The role of derivatives in the 2008 crisis

“More generally, the 2008 credit crunch was never related to worries over traded derivatives; it was — like all credit crunches — related to much more general worries over bank solvency and the quality of banks’ balance sheets.”  Felix Salmon

The claim that the 2008 crises were not related to worries over traded derivatives is simply wrong.  And I write this post to present some of the considerable evidence against this claim.  (That said, I agree with Felix Salmon’s critique of this article that the Greek default is not a good example of CDS-generated systemic risk.)

First, William Dudley the President of the New York Federal Reserve Bank has stated publicly that:  “The novation of OTC derivatives was an important factor behind the liquidity crises at both Bear Stearns and Lehman Brothers.”

Novation takes place when, for example, a hedge fund decides that it doesn’t want to face Bear Stearns as a counterparty and therefore transfers the contract from Bear Stearns in order to face JP Morgan Chase.  In the process any collateral the hedge fund has posted to Bear Stearns must be transferred to JP Morgan Chase.

Second, the OCC derivatives reports (that include derivatives held by regulated commercial banks, but not by the investment banks) indicate that credit derivatives experienced much greater changes in values than other derivatives over the course of 2008.  Specifically credit derivatives comprised 20% of the fair value (summing positive fair value with negative fair value) of derivative portfolios in the first quarter of 2008.  (See Table 6 here.)    And by the third quarter had jumped to 32% of the fair value.  (here)  Thus, it reasonable to conclude that a minimum of 20% to 30% of the novations that played an important role in the collapse of both Bear and Lehman were due to credit derivatives.

It is entirely possible that significantly more of these novations were due to credit derivatives.  Since the aggregate fair value of bank derivative portfolios actually fell from Q1 to Q3 2008 by 6% or $250 billion, the increase in fair value of credit derivatives reflected a move from approximately $1 trillion to $1.3 trillion.  In other words, as one might predict, the value of credit derivatives moved much more dramatically during the “credit crunch” than the value of other derivatives.  Under the circumstances of these dramatic price changes, it seems safe to assume OTC derivative related collateral calls between Q1 and Q3 2008 were more likely to involve credit derivatives than other derivatives.  And I would posit that such collateral calls can trigger demands for novation.  Attibuting 30% of the novations in the credit crises of 2008 to credit derivatives is therefore probably a low estimate.

[Update 3-2-10:  The ISDA Margin Survey 2009, Table 4.2, indicates that from 2007 through 2009 66% of credit derivative exposures were collateralized.  Thus when the fair value of credit derivatives held by regulated banks increased by $300 billion from March 31, 2008 to September 30, 2008, it’s fair to assume that this had the direct result of increasing the demand for collateral over this period by $200 billion.  And this number excludes the increased demand in collateral created by the investment banks’ credit derivatives portfolios.]

Finally, we have the fact that New York Fed jumped on the CDS market after the Bear Stearns bailout – and didn’t allow Lehman to fail until after “centralized settlement among major dealers” for credit derivatives was implemented.  Previous industry commitments with respect to credit derivatives were focused on back office infrastructure issues and had a leisurely timeframe.  (This September 2006 press release indicates that significant advances for the industry included an end to novation without consent, an 80% reduction in the number of confirmations outstanding for more than 30 days, and a significant increase in the confirmation of trades on an electronic platform.)

In March 2008, by contrast, the industry agreed to automated novations processing by the end of 2008, and full implementation of centralized settlement among major dealers by September 2008.  The latter commitment was confirmed by the dealers in July 2008.  (page 3 here.)  In other words, the regulators moved from jawboning to a demand for commitments from the credit derivatives dealers for major changes in the clearing process that included very close deadlines, due to concerns over “the resiliency of the OTC derivatives market.”

While Felix Salmon may argue that this sudden seriousness about reform of the credit derivatives market was pure coincidence, most would conclude that it reflected regulators’ concern about the market after the failure of Bear Stearns in March 2008.

Overall, the claim that “2008 credit crunch was never related to worries over traded derivatives” is contradicted by the facts.  Insiders have acknowledged that novation of OTC derivatives played an important role in the crisis.  And I think Felix Salmon would have difficulty finding a member of the industry who is willing to assure him that the credit derivatives market would have handled the failure of Lehman effectively, if it had still been working with the market infrastructure of March 2008. Given this situation, the evidence points pretty clearly to likelihood fact that the CDS market was one of the reasons the Federal Reserve was unwilling to let Bear Stearns fail the way it let Lehman fail.

An additional note.  Felix Salmon writes, comparing bilateral clearing to a clearinghouse:

“If a bank has written so much credit protection that it becomes insolvent, then there’s significant systemic counterparty risk regardless of how its derivatives trades are cleared.”

Huh? The whole point is that the bank default to the clearinghouse is born jointly by the banks that guarantee the clearinghouse, instead of being born by individual counterparties – who are naturally more likely to be bankrupted by the bank’s failure to pay, then if they share the losses and thus divide them by 3 or 5 or some such number.

The point of a clearinghouse is not to prevent bad banks from facing a credit-crunch.  Obviously from an efficient markets point of view the sooner that happens, the better.  The point is that clearinghouse should help prevent the credit crunch/failure of a bad bank from taking down other banks that could potentially be made insolvent by excessive exposure to the bad bank — and thus to prevent the bad bank from setting off the chain of failures that defines a systemic crisis.  Of course, if the banks are willing to rely on collateral and choose not to limit credit to bad banks, then we’re in big trouble in either system.

Misunderstanding data on economic growth

According to Paul Krugman, we know that the growth estimates of the naughties are close to accurate because:

On the financial side, the point is that we measure growth by output of final goods and services, and fancy finance is an intermediate good; so if you think Wall Street was wasting resources, that just says that more of the actual growth was created by manufacturers etc., and less by Goldman Sachs, than previously estimated.

This just shows how little economists have tried to understand the nature of recent financial innovations.  Wall Street can now create synthetic assets.  That’s what a synthetic CDO is — it goes on someone’s balance sheet as an asset and there’s no requirement in accounting conventions that it go on somebody else’s balance sheet as a countervailing liability.  AIG is just an illustration of how the accounting for such CDOs takes place.

In an environment where Wall Street can fabricate assets that enter into financial accounts in this way, it’s not realistic to claim that “fancy finance is just an intermediate good”.  That used to be true in the good old days, when there was no reason to believe that the CDS contracts underlying synthetic CDOs would be enforceable contracts, but after the CFMA of 2000 (and other changes in the law), that isn’t true anymore.

For this reason, the economic assumptions underlying analyses like Krugman’s and Steindel’s do not reflect reality — and in fact they function as a blinder that prevents these economists from seeing and understanding what’s actually going on.  By assuming that financial institutions can’t do what they did do, economists hobble their understanding of the nature of the current economic malaise.

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 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.

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?

Regulation and derivatives

The Goldman Sachs fraud case seems to hinge pretty heavily on this question:  Is there a presumption that a product marketed to investors is designed to be a long capital market product?  If a product has been designed as a short vehicle, is that inherently a material fact?  Because the world with credit derivatives is a very new one, these are legal issues that have yet to be resolved.

In terms of regulation the brouhaha over the case leads me to think that we are faced with two possibilities:

(i) Return to the traditional legal framework where OTC derivatives were “legally enforceable only if one of the parties to the bet was hedging against a pre-existing risk”  (quoting from Prof. Lynn Stout here).  This view was relevant in a world where investment was viewed as necessarily a long exposure and shorts/speculation were discouraged, or

(ii) Recognize that capital market vehicles can be designed to be either short or long.  Then the long vs. short structuring of every product must be an important part of its marketing.  And fraud must be severely punished.

Personally I think that difficulties of policing fraud will mean that choosing (ii) is more likely to destroy capital markets — by scaring all the real money investors away from a rigged game — than to save them.

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.