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.

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Subprime vs subprime

The financial industry’s way with words — that is, the industry’s way of making sure that words never mean what you think they mean — has tripped up the academics once again.  The recent debate between Raghuram Rajan and Paul Krugman over the role played by Fannie Mae and Freddie Mac seems to hinge on the fact that they are talking at cross purposes.

The commonly understood meaning of “subprime” when referring to securitized mortgages is to be found in wikipedia:

Varieties of underlying mortgages in the pool:

  • Prime: conforming mortgages: prime borrowers, full documentation (such as verification of income and assets), strong credit scores, etc.
  • Alt-A: an ill-defined category, generally prime borrowers but non-conforming in some way, often lower documentation (or in some other way: vacation home, etc.) (Article on Alt-A)
  • Subprime: weaker credit scores, no verification of income or assets, etc.

There are also jumbo mortgages, when the size is bigger than the “conforming loan amount” as set by Fannie Mae.

Since a “conforming mortgage” is one that meets the criteria set by Fannie Mae and Freddie Mac, the traditional meaning of subprime is a loan that does not meet Fannie Mae and Freddie Mac’s criteria for a reason other than loan amount.  (Alt-A came much later than sub-prime.)  For this reason it is common to see the words “prime” and “conforming” used interchangeably in mortgage articles.

Thus using the traditional approach, any MBS issued by Fannie or Freddie is, by definition, not a sub-prime MBS.  When Fannie and Freddie invested in sub-prime they did so by buying up privately issued sub-prime MBS.  It seems obvious that in this market Fannie and Freddie were two of many, many guilty parties.

What makes the whole discussion complicated is that (I think) the GSE’s loan criteria became less discriminating over time.  Thus, if one wants to fix the definition of sub-prime based on the GSE’s standards in, for example, 1998, one can claim that the GSEs themselves were issuing “non-conforming” MBS.  On the other hand, it is unarguable that even when the GSEs were issuing “non-conforming” MBS, the loan criteria were always noticeably stricter than those in the privately issued subprime MBS market.  The bottom line is that the lending behavior of the GSEs is not well suited to a casual assertion that they started issuing subprime MBS, but instead deserves a carefully researched dissertation that breaks loans into far more granular categories than prime, subprime and Alt-A.

Tanta is of course the go-to source for anyone who wants to understand the nitty-gritty details of the mortgage market.  For an extremely thorough discussion of what precisely it means for a loan to be sub-prime or Alt-A see here, and here for a thorough discussion of what precisely the GSEs were doing when they securitized loans — see in particular the paragraph that starts:  “Propaganda from certain other market participants aside, you cannot just put any old loan in a GSE MBS.”

On selling “crap”

After reading the Lex column’s defense of the not-so-uncommon practice of peddling “crap”, I want to make two points:

(i)  Because the asymmetric information is built into many business relationships, it’s impossible to outlaw the sale of “crap” and I don’t think anybody will argue that first goal of financial regulation should be to put an end to transactions involving “crap”.  In the initial “caveat emptor” decision the judges explicitly recognize the limits of the law in practical matters of contract.  According to Jon Faust:

What is striking is that caveat emptor arises as a legal principle mainly because of the tangle the courts would get into if they tried to enforce a more ambitious standard of right and wrong.

(ii) There’s a big difference between arguing that peddling “crap” is a deplorable practice that it is impossible to end, and arguing that peddling “crap” has economic benefits.  (I criticize the “two people made a deal, therefore it must be good” approach to markets here.)

Issuing a security that is designed as a short vehicle and then marketing it to long investors without full disclosure about the design of the security — that is, deliberately creating asymmetric information  — quite simply cannot be viewed as a positive contribution to “the liquidity and vitality of our financial system“.  In fact as Steve Waldman argues the Abacus CDO — by giving Paulson the opportunity to trade off the public ABX market at below market prices — undermined public information about the state of the subprime mortgage market.

There’s not much that can be done about eliminating the practice of selling “crap”.  We can, however, force over the counter markets and any other dark markets to shrink dramatically and drive as much trade as possible to an environment where it will be publicly observed.

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.