Archive for the ‘Structured Finance’ Category
Market turmoil is still quite fascinating to me and I still believe the current environment will be one for the history books and I’m still trying to take as much as I can from this learning experience.
My professional work experience is in fixed income. For two years, I was very “plugged in” to the markets and was meeting regularly with some of the greatest thinkers out there, but now I’m more of a pure “quant” and most of my news comes from blogs, web news, etc. Unfortunately, I’m not yet spending as much time with the traders as I’d like (but that should change soon I hope). Most of the major news sources, e.g. Bloomberg, seem to concentrate more on equity markets than credit and fixed income. I pay more attention to the Dow now than ever before. That is why I am so perplexed by the stock market. I thought stocks were supposed to be easier than bonds, i.e all the smart guys are in fixed income, right?
So while the credit markets seem to be imploding, stocks are doing just dandy. Maybe people are taking cues from the market cheat sheet?
Anyway, I’ve blabbered quite a bit on this blog (and at my former employer) expressing my opinion of CDOs. I even managed to upset quite a few people while expressing my opinions as well. No regrets though. I’m happy to have this hugely public diary, both here and on NP, to later look back and see how I did in regards to thinking events through. Occasionally, I still like to poke my nose in over at NP and I see kr is still giving out the occasional nugget. Here is one of his latest:
A few thoughts:
– If you took all the writedowns at a single med-to-large bank rather than seeing them across the street, you could have reduced that entity’s equity to ZERO. For instance, MER has only something like USD54bn of mkt cap and USD39bn of book equity.
– If the view is that there will be another round of writedowns in the same amount as Q3 then you will have banks desperate to raise equity (i.e. it is not just the monolines). Who would buy that equity right now? Prince Alwaleed for example has floated his own holdings so I see him more as seller than buyer for example. I don’t see guys like JC Flowers or Cerberus well positioned for this job – in retrospect, even Barclays/RBS have not been with respect to ABN, as can be seen by the action in their share price and cost of jr capital.
– Another possibility would be the downgrade to BBB like the Japanese banks, with all the implications that brings with it. I.e. serious change in business model. That has contagion and macro effects. One example is that flow trading of financials has cost people a lot.
– I think investors will call foul on the FAS157 Level-3 assets, and it will hit guys like GS seriously as their L3 reporteds are a big multiple of their mkt cap.
– There was a funny comment in this month’s BBG mag about “nobody really knows how desks are hedging the CDO assets.” That is bull – the answer is that most people were NOT HEDGING AT ALL, BECAUSE THEY COULDN’T. Stuff was originated to sell, and the exit has vanished, or, it was originated to live forever on a trading book even though people tried to avoid saying that, and there is no decent MTM approach so instead banks are showing huge volatility, mostly to the downside.
– Implications of SIV / CDO / CP demise are pretty vast. There seem to be an increasing amount of trade receivables on the market, b/c there are no conduits to fund them… means corp cost of cap is going up in unexpected areas.
My hunch is that the fed cuts on the 11th b/c liquidity is dropping again, especially with year-end. It is out of control – specifically Ben’s control. It looks like political support for the various subprime fixes has stalled. What I think is that liquidity of all things financial (i.e. non-corporate) is going to get weaker and cause a full-on crisis for a market-traded institution. The talk about Citi cutting their div is one tremor, trading activity in Barclays is another, and the fact that even AFTER all the reported loss numbers, people still don’t feel comfortable, is yet another.
I think vols are still cheap, maybe looking to buy some.
All the while I was complaining about CDOs, I was coming at it from the angle of a “quant”, i.e. thinking about how to model CDOs and how those models are used in risk management, asset allocation, etc. Too bad I didn’t understand more about the legal/accounting aspects of CDOs. The term everyone has now heard of is SIV. I was blabbering about off balance sheet leverage and fair value accounting, but didn’t realize that the entire CDO market was (to a jaded eye) a big play on accounting in addition to the obvious play on ratings agencies. If I had known about SIVs, I might have been able to do more to help some who may have now lost a lot of money. Maybe not. That’s all in hindsight. But what am I missing now? Where is the next weakest link? How are corporations hiding off balance sheet debt? Has anyone looked at “Level 3” assets in corporate, i.e. non-financial, balance sheets? Are they as scary as the big banks?
I’ll say it again… this is not a subprime issue. Subprime contagion does not explain the current environment. Subprime was just the first to blow. We are experiencing the blowup of a global fixed income bubble. In fact, some would say we’re experiencing a general global asset bubble.
Who’s going to get hurt? Financial institutions for sure. Anyone who depends directly on the value of paper assets.
Who’s going to win? People whose wealth depends on physical assets.
I’ve already lost all hope in Bernanke. He is not going to let his monicker “Helicopter Ben” go by the wayside in a “time of need”. Bernanke is going to lower rates and weaken the USD until oil exporters are forced to break the peg to the USD and inflation skyrockets. I predict that all these gloom mongers about home prices dropping by 30% will turn out to be wrong in nominal terms even if they are correct in real terms. In other words, home owners are going to be saved by the dropping value of the USD. All those on Wall Street who were so gleeful every time rates dropped are suddenly going to feel the pain when the value of their paper securities go up in smoke.
Watch out for the “happy stage of inflation”, i.e. wage increases. It will be interesting to see what the world will look like when oil is priced in EUR and the USD is no longer the world currency. Fortunately, I still have faith that we’ll come out of the current mess stronger as a country, but there will certainly be pain felt at the higher end of the wealth spectrum.
I’m actually ironically optimistic about the outlook for suburban and rural economic development. A weaker dollar will make outsourcing less attractive. That will bring manufacturing jobs back home. I can imagine a boon in suburban and rural development. Just imagine if communities developed decent broadband via fiber-to-the-home/business. Suddenly, there will be attractive jobs and living standards in affordable places.
Maybe a weak dollar is what this country needs, i.e. a good kick in the pants. Pain is the best teacher, right?
[Edit: PS, the title of the post was inspired by a great article on Financial Armageddon, but I never got around to explaining why, but have a look and it might be obvious.]
Way way back a long time ago (in August), I clarified a semantic issue regarding one of my market forecasts (more like voodoo analysis) I made on July 24 here:
Here is a snippet:
But regarding that quote above from my last post, there is something I wanted to clarify. Particular the chain of events that I outlined, i.e.
subprime CDO imploding -> HY repricing -> CLO slowing -> LBO stopping -> private equity choking -> equities tanking -> M&A increasing -> ???
At the time I wrote that, we were only on step two, i.e. subprime had imploded and HY had repriced (a bit). I think their is still long way down to go for credit, but at the time I wrote that CLOs hadn’t been hit yet, LBOs were not on the radar screen (of most anyway), and the idea that private equity was in trouble seemed ludicrous. How about now?
Now, everything has occurred except “M&A increasing”. At the time I wrote that I was distinguishing LBOs from M&A, but have since learned that many people include LBOs under the M&A umbrella, so I thought I would clarify what I meant by that last item before the “???”.
LBO activity was driven by (at least) two factors: easy credit and value in acquiring companies. The first factor is now gone, which is why private equity is hurting. The second factor remains. Easy credit made it difficult for real-money people to take advantage of the value in acquiring companies because of competition from private equity. With easy credit gone and private equity struggling to get LBOs done, now people/corporations with real money on hand can take advantage of the situation.
By “M&A increasing” I meant that mergers and acquisitions that are not dependent on leverage, i.e. by people/corporations with “real money”, would increase. This, I thought, would prop up equities for a while longer. For example, on July 25, I said:
Since I expect LBO activiate to be significantly hampered, if not halted, and since there is value in stripping some of the companies, I expect more M&A activity to replace LBO activity.
I meant “non-leveraged” M&A. So watch for this. The first sign of this happening that I’ve seen comes from Bloomberg in regard to Warren Buffett. Certainly a “real money” guy.
Here’s an excerpt:
Berkshire Hathaway Inc. Chairman Warren Buffett is ready to spend $40 billion to $60 billion on an acquisition, and his opportunities are expanding as stocks fall and leveraged buyouts dry up.
Shares of health insurers, steelmakers and department stores are as much as 22 percent cheaper than in May, when Buffett said he would “figure out a way” to come up with $60 billion for the right deal. WellPoint Inc., Nucor Corp., Kohl’s Corp. and dozens more companies are now closer to meeting his investment criteria.
It seems we are approaching the faintest regions of that earlier “prediction”. Real money seems to be stepping up and it is not necessarily from the obvious candidates. Watch out for sovereign wealth funds to keep things propped up for a while longer.
A bit dated due to my reduced blogging pace:
and a bit more recent via a guest appearance on Brad Setser’s blog
Michael Pettis seems to think sovereign wealth funds can prop up the market for years to come. I tend to agree with him (but not sure if the time span is years… or months). By the way, as a sidenote, when I asked someone at work about the possible positive influence of sovereign wealth funds on structured finance, I was shot down pretty publicly. It was brutal. Friendly new colleagues seemed to get a kick out of it and still rib me about it to this day. Pick on the new guy! 🙂 Oh well. I’ve decided to keep my mouth shut about markets and economies during high-profile meetings. After all, I’m not an economist or even a market analyst. I’m a quant. As a quant, I am quite competent and should just stick with what I know when it comes to my actual career. On the “quant” front, however, I’ve recently developed some massively cool technique for rapidly producing analytics, e.g. OAS, OA duration, etc for a large pool of securities. In the “privacy” of my own blog, I can say whatever I want though 😉
Another 16 hour day! Phew! Kick @$$!!
Anyway, although I should be sleeping, I decided to compose another stream of consciousness over at NP.
“In my opinion, the CDO market is history.”
[From RRP:]Eric, this is the kind of stuff that you say that drives me nuts.
Come on. Admit it. This is exactly the worry that has driven you to drink and you know it
Look at it from the flip side. You’re a pension fund or university endowment. Why would you invest in CDOs? Because they have a good credit rating and provide an attractive yield compared to other AAAs. Do you really think these guys are going to continue falling for the same joke? Do ratings agencies have any credibility left? How can a pension fund manager look at their retired investors in the eyes and tell them that CDOs are as good as GE debt? Senior citizens are losing their livelihoods. That smells like political action to me.
The ONLY reason for the existence of CDOs as far as I can tell is “ratings arbitrage”. That boat has sailed.
There is no doubt the underlying cashflows are good, but the justification for the existence of tranches is diminishing. Why invest in something that the smartest people on the planet do not understand when you could invest in the same cashflows with less hokus pokus, i.e. untranched structured products, e.g. vanilla MBS, ABS? In crises, it seems the more exotic fringe products disappear and the surviving assets will eventually become commoditized.
I think the CDO market is going to effectively disappear because the newly found liquidity premium will swamp out even the most optimistic present value analysis making it uneconomical to issue. I could certainly be wrong.
I do not know the mechanism by which this could occur, but just thinking aloud, it makes a certain amount of sense for a servicer to repackage a CDO into a more palatable structure. That way, they could at least make a market even if it isn’t selling voodoo to senior citizens.
Having said all that, if the liquidity premium does force a drastic reduction (or complete halt) in CDO issuance, then those with the guts to buy up whatever is left at bargain basement prices will make a total killing as long as they have the patience (and freedom) to sit back and collect the cashflows (with no intention of selling). If I had the luxury of a lot of cash sitting around, I would be circling over head.
Good night and keep up the good fight!
What a week!! I certainly picked a good time to start a new job in structured finance. It’s only my first week and I’ve already had two 16 hour days where I was in the office until after midnight 😮
Actually, I love it! I love the intensity and love pushing myself. Reminds me of grad school 😉
Anyway, the big news from the Fed last week was the lowering of the discount rate. Over on NP, I voiced my opinion in a brief statement:
I think it is a smart move. The first sign that Bernanke isn’t as bad as Greenspan.
I thought it was an innocuous enough statement, but apparently Greenspan has a lot of fans out there. I was immediately greeted with:
Care to elaborate on this? I agree that boosting liquidity even modestly right now will be extremely helpful but I’m not sure that G-Span would have acted differently in this circumstance. Sure he was a bit compulsive about inflation but he gave the system liquidity when it really needed it. In 98 after Russia the discount window borrowing rate went from 5 to 4.50. Same magnitude move we are seeing here. You do realize that the target rate isn’t changing, the secured lending rate is?
I’d like to know what IAmEric is going on about as well. Greenspan was adamant about making sure that bubbles didn’t end up as complete disasters. He was well known to provide liquidity in times of crisis. So how is Bernanke better than Greenspan?
I’d also like to hear IAE’s reasoning…
Then, I replied with what I thought was a reasonable succinct explanation:
Greenspan would have already cut the Fed rate by 1% (or more). That kind of behavior is what got us here. Cutting the discount rate while keeping the target rate at 5.25% makes sense. Nothing more nothing less.
This is where I think RRP got a little out of line, but hey, we are all adults, right? No biggie.
Please, don’t let facts get in the way of your hyperbole but a quick check would reveal this to be pretty much untrue. Taking 98 (which was worse than this crisis has been to this point) to be a good comp (an article of faith no doubt, but bear with me) we saw three rate cuts for a total of 75bps by mid november. This is a full 3 months after the default and two months after things started getting extremely nasty. Lo and behold target rates were back to pre crisis levels by mid November 99. It looks like an effective use of policy to get through a crisis to me.
Now you can fall into the camp that will blame the fed policy for the run-up in home prices and ultimately the housing bubble. That’s well and good, but cheap fed funds do not a bubble make. It takes a great deal of complacancy from the whole financial community to ignore the facts which are now so blindingly obvious and had been obvious to most people paying attention for the past 5 years. If you want to make a substantial loan to somebody and require less verification than it would take to get a Sears card be my guest, just don’t cry to me when you get hurt. There’s a lot of pain out there right now and there’s not a single fucking person feeling it who doesn’t deserve it. Idiotic borrowers, opportunistic originators, greedy investors, lax rating agencies, traders with tunnel vision, bankers with short time horizons, every last one of them is getting stomped (including yours truly). It’s their own goddamned fault so don’t put it at old Alan’s doorstep.
And for the record, I’m not in the camp that thinks Greenspan is one step removed from Jesus, I just belive he performed more than adequately in an extremely difficult job.
I’m really not sure what kind of logic it takes to look at the historical funds rate as evidence against my “opinion” that Greenspan would have already dropped rates by a “1% (or more)” in the last 5 months. I replied with:
You are certainly entitled to your opinion. I hope it has served you well. Comparing this to 1998 may be justified, maybe not. I think not.
The data you yourself supplied shows 8 – 50 bp drops and 3 – 25 bps drops in 2001 alone. ABX tanked in Feb-March. I think Greenspan would have thrown in a few 50 basis pointers during the last 5 months. It’s just my opinion and as we all know, that is what this entire industry is built on, i.e. art versus science.
Then energetic chimed in with…
I think Greenspan would have thrown in a few 50 basis pointers during the last 5 months.
Eric, dude …
I could only afford one last comment before being buried in modeling…
Look at the data man! If anyone should be frustrated, it should be me. I don’t blame people for talking their books though.
Edit: Here is the data for 2001
December 11 – Rate cut 25 bps to 1.75
November 6 – Rate cut 50 bps to 2.00
October 2 – Rate cut 50 bps to 2.50
September 17 – Rate cut 50 bps to 3.00
August 21 – Rate cut 25 bps to 3.50
June 27 – Rate cut 25 bps to 3.75
May 15 – Rate cut 50 bps to 4.00
April 18 – Rate cut 50 bps to 4.50
March 20 – Rate cut 50 bps to 5.00
January 31 – Rate cut 50 bps to 5.50
January 3 – Rate cut 50 bps to 6.00
RRP chose to argue against a Greenspan “1% (or more)” rate cut by pointing at 1998 (as if today somehow resembles 1998). Using similar logic (which admittedly isn’t very sound), I pointed at 2001. That is not to say I think today’s environment resembles 2001, but was simply meant to point out that
the Fed Greenspan could have a lead foot when it comes to rate cuts in times of “crisis”, which I think current events count as.
Then the fun started:
So, you want to compare the current crisis with the aftermath of .com collapse? AFAIC, this is a bad model, but you would agree, would you not, that there was a considerable delay in Fed reaction even then?
IAE, regarding 2001, comon man… that was a recession with 9/11 thrown on top to boot. Where is the comparison?
[From RRP: (my emphasis in bold)]
And I tend to agree with him. But seriously, this is not some random trash bin on the internet where anyone can say whatever pops into their head and not have to defend it.
So in the spirit of fairness here is whyI think that this is more similar to 98 than not (and coincidentally 98% of the people I’ve spoken to on this are in agreement).
- Seemingly isolated events torching unrelated markets
- Deals ground to a halt
- Media panic about shadowy hedge funds toppling the global financial markets
- Decrying the fed bail out that has yet to materialize
- The feeling that there is no end in sight
- Summer totally getting fucked; My drinking is purely therapeutic at this point and not for recreation
Please let me know why you don’t think it’s similar. And just an aside in my youth, some really old dudes informed me that everyone thinks the first market crisis they experience is really new new new when in fact history repeats itself more than we’d like to admit. It’s just better sales to say we’ve never seen anything like this before, making the same mistake twice appears really really dumb for some reason.
As for 2001 and this being similar, or similar enough to compare fed reactions, please elaborate. Seriously, people got what the hell was going on there, equity markets were getting trounced on the heels of the dot com shutdown but fixed income was in fine shape. Business investment dried up very quickly. This whole irrational exuberance drum was getting pounded before the equities collapse(Greenspan 96). Again, not that it matters if you are ultimately right, because if you miss out on the way up you’re not going to keep your job long enough to be vindicated. Also to the point 2001 was a reaction to fundamental economics, 98 was a reaction to a crisis in confidence. Two different animals in my book. Sir Appleby, I don’t necessarily disagree with you on the Drexel thing but 91 was really a recession as well and I think trying to separate the fed motives for liquidity provision vs. managing targets for key economic variables is a little tougher task. Plus I was just getting pubes in 91 so I don’t have a lot of knowledge of it.
The problem I have with second guessers is that they generally are the last to the party and the first to point out how shitty it is. It’s easy to criticize and hard to create, I mean really are you really disappointed with the Greenspan track record en total from 87 to 06? What would you have done differently? Why do you think things would have turned out better?
Wow. What can I say? That is just real %$#^ed up. To be fair, RRP is probably sitting on a portfolio of CDOs and is understandly not in such a great mood these days (even though I did warn him long ago) 😉
It didn’t end there though. Tabris, ironically speaking of jumping on band wagons, had this to say:
Now with regards to the Fed discount rate, we can all speculate on what G-span would have done (my bet on 25bps cut next meeting if G-span still in office) but it is really a moot point. The fact is, Big Ben is beginning to realise the issue they are having in liquidity and is taking pre-cautionary steps in correcting the LIQUIDITY problem. They are not bailing out HFs or mortgage clowns as HFs will still blow up and Mortgage clowns still have to sit on their bed of toxic subprime loans. Nothing more, nothing less…
Now, less bandwagon jumping, and more evident based debate please.
RRP, you have my respect for being one of the few guys trying to bring this debate back from the pits. Drinks on me next time!
Then, last night before hitting the sack after a very long week, I posted the following:
Why is this not like 1998? In 1998, it was a “liquidity” event. As such, pumping liquidity into the markets does make a certain amount of sense. What is unfolding now is a combination of “liquidity event” with a bursting “credit bubble”. It is not a “mortgage” issue that has spread. Rather, it is a general “fixed income bubble” that is bursting. THAT is different and that will not be made better by pumping the system with liquidity. You can argue all you want (and you’re certainly entitled to) that the Fed had nothing to do with inflating the credit bubble since 2000-2001. You’d be in good company. Conversely, if you thought the Fed’s policies encouraged the credit bubble, you’d also be in good company.
That is the kind of conversation that can be potentially interesting. One where you have super sharp and experienced people on both sides of the aisle with completely opposite views on things. As I’ve said before, I subscribe to the concept of “economic Darwinism” and that a recession now and then is a good thing for long term growth. I am in good company on that one. I particularly enjoyed Andy Xie’s recent piece:
If central banks try to bail out Wall Street, it would lead to high inflation for years. The inflationary effect of loose monetary policy of the past was offset by the deflationary effect of globalisation. Now China and other developing countries are experiencing high and rising inflation. Loose money will go straight into inflation. The vicious cycle of the wage-price spiral of the 1970s has not occurred as both labour and capital still believe in the inflation- fighting credibility of the central banks. If they loosen up again to bail out Wall Street, this credibility may be squandered. The ensuing wage-price spiral could ruin the global economy for years to come.
What is occurring is an opportunity for central banks to restore their credibility. Markets have been taking more risk than they should because they believe that central banks will come to their aid during times of crisis, like now. The penchant of Alan Greenspan, former US Federal Reserve chairman, to flood the market with liquidity during financial instability is the genesis of this “central bank put”. As long as this expectation remains, financial bubbles will occur again and again. Now is the time to act. Let the crooks go bankrupt. Central banks should bury the Greenspan “put” for good.
Band wagon? There certainly may be a lot of that going on these days, but I hope you don’t put me in that category. Just read what I’ve said over the last couple of months. Private equity? LBOs? CLOs? Structured finance in general? High yield? Those might be headlines now, but they certainly weren’t back when I first began blabbering about them (Maybe it was incoherent blabbering, but blabbering all the same). The first time I began publicly voicing my opinion about Bernanke and Greenspan was on July 3 in the “Liquidity Liquidity Everywhere” thread (and no, I am not running around in glee ).
Greenspan and Bernanke are both wankers. I call it “forest fire monetary policy” (there is probably a better academic name). It is better to let the forest burn once in a while in a controlled blaze then to let timber build up over years and years. That situation can only end in inferno.
Believe me, I had been arguing with economists and other analysts about the point far earlier than that. [Sidenote: If you are a noob to monetary policy, but would like to a know a bit about what its all about, I highly recommend A Term at the Fed.] Not that any of that matters, I just felt like debunking the “band wagon” statement, which is a bit like setting up a straw man, don’t you think?
And I’m certainly not criticizing in bad times and chearleading in good. I’ve been warning anybody who would listen about CDOs since the moment I learned about them (and have the well-received research reports to prove it). And now that the sheah has hit the fan, I’ve joined a structured finance group. One reason being that I know there are some great opportunities and working through this time will be a killer learning experience. Having said that, I still wouldn’t touch a CDO with a 10 foot pole, but there is more to structured finance than toxic voodoo magic.
Anyway, it seems that jumping on “IAmEric” has become an increasingly popular recreation sport on NP these days, and since I value the community there, I still want to avoid senseless rants or jibes against my comments which just distracts from the conversation (and decreases the likelihood of having an actual valuable contribution from kr or Bachelier etc). So… I recreated the relevant parts of the conversation here. Have at it! That is what blogs are for. Give me what you got 😉
This is bound to end up badly.
From the Wall Street Journal:
Here are some excerpts (my emphasis in bold):
The SEC is looking into whether Wall Street brokers are using consistent methods to calculate the value of subprime-mortgage assets in their own inventory, as well as assets held for customers such as hedge funds, the same people said. The concern: that the firms may not be marking down their inventory as aggressively as assets held by clients.
… few big Wall Street firms have reported big subprime losses despite the turmoil roiling the markets.
“No one really knows how to price asset-backed securities and CDOs and that’s a real problem in the market now,” says Ann Rutledge, principal of R&R Consulting, a structured finance consultancy in New York.
The pricing issue is crucial for brokers and banks, some of which hold significant amounts of mortgage or CDO securities on their books. Analysts said it was common in past years for Wall Street underwriters to keep portions of the securities of CDOs or mortgage bond deals they arranged.
The SEC’s market-regulation division has been in touch with all big brokerage firms to ensure their risk-management systems are up to speed in light of the quick deterioration in the subprime market. The asset-pricing inquiry is being conducted by the agency’s office of compliance, inspections and examinations.
This is all part of a bigger picture we are discussing here
- Risks of risk management
- BNP Paribas and fair value accounting
- GS Global Alpha Fund
- Fair value accounting
- Voodoo analysis: Goldman Sachs in trouble
- “Mark to model”
- Conspiracy of silence
- CDOs and Risk Management
- “The End is Near”
Some of the best quants in the world are hotly debating appropriate methods for pricing CDOs. When I hear their arguments, the only conclusion I can come to is that NOBODY KNOWS how to price these things. If you can’t price them to determine the value of fund shares and if you can’t value them for GAAP accounting and if you can’t price them for the purposes of allocating capital for risk management purposes, then what does that mean? It means people have been flying blindfolded for years. Who knows where we will end up, but my suspicion is that the place will not be pretty.
Oh yeah, don’t forget I’m an optimist 😉