Saturday, March 27, 2010

Were There Widespread Fire Sales of Assets During the Financial Crisis?

Last week I argued that Gary Gorton failed to prove there were fire sales of assets during the financial crisis. Of course he chose a bad indicator, and so set himself up for a formidable challenge, sort of like trying to hit a home run with a plastic whiffle bat. He looked at spreads of investment-grade corporate bonds -- specifically, at periods during the crisis when, inexplicably, investors demanded higher yields for AAA corporates than for AA. But, alas, the inexplicable proved all too explicable on closer examination.

Still, that's a narrow example. What about those big U.S. banks that refused to sell securities, citing "fire sale" prices they were being offered. Was that accurate at least?

This is worthwhile to ponder because the Treasury and the Fed completely bought into the "fire sale" story. They fashioned a response to the crisis appropriate to a situation where the biggest problem was not bad assets, but investors with bad (irrational) thoughts about assets that were good ... or at least not all that bad. Remember these words from the Treasury rollout of PPIP?
The ... need by investors and banks to reduce risk triggered a wide-scale deleveraging in these markets and led to fire sales. As prices declined, many traditional investors exited these markets, causing declines in market liquidity.
For starters, it's worth disentangling some self-interest here. The banks had a huge vested interest in having us believe the "fire sale" thesis. Because, if we did, that meant: (1) They could justifiably refuse to sell the assets at the "fire sale" price and not confront the fact that they might be insolvent. (2) They not only could keep the asset on their books, but also they could justify fudging the price -- after all, if a market isn't rational, shouldn't you inject your own rationality? (3) If the problem lay not in the asset, but in the broader market, they could slough off blame for having made a bad investment. (5) Not only could they shed blame, but they also could make a play for sympathy: "vultures" who prey on the distressed by seeking "fire sale" prices aren't very sympathetic figures. (6) They could wait for a bailout that they could already see coming on the horizon.

So the "fire sales" thesis was a very, very powerful one, in many ways, for the big banks.

But again: to what degree was it true?

I thought about this for a while and came up with a back-to-basics approach to understanding where the truth lies. It starts with a typical "fire sale" example from real life.

Joe, in Detroit let's say, just lost his job Friday. It's Saturday. He needs to make rent Monday. He's on the front lawn next to a large hand-lettered sign that says, "Yard Sale." All around him: the armoire, his old Spider-Man comics, a few boxes of hand tools, and other odds and ends marked really cheap. Consider the armoire alone. Say its "true" price, secondhand, should be $100, but Joe's selling it for $20.

80% off! A real "fire sale" price.

But what is meant by its "true" secondhand price? "True" in this context is a slippery word. So let's define further -- okay, a bit arbitrarily, but some benchmark of value must be established. Let's stipulate the "true" price represents what a used-furniture dealer in the middle of Detroit would typically get for the item within a one-month time frame, were it offered for sale in his showroom.

This example allows three important factors to be isolated, in determining whether something is being subject to a "fire sale" price:

1. Time urgency -- The quicker something needs to be sold, the more "fire sale" pressure on the price, all else being equal. If Joe had more than two days to sell the armoire (the furniture dealer typically counts on a month), chances are good he could get a better price.

2. Breadth of universe of buyers -- Joe is counting on finding a buyer among the people who happen to drive by his house, and who at the same time happen to be looking for an armoire. The furniture store, on the other hand, has more relevant buyers by virtue of the fact that there's a regular flow of clients that cross the threshold expressly looking for pieces such as what Joe is selling.

3. The "money like" nature of the asset -- The less "money like" the asset, the more likely it will be subject to "fire sale" pricing pressure. Joe's armoire is very "un-money like." But if Joe was selling a $100 savings bond coming due in six months (and, to keep the example simple, we assume a zero interest and inflation environment over that time), he should receive close to $100 for it.

Now consider a residential mortgage-backed security in the fall of 2008. A big U.S. bank holding the asset says it's worth 90 cents on the dollar. A buyer says it's worth 40 cents. So is that a "fire sale" price? How does the above criteria apply here?

1. Time urgency: Does the asset need to be sold immediately? Small hedge funds and thinly capitalized speculators did have to dump assets at stress points during the crisis, trying to meet margin requirements or cover large withdrawals. But the big banks didn't appear to be in dire straits. They freely turned away buyers. So there really wasn't time urgency that the buyer could leverage for advantage.

2. Breadth of universe of buyers: Markets these days are increasingly global. U.S. subprime dreck, after all, found a home in insurance company portfolios in Taiwan. Likewise, if there really was a liquidity crunch in the U.S., the big bank's assets could have been offered up around the world. The Chinese have huge dollar reserves. Well before 2008, they complained publicly about having to hold so many Treasuries. If the "fire sale" assets were really woefully underpriced by investors in the U.S. and a surefire bet to offer reasonable returns at 90 cents on the dollar, China's state investment vehicle could have snatched them up.

3. The "money like" nature of the asset: The RMBS is a bond backed by streams of payments from mortgage holders. So it's fairly "money like." Granted, you do need to crank through calculations of expected defaults etc. But that all translates into a degree or risk, for which you demand a premium. At the end of the day, you still get compensated with money.

So what happened? How can you get so fast from 90 cents on the dollar to 40 cents without a fire sale? There must be some irrationality wrapped up in that low price, right?

Maybe not much. Consider that a buyer of the asset will demand some discounts, for sensible (not "fire sale") reasons:

1. The underlying assets, as home prices plunged, were starting to rot out, even if homeowners were at that moment current in their payments. Negative equity loomed.

2. The assets were further suspect because it was becoming obvious that the ratings agencies had improperly bestowed AAA ratings on many of them when they shouldn't even have been rated investment grade.

3. The buyer would have to do a certain amount of due diligence on a complex asset to become comfortable with the risk contained in the thousands of underlying home mortgages, and would naturally need to be compensated for this information gathering.

4. The broader RMBS asset class was tainted and so the asset was no longer as valuable for use in the huge repo market (just as, in the repo market, a bond that becomes "special" becomes more valuable in a quantifiable way, so the reverse is true -- when it becomes "stinky special" it's worth less for repo transactions and so a bond that's heavily repo'ed -- as AAA securities were -- should drop in price).

5. The very complexity of the asset, and its reputational damage, would impair the ability of the buyer to resell it, so the perceived illiquidity would impair value.

6. The complicated nature of the asset created possible minefields for the buyer, minefields that would most likely start blowing up if the asset were to deteriorate further, so taking on the risk related to complexity demanded some discounting.

7. There was significant systemic risk in the world at large, and this led to risk profiles being adjusted upwards for even apparently safe tranches of dicey securities.

So of the 50 percentage point gap, what can be attributed to "fire sale" pressure? Of course it's impossible to say without a concrete example. But I think if you went through these assets for the big banks, one by one, the "fire sale" factor would generally account for a small to very small part of the discount.

If you want another take on this issue -- basically agreeing with me, but using a capital asset pricing model where equity and credit markets are compared (and using a lot of formulas) -- check out The Pricing of Investment Grade Credit Risk during the Financial Crisis. Its conclusion:
Many analysts appear to be looking at large recent price changes and concluding that we must be witnessing distressed pricing and widespread market failure. This conclusion is based on intuition that fails to appreciate the extreme nonlinearity in the risks of credit securities, especially those manufactured by securitization (i.e. CDO tranches). Our analysis suggests that the dramatic recent widening of credit spreads is highly consistent with the decline in the equity market, the increase in its volatility, and an improved investor appreciation of the risks embedded in these securities. From this perspective, policies that attempt to prevent a widespread mark-down in the value of credit-sensitive assets are likely to only delay -- and perhaps even worsen -- the day of reckoning.
Now, after having expressed all this skepticism, I'm going to do a bit of a pivot here and move in the other direction: I do think that "fire sale" risk is a growing danger going forward.

If the first of the three stress points for "fire sales" is time urgency, that means when everyone beelines for the exits simultaneously, you're in deep trouble. Now the way the modern financial system has been evolving -- quants who seem to be copying each other's homework and modeling the same assumptions, super-computers that trade at blistering speeds, a global system where money flows easily across borders, interconnected networks of growing complexity -- it's becoming easier to imagine a situation where everyone does try to cash out all at once, and that causes the system to lock up. And a systemic regulator should be looking hard at this issue.

But in late 2008 and early 2009, I don't think the "fire sales" thesis explains the huge pricing gaps for securitized assets such as RMBS the big banks were trying to sell, especially considering the Fed's activist role during this period. Rather, this was simply a clever decoy that the banks used to redirect attention away from the truth. It's what they want you to believe happened because it lets them off the hook ... and helps create the rationale for the Great Hidden Bailout of 2009 that we'll all be paying for, in ways large and small, for years to come.

Saturday, March 20, 2010

Debunking Gary Gorton's "Fire Sale" Thesis

A few weeks ago I looked at Gary Gorton's Somewhat Flawed Take on Shadow Banking. One big problem I had with his paper (which now has been enshrined as part of the public record at the Financial Crisis and Inquiry Commission) is his analysis of a very curious phenomenon during the first half-year of the worst part of the crisis. Namely, at several points, AAA rated corporate bonds paid bigger yields than AA rated. This is a real "upside down topsy turvy" kind of thing. Bonds that achieve a triple AAA rating -- the highest possible -- are supposed to be really safe, almost U.S. Treasury safe. AA, the next ranking down, denotes a bit more risk. And a bit more risk means that investors demand a higher yield.

But over two periods -- one in the fall of 2008 and the other early in 2009 -- investors were getting a dramatically lower yield (well, dramatic in the bond world) for AA than AAA. That's Alice in Wonderland stuff, it seems.

Gorton explains the market weirdness on page 13 of his paper to the commission. (First, here's background you need: just before the excerpt below, he was discussing the sudden withdrawals of funds from the shadow banking system, withdrawals that took the form of repo haircuts on structured debt -- if you're lost by that last sentence, see my earlier post on Gorton's paper, linked above):
Faced with the task of raising money to meet the withdrawals, firms had to sell assets. They were no investors willing to make sufficiently large new investments, on the order of $2 trillion. In order to minimize losses firms chose to sell bonds that they thought would not drop in price a great deal, bonds that were not securitized bonds, and bonds that were highly rated. For example, they sold Aaa‐rated corporate bonds.

These kinds of forced sales are called “fire sales” – sales that must be made to raise money, even if the sale causes to price to fall because so much is offered for sale, and the seller has no choice but to take the low price. The low price reflects to distressed, forced, sale, not the underlying fundamentals. There is evidence of this. Here is one example. Normally, Aaa‐rated corporate bonds would trade at higher prices (lower spreads) than, say, Aa‐rated bonds. In other words, these bonds would fetch the most money when sold. However, when all firms reason this way, it doesn’t turn out so nicely.

The figure below shows the spread between Aa‐rated corporate bonds and Aaa‐rated corporate bonds, both with five year maturities. This spread should always be positive, unless so many Aaa‐rated corporate bonds are sold that the spread must rise to attract buyers. That is exactly what happened!!
When I read this, his "fire sales" thesis didn't smell right. Before we see how it falls apart -- I chose to look at a puzzling period in March 2009 when it appears that the worst outbreak of "fire sales" occurred, according to his own graphic -- let's make a couple of stops.

Why does this matter anyway? This "fire sale" section is buried on page 14 of his presentation.

Because -- and this is very important -- there are two dominant views of this financial crisis. They are so critical to shaping perception, they are practically worldviews. Depending on which you hold, you're likely to propose a different set of policies to revive the financial system. They are:

At the heart of this crisis was a liquidity crunch. The banks peddled this line furiously. Credit markets seized up and poor bankers were innocent bystanders, stuck with valuable assets they could only sell at ... here it comes ... fire-sale prices. The market was valuing their assets, worth 90 cents on the dollar, at 40 or 50 cents! If you believe this: you probably thought that Geithner's PPIP proposal made sense and was going to work, and that the big banks just needed a little breathing room and an infusion of liquidity (which the Fed happily provided in spades) and they'd get back on their feet and start lending normally again.

At the heart of this crisis were plain ol' crappy, overvalued assets. Their values had become inflated by a combination of loose money spurred by too-low Fed interest rates, rating-agency complicity, opaque markets (RMBS, CMBS), and maybe a dash of housing-bubble mania. If you believe this: you probably thought that tougher measures needed to be taken with the big banks, that these crappy assets had to be honestly accounted for and cleared at market prices, and that large swaths of the banking system were insolvent.

Notice most smart observers would assign some truth to both; they are not mutually exclusive concepts. However, people tend to align themselves with either the first or second idea. I am in the second camp, firmly, and Gorton seems to be more in the first.

Okay then: why doesn't Gorton's explanation smell right in the first place?

This is sort of interesting. Let's go meta-finance for a moment.

There are many classes of assets. And there is money, the ultimate liquid asset, extremely flexible and wonderfully fungible. One way of looking at assets is to see how "money like" they are (I'm not precisely talking about liquidity here, so I'm going to stick with "money like"). By "money like" I mean how much "objective value" (as expressed in a unit of money, say dollars) the asset contains. So if we all were guaranteed $2 for any loaf of bread (that met certain criteria of course, pertaining to such attributes as dimensions), and the bread could be redeemed at "bread banks" (a groaner, I know), loaves of bread would be very "money like."

Okay, let's take Beanie Babies. Gong! Not very "money like" at all. At the height of the fad, you might receive $50 for a rare stuffed penguin that might not fetch 15 cents a year later. Let's slide quickly down the asset scale. House -- more "money like." Share of stock: even more "money like." A plain-vanilla corporate bond: very "money like."

For what is an ordinary "bullet" corporate bond? A series of interest payments, usually semi-annual, and then a lump sum spit out at the end of its lifespan of maybe 5, 10, 20, or even 30 years. And these payments are all made in ... money. Bonds don't pay you in Toblerones, iPads, or dental floss. It's all money, money, money.

Now what's a simple way to think about a bond's coupon? Say IBM's 5-year plain-vanilla bond pays 4 percent interest and is rated AA. Part of that coupon -- let's say 2.5 percent -- reflects interest rate and inflation risk over the five-year life of the bond. The remainder -- and this is where it gets interesting -- is for credit risk. Since IBM is perceived as really safe, it pays out 1.5 percent interest for credit risk. If it were Johnson & Johnson, let's say, and rated AAA, and perceived as really, really safe, it might pay only 1.3 percent.

Now which of these bonds would you, Joe Investor, buy? You might think the IBM at 4 percent instead of the Johnson & Johnson at 3.8 percent. The IBM pays more, right? But that company also stands a higher chance of defaulting on its debt. There's no free lunch. You take more risk; you get more money.

But what if the Johnson & Johnson, with its AAA rating, paid 4 percent, and IBM, a whole grade lower, paid only 3.8 percent. That's a no brainer. Bonds are very "money like," remember? You don't "like" a bond more because it's prettier, has a dormer window on the third floor, or would look good on a pendant. You like it for its money-ness. So you'd snap up Johnson & Johnson at 4 percent and marvel at your wonderful luck.

Which brings us to our main subject ...

Why did yields on AAA corporates balloon out over AAs if that doesn't make any sense? Was it indeed a "fire sale" as Gorton claims, a mass rush to the exits, with perfectly good AAAs being chucked overboard at whatever price the market would offer?

I did some research. I did so knowing that Gorton's thesis would stand under three conditions: (1) the AAA corporates were "true" AAAs and not lower grades masquerading as AAAs (2) the universe of AAAs was reasonably diverse in nature (as in, not skewed to one particular industry) (3) there was a reasonably large number of AAA corporates trading (as in, you might have a diverse selection of bonds, but if there are only six of them, that's too few and the volatility of small numbers could explain the strange inversion between AAA and AA yields.)

I could have looked at the period in late 2008, but instead I chose an even more dramatic one, where an even larger inversion occurred (even more "fire sales"!). If you look at Gorton's graphic on page 14, you'll see the icicle-shaped spike in early March of 2009. Briefly, AAA corporate bonds paid more than 2 percentage points more than AAs! That's a huge spread. Gorton would have us think that investors were just dumping truckloads of perfectly good AAAs and the market, facing a glut of the bonds, irrationally pushed their prices way down (and their yields up).

So I looked behind the curtain, using a handy Bloomberg machine. And what I found was nothing like what he suggested was going on.

First, using Merrill Lynch indexes, I saw evidence of the inversion easily enough. The components of Merrill Lynch's AAA index may not exactly match what Gorton looked at, but the curves seem pretty close, so I think we're on fairly solid ground (as you'll soon see, there aren't a lot of AAAs in the first place, so I'm confident there's large overlap in both our data sets; I may graph my numbers later and drop in that visual here). Also I focused on AAAs because that's where the real story is: while AA yields did creep higher during that period, the AAAs zoomed past them and were mainly responsible for creating the gap.

And what a gap it became: AAA pulled ahead of AA by 11 basis points on March 2. That spread widened out to 191 on March 4, hit a high on March 5 of 195, then subsided to 135 on March 10 and fell to 74 on March 13. (Note: there are 100 basis points in 1 percent, so 195 basis points is 1.95% -- which may not seem like much, but in bondland, between investment-rating grades, it's huge.)

Then the meat of the investigation began. Who was in the AAA corporate index at that time? A diverse, large number of companies?

Nope. Not by a long shot. Not many companies win a AAA rating, understandably, only the best of the best. I went through a half-dozen screens of the bonds in the Merrill Lynch index as of March 6, 2009 (the screens show a company name, and the specific bond that belongs to the index). And guess what? To call it an index at that time was pretty much a misnomer. It was General Electric.

General Electric bonds (or those of its financing arms) accounted for 71.5 percent of the index weighting. Berkshire came in second at 8.9 percent. That leaves less than one-fifth for everyone else (and there weren't a lot of others, though it hardly mattered because they made up so little of the overall weighting anyway).

(Note: a careful reader of Gorton will see that he looks at only 5-year bonds. Even so, it turns out that when I filtered for that criterion, it mattered little: GE's weighting drops a little, but only to 68 percent, and Berkshire's rises a little, and everyone else is about 20 percent again.)

So the story of AAAs in March 2009 is not really a market story about AAAs ... it's a story about GE. Still, to be fair to Gorton -- it could be that investors were irrationally chucking their solid GE bonds, desperating trying to raise cash, even though GE was a top-tier company. So what was the GE story right about March 5, 2009? A great AAA corporation with the wind at its back, sailing toward a sparkling future? Let's concede that the early part of that year was turbulent, and markets were down, so one might expect a ding or two in the giant's armor.

It turns out GE's armor was more than lightly dinged:
1. Its stock had plunged 61 percent from Jan. 1 to the end of the day March 5, almost three times the drop of the S&P 500.
2. Its credit default swaps were trading sky-high, meaning investors saw GE as a poor credit risk. The swaps were 1,037 basis points on March 5, compared with JPMorgan's 219 -- and JPMorgan was rated only AA! So let's mull that: JPMorgan at the time was considered almost five times safer than GE, even though GE was a higher-rated company.

And, if you're still not convinced, a March 5 Bloomberg story quotes Marilyn Cohen of Envision Capital Management on GE: "It's a leper right now."

A AAA rated leper? Sounds like an oxymoron. What were investors so bent out of shape about? Bloomberg's article says:
Investors are punishing the shares on a presumption, which the company disputes, that GE Capital will need more outside funding to cover potential writedowns and losses in real estate, consumer credit cards and leasing.
There was a fear that GE's finance arm would need to post $12 billion in collateral if its long-term ratings were cut to single A. Whence this downgrade fear? Well, Moody's said on Jan. 27, just a month earlier, that it was looking at lowering GE's rating. And in fact, if you look at the same AAA Merrill Lynch index on April 15, 2009 -- about a month later -- neither GE nor Berkshire are there; they've dropped off.

So did AAA corporates irrationally leap above AAs during this tumultuous period in March, when the greatest spread inversion of the financial crisis occurred? Absolutely not.

There were no "fire sales," as Gorton would have us believe. This wasn't a story about investors in hard times selling grandma's fine china at big discounts so they could afford a little soup for dinner. This is a story of ratings lagging behind reality, legitimate investor concerns, and GE's peculiar circumstances. So next time you hear the "fire sale" argument advanced, approach with full skepticism.

Saturday, March 13, 2010

What Does Repo 105 Tell Us About This Crisis?

Now that a couple of news cycles have washed over us since the revelation of the Lehman Brothers accounting scheme known as "Repo 105" (cute street drug name that suggests quick-hit crack for financiers), I thought it was worth trying to distill the takeaways from this news.

First, if you need to get up to speed: Lehman was very heavily massaging its books so as to hide its high leverage from shareholders and other outsiders (such as the credit-rating agencies). It was using "repo" transactions to shift large sums off the balance sheet temporarily at quarter's end. The program was known as "Repo 105" because Lehman would get $1 for each $1.05 of securities that it temporarily parked with any of seven counterparties (Mizuho, Barclays, UBS, Deutsche, etc.).

If you want more on Repo 105:
The original (gasp!) 2,200+ page report by examiner Anton Valukas
Here's Zero Hedge as one of the first to weigh in
Karl Denninger waxes indignant (and justifiably so)
My favorite Repo 105 blog headline

Okay, so what does the unfolding Repo 105 scandal tell us about this financial crisis?

1. That shadow banking is a big issue that must be addressed.

Most Americans know of the word "repo" only as it pertains to some guy who shows up to take your car after you miss half a dozen payments. But a different "repo" lies at the heart of the shadow banking system. It's short for a "repurchase agreement," originally designed for rock-solid government securities "sold" to investors, usually overnight to be bought back the next day, in this way generating short-term financing for the seller. The repo market gradually broadened out to other seemingly rock-solid products rated triple AAA, such as what turned out to be dodgy securitizations. The repo market is opaque and unstable ... and HUGE ... and needs to be much better regulated on these grounds alone. But now we find out that it can be used for playing accounting games too.

2. That regulators were really, really asleep at the switch. Catatonic perhaps.

It just keeps getting worse and worse. I thought the serial bungling at the SEC on the Madoff case was mind-boggling, but Denninger quotes a section of the Valukas report that will make your jaw drop and hit the kitchen table with an audible thud. Get this: the SEC and Federal Reserve Bank of New York began onsite daily monitoring of Lehman in March 2008. Worried whether the firm could survive a bank run, the New York Fed devised two stress tests. And Lehman failed both. Then the New York Fed came up with a third test. And Lehman failed that too. So you'd expect the Fed to lower the boom, right? Demand Lehman raise capital or at least ... do something for chrissakes. No, instead Lehman is allowed to create its own test that the firm ... passes. Is there any planet on which this makes any sense at all? Head of NY Fed at the time: one Timothy Geithner. And oh yeah, so much for confidence in those "stress tests" the banks underwent last year.

3. That, faced with a banking culture of gold-medalist loophole divers, we must adopt much more principle-based accounting.

How can you "sell" securities with an agreement to "buy" them back a week later, solely to skirt a true accounting of your assets and liabilities, and this isn't considered fraud? The answer: because you found a nifty loophole (Lehman's had to go to England to get it) that ratifies the highly dubious transaction as a "true sale" and it sounds like this:
If two parties intend to exchange assets for cash, and then later the party receiving the assets decides to hand back “equivalent assets (such as securities of the same series and nominal value) rather than the very assets that were originally delivered,” that amounts to a sale.
4. That effective financial regulation demands global cooperation.

Lehman couldn't get a U.S. law firm to sign off on Repo 105, so it looked overseas and got the approval and justification from London-based Linklaters. Also Lehman shuffled the Repo 105 sales through its European arm, Lehman Brothers International (Europe). So in an age of easy global money transfers, and of financial companies adept at arbitraging regulatory regimes, we need to find ways to make sure bad behavior doesn't simply hop over a body of water and wreck our financial system from afar.

5. That our biggest failing in the U.S. may be that we have not seen fit to prosecute a single top executive from a major financial institution for their role in helping precipitate the crisis, a year and a half after it erupted, a failure that has badly corroded faith in our government.

Why can't we summon the courage to do the right thing? Sure, many executives just made bad bets -- greedy and stupid though they were. But others, as we clearly see in Lehman's case, purposefully misled the world. Why is this any less serious than Enron? The government's gross failure only gives ammunition to the critics that say that the Wall Street titans have a choke chain on our leaders in Washington.

Sunday, March 7, 2010

Felix Salmon: Your Dyed-in-the-Wool Credit Default Swaps Enthusiast

Every smart guy has to have a blind spot.

Felix Salmon -- whom I usually find myself nodding vigorously in agreement with -- is an ardent credit default swaps supporter. In a recent post, he uses Greece's recent successful bond sale as a way to trot out his favorite hobbyhorse. Why did the 10-year issue go off so well? Wait for it ... credit default swaps! His take:
A liquid CDS market is a great way of enabling countries to access the primary markets even when the secondary markets are full of uncertainty and turmoil.
The commenters below his short post are understandably angry and baffled, as Salmon doesn't quite explain how the CDS market played savior to beleaguered Greece. So I'll take a stab here: (1) Greece was beset by uncertainty and turmoil. (2) There wasn't enough trading in its existing bonds to give potential investors confidence about what the "correct" credit-risk spread should be for the bonds it was selling, thus threatening to push up yields demanded on the debt. (3) Enter the more active, or liquid, CDS market to save the day -- it stood in as a gauge of credit risk. (Geeky bond talk: offered rates on bonds comprise expectations of future interest rates + inflation along with credit risk; a credit-default swap is pure credit risk, and so isolates that piece of the puzzle for investors wondering what rate they should require on hardly-risk-free Greek debt.)

First, to back up the truck for a second: credit default swaps are reaching the point where they are sometimes unfairly demonized. For example, some European leaders had started to beat up on CDS speculators, saying they were driving up the cost for Greece to issue debt.

Ummm ... don't think so.

Check out Citigroup's rebuttal in this paper: You Can't Blame the Mirror for Your Ugly Face. It happens to be an apt metaphor. Sure, it was becoming more expensive to insure Greek debt against default. But that wasn't because of mischievous hedge funds scheming in smoke-filled rooms; it was because Greece was dithering and making mousy squeaking noises about taming its out-of-control budget deficit.

So let's concede the demonizing-is-occurring-sometimes point up front.

But I think Salmon all too often misses the forest for the trees on credit default swaps. He extols them for supplying liquidity, and that has informational value for the larger bond market and contributes to efficiency in pricing. But, at least in my reading of him, he doesn't step back and look at the big picture. Namely, if financial bust-and-boom cycles are inevitable (and yes, they are), then it behooves us to look at what exacerbates and ameliorates them. And there is good evidence, from this last crisis, that a huge CDS market (that's now shrunk to $25 trillion notional from $50 to $60 trillion), changes a garden-variety financial crisis to a financial crisis on steroids.

Think of what happens in a financial crisis: credit tends to freeze or contract, making liquidity scarce. Now think of what happens right at the same time in the CDS market: there's a large hoovering up of liquidity. You have CDS writers scrambling to post collateral or make good on their bets on the debt of failed companies. They need money and tap available cash and sell assets, just when the economy needs more liquidity. Credit swaps are cyclical enhancers, in a bad way.

And there's more: default swaps are highly leveraged and become highly volatile in times of economic distress. So a CDS on Bank of America trades at 80 basis points, nice and steady, for four or five years, then boom -- all of a sudden Bank of America takes a huge writedown and the swap is zooming back and forth between 600 and 900 basis points. Multiply this by a handful of companies -- you can be assured in a downturn that others will be revealed to be on thin ice -- and now you've got large amounts of money sloshing back and forth, even before a default has been declared, as swap writers try to meet collateral obligations.

All this volatility is not what the distressed financial system needs at this time, but that's what swaps contribute. As they add to systemic volatility, they can feedback-loop in an unpleasant way -- the posters of collateral, if they are not well hedged, can begin adding strains of their own in unexpected places.

And then, because our modern financial system is so interconnected, at some point the very interlaced network of swap sellers and buyers will expose a weak point. AIG was a big weak point last time -- and it was engaged in an undeniably stupid activity. But next time there will be another weak point, probably more subtle. We're not dumb enough, hopefully, to let another AIG write swap protection ad nauseum until the house burns down. But when the markets grow more volatile, and money is shifting back and forth to cover the multi-trillion-dollar exposures on credit default swaps, you can bet that there will be a weak point again -- it could be a hedge fund, a small one that goes down, that leads to cascading failures and, at some point, another giant bailout.

So all that -- the macro, systemic stuff -- is what I'm surprised Salmon doesn't spend more time thinking about because he's a really smart guy.

The suggestion right now is to put credit default swaps on exchanges for trading, to increase transparency and make exchanges the backstop for failure (and who backstops the exchanges? Three guesses and one hint: it rhymes with "shmaxpayers.") It may be worth trying that. But I think we also should look hard at the alternative: even though credit swaps do some micro-good for the market (pricing efficiency on little-traded bonds) they may do too much macro-bad to be allowed to exist.

Saturday, March 6, 2010

Why Barney Frank Tied His Tongue In Knots Over Fannie and Freddie

Barney Frank got caught in an interesting bit of backpedaling and sidestepping this week on mortgage giants Fannie Mae and Freddie Mac after he suggested that, as the Washington Post worded it, "investors who have lent money to the two firms or bought their mortgage-backed securities could one day suffer losses."

In other words, he tried to make the case that Fannie and Freddie don't enjoy implicit U.S. government support, as investors have been assuming for a long time.

This created predictable consternation. Later Frank executed a cute little spin move and sought to clarify: His position, he said, "does not prevent the Treasury from treating the debt of Fannie and Freddie in the manner that it believes best supports the important goal of stabilizing the financial system." So Congress won't try to interfere with the folks at Treasury as they infuse billions of dollars ($100 billion so far, the Post tells us) into the tottering agencies.

Got that? Here's what he's saying: "No, we don't stand behind Fannie and Freddie, but yes we do stand behind Fannie and Freddie."

What's going on and why would Frank even start down this loser of a path in the first place?

Here's the important background: Fannie and Freddie are frauds. Easy to remember: all three words begin with the letter "f." They're accounting frauds. They're not "government-sponsored entities;" they're off-balance sheet vehicles of the U.S. government.

For decades people have suspected as much ... the difference now is, this financial crisis finally presented us with the irrefutable proof. Fannie and Freddie started to tank, and before you could blink an eye, the U.S. government rushed in to rescue them in early September of 2008. Then came the Christmas Eve surprise a few months ago. The Obama administration sprang a biggie on us while we were trilling fa-la-la-la-la's and getting groggy on the eggnog, pledging unlimited financial assistance to Fannie and Freddie.

Now think about that word. Unlimited. What else does the government support in an unlimited way? Oh, maybe the Defense Department. Medicare. Social Security.

Things that are part of the government.

So what prompted Frank's initial comments was that some on Capitol Hill want Fannie and Freddie's finances to be incorporated into the federal budget. That would be honest accounting. If Aunt Fannie and Uncle Fred are living in your attic, you may tell Tom living next door that you're not responsible for them even though Tom suspects otherwise. Then, once you decide to guarantee them unlimited assistance, that game should be over. You can't pretend any longer. Aunt Fannie and Uncle Fred belong in your household budget somewhere.

The problem: Frank knows that if Fannie and Freddie are on the books, the budget blows up -- the deficit would soar. Then we'd really look like Greece. So Frank tries the conflicted damsel pose. He thrusts out one arm, protesting that Fannie and Freddie bondholders are mistaken to think the U.S. will automatically bail them out (see? the government doesn't support the mortgage companies after all!), then when the investors get nervous, he gives them a sly wink and beckons them a little closer (see? the government does support the mortgage companies after all!).

Well, it's time to stop jerking everyone around. Either Fannie and Freddie are U.S.-backed and they belong on the government's books or they're private entities and caveat investor. It's bad enough that Wall Street plays these off-balance sheet games; the U.S. government shouldn't be given a free pass to do so as well.