READ THIS CDO Boom Masks Subprime Losses, Abetted by S&P, Moody's, Fitch
By Richard Tomlinson and David Evans
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Arturo Cifuentes of RW PressPrich & Co Inc.
May 31 (Bloomberg)
Investors snapped up the $340.7 million CDO, a collection of securities backed by bonds, mortgages and other loans, within days of the Dec. 12, 2000, offering. The CDO buyers had assurances of its quality from the three leading credit rating companies --Standard & Poor's, Moody's Investors Service and Fitch Group Inc. Each had blessed most of the CDO with the highest rating, AAA or Aaa....
The rating companies apply their usual disclaimer about the reliability of their analyses to CDOs. S&P says in small print: ``Any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision.''
Joseph Mason, a finance professor at Philadelphia's Drexel University and a former economist at the U.S. Treasury Department, says the ratings are undermined by the disclaimers. I laugh about Moody's and S&P disclaimers,'' he says.The ratings giveth and the disclaimer takes it away. Once you're through with the disclaimers, you're left with very little new information.''
When it comes to CDOs, rating companies actually do much more than evaluate them and give them letter grades. The raters play an integral role in putting the CDOs together in the first place.
Banks and other financial firms typically create CDOs by wrapping together 100 or more bonds and other securities, including debt investments backed by home loans....Credit rating companies help the financial firms divide the CDOs into sections known as tranches, each of which gets a separate grade....Credit raters participate in every level of packaging a CDO... The rating companies tell CDO assemblers how to squeeze the most profit out of the CDO by maximizing the size of the tranches with the highest ratings, he says.
CDOs have been a bonanza for the rating companies. In the past three years, S&P, Moody's and Fitch have made more money from evaluating structured finance -- which includes CDOs and asset- backed securities -- than from rating anything else...S&P charges as much as $600,000 to rate a $500 million CDO. Fitch charges 7-8 basis points to rate a CDO, more than its 3-7 basis point fee to rate a bond, based on the company's fee schedule. Moody's doesn't publish its pricing for any ratings. Fitch's role in helping to put together a CDO came to light in a civil court case. American Savings Bank of Hawaii Inc. sued UBS PaineWebber Inc. in 2001, claiming that in 1999 UBS had incorrectly said a CDO it had sold was investment grade when it wasn't.... Fitch had advised UBS on how to structure the CDO to get the ratings the bank wanted. Fitch itself was not a party to the lawsuit....
Investors shouldn't put much credence in the risk that rating companies assign to CDO squareds and cubeds,
Investors shouldn't put much credence in the risk that rating companies assign to CDO squareds and cubeds, says Stanford's Duffie. ``The complexity of analyzing that is beyond current methodology,'' he says.
The grades that rating companies give CDO squareds and cubeds are worthless, says Janet Tavakoli, founder of Chicago-based consulting firm Tavakoli Structured Finance Inc., which advises investors on CDO purchases.
``Ratings on these products are based on smoke and mirrors,'' Tavakoli says.
(end quote)
ALL in all this article is the clearest explaination of the rating agencies roles in the the CDO market
Also, if ``The complexity of analyzing CDO squared and cubed is beyond current methodology,'' doesn't this explain the no bid or low bid auction results?
"The grades that rating companies give CDO squareds and cubeds are worthless".
``Ratings on these products are based on smoke and mirrors,''
Think about that product as a proportion of anyone's portfolio. You might as well head to Las Vegas with a "winning system" in mind.
Lever up and mismark, a toxic combination. That's my understanding of what happened at Bear Stearns' (BSC - Cramer's Take - Stockpickr) hedge funds. And I believe there will be no fallout whatsoever beyond the funds, despite the innate desire by so many people to rumor and panic the marketplace.
It's driving me crazy that there is such unsophisticated reportage of this subprime issue.
First, most of the subprime blowups do not involve credit defaults. In fact, other than New Century Financial, which had to restate all its financials because of defaults, most of the problems have been a lack of liquidity caused by the fear of defaults.
I say that because there is tons of demand for this paper from the likes of sophisticated hedge funds at Lone Star and Farallon Partners. I don't know the Lone Star guys, but the people at Farallon are just about the best in the game and there is no way they'd be buying up these loans if they weren't confident that there would be a payoff well in excess of what they are putting up. Lone Star seeks a similar return. These are the buyers of this kind of paper, and they have done amazingly with it.
That's because they have cash. Which brings me to what these crises are really about: liquidity.
When banks loan to these subprime lenders -- and they can't lend without that capacity -- the subprime lenders become hostage to the credit committees of the big outfits, outfits like Merrill (MER - Cramer's Take - Stockpickr) and J.P. Morgan Chase (JPM - Cramer's Take - Stockpickr).
If the credit committees of these big banks smell trouble, they cut off the credit. That's the real worry for the subprime outfits, liquidity, not creditworthiness. Any hint of problems and the liquidity dries up even if there will turn out not to be much of a credit problem with the actual loans. I say that because the Farallons and the Lone Stars are buying these loans fairly close to par. They wouldn't if there was a real risk of credit defaults on subprime.
Not everyone has been that careful. These Bear funds weren't. They borrowed a huge amount of money from the likes of J.P. Morgan and Merrill, and now those guys are squeezing Bear. And believe me, this is a competitive world and they like to squeeze Bear.
It was quite a business to do what the Bear hedge funds did, which was to borrow a lot of money and buy high-yielding debt at, say, 10 times the capital they had under management. But the same credit committees that were worried about the credit of the subprime loans -- and again, I am saying that there is an overreaction by these credit committees but they are overreactors from way back because their whole job is pretty much to say no because one error can wipe out a year of profits -- are now worried about the lack of liquidity at the Bear fund, most likely because of redemptions.
The problem will go away with liquidity, which is why Bear Stearns is ponying up the money. The credit committee
Or could it be that everyone else is, in fact, marking to that price, but no one else was either stupid or criminally insane enough to buy illiquid and hence somewhat fuzzily-valued bonds for customer accounts at 9 to 1 leverage?
Tanta, I don't see what the big deal is. Americans are being taken advantage of in many ways. It is better to have the press defend them for rights they don't deserve rather than for the press to stay out of it completely. If they don't do it, people would rebel against established media and run away to blogs.
So if we accidentally knock Wells Fargo and accidentally praise Brookstreet along the way, well, that's not the end of the world. 20 years from now, all we'll remember is the press stood with consumers and against those who ripped them off.
You can't compare these CDO ratings with corporate bond ratings,'' Duffie says.These ratings mean something else -- entirely.''
Corporate bonds rated Baa, the lowest Moody's investment rating, had an average 2.2 percent default rate over five-year periods from 1983 to 2005, according to Moody's. From 1993 to 2005, CDOs with the same Baa grade suffered five-year default rates of 24 percent, Moody's found.
Non-investment-grade CDOs, rated Ba, had an almost identical default rate of 25.3 percent in the same period. ``In CDO-land, there's almost no difference between Baa and Ba,'' says Cifuentes, a former Moody's vice president who helped develop the company's original method of rating CDOs in the late 1990s.
END QOUTE
So, the same rating system but entirely different scale of danger-isn't this deception in itself?
An almost no difference in default between "investment grade" and lower grade?
bdf: You seem to by implying that the problem is manufactured and not systemic. It seems to me that the problem was caused, ultimately, by greed: greed for greater returns, greed for that bigger house that the borrower really couldn't afford. The get-rich-quick (and with no effort) mentality that seems to dominate.
There's a very pretty essay by Michael Kilbach about how and when these bust-up stories get told. Even with the split infinitives, it was a pleasure to read...
Looks like the "resolution" is going to be a replay of LTCM. Each big investment house wants to minimize its losses as best it can, but at the end of the day motivated self-interest prevents the group from doing anything that would kill the game for them all.
The Prisoner's Dilemma analogy breaks down because the prisoners cooperate.
bdf, it would help matters if you provided the link and possibly a chunk of the text in quotation marks, instead of just dropping unidentified copy into the comments.
bdf's comment above is the first part of this essay by Cramer:
Personally, I think Cramer's making an either-or argument that won't hold. But his point is certainly valid that there is no way you can chalk all this up to realized credit losses on the underlying bonds. No way.
I'm not arguing, as Cramer is, that this means it is "contained." I suspect round two will start when we do begin to realize some major losses on some bonds. I don't think that fun has even really started yet.
But in the meantime, here's everyone all knicker-knotted because some University endowments are buying some of this paper at 18 cents or something. Shit, I'd buy it for 18 cents. It was the folks who bought it for par-and-a-buck who got the problems. Does anyone really want to argue that all tranches of all subprime-backed securities are literally worthless? That's nuts.
You don't get killed by the fire. You get trampled in the rush for the exits. Didn't we used to know that? How did "subprime paper" get endowed with magical properties that no other junk collateral has ever had?
The Prisoner's Dilemma analogy breaks down because the prisoners cooperate.
Yup. This time.
But the problem is if it happens again. And again. And again. Each time the prisoners all have a fresh new opportunity to sell the others out & go apocalyptic.
If BS High Leverage is the only event it will be a footnote... a one per.
If not, then it gets interesting.
If I had to bet I'd guess there aren't going to be too many more of these 'events' - I tend to believe the Masters of the Universe aren't that stupid. The 'few' other funds out there like this one just got a wake up call and will be unwinding quietly in the shadows before the MTMkt triggers kick in. I would hope anyway.
If the Masters are all this stupid with leverage then we all got problems. Big problems.
Funny thing about that analogy to LTCM. If I remember correctly from the time, Bear was one of the houses that didn't want to go along with that work-out. If true, then I suppose Bear found themselves on the other side of the fence this time, and ended up having to save their own skins/reputation by injecting some capital. Karma is a beautiful thing.
I think CR's general take is right--no matter if this debacle spreads or is contained--it's bad for the CDO market, ergo bad for the MBS market, ergo interest rates on mortgages are going to rise, just as the reset tsunami crests, which means more people are going to get foreclosed on...
What was virtuous has become vicious...it'll play out slow, but the tide is going out and its picking up speed.
Do we get to Full Spectrum Disorder? Maybe. Do we get to lower house prices than almost anyone is currently predicting--i.e. a return to the long term medians, that takes away the gains of the last five years? Looks more likely every day to me.
Bottom in 2012 for housing, maybe longer.
OT: I highly recommend THE BLACK SWAN, the new pop philosophy book by ex-quant Taleb, for the august group assembled here. One of his main points: that the Gaussian mathematics that underlie all rating models is fundamentally flawed, and we would all be better served by a Mandelbrotian approach. Clearly the BS debacle was enabled by some faulty modeling. The book's dismantling of the mathematical approach that has spawned all this leverage is effing....disturbing.
Looks like the "resolution" is going to be a replay of LTCM. Each big investment house wants to minimize its losses as best it can, but at the end of the day motivated self-interest prevents the group from doing anything that would kill the game for them all.
Sebastian
This is the optimal solution for them, for now, but it's probably the 2nd least desirable outcome. By not blowing out inventory and causing a flight to quality, bonds stay up in yield, ensuring ARM resets to cause even more defaults in these CDO/CMOs.
The smart hedgies will have already realized this, with them trying to unwind their CDO positions(Hello, CALPers!! Can I buy you a drink?) while slowly trying to unload treasuries(selling 2% of ADV per day) to be ready for redemptions, driving yields even higher over the next two months, making ARM reset defaults even worse.
A slow motion car crash, or a Prisoner's dilemma by stealth.
I have a bit of insight into what's going on specifically with Bear and generally with geared CDOs.
Tanta's post is not far off the mark although the incestuous ramifications are very much worse (in fact frightening) than he identifies. Mmybe he is acting responsibly (see Jim Cramer re Bear Sterns on CNBC on June 22).
The only question is at what end of the US Treasury curve should US dollar based investors purchase? Two year Treasuries offer the lowest capital risk; but if there is a "Benanke put" and the Fed has to step in to refinance the financial markets, 10 year Treasuries offer more upside.
That is, of course, if the 10 year Tteasuries don't get wacked by the consequential inflationary risks and an implosion of the US dollar.
Investors could do a lot worse that hedging currency risk (when necessary) and buying at the SHORT end of the UK government (i.e. "gilts") bond market. The short end, because UK rates are rising which should be supportive of the UK currency if Bernanke does a Greenspan.
As our Chinese friends say, "may you live in interesting times". I think that we all are.
Common sense would dictate that if the underlying security for all these MBS/CDOs are subprime mortgages that are not paying out the expected cash flows and are in fact rising in delinquencies that the derivatives would be impaired.
Since the rating agencies don't want to screw their customers that pay their bills and bonuses they will only lower ratings after the fact. As we saw with the ratings downgrades on the Bear Stearns CDOs.
Since there are no markets its all mark-to-model and the model says these derivatives are at par or better. Why worry when the sky is blue? And investors don't want to write down anything so they can keep with their fantasy that their investment is going great guns.
Since this all an incestuous racket with hedge funds, prime brokers, securitizers, etc who all have teir hands in the pie - there's no incentive take any losses - until they have to. By then Uncle Sam - that's you and me - will be riding to the rescue - and no one will be any worse for it. What's a few $trillion more to the national debt?
Truly. I want someone with some good dirt on the two Bear funds to convince me that Fund 2, the high-leverage fund, the Unbailed, which appears to own a bunch of CDO2 and CDO3, isn't in fact making swap bets on the underlying of the underlying of the underlying assets that are in fact owned by . . . Fund 1, The Bailed.
"But in the meantime, here's everyone all knicker-knotted because some University endowments are buying some of this paper at 18 cents or something. Shit, I'd buy it for 18 cents. It was the folks who bought it for par-and-a-buck who got the problems. Does anyone really want to argue that all tranches of all subprime-backed securities are literally worthless? That's nuts."
And you know it was the freakin endowments that bought the shit at par and have now decided to employ a dca startegy to lower basis, so now they have an average cost of approx. 60 cents, if this shit is worth 20 cents they are screwed. It is one thing to speculate with OPM and pull some dumbshit move and another to waste/speculate with your own.
Now Tanta, what could we expect. Isn't this the same crowd that cries for personal responsibility for everyone but the corporate elite. They are never responsible for their actions. Some one else either made them do it or for some other reason it is the other guy's fault.
And you know it was the freakin endowments that bought the shit at par and have now decided to employ a dca startegy to lower basis, so now they have an average cost of approx. 60 cents, if this shit is worth 20 cents they are screwed.
I must have missed that part of the reporting. I didn't see anyone suggesting the endowments were buying this crap from themselves.
In any case, I said I'd buy the stuff for 18 precisely because I suspect most of it is worth a good 60 so far. Of course it depends on what, exactly, "this shit" is, but except for the stuff that's either entangled in lawsuits or servicing problems (like the Fremont pile of crap, for instance), I'm still not sure why your run-of-the-mill RMBS mezz tranche isn't worth 60 to someone who does not have to liquidate it this very minute.
We're confusing fire sale valuations with a useful mark, I think.
nor am I, I am suggesting that they may be adding to the "equity" tranches they already own.
" Of course it depends on what, exactly, "this shit" is, but except for the stuff that's either entangled in lawsuits or servicing problems (like the Fremont pile of crap, for instance), I'm still not sure why your run-of-the-mill RMBS mezz tranche isn't worth 60 to someone who does not have to liquidate it this very minute."
agree., except, I don't think they are getting bids on your run-of-the-mill RMBS mezz tranches at 18.
nor am I, I am suggesting that they may be adding to the "equity" tranches they already own.
Well I have heard completely unfounded rumors that endowments just might be helping some of their well connect 'friends' & 'contributers' off load this ilk. I've read that 'charge' a couple places lately on the 'internets'.
I don't believe it myself (having family working in the 'gifting & endowment' business for a large prestigious university - heard plenty of dirt but nothing that dirty).
If it were a case of less-than-arms-length transactions involving these sales to endowments then that WOULD BE real news.
Where to start ? here's a simplistic view of a CDO... consider it a 50 story Condo tower. If the bottom 5 floors are contaminted by PCBs for example , I think there's a problem with the entire building 1 Just my view of the world . Well , the CDO complex , as a general statement , is contaminated with mezz and equity tranches of toxic waste... that's why JP Morgan and Merrill had to back off this week from auctioning stuff the Bear waste..... they were getting 10 -25 cent on the dollar bids... IMHO. In fact , if Cantor did sell collateral for 10 cent on the dollar as reported , it gives you an idea as to how bad things are... they took the 10 cents ! Back to Bear for a minute , as best as I can tell , the more leveraged fund ( Enhanced ) is not being bailed out / supported by Bear.... not surprising to me since they have assets that are worhless as far as I can tell.... maybe they aren't worhtless but no one seems to want to put a meaningful bid in to date. You will see collateral related to Enhanced sold and mark to market is already going on ( Ask the Brookstreet investors what that's like if you doubt that fact .) Moreover , a fair read of what's been placed in the public domain is that the 3.2 billion put up by Bear to prop up the less leveraged fund represents about 25 percent of Bear's shareholder equity. Let's assume that to bail out Enhanced would require a greater sum ( due to greater losses ar Enhanced , greater leverage and questionable value for the assets in Enhanced ) , it would seem that we're talking about an additional 25- 50 percent of shareholder equity of Bear Stearns itself , to prop up said hedge funds..... can you see Jimmy Cayne doing that ! LOL This is the same guy who did not put up squat regarding LTCM ...read " When genius Fails " to get the full extent of that fugly situation !Any way , Cayne is not going to risk Bear itself to save a small component.... book that Dano ! Not going to happen IMHO. Then , let's not forget out there in the bushs is the Everquest debacle to be dealt with at some point .... toxic waste which was to be IPOed off to the public but now that is off the table... well , we know Bear itself and the Cioffi managed Bear Stearn hedge funds own about 75 percent of that toxic waste.... so what has Everquest been up to lately ? what's their leverage , what are they currently holding and who hold the warehouse lines for this structured finance wiz ( or POS ? ) The BS ( no pun intended ) story isn't over.... by the way , do you think there's the slightest chance they have additional exposure beyond what's been discovered and discussed this past week or so ? IMHO.. I say , probably so... what do you think ? ?
agree., except, I don't think they are getting bids on your run-of-the-mill RMBS mezz tranches at 18.
Right. So a small subset of a small subset of the large category "subprime mortgage-backed bonds" is unloading for 18 because somebody somewhere has a nasty margin call to meet.
So, how big is the segment of this market that is being marked to prices like that, and how can it be enough wipe out Bear's hedge funds?
And to think all this enormous financial mirage is built upon a foundation of sand.
Sub-standard construction in semi-desert areas or in areas with a 4-5 hour daily commute to any kind of job, built only for speculation not habitation, likely to collapse in ummm maybe 5 years.
The US as a nation has shrunk to this? Vain efforts to keep its market value up thru valuations and revaluations of trash.
Isn't the subprime universe about a trillion bucks ? And some undefined portion of that universe is lodged in the first 5 floors of those CDO structures.... which makes a mess of those structures , no ?
koteli, thanks for that link. I hadn't seen the entire Wall Street Urinal story. From which:
the Bear funds were concentrated in little-traded derivative instruments known as collateralized debt obligations, or CDOs. These investments package together pools of assets and pay investors interest based on the payments they receive from the assets. The assets backing many of these CDOs were subprime mortgages.
Though subprime mortgages are highly risky, Wall Street carves CDOs into pieces so that some investors can take on more risk than others. The Bear hedge funds took on many less-risky pieces. They also borrowed heavily, which helped to enhance their returns on those less-risky pieces.
That's an excellent thumbnail definition of a collateralized mortgage obligation. What the hell it's got to do with a reasonable definition of a CDO beats the shit out of me.
On June 8 the margin call for the High Grade Structured Credit Fund was $63 million.
We also know yesterday BS agreed to lend an additional $3.2 Billion to this fund to stabilize it.
The margin call on June 8 for the Enhanced Leveraged Fund was $145 million. Bear Stearns has not added any capital to this fund.
The Enhnaced Fund has the riskier tranches and is highly leveraged. This fund will likely collapse.The Enhanced Fund had capital of $667 million as of January 2007. That obviously is vaporized.
What no one know is how much is in either fund, nor what the composition of.
Intuitively, you don't pledge an additional $3.2 billion if the margin call is $63 million. Obviously there is a glaring dispute between par value and market value.
What is apparent is that Bear Stearns and others are trying to prop up a market and cover up huge losses. They are now buying time. The only problem is that foreclosures are escalating and the problems are getting bigger.
The theory that there is no spillover and contagion is ludicrous. These losses cannot be hidden.
Keep in mind that the $3.2 Billion was 25% of capital. And that there aren't that many players that can pony up that kind of money.
The next shoe will drop. Inevitably the FED will have to step in and lower rates to improve the values of the underlying securities.
The easy money salad days are over. Credit quality will matter again.
Sebastian, I think, has a limited view of who the "prisoners" are.
Yes, the prime brokers may find reason to cooperate. In a multi-period game, with LTCM having been the first period, the prisoner's dilemma may in fact break down.
However, this is a one-period game for most hedge fund investors. What's in it for them if they wait to redeem? Nothing. The first one out the door gets near-par, the last one near-zero. Its not hard to predict the outcome.
And then there's the buyers of new CDO's. What's the benefit to stepping up to the plate? Wouldn't you ask for better spreads? And don't wider spreads cause margin calls for existing holders?
Remember, LTCM had a unique strategy. Diffuse that bomb, and presto -- no explosion. Levered vol-selling, on the other hand, is near universal in the $1+ trillion hedge fund industry. Lots of nickels being picked up in front of steamrollers...
Thanks, frank. Hoo-boy. So an observer, like maybe a central banker, sees 1) a $63 million margin call, and 2) a comparatively huge set-aside, whether you look at it as two orders of magnitude greater, or as a quarter of the capital (as of a certain date, anyway) of the funding entity.
Now, the underlying reality to this has to be pretty funky as we mostly know around here, but is there a chance that the $3.2 billion is meant as a very loud dog whistle? Apparently, FOMC meets this coming week (scroll to the end of the March minutes).
So how big is this problem? Here is a back of the envelope range calculation. Estimated minimum losses - 1 million foreclosures, average balance $300,000, at 30%loss = $90 Billion. Estimated maximum losses - 3 million foreclosures average balance $300,000 at 40% loss = $360 Billion. Of course some losses are already taken and some are included in reserves so the current range is probably around $50 Billion to $300 Billion of future losses. It looks like the econonomy is in the 3rd or 4th inning of this ball game. Other players with significant leverage are approaching the breaking point.
the whole business of transferring the lower rated shit to Everquest is what led me to the belief that it was entirely plausible that this manager increased his bets to attempt to recover, then understood shit was worse than he had imagined, and this move could have potentially been an attempt to hide the carnage.
Koteli, Thanks for the link which makes sense in relation to the actions of the various parties. Do you (or anyone else)know if other hedge funds have similar positions to the Bear funds? Do you think there will be material tightening of credit for other hedge funds becauses of losses lenders will incur with the Enhanced Bear Stearns fund?
"In a multi-period game ...the prisoner's dilemma may in fact break down."
It often does, in fact it's likely to at Nash Equilibrium. From a game theory standpoint the investment banks were and probably still are in a Stag Hunt but that can break down in 'betrayal' (prisoner's dilemma outcome at equilibrium) easily enough if circumstances change; e.g., if the majority of 'hunters' believe they can benefit by sacrificing another 'hunter' -- that aside, keep pursuing the game until bagged (which in this context probably includes everyone else, from hedgies to retail investors).
I'm no expert in game theory but I know the logical problem(s) of cooperation and betrayal have been around awhile; e.g., Rousseau and David Hume alike wrote treatises on the subject and I'm sure there were others.
In terms of these hedge funds and the investment banks, I've seen a couple interesting models of biological natural selection that assume Nash Equilibrium but, depending upon how fitness is defined/calculated, either prisoner dilemma or stag hunt can be equilibrium.
That kind of sensitivity suggests that resolution of the loan derivative(s) crisis hangs by thread even if only the major players are considered. However the system becomes entirely unpredictable because not only are there multiple stakeholders in this game, they are not all working to the same purpose nor by the same rules; e.g., litigation, etc.
Since uncertainty rightly or wrongly is often perceived as risk I'd guess that in the absence of a major intervention by Federal authorities the stag hunt will break down and the defections (betrayals) will begin to cascade.
Reading these posts, it seems to me that people like Sebastian misunderstand the essence of credit cycles.
In every credit cycle, the potential losses are thought to be small as a percent of GDP. That's not the number that matters. What matters is the ratio of losses to the equity of levered investors. In previous cases, these were banks levered 12:1, but with "stable" funding. Now we have mostly hedge funds levered anywhere from 2:1 to 20:1, but with HIGHLY unstable funding. And then there's the investment banks levered 25:1 on the visible debt (not counting derivatives), and the banking system with a higher concentration of real estate lending than in the 1990's.
Why do we care so much about the equity of levered investors? Because credit cycles can spark a chain of events that leads to recession. This seems like heresy now, as the causality is supposed to run the other direction. Where did people get that idea?
There's chaos on Wall Street, as the NYSE officially shut down this morning after the Dow crashed below 1000, threatening unknown consequences throughout the derailed global capitalist economies. It seems that one of the oldest and most respected investment banks was the death knell of the modern economic system with the heralding of hedge fund problems in June.
Nearly done in by rogue hedge fund Long Term Capital Management nine years ago, capitalism as we know it was eaten alive from within, as it seems the investment banks were cannibalizing each other to the extent that all modern wealth is effectively destroyed. This effect has been seen globally, as the connection of assets through derivatives has tied the collapse like a lasso around a wild bronco's head.
Halloween is early here in Manhatten, where the orange glow of arson fires are scattered through the city.
How did "subprime paper" get endowed with magical properties that no other junk collateral has ever had?
C'mon, Tanta, I hope your joking with that.
Uh, it's because this subprime paper is to the people who didn't qualify 7 years ago, but now were given 110% loans on 50+% overvalued property. On top of the 20% pure fraud that's lurking underneath. This garbage is beyond the junk of the junk. Buying protection is like insuring your toejam for $5000/oz. Good luck getting the payment when you make your claim against its loss.
I thought this was old news, why are you in denial of this now? This is absolutely a subprime problem, that has now also become a gigantic problem of much, much more.
It's rather funny to watch these investment bankers scramble to hide their lies from the market. That sinking feeling they have is the result of their own greed and the greed of their clients who are not happy with 12 to 18% gains per year. My father, who lived through the depression, taught me to be satisfied with earning your money through work and saving at least 25% of what you earn. It was good advice and maybe after all of the lies on Wall St. are finally uncovered the people in this country will return to saving for a rainy day. It's going to rain pretty hard for a very long time in the near future.
Great post. And this comment absolutely nails the bigger issue-
"I want someone with some good dirt on the two Bear funds to convince me that Fund 2, the high-leverage fund, the Unbailed, which appears to own a bunch of CDO2 and CDO3, isn't in fact making swap bets on the underlying of the underlying of the underlying assets that are in fact owned by . . . Fund 1, The Bailed."
Cannot for the life of me figure out another reason they would bail out fund 1 - unless some form of triage where they know they've got a lot in #1 and it is actually worth something, while fund #2 is a gone and they don't have much invested (although aren't they a prime broker for the fund)
I think we need to be clear about what the bail out of fund 1 consist of.. BSC pledge up to 3.2B (and the latest WSJ put the number closed to 2B) for credit line that the fund can draw on. The fund can use this money to purchase CDO that was seized by the lender or use it to pay the shareholder when the fund finally open their doors. What is not said here is what collateral BSC get for this 3.2B (or 2B) loan. They are not infusing capital into the fund. So it is not a bail out as the headline portrayed. Also as part of the news, quite a few lenders agreed to "unwinding" their positions with BSC (I think everyone except MRL and Cantor did). WSJ did not detail what is "unwinding" mean. My speculation is that the lender seize the collateral from the fund, sell it to BSC with a deep discount and write off their loan to the two funds. But in any event, the lender is going to loss some money. We probably will know soon enough how much they loss (since they all have to report the loss in their respective next Q earning). No one really know how much is the shares for fund 1 is going to be worth nor we know anything about fund 2's worth. It is a continue saga and we don't know if BSC will actually make money comming out of this fiasco. We know for sure that the shareholders for these 2 funds is going to loss some or all their money, the lender is going to loss some money. The $64K question is what will it do to the CDO market? Would the University endowment/pension/foreign buyers continue to buy CDO at par? If they slow down purchase of future CDO, then the mortgage rate and term will definitely move up drastically and BSC will have a diffical time moving forward since so much of their business is tie to CDO.
The Prisoner's Dilemma analogy breaks down because the prisoners cooperate.
Too late.
The brokerage firms already got price lists from their clearings with new prices. And every margin call leads to liquidation, which leads to mark-to-market, so that the brokerage firms get new price lists from their clearings with new prices, which ....
Actually it is wrong that prisoners are cooperating.
Remember, Tuesday Merrill L. was sitting on the phone waiting promised 24 hours while B.S. and Blackstone were coming with salvation plan.
How surprised it was to learn that JP Morgan already dumped his positions on the market the same day, not waiting until Merrill L. will start selling his 400 million. Ha, I can imagine how mad Merrill L. went, when it announced at 5:30pm that it will dump $800 million the next day.
In previous years they would send killers in that kind of misunderstanding.
Auto insurance companies do a much better job than the mortgage industry in breaking down people into categories and looking at how the group behaves statistically. If you are a single male under 30 driving a Camaro you get a much different rate than a single mom in her 30's with three kids driving a Honda Odyssey.
So why can't the mortgage industry take a page from the auto insurers? Imagine a future when your morgage rate depends on not just your current income and credit, but also factors like how old you are and what your risk profile is, where you live, etc. In this high tech world we live in, I can't think that this is not a workable proposition.
Imagine if an auto insurer behaved like some of these sub-prime mortgage outfits ... they'd be charging the same rate to the kid in the IROC and the lady in the minivan ... now how can that make any sense? Can anyone with any credibility not believe that this whole subprime thing is going to go down as one of the worst debacles in modern financial history?
It gets unwound slowly and quietly as the loans are paid off, refied or defaulted and BS gradually and quietly takes millions in losses when the funds fail to pay off the loans.
Jeepers Tanta! I've been waiting since the 70's to see the effect on this edifice of cards when someone plucked one from the bottom. Now, with 'hedgies' and leverage, we can all see what happens when a bowling ball goes through said cards.
It has been said that the markets are incapable of seeing The Black Swan. I suppose that is like the soldiers saying you don't hear the one that kills you. The unwinding of all of this may take on the appearance of a failing dam. BS is a mere trickle, and generations to come will talk about the deluge that follows.
I like the part about the rating agency disclaimers, that investors should not use the rating or information provided in making investment decisions. One wonders, perhaps naively, what is the point of a rating if not to inform investment decisions?
"One wonders, perhaps naively, what is the point of a rating if not to inform investment decisions?"
Certain investors are only allowed to invest in assets rated a certain level or better. But these investors needed (or wanted) a higher yield than what they would get from traditional paper with those ratings, hence their interest in the new-fangled stuff. Investors, knew, or should have known, that the higher yield was in fact coming with higher risk. If someone offers you a riskless TBond and a yield of 10%, you'd begin to wonder, right?
Why did the agencies go along with this? Well, the rocket scientists behind this stuff where paying them to do the ratings. If the ratings didn't come through, they would lose business. So there was constant communication between the rocket scientists and the agencies how to tweak the product in order to get the desire rating. Basically the rocket scientists would arbitrate the rating agencies, creating a product which was riskier than what the rating "said".
From the Nake Capitalisim article (about the raters):
"they will only downgrade when forced to by experienced losses; not rising default rates, not a worsening economy, but only actual, experienced losses."
In this sense, the CDO market would be much like the housing market. The lack of immediate mark-to-market lets people live in la-la land for a while. You'd expect professional investors to catch on quicker than an average homeowner, and maybe they will - to a degree. However, I think there is a long, slow death ahead for many of them.
Funny I said this looked like LTCM on this blog now the media has jumped aboard.
Whats next? Who knows but if the past is any indication you can throw the "inflation worries" in the trash, if this gets worse. LTCM prompted an "emergency meeting" by the fed and then came the rate cuts...........
Great post, tanta. It won't be the end of the world, but it will be a good-sized mess, and highlight the extra risk inserted into the system as a whole (the stampede for the exits amplification) by the highly leveraged treatment of an otherwise useful mechanism (pooled mortgages) by a low number of super-wealthy investors, compounding another otherwise useful mechanism (a well-collateralized, reasonable-risk mortgage loan) twisted into badly-founded jumbo ARMs that allow some other shysters to cream off the front of the large-home buying action. Good old regulation of the mortgage martket would have cut it off at the pass...
In spite of the fluctuations seen in the last few years, the hedge fund industry is flourishing as people have realized that hedge funds can prove to be beneficial as long as they plan there moves carefully.
Tanta,
Please correct the first URL -- courtesy of the "New York Times"
(it has one too many http's)
$3.2 Billion Move By Bear Stearns To Rescue Fund - NY Times
READ THIS CDO Boom Masks Subprime Losses, Abetted by S&P, Moody's, Fitch
By Richard Tomlinson and David Evans
Enlarge Image
Arturo Cifuentes of RW PressPrich & Co Inc.
May 31 (Bloomberg)
Investors snapped up the $340.7 million CDO, a collection of securities backed by bonds, mortgages and other loans, within days of the Dec. 12, 2000, offering. The CDO buyers had assurances of its quality from the three leading credit rating companies --Standard & Poor's, Moody's Investors Service and Fitch Group Inc. Each had blessed most of the CDO with the highest rating, AAA or Aaa....
The rating companies apply their usual disclaimer about the reliability of their analyses to CDOs. S&P says in small print: ``Any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision.''
Joseph Mason, a finance professor at Philadelphia's Drexel University and a former economist at the U.S. Treasury Department, says the ratings are undermined by the disclaimers. I laugh about Moody's and S&P disclaimers,'' he says.The ratings giveth and the disclaimer takes it away. Once you're through with the disclaimers, you're left with very little new information.''
When it comes to CDOs, rating companies actually do much more than evaluate them and give them letter grades. The raters play an integral role in putting the CDOs together in the first place.
Banks and other financial firms typically create CDOs by wrapping together 100 or more bonds and other securities, including debt investments backed by home loans....Credit rating companies help the financial firms divide the CDOs into sections known as tranches, each of which gets a separate grade....Credit raters participate in every level of packaging a CDO... The rating companies tell CDO assemblers how to squeeze the most profit out of the CDO by maximizing the size of the tranches with the highest ratings, he says.
CDOs have been a bonanza for the rating companies. In the past three years, S&P, Moody's and Fitch have made more money from evaluating structured finance -- which includes CDOs and asset- backed securities -- than from rating anything else...S&P charges as much as $600,000 to rate a $500 million CDO. Fitch charges 7-8 basis points to rate a CDO, more than its 3-7 basis point fee to rate a bond, based on the company's fee schedule. Moody's doesn't publish its pricing for any ratings. Fitch's role in helping to put together a CDO came to light in a civil court case. American Savings Bank of Hawaii Inc. sued UBS PaineWebber Inc. in 2001, claiming that in 1999 UBS had incorrectly said a CDO it had sold was investment grade when it wasn't.... Fitch had advised UBS on how to structure the CDO to get the ratings the bank wanted. Fitch itself was not a party to the lawsuit....
Investors shouldn't put much credence in the risk that rating companies assign to CDO squareds and cubeds,
httpsorry. I think I httpfixed it. Thanks for bringing it to my httpattention.
Same Bloomberg article from above:
Investors shouldn't put much credence in the risk that rating companies assign to CDO squareds and cubeds, says Stanford's Duffie. ``The complexity of analyzing that is beyond current methodology,'' he says.
The grades that rating companies give CDO squareds and cubeds are worthless, says Janet Tavakoli, founder of Chicago-based consulting firm Tavakoli Structured Finance Inc., which advises investors on CDO purchases.
``Ratings on these products are based on smoke and mirrors,'' Tavakoli says.
(end quote)
ALL in all this article is the clearest explaination of the rating agencies roles in the the CDO market
Hey, Where's the Billboard in Vegas that says 100% payback at Bear Stearn's ---
Come on over, our Player's never lose....
Bear , ya sold me,how do i open an account
This is where Gordon Gecko gets the hairy eyeball from Bud Fox's dad.
Also, if ``The complexity of analyzing CDO squared and cubed is beyond current methodology,'' doesn't this explain the no bid or low bid auction results?
"The grades that rating companies give CDO squareds and cubeds are worthless".
``Ratings on these products are based on smoke and mirrors,''
Think about that product as a proportion of anyone's portfolio. You might as well head to Las Vegas with a "winning system" in mind.
Lever up and mismark, a toxic combination. That's my understanding of what happened at Bear Stearns' (BSC - Cramer's Take - Stockpickr) hedge funds. And I believe there will be no fallout whatsoever beyond the funds, despite the innate desire by so many people to rumor and panic the marketplace.
It's driving me crazy that there is such unsophisticated reportage of this subprime issue.
First, most of the subprime blowups do not involve credit defaults. In fact, other than New Century Financial, which had to restate all its financials because of defaults, most of the problems have been a lack of liquidity caused by the fear of defaults.
I say that because there is tons of demand for this paper from the likes of sophisticated hedge funds at Lone Star and Farallon Partners. I don't know the Lone Star guys, but the people at Farallon are just about the best in the game and there is no way they'd be buying up these loans if they weren't confident that there would be a payoff well in excess of what they are putting up. Lone Star seeks a similar return. These are the buyers of this kind of paper, and they have done amazingly with it.
That's because they have cash. Which brings me to what these crises are really about: liquidity.
When banks loan to these subprime lenders -- and they can't lend without that capacity -- the subprime lenders become hostage to the credit committees of the big outfits, outfits like Merrill (MER - Cramer's Take - Stockpickr) and J.P. Morgan Chase (JPM - Cramer's Take - Stockpickr).
If the credit committees of these big banks smell trouble, they cut off the credit. That's the real worry for the subprime outfits, liquidity, not creditworthiness. Any hint of problems and the liquidity dries up even if there will turn out not to be much of a credit problem with the actual loans. I say that because the Farallons and the Lone Stars are buying these loans fairly close to par. They wouldn't if there was a real risk of credit defaults on subprime.
Not everyone has been that careful. These Bear funds weren't. They borrowed a huge amount of money from the likes of J.P. Morgan and Merrill, and now those guys are squeezing Bear. And believe me, this is a competitive world and they like to squeeze Bear.
It was quite a business to do what the Bear hedge funds did, which was to borrow a lot of money and buy high-yielding debt at, say, 10 times the capital they had under management. But the same credit committees that were worried about the credit of the subprime loans -- and again, I am saying that there is an overreaction by these credit committees but they are overreactors from way back because their whole job is pretty much to say no because one error can wipe out a year of profits -- are now worried about the lack of liquidity at the Bear fund, most likely because of redemptions.
The problem will go away with liquidity, which is why Bear Stearns is ponying up the money. The credit committee
The excuse of the 2000 decade: No one could have forseen.
All purpose excuse for all situations, from 911, WMD, Iraq to housing and hedge funds.
Trumps all of the warnings of the people who ran around before with "their hair on fire".
Or could it be that everyone else is, in fact, marking to that price, but no one else was either stupid or criminally insane enough to buy illiquid and hence somewhat fuzzily-valued bonds for customer accounts at 9 to 1 leverage?
Tanta, I don't see what the big deal is. Americans are being taken advantage of in many ways. It is better to have the press defend them for rights they don't deserve rather than for the press to stay out of it completely. If they don't do it, people would rebel against established media and run away to blogs.
So if we accidentally knock Wells Fargo and accidentally praise Brookstreet along the way, well, that's not the end of the world. 20 years from now, all we'll remember is the press stood with consumers and against those who ripped them off.
So Cramer's comments' can be summed up to sentiment?
So Craig Crackpipe and Mary Meth
were credible when we loaned them money, and now there not....
oookkkkkkkkk
Same Bloomberg article
You can't compare these CDO ratings with corporate bond ratings,'' Duffie says.These ratings mean something else -- entirely.''
Corporate bonds rated Baa, the lowest Moody's investment rating, had an average 2.2 percent default rate over five-year periods from 1983 to 2005, according to Moody's. From 1993 to 2005, CDOs with the same Baa grade suffered five-year default rates of 24 percent, Moody's found.
Non-investment-grade CDOs, rated Ba, had an almost identical default rate of 25.3 percent in the same period. ``In CDO-land, there's almost no difference between Baa and Ba,'' says Cifuentes, a former Moody's vice president who helped develop the company's original method of rating CDOs in the late 1990s.
END QOUTE
So, the same rating system but entirely different scale of danger-isn't this deception in itself?
An almost no difference in default between "investment grade" and lower grade?
bdf: You seem to by implying that the problem is manufactured and not systemic. It seems to me that the problem was caused, ultimately, by greed: greed for greater returns, greed for that bigger house that the borrower really couldn't afford. The get-rich-quick (and with no effort) mentality that seems to dominate.
There's a very pretty essay by Michael Kilbach about how and when these bust-up stories get told. Even with the split infinitives, it was a pleasure to read...
http://safehaven,com/article-7816.htm
o, I'm not trying to suggest anything.
Just wanted to post an alternative view point of whats going down.
That's
Safe Haven | Predicting The Future
Looks like the "resolution" is going to be a replay of LTCM. Each big investment house wants to minimize its losses as best it can, but at the end of the day motivated self-interest prevents the group from doing anything that would kill the game for them all.
The Prisoner's Dilemma analogy breaks down because the prisoners cooperate.
Sebastia
bdf, it would help matters if you provided the link and possibly a chunk of the text in quotation marks, instead of just dropping unidentified copy into the comments.
bdf's comment above is the first part of this essay by Cramer:
Why the Bear Stearns Mess Will Be Contained | Active Trader Update | Financial Articles & Investing News | TheStreet.com
Personally, I think Cramer's making an either-or argument that won't hold. But his point is certainly valid that there is no way you can chalk all this up to realized credit losses on the underlying bonds. No way.
I'm not arguing, as Cramer is, that this means it is "contained." I suspect round two will start when we do begin to realize some major losses on some bonds. I don't think that fun has even really started yet.
But in the meantime, here's everyone all knicker-knotted because some University endowments are buying some of this paper at 18 cents or something. Shit, I'd buy it for 18 cents. It was the folks who bought it for par-and-a-buck who got the problems. Does anyone really want to argue that all tranches of all subprime-backed securities are literally worthless? That's nuts.
You don't get killed by the fire. You get trampled in the rush for the exits. Didn't we used to know that? How did "subprime paper" get endowed with magical properties that no other junk collateral has ever had?
Can someone re-hash the BB or AG comment "wave a magic wand and have houses prices appreiate 10%"
Are we yet seeing prime magically (so to speak) turning into "subprime paper"?
The Prisoner's Dilemma analogy breaks down because the prisoners cooperate.
Yup. This time.
But the problem is if it happens again. And again. And again. Each time the prisoners all have a fresh new opportunity to sell the others out & go apocalyptic.
If BS High Leverage is the only event it will be a footnote... a one per.
If not, then it gets interesting.
If I had to bet I'd guess there aren't going to be too many more of these 'events' - I tend to believe the Masters of the Universe aren't that stupid. The 'few' other funds out there like this one just got a wake up call and will be unwinding quietly in the shadows before the MTMkt triggers kick in. I would hope anyway.
If the Masters are all this stupid with leverage then we all got problems. Big problems.
Funny thing about that analogy to LTCM. If I remember correctly from the time, Bear was one of the houses that didn't want to go along with that work-out. If true, then I suppose Bear found themselves on the other side of the fence this time, and ended up having to save their own skins/reputation by injecting some capital. Karma is a beautiful thing.
Great point Tanta. And this part is key:
Shit, I'd buy it for 18 cents. It was the folks who bought it for par-and-a-buck who got the problems.
Hell they bought it at par & levered it 10:1!!!
I think CR's general take is right--no matter if this debacle spreads or is contained--it's bad for the CDO market, ergo bad for the MBS market, ergo interest rates on mortgages are going to rise, just as the reset tsunami crests, which means more people are going to get foreclosed on...
What was virtuous has become vicious...it'll play out slow, but the tide is going out and its picking up speed.
Do we get to Full Spectrum Disorder? Maybe. Do we get to lower house prices than almost anyone is currently predicting--i.e. a return to the long term medians, that takes away the gains of the last five years? Looks more likely every day to me.
Bottom in 2012 for housing, maybe longer.
OT: I highly recommend THE BLACK SWAN, the new pop philosophy book by ex-quant Taleb, for the august group assembled here. One of his main points: that the Gaussian mathematics that underlie all rating models is fundamentally flawed, and we would all be better served by a Mandelbrotian approach. Clearly the BS debacle was enabled by some faulty modeling. The book's dismantling of the mathematical approach that has spawned all this leverage is effing....disturbing.
Josh I'm always amused (and amazed) to see esoteric garbage (the current market) wrapped up in meaningless mathematical gook.
Looks like the "resolution" is going to be a replay of LTCM. Each big investment house wants to minimize its losses as best it can, but at the end of the day motivated self-interest prevents the group from doing anything that would kill the game for them all.
Sebastian
This is the optimal solution for them, for now, but it's probably the 2nd least desirable outcome. By not blowing out inventory and causing a flight to quality, bonds stay up in yield, ensuring ARM resets to cause even more defaults in these CDO/CMOs.
The smart hedgies will have already realized this, with them trying to unwind their CDO positions(Hello, CALPers!! Can I buy you a drink?) while slowly trying to unload treasuries(selling 2% of ADV per day) to be ready for redemptions, driving yields even higher over the next two months, making ARM reset defaults even worse.
A slow motion car crash, or a Prisoner's dilemma by stealth.
I have a bit of insight into what's going on specifically with Bear and generally with geared CDOs.
Tanta's post is not far off the mark although the incestuous ramifications are very much worse (in fact frightening) than he identifies. Mmybe he is acting responsibly (see Jim Cramer re Bear Sterns on CNBC on June 22).
The only question is at what end of the US Treasury curve should US dollar based investors purchase? Two year Treasuries offer the lowest capital risk; but if there is a "Benanke put" and the Fed has to step in to refinance the financial markets, 10 year Treasuries offer more upside.
That is, of course, if the 10 year Tteasuries don't get wacked by the consequential inflationary risks and an implosion of the US dollar.
Investors could do a lot worse that hedging currency risk (when necessary) and buying at the SHORT end of the UK government (i.e. "gilts") bond market. The short end, because UK rates are rising which should be supportive of the UK currency if Bernanke does a Greenspan.
As our Chinese friends say, "may you live in interesting times". I think that we all are.
hey, but if we buy it at 18 and sell it at 27 , that's 50%
oy vey
marty
You say you have specific insight as to the ongoings at the bear blowup.
can you shed more details?
Common sense would dictate that if the underlying security for all these MBS/CDOs are subprime mortgages that are not paying out the expected cash flows and are in fact rising in delinquencies that the derivatives would be impaired.
Since the rating agencies don't want to screw their customers that pay their bills and bonuses they will only lower ratings after the fact. As we saw with the ratings downgrades on the Bear Stearns CDOs.
Since there are no markets its all mark-to-model and the model says these derivatives are at par or better. Why worry when the sky is blue? And investors don't want to write down anything so they can keep with their fantasy that their investment is going great guns.
Since this all an incestuous racket with hedge funds, prime brokers, securitizers, etc who all have teir hands in the pie - there's no incentive take any losses - until they have to. By then Uncle Sam - that's you and me - will be riding to the rescue - and no one will be any worse for it. What's a few $trillion more to the national debt?
Truly. I want someone with some good dirt on the two Bear funds to convince me that Fund 2, the high-leverage fund, the Unbailed, which appears to own a bunch of CDO2 and CDO3, isn't in fact making swap bets on the underlying of the underlying of the underlying assets that are in fact owned by . . . Fund 1, The Bailed.
Tanta-
you said-
"But in the meantime, here's everyone all knicker-knotted because some University endowments are buying some of this paper at 18 cents or something. Shit, I'd buy it for 18 cents. It was the folks who bought it for par-and-a-buck who got the problems. Does anyone really want to argue that all tranches of all subprime-backed securities are literally worthless? That's nuts."
And you know it was the freakin endowments that bought the shit at par and have now decided to employ a dca startegy to lower basis, so now they have an average cost of approx. 60 cents, if this shit is worth 20 cents they are screwed. It is one thing to speculate with OPM and pull some dumbshit move and another to waste/speculate with your own.
Now Tanta, what could we expect. Isn't this the same crowd that cries for personal responsibility for everyone but the corporate elite. They are never responsible for their actions. Some one else either made them do it or for some other reason it is the other guy's fault.
They are such frauds.
And you know it was the freakin endowments that bought the shit at par and have now decided to employ a dca startegy to lower basis, so now they have an average cost of approx. 60 cents, if this shit is worth 20 cents they are screwed.
I must have missed that part of the reporting. I didn't see anyone suggesting the endowments were buying this crap from themselves.
In any case, I said I'd buy the stuff for 18 precisely because I suspect most of it is worth a good 60 so far. Of course it depends on what, exactly, "this shit" is, but except for the stuff that's either entangled in lawsuits or servicing problems (like the Fremont pile of crap, for instance), I'm still not sure why your run-of-the-mill RMBS mezz tranche isn't worth 60 to someone who does not have to liquidate it this very minute.
We're confusing fire sale valuations with a useful mark, I think.
Oh, Tanta, what a wonderful post.
I know I sound like a broken record, but you really are the Jane Hamsher of lending.
Super post!
Arbogast, Jane Hamsher is the Tanta of politics. She just doesn't know it yet.
"were buying this crap from themselves."
nor am I, I am suggesting that they may be adding to the "equity" tranches they already own.
" Of course it depends on what, exactly, "this shit" is, but except for the stuff that's either entangled in lawsuits or servicing problems (like the Fremont pile of crap, for instance), I'm still not sure why your run-of-the-mill RMBS mezz tranche isn't worth 60 to someone who does not have to liquidate it this very minute."
agree., except, I don't think they are getting bids on your run-of-the-mill RMBS mezz tranches at 18.
"were buying this crap from themselves."
nor am I, I am suggesting that they may be adding to the "equity" tranches they already own.
Well I have heard completely unfounded rumors that endowments just might be helping some of their well connect 'friends' & 'contributers' off load this ilk. I've read that 'charge' a couple places lately on the 'internets'.
I don't believe it myself (having family working in the 'gifting & endowment' business for a large prestigious university - heard plenty of dirt but nothing that dirty).
If it were a case of less-than-arms-length transactions involving these sales to endowments then that WOULD BE real news.
and these guys must be salivating-
Bear Stearns -- The First Wave Mortgage Failure | InjuryBoard Los Angeles
Hi Tanta,
I think that the best coverage of BS fallout is here:
naked capitalism
Bear Stearns Hedge Fund Fallout Continues
Where to start ? here's a simplistic view of a CDO... consider it a 50 story Condo tower. If the bottom 5 floors are contaminted by PCBs for example , I think there's a problem with the entire building 1 Just my view of the world . Well , the CDO complex , as a general statement , is contaminated with mezz and equity tranches of toxic waste... that's why JP Morgan and Merrill had to back off this week from auctioning stuff the Bear waste..... they were getting 10 -25 cent on the dollar bids... IMHO. In fact , if Cantor did sell collateral for 10 cent on the dollar as reported , it gives you an idea as to how bad things are... they took the 10 cents ! Back to Bear for a minute , as best as I can tell , the more leveraged fund ( Enhanced ) is not being bailed out / supported by Bear.... not surprising to me since they have assets that are worhless as far as I can tell.... maybe they aren't worhtless but no one seems to want to put a meaningful bid in to date. You will see collateral related to Enhanced sold and mark to market is already going on ( Ask the Brookstreet investors what that's like if you doubt that fact .) Moreover , a fair read of what's been placed in the public domain is that the 3.2 billion put up by Bear to prop up the less leveraged fund represents about 25 percent of Bear's shareholder equity. Let's assume that to bail out Enhanced would require a greater sum ( due to greater losses ar Enhanced , greater leverage and questionable value for the assets in Enhanced ) , it would seem that we're talking about an additional 25- 50 percent of shareholder equity of Bear Stearns itself , to prop up said hedge funds..... can you see Jimmy Cayne doing that ! LOL This is the same guy who did not put up squat regarding LTCM ...read " When genius Fails " to get the full extent of that fugly situation !Any way , Cayne is not going to risk Bear itself to save a small component.... book that Dano ! Not going to happen IMHO. Then , let's not forget out there in the bushs is the Everquest debacle to be dealt with at some point .... toxic waste which was to be IPOed off to the public but now that is off the table... well , we know Bear itself and the Cioffi managed Bear Stearn hedge funds own about 75 percent of that toxic waste.... so what has Everquest been up to lately ? what's their leverage , what are they currently holding and who hold the warehouse lines for this structured finance wiz ( or POS ? ) The BS ( no pun intended ) story isn't over.... by the way , do you think there's the slightest chance they have additional exposure beyond what's been discovered and discussed this past week or so ? IMHO.. I say , probably so... what do you think ? ?
agree., except, I don't think they are getting bids on your run-of-the-mill RMBS mezz tranches at 18.
Right. So a small subset of a small subset of the large category "subprime mortgage-backed bonds" is unloading for 18 because somebody somewhere has a nasty margin call to meet.
So, how big is the segment of this market that is being marked to prices like that, and how can it be enough wipe out Bear's hedge funds?
And to think all this enormous financial mirage is built upon a foundation of sand.
Sub-standard construction in semi-desert areas or in areas with a 4-5 hour daily commute to any kind of job, built only for speculation not habitation, likely to collapse in ummm maybe 5 years.
The US as a nation has shrunk to this? Vain efforts to keep its market value up thru valuations and revaluations of trash.
"So, how big is the segment of this market that is being marked to prices like that, and how can it be enough wipe out Bear's hedge funds?"
No question, we may never know the truth behind this story.
An absolute guess,
1) there was far more concentration in the riskiest of securities due to a bet by the manager in an attempt to bring the fund back to even.
2)as you have suggested, there may be ties between the two funds and counterparty risk that we may never know.
Isn't the subprime universe about a trillion bucks ? And some undefined portion of that universe is lodged in the first 5 floors of those CDO structures.... which makes a mess of those structures , no ?
koteli, thanks for that link. I hadn't seen the entire Wall Street Urinal story. From which:
the Bear funds were concentrated in little-traded derivative instruments known as collateralized debt obligations, or CDOs. These investments package together pools of assets and pay investors interest based on the payments they receive from the assets. The assets backing many of these CDOs were subprime mortgages.
Though subprime mortgages are highly risky, Wall Street carves CDOs into pieces so that some investors can take on more risk than others. The Bear hedge funds took on many less-risky pieces. They also borrowed heavily, which helped to enhance their returns on those less-risky pieces.
That's an excellent thumbnail definition of a collateralized mortgage obligation. What the hell it's got to do with a reasonable definition of a CDO beats the shit out of me.
On June 8 the margin call for the High Grade Structured Credit Fund was $63 million.
We also know yesterday BS agreed to lend an additional $3.2 Billion to this fund to stabilize it.
The margin call on June 8 for the Enhanced Leveraged Fund was $145 million. Bear Stearns has not added any capital to this fund.
The Enhnaced Fund has the riskier tranches and is highly leveraged. This fund will likely collapse.The Enhanced Fund had capital of $667 million as of January 2007. That obviously is vaporized.
What no one know is how much is in either fund, nor what the composition of.
Intuitively, you don't pledge an additional $3.2 billion if the margin call is $63 million. Obviously there is a glaring dispute between par value and market value.
What is apparent is that Bear Stearns and others are trying to prop up a market and cover up huge losses. They are now buying time. The only problem is that foreclosures are escalating and the problems are getting bigger.
The theory that there is no spillover and contagion is ludicrous. These losses cannot be hidden.
Keep in mind that the $3.2 Billion was 25% of capital. And that there aren't that many players that can pony up that kind of money.
The next shoe will drop. Inevitably the FED will have to step in and lower rates to improve the values of the underlying securities.
The easy money salad days are over. Credit quality will matter again.
Sebastian, I think, has a limited view of who the "prisoners" are.
Yes, the prime brokers may find reason to cooperate. In a multi-period game, with LTCM having been the first period, the prisoner's dilemma may in fact break down.
However, this is a one-period game for most hedge fund investors. What's in it for them if they wait to redeem? Nothing. The first one out the door gets near-par, the last one near-zero. Its not hard to predict the outcome.
And then there's the buyers of new CDO's. What's the benefit to stepping up to the plate? Wouldn't you ask for better spreads? And don't wider spreads cause margin calls for existing holders?
Remember, LTCM had a unique strategy. Diffuse that bomb, and presto -- no explosion. Levered vol-selling, on the other hand, is near universal in the $1+ trillion hedge fund industry. Lots of nickels being picked up in front of steamrollers...
Thanks, frank. Hoo-boy. So an observer, like maybe a central banker, sees 1) a $63 million margin call, and 2) a comparatively huge set-aside, whether you look at it as two orders of magnitude greater, or as a quarter of the capital (as of a certain date, anyway) of the funding entity.
Now, the underlying reality to this has to be pretty funky as we mostly know around here, but is there a chance that the $3.2 billion is meant as a very loud dog whistle? Apparently, FOMC meets this coming week (scroll to the end of the March minutes).
tanta-
one more thing, and one might say, is this somehow related to the allegations of manipulating the market in subprime?
Could one fund have been the counterparty for the other?
Most would say absolutley no way, but, then most would say Everquest would NEVER have been created.
So how big is this problem? Here is a back of the envelope range calculation. Estimated minimum losses - 1 million foreclosures, average balance $300,000, at 30%loss = $90 Billion. Estimated maximum losses - 3 million foreclosures average balance $300,000 at 40% loss = $360 Billion. Of course some losses are already taken and some are included in reserves so the current range is probably around $50 Billion to $300 Billion of future losses. It looks like the econonomy is in the 3rd or 4th inning of this ball game. Other players with significant leverage are approaching the breaking point.
and-
the whole business of transferring the lower rated shit to Everquest is what led me to the belief that it was entirely plausible that this manager increased his bets to attempt to recover, then understood shit was worse than he had imagined, and this move could have potentially been an attempt to hide the carnage.
Then Merrill said uh-uh Ralphy-boy, time to bend over and say hum-in-na-hum-in-na.
Koteli, Thanks for the link which makes sense in relation to the actions of the various parties. Do you (or anyone else)know if other hedge funds have similar positions to the Bear funds? Do you think there will be material tightening of credit for other hedge funds becauses of losses lenders will incur with the Enhanced Bear Stearns fund?
Everquest Mission Statement-
In search of the greatest fool
"In a multi-period game ...the prisoner's dilemma may in fact break down."
It often does, in fact it's likely to at Nash Equilibrium. From a game theory standpoint the investment banks were and probably still are in a Stag Hunt but that can break down in 'betrayal' (prisoner's dilemma outcome at equilibrium) easily enough if circumstances change; e.g., if the majority of 'hunters' believe they can benefit by sacrificing another 'hunter' -- that aside, keep pursuing the game until bagged (which in this context probably includes everyone else, from hedgies to retail investors).
I'm no expert in game theory but I know the logical problem(s) of cooperation and betrayal have been around awhile; e.g., Rousseau and David Hume alike wrote treatises on the subject and I'm sure there were others.
In terms of these hedge funds and the investment banks, I've seen a couple interesting models of biological natural selection that assume Nash Equilibrium but, depending upon how fitness is defined/calculated, either prisoner dilemma or stag hunt can be equilibrium.
That kind of sensitivity suggests that resolution of the loan derivative(s) crisis hangs by thread even if only the major players are considered. However the system becomes entirely unpredictable because not only are there multiple stakeholders in this game, they are not all working to the same purpose nor by the same rules; e.g., litigation, etc.
Since uncertainty rightly or wrongly is often perceived as risk I'd guess that in the absence of a major intervention by Federal authorities the stag hunt will break down and the defections (betrayals) will begin to cascade.
Reading these posts, it seems to me that people like Sebastian misunderstand the essence of credit cycles.
In every credit cycle, the potential losses are thought to be small as a percent of GDP. That's not the number that matters. What matters is the ratio of losses to the equity of levered investors. In previous cases, these were banks levered 12:1, but with "stable" funding. Now we have mostly hedge funds levered anywhere from 2:1 to 20:1, but with HIGHLY unstable funding. And then there's the investment banks levered 25:1 on the visible debt (not counting derivatives), and the banking system with a higher concentration of real estate lending than in the 1990's.
Why do we care so much about the equity of levered investors? Because credit cycles can spark a chain of events that leads to recession. This seems like heresy now, as the causality is supposed to run the other direction. Where did people get that idea?
-1130am -Oct 30, 2007
Bear Stearns Destroys Capitalist System
There's chaos on Wall Street, as the NYSE officially shut down this morning after the Dow crashed below 1000, threatening unknown consequences throughout the derailed global capitalist economies. It seems that one of the oldest and most respected investment banks was the death knell of the modern economic system with the heralding of hedge fund problems in June.
Nearly done in by rogue hedge fund Long Term Capital Management nine years ago, capitalism as we know it was eaten alive from within, as it seems the investment banks were cannibalizing each other to the extent that all modern wealth is effectively destroyed. This effect has been seen globally, as the connection of assets through derivatives has tied the collapse like a lasso around a wild bronco's head.
Halloween is early here in Manhatten, where the orange glow of arson fires are scattered through the city.
You don't get killed by the fire. You get trampled in the rush for the exits.
Exactly. And we all should know that fire doesn't kill. (/sarcasm)
Everyone better run for the exits or they will have nothing left to pick from.
Hurry, folks, the door is closing. And if the investment banks want you to believe it's contained, here's some advice, it ain't contained!!!!
How did "subprime paper" get endowed with magical properties that no other junk collateral has ever had?
C'mon, Tanta, I hope your joking with that.
Uh, it's because this subprime paper is to the people who didn't qualify 7 years ago, but now were given 110% loans on 50+% overvalued property. On top of the 20% pure fraud that's lurking underneath. This garbage is beyond the junk of the junk. Buying protection is like insuring your toejam for $5000/oz. Good luck getting the payment when you make your claim against its loss.
I thought this was old news, why are you in denial of this now? This is absolutely a subprime problem, that has now also become a gigantic problem of much, much more.
Great post Tanta,
It's rather funny to watch these investment bankers scramble to hide their lies from the market. That sinking feeling they have is the result of their own greed and the greed of their clients who are not happy with 12 to 18% gains per year. My father, who lived through the depression, taught me to be satisfied with earning your money through work and saving at least 25% of what you earn. It was good advice and maybe after all of the lies on Wall St. are finally uncovered the people in this country will return to saving for a rainy day. It's going to rain pretty hard for a very long time in the near future.
The US as a nation has shrunk to this? Vain efforts to keep its market value up thru valuations and revaluations of trash.
Hazard | 06.23.07
Yes, Hazard, I'm afraid that is the result of politically-powered capitalist greed.
The revolution is here.
Great post. And this comment absolutely nails the bigger issue-
"I want someone with some good dirt on the two Bear funds to convince me that Fund 2, the high-leverage fund, the Unbailed, which appears to own a bunch of CDO2 and CDO3, isn't in fact making swap bets on the underlying of the underlying of the underlying assets that are in fact owned by . . . Fund 1, The Bailed."
Cannot for the life of me figure out another reason they would bail out fund 1 - unless some form of triage where they know they've got a lot in #1 and it is actually worth something, while fund #2 is a gone and they don't have much invested (although aren't they a prime broker for the fund)
BTW- anybody want to take bets that the First Data LBO blows up? I think there's no way it gets done. LBO wave has already crested.
Now it breaks.
I think we need to be clear about what the bail out of fund 1 consist of.. BSC pledge up to 3.2B (and the latest WSJ put the number closed to 2B) for credit line that the fund can draw on. The fund can use this money to purchase CDO that was seized by the lender or use it to pay the shareholder when the fund finally open their doors. What is not said here is what collateral BSC get for this 3.2B (or 2B) loan. They are not infusing capital into the fund. So it is not a bail out as the headline portrayed. Also as part of the news, quite a few lenders agreed to "unwinding" their positions with BSC (I think everyone except MRL and Cantor did). WSJ did not detail what is "unwinding" mean. My speculation is that the lender seize the collateral from the fund, sell it to BSC with a deep discount and write off their loan to the two funds. But in any event, the lender is going to loss some money. We probably will know soon enough how much they loss (since they all have to report the loss in their respective next Q earning). No one really know how much is the shares for fund 1 is going to be worth nor we know anything about fund 2's worth. It is a continue saga and we don't know if BSC will actually make money comming out of this fiasco. We know for sure that the shareholders for these 2 funds is going to loss some or all their money, the lender is going to loss some money. The $64K question is what will it do to the CDO market? Would the University endowment/pension/foreign buyers continue to buy CDO at par? If they slow down purchase of future CDO, then the mortgage rate and term will definitely move up drastically and BSC will have a diffical time moving forward since so much of their business is tie to CDO.
Tanta, great post. That's coming from someone who supposedly understands this stuff.
Too late.
The brokerage firms already got price lists from their clearings with new prices. And every margin call leads to liquidation, which leads to mark-to-market, so that the brokerage firms get new price lists from their clearings with new prices, which ....
I think those two BS funds will just short each other and make tons of money on that...
Actually it is wrong that prisoners are cooperating.
Remember, Tuesday Merrill L. was sitting on the phone waiting promised 24 hours while B.S. and Blackstone were coming with salvation plan.
How surprised it was to learn that JP Morgan already dumped his positions on the market the same day, not waiting until Merrill L. will start selling his 400 million. Ha, I can imagine how mad Merrill L. went, when it announced at 5:30pm that it will dump $800 million the next day.
In previous years they would send killers in that kind of misunderstanding.
Auto insurance companies do a much better job than the mortgage industry in breaking down people into categories and looking at how the group behaves statistically. If you are a single male under 30 driving a Camaro you get a much different rate than a single mom in her 30's with three kids driving a Honda Odyssey.
So why can't the mortgage industry take a page from the auto insurers? Imagine a future when your morgage rate depends on not just your current income and credit, but also factors like how old you are and what your risk profile is, where you live, etc. In this high tech world we live in, I can't think that this is not a workable proposition.
Imagine if an auto insurer behaved like some of these sub-prime mortgage outfits ... they'd be charging the same rate to the kid in the IROC and the lady in the minivan ... now how can that make any sense? Can anyone with any credibility not believe that this whole subprime thing is going to go down as one of the worst debacles in modern financial history?
It gets unwound slowly and quietly as the loans are paid off, refied or defaulted and BS gradually and quietly takes millions in losses when the funds fail to pay off the loans.
Jeepers Tanta! I've been waiting since the 70's to see the effect on this edifice of cards when someone plucked one from the bottom. Now, with 'hedgies' and leverage, we can all see what happens when a bowling ball goes through said cards.
It has been said that the markets are incapable of seeing The Black Swan. I suppose that is like the soldiers saying you don't hear the one that kills you. The unwinding of all of this may take on the appearance of a failing dam. BS is a mere trickle, and generations to come will talk about the deluge that follows.
I like the part about the rating agency disclaimers, that investors should not use the rating or information provided in making investment decisions. One wonders, perhaps naively, what is the point of a rating if not to inform investment decisions?
"One wonders, perhaps naively, what is the point of a rating if not to inform investment decisions?"
Certain investors are only allowed to invest in assets rated a certain level or better. But these investors needed (or wanted) a higher yield than what they would get from traditional paper with those ratings, hence their interest in the new-fangled stuff. Investors, knew, or should have known, that the higher yield was in fact coming with higher risk. If someone offers you a riskless TBond and a yield of 10%, you'd begin to wonder, right?
Why did the agencies go along with this? Well, the rocket scientists behind this stuff where paying them to do the ratings. If the ratings didn't come through, they would lose business. So there was constant communication between the rocket scientists and the agencies how to tweak the product in order to get the desire rating. Basically the rocket scientists would arbitrate the rating agencies, creating a product which was riskier than what the rating "said".
From the Nake Capitalisim article (about the raters):
"they will only downgrade when forced to by experienced losses; not rising default rates, not a worsening economy, but only actual, experienced losses."
In this sense, the CDO market would be much like the housing market. The lack of immediate mark-to-market lets people live in la-la land for a while. You'd expect professional investors to catch on quicker than an average homeowner, and maybe they will - to a degree. However, I think there is a long, slow death ahead for many of them.
To see all this mess unfold---a Star Treck Spock quote--"Quiet facinating"
Funny I said this looked like LTCM on this blog now the media has jumped aboard.
Whats next? Who knows but if the past is any indication you can throw the "inflation worries" in the trash, if this gets worse. LTCM prompted an "emergency meeting" by the fed and then came the rate cuts...........
Great post, tanta. It won't be the end of the world, but it will be a good-sized mess, and highlight the extra risk inserted into the system as a whole (the stampede for the exits amplification) by the highly leveraged treatment of an otherwise useful mechanism (pooled mortgages) by a low number of super-wealthy investors, compounding another otherwise useful mechanism (a well-collateralized, reasonable-risk mortgage loan) twisted into badly-founded jumbo ARMs that allow some other shysters to cream off the front of the large-home buying action. Good old regulation of the mortgage martket would have cut it off at the pass...
In spite of the fluctuations seen in the last few years, the hedge fund industry is flourishing as people have realized that hedge funds can prove to be beneficial as long as they plan there moves carefully.
Regards.
ForexCTAs