Deus Ex Macchiato

Lisa Pollack has an interesting, if rather too fair minded post on Alphaville about the dubious claim that the Black-Scholes formula somehow caused the crisis.

Let’s be clear. Black-Scholes is about options pricing, and hedging in particular. It has nothing to do with securitization, and little with tranching. So the claim that Black-Scholes caused the crisis is BS.

There is a boarder claim that somehow mathematical finance in general – and risk models in particular – were to blame. Certainly many VAR models under-estimated risk before the crisis, while some models of tranches were response for assigning great ratings to assets that didn’t perform well. But no model went out on a wet Wednesday about bought fifty billion of sub-prime ABS. A trader did that. Blame them, and the incentive structure in their firm that encouraged them.

Posted in: ABS, Model risk by David /
3 Comments

A major cause of systemic risk in the financial system is things that are mostly one thing, but occasionally another. Unlike Gremlins – where you are safe provided you don’t get them wet* – these things change without your intervention. Euro-periphery government bonds are one example; AAA RMBS during the crisis are another.

These things are dangerous precisely because you are lulled into thinking that they are always safe, when in fact they mostly are. A shortage of things that are always safe, plus perhaps a touch of greed, causes folks to buy the almost-safes. And we all know how that ends: a flight to (genuine) quality and contagion as investors exit all assets that might even possibly be risky.

There are two reactions to this. FT alphaville nicely sets out the positions in relation to uninsured bank deposits. You can say folks should grow up, and understand the risk; or you can say the risk ought to be removed. For me, the ‘grow up’ position is naïve. Just saying people should not be mistaken solves nothing. At least the ‘do something’ school (represented by Amar Bhidé) recognises the risk that investors will fail to recognise the risk, then flee when bad things happen. If those same investors are forced to pay now for the protection they will need later, maybe stability is enhanced.

Now, of course, there are lots of issues with this, and lots of potential to get the design of the solution wrong. But just throwing your hands up in the air and saying people should be smarter – well, that’s as dumb as a fish trying to swim up Kingston Falls.

(For a further discussion of the importance of genuinely safe assets, see here.)

* Or feed them after midnight, or expose them to sunlight.

Posted in: ABS, Bank Run, Clearing and Collateral by David /
2 Comments

Yes we do. Felix Salmon is wrong. Let me explain.

First, what is informationally insensitive debt?

financial assets which (normally) don’t change in price when new information about them emerges

That’s not a good definition, actually, as there are no assets (apart from cash) which satisfy it. But it hints at a more useful definition, namely an asset whose credit spread does not change when more information about its issuer becomes available. A good example is a government bond from a genuinely AAA issuer. (See here for a longer discussion from Gary Gorton where he mentions the content of a CDS spread and conjectures that the universe of informationally insensitive assets has declined thanks to CDS trading.)

Now, Felix thinks assets like this are a bad idea because “bankers and other financial innovators the world over have every incentive to structure products which turn risky assets into informationally-insensitive debt“. These then “cause crises“.

I see it entirely the other way. The absence of enough genuinely informationally insensitive assets caused a demand which was met by the creation of almost, but not quite informationally insensitive ones, namely AAA-rated ABS. There is a massive demand for informationally insensitive assets, notably from those with low risk tolerance. We need more of them, as I suggested in my posts on policy on the asset side. Indeed, as Matt Yglesias says:

we need to do something—like maintain the existence of a large pool of federal debt—to make sure that the world has the quantity of information-insensitive debt it needs to continue routine operation.

Posted in: ABS, Economic Theory, Securitisation and Tranching by David /
3 Comments

A little while ago I speculated on a possible Ponzi scheme (in fact if not in intention) in pre Crunch CDOs of ABS. The basic idea is that there was a false market in subprime RMBS tranches if there were no real bids, or few real bids, for mezz tranches other than other CDOs.

Bloomberg now leaps into the debate with an article How Wing Chau Helped Neo Default in Merrill CDOs Under SEC View. The key part:

“People on the outside thought the market was going gangbusters because of all the deals getting done,” said Gene Phillips, director of PF2 Securities Evaluations, a New York- based company that helps banks and funds evaluate CDOs. “People on the inside knew this [i.e. the CDO-squared and managed CDO business] was a last-gasp attempt to clear out the warehouses”…

Interactions across the industry among bankers, asset managers, ratings firms and lawyers contributed to what Lang Gibson, head of CDO research at Merrill until early 2008, called a “Ponzi scheme” of CDOs buying other CDOs.

Posted in: ABS, Securitisation and Tranching by David /
2 Comments

At Jack on tap we find:

Generally speaking and contrary to popular belief, caveat emptor is not a well-established legal principle… Professionals in other fields have many avenues of recourse when they are sold a defective product—just because you’re an expert doesn’t mean you’ve disclaimed all warranties (if this wasn’t true, we wouldn’t need lawyers). Certainly, if a supplier sold GM a faulty $1 part used in a Chevrolet, we wouldn’t want to shield the supplier from liability simply because there are automotive “professionals” that also work at GM. It eludes me as to why you’re liable if a $15 toaster blows up, but not if a $1 billion collateralized debt obligations of asset-back securities does.

(Hat tip FT alphaville.)

This all seems reasonable (and comes with the usual I-am-not-a-lawyer-indeed-I-don’t-even-know-how-to-cook-one disclaimer). And undoubtedly there are many instances of devious, scheming bankers selling products they knew (or strongly suspected) were toxic to naive investors, including naive professional investors. The industry short hand in some quarters used to be `Belgian pension fund’, meaning any sleepy, ill-informed party who had the authority to enter into transactions they could not price and might well not have understood the risks of. If some people had something they really couldn’t sell to the cognoscenti, they found a Belgian pension fund.

CDOs of ABS, however, are a slightly different story, at least in some cases. These were products that neither buyer nor seller understood. In many cases both parties used the same flawed model to analyse the product; both parties failed to dig deeply into the underlying collateral; both parties did not think through the consequences of the forms of credit enhancement present*. It suits the current mood to blame the industry – or just Goldman Sachs if you prefer – for knowingly blowing investors up. But the truth is rather more complex. I doubt that this will ever come out. The `we didn’t understand it either’ defence might work against a claim of fraud or misrepresentation, but it does rather open the door to a case of failure of due diligence…

* A good example is the use of excess spread accounts. These work as credit enhancement providing defaults happen late enough in the life of the structure. If they happen early, however, as in most of the 2006 and 2007 vintage CDOs of ABS, they are useless.

Posted in: ABS, Reputational Risk, Securitisation and Tranching by David /
2 Comments

There has been much incendiary and ill-informed comment on the ‘shadow banking system’ and Wall Street as ‘a giant Ponzi scheme’. As always in the aftermath of a crisis, hyperbole is not in short supply. Still, there is one sense in which a limited version of this claim might be true: the business of making CDOs of ABS could have been a form of Ponzi scheme. Here’s how.

Note that there are three types of tranche in a CDO: senior, mezz, and junior. One main reason for making a CDO in the pre Crunch period was to create AAA-rated senior securities. Lots of people wanted to buy these, so distributing them was not a problem. (Of course, these securities turned out to much more dangerous than many people thought, but that is not the point: in 2003-07 selling AAA ABS tranches was not a problem.)

The junior was typically retained by the originator; if it wasn’t, there were plenty of (mostly hedge fund) buyers. So that was not a problem either.

In order to have a real transfer, and to convince their risk managers that they really had sold the CDO, the makers of CDOs of ABS had to sell the mezz too. This was a lot more problematic. The ratings were not AAA; the yields were not that attractive (often high tens or low hundreds of bps for risk in the low investment grade or high junk area); and buyers knew that there was risk in these tranches.

So what might some banks have done? One answer could have been to set up (or find) friendly asset managers to buy the mezz. Remember, in managed CDOs the asset manager has considerable discretion about which collateral to buy. If you could find a supposedly independent third party who you could somehow persuade to buy your mezz – perhaps because you had provided them with support somehow – then you could claim that you had sold the whole CDO, and you would be allowed to make another one.

This would be a kind of Ponzi scheme if the originator was covertly financing the mezz purchaser, or otherwise providing sufficient support that the mezz purchase was not a free market transaction. It would mean that CDO tranches prices were not the result of willing buyers interacting with willing sellers, but rather connected buyers taking subsidies for being seen to buy known rubbish. These prices in turn would then support the AAA pricing: after all if the As were seen to be trading at 80 over, it made 15bps for the AAAs seem reasonable.

What do we learn from this hypothetical? Simply that if you want to understand what happened in the CDO of ABS market in the run up to the Crunch, the question ‘who bought the mezz and why?’ is particularly relevant.

Posted in: ABS, Securitisation and Tranching by David /
2 Comments

MBIA, once one of the most important monoline insurers, is sueing Credit Suisse for pervasive and material misrepresentation of the risk that they insured on RMBS. From Bloomberg via FT alphaville:

A Credit Suisse Group AG unit was accused in a lawsuit by MBIA Insurance Corp. of making fraudulent misrepresentations about mortgage-backed securities… [in a] transaction that was sponsored, marketed and serviced by the Credit Suisse units…

“CS Securities fraudulently induced MBIA to participate in the transaction,” MBIA said in the complaint. MBIA said the bank claimed it had “used certain strict underwriting guidelines to select the loans sold into the transaction when in fact it did not.”

So far, so ordinary. Insurers takes risk, insurer takes hit, insurer claims it did not know what it was doing because the client did not tell them everything, insurer sues is a sadly common story. But this one gets better:

Since the transaction closed, the securitized loans have defaulted “at a remarkable rate,” MBIA said.

“Through Oct. 31, 2009, loans representing more than 51 percent of the original loan balance, or approximately $464 million, have defaulted and been charged-off, requiring MBIA to make over $296 million in claim payments,” MBIA said.

MBIA said that a review of the defects of the loans included in the transaction show they were “systematically originated with virtually no regard for the borrowers’ ability or willingness to repay their obligations.”

One might wonder why MBIA did not notice this before they agreed to take the risk. So (as FT alphaville puts it) in order for MBIA to succeed, it will have to convince a court that its much-vaunted underwriting and due diligence weren’t actually all that great. Mind you, given that MBIA have gone from being AAA-rated to BB-, that might not be too much of a surprise to some people.

Posted in: ABS, Legal Risk and Trade Documentation, Monoline, Mortgages by David /
2 Comments

In the bad mad days of 2005 and 2006, some people valued ABS by estimating the future cashflows and then discounting them back at Libor flat. In situations with significant prepayment risk, they might well have option adjusted this value to account for interest rate convexity based on some prepayment model.

That process does not produce values that are market consistent these days. The reason is there is compensation in the spread of an ABS for features other than default and interest rate optionality. These other factors include current liquidity risk, potential future liquidity risk, funding cost (remember you cannot necessarily repo an ABS), and the volatility of both the mark to market of the asset and its capital requirements. (The last two can just be thought of as a convexity adjustment for the volatility of EL and UL.)

The market handles this ‘problem’ rather crudely. The convention is to discount tranche cashflows at a rate higher than Libor. Thus for instance one might recover the market price of a AAA tranche by discounting at Libor plus sixty, while a BB tranche might have to be discounted at Libor plus six hundred to get the right price.

These higher rates solve the problem at the expense of introducing an arbitrary step much like the use of implied volatility to recover market prices for options using the Black-Scholes formula. Just as options dealers think in terms of implied vol without for a moment believing that the underlying follows a diffusion, so ABS traders think in terms of these discount factors without believing that they are anything more than an ad hoc market adjustment. Clearly we still have a long way to go in being able to price ABS based on fundamental factors.

Posted in: ABS, Credit, Decision Making, Liquidity and liquidity risk by David /
Comments Off

From Wells Fargo via Creditflux:

In their latest research report, Wells Fargo (formerly Wachovia) analysts calculate that 360 CDO of ABS have now triggered an event of default – up from 343 last month. At $351.6 billion, the notional value of these deals accounts for just over half of all CDOs of ABS.

Posted in: ABS by David /
Comments Off

The Atlantic has an interesting if over-simplistic article on the role of securitisation in the crunch. I agree with this last paragraph to some extent:

It’s important for people to realize that the credit crunch was not caused by securitization — it was caused by very poor assumptions used to rate securitizations. In a different world, with smarter rating agencies and investors who did due diligence, things might have turned out better. The future of finance should not exclude securitization. It should continue to be utilized, just with better assumptions.

It is worth noting, though, that securitisation did faciliate the crunch since it allowed the interests of those making loans to diverge dramatically from the interests of those holding the risk of those loans.

Another key issue is that people didn’t – and to some extent still don’t – understand the risks of ABS. An ABS is not like a corporate bond for a number of reasons. First, many of these securities have uncertain duration: if things go well, they can have quite a short weighted average life; whereas if things go less well, you can be on risk for much longer. Second, in a corporate bond, management have real options: they can sell parts of the business, pledge assets to raise liquidity and so on; in an ABS, in contrast, (at least if the collateral pool is not managed), you are stuck with the assets for better or for worse. Third, the credit enhancement in ABS often means that the expected probability of default is low but the loss given default is very high. Corporate bonds may well have a higher recovery. Hence there can be a huge difference between the expected losses on two securities with the same probability of default. None of this means that ABS are necessarily toxic, but it does mean that the buyers of these securities need to understand these risks in detail. More conservative ratings will help, but a single rating alone can never be enough to distinguish the complex risks of ABS.

Posted in: ABS, Securitisation and Tranching by David /
2 Comments

Sorry, I couldn’t resist the bastard cross of chess and bond ratings. Let me explain. Once upon a time there was a leveraged loan CDO arranged by Goldman called Greywolf. Greywolf, which sounds like a monster who wants to gobble up your money, was in fact a monster who wanted to gobble up your money. In the fullness of time, the AAA tranche was downgraded to A-, or A3 in Moody’s speak. Now, according to Bloomberg, Morgan Stanley is doing the Re-REMIC (aka CDO-squared) trick on the Greywolf AAAs. That is, they are buying the AAAs into a SPV and issuing two tranches of notes on the other side, a CDO-squared structure. Bloomberg suggests the tranching is roughly two of AAA to one of Baa2.

My only question, really, is if these new bonds are downgraded too, will someone else step in and ReRe-Remic them?

Posted in: ABS, Securitisation and Tranching by David /
Comments Off

No, not my standard broker’s commission, but the average level of credit enhancement in CMBS before 2003. FT alphaville, commenting on the forthcoming tsunami of CMBS downgrades, reprints this enlightening table from S&P:

This very clearly shows how investors let their standards slip in the hurt for yield during the Boom years. Not everyone was convinced though: from 2004 the practice of splitting the AAA into two or more tranches became commonplace. The top tranche, amusingly, is called super duper AAA.

S&P want at least 19% credit enhancement for AAA going forward. At least this is generating a nice repack business as banks take junior AAAs and resecuritise to keep most of the notional at AAA. The Americans call this a Re-Remic* — which isn’t nearly as cool sounding as super duper AAA.

* Real estate mortgage investment conduit, or CDO-squared to its friends.

Posted in: ABS, Ratings by David /
Comments Off

This is a geeky post about the CDS market.

The newswires have been buzzing recently with news of a ‘daring’ CDS trade by Amherst Holdings. I didn’t comment on it at first as I didn’t understand the trade from the initial news items, but I now think it is possible to work out what’s going on.

Let’s start with the bonds this trade refers to. They are subprime MBS. Like most MBS, these are amortising, prepayable bonds. The fact that these are amortising bonds means that the face value of the security is irrelevant: what counts is the principal balance at the time the trade was done. [Quite a lot of the stories were confused about this point, so it is worth pointing out.]

So, let’s say we have some bonds with $100M left to repay.

The next bit that is tricky is the nature of the CDS protection sold. Everyone agrees Amherst sold protection and some banks bought it. But what protection exactly? It is most common for CDS on MBS to be pay as you go, meaning that the protection sellers compensates the protection buyer for principal deficiencies as and when they occur. There is no event of default as such, unlike corporate CDS. [To be strictly honest, there may be an event of default as well, such as bankruptcy of the issuing SPV, but that is irrelevant for our purposes.]

Let’s suppose then that Amherst sold pay as you go protection on $100M of bonds.

Since the bonds were thought likely to repay little to nothing of the outstanding principal balance, the banks paid Amherst, say, $80M up front for their protection. [There may have been an ongoing coupon as well, but we'll ignore that.]

Amherst then paid the servicer to buy out the underlying mortgages and pay off the bonds. Thus the bond holders got their $100M. The servicer could do this because the bonds had a 10% clean up call, meaning that if more than 90% of the face had amortised, they could repay the remaining principal balance at any time. [So to keep with the example, the face amount was more than $1B.] 10% cleanup calls are common in ABS, and they are what makes Amherst’s trade work*.

Now, here’s the confusing part. Who won and who lost?

First the banks. If they had held the bonds, then they would be about flat. $80M for CDS protection paid out, but $100M paid back is a $20M profit, from which subtract the (few cents) cost of the bonds. So the only way the banks could have lost massively on the trade, as reported, would have been if they had been net short the bonds. That is, they did not own the bonds, and bought protection, betting that total losses would be more than $80M. The losers, then, were parties who did not own the bonds and who did not realise the significance of the cleanup call to their short.

[The WSJ story suggests that JP Morgan lost money but that RBS and BofA didn't. This would be consistent with JP being net short, while RBS and BofA had a negative basis trade on, i.e. owned the bonds and bought CDS on them. The presence of net shorts is also consistent with the WSJ's suggestion that more protection had been traded than the notional of bonds outstanding.]

Next Amherst. They had the $80M of CDS premium. But how much did they have to pay to get the bonds repaid? Clearly a logical answer would be about $80M. Therefore the only way that Amherst could have made money would have been if they had sold more protection than there were bonds – $200M say rather than $100M. Say they sold $50M to JPM, $50M to RBS and $50M to BofA. Then they would have had to pay $80M, roughly, to buy back the mortgages behind the RBS and BofA CDS, but the JPM CDS was not backed by any bonds and so the $40M premium from JPM would be straight profit.

In other words, the only way Amherst could have made a lot of money on this trade would have been if it sold more protection than there were bonds. The only way that the banks could have lost money would have been if they bought more protection than there were bonds. In a situation like this someone was always going to be squeezed. It’s just that this time, that party wasn’t an investment bank.

The lesson of this amusing little situation? Nothing more than read the small print. The buyers of protection — and in particular naked shorts — should have understood that arbitrary action by servicers is possible, and that in particular the 10% clean up call could be exercised. This is a much bigger risk late in the amortisation profile of a bond than early, but it is there for most ABS. Caveat emptor.

* Contrary to what Willem Buiter writes in his blog, if you own 100% of a bond, you cannot necessarily control whether it defaults or not. A default on a public security is a default, regardless of who is affected.

Another mistake Buiter makes is assuming that centralising CDS trading would not have helped in this situation. It would certainly have helped the banks to avoid their losses, in that the size of Amherst’s long vs. the cash would have been obvious thanks to trade reporting. Personally I don’t particularly feel the need to help the CDS trading desks of investment banks, mind you.

Posted in: ABS, CDS and Negative Basis, Legal Risk and Trade Documentation by David /
3 Comments

I have been surprised at the slow takeup of the TALF. It looked to me like a license to print money. As Zero Hedge points out, less than $30B has been allocated to a program with a trillion dollar capacity.

Part of my surprise is that to be eligible for the TALF (at the moment at least – this will probably change) a security needs to be AAA rated. And S&P are on the downgrade war path. As Calculated Risk reports, quoting S&P, approximately 25%, 60%, and 90% of the most senior tranches (by count) within the 2005, 2006, and 2007 vintages [of CMBS}, respectively, may be downgraded. So you would have thought that people would have rushed to throw things into the TALF before they became ineligible.

Bloomberg suggests that the TALF, and its brother the PPIP, is stalling. They seem to have a point.

Posted in: ABS, Mother of all Bailouts by David /
Comments Off

…as the FT says, will be felt mostly by the banksWhat is interesting about this is how vintage insensitive it is. In the US, there is a world of difference between the 2005s and the 2007s: in Spain, not so much.

Update. Downgrades loom for the Spanish banks as an interest diversion test is tripped on a Caja Madrid RMBS.

Posted in: ABS, Mortgages by David /
2 Comments

Bruce Krasting has an interesting story on sub-prime related litigation in Massachusetts:

Goldman has agreed to pay the state of Massachusetts $60 million to settle a dispute regarding Goldman’s “predatory lending” practices in and around Boston. $50 million will be made available to reduce the loan principle on 714 individual mortgages… In the critical years 2005-2007 Goldman was ranked 15th in the League Tables for sub prime and Alt-A origination/securitization. Goldman’s management must be pleased as punch with that poor showing today.

As Bruce says, this is not a big deal for Goldman — but it might set a nasty precedent for those higher up the subprime ABS underwriting tables, notably BoA (labouring under both Countrywide and Merrill) and Citi. You can expect this story, like Enron-related litigation, to run and run.

Update. A different account of the case from Jonathan Weil at Bloomberg is here. His take is that Goldman paid greenmail to Mass, perhaps to avoid the disclosure associated with a full hearing. His article certainly makes interesting reading.

Posted in: ABS, Legal Risk and Trade Documentation, Photography, Securitisation and Tranching by David /
Comments Off

According to the FT, 47.6 per cent of all CDOs of ABS by volume issued since the market substantively began in 2002 have now hit an event of default. Wow.

Posted in: ABS, Securitisation and Tranching by David /
Comments Off

No, not the closing down sale at one of Britain’s many bankrupt retailers, although it could be. Rather it is the fall in property prices from the peak in one of the exurbs of Fort Myers, Florida. The NYT story is here. But mull on that number for a second. 80%. Then consider putting -0.8 in the HPI vector, and think what that will do for the price of even prime RMBS.

Posted in: ABS, Fair Value, Mortgages by David /
Comments Off

Accrued Interest has a great post on the newly expanded TALF. An edited version follows:

Fed will loan funds for purchase of recently issued ABS. This [means] ABS issued after January 1, 2009 made up of loans no older than October 2007. The ABS must be rated AAA, and be made up of student loans, auto loans, small business loans, or credit cards.

Loans will be non-recourse and not marked-to-market.

The loan term will be up to 3-years.

The loan rate will be set at “yield spreads higher than in more normal market conditions but lower than in the highly illiquid market conditions that have prevailed during the recent credit market turmoil.”

So, buy some ABS, repo it to term with the FED. Sit back and enjoy positive carry, no margin calls, and, err, that’s it. Gentlemen, start your engines.

Posted in: ABS, Liquidity and liquidity risk by David /
Comments Off

From FT alphaville:

Posted in: ABS, Ratings by David /
Comments Off

Just like these council workers taking down fly posters only for them to reappear in a few days, so banks are getting ABS off balance sheet by offering to finance them. The FT reports one such set of tricks here and Naked Capitalism has a discussion of Lehman’s deleverage using related shenanigans here. The bottom line is obvious: if you can’t sell something but you need to look as if it is gone, find somewhere to park it, pay the parking fee and transfer any risk you can get rid of, and hope that when or if the asset comes back, it is worth more.

Posted in: ABS, Accounting by David /
Comments Off

I have been reading a fascinating (if long) article Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions by Joseph Mason and Joshua Rosner. There is an awful lot in the document, but here I want to concentrate on one issue they raise which I had not thought about before, namely the shape and trajectory of the loss distribution through time.

Consider a corporate bond. For a holder of the bond, the (hold to maturity) loss distribution has a big lump of probability in the 95%-100% return bucket corresponding to the likelihood that they will get their money back. Then there is a gentle bell curve lower down corresponding to the distribution of recovery values. Two observations:

• As the credit quality of the corporate declines, this shape moves but typically those moves are slow. The big lump gets a little smaller and default gets a bit more likely, fattening out the curve around the expected average recovery.
• One of the reasons that moves are slow is that the company has management. Default is bad for these folks so they try to avoid it by altering their strategy or the capital structure and/or by asset sales. They have strategic options which they exploit, often saving the company.

Now consider a typical tranched ABS backed by a pool of collateral. Here tranching and other credit enhancement means that default is unlikely for the rated tranches. However:

• The shape of the distribution is different. In particular, the average loss given default can be much higher.
• The time evolution of the distribution is different: most static ABS pools evolve so that for a given tranche, default becomes either certain or vastly improbably.
• Thus if the pool behaves a bit better than expected, most or all of the rated tranches will be money good. Mason and Rosner say this `wastes’ credit enhancement, which I don’t really see, but certainly even lower tranches can become risk free in some deals fairly fast.
• On the other hand, if the pool behaves even a little worse than expected, the impact on the lower tranches can be severe. Therefore ABS downgrades, when they come, are often multiple notch downgrades.
• Note that this is partly because most ABS has no asset diversification and no time diversification: unlike a corporate, there are no strategic options for the issuer to do something that doesn’t lose as much money as their current approach.

None of this means that ABS ratings are wrong, necessarily, but it does mean that the users of ratings need to understand the key differences in the time evolution of credit risk between corporates and ABS.

Posted in: ABS, Ratings by David /
Comments Off

The Economist points out an issue:

The European Central Bank (ECB), widely praised for providing banks with ample liquidity during the credit crunch, now has a problem: how to encourage banks to place freshly created asset-backed securities (ABS) with investors, rather than dumping them, like so much radioactive waste, in its vaults…

On the face of it there is no immediate problem. Only around 16% of the ECB’s collateral so far is ABS. Banks are drinking from the liquidity fountain and keeping the cost of high-street mortgages contained at the same time, which they might not be able to do otherwise.

But it is not helping the revival of a publicly traded ABS market, and may be fostering the creation of even murkier securities. Many of today’s ABS are even less transparent than those sold before the crisis—the ECB requires a rating by only one agency, not the usual two, and pre-sale reports are often sloppily prepared.

What’s the answer? Well one obvious one is slowly, and with considerable vigilance over the market impact, to raise the haircuts. Countercyclical central bank window haircuts make sense. As matters improve, the ECB can tone down its roll as financer of first (and only) choice.

Another is to permit the assignment of the financing as I mentioned earlier. The ECB could allow banks to sell the securities and transfer the obligation to repay to a third party. Obviously that means the ECB would have to be willing to offer liquidity for a short period to firms who were not necessarily member banks. But if that helps restart the ABS market, it might be a small price to pay.

Posted in: ABS, Liquidity and liquidity risk by David /
Comments Off

Whither the CMBX? Specifically, where are the 08-01s going to come from, given that CMBS issuance has plunged along with prices. According to the FT:

The amount [of CMBS] issued in the first five months of this year fell 89 per cent to $10.8bn, the lowest level since the late 1990s, according to Commercial Mortgage Alert. Overall issuance last year was $253bn.

That does not just mean hard times for securitisation desks and commercial property investors looking for leverage. It means that it is hard to build a representative index of recent deals. Spreads have come in a little from the wide levels earlier in the year, but it will take months for the market to recover. Could it be a good time to buy what little there is out there?

Posted in: ABS, Markets by David /
Comments Off

On Wednesday HBOS closed the first UK RMBS deal since August 2007 (that we know about, anyway). Libor + 85 for AAA bonds with a 160% OC. Yep, the deal is £500M and there is £800M of collateral. 800. Just pause a moment and think about that OC. The deal can suffer 35% delinquencies with zero recovery and still be money good. That is truly an astonishing level of safety for the market to demand in return for something as rich as 85bps. Remember AAA prime UK RMBS used to trade at low teens of bps: 85 was BBB territory. Verily the Crunch is a harsh mistress.

For the curious, there are more details here and here.

Posted in: ABS, Mortgages by David /
Comments Off

The UBS shareholder report on the firm’s subprime losses makes fascinating reading and I will try to return to it later in the week. Meanwhile however it is worth noting that a major cause of the UBS losses were AMPs. Let the report take up the story:

[AMPs] were Super Senior positions where the risk of loss was initially hedged through the purchase of protection on a proportion of the nominal position (typically between 2% and 4% though sometimes more). This level of hedging was based on statistical analyses of historical price movements that indicated that such protection was sufficient to protect UBS from any losses on the position.

Let’s try and tease this apart. The bank is long the supersenior tranche in a CMO. They ‘hedged’ this position by buying credit protection on the underlying mortgage portfolio in an amount calculated to minimise short term P/L volatility. I think.

Isn’t this pure gaming of the VAR model? This ‘hedge’ dramatically reduce the VAR. But losses build up in the junior and rise through the mezz, the bank will need to short a larger and larger percentage of the underlying mortgages to remain hedged. In other words this position is massively short credit convexity even if it is credit delta neutral. And even that is assuming that you can short more of the underlying pool into a falling market, an assumption that is highly questionable.

Anyway, even if the AMPs position was not designed to game the VAR model, it certainly achieved that effect:

Once hedged, either through NegBasis or AMPS trades, the Super Senior positions were VaR and Stress Testing neutral (i.e., because they were treated as fully hedged, the Super Senior positions were netted to zero and therefore did not utilize VaR and Stress limits). The CDO desk considered a Super Senior hedged with 2% or more of AMPS protection to be fully hedged. In several MRC reports, the long and short positions were netted, and the inventory of Super Seniors was not shown, or was unclear.

(See here for a discussion of negative basis trading.) For something like this there is real danger that the system’s view is seen as the only reality. If the VAR model says there is no risk, the firm might actually think that’s true.

Next we come to model risk:

The AMPS model was certified by IB [UBS investment bank] Quantitative Risk Control…but with the benefit of hindsight appears not to have been subject to sufficiently robust stress testing. [...] The cost of hedging through a Negative Basis trade was approximately 11 bp, whereas the cost of hedging through an AMPS trade was approximately 5 – 6 bp.

So, a positive carry asset hedged very cheaply but leaving a large short gamma position which was not captured by the firm’s risk model. They really were asking to be creamed by a big market move. And then one came along.

Posted in: ABS, Derivatives, Hedging and Convexity, Model risk, Mortgages, VAR by David /
Comments Off

Gillian Tett comments on the large supersenior ABS holdings at Merrill and UBS in the FT backed by mortgages on properties like the fine abode above:

Most notably, as these banks have pumped out CDOs, they have been selling the other tranches of debt to outside investors – while retaining the super-senior piece on their books. Sometimes they did this simply to keep the CDO machine running

Absolutely. And also as a funding arbitrage: for a bank that funds at Libor flat and views supersenior as risk free supersenior paying Libor plus ten is a good investment. Tett continues:

[Since] super-senior debt carried the AAA tag, banks were only required to post a wafer-thin sliver of capital against these assets

Again true, but I doubt that the advantageous reg. cap. position of these assets was that important. Any low volatility bond would do in a VAR setting, or any internally highly rated one under Basel 2 in the banking book. And there are plenty of AAAs that yield more than Libor plus ten. The real issue is the risk assessment: some banks managed to persuade themselves this paper was risk free. And that brings us nicely to an article in the WSJ on how exactly the firm got to that assessment. Enjoy.

Posted in: ABS, Basel, Photography, Regulation, VAR by David /
Comments Off

Should the Bank reduce its collateral quality requirements and/or buy ABS outright? It is certainly thinking about it. The FT reports:

Mervyn King indicated on Wednesday that the Bank of England was poised to take a revolutionary step and buy or swap illiquid assets on banks’ books for cash or liquid assets as way to find a “longer-term resolution” to the problems faced by British banks.

One of Mervyn’s motivations is to try to reopen the market for these assets, or at least allow them to be financed until such a time as the market reopens.

Commenting on the “fragility” that exists in the financial system, Mr King said there was an “overhang on banks’ balance sheets of assets in which markets have closed”

“These assets cannot now be sold or used to secure funding in the market – they are difficult to finance. That has created uncertainty about the strength of banks’ financial positions”.

This is, if late, at least right. Many ABS assets have no market at the moment. Hence they cannot be marked to market. That in turn means that they are not good collateral and hence they cannot be used in secured funding. Having to use unsecured funds to finance these assets is gumming up banks’ balance sheets and making them reluctant to lend. A short term answer to this problem is a key step in regularising the markets. However, this intervention needs to be strictly limited. The FT reports:

In the short-term, [King] said the Bank would continue to lend against mortgage-backed securities and other asset-backed securities where markets are closed, but he added that such lending, while “a useful bridge to a longer-term solution” can “be only a temporary measure”.

Weaning the banks off cheap financing of illiquid assets will be difficult and there is very little experience to draw on. But still King’s proposed action is the right one, even if he does not know how the story ends.

He was not specific about the longer-term resolution, since he said “it is too soon to say where these discussions will lead”, but he indicated more radical moves were necessary because “it is unrealistic to assume that markets for many asset-backed securities are likely to re-open speedily or, when they do, to their previous levels of activity”.

It is important to ensure that this does not introduce too much moral hazard, nor does it act as a guarantor for new issues.

“First,” [King] said, “the risk of losses on their lending should remain with banks’ shareholders”. This implies the Bank would only accept assets at well below face value, or would insist on banks’ indemnifying taxpayers for the credit risk they would adopt if they took hold of the assets.

“Second,” he added, “a longer-term solution must focus on the overhang of assets and not subsidise issues of new assets”. Mr King is keen not to allow another frenzy of lending and it implies the Bank would not be willing to take any new mortgage-backed securities on its books.

The devil is in the details, of course, but all-in-all the Bank’s strategy is encouraging.

Posted in: ABS, Liquidity and liquidity risk by David /
Comments Off

Even though this article appeared on the Sunday before a Bank Holiday Monday, I don’t really think it was deliberately buried. It is just that it might be troubling to some. From the FT:

The first public price estimates for specific structured credit securities to have emerged since the start of the credit crisis show that values have fallen sharply.

Some securities have lost almost a third of their value – even though many were considered to be so safe that they carried top-notch ratings from the credit ratings agencies.

Meanwhile, some subprime mortgage-linked securities issued by groups such as UBS have lost almost 95 per cent of their value.

The price estimates were made in a legal filing following a decision by JPMorgan Chase to ­publish detailed securities valuations in a Canadian court. The securities are linked to commercial loans and medium-grade mortgages.

The estimates are likely to be scrutinised by auditors and regulators since they come at a time when the issue of security pricing has become controversial.

Banks are under pressure from regulators to book losses they have incurred on such instruments. However, trading has virtually dried up in many corners of the credit markets, and it is hard to compare prices for these instruments between banks.

Many regulators and investors fear that banks are still varying in the degree to which they have booked losses on their credit instruments in recent months – not least because it is hard for auditors to compare internal estimates with external benchmarks.

The figures have emerged because the US bank is leading an effort to restructure a group of 20 Canadian structured investment vehicles that issued $32bn of asset-backed commercial paper.

JPMorgan and Ernst & Young lodged a report with an Ontario court gives estimates for the securities held by the Canadian SIVs based on implied values.

This is undoubtedly a data point but it is not definitive. Remember these are estimates, and liquidity has largely or completely disappeared in these instruments. It may be that the idea that the value of these instruments is impossible to determine precisely in the current market is lost on the court, but that particular fallacy should not trouble market participants.

Posted in: ABS, Fair Value, Markets by David /
Comments Off

I have long argued that the split between solvency and liquidity is a false dichotomy in the current market. Decreasing liquidity can of itself and without changes in expectations of default depress the price of an asset and hence create a solvency problem. Similarly institutions that whose insolvency is rumoured find their liabilities illiquid. The FED’s actions recently would, I suggest, support this view. They have been creating liquidity – as Alea notes by selling treasuries and repoing in illiquid assets, primarily ABS – in order to support asset prices. This explicit management of liquidity premiums is as important a factor as interest rate cuts. The early signs are that the two effects are working, especially now the primary dealers can assess the FED too. We’ll see.

Update. The argument above broadly motivates my concerns with the positions of those, like Willem Buiter, argue that central banks should repo in ABS collateral, but should do so at aggressive haircuts. (See here for Buiter on Radio 4′s today programme – be warned that that link might not persist for long however.) In purely financial terms Buiter is correct: this is the prudent approach. However it is seriously unhelpful in meeting the broader policy objective of reducing soaring liquidity premiums. If the Bank takes risk on the collateral it is much more likely to be effective in ensuring that it does not take as much risk on its counterparties.

Posted in: ABS, Liquidity and liquidity risk by David /
Comments Off