Thursday, July 29, 2010
A Correction
The second paragraph of the last post on the destruction of the Constitution, starting with “In places, content dominates...” was missing; since when I know not. Perhaps since Monday when I began writing the epilogue to the Goldman Case and somehow inadvertently deleted it. Or maybe it had been missing since the time of the posting. In any event, it is now corrected. My apologies for the omission which you no doubt noticed.
Monday, July 5, 2010
The Destruction of the U.S. Constitution: An Essay on the Commemoration of the 4th of July, 2010
The relation between form and content is a complex one. It lies at the core of man’s recognition of himself and his environment. It is the central question of all artistic activities, indeed all human communications: what to say and how to say it. It is a critical link in Hegel’s dialectics and the key to understanding Marx’s Capital.
In places, content dominates form, as in a rock, where the form is but the extension of the content, what the rock is. At times, the form dominates by virtue of the content’s absence, as in the Senate hearings surrounding the confirmation of Elena Kagan to the Supreme Court.
Pity the media which must hype up the event as a sign of the citizenry’s vibrant democracy in action. Hence the live coverage of the embarrassing exchanges on TV and over-the-top reporting in the press: CONSERVATIVES ATTACK KAGAN!!! MISSISSIPPI SENATOR ACCUSES KAGAN OF BEING A LEFT WING!!! CONFIRM KAGAN!!!
The citizenry, alas, refuses to bite. Call it apathy or passive resistance. But Joe Sixpack is just not going to care. And why should he, with the event being so removed from his daily concerns that it might as well be taking place in another planet?
So a calculating self promoter with little knowledge of the law and deep superficiality – she calls herself “famously excellent teacher” – is finally within her goal of becoming a Supreme Court judge. She would be “impartial”, she told the committee.
IMPARTIAL.
As if that word had any meaning in the context of interpreting the U.S. Constitution. As if she were going to be a referee in some ball game. Then again, misunderstanding their role seems to be a requirement for the Supreme Court judges.
I thought of all this because this past Wednesday, an NYU law professor by the name of Noah Feldman wrote a commentary in the New York Times in which he noted that after the confirmation of Kagan, the Supreme Court would have three Jews and six Catholics and no white, Anglo-Saxon Protestants, the so-called WASPs.
From this fact, he went on to conclude that the WASPs’ graceful, voluntary exit from the corridors of power, and especially the universities, had allowed other races and minorities to shine. Harvard is richer by the presence of Alan Dershowitz.
When Noah Feldman was not even 30, the Bush administration dispatched him to Iraq to write a constitution for the occupied country. He accepted the assignment with eagerness, never allowing a complete lack of familiarity with the country and its language, culture and history to stand in his way. On the strength of that “experience” he was made the commentator in matters of law, U.S. foreign policy, international relations, and please don’t mention Iraq.
An egregious fool like Feldman is programmed to get everything wrong; misreading things is probably in his DNA. But his statistics cannot be argued with. Three Jews and 6 Catholics and no WASPs on the Supreme Court. Does this make-up signify anything?
The answer is, Yes. It signifies the rise of speculative capital and its destruction of the “system” – including the legal system – about which I have repeatedly written on this blog and elsewhere.
For the proof of this assertion, we need to go no further than the front page of the same paper on the same day, which ran an article on the “evolution” of Chief Justice Roberts, how “The Roberts Court” had come of age.
The article began by quoting an ex-solicitor general that “more than in any other year since he became chief justice, this has truly become the Roberts court.” He was in the majority 92 percent of the time, more than any other justice.
Also quoted was one Tom Goldstein, a snapper up of trifles, who said that Chief Justice Roberts “cares about the position of the court in the American life. He is not pressing every ideological question but is willing to cross over.” Roberts, the readers were informed, “is not wedded to a single judicial methodology like the originalism and textualism that are the touchstones for Justices Scalia and Thomas.”
Let us see now.
Chief Justice Roberts dominates the Supreme Court and its decision-making process. He was in the majority an astonishing 92 percent of the time, which is another way of saying that in 92 percent of the time, the Supreme Court’s ruling followed his way of thinking.
There is nothing wrong per se with that. But the article goes further. It presents the Chief Justice as a man free from the constraints of a judicial philosophies and thus, a more flexible jurist. The message meant to register in the reader’s mind is this: Chief Justice Roberts who cares about the position of the court in American life is not wedded to a single judicial methodology and is willing to cross over ideological lines.
Yet, how does one interpret the U.S. Constitution without a judicial philosophy?
When you are asked to read and interpret a text, you must either focus on the words – what they actually mean to you as a reader – or go beyond the words to what you think the writer intended to say but for whatever reason did not, or could not, say.
The circumstances and context determine the approach. If you are reading an operating manual for a machinery, you should stick to the plain meaning of the words. If you are reading poetry, you must go beyond the words to find deeper meanings and truths, leading readers to such discoveries being the purpose and the very point of poetry.
The U.S. Constitution is but one document with a set language. In reading it, there is no equivalent of going back and forth between a technical manual and poetry. So, when you are asked to read and interpret it, you must decide on the approach. You have to go either with the plain meaning of the words or the intent of the Framers. What the actual case is all about does not matter; the entire point of taking a case to the Supreme Court is to determine which side’s arguments and facts are (more) in line with the Constitution. If you decide to decide the case on its own merits, you would probably have to tweak the interpretation of the Constitution to support your decision. That would be “judicial activistism”, a cardinal sin to conservatists who insisted on being faithful to the Constitution at all times.
Of course, reasonable men could disagree on what the Framers meant in each instance. So, there are various arguments and counter-arguments in interpreting the Constitution. But the point here is the consistency of the approach to the text and the role that such consistency plays in forming the judgment. The Times article highlighted that role:
The judicial principles, then, are the tools of legal standardization. But they work in a different way from the “sentencing guidelines” that are usually written by a vengeful and bigoted legislature. The judicial principles are the result of collective, i.e., social, delibrations and, as such, transcend the individual tastes and preferences. They logically enforce judicial consistency by compelling judges to subjugate their personal views and tastes to more universal principles of humanity.
Chief Justice Roberts follows no principles:
In the case of a central banker, though, it was at least possible to discern a meaning for pragmatism. It meant ignoring and breaking the rules to flood the system with money. Of course, the “system” was made up of large institutions which benefited from the policy. But we understood that.
What does the word mean when applied to the chief judge of the U.S. Supreme Court? What is the pragmatic way of reading and interpreting the Constitution?
The Times article had the the answer, only it was scattered throughout the article. I have put the pieces together for your ease of reading:
First, contrary to what the sycophant Bernstein said about Roberts “caring about the position of the court in the American life”, Chief Justice Roberts decides the cases the way he pleases, with the court following him 92 percent of the times. He doesn’t give a hoot to what “we, the people” think.
And he votes for the business interests, which is why he cannot follow any judicial principles. Such principles act as legal/philosophical straightjackets for the judges. A doctrinaire judge with a set agenda must, or necessity, ignore them. The results could at times be contradictory and embarrassing, but so what?
What is her judicial philosophy, beside the famous impartiality?
One of the tidbits that came out in the hearing was that one of Kagan’s judicial heroes is the retired president of the Supreme Court of Israel.
Why would someone nominated to uphold the principles of the Anglo-Saxon jurisprudence have a hero in Talmudic law?
What would you say of a cardinal – or even a pope – whose spiritual hero was a mullah in Qum?
Wouldn’t that be strange? In fact, how could it possibly be?
The answer is that it could be because there is little left of the Anglo-Saxon jurisprudence, which is why there aren’t any Protestants in the Supreme Court.
Protestants created the system that governed much of the word throught the 20th century, and especially, after the WWII in the West. The “system” had many parts. There was the legal system, the economic and financial system, the individual government system and the cultural and artistic system. These aspects of social life naturally took local forms in individual countries. But it is impossible to look at any of these aspects in any country in the past century and not immediately see the handiwork of the WASPs.
WASPs were not magnanimous benefactors. Only the most ignorant fool would think of them that way. What they did they did for their own self-interests. The list of their failures and crimes is a legion, which is another way of saying that they were no different from other rulers. The system they created was was discriminatory and unfair and could be oppressive, but, as system, it was consistent. A vile usurer could invoke its rules to demand his pound of flesh.
When the system came under the attack by the rise of speculative capital, the WASPs who had the pride of ownerhsip, refused to take part in dismantling it. And they prevented other from dismantling it. Remember “the Arabists” in the State Department?
But the other side was more powerful and pushed the WASPs aside. In their place it put Catholics and Jews, Gonzaleses and Yoos. They were brought in to wreck the system – not directly and in plain sight, as that could not be done, but to hollow it from the inside like termites do.
That’s “meritocracy” for you.
And that’s the story behind the makeup of the Supreme Court.
But, Nasser, how does all this relate to speculative capital? So Elena Kagan is superficial. So Chief Justice Roberts is a doctrinaire. What is the relation of these people and their character with finance?
Marx famously remarked that people make their own history but not in circumstances of their own choosing. Everyone has to play the hand they are given.
But there is more to this observation. The circumstances into which people are born also play a role in shaping their character. Circumstances could make the man.
Weak men succumb to circumstances and are shaped by them. Heroes rise above the circumstances and shape the events.
In general, though, it is not easy to be a hero and men, who must earn a living, yield to the economic circumstances. In the age of the dominance of speculative capital, they take the characteristics of speculative capital as their own, which is how they become functionaries.
Speculative capital, you recall, is capital engaged in arbitrage. Arbitrage is generating short-term profits from the price difference between any two “targets”: buying one low, selling the other high. The larger the difference, the bigger the profit.
If there is no abitrageable price difference, speculative capital will create it. That is volatility. Speculative capital generates profit from volatility, which is why it “crosses the boundaries” and is not “wedded” to one particular strategy.
What speculative capital abhors is any mechanism, regulation, for example, that might stabilize the market and reduce the volatility. That would be interfering with the lifeline of speculative capital. From Vol. 1:
But speculative capital is self-destructive. It eliminates the opportunities that give rise to it. Which is how we know John Roberts is speculative capital in robes: judging with no judicial principles, no attention to the public opinion and no consideration of the lower courts rulings or the case law, doing, in short, his work inside the crumbling apparatus of the Anglo-Saxon jurisprudence in particular and the overall “system” in general.
In places, content dominates form, as in a rock, where the form is but the extension of the content, what the rock is. At times, the form dominates by virtue of the content’s absence, as in the Senate hearings surrounding the confirmation of Elena Kagan to the Supreme Court.
Pity the media which must hype up the event as a sign of the citizenry’s vibrant democracy in action. Hence the live coverage of the embarrassing exchanges on TV and over-the-top reporting in the press: CONSERVATIVES ATTACK KAGAN!!! MISSISSIPPI SENATOR ACCUSES KAGAN OF BEING A LEFT WING!!! CONFIRM KAGAN!!!
The citizenry, alas, refuses to bite. Call it apathy or passive resistance. But Joe Sixpack is just not going to care. And why should he, with the event being so removed from his daily concerns that it might as well be taking place in another planet?
So a calculating self promoter with little knowledge of the law and deep superficiality – she calls herself “famously excellent teacher” – is finally within her goal of becoming a Supreme Court judge. She would be “impartial”, she told the committee.
IMPARTIAL.
As if that word had any meaning in the context of interpreting the U.S. Constitution. As if she were going to be a referee in some ball game. Then again, misunderstanding their role seems to be a requirement for the Supreme Court judges.
I thought of all this because this past Wednesday, an NYU law professor by the name of Noah Feldman wrote a commentary in the New York Times in which he noted that after the confirmation of Kagan, the Supreme Court would have three Jews and six Catholics and no white, Anglo-Saxon Protestants, the so-called WASPs.
From this fact, he went on to conclude that the WASPs’ graceful, voluntary exit from the corridors of power, and especially the universities, had allowed other races and minorities to shine. Harvard is richer by the presence of Alan Dershowitz.
When Noah Feldman was not even 30, the Bush administration dispatched him to Iraq to write a constitution for the occupied country. He accepted the assignment with eagerness, never allowing a complete lack of familiarity with the country and its language, culture and history to stand in his way. On the strength of that “experience” he was made the commentator in matters of law, U.S. foreign policy, international relations, and please don’t mention Iraq.
An egregious fool like Feldman is programmed to get everything wrong; misreading things is probably in his DNA. But his statistics cannot be argued with. Three Jews and 6 Catholics and no WASPs on the Supreme Court. Does this make-up signify anything?
The answer is, Yes. It signifies the rise of speculative capital and its destruction of the “system” – including the legal system – about which I have repeatedly written on this blog and elsewhere.
For the proof of this assertion, we need to go no further than the front page of the same paper on the same day, which ran an article on the “evolution” of Chief Justice Roberts, how “The Roberts Court” had come of age.
The article began by quoting an ex-solicitor general that “more than in any other year since he became chief justice, this has truly become the Roberts court.” He was in the majority 92 percent of the time, more than any other justice.
Also quoted was one Tom Goldstein, a snapper up of trifles, who said that Chief Justice Roberts “cares about the position of the court in the American life. He is not pressing every ideological question but is willing to cross over.” Roberts, the readers were informed, “is not wedded to a single judicial methodology like the originalism and textualism that are the touchstones for Justices Scalia and Thomas.”
Let us see now.
Chief Justice Roberts dominates the Supreme Court and its decision-making process. He was in the majority an astonishing 92 percent of the time, which is another way of saying that in 92 percent of the time, the Supreme Court’s ruling followed his way of thinking.
There is nothing wrong per se with that. But the article goes further. It presents the Chief Justice as a man free from the constraints of a judicial philosophies and thus, a more flexible jurist. The message meant to register in the reader’s mind is this: Chief Justice Roberts who cares about the position of the court in American life is not wedded to a single judicial methodology and is willing to cross over ideological lines.
Yet, how does one interpret the U.S. Constitution without a judicial philosophy?
When you are asked to read and interpret a text, you must either focus on the words – what they actually mean to you as a reader – or go beyond the words to what you think the writer intended to say but for whatever reason did not, or could not, say.
The circumstances and context determine the approach. If you are reading an operating manual for a machinery, you should stick to the plain meaning of the words. If you are reading poetry, you must go beyond the words to find deeper meanings and truths, leading readers to such discoveries being the purpose and the very point of poetry.
The U.S. Constitution is but one document with a set language. In reading it, there is no equivalent of going back and forth between a technical manual and poetry. So, when you are asked to read and interpret it, you must decide on the approach. You have to go either with the plain meaning of the words or the intent of the Framers. What the actual case is all about does not matter; the entire point of taking a case to the Supreme Court is to determine which side’s arguments and facts are (more) in line with the Constitution. If you decide to decide the case on its own merits, you would probably have to tweak the interpretation of the Constitution to support your decision. That would be “judicial activistism”, a cardinal sin to conservatists who insisted on being faithful to the Constitution at all times.
Of course, reasonable men could disagree on what the Framers meant in each instance. So, there are various arguments and counter-arguments in interpreting the Constitution. But the point here is the consistency of the approach to the text and the role that such consistency plays in forming the judgment. The Times article highlighted that role:
Justices Scalia and Thomas, who voted together 92 percent of the time — the highest of any pair of justices — often take positions based on jurisprudential principles without regard to the outcome in a particular case. [According to a former solicitor general]: “It’s striking how often if the court gets to a pro-defendant result the majority includes Justice Scalia.”Scalia is neither a thinker nor a legal scholar. He is more of a thug than a judge, what with his pugnacious and in-your-face way of expressing nonsensical ideas. At times almost child-like, he is a man who cites the performance of a fictional TV character to defend and justify torture. Yet, because he follows judicial principles, his rulings tend to favor the defendants. That is precisely the point and the philosophy of the law: to protect the accused (even though the accused in the Supreme Court cases are generally the defendant in the lower courts.) That was the purpose of Magna Carta, which formed the foundation of the Anglo-Saxon jurisprudence.
The judicial principles, then, are the tools of legal standardization. But they work in a different way from the “sentencing guidelines” that are usually written by a vengeful and bigoted legislature. The judicial principles are the result of collective, i.e., social, delibrations and, as such, transcend the individual tastes and preferences. They logically enforce judicial consistency by compelling judges to subjugate their personal views and tastes to more universal principles of humanity.
Chief Justice Roberts follows no principles:
Chief Justice Roberts and Justice Alito, by contrast, can appear more pragmatic.What does it mean for the Chief Justice of the U.S. to be “pragmatic”? I commented on this adjective when it was being used to flatter Bernanke. I wrote:
The most outstanding characteristic of the “pragmatic man” is lack of conviction. He believes in no ideology, honors no conventions, adheres to no principles, follows no set rules, finds nothing per se wrong and rules out nothing categorically.
In the case of a central banker, though, it was at least possible to discern a meaning for pragmatism. It meant ignoring and breaking the rules to flood the system with money. Of course, the “system” was made up of large institutions which benefited from the policy. But we understood that.
What does the word mean when applied to the chief judge of the U.S. Supreme Court? What is the pragmatic way of reading and interpreting the Constitution?
The Times article had the the answer, only it was scattered throughout the article. I have put the pieces together for your ease of reading:
The centerpiece of the last term was, of course, the 5-to-4 decision in Citizens United, allowing unlimited corporate spending in elections. The ruling generated waves of criticism, including comments from President Obama … The outcry did not chasten the court. “I don’t think it made the least bit of difference to the five justices in the majority,” said Paul D. Clement, who also served as solicitor general in the second Bush administration
The Citizens United decision contained not a trace of minimalism, and it showed great solicitude to the interests of corporations. “They’re fearless,” said Lisa S. Blatt [a former solicitor general]: “This is a business court. Now it’s the era of the corporation and the interests of business.”Let us take the points one at a time.
That trend, lawyers and legal scholars said, may well threaten recent legislation overhauling financial regulation and the health care system when challenges to them reach the court.
First, contrary to what the sycophant Bernstein said about Roberts “caring about the position of the court in the American life”, Chief Justice Roberts decides the cases the way he pleases, with the court following him 92 percent of the times. He doesn’t give a hoot to what “we, the people” think.
And he votes for the business interests, which is why he cannot follow any judicial principles. Such principles act as legal/philosophical straightjackets for the judges. A doctrinaire judge with a set agenda must, or necessity, ignore them. The results could at times be contradictory and embarrassing, but so what?
The court acted quickly – and, some critics said, rashly – in intervening in cases without full briefing and argument. In January, it halted the broadcast of the trial over the same-sex marriage in San Francisco partly on a rationale it seemed to disavow five months later. This month, it sent elections in Arizona into disarray by barring the use of a 12-year old campaign finance law.It is this court that Elena Kagan will be joining.
What is her judicial philosophy, beside the famous impartiality?
One of the tidbits that came out in the hearing was that one of Kagan’s judicial heroes is the retired president of the Supreme Court of Israel.
Why would someone nominated to uphold the principles of the Anglo-Saxon jurisprudence have a hero in Talmudic law?
What would you say of a cardinal – or even a pope – whose spiritual hero was a mullah in Qum?
Wouldn’t that be strange? In fact, how could it possibly be?
The answer is that it could be because there is little left of the Anglo-Saxon jurisprudence, which is why there aren’t any Protestants in the Supreme Court.
Protestants created the system that governed much of the word throught the 20th century, and especially, after the WWII in the West. The “system” had many parts. There was the legal system, the economic and financial system, the individual government system and the cultural and artistic system. These aspects of social life naturally took local forms in individual countries. But it is impossible to look at any of these aspects in any country in the past century and not immediately see the handiwork of the WASPs.
WASPs were not magnanimous benefactors. Only the most ignorant fool would think of them that way. What they did they did for their own self-interests. The list of their failures and crimes is a legion, which is another way of saying that they were no different from other rulers. The system they created was was discriminatory and unfair and could be oppressive, but, as system, it was consistent. A vile usurer could invoke its rules to demand his pound of flesh.
When the system came under the attack by the rise of speculative capital, the WASPs who had the pride of ownerhsip, refused to take part in dismantling it. And they prevented other from dismantling it. Remember “the Arabists” in the State Department?
But the other side was more powerful and pushed the WASPs aside. In their place it put Catholics and Jews, Gonzaleses and Yoos. They were brought in to wreck the system – not directly and in plain sight, as that could not be done, but to hollow it from the inside like termites do.
That’s “meritocracy” for you.
And that’s the story behind the makeup of the Supreme Court.
But, Nasser, how does all this relate to speculative capital? So Elena Kagan is superficial. So Chief Justice Roberts is a doctrinaire. What is the relation of these people and their character with finance?
Marx famously remarked that people make their own history but not in circumstances of their own choosing. Everyone has to play the hand they are given.
But there is more to this observation. The circumstances into which people are born also play a role in shaping their character. Circumstances could make the man.
Weak men succumb to circumstances and are shaped by them. Heroes rise above the circumstances and shape the events.
In general, though, it is not easy to be a hero and men, who must earn a living, yield to the economic circumstances. In the age of the dominance of speculative capital, they take the characteristics of speculative capital as their own, which is how they become functionaries.
Speculative capital, you recall, is capital engaged in arbitrage. Arbitrage is generating short-term profits from the price difference between any two “targets”: buying one low, selling the other high. The larger the difference, the bigger the profit.
If there is no abitrageable price difference, speculative capital will create it. That is volatility. Speculative capital generates profit from volatility, which is why it “crosses the boundaries” and is not “wedded” to one particular strategy.
What speculative capital abhors is any mechanism, regulation, for example, that might stabilize the market and reduce the volatility. That would be interfering with the lifeline of speculative capital. From Vol. 1:
Such capital is, by definition, “opportunistic” . it is constantly on the lookout for “inefficiencies” across markets which it can exploit. The opportunities arise suddenly and at random points in time, so the capital that hopes to exploit them must always be available; it cannot afford to be locked into long-term commitments and investments. The requirement to be opportunistic translates into the need to be mobile, to be nomadic and interested in short-term ventures.Short-term, profit maximizing speculative capital then creates men of the kind we have met in this blog as mountaineers, philosophers, intellectuals and businessmen. John Roberts is speculative capital in robes.
But speculative capital is self-destructive. It eliminates the opportunities that give rise to it. Which is how we know John Roberts is speculative capital in robes: judging with no judicial principles, no attention to the public opinion and no consideration of the lower courts rulings or the case law, doing, in short, his work inside the crumbling apparatus of the Anglo-Saxon jurisprudence in particular and the overall “system” in general.
Sunday, June 27, 2010
The Goldman Case – 4: CDSs and Synthetic CDOs
The CDO at the center of Goldman case is a synthetic CDO.
According to the New York Times, a paper that has won many awards for educational reporting – that would be reporting that educates the public:
According to Investopedia, a synthetic CDS is:
Acquiring knowledge is an active process. It demands the conscious participation of the learner, which is another way of saying that knowledge has to be arrived at; it cannot be given. Let us return then to our investor group and see if, starting from where we left, we could arrive at comprehension of synthetic CDOs. Recall that we had “shot” the housing market by pressuring lenders and underwriters to indiscriminately create mortgages so we would bundle them into the CDOs and make a bundle in the process. The process wrecked the underwriting standards and pushed housing prices ever higher. With chickens about to come home to roost, the time has come to reverse gears. Now is the time to make money from the crashing housing market and defaulting mortgages. But, how?
Every trader knows the tools of the trade when things start going south: short selling and buying put options. Short selling is selling a security you do not own. The idea is to buy it back later, after it has fallen in price, for a profit. It is the time-honored buy low/sell high rule executed in the reverse order. While selling something you do not own is fraud in the standard commerce, in the securities market, it is de rigueur. The reason has to do with the peculiarities of the concept of security. From Vol. 2:
The other bear strategy, buying put options, is likewise not an option. There are no put options on mortgages, not the least because options pricing is based on a process that depends on short selling.
All this, however, is beside the point. It is missing the point, really, as these methods would not suit our purpose even if they were available.
Short selling and buying puts, you see, are capital market strategies in the sense that they are derived from, and exist, on the assumption of capital markets being a going concern. They assume uninterrupted trading. They are bearish strategies, of course, but they are the logical flip side of the bullish strategies which, combined, make up and define trading and capital markets.
We have an entirely different focus. We do not want a mere big win, a 10, 20, or 30 point gain from the price decline of some securities. Those are for boys -- and birds. We are men. Our aim is accordingly high. Why settle for mortgages declining when mortgages defaulting is in the cards? Since default is the extreme case of decline, our profits should be accordingly – and unprecedentedly – bigger. Our byword is implosion. We are shooting for a clean sweep that will come about in consequence of the collapse of mortgages.
Our strategy, then – and, by extension, the “products” designed to execute it – cannot be of capital markets. Implosion of securities negates securities trading.
Very little by way of contemplation is needed to realize that the only tool that fits the bill is a bet. We need a bet in which, if mortgages default, we would win big. But we need an intermediary, a financial powerhouse with contacts, which could find a counterpart to the bet and design and execute the plan. Would this intermediary let us pick the mortgages as well? After all, if we are betting big time, we need a fighting chance. It's only fair. Remember the $700,000 mortgage given to that Mexican strawberry picker who had made all of $14,000 in the prior year? How about something marginally better?
So, we take 5 “good” mortgages to the intermediary – Goldman, for example – and explain our plans. Here they are. We saw them in Part II:
1: $200,000 [$1,150]
2: $240,000 [$1,250]
3: $250,000 [$1,300]
4: $300,000 [$1,700]
5: $260,000 [$1,600]
The total value of the mortgages is $1,250,000; their combined monthly payment, $7,000.
The first step is creating a CDO in 3 tranches. Here is the CDO in three tranches: super senior (SS), mezzanine (MZ) and first loss (FL). The total principal and the monthly payment [in brackets] of each tranche is also given. We are familiar with this one as well from Part II:
SS: $700,000 [$3,600]
MZ: $500,000 [$3,000]
FL: $50,000 [$400]
Recall that the annual yield on the super senior (SS) tranche is 6.17%:
SS: 3,600 x 12 / 700,000 = 6.17%
With the raw material in hand, the intermediary calls upon its financial engineers, structure finance specialists, quants, wizards, rocket scientists and gurus to satisfy our demand, i.e., deliver to us a bet that would have the potential of a clean sweep. The focus, for the reason that will become clear in the sales pitch, is on the SS tranche only.
This is how the bet’s design process progresses:
What is the “other side” of the bet, the opposite of mortgages defaulting?
Well, it is mortgages not defaulting.
Good. How do we create the payoff? Who wins what if mortgages default – or don't?
Let us begin with the other side. What does the other side win if the mortgages in the SS tranche do not default?
The answer is, what the tranche pays, as long as there is no default. That is, $3,600 each month or $43,200 a year.
What would our client – here they are talking about us, the investor group – win, if SS mortgages default? Keep in mind that the client wants to win BIG.
What is the biggest number “pertaining” to the SS tranche? Yes, the absolute largest number “related” to the SS tranche, even if the question does not make sense.
The answer is the total principal of all mortgages in the tranche, equal to $700,000.
That is it then. The bet is set. Here is how it works.
One side gets $3,600 a month. The other side – we, the investor group – undertakes to pay it. Now, suppose mortgage No. 3, with the principal amount of $250,000 defaults. Nothing would happen in theory – and practice – because that does not affect the SS tranche. We would still have to pay $3,600 a month to our counterpart.
Then mortgage No. 4, with the principal amount of $300,000 defaults. Still, nothing happens to the SS tranche – in theory. We still would have to pay $3,600 a month to our counterpart.
Now, however, $550,000 worth of mortgages out of the total $1,250,000 have defaulted. The cushion that was protecting the $700,000 SS tranche is gone. One more default, and it will hit the SS tranche.
Suppose now mortgage No. 1 defaults. In that case: i) our monthly payment to the counterpart is reduced by $1,150, which is the monthly payment of mortgage No. 1; and ii) our counterpart has to pay us $200,000, which is the principal value of mortgage No. 1!
It gets better.
If mortgage No. 5 also defaults, the payment to our counterpart will be reduced by a further $1,600. Furthermore, the counterpart has to pay us an additional $260,000, which is the full principal of mortgage No. 5
Finally, if the last remaining piece, mortgage No. 2, also defaults, we would owe nothing in monthly payment to the other side. But the other side has to pay us $240,000, the mortgage’s principal amount.
If these scenarios were to happen, we would pay $3,600 a month for a few months, or a few years, until the mortgages began defaulting. In return, we would receive $700,000. That is the clean sweep, the big play. If you multiply the amounts in this example by about 1,500, they would approximately correspond to the transaction in the center of the Goldman case.
Note what happens to the mortgages when they are made the subject of a bet: they lose their characteristics as securities. To bet on their demise or survival, we no more need to own the legal title to them than a bettor in the race track needs to own the legal title to the horse he is betting on. This follows from the fact that our “strategy” is a mere bet and hence, outside the realm of finance. The sole role of the mortgages is now being a reference point – reference securities, they are called – for the determination of the winner and loser of the bet. In this way, our original, cash CDO becomes a synthetic CDO, where the mortgages as securities have been turned into mere virtual indices.
How is a synthetic CDO to be priced? If legal ownership existed, the question would be a simple matter of bond pricing. But there is no ownership, only the privilege to receive the monthly payment of mortgages, as if one owned them. So the question becomes, how much is that privilege worth?
The raison raison d'être of synthetic CDOs answers that question. The purpose of a synthetic CDO is generating a potential windfall for the seller, should the mortgages default. So, in return for receiving $3,600 a month, the buyer of a synthetic CDO tranche undertakes to pay to the seller the full principal amount of any bond in the tranche that defaults. This latter is a credit default swap: paying the full principal of a bond in case it defaults.
Synthetic CDOs, CDSs and their relations to one another are now clear. Return to the top and read the definitions. They will make sense.
All that is left is the small matter of selling this bet to the prospective buyers of the synthetic CDOs, say, ACA Management and IKB Deutsche Industriebank.
Here is the pitch:
Everything said or written about the CDOs and CDSs comes from this pitch, which goes to show how the Wall Street controls the narrative of anything related to finance. That is why I started this series with a treatise of sorts on the importance of knowing and the need to penetrate the surface of the phenomena.
Note how a “synthetic CDO” is presented as a “you can have it all” product: getting the monthly payments without buying the securities that pay those payments. That is what is taught in the business schools and promoted in the financial press as one of the benefits of modern finance.
Note, also, how a CDS is presented as an insurance product. To the best of my knowledge, not a single person anywhere has challenged this spin. The most vocal critics of the CDSs start from the premise of a good idea of insurance gone bad by the misuse by bad people.
Bond insurance existed in the U.S. and many western countries for the longest of times. The businesses were known as monolines, mono because they only insured bonds. The business was low-margin but also extremely low risk. Ambac, MBIA and SCA were among the more well-known names that were sucked into the orbit of the CDSs and paid dearly for it.
A CDS is the “other side” of a bet that involves the default of a bond. It has absolutely nothing whatsoever to do with insurance. A CDS is designed to insure a bond in the same way that gallows is designed to support the weight of a man. The moment you speak of insurance, you are lost. You have understood nothing about them.
Look at this childish nonsense from Floyd Norris of the New York Times. I mention him because he is the most perceptive and competent among the financial reporters.
The creation of CDSs as a bet is the logical extension of cash settlement that took the physical delivery of the underlying security out of financial transactions. From Vol. 2:
We are in a position to judge.
I will return with the epilogue.
According to the New York Times, a paper that has won many awards for educational reporting – that would be reporting that educates the public:
During the later stages of the boom, banks began offering so-called synthetic CDOs. Instead of combining bonds, these combine credit default swaps written against specific bonds or pools of bonds. Credit default swaps were developed as a kind of insurance on financial instruments, albeit in an unregulated form. Essentially, one party swaps the risk of holding debt with another by paying a fee to that swapholder in return for a promise that a certain amount of money would be paid in case of default.According to Wikipedia:
In technical terms, the synthetic CDO is a form of collateralized debt obligation (CDO) in which the underlying credit exposures are taken on using a credit default swap rather than by having a vehicle buy assets such as bonds.
According to Investopedia, a synthetic CDS is:
A collateralized debt obligation that invests in credit default swaps. This investment can lead to large returns for holders of the CDO; however, the nature of credit default swaps may leave the holders liable for more than their initial investments, should there be significant changes in the credit default swaps.These descriptions are not, per se, inaccurate. They are useless. You do not understand anything about CDOs from them because their language is clinical, the way a torturer would describe the details of torture without communicating anything about the horrors of the act. Clinical language is pernicious because it masquerades as the detached language of the “expert”, while decontextualizing the event it is supposed to describe. So we get empty words and the impression of knowledge being imparted, while nothing of the sort happens. Note how every definition above has a reference to credit default swaps without saying what they are or how they relate to the synthetic CDOs. Obscurum per obscuris.
Acquiring knowledge is an active process. It demands the conscious participation of the learner, which is another way of saying that knowledge has to be arrived at; it cannot be given. Let us return then to our investor group and see if, starting from where we left, we could arrive at comprehension of synthetic CDOs. Recall that we had “shot” the housing market by pressuring lenders and underwriters to indiscriminately create mortgages so we would bundle them into the CDOs and make a bundle in the process. The process wrecked the underwriting standards and pushed housing prices ever higher. With chickens about to come home to roost, the time has come to reverse gears. Now is the time to make money from the crashing housing market and defaulting mortgages. But, how?
Every trader knows the tools of the trade when things start going south: short selling and buying put options. Short selling is selling a security you do not own. The idea is to buy it back later, after it has fallen in price, for a profit. It is the time-honored buy low/sell high rule executed in the reverse order. While selling something you do not own is fraud in the standard commerce, in the securities market, it is de rigueur. The reason has to do with the peculiarities of the concept of security. From Vol. 2:
As a condition of opening an account in a brokerage firm, customers must sign a form granting the firm the right to lend the securities in their accounts to short sellers. When a security is “lent,” short sellers must compensate the original owners of the securities – the customers – in all respects such as dividends and splits save one: they do not and cannot grant the voting power to the customers because voting power is attached to shares and not the accounts. If the shares leave, so does the voting power. The condition for purchasing ownership in a corporation is agreeing to give up the legal rights of that ownership!But to be shorted, a security must be widely held, otherwise we cannot borrow it from another holder for the delivery. Individual mortgages are held by a single party. It would be impractical – indeed, impossible – to short them. How could we buy them back if the sole holder did not want to sell?
This fact may strike many as an absurd manipulation by the brokerage houses, but it is in fact a consequence of the very nature of a security. A security is evidence of ownership of notional capital. It confers on its owner not the right of ownership of the physical production apparatus but the right to appropriate a pro rata share of profits only. Since the short seller compensates the security’s owner for the profit portion, the owner has no more “rights” left.
The other bear strategy, buying put options, is likewise not an option. There are no put options on mortgages, not the least because options pricing is based on a process that depends on short selling.
All this, however, is beside the point. It is missing the point, really, as these methods would not suit our purpose even if they were available.
Short selling and buying puts, you see, are capital market strategies in the sense that they are derived from, and exist, on the assumption of capital markets being a going concern. They assume uninterrupted trading. They are bearish strategies, of course, but they are the logical flip side of the bullish strategies which, combined, make up and define trading and capital markets.
We have an entirely different focus. We do not want a mere big win, a 10, 20, or 30 point gain from the price decline of some securities. Those are for boys -- and birds. We are men. Our aim is accordingly high. Why settle for mortgages declining when mortgages defaulting is in the cards? Since default is the extreme case of decline, our profits should be accordingly – and unprecedentedly – bigger. Our byword is implosion. We are shooting for a clean sweep that will come about in consequence of the collapse of mortgages.
Our strategy, then – and, by extension, the “products” designed to execute it – cannot be of capital markets. Implosion of securities negates securities trading.
Very little by way of contemplation is needed to realize that the only tool that fits the bill is a bet. We need a bet in which, if mortgages default, we would win big. But we need an intermediary, a financial powerhouse with contacts, which could find a counterpart to the bet and design and execute the plan. Would this intermediary let us pick the mortgages as well? After all, if we are betting big time, we need a fighting chance. It's only fair. Remember the $700,000 mortgage given to that Mexican strawberry picker who had made all of $14,000 in the prior year? How about something marginally better?
So, we take 5 “good” mortgages to the intermediary – Goldman, for example – and explain our plans. Here they are. We saw them in Part II:
1: $200,000 [$1,150]
2: $240,000 [$1,250]
3: $250,000 [$1,300]
4: $300,000 [$1,700]
5: $260,000 [$1,600]
The total value of the mortgages is $1,250,000; their combined monthly payment, $7,000.
The first step is creating a CDO in 3 tranches. Here is the CDO in three tranches: super senior (SS), mezzanine (MZ) and first loss (FL). The total principal and the monthly payment [in brackets] of each tranche is also given. We are familiar with this one as well from Part II:
SS: $700,000 [$3,600]
MZ: $500,000 [$3,000]
FL: $50,000 [$400]
Recall that the annual yield on the super senior (SS) tranche is 6.17%:
SS: 3,600 x 12 / 700,000 = 6.17%
With the raw material in hand, the intermediary calls upon its financial engineers, structure finance specialists, quants, wizards, rocket scientists and gurus to satisfy our demand, i.e., deliver to us a bet that would have the potential of a clean sweep. The focus, for the reason that will become clear in the sales pitch, is on the SS tranche only.
This is how the bet’s design process progresses:
What is the “other side” of the bet, the opposite of mortgages defaulting?
Well, it is mortgages not defaulting.
Good. How do we create the payoff? Who wins what if mortgages default – or don't?
Let us begin with the other side. What does the other side win if the mortgages in the SS tranche do not default?
The answer is, what the tranche pays, as long as there is no default. That is, $3,600 each month or $43,200 a year.
What would our client – here they are talking about us, the investor group – win, if SS mortgages default? Keep in mind that the client wants to win BIG.
What is the biggest number “pertaining” to the SS tranche? Yes, the absolute largest number “related” to the SS tranche, even if the question does not make sense.
The answer is the total principal of all mortgages in the tranche, equal to $700,000.
That is it then. The bet is set. Here is how it works.
One side gets $3,600 a month. The other side – we, the investor group – undertakes to pay it. Now, suppose mortgage No. 3, with the principal amount of $250,000 defaults. Nothing would happen in theory – and practice – because that does not affect the SS tranche. We would still have to pay $3,600 a month to our counterpart.
Then mortgage No. 4, with the principal amount of $300,000 defaults. Still, nothing happens to the SS tranche – in theory. We still would have to pay $3,600 a month to our counterpart.
Now, however, $550,000 worth of mortgages out of the total $1,250,000 have defaulted. The cushion that was protecting the $700,000 SS tranche is gone. One more default, and it will hit the SS tranche.
Suppose now mortgage No. 1 defaults. In that case: i) our monthly payment to the counterpart is reduced by $1,150, which is the monthly payment of mortgage No. 1; and ii) our counterpart has to pay us $200,000, which is the principal value of mortgage No. 1!
It gets better.
If mortgage No. 5 also defaults, the payment to our counterpart will be reduced by a further $1,600. Furthermore, the counterpart has to pay us an additional $260,000, which is the full principal of mortgage No. 5
Finally, if the last remaining piece, mortgage No. 2, also defaults, we would owe nothing in monthly payment to the other side. But the other side has to pay us $240,000, the mortgage’s principal amount.
If these scenarios were to happen, we would pay $3,600 a month for a few months, or a few years, until the mortgages began defaulting. In return, we would receive $700,000. That is the clean sweep, the big play. If you multiply the amounts in this example by about 1,500, they would approximately correspond to the transaction in the center of the Goldman case.
Note what happens to the mortgages when they are made the subject of a bet: they lose their characteristics as securities. To bet on their demise or survival, we no more need to own the legal title to them than a bettor in the race track needs to own the legal title to the horse he is betting on. This follows from the fact that our “strategy” is a mere bet and hence, outside the realm of finance. The sole role of the mortgages is now being a reference point – reference securities, they are called – for the determination of the winner and loser of the bet. In this way, our original, cash CDO becomes a synthetic CDO, where the mortgages as securities have been turned into mere virtual indices.
How is a synthetic CDO to be priced? If legal ownership existed, the question would be a simple matter of bond pricing. But there is no ownership, only the privilege to receive the monthly payment of mortgages, as if one owned them. So the question becomes, how much is that privilege worth?
The raison raison d'être of synthetic CDOs answers that question. The purpose of a synthetic CDO is generating a potential windfall for the seller, should the mortgages default. So, in return for receiving $3,600 a month, the buyer of a synthetic CDO tranche undertakes to pay to the seller the full principal amount of any bond in the tranche that defaults. This latter is a credit default swap: paying the full principal of a bond in case it defaults.
Synthetic CDOs, CDSs and their relations to one another are now clear. Return to the top and read the definitions. They will make sense.
All that is left is the small matter of selling this bet to the prospective buyers of the synthetic CDOs, say, ACA Management and IKB Deutsche Industriebank.
Here is the pitch:
Interest rates are at historically low levels. Five year Treasury rates are just over 4.17%, so if you invest $1 million, you will get $4,170 a year. How would you like to better that by 2 percentage points, to 6.17%, with the same credit quality?Game. Set. Match.
Yes, really! Of course, in the fixed income area where the managers fight for two-hundredth of a percentage point, 2 percentage points does seem beyond the realm of possible, especially without sacrificing the credit quality and in fact improving it.
How do we do that? Well, we wouldn’t be a financial powerhouse if we couldn’t.(Smiles all around). But we offer this only to our best clients; not everyone can get into these deals, you know. Correct, exclusive deal, just like Madoff's.
But permit us to say that our deal is in fact better than it sounds. This will become clear if we get into the details.
How do you get $4,170 a year in Treasuries? You have to first invest $1 million. You will not earn interest unless you own the securities.
In the deal we are proposing, you invest nothing. Zilch. Zero. But receive $3,600 a month, as if you had invested $700,000 in these securities.
The catch? There is no catch. You pay for these securities, so to speak, by selling a credit default swap to the party that pays you the monthly $3,600.
What is a credit default swap? That's an excellent question. The best way to describe it is to say that it is an insurance policy. Basically, if the mortgage defaults, you have to pay the mortgage principal to the other party. As per the SEC requirements, we must warn you that this is risky. There is a potential that you will lose some money – or even a sum equal to the principal of mortgages – blah, blah, blah; you know how it works. As if life had no risk. As if there were any guarantees.
But, look! The securities are the super senior tranche of a synthetic CDO. The tranche is rated AAA by both Moody's and Standard & Poor's. The probability of default of a AAA-rared security, based on the historical default tables, is almost zero. They are like the U.S. Treasuries in terms of credit worthiness. Between us, though, they are probably safer, what with this runaway U.S. expenditure and the beating the dollar is taking in the international arena.
Why even safer than the Treasuries, you may ask? We are not exaggerating. Let us look at the facts. The mortgage default rates in the U.S. stand around 3%. The $700,000 SS tranche we are offering is part of $1,250,000 CDO. So, it is protected by a $550,000 cushion of mortgages, so to speak. That is, 44% of mortgages in the CDO must default before the SS tranche is affected. Now, do you believe that the historical mortgage default rates in the U.S. could suddenly jump to 44%? You decide.
Yes, we have the list of mortgages. You are welcome to perform your own due diligence. But we must warn you that it is not always easy to get background information about mortgages. Underwriters are not known for keeping the best of records. (Smiles all around.) Now, if you could sign here.
Everything said or written about the CDOs and CDSs comes from this pitch, which goes to show how the Wall Street controls the narrative of anything related to finance. That is why I started this series with a treatise of sorts on the importance of knowing and the need to penetrate the surface of the phenomena.
Note how a “synthetic CDO” is presented as a “you can have it all” product: getting the monthly payments without buying the securities that pay those payments. That is what is taught in the business schools and promoted in the financial press as one of the benefits of modern finance.
Note, also, how a CDS is presented as an insurance product. To the best of my knowledge, not a single person anywhere has challenged this spin. The most vocal critics of the CDSs start from the premise of a good idea of insurance gone bad by the misuse by bad people.
Bond insurance existed in the U.S. and many western countries for the longest of times. The businesses were known as monolines, mono because they only insured bonds. The business was low-margin but also extremely low risk. Ambac, MBIA and SCA were among the more well-known names that were sucked into the orbit of the CDSs and paid dearly for it.
A CDS is the “other side” of a bet that involves the default of a bond. It has absolutely nothing whatsoever to do with insurance. A CDS is designed to insure a bond in the same way that gallows is designed to support the weight of a man. The moment you speak of insurance, you are lost. You have understood nothing about them.
Look at this childish nonsense from Floyd Norris of the New York Times. I mention him because he is the most perceptive and competent among the financial reporters.
Credit default swaps are, in reality, insurance. The buyer of the insurance gets paid if the subject of swap cannot meet its obligation. The seller of the swap gets a continuing payment from the buyer until the insurance expires. Sort of like an insurance premium, you might say.A word is changed and the entire regulatory apparatus is fooled and, as a result, something bad is introduced to the financial system. Just like that.
But the people who dreamed up credit-default swaps did not like insurance. It smacked of regulation and of reserves that insurance companies must set aside in case they were claims. So they called the new thing a swap.
In the antiregulatory atmosphere of the times, they got away with it. As Humpty would have understood, Wall Street was master. Because swaps were unregulated, calling insurance a swap meant those who traded in them could make whatever decision they wished.
The creation of CDSs as a bet is the logical extension of cash settlement that took the physical delivery of the underlying security out of financial transactions. From Vol. 2:
To make themselves more appealing to speculative capital, derivatives undergo changes which are intended to bring out and emphasize their betting aspects. One such change is cash settlement.The Goldman case is now clear, not based on the SEC allegations or the firm’s denial but “as God sees it”. The role of the firm, the role of us, the investor groups – that would be Paulson and his hedge fund – and the role of the buyers of the synthetic CDO – ACA and IKB, which lost a combined $1 billion – is understood.
In cash settlement, the product on which the derivative is based does not change hands. Rather, the profit and loss of the trade is settled by exchange of money, calculated as the difference between the purchase and sale price. The commodity itself need not – actually, cannot – be delivered to satisfy the contract.
On the surface, this arrangement seems as a mere technicality, a change in rules for the sake of promoting “efficiency.” Otherwise, the P&L of the two sides remains unchanged … But the P&L is not the only thing that “matters” in trading derivatives … In cash settlement, the price of a commodity becomes a mere index that is used to determine the winner or loser of the transaction.
The implication of this change becomes apparent if we look at the flow of money. Previously, the seller delivered, and the buyer took delivery of, the underlying commodity [i.e,] always buyers paid, and sellers received, money. In cash settlement, not only the seller cannot deliver the commodity, he must also think of a possible payment obligation.
Cash settlement accommodates speculation.
We are in a position to judge.
I will return with the epilogue.
Thursday, June 17, 2010
Of Labor and Women’s Rights in Europe
Today’s Financial Times published a joint commentary piece by the prime ministers of the UK and Sweden under the heading Reining in Europe’s deficit is just the first step. As you can infer from title, it was an economic manifesto put together “to ensure that Europe thrives and prospers”. It had “four clear steps”.
The first step was cutting back. “We have to accept that there are things we can no longer afford,” the authors said. Note the wording. First, a reference to things that we cannot afford, which everyone knows to be true. Then the “no longer”, slyly inserted; we are now talking about the things that “we” used to be able to afford but now, we have to accept, we cannot. Here, the two gentlemen of Europe are not talking about private jets. They are talking about retirees affording to live with some dignity. It is that, that “we” can no longer afford.
The second one was fixing the financial system.
Then came the third step:
Women in Europe are not particularly oppressed. I know of no country in Europe that discriminates against women in the workplace. And why this emphasis on women and their “full potential as workers” when tens of millions of European men are unemployed?
The answer is in the very text that gives rise to these questions. Note the concern for women’s right in the workplace is brought up in the “step” that talks about productivity. Productivity is output per labor; not labor in flesh and blood but labor as measured by wages. An enterprise producing 100 units of output with 3 laborers each earning $30 is more productive than one producing the same unit with one laborer earning $100.
Women and children have been historically used as tools for reducing the overall wages. They have less bargaining power and are more vulnerable to pressure, so they do the same work that men do, only with less wages. The result is downward pressure on all wages.
European children are protected by a variety of laws. And anyway, the manufacturing jobs, of the kind that employ children, have migrated to Asia and Latin America.
That leaves women.
One component of the “labor market overhaul” that is on the agenda of all the European governments is the reduction in wages. Women are the Trojan Horse that will be taken to the labor market to accomplish that goal. That is the source and extent of the prime ministers' interest in the women's rights. Read it. They clearly say it: By giving equal rights to women in the workplace, Europe will be able to compete with India and China!
But isn’t this plan too long-term and too complicated? Even if we assume that Cameron and Reinfeldt know of these complex relations, why would a couple of politicians care about implementing a plan which will come to fruition long after they have left the office?
The answer is that the plan is not theirs. It is given to them – and all the European prime ministers – as the policy issue to be implemented. No questions are permitted. That is why Socialists Papanderou and Zapatero, center right Sarkozy, Moderate Reinfeldt and Conservative Cameron all speak the same way. That is how you know everything is scripted at a supra-national level: politicians of different political orientations all say the same things. We are approaching the grand goal of divorcing policy decisions from politics.
As for the moral aspects of women’s rights, frankly I don't think they give a damn.
The first step was cutting back. “We have to accept that there are things we can no longer afford,” the authors said. Note the wording. First, a reference to things that we cannot afford, which everyone knows to be true. Then the “no longer”, slyly inserted; we are now talking about the things that “we” used to be able to afford but now, we have to accept, we cannot. Here, the two gentlemen of Europe are not talking about private jets. They are talking about retirees affording to live with some dignity. It is that, that “we” can no longer afford.
The second one was fixing the financial system.
Then came the third step:
The third step is creating the conditions for growth. Europe has huge advantages ... But we have deep structural problems. Productivity is shrinking. Our average growth rate is lower than the US, India and China ... So it is clear, we need deep-seated reform and we need it now. There is one area in particular where we both believe there is need for urgent change. It is shocking that in many parts of Europe women still do not have equal rights in the workplace. This is not just unfair; it makes no sense – because it deprives our economies of their full potential as workers and consumers. That is why in Brussels today we will be pushing this issue in discussion on Europe's next strategy for growth and employment.What is this sudden, clearly out of place, reference to women’s rights in the middle of an economic manifesto?
Women in Europe are not particularly oppressed. I know of no country in Europe that discriminates against women in the workplace. And why this emphasis on women and their “full potential as workers” when tens of millions of European men are unemployed?
The answer is in the very text that gives rise to these questions. Note the concern for women’s right in the workplace is brought up in the “step” that talks about productivity. Productivity is output per labor; not labor in flesh and blood but labor as measured by wages. An enterprise producing 100 units of output with 3 laborers each earning $30 is more productive than one producing the same unit with one laborer earning $100.
Women and children have been historically used as tools for reducing the overall wages. They have less bargaining power and are more vulnerable to pressure, so they do the same work that men do, only with less wages. The result is downward pressure on all wages.
European children are protected by a variety of laws. And anyway, the manufacturing jobs, of the kind that employ children, have migrated to Asia and Latin America.
That leaves women.
One component of the “labor market overhaul” that is on the agenda of all the European governments is the reduction in wages. Women are the Trojan Horse that will be taken to the labor market to accomplish that goal. That is the source and extent of the prime ministers' interest in the women's rights. Read it. They clearly say it: By giving equal rights to women in the workplace, Europe will be able to compete with India and China!
But isn’t this plan too long-term and too complicated? Even if we assume that Cameron and Reinfeldt know of these complex relations, why would a couple of politicians care about implementing a plan which will come to fruition long after they have left the office?
The answer is that the plan is not theirs. It is given to them – and all the European prime ministers – as the policy issue to be implemented. No questions are permitted. That is why Socialists Papanderou and Zapatero, center right Sarkozy, Moderate Reinfeldt and Conservative Cameron all speak the same way. That is how you know everything is scripted at a supra-national level: politicians of different political orientations all say the same things. We are approaching the grand goal of divorcing policy decisions from politics.
As for the moral aspects of women’s rights, frankly I don't think they give a damn.
Thursday, June 10, 2010
The Goldman Case – 3: Recapping CDOs
Recall that our purpose, when we got together as a group of investors, was making money. “A group of investors” has no other purpose.
I said the way to go was arbitrage.
Some of you were not clear on that point. You thought we were going to buy mortgages with the idea of selling them later – presumably for a profit. Where is arbitrage?, you asked, echoing the confusion of some of the country’s best quants.
“Friends”, I recall saying to you. “Let us set aside the not so small matter of being short in cash and focus on basic finance. A mortgage is a bond. Bond prices increase when interest rates decrease. Are we saying that we are buying the mortgages because we know interest rates will go down? If so, why bother with mortgages which have prepayment and relatively high default risks? Why not simply buy a bond – or a pool of bonds?
“No,” you responded. “We do not know which way the interest rates will go. And yes, we are short in cash. And now that you mention it, why indeed bother with mortgages? Why not just buy regular bonds?”
“Glad you asked,” I said. “Expecting to make money without initial investment and without knowing the future is a great expectation. Fortunately, in the age of speculative capital, the cause is not lost as the statement of our problem is the definition of arbitrage: making risk free profit without initial investment. But one has to know the game, and the game cannot be played with the Treasuries or corporate bonds. We need the relatively inefficient mortgage market. Even then, the plan is complicated and you must pay attention to understand it.”
“Tell us how”, you cried in unison, excited at the prospects of getting rich with no effort and no money down.
I explained the plan in easily digestible parts:
Arbitrage is the anima mundi of modern finance, the single pillar on which the “whole intellectual edifice” of finance rests. It is at the core of everything that is taught at Chicago, Wharton, Stanford, Harvard and London business schools. It is the foundation of everything that the best of brightest of Europe and Asia vie to learn at INSEAD and Heyderabad.
Options, futures, swaps and all derivatives are priced from arbitrage. Relative value trading is based on arbitrage. Rise of the hedge funds, advent of prop trading, onset of globalization and the push for deregulation are all driven by arbitrage. Securitization? Due to arbitrage. Rise in markets volatility? Arbitrage. Synchronization of markets? That, too.
And yet, not a single one of the students and professors who study finance can define arbitrage, much less recognize the specific form of capital that is engaged in it.
I said the way to go was arbitrage.
Some of you were not clear on that point. You thought we were going to buy mortgages with the idea of selling them later – presumably for a profit. Where is arbitrage?, you asked, echoing the confusion of some of the country’s best quants.
“Friends”, I recall saying to you. “Let us set aside the not so small matter of being short in cash and focus on basic finance. A mortgage is a bond. Bond prices increase when interest rates decrease. Are we saying that we are buying the mortgages because we know interest rates will go down? If so, why bother with mortgages which have prepayment and relatively high default risks? Why not simply buy a bond – or a pool of bonds?
“No,” you responded. “We do not know which way the interest rates will go. And yes, we are short in cash. And now that you mention it, why indeed bother with mortgages? Why not just buy regular bonds?”
“Glad you asked,” I said. “Expecting to make money without initial investment and without knowing the future is a great expectation. Fortunately, in the age of speculative capital, the cause is not lost as the statement of our problem is the definition of arbitrage: making risk free profit without initial investment. But one has to know the game, and the game cannot be played with the Treasuries or corporate bonds. We need the relatively inefficient mortgage market. Even then, the plan is complicated and you must pay attention to understand it.”
“Tell us how”, you cried in unison, excited at the prospects of getting rich with no effort and no money down.
I explained the plan in easily digestible parts:
- We have to borrow money, but it must be at rates below the current mortgage market; it would be madness to pay 8% to get mortgages that pay 6%.
- Low rates are available in the commercial paper (CP) market, but only large corporations like Microsoft and IBM have access to that market.
- We cannot pass ourselves off as a large industrial corporation. Fortunately, we do not have to. What matters in the CP market is not the size per se but the credit rating. Since our ratings, as a group of investors, can never be AAA or its short-term equivalent, A1/P1, we shift the focus from ourselves to the product; we make the product to be AAA.
- Of course, in a million years, a pool of mortgages will not qualify for AAA rating; they're just too damn risky and triple-A means no default risk. So we will need to be innovative. We'll call it financial innovation! (Smiles all around). That is where the CDO structure comes in. You know the routine. Pool the mortgages and force a class system to the pool where the super senior tranche is protected against historical default rates.
- We take the CDO to the rating agencies and ask for AAA rating. They need revenues and will play ball. In fact, they will tell us what we need to do to get AAA rating. They might, for example, ask that we sign up a bank as a “liquidity provider”, or strengthen the loan covenants, but these are technicalities and you do not have to worry about them.
- Triple-A is the key to the CP market. We could now borrow at 2% to and buy mortgages that yield 6%. That's the golden goose of finance if there ever was one. We'd be the king of the world, the master of the universe.
Arbitrage is the anima mundi of modern finance, the single pillar on which the “whole intellectual edifice” of finance rests. It is at the core of everything that is taught at Chicago, Wharton, Stanford, Harvard and London business schools. It is the foundation of everything that the best of brightest of Europe and Asia vie to learn at INSEAD and Heyderabad.
Options, futures, swaps and all derivatives are priced from arbitrage. Relative value trading is based on arbitrage. Rise of the hedge funds, advent of prop trading, onset of globalization and the push for deregulation are all driven by arbitrage. Securitization? Due to arbitrage. Rise in markets volatility? Arbitrage. Synchronization of markets? That, too.
And yet, not a single one of the students and professors who study finance can define arbitrage, much less recognize the specific form of capital that is engaged in it.
In order to be company he must display a certain mental activity. But it need not be of a higher order. Indeed it might be argued the lower the better. Up to a point. The lower the order of mental activity the better the company. Up to a point.
The finance professor, the financial journalist, the think tank “scholar” and the PhD candidate constantly exalted and promoted the advantages of securitization and CDOs without realizing that these innovations were merely the prerequisites for the operation of speculative capital. To the extent that the innovations provide local collateral benefits, such benefits are accidental and incidental. What is more, they must always be in line with the immediate needs of speculative capital.
In our example, what happens after the first CDO? To continue the arbitrage, we would need more CDOs, i.e., more mortgages. Mortgages are provided by banks and mortgage bankers. So they are pressured to do more. At some point, the pool of the eligible people who could afford houses is drained. But that is no excuse to stop the arbitrage. We, the group of investors, cannot simply allow our golden goose to sit idle just because there are no eligible home buyers. Why, that would be hampering the American dream.
So the pressure doubles on banks and mortgage bankers to loosen the standards. They comply, because they, too, make money from issuing mortgages. At some point, that, too, ends. It is clear that no more life is left in the mortgage market. Nay, more than that: it is clear that a train wreck in the form of a housing collapse is coming towards us.
What do we do?
Après moi, le déluge, said Louis XV, the king of France. What a rogue peasant he was. We make money from the deluge. The Jew of kings had it right – Jews always have it right – that you buy when there is blood in the streets.
When there is no blood, we will see to it that there is. It’s business, you know. Nothing personal.
We, the group of investors, have shot the housing market in the US multiples of times. The blood will soon be running in the street. How can we make money from it?
The game plan is not immediately clear. What is clear is that we would need more financial innovation. We would need synthetic CDOs. We would need credit default swaps.
Wednesday, June 2, 2010
The Shape of Things to Come in Spain
Fundamental misunderstanding, when it comes from animals, is funny; we find the animals’ innocence in terms of “not getting it” endearing. Hence, the “animal jokes”. You’ve probably heard the old one about the horse turning to the jockey and saying: what are you hitting me for, there is no one behind us?!
Fundamental misunderstanding from people is not funny. It reeks of pathos, which is depressing.
It must have been over twenty years ago. I was waiting for a friend at the headquarters of then Citibank in New York. The bank had recently increased the minimum withdraw from its ATM machines from $20 to $40. A young woman came to withdraw what must obviously have been $20 and could not. She made a scene, complaining aloud to the bank staff, threatening that she would take her business elsewhere.
If she were a horse, the episode would have been funny. But as she was not, it was not: the spectacle of a young woman who thought she had money until she came head to head with the mass of finance capital.
I remembered all this because today’s New York Times ran an article about the austerity measures in Spain. It said in part:
The New York Times is a sleazy paper, a systemic falsifier of events, as coverage of the events of the past several days showed. And its reporters are as clueless as a horse.
You see, the focus, the aim, the central point of the crisis in Spain is precisely to smash the elaborate safety network of public aid. That is what the hoopla is all about. Without that destruction, Spaniards cannot be made to work for low wages, in the same way that without the destruction of the feudal system which made serfs homeless, they could not be made to toil in factories.
This will not happen tomorrow, or the next week, but will happen with the inevitability of night following day. The inevitability is there, in the internal logic of the very development that tripled home prices.
Thirty years from now, Spaniards will look back and will barely recognize their country. It will not be all bad. Some of them will be driving shinier cars and living in bigger houses. But they will also see homeless people in numbers that they do not presently see – or can imagine. The old trade-off stuff, you know. As for that famous family support? Well, that is partially a function of the elaborate social safety net. So it, too, will be gone. It will be every man for himself.
I am not preaching or haranguing or warning, merely stating an economic reality that Karl Marx used the wording of a “fish-blooded bourgeois doctrinaire” – “fish blooded” because what he “blurts out brutally” was accurate – to state succinctly:
Fundamental misunderstanding from people is not funny. It reeks of pathos, which is depressing.
It must have been over twenty years ago. I was waiting for a friend at the headquarters of then Citibank in New York. The bank had recently increased the minimum withdraw from its ATM machines from $20 to $40. A young woman came to withdraw what must obviously have been $20 and could not. She made a scene, complaining aloud to the bank staff, threatening that she would take her business elsewhere.
If she were a horse, the episode would have been funny. But as she was not, it was not: the spectacle of a young woman who thought she had money until she came head to head with the mass of finance capital.
I remembered all this because today’s New York Times ran an article about the austerity measures in Spain. It said in part:
Spaniards once thought their country was largely insulated from the debt crises in Ireland and Greece. Their mood has changed from giddy, when their homes tripled in value and they were protected by an elaborate safety net of public aid and family support, to grim.
The New York Times is a sleazy paper, a systemic falsifier of events, as coverage of the events of the past several days showed. And its reporters are as clueless as a horse.
You see, the focus, the aim, the central point of the crisis in Spain is precisely to smash the elaborate safety network of public aid. That is what the hoopla is all about. Without that destruction, Spaniards cannot be made to work for low wages, in the same way that without the destruction of the feudal system which made serfs homeless, they could not be made to toil in factories.
This will not happen tomorrow, or the next week, but will happen with the inevitability of night following day. The inevitability is there, in the internal logic of the very development that tripled home prices.
Thirty years from now, Spaniards will look back and will barely recognize their country. It will not be all bad. Some of them will be driving shinier cars and living in bigger houses. But they will also see homeless people in numbers that they do not presently see – or can imagine. The old trade-off stuff, you know. As for that famous family support? Well, that is partially a function of the elaborate social safety net. So it, too, will be gone. It will be every man for himself.
I am not preaching or haranguing or warning, merely stating an economic reality that Karl Marx used the wording of a “fish-blooded bourgeois doctrinaire” – “fish blooded” because what he “blurts out brutally” was accurate – to state succinctly:
In poor nations, the people are comfortable, in rich nations they are generally poor.
Sunday, May 30, 2010
The Goldman Case – 2: CDOs
The Goldman case revolves around the CDOs. So, we must begin with these vehicles.
A CDO, or collateralized debt obligation, is a security, only more complex than traditional securities such as stocks and bonds. The complexity is not conceptual, as in, say, quantum mechanics, but procedural and functional. It can be measured by the words that are needed, as per requirement of the law, to describe the structure, pay off pattern and risks of the CDOs in the offering memoranda. These documents can run into hundreds of pages of legalese and still not cover all the material facts. The SEC’s charge against Goldman is precisely this “failure to disclose”, which constitutes fraud under the securities law.
A procedural/functional complexity can best be shown via an an example.
Take a bank which has lent the following amounts to 5 home buyers. The monthly payment for each loan is shown in brackets.
1: $200,000 [$1,150]
2: $240,000 [$1,250]
3: $250,000 [$1,300]
4: $300,000 [$1,700]
5: $260,000 [$1,600]
The total value of the mortgages is $1,250,000; their combined monthly payment, $7,000.
Mortgages are long-term loans, ranging from 10 to 30 years. So, the bank has locked $1,250,000 of its assets for at least a decade. Of course, in that period, it will receive interest and principal which is what banking is all about. But capital is locked and the bank’s ability to lend is reduced. If we assume the bank’s total lending assets to be $100 million and a typical mortgage around $250,000, then the bank can only make 95 loans – and no more. Afterwards, unless it could grow, it would have to seize lending.
We, as a group of investors, approach the bank and offer to buy the mortgages at their full value. The bank welcomes the idea because it would unlock its capital. With the $1,250,000 it gets from us, it could make 5 new loans and generate additional closing fees. In this way, the bank is out of the picture. We are now the owner of a pool of debt totaling $1,250,000 that brings in $7,000 a month.
Money is fungible, which is why we could speak of “one” loan of $1,250,000. We could also divide. For example, we could divide the pool into 10 equal parts of $125,000, with each bringing in $700 in monthly payments. In fact, that would be the math we had to follow if our investor group had 10 partners.
With the total mortgages ($1,250,000) and monthly payments ($7,000) remaining the same, the number of “pieces” the original pool is divided into determines the principal amount and the monthly payment of each piece. If the pool is divided into 100 pieces, each will be worth $12,500 with $70 expected monthly payment.
Such “slicing and dicing” is one of the technical conditions for securitization: selling private, illiquid assets and liabilities to investors. But securitization, precisely because it involves sales, requires the knowledge of market conditions, so that the product would appeal to potential buyers. The list of items to be considered in that regard is a legion. But two factors stand out above the rest.
One is the number of “slices”. Obviously, the more pieces a given pool is divided into, the smaller the principal amount and the monthly payment of each slice. If our pool is divided into 1000 pieces, each will be worth $1,250 with a monthly payment of $7. But, needless to say, if we divide the pool into 1000 pieces, we must sell 1000 pieces. For that, we would need a sales network, a critical factor to consider as few financial institutions have such networks in place. A large volume of products with low principal and monthly payments, further, is a retail product, while a product with a relatively large principal of $125,000 and only in 10 lots, is more geared towards the institutions or “sophisticated investors”. This technical phrase is pivotal to the Goldman case, so we will return to it. I only note here that the retail products, i.e., products that are offered to public, are governed by stricter disclosure requirements.
The other factor to be considered in securitization is the “risk appetite” of the CDO buyers: the yield they seek vs. the risk they are willing to accept. The fact remains that under the best of economic conditions, some borrowers would default. The reasons for default – a loss of job, disability or even death – do not concern us. But if that were to happen, if, for example, borrower 5 were to default, the pool would receive $1,600 less in monthly payments. That would reduce the pool’s annual return from 6.72% (7000 x 12/125,000) to 5.20% (5,400 x 12/125,000). That is a 23% decline, a tremendous loss in the fixed income world. Such potential volatility would keep away many investors. To appeal to them, we must reduce the uncertainty.
Finance professors speak of “risk averse” and “risk appetite” as if they were psychological and genetic attributes of investors. In reality, they are the investing parameters of mutual and pension funds which forbid them from buying any security not rated AAA. As these funds are the largest investors in the CDOs – because they sit on large piles of cash – their concerns must be taken into account.
The risk of our pool as a whole is given and cannot change; it is the risk of default of 1 or more of the 5 original borrowers. But the introduction of some “class system” solves our problem.
Let us “divide” the pool into three “tranches”. We'll call them the equity or first loss (FL) tranche, mezzanine (MZ) tranche and super senior (SS) tranche, and declare:
SS: $700,000 [$3,600]
MZ: $500,000 [$3,000]
FL: $50,000 [$400]
Based on this allocation, the yield for each tranche is as follows:
SS: 3,600 x 12 / 700,000 = 6.17%
MZ: 2,800 x 12 /500,000 = 7.2%
FL: $400 x 12/ 50,000 = 9.6%
The CDO structure is now complete. All we need at this point is to convince a rating agency – S&P’s or Moody’s – that the SS tranche that is “protected” against default by two loss absorbing layers FL and MZ, is as safe as the safest corporate bond or even the U.S. treasuries and therefore, should command AAA rating. With that, our lawyers put all these details into an offering memorandum and we begin contacting investors.
A while back, in discussing the “collapse of the whole intellectual edifice”, I mentioned Kurosowa’s Rashomon in which the director explores the relation between the narrative and Truth: what do we need to know about something so we could say we know it?
What do we now know about the CDOs?
First and foremost, it must be clear why CDOs are called “vehicle” or “structural products”. They are vehicles for transforming: i) the risk of loans from the bank to investors in capital markets; and ii) the risk profile of a given pool of securities from moderately risky to supposedly riskless and very risky – the latter would be SS and FL tranches. As for structured product, it is the very description of how we created the CDO; a CDO is nothing if not a structured product, a fact that is reflected in the limitless flexibility we have in its design.
I am not exaggerating about the limitless flexibility. Let us begin with the number of tranches. I suggested three. You could make it four. Or five. Or six. Or even seven, if you prefer.
Then there is the number of original loans in the pool. I had 5 because that was sufficient for illustration, but CDOs typically have over 100 securities in the pool. That large number is necessary to make the structure robust so that 3 or 4 defaults will not wipe out the entire pool. The ABACUS 2007-AC1 in the center of the Goldman case had 127 securities.
Then there is the matter of allocating the total pool between tranches. I had 56% of the total allocated to the SS tranche (700,000/1,250,000). You could make it 60% or 70%. Likewise with the MZ tranche. Finally, I allocated 4% to the FL tranche, which is just about standard. This tranche, also known as “toxic waste”, is the riskiest tranche and rarely finds any takers. So the originator of the CDO – Goldman, for example – is usually stuck with it. That must have been the reason why Goldman claimed that it had lost $75 million. The loss had to come from the toxic waste piece that the firm could not unload.
Now comes the most complicated part: the pricing and price behavior of the securities in each tranche. In our example, we have allocated $500,000 to the MZ tranche. Assume that we divide it into 1000 securities, each worth $500 and with $3 a month in payments. What would be the price of this security?
On one hand, the security is a simple bond. We price it using standard bond mathematics. We know if the interest rates increase, the bond price would decrease, and vice versa.
But this security is not a stand-alone bond. It is a mezzanine note from a CDO in which cash flows come from a pool of mortgages. If the default in the pool rises, it will first hit the toxic waste tranche, it is true, but by virtue of “eroding” this tranche, it will begin to threaten the MZ tranche. The MZ tranche, in other words, will be riskier. And since the yield of the bond is fixed at 7.2%, its price would drop, even if interest rates remain unchanged.
The same is true for the SS tranche whose price can show no sensitivity to the defaults in the FL tranche – until it does. This is the so-called “cliff effect” that everyone in the CDO market was aware of. Financial Times, March 21, ‘06, p. 25:
Here is Exhibit A, a quant with impeccable academic credentials and work experience, writing to make us “understand” the risk of synthetic CDOs. I am not picking on him. I mention him precisely because his paper is well written and a cut above others. I urge you to read it. Yet, here is what the author wrote on page 2:
Where is the arbitrage in a CDO? You would not see it in a million years by looking at a CDO structure.
Let us return to our example where “we”, a group of investors, approached the bank and offered to buy its mortgages. Why would we do this? What is in it for us?
Taking into account the expenses of creating a CDO – in millions of dollars that we have to pay to agents like Goldman Sachs – we could find easier and better uses for our $1,250,000. So what drives the market? The answer is arbitrage. From Vol. 3:
In the example, you assumed that “we”, the group of investors, had $1,250,000. But we did not. Even if we did, the exercise would have been pointless because of its costs.
If the transaction was consummated, we must have borrowed the money. What is more, we’d borrow the money through a Special Investment Vehicle, with a large bank such as Citi as the guarantor, which allowed us to borrow at the commercial paper market at about 2%.
Now, the mystery is solved: borrowing at 2% and lending, i.e., buying the mortgages that yield 6, or 7 or 8%. That is arbitrage for you and God Bless America. See Part 8 of the Anatomy of a Crisis for more details.
But we are not done. The CDO in the center of the Goldman case is a synthetic CDO, where there are no real mortgages. A synthetic CDO “replicates” the behavior of real mortgages. For that, credit default swaps must be brought in.
A CDO, or collateralized debt obligation, is a security, only more complex than traditional securities such as stocks and bonds. The complexity is not conceptual, as in, say, quantum mechanics, but procedural and functional. It can be measured by the words that are needed, as per requirement of the law, to describe the structure, pay off pattern and risks of the CDOs in the offering memoranda. These documents can run into hundreds of pages of legalese and still not cover all the material facts. The SEC’s charge against Goldman is precisely this “failure to disclose”, which constitutes fraud under the securities law.
A procedural/functional complexity can best be shown via an an example.
Take a bank which has lent the following amounts to 5 home buyers. The monthly payment for each loan is shown in brackets.
1: $200,000 [$1,150]
2: $240,000 [$1,250]
3: $250,000 [$1,300]
4: $300,000 [$1,700]
5: $260,000 [$1,600]
The total value of the mortgages is $1,250,000; their combined monthly payment, $7,000.
Mortgages are long-term loans, ranging from 10 to 30 years. So, the bank has locked $1,250,000 of its assets for at least a decade. Of course, in that period, it will receive interest and principal which is what banking is all about. But capital is locked and the bank’s ability to lend is reduced. If we assume the bank’s total lending assets to be $100 million and a typical mortgage around $250,000, then the bank can only make 95 loans – and no more. Afterwards, unless it could grow, it would have to seize lending.
We, as a group of investors, approach the bank and offer to buy the mortgages at their full value. The bank welcomes the idea because it would unlock its capital. With the $1,250,000 it gets from us, it could make 5 new loans and generate additional closing fees. In this way, the bank is out of the picture. We are now the owner of a pool of debt totaling $1,250,000 that brings in $7,000 a month.
Money is fungible, which is why we could speak of “one” loan of $1,250,000. We could also divide. For example, we could divide the pool into 10 equal parts of $125,000, with each bringing in $700 in monthly payments. In fact, that would be the math we had to follow if our investor group had 10 partners.
With the total mortgages ($1,250,000) and monthly payments ($7,000) remaining the same, the number of “pieces” the original pool is divided into determines the principal amount and the monthly payment of each piece. If the pool is divided into 100 pieces, each will be worth $12,500 with $70 expected monthly payment.
Such “slicing and dicing” is one of the technical conditions for securitization: selling private, illiquid assets and liabilities to investors. But securitization, precisely because it involves sales, requires the knowledge of market conditions, so that the product would appeal to potential buyers. The list of items to be considered in that regard is a legion. But two factors stand out above the rest.
One is the number of “slices”. Obviously, the more pieces a given pool is divided into, the smaller the principal amount and the monthly payment of each slice. If our pool is divided into 1000 pieces, each will be worth $1,250 with a monthly payment of $7. But, needless to say, if we divide the pool into 1000 pieces, we must sell 1000 pieces. For that, we would need a sales network, a critical factor to consider as few financial institutions have such networks in place. A large volume of products with low principal and monthly payments, further, is a retail product, while a product with a relatively large principal of $125,000 and only in 10 lots, is more geared towards the institutions or “sophisticated investors”. This technical phrase is pivotal to the Goldman case, so we will return to it. I only note here that the retail products, i.e., products that are offered to public, are governed by stricter disclosure requirements.
The other factor to be considered in securitization is the “risk appetite” of the CDO buyers: the yield they seek vs. the risk they are willing to accept. The fact remains that under the best of economic conditions, some borrowers would default. The reasons for default – a loss of job, disability or even death – do not concern us. But if that were to happen, if, for example, borrower 5 were to default, the pool would receive $1,600 less in monthly payments. That would reduce the pool’s annual return from 6.72% (7000 x 12/125,000) to 5.20% (5,400 x 12/125,000). That is a 23% decline, a tremendous loss in the fixed income world. Such potential volatility would keep away many investors. To appeal to them, we must reduce the uncertainty.
Finance professors speak of “risk averse” and “risk appetite” as if they were psychological and genetic attributes of investors. In reality, they are the investing parameters of mutual and pension funds which forbid them from buying any security not rated AAA. As these funds are the largest investors in the CDOs – because they sit on large piles of cash – their concerns must be taken into account.
The risk of our pool as a whole is given and cannot change; it is the risk of default of 1 or more of the 5 original borrowers. But the introduction of some “class system” solves our problem.
Let us “divide” the pool into three “tranches”. We'll call them the equity or first loss (FL) tranche, mezzanine (MZ) tranche and super senior (SS) tranche, and declare:
In the event of a default, the FL tranche, as its name implies, will have to absorb the loss. If more defaults follow, the FL tranche will continue absorbing losses until no more FL tranche is left, after which the MZ tranche will absorb the losses. The SS tranche, as the name implies (it refers to the order of being paid) will be the last piece to be affected by a default. The arrangement follows a “water fall” pattern where the $7,000 monthly income first satisfies the payment for SS, then “flows” to MZ and then, finally to FL.The last part is the allocation of principal and yield to each tranche. Keeping in mind that the SS tranche is the most popular and that yield has to increase as the riskiness of the tranche increases, we allocate the original $1,250,000 principal and the $7,000 monthly payment in the following way among the tranches.
SS: $700,000 [$3,600]
MZ: $500,000 [$3,000]
FL: $50,000 [$400]
Based on this allocation, the yield for each tranche is as follows:
SS: 3,600 x 12 / 700,000 = 6.17%
MZ: 2,800 x 12 /500,000 = 7.2%
FL: $400 x 12/ 50,000 = 9.6%
The CDO structure is now complete. All we need at this point is to convince a rating agency – S&P’s or Moody’s – that the SS tranche that is “protected” against default by two loss absorbing layers FL and MZ, is as safe as the safest corporate bond or even the U.S. treasuries and therefore, should command AAA rating. With that, our lawyers put all these details into an offering memorandum and we begin contacting investors.
A while back, in discussing the “collapse of the whole intellectual edifice”, I mentioned Kurosowa’s Rashomon in which the director explores the relation between the narrative and Truth: what do we need to know about something so we could say we know it?
What do we now know about the CDOs?
First and foremost, it must be clear why CDOs are called “vehicle” or “structural products”. They are vehicles for transforming: i) the risk of loans from the bank to investors in capital markets; and ii) the risk profile of a given pool of securities from moderately risky to supposedly riskless and very risky – the latter would be SS and FL tranches. As for structured product, it is the very description of how we created the CDO; a CDO is nothing if not a structured product, a fact that is reflected in the limitless flexibility we have in its design.
I am not exaggerating about the limitless flexibility. Let us begin with the number of tranches. I suggested three. You could make it four. Or five. Or six. Or even seven, if you prefer.
Then there is the number of original loans in the pool. I had 5 because that was sufficient for illustration, but CDOs typically have over 100 securities in the pool. That large number is necessary to make the structure robust so that 3 or 4 defaults will not wipe out the entire pool. The ABACUS 2007-AC1 in the center of the Goldman case had 127 securities.
Then there is the matter of allocating the total pool between tranches. I had 56% of the total allocated to the SS tranche (700,000/1,250,000). You could make it 60% or 70%. Likewise with the MZ tranche. Finally, I allocated 4% to the FL tranche, which is just about standard. This tranche, also known as “toxic waste”, is the riskiest tranche and rarely finds any takers. So the originator of the CDO – Goldman, for example – is usually stuck with it. That must have been the reason why Goldman claimed that it had lost $75 million. The loss had to come from the toxic waste piece that the firm could not unload.
Now comes the most complicated part: the pricing and price behavior of the securities in each tranche. In our example, we have allocated $500,000 to the MZ tranche. Assume that we divide it into 1000 securities, each worth $500 and with $3 a month in payments. What would be the price of this security?
On one hand, the security is a simple bond. We price it using standard bond mathematics. We know if the interest rates increase, the bond price would decrease, and vice versa.
But this security is not a stand-alone bond. It is a mezzanine note from a CDO in which cash flows come from a pool of mortgages. If the default in the pool rises, it will first hit the toxic waste tranche, it is true, but by virtue of “eroding” this tranche, it will begin to threaten the MZ tranche. The MZ tranche, in other words, will be riskier. And since the yield of the bond is fixed at 7.2%, its price would drop, even if interest rates remain unchanged.
The same is true for the SS tranche whose price can show no sensitivity to the defaults in the FL tranche – until it does. This is the so-called “cliff effect” that everyone in the CDO market was aware of. Financial Times, March 21, ‘06, p. 25:
[An independent consultant] describes how a CDO tranche can absorb a number of credit events, such as defaults and downgrades, and retain its level of subordination – or the size of the cushion that protects it from losses – until it reaches a point at which one further piece of bad news can push it over the edge. “Several things can go wrong in a deal and it will still be triple-A,” she say. “But then you get one more event and boom!”You see what I mean by procedural complexity. There is nothing about the CDOs that a 6th grader cannot understand or follow. But no one can account for all the parameters that influence the price of a CDO.
- Are the original mortgages from California, New York, Florida or Chicago? Mortgages from these geographies have different default patterns.
- Are the houses occupied by younger or older occupants? That would impact the default rates.
- Who wrote the mortgages and when? (If Countrywide in 2006, you’d better run for the hills).
- How is the national and regional economy doing? Can it maintain a steady employment rate?
Here is Exhibit A, a quant with impeccable academic credentials and work experience, writing to make us “understand” the risk of synthetic CDOs. I am not picking on him. I mention him precisely because his paper is well written and a cut above others. I urge you to read it. Yet, here is what the author wrote on page 2:
These “bank balance sheet” deals were motivated by either a desire to hedge credit risk, a desire to reduce regulatory capital, or both. Following these early deals, the same synthetic CDO technology has been used to create CDO tranches with risk-return profiles that investors find attractive. These later deals, driven by the needs of credit investors rather than banks, are termed “arbitrage” deals.He goes on to opine:
The terminology has taken hold despite the absence of a true “arbitrage,” which can be loosely defined as a risk-free investment with a positive excess return.What the author is looking at is the genesis of speculative capital: the transformation of hedging to arbitrage; I spend the entirety of Vol. 1 explaining it. But he does not see it because his professors at Stanford and MIT failed to teach him that words have meanings. So, he does not pause on the word arbitrage to ask himself, You, horse’s behind, what does this word exactly mean and why do you have to define one of the key terms of modern finance “loosely”?
Where is the arbitrage in a CDO? You would not see it in a million years by looking at a CDO structure.
Let us return to our example where “we”, a group of investors, approached the bank and offered to buy its mortgages. Why would we do this? What is in it for us?
Taking into account the expenses of creating a CDO – in millions of dollars that we have to pay to agents like Goldman Sachs – we could find easier and better uses for our $1,250,000. So what drives the market? The answer is arbitrage. From Vol. 3:
The point is that arbitrageur, by definition, has no money. That is why he could not put it in the mattress. Yet, to exploit the arbitrage opportunity, he has to create a portfolio that requires an outlay of cash. For that, the moneyless arbitrageur has to go to a lender. He must borrow money. One blushes at emphasizing this point. But the emphasis must be made...
In the example, you assumed that “we”, the group of investors, had $1,250,000. But we did not. Even if we did, the exercise would have been pointless because of its costs.
If the transaction was consummated, we must have borrowed the money. What is more, we’d borrow the money through a Special Investment Vehicle, with a large bank such as Citi as the guarantor, which allowed us to borrow at the commercial paper market at about 2%.
Now, the mystery is solved: borrowing at 2% and lending, i.e., buying the mortgages that yield 6, or 7 or 8%. That is arbitrage for you and God Bless America. See Part 8 of the Anatomy of a Crisis for more details.
But we are not done. The CDO in the center of the Goldman case is a synthetic CDO, where there are no real mortgages. A synthetic CDO “replicates” the behavior of real mortgages. For that, credit default swaps must be brought in.
Subscribe to:
Posts (Atom)
