My understanding is that Paulson's hedge fund has a big on ABX CDS's. That is, they own the credit protection, and folks like Bear are short of it. That entitles Paulson to be paid out at par in the event of a "credit event" that causes a decline in the value of the underlying bonds.
Basically, Paulson is accusing Bear of buying up the underlying ABX BBB- bonds, which in turn supports their price and in turn the index. What does Bear do with those ABS? Well, for one thing its trying to market it as a toxic-waste CDO fund geared towards individual investors. For another, it keeps the ABS on its books, waiting for the day when a rating agency downgrade finally forces them to mark the ABS down.
The real question is, why does Bear have an interest in propping up the ABX index? They said all over their last call that their exposure to subprime is minimal.
I think the main reason is that they are the prime broker to lots of fixed income hedge funds that were on the wrong side of the ABX trade. We haven't heard of any of these going under, which is nothing short of amazing. Perhaps this is just Bear's way of trying to make sure these hedge funds can pay back their margin loans/repos. At the end of the day, these repos are the mother's milk of the credit bubble, and Bear and Lehman have grown their balance sheets 20% sequentially of late to accommodate the explosion of hedge fund balances.
Just one more clarification: the holder of the CDS gets paid the difference between the written down principal and par. So the lower the ABX goes, the lower the market expects the underlying bonds to be written down, and the more Paulson gets paid. That's how they can be "long" something and profit when it falls -- they are long the insurance.
I'm wondering if litigation seizure is the biggest risk to financial markets right now? By that I mean risk premiums explode higher (ie. return to some semblance of normality) when parties to credit insurance recognize that this doesn't settle neatly and predictably like financial futures, but could in fact be subject to drawn out litigation with an uncertain outcome, like (surprise, surprise) any insurance contract when the stakes are high enough.
Basically, Paulson is accusing Bear of buying up the underlying ABX BBB- bonds, which in turn supports their price and in turn the index.
Thanks for educating me, David. I think I understand what you are saying.
What I'm not getting, I think, is the "manipulation" part.
Is it a hopelessly naive question to ask why the hedgies think this is "cheating"? (This is a separate question from what hell Bear is up to and who it's trying to lay this crap off on.)
I guess I keep coming back to the same question, whether we're talking mods or buybacks or ABX trades: what makes these people think that no one will ever attempt to "manage" risk?
The answer seems to be that everyone thought they were entering contracts that forbid the counterparty to take active steps to mitigate loss.
That is the most mind-numbingly stupid thing I have ever heard.
Wall Street appears to be hell-bent on destroying the residential mortgage market in order to "protect" it. Gee, thanks, guys. We did better when you didn't take the risk off our backs.
when parties to credit insurance recognize that this doesn't settle neatly and predictably like financial futures
You mean when they figure out that the collateral is, um, mortgage loans, not corporate junk, and that, um, there is a giant social and political and regulatory stake in the the mortgage market that predates these hedge masters by a few decades? They thought they were going to be allowed to let all this "cash settle"?
ozajh, I think we have three problems in play here: modifications, repurchases of mortgage loans, and "hedges" of those mortgage securities (CDS, debt-funded CDOs) all of which are real and all of which, for our watchdogs in the press, are interchangeable.
I get about five consecutive minutes where I think I understand something, and then I read something else and I'm back to head-banging . . .
The manipulation accusation stems from the thesis that the mortgages being purchased by Bear cannot feasably be modified to be made viable, i.e. they're too far gone. Ergo, Bears purchase appears as an attempt to 'prop' up the ABX BBB- tranche, because the probability of acutually turning a profit from these loans seems very small. The WSJ article implied that Bear was a big seller of the protectin there.
There seems to be a lot of smoke here.
It's good to remember that the House of Bear was adamant last year and before that there was no little or no excess taking place in the mortgage market. They been caught wrong footed, as the Everquest IPO exemplifies.
Add the Paulson accusations to the mix and one can surmise that there is much fire behind the curtains, or I should say in the VIE's.
Tanta-
They thought they were going to be allowed to let all this "cash settle"?
My understanding is that CDS do NOT cash settle. Although I think there have been efforts to establish some sort of system to allow cash settlement.
There have been several cases in teh past where there have been runs on the actual bonds near or in default because there have been more CDS written than actual bonds.
If this is the case, could give incentive to Bear Stearns to manipulate underling?
They thought they were going to be allowed to let all this "cash settle"?
Rob, that was a possibly unfortunate rhetorical flourish; by "all this" I meant the mortgages as well as the bonds and the swaps.
One way to look at the whole "modification" uproar is that it's a bunch of people who think the best strategy is to liquidate, or "cash settle," what are mortgage loans for people's homes. My point, I guess, was if some of these parties thought the regulators were going to allow that without any, um, "intervention," they were drinking good bong water. It's not the same social or political or financial thing at all as letting some junk-rated corporation go BK.
That aside, I have been told repeatedly that the CDS do cash-settle and everyone was planning on them cash-settling.
Suppose that I am the manager of a securitized pool of mortgages. Can I sell individual mortgages out of that pool? The proceeds would be (presumably principal) income to the pool and disbursable as such. If so, to whom can I sell them? It would have to be an arms-length transaction, I assume.
Now, suppose Bear Stearns has an interest in propping up the price of some derivative from my pool. If Bear Stearns approaches me to buy some of the individual mortgages at a price above what I think they're worth, would I not sell them? Bear Stearns would then have to dispose of those mortgages at a loss, but the rise in value of the derivative might overweight that.
I'll bow out now as I'm getting way over my head, but cash settlement still seems to be ad hoc - see below:
Corrigan: Cash Settlement a CDS Missing Link
28 May 2007
Securities Industry News
Goldman Sachs Group managing director and systemic risk expert E. Gerald Corrigan, who led the Counterparty Risk Management Policy Group initiative to resolve problems in post-trade processing of credit default swaps (CDS), believes one of the panel's central recommendations still needs attention.
During the Federal Reserve Bank of Atlanta's conference on credit derivatives two weeks ago in Sea Island, Ga., Corrigan said that the policy group's prescriptions for reducing CDS confirmation backlogs and bringing order to assignments or novations of the instruments have been successfully met. But a uniform cash settlement process for actual defaults, or credit events, has yet to be fully realized.
Speaking to reporters, Corrigan said that such a cash settlement mechanism is "not fully institutionalized," and it needs to be in place "sooner rather than later."
Over the last two years, Corrigan estimated, there have been eight to ten reference-entity credit defaults--auto parts companies Collins & Aikman and Delphi Corp. and the Delta and Northwest airline bankruptcies among them--that prompted a cash settlement procedure. These events posed varying degrees of difficulty, according to a paper presented at the conference by David Mengle, head of research at the International Swaps & Derivatives Association (ISDA), which has proposed a protocol approach for managing the multilateral complexities of large-scale defaults.
In Corrigan's view, "We have successfully muscled through the settlement process in the aftermath of defaults and gained a great deal of experience in how to manage these situations." But he is still looking for a "single ISDA-type protocol" that puts a uniform and fully institutionalized cash settlement mechanism in place for future eventualities. He said the possibility of a "large-scale default and multiple defaults" is the "great imponderable" that could make it far more difficult to just "muscle through" on an ad hoc basis.
Buying troubled mortgages out allows the deal to pass triggers when it otherwise won't (and the mezz wouldn't get paid until the seniors). If the triggers are performing, then the CDS is worth more, which they need to stay tight to keep both the CDS they own and in CDO deal pipeline from spreads blowing out. thank you.
Well, see, if the security in question is a REMIC, then you aren't the manager of it because of the Q election, which means it's a static ("brain dead") pool. The only way the trust can "sell" a loan is to put it back to the sponsor under contractual reps/warranties.
If the "security" in question is a CDO, then yes, it's managed, but the manager would be selling tranches of securities, not underlying mortgage loans.
I personally have zero experience with a mortgage-backed security that allows the trustee to hold the loans for sale as opposed to holding them to maturity. This would undoubtedly be part of what's bugging FASB, if those ABS (non-REMIC) are set up to allow that.
In any case, yes, sales gains would belong to the trust. I'd be more puzzled about the accounting treatment of the loans pre-sale. If they're HFS they are subject to MTM. That'd be one reason why investors prefer static pools.
No fair! If I bowed out every time I was over my head, we wouldn't have a blog to comment on. Nobody gets out of this one by claiming to be drowning in confusion. Who isn't?
Buying troubled mortgages out allows the deal to pass triggers
Thanks, regular reader, but I'm still confused about what kind of deal you're talking about and at what level we're talking about buying individual loans.
This is my current five minute confusion: who gets to hold securitized loans for sale?
Ok,
Say BS created $100 of derivatives on $10 of underlying debt. Now 20% of those underlying assets are worthless. Depending on the way the derivatives contracts are written, the loss on the derivatives from that swing will likely exceed the 20% drop in the underlying asset. This is the vicious side of leverage. So, by buying out the $2 of non-performing debt and taking the total loss on it, and not selling it, they can stabilize the market price for the remainder of the debt, and prop up the derivatives.
If it feels like you've entered a hall of mirrors, it's because you have.
Buffett keeps on looking smarter every day, by the way. For those who haven't, go back and read his 2002 through 2005 letters to shareholders, where he talks extensively about the risks in derivatives operations.
Look back at Adelphia, they had use an auction process to determine who settled what, since the notional value of insurance written vastly exceeded the actual amount of bonds in default. Perhaps they will establish daily auctions to match defaulted mortgage debt to the lucky insurer? I have this sinking feeling that default insurance will end up like portfolio insurance - a great financial engineering concept that just doesn't function under the stress of reality - but thanks all the same for the premium income!
Brought to you, if certain informed participants are to be believed, by homeowners who are paying subprime interest rates even though they could have qualified for a prime interest rate. At least some of these borrowers are failing not because they were poor credit risks, but because they got charged too much.
Indeed, thanks for collecting all the premium income. I'm sure young families trying to pay 50% of gross monthly income on the mortgage payment are happy to have helped out.
Once again I look into my heart and find no sympathy for the vultures.
It looks to me what Bear is trying to do here is repurchase loans out of existing securities when they are in the early stages of delinquency.
This would allow them to stop advancing on these loans and effectiveley have them treated as paid in full loans. This would help the securitization by reducing the delinquency rates.
Bear then owns this loan on it's books. And can modify it as it pleases.
They can then, if they wish resecuritze these types of loans in some way.
Their postion here is that they are cutting their losses by buying out now.
The Hedge funds don't like this because the longer the bad loans stay in the securitization the more money they can make.
When hedge funds take a position they are large enough to move markets. BearS also has positions large enough to move markets. BearS uses market transactions to enhance their positions. The Hedgies cry foul because well... because the market moved due to ummm... well.
Think of it like a poker game, except nobody knows how many decks of cards are being used, so nobody knows what actually constitutes a good hand, so it becomes nothing more than a game of bluff and raise. Problem with this game is the loser of each hand is then handed a revolver, with an undetermined number of bullets in the chamber, and told to move to the roulette room.
Wow, looks like my interpretation of the article and the accusations is completely different than most, the reporter may be responsible for some of the confusion.
My interpretation is that the "triggers" in the various the swaps in question are based on the ABX indexes which are easily manipulated due to the illiquid nature of the index itself. Accusations have been in the marketplace for sometime that the ABX indexes have not accurately reflected the value of the underlying securities in the secondary market.
The accusation, as I see it, is that BS, to support being on the other side of the trade in regard to the hedge funds, has determined due the illiquid nature of the ABX indexes, that is is far easier and less costly to move the "trigger" index as opposed to potentially settle out the swaps, even if it represent overstating the value of the actual collateral backing these loans in the secondary market based on current default rates.
As to the manipulation charge, think of it in terms of the rhetoric and hoopla surrounding Reg SHO and smaller illiquid companies and the claim that due to the underlying floats the securities were easily manipulated and depressed thus not accurately reflecting the underlying value and artificially controlling the value in the marketplace for one's benefit, the same allegations are being made here in my opinion, only in the opposite fashion. The other potential pitfall are the various issues surrounding the potential for the upcoming IPO amongst a long list of others.
The hedge funds are crying foul because Bear is their prime broker and probably knows their positions.
Somewhat related to investment banks organising concert parties to attack smaller funds (hold a cocktail party for a bunch of funds and say, for example - there's one fund that's overextended in natural gas futures, maybe you should all attack it)
In any case, my sympathies lie more with witless anchovies than sharks in a feeding frenzy.
this is where the Fitch report gains importance with the assumption that hedge assets would potentially all become correlated in the event of a credit event.
I see your point but it looks like Bear is trying to maintain the perfomance of their products at expected levels and the anchovies are getting various forms of debt relief in the process. The Hedgies seem to be complaining that these products are performing as expected because Bear is looking after their interests.
Are you saying that Bear is acting poorly because they are shoring up their own position and the only fair thing to do is let their products fall in value so that hedge funds can make money?
Should I miss a creditcard payment deadline so the ccard company can make the money they statistically expect? Isnn't my paying on time a way of moving that market?
It looks to me what Bear is trying to do here is repurchase loans out of existing securities when they are in the early stages of delinquency.
Well, see, that's the thing. Fannie and Freddie can do something like that. They guarantee their MBS. Nobody ever takes a principal write-down on a GSE MBS, so nobody suffers when delinquent loans are bought out of the security by the servicer: it's just principal return to the investor, and maybe it's 30 days sooner than it should have been, but in my experience that's the extent of any uproar over it.
But how the hell does Bear get to buy delinquent loans out of a security that it does not guarantee? This is the part I don't understand.
That's why I assumed they must be treating them as repurchases for violation of contract. Are you telling me they have the right in these ABS deals to buy back loans just because? Well, in that case the sale of the loans to the security trust must have included some form of recourse. Enter the accountants. If Bear has the right to buy individual delinquent loans out a deal for any reason other than warranty for defect, then Bear owns a big boad load of liability. Did we know about that? No wonder Seidman is a bit pissy.
Is your Adelphia comment referring to subrogation? I haven't looked into it but it seems like subrogation should only apply to a real insurer who has insured an insurable interest. As far as I know the ABS are nothing but side bets.
Two points from my experience as a junk bond fund manager many moons ago. The ABX index is probably comprised of not that many bonds so it would be easy to buy a few of them to move the market. Especially since these sorts of bonds are not very liquid. If the word gets out that there is a big buyer in this type of security, all the selling dries up FAST. They could move these bonds up by 10c on the dollar any time they care to. And if people do that, the index no longer reflects the market.
Here's where Bear gets lots of bang for the buck on this one. They are on the other side of the CDS trade. There could be BILLIONS of dollars out on the CDSs as both speculators like hedge funds and perhaps smarter real estate players do something to hedge real estate exposure. So Bear can wag the dog just by letting it be known that they are willing to buy a few of these bonds here and there. They avoid big losses at a cost that is chump change for them. Brilliant, really.
I suspect " Glen | 06.07.07 - 10:32 am" has it right. When I first read the WSJ article, my thought was, "Won't they lose as much on the mortgages as they gain by avoiding loss on the swaps?" But I was forgetting that the volume of "swaps" (a misnomer -- it's really insurance) sold is not limited to the amount of the securities insured. If Bear has sold $100 of insurance on $10 of debt, it has a 10:1 payoff from preventing the default.
Imagine if hedge funds were able to buy billions of dollars of life insurance on you, and Bear were selling the insurance. It would be well worth it to Bear for them to surround you with a security force rivaling that around G. W. Bozo.
OT--the home builder stocks are breaking down today, even though there were oversold coming into the day. Evidently, the combination of higher 10-year bond yields and the MTH warming are having an effect.
This may be very significant, as according to Jim Stack's Investech.com, the RE stocks are sitting on significant resistance that they did not break during last summer's downturn. If resistance really breaks, the downside might continue sharply. Financials are also looking very weak today.
The reason the hedge funds are mad is that BS has essentially made (to use the example above) a $100 bet that someone would buy the underlying asset for $10... and when it didn't look like anyone would, bought it themselves for $10, and told everyone else to pay up. What's more the hedges are upset that they didn't think of that first!
Yes, Bear acting irresponsibly if they are trading on inside info. At same time, I don't care if the hedge funds shorting the ABX lose money.
(My anchovy comment was misplaced in this context - nobody's an anchovy here. I think I just found the metaphor amusing)
Anyway, who really knows what's going on here. I suspect there's lots of insider trading going on anyway, so some parties purposefully lose money and get kickbacks from the winner.
My guess is BS is on both sides of credit event with different set of counterparties. Surely sounds like a risk management strategy except amounts on both sides are not equal. So there is an incentive for BS to take loss on the side with smaller amount. However it is surprising to me why Hedgies cried foul instead of taking advantage of BS's seemingly willingness to take loss at one direction of trade. Surely WS can entertain us with a new round of financial innovations to make BS's loss mitigation actions more expensive. Eventually BS has to stop.
Just to clarify, it does seem from WSJ that Bear is buying back underlying mortgages rather than bonds themselves. Having said that, I still think the logic of my 11:27 post stands... they move the bonds up when they buy back a few mortgages, which in turn moves up the index.
Jim is correct - The fact is, BS can overpay to buy distressed mortgages, then end out ahead in the options contracts... of course part of this is speculative on BS part because they don't know what the severity of loss on the mortgages will ultimately be.
I was an analyst when the CMBX index was released (protection on commercial mortgage backed securities) last year. A big concern was that this type of quasi-arbitrage situation was never allowed, like it is in the residential bond market (in fact many of the other analysts were speculating it was already happening with non-public purchases in the residential market since the buyer-name is NOT public). As a result CMBX has an disclosure rule where CMBX issuers must give a 30 day public notice before purchasing the long position.
Also in regards to lack of liquidity, residential has nothing on commercial. I would guess a cmbx contract trades about 15 times per week... and when I say a cmbx contract I don't mean a specific contract... I mean the sum of every trade amongst all contracts comes to 15 times per week.
Kudos to the guys who packaged the CMBX. As an aside, big traders do manipulate the Dow 30 and the S&P500... for a few minutes at a time, but no one has the money to peg the big indexes on a sustained basis. The people who constructed ABX did not pay enough attention to susceptibility to manipulation and they risk having the index become a useless "indicator" of market values.
Well, I found it amusing. I always root for the underfish. I am also only one of two people I know who likes anchovies. Give me a plate of anchovies in olive oil, a decent loaf of bread, and a jug of some brash young wine, and I'm a happy little camper. (I must say it does make for an, um, redolent hangover the next morning.)
The problem of deciding who is the underfish in all this is, of course, the big deal. I would personally counsel all those consumers who are trying to make their mortgage payments but can't get the servicers to work with them, because it might or might not screw some [obcenity] hedge fund, to march on Washington.
Thanks for addressing this difficult and seemingly mysterious topic. For many years it was (mostly) easy to understand enough about stocks and bonds to have some sense of what was happening and why. With the dawn of the age of derivatives and hedge funds etc. that basic understanding is under steady assault. You and your more knowledgeable readers give a bit of hope that all this murkiness will one day be made clear.
BTW, you wrote above:
"Are you telling me they have the right in these ABS deals to buy back loans just because? Well, in that case the sale of the loans to the security trust must have included some form of recourse."
It isn't clear to me why that would be. Suppose I write a contract that says I have a "call" on an asset I sold to you, but you have no right to "put" it back to me. Why would that give me a liability?
What I like is the idea that Bear Stearns buys mortgages out of the pool to protect [something] and then resecuritizes them.
It's as if they are blaming each other for not understanding who's supposed to get hurt in this feculent criminality:
Look, Paulson, you don't understand who's supposed to get hurt. It's the little guy: either the shmuck who's going to lose his home, or the shmuck who's pension fund just bought the equity tranche of our garbage. It isn't you and me. Got it!
It looks to me (and I am as confused as anyone) like BS got caught with their hand in the cookie jar. They were attempting to manipulate the CDO market as described above by (1) buying loans which were not covered by the recourse provisions and/or (2) buying loans for which they were not the originator.
I think the Aldelphia auction was a hasty gentleman's agreement (or shark's agreement if you prefer) to assign collateral among competing "insurers", and required that the counterparties agree in advance not to dispute the lottery assignment. The first problem is in calling it insurance - it's really a put option, but you can sell it to the average pension fund trustee if you call it insurance instead. I guess all of the pension fund trustees who bought portfolio insurance have either retired or are succumbing to collective amnesia. Secondly, the settlement mechanism has yet to really be tested. Given the massive imbalance between notional derivatives and the physical delivery requirement for settlement, some sort of cash settlement will have to be hammered out, or this market will crumble into legal chaos.
Is it just me, or is Bear propping up a bad position by adding to a bad position? It may work for them today, but it's still a long way until bonus time...
It isn't clear to me why that would be. Suppose I write a contract that says I have a "call" on an asset I sold to you, but you have no right to "put" it back to me. Why would that give me a liability?
It would depend on how you accounted for your "sale." FASB says if you can take it back like that at no penalty, it's not a "true sale," but a financing. So by "liability" here I meant at a certain point such a contract would keep risk on your books, not transfer it to the buyer's books.
wow ... I can t help. I need help reading you. Gee is this how complicated it got ?
I stayed at level 1 : money creation lead to higher asset prices instead of higher consumption good prices because all other policies (trade, labor, budget policies) were hostile to workers. THe asset price boom is credit backed. Once debt reaches some limit, all lenders and borrowers will panic and debt deflation will follow.
As near as I can tell the posters rj, NJMortgages and sunlight have illuminated the situation pretty well.
The fact that it involves derivatives makes the situation seem more complex than it really is. I would simplify it like this:
The hedge funds are "short" because they thought things were going to be worse, Bear Stearns is "long" because they thought things were going to be better. Now, Bear is trying to change the "deal" (by manipulation of the make-up within a derivative) to avoid large losses on their position, which the hedge funds don't like because it will reduce their profits on the trade.
I've read about stuff like this before, I think it happens all the time on Wall Street, one crook trying to take advantage of another.
Is it just me, or is Bear propping up a bad position by adding to a bad position? It may work for them today, but it's still a long way until bonus time...
Turbo
No, no, no, Turbo. With immense respect, you're wrong, I believe.
Bear is going to securitize the crap they are buying and sell it to suckers.
That's what they do. Vultures eat dead animals. E. coli colonizes the colon. And Bear Stearns sells worthless sh*t to suckers.
I see the problem with Bear Stearns strategy as this. They can prop the prices up for a while by buying out delinquent loans.
However, If rates keep moving higher as they are today they will be faced with a greater delinquency problems when these loans reset even higher in the months to come.
Higher rates will mean less buyers to qualify for mortgage to purchase new homes. Real estate Prices will have to continue to fall to help offset this.
Lower real estate prices mean more foreclosure loses on these securitizations.
Personnally, I wonder if Bear is trying to prop-up MBIA and AMBAC the bond insurers. These two compnaies stand to lose the most if they are required to fund pool underfundings.
Tanta posted on this several days ago.
If these companies start to have going concern issues the whole securitizations start to unravel.
Where does this leave the Bond holders then?
This seems to be the scenerio the hedge funds are hoping for.
Couldn't the hedgies work the derivative leverage the other way? For instance, to counter this, couldn't they offer actual homeowners money (to compensate for credit-rating damage) to stop making their mortgage payments?
If I understand the leverage argument, this would cost them less than the large leveraged swings in the index would bring them.
(Kind of like bribing one of jm's bodyguards...)
(Please note I'm not advocating such behavior, just trying to make sure I understand what's going on here.)
Couldn't the hedgies work the derivative leverage the other way? For instance, to counter this, couldn't they offer actual homeowners money (to compensate for credit-rating damage) to stop making their mortgage payments?
Funny you should bring that up . . . every mortgage loan purchase contract I've ever dealt with has a "nonsolicitation clause" in it. In essence, it prevents the seller of loans from soliciting the borrowers for refinance--you can't sell a loan for 102 and then call the borrower (whose phone number you have; you just originated a loan) to talk him into refinancing so that the buyer of the original loan is stuck with a loss and you get to sell a new loan at 102.
I know you're describing something rather different; I'm simply pointing out that on the mortgage side of this, people have been dealing with perverse incentives and bad faith problems for a long time, and have formed standard contractual language to prevent or mitigate it. I am therefore mildy amused at the idea that our overlords on Wall Street seemed to have been caught with their counterparty risk pants down. They were more trusting souls than a mortgage originator? Holy mackerel. Or anchovy. As it were.
If the CDS sellers were actually given access to the mortgage servicers' database--which they aren't--your scenario would undoubtely materialize.
NJM, it depends on the size of the issues that underlie the index. There is a total of 20 CDOs in the ABX BBB- Index, which I believe is the vehicle at issue here. Suppose the average bond has a total issuance of $150 million... we are talking about $3 billion in total principal amount.
underlying the whole index.
If you read the annual reports of the private mortgage insurers you know that when a loan actually defaults they take an average loss per loan of 25-30%. Soooo...
Let's assume a doomsday scenario of 40% of the underlying mortgages default, and that Bear actually eats 30% per loan... so Bear's loss would be 12% of the total outstandings (40% of 30%) or about $360 million. Can Bear afford that? You bet. Is it worth it to them if they are big on the other side of CDS's? Probably. Will it get that bad? I wouldn't bet on it, even though I agree with the editors and most of the readership here that housing is worse than the MSM says it is.
My request is that folks read the section "Close Call" in the post "Safety Net IV" (August 7, 2006). I believe yesterday's FASB comments imply a serious risk that Fannie (and perhaps other players) will soon be asked to sell additional stock up to nearly doubling of their market cap in order to satisfy the sales accounting problems Leslie Seidman is talking about. After all, the nightmare scenario spoken of in April 2005 of an additional $30 billion of Fannie capital may not have been such a stretch as thought at the time.
I'm at a $500 million Foundation and got a cold call on Tuesday from Bear Sterns. VERY UNUSUAL. First most of these calls are about building a relationship. This call was a direct solicitation of CDO's. No prelude. Second most big houses are very careful about due dilligence and "sophisticated investors". The day before I got a 3 page legal doc just to be able to receive info on structured products. I got the feeling the BS guy was a trainee they put on the phones to make cold calls. At the time it reeked of desperation and then I did a search and discovered Evergreen and then the next day the hedgies start complaining and the FASB starts squirming.
Methinks BS is holding a sackload of sh$%^t and the fuse on the financial bomb is getting very short. It looks to me like BS is in a very bad position. They either hold the bag when the finfnacial bomb goes off or after the fact it becomes very apparent that they were pushing the stuff to investors who should not be - ie small pensions and endowments
I think the comments have been close to the key issue, but let me state it clearly.
The hedge funds have a position that is long CDO equity and short the ABX, where the latter position is 5x the former. The position has positive carry in normal times because the payment to equity is high relative to the cost of protection purchased, and goes in the money when subprime spreads blow up.
The key insight is that the "bag holders" are not the owners of CDO equity tranches, but whomever sold them all this protection on the ABX. That is likely the investment banks.
The investment banks can avoid paying these huge losses by taking bad loans out of the pools underlying the ABX, which makes them perform better. Spreads tighten, and the hedge funds lose their paper gains.
Now it seems implausible that Bear could do this all on its own. It is only 1/20th of the ABX. But if investment banks coordinated these repurchases, they could avoid serious losses.
The issue in the background is that the hedge funds were betting against subprime because of reset risk and a slowing housing market. The EPDs on the 2006 vintage were a pleasant surprise that gave them their gains earlier than they throught. If the i-banks are just making good on reps and warranties that they never had to make good on before, I don't see the big deal. Hedge funds might lose their unexpected gains, but unless the i-banks are going to repurchase all of the resets, they will still make a killing in the end.
looks like there is a lot of confusion on this -- hope this helps...
basically the manipulation part comes into play as folks were allegedly scheming to sell protection and subsidize the proceeds to buy out loans - they blatantly talked about it in vegas at the ASF convention - not just bear, every dealer on the street at least thought about it out loud --
idea is you inflate your CDS positions on your derivatives desk, have your mortgage servicer (which sits behind a chinese wall of course )buy back loans where default is "reasonable forseeable". thats the grey area here, and that has not yet happened. loans that have been bought back are loans that have already defaulted one month -- what some firms are proposing to rating agencies, is buying back loans before they default. paulson and others want to assure that servicers are telling their brothers on the derivatives desk to sell protection till they are blue in the face. they take the hit on their balance sheet but profit on the swap.
If they put on a CDS position in large size even if buying out loans is noneconomic for the underlying deal, the effect on the CDS is significant both on a MTM basis and in terms of triggering the swap payout.
Paulson and other macro funds have massive positions both in single name CDS as well as the ABX ---its been said that they doubled up by buying protection on the ABX as well as the constituent names that make up the index hence why they are so pissed that the deals in the ABX may not have writedowns after all - they lose after. Dealers and credit intensive hedge funds that think the whole subprime meltdown is overblown have a distinct interest in propping the ABX up for soooo many reasons
Every time they issue a synthetic CDO, they use the ABX to delta hedge every time it widens out their gammas are screwed and they lose money buying more single name protection to adjust their hedge. ( you can see how many moving parts there are to this whole thing)
The CDS contract and the ABX which is structured to mirror it, is triggered when the OC cushion is released on the deal this happens as writedowns occur. No writedowns, the contract does not have to pay out and on a mark basis, the contract can be valued in favor of the protection seller.
ISDA is in the process of discussing with members whether or not an amendment is necessary to the template
Paulson has proposed that the current ABS template be amended to include language that would prohibit the seller of protection from purchasing loans or any other action that would improve the trust's performance or decrease the floating payment based on information gleaned from other areas of its firm. The letter was written in response to a proposal made by Bear Stearns to ISDA, and sent to clients to reiterate that sellers of protection may wear other hats with regards to the underlying and may act in accordance with laws governing those roles.
Some years ago on a trip to the Sea of Cortez, I had a Mexican fisherman explain to me how, when he gaffed a shark into his boat, he would slit its belly so that it could chew on its own entrails -- thereby sparing his legs. More or less the same thing that's happening on Wall Street, no?
Just to follow up on rcryan's comment on the cash settlement issue; I blogged about how credit derivatives trades take forever to get cleared back in February at my post Source of market risk under the radar. The post includes a quote from the Daily Institutional Investor to the effect that "it took the largest banks 44 days to confirm a basic credit derivatives trade and about twice that for complex deals"...referring to the time frame between November 2006 and March 2007. The same II story mentioned that at 3-31-07 there were 74,000 trades executed that hadn't been cleared...in my mind that is a significant source of liquidity risk.
So there are a lot of recent trades that haven't even cleared, much less reached any kind of cash settlement. It's mind-boggling to realize that the CDS market makers don't have any system in place to essentially process insurance claims.
Thanks Anonymous - that is very helpful. I have one question:
You say : "Every time they issue a synthetic CDO, they use the ABX to delta hedge every time it widens out their gammas are screwed and they lose money buying more single name protection to adjust their hedge. ( you can see how many moving parts there are to this whole thing)"
Most of the ABS CDO deals have been cash not synthetic haven't they? I would have thought most delta hedging would be done by investors who are long CDO tranche/short ABX hedge??
This has to be one of the best threads of the year ... Tanta is asking the right questions, and the quality of the responses is top-rate. I learn more here than anywhere else on the web.
This derivative stuff is way beyond my skill set, but I'll share one observation made recently when deciding how to invest a small amount of cash in an IRA, with a large institutional investment house. If you are curious, the name starts with a "V" and rhymes with "plan-charred".
Being a conservative type, I wanted to put the money into a bond fund, preferably US treasuries, for a nice conservative 5% return. However, in reading the prospecti online, I kept noticing a lot of fine print with the terms CDO and MBS. Even in funds with innocent sounding names like "US total bond market fund" and "Treasury fund." Not wanting to end up a bag-holder for some toxic waste from an i-bank, I decided to put my money into an international stock fund. However, I thought it was odd that every single bond fund available to me as a small retirement investor had some reference to holdings of mortgage-backed securities.
If this thing blows up, I have a feeling that a lot of anchovies are going to be in for a surprise when they open up their 401K and IRA statements.
I could be missing the point, but "all this" this strikes me as relatively simple: the CDS seller gains liquidity up front in exchange for transferring mortgage default risk to the buyer. The buyer gains the right to later payment should a "trigger event" take place, meaning a default. Both buyers and sellers are engaging in a complex game of arbitrage.
The CDS index in question here tracks these sorts of transactions, and the value of a CDS contract drops if the risk of mortgage default materially increases.
Which gets us into the conflict of interest: what if a market participant could artificially prop up index values, thus keeping the trading balance in its favor?
Well - not surprising to me given how incestuous most of the secondary market is elsewhere - there is just such a way: servicers holding the MSRs on a pool of loans have the right to purchase troubled loans out of a pool under certain conditions.
So what happens when that servicer is captive to the Wall Street issuer? That servicer does what its trading desk requires, and purchases loans out of the pool that would in theory cause a "trigger" event.
P. Jackson...if you are correct, those who've sold insurance would have a big incentive to buy the servicers and bring them in house...to a desk right next to their trading desk.
Just realized I completely foo-barred my original comment. Reverse what I said, and be careful what you write when having some whiskey.
So if Bear Stearns is making "payments" to whomever holds the swap, and receives "payment" in the event of a credit event, under certain circumstances it has a strong incentive to buy out troubled loans en masse. ("Payments" is in quotes because a cash settlement is rare.)
The "why" here is not as straightforward as you might think, but starts with the realization that Bear Stearns cannot control the existence of a credit event (they might be able to influence the timing, but that's another issue).
Instead, Bear Stearns might be able control something infinitely more important: the cost of engaging in a swap transaction to begin with. And that's a much, much larger factor when it comes to bond issuance.
By buying loans out a pool, Bear Stearns forfeits the "payment" it would get in the event of a credit event. But consider that it's essentially "paying" for CDS contracts at a pooled level -- most of which will not default -- and it can make more sense to keep the cost of selling swaps down than it does to simply reap "payment" whenever a credit event occurs.
This is especially true in a market where the underlying assets are flat to declining in value, and the number of credit events is experiencing an rapid increase that would lead the cost of swaps to outstrip whatever little recourse would come from from "collecting" on those credit events.
So, I think the argument here is that by allegedly moving to keep the cost of selling a swap low, the indices tracking the swaps market are artificially inflated and don't reflect the true cost of engaging in a swap transaction.
So if I've followed this correctly so far, any investor that took a short position expecting to see the cost of swaps increase (and the associated index take a nose dive), is going to be pretty pissed that Bear Stearns is "manipulating" the market such that their short positions aren't as profitable as they'd be otherwise.
Worse yet, Bear Stearns is alleged by some to have been going long on these same markets, making it so it could profit on both ends of the deal -- swaps stay manageable, and its bet that this would be the case nets it additional bond yield.
Look back at Adelphia, they had use an auction process to determine who settled what, since the notional value of insurance written vastly exceeded the actual amount of bonds in default. Perhaps they will establish daily auctions to match defaulted mortgage debt to the lucky insurer?
This reminds me of playing Pai Gow Poker in a card room in Oakland about ten years ago. The first time I played I noticed that each table had a compass embedded in it (the little magnetic kind that point north) and assumed it must have something to do with Feng Shui. In each round one player was the "bank", and played against all the other players. Under the rules of Pai Gow the bank has a slight advantage. If the bank didn't have enough money to match all the other players other people were allowed (before the bank's hand was revealed) to be "second bank" (or even third), meaning you got the action on the bank hand after the first bank's stake was used up (and you didn't have to pay the normal vig, so you had actual positive expectation value). Because each hand was resolved in turn it was possible for the first bank to get wiped out (say the first 3 players had good hands) but second bank could wind up winning (if the remaining players had bad hands). Which leads me back to why they had compasses in the table--the order of the resolution of the hands is determined by rolling dice in a sealed cup, apparently the easiest way to cheat was to use magnets to manipulate the dice.
Tanta (and commenters),
Thanks for posing this gobsmack so constructively. Unless our Congress gobsmacks us, this will probably be among the threads of the year, anywhere.
I suppose that since all Paulson has done is write a complaint letter to a regulator, he doesn't have to supply any evidence of intent by Bear.
Josh, thanks for the NY Post link. That's one more piece (in addition to the Financial Times) to argue that the accusation here involves loan modifications, not loan purchases. So I continue to not know whom to believe.
Maybe Bear is buying specific ABS bonds to prop up the ABX, putting them on-balance sheet, and then moving to aggressively modify problem loans in order to keep the value of those bonds up.
I have no idea how much of the tranche Bear would have to own to be able to unilaterally move to modify individual loans, but maybe thy're buying up the whole thing, or maybe there is a threshold built into the prospectus?
Tanta,
My understanding is that Paulson's hedge fund has a big on ABX CDS's. That is, they own the credit protection, and folks like Bear are short of it. That entitles Paulson to be paid out at par in the event of a "credit event" that causes a decline in the value of the underlying bonds.
Basically, Paulson is accusing Bear of buying up the underlying ABX BBB- bonds, which in turn supports their price and in turn the index. What does Bear do with those ABS? Well, for one thing its trying to market it as a toxic-waste CDO fund geared towards individual investors. For another, it keeps the ABS on its books, waiting for the day when a rating agency downgrade finally forces them to mark the ABS down.
The real question is, why does Bear have an interest in propping up the ABX index? They said all over their last call that their exposure to subprime is minimal.
I think the main reason is that they are the prime broker to lots of fixed income hedge funds that were on the wrong side of the ABX trade. We haven't heard of any of these going under, which is nothing short of amazing. Perhaps this is just Bear's way of trying to make sure these hedge funds can pay back their margin loans/repos. At the end of the day, these repos are the mother's milk of the credit bubble, and Bear and Lehman have grown their balance sheets 20% sequentially of late to accommodate the explosion of hedge fund balances.
Tanta,
Just one more clarification: the holder of the CDS gets paid the difference between the written down principal and par. So the lower the ABX goes, the lower the market expects the underlying bonds to be written down, and the more Paulson gets paid. That's how they can be "long" something and profit when it falls -- they are long the insurance.
I'm wondering if litigation seizure is the biggest risk to financial markets right now? By that I mean risk premiums explode higher (ie. return to some semblance of normality) when parties to credit insurance recognize that this doesn't settle neatly and predictably like financial futures, but could in fact be subject to drawn out litigation with an uncertain outcome, like (surprise, surprise) any insurance contract when the stakes are high enough.
Basically, Paulson is accusing Bear of buying up the underlying ABX BBB- bonds, which in turn supports their price and in turn the index.
Thanks for educating me, David. I think I understand what you are saying.
What I'm not getting, I think, is the "manipulation" part.
Is it a hopelessly naive question to ask why the hedgies think this is "cheating"? (This is a separate question from what hell Bear is up to and who it's trying to lay this crap off on.)
I guess I keep coming back to the same question, whether we're talking mods or buybacks or ABX trades: what makes these people think that no one will ever attempt to "manage" risk?
The answer seems to be that everyone thought they were entering contracts that forbid the counterparty to take active steps to mitigate loss.
That is the most mind-numbingly stupid thing I have ever heard.
Wall Street appears to be hell-bent on destroying the residential mortgage market in order to "protect" it. Gee, thanks, guys. We did better when you didn't take the risk off our backs.
The CDSs written for a given instrument often total 1000% or more of the value of the instrument. These trade now more like options than insurance.
So part of the answer could lie in, who wrote the CDSs? Did Bear Stearns write some? Almost certainly. Maybe they are protecting their own trades?
Tanta,
the answer, and David gave you a good response, is the actually illiquidity of these indexes, and the potential for manipulation.
when parties to credit insurance recognize that this doesn't settle neatly and predictably like financial futures
You mean when they figure out that the collateral is, um, mortgage loans, not corporate junk, and that, um, there is a giant social and political and regulatory stake in the the mortgage market that predates these hedge masters by a few decades? They thought they were going to be allowed to let all this "cash settle"?
How are we coming with the head-banging pillow?
is the actually illiquidity of these indexes
I suppose I'm being dense, but I still don't understand why that's the answer instead of the question.
How old is the ABX index? Who thought it was liquid? Why?
Tanta,
David Pearson may well be correct, but the WSJ teaser refers to accusations that BS is buying the actual mortgages, not the bonds.
The Sure Bet Turns Bad - WSJ.com
ozajh, I think we have three problems in play here: modifications, repurchases of mortgage loans, and "hedges" of those mortgage securities (CDS, debt-funded CDOs) all of which are real and all of which, for our watchdogs in the press, are interchangeable.
I get about five consecutive minutes where I think I understand something, and then I read something else and I'm back to head-banging . . .
The manipulation accusation stems from the thesis that the mortgages being purchased by Bear cannot feasably be modified to be made viable, i.e. they're too far gone. Ergo, Bears purchase appears as an attempt to 'prop' up the ABX BBB- tranche, because the probability of acutually turning a profit from these loans seems very small. The WSJ article implied that Bear was a big seller of the protectin there.
There seems to be a lot of smoke here.
It's good to remember that the House of Bear was adamant last year and before that there was no little or no excess taking place in the mortgage market. They been caught wrong footed, as the Everquest IPO exemplifies.
Add the Paulson accusations to the mix and one can surmise that there is much fire behind the curtains, or I should say in the VIE's.
Tanta-
They thought they were going to be allowed to let all this "cash settle"?
My understanding is that CDS do NOT cash settle. Although I think there have been efforts to establish some sort of system to allow cash settlement.
There have been several cases in teh past where there have been runs on the actual bonds near or in default because there have been more CDS written than actual bonds.
If this is the case, could give incentive to Bear Stearns to manipulate underling?
They thought they were going to be allowed to let all this "cash settle"?
Rob, that was a possibly unfortunate rhetorical flourish; by "all this" I meant the mortgages as well as the bonds and the swaps.
One way to look at the whole "modification" uproar is that it's a bunch of people who think the best strategy is to liquidate, or "cash settle," what are mortgage loans for people's homes. My point, I guess, was if some of these parties thought the regulators were going to allow that without any, um, "intervention," they were drinking good bong water. It's not the same social or political or financial thing at all as letting some junk-rated corporation go BK.
That aside, I have been told repeatedly that the CDS do cash-settle and everyone was planning on them cash-settling.
Let me ask a related question.
Suppose that I am the manager of a securitized pool of mortgages. Can I sell individual mortgages out of that pool? The proceeds would be (presumably principal) income to the pool and disbursable as such. If so, to whom can I sell them? It would have to be an arms-length transaction, I assume.
Now, suppose Bear Stearns has an interest in propping up the price of some derivative from my pool. If Bear Stearns approaches me to buy some of the individual mortgages at a price above what I think they're worth, would I not sell them? Bear Stearns would then have to dispose of those mortgages at a loss, but the rise in value of the derivative might overweight that.
Such behaviour might be regarded as manipulation.
Tanta-
I'll bow out now as I'm getting way over my head, but cash settlement still seems to be ad hoc - see below:
Corrigan: Cash Settlement a CDS Missing Link
28 May 2007
Securities Industry News
Goldman Sachs Group managing director and systemic risk expert E. Gerald Corrigan, who led the Counterparty Risk Management Policy Group initiative to resolve problems in post-trade processing of credit default swaps (CDS), believes one of the panel's central recommendations still needs attention.
During the Federal Reserve Bank of Atlanta's conference on credit derivatives two weeks ago in Sea Island, Ga., Corrigan said that the policy group's prescriptions for reducing CDS confirmation backlogs and bringing order to assignments or novations of the instruments have been successfully met. But a uniform cash settlement process for actual defaults, or credit events, has yet to be fully realized.
Speaking to reporters, Corrigan said that such a cash settlement mechanism is "not fully institutionalized," and it needs to be in place "sooner rather than later."
Over the last two years, Corrigan estimated, there have been eight to ten reference-entity credit defaults--auto parts companies Collins & Aikman and Delphi Corp. and the Delta and Northwest airline bankruptcies among them--that prompted a cash settlement procedure. These events posed varying degrees of difficulty, according to a paper presented at the conference by David Mengle, head of research at the International Swaps & Derivatives Association (ISDA), which has proposed a protocol approach for managing the multilateral complexities of large-scale defaults.
In Corrigan's view, "We have successfully muscled through the settlement process in the aftermath of defaults and gained a great deal of experience in how to manage these situations." But he is still looking for a "single ISDA-type protocol" that puts a uniform and fully institutionalized cash settlement mechanism in place for future eventualities. He said the possibility of a "large-scale default and multiple defaults" is the "great imponderable" that could make it far more difficult to just "muscle through" on an ad hoc basis.
I get about five consecutive minutes where I think I understand something, and then I read something else and I'm back to head-banging . . .
Me too! But thank you for putting it so plainly. And isn't this the point in the show when "magic" (i.e., deception) occurs?
Buying troubled mortgages out allows the deal to pass triggers when it otherwise won't (and the mezz wouldn't get paid until the seniors). If the triggers are performing, then the CDS is worth more, which they need to stay tight to keep both the CDS they own and in CDO deal pipeline from spreads blowing out. thank you.
the manager of a securitized pool of mortgages
Well, see, if the security in question is a REMIC, then you aren't the manager of it because of the Q election, which means it's a static ("brain dead") pool. The only way the trust can "sell" a loan is to put it back to the sponsor under contractual reps/warranties.
If the "security" in question is a CDO, then yes, it's managed, but the manager would be selling tranches of securities, not underlying mortgage loans.
I personally have zero experience with a mortgage-backed security that allows the trustee to hold the loans for sale as opposed to holding them to maturity. This would undoubtedly be part of what's bugging FASB, if those ABS (non-REMIC) are set up to allow that.
In any case, yes, sales gains would belong to the trust. I'd be more puzzled about the accounting treatment of the loans pre-sale. If they're HFS they are subject to MTM. That'd be one reason why investors prefer static pools.
I'll bow out now as I'm getting way over my head
No fair! If I bowed out every time I was over my head, we wouldn't have a blog to comment on. Nobody gets out of this one by claiming to be drowning in confusion. Who isn't?
Buying troubled mortgages out allows the deal to pass triggers
Thanks, regular reader, but I'm still confused about what kind of deal you're talking about and at what level we're talking about buying individual loans.
This is my current five minute confusion: who gets to hold securitized loans for sale?
Ok,
Say BS created $100 of derivatives on $10 of underlying debt. Now 20% of those underlying assets are worthless. Depending on the way the derivatives contracts are written, the loss on the derivatives from that swing will likely exceed the 20% drop in the underlying asset. This is the vicious side of leverage. So, by buying out the $2 of non-performing debt and taking the total loss on it, and not selling it, they can stabilize the market price for the remainder of the debt, and prop up the derivatives.
If it feels like you've entered a hall of mirrors, it's because you have.
Buffett keeps on looking smarter every day, by the way. For those who haven't, go back and read his 2002 through 2005 letters to shareholders, where he talks extensively about the risks in derivatives operations.
Look back at Adelphia, they had use an auction process to determine who settled what, since the notional value of insurance written vastly exceeded the actual amount of bonds in default. Perhaps they will establish daily auctions to match defaulted mortgage debt to the lucky insurer? I have this sinking feeling that default insurance will end up like portfolio insurance - a great financial engineering concept that just doesn't function under the stress of reality - but thanks all the same for the premium income!
but thanks all the same for the premium income!
Brought to you, if certain informed participants are to be believed, by homeowners who are paying subprime interest rates even though they could have qualified for a prime interest rate. At least some of these borrowers are failing not because they were poor credit risks, but because they got charged too much.
Indeed, thanks for collecting all the premium income. I'm sure young families trying to pay 50% of gross monthly income on the mortgage payment are happy to have helped out.
Once again I look into my heart and find no sympathy for the vultures.
Tanta,
It looks to me what Bear is trying to do here is repurchase loans out of existing securities when they are in the early stages of delinquency.
This would allow them to stop advancing on these loans and effectiveley have them treated as paid in full loans. This would help the securitization by reducing the delinquency rates.
Bear then owns this loan on it's books. And can modify it as it pleases.
They can then, if they wish resecuritze these types of loans in some way.
Their postion here is that they are cutting their losses by buying out now.
The Hedge funds don't like this because the longer the bad loans stay in the securitization the more money they can make.
[The dumb kid in the back raises his hand.]
When hedge funds take a position they are large enough to move markets. BearS also has positions large enough to move markets. BearS uses market transactions to enhance their positions. The Hedgies cry foul because well... because the market moved due to ummm... well.
Is that about it?
Think of it like a poker game, except nobody knows how many decks of cards are being used, so nobody knows what actually constitutes a good hand, so it becomes nothing more than a game of bluff and raise. Problem with this game is the loser of each hand is then handed a revolver, with an undetermined number of bullets in the chamber, and told to move to the roulette room.
Wow, looks like my interpretation of the article and the accusations is completely different than most, the reporter may be responsible for some of the confusion.
My interpretation is that the "triggers" in the various the swaps in question are based on the ABX indexes which are easily manipulated due to the illiquid nature of the index itself. Accusations have been in the marketplace for sometime that the ABX indexes have not accurately reflected the value of the underlying securities in the secondary market.
The accusation, as I see it, is that BS, to support being on the other side of the trade in regard to the hedge funds, has determined due the illiquid nature of the ABX indexes, that is is far easier and less costly to move the "trigger" index as opposed to potentially settle out the swaps, even if it represent overstating the value of the actual collateral backing these loans in the secondary market based on current default rates.
As to the manipulation charge, think of it in terms of the rhetoric and hoopla surrounding Reg SHO and smaller illiquid companies and the claim that due to the underlying floats the securities were easily manipulated and depressed thus not accurately reflecting the underlying value and artificially controlling the value in the marketplace for one's benefit, the same allegations are being made here in my opinion, only in the opposite fashion. The other potential pitfall are the various issues surrounding the potential for the upcoming IPO amongst a long list of others.
Robert Cote
The hedge funds are crying foul because Bear is their prime broker and probably knows their positions.
Somewhat related to investment banks organising concert parties to attack smaller funds (hold a cocktail party for a bunch of funds and say, for example - there's one fund that's overextended in natural gas futures, maybe you should all attack it)
In any case, my sympathies lie more with witless anchovies than sharks in a feeding frenzy.
"all risk has been hedged" -
this is where the Fitch report gains importance with the assumption that hedge assets would potentially all become correlated in the event of a credit event.
hedging of risks will take on a new meaning.
I can hear it now-
"But, we were hedged in a risk-free trade".
Rob
I see your point but it looks like Bear is trying to maintain the perfomance of their products at expected levels and the anchovies are getting various forms of debt relief in the process. The Hedgies seem to be complaining that these products are performing as expected because Bear is looking after their interests.
Are you saying that Bear is acting poorly because they are shoring up their own position and the only fair thing to do is let their products fall in value so that hedge funds can make money?
Should I miss a creditcard payment deadline so the ccard company can make the money they statistically expect? Isnn't my paying on time a way of moving that market?
It looks to me what Bear is trying to do here is repurchase loans out of existing securities when they are in the early stages of delinquency.
Well, see, that's the thing. Fannie and Freddie can do something like that. They guarantee their MBS. Nobody ever takes a principal write-down on a GSE MBS, so nobody suffers when delinquent loans are bought out of the security by the servicer: it's just principal return to the investor, and maybe it's 30 days sooner than it should have been, but in my experience that's the extent of any uproar over it.
But how the hell does Bear get to buy delinquent loans out of a security that it does not guarantee? This is the part I don't understand.
That's why I assumed they must be treating them as repurchases for violation of contract. Are you telling me they have the right in these ABS deals to buy back loans just because? Well, in that case the sale of the loans to the security trust must have included some form of recourse. Enter the accountants. If Bear has the right to buy individual delinquent loans out a deal for any reason other than warranty for defect, then Bear owns a big boad load of liability. Did we know about that? No wonder Seidman is a bit pissy.
Turbo -
Is your Adelphia comment referring to subrogation? I haven't looked into it but it seems like subrogation should only apply to a real insurer who has insured an insurable interest. As far as I know the ABS are nothing but side bets.
Two points from my experience as a junk bond fund manager many moons ago. The ABX index is probably comprised of not that many bonds so it would be easy to buy a few of them to move the market. Especially since these sorts of bonds are not very liquid. If the word gets out that there is a big buyer in this type of security, all the selling dries up FAST. They could move these bonds up by 10c on the dollar any time they care to. And if people do that, the index no longer reflects the market.
Here's where Bear gets lots of bang for the buck on this one. They are on the other side of the CDS trade. There could be BILLIONS of dollars out on the CDSs as both speculators like hedge funds and perhaps smarter real estate players do something to hedge real estate exposure. So Bear can wag the dog just by letting it be known that they are willing to buy a few of these bonds here and there. They avoid big losses at a cost that is chump change for them. Brilliant, really.
I suspect " Glen | 06.07.07 - 10:32 am" has it right. When I first read the WSJ article, my thought was, "Won't they lose as much on the mortgages as they gain by avoiding loss on the swaps?" But I was forgetting that the volume of "swaps" (a misnomer -- it's really insurance) sold is not limited to the amount of the securities insured. If Bear has sold $100 of insurance on $10 of debt, it has a 10:1 payoff from preventing the default.
Imagine if hedge funds were able to buy billions of dollars of life insurance on you, and Bear were selling the insurance. It would be well worth it to Bear for them to surround you with a security force rivaling that around G. W. Bozo.
Excellent post by sunlight above.
OT--the home builder stocks are breaking down today, even though there were oversold coming into the day. Evidently, the combination of higher 10-year bond yields and the MTH warming are having an effect.
This may be very significant, as according to Jim Stack's Investech.com, the RE stocks are sitting on significant resistance that they did not break during last summer's downturn. If resistance really breaks, the downside might continue sharply. Financials are also looking very weak today.
The reason the hedge funds are mad is that BS has essentially made (to use the example above) a $100 bet that someone would buy the underlying asset for $10... and when it didn't look like anyone would, bought it themselves for $10, and told everyone else to pay up. What's more the hedges are upset that they didn't think of that first!
Robert Coté
Yes, Bear acting irresponsibly if they are trading on inside info. At same time, I don't care if the hedge funds shorting the ABX lose money.
(My anchovy comment was misplaced in this context - nobody's an anchovy here. I think I just found the metaphor amusing)
Anyway, who really knows what's going on here. I suspect there's lots of insider trading going on anyway, so some parties purposefully lose money and get kickbacks from the winner.
My guess is BS is on both sides of credit event with different set of counterparties. Surely sounds like a risk management strategy except amounts on both sides are not equal. So there is an incentive for BS to take loss on the side with smaller amount. However it is surprising to me why Hedgies cried foul instead of taking advantage of BS's seemingly willingness to take loss at one direction of trade. Surely WS can entertain us with a new round of financial innovations to make BS's loss mitigation actions more expensive. Eventually BS has to stop.
Just to clarify, it does seem from WSJ that Bear is buying back underlying mortgages rather than bonds themselves. Having said that, I still think the logic of my 11:27 post stands... they move the bonds up when they buy back a few mortgages, which in turn moves up the index.
Jim is correct - The fact is, BS can overpay to buy distressed mortgages, then end out ahead in the options contracts... of course part of this is speculative on BS part because they don't know what the severity of loss on the mortgages will ultimately be.
I was an analyst when the CMBX index was released (protection on commercial mortgage backed securities) last year. A big concern was that this type of quasi-arbitrage situation was never allowed, like it is in the residential bond market (in fact many of the other analysts were speculating it was already happening with non-public purchases in the residential market since the buyer-name is NOT public). As a result CMBX has an disclosure rule where CMBX issuers must give a 30 day public notice before purchasing the long position.
Also in regards to lack of liquidity, residential has nothing on commercial. I would guess a cmbx contract trades about 15 times per week... and when I say a cmbx contract I don't mean a specific contract... I mean the sum of every trade amongst all contracts comes to 15 times per week.
Repair, repackage, resell.
Kudos to the guys who packaged the CMBX. As an aside, big traders do manipulate the Dow 30 and the S&P500... for a few minutes at a time, but no one has the money to peg the big indexes on a sustained basis. The people who constructed ABX did not pay enough attention to susceptibility to manipulation and they risk having the index become a useless "indicator" of market values.
I think I just found the metaphor amusing
Well, I found it amusing. I always root for the underfish. I am also only one of two people I know who likes anchovies. Give me a plate of anchovies in olive oil, a decent loaf of bread, and a jug of some brash young wine, and I'm a happy little camper. (I must say it does make for an, um, redolent hangover the next morning.)
The problem of deciding who is the underfish in all this is, of course, the big deal. I would personally counsel all those consumers who are trying to make their mortgage payments but can't get the servicers to work with them, because it might or might not screw some [obcenity] hedge fund, to march on Washington.
Tanta,
Thanks for addressing this difficult and seemingly mysterious topic. For many years it was (mostly) easy to understand enough about stocks and bonds to have some sense of what was happening and why. With the dawn of the age of derivatives and hedge funds etc. that basic understanding is under steady assault. You and your more knowledgeable readers give a bit of hope that all this murkiness will one day be made clear.
BTW, you wrote above:
"Are you telling me they have the right in these ABS deals to buy back loans just because? Well, in that case the sale of the loans to the security trust must have included some form of recourse."
It isn't clear to me why that would be. Suppose I write a contract that says I have a "call" on an asset I sold to you, but you have no right to "put" it back to me. Why would that give me a liability?
What I like is the idea that Bear Stearns buys mortgages out of the pool to protect [something] and then resecuritizes them.
It's as if they are blaming each other for not understanding who's supposed to get hurt in this feculent criminality:
Look, Paulson, you don't understand who's supposed to get hurt. It's the little guy: either the shmuck who's going to lose his home, or the shmuck who's pension fund just bought the equity tranche of our garbage. It isn't you and me. Got it!
It looks to me (and I am as confused as anyone) like BS got caught with their hand in the cookie jar. They were attempting to manipulate the CDO market as described above by (1) buying loans which were not covered by the recourse provisions and/or (2) buying loans for which they were not the originator.
I think the Aldelphia auction was a hasty gentleman's agreement (or shark's agreement if you prefer) to assign collateral among competing "insurers", and required that the counterparties agree in advance not to dispute the lottery assignment. The first problem is in calling it insurance - it's really a put option, but you can sell it to the average pension fund trustee if you call it insurance instead. I guess all of the pension fund trustees who bought portfolio insurance have either retired or are succumbing to collective amnesia. Secondly, the settlement mechanism has yet to really be tested. Given the massive imbalance between notional derivatives and the physical delivery requirement for settlement, some sort of cash settlement will have to be hammered out, or this market will crumble into legal chaos.
Is it just me, or is Bear propping up a bad position by adding to a bad position? It may work for them today, but it's still a long way until bonus time...
"Give me a plate of anchovies in olive oil, a decent loaf of bread, and a jug of some brash young wine"
In this case, the underlying sounds far more appealing than the derivative: small handful of oily salt; flour; and shot of grain.
It isn't clear to me why that would be. Suppose I write a contract that says I have a "call" on an asset I sold to you, but you have no right to "put" it back to me. Why would that give me a liability?
It would depend on how you accounted for your "sale." FASB says if you can take it back like that at no penalty, it's not a "true sale," but a financing. So by "liability" here I meant at a certain point such a contract would keep risk on your books, not transfer it to the buyer's books.
For the REAL UberNerds:
FASB: Financial Accounting Standards Board
FASB says if you can take it back like that at no penalty, it's not a "true sale," but a financing.
OK -- I see it now.
Thanks
wow ... I can t help. I need help reading you. Gee is this how complicated it got ?
I stayed at level 1 : money creation lead to higher asset prices instead of higher consumption good prices because all other policies (trade, labor, budget policies) were hostile to workers. THe asset price boom is credit backed. Once debt reaches some limit, all lenders and borrowers will panic and debt deflation will follow.
THe rest is too complicated for me. But amazing.
As near as I can tell the posters rj, NJMortgages and sunlight have illuminated the situation pretty well.
The fact that it involves derivatives makes the situation seem more complex than it really is. I would simplify it like this:
The hedge funds are "short" because they thought things were going to be worse, Bear Stearns is "long" because they thought things were going to be better. Now, Bear is trying to change the "deal" (by manipulation of the make-up within a derivative) to avoid large losses on their position, which the hedge funds don't like because it will reduce their profits on the trade.
I've read about stuff like this before, I think it happens all the time on Wall Street, one crook trying to take advantage of another.
Sebastia
Is it just me, or is Bear propping up a bad position by adding to a bad position? It may work for them today, but it's still a long way until bonus time...
Turbo
No, no, no, Turbo. With immense respect, you're wrong, I believe.
Bear is going to securitize the crap they are buying and sell it to suckers.
That's what they do. Vultures eat dead animals. E. coli colonizes the colon. And Bear Stearns sells worthless sh*t to suckers.
I see the problem with Bear Stearns strategy as this. They can prop the prices up for a while by buying out delinquent loans.
However, If rates keep moving higher as they are today they will be faced with a greater delinquency problems when these loans reset even higher in the months to come.
Higher rates will mean less buyers to qualify for mortgage to purchase new homes. Real estate Prices will have to continue to fall to help offset this.
Lower real estate prices mean more foreclosure loses on these securitizations.
Personnally, I wonder if Bear is trying to prop-up MBIA and AMBAC the bond insurers. These two compnaies stand to lose the most if they are required to fund pool underfundings.
Tanta posted on this several days ago.
If these companies start to have going concern issues the whole securitizations start to unravel.
Where does this leave the Bond holders then?
This seems to be the scenerio the hedge funds are hoping for.
Couldn't the hedgies work the derivative leverage the other way? For instance, to counter this, couldn't they offer actual homeowners money (to compensate for credit-rating damage) to stop making their mortgage payments?
If I understand the leverage argument, this would cost them less than the large leveraged swings in the index would bring them.
(Kind of like bribing one of jm's bodyguards...)
(Please note I'm not advocating such behavior, just trying to make sure I understand what's going on here.)
Tanta, GREAT POST!!!!!!!!!!!!!!!!!!!!!
Couldn't the hedgies work the derivative leverage the other way? For instance, to counter this, couldn't they offer actual homeowners money (to compensate for credit-rating damage) to stop making their mortgage payments?
Funny you should bring that up . . . every mortgage loan purchase contract I've ever dealt with has a "nonsolicitation clause" in it. In essence, it prevents the seller of loans from soliciting the borrowers for refinance--you can't sell a loan for 102 and then call the borrower (whose phone number you have; you just originated a loan) to talk him into refinancing so that the buyer of the original loan is stuck with a loss and you get to sell a new loan at 102.
I know you're describing something rather different; I'm simply pointing out that on the mortgage side of this, people have been dealing with perverse incentives and bad faith problems for a long time, and have formed standard contractual language to prevent or mitigate it. I am therefore mildy amused at the idea that our overlords on Wall Street seemed to have been caught with their counterparty risk pants down. They were more trusting souls than a mortgage originator? Holy mackerel. Or anchovy. As it were.
If the CDS sellers were actually given access to the mortgage servicers' database--which they aren't--your scenario would undoubtely materialize.
NJM, it depends on the size of the issues that underlie the index. There is a total of 20 CDOs in the ABX BBB- Index, which I believe is the vehicle at issue here. Suppose the average bond has a total issuance of $150 million... we are talking about $3 billion in total principal amount.
underlying the whole index.
If you read the annual reports of the private mortgage insurers you know that when a loan actually defaults they take an average loss per loan of 25-30%. Soooo...
Let's assume a doomsday scenario of 40% of the underlying mortgages default, and that Bear actually eats 30% per loan... so Bear's loss would be 12% of the total outstandings (40% of 30%) or about $360 million. Can Bear afford that? You bet. Is it worth it to them if they are big on the other side of CDS's? Probably. Will it get that bad? I wouldn't bet on it, even though I agree with the editors and most of the readership here that housing is worse than the MSM says it is.
Tanta, you rock.
So do all the illuminating commentators.
Thanks for a fascinating, and I think in this period vital, discussion.
My request is that folks read the section "Close Call" in the post "Safety Net IV" (August 7, 2006). I believe yesterday's FASB comments imply a serious risk that Fannie (and perhaps other players) will soon be asked to sell additional stock up to nearly doubling of their market cap in order to satisfy the sales accounting problems Leslie Seidman is talking about. After all, the nightmare scenario spoken of in April 2005 of an additional $30 billion of Fannie capital may not have been such a stretch as thought at the time.
I'm at a $500 million Foundation and got a cold call on Tuesday from Bear Sterns. VERY UNUSUAL. First most of these calls are about building a relationship. This call was a direct solicitation of CDO's. No prelude. Second most big houses are very careful about due dilligence and "sophisticated investors". The day before I got a 3 page legal doc just to be able to receive info on structured products. I got the feeling the BS guy was a trainee they put on the phones to make cold calls. At the time it reeked of desperation and then I did a search and discovered Evergreen and then the next day the hedgies start complaining and the FASB starts squirming.
Methinks BS is holding a sackload of sh$%^t and the fuse on the financial bomb is getting very short. It looks to me like BS is in a very bad position. They either hold the bag when the finfnacial bomb goes off or after the fact it becomes very apparent that they were pushing the stuff to investors who should not be - ie small pensions and endowments
I think the comments have been close to the key issue, but let me state it clearly.
The hedge funds have a position that is long CDO equity and short the ABX, where the latter position is 5x the former. The position has positive carry in normal times because the payment to equity is high relative to the cost of protection purchased, and goes in the money when subprime spreads blow up.
The key insight is that the "bag holders" are not the owners of CDO equity tranches, but whomever sold them all this protection on the ABX. That is likely the investment banks.
The investment banks can avoid paying these huge losses by taking bad loans out of the pools underlying the ABX, which makes them perform better. Spreads tighten, and the hedge funds lose their paper gains.
Now it seems implausible that Bear could do this all on its own. It is only 1/20th of the ABX. But if investment banks coordinated these repurchases, they could avoid serious losses.
The issue in the background is that the hedge funds were betting against subprime because of reset risk and a slowing housing market. The EPDs on the 2006 vintage were a pleasant surprise that gave them their gains earlier than they throught. If the i-banks are just making good on reps and warranties that they never had to make good on before, I don't see the big deal. Hedge funds might lose their unexpected gains, but unless the i-banks are going to repurchase all of the resets, they will still make a killing in the end.
looks like there is a lot of confusion on this -- hope this helps...
basically the manipulation part comes into play as folks were allegedly scheming to sell protection and subsidize the proceeds to buy out loans - they blatantly talked about it in vegas at the ASF convention - not just bear, every dealer on the street at least thought about it out loud --
idea is you inflate your CDS positions on your derivatives desk, have your mortgage servicer (which sits behind a chinese wall of course )buy back loans where default is "reasonable forseeable". thats the grey area here, and that has not yet happened. loans that have been bought back are loans that have already defaulted one month -- what some firms are proposing to rating agencies, is buying back loans before they default. paulson and others want to assure that servicers are telling their brothers on the derivatives desk to sell protection till they are blue in the face. they take the hit on their balance sheet but profit on the swap.
If they put on a CDS position in large size even if buying out loans is noneconomic for the underlying deal, the effect on the CDS is significant both on a MTM basis and in terms of triggering the swap payout.
Paulson and other macro funds have massive positions both in single name CDS as well as the ABX ---its been said that they doubled up by buying protection on the ABX as well as the constituent names that make up the index hence why they are so pissed that the deals in the ABX may not have writedowns after all - they lose after. Dealers and credit intensive hedge funds that think the whole subprime meltdown is overblown have a distinct interest in propping the ABX up for soooo many reasons
Every time they issue a synthetic CDO, they use the ABX to delta hedge every time it widens out their gammas are screwed and they lose money buying more single name protection to adjust their hedge. ( you can see how many moving parts there are to this whole thing)
The CDS contract and the ABX which is structured to mirror it, is triggered when the OC cushion is released on the deal this happens as writedowns occur. No writedowns, the contract does not have to pay out and on a mark basis, the contract can be valued in favor of the protection seller.
ISDA is in the process of discussing with members whether or not an amendment is necessary to the template
Paulson has proposed that the current ABS template be amended to include language that would prohibit the seller of protection from purchasing loans or any other action that would improve the trust's performance or decrease the floating payment based on information gleaned from other areas of its firm. The letter was written in response to a proposal made by Bear Stearns to ISDA, and sent to clients to reiterate that sellers of protection may wear other hats with regards to the underlying and may act in accordance with laws governing those roles.
Paulson said that
Some years ago on a trip to the Sea of Cortez, I had a Mexican fisherman explain to me how, when he gaffed a shark into his boat, he would slit its belly so that it could chew on its own entrails -- thereby sparing his legs. More or less the same thing that's happening on Wall Street, no?
Just to follow up on rcryan's comment on the cash settlement issue; I blogged about how credit derivatives trades take forever to get cleared back in February at my post Source of market risk under the radar. The post includes a quote from the Daily Institutional Investor to the effect that "it took the largest banks 44 days to confirm a basic credit derivatives trade and about twice that for complex deals"...referring to the time frame between November 2006 and March 2007. The same II story mentioned that at 3-31-07 there were 74,000 trades executed that hadn't been cleared...in my mind that is a significant source of liquidity risk.
So there are a lot of recent trades that haven't even cleared, much less reached any kind of cash settlement. It's mind-boggling to realize that the CDS market makers don't have any system in place to essentially process insurance claims.
Thanks Anonymous - that is very helpful. I have one question:
You say : "Every time they issue a synthetic CDO, they use the ABX to delta hedge every time it widens out their gammas are screwed and they lose money buying more single name protection to adjust their hedge. ( you can see how many moving parts there are to this whole thing)"
Most of the ABS CDO deals have been cash not synthetic haven't they? I would have thought most delta hedging would be done by investors who are long CDO tranche/short ABX hedge??
This has to be one of the best threads of the year ... Tanta is asking the right questions, and the quality of the responses is top-rate. I learn more here than anywhere else on the web.
This derivative stuff is way beyond my skill set, but I'll share one observation made recently when deciding how to invest a small amount of cash in an IRA, with a large institutional investment house. If you are curious, the name starts with a "V" and rhymes with "plan-charred".
Being a conservative type, I wanted to put the money into a bond fund, preferably US treasuries, for a nice conservative 5% return. However, in reading the prospecti online, I kept noticing a lot of fine print with the terms CDO and MBS. Even in funds with innocent sounding names like "US total bond market fund" and "Treasury fund." Not wanting to end up a bag-holder for some toxic waste from an i-bank, I decided to put my money into an international stock fund. However, I thought it was odd that every single bond fund available to me as a small retirement investor had some reference to holdings of mortgage-backed securities.
If this thing blows up, I have a feeling that a lot of anchovies are going to be in for a surprise when they open up their 401K and IRA statements.
Most insurance has an expiration date, at which point one is either uninsured or buys replacement insurance at a new price.
Maybe the hedgies are upset because BS is going to put the dying CDOs on a breathing apparatus, at least until the life insurance coverage runs out...
I think somewhere someone just figured out their returns aren't going to be what they thought....
Tanta -
I could be missing the point, but "all this" this strikes me as relatively simple: the CDS seller gains liquidity up front in exchange for transferring mortgage default risk to the buyer. The buyer gains the right to later payment should a "trigger event" take place, meaning a default. Both buyers and sellers are engaging in a complex game of arbitrage.
The CDS index in question here tracks these sorts of transactions, and the value of a CDS contract drops if the risk of mortgage default materially increases.
Which gets us into the conflict of interest: what if a market participant could artificially prop up index values, thus keeping the trading balance in its favor?
Well - not surprising to me given how incestuous most of the secondary market is elsewhere - there is just such a way: servicers holding the MSRs on a pool of loans have the right to purchase troubled loans out of a pool under certain conditions.
So what happens when that servicer is captive to the Wall Street issuer? That servicer does what its trading desk requires, and purchases loans out of the pool that would in theory cause a "trigger" event.
At least, that's the theory here. Did I get it?
BTW, I posted on this over at HousingWire (http://www.housingwire.com).
Via bankstocks.com, here's a clearer summary of what Paulson is alleging of Bear.
HEDGE FUND BEAR-ISH ON SUBPRIME RELIEF - NYPOST.com
P. Jackson...if you are correct, those who've sold insurance would have a big incentive to buy the servicers and bring them in house...to a desk right next to their trading desk.
RP - whoops.
Just realized I completely foo-barred my original comment. Reverse what I said, and be careful what you write when having some whiskey.
So if Bear Stearns is making "payments" to whomever holds the swap, and receives "payment" in the event of a credit event, under certain circumstances it has a strong incentive to buy out troubled loans en masse. ("Payments" is in quotes because a cash settlement is rare.)
The "why" here is not as straightforward as you might think, but starts with the realization that Bear Stearns cannot control the existence of a credit event (they might be able to influence the timing, but that's another issue).
Instead, Bear Stearns might be able control something infinitely more important: the cost of engaging in a swap transaction to begin with. And that's a much, much larger factor when it comes to bond issuance.
By buying loans out a pool, Bear Stearns forfeits the "payment" it would get in the event of a credit event. But consider that it's essentially "paying" for CDS contracts at a pooled level -- most of which will not default -- and it can make more sense to keep the cost of selling swaps down than it does to simply reap "payment" whenever a credit event occurs.
This is especially true in a market where the underlying assets are flat to declining in value, and the number of credit events is experiencing an rapid increase that would lead the cost of swaps to outstrip whatever little recourse would come from from "collecting" on those credit events.
So, I think the argument here is that by allegedly moving to keep the cost of selling a swap low, the indices tracking the swaps market are artificially inflated and don't reflect the true cost of engaging in a swap transaction.
So if I've followed this correctly so far, any investor that took a short position expecting to see the cost of swaps increase (and the associated index take a nose dive), is going to be pretty pissed that Bear Stearns is "manipulating" the market such that their short positions aren't as profitable as they'd be otherwise.
Worse yet, Bear Stearns is alleged by some to have been going long on these same markets, making it so it could profit on both ends of the deal -- swaps stay manageable, and its bet that this would be the case nets it additional bond yield.
God, now I'm just hopelessly confused.
Look back at Adelphia, they had use an auction process to determine who settled what, since the notional value of insurance written vastly exceeded the actual amount of bonds in default. Perhaps they will establish daily auctions to match defaulted mortgage debt to the lucky insurer?
This reminds me of playing Pai Gow Poker in a card room in Oakland about ten years ago. The first time I played I noticed that each table had a compass embedded in it (the little magnetic kind that point north) and assumed it must have something to do with Feng Shui. In each round one player was the "bank", and played against all the other players. Under the rules of Pai Gow the bank has a slight advantage. If the bank didn't have enough money to match all the other players other people were allowed (before the bank's hand was revealed) to be "second bank" (or even third), meaning you got the action on the bank hand after the first bank's stake was used up (and you didn't have to pay the normal vig, so you had actual positive expectation value). Because each hand was resolved in turn it was possible for the first bank to get wiped out (say the first 3 players had good hands) but second bank could wind up winning (if the remaining players had bad hands). Which leads me back to why they had compasses in the table--the order of the resolution of the hands is determined by rolling dice in a sealed cup, apparently the easiest way to cheat was to use magnets to manipulate the dice.
Tanta (and commenters),
Thanks for posing this gobsmack so constructively. Unless our Congress gobsmacks us, this will probably be among the threads of the year, anywhere.
I suppose that since all Paulson has done is write a complaint letter to a regulator, he doesn't have to supply any evidence of intent by Bear.
Josh, thanks for the NY Post link. That's one more piece (in addition to the Financial Times) to argue that the accusation here involves loan modifications, not loan purchases. So I continue to not know whom to believe.
Maybe Bear is buying specific ABS bonds to prop up the ABX, putting them on-balance sheet, and then moving to aggressively modify problem loans in order to keep the value of those bonds up.
I have no idea how much of the tranche Bear would have to own to be able to unilaterally move to modify individual loans, but maybe thy're buying up the whole thing, or maybe there is a threshold built into the prospectus?