In the Huffington Post, David Fiderer remarks on the CDOs in Maiden Lane III, that in each case the lion’s share of each CDO appears to be held by a single bank. Yves Smith replies that this was just how the business was run. I think there’s something to Fiderer’s remarks, but it will take me a while to explain why.
Let’s start with some background on Maiden Lane III. After the “rescue” of AIG in mid-September 2008, regulators found that they had granted AIG’s counterparties the right to demand cash payments of AIG/Fed/Treasury whenever the CDOs that AIG had guaranteed fell in value. Since these payments were in the billions of dollars, the Fed and Treasury found the situation objectionable. There were two choices for dealing with the situation (i) provide a formal (rather than de facto) government guarantee of the assets, which by putting a AAA backstop behind the guarantees would allow the government to take back all the collateral that had been posted or (ii) pay off the full value of the guarantee in exchange for the CDOs themselves. It’s pretty clear that the Fed did not have legal authority to provide the guarantee in (i). After TARP was passed, Treasury unquestionably had the authority to implement (i) and no one has made any effort to explain why this authority was not used.
Instead Treasury apparently decided that the AIG CDOs were not their problem. (Paulson claims that he left this one to be handled by the Fed.) The only thing the Fed could do to avoid a continuous drain due to the CDO guarantees was to buy the CDOs from the banks. (I believe that the 100% pay off was indeed to avoid triggering an AIG default per ISDA contractual terms, and thereby avoid granting all of AIGs OTC derivatives counterparties the right to terminate their contracts — that is, to avoid an implosion of the OTC derivatives market.) For this reason the NY Fed holds Maiden Lane III, a portfolio of CDOs that were once guaranteed by AIG.
It is important to understand that there were several CDOs, guaranteed by AIG that were not purchased by Maiden Lane, because the counterparties did not own them. As far as we know, whenever these CDOs fall in value AIG continues to post collateral on the guarantees. One consequence of handling the guarantee problem via Maiden Lane III is that some purely speculative contracts did not receive a formal government guarantee.
While the purely speculative contracts that received a government guarantee were limited by Maiden Lane III’s structure, the data that David Fiderer points to makes it clear that Maiden Lane III provides a formal government guarantee to billions of dollars of Wall Street’s speculative contracts.
In order to understand what is in Maiden Lane III, it is essential to understand the difference between cash, hybrid and synthetic CDOs. A cash CDO is a product that was created about twenty years ago. It puts together a portfolio of loans that were used to finance real economic activity and allows investors to choose whether they want a high or a low risk exposure to this portfolio. A synthetic CDO is a product that was created over the past decade which allows investors to take on risk comparable to that of investing in a cash CDO (plus the swap counterparty risk of a large financial institution) without financing any real economic activity. Thus the purpose of a synthetic CDO is to make it possible for CDO investors to sell guarantees on loan performance to the financial industry that is originating the loans (thus creating a massive moral hazard problem). A hybrid CDO has some cash assets but also uses swaps guaranteeing loan performance to generate a large portion of the CDO’s exposure.
As far as I can tell almost all the CDOs in Maiden Lane III are hybrid CDOs and therefore a significant portion of Maiden Lane III is being used to recieve premium payments from Wall Street firms, hedge funds, etc. in exchange for payments from the federal government on their speculative positions if the financiers’ asset price predictions (on the loans originated by other financiers) turn out to be correct. The question, however, is how much of Maiden Lane III is financing speculative positions and how much is financing real loans. A brief review of some of the deal documents (many of which are available at the Irish Stock Exchange website) shows that many of the Maiden Lane III CDOs had limits on synthetic securities of about 20%. This leads to an preliminary estimate that up to 20% of Maiden Lane III is financing speculative positions.
The data David Fiderer has pointed to makes it clear, however, that 20% is almost certainly too low an estimate. Fiderer focuses on the magnitude of Societe General and Goldman Sachs’ exposure to each of the CDOs that AIG guaranteed for them. Now SocGen’s exposure is, in fact, unremarkable. When you look into the SocGen deals you find that in almost every case the senior tranche was initially funded by commercial paper. It’s pretty clear that in 2007 SocGen, like Citibank, had massive off-balance sheet exposure in the form of liquidity puts that supported commercial paper issuance by CDOs. When the asset-backed commercial paper market collapsed in 2007, SocGen was forced to honor the liquidity puts and take the CDOs on balance sheet. Unlike Citi, SocGen had chosen to pay for a guarantee from AIG, just in case the market collapsed.
Goldman Sachs exposure is much harder to explain. I’m going to focus on the Broderick CDO I deal, since the specifics matter and it takes too much time to look into all of the deals. It’s pretty clear that Goldman had almost all of the first priority exposure to Broderick I and that it had chosen to buy protection on this exposure from AIG.
What I’m having difficulty making sense of is how the economics of this deal could possibly work if only 20% of the $1 billion deal was synthetic. If 80% of the deal was cash, $800 million were needed to buy cash assets. Goldman with the first priority exposure took 84% of the deal, so only $160 million were raised from other investors. This implies that Goldman put $640 million cash into this one CDO. Not likely.
Here are my possible explanations of what’s going on:
(i) Positive carry. Goldman’s cost of funds were so low that it actually did choose to put $640 million into Broderick I and earn an interest rate differential. But this differential could not be large and would probably be consumed by the costs of paying AIG for protection — on a fully funded position — and of hedging interest rate risk on Goldman’s cost of funds. The positive carry explanation works for firms like UBS that believed the most senior tranches of CDOs were riskless, not for a firm that pays to hedge its risks.
If there wasn’t positive carry, then the position could only work for Goldman if it wasn’t fully funded. So I go back to the Broderick documents and investigate the other possibility:
(ii) Goldman funded much less than 64% of Broderick. The collateral eligibility criteria are on pages 73 to 79. It turns out that while there is a 20% limit on synthetic collateral, it appears to me that synthetic CDO securities may not fall within this limit. Synthetic CDO securities may be subject only to the CDO security limit of 20%. If my reading of the document is correct then, 40% of the CDO may be synthetic, and now we’re down to Goldman funding only $440 million cash.
This still seems unrealistically high, so I read up on the first priority tranche structure. It turns out that the $485 million of A-1 INVB notes that Goldman holds are “delayed draw” notes. They aren’t funded at the start of the deal, there is just an obligation to fund at the manager’s request. Is it possible that Goldman holds the notes, but because the manager ended up funding far less than $1 billion in assets Goldman wasn’t called on to fund the notes? No, that’s a red herring. At ramp up completion (that is, by three months after the start of the deal) any unfunded INVB position gets written down to zero.
And maybe I need to let it go there. Maybe the economics of this deal works: Goldman put $485 million cash into a deal that gave Goldman $840 million first priority exposure to about $600 million in “cash” assets and about $400 million in synthetic exposure to credit risk.
So what does this imply about Maiden Lane III’s purchase of the Broderick CDO I from Goldman Sachs? If I am correct that the $355 million A-1 INVA tranche of Broderick was unfunded and if I am correct that approximately 40% of Broderick I’s collateral is synthetic, then:
(i) Goldman was paid $840 million for a position that cost it $485 million plus an unfunded guarantee (the same kind of guarantee that the government refused to enter into when considering how to resolve AIG’s CDOs).
(ii) By buying the CDO the government has committed itself to honor the synthetic positions in the CDO. Thus the government is collecting premiums from financiers who realized the debt market was going crazy and is obliged to pay up to $400 million on contracts that referenced but did not finance real economic assets.
The question I really want to raise here is: How much does synthetic exposure in the Maiden Lane portfolios matter? Are we okay with the fact that financiers who saw how dysfunctional our debt markets were didn’t go off and raise hell at the Fed and SEC, but instead expressed their views via the market? Are we okay with the fact that when one of their counterparties to the expression of these views couldn’t honor it’s obligations, the taxpayer stepped to validate the existence of this market? Is there a difference between bailing out banks that were financing real economic activity and grossly underestimated the risks of that activity and bailing out traders who used derivative markets to express their views on the dysfunctionality of the debt markets?
I’m not going to answer these questions. But it’s certainly a discussion that needs to be carried out in full view of the public.
Update 2-10-10: Further thoughts here and here.