Chickens, eggs and CDOs

After a turkey, successful construction of a 1100 piece K’nex rocket rollercoaster, many turkey sandwiches, several 10 person games of farkle, too many goodbyes and two “could have been much worse” flights, I can get back to the question of whether the causality in the CDO market ran from the “dumb” money to the low spreads or not.

What is missing from the argument that “dumb” money caused low spreads is an analysis of how synthetic assets (e.g. CDS on MBS and CDOs) affected the market.  By definition a CDS has a short and a long side, so from a purely theoretic perspective it should have no effect on the price of the underlying — but this theoretic argument is based on a world without asymmetric information, so it is likely to be misleading (since one thing that’s pretty clear at this point is that the buyers and sellers of CDOs (and CDS via CDOs) definitely did not have similar information — the buyers were “dumb” because they relied on credit ratings).

Most participants in the market argue that the CDO market “needed” synthetic assets in order to meet the demand of the “dumb” money.  But what this implies is that, in the absence of synthetics, spreads would have fallen even further and that, in the absence of synthetics, the demand would have extinguished itself as spreads fell to the level of treasuries and there was literally no point in buying CDOs because the yield advantage was completely gone.  In other words, in the absence of synthetics, market forces would have worked to eliminate the “dumb” money demand for CDOs by eliminating the spread differential between Treasuries and CDOs entirely.

In other words, the role of synthetics was to artificially sustain the yield spread over Treasuries (small as it was) offered by CDOs.  By keeping the yield spread up and delaying the function of market forces, synthetics kept the “dumb” money in the market and helped create a situation where the market collapsed abruptly (rather than slowly having the air pushed out of it by yield spreads that fell steadily to zero, discouraging demand in a natural manner).

In short, I think the “dumb” demand for CDOs was sustained for months and years, because synthetic assets created an artificial supply of CDO assets that kept yields at an artificially high level — in order to attract and sustain that demand.

The de(con)struction of the “market maker”

Sometimes I think that the financial crisis is driven by a collapse in the meaning of words.  The whole financial industry has gone completely post-modern on us:  Derivatives are “investments”, even when they are as likely to be liabilities as assets.  The asset side of a synthetic CDO is effectively an insurance obligation.  In a world where liabilities are assets and assets are liabilities, it can be far from clear how to interpret a balance sheet.

So I guess I shouldn’t really be surprised that the term “market maker” doesn’t mean what you think it means any more.  For a little history lets start with the definition of “market maker” from NASDAQ, one of the earlier OTC markets.

A market maker is a NASDAQ member firm that buys and sells securities at prices it displays in NASDAQ for its own account (principal trades) and for customer accounts (agency trades).

Traditionally market makers were always required to post bid and ask prices for the securities they quote — but there are exceptions to that rule.  For example, on Thursday in the midst of the stock market crash of 2:45, for several minutes there were no quotes on some option contracts.  Also, for a NASDAQ listed company the market must have at least three market makers quoting the stock.

Now for a view of the post-modern version of “market making”, let’s look at the discussion of the CDO market in the risk factors section of Goldman’s Abacus prospectus (thanks to Danny Black for pointing me here).

Limited Liquidity and Restrictions on Transfer.
There is currently no market for the Notes.
Although the Initial Purchaser has advised the Issuers that it intends to make a market in the Notes, the Initial Purchaser is not obligated to do so, and any such market-making with respect to the Notes may be discontinued at any time without notice. There can be no assurance that any secondary market for any of the Notes will develop, or, if a secondary market does develop, that it will provide the Holders of such Notes with liquidity of investment or that it will continue for the life of such Notes. Consequently, a purchaser must be prepared to hold the Notes for an indefinite period of time or until Stated Maturity.

Here Goldman is making it clear that no market exists for the Abacus CDO and there is no reason to believe that a market will exist.  At the same time Goldman states that the firm “intends to make a market” without entering into any obligation whatsoever to do so.

Here are my questions:  Given our understanding of what a market maker is based on the NASDAQ OTC market,

(i)  Does it make any sense to state that a single firm will “make a market” where no market exists?  What Goldman appears to mean in its statement is that Goldman intends to quote bid and ask prices for the CDO on demand.

(ii)  Does the statement that a firm “intends to make a market” in a security have any meaning whatsoever when it is followed by the qualification that “any such market making may be discontinued at any time without notice”?

In short, Goldman is (appropriately) disclosing that there is no secondary market in the Abacus CDO, and that, while Goldman may choose to buy the CDO back in the future, the firm is under no obligation to do so.

The mystery is why the terms “make a market” and “market-making” are used in the disclosure that there is no market. The effect of this new usage is to create a new definition of “to make a market”:

To quote a bid price at which a security will be purchased and an ask price at which the security will be sold.

In other words, market making has gone synthetic too:  It’s no longer necessary to maintain inventory and buy and sell an asset class in order to make a market in it;  in the financial world’s newspeak all a firm needs to do to make a market is to quote bid and ask prices — without actively trading in the product class at all.

And one consequence of this synthetic market making is that a new asset class was created — the ABS CDO — that for accounting purposes could be marked to a market that the prospectuses stated very clearly did not exist.  Only to be marked down to zero, when the little matter of cash flow entered the picture.

Maybe Ann Rutledge is right:  the first step in fixing financial markets is to clearly define the words we are using.

The Myth of the Market-Maker in CDOs

The repeated appeals to the market-maker excuse for Goldman’s CDO sales merits a rant.  (Note:  inspired by zerobeta tweets).

The secondary market for CDOs has always been very thin.  Basically the bank that issued the CDO stood ready theoretically to buy the CDO back, but, well, it almost never happened.

So when people claim that banks were making markets in CDOs, I think the question is:  “Well, then, where was your CDO trading inventory?” CDO trading inventory — as I am using the term — can only include CDOs that were placed by the issuing investment bank with an investor and were subsequently repurchased by the same or another investment bank.  Such trading inventory is entirely distinct from the CDO inventory that was created by issuing new CDO securities and failing to sell them. (Citigroup, Merrill Lynch and UBS were chock of new issue CDO inventory).

Now, maybe somebody will correct me, but it’s my understanding that there really wasn’t any secondary market to speak of in CDOs and that the investment banks held minuscule quantities, if any, of second-hand CDOs in their trading inventories.  If this understanding of the market is correct, I would like to know how anybody can claim that investment banks “made markets” in CDOs.  They may have originated CDOs, issued CDOs and placed CDOs, but unless they carried trading inventories in second-hand CDOs, the investment banks can not claim to have made markets in CDOs in any meaningful sense of the word.

Using models to give  theoretic prices to clients who need to mark their CDOs to market is not market making — for the simple reason that these prices are not tested by the market unless transactions are actually taking place at these prices.  Unless we have the evidence of a transaction to demonstrate that the market maker was willing to take the CDO onto it’s books at the price in question, the price quoted has very, very limited meaning in a market economy.

In short, one of the biggest failures of the investment banks in the CDO market was precisely the failure to make markets in CDOs.  The creation of an illiquid, untradeable product that the issuers themselves did not want to hold in trading inventory on their books was a disaster.   And for these same investment banks to turn around now and claim market making as a shield in their defense is almost beyond belief.

The problem with structured finance

It’s widely recognized that structured finance was used to arbitrage regulations.  Less well recognized is that fact that structured financial products were also used to arbitrage the ignorance or the ego of investors.

CDOs — at least in the quantity they have been issued in recent years — are inherently suspect as innovations that add economic value.  The reason for these doubts are simple:  If the assets underlying the CDO are priced to reflect fundamental values and all of the CDO tranches are also priced to reflect fundamental values, then what the CDO as a product brings to the market is the opportunity for investors to choose their preferred level of credit risk exposure to the assets in the CDO.  To believe that CDOs are a value adding financial innovation one must also believe that the gains from this division of credit risk into tranches are more than sufficient to cover the multi-million dollar cost of creating the CDO.*

The question is whether investors actually demand that wide variety of exposure.  The CDO needs different investors who want (i) a very safe, diversified portfolio of assets that pay a yield just a little higher than Treasuries and (ii) a relatively high fixed income return on a product that concentrates risk — and is likely to behave more like equity than a bond, and a range of possibilities in between.

Thus, the very concept of a CDO (as a product that distributes risk in an economically efficient manner) requires that there exists a full spectrum of investors who prefer different levels of risk including equity (the first loss position), equity-like risk with fixed income returns (the lower mezzanine tranches, that are unlikely to get any recovery in case the deal goes bad), and low risk, low returns on a diversified portfolio (the senior tranche — or super senior tranche in a hybrid or synthetic CDO).  In practice it seems to be relatively rare that all the different groups of investors exist for given CDO, because the banks frequently end up holding at least one of the tranches.

If it is not the case that the full spectrum of investors exists and that the gains from serving the needs of these investors more than cover the fees of creating the CDO, then the “value” of the CDO is likely to come from selling to one or more groups of investors a product whose risks they do not understand.  While a CDO that arbitrages such misunderstandings is likely to be very profitable for the investment bank that issues it, these profits clearly do not represent economically efficient allocation of risk.  In fact, after the recent crisis there is support for the view that trade in mispriced CDOs actually reduces social welfare.

Some more specific examples have popped up on the web recently:

(i)  Felix Salmon has a post up on:  super senior CDOs.  As I commented there

I think the reason the super senior “had” to exist in the 2006-2007 environment is because that’s where the risk was most underpriced. Many of the CDO “investors” were interested in high yield AAA assets, that is the leveraged senior, but not super senior segment of the CDO. But if market makers had tried to sell protection on this segment of the CDO only, that protection would have tended to be expensive for the same reason that it paid investors well relative to the super senior.

Selling packages that included large super senior tranches allowed the structured financiers to earn their salaries by keeping costs down for protection buyers, while also meeting the needs of CDO “investors” looking for high yield assets. Unfortunately they ended up warehousing large quantities of the residual super senior risk in the banks.

(ii) In a series of posts on Goldman’s Abacus CDO, Steve Waldman discusses another case of welfare reducing structured finance.  He argues that the Abacus CDO that is the subject of the SEC lawsuit allowed Paulson (the hedge fund manager) to take out a short position on subprime that was significantly underpriced relative to a comparable position on the public ABX markets.  By hiding the fact that the CDO was selected as a short vehicle for Paulson, Goldman induced ACA Capital, IKB and ABN Amro to take on the offsetting long position for compensation well below that available on public markets — this leads one to conclude that these counterparties did not understand that they were just serving as a cheap means for Paulson to take on a position comparable to shorting the ABX.

Effectively Waldman argues that Goldman used this Abacus CDO as a vehicle to create information asymmetry in the market.

(iii) Critics of structured finance have long argued that many of these “innovations” are profitable precisely, because they are carefully designed to exploit misinformation and hubris in financial markets.  Satyajit Das takes this view in his book, Traders, Guns and Money and gives a multitude of examples.  Two classic cases:  in 1993 Proctor and Gamble thought it was lowering its cost of funds when it entered into a transaction that involved the sale of interest rate puts;  in the early 1990s Orange County tried to raise its investment returns by entering into highly leveraged interest rate swap transactions.  Both of these cases ended up in court when interest rates rose and vast sums were lost.

It’s hard to believe that this needs to be stated, but here goes:  When a financial product is used to arbitrage misinformation or hubris, it does not contribute positively to economic welfare.  When such transactions result in bankruptcies there is little question that they are harmful to economic welfare.

These transactions do not add valuable pricing information to the economy for the simple reason that the basis of the transaction is a failure to understand the product.  If prices created by such transactions are viewed by other participants in the economy, they may lead to further misallocation of resources.

When structured finance innovations are designed to arbitrage misinformation, the markets in these products are inefficient and are likely to generate significant economic costs via unnecessary bankruptcies.  For this reason it is important to shine a light on these markets, not only through clearing and exchange trading of standardized products, but also by requiring delayed public reporting of transactions and transaction prices for those products permitted to trade over the counter.

*Note that tranched MBS are not necessarily subject to the same criticism because they distribute prepayment risk across investors — that is, the tranches are differentiated by their expected maturity — and thus they cater to the fact that different investors have different investment horizons.  In my view it’s much more intuitive that investors can be distinguished by their maturity preferences, then by their desire to take on different levels of credit risk.

Goldman’s role in the ABS CDO market

If Lehman’s ABS CDO data (as presented by Barnett Hart) is accurate, then Goldman’s role in the ABS CDO market is both interesting and unique.

First recall that ABS CDOs (along with CDO squareds) were the worst performing CDOs by far and that this potential for truly disastrous performance is obvious to anyone who understands their structure.  (ABS CDOs will one day probably be used to define “cliff risk”.) (Note Nomura document h/t Alea.)

Second, according to the Lehman data the ABS CDO league table for 1999 – 2007 (from Appendix A2 Panel D I calculate Total Balance/Sum of Total Balance) reads as follows:
Merrill Lynch     16.5%
Goldman Sachs    13%
Citigroup       12.3%
Wachovia     6%
Credit Suisse    5.7%
UBS     5.4%
Bear Stearns    4.3%
Deutsche Bank  3.8%
RBS    3.7%
Lehman   3.5%

Observe that the top three ABS CDO originators were responsible for 40% of the market and that Goldman was the number two originator.  Table 4 of the Barnett Hart paper presents S&P ABS CDO information and indicates that a disproportionate share of Goldman’s ABS CDO origination took place in 2005 and 2006.

Third, it is clear that Merrill and Citi believed that the ABS default cliff was far enough away that senior losses were unlikely to occur.  The evidence of this is the fact that Merrill and Citi carried large quantities of super senior ABS CDO risk on their balance sheets — and both had to be rescued in no small part because of their ABS CDO losses.

Goldman is a very different story.  When Goldman originated ABS CDOs it was apparently careful to lay off the senior risk onto other parties (the growing difficulty of this undertaking probably explains the relative decline of Goldman’s ABS CDO origination in 2007).

How big is the difference between CDOs and CDS?

Steve Waldman has a great post  up deconstructing the Abacus CDO that was the source of the SECs charges against Goldman.  What has become clear is that Abacus was not a synthetic CDO as those of us outside the industry understood them.  It was a bespoke CDO — a CDO tranche designed to meet the needs of a particular client with the investment bank taking on the responsibility of hedging or laying off the risk relating to the rest of the CDO.

Because most of the tranches of a bespoke CDO are not sold, but are held on the books of the originating bank, bespoke CDOs are very different from synthetic CDOs — in particular their price structure is not market-tested.  (See Steve Waldman for further details.)  This raises three questions,

(i)  To what degree have the investment banks been issuing bespoke CDOs, but presenting them to the public (and possibly to counterparties) as synthetic CDOs?

(ii)  Were the losses that were attributed to super senior CDOs at Merrill Lynch and Citigroup really just unhedged (or perhaps poorly hedged) CDS exposure — just like AIG?

(iii)  After 2008 is there any reason to believe that the investment banks as a group will ever be able to manage their CDS exposure wisely?

Abacus and the credit crisis

Just a quick note on one of the reasons the Goldman-Abacus case is so interesting.  The Abacus program definitely plays at least a small role in the credit crisis.

(i) Goldman itself notes that IKB was a notable Abacus counterparty  (See Part I here).

(ii) One of the first SIVs to fail was IKB’s Rhineland funding.  According to Acharya Schnabl and Suarez, Rhineland funding specialized in financing CDOs.

(iii)  In August 2007, when Rhineland couldn’t role over it’s commercial paper, IKB was the guarantor of the commercial paper.  This caused IKB to be one of the first banks to fail due to the subprime crisis.  In short, IKB was one of the banks that set off the asset backed commercial paper collapse of 2007 — a market that ended up requiring extraordinary accommodation from the Fed.

So there’s no question that IKB was right there at the heart of the credit crisis when it started.