuck was totally new to the job. He didn’t know a C.D.O. from a grocery list, so he looked for someone for advice and support. That person was Rubin. And Rubin had always been an advocate of being more aggressive in the capital markets arena. He would say, ‘You have to take more risk if you want to earn more.’ ”

Now, this quote from Rubin is terribly important. It clearly shows that CDOs involve more risk, not, not, as some people are claiming, that the CDOs were intended to lessen risk. No way.

So, the story is clearly one of known risk and, at the very least, negligent investment advice, perhaps rising to the level of fiduciary mismanagement and even fraud.

"In fact, when examiners from the Securities and Exchange Commission began scrutinizing Citigroup’s subprime mortgage holdings after Bear Stearns’s problems surfaced, the bank told them that the probability of those mortgages defaulting was so tiny that they excluded them from their risk analysis, according to a person briefed on the discussion who would speak only without being named."

How can risky investments reduce risk? It defies human understanding.

"Earlier this year, Federal Reserve examiners quietly presented the bank with a scathing review of its risk-management practices, according to people briefed on the situation.

Citigroup executives responded with a 25-page single-spaced memo outlining a sweeping overhaul of the bank’s risk management.

In May, Brian Leach, Citigroup’s new chief risk officer, told analysts that his bank had greatly improved oversight and installed several new risk managers. He said he wanted to ensure “that Citi takes the lessons learned from recent events and makes critical enhancements to its risk management frameworks. A change in culture is required at Citi.”

Meanwhile, regulators have criticized the banking industry as a whole for relying on outsiders — in particular the ratings agencies — to help them gauge the risk of their investments.

“There is really no excuse for institutions that specialize in credit risk assessment, like large commercial banks, to rely solely on credit ratings in assessing credit risk,” John C. Dugan, the head of the Office of the Comptroller of the Currency, the chief federal bank regulator, said in a speech earlier this year. "

We've already dealt with the Credit Ratings Agencies. Here, the idea that you need better risk management is beyond hilarious. If they're to be believed, investments known to be riskier were thought to be less risky by risk managers. Too much.

"The bank has already put more than $55 billion in assets back on its balance sheet. It now says an added $122 billion of assets related to credit cards and possibly billions of dollars of other assets will probably come back on the books.

Even though Citigroup executives insist that the bank can ride out its current difficulties, and that the repatriated assets pose no threat, investors have their doubts. Because analysts do not have a complete grip on the quality of those assets, they are warning that Citigroup may have to set aside billions of dollars to guard against losses.

In fact, some analysts say they believe that the $25 billion that the federal government invested in Citigroup this fall might not be enough to stabilize it.

Others say the fact that such huge amounts have yet to steady the bank is a reflection of the severe damage caused by Citigroup’s appetites.

“They pushed to get earnings, but in doing so, they took on more risk than they probably should have if they are going to be, in the end, a bank subject to regulatory controls,” said Roy Smith, a professor at the Stern School of Business at New York University. “Safe and soundness has to be no less important than growth and profits but that was subordinated by these guys.”

Now the shocking part. I believe that Citi can ride out this crisis, and the panic of fear and aversion to risk is driving the stock price down more than fundamentals, and the idea that we might bailout Citi even though we don't need to is deeply troubling to me. A disaster.

Multimedia Graphic Citigroup and CDO’s

“Where’s the Risk?” : Geithner's Talk

Via Justin Fox, another post from Timothy Geithner, this one called "Liquidity Risk and the Global Economy:

"Although there is much that is positive in the world today, there is little reason to believe we have entered a new era of permanent stability. Financial innovation and global financial integration do not offer the prospect of eliminating the risk of asset price and credit cycles, of manias and panics, or of shocks that could have systemic consequences."

Nor will they. However, we can do better.

"Over the past 25 years or so, we have seen a significant number of episodes of financial shocks, in U.S. markets and globally. Although more different than similar in their nature and impact, they had some common features. They were unanticipated. The causes varied, with some associated with a substantial deterioration in the real economy, and others not. And they typically involved the dynamic in which a sharp change in risk perception results in a fall in asset prices and a sharp reduction in market liquidity, and an increase in correlations across asset classes. As market participants move to protect themselves against further losses, by selling positions, requiring more margin, hedging against further declines, the shock is amplified and the brake becomes the accelerator."

I agree that the sharp change in risk perception is key.

"All markets are vulnerable to this dynamic. The degree of vulnerability is not something we can measure with any confidence, for it depends not just on the how market participants behave in the event, but on the complex interaction of a number of different factors. The vulnerability depends, for example, on the size of the asset price misalignment, the conditions that produced it, and the magnitude of the shock to confidence in economic fundamentals. It depends on the scale of leverage in the system, and the incidence of leverage or concentration of exposure to different risk factors. It depends on the diversity of exposures or positions of different financial institutions. It depends on the presence or absence of distortions or market failures, moral hazard being the typical problem. It depends on perceptions of the capacity for monetary policy and other policies to adjust to mitigate the damage."

I like that he focuses on how market participants behave. This is the most important factor.

"The dramatic changes we’ve seen in the structure of financial markets over the past decade and more seem likely to have reduced this vulnerability. The larger global financial institutions are generally stronger in terms of capital relative to risk. Technology and innovation in financial instruments have made it easier for institutions to manage risk. Risk is less concentrated in the banking system, where moral hazard concerns and other classic market failures are more likely to be an issue, and spread more broadly across a greater diversity of institutions."

This is where there's a big disagreement. I feel that government actions, particularly the S & L crisis, had reduced moral hazard to almost nil. The financial institutions believed, correctly, I'd point out, that the government had given both implicit and explicit guarantees to intervene in a financial crisis. There was consequently more risk, because there was no Plan B. It was the government or nothing if things spiraled out of control. Consequently, businesses focused on the more limited crises that might effect them, and ignored the major ones. While this might sound rational, it isn't, because it's impossible to tell when a small problem becomes a major one until you've let it happen. The tendency is, as he has described earlier, to ignore more and more of the serious risk as time goes by, and so fall asleep at the switch, having inadvertently narrowed your range of focus.

"And yet this overall judgment, that both financial efficiency and stability have improved, requires some qualification. Writing a decade ago about the history of the financial shocks of the 1980s and early 1990s, Jerry Corrigan argued that these same changes in financial markets we see today, though less pronounced then than now, created the possibility that financial shocks would be less frequent, but in some contexts they could be more damaging. This judgment, that systemic financial crises are less probable, but in the event they occur could be harder to manage, should be the principal preoccupation of market participants and policymakers today."

Actually, that's a version of what I just said.

"What factors might contribute to this risk, a risk that could be described as the possibility of longer, fatter tails? One reason is a consequence of consolidation. The major banks are larger and stronger today, and it would take a much larger shock to make them vulnerable than was true in the past. But in that event, the consequence of their failure could be greater for markets."

See, I don't agree. They'd understood the meaning of "Too big to fail" in the S & L crisis. They simply worried less about the consequences of massive failure, than about more mundane and contained crises. They were buying a kind of insurance policy from the government by being big. So, I agree with the point, but take a different view of it. They were stronger in smaller crises, much weaker in anything of major import.

"Another reason is the consequence of leverage. Leveraged arbitrage activity, so some of the literature suggests, is likely to reduce volatility in normal times and increase it in times of stress, because of the greater financial constraints faced by leveraged funds relative to larger, more diversified banks and investment banks. Whether this matters in a systemic sense or not depends on the heterogeneity of funds and how correlated their exposures are with those of the major banks and investment banks."

See, to me, leverage means more risk. Period. I don't buy the lessening of risk scenario. The risk always has to come back to the originator, and to them leverage is added risk.

"A third reason is the consequence of long periods of low losses and low volatility. When markets have been through a sustained period of relative stability and low credit losses, this reduces the estimates of potential losses produced by conventional risk management tools. Like gravity, this force is hard to counteract. And when we’ve had a long period of low realized losses, rapid change in markets, dramatic growth in new instruments, and larger potential leverage, this creates a greater possibility of unanticipated losses, and therefore a greater potential for the trend–amplifying, positive feedback effects that have characterized the major asset price shocks of 1987 and 1998."

Because this is the tendency, this is when you should be scared. It's like value investing. Be most afraid in these types of periods. If value investors can do it, we can as well.

"Policymakers do not have the capacity to eliminate the risk of excess leverage or asset price misalignments, nor do we have the ability to act preemptively to diffuse them. And yet policy can play a very important role in limiting the vulnerability of financial markets to the risk that a shock will pose greater potential risks to the stability of the financial system and to economic growth. A few points about both monetary policy and supervision in this context."

It might not be fair, but given what we've just been through, this sounds like a nostrum.

"This approach to supervision is designed to look ahead to try to ensure the adequacy of capital and liquidity, and the sophistication of risk management discipline relative to risk, over time and at all points in the cycle. I outlined earlier the reasons why monetary policy has only limited capacity to deal preemptively with financial bubbles. Similarly, I see little prospect that supervision will have the capacity to identify and address potential concentrations in exposure to individual risk factors, whether through changes to capital charges or other means. Focusing on the quality and strength of cushions against tail risk is the best way for supervision to be countercyclical rather than procyclical."

This I disagree with. It should be possible to significantly decrease risk, with a wide mouthed funnel approach to investments.

"The conditions we see prevailing in global financial markets today reflect a range of different factors, some fundamental and others that are less likely to be enduring. The most effective thing that policymakers and market participants can do in what is a necessarily uncertain world is to work to ensure that the shock absorbers are strong relative to the range of potential economic and financial outcomes."

I'm not sure that we want to rely on shock absorbers. They're going to have to be pretty large unless you can lessen the load.

It's very true that, even here, he doesn't agree with me about implicit and explicit government guarantees increasing risk, or mention fraud very much, which to me is also important. I also think that my Bagehot's Principles would be a serious deterrent to future crises.

"nervous investors sought sanctuary from the turbulence in equities and other asset classes."

Here's more evidence of the Flight From Risk going on in the FT:

"The spectre of looming deflation drove government bond yields on both sides of the Atlantic to historic lows on Thursday as nervous investors sought sanctuary from the turbulence in equities and other asset classes.

Some US Treasury bills were quoted at 0 per cent, while the two-year note and the 30-year bond recorded their lowest yields since they were first regularly issued in the 1970s. The five-year note was at its lowest since 1954, based on historical data from the Federal Reserve. In the UK, the two-year gilt yield dropped to its lowest level since since the second world war."

So, people are buying bonds with no interest in order to buy a government guarantee that their money is safe. Does this even make sense?

"Buying government bonds as a safe haven investment has dominated flows in recent months. The latest moves come as increasingly worrying economic data point to rising unemployment and plunging inflation.

“Given the recent deflationary data, not just in the US but globally, the world is starting to build in a Japan-style deflationary scenario,” said Jim Caron, head of interest rate strategy at Morgan Stanley."

It can make sense in a time of Deflation, since your money is essentially appreciating in value because you can now buy more with it at cheaper prices. Is Deflation even realistic given the Fed?

"Recently, the Federal Reserve’s effective Fed funds rate has traded at around the 0.25 percentage point level, well below the target rate of 1 per cent. Meanwhile, Treasury inflation securities have moved to price in deflation for the next nine years.

Bill O’Donnell, strategist at UBS, said the bond market was reacting to the very low effective Fed funds rate and the possible start of a deflationary period. “The mood is ‘give me Treasuries at the expense of all other asset classes’ as spreads blow out and stocks slump,” said Mr O’Donnell.

Tom di Galoma, head of Treasury trading at Jefferies & Co said: “There is no place to hide but in US Treasuries. You cannot hide in corporate or mortgage bonds.”

So, investors are buying US Treasuries because they're the safest bet, and are willing to get almost nothing for that. It's hurting investment because investors are avoiding corporate and mortgage bonds, read loans. TIPS see deflation for 9 nine years. Is this even realistic?

"Deflation fears drove the 30-year swap rate to more than 50bp below that of the 30-year bond yield. Some investors are using swaps rather than buying bonds to keep their cash reserves intact as they seek greater exposure to long-term rates.

“If you already have a portfolio, using swaps allows you to increase duration without liquidating cash bonds,” said Jay Mueller, portfolio manager at Wells Capital Management."

So there's a rush into Swaps to maintain liquidity to be able to purchase long term rates, read more interest.

"The demand for long-term debt pushed the 30-year bond yield to a new record low of 3.71 per cent on Thursday; the two-year note traded as low as 0.96 per cent."

That shift to government backed long term bonds have driven their interest rate down. Supply and Demand. There's a large supply of fear, and a demand for less risk. But is this rational?

“This is about the collapse of inflation from official numbers this week and the very real spectre of disinflation in the UK,” said Moyeen Islam, fixed income strategist at Barclays Capital. “We expect yields will go lower as inflation is likely to be negative between May and October next year.”

The yields on the two-year German Schatz fell to levels not seen since September 2005. Yield spreads between Germany, the most liquid and deepest bond market in Europe, and other eurozone countries, also widened as it continued to outperform."

Since I don't fear deflation, as opposed to a drop in prices for a short period of time, and always fear inflation, I consider this behavior to basically panic behavior, based on the more unlikely scenarios going forward. Time will tell if I'm being foolish. But, given my beliefs, you can see why I believe that the Fear and Aversion to Risk at the expense of ignoring fundamentals and the most likely outcomes is our main problem now, and we need to attack these fears with incentives and moves to encourage risk.

"to underestimate the amount of risk they faced and overestimate the amount of leverage they could handle"

Thomas F. Cooley gives the general consensus view of risk in Forbes:

"There is another, deeper possible link between the Great Moderation and the financial crisis that is worth thinking about, because it may help to inform the financial regulation of the future. The idea is simply that the decline in volatility led financial institutions to underestimate the amount of risk they faced and overestimate the amount of leverage they could handle, thus essentially (though unintentionally) reintroducing a large measure of volatility into the market.

Financial institutions typically manage their risk using what they call value at risk or VaR. Without getting into the technicalities of VaR (and there is a very long story to be told about the misuse of these methods), it is highly likely that the Great Moderation led many risk managers to drastically underestimate the aggregate risk in the economy. A 50% decline in aggregate risk is huge, and after 20 years, people come to count on things being the same.

Risk managers are supposed to address these problems with stress testing--computing their value at risk assuming extreme events--but they often don't. The result was that firms vastly overestimated the amount of leverage they could assume, and put themselves at great risk. Of course, the desperate search for yield had something to do with it as well, but I have a hard time believing that the managers of Lehman, Bear Stearns and others knowingly bet the firm on a systematic basis. They thought the world was less risky than it is. And so, the Great Moderation became fuel for the fire.

If there is a moral to this story it is probably to do with the filters we put on historical events. Succession and causality are often confused. As are the limits on our ability to think historically. What we see right now is only the great conflagration that consumes us, leaving us little appetite, and even less oxygen, to moderate our responses and hold onto a broad historical outlook."

I don't credit this, and now I think that I can explain why.

Many years ago, I read an essay which I've tried to find, but can't, about the modern conflict between Great Britain and the IRA. The essay started by stating that each side dated the conflict differently. For Great Britain, it began in the 20th Century, but for the IRA, it began in the 17th Century. The differences in dating led to completely opposite developments in the narrative and explanation of the problem.

So, when Cooley says this:

"Take, for example, "the Great Moderation."

The last really sharp recession in the United States was from 1981 to 1982, when real output fell by more than 4% below trend, and the unemployment rate rose to over 10%. It is often referred to as the Volcker Recession because it was triggered in part by then Fed Chairman Paul Volcker's efforts to squeeze inflation out of the U.S. economy.

Following that recession, something remarkable happened. The volatility in the U.S. economy declined sharply. Even though we have had two recessions in the ensuing years--in 1991 and 2002--both were relatively mild and short-lived.

Surprisingly, the U.S. economy remained dramatically more stable in spite of some major disruptions in financial markets in the U.S. and abroad over the same period. There was a major stock market crash in the U.S. in October 1987; the Mexican Financial Crisis in 1994; the Asian Financial Crisis in 1997 and 1998; the Russian debt crisis and the Long-Term Capital Management crisis in 1998 and the bursting of the dot-com bubble. In addition, there were the terrorist attacks of 9/11, and the U.S. got itself involved in two wars. In short, there were many dramatic events both in the U.S. and abroad--and yet the aggregate U.S. economy was relatively calm."

He leaves out the S & L Crisis. To me, the obviously most important factor. The implicit and explicit government guarantees to intervene in a crisis. So, we approach the history of this debacle from, not only philosophical differences, but historical differences. To me, the most important fact is how humans react to crises in real life, and what they are actually acting upon.

I've used this example before. Take illegal immigration. It's illegal. What do the government's actions over the last 20 years tell you about any implicit or explicit guarantees about whether the illegal immigrants will basically all allowed to remain in the end?

I don't know how to resolve this difference.