although the locus of the crisis was ABS, there’s no particular reason that it couldn’t have been munis instead

From Reuters:

"Notes for a speech to the Regional Bond Dealers Association

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Posted by: Felix Salmon

Tags: bonds and loans, derivatives

Blogging will be light today and tomorrow, since I’m flying to and from the annual meeting of the Regional Bond Dealers Association in Dallas. They’ve asked me to give a speech: here are my notes.

Like everybody else at this conference, I’m sure, I’m here to talk about risk – the main part of what you all do for a living. You buy it, you sell it, you measure it, you underwrite it. But like most of us, I’ve changed my view on risk considerably over the past couple of years. And it seems to me that one of the biggest mistakes that we all made during the credit boom was that everybody overestimated the demand for risk, when in reality there was much more demand for safety.

I believed along with Alan Greenspan that when it comes to debt instruments in general, and credit derivatives in particular, “These instruments enhance the ability to differentiate risk and allocate it to those investor most able and willing to take it.”

But if you look at what happened in practice, the art of securitization always seemed designed to create ever-increasing quantities of risk-free debt. Banks thought they were selling loans and mortgages to people who wanted the risk, but they weren’t: they were carefully packaging those loans and mortgages into bonds carrying a triple-A credit rating. And people buying triple-A risk don’t want any risk at all.

So what happened to the risk? The answer is that it was essentially modelled away. And one of the most important enablers of that modelling is the subject of my Wired cover story, the Gaussian copula function.

But the story is bigger than one formula.

Consider the very first synthetic CDO: it was called Bistro, and it was issued by JP Morgan in the late 1990s. The bank sold off the risk associated with $10 billion in loans on its balance sheet – this was credit risk which the bank didn’t want, even though it valued its lending relationshipsvery highly. So it kept the loans on its book, and kept the relationships, but sold off the risk by using credit default swaps to structure a synthetic CDO.

But here’s the astonishing thing. The credit risk on that $10 billion in loans managed to somehow get squeezed into a CDO of just $700 million: there was no chance that all the loans would sour at the same time, and JP Morgan managed to persuade Moody’s that the CDO could be just 7% of the size of the underlying loan pool, while hedging all of the credit risk.\

And it gets better: of that $700 million, fully two-thirds carried a triple-A rating. And triple-A, for those of you who remember as far back as 2006, means “no credit risk at all” – it means “risk free” – it means “you’re only taking interest-rate risk”. Which makes no sense when the whole point of credit default swaps is to separate out credit risk from interest-rate risk.

Add in the double-A rated tranches of Bistro, and you have holders of less than $200 million of risky paper taking substantially all the credit risk on $10 billion of corporate loans. That’s less than 2%. And Moody’s happily signed off on this, for two reasons. One was that the business of rating structured-finance vehicles was highly profitable; the second was that their entire business and reputation was based on the idea that they could model credit risk. If they couldn’tmodel credit risk, then they couldn’t rate credit. And so they were backed into a corner, and forced to apply their storied credit ratings to structured products which were simply the logical conclusion of their own models, rather than the result of a fundamentals-based look at a certain credit.

If you take a step back, you can see what’s going on here. You and I and Alan Greenspan all thought that credit derivatives were wonderful things because they moved credit risk out of the hands of people who didn’t want it, like banks, and into the hands of people who did want it.

In reality, however, the appetite for risk was never nearly as great as we all thought. $10 billion of loans becomes less than $200 million of credit-risk instruments, and everybody else reassures themselves that they’ve managed to reduce their credit risk to zero, even as the people holding that $200 million in synthetic CDO tranches are reassured by their own single-A or triple-B credit ratings that theyaren’t taking a particularly large amount of risk either.

And of course you know what happens next: some bright spark invents the CDO-squared, which seems to reduce the total amount of risk even further. You take the mezzanine debt, the triple-B stuff, and you do all manner of securitization magic to it, and it turns out that you can turn most of that into triple-A paper, too!

Because it was all triple-A, no one felt much in the way of need to do any analysis of their own: it’s almost impossible to overstate the power of the laziness of the bond investor. You know this from your own work with municipal issuers: the reason for those monoline wraps is not because the issuers have a lot of credit risk, but because the investors are lazy, and don’t want to do their homework, and reckon they can get out of doing their homework so long as there’s a monoline guarantee. Essentially, they’re outsourcing their own job to the monolines. Which might be reasonable for a small retail investor, but is not a good idea if your job is to invest in fixed-income instruments which carry a higher yield than Treasury bonds.

Of course, we all know how reliable those monoline guarantees turned out to be – and that’s a related story. The monolines, just like the ratings agencies, believed far too much in the power of models.

But things didn’t go completely insane until the technology behind Bistro started being used on asset-backed bonds in general, and mortgage-backed securities in particular.

Once again, we have a situation where everybody is trying to farm off risk to everybody else, to the point at which everybody thinks that someone else has it. For one thing, virtually nobody ever even stopped to worry about credit risk in the MBS market – I know that I didn’t, until it was far too late. I believed what the professionals told me, which was that the only thing a mortgage-bond investor needs to worry about is prepayment risk, and that credit risk is a non-issue.

But even those people who did stop to worry about credit risk were rapidly reassured. Most mortgages were always sold to Fannie and Freddie – and, presto, all that risk magically disappeared. These were hugely profitable corporations, what could possibly go wrong?

Then of course there were the non-conforming mortgages, mostly subprime, which couldn’t get sold to Frannie. How could you securitize those? They all looked very similar, with the same originators and underwriters and loan-to-value ratios and underlying FICO scores and so on and so forth. And so the key aspect of securitization which allowed the ratings agencies to dole out triple-A ratings like so much confetti – diversification – would seem to have been missing.

At least in the Bistro deal, the underlying loans came from a broad and healthy group of companies. When people started securitizing subprime mortgages, the underlying assets were neither broad nor healthy. And so were the seeds of disaster sown.

Common sense says that you can’t start lending money to very risky borrowers without taking on lots of credit risk – but somehow, by the time the loans made their way through the system, almost nobody thought that they were taking on credit risk. Most of the participants in the market thought they had triple-A-or-better debt, and they all believed, without ever really stopping to check, that the enormous amounts of credit risk being produced were being willingly held elsewhere.

And so we come to David Li’s Gaussian copula function. What the copula did was, in effect, nullify the effects of common sense: it blinded bankers and traders and bond investors with quant science. The formula decided that you could measure the degree of diversification in a mortgage pool scientifically, by looking at a single number known as correlation. Correlation was treated as a constant – which was ridiculous on its face – and then the ratings could be derived from it. By plugging in a suitably low correlation number at one end, you could churn out triple-A ratings and healthy bond valuations at the other. And since the trade was so incredibly profitable for anybody who entered into it, no one asked too many questions, and everybody piled in.

Of course, on Wall Street, if everybody is making the same trade, that’s a tried-and-true recipe for bubbles and crashes, which is exactly what we got.

It turns out that while everybody was concentrating on credit ratings, no one spent nearly enough time worrying about model risk. All those models, including the Gaussian copula function, which were used to generate the ratings, turned out to have enormous flaws. For one thing, models generally try to describe some external reality – but in this case, the models were driving the reality, creating feedback loops which were entirely outside the ability of the modelers to comprehend or hedge.

More generally, the models were based on data from a period of time when nothing ever blew up, and as a result they had a tendency to produce results saying that nothing was ever going to blow up. Eventually, you got to the ridiculous situation where the chief financial officer of Goldman Sachs could get on a quarterly earnings call and talk with a straight face about 25-sigma events, as though such concepts had real meaning.

At this point, there might be a couple of you in this audience feeling just a tiny bit smug about all this. Sure, you’ve been hit by the financial crisis – we all have. But you never got into the mortgage securitization space, you never traded correlation, you never got blindsided by a multi-billion-dollar “liquidity put” you never even knew that you had written. In other words, it wasn’t your fault.

But it’s worth asking why the regional bond dealers managed to dodge the bullet. And the answer, I’m afraid, is basically that you got lucky.

For one thing, you don’t have massive balance sheets. JP Morgan, when it did its Bistro deal, was perfectly happy keeping $10 billion in assets on its balance sheet. In New York, at the time, big balance sheets were considered a good thing: they were ways of making lots of money, and even investment banks without a commercial bank attached – Goldman Sachs is the prime example here, but you could look just as easily at Morgan Stanley or Lehman Brothers or Merrill Lynch – had as much as $1 trillion of assets. Why did they need such an enormous balance sheet? No one really asked. But it did make it easy to hide things like super-senior risk.

Remember that the Bistro deal was only for $700 million, which meant that JP Morgan kept $9.3 billion of so-called “super-senior” risk on its own books – unless and until it managed to hive that risk off to AIG. Later entrants to the game, like Citi and Merrill, never bothered to sell much if any of their super-senior exposure, and when suddenly correlations spiked and mortgages across the country started defaulting at the same time, they realized that their models had been flawed, that they hadn’t sold off all their credit risk after all, and that they had hundreds of billions of dollars in risk so well buried in these trillion-dollar balance sheets that no one really knew it was there.

So, congratulations on not being huge. And congratulations too on largely avoiding the securitization/ABS space, which was mainly the province of the big banks with lots of warehousing capacity.

But if the next shoe does drop, it’s likely to be munis, and that’s bread and butter for a lot of you guys. Correlations can go to 1 in any market, not just ABS. And although the locus of the crisis was ABS, there’s no particular reason that it couldn’t have been munis instead.

A lot of people think that municipal bonds are just inherently very safe things, but we just don’t live in a world of “inherently very safe”. I’d highly encourage you all to get out your copy of the last Berkshire Hathaway annual report, where Warren Buffett talks about the risks in the muni market:

The rationale behind very low premium rates for insuring tax-exempts has been that defaults have historically been few. But that record largely reflects the experience of entities that issued uninsured bonds…

A universe of tax-exempts fully covered by insurance would be certain to have a somewhat different loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different. To understand why, let’s go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds - virtually all uninsured - were heavily held by the city’s wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city’s fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it was apparent to all that New York’s citizens and businesses would have experienced widespread and severe financial losses from their bond holdings.

Now, imagine that all of the city’s bonds had instead been insured by Berkshire. Would similar belt- tightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to “share” in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial.

Local governments are going to face far tougher fiscal problems in the future than they have to date…

When faced with large revenue shortfalls, communities that have all of their bonds insured will be more prone to develop “solutions” less favorable to bondholders than those communities that have uninsured bonds held by local banks and residents. Losses in the tax-exempt arena, when they come, are also likely to be highly correlated among issuers. If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow. What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer?

To put it simply: if one muni defaults, that’s nasty for its creditors, including the monolines. And default is much more likely now than it was when most munis were unwrapped – insurance, as any insurer will tell you, is rife with moral hazard.

But if five or six munis default, things get much, much worse. At that point, the cost of default for a wrapped muni issuer plunges, and possibly even goes negative. Once a few munis default, no one’s going to lend to any muni, even the ones which are current on their debt. So why bother staying current? Why not just default and let the insurer, rather than your local taxpayers, take most of the pain?

In other words, there’s a very serious, and pretty much impossible to hedge, risk of snowballing muni defaults.

The fact is that the muni market is still heavily reliant on monoline wraps, which are at heart an artifact of the credit bubble, and of the fact that no one wanted to do homework or admit that they were taking risk. Those days are over now, and the new financial world which emerges from the current rubble is going to be one where investors are forced to face up to the fact that risk is endemic and can’t simply be modelled away.

What’s that going to mean for your business? I fear the news isn’t good. No fixed-income investors have the time to do detailed credit analysis on a regional hospital. That’s something banks do: these things should often by rights be loans rather than bonds. Which implies that we’re going to move back to a world of reintermediation, with less of a role for bond dealers and more of a role for boring bankers who know their clients and do their homework. And more generally, the financial sector is going to be a much smaller part of the economy than it has been over the past couple of decades.

So even if and when the economy rebounds, I wouldn’t expect your business to necessarily rebound with it. Ask yourself how many of your buy-side clients really want to analyze and buy substantial amounts of credit risk, which is the main product that you’re selling. Remember that they can’t be lazy any more, and rely on copulas and credit ratings and monline wraps, they have to do it all themselves. Do you see a business selling to these people? I hope so, because that’s going to be a large part of your job from now on, and I wish you all good luck."

Me:

“Of course, on Wall Street, if everybody is making the same trade, that’s a tried-and-true recipe for bubbles and crashes, which is exactly what we got.”

At the risk of constantly being the one kid in class who never gets it, as regards David Li’s Gaussian copula function, is it:

1) The 1st user thought that he was making money, which led people to follow him, but he was actually losing money. Eventually, the losses added up to a figure that was a very substantial loss to society.

2) The users were making money until a certain money-losing number of users was reached.

As for stocks, I’m having a problem understanding how everybody can be doing the same thing. For every buyer, doesn’t there have to be a seller?

I sold my house last year. I made money. Even though that house has probably gone down in value, the people who bought it are still in it because they can afford the payments, taxes, etc. When I bought that house, the price fell 10% to 15%, but I could afford the upkeep. I even petitioned for a decrease in my property taxes.

The problem has to be that people took out loans that they can’t afford to pay, and lenders gave out loans to people who can’t afford to pay. In other words, the problem was the amount of debt as against the resources that people had.

In the case of CDOs, surely the bottom line has to do with the situation that I just described. The problem is that people don’t have enough resources to make good on the claims against them. Again, it’s not really the model, it’s the lack of resources. People were trying to get in on a rising market on the cheap. That is, they were investing more and more with less and less backing, and lending to people with less and less backing. I’m sorry, that’s absolutely clear, whatever your models tell you about the future.

Suppose the investors had used an eight ball, a ouija board, a medium, etc., claiming that they believed that it worked. Would we be as forgiving of their mistakes? What is it about a math model that leads people to conclude that it mirrors or predicts reality? In that sense, what differentiates the people who invested in Madoff as opposed to AIG? They both simply trusted people and the methods that they claimed that they were using.

If the mis-interpreters of Li were followed because they believed that they were right, what possible law can stop people believing in other people.Laws could only help if the managers invested against sensible criteria or were committing fraud. There’s no law capable of stopping people from making bad investments or loans with people that they trust.

Bottom line, isn’t all that bond dealers are marketing is trust?

- Posted by Don the libertarian Democrat

S&P also downgraded all the major US mortgage insurers, and most by multiple notches.

TO BE NOTED: From Alphaville:

"The travails of the financial guarantors Posted by Stacy-Marie Ishmael on Apr 22 15:40.

There’s been a slew of (mostly negative) ratings actions on the financial guaranty sector - the bond insurers, mortgage insurers and the like - recently. Here’s a recap.

Subsequent to a warning from FGIC’s auditor that there is substantial doubt over the bond insurer’s ability to “continue as a going concern,” Standard & Poor’s on Wednesday wrote off the company completely:
NEW YORK April 22, 2009–Standard & Poor’s Ratings Services said today that it lowered its counterparty credit, financial strength, and financial enhancement ratings on Financial Guaranty Insurance Co. (FGIC) to ‘CC’ from ‘CCC’ and assigned a negative outlook.

Standard & Poor’s also said that it subsequently withdrew the ratings on FGIC and its ‘CC’ counterparty credit rating on the holding company, FGIC Corp., because of our expectation that timely and comprehensive financial information will no longer be available.

“Recently released GAAP financial statements for both FGIC and FGIC Corp. contain a statement from the independent auditor that there is substantial doubt regarding the company’s ability to continue as a going concern,” noted Standard & Poor’s credit analyst Robert E. Green. “The issuance of this opinion results in an event of default by FGIC Corp. under the terms of the company’s revolving credit agreement.” There is $46 million outstanding under the facility, and FGIC Corp., though it is attempting to secure a waiver, does not have the resources to repay this amount in full if it were to become due on an accelerated basis. In addition, because FGIC is in a negative earned surplus position, it is not able to pay dividends to FGIC Corp.

The negative outlook reflected the possibility that additional losses incurred, as suggested by our RMBS and CDO of ABS loss estimate, could result in capital and surplus below the minimum statutory requirement of $65 million. The negative outlook on holding company FGIC Corp. reflected the independent auditor’s issuance of a going concern opinion, which triggered an event of default on the company’s revolving credit facility.

S&P also downgraded all the major US mortgage insurers, and most by multiple notches. Companies affected include Radian, PMI, Genworth Mortgage Insurance and RMIC.

But - in a rare display of confidence - S&P affirmed the triple-A rating on Financial Security Assurance (FSA) and removed it from credit watch negative.

Over at Moody’s, Ambac was downgraded to Ba3 from Baa1 (deep, deep into junk territory):

The downgrade of Ambac’s ratings primarily reflects weakened risk adjusted capitalization, as Moody’s loss estimates on RMBS securities have increased significantly (particularly with respect to Alt-A transactions). These higher loss estimates increase the estimated capital required to support Ambac’s sizable direct RMBS portfolio (including securities owned as well as securities guaranteed) and also the insurer’s large portfolio of ABS CDO risks. The rating agency noted that the claims-paying resources of Ambac remain above Moody’s expected loss estimates for the firm, though this cushion has been significantly eroded, and losses in more severe stress scenarios would exceed available resources.

Related links:
Moody’s sets its sights on the mortgage insurers - FT Alphaville

This entry was posted by Stacy-Marie Ishmael on Wednesday, April 22nd, 2009 at 15:40 and is filed under Capital markets. Tagged with Ambac, FGIC, Financial Security Assurance, Monolines, PMI, radian.

Instead of holding the unsold inventory, the dealers were exercising their rights to push bonds they couldn't remarket back to the LOC bank

TO BE NOTED: From Accrued Interest:

"Muni Swaps: Let's hope we don't have a burnout

Regular reader and sometimes commenter Gingcorp asked me to comment on this article in the New York Times about some, shall we say, questionable practices at Morgan Keegan's muni department.

I happen to know a fair amount about the problem of swapped muni VRDB's as I had a two clients threatened by similar circumstances. Unfortunately, the NYT article makes it sound like the municipalities were betting on interest rates which simply isn't the case. So I feel compelled to tell the world what's really going on here. Bear in mind that I can't speak to the situation in Tennessee specifically, because every situation can be a little different, but this should give you the general picture.

First, let's say its five years ago and you are one of these poor unsuspecting municipal authorities. Let's assume you are the authority who manages the local airport, the Bumpkin Airport Authority. You'd like to issue debt, and like any responsible financial steward, you want to minimize your interest cost.

Your banker suggests that a variable rate bond would lower your expected interest cost, because demand for short-term bonds is extremely strong. In 2004, the typical rate on variable rate muni debt (either auction rate or VRDN) was around 1.5%. (There are some additional fees involved, which we'll get to in a minute.)

First, a quick lesson on muni variable rate bonds. In a VRDN, the investor has the option to "put" the bond back to the municipality on any interest rate reset date, usually every 7 days, at par value. With an auction rate, investors can choose to "sell" at any auction, assuming the auction doesn't fail. Remember that until 2007, auctions almost never failed, so this wasn't seen as a big risk.

In both cases, the interest rate isn't based on some reference index, like LIBOR, but whatever interest rate clears the market.

But you, as the municipal airport authority, aren't interested in taking variable interest rate risk, as you don't have any natural variable rate assets. You'd rather lock in a certain interest rate today and have a known cost for whatever you are selling the debt to construct.

Your friendly banker has a solution. Sell the debt variable rate, and at the same time enter into a pay fixed, received floating swap. On its face, this can hardly be called creative finance. Its really finance 101. You have a floating liability, you want a fixed liability, just enter into a swap. Simple.

The Sith Lord was in the details. First of all, in order to do a VRDN, you needed to get a letter of credit from a bank. See, investors needed to know that the municipality had the cash to fund that put option I described above. The bank LOC allowed for that. So let's say the bank was charging 0.25% for the LOC. In the case of an airport authority, the bank would probably require that the municipality also buy a monoline insurance (e.g. Ambac) policy to protect the bank in the event the municipality defaults and the bank gets hit with a wave of puts. Let's say that costs about 0.10%.

But even in the face of those extra fees, the issue floating/swap to fixed still saves you a lot of money, because the fixed side of the swap is actually below where you could sell fixed rate debt. Everything is peachy.

The only remaining hitch is that, as I said above, muni VRDNs don't reset based on a specific index, but on whatever rate clears the market. This left the possibility that issuer A might pay a slightly higher rater than issuer B one week, but then issuer B would be higher the next week. Not because of anything about the issuers themselves, but just because of random variations in supply and demand at any point in time.

Unfortunately, the floating side of the swap had to be based on some predetermined index. Bankers usually picked one of two options. Either the SIFMA index, which is a published index of muni VRDN rates. Or they used 67% of LIBOR. E.g., if 1-week LIBOR was 3%, the the swap rate would be 2%. The 67% number was intended to reflect the typical gap between taxable and tax-exempt money market instruments. I believe the LIBOR version was more popular than the SIFMA version, and I have also heard swaps struck at 80% of LIBOR.

Right there was the red flag. What happens if the VRDN rate set by market forces isn't equal to the 67% of LIBOR level? This is known as basis risk, and it did happen under normal times. But it was always short lived. For example VRDN rates always rose during times when retail investors were pulling money out of muni money market funds, such as tax time. But those periods of elevated rates was always short-lived. The huge savings from the synthetic fixed rate structure overwhelmed these short-term costs.

Let's go back to the bank providing the LOC. Remember they required you to have a monoline insurance policy from Ambac to protect themselves. The actual legal language probably says something to the effect of...

"ABC Bank requires that Bumpkin Airport Authority acquire an insurance policy from a monoline insurer rated in the top ratings category from Standard & Poors and Moody's Investor Service. Should the authority be unable to acquire such a policy or should the monoline insurer be downgraded below Baa3/BBB- ABC Bank may withdraw the letter of credit."

Of course, don't need to worry about Ambac being downgraded right? Er... From the investor's perspective, you didn't wait around for Ambac to actually be downgraded. You were allowed to put these bonds back to the issuer at par! You hit that bid as hard as you could as fast as you could.

So now what happens? Remember that the interest rate that the Bumpkin Airport Authority actually pays is set by supply and demand. Now that the LOC is threatened, there is no demand, all supply. In order to actually entice some buyers, they had to set the rate at 7%, 8%, 9%, etc. Note that these weren't the failing auction rate bonds we heard so much about, although a similar story would apply have Bumpkin decided to go ARS.

Now Bumpkin is paying 9% on their VRDN, while the floating end of the swap is only paying you 67% of LIBOR, currently a glorious 0.25%. On top of the 9% you are paying investors, you are also paying your swap provider whatever the fixed leg of the swap is, probably something in the 4% area. Ugly.

But wait... it get worse. The interest rates are actually set by some dealer, called the remarketing agent. In normal times, the dealers would set the rate at something reasonable, and if they couldn't sell all their bonds right away, they'd just inventory them. So if it happened to be that a big holder of the Bumpkin Airport bonds wanted to put their bonds back on a given day, it was no big deal. The investment bank was willing to just hold the bonds waiting for the right investor to come along. It was considered a good use of balance sheet because it justified the remarketing fees the bank was collecting.

Once dealer balance sheets became crunched, nicities like this went right out the window. Instead of holding the unsold inventory, the dealers were exercising their rights to push bonds they couldn't remarket back to the LOC bank. These then because so-called bank bonds, and Bumpkin was charged some pre-determined rate on these, I think it was set off Prime.

But wait... it gets worse. Remember that the swap was intended to be a hedge against rising interest rates. It is therefore effectively a short position on long-term fixed rate bonds. In fact, long-term bonds have skyrocketed in value. Thus your swap is getting crushed. A 30-year swap struck on January 1, 2008 for $10 million notional value would currently be down $3 million in market value. Put another way, if you want out of this swap, you need to pay the investment bank $3 million.

Had the swap remained an effective hedge, this wouldn't be a problem, because Bumpkin Airport would be saving an equivalent amount of money on plummeting short-term rates. But in fact, Bumpkin is paying a usurious 9%.

So the VRDN itself is killing you. The swap is killing you. Basically, you're dead unless something changes.

What most municipalities did was refinance the Ambac-backed deal with a new VRDN without that stipulation. Except for a brief period in September and October 2008, the VRDN market has been pretty healthy. So once you refinance the VRDN, then the swap goes back to being a decent hedge. Everything works out just fine.

But even if you do a new VRDN deal, you still need a LOC from a bank. Guess what? Banks aren't so keen on tieing up their capital to make 25bps on muni LOCs. Instead, they've been picking carefully who they deal with, and charging a lot more to do it.

Even if the municipality can restructure, it isn't out of the woods entirely. If the swap is deeply underwater in nominal market value, the municipality probably has to post additional collateral. Think of it similar to margin posting on a futures contract. In some cases, this is no big deal, because the municipality has a decent sized general fund and simply must set aside certain securities as collateral. But in other cases, the municipality has little safety net. In fact, its more likely an issuer like Bumpkin Airport Authority has a sizeable investment portfolio compared with some county or school district which collects taxes directly. A lot of times, issuers with full taxing authority keep less in general funds. Politically, if the voters see that their county has a big investment balance they start wondering why tax rates aren't being lowered and/or why the money isn't being spent on new projects. An issuer with more volatile revenue, like a airport, toll road, hospital, etc., is more likely to build a reserve. It tends to be less politically sensitive if there aren't any direct taxes involved.

If you are an investor in munis, the best thing to do is hunt down how much VRDN exposure your bond issuers have, whether they have any monoline contracts attached, and what their plan for dealing with both is. You will probably find that you have nothing to worry about, but if you are sloppy, you could wind up with the next Jefferson County."

ome banks used the monolines to hedge their exposure to CDO tranches while they waited to offload them to investors

TO BE NOTED: From A Credit Trader:

"The Monoline Delusion

"monoline n. a company specializing in a single type of financial business, such as credit cards, home mortgages, or a sole class of insurance" DON

In late 2007, as the monoline act of the crisis drama played out, credit traders were being repeatedly pulled off the desk to attend two kinds of meetings. In both they heard bad news.

CDO Writedowns
In the first type of meetings, heads of trading desks would say they were writing down their exposure to a particular monoline. For instance, in the case of ACA, the ugly stepchild of the monoline business, Merrill wrote down $3.1bn in exposure, CBIC wrote down $2, Calyon $1.7bn and Citi $900mm in the fourth quarter of 2007 when ACA was downgraded from A to CCC. Prior to that, the banks had reported having little net exposure to CDO’s as their long bond positions were matched by CDS hedges.

The problem was, of course, that the hedges, or short positions, were done mostly with monolines. Merril, for example, gave their net CDO exposure only as $7bn, which consisted of $30bn gross CDO exposure against $23bn of hedges. What the bank omitted to say was that $20bn of those hedges were on with monolines. Assuming, 50% losses on the CDOs and a default by the monoline, real exposure was actually more than double the declared amount.

Lehman

Estimates of net CDO protection written by monolines come to around $125bn of mostly super-senior but also some junior super-senior and mezz exposure. Assuming 40%/60% recoveries, losses from monolines defaults would come out to around $50bn. This is a conservative assumption as

1. not all monolines would default
2. the banks hold some collateral / have collateral agreements in place (AAA monolines had much less strict collateral posting provisions and it appears even ACA, which due to its A rating was required to post collateral, won forbearance agreements from its counterparties)
3. the banks hold hedges against the monolines (though this will have been recognized long before the writedowns on the cash assets as vanilla CDS on liquid names are marked-to-market)

Without going into detail, the case of Merrill is particularly disheartening from a risk management perspective as it appears to have committed two basic mistakes. Just as the investors were becoming wary of CDO’s, and ABS CDO’s in particular given the apparent weakness in the housing market, one division of Merrill continued accumulating cash ABS assets just as another division was failing to find buyers for the securitized products.

Why Merrill was aggresively buying up assets it knew could no longer be offloaded is puzzling and speaks of disincentives in the firm. At some point though, the bank did realize that this practice was not a particularly wise strategy and if it couldn’t find buyers of the cash assets it was going to find a seller of CDO protection. At that point the only insurer willing to stick its neck out was ACA (XL Capital having walked away) which was even then on particularly shaky ground. Merril put on $10bn of hedges with the firm, however, soon after ACA was downgraded and the bank was again swimming naked.

The obvious question is why did banks have exposure to monolines in the first place? The short answer is the negative basis trade (isn’t it always?).

Moody's

The slightly longer answer is that, as mentioned, above some banks used the monolines to hedge their exposure to CDO tranches while they waited to offload them to investors.

1. For example, say a bank comes out with a $1.5bn issue of a CDO but can only find interest for half the size. The internal trading desk, whether it wanted or not, would have to hold whatever wasn’t placed.
2. Another reason was that a monoline wrapped tranche could be marketed as a higher quality product (super-AAA rather than a plain AAA) and so could reach a broader set of investors.
3. Also, buying protection from monolines was often the only way to manage the risk of CDO assets as single-name CDS on ABS CDOs hadn’t come into the existence (or at least standardized existence) yet.
4. Finally, this trade was attractive from a regulatory capital perspective and, more importantly, was positive carry which meant that holding it on the books seemed like a good strategy given the cheap balance sheet cost and a failure to recognize that funding costs may rise in the future.

Monoline Risk
The second type of meetings that credit traders were ushered into were with internal sales teams who marketed wrapped products to the banks’ clients. These were typically municipal bonds, including the poster child of muni distress: auction-rate securities. Prior to the monoline crisis, banks and investors were not particularly concerned with proper valuation of the credit risk in these securities as the monolines stood ready to pay up if the issuer were unable to do so.

However, with the monolines faring far worse than the issuers whose credit risk they were guaranteeing, investors began discounting the wrap and focusing on the underlying risk in the products. Suddenly, salespeople, whose eyes would glaze over at any mention of credit risk, were forced to understand first and second-to-default basket products and the concept of default correlation.

In a way, these “vanilla” folks had a better sense of what was happening than the more “exotic” CDO originators. They understood the fact that the guarantees offered by monoline wraps were largely illusory and offered no protection or diversification of risk.

Prior to the crisis, monoline wraps were viewed as monoline risk. This leap of faith required two assumptions: first, that the rating of the monoline was higher than the rating of the product it was insuring – this seems commonsense (ignoring for the moment the controversy over artificially low muni ratings), however this is an assumption that went out the window in the case of ACA-insured CDO tranches. The second assumption was that the default risks of the monoline and the underlying product were uncorrelated. I go into this in more detail below, but siffice it to say that in the extreme case of perfect correlation between the two entities, the monoline is expected to default at the same time as the underlying product, suggesting that the wrap added no extra protection. If 100% correlation seems high, consider the fact that the monolines were thinly capitalized relative to the risk they guaranteed (something that was made clear after the fact) and that both the monoline and the product were fundamentally exposed to systemic risk, a scenario in which both would and did suffer massive losses.

The Monolines’ Way-ward Ways
In my AIG post, I’ve described the concept known as “way-ness” which, essentially, requires us to consider the likely state of the world in the scenario a given entity of product defaults. This is particularly relevant in managing counterparty risk. For example, all else equal, you would much rather have an airline client sell you puts on WTI than calls. This is because a lower oil price (though not too low) is more likely to boost airline profits and the company would have less difficulty in making good on the put contracts.

What are the considerations for monoline way-ness risks:

1. An important question a bank has to ask itself each time it does a trade with a client that may expose it to counterparty risk (i.e. a derivative rather than a fully funded trade) is what is the client’s motivation for doing the trade. For example, if a client is punting in the market in an attempt to make up for heavy losses on other trades, the bank should be more cautious. In recent years, municipal insured penetration has steadily declined, driven by increased investor risk appetite (less need for wraps) and a perception by municipalities of a fundamental bias in the rating methodology for their sector. This has led the monolines to expand into new markets and consider new business opportunities just as the price of risk was hitting new lows. Rating agencies were also keen to expand the structured products business for which they gathered high fees. They may also have influenced the monolines to pursue the business as a way to diversify their revenue stream and ultimately keep their AAA ratings. Also, a client that is aggresively pursuing highly leveraged opportunities outside of its historic mandate, for example a corporate putting on exotic curency trades, is particularly at risk as it points to possibly broken risk controls and poor risk management. As the market discovered later, the monolines that were particularly aggressive in bidding for structured finance business, such as ACA, were the ones that would be less able to withstand losses in a stress environment



2. The key difference between the staid muni bond insurance business and the new CDO tranche insurance business that monolines were underwriting has to do with the static/dynamic mark-to-market risk profiles of the two products. This is an important consideration as the mark-to-market gains and losses are linked to the capital the insurer is required to hold as well as the collateral it may be required to post. An insurance provider prefers a lower mark-to-market sensitivity (and hence less onerous capital charges and potential collateral calls) if the product it is insuring performs badly, all else equal. For example, for a typical bond, the MTM sensitivity decreases as the credit risk worsens (since the duration of the bond decreases) – exactly what the insurer prefers. In the case of a super-senior tranche, however, the MTM sensitivity will actually increase – precisely in the worst possible time (since the delta of the tranche will increase). To provide intuition for this, consider the tranche as a initially deep-out-of-the-money option on expected loss. The wider spreads rise, the closer the super-senior tranche is to suffering impairment and hence the higher its sensitivity to credit spreads. So, as the performance on these tranches suffers, the insurers would be marginally more on the hook for each basis point wider in spread. An attempt by the insurer to delta-hedge its exposure is likely to lead to losses since the monoline would be hedging a negative-gamma position and locking in losses with each rebalancing trade as spreads move.
3. If at some point, monolines decided to offload their super-senior tranche exposure because of their view of the market or as a preventative measure to shed risk, they would likely find it very difficult to do so. The scenario in which super-senior tranches are under stress is a scenario when liquidity is at a premium and buyers of risk are on the sidelines.
4. Going back to the point briefly mentioned above, super-senior tranches are likely to sufer in a “systemic” crisis environment – precisely the one in which we find outselves today. This environment is the one where the monoline itself would be struggling, unable to source new business as issuance and risk appetite dry up. It would be difficult for the monoline to find new sources of revenue to offset the bleeding in cash due to collateral postings or recapitalization efforts.
5. Poor performance of super-senior tranches would put additional stress on the monolines which may ultimately lead to ratings downgrades – precisely what we have seen in the last few years. Ratings downgrades would automatically trigger collateral calls and increased capital cushions, precisely when the monolines would be least able to afford it. Though rating agencies try to rate companies “through the business cycle”, the fact is that there are more downgrades than upgrades during recessions.
6. The hedging of monoline exposure by banks will increase the stress on these companies. Since the monoline spreads are correlated to super-senior tranches, banks having counteparty exposure to these insurers found that their exposure increased as credit spreads widened. This caused them (at least for the one who were actively hedging their exposure) to buy protection on the monolines exacerbating the perception of monoline risk in the market and leading to a self-fulfilling spiral.
7. Recoveries in an environment of high defaults would be lower than average putting further pressure on monolines.
8. An alternative to buying protection on the monolines to manage the banks’ exposure was to buy protection on the underlying bonds in the CDO. This was not possible in the early stages of the market as single-name ABS CDOs did not trade. However, in the last few years liquidity improved and banks were able to source protection. However, buying protection on CDS will likely push cash bond and CDO spreads wider which will increase banks’ exposure and cause further MTM losses to the monolines
9. We should differentiate willingness from ability to pay. Insurance companies are generally loath to make payouts on policies, so it is not surprising that we would witness monolines balking at making payouts on the CDO tranches. Merrill, sued SCA over $3bn of CDS positions. AIG has also tried to wiggle out of some protection it wrote. This is not surprising as none of the insurers ever considered it remotely possible to have to pay out on these contracts which contributed to insufficient reserves and lax risk management. There is also some controversy over side letters suggesting that neither the insurer nor the insured expected cash to change hands on these contracts.
10. Though few people take ratings very seriously (especially now), the fact was that Merril entered into contracts with ACA (then A-rated) to buy protection on a AAA underlying. The ratings suggest that ACA is more likely to default than the product on which it is providing insurance. This is actually worse than “buying insurance on the Titanic from someone on the Titanic”.

The monoline crisis provides a textbook case for the do’s and don’ts of managing counterparty risk and why some banks ended up suffering much more than if they had pursued a more sound risk management strategy. Greed will get you every time…"

"He estimates that such a shock causes a sharp contraction for two quarters, which is then followed by abnormally high growth. "

Another interesting post on the FT:

"Normality is just a few policy steps away

December 18, 2008

by FT

By Ricardo Caballero

Economic agents of all sorts, from creditors to consumers, are frozen waiting for some sense of normality to be restored amid the financial crisis. However, normality is much closer —just a few bold policy steps away— than is the conventional wisdom. ( I AGREE )

The system we had before the crisis is not permanently broken, but it needs to be made more resilient to aggregate shocks, especially panic-driven ones. ( I AGREE )

I build my analysis and policy prescription on three premises and observations.

First, before the crisis the world economy had an excess demand for assets, especially AAA assets, and this will not change significantly once the crisis ends. ( FINE )

Second, and contrary to what investors thought at the peak of the boom, the (private) financial sector in the US is not able to satisfy this demand for AAA assets when large negative aggregate events take place. ( OK )

However, the US government does have the capacity to fill this gap, especially because it is the recipient of flight-to-quality capital, even when the core of the global financial crisis is located in the US. ( TRUE )

Third (and with the benefit of hindsight), the main policy mistakes were made during rather than before the crisis. ( DON'T AGREE )

These observations hint at a policy framework for the crisis and the medium run. For the latter, we can go back to a world not too different from the one we had before the crisis (real estate prices and construction sectors aside), as long as the government becomes the explicit insurer for generalised panic-risk. ( ISN'T THAT WHAT WE HAVE? )

That is, while monolines and other financial institutions can lever, their capital for the purpose of insuring microeconomic risk and moderate aggregate shocks, they cannot be the ones absorbing extreme, panic-driven, aggregate shocks. This must be acknowledged in advance, and paid for by the insured institutions. ( OK )

Reasonable concerns about transparency, complexity, and incentives can be built into the insurance premia. Collective deleverage, as being done, should not constitute the core response; macroeconomic insurance should. ( OK )

The structural policy framework for the medium run also carries over to the crisis-policy itself. The essence of a solid recovery should build not from deleveraging and a forced brutal contraction of the financial sector ( I'D LIKE TO AVOID THIS ), but from the explicit and systemic insurance provision against further negative aggregate shocks to their balance sheets caused by panic or predatory actions. ( I STILL SAY THAT WE HAVE THAT )

The recent intervention of Citi, with a mixture of (paid) insurance and capital, is promising, and so is the second intervention of AIG (see the recent FT-forum articles by Caballero and Krishnamurthy, and Kotlikoff and Merheling for similar assessments). ( HOW'S THAT? )

These interventions need to be scaled up to the whole financial system (banks and beyond), and it is better to do it all at once, for in this case the likelihood of the government ever having to disburse funds for its insurance provision becomes negligible. ( WE HAVE THAT )

The good side of panic-driven contractions (as opposed to those driven by more structural factors) is that the potential for a strong recovery is always around the corner. ( TRUE )

Although the current crisis has already caused enough collateral damage to add persistence to the recession, there are still plenty of resources waiting on the side to make a sharp rebound possible. ( I AGREE )

I do not mean to say that this recession is an imaginary one. On the contrary, I believe it is a very serious recession. My point is simply that good policy has an opportunity to bring the recession back to familiar turf by defeating the extra gloom ( I AGREE ), and if this happens, the recession will become a manageable one from which current asset prices, on average, will look like once-in-a-lifetime deals ( I AGREE ).

Along the ideal recovery path described earlier, the real interest rate would remain at record low levels for a long time; risk-spreads and the VIX index (the Chicago Board Options Exchange Volatility Index, known as Wall Street’s “fear gauge”,) would decline gradually but consistently; asset prices and financial leverage would rise rapidly; the yen and dollar would depreciate vis-á-vis most other currencies, helping net exports in Japan and the US; commodity prices would recover but not to record levels. ( SOUNDS GOOD )

In addition, non-residential investment, inventory accumulation, and durable expenditures would snap back, joining and leveraging on the fiscal and monetary expansions; global imbalances would stabilise and build back a bit; unemployment would peak at single digit levels and then begin to turn around; and inflation would rise only gradually in the developed world, creating the needed space for a recovery consolidation. ( WOULD WORLD PEACE ENSUE AS WELL? )

There is no way out of a dreadful last quarter of 2008 and well into the first quarter of 2009. But the big difference with the consensus forecast is in the sharp recovery after that. ( I AGREE )

The source of this difference is in the assessment of the dominant nature of the recession. Slow recoveries follow the typical credit crunch, as financial resources have to rebuild for growth to resume.

But while I think this was the nature of the mild recession preceding the events at stricken insurer AIG, and Lehman, the collapsed investment bank, the dominant recession now is very different in nature. ( I AGREE )

It is a systemic run on all forms of explicit and implicit insurance contracts ( THAT'S IT ), but with no shortage of resources on the side. If confidence recovers, the resources to support the recovery are abundant and ready ( I AGREE ).

Nick Bloom, assistant professor of economics at Stanford University, provides the best available evidence of how an economy is likely to react to a temporary bout of volatility.

He estimates that such a shock causes a sharp contraction for two quarters, which is then followed by abnormally high growth. I think this is the correct way to view the current recession, as long as bold policy actions are undertaken. ( OK )

Of course many things can go wrong to cause a disastrous outcome, but enough has been written about these negative scenarios. It is time to, at the very least, begin to sketch what the good scenarios may look like.

I believe that we Implicitly have the guarantees he's asking for.

"The case underscores the potential for growing litigation that centers on the role of issuers and disclosures made to investors"

Here's some good news from my perspective, from Paul Jackson on Housingwire:

"The mortgage litigation machine is now turning its attention towards RMBS issuers as investors allege fraud and misrepresentation by firms that sold off loans into securitization trusts, with a new putative class-action suit filed Thursday in New York against Goldman Sachs Group Inc. (GS: 67.74 -2.83%) and some of the firm’s individual directors. The case, filed in Southern District Court in New York on Dec. 11 by the San Diego-based law firm of Coughlin Stoia Geller Rudman & Robbins LLP, a well-known securities litigation firm, argues that Goldman made false statements or omitted key information regarding the nature of the mortgages it sold into 17 different trusts during 2007."

The lead plaintiff in the case is a pension fund administered by NECA-IBEW, an electrician’s labor union that purchased securities in the deals in question, and has since seen the value of investments plummet.

The case underscores the potential for growing litigation that centers on the role of issuers and disclosures made to investors, regarding loans that were often originated by monoline mortgage bankers and commercial banks and then sold to the issuing party for securitization; it also underscores the often complex relationships that exist between mortgage originators and participants in the secondary market.

In the Goldman case, NECA-IBEW alleges that Goldman misled investors on the underwriting standards used by various originators, including — who else? — Countrywide Financial; other claims center on the use of inflated appraisals by originating entities for the trusts. Many of the loans in the trusts named in the lawsuit are of the reduced-doc, no-doc, stated-income variety, which NECA-IBEW says are rife with fraud.

“The lenders or lenders’ agents knew that the borrowers either could not provide the required documentation or the borrowers refused to provide it,” the complaint read in part.

“The underwriting, quality control, and due diligence practices and policies utilized in connection with the approval and funding of the mortgage loans were so weak that borrowers were being extended loans based on stated income … with purported income amounts that could not possibly be reconciled with the jobs claims on the loan application or through a check of free “online” salary databases.”

Read the full complaint.

A wave of litigation
For Coughlin Stoia et al, the law firm in San Diego, the case is the second such high-profile class-action suit brought against a secondary mortgage market issuer this year. In October, the firm also sued Citigroup Inc. (C: 7.70 +1.72%) and its mortgage units on behalf of a retirement fund managed by Ann Arbor, Michigan, under similar claims.

In the Goldman case, very few of the mortgages were actually originated by the Wall Street firm itself — instead, mortgages were either originated by companies including Countrywide Financial, American Mortgage Network, Fifth Third Mortgage, and Green Point and then sold to Goldman, or funneled to the issuer via conduit lending channels. Investors in both lawsuits against Citi and Goldman claim that weak quality control by issuers and rampant fraud by third-party brokers and borrowers misled investors as to what was being bought.

The cases also underscore just how far the mortgage securities mess reaches, even in the United States, where many of the firms purchasing AAA-rated mortgage securities were municipalities and pension funds.

Bank of America Corp. (BAC: 14.93 +0.13%) agreed to a settlement on Oct. 6 with fifteeen state attorneys general over claims of predatory lending by Countrywide, in a deal that will see the nation’s largest lender and servicer modify as many as 400,000 loans. That loan modification agreement led to a separate lawsuit from investors, alleging that Countrywide’s pooling and servicing agreements with investors did not permit mass-scale loan modifications unless Bank of America purchased each modified loan out of a securitized pool at par value.

While the claims are different across cases, it’s clear that investors aren’t taking the loss of their investments lying down. And legal experts that spoke with HousingWire have said, emphatically, to expect a wave of litigation surrounding secondary mortgage market contracts in the next year.

“Prosecutors will not be wanting for work, or lacking in class-action claims,” said one source, an attorney that asked not to be identified in this story.

It’s unclear what sort of liability Goldman, or likely other issuers as well, may face as a result of suits surrounding its issuance practices for RMBS deals. But experts have suggested that fraud in Alt-A loans originated during recent years is overwhelmingly common.

“Our data point to the likelihood that a significant number of the loans originated between 2002 and 2008 are ticking time bombs,” said Ann Fulmer, a vice president at fraud detection specialist Interthinx. “When they explode, the costs will be overwhelming.”

In October, Fulmer warned of an “ominous” outcome for existing mortgages. Despite tightened underwriting standards and low origination volumes, misrepresentation indicators for loans reviewed in 2007 averaged 22.54 percent of all loans from the top ten fraud-heavy states, she said.

An Interthinx study of applications originated in the last half of 2007 showed that over 42,000 — representing $11 billion — contained materially misstated borrower income. Potential misrepresentation rates are rising, as well, the company said, accounting for nearly 24 percent of loans reviewed in 2008. Fulmer said the rising incidence fo fraud, even in a down market, tends to reflect the desperation of sellers, over-mortgaged borrowers, commission-starved mortgage professionals as well as nouveau “investors” trying to cash in on foreclosed properties — and, of course, ever-present criminal profiteers.

Write to Paul Jackson at paul.jackson@housingwire.com.

"Instead they are rating based on public relations."

Accrued Interest has an important post about how the Credit Ratings Agencies, as I've said, are erring now in being too tough on companies:

"Here is the problem with Moody's stance. It has nothing to do with their actual view of municipal insurance. Its painfully obvious that this is nothing more than CYA. Its like a referee doing a make-up call. They completely screwed up structured finance ratings from 2002-2007 or there abouts. And thus they have a lot of egg on their face in regards to FGIC, Ambac, MBIA, etc.

So now they want to act all tough and refuse to give Aaa ratings to monolines under any circumstances. Does this make any more sense than when they were giving out Aaa like business cards? Aren't they essentially making Assured Guaranty pay for the sins of FGIC?

Consider this. Let's say that a new municipal insurer is created and that insurer acquires all the municipal policies from Ambac. Now let's say that the new insurer has enough capital such that if it immediately went into run off, it could pay all realistic potential premiums with a significant cushion. What is "realistic" and "significant" in the previous sentence would need to be defined, but there is no reason why Moody's can't come up with those numbers.

Why can't such a firm be rated Aaa?

Notice how in the above scenario, the firm's ability to generate new revenue isn't relevant. The firm's ability to raise new capital isn't relevant. Its simply does the firm right now have adequate capital to pay its liabilities. Why is that concept so unreasonable?

For Moody's to claim they cannot rate on this basis is a total cop out, because this is exactly how all securitized deals are rated. A securitization is always a closed loop. The ratings have to be based on available capital versus expected losses. Obviously mistakes were made in rating securitized deals in recent years. But for Moody's to claim they cannot rate on such a basis is complete bullshit. Do we need to alter our models? Absolutely. But Moody's cannot on one hand claim to be a competent ratings agency and on the other hand claim they can't estimate muni losses versus available capital.

Municipal insurance benefited both investors and municipalities. Now it will die, all because Moody's doesn't have the courage to rate insurers based on dollars and cents. Instead they are rating based on public relations."

Here's my comment:

Don said...

"So now they want to act all tough and refuse to give Aaa ratings to monolines under any circumstances. Does this make any more sense than when they were giving out Aaa like business cards? Aren't they essentially making Assured Guaranty pay for the sins of FGIC?"

It made sense going up, because they made a lot more money. It makes sense going down because they were trading on their reputation going up, and they're trying to get it back now. In doing so, they are abetting, once again, not focusing on fundamentals.

The model here is broken. I be interested if you have read this, or I've missed your ideas on this problem:

http://www.glgroup.com/News/White-Paper-on-Rating-Competition-and-Structured-Finance-(Part-1)-23549.html

Don the libertarian Democrat

11/26/08 2:30 PM

I didn't get a reply, or I would have posted it.

"the more we think we're safe, the riskier things actually are."

Once more into CDS's with Felix Salmon:

"In other words, the driver of the financial meltdown was good old-fashioned credit markets: not the CDS market at all. A few buy-side investors, to be sure, lost a lot of money selling default protection, among them the two Bear Stearns hedge funds which went bust in the summer of 2007 and really got this credit crisis going. But financial institutions, with the exception of the monolines and AIG, were not net sellers of default protection, and therefore did not lose money on CDS when spreads started gapping out and people started defaulting on mortgages. Insofar as banks have lost money, they've lost money on real-money loans to real-world individuals and companies. They have not lost money by speculating in the CDS market."

Seems clear.

"The first question is to determine, in a sober and responsible manner, whether CDS were abused. So far, I've seen little if any indication that they were. The second question is how to regulate the amount of leverage that banks take on. And far from being "a hard thing to get at directly", that's actually very easy to measure: you just look at how big the bank's balance sheet is, and how much capital it has to support that balance sheet.

To be sure, hedge funds and other shadow financial institutions can use CDS to replicate a bank's balance sheet without regulation, and that's a problem. So maybe hedge funds should be regulated -- although now that their cost of funds is much higher than that of the banks, that might no longer be necessary.

As far as the banks are concerned, most of the losses they've taken have come straight out of their balance-sheet assets, or maybe out of SIVs which once were off-balance-sheet but which now are much more transparent. Occasionally you'll find some weird and wonderful instrument like the liquidity put, which seemingly comes out of nowhere to saddle a bank with enormous losses. But the liquidity put had nothing to do with CDS, and regulating derivatives would have done nothing to prevent it from happening.

This is why the CDS demonization meme is dangerous: it's basically the financial equivalent of all the security theater at airports. Regulating CDS might trick the public into feeling safer, but it won't do any real good at all. And if there's one thing we've learned over the course of this crisis, it's that the more we think we're safe, the riskier things actually are."

It all comes down to leverage, not the actual investment. What's so hard to understand? To the extent that people believe some voodoo is being used, that constitutes Fraud, not complexity, in and of iteself.