Finance and Econ 101 again

Over at Felix Salmon’s blog, the discussion of synthetic CDOs has included comments like “there was unlimited demand for the AAA tranches” and “the supply of underlying bonds was insufficient”.  This inspires the following Econ 101 exam question.

Econ 101 question:  There is a market that is a “black box” — that is, we have very little information about how it operates.  We do, however, have some information about this market:

(i) the supply of the good is universally viewed as insufficient
(ii) demand for the good is excessive, in fact, it’s sometimes described as unlimited

Explain what you think is going on in this market. [Hint: Draw a demand and supply diagram, and then find a situation that we have studied that would have the characteristics of this market.]

Answer:  A price ceiling.  Prices are so low that supply is “insufficient”, but at the same time demand is “excessive”.  These are the characteristics of a market where a price ceiling has been set by government policy.  If demand is actually being met it must come from outside the market — perhaps from abroad.

In a market with a price ceiling — for example, when government wants to keep staple items cheap for consumers — it is very clear that market forces are not operating to bring supply and demand into equilibrium.  On the contrary, the government must act so that consumer demand is actually satisfied — one method is to subsidize production of the good in question.

So when financiers claim that there was “insufficient supply” and “unlimited demand” for bonds, they are describing a classic case of an environment where the market price of these bonds is being held down below the equilibrium price.  This is only possible if some “identical” substitute is being sold to the buyers with “unlimited demand”.  The financiers are pretty clear about how demand was met:  “the synthetic was only useful because the supply of underlying bonds was insufficient”.  In other words, synthetic bonds (or credit default swaps) were used to manufacture a larger supply of mortgage bonds than the market could provide.

Basic Econ 101 analysis indicates that it was these synthetic bonds that made it possible for a disequilibrium environment that looks just like a price ceiling to be sustained in the mortgage market for a prolonged period of time.

On synthetics in Maiden Lane III

Calculating the exposure of a CDO to synthetic assets is complicated for two reasons:  (i) first because, not only can the CDO itself use swaps to generate synthetic exposure, but also the CDO and RMBS tranches in which the CDO invests may include synthetics; and (ii) secondly, because the tranche structure of CDOs complicates things.

Because it is easier to create synthetic exposure to an asset than to originate an actual loan (remember creating a synthetic asset involves selling protection on an asset, not buying it — thus you just need to find counterparties willing to pay small premia for protection), I will generally assume that the synthetic exposure of a CDO or RMBS is close to the limits permitted in the deal documents.  This is an assumption and therefore subject to correction if the actual data is ever made public.

The collateral underlying the Broderick I CDO is 20% CDO, 80% RMBS.  20% of this collateral may be in the form of synthetic assets.  Since the industry (and undoubtedly Merill Lynch in particular as a major CDO issuer) had a great need to place junior CDO tranches most likely it was the RMBS that was referenced synthetically, not the CDOs.  So as a working assumption lets consider that the Broderick I CDO is 20% CDO, 20% synthetic referencing RMBS and 60% RMBS.

The thing to remember is that the 20% CDO collateral is likely to also be 20% synthetic.  I’m not going to make any assumptions about the synthetic exposure in the RMBS, because I haven’t found reliable information on the issue, but there is no question that some synthetic RMBS were issued.  Thus Broderick I could easily be backed by 24% synthetic assets — and possibly more.

But it’s important to understand that 24% would be a low estimate of Broderick’s exposure to synthetic assets.  This is because the structure of a CDO is designed to concentrate risk by increasing the exposure of the junior investors to losses..

To explain, consider a simple tranched securitization of five $1 million mortgages with one junior $1 million investor and one senior $4 million investor.  It should be obvious that the junior investor — because he absorbs losses first — has 100% exposure to each of the five mortgages.  If one of those mortgages is synthetic, then the junior investor has 100% exposure to the synthetic mortgage.  In short, in a CDO you must always remember that only the first priority investor is guaranteed to benefit from diversification of assets.

For this reason when calculating the exposure of subordinate CDO tranches to synthetic assets, what is important is whether the detachment point of the tranche (that is the point at which it stops absorbing losses because it is worth nothing) is lower than the fraction of synthetic assets in the CDO.  If the CDO has 20% synthetic assets and the tranche in question detaches at 10%, then the tranche can be wiped out twice over by losses on synthetic assets alone.  Thus it doesn’t really make sense to claim that the tranche has less than 100% exposure to synthetic assets.

Since the subordinate tranches in Broderick (as a group) detach at 16%, every one of them probably has 100% exposure to synthetic assets.  If the CDOs included in Broderick are similarly structured (and if I am right that these CDOs made maximal use of synthetic assets), then it is fair to say that Maiden Lane’s exposure to synthetic assets via Broderick I is $400 million or 40% of the CDO.

Why does this matter?  Because as I asked in my first post on Maiden Lane III as taxpayers we need to consider these issues:

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 think we need public disclosure on each of the Maiden Lane vehicle’s exposure to synthetic assets.  So we can have a robust public discussion about the role of government in underwriting synthetic assets.

On Maiden Lane III – 2

This post will continue my effort to understand Goldman Sach’s huge first-priority exposure to a few of the CDOs in Maiden Lane III.

Yves Smith has some nice clues to what was going on, pointing out that the November Blackrock memo at the time of Maiden Lane III’s formation states:  “Access to assets:  Goldman has said that it does not hold the cash CDOs, but has back-to-back swaps on most of the positions”.  (I’ll address the remarkable fact that a 20% synthetic CDO could be considered a “cash CDO” in another post.)  This indicates that Goldman probably sold the first priority exposure in Broderick I on to customers, offering a Goldman guarantee on the returns in the form of a swap.  Goldman then transferred this risk to AIG using another swap.  In other words, this was Goldman’s clients’ CDO exposure that was protected first by a Goldman and then by an AIG swap.  That this is a likely explanation is confirmed by the fact that $7.4 billion of the CDOs in Maiden Lane settled almost a month after the first CDOs were transferred because they were “contingent upon the ability of the related counterparty to obtain the related multi-sector CDOs”.  In short, Goldman probably had to buy Broderick I from its clients before it could make use of the Maiden Lane facility.

However, if we are interpreting the available facts correctly and, if Goldman took almost all of the first priority Broderick I exposure in order to sell it on to clients, then we still need an explanation for why Merrill Lynch rather than Goldman was the firm originating the CDOs.  The answer is probably that Merrill had the collateral and Goldman had the clients.  Although Merrill wasn’t a big player in the mortgage market (and purchased First Franklin in order to change that situation), Merrill was one of the lead issuers of CDOs (2004 thru 2006).  It is likely that Merrill had established an RMBS pipeline while GS had clients to whom senior CDO tranches could be sold.

It occurs to me that because the senior CDOs that Goldman was selling to clients were like covered bonds (that is investors were protected by the guarantee of the bank in case the mortgages themselves went into default) and the legal structure for the covered bond market does not exist in the US, there may have legal reasons for the issuer of the CDO and its guarantor to be distinct parties.

This innocuous explanation of Goldman’s large first priority exposure to Maiden Lane’s CDOs does not, however, obviate the main concern of my previous post:  There is still plenty of reason to be concerned that Maiden Lane III has far too much synthetic exposure for taxpayers’ comfort — in part because the CDOs in question were issued right at the time that synthetic RMBS started to become more common.  More in the next post.

On Maiden Lane III

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.

A problem with credit default swaps

Once again a lot of dust is being raised over the fact that Goldman Sachs survived the crisis better than any other stand-alone investment bank in part because the bank took a large short position in subprime mortgages.  People are asking whether it was right for Goldman to sell subprime mortgages securities to clients at the same time that it was expecting them to perform poorly.

I think that framing the question in this way gets the problem precisely backwards.  Credit default swaps by their very nature pose a problem for the party that wishes to buy protection against a bond default:  the protection buyer has to find a counterparty who wishes to sell protection (i.e. take on the obligations of an insurer against the possibility that a bond defaults).

Because of the “cliff risk” built into these contracts, it’s not clear that there is any natural seller of credit default swap protection.  The monoline insurers, which used to specialize in municipal bond insurance, come closest — but even they were unwilling to write protection based on the standard CDS contract, which requires that the full value of the bond be paid to the protection buyer on the event of default.  The monoline CDS contract requires only that the insurer make the payments required by the defaulted bond as they become due.  This has the effect of pushing the “cliff risk” of being obliged to pay the notional value of the bond five, ten or even thirty years into the future.

Thus the protection buyers were faced with a challenge:  How do you create a marketable product that involves the sale of credit default protection?  This is precisely the kind of challenge that Wall Street’s innovative structured financiers specialize in.  The Wall Street Journal explains what happened:

Mr. Paulson and Mr. Pellegrini were eager to find more ways to bet against risky mortgages. Accumulating mortgage insurance in the market sometimes proved slow. They soon found a creative and controversial way to enlarge their trade.  They met with bankers at Bear Stearns, Deutsche Bank, Goldman Sachs, and other firms to ask if they would create securities—packages of mortgages called collateralized debt obligations, or CDOs—that Paulson & Co. could wager against.

Synthetic and hybrid CDOs are designed to sell precisely the credit default protection that John Paulson, Goldman Sachs and Deutsche Bank were looking to buy.  Using both BIS and SIFMA data on CDO issuance, I estimate that from July 2006 through June 2007 at least $1.2 trillion in notional value of credit default swap protection was sold via synthetic and hybrid CDOs.*  I further estimate that CDS sold by CDOs from mid 2006 through mid 2007 accounted for between 30% and 100% of CDS protection sold by end users over this period.**

Thus we have reason to believe that CDOs were some of the most important credit protection sellers on the market when Paulson & Co, Goldman and Deutsche Bank were building up their short position in subprime.  While it is certainly the case that the banks that ended up with these CDOs on their balance sheets should have understood what they were investing in, it is far from clear that the CDO investors in tranches with investment grade and even AAA ratings that sit at the bottom of the structures — the ones in the second, third and fourth loss positions that protect the banks’ super senior AAA tranches — understood that they were selling credit protection to hedge funds and investment banks.  There is plenty of evidence that CDOs were marketed as bonds, not as packages of derivatives. And we, after the crisis, are left with the question:  If investors had understood that they were selling credit protection to sophisticated counterparties, would these CDOs ever have been issued?

Thus the problem with credit default swaps is that the market has very few, if any, natural sellers of protection.  This drives financiers who wish to buy protection to create products that make credit default swaps look like something that investors actually want to put their money into.  Given the consequences of generating supply in such a manner, regulators need to take a much more jaundiced view of the role that financial innovation plays in the economy.

* My estimate is derived as follows:  I use SIFMA data to generate the fraction of annual CDO issuance that was issued in each quarter of 2006 and 2007.  I use these figures to interpolate quarterly data from the BIS annual data.  Since SIFMA data only includes unfunded tranches of CDOs and BIS data includes all CDO tranches, I take the difference between the two data series as an indicator of the unfunded tranches that were issued.  Since the cash assets in CDOs must be funded, this is a lower bound on the notional value of CDS sold by CDOs.

**  The notional amount of CDS outstanding grew over the same period by $20 trillion.  Taking into account the fact that ISDA data tends to double count derivatives and that some derivatives expired, this probably reflects that over this period around $12 trillion in notional value of credit default swap protection was sold.  When we recognize that the difficulty of terminating these contract led to a situation where many dealer banks chose to offset exposures by entering into new contracts, we realize that most likely at least 2/3 of the CDS sold over this period reflects inter-dealer transactions and not end user sales of CDS protection.  Thus most likely less than $4 trillion of net CDS exposure was generated in the period from July 2006 through June 2007.  In fact, current DTCC data indicates that once offsetting dealer positions are taken into account the net value of CDS is only about one-tenth of the notional value.  This would lead us to estimate that about $1.2 trillion of net CDS exposure was generated from mid 2006 through mid 2007.  These figures indicate that CDOs sold between 30% and 100% of the CDS protection provided by end users in the market from mid 2006 through mid 2007.

Are CDOs voodoo finance?

Johnson and Kwak claim:  “The fact remains that at least some CDOs boosted financial intermediation by tricking investors into making investments they would not otherwise have made–because they destroyed value.”  They described the process of tricking investors as “the magic of a CDO”.

And Economic of Contempt responds:  “This is usually how CDOs are portrayed these days: they’re obviously voodoo finance … But as you can see, the idea that the senior tranche would be “safe” isn’t at all ridiculous—after all, there’s almost always some level of subordination that will make the senior tranche a safe investment.”

Of course, this is not actually a response to the claim that “some” CDOs destroyed value. EoC doesn’t claim that for every single CDO there is a level of subordination that will make the senior most tranche a AAA investment, because EoC knows very well that for certain classes of CDOs (e.g. mezzanine ABS CDOs) there is no level of subordination that will turn the senior most tranche into a AAA investmnet.

Furthermore even when one deals with those CDOs for which it is true that there exists some level of subordination that makes the senior most tranche AAA, as EoC himself notes, the problem is that each CDO defined a specific level of subordination at which the investment became AAA.  In recent years this level was usually set at a ridiculously low level.

Finally investment banks claimed to be able to price these CDOs accurately enough to sell them as investments to their clients.  Of course, the truth was that very few investment banks (i) made appropriate allowances for the likelihood that mortgage defaults would be highly correlated when the housing bust finally arrived — which would have resulted in higher fair market yields for every tranche and rendered many CDOs non-viable economically as recognized by the folks at JP Morgan (who apparently concluded that “the idea that the senior tranche would be ‘safe’ ” is ridiculous when you’re talking about mortgage based CDOs); and (ii) apparently didn’t do the loan level research necessary to accurately price CDOs — or they would have found lots of fraud in recent vintage CDOs that included subprime RMBS.

So in answer to the question:  Are the CDO issuance practices of 2005 – 2007 accurately described as voodoo finance?  The answer is yes.  Because some fortune teller in an investment bank was claiming (with advice from the rating agencies) to be able to (i) determine subordination levels for AAA and other tranches with extraordinary accuracy; (ii) to be able to predict future correlations, even though two-bit investor is warned that “past performance may not be a good indicator of future performance” and you’d think the investment bankers had been around long enough to learn that simple rule and (iii) to be able to accurately price a composite asset without doing extensive research on the underlying individual assets.

What’s ridiculous is the claim that people like Johnson and Kwak are giving CDOs a bad name.  The investment banks were able to do that all by themselves.