The 2007-09 crisis: not a panic, but the collapse of shadow banking models

This post is a response to Ben Bernanke’s retrospective on the crisis and also addresses some of the comments others have made on his retrospective.

But first let me start the post with a little etymology. The term “lender of last resort” is generally acknowledged to have originated with Francis Baring’s 1797 tract, Observations on the Establishment of the Bank of England. Baring, however, did not use the English phrase; instead he called the Bank of England, the dernier resort. The use of the French is telling, because it is a well-established French phrase referring to the “court of last appeal.” Thus, the etymology of the phrase “lender of last resort” indicates that this is the entity that makes the ultimate decision about rescuing a firm or affirming the market’s death sentence. In short, when we talk about the central bank as lender of last resort, we are talking about the final arbiter of which troubled firms have a right to continue to exist in the economy.

Why would a lender of last resort allow some firms to fail? Because in an economy where bank lending decisions can expand or contract the money supply, banks that engage in fraud or make dangerously stupid lending decisions affect financial stability. So a lender of last resort has to police the line between good bank lending and bad bank lending. This almost always means that some lenders need to be closed down — preferably before they destabilize the financial system.

Framing the lender of last resort as having a duty to determine which of the entities that are at risk of failing for lack of funding will survive and which will not, sheds light on the debate between Ben Bernanke, Paul Krugman, Dean Baker, and Brad Delong. The key to this is to reframe Ben Bernanke’s “panic” which he describes as lasting from August 2007 to Spring 2009 as the process by which the Federal Reserve allowed certain shadow banks — which had no reasonable expectation of Federal Reserve support — to collapse completely.

I. “Financial fragility” was initially driven by the collapse of non-viable funding models

  1. Collapse of shadow banking vehicles (for details see this post)

In 2007 most of the commercial paper segment of the shadow banking system collapsed. These shadow banks included SIVs, and a few CDOs. (The commercial paper collapse was extended over three years, apparently due to Fed approved bank support of the market.) Several categories of commercial paper issuer entirely disappeared.

From 2007 to 2008 several other categories of shadow bank collapsed and disappeared. Some can be classified as existing only due to the excesses of the boom: e.g. Leveraged Super Senior CDO, Constant Proportion Debt Obligations, CDO squared, and ABS CDO. (The  latter two products are best described as combining the return of a bond with the risk of an equity share. Once investors figured this out, they ran for the hills.) Others, such as Private label mortgage backed securities, are less obviously flawed products, and yet 10 years after the crisis are hardly to be found.

All of these shadow banks were “market-based” products with no claim whatsoever to Federal Reserve support, so it was unremarkable that the Fed allowed them to collapse. On the other hand, they had been used to provide funding to the real economy. So their collapse was necessarily accompanied by a decline in real economy lending.

To describe this phenomenon of the collapse of non-viable shadow bank lending models as a “panic” is inaccurate. Lax financial regulation allowed non-viable entities to play a significant role in funding real activity pre-crisis. These entities failed when reality caught up to them. They did not fail because of a panic, they failed because they were non-viable. Because of the significant degree to which banks were exposed to these non-viable shadow banks, short-term funding costs rose more generally, but to a large degree rationally.

2.  End of the 2000’s investment banking model

Over the final decades of the 20th century U.S. investment banks transformed themselves from partnerships into corporations. As corporations they grew to rely much more significantly on borrowed funds than they had when partners’ capital was at risk. By 2007 the investment bank funding model in the U.S. relied extremely heavily on repurchase agreements, derivatives collateral, and commercial paper. Arguably, this was another non-viable shadow bank model.

Bear Stearns failed in March 2008 because of runs on these instruments. Lehman Brothers failed in September for similar reasons. Merrill Lynch was purchased by Bank of America in an 11th hour transaction. Morgan Stanley and Goldman Sachs were at the edge of failure, but saved by the Federal Reserve’s extremely fast decision to permit them to become bank holding companies with full access to the Federal Reserve’s lender of last resort facilities.

While some may believe that financial stability would have been better served by the Federal Reserve’s support of the 2000’s investment banking model, at this point the question is an unanswerable hypothetical. Because the Federal Reserve exercised its lender of last resort authority to refuse to support the 2000’s investment banking model, this shadow banking model no longer exists.

Thus, in September 2008, just as was the case in earlier months of short-term funding pressures,  a major cause of these pressures was real (though in this case elements of “panic” were also important): i.e. the collapse of a shadow banking model that was non-viable without central bank support. Once again, the fact that such a collapse had real effects is not at all surprising.

II. “Financial fragility” did culminate in a well-managed, short-lived panic

Unsurprisingly the collapse of the 2000’s investment banking model was such a significant event that it was in fact accompanied by panic. It is in the nature of a financial panic that it is best understood as the market’s expression of uncertainty as to where the central bank will draw the line between entities that are to be saved and those that are allowed to fail. Effectively, funding dries up for all entities that might hypothetically be allowed to fail. As the central bank makes clear where the lines will be drawn, the panic recedes. This view is supported by the programs that Bernanke lists as having had a distinctly beneficial effect on crisis indicators (p. 65): the Capital Purchase Program, the FDIC’s loan guarantee program, and the announcement of stress test results were all designed to make it clear that depository institutions would be supported through the crisis. Similarly, the support of money market funds gave confidence that no more money market funds would be allowed to “break the buck.”

As Bernanke observes “the [post-Lehman] panic was brought under control relatively quickly” (p. 65). Within six weeks funding pressures had already begun to ease up and by the end of 2008 they had almost entirely receded. In short, once it was clear which entities would be saved by the lender of last resort, there was no longer any cause for panic.

Brad DeLong in a review of Gennaioli and Schleifer’s new book argues that there might not have been a panic associated with Lehman’s failure if some form of resolution authority had been in place. With this I agree. As I argued here: it is almost certainly the case that if Treasury had reacted to the March 2008 Bear Stearns failure by carefully drawing up a Resolution Authority instead of the 3-page original TARP document, 2008 would have looked very different indeed. I also agree with DeLong’s positive evaluation of Gennaioli and Schliefer’s theory of investor psychology. In my view, however, their theory is more properly framed as putting modern bells and whistles on financial market dynamics that have been well-understood for centuries. The whole point of having a central bank and a lender of last resort is, after all, to control the dynamics generated by investor psychology (see e.g. Thornton 1802).

III. Additional bubbles explain Bernanke’s “non-mortgage” credit series

Ben Bernanke focuses on the housing bubble, but there were actually three bubbles created by the shadow banking boom of the early naughties: the housing bubble, the commercial real estate (CRE) bubble, and the syndicated loan “bubble”. SIFMA’s Global CDO data shows how MBS was only one form of shadow banking collateral. Lending to corporations was almost equally important.
Global CDO collateral
As Dean Baker points out the CRE bubble peaked in September 2007. Commercial real estate prices dropped by over 30% over the course of the next 18 months.

The syndicated loan “bubble” has behaved differently. While the market was subject pre-crisis to a deterioration in loan terms that was comparable to the mortgage or CRE market, this “bubble” never popped. The length of the loans was such that not many matured in 2008, and many corporations had committed credit lines from banks that they were able to draw down. Thus, it was in 2009 that concerns about likely corporate defaults weighed heavily on the market (see here and here). These concerns were, however, never realized. The combination of ultra low interest rates, retail investors shifting their focus to bond funds and ETFs, and pension funds reaching for yield meant that corporations were typically able to refinance their way out of the loans, and no aggregate collapse was ever realized. (To see how short lived corporate deleveraging was, see here.)

Thus, the fact that 2009 was a year in which massive corporate bankruptcies were expected just over the horizon probably explains a lot of the stress exhibited by Bernanke’s non-mortgage credit series (which is composed of non-financial corporate credit indicators and consumer-oriented securitization indicators). Treating this series as representing “a run on securitized credit, especially non-mortgage credit” (p. 46) as if it can only be explained by “panic,” does not seem to address the deterioration of corporate fundamentals and the implications of those fundamentals for corporate employees.

Bernanke considers the possibility that borrower financial health drives this indicator, but rejects this explanation, because:  “First, aggregate balance sheets evolve relatively
slowly, which seems inconsistent with the sharp deterioration in the non-mortgage credit factor after Lehman, and (given the slow pace of deleveraging and financial recovery) looks especially inconsistent with the sharp improvement in this factor that began just a few months later” (p. 41). Bernanke appears to assume that the deterioration would have been driven by the housing bubble, but that is not my (or Dean Baker’s) claim. I am arguing that the collapse of the CRE bubble and the weight of needing to refinance maturing syndicated loans in an adverse environment caused corporate balance sheet deterioration. The improvement is then explained by the fact that CRE prices bottomed in mid-2009 and in early 2009 the Federal Reserve made clear its commitment to keep interest rates ultra-low for “an extended period” of time. Both of these helped corporates deal with their debt burden.

In short, I find that Ben Bernanke’s data is entirely consistent with the presence of only a short-lived panic in late 2008. The economic deterioration that Bernanke associates with the prolonged short-term funding crisis and the more short-lived non-mortgage credit crunch can be explained respectively by the collapse of a large number of shadow banking vehicles and by the deflation of the other two lending booms associated with the crisis.

IV. Why Ben Bernanke’s characterization of the crisis is problematic

Thus, my most serious objection to Ben Bernanke’s characterization of the crisis is that, having exercised the lender of last resort authority appropriately to its full potential by permitting shadow bank funding models that were deemed destabilizing to collapse, he seems to want to avoid acknowledging the actual nature of the central bank’s lender of last resort role. His description of the 2007-09 crisis as “a classic financial panic” implies that the crisis was fundamentally a coordination problem in which the public was choosing a bad equilibrium and just needed to be redirected by the central bank into a good equilibrium in order to improve economic performance. Brad DeLong also embraces the language of panic in his response to Bernanke on the AEA Discussion Forum: “all that needed to be done was to keep demand for safe assets from exploding.”

(For Paul Krugman the problem is to explain not just the depth of the recession that ended in mid-2009, but the extraordinarily slow recovery from that recession, which he dubs “the Great Shortfall”. I suspect much of the explanation for the Great Shortfall will be found in post-crisis policies that were designed to protect Wall Street balance sheets at the expense of pension funds and the public, but that is a very different post.)

If one reframes Bernanke’s data from August 2007 to Spring 2009 as representing the complete collapse of certain shadow bank funding models, we see the Federal Reserve as the ultimate decision maker over which funding models were allowed to survive. Because some shadow bank funding models were allowed — properly — to collapse short-term funding rates skyrocketed and areas of the real economy that had adapted to rely upon the doomed funding models struggled as they had to adjust to a world with a different set of choices. This adjustment was temporary because the Federal Reserve — properly — acted to promote restabilization of a financial system without the terminated shadow banks.

What drove the data was not the public choosing a bad equilibrium, (that is, a panic), but the Federal Reserve properly exerting its authority by allowing market forces to eliminate certain shadow banks. This authority is properly exercised because in a world with credit-based money such as ours, financial stability is only possible if the lines between bank-like lending that is acceptable and bank-like lending that is not acceptable are strictly drawn and carefully policed. Thus, the Federal Reserve’s most significant error was its failure to exercise this authority stringently enough long before the crisis broke in order to act preventively to forestall the financial instability that was experienced in 2007-09.

That said, Bernanke is rightly proud of the speed with which the post-Lehman panic was brought under control and is right to conclude that “the suite of policies that controlled the panic likely prevented a much deeper recession than (the already very severe) downturn that we suffered” (p. 66). He also draws a lesson from the crisis that is entirely consistent with the view of it presented here: “continued vigilance in ensuring financial stability” is absolutely necessary. Indeed, I suspect that he would agree with me that that the Federal Reserve should have exercised greater vigilance prior to 2007.

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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?