I recently read an article by Mr Roubini (whose name always carries the editorial comment "who predicted the financial crisis) comparing India with China and what the Indian will have to do to catch up with China.
In the article Mr Roubini compares China to the hare, and India to the tortoise. Funny, we all know who won that race so why is he advocating a massive need for financial and human capital for India to run faster.
The Achilles Heel in both countries, if not all countries, is the spectre of social instability. In China the government has effected an almost total capture of household and business savings. Essentially all deposits go to state-run banks which then lend to state-linked firms at below-market rates. It's not really surprising that China has achieved an amazing growth rate:it has an almost unlimited supply of 0 percent loans, which it lends relatively consequence-free to companies that employ the very people from whom the loans come.
Sounds good, like a perpetual motion machine. Well if that's the case, then someone should explain to me why, according to China's own official statistics, that more than 600 million urban citizens live on an average of around $7 a day, and another 700 million rural peasants live on an average of $2 a day, and yet China has one of the highest number of millionaires, not to mention billionaires in the world.
Oh, and as an aside, the same statistics source cites a total population of 1.3 billion, so I guess the wealthy aren't included in the numbers?
Now, back to social instability. China is an export nation, and in the fashion of Japan and the nations of Southeast Asia they have built their exports predicated on restricted capital markets which means that China is managing capital to keep costs artificially low. This creates a system of bulk, maximum employment and a focus on market share as opposed to focusing on a rational return on investment.
It works, but only so far. If you are going to focus on exports-China's consumer sector is about the same size as France's 60 odd million consumers-then you need buyers. The US was the buyer of choice. Since the financial crisis the US's imports from China are down about a fifth.
The Chinese haven't stopped producing, yet. To do so would create massive unrest. But if you produce goods that no one buys, you end up with waste. This also means that a lot of loans made to state-linked enterprises are probably not good loans. And last year China made loans equal to about one third of their GDP. Waste and bad loans? Sounds dicey.
Now remember one last bit of the puzzle. One of the reasons the Chinese could export so much to the US is that since 2000 they have Most Favored Nation status. Right now the fact that China is one of the largest buyers of US Treasuries-and the US has a lot to sell-makes it unlikely that this would be revoked. Indeed, last week the Deputy Secretary of State James Steinberg told reporters in Washington that the US reaffirmed it does not support independence for Taiwan and restated its policy that Tibet is part of China. All this after a series of dismal treasury auctions. Next week is another auction. If that goes poorly...
Now back to India. Why is it that Mr Roubini is advocating that India emulate China?
I have no idea.
Wednesday, 31 March 2010
Tuesday, 30 March 2010
Sarah Palin and US Treasuries trading Swaps PLUS?
The other day I was confronted with two disturbing situations. I don't necessarily believe they are related, but I did observe them on the same day which may or may not be a coincidence.
First of all, there was John McCain on the stump for his Senate seat welcoming the Sarah Palin in support of his campaign. Now this is the same Sarah Palin who singlehandly lost him the presidential election and from whom he distanced himself during and after the campaign. Now he is praising her as a great American who(m) he was proud to have bolstering his campaign? I mean damn, what on earth was he thinking? He is adding gravitas to a hockey mom who has her sights on the presidency! Does he really want Sarah "I can see Russia from my house" Palin to be one of the most powerful people in the world?!
The second observation was less eye-catching and certainly less likely to stir as much emotion as Ms Palin, but it is equally disturbing. For the first time in over 30years US Treasuries are trading cheap to swaps.
OK, generally speaking swap spreads represent the relative credit of a group of banks that pool together and every day at 11:00 GMT post LIBOR. Again, under normal conditions banks are viewed as a higher credit risk than the "risk free" rate represented by the government. So government debt under normal circumstances as a function of their yield and swap spreads trade at Swaps minus a spread. Last Friday they traded at Swaps PLUS a spread. This is perverse.
The US (and UK)Government have underwritten the banks and transferred large chunks of toxic assets to the tax payers. The result of this is that ASW spreads have imploded. By socialising the losses of banks by insuring them the stress has been transferred to the governments who are forced to issue unprecedented quantities of bonds to finance the underwriting of banks. So now the government as insurer of the banks thereby "saving" the financial system has become a credit risk itself!
Now, as I mentioned these two situations were first observed (by me) on the same day. My question is are Treasuries trading Swaps plus because of concerns about issuance, or are they trading Swaps plus reflecting the fear that any nation that could seriously consider Sarah Palin as presidential quality is doomed to failure?
First of all, there was John McCain on the stump for his Senate seat welcoming the Sarah Palin in support of his campaign. Now this is the same Sarah Palin who singlehandly lost him the presidential election and from whom he distanced himself during and after the campaign. Now he is praising her as a great American who(m) he was proud to have bolstering his campaign? I mean damn, what on earth was he thinking? He is adding gravitas to a hockey mom who has her sights on the presidency! Does he really want Sarah "I can see Russia from my house" Palin to be one of the most powerful people in the world?!
The second observation was less eye-catching and certainly less likely to stir as much emotion as Ms Palin, but it is equally disturbing. For the first time in over 30years US Treasuries are trading cheap to swaps.
OK, generally speaking swap spreads represent the relative credit of a group of banks that pool together and every day at 11:00 GMT post LIBOR. Again, under normal conditions banks are viewed as a higher credit risk than the "risk free" rate represented by the government. So government debt under normal circumstances as a function of their yield and swap spreads trade at Swaps minus a spread. Last Friday they traded at Swaps PLUS a spread. This is perverse.
The US (and UK)Government have underwritten the banks and transferred large chunks of toxic assets to the tax payers. The result of this is that ASW spreads have imploded. By socialising the losses of banks by insuring them the stress has been transferred to the governments who are forced to issue unprecedented quantities of bonds to finance the underwriting of banks. So now the government as insurer of the banks thereby "saving" the financial system has become a credit risk itself!
Now, as I mentioned these two situations were first observed (by me) on the same day. My question is are Treasuries trading Swaps plus because of concerns about issuance, or are they trading Swaps plus reflecting the fear that any nation that could seriously consider Sarah Palin as presidential quality is doomed to failure?
Sunday, 28 March 2010
The Dismal Science
There are any number of discussions currently analysing economics or "the dismal science" as it is commonly referred to all in an attempt to try and explain why all the economists in the world got it wrong and missed the great crisis of '08-'09.
Now two things jump out at me on this account. The first is that not every economist missed it. Some like Dr Doom had been calling for catastrophe for the last decade. (Brings to mind the joke that economists got five out of the last two recessions right.) The second is that the crisis began in 2007, and the houses that made the most money up to 2008 were fully aware what was going on-it just never occurred to them that the fire they were playing with could get out of hand.
Take the "seminar" held in April '07 by a major international bank for its' hedge fund and proprietary trading clients. They spoke openly of their concerns surrounding the sub prime mortgage market and that they were actively building up a portfolio hedging their exposure to the mortgage market.
This was a meeting by traders for traders. The "real money" investor accounts of the bank were not invited. The host bank was however marketing mortgage CDO's to those "real money" investors-in fact one could go so far as to say that the investors were actually supplying the hedge for which the CDO traders were seeking.
In the summer of '07, a French firm packed with French mathematicians-its' Fixed Income Department had over 100 quants cranking out models for everything-suddenly announced that it could not value three of its' funds properly and so froze them.
I was always amused by this proclamation. It was almost as funny as the claim by another major French bank that the mass of models and risk management systems built by their French mathematicians-and theirs were the best- Polytechnique but of course-couldn't catch a rogue trader.
But I digress. I would suggest that it wasn't that they couldn't value the funds, but rather that they wouldn't. There was always an argument in the Street between the mark-to-market, and the mark-to-model. The difference often representing P&L. In this case the model and the market were both clearly suggesting that the value was ugly. To admit that would open up a can of worms. Their solution was to freeze the funds because they couldn't value them.
I believe this was the trigger which set the whole crisis in motion. I also believe that there were many-and I mean many bankers who were intelligent enough to understand what was happening. These were people involved in Derivative Sales, Trading and Structuring/Origination.
They had been playing with fire for over a decade and every time it got a little too hot at one house another one would jump into the fray and so the blow-ups were relatively small and self-contained. Ironically, many of those banks that would not get involved on the origination and distribution of these products were historically not comfortable with the concept of risk in their Sales and Trading Operations, but their Bank Treasuries came to be some of the largest buyers of these constructions.
No one seriously enters into banking without the hope/intent to make a lot of money. Financial Firms provide the opportunity to get rich-they are not charity organisations,are not for the faint hearted and the moral compass seldom points to money.
Firms were supposed to be structured such that Risk Management, Trading Management, Sales Management and Senior Management knew the risks they were running, and the profits they were generating. They were all expected to manage and understand this balance. Part of the problem however was that except for Risk they all had budgets, and even Risk was dependent upon those budgets to get paid. It was really in no one's interest to speak up and block what looked to be an extremely profitable proposition.
But back to the dismal science. Economists have always tried to get their subject into the hard sciences. They created first an extremely rational human nature that presumed the existence of a utility maximising automaton. This created one set of maxims generally under the rubric "rational and efficient" markets.
Then they got caught up in the fact that humans might not be totally rational. This created a new set of maxims such as "Random Walk" and "Chaos Theory".
They continued to develop and with the onslaught of math and physics brought the power of super-computers to crunch out statistics which would somehow divine the future path of economics/markets.
Now I understand that there is a movement to take some of the "hard" science out of economics and put it more into the realm of humanism.
This might be a good start- but I am concerned they will always want to start with the premise that there is an "ideal" circumstance. There is, but it is not the one they are imagining.
What they need to recognise is that the financial markets are actually run by a relatively small oligopoly. They are in a unique position to extract huge value from an activity that is intentionally opaque. Everyone clamors for transparency, but the combination of power and money makes it very difficult to effectively enforce.
The way to break it is to go after the money. That means regulation. I wouldn't bet on it.
Now two things jump out at me on this account. The first is that not every economist missed it. Some like Dr Doom had been calling for catastrophe for the last decade. (Brings to mind the joke that economists got five out of the last two recessions right.) The second is that the crisis began in 2007, and the houses that made the most money up to 2008 were fully aware what was going on-it just never occurred to them that the fire they were playing with could get out of hand.
Take the "seminar" held in April '07 by a major international bank for its' hedge fund and proprietary trading clients. They spoke openly of their concerns surrounding the sub prime mortgage market and that they were actively building up a portfolio hedging their exposure to the mortgage market.
This was a meeting by traders for traders. The "real money" investor accounts of the bank were not invited. The host bank was however marketing mortgage CDO's to those "real money" investors-in fact one could go so far as to say that the investors were actually supplying the hedge for which the CDO traders were seeking.
In the summer of '07, a French firm packed with French mathematicians-its' Fixed Income Department had over 100 quants cranking out models for everything-suddenly announced that it could not value three of its' funds properly and so froze them.
I was always amused by this proclamation. It was almost as funny as the claim by another major French bank that the mass of models and risk management systems built by their French mathematicians-and theirs were the best- Polytechnique but of course-couldn't catch a rogue trader.
But I digress. I would suggest that it wasn't that they couldn't value the funds, but rather that they wouldn't. There was always an argument in the Street between the mark-to-market, and the mark-to-model. The difference often representing P&L. In this case the model and the market were both clearly suggesting that the value was ugly. To admit that would open up a can of worms. Their solution was to freeze the funds because they couldn't value them.
I believe this was the trigger which set the whole crisis in motion. I also believe that there were many-and I mean many bankers who were intelligent enough to understand what was happening. These were people involved in Derivative Sales, Trading and Structuring/Origination.
They had been playing with fire for over a decade and every time it got a little too hot at one house another one would jump into the fray and so the blow-ups were relatively small and self-contained. Ironically, many of those banks that would not get involved on the origination and distribution of these products were historically not comfortable with the concept of risk in their Sales and Trading Operations, but their Bank Treasuries came to be some of the largest buyers of these constructions.
No one seriously enters into banking without the hope/intent to make a lot of money. Financial Firms provide the opportunity to get rich-they are not charity organisations,are not for the faint hearted and the moral compass seldom points to money.
Firms were supposed to be structured such that Risk Management, Trading Management, Sales Management and Senior Management knew the risks they were running, and the profits they were generating. They were all expected to manage and understand this balance. Part of the problem however was that except for Risk they all had budgets, and even Risk was dependent upon those budgets to get paid. It was really in no one's interest to speak up and block what looked to be an extremely profitable proposition.
But back to the dismal science. Economists have always tried to get their subject into the hard sciences. They created first an extremely rational human nature that presumed the existence of a utility maximising automaton. This created one set of maxims generally under the rubric "rational and efficient" markets.
Then they got caught up in the fact that humans might not be totally rational. This created a new set of maxims such as "Random Walk" and "Chaos Theory".
They continued to develop and with the onslaught of math and physics brought the power of super-computers to crunch out statistics which would somehow divine the future path of economics/markets.
Now I understand that there is a movement to take some of the "hard" science out of economics and put it more into the realm of humanism.
This might be a good start- but I am concerned they will always want to start with the premise that there is an "ideal" circumstance. There is, but it is not the one they are imagining.
What they need to recognise is that the financial markets are actually run by a relatively small oligopoly. They are in a unique position to extract huge value from an activity that is intentionally opaque. Everyone clamors for transparency, but the combination of power and money makes it very difficult to effectively enforce.
The way to break it is to go after the money. That means regulation. I wouldn't bet on it.
Friday, 26 March 2010
Mutti Merkel
After having bashed Frau Merkel for jumping on the anti-CDS Bandwagon I have to tip my hat to her for having crafted an extremely clever response to the Greece problem.
In one fell swoop she has given notice to Greece and any other "Euro" nation which is in financial difficulty: If you are in trouble you must first trudge on with painful austerity measures and only if you are unable to finance yourself in the international market will any support be forthcoming. Germans will no longer "pay" unconditionally and the IMF's role is kept to a minimum, but is still held in abeyance....
Perhaps another step to a federal Europe.
In one fell swoop she has given notice to Greece and any other "Euro" nation which is in financial difficulty: If you are in trouble you must first trudge on with painful austerity measures and only if you are unable to finance yourself in the international market will any support be forthcoming. Germans will no longer "pay" unconditionally and the IMF's role is kept to a minimum, but is still held in abeyance....
Perhaps another step to a federal Europe.
Wednesday, 24 March 2010
A Poor Workman blames his Tools
In following the debate around financial regulation it appears to me that there are two main hurdles to overcome which will occupy center stage without really dealing with the root of the problem.
The first obstacle is the Free-Marketeers. They profess an adherence to an Adam Smith that most of them have never read compounded by their allegiance to Milton Friedman which is used to support an agenda of greed bridled only by the occasional bout of fear that is forever lurking in the marketplace. For these people there is no debate about regulation-they would remove all regulation, everywhere, if given the chance.
They realise that the world of no regulation only exists in an extreme state when political, social and economic upheaval occurs such as in Chile after Allende, Russia after Glasnost, and perhaps Iraq after the Second Iraq War, so in all other instances their response is to clamor for self-regulation.
I am somewhat dumbfounded at this blatant ploy of self-serving self-righteousness. Watch any sport and imagine there were no referees or umpires. Every player knows the rules, and yet even in the presence of officials they continually break the rules-aka fouling-and yet I have yet to hear of anyone suggesting that a game of football should be played without a referee.
Why should we expect the players in the world of finance to act differently?
The second obstacle is the pursuit of the perfect system of regulation- as if there were one. Searching for a Fail-Safe System implies absolutes. I would maintain that outside of death and taxes there are no absolutes-and I am sure there are any number of arguments that would debate even this.
But look at the debate on financial regulation. At its' most basic level and yet apparently of the gravest importance is the question as to what structure should the regulator have. Should there be separate regulators that specialise in various sectors? Should there be a single agency which integrates all of the sectors? Should there be one agency for safety and soundness and another for business conduct and consumer protection? Should there be an institutional approach which separates banks, broker-dealers, insurance companies etc. and places them under their own regulator? How do we manage states versus federal jurisdictions, or national versus international or even multinational?
And of course, should there be a hybrid system which takes the best from all?
I don't know that there is any one right structure. I do know that the current system allows institutions to shop around to find the regulator that best suits their needs. This might be deemed to be clever by the perpetrators. I also know that the institution and the individuals responsible at such institutions should indeed be viewed as perpetrators and be held to account and that does not mean merely a slap on the wrist.
I believe the single biggest failure of the current regulatory system is that it is very difficult to separate the gamekeepers from the poachers. Everybody has an angle, and their motto seems to be: "Separate the Fools from their Money".
The first obstacle is the Free-Marketeers. They profess an adherence to an Adam Smith that most of them have never read compounded by their allegiance to Milton Friedman which is used to support an agenda of greed bridled only by the occasional bout of fear that is forever lurking in the marketplace. For these people there is no debate about regulation-they would remove all regulation, everywhere, if given the chance.
They realise that the world of no regulation only exists in an extreme state when political, social and economic upheaval occurs such as in Chile after Allende, Russia after Glasnost, and perhaps Iraq after the Second Iraq War, so in all other instances their response is to clamor for self-regulation.
I am somewhat dumbfounded at this blatant ploy of self-serving self-righteousness. Watch any sport and imagine there were no referees or umpires. Every player knows the rules, and yet even in the presence of officials they continually break the rules-aka fouling-and yet I have yet to hear of anyone suggesting that a game of football should be played without a referee.
Why should we expect the players in the world of finance to act differently?
The second obstacle is the pursuit of the perfect system of regulation- as if there were one. Searching for a Fail-Safe System implies absolutes. I would maintain that outside of death and taxes there are no absolutes-and I am sure there are any number of arguments that would debate even this.
But look at the debate on financial regulation. At its' most basic level and yet apparently of the gravest importance is the question as to what structure should the regulator have. Should there be separate regulators that specialise in various sectors? Should there be a single agency which integrates all of the sectors? Should there be one agency for safety and soundness and another for business conduct and consumer protection? Should there be an institutional approach which separates banks, broker-dealers, insurance companies etc. and places them under their own regulator? How do we manage states versus federal jurisdictions, or national versus international or even multinational?
And of course, should there be a hybrid system which takes the best from all?
I don't know that there is any one right structure. I do know that the current system allows institutions to shop around to find the regulator that best suits their needs. This might be deemed to be clever by the perpetrators. I also know that the institution and the individuals responsible at such institutions should indeed be viewed as perpetrators and be held to account and that does not mean merely a slap on the wrist.
I believe the single biggest failure of the current regulatory system is that it is very difficult to separate the gamekeepers from the poachers. Everybody has an angle, and their motto seems to be: "Separate the Fools from their Money".
Tuesday, 23 March 2010
Simple Right and Wrong
Last night while watching the news my medical student daughter turned to me and said that her biggest disappointment has been to realise that her image of adults as mature, intelligent beings is shattered almost daily. She had thought that adulthood would free her from the schoolyard shenanigans of her youth.
This outburst was triggered by a report on how some former ministers who are still currently MP's in the UK Parliament are either actively engaged in lobbying for business or are trying to position themselves to do so for when they leave Parliament.
The rules clearly say that ex-Ministers must wait 12 months before they engage in lobbying. The accused all deny wrongdoing.
I spent years discussing with my children good and bad; right and wrong. The goal was to instill a moral compass. I wasn't trying to create good Samaritans, but rather to provide a framework, which I am sure somehow morphed into a belief that the adult world was a righteous one.
Watching ex-Ministers decry their innocence while caught with their hands in the till reveals a different reality.
Scroll forward to the passage of the Health Care Bill in the US and listen to Newt Gingrich describe this bill as political suicide-and then compare it to the passage of Civil Rights Legislation under LBJ which he also described as political suicide.
What planet is Mr Gingrich on? Is he seriously suggesting that LBJ was wrong to enact Civil Rights legislation which essentially granted all Americans the rights theoretically safeguarded in the Constitution?
Contrast this sentiment with President Obama's invocation to vote for Health Care: "Every once in a while a moment comes where you have a chance to vindicate all those best hopes that you had about yourself, about this country,” he said. “This is one of those moments.”
Regardless of your views on the Health Care Bill, here is an adult beseeching politicians to essentially do what they think is right. Not what will get them elected; not what will further their careers; but to actually do what we all do when we enter the polling booth-vote our conscience.
This outburst was triggered by a report on how some former ministers who are still currently MP's in the UK Parliament are either actively engaged in lobbying for business or are trying to position themselves to do so for when they leave Parliament.
The rules clearly say that ex-Ministers must wait 12 months before they engage in lobbying. The accused all deny wrongdoing.
I spent years discussing with my children good and bad; right and wrong. The goal was to instill a moral compass. I wasn't trying to create good Samaritans, but rather to provide a framework, which I am sure somehow morphed into a belief that the adult world was a righteous one.
Watching ex-Ministers decry their innocence while caught with their hands in the till reveals a different reality.
Scroll forward to the passage of the Health Care Bill in the US and listen to Newt Gingrich describe this bill as political suicide-and then compare it to the passage of Civil Rights Legislation under LBJ which he also described as political suicide.
What planet is Mr Gingrich on? Is he seriously suggesting that LBJ was wrong to enact Civil Rights legislation which essentially granted all Americans the rights theoretically safeguarded in the Constitution?
Contrast this sentiment with President Obama's invocation to vote for Health Care: "Every once in a while a moment comes where you have a chance to vindicate all those best hopes that you had about yourself, about this country,” he said. “This is one of those moments.”
Regardless of your views on the Health Care Bill, here is an adult beseeching politicians to essentially do what they think is right. Not what will get them elected; not what will further their careers; but to actually do what we all do when we enter the polling booth-vote our conscience.
Monday, 22 March 2010
CDO/CDS Part VI
Now today we should be discussing the passage of the Health Care Bill in Congress but I will leave that to tomorrow as at the same time I would like to discuss Senator Dodd's regulatory reform bill.
But first I will finish with the CDO/CDS discussion.
In the Cash as well as the Synthetic CDO there were on average 4 names which were very cheap (i.e. yielded much more than their rating would have suggested) which, because of their rating still fit the requirements to achieve the sought after AAA rating. Every financial engineer knew that; any good salesman knew that; and any investor who understood that would fall out of basket of potential clients because they would want to remove those names which would give a stronger investment, at a significantly lower yield.
The investor of choice could be convinced of the validity of the rating agencies; could be made to pay up for a AAA piece of paper; and would crash and burn with their CDO portfolios when the market turned and one or more of the "cheap names" defaulted.
It is an old adage that if something looks too good to be true it probably isn't. If a traditional AAA security like IBM yielded .15% more than the risk-free rate what did the investor buying a AAA CDO yielding .30% think they were buying? Actually the real question should have been what additional risk were they taking on to earn .15% more, and was it worth it?
Lastly, almost as an aside let's talk about AIG and their role in the Synthetic CDO debacle.
The financial engineers were so sure of their statistical analysis that they came to the conclusion that the AAA securities they were creating were so secure that they could actually slice off the top of the structure and create a part of the security called the "super-senior or super AAA". That's how they described it.
The truth was that they were carrying more risk than they wanted to and so they went around and found investors who were interested in taking on that part of the default risk that should never default. The bankers found people like AIG Financial Products and bought insurance for the top of the structure.
Think of it like this. At the bottom of the Capital Structure is the First Loss Piece. Any losses in the portfolio are first attributed to this portion. It usually makes up the first 3%. On top of this is the mezzanine slice, another ~15% and would be rated BBB normally and would take the next losses above the original 3%. On top of this is the AAA piece which would be the next ~67% and would take the next set of loss, and on top of this was the super-AAA, the top ~15% which would take the remaining losses. Strangely the bankers chose to go to people like AIG and pay them .15% to assume the risk of the super-AAA. AIG FP convinced their parent AIG that they were just providing financial insurance. They would get paid .15% on billions of dollars of financial risk which should never be realised. Sound like "something for nothing". AIG FP thought it was as if they were getting paid to insure for flood risk in the desert. Obviously the geniuses at AIG FP had never been to the desert and didn't know that what looks like a dry gully or wadi quickly becomes a death trap when there is a flash flood and that rain occurs more often than they thought and when it does, it's a real problem.
So now the credit crisis starts to bite. the "cheap" names in the portfolio start to deteriorate and so no longer fit the requirements for the AAA rating. When the bottom 3% collapses, then the bottom of the next 15% becomes the bottom of the structure, weakening the mezzanine which means that the top 15% of the super-AAA is no longer super-AAA, but rather just AAA. The flash flood has started. Suddenly names like Ford and GMAC which were part of the "good" names in the pool of 100 are no longer good and they fall outside of the guidelines etc.
Now forget the corporate names, and remember the Sub-prime structures. Same story, except that not only does the bottom 3% disappear, but the next 15% as well, and if the real estate market plunges 50%, so does the CDO. Before an investor can blink their AAA security is A, or worse. A security that was valued at 100 is now trading at 20-if you can find a buyer.
Those mortgages held by the GSE's are crushed. The first-loss pieces held by the investment banks are crushed. The providers of super-AAA insurance are crushed.
Welcome to the Credit Crisis.
But first I will finish with the CDO/CDS discussion.
In the Cash as well as the Synthetic CDO there were on average 4 names which were very cheap (i.e. yielded much more than their rating would have suggested) which, because of their rating still fit the requirements to achieve the sought after AAA rating. Every financial engineer knew that; any good salesman knew that; and any investor who understood that would fall out of basket of potential clients because they would want to remove those names which would give a stronger investment, at a significantly lower yield.
The investor of choice could be convinced of the validity of the rating agencies; could be made to pay up for a AAA piece of paper; and would crash and burn with their CDO portfolios when the market turned and one or more of the "cheap names" defaulted.
It is an old adage that if something looks too good to be true it probably isn't. If a traditional AAA security like IBM yielded .15% more than the risk-free rate what did the investor buying a AAA CDO yielding .30% think they were buying? Actually the real question should have been what additional risk were they taking on to earn .15% more, and was it worth it?
Lastly, almost as an aside let's talk about AIG and their role in the Synthetic CDO debacle.
The financial engineers were so sure of their statistical analysis that they came to the conclusion that the AAA securities they were creating were so secure that they could actually slice off the top of the structure and create a part of the security called the "super-senior or super AAA". That's how they described it.
The truth was that they were carrying more risk than they wanted to and so they went around and found investors who were interested in taking on that part of the default risk that should never default. The bankers found people like AIG Financial Products and bought insurance for the top of the structure.
Think of it like this. At the bottom of the Capital Structure is the First Loss Piece. Any losses in the portfolio are first attributed to this portion. It usually makes up the first 3%. On top of this is the mezzanine slice, another ~15% and would be rated BBB normally and would take the next losses above the original 3%. On top of this is the AAA piece which would be the next ~67% and would take the next set of loss, and on top of this was the super-AAA, the top ~15% which would take the remaining losses. Strangely the bankers chose to go to people like AIG and pay them .15% to assume the risk of the super-AAA. AIG FP convinced their parent AIG that they were just providing financial insurance. They would get paid .15% on billions of dollars of financial risk which should never be realised. Sound like "something for nothing". AIG FP thought it was as if they were getting paid to insure for flood risk in the desert. Obviously the geniuses at AIG FP had never been to the desert and didn't know that what looks like a dry gully or wadi quickly becomes a death trap when there is a flash flood and that rain occurs more often than they thought and when it does, it's a real problem.
So now the credit crisis starts to bite. the "cheap" names in the portfolio start to deteriorate and so no longer fit the requirements for the AAA rating. When the bottom 3% collapses, then the bottom of the next 15% becomes the bottom of the structure, weakening the mezzanine which means that the top 15% of the super-AAA is no longer super-AAA, but rather just AAA. The flash flood has started. Suddenly names like Ford and GMAC which were part of the "good" names in the pool of 100 are no longer good and they fall outside of the guidelines etc.
Now forget the corporate names, and remember the Sub-prime structures. Same story, except that not only does the bottom 3% disappear, but the next 15% as well, and if the real estate market plunges 50%, so does the CDO. Before an investor can blink their AAA security is A, or worse. A security that was valued at 100 is now trading at 20-if you can find a buyer.
Those mortgages held by the GSE's are crushed. The first-loss pieces held by the investment banks are crushed. The providers of super-AAA insurance are crushed.
Welcome to the Credit Crisis.
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