Securitization’s House of Cards

After reading Felix Salmon’s post about the Australian judge who stood up to ratings giant Standard & Poor’s (which slapped a AAA grade on some securitizations that all too quickly crapped out), I got curious.

How badly did S&P and ABN Amro (the creator of the investment) behave? What exactly happened with these odd products (called “constant proportion debt obligations,” or CPDOs for short)?

Felix made it sound pretty bad. After digging around some, I’m convinced now that it was even worse.

What follows are some damning things about the case that Felix -- and sometimes even the judge herself, in her decision -- didn’t touch upon.

Judge Jayne Jagot found S&P liable for losses suffered by investors that trusted their shoddy ratings. That was a big blow to S&P, which in the U.S. is used to hiding behind the skirt of the First Amendment, protesting that its ratings are only “opinions,” as if the company’s analysts were no more than film critics for a free alternative weekly.

Now CPDOs are awfully complex (Jagot approvingly quotes a description of them as “grotesquely complicated”). The way you rate one of these Rube Goldberg-ian securitizations is through a model, into which you feed a bunch of variables, then observe how the original investment fares in a series of random trial runs.

Investors in the ill-fated “Rembrandt” 10-year CPDOs were basically selling insurance (in that credit default swap kind of way) on the members of a couple of CDS indexes, known together as the Globoxx. The insurance protects against default on the debt of the companies in the indexes (each has 125 members, I think). That put the investors in a “long” position on the underlying bonds. So they benefit when the debt becomes safer and doesn’t default.

Sort of.

PARADOX OF A CPDO

Because here’s the problem with a CPDO.

It needs higher credit spreads (which indicate higher risk, which leads to fatter “insurance premiums”), while at the same time it paradoxically needs lower credit spreads (as they indicate a lower risk of default, and thus a smaller chance of taking losses).

How the heck do you square that circle? Well, ABN Amro started by jamming bad, incomplete data into the model. And the bank succeeded because S&P stunningly accepted whatever ABN Amro spoon-fed it, like a lapdog with its eye solely on the milk bone (that would be the rating fee it was promised).

To see the problems with one bit of data in particular, you need to take a closer look at the plumbing of these things:

The Rembrandt CPDOs were actually selling insurance in a rolling series of contracts. They started out by issuing protection through 5 1/4 year default swaps on the Globoxx basket. Six months later, they exited that position and sold a fresh 5 1/4 year contract on the new Globoxx (every six months, companies that no longer meet the investment-grade criteria are replaced in the indexes). By that time, of course, the original 5 1/4 year contract has become a 4 3/4 year contract. The process of changing over from the old index to the new is called “the roll.” The old “off the run” contract gives way to the new “on the run” one.

ABN Amro won a coveted AAA rating on the CPDO partly because of its wrongheaded exploitation of “the roll.”

ROLLING DOWN THE RIVER

See, credit risk curves for a company (of investment-grade quality anyway) tend to slope slightly upwards. Not by a whole lot -- but enough. Generally the longer you commit to insuring debt, the more you want to receive each year, because the more scary unknowns may be lurking way out in the future.

Why did that matter for a Rembrandt CPDO investor? Simple: When the CPDO does “the roll,” it buys a 4.75 year Globoxx contract (in CDS land, if you’ve sold a contract, you can later buy the exact same contract to cancel out your earlier position) and starts selling a 5.25 year default swap. So, assuming nothing else has changed, you reap a neat little benefit from the six-month difference in term. You buy a 4.75 year contract at x and sell a 5.25 year at x plus a little something.

ABN Amro calculated that “little something” at 7 basis points, or 0.07%. Seems like a puny, negligible number. Yet it was anything but. The CPDO could be as much as 15 times leveraged (and 15 times 7 is 105, or more than a full percentage point). Without that 7 basis points of roll-down benefit, occurring every six months, this AAA investment would have received a junk rating.

Yet this 7 points of roll-down benefit was a grossly flawed number -- and ABN Amro’s own model inputs showed as much!

NOW IT'S IG, NOW IT'S NOT 

It was never adjusted for the danger of “ratings migration,” which Jagot describes as “the phenomenon ... by which the rating of a reference entity might decrease between rolls without default.” That’s an especially insidious problem with an investment-grade index that’s changing its composition every six months.

Here’s an example of how ratings migration could sting the CPDO: It sells a Globoxx contract at 60 basis points. The economy lurches south, and some of the companies that belong to the index (what the judge refers to as “reference entities”) slip a few notches, into junk territory. After six months, let’s say the Globoxx has climbed to 80, indicting higher levels of risk. The “junk” members are replaced by new investment-grade companies, so let's suppose the new Globoxx contract is at 60 again. Got that?

Here’s the math: +7 basis points of roll-down benefit, -20 points of ratings migration. That equals a net loss of 13 basis points.

What’s worse is ABN Amro practically assures this negative ratings migration will occur -- then apparently never adjusts the model for it!

We know that because ABN Amro had to feed another bit of data into the model called “long-term average spread” (LTAS), which we’ll call “average spread,” to keep things simple. This starts at 40 in year one, then balloons to 80 in year two. In other words: ABN Amro itself expected the average level of the Globoxx to jump 40 basis points. So it’s highly likely, if that’s true, that at least a few companies were going to migrate right out of the index. This alone should have knocked out a chunk of that roll-down benefit.

NEVER SHALL THE VARIABLES MEET

But it didn’t. One reason: a glaring weakness of the model was that various key parts apparently didn’t “talk to each other” -- which made it ripe for exploitation.

Never was this weakness more apparent than with the interaction between the model’s assumptions for average spreads and volatility and default probabilities. Quite simply, there didn't seem to be any! Each variable lived in its own walled-off silo, informing the model without disturbing variables anywhere else. That’s beyond absurd.

Here’s one illustration why.

Initially ABN Amro made certain observations about the Globoxx: there was a certain expected default rate for companies in the indexes, the historical volatility was 15% (wrong, by the way -- it was actually almost twice that, and S&P never bothered to check either), the average spread was 40 to start out with (inexplicably, this simple, easily confirmable fact was wrong too -- by 25 percent!).

But, in the real world, these variables don’t live in separate silos. Actually, they’re more like joined at the hip. So when ABN Amro estimated that average spread would increase from 40 to 80 after one year -- a big jump -- to be thorough and honest and reflect reality -- it should also have adjusted volatility higher and the default rate higher as well.

The CPDO should have performed worse, not better, when average spread increased. But the investment actually did better when credit risk doubled!

PLAY THE GAME

If you’re getting the impression that ABN Amro cleverly worked the S&P model like deaf, dumb, and blind Tommy would a cheap pinball machine, you’re not the only one.

From Judge Jagot’s summary: “At least one person within S&P considered that ABN Amro, whether intentionally or not, had effectively ‘gamed’ the model.” The bank would have been in a good position to figure out how to game the model, too, because two former employees of S&P were on its payroll.

One way to game a model for a CPDO, as this Federal Reserve working paper by Michael B. Gordy and Sren Willemann shows:

If spreads widen early in the life of the CPDO and then hold steady, the higher carry on future index positions can outweigh the initial loss of NAV [net asset value].

And what scenario for spreads did ABN Amro predict? 40 basis points for the first year, then widening out to 80 basis points in the second year, and holding steady for the next nine years! Sheer coincidence?

DEEPLY FLAWED MODEL

So ABN Amro crammed bad data into the model, exploited weaknesses of the model ... but wait, there’s more. The CPDO models being used at the time, it turns out, were intrinsically flawed anyway. They assigned extremely low probabilities to credit spreads blowing out to the levels seen in late 2007. Now, this isn’t late 2008 we’re talking -- only 2007.

The Fed paper notes:

The spread levels realized in late 2007 are qualitatively comparable to the levels seen in 2002, so ought not to have been taken as extreme events.

(By the way, I haven’t even really explored the question of whether any investment using 15 times leverage, and thus susceptible to the smallest of price movements, should ever be rated AAA. Also the CPDO used a “doubling down” gambler’s strategy: whenever credit spreads moved the wrong way, leverage was increased, to a maximum of 15 times. Interestingly, the CPDO began its life at 15 times leverage, underscoring the absurdity of this strategy. How could it double down when it’s already at its limit? This is like Dumb and Dumber go to the casino with $1,000 in pocket, intending to use the “double down” approach, then put the whole thousand on the very first bet.)

THE HOUSE OF CARDS

What ABN Amro did -- and what S&P contributed to -- seems pretty much like fraud to me. But here’s the thing: at the heart of most (if not all) securitizations, I bet you’ll find similar kinds of “fraud” -- negligent and poor modeling, wrong or unrealistic data inputs, massaging of data to barely achieve desired ratings. It may not occur to this degree, but it’ll be there.

That’s because, as I’ve said before in looking at CLOs, the complexity of securitization disguises a simple truth: amid all the fee extraction and other costs, there simply isn’t enough yield available in the underlying assets -- whether they’re loans, or mortgages, or credit default swap contracts -- to justify all the high ratings, after all the slicing and dicing. This is the mathematical fraud at the heart of securitizations (liquidity and diversification arguments notwithstanding).

Someday I think someone from the world of academic finance will take a deep look at this issue, and expose securitization’s house of cards. That person could do worse than starting with such egregious instruments as these Australian CPDOs and their clearly flagrant abuses of models and ratings.

Australian Judge Sees the Light, Rules Against S&P

Felix Salmon has a good post saluting Jayne Jagot. The Australian judge (color me amazed) actually took the time to understand what was going on with CPDO securitizations that Standard & Poor's rated AAA and that later tanked. Once she did, she was a bit horrified, one gathers. She ruled that S&P must pay damages to the suckers investors that believed its ratings were professionally derived in good faith.

Here's the "why it matters":

The coverage of the decision (Quartz, FT, WSJ, Bloomberg, Reuters) concentrates, as it should, on the hugely important precedent being set here: that a ratings agency — in this case, S&P — is being found liable for losses that an investor suffered after trusting that agency.

Jagot found that S&P wasn't even "reasonably competent" (actually, the insinuation is they were grossly incompetent). Her decision spans a numbing 635,000 words (context: an average longish novel runs about 100,000).

The upshot: S&P never bothered to develop its own models or assumptions; it just lazily accepted what it was fed by its "boss" (ABN Amro, which paid for the ratings).

One of my favorite parts of the post was actually post-post, in the comment section:

Very good article. The question that you don’t ask is: why is an Australian judge the first to do this research, and what have the SEC and FSA been doing for the last five years?

Indeed.

The Smartest Paper Ever From a Regulator

In case you missed it, Andrew Haldane's "The Dog and the Frisbee," the paper he recently presented at Jackson Hole, was brilliant.

According to the understated prose of the Bank of England, the paper by the Bank of England's head of financial stability "explores why the type of complex financial regulation developed over recent decades may be sub-optimal for crisis control."

In other words, fighting complexity with complexity is a prescription for failure. The financial system has evolved into mind-numbing complexity, partly in attempts to creatively evade letter-of-the-law regulatory regimes.

Regulators will always be outgunned, if they choose to do battle on this field. The banks have the intellectual firepower, the sheer manpower, the profit incentives -- basically, everything in their favor -- to keep running circles around hapless regulatory officials.

So Haldane (my bold):

...calls for a fresh approach to financial supervision, one which is less rules-focused and more judgment-based. He notes that this approach: “...will underpin the Bank of England’s new supervisory model when it assumes prudential regulatory responsibilities next year.” To be effective, he says that will require more experienced regulators working to a smaller, less detailed rulebook. He adds that greater simplicity and consistency in disclosure practices could also strengthen market discipline.

As I wrote on this blog three years ago (arguing for a new philosophy of regulation based more on principles than on a myriad of rules purporting to cover every relevant situation):

One problem right now is that we lay out rules, in staggering detail, and anything not prohibited is generally assumed to be legal. That invites the creation of a loophole-seeking culture in the financial system.

I don't think the U.S. has any visionaries of Haldane caliber in the upper ranks of its regulatory bodies. Maybe the best we can hope for is that if England develops a regulatory system that's smarter, better -- and simpler -- we might have someone bright enough in our country to realize that, and copy the best parts of it.

P.S. For evidence of the complexity rampant in the financial system, that exists only to arbitrage regulations, check out SunTrust’s postpaid bifurcated collateralized variable share forward on its stake in Coca-Cola in this wonderfully titled Dealbreaker piece, "Spoilsport Regulators Ruin Another Derivative That Was Too Beautiful to Live."

Rhetoric of the Ridiculous

Did you happen to see this recent dramatic quote:

We are in a POW camp, trying to survive.

That's Christopher Donahue, chief executive officer of Federated Investors Inc., whose firm has most of its assets in money market funds.

So who has taken Donahue prisoner? The Afghans? Syrians? Iraqis? How did he smuggle out this message, past his captors? Who else is trapped in the camp? How long have they been held against their will? Why doesn't the U.S. --

Oh right. He's just straining for a metaphor.

Well, at least it's a richly deserved metaphor, yeah?

Judge for yourself.

Here's the context: SEC chairman Mary Schapiro believes that, in an effort to rein in the systemic risks of shadow banking, money market funds should declare a floating NAV (net asset value). That would replace the current fake $1 a share NAV that leads a dumb schmuck investor to believe the funds are invested in fairy tale assets that can never go down in price. Alternatively, the money market funds could hold higher levels of capital or put limits on withdrawals, to better protect themselves.

Remember something: this is an industry that could have undergone a catastrophic meltdown during the financial crisis. The Boston Fed recently reported that 21 money market funds had to be bailed out by their parents. Rules for money market funds need to be reformed. These funds are critical players in the unregulated shadow banking system.

And Mr. Donahue's response is to suggest ... we do nothing, while he spouts war rhetoric of the aggrieved and besieged.

Of course he's still not the winner in over-the-top, completely ridiculous rhetoric from the financial industry. That honor, as CBS recently reminded us, is still held by Blackstone chairman and co-founder Steve Schwarzman, who two years ago said, also choosing battleground imagery:

It's war. It's like when Hitler invaded Poland in 1939.

Schwarzman, if you recall, was talking about President Obama's suggestion to close the carried interest loophole that enables private equity bigwigs to pay a tax rate of only 15 percent on millions of dollars of income.

CBS breaks down what that's all about:

Fund managers earn a management fee, typically 2 percent of assets under management, and a share of the profits, typically 20 percent ... In some cases, Bain charged 2 and 30. The 2 and 20 structure makes for a nice tax deal: While the 2 percent management fee is taxed as ordinary income, the 20 is treated as a long-term capital gain, which is taxed at 15 percent. In private equity lingo, the income from profits is called "carried interest." Many people, including Warren Buffett, have criticized the tax treatment of carried interest, arguing that it's simply compensation, and ought to be taxed as such.

Indeed, it's a distortionary tax break that encourages excessive takeover activity.

And by the way, that 15 percent is the same marginal tax rate that someone with $9,000 of taxable income is paying ... and Mr. Schwarzman is worth oh, let's say, $5.5 billion (according to Forbes).

It's amazing how out of touch some people are.

JPMorgan and the House of Spin

Wow, talk about ironic biteback.

JPMorgan, with golden boy Jamie Dimon at the helm, has apparently lost $2 billion on bad credit derivative bets.

What's most revealing is how Dimon is furiously spinning the activities of the unit that screwed up. They were doing nothing more than hedging. Not proprietary trading, but hedging. Nothing to see here, just a few hedges that went bad, cough cough, move along people.

H-E-D-G-I-N-G.

(Insert eyeroll.)

So Dimon shows us how the banks have recast prop trading. Meanwhile, that silence you hear is the sharp knives going quiet in the next room, as those regulators and others busily gutting the carcass of the Volcker Rule pause in their labors, wondering what happens now.

Should be interesting.

Must Read of the Week

Great lineup of papers from the Russell Sage Foundation and Century Foundation conference on the financial crisis on Friday.

Behavioral finance, efficient market theory revisited ... your inner finance wonk will rejoice. (The only one so far that I've found head-wagging is "Shadow Finance" and its theory of "cream skimming," which seems way out in left field -- more on that later, I hope.)

The "talker" of the set is this paper that, fundamentally, questions the intrinsic value of financial innovation by showing that, over the last century and a half, the industry has become more inefficient at its core role of intermediation, not less. Yes, there are numbers and charts.

In brief:

The finance industry that sustained the expansion of railroads, steel and chemical industries, and the electricity and automobile revolutions was more efficient than the current finance industry.

The conclusion:

In the absence of evidence that increased trading led to either better prices or better risk sharing, we would have to conclude that the finance industry's share of GDP is about 2 percentage points higher than it needs to be and this would represent an annual misallocation of resources of about $280 billions for the U.S. alone.

Ben Bernanke's Great Delusion?

Ben Bernanke made a speech Friday in which he made a couple of curious comments about the financial crisis.

First (my bold):

The multiple instances of run-like behavior during the crisis, together with the associated sharp increases in liquidity premiums and dysfunction in many markets, motivated much of the Federal Reserve's policy response. Bagehot advised central banks--the only institutions that have the power to increase the aggregate liquidity in the system--to respond to panics by lending freely against sound collateral.

And then:

The Federal Reserve's responses to the failure or near failure of a number of systemically critical firms reflected the best of bad options, given the absence of a legal framework for winding down such firms in an orderly way in the midst of a crisis--a framework that we now have. However, those actions were, again, consistent with the Bagehot approach of lending against collateral to illiquid but solvent firms.

Really?

Was the Fed really lending against sound collateral, or was it more the fact that, whatever it chose to lend against became, ipso facto, "sound collateral."

And were these really "illiquid but solvent firms" or "illiquid and insolvent firms" that the Fed, through a bevy of support programs, succeeded in reviving?

I can't tell if Bernanke really believes what he's saying or, deep inside, realizes it's a necessary intellectual cover for a spate of unprecedented Fed activism.