banks load up on exposures when measured risks are low, only to shed them as fast as they can when risks materialise

TO BE NOTED: From Vox:

"Securitisation and financial stability

Hyun Song Shin 18 March 2009

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Did securitisation disperse risks? This column argues that it undermined financial stability by concentrating risk. Securitisation allowed banks to leverage up in tranquil times while concentrating risks in the banking system by inducing banks and other financial intermediaries to buy each other’s securities with borrowed money.

Financial booms and busts are as old as finance itself, but the current global financial crisis has the distinction of being the first post-securitisation crisis. Securitisation refers to banks’ practice of parcelling and selling loans to other investors. Securitisation was meant to disperse risks associated with bank lending so that deep-pocketed investors who were better able to absorb losses would share the risks.

But in reality, securitisation worked to concentrate risks in the banking sector. In a paper published this week (Shin 2009)), I argue that there was a simple reason for this. Banks wanted to increase their leverage ( NB DON ) – to become more indebted – so as to spice up their short-term profit. So, rather than dispersing risks evenly throughout the economy, banks bought each other’s securities with borrowed money. As a result, far from dispersing risks, securitisation had the perverse effect of concentrating all the risks in the banking system itself.

Against received wisdom

To understand the true role played by securitisation in the current financial crisis, we need to dispose of two pieces of received wisdom concerning securitisation - one old, one new. The old view, now discredited, emphasised the positive role played by securitisation in dispersing credit risk, thereby enhancing the resilience of the financial system to defaults by borrowers.

But having disposed of this old conventional wisdom, the fashion now is to replace it with a new one that emphasises the chain of unscrupulous operators who passed on bad loans to the greater fool next in the chain. We could dub this new fashionable view the “hot potato” hypothesis. The idea is attractively simple and blames a convenient villain, so it has appeared in countless speeches given by central bankers and politicians on the causes of the subprime crisis.

But the new conventional wisdom is just as flawed as the old one. Not only does it fall foul of the fact that securitisation worked well for thirty years before the subprime crisis( NB DON ), it fails to distinguish between selling a bad loan down the chain and issuing liabilities backed by bad loans. By selling a bad loan, you get rid of the bad loan from your balance sheet. In this sense, the hot potato is passed down the chain to the greater fool next in the chain. However, issuing liabilities against bad loans does not get rid of the bad loan. The hot potato is sitting on your balance sheet or on the books of the special purpose vehicles that you are sponsoring. Thus, far from passing the hot potato down the chain to the greater fool next in the chain, you end up keeping the hot potato. In effect, the large financial intermediaries are the last in the chain. They are the greatest fool. While the investors who buy your securities will end up losing money, the financial intermediaries that have issued the securities are in danger of larger losses. Since the intermediaries are leveraged, they are in danger of having their equity wiped out, as many have painfully learned.

Figure 1. Total subprime mortgage exposure

Source: Greenlaw, Hatzius, Kashyap and Shin (2008)

Indeed, Greenlaw, Hatzius, Kashyap and Shin (2008) report that, of the approximately $1.4 trillion total exposure to subprime mortgages, around half of the potential losses were borne by US leveraged( NB DON ) financial institutions, such as commercial banks, securities firms, and hedge funds (see Figure 1). When foreign leveraged institutions are included, the total exposure of leveraged financial institutions rises to two-thirds. So, far from passing on the bad loan to the greater fool next in the chain, the most sophisticated financial institutions amassed the largest holdings of the bad assets – they were the greatest fools.

It’s all about leverage ( NB DON )

Securitisation should be viewed in the larger context of balance sheet management by banks. Financial intermediaries manage their balance sheets actively in response to shifts in measured risks. In the name of modernity and price-sensitive risk management, banks load up on exposures when measured risks are low, only to shed them as fast as they can when risks materialise. The supply of credit is the outcome of such decisions and depends sensitively on key attributes of intermediaries' balance sheets. Three attributes merit special mention – equity, leverage, and funding source. The equity of a financial intermediary is its risk capital that can absorb potential losses. Leverage is the ratio of total assets to equity and reflects the constraints placed on the financial intermediary by its creditors on the level of exposure for each dollar of its equity. Finally, the funding source matters for the total credit supplied by the financial intermediary sector as a whole to the ultimate borrowers.

At the aggregate sector level (i.e. once the claims and obligations between leveraged entities have been netted out), the lending to ultimate borrowers must be funded either from the equity of the intermediary sector or by borrowing from creditors outside the intermediary sector. Aggregate lending to end-user borrowers by the banking system must be financed either by the equity in the banking system or by borrowing from creditors outside the banking system. For any fixed profile of equity and leverage across individual banks, the total supply of credit to ultimate borrowers is larger when the banks borrow more from creditors outside the banking system.

In a traditional banking system that intermediates between retail depositors and ultimate borrowers, the total quantity of deposits represents the obligation of the banking system to creditors outside the banking system. However, securitisation opens up potentially new sources of funding for the banking system by tapping new creditors. The new creditors who buy the securitised claims include pension funds, mutual funds, and insurance companies, as well as foreign investors such as foreign central banks. Foreign central banks have been a particularly important funding source for residential mortgage lending in the US.

As balance sheets expand, new borrowers must be found. When all prime borrowers have a mortgage, but balance sheets still need to expand, banks have to lower their lending standards in order to lend to subprime borrowers. The seeds of the subsequent downturn in the credit cycle are thus sown.

When the downturn arrives, the bad loans are either sitting on the balance sheets of the large financial intermediaries, or they are in special purpose vehicles that are sponsored by them. This is so since the bad loans were taken on precisely in order to utilise the slack on their balance sheets. Although final investors such as pension funds and insurance companies will suffer losses, too, the large financial intermediaries are more exposed in the sense that they face the danger of seeing their capital wiped out. The “hot potato” was sitting inside the financial system, carried by the largest and most sophisticated financial intermediaries. The severity of the current financial crisis attests to this feature.

References

Greenlaw, David, Jan Hatzius, Anil Kashyap and Hyun Song Shin (2008) “Leveraged Losses: Lessons from the Mortgage Market Meltdown” US Monetary Policy Forum Report No. 2.

Shin, Hyun Song (2009) “Securitisation and Financial Stability” paper presented as the Economic Journal Lecture at the Royal Economic Society meeting, Warwick, March 2008."

a lot of risk that the bank regulators thought had been dispersed into many strong hands ended up in a single weak hand

From Follow The Money:

“Concretations of risk, plagued with deadly correlations”

Posted on Tuesday, March 17th, 2009

By bsetser

The FT’s Gillian Tett makes a simple but important point: AIG’s role in the credit default swap market meant that a lot of risk that the bank regulators thought had been dispersed into many strong hands ended up in a single weak hand.

Tett:

What is equally striking, however, is the all-encompassing list of names which purchased insurance on mortgage instruments from AIG, via credit derivatives. After all, during the past decade, the theory behind modern financial innovation was that it was spreading credit risk round the system instead of just leaving it concentrated on the balance sheets of banks.

But the AIG list shows what the fatal flaw in that rhetoric was. On paper, banks ranging from Deutsche Bank to Société Générale to Merrill Lynch have been shedding credit risks on mortgage loans, and much else. Unfortunately, most of those banks have been shedding risks in almost the same way – namely by dumping large chunks on to AIG. Or, to put it another way, what AIG has essentially been doing in the past decade is writing the same type of insurance contract, over and over again, for almost every other player on the street.

Far from promoting “dispersion” or “diversification”, innovation has ended up producing concentrations of risk, plagued with deadly correlations, too. Hence AIG’s inability to honour its insurance deals to the rest of the financial system, until it was bailed out by US taxpayers.

If the US creates a “systemic risk” regulator, it should be on the lookout for similar concentrations of risk.

One other point. The fact that several of AIG’s largest counterparties are European financial firms is by now well known. What is I think less well known is that the expansion of the dollar balance sheets of “European” financial firms — the BIS reports that the dollar-denominated balance sheets of major European financial institutions (UK, Swiss and Eurozone) increased from a little over $2 trillion in 2000 to something like $8 trillion (see the first graph in this report) — played a large role in the US credit boom.

As the BIS (Baba, McCauley and Ramaswamy) reports, many European banks were growing their dollar balance sheets so quickly that many started to rely heavily on US money market funds for financing. And if an institution is borrowing from US money market funds to buy securitized US mortgage credit, in a lot of ways it is a US bank, or at least a shadow US bank.

Consequently I think it is possible to think of AIG as the insurer-of-last resort to the United States’ own shadow financial system. That shadow financial system just operated offshore. There was a reason why investors in the UK were buying so many US asset backed securities during the peak years of the credit boom."

Me:

1. Don the libertarian Democrat responds:
   

   From A Credit Trader:

   http://www.acredittrader.com/?p=65

   ” * A bank buys CDS protection from an insurance company (wrong-way because credit spreads tend to be correlated suggesting that when the trade is positive mtm to the bank, the insurance co’s credit spread is wider)

   Did you catch that last one? This is what happened with AIG.

   In fact, I would argue that the credit quality of AIG was not just somewhat correlated to the credit quality of the insured CDOs but was in fact 100% correlated, especially in the case that matters i.e. impairment of super-senior tranches. By the time this happens AIG will have gone bankrupt posting collateral and even if it survived up to this point the very high correlation between the super-senior tranches it wrote protection on means AIG would have to pony up an unbelievable amount of cash.

   So, where does that leave us? Making the back-of-the-envelope assumptions above of 100% correlation in credit quality between AIG and its insured CDO as well as zero recovery, the value of protection that investment banks bought was zero. Remember that the correct value of the trade is the risk-free valuation less the credit exposure. In our case, the credit exposure would be equal to the risk-free value of the trade.

   Why did Banks buy Protection from AIG?
   Did the banks realize the value of its protection held against AIG was zero? Of course they did - they aren’t as dumb as the media suggests. The reason they continued to pay the full market CDS offer (rather than a much lower level due to AIG’s massive wrong-wayness) to AIG was because they considered it a cost that allowed them to continue originating CDOs. If they could not offload super-senior risk to someone, their originating desks would be effectively shut down.

   So, while the trading desks continued to buy super-senior protection from AIG, the risk management desks, realizing that the protection was effectively worthless, bought protection on AIG itself from the street and clients in large size. In fact, I would imagine the size they needed to buy was too large and they likely ended up buying puts on the AIG stock or just shorting outright. Let’s hope the Fed unwinds of AIG’s trades took into account the huge gains these banks took on the AIG hedges.

   Onwards and Upwards: the CDS Clearinghouse
   In the better late than never column, market participants are establishing a CDS Clearinghouse whose members will face the clearinghouse on all trades, rather than each other as is the case now. This will help in assigning trades, posting collateral, unwinding trades etc. This will hopefully do away with zero-collateral posting by AAA counterparties, which means that selling protection in massive size will be less of a “free money” trade than before.”

   And Tett:

   “And therein lies an important moral. Notwithstanding the disaster at AIG, the basic idea of using derivatives contracts to share risk is not stupid; on the contrary, risk dispersion remains a sensible idea, if used in a prudent, modest manner.

   But diversification can only occur if potential correlations are monitored – and that oversight can only take place if the business of risk transfer is made as visible as possible. That means that regulators and investors should demand dramatically more disclosure about credit derivatives deals and about their counterparties, too. The type of transparency seen at AIG this week, in other words, is not just badly overdue; it now needs to be replicated on a much bigger scale.”

   I agree with Tett. CDSs and CDOs can be very useful in certain marginal investments. What occurred here was the result of human decisions. I consider them fraud or negligence, while others disagree.

"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.