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.

Query re AIG

According to the NYTimes:

The debate within the Fed centered on which part of the government could provide the guarantee, according to the documents. Staff at the Board of Governors told Fed officials in New York that a Fed guarantee “was off the table,” according to an e-mail message to Mr. Geithner and others on Oct. 15 from Sarah Dahlgren, the New York Fed official overseeing the A.I.G. rescue.

“We countered with questions about why it was so clearly off the table and suggested, as well, that perhaps this was something that Treasury could do,” Ms. Dahlgren continued.

Supporters of the plan considered a guarantee a good option because A.I.G.’s debt rating was at risk of a downgrade by the credit rating agencies and the company would then have to post more collateral with the banks.

“If a ratings downgrade happens at any time in the next three weeks or afterward, we will need this to protect any value in the insurance companies and, importantly, to avoid a disorderly seizure,” Ms. Dahlgren wrote.

The New York Fed pursued the guarantee option with the Treasury, the documents indicate. But by Oct. 23, the Treasury had refused to provide the guarantee, according to an e-mail message sent by Ms. Dahlgren to Mr. Geithner. In early November, the Fed decided to make the counterparties whole on their insurance contracts.

How does Treasury explain its decision not to provide a guarantee to the AIG CDOs that were absorbing so much collateral?  This would clearly have saved taxpayer money in the short-run — and would be unlikely to end up adding to taxpayer losses in the long-run.  (As far as I can see, the only situation in which Maiden Lane III is a better choice for Treasury than an outright guarantee of the same assets is if Blackrock manages to pull off an extraordinarily well timed sale of the CDOs, thus transferring yet to be realized losses to someone in the private sector.)

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.

The role of toxic assets in global imbalances 2

For a follow up piece discussing this question:  Did synthetic assets slow the current account adjustment process by vastly expanding the supply of investment grade assets and thus maintaining interest rates at a level well above the market rate?

see here:  http://www.scribd.com/doc/20970681/Synthetics-and-the-Current-Acct

The role of toxic assets in global imbalances

In June Martin Wolf wrote approvingly of a report on the role of global imbalances in the financial crisis:

The authors conclude that the low bond yields caused by newly emerging savings gluts drove the crazy lending whose results we now see. With better regulation, the mess would have been smaller, as the International Monetary Fund rightly argues in its recent World Economic Outlook. But someone had to borrow this money. If it had not been households, who would have done so – governments, so running larger fiscal deficits, or corporations already flush with profits? This is as much a macroeconomic story as one of folly, greed and mis-regulation.

Since then this view has become common.  For example Wolfgang Munchau in Monday’s Financial Times states:  “Without excessive imbalances, the demand for products we now refer to as toxic assets would have been smaller.”

It is not clear, however, that this causal story really makes sense when analyzed in a demand and supply framework.  Afterall, the “crazy lending” that Martin Wolf references represents an increase in the supply of financial assets over and above what would exist in a world with normal lending.  It is far from clear why it is correct for anyone to claim that a shift in the demand for financial assets “causes” a shift in the supply of financial assets.  Standard economic analysis would usually claim that a shift in the demand for financial assets results in a movement along an existing supply curve raising the price of the assets and lowering their yield.

While it is true that we observe in the data a decline in the yields of fixed income assets, this phenomenon is consistent with the observed increase in supply of these assets – as long as the shift in demand was sufficient to outweigh the effect of an increase in supply.  In other words, while “crazy lending” caused an increase in supply and tended to raise the yields on these assets, this effect was overwhelmed by the increase in demand.

Now in a world with alternate assets, like ownership interests, increasing the supply of fixed income assets and therefore their yields will tend to attract investors to bonds and discourage them from entering more pricey stock markets.   Thus, as long as we acknowledge that there was “crazy lending” going on and thus that the supply of fixed income assets was greater than it would have been a world without “crazy lending,” surely we must also acknowledge that this raised fixed income yields above their natural level and reduced the tendency of investors to put their money into equity and alternative assets instead of fixed income assets.

In fact, it is entirely possible that extremely low yields in fixed income markets and a shift by emerging market money into equities would have prompted reconsideration on the part of both developing and developed economies of the wisdom of maintaining massive current account imbalances.  That is, it is entirely possible that “crazy lending” actually slowed the current account adjustment process – precisely because “crazy lending” prevented the returns on fixed income assets from falling to derisory levels.

In short, elementary economic analysis allows us to reach a conclusion opposite to Wolfgang Munchau’s:  Without toxic assets, the quantity demanded of fixed income assets would have been smaller.  We can also conclude that in the absence of toxic assets, foreign capital flows into US equity investments would have been greater.  Left with a choice between derisory fixed income returns and riskier investments, foreign investors would have had a strong incentive to reduce their allocation of funds to the US market.  In other words, in the absence of toxic assets the “savings glut” might have started to unwind on its own.

Thus, while emerging market demand for fixed income assets made it possible for financiers to produce and sell toxic assets, the fact remains that the supply of toxic assets increased the supply of bonds, raised the yields on bonds relative to an environment without toxic assets and by doing so interfered with the price mechanism that would tend to reduce emerging market demand for fixed income assets.   Whether allowing market forces to operate would have been enough to start the unwind of global imbalances is unknowable, but we can be sure of one thing:  the production and sale of toxic assets worked to keep the demand for fixed income assets high and by doing so worked against the resolution of global imbalances.