Friday, December 30, 2011

Bill Black Takes on the "Fannie and Freddie Did It" Meme

I really enjoyed this piece for its knowledgeable, historical analysis. Black doesn't exactly side with the "It Wasn't Fannie and Freddie" crowd, but he's more unsparing in his criticism of ideologue Peter Wallison, whose position "It Was All Fannie and Freddie" is laughable (and Black shows us even more reasons why).

I'm willing to move up Fannie and Freddie on my list of causes of the crisis to, say, number 6 or 7 from number 11. ;)

Black frames the problem well, I think. What caused problems wasn't Fannie and Freddie's mandate to help the poor -- in other words, all those do-good liberals trying to put welfare Moms in houses they couldn't afford. It was, plain and simple, accounting fraud to lavish bonuses on the top echelon of executives -- the same problem found at investment banks that were more direct causes of the crisis.

Monday, December 26, 2011

Joe Nocera Takes on the Big Lie

I've often thought you could make a case for Fannie Mae's and Freddie Mac's culpability in the financial crisis: a very, very small case.

So, if you started listing reasons for the crisis, they might come in, say, number 11 or thereabouts.

What amazes me is the persistence of the simple-minded Republican narrative that they were the cause of the financial crisis. Not a cause. But the cause. (And the hard-core faithful don't want any other causes entered into the record, as when the four Republicans on the FCIC voted to ban the words "shadow banking" and "deregulation" from the final report!)

This viewpoint is so ignorant and ill-informed, so contrary to "the truth on the ground" that we know from how this crisis developed and what it looked like as it unfolded, that it strains credulity. Is Peter Wallison so ideologically blinkered that he can't even process a set of historical facts in a logical way?

Joe Nocera had a good recent column about this, The Big Lie.

What I enjoyed best though was the second comment that appeared afterward. Excerpts:
I was a mortgage broker during the housing bubble. I can tell you that a "conforming" loan -- one that was run through Fannie or Freddie's "desktop underwriting" software -- always made us nervous. We got rejected for approval regularly whereas if we sold a subprime loan with a higher interest rate we got approved more easily and made much more on the loan ... rather than blame what was in essence a good government program for the housing collapse I say a lot of it deserves to go to the lenders and brokers who hustled these loans.

Once mortgages became securitized and the lenders had no skin in the game the whole system went to hell.
Exactly, and a flaw I noted in the securitization model (and I'm far from the first person to make the observation) almost two years ago.

Earth to Peter Wallison: Are you listening?

Saturday, December 10, 2011

Keep an Eye on That Shadow Banking, Folks

Because it's starting to rear its ugly head again.

Turns out that what may be at the heart of MF Global's gaping hole on its (off) balance sheet: collateral that may have been shifted over to its U.K. unit to permit rehypothecation.

"Rehypothecation" is one of those mouth-filling words that basically says you can repledge the same piece of collateral (a useful trick in the shadow banking world of repo).

In the U.K., the collateral can be endlessly rehypothecated, again and again and again, creating long, unstable, dangerous chains -- and the interesting concomitant, lots of liquidity (which tends to act like a stimulant -- call it cocaine for the financial system -- and we know how hard it is to break a drug habit). Reuter's Christopher Elias:
This churning of collateral means that re-hypothecation transactions have been creating enormous amounts of liquidity, much of which has no real asset backing.
Ladies and gentlemen, this is h-u-g-e. Too few people have wrapped their brains around this. We have central banks that greatly influence money supply/liquidity through their open market operations. Then we have a massive, off-balance sheet system of shadow banking that does the same with no oversight, in complex ways we barely comprehend.

This is a powder keg waiting for a spark.

For more, check out Alphaville's "Shadow Banking and the Seven Collateral Miners."

Wednesday, November 30, 2011

Europe's Bailout Fund -- Seriously, WTF Is This Thing?

I tried to figure out the EFSF again (the European Financial Stability Facility) and, once again, my brain exploded.

I can't figure out if this Rube Goldbergian mother of all securitization schemes is:

(a) a way to secretly print a whole bunch of euros behind door #24 while everyone is distracted by the elephant and monkey show in Exhibition Room C.

(b) a clever new way of shunting tail-risk into a vehicle that, when it fails, will send fireworks high into the night sky as the eurozone spectacularly implodes.

(c) a way of handing out 1,000 gold-plated pigs when there are only 10 gold-plated pigs in the warehouse, vague promises of 990 more gold-plated pigs, and a whole lot of securitization in between.

(d) a full-employment act for structured finance professionals on the continent.

(e) some combination of the above.

Or add your own speculation below. Because, in this Brave New World of Structured Finance, we're obviously beyond the point where an entity (say the IMF) simply extends a loan to some country (or countries) in fiscal straits.

Here's some more commentary on this bewildering high-finance thingamabobby:

More European Financial Chicanery

Monday, November 28, 2011

Fed Funnels Money to Banks on the Sly

Excellent Bloomberg story showing what was largely an open secret (even if the details weren't known), well before the Fed was forced to cough up the paperwork on its bailout of the U.S. financial system:

Secret Fed Loans Gave Banks Undisclosed $13 Billion

This should be required reading for every American.

The hard-hitting article also reinforces the image of Geithner as a complete tool.

The ground left uncovered: that, for this enormous bailout, we the taxpayer got very little. Our financial regulators, our political leaders, failed to effectively reform a banking system that has metastasized out of control.

Sunday, November 20, 2011

New Song Charting on YouTube: "Eat a Banker"

I found this song on YouTube with its timely message for the 99%:

"Eat a Banker"

It has a rather mellow, swaying beat -- not a violent-sounding song at all. I can even imagine it playing softly in the restaurant as some downtrodden poor person is dining on one of those overfed Wall Street bankers. ;)

In Case Anyone Forgets Why "Occupy Wall Street" Exists

1. Our Congress -- ahem, the best Congress money can buy -- decided that pizza is a vegetable. This decision makes absolutely zero sense from a health and nutritional standpoint (I love pizza -- I had three slices yesterday -- but if what I ate qualifies as a vegetable, I'm a living, breathing zucchini). However, it makes perfect sense from a food industry lobbying standpoint.

2. AIG won't help struggling homeowners. From Bloomberg: "American International Group Inc. (AIG) is holding out as rival mortgage insurers accept policy changes that support the U.S. government push to stoke refinancing among borrowers with little or no home equity."

Reminder: Not only did the U.S. bail out AIG, the U.S. is currently the MAJORITY OWNER OF AIG. If the U.S. government is too weak-spined to compel AIG to get on board with refis (which almost everyone agrees need to take place to right the listing housing market), then it's clear who's really running the show.

3. Corporations are increasingly paying a smaller percentage of their profits as income tax. At the same time, childhood poverty has been on the rise. Those trends aren't likely to change anytime soon as corporations are the kind of "people" who can write big campaign checks, but a child in poverty isn't similarly flush with excess funds to fertilize Senator Gasbag's re-election efforts.

Sunday, November 6, 2011

Working on Wall Street Means Never Having to Say You're Sorry

Felix Salmon waxed indignant about Jon Corzine's peculiar resignation statement, and laugh-out-loud lines such as, "This was a difficult decision, but one that I believe is best for the firm and its stakeholders."

This is as absurd as someone driving a bus off a cliff, killing everyone aboard but himself, then holding a press conference during which he says in a conflicted voice, "It is with a heavy heart that I wish to announce that I have decided to part ways with the company."

Felix comments, "... would it be too much to ask for just a tiny hint of remorse here? A short apology, perhaps, to the thousands of employees and customers who have lost their jobs or their money?"

Remorse? How do you spell that again?

Wall Street doesn't DO remorse, Felix. C'mon, man. You're smarter than that. Throughout the financial crisis and its aftermath, the lack of remorse was painfully striking.

Almost two years ago to the day, I commented on this phenomenon. We taxpayers weren't thanked by the big banks that received bailout funds (as I recall, Citigroup was a notable exception that came rather late). No apology for their securitization meltdown either. But Blankfein did see fit to note that they were all doing God's work.

And AIG's Robert Benmosche memorably threw a hissy fit about not being able to pay his executives more than $500,000 a year.

Is there really any mystery any longer why "Occupy Wall Street" exists?

Saturday, October 29, 2011

Saturday Morning Housecleaning

I went back and cleaned up a bunch of comment spam. Comment spam, I'm finding out, grows geometrically once it takes root. For instance, my most-popular post ever:

Debunking Gary Gorton's Fire Sale Thesis

Was completely lousy with comment spam, with more than 50 comments, and all but six just crap. The spam had overrun the comment section like some kind of kudzu-inspired mold life form.

In cleaning up the spam, I found myself in the ironic position of deleting comments that offered high (but phony, non-specific) praise of my intellectual insights, while leaving a few comments that basically suggested I was a blowhard (but that were real).

Vive l'open society.

So anyway, be forewarned if you're hawking UK dissertation papers, low auto insurance quotes, shutters for sale in Clearwater, Florida -- I'm onto you. Go foul someone else's watering hole.

Friday, October 28, 2011

Well, I Got This One Right at Least

Every so often, as a blogger, you look back on previous posts to answer the question, "Was I just being shrill and pessimistic or was I onto something?"

A year ago, I wrote "The Foreclosure Mess: 7 Reasons Why It's Much Worse Than You Think."

And I'd say, though the post wasn't wholly original content, that I got this one right as the MERS mess drags on (random observation: MERS and MESS are practically the same word, as the "r" in MERS is only one letter space -- i.e., p-q-r-s -- away from being MESS. Keep those ironies coming, mortgage industry!)

Tuesday, October 18, 2011

DVA: Accounting Gimmickry That Makes No Sense

Once again, the banks are booking big profits based on DVA -- debt valuation adjustment -- because their creditworthiness has deteriorated. Once again, this accounting gimmickry makes absolutely no sense.

The rationale for booking DVA gains: the debt you have issued becomes cheaper as your credit risk rises, so theoretically you can buy it back at a lower price, saving money.

This is ridiculous because it ignores the fact, as I explain in this post from two and a half years ago, that it costs more to raise the money to buy back the debt.

The gains don't exist. They're completely illusionary.

The DVA accounting convention is a sham. It shouldn't be allowed. Isn't there an accountant out there bright enough to see the inherent absurdity in it?

Tuesday, October 11, 2011

Is Occupy Wall Street the Beginning of the Revolution?

When I returned to my homeland a few years ago, after the financial crisis and a brief period abroad, I was quite dismayed.

It's not that America suddenly had changed. We had been changing for a while. Money had been growing into a monster force in politics. Our Washington politicians were far too quiet on social issues, like poverty and the distribution of wealth, where armies of lobbyists didn't represent entrenched interests.

Our politics were getting uglier in other ways. There was less ability to work together for the common good. It was as if, in an age of drama-seeking reality TV shows, politicians thought they had to vie for airspace by pumping out increasingly ludicrous and confrontational soundbites.

But what angered me the most was how we blew the opportunity to have a soul-searching moment about our financial system and effect real change after the 2008 crisis.

Steve Waldman has a brilliant paragraph over at his interfluidity blog about the unfairness of TARP:
Once you understand that the problem is a fairness issue rather than a dollars-and-cents issue, the policy space grows wider. Holding constant the level of expenditure, one can make bail-outs more or less fair by the degree to which you demand sacrifice from the people you are bailing out. TARP was deeply stupid not because it meant socializing risks and costs created by bankers. TARP was terrible public policy because it socialized risks and costs while demanding almost no sacrifice at all from the people most responsible for those risks. The alternative to TARP was never “let the banks fail, and see how the bankruptcy system deals with it.” The alternative would have been to inject public capital (socialize risks and costs!) while also haircutting creditors, writing-off equityholders, firing management, and aggressively investigating past behavior. It was not the money that made TARP unpopular. It was the unfairness. And the unfairness was not at all necessary to resolve the financial problem.
Make no mistake: Something like TARP was necessary after credit markets seized up. Letting giant, highly interconnected banks collapse right and left was not an option. But, out of the ashes of the crisis, who was the leader of power and conviction who emerged and swore, Never again!, and who acted boldly and with courage to reform a financial sector that had metastasized out of control?


Everyone pretended what we had gone through was just a bad dream. What we got instead was watered-down legislation that the banks are already skillfully plotting how to evade.

I would say to friends at work, "It's amazing to me that there isn't someone agitating for a revolution. This is awful, with so many people unemployed, and the rich getting richer, and Wall Street's most powerful getting bailed out without punishment or consequence -- why isn't there a populist uprising?"

Finally, along came Occupy Wall Street. The movement has spread. Winter will probably kill the mass protests, or at least put them on hiatus until spring.

But at least the disenfranchised and angry are speaking, maybe not with enough coherence for the media, who are fussing over their nut graphs and story structure, but their frustration is 100 percent genuine and runs wide and deep.

They're speaking, and I find that quite heartening.

Sunday, September 11, 2011

Unemployment vs. Inflation: Why Do We Worry Too Much About One, Not Enough About the Other?

Something that's been kicking around my brain for a few months now:

Why do we get so bent out of shape about the threat of inflation? And why don't we get more bent out of shape about the reality of high unemployment?

I find this really, really puzzling. Inflation, it seems to me, is a bookkeeping problem. Unemployment (beyond the minimal frictional level) is a tragedy.

Thought experiment: Prices of all goods and services inflate exactly 10 percent a year, again and again, steady as clockwork. Manufacturers adjust by raising their prices 10 percent annually. Labor demands 10 percent higher wages. Savers and investors build this 10 percent inflation into their "risk-free return" expectations. Social Security checks increase 10 percent a year.

So who gets hurt? Nobody. Psychologically, you may feel dismayed that last year's $2 loaf of bread now costs $2.20, but your wages of $55,000 are $5,000 higher too.

Now try to create a similar thought experiment for 10 percent unemployment. Millions of workers in the labor force are idle. They're frustrated, angry. For every minute they lack jobs, we as a country lose part of our productive capacity. Their power to consume is weakened. They siphon resources through the social safety net, through food stamp and Medicare programs.

This is unquestionably terrible: for our economy, for our country's self-image, for social and political stability. You can't spin high unemployment in a neutral light. It's impossible.

Now, granted, I know inflation can be harmful. Runaway inflation (Zimbabwe) does have real costs. Also high inflation can inject uncertainty into economic forecasting and planning. And it often does produce classes of winners and losers.

But still: it's not net destructive, not like high unemployment. After all (from an illustrated encyclopedia of economics),
Ignoring menu and distortion costs for a moment, inflation is roughly what mathematicians call a zero sum game. For every loser during inflation (someone who must pay more for a given good), there is a winner (someone who receives a greater price for the things sold).
I dare you to find a respectable economist who maintains that high unemployment is a "zero sum game."

So one more time: Why do we care so much about inflation and so little about unemployment?

One (rather depressing) possibility -- look who's affected.

Unemployment tends to hit the more marginal members of the workforce. If they were any good, some of us think, they'd have jobs, wouldn't they? Inflation though tends to be more of a concern among savers, among those on a fixed income, among businesses (who might even like unemployment to be a bit high to keep their labor costs down). All these groups are politically strong and speak with a louder voice (and fling around more campaign cash) than those bitter, disenfranchised unemployed people.

So what do you think? How to explain our lopsided concern, especially with unemployment at 9.1 percent?

Sunday, August 21, 2011

After Many Words, a Short Conclusion on Information-Insensitive Debt

Why six lengthy blog posts on information-insensitive debt? (By the way, they were published all at once because Blogger has been acting screwy lately, barring me from my account for more than a month. In case you want to refer back to them: Part 1, Part 2, Part 3, Part 4, Part 5, Part 6.)

I strongly believe that the shadow banking system was never confronted and dealt with properly after the financial crisis, and that this was a tragic error.

I suspect that the shadow banks will be back, with fresh problems, in the not-too-distant future.

At that time, we may finally be forced to figure out what to do with them. I expect various approaches to be proposed.

To decide wisely how to deal with the shadow banking system, I think we have to possess the right theoretical framework for understanding it. In my opinion, policy based on a flawed theory of “information-insensitive debt" will lead us to create an even more dangerous financial system.

Information-Insensitive Debt and the Strange Case of Haircuts

Now for part 6 of my rather exhaustive (and exhausting) look at Gary Gorton's theory of information-insensitive debt.

This post is rather granular, to show inside-out how a very dubious assertion at the theory's center leads Gorton to what (I think) is a wrong-headed interpretation of what occurred during the height of the financial crisis.

We start with haircuts -- in the repo market, not at the local barber shop. Anyone who needs a refresher on how repurchase agreements work, go here.


Per Gorton, the haircut is the "percentage by which an asset's market value is reduced for the purpose of calculating the amount of overcollateralization of the repo agreement."

That's very gnarly sounding. Here's an unpack that gets at the gist of the matter.

When you "deposit" say $100 million in a shadow bank through a repurchase agreement, the bank essentially posts collateral (to guarantee your funds in case it defaults). The haircut can be thought of as a way to ensure you get ALL your money back. So you may receive $105 million of securities for that $100 million -- a haircut of 4.8 percent (5/105). If the shadow bank collapses overnight, you're holding $105 million of securities to make you whole on $100 million -- not a bad proposition, it seems.

Haircuts vary with the nature of the collateral debt. During the financial crisis, for AAA corporate debt, they were minor (about 5 percent, according to Gorton). A graph of haircuts on asset-backed securities, on the other hand, resembles a Stairmaster in profile. They climbed from zero percent to about 40 percent when the financial system was in extremis. That deep 40 percent haircut was the shadow banking equivalent of a large amount of money being sucked out of the system -- a bank run, in other words.


Now comes a question that turns out to be more interesting than it first appears. Namely, what are these haircuts based upon? This is where things get curious. You might assume, if you're a common-sensical markets person, that “depositors” demand haircuts because if their counterparty in the repo agreement fails (a la Lehman), they need to be compensated for the fact that the securities may not really be worth what they were told. Or, an alternative explanation could be that they’re afraid the value of the securities might drop while they’re holding them.

Both interpretations, however, would be incorrect, according to Gorton.

Gorton informs us that:
Haircuts are a function of the default probabilities of the two parties to the transaction, as well as of the information-sensitivity of the collateral.
Now, before we analyze that, here's another excerpt you need to read, to get the full picture of where Gorton is coming from (this is also from his paper titled Haircuts, the bold is mine):
Keep in mind that the collateral offered in repo is valued at market prices. If the bonds become riskier, and their prices go down, then they would be valued at these lower prices. Furthermore, if there is more uncertainty about their price in the future, that risk can be addressed with a higher repo rate. Repo rates can and did go up (see Gorton and Metrick (2009)). Why should repo collateral be haircut? And why should these haircuts go up? Our answer, following Dang, Gorton, and Holmström (2010a,b), is that a haircut amounts to a tranching of the collateral to recreate an information-insensitive security so that it is liquid. The risk that is relevant here is different than the risks we usually think about, which are related to the payoff on the security. A haircut addresses the risk that if the holder of the bond in repo, the depositor, has to sell a bond in the market to get the cash bank, he may face a better informed trader resulting in a loss (relative to the true value of the security). This risk is endogenous to the trading process. It is not the risk of loss due to default. Consequently, the price cannot adjust to address this risk.

The first thing you should have noticed: Gorton very much appears to be some form of EMHer (Efficient Markets Hypothesis, or the belief that market prices are efficient and reflect all existing public information). (As a reformed EMHer, I can spot a member of the species. This is precisely how they talk: "If the bonds become riskier, and their prices go down, then they would be valued at these lower prices." They don't simply make a point; their stating of a proposition has a whiff of the evangelical.)

Being an EMHer, though, paints him in a corner, starting with his explanation of the two factors contributing to haircuts. Because for an efficient markets guy, the "default probabilities of the two parties to the transaction" -- reason #1 for haircuts -- shouldn't matter at all.

After all, if the collateral for your deposit is a security at market price, that's what someone would buy it for at that moment. And you're only holding the security overnight -- or for a few days -- so where's the risk? Of course, the price may change. But Gorton covers that in the longer excerpt above, saying you'll demand a higher repo rate to compensate for that risk. The more detailed excerpt, in fact, appears to conveniently forget about counterparty risk.

So, back to square one: why do you need a haircut?


This is where the theory starts crumbling around the edges. Remember, the centerpiece is information sensitivity, so that's the Procrustean bed Gorton has to fit his analysis into. Here's how he explains why a shadow banking “depositor” requires a haircut: if forced to sell the debt (my bold again), "he may face a better informed trader resulting in a loss (relative to the true value of the security)."

Ah, so the real problem is a "better informed trader." But what does that phrase mean? And what does it imply? I'm not sure whether Gorton tries to use it in a special way, but let's assume he doesn't. In that case, a "better informed trader" would presumably be a trader who knows the worth of the debt better than you do. And, it appears, you're worried that his information will be negative and push his offer price lower.

So a better informed trader knows something about the value of the security that you don't, so you're afraid that the debt may be mispriced, and that's why you demand a haircut?

No, Gorton would probably demur, it's not quite that. He tells us "This risk is endogenous to the trading process. It is not the risk of loss due to default." See, the market price plus the repo rate has already captured the risk of loss due to default, according to Gorton. But then, what is the nature of the knowledge possessed by a better-informed trader? When the donut cart makes its rounds at corporate headquarters? Because, seriously, when I hold a debt security, I'm concerned mainly with one thing: getting paid what I'm due, when I'm due it (and the probability of that occurring).

(Another thing: what is the "true value" of the security? What relationship does it have to the "market price"? Which should I care about? If the true value is $100 million but the market price is $200 million, why should I mind paying $200 million as long as other traders in the market are willing to pay that, especially if I possess the security for only a day or two?)

The other problem with these "better-informed traders" is that it stretches credulity that they suddenly appear on the horizon, a sagacious glint in their eyes, waiting to take advantage of you. Presumably they were also there the day before. So why weren't they pushing down the "market price" before? And if these better-informed traders are feared, why not find some of the apparently dumb traders of the day before who helped set the "market price" -- and simply sell to them instead, if they're so enamored of the security?


Gorton wants to convince us that the securities were fairly priced (they capture all the risk of loss due to default, remember) and that depositors extracted giant haircuts of 40 percent for fear that, if they got stuck with the debt, the only traders they encounter may possess an "information advantage." He never clarifies why, if this information advantage necessitates such a large haircut, the better informed traders aren't already profiting from their (considerable) advantage by trading in the market.

So Gorton basically says that market prices on asset-backed securities (a key kind of collateral in the shadow banking system) during the financial crisis were accurate. He makes this claim even though there were some 100,000 of them -- sui generis problems abound* -- and trading in particular ones probably got pretty thin and the value of asset-backed securities is often derived from a model (hence "mark to model") and investors were just starting to realize these things had been misrated and were probably lousier than they thought and ... you get the idea.

*(Brief aside: The uniqueness of these assets, and the difficulty accounting for them, was why Paulson scuttled his original plan for TARP, as Hernando de Soto recounted in Businessweek: “When then-Treasury Secretary Henry Paulson initiated his Troubled Asset Relief Program (TARP) in September 2008, I assumed the objective was to restore trust in the market by identifying and weeding out the "troubled assets" held by the world's financial institutions. Three weeks later, when I asked American friends why Paulson had switched strategies and was injecting hundreds of billions of dollars into struggling financial institutions, I was told that there were so many idiosyncratic types of paper scattered around the world that no one had any clear idea of how many there were, where they were, how to value them, or who was holding the risk.”)


Is there an alternative explanation of what happened?

Yes, and it might go like this: Before the financial crisis, the haircut was zero on asset-backed securities because it was practically unthinkable that the large investment bank opposite you on the repo transaction would fail. And so, because the counterparty is deemed safe, the asset-backed securities being offered for repo aren't examined too carefully. The "magic pig" phenomenon starts to set in. "Sure, they're worth what we claim," Mr. Investment Banker says. "Would you like to see our math-heavy, extremely complex model or just take our word that you'll get repaid?" And you say: "I'll take your word, no problem."

But then the investment banks start looking shakier, and the asset-backed securities begin looking dodgier as well. You realize too that the banks are frightfully interconnected, boosting risk further. So you begin looking askance at asset-backed securities that you suspect aren't at "market price" at all. Further, you expect you'll have trouble reselling them. This would naturally lead you to demand deep haircuts.

Now you may resist going as deep as 40 percent -- that's pretty severe -- until you get really, really scared. What would scare you the most? If you think that the collateral may be mispriced, the scariest thing would be seeing one of those investment banks go under. Say Lehman Brothers. Until then, if you think the chance of the investment bank failing is remote, you may not extract much of a haircut for the mispriced securities. Who cares what they’re really worth? But once it becomes clear you may get stuck with this collateral -- the game changes totally.

You need a deep discount, and 40 percent would be reasonable. Gorton would have you think that such a discount implies crazy sale prices. This alternative explanation doesn't need to invoke a fire sale to make sense. It would, however, suggest there was a bit of the "magic pig" in those asset-backed securities.

Next: Many words later, a short conclusion: why should anyone care so much about this arcane subject?

Down the Rabbit Hole on Information-Insensitive Debt: Inscrutable Complexity Is a Good Thing!

Part 5 of a detailed look at Gary Gorton's curious theory of information-insensitive debt in which we ask two key questions.


Not really, it seems.

A more useful theoretical construct would steer away from the bi-phase nature of "information insensitive" and "information sensitive" and would at least posit a sliding scale between the two. But an even better theory would ditch information sensitivity completely. Risk is the key to understanding how the world of debt works and how securities are analyzed, not information sensitivity (note: it’s probably no accident, in fact, that certain bloggers have equated Gorton's "information insensitivity" phrasing with the quality of being "risk free" -- but a careful reading of Gorton shows he makes no such equivalence, so he appears to be aware that there's a critical distinction).

A better theory might assert that, with the financial sector's demands for collateral to back derivatives transactions and so on, there will be a need for less-risky securities to fill that role.


Gorton seems to like asset-backed securities as information-insensitive debt for all the wrong reasons.

He likes them partly because of the senior nature of the debt and the fact that it's backed by a portfolio. He doesn’t recognize that the worth of being senior is firmly attached to credit risk. As an investor, which would you rather hold, if you're anti-risk: the senior debt of Energy Future Holdings (the former TXU that’s freighted with debt after being bought in the biggest LBO in history) or some (not senior) debt of AAA rated Johnson & Johnson?

This isn't a gratuitously needling point, because structured debt likes "yieldy" (read: riskier) assets. Collateralized loan obligations, a type of CDO, are stuffed with leveraged loans -- the high-risk borrowing that private-equity firms take out to make an acquisition. Why? The structuring doesn't make sense using investment-grade debt; you can't wring out enough yield.

So to say a securitization is more "information insensitive" because it may be backed by a portfolio composed of senior debt -- and then to be agnostic about the contents of that portfolio -- is very wrong. And what's more, you should be looking at how correlated the movements within the portfolio are. Junk loans in CLOs will display high correlation if the economy double-dips; that's pretty much a given.


Then there's the really dangerous feature of asset-backed securities that Gorton, bizarrely, is attracted to: complexity. This should be a bug, not a feature, but we've gone down the rabbit hole, folks. Here's his rationale: complexity raises the cost of producing private information. It's too expensive to figure out the debt is mispriced. Ingenious, though the arrant screwiness of this is never acknowledged.

However, here's the catch: that same complexity will, at some point, confer a significant advantage for a dedicated investor (such as a Michael Burry type in the Big Short) to do enough research to determine the extent of the mispricing. This will only occur though, after the mispricing becomes significant enough.

So what you get in the trading of this complex debt is the equivalent of a tectonic shift, violent and jarring, instead of the smooth adjustments that are made by say a U.S. Treasury, which trades largely on public information -- millions of bits of it, clashing and conflicting and impressing various traders in various ways. The asset-backed security, however, manifests itself as stable and information-insensitive -- partly because of its impenetrability -- then, on reaching a certain tipping point of mispricing, lurches into “information sensitivity.” Also, because of its complexity, ratings services will be sluggish to downgrade the debt -- especially after they have been complicit in the initial misrating -- adding to the sudden volatility.

Note, however, that this volatility wouldn't have to be characteristic of a panic or widespread fire sales, as Gorton wants us to believe was the main problem during the financial crisis. This aspect of volatility is inherent in the very nature of complex debt -- a kind of debt that Gorton lauds because it raises the cost of producing private information.

And Gorton sees this as a feature, not a bug. Hmmm.


Information insensitivity is NOT what we need more of in our financial system. Magic pigs are information insensitive, until there is a revelation (the discovery that they are not magic), at which time they become dangerously information sensitive. We DON'T WANT a shadow banking system built on magic pigs (or on securities that want to become magic pig-like).

Next: What’s behind haircuts in the repo market, according to Gorton? (Surprise: It’s not what you think.)

The Worrisome Analogy at the Heart of the Theory on Information-Insensitive Debt

Now for Part 4 on Gary Gorton's theory about information-insensitive debt, in which we begin by dusting off our SAT analogy skills.

Retail banking : deposit insurance :: Shadow banking : x

"X" is, of course, the kind of insurance that will save the day when there's another run on the shadow banks, as we saw during the financial crisis. Deposit insurance is a neat innovation that traces back to 1934; it eliminated runs on commercial banks in times of panic. It also made deposits at a bank "information-insensitive" debt -- the value of your $1,000 at Fidelity and Security Trust is secure, even if the CEO absconds to Tahiti with $10 million in a duffel bag.

Before solving for "x" -- or, better, asking whether we should even try to solve for "x" -- let's look at how shadow banking works.


Retail banking is for you, me, Aunt Edna. Shadow banking is for the giants in the financial system, who have large amounts of cash to park -- typically money market mutual funds, insurers, pension funds. They make “deposits” and “earn” interest through a process that involves something called a repurchase (repo) agreement.

Here's an example of how that works.

A pension fund spends $100 million to "purchase" AAA asset-backed securities from JPMorgan. As part of the deal, JPMorgan agrees to buy back these securities, after a short period of time -- overnight, or maybe a week or two. The pension fund will receive a small amount of interest (a fraction of 1%, as the lending is so short term). If JPMorgan goes insolvent, the pension fund holds those securities as collateral. They can be sold and (theoretically) the pension fund recovers all its money.

Now consider what happens with retail banking with a $100 deposit if the bank becomes insolvent. The FDIC makes the investor whole, paying the $100. Similarly, the pension fund in our example really wants its $100 million returned and doesn't want to deal with those collateral securities, which may not really fetch $100 million on the open market if they happen to be complex products, especially in times of stress.

So what happens in the repo market during a "bank run"? Nervous depositors -- like this pension fund -- demand greater and greater haircuts on securities they “purchase.” In other words, instead of “depositing” $100 million and accepting say $102 million of securities, they may demand much more collateral: $110 million, $120 million. Haircuts on asset-backed securities may go from zero to 40 percent (as they did in the crisis). This has the effect of sucking 40 percent of that $100 million out of the shadow banking market.

Spread this effect around, and the impact is similar to that of a bank run.


Here’s a big problem, for those who see insuring shadow banking "deposits" as the obvious solution to bank runs: This kind of banking has a wrinkle that's not found with its retail counterpart. In the shadow system, to guarantee a depositor’s $100 million, you essentially would have to say, “Whatever the actual value of that security you bought in a repo agreement, we’ll buy it back for $100 million.”

Think about this. If you deposit $100 in a commercial bank, the FDIC says you’ll get that $100 back -- which seems fair; you have deposited a fiat currency, and you receive the same amount of that fungible currency in return. But this differs hugely from what the shadow banking system would be guaranteeing: that you would be made whole no matter what the true value of the security that you hold as collateral.

Why is this problematic (other than for the obvious reason that the security, especially if thinly traded and "marked to model," could be mispriced -- and that this tendency to mispricing will be exacerbated because of the very existence of the insurance)?


Well, significant differences exist between retail and shadow banking systems.

"Deposit insurance" for commercial banking means: You're insuring that a depositor of money (common currency) will receive that money back. The bank involved is usually not too risk-loving, not too large, not too interconnected, and not too complex -- plus its commercial banking activities are regulated.

"Deposit insurance" for shadow banking means: You're insuring that a depositor of money (common currency) will receive that money back. The bank involved is usually risk-loving (often an investment bank), large, highly interconnected and complex -- plus its shadow banking activities are unregulated.

Being large and highly interconnected implies that when a bank in the shadow system gets in trouble, others will soon be at risk and the amount of "deposit insurance" ultimately needed may be very high (and the FDIC model won't work, where a team of examiners takes over the bank on Friday and sorts out things so the institution can re-open on Monday -- Lehman, which was enmeshed in the shadow banking system, is still painfully crawling through bankruptcy, almost three years later, even spawning its own periodical: Lehman Brothers Bankruptcy News).


Enormous problems arise when it comes to how securities will be chosen to be insured in the shadow banking system. It's comparatively easy in retail banking. The FDIC insures dollar claims. Dollar claims are in money, or fungible currency.

But in shadow banking, how will securities be selected that will qualify as "information-insensitive" collateral worthy of insuring? Will government regulators be involved in picking and/or rating them? If so, why does anyone think our regulators have the expertise to assess asset-backed securities (one form of information-insensitive debt prevalent in shadow banking) that S&P and Moody's failed miserably to understand properly during the financial crisis?

Who determines how much of this insured information-insensitive debt is appropriate? Who pays for this "insurance" and how? And, if the debt is insured to market value, that will pervert the price at which it trades (Q: What would you pay for a security that is insured for however much you pay for it? A: Potentially, the sky’s the limit.).

And if the debt is insured to market value minus a haircut, who sets the haircut? How is the haircut adjusted if that debt class grows riskier? And, even with a haircut, insurance will tend to push the price higher as traders discover ways to game the system (Here's a scenario: X buys Security C for $100, its true price. Security C, which is classified as "information-insensitive" debt, is insured up to 90 percent of its market value. X sells Security A to Y for $200, who later sells it back to X for $210. Y makes $10 and X now possesses a security that's insured to $189 -- a great game for everyone but the insurer of the debt.)

Also what precautions will be taken to ensure that financial institutions don't start smuggling in junk disguised as quality securities, trying to get them classified as "information-insensitive debt" -- the designation of which will immediately boost the value of the assets?

Next: Is “sensitivity to information” really the way investors analyze debt?

The Theory of Information-Insensitive Debt Prompts Some Head-Scratching Questions

Here's Part 3 on the magic pigs of high finance, information-insensitive debt (everyone still awake?). Last time we looked at the concept using a common-sense definition of the term. Now let's try to figure out where the theory is unsatisfying on a more granular level, by using Gorton’s own words.

First, to show us what qualifies as information-insensitive debt, he offers examples: high-grade corporate debt, government bonds (presumably U.S. Treasuries, and not Greek 10-year bonds), and AAA rated asset-backed securities.

In different places, he characterizes such debt as (the bold is mine):
[Debt that] "is very liquid because its value rarely changes and so it can be traded without fear that some people have secret information about the value of the debt. If speculators can learn information that is private (only they know it), then they can take advantage of the less informed in trade. This is not a problem if the value of the security is not sensitive to such information."
Also (page 7 of the same document, Slapped In the Face by the Invisible Hand):
"Bank debt is designed to be informationally-insensitive, that is, these bonds are not subject to adverse selection when traded because it is not profitable to produce private information to speculate in these bonds."
These definitions sound impressive, in that arid academic way, but what do they mean when applied to real debt in the wild? For example, the first one doesn't really make sense. He's saying that speculators can't take advantage of the less informed while trading information-insensitive debt, even after learning private information, because "the value of the security is not sensitive to such information."


What debt could Gorton possibly be thinking of here? Does he really believe that even Treasuries are immune to being profited upon, by someone who possesses private information? If I wiretap the Federal Reserve Board meeting, and learn the Fed is about to announce an operation to purchase $800 billion of Treasuries, he doesn't think that gives me an advantage trading in this market? (Note: the second definition does add "it is not profitable" to produce private information, but this opens a new can of worms, which we’ll soon see.)

Also, U.S. Treasuries are very liquid, but it’s not true that their value rarely changes -- their value changes constantly. Now, do the bonds trade without fear that some people possess secret information about that value? For the most part, yes -- but there may also be certain junk bonds that trade without fear that some people have secret information about them. If so, could these junk bonds qualify?

And what if the junk bonds are "information insensitive" for six years, then the company reveals itself to be tottering near bankruptcy and their price becomes volatile? Do they suddenly become information sensitive, or were they always information sensitive but only seemed information insensitive?

In other words, is this quality of being “information insensitive” only ascertained after empirical evidence of how the security actually behaves? Or is a security considered information insensitive only if we can’t imagine a situation in which someone could profitably produce private information to speculate in the debt? But, honestly, no security exists for which that’s an inherent quality, as the thought experiment for Treasuries shows.


And "it is not profitable to produce private information" raises many fresh questions. What's profitable for a trader to do at any given moment depends on many variables that seem as though they should have little to do with information sensitivity.

A trade may be profitable simply because I can lay my hands on large-enough blocks of securities to make chasing a minuscule gain on each one worthwhile. Or, a narrower trading spread may allow me to turn a profit more easily. (Of course more-liquid securities tend to trade with narrower spreads, which leads to a Gortonian paradox, as being liquid is supposed to be a sign of information-insensitivity.) Profitability also hinges on what I pay my workforce -- so does a security become information sensitive simply because I’ve got six traders in Bangladesh who work at one-sixth the salary of their U.S. counterparts? Also how does "private information" factor in? What if it's profitable to ransack Company X's Dumpster for trading information. Does that make its debt information sensitive until the Dumpster is relocated to a more secure place?

Some of the above may sound a bit picayune. But here are the takeaway points: (1) If so many questions can be posed, doesn’t information-insensitive debt sound like a theory that presents a false dichotomy at best? (2) There are so many trades, and so many price movements on securities (especially liquid ones), how do you sort out evidence that proves a security is information insensitive, instead of the opposite?

Next: The troublesome analogy that Gary Gorton’s theory leads to.

Information-Insensitive Debt: An Unnatural Concept, For Starters

Now for Part 2 on Gary Gorton’s theory of "information-insensitive debt" in which we continue to study the question, "Is it a bad thing or is it a really bad thing?" :)

One big problem: the concept happens to be quite unnatural.

Fiat currency is probably the best example of information-insensitive debt, but it's essentially a trivial, artificial case. Retail banking deposits also qualify as a good example, but they're something different: a special case. Exactly how they're special is important to understand.


Gorton likes to illustrate the information insensitivity of retail banking deposits by using an example involving a check. Let's say I write a check for a $14 haircut. That piece of paper isn't worth $13.89 or $14.05 to my barber. It's worth exactly $14.

Likewise, if I go directly to my bank instead to withdraw that $14, I can be sure of getting the full amount, even if my bank is Lehman Brothers Savings Inc. and everyone's glumly packing their desk contents into boxes when I arrive. The FDIC insures my deposits up to $250,000. I can breathe easily.

So it doesn't behoove me, or anyone I trade with, to spend time investigating the financial soundness of my bank. No matter what terrible information surfaces about that bank, my deposits are covered.

See a problem already? The debt isn't naturally insensitive to information. It achieves this property by being insured. But the value of anything -- your collection of Pokemon cards or seashells -- can become information insensitive if insured. So, becoming information insensitive this way feels like cheating a bit.

That leaves the tantalizing question: which debt is naturally information insensitive?

None of it, really. On its face, the phrase is oxymoronic, like “jumbo shrimp.” (Note: Gorton parses the term in a special way, which we'll look at later.)


Pretty much all debt in its natural state is information sensitive. Markets trade on this information. Some is public. Some is private (e.g., a stock price spikes right before a merger announcement, as the news leaks out). Much information arguably occupies a gray area between public and private. Is private analysis of public data showing that a bond is undervalued private or public information?

Even fear and wild speculation is information of a sort. Say there's a rumor that a neutron bomb will be detonated in Microsoft's main cafeteria tomorrow, based on absolutely nothing. If enough stupid investors believe it (ever hear the phrase "dumb money"?), they may sell their bond holdings in the software giant. Information about this crazy rumor will prompt a smart trader to jump in, scoop up Microsoft debt, and score a neat profit when the price rebounds.

A smart theory would posit that just about all debt is information sensitive. The theory might make an argument that there are varying degrees of sensitivity, and that a particular instance of debt lies on a continuum between very information sensitive and not-that-information sensitive. Okay, fine -- that would at least be nuanced and cautious. But instead, in Gorton's world, we get debt that is either "information insensitive" or "information sensitive" -- and of course debt that lurches from the former to the latter during a financial panic, as if undergoing a change of phase, like ice to water.


Because there’s a shadow banking system in the U.S. that’s larger than the retail banking system. It’s where the financial crisis began in 2008.

Information-insensitive debt plays a key role in shadow banking’s repo market, according to Gorton (later, we’ll look at how repo works). Asset-backed securities, for example, are posted as collateral against repo borrowings. During the financial crisis, the securities suffered huge haircuts once they became "information sensitive" (or once investors discovered they more closely resembled magic pigs than Treasuries). At the same time, Gorton notes, other kinds of debt suffered very minor haircuts.

So here’s something to ponder: If we must have "information-insensitive" debt in our financial system, shouldn't we look to these other types for what it should look like, and not to securitizations that are opaque and become thinly traded with alarming suddenness?

Next: Gorton’s own definition of information-insensitive debt comes up short.

Everything You Always Wanted to Know About Information-Insensitive Debt But Were Afraid to Ask

Over the last few months, I’ve spent a lot of time studying the idea of "information-insensitive debt" (also known less gracefully as "informationally insensitive debt"). Gary Gorton, a professor at Yale’s graduate business school, appears to be the intellectual progenitor (or one of them) of this concept. In 1990, he wrote an academic paper with George Pennacchi titled "Financial Intermediaries and Liquidity Creation."

My fascination with information-insensitive debt arose from a sneaking suspicion that it was a bad thing (except for a couple of notable exceptions). My keen interest in writing about it, after all this research, arises from a conviction that it is a bad thing, and that the theory itself isn't much good either.

A rough-and-ready definition of information-insensitive debt -- we'll return later to Gorton's own more nuanced and precise definition -- is this, by way of Felix Salmon:
Financial assets which (normally) don’t change in price when new information about them emerges.
Now if you're a markets-oriented person, this very idea should make your skin crawl from the get go. What kind of zombie asset doesn't change in price when new information about it emerges? How weird is that?


To begin this series of posts about information-insensitive debt (there’s waaay too much to fit into a single piece, unfortunately), let me introduce you to my magic pigs.

Each magic pig is worth exactly $1 million. Its astonishing value resides in something I call a noumenon. When asked what this noumenon is, which is a thing unseen, I gladly provide a 9,000-word document, with much high-level math and abstruse concepts and economic formulas, to justify its value. I trade a lot in financial markets, and whenever my counterparty demands collateral, I offer bonds entitling him to a number of my magic pigs, should I fail to deliver on whatever I have promised.

So when $10 million of collateral is requested, I hand over certificates for 10 magic pigs. My counterparty doesn't object: the whole market has accepted that these pigs are magic and worth $1 million apiece (after all, I do have documentation and the pigs have been rated top grade by Standard & Poor’s -- ignore for the moment their pro-animal bias, as one of their officials once famously observed, “It could be structured by cows and we would rate it”).

Sometimes I sell a magic pig for $1 million, and the holder of that pig then uses it for collateral, or sells it. Or whatever. Because the value of the pig lies in this complex noumenon, no market participant has any advantage in trying to profit on my pigs (through trading), by first gaining private information. And if a leg falls off a pig, that doesn't matter because its noumenon isn't affected. Even if the pig dies, its noumenon stays intact. So it's still worth $1 million.

The certificates for my magic pigs are truly information insensitive debt -- at least, until I am revealed as a fraud, at which point they very rapidly become information sensitive and start rising and falling in accordance with the market on hog futures.

Next: What do “jumbo shrimp” and “information-insensitive debt” have in common?

Saturday, August 6, 2011

S&P Demonstrates Its Utter Hypocrisy

This morning, I saw S&P had "bravely" downgraded the U.S. to AA+.

What horsecrap.

If nothing else, this shows how irrelevant ratings have become.

Yields on 10-year Treasuries are about 2.5 percent, nearly at historical lows. Every time the market catches a whiff of fear, investors pile into Treasuries. U.S. debt is considered about the safest stuff out there, bar none, as indicated by the yield.

The yield is truth, the market itself speaking.

Meanwhile, S&P is still willing to rate lots of securities AAA -- if you call them CDOs and pay S&P a handsome fee for the rating, even when these securitizations are paying a yield that far exceeds that on U.S. government debt.

What we're seeing today is just rank hypocrisy from a ratings service that has the gall to claim that AAA is AAA, across asset classes.

Tip to Washington: just figure out a way to combine and tranche your Treasuries in some kind of god-awful complex structure -- make it really, really complicated -- then go back and pay S&P a fat fee to rate the mess. You'll get your AAA back. I guarantee it.

Saturday, April 16, 2011

Felix Salmon: Quote of the Week

I was beginning to despair this week. It seemed like the theme was Free Market Idiots Run Amok and someone had forgotten to tell me to put on my Atlas Shrugged underwear.

First, there was Larry Summers saying don't blame financial innovation, but rather, the housing bubble, for the Financial Crisis on Steroids that we went through. Which leaves me wondering: This guy was the president of What-vard? You gotta be kidding.

Larry has nary a disparaging word to utter about any CDO, CLO, CDS, SIV, RMBS, CMBS, REMIC, re-REMIC, structured note. None of those products are bad, fee-gouging, or in any way contributed the teensiest to systemic instability?

Thus, I sentence the estimable Mr. Summers to hereafter receive all his compensation as an income stream from the bottom tier of a synthetic CDO squared.

The second forehead-slapper was Peter Wallison, who at this point isn't even interesting any longer. He's too busy riding his ideological hobbyhorse: Fannie and Freddie are the chief perps in the financial crisis, get the government out of the housing market, private enterprise can do no wrong, blah blah blah. His latest wildly inaccurate piece, on the Bloomberg Web site, was easily shredded by Daily Kos.

Which brings me to Salmon's quote of the week ... the antidote to all the uninformed opinion.

Responding to Gary Gorton's assertion that we need "informationally insensitive financial assets" (debt whose price doesn't change when new information about it emerges), Salmon is quick to respond, "No, we don't."
Informationally-insensitive debt is the best repository the world has ever constructed for housing tail risk in an invisible and impossible-to-measure manner.
That's a great line. Because "informationally insensitive debt" (except when applied to common currency, which is arguably a trivial usage) is a dangerous, oxymoronic twist of phrase. The varieties of "informationally insensitive debt" spawned in the shadow banking system, and used in the repo market before the financial crisis, didn't collapse because of a panic. Rather, the values plunged because investors realized this debt was complex, misrated and overvalued.

Gorton likes to think there was an irrational panic in the shadow banking system. He's right there was a panic, but it was more the sort of panic you experience when you realize the gold bars you're holding are bricks of horse manure spray-painted gold. It wasn't all that irrational. And to prevent that kind of panic, you need assets to be more informationally sensitive, and constantly adjusting for risk -- not less sensitive.

Monday, March 7, 2011

In Case You Were Thinking That Lawsuits Might Reform the Credit Raters ...

Well, think again.

Time to play connect the dots, with the New York Times getting us started in fine fashion. First, the article linked above notes a disturbing trend taking shape:
... since Dodd-Frank passed, Congress’s noble attempt to protect investors from misconduct by ratings agencies has been thwarted by, of all things, the Securities & Exchange Commission. The S.E.C., which calls itself “the investor’s advocate,” is quietly allowing the raters to escape this accountability.
What accountability? As Gretchen Morgenson tells us:
The Dodd-Frank financial reform law, enacted last year, imposed the same legal liabilities on Moody’s, Standard & Poor’s and other credit raters that have long applied to legal and accounting firms that attest to statements made in securities prospectuses. Investors cheered the legislation, which subjected the ratings agencies to what is known as expert liability under the securities laws.
Why would the SEC do anything that subverts Dodd-Frank so openly? Aren't these our brave regulators, our white knights (yes, with a fondness for porno, but what do you expect in the postmodern age)? Ah, but see, there was a problem when push came to shove on this "expert liability" point.
When Dodd-Frank became law last July, it required that ratings agencies assigning grades to asset-backed securities be subject to expert liability from that moment on. This opened the agencies to lawsuits from investors, a policing mechanism that law firms and accountants have contended with for years. The agencies responded by refusing to allow their ratings to be disclosed in asset-backed securities deals.
So basically, the credit rating services said, "We'll hold our breath until we turn blue."

And the SEC blinked. Actually, double-blinked. Check out this whopping beaut of negligence:
At the time, the S.E.C. said its action (i.e., the agency temporarily removed the "expert liability" threat and said it wouldn't bring enforcement actions against issuers that did not disclose ratings in prospectuses) was intended to give issuers time to adapt to the Dodd-Frank rules and would stay in place for only six months. But on Jan. 24, the S.E.C. extended its nonenforcement stance indefinitely.
Indefinitely. Golly, that has a sort of open-ended ring to it. Hey, let's face it: Like diamonds, indefinitely may be forever.

Okay, now let's do the New York Times one better and finish connecting the dots for them. Because left unanswered is a big question: why the hell are credit rating services so scared of being held responsible for how they grade asset-backed products?

Jeez, I think I know this one -- in fact I think I blogged this one -- twice over! Just go here for a full explanation:

The Ratings Charade Continues: a CLO Investigation, Part I
The Ratings Charade Continues: a CLO Investigation, Part II

You see, the credit rating companies can't afford to be held legally responsible for the grades they assign to asset-backed securities, such as collateralized loan obligations, because they know they would lose in court if these ratings were challenged! The ratings are clearly bogus. I show that above, using nothing more sophisticated than sixth-grade math.

Further, these companies must know their ratings on asset-backed securities are wrong, unless they're incompetent to a mind-blowing degree.

And now the SEC is giving Standard & Poor's and Moody's a free ride on their bogus ratings, aiding and abetting the crime ...

What a great country we live in, eh? Where does the U.S. rank on that global corruption scale again? ;)

Saturday, February 5, 2011

The Ratings Charade Continues: A CLO Investigation, Part II

To bring you up to speed on this exciting melodrama:

Last time I showed you why CLO (collateralized loan obligation) ratings are almost certainly a scam, and why Mr. Ratings Guy from Standard & Poor's should know as much. It was (I hope) a math-lite and entertaining trip through the bowels of high-finance complexity, Wall Street style.

Of course I reached the end of the rather long post with more questions than answers. Why does this ratings scam exist in the first place? Who benefits? Who loses? In today's conclusion, we'll look at the not-so-surprising answers. Center stage in this discussion will be the misrated AAA tranche. It's the largest CLO piece by far, a good 70 percent or so of the overall fund -- and, as you're about to find out, that's no accident.

So why does Mr. Ratings Guy turn a blind eye to ratings that, deep in the pit of his stomach, he knows can't be correct?

Remember Upton Sinclair's little gem of wisdom:
It is difficult to get a man to understand something when his salary depends on his not understanding it.
Structured finance (e.g., CLOs) is very lucrative for ratings agencies. Even if you're the Jim Carrey character in "Dumb and Dumber," you can rate U.S. Treasuries with your eyes closed. Can you say "AAA"? With a bit more work, you can rate investment-grade bonds and loans. But once you dip into junk-rated and structured finance stuff -- ah, that's where it gets complicated. And complicated = higher fees.

So S&P gets paid more to rate CLOs. If the company started to challenge specific CLOs -- if it dared to say, "You know, these ratings don't make sense for this CLO" and began to push back against investment banks, one of two things would happen. (1) The bank, realizing its screwy models had been sussed out, would not structure more CLOs. (2) The irritated bank, which is paying the ratings firm, would simply find another ratings patsy -- Moody's? -- to play along with the bogus rankings for a big fee check.

Either way, it's clear what happens to S&P: It loses a rather fat revenue stream.

Now, why does the investment bank want to structure these things in the first place? This is pretty easy to answer too. Fees, fees, fees, fees. Underwriting fees for CLOs run to 1.75 percent, compared with an average of 0.4 percent for investment-grade bonds, according to Bloomberg News data.

Okay, that explains what's going on on the supply side. But it takes at least two to play in the markets. What's the incentive for the investor to buy misrated CLOs? Is the investor just the naive fool here, hoovering up misrated junk that will later plunge in value, leading him finally to clap a hand against his forehead and exclaim, "Oh, what a terrible mistake I have made!"

Probably not. At least not anymore. Recall that well-worn saying, "Fool me once, shame on you, fool me twice, shame on me."

There was a lot of complex, securitized crapola that cratered during the financial crisis (and has since recovered in value to some degree, but not to the degree that its initial AAA ratings would suggest is proper). So investors got caught playing with the effluvia from the sewer pipe and got burned. Are they really as stupid as they once were?

Nope. In fact, just return to my first post and look at what the tranches of a CLO pay these days. The "AAA" piece that, pre-credit crisis, would have paid 25 basis points plus the Libor rate, now yields 160 to 170 basis points plus Libor. Big, big difference. For those who aren't finance geeks, here's what that means in actual interest rates: three-month Libor is about 0.3 percent, so the CLO buyer who in 2006 would have accepted 0.55 percent as initial interest (assuming today's Libor) now insists on more than three times as much, or as much as 2 percent.

Last time we proved the ratings are an illusion, a clever chimera ... so let's say today's investor, being smarter about these CLOs, knows the game too. What does the 2 percent imply about the true rating? Well, you'd have to skip down S&P's ratings scale a bit to find the "true" rating, based on what investors are willing to pay. And that happens to be about six or seven rungs below the professed rating: much closer to "junk" level than AAA.

This is essentially what the investor is saying to the investment bank selling this stuff: "Sure, I'll take some of that 'AAA.' I know the market is just irrationally frightened of CLOs right now -- (nudge, nudge, wink, wink). I know that I'm getting real AAA at a great price, just because this asset class is out of favor because of the lingering taint from the financial crisis that has unfairly tarred securitized products! (nudge, nudge, wink, wink)."

Inside the investor is thinking: "Yeah, AAA my ass."

Now you may be wondering: What's the incentive for an investor to do this? What's the point of going along with this charade? And this is where things get interesting. There are a number of good reasons to play along with the fake "AAA" ratings:

1. You can use the AAA ratings to burnish your investment results. Say you manage a money market fund that can buy only AAA securities. You can sneak some pseudo AAA into your portfolio and goose your returns. How? Because it's rated AAA, but it pays about 165 basis points more than Libor, or more than three times ordinary AAA. So you'll look like a genius, outperforming your peers, until this junk explodes in your hands (and that could take a while -- remember, it's still probably investment grade, just a good deal lower than AAA).

Update: Ah, the perils of working too quickly! I meant to check out investing requirements for money market managers because I feared -- and I was right -- that my example doesn't work because they can't buy certain AAA products. It turns out money market funds must contain investments with a maximum weighted average maturity of 60 days. (A lot of structuring does spin out tranches with special A-1 or P-1 ratings that are of this shorter, desired maturity, but I don't think any CLOs do.) However, the idea still holds for other AAA-only fund managers: They can use pseudo-AAA from a CLO to burnish their results. A relevant fund for such a strategy might look more like one of these (note: the funds on this Web page invest in "AAA-rated fixed-income products" so I'm not sure if "structured fixed-income products" could qualify for the portfolio, but clearly if they could, the money manager will quickly jump to the head of the class, using pseudo-AAA from a CLO as "performance steroids," if you will.)

2. Certain entities, such as insurance companies and pension funds, have limits on what they can invest in. They can buy only AAA, or a certain percentage of their investments must be rated AAA. So these "AAA" (wink, wink) CLO tranches fit that criterion. This then becomes a neat little way to do an end run around an investing mandate that seems too restrictive to them, especially when they are under pressure to achieve higher returns (pension funds).

3. AAA securities are very useful in the huge "repo" market, where they are used to secure overnight loans, sometimes being rolled over continually. While AAA CLOs may be subject to higher haircuts (or discounts) than say a AAA Treasury, they still may find an important role once again in the repo market.

4. The new Basel III rules are coming, the new Basel III rules are coming! They are intended to make sure that a bank has enough capital to withstand shocks. These rules determine capital adequacy based partly on -- surprise! -- ratings of assets a bank holds. So having a bunch of misrated AAA on its books will help a bank heap on the risk again and plump up profits.

From Minyanville (my bold):
In the afterglow of yesterday’s “hugely oversubscribed” bond issue by the European Financial Stability Facility, (the “EFSF”), EFSF CEO Klaus Regling noted that demand was growing for AAA-rated assets “spurred by Basel III capital rules."
From Bloomberg (my bold):
Three years after collateralized debt obligations (note: a CLO is a type of CDO) helped trigger the worst financial crisis in 70 years, Wall Street’s math wizards are exploring how to use them to deflect rules intended to prevent the next crisis.
Credit Suisse Group AG traders are testing a risk model that may help them reduce capital charges imposed by the Basel Committee on Banking Supervision on derivative products.
Claudio Albanese, a quantitative economist who is advising the lender on the plan, says it could also help banks to limit one of their biggest risks by allowing them to offload through a CDO the risk that one of their trading partners, or counterparties, defaults. Critics say such CDOs could trigger a new crisis.
Albanese’s plan shows how banks are likely to try and mitigate rules that impose higher capital requirements on their operations and threaten profit ...
Okay, a cynic might say after reading up to this point, so what? Investment banks make out like bandits, the ratings firms get their cut, and everyone enjoys goosed returns and higher leverage. Why should I care?

For one, the existence of this ratings scam has the potential to create a distortionary effect in the market. It hasn't yet -- CLO issuance has dropped off a cliff since the glory days of several years ago -- but if the CLO machine cranks up again, suddenly there will be greater investor appetite for the securitizations. Now what's the hamburger that needs to go into the CLO meat grinder to produce these sweet patties of higher-than-normal yield? Leveraged loans. And who takes out leveraged loans? Private-equity firms. And why do they? To engineer sometimes-destabilizing takeovers that load up companies with debt.

So we encourage distortionary economic activity, higher leverage, more debt ... though in the short run, all this will give us a little meth-type boost in prices of stocks and other assets, and investors will feel a little richer, and we'll buy a few more big-screen TVs, and take a few more Acapulco vacations, and exult about how it's great we survived that bad ol' financial crisis ...

Now for the $64,000 question, the one that really matters.

Who's on the hook when all this collapses?

When CLOs go belly up, and massive wealth is destroyed, and credit freezes, and money market funds are about to break the buck once more, and we gnash our teeth and scream, "How can this be happening again?!?" and Jamie Dimon tells us not to worry because we go through financial crises every five years or so, so just take a pill and chill and stop standing on his bonus check?

That would be you. And me. That's right. Joe Taxpayers. A bailout will be orchestrated, overt or covert, and we'll all shoulder the burden.

Perhaps Ben Bernanke will do a slow-bleed of seniors and savers by infusing liquidity, rescuing the large and foolish banks (and other too-big-to-fail pieces of the financial infrastructure).

Just remember: It all starts with a misratings scam your Congress, snugly in the pockets of the banking lobby, never bothered to fix ... ;)

Sunday, January 30, 2011

The Ratings Charade Continues: A CLO Investigation, Part I

The role of the ratings agencies in the financial crisis went largely unexamined by the powers that be. That's a crying shame. Because the game hasn't changed: Investment banks fork over big fees for ratings agencies to sign off on phony ratings for complicated products.

Today I'm going to prove it, step by step. I'm not going to show all my work (I don't want this expanding to the length of a Scribd academic paper), but I can separately (in the comments section or in a separate post) for anyone who's interested.

We start with one of Wall Street's darlings of complexity, called a collateralized loan obligation.

If you're going to hang with me here, you have to grasp the basics of how one works. It's like this: An investment bank bundles together say 30 leveraged loans (this is the risky debt that companies take on in leveraged buyouts). Now, recognizing that different investors have different risk appetites, the bank creates "tranches" of securities that receive payments in a "waterfall" structure, which is the complicated heart of the CLO.

Okay, that sounds confusing. But there's a simple way to look at it. Each of these 30 leveraged loans makes periodic payments (of interest, or interest and principal). Once you strap all the loans together, individually they still make the same payments on the same schedule. But how the money is distributed becomes a bit more complex.

That "pot of yield" generated by the 30 loans is divided as follows. The investors in the top, or safest tranche, get paid first. This tranche is generally ranked AAA. Investors in the next tranche down, which we'll say is AA rated, get paid after that. Then the A rated tranche holders receive their money, or "water." And so it goes, right down to the bottom layer of this structure, sometimes called equity (though it's not technically equity, for you finance nerds -- and there's often also something called an "overcollateralization" feature in a CLO, but we don't need to get into that here.)

When times are good, with all the leveraged loans paying on schedule, the waterfall is bountiful and everyone gets "wet" (i.e. paid). When some of the loans default, and the gushing waterfall of yield slows to something more akin to a trickle, there won't be enough money to go around. But you always start paying off investors at the top (AAA), then move down the structure. If the loans start to sour, the AAA guys are supposed to have an ample cushion before they feel any pain.

So, in a nutshell, an investment bank has taken 30 leveraged loans, tied to 30 companies that have 30 different stories, and roped them all together into a securitization that pours forth a stream of money that satisfies investors in the manner described above. If you're Standard & Poor's, it's a walk in the park to rate any one of those 30 loans compared with rating the slices of this Rube Goldberg-ian CLO. Which is probably why banks helpfully "suggest" the ratings to the ratings agencies and provide models to demonstrate their reasoning behind those "suggestions."

Now let's say you're Mr. Ratings Guy at Standard & Poors, in charge of signing off on CLO ratings. Your bull***t detector ought to be pinging pretty hard when something with these proposed ratings lands smack dab in the middle of your desk (I've condensed this from a Jan. 13 Bloomberg story):
Citigroup Inc. has revised the proposed interest rates on a collateralized loan obligation to be managed by WCAS Fraser Sullivan Investment Management LLC, according to people familiar with the terms.
A $15 million piece rated BBB by Standard & Poor's will pay lenders 400 basis points (note: there are 100 basis points in one percentage point) to 450 basis points more than the London interbank offered rate, while a $19 million slice, graded BB, will pay lenders 600 basis points more than the benchmark...
A $273 million piece rated AAA will pay lenders 160 basis points to 170 basis points more than Libor and a $13.5 million portion graded AA will pay lenders 250 basis points more than the benchmark, the people said. There is also a $31.1 million piece with an A rating and a $51.075 million slice of subordinated notes, the people said.
Why? Remember how our CLO was constructed: out of 30 leveraged loans. These loans pay a certain floating interest rate over Libor (the London interbank offered rate, or what banks charge when they lend to each other). And that's it. You can't wring out any more yield. So the size of our "waterfall" is constrained by what those underlying loans pay. Let's say it's 10% overall right now (not a bad assumption: a CCC and lower bond index right now is at 9.97%).

Now structuring isn't free. Citigroup isn't creating this CLO out of altruism. Here are some categories of CLO expenses: 1. The cost to structure the CLO and earn a profit. 2. The yearly costs to manage the CLO (for example, there's a reinvestment period, during which the manager must replace loans in the portfolio that pay down) 3. All other expenses, including paying the ratings agency.

Let's fill in some blanks. Let's say management fees average 51 basis points, or about half of 1% (source: 2009 report from PF2 Securities Evaluations). Let's say structuring fees run about 1.75 percent (this is according to a Bloomberg story). And, finally, let's say the life of the CLO will be six to eight years. Even though the management fee must be paid yearly, the structuring is a one-time expense, and can be averaged over the life of the securitization.

Do a little math and you get about 76 basis points as the yearly cost that has to be extracted from that 10% pot of yield you're getting every year. Now the size of that pot has been whittled down to 9.24% effectively.

So, as Mr. Ratings Guy at S&P, you should be getting a little suspicious at this point, even before you look at the proposed ratings: Citigroup claims to be able to strap these loans together and, through some bit of diversification/alchemy, just sort of poof! -- extract 76 basis points a year. If these loans, after being structured, were somehow "de-structured" but with all the fees still intact, you'd be left with the original 30 loans, but paying 76 basis points less apiece, which is a pretty significant gap in bond land.

That should make you go "hmmm." But once you look at the actual numbers for the proposed ratings, your reaction should be something like, "no way."

Just look at the generous yields on the tranches of the CLO! The AAA slice is 160 to 170 basis points over Libor. That's a super-juiced AAA yield. A AAA corporate bond -- once you make a few tweaks (for the fixed-to-floating swap rate, the difference in Libor vs. Treasury -- I won't show my work now but can later for anyone interested) has a comparable yield of about 54 basis points. How can this be, at a time when the credit markets are relatively calm, when even junk debt is selling like hotcakes? This isn't a period of high market stress and irrationality.

(Brief aside: Some readers may object: "Well, a AAA bond doesn't imply the same risk profile as a AAA slice from a securitization." If you think that, you may want to look at S&P's own writing on the issue from January 2010: "In developing our updated corporate CDO criteria (note: a CLO is a type of CDO), we collaborated with Standard & Poor's corporate and government ratings group to promote comparability of CDO ratings with ratings in corporate, municipal and sovereign, as well as other areas of structured finance. When we assign the same rating level to debt instruments in varying sectors, we are expressing the opinion that they have comparable credit risk.")

Back to our unfolding narrative! This is what Citigroup is essentially saying to you, Mr. Ratings Guy: "Hey, ya know, we just structured it and all, and found this great big pot of yield left over! Son of a bitch, funny huh? I mean, there was so much yield we shook out of this thing, thanks to our genius in structuring, that we could pay the structuring fees, pay the annual manager fees, pay all other fees, PLUS hand out extra yield like candy canes right up and down the waterfall structure!"

Because here's what you have: AAA is getting 111 basis points (1.11 percentage points) more than comparable corporate bonds. AA is raking in an extra 149.5 basis points, BBB an extra 229.5, BB an extra 218.5 ... (the spread for the A rated isn't given, but it's got to be consistent with the others because this grade lies between AA and BBB, so I extrapolated that one.)

That gives us another 116 basis points of yield a year, over the size of the entire CLO, that the structuring genies claim to have conjured from somewhere, for a total of 1.92%.

[Update: Reader “Anonymous” makes a good point below about the need to adjust the numbers to account for a call option premium. A fuller explanation of what that means appears at the end of this post. So the structuring genies are actually conjuring up closer to 152 to 180 basis points of yield out of thin air -- not 192 -- but that’s still a whole heck of a lot.)]

Think about that. These individual loans pay 10% overall. That was presumably their fair value. Somehow Citigroup is claiming, through the miracle of structuring, that it has been able to shave almost 2 percentage points -- one whole fifth -- of that risk away.

This structure makes no sense, right on the ground floor. You can't extract a bunch of fees, pay a bunch of rich yields, and have the math work out, considering there's finite money being paid out by the underlying loans. Structuring, in and of itself, can't produce such enormous savings. If it could, everything in the corporate debt universe would be immediately structured for huge and immediate gains.

Now, Mr. Ratings Guy, you should be saying, "Something smells really fishy here." And if you were thinking like this, you would reach an obvious conclusion:

These ratings have to be bull***t. The AAA tranche of this CLO, for example, deserves a grade closer to junk than to AAA.

Yet Mr. Ratings Guy still signs off on the ratings. Why? Hmmmm...

Stay tuned for Part II in which we answer: Why does Mr. Ratings Guy sign off on ratings he knows can't be correct and why does this farce exist at all? Is what's going on a benign "nobody gets hurt" kind of transgression? And who gets burned if these ratings blow up down the line?

Update: One objection that's been raised: S&P doesn't actually see the pricing when these ratings are proposed. It doesn't see that the AAA tranche, for example, would pay 160 basis points over Libor. Okay, that's somewhat exonerating for S&P, but it doesn't change the math. And what's more, Mr. Ratings Guy isn't that stupid. He can figure out what's going on.

He can easily find out what AAA rated debt pays for other asset classes. Even if he doesn't have the CLO pricing in front of him, he'll discover the same problem I outlined above. This structure supports a tremendous amount of what should be low-yield AAA, and even after you add in yields for the other stuff, there's an awful lot of leftover yield to go around (some of which is used to pay structuring and management fees). All of which leads back to the same questions: How does that act of structuring manage to create so much extra yield? How can these CLO ratings be accurate?

Update, Part II: I wanted to sneak in a second update for those readers who will say -- rightly -- wait a moment, don't loans amortize? So aren't you really receiving the interest rate on the loan plus a certain chunk of principal each year? That's typically correct, and I reference that up high in the post. But just to make clear: I am keeping this example simple with a focus on the interest rate portion only, because the yield is the sexy part. That's what you make over and above your initial investment -- the return of principal is just making you whole. If anyone has further questions/comments, put 'em below and I'll tackle them. The bottom line is the math doesn't really change.

Update, Part III: Explanation of the accounting for the call option: the equity investors (the ones who hold the junkiest tranche) have a call option on the CLO fund, which typically can be exercised after 3 to 5 years. The existence of that call option is undesirable for the other investors, so they’ll demand a premium to compensate for it. So in other words, if investors wanted to be paid 30 basis points above Treasuries for a AAA CLO tranche that can’t be redeemed early, once you add a call option, they’ll want even more.

How much more? That’s the key question. See more details in my reply in the comment section, but basically I give the example of a Wells Fargo note that’s effectively 6-year debt with a call option in two years, where the option appears to be worth 18.5 basis points. In a longer-dated note, the option is worth more: a Bank of America note that matures in 13 years has a call option that kicks in 3 years from now that’s worth 39.9 basis points.

Of course those examples aren’t CLO tranches. Still, for CLOs, the call seems even less valuable. Babson Capital Management looked at spreads for CLO bonds and found in the first quarter of 2007, they were 22 - 26 basis points for the triple A tranche. So even if you assume the investor is assigning negligible credit risk (say 10 basis points, which is paltry) to the asset itself, that leaves only 12 to 16 bps for the call option.

So, relating this to the example above, you can subtract somewhere from 12 to 40 basis points from the 192 estimate to account for the call option. Still, you get a good 152 to 180 bps of mis-rating -- which is quite a lot.