Monthly Archive for November, 2008

Peter Fisher on 900:1 leverage…

Published on 11/30/2008 in Financial Crisis . 0 Comments

FISHER: …we have got to think harder about all the embedded leverage.

I mean it’s a little shocking that not more people understood, that if you take a 30 to 1 leverage structure product and you put it on a 30 to 1 levered balance sheet, you are not talking about 30 to 1 leverage, you are talking about 900 to 1 leverage. And you can magnify gains and losses pretty dramatically when you do that.

So, the risk management system, the capital rules just haven’t kept up with the instrument innovation, another decade has gone by.

The Bloomberg on the Economy podcasts are a priceless (fortunately free) resource. I will attempt to motivate you to download the Aug 15, 2008 interview with former Treasury Under Secretary Peter R. Fisher. The above-captioned quote is from about 8:20 in the audio. Or you can read the interview transcript here.

Fisher seems to be one of the most well-informed on the inner clockwork of the financial system — that I’ve heard anyway. Fisher left Treasury in 2004 to join asset manager Blackrock, Inc. And now he is one of the names mentioned as a candidate to take over the New York Fed from Timothy Geithner.

Unanswered question: how much of this 900:1 leverage is still in play — specifically contracts that are not adequately hedged?

Cash flow — current and expected

Published on 11/30/2008 in Financial Crisis . 0 Comments

…is what really matters. From Jan 2003 remarks the AEI by Peter R. Fisher, then-current Under Secretary Treasury:


…In recent years, I have often heard it said that “There’s too much leverage in the system.” My question is: how would anyone know?

The balance sheet was a wonderful Italian invention that helped move us out of the dark ages and into the Renaissance. But 500 years later, and after the last 50 years of innovation, we have learned a little bit more about finance. We now know that the value of a firm is its future unencumbered cash flow. The balance sheet and last quarter’s earning statement are of little help in divining that value.

Investors need to know the real economic leverage being employed, whether through on- or off-balance sheet devices. We need a measure of all the contractually-obligated liabilities, whether contingent or fixed, future or current. We need a parallel measure of all the firm’s contractually obligated revenues.

Tying them together will give the firm’s contractually-obligated net present value – a true indicator of the firm’s leverage. This is not an untested or novel idea. The concept of NPV appears everywhere in modern finance except in financial reporting. This kind of disclosure is critical to the performance of our capital markets.

What’s blocking investment — is it liquidity hoarding?

Published on 11/30/2008 in Financial Crisis . 0 Comments

Yes — more important than uncertainty about the condition of borrowers, according to this presentation: Comments on Franklin Allen & Elena Carletti “The Role of Liquidity in Financial Crises” by BlackRock’s Managing Director Peter R. Fisher at the Federal Reserve Bank of Kansas City’s Symposium “Maintaining Stability in a Changing Financial System” Jackson Hole, Wyoming, August 23, 2008. The introduction:

Allen and Carletti provide an insightful review of the literature on liquidity and financial crises and a useful framework for considering the role of liquidity in the events of the past year. I find myself in fundamental agreement with what I take to be their two key points: first, on liquidity hoarding as the more significant explanation of the breakdown in inter-bank markets and, second, on the impact of cash-in-the-market pricing on asset values. As a consequence of this agreement, my comments will necessarily digress into quibbling about how one reaches these conclusions, how they should be characterized and into my own thoughts on the key puzzle of the past year, the Federal Reserve’s new facilities and suggested areas for further work.

Liquidity hoarding as “balance sheet defensiveness”

In their analysis of the drying up of inter-bank lending markets, the authors conclude that “liquidity hoarding” by banks has probably been the more-important factor than has uncertainty about the condition of borrowers. (Allen & Carletti, 20-21.) I certainly agree. (See Fisher 2008) In public, bankers would always prefer to blame uncertainty about their borrowers’ balance sheets than anxiety about their own balance sheets. However, in my own conversations with bank CFOs, Treasurers, and trading desks from August of 2007 through March of 2008, there was a frank acknowledgement of a defensive concern with their ability to finance their own positions and those of their key customers. The simultaneous and generalized widening of unsecured, inter-bank lending rates across U.S. Dollar, Sterling and Euro markets last August and the persistence of these wider spreads for the past year, also supports the idea of a lenders’ strike as the more useful explanation.

I see “liquidity hoarding” as a form of “balance sheet defensiveness” by bankers unwilling to rent space on their balance sheets to their competitors at traditional spreads.

CDS: leveraged super senior tranches

Published on 11/30/2008 in Financial Crisis . 0 Comments

I am still trying to work out:

1. of the global notional total market, how big is the unhedged proportion of the synthetic CDS market? Especially, the unhedged leveraged super senior tranches?

2. how much leverage is incorporated in such innovations as the leveraged super senior tranches?

Some 60 days ago one of the Wall Street economists interviewed on Bloomberg on the Economy mentioned that the effective leverage for some of the firms was 900:1, created by firm leverage of 30:1 applied to derivative securities which incorporated 30:1. I think he was talking about such as the leveraged super senior tranches, but I’ve not yet found a reference in print.

For reference, from Creditflux:

The synthetic CDO market has seen frequent waves of innovation as credit derivative dealers try to take advantage of new market conditions, and seek to achieve top ratings with the least possible subordination so that a structure can pay an attractive return for its rating.

Two of the most popular products have been synthetic CDOs-squared and leveraged super senior tranches. The first of these became extremely popular around 2003, but faded away following the sharp change in correlation pricing that took place in May 2005. Following the correlation repricing, leveraged super seniors surged in popularity, but volumes abated by the end of 2005 as market prices adjusted to the increase in super senior activity.

A synthetic CDO-squared, usually written CDO^2, is a synthetic CDO in which the reference assets are themselves single tranche CDOs. This results in a two-tier structure. Once losses attach in the bottom tier of ‘inner CDOs’ this causes losses to the top tier ‘master CDO’. A CDO squared increases the leverage of the investment, paying a higher return than synthetic CDOs on single name CDS, but also increasing the speed with which losses will eat through the tranche. (This risk is known as ‘cliff risk’.)

A super senior tranche is one with a high attachment point (the percentage of subordination beneath the tranche) and very low expected losses. A leveraged super senior investor has exposure to the entire super senior tranche, but its investment notional is only a small proportion of the notional of the super senior tranche. Since they have leveraged exposure to the super senior tranche, investors receive a leveraged return. However, if the market value of the super senior tranche decreases – for example, because losses start to occur on the underlying portfolio – the dealer has the right to ask the investor to increase the size of its notional investment. If the protection seller is unable or unwilling to put up more funds, the trade is unwound, causing a mark-to-market loss to the investor even though actual portfolio losses may be far from reaching the attachment point of the tranche.

Leveraged super senior tranches allow dealers to hedge the most senior part of the capital structure of synthetic CDOs, for which there has historically been little demand, while offering leveraged returns that attract typical CDO investors. Like all single tranches, super senior trades are sensitive to portfolio correlation assumptions, which is why a shift in correlation can significantly change the price of leveraged super senior deals.

CDS: super senior tranches

Published on 11/30/2008 in Economics and Financial Crisis . 0 Comments

A “for reference” post on Synthetic CDOs — especially the super senior tranche, by Janet Tavakoli in International Financing Review, 2003.

Credit Derivatives: An Overview

Published on 11/30/2008 in Economics and Financial Crisis . 0 Comments

This is another “for reference” post. From the Atlanta Fed’s 2007 Financial Markets Conference, “Credit Derivatives: Where’s the Risk?”, we have David Mengle, head if research at ISDA. summarizing how the key derivatives operate, and their risks. Included are statistics on fully funded and partially funded Synthetic CDOs [through 2006]. Also included are the 2006 twenty largest CDS couterparties.

Financial Crisis: the Need for Reliable Information

Published on 11/30/2008 in Financial Crisis . 0 Comments
As I think through each stage of the mortgage process and what has gone wrong, it seems to me that the traditional information flows that are needed for people to make economic decisions, especially risky ones, are no longer present, or if they are present, simply not believed. And without the information people need to make decisions, the markets freeze up.

I agree with economist Mark Thoma. Note that absence of price discovery can lead directly to solvency fears.

There has been much debate about whether the financial crisis is driven by lack of liquidity or from fears about lack of adequate capital and solvency, but I’m starting to think a third component is important as well, the complete breakdown of traditional information flows, and a loss of confidence in the models used to evaluate that information. Markets need information to work properly, and the information financial markets need is not available.

For example, investors can no longer trust what ratings agencies tell them. A crucial piece of information, information designed to break informational asymmetries between firms and investors, turned out to be unreliable. In addition, investors can no longer believe the numbers they see on bank books. The numbers might say the bank is solvent, but how reliable are those numbers? And even if the numbers are meaningful today, will they be meaningful tomorrow? Is there any way to actually value the assets a lot of these banks have on their books when there is essentially no market for them, no way to engage in price discovery? Investors no longer trust analysts and the models they use. They watched the business channel dutifully and all they heard was about the gold mine in housing. Sure, there were a few voices on the other side, but they were in the minority and mostly marginalized. All that bullish advice about housing turned out to be wrong. And there’s no reason investors should trust the models used to process information either. The models used for risk assessment turned out to be far wide of the mark – a costly deviation – and if you go back and look at the Fed’s forecasts of coming economic conditions (or the forecasts coming from the regional banks), it’s very clear the models were underestimating the severity and length of the downturn, enough so to be relatively useless. At a more individual, face to face level, I suspect there are many homeowners who believed what their real estate or mortgage broker told them are now wondering how they could have been so foolish. They won’t believe them next time. They won’t know what to believe.

…Big shocks don’t necessarily shake the informational foundations of markets. There can be an event that occurs in the tail of the distribution of possible events that is viewed as just that, an unusual, costly event, but not one that fundamentally upsets our understanding of how the world works while at the same time undercutting the informational flows we use to understand these markets. I don’t think the dot.com crash, for example, caused us to question the reliability of the information we receive the way this episode has. After the crash, we still thought we understood how to use models to process reliable information. But this crisis has destroyed confidence in the information and the models we use, and it won’t be easy to bring this back.

CDS: zero sum game, not

Published on 11/30/2008 in Financial Crisis . 1 Comment

I think the commenters got this right, compared to Felix Salmon’s description. E.g., here

…CDS are very risky to the sellers in a declining market since the the CDS seller’s porfolio usually will contain instruments which need to be marked down after a speculative bubble pops i.e, the mortgage backed securities. The CDS seller’s capital reserves then decrease and the ratings agencies then downgrade the CDS seller. Collateral calls on the CDS protection they sold follow the downgrade. Remember AIG? The reason the feds needed to rescue AIG was because AIG could not meet the collateral calls on all the CDS contracts they sold.

Why are banks buying CDS protection anyway? Right, you said it above. CDS’ allowed banks to increase their leverage. You didn’t say how. CDS’ were being used as a substitute for capital instead of actual capital. Since the banks held the bonds and swapped the default risk to companies like AIG, this in theory changed the bonds into capital. If these CDS sellers could not meet their obligation to the banks, then the banks would have been seriously undercapitalized right?

It’s not necessarily a zero sum game in a declining market, you might have to get the feds to bail you out.

And this by David Levner

I think a CDS is really a zero-sum game only if 1) there are no defaults, or 2) if the counter-party makes good after a default. Consider the following scenario:

ABC Investment Bank sells bonds to pension fund PQR. PQR gets worried about ABC’s ability to repay and buys a CDS from hedge fund HIJ. A year later, ABC declares bankruptcy and defaults on its bonds. However, HIJ doesn’t have enough money to pay PQR the amount it has lost because of ABC’s default, and HIJ also declares bankruptcy. Who is the winner here? Perhaps ABC, because it took PQR’s money for the bond and didn’t pay it back. Or maybe HIJ is a winner, because it took PQR’s money for the CDS and didn’t make good when ABC defaulted. However, both the “winners” are bankrupt and have broken their contracts.

The essential problem is that no one required HIJ to have enough reserves/collateral to make good on all the CDS contracts it wrote.

Larry Summers on unemployment

Published on 11/30/2008 in Economics and Financial Crisis . 0 Comments

You might wish to archive this chapter of The Concise Encyclopedia of Economics on Unemployment, by Larry Summers, the Obama-nominated chair of the National Economic Council. I’m confident that Dr. Summers will properly represent to the White House and Congress the best that we know on this topic. E.g., see his comments on causes [emphasis mine - Ed.]:

What Causes Long-Term Unemployment?

To fully understand unemployment, we must consider the causes of recorded long-term unemployment. Empirical evidence shows that two causes are welfare payments and unemployment insurance. These government assistance programs contribute to long-term unemployment in two ways.

First, government assistance increases the measure of unemployment by prompting people who are not working to claim that they are looking for work even when they are not. The work-registration requirement for welfare recipients, for example, compels people who otherwise would not be considered part of the labor force to register as if they were a part of it. This requirement effectively increases the measure of unemployed in the labor force even though these people are better described as nonemployed—that is, not actively looking for work.

In a study using state data on registrants in Aid to Families with Dependent Children and food stamp programs, my colleague Kim Clark and I found that the work-registration requirement actually increased measured unemployment by about 0.5 to 0.8 percentage points. If this same relationship holds in 2005, this requirement increases the measure of unemployment by 750,000 to 1.2 million people. Without the condition that they look for work, many of these people would not be counted as unemployed. Similarly, unemployment insurance increases the measure of unemployment by inducing people to say that they are job hunting in order to collect benefits.

The second way government assistance programs contribute to long-term unemployment is by providing an incentive, and the means, not to work. Each unemployed person has a “reservation wage”—the minimum wage he or she insists on getting before accepting a job. Unemployment insurance and other social assistance programs increase that reservation wage, causing an unemployed person to remain unemployed longer.

Consider, for example, an unemployed person who is accustomed to making $15.00 an hour. On unemployment insurance this person receives about 55 percent of normal earnings, or $8.25 per lost work hour. If that person is in a 15 percent federal tax bracket and a 3 percent state tax bracket, he or she pays $1.49 in taxes per hour not worked and nets $6.76 per hour after taxes as compensation for not working. If that person took a job that paid $15.00 per hour, governments would take 18 percent for income taxes and 7.65 percent for Social Security taxes, netting him or her $11.15 per hour of work. Comparing the two payments, this person may decide that an hour of leisure is worth more than the extra $4.39 the job would pay. If so, this means that the unemployment insurance raises the person’s reservation wage to above $15.00 per hour.

Unemployment, therefore, may not be as costly for the jobless person as previously imagined. But as Harvard economist Martin Feldstein pointed out in the 1970s, the costs of unemployment to taxpayers are very great indeed. Take the example above of the individual who could work for $15.00 an hour or collect unemployment insurance of $8.25 per hour. The cost of unemployment to this unemployed person was only $4.39 per hour, the difference between the net income from working and the net income from not working. And as compensation for this cost, the unemployed person gained leisure, whose value could well be above $4.39 per hour. But other taxpayers as a group paid $8.25 in unemployment benefits for every hour the person was unemployed, and got back in taxes only $1.49 on this benefit. Moreover, they gave up $3.85 in lost tax and Social Security revenue that this person would have paid per hour employed at a $15.00 wage. Net loss to other taxpayers: $10.61 ($8.25 − $1.49 + $3.85) per hour. Multiply this by millions of people collecting unemployment, each missing hundreds of hours of work, and you get a cost to taxpayers in the billions.

Unemployment insurance also extends the time a person stays off the job. Clark and I estimated that the existence of unemployment insurance almost doubles the number of unemployment spells lasting more than three months. If unemployment insurance were eliminated, the unemployment rate would drop by more than half a percentage point, which means that the number of unemployed people would fall by about 750,000. This is all the more significant in light of the fact that less than half of the unemployed receive insurance benefits, largely because many have not worked enough to qualify.

Another cause of long-term unemployment is unionization. High union wages that exceed the competitive market rate are likely to cause job losses in the unionized sector of the economy. Also, those who lose high-wage union jobs are often reluctant to accept alternative low-wage employment. Between 1970 and 1985, for example, a state with a 20 percent unionization rate, approximately the average for the fifty states and the District of Columbia, experienced an unemployment rate that was 1.2 percentage points higher than that of a hypothetical state that had no unions. To put this in perspective, 1.2 percentage points is about 60 percent of the increase in normal unemployment between 1970 and 1985.

ISDA: notional credit derivatives survey

Published on 11/30/2008 in Financial Crisis . 0 Comments

This is a “for reference” post. Note that this is survey data, not the hard data you would obtain for instruments that are exclusively exchange-traded :

The ISDA Mid-Year 2008 Market Survey reports notional amounts outstanding for the interest rate derivatives, credit default swaps, and over-the-counter equity derivatives as of June 30, 2008. All notional amounts have been adjusted for double counting of inter-dealer transactions. ISDA surveys its Primary Membership twice yearly on a confidential basis. In this survey, 79 firms provided data on interest rate swaps; 69 provided responses on credit derivatives; and 68 provided responses on equity derivatives. Although participation in the Survey is voluntary, all major derivatives houses provided responses.

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