Anatomy of a Crisis: The "Credit Woes" of the Summer of '07 – (8)

So, why CDO and not MBS? What is the difference between these securities?

Considered in isolation, the answer is, very little.

But nothing exists out of context, certainly not when it involves speculative capital that can only exist within a relation.

The critical difference between an MBS and a CDO is this, that an MBS is created to securitize mortgages, but CDO is a created to satisfy an arbitrage relation. Therein lies a world of difference.

The starting point of an MBS is the pool of available eligible mortgages. When all the mortgages in the pool are used up in the creation of the security, no more MBS could be created until the pool is replenished through the arrival of new mortgages. What is more, after an MBS is created, it must be marketed to investors.

In a CDO, the driver of the product creation is the demand, which is endless as long as the arbitrage opportunity persists; the availability of the eligible mortgage pool is secondary. Of course, a CDO cannot exist without mortgages. So in the face of the constant demand from a perpetual arbitrage machine that guarantees demands, what follows in a “free market” environment follows with the predictability and inexorability of day following the night.

First, the eligible mortgages run out so out goes the eligibility. “Alt A” mortgages, “No Doc” mortgages, subprime mortgages and any other form of mortgages are created and offered for the asking. New York Times, May 8, 2007:

[The founder of a mortgage broker] recalls being asked to make more “stated income” loans, in which lender do not verify the information provided by borrowers and brokers with tax returns, pay stubs or other documentations. The message, he said, was simple: You are leaving money on the table – do more of them.

To do more requires offering mortgages to borrowers who cannot even make the initial payments. But if there is a will, there is away. So the terms are manipulated to artificially lower the payments for the first couple of years. Hence the appearance of 2/28 loans, where for the first two years, the interest rate is kept artificially low only to rise by over 50% afterwards.

Even this vast pool of credit impaired is soon emptied by the insatiable demand. Speculative capital then pulls out its ace-in-hole: it brings in new cash-flow generating “securities,” including tranches from other CDOs. Financial Times, Jun 8, 2006:

Investors in the complex credit derivatives known as collateralized debt obligations will soon be more easily able to add or reduce risk through an extra layer of derivatives. The International Swap and Derivatives Associations … yesterday published a … template for writing credit default swaps on cash flow-CDOs. Bankers in the industry said the driving force behind this new layer of business was the excess of investor demand for risk above what the cash-flow CDO industry could currently supply.

“Industry” indeed.

The full cast of characters is now on the stage: home buyers and sellers, appraisers, mortgage lenders, real estate speculators, brokers, banks, investment banks, lawyers, rating agencies, “financial engineers,” product developers, fund managers and investors. As in the opening scene in Macbeth, the stage is set for the terrible things to come.

True to their nature and circumstances of creation, the CDOs finally broke the circuitry of arbitrage by a forcible revaluation of cash flows. The first sign of this rupture was the loss of quantitative funds that was universally interpreted as the “abstract” models of detached academics finally meeting the real world—and thus misinterpreted. What caused the loss of quantitative funds was the breakdown of the market relations that models (must) presuppose. The relations are the foundation of the “system.” Their breakdown is the materialization of the systemic risk par excellence.

Repricing alone, though, even of the severity we have seen, cannot in itself cause a widespread market breakdown. A crisis can develop only when the impact of speculative capital’s activities–its foot prints, if you will–come to disturb the structure of markets. We must therefore take a closer look at that structure, beginning with the role of broker-dealers and their clearing banks.

Anatomy of a Crisis: The "Credit Woes" of the Summer of '07 – (7)

For arbitrage to be possible, there must be a difference in rates; the larger the difference the bigger the arbitrage profit. Differences in rates are due to either the variation in tenor (time to maturity) or credit quality. To maximize its profit, speculative capital sets to borrow at the lowest short term rate and use it to buy highest-yielding, longest term asset.

The superlatives "lowest" and "longest", nota bene, do not pertain to a logical or mathematical extreme; speculative capital is too pragmatic to chase abstractions. Rather, they connote a practical consideration: speculative capital strives to create and exploit the widest borrowing-lending rate differential doable.

The lowest short term rates are available in the commercial paper (CP) market. The rates are low precisely because the CP market is accessible only to highest rated corporations. Speculative capital is, alas, nomadic, with no corporate lineage and a short engagement horizon. Like a mule, it has neither the pride of ancestry nor the hope of future to offer to lenders. Consequently, it seems to be hopelessly shut out of the CP market.

Then, mustering its will in the form of everything structured finance wizardry could offer, it finds a way and calls it Special Investment Vehicle—notice “vehicle,” as in a means of “getting there”. In an SIV, all the necessary requirements for arbitraging CP-CDO rates are brought together:

1. The first and foremost is the concern of CP investors—the lenders—about the creditworthiness of the SIV. Without satisfying them, there would be no money. The concern is addressed, in consultation with the rating agencies that will rate the vehicle, through multiple provisions:

• i) Pledged assets: CDO asset is pledged to lenders as collateral;
  
  ii) Marking-to-market and price triggers: Collateral is marked-to-market and automatic triggers are put in place to force sell the asset should the price drop below a comfort level.
  
  iii) Bank liquidity lines: As the final line of defense a bank provides a guaranteed liquidity line to compensate for any short fall in the securities price.

2. The asset to be purchased is CDO because:

• i) It has familiar form, similar to a mortgage-based security (MBS), with an established origination and distribution network;
  
  ii) it offers the highest rates and is at the same time acceptable as collateral to CP investors.

We are familiar with this structure. It is the option that Arbitrageur pitched to Lender. Here, the relatively small sum that the “qualified investors” put into the SIV is the option price—the $5 in our example—which gives them the right to default should something go wrong with the asset. The asset is the CDO, CP buyers are the lender and the SIV manager is the arbitrageur.

The SIV is a legal structure, so it include hundreds of details, from loan covenants to bank obligations. These details, while critical in their own right, do not concern us. The most critical component of SIV is its CDO asset.

A CDO is a security created by combining a pool of cash flows, typically mortgages. The pool is divided into various tranches, from the most highly-rated “super senior” to the riskiest “equity piece.” This structure is very similar to collateralized mortgage obligation (CMO) which has been around since the early 1980s. So, why CDO and not CDO? What is the difference between these securities?

This point is critical to understanding the modus operandi of speculative capital which lies in the root of current crisis. We need to take a short break to get ready for it.

Struggling Not to Name Names

When it was announced a few days ago that Tony Blair was going to teach religion at Yale – he will teach “how religious values can be channeled toward reconciliation rather than polarization” – I thought we had hit the equivalent of Absolute Zero on the absurdity index. You could not possibly top that – or go lower.

Then came the announcement of the Fed's latest design to stabilize the markets. It said, in part:

The Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured ... by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS.

The Fed's normal lending mechanism is similar to the way a pawn shop operates. You pledge US Treasuries or other Fed eligible securities and receive cash in return. When you pay back the debt, you get back your securities. The operation injects money into the financial system. The Fed could also pledge securities for cash. This reversing drains money from the system. Both are well known tools of monetary policy.

Notice now what is missing from the new arrangement: MONEY. The dealers will get Treasuries as before, but instead of paying money for them, they will pledge, i.e., give to the Fed, “other securities” including “private label residential MBS.” That is the junk they cannot sell because securities prices, and especially mortgage-backed securities prices, are way below what they were a year ago. Any sale at the current prices will result in substantial loss. Banks and broker/dealers have already posted over $160 billion of losses and have little capital left to absorb further losses. It is this scenario that the Fed is hoping to avoid.

At one level, this new lending facility is a laundering operation in excelsis: swapping impaired, “dirty” securities for clean US Treasuries. But note what happens in consequence: an entity whose raison d’etre is regulating the quantity and movement of money is pushed into the position of promoting and carrying out a barter exchange, one specifically designed to exclude money. No dialectician has thought of a more pointed example of self negation!

What brings about this mix of shadiness and absurdity is the incomprehension of events that we saw turn a liberal New York sophisticate into a man of faith. (See “Finance as Discipline of Faith” below.)

Will the gimmickry work? The bankers at the helm of the Fed must think and hope so. But the world is a complicated place, especially to those who do not understand it!

A few years ago, a Bush aide made his now famous “reality-based” comment against the backdrop of Iraq War. “We’re an empire now, and when we act, we create our own reality,” he said. What the cretin did not understand was that “the reality” has its own logic that acts as an elemental force, frequently subjugating and overpowering the individual designs. The turn of events in Iraq provided the ample proof.

Finance, too, has its laws that operate independent of the will of individual market players, often frustrating their plans.

Price, Karl Marx noted, is the money name of commodities. Commodities have money names because they have value, so price is the money name of value as well. By means of its new lending facility, the Fed wants to avoid naming names, avoid assigning prices to values. But merely ignoring prices will not make them go away. Transformation of values to prices is a fundamental principle of economics. No one need be conscious of it for it to operate. It will not, in the like manner, go away by wishful bankers wishing it to go away.

What the Fed has succeeded in doing is correlating, however indirectly, US Treasuries with junk. Under the current market conditions, that could only lead to the degradation of the Treasuries, as we must see in coming weeks.

Anatomy of a Crisis: The "Credit Woes" of the Summer of '07 – (6)

The essence of arbitrage is constant. Its form varies from one occasion to the next, depending on the circumstances. So while it is possible to demonstrate the concept of arbitrage with a simple example, the particular form in each case must be elaborated. It is this variation of the form that appears as a new product, a new market or a new strategy and for which financial engineers in the City and Wall Street are eternally given credit.

The critical point to note is that the particular form of arbitrage disrupts the status quo with varying degree of severity. In the heydays of globalization in 1998, the New York Times Magazine devoted a section to globalization under the heading “The Nuke of the 90’s.” An awestruck former Treasury official was quoted as comparing the “global markets” to nuclear weapons and adding: “The global markets are the most powerful force the world has ever seen, capable of obliterating governments almost overnight.”

Hegel said that myth is the expression of impotence of mind that cannot express itself independently. Hyperbole of this kind, too, is the expression of the impotence of a mind that notices the potency of a force but can neither comprehend it theoretically nor, consequently, describe it logically. The nuclear-force like irresistibility and destructiveness that overwhelms the uncomprehending observer is the resolve and drive of speculative capital to exploit arbitrage opportunities no matter the obstacles or consequences. This "ruthlessness" is a natural appendage to speculative capital’s modus operandi.

How does speculative capital react to the circumstance of low interest rates, a relatively flat yield curve and decreasing default rates (that lowers credit spreads)? How did it react in actuality when these conditions prevailed beginning 2002?

We are now ready to focus on the current crisis.

Anatomy of a Crisis: The "Credit Woes" of the Summer of '07 – (5)

Note the "nature" of the $5.

In so far as this sum pertains to a potential loss in lending, it belongs to the realm of credit. In so far it is bought and sold as a commodity with fluctuating price, it is in the realm of market. It is in the latter capacity that it becomes the subject of arbitrage. If, for example, the price of this "$5 value" rises to $6, Arbitraguer would create a riskless position by:

• Selling the call for $6 (+$6)

• Borrowing $20 (+$20)

• Buying ½ share of stock at $25 (– $25)

Numbers in parenthesis show the amount of direction of the cash flow, with “+” for inflow. The strategy yields $1 net income no matter what the future stock price, as shown below:

If stock is $60:

• Sell ½ shares for $30 (+30)
• Pay back the $20 debt (– $20)
• Pay $10 to call holder (– $10)

Keep the $1 net income.

If stock is $40:

• Sell ½ shares for $20 (+$20)
• Pay back the $20 debt (–$20)
• Option expires worthless

Keep the $1 net income

The idea of “$5 value” being bought and sold in the market for more or less than $5 might seem counter-intuitive. But that is precisely what commoditization entails: subjecting a product with a definite value to the supply and demand of sellers and buyers, only in the case of a “financial product” all attributes of utility are stripped away so that “value” alone remains.

The “$5 value” trades for more or less than $5 due to the transformation of values to prices. This subject is beyond our discussion. Suffice it to say that the phenomenon takes place millions of times each day in every sphere of economic life. A man who spends $300,000 on land, $200,000 on labor and $500,000 on material to build a 1-million dollar house and receives an offer for only $800,000 is experiencing this law, which to him appears as “lack of demand.”

The “fair value” of financial products is derived under such grotesquely distorting assumptions. But when presented to the market, the product must come down to earth. It must incorporate, however imperceptibly or crudely, the actual conditions of the market into its price structure. It must pay for the sins of the imperfect theory from which it is born by shedding its value. Thus, its theoretical and idealized value is turned into market price. (Nasser Saber, Speculative Capital. Vol. 1)

The more complicated a financial product in terms of cash flows and covenants, the more severe its value-to-price adjustment and the more complicated the mode of the adjustment. In the Summer of ’07, CDOs provided a graphic example of this complexity. As a series of credit events materialized, the equity piece of CDOs suffered but the AAA tranche retained its price. Then came one additional event, no more significant than others, and the entire price CDO collapsed. With their practical acumen, traders termed this the “cliff risk,” a vivid example of the dialectical principle of the accumulation of quantitative changes resulting in a qualitative change.

Note the critical interplay that is set in motion by the actions of Arbitrageur: Lender, Option Player and Arbitrageur are now “linked” through a process that puts a value on the default and then makes it the subject of trading. That is how – through this commoditization driven by Arbitrageur’s search for riskless profit – speculative capital makes credit “game”.

Anatomy of a Crisis: The "Credit Woes" of the Summer of '07 – (4)

Option Player is a piker. He wants to make it big in the markets but has neither Arbitrageur’s acumen nor Lender’s capital. The combination makes him vulnerable to manipulation. Against this backdrop, Arbitrageur and Lender appear at his door. The arbitrageur is a descendent of the Music Man and knows the Alpha and Omega of salesmanship, beginning with sympathizing:

“I understand you are in the market to invest but you are in a jam because you have no money. Indeed $50 is a great sum. Who has that kind of money these days?"

Option Player nods in approval.

Arbitrageur continues: “But look! Perhaps you are not approaching this thing from the right angle. Allow me to show you a way that you could profit from a rise in the stock without owning it. I know it sounds too good to be true but this one is good and true!

“The stock you want to buy is $50. One year from now, it could rise to $60 or fall to $40. Here is my offer. One year from now, if the stock is $60, I would pay you $10, which is the difference between $60 and the current price. If the stock is under $40, you pay me nothing. All you need for this once-in-a-lifetime opportunity is $5 which you have to pay me now.”

Option Player is tempted but remains skeptical. He remembers Melville from The Confidence Man that being asked to believe in something is being set up. But perhaps Melville was getting cantankerous at old age, he tells himself and mentally regurgitates the sale brochure of exchanges and brokerage houses: Options are the revolutionary products of the modern financial markets. The best and the brightest of finance have attested to their power and fairness. So big and complex a game could not be fixed.

He signals his interest by inquiring about the size of the payment.

“The prepayment is very small, merely $5” says Arbitrageur. “I have always believed in giving the little guy a chance. (It is so American.)

- You mean $5 is the only money I will have to pay even if the stock price goes down to $40? And I will still get paid $10 if it goes up to $60.

“Absolutely,” Arbitrageur ensures him. “In return for $5 upfront payment, all your future obligations will be extinguished. You will never have to pay a dime no matter how low the stock drops. Your upside potential would remain unlimited. The calculation of your $5 prepayment, by the way, is due to three eminent scholars who won fame and fortune for their discovery. So it is fair and objective. If you accept this bet, you could say that you buy a call option on the stock where you will have the right, but not the obligation, to buy the stock. ” (Again, he emphasizes the right but not the obligation.)

Option Player is sold. He pays $5 to Arbitrageur who takes it to Lender as the proof of his – Arbitrageur’s – having the required $5 “equity.” The lender pays the arbitrageur $20. With $25 in hand, Arbitrageur buys ½ share of stock. The loop is closed.

Lender has understood everything. He has one question: “How did you come up with the definition of option as the right to buy or sell?” he asks Arbitrageur.

- Well, it is the standard definition of option repeated untold number of times in markets, business schools, finance seminars, scholarly papers, dissertations and professional journals for decades. I myself have taught it to many students.

Lender is flabbergasted: “But that is not what an option is!”

Arbitrageur is even more surprised: “What do you mean? Then what is an option?”

Lender explains: “An option is a right to default. You said it so yourself to Option Player except that you did not listen to what you were saying. The ‘price’ of your option is nothing but the value of a credit loss – the loss that I had to absorb had I lent you $25 and stock had dropped to $40. It is also the cost of default of Option Player that you have to absorb if the stock drops to $40, as in that case he would not have to pay you the full amount of loss, $50 – 40 = $10. Of course, you might not care about this scenario because you benefit from the trade in a different way but that does not make an option any less a right to default. It is truly strange that this simple concept has escaped comprehension for so long.”

Arbitrageur understands what the lender is saying but cannot bring himself to agree: “I guess what you are saying is one way of looking at the problem. But thousands of finance professors, students, researchers and the Wall Street ‘quants’ have worked on this since 1973. They all believe – nay, know – options to be right to buy or sell the stock. In fact, that is how options are valued, as you just saw.”

“Yes, and that is the puzzlement,” Lender answers with a smile. “What I saw is that you calculated the dollar amount of your shortfall in the down scenario of stock and transferred it through the call option to Option Player. That did not give him any right to buy or sell. It merely insulated him against a fall in the stock price. If you did not mean to mislead the options buyer you must be one confused fellow yourself. And by the way, defining an option as a right to default is not a way of looking at it. It is the only way. Any other way is misreading and misunderstanding the situation in the same way that describing the solar system with the sun in any place but the center would be incorrect."

After this Socratic discourse, the protagonists return to the world of abstract finance, having shown us the “nature” of $5 in our example. It is the potential loss of speculative capital that is financed by speculative capital through the derivatives market.

Will return with Part 5.

Anatomy of a Crisis: The "Credit Woes" of the Summer of '07 – (3)

To arbitrage credit, speculative capital must first bring it into its orbit, make it “game.” The idea develops gradually from the practical consideration of trading. The arbitrageur is the personification of speculative capital. In that capacity, he is a practical man, interested only in profit and loss. When he sees a new opportunity, he rushes in to exploit it without giving much thought to the theory. “How could practical man think?”

What follows is the fascinating story behind the creation of the foundation on which the entire financial markets in the industrial world rest. If also offers a lesson in the limits of empiricism, however intuitive and obvious, of the kind the central bankers routinely practice.

Let us go then together to the scene of the discovery of credit as a tradable product, where Arbitrageur has gone to Lender to borrow money for a sure-fire, cannot-miss trading strategy. For simplicity, we assume interest rate is zero. This assumption does not affect the logic of the discourse.

“What do you need the money for?” Lender inquires.

“I am borrowing money to buy a stock,” answers Arbitrageur and shows him the “technical chart” of the stock, below:




The stock is currently trading at $50. It is expected to rise to $60 or fall to $40 in one year.

“How much are you putting up?” Lender demands to know: “How much equity do you have?”

- None. Zero

Lender is surprised. What chutzpah, he thinks and sharply asks Lender: “Then what happens if I lend you $50 and the stock drops to $40? Do you expect me to risk losing $10 ‘just like that’?"

“Not at all,” Arbitrageur explains. “I have a plan. It involves creating a riskless portfolio of the stock and option that guarantees you would get your money back no matter what happens to the stock price.”

“What is an option?” Lender demands to know

Arbitrage quotes from some respected finance textbook:

An option is a right but not the obligation to buy, in which case it is called call, or sell, in which case it is called put, some underlying stock or bond or currency or index or commodity or …

“Enough,” Lender interrupts. He does not suffer fools gladly. At the same time, a new prospect need not be completely dismissed. So he gives him a lecture on fine points of credit capital:

“You speak of risklessness. Long before you smart alecs came along with your fancy terms – options, portfolio insurance, hedging, arbitrage, financial engineering, what have you – I knew how to protect my capital. I have to, because it is the source of my livelihood. If I lose it, I would be on the street. Heaven knows it is a tough world out there.”

He warms up to his speech:

“I could begin with the 4 pillars of the loan evaluation: purpose, payback, risk and structure. But that is too technical. I am going to lay it out before you in layman ’s term.

“First, keep in mind that there are different forms of capital. I have chosen to employ my money as credit capital, which stands in a unique legal and social relation to other forms of capital, codified even before the time of my ancestor, Shylock.

“Accordingly, when I give money, I lend. It concerns me not whether the borrower uses the money for personal consumption or in an economic venture. In all events, I would collect no more than what is due me based on the agreed upon rate of interest.

“Because I do not share in the upside of the venture, you must, as a fair person, agree that I should not be expected to risk my capital in the downside. So I must make sure that you have enough money to pay me back when the downside hits. The most effective way of ensuring the return of loaned money is grabbing a piece of borrower’s property and holding it – physically or contractually – against the repayment of the loan.

“Now, you want to use my money to buy a stock that could fall from $50 to $40. That would leave me – you, really – $10 short. So you have to have $10 in cash in collateral before I could lend you $50.”

Arbitrageur repeats his main point, this time adding more details:

“I do not have any equity but I have a strategy. I could guarantees payment in full of your principal regardless of the stock price. In fact that very consideration is what drives my strategy. Briefly, I plan to buy ½ share of stock. For that, I will only need $20. Now if the stock falls ..."

“My friend,” Lender again interrupts: “You must have a reason for buying 1/2 share instead of full share. But before getting there, let me tell you that by the demand of my profession, I am good with numbers. If you borrow $20 from me, you would not be able to buy ½ share of stock. The stock is currently trading at $50. Its ½ shares would cost $25. So if you borrow $20, you would be short by $5. You just told me you have no money.” He assumes a sarcastic tone: “Does your strategy show you how to create $5 out of the thin air?"

“In fact it does.” Arbitrageur responds in earnest: “I would enter into a bet with an option player for which I would receive $5.”

- Why would anyone give you $5 upfront?

- Because I will construct the bet in such a way that the participation in it will cost $5. If the bettor wins, he can collect like in any other bet. If he loses, he does not have to pay. You could say that he could choose to default. This, I must say, is the mother of the structured finance products.

- And that is this 'option thing' you mentioned?

- That is the 'option thing'.

- As long as you sell the option before coming me for money! I will have to see $5 in your hand. Only then will I lend you $20 for buying 1/2 share.

- Of course.

Lender is curious to see how the 'option thing' works and asks Arbitrageur if he could accompany him. Arbitrageur is happy to oblige. Together, they go to Option Player.