Friday, August 17, 2007

Blowing Up the Lab on Wall Street -- Time Magazine

I was asked to write a column for Time Magazine on what is causing the subprime mortgages to have so broad an impact. Since you can see it there via the link, I am not also putting it here. But comments here are welcome. (To make a comment, click on the title so that the post appears on its own page).

9 comments:

  1. I don't have the relevant references here to check (Dunbar, Lowenstein) -- and with your background, you may be better informed than the references -- but i was under the impression that LTCM had dabbled just a bit in russia, and it held a few GKOs (though all accounts also suggest that the GKOs were not the problem, the problems came from highly leveraged positions elsewhere that overlapped with the positions of folks who had more GKO exposure).

    appreciated the article and the very clear explanation of CDOs.

    bsetser
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  2. hi rick,

    somebody mentioned your book a few months back and I read it having remembered your name as part of the CFA level 3 curriculum -- and I am so glad you wrote it and I read it prior to all of this current turmoil -- kudos for putting this all down in writing and getting it published long before it played out (again).

    My question really is, given how much leverage has been in the system -- far more than 1998 -- why do you suppose the markets volatility stayed so low for so long? the VIX, to take one measure as an example, stayed low for about 4 years -- despite much more significant complexity in the system than the last period of low vol -- the mid 90's. Why do you suppose it did this?

    also, do you have a measure any more useful than the VIX as a way to measure 'volatility storms' that come and go?
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  3. On LTCM's exposure to Russia: "Nary" might have been the wrong word to use; but they did not have enough exposure for it to matter -- it was not an exposure of any note for them.

    On leverage and volatility in the system: I don't know how leverage has changed. And that is the problem: no one knows. But I think one of the reasons we have seen such low volatility is that there is more capital chasing any opportunity of dislocation, so that if you are a liquidity demander, prices do not have to move as far for you to get filled. And if new information comes along, there is more capital on the tail of the expectations to absorb the information-based flows without as much price disruption.
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  4. I have a question regarding the creation of "tranches," specifically how the "risk of default is allocated to the tranches...is the default risk allocated based on "inherent risk" ("fundamental risk", loan to value, income/debt service coverage, etc) or on "cortractural risk" of the tranche, i.e. the lowest rated tranches take the first hits whether or not the underlying mortgages in That Tranche have actually defaulted.
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  5. In response the the question about tranche defaults, each tranche contains exposure to the same package of bonds, and what matters to each tranche is the total cash flow being generated. The higher quality tranches with continue to get their promised cash flow and the lowest one will see its cash flow from the CDO decline with the first default. Finally, if many bonds default, even the top tranche will have reduced cash flows.
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  6. Rick,

    I am delighted that you are now writing these log entries. I am a proud owner of your Morgan Stanley reports, and I see from your "About Me" that I have all your earlier books.

    Just one comment on the last two on "tranches". It goes without saying that in general, as the lower rated "tranches" are impaired the more senior ones may see their ratings altered. This may eventually lead to their exclusion as permissible assets under certain investment policy rules.

    However, a few years ago I came across a situation in which a faster retirement of impaired assets with a high recovery ratio, ended up raising the ratings of the more senior "tranches".

    Thanks.

    F
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  7. Rick,

    It has taken me a little longer to prepare these comments on your very elegant piece for TIME magazine.

    1
    CDO’s have been around for almost twenty years. I recall that the first CDO was a 7-year, $300 million issue arranged by the late William E. Simon through his own Western Federal S&L, in California. The assets were high yielding securities that had been distributed by Drexel Burnham Lambert. There was a single “tranche” rated AAA. An interest rate swap with a AAA-rated counterparty was used, to match the risk profile of the income from the securities to the profile of the promised income of the vehicle’s units.

    2
    I tend to agree with you that the AAA-rating of CDO’s in general lacked the historical experience to support the probabilities used in stress tests. But I find it difficult to blame credit rating agencies for this market instability and all these losses. Much in the same way that I find it difficult to blame the global regulatory entities for the incentives they created to offload assets from banks’ balance sheets by imposing new risk metrics.

    I like to think that the main reason lies in the liquidity “pool” used by the different varieties of managed leveraged finance--the asset backed commercial paper (ABCP) market. I think that this is the source of the “improbable linkage”.

    3
    But I am most optimistic. Many will recall the year 1990 when difficult liquidity circumstances led to the demise of the firm that created the “junk” bond market. “Junk” bonds were then the subprime issues of the day. This segment of the bond market has evolved and I like to believe that the global high-yield bond market is today a very important source of SME financing.

    Security design will evolve as well in the subprime market, to ensure that those who are less fortunate in our society can have access to new forms of ownership of household capital goods.

    Thanks.

    F
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  8. Rick:

    I really liked the Time piece.

    You neglected, I assume for brevity’s sake, to mention the leverage inherent in derivatives, which I believe is incalculable.

    What is known is that notional value of OTC derivatives outstanding is more than $415 trillion at 12/31/06 (per Bank of International Settlements Quarterly Review, June 2007, available at: www.bis.org/publ/qtrpdf/r_qa0706.pdf#page=103). This is a nearly four-fold increase from the $111 trillion at 12/31/01.

    The vast majority of these positions are hedged against securities (or physical assets, as appropriate) or other derivatives, but some are speculative positions.

    There are a great many players in these markets, each with their own proprietary positions and strategies(almost all of which are closely guarded secrets – although recent events indicate that, as you noted elsewhere, some appear to be highly correlated - see your post of 8/16). I believe, therefore, that there are significant potential liquidity and counter-party risks (particularly given that there are still a number of problems in the recording and settlement of these positions per BIS - available at: www.bis.org/publ/cpss77.htm).

    Furthermore, the ability of hedge fund LPs to redeem their interests for cash on a somewhat regular basis (perhaps requiring the unexpected unwinding of illiquid positions), while technically not leverage, means that these funds are exposed to the risk of a run of redemptions (subject, of course, to the terms of the specific LP agreements).

    All of this complexity, I believe makes any estimate of effective leverage almost, if not completely, incalculable.

    As long as markets remain somewhat rational, there shouldn't be a problem. As you point out in your book, however, tail events DO happen and the impact would be potentially catastrophic. Hopefully I'm overstating the potential impact.
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  9. Understanding that the Time piece is written for a general audience, it still sounded oversimplistic to me. It makes CDO's sound like a mad scientist's creation with no rational foundation. But of course there are multiple macro reasons why CDO's came into existence and why the demand is so great: two points that should have been made are a) the support in principle for the structure in basic portfolio theory about diversification; and b) pension and insurance demand, fueled in large part by demographics, for an investment grade credit vehicle that will yield more than treasuries, coupled with declining credit quality of corporates.

    Also agree with the poster above about way too much emphasis on rating agencies, who are mere third parties. IMO, it is the buyer's job to either do the diligence on a specific issue, or understand the macro environment, or both, and in either case to hedge against the credit risk, and control their own leverage, regardless of what some third party is saying.
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