A lot of money being "invested" in these things comes from the Yen carry trade, I would imagine. I guess that's leverage on both sides.
But I actually don't understand the Yen carry trade. Can someone explain it to me?
This is as far as I've gotten. Players in the US borrow Yen for essentially zero interest rates. They then buy dollars (incidentally keeping the dollar strong and the yen weak) and invest those dollars in instruments such as those discussed by Tanta.
My question is: who do they buy the dollars from? And why doesn't it all come out in the wash? Who is selling them the billions of dollars involved?
We have not succeeded in solving all of your problems. The answers that we have found only serve to raise a whole new set of questions. In some ways we feel we are as confused as ever but we believe we are confused on a higher level and about more important things.
Because your 12-year-old children are happily devouring a 700-page novel that they stood in line at midnight to buy, while you whine about a 300-word blog post?
I suggest you immediately halt this line of questioning..
If you start wondering about things like "so they borrow yen to buy dollars and then buy other paper with the dollars", you're head will explode (very messy).
It's one of those confusing things where.. Oh, you know... No one wants Yen so it's easy to borrow and use to buy things.. But then that means someone wants it if they trade you for it.
Or how about.. Oh you know, China saves money and they use all that cash (Yuan and dollars from exports) to buy Treasuries to keep the Yuan devalued vs the Dollar. Who wants Yuan then? If you know China's just dropping it for Dollars?
Try to draw diagrams of where the money flows. Maybe the Fed is just printing Dollars, buying up Yen and Yuan, and just burning them?
Maybe it makes sense for whatever part of the system is sopping up Yen,Yuan... Because, one day.. That paper will be worth a lot vs the Dollar.. One would guess.
Similar to how smugglers have worked since the beginning of time... you put the bad stuff in the bottom of a box mixed in with good stuff, in the back of container, 1 of 1000 on a ship, 1 of 100 at a port.
All the inspectors and captains know its out there, just convencing each other its not on their boat.
Too early in the a.m. for the Blended Scotch analogy.
"Whether that "diversification" is helping any, insofar as some of it involves commercial RE and LBO notes and other perfectly "uncorrelated" risk-free no-brainers, is another question"
Tanta-yesterday i recomm everyone listen to Fin. Sense's Online interview with Richard Arbogast, a man of your ilk, an MIT PhD economic graduate who gives us a glimpse into the wonderful world of Wall st. derviatives. one of his pts was that in times of crisis things normally with a -1 correlation coefficient (maximally uncorrelated) can become +1 perfectly correlated). one ex. he gave was hi yield junk bonds normally correlate (move together) with Treasuries so everyone was buying junk and shorting Treas. to take advant. of the spread. when the 1987 crash hit, everyone sold junk and BOUGHT Treas.(flight to quality) thus imparting a double whammy hit. i wonder if that is whatt is happeening now? he also said that the mere fact of grouping these seemingly uncorrel. components into a cdo which on the face of it suggests diversification really forces a correlation in a selloff. ex: the Blockbuster bonds get hit equally to the Chrylser bonds when the entire cdo tanks. i think you'd find the listen worthwhile.
before the subprime collapse, i was thinking about starting a subprime conduit. i was going to call it, 'ABS of Steel' to reflect the awesome safety provided by the tranching of risk...Billy Blanks was going to be head of marketing...
Arbogast-i'm not an expert but i assumed they could just get dollars in the foreign exchange mkts or just go to the banks and exchange. its not just US investors either. everyone pokes fun at the Japanese housewife driving alot of the trade so there must be some truth to that as well as japanese bank, hedge funds, and their mothers. i've also often wondered how i could get my hands on some yen for the same purposes. i wouldn't just dismiss this though as some arbitrary anomaly with no significance. its extremely significant to our world wide imbalances and should be watched carefully. if it starts to unwind as we started to see Friday it could be an indicator of bad things to come.
Great post as usual, Tanta, but one minor suggestion. You appear to be using "equity" to mean two different things in this paragraph:
Therefore, the fund sells $20 in assets and pays the lender with the proceeds. That results in a $75 investment ($95 minus $20), $15 of which is EQUITY and $60 of which is borrowed, bringing the leverage back to 4x. . . . You see here how leverage magnifies losses on the downside: a 5% drop in value of the investment results in a 20% drop in the EQUITY of the fund.//
The first equity appears to mean investor equity, which drops by 25% because the entire $5 loss comes out of the investor equity, regardless of margin requirements. The second equity appears to mean the total holdings of the fund, no?
I think most people here can figure this out, but it took me a couple minutes.
The "official" community has been warning about this structured credit "complexity" risk for years (e.g., http://www.bis.org/publ/qtrpdf/r_qt0506f.pdf and recent issues of the IMF's Global Financial Stability Report). I guess it's welcome to the Rodney Dangerfield club...
albrt, you're right, that was a less than fully effective way of putting it, wasn't it? All I can say in my own defense is that I was watching a golf tournament at the time and so got distracted. I'll fix . . .
Tanta/Arbt-ok you guys are losing me here. "The first equity appears to mean investor equity, which drops by 25% because the entire $5 loss comes out of the investor equity, regardless of margin requirements. The second equity appears to mean the total holdings of the fund, no?
Tanta pls take me thru the calc of "20% drop in the EQUITY of the fund."
idoc, Tanta's mind was temporarily elsewhere when that sentence was written. Refresh and try the new version. God help me if I screwed it up again . . . I'm listening to the Beach Boys, and being compelled to join in the chorus of "Don't Worry Baby" at a falsetto register about 3x outside of my so-called "singing voice" tends to require a lot of my energy . . .
Isnt the essence of the carry trade borrowing at a low rate in Japan and investing in a higher rate elsewhere? The arbitrage being in interest rates more than in currencies. A game that very few are positioned to play.
It makes sense, on the surface, going out and borrowing a pile of Yen for 2% to, say, pay off some dollar denominated debt that's costing you 8% a year.
For simplicity's sake (who is this simplicity person?), let's say you got 1Dollar for each 1Yen that you borrowed. (the benefit being that you lowered your APR to 2% from 8%).
What happens if the Yen starts to rise (for whatever reason) versus the dollar? If you have to pay off the Yen debt with Dollars that you earn in the US.. this could (for lack of a more sophisticated way to say it) start to suck real quick. In 12 months, you could easily need to pay $1.20 for each 1Yen. So.. while saving that 6% spread APR.. you just added 20% to your total debt.
Now, it can work both ways.. and the value of the YenVSDollar can change as rapidly as it wants.
Who knows what'll happen over the next few years.. but I'm guessing it'll get very interesting.
One aspect of recent developments was odd and has turned out to be the source of much difficulty in the non-prime market. The steep yield curve during much of the 2002-04 period reflected investor expectations that short-term interest rates would be rising, which they in fact did. Yet, many mortgage-market participants apparently did not anticipate this increase. Of course, I would not expect average homeowners to be able to read the yield curve, but I find it odd that apparently sophisticated investors in non-prime mortgage-backed securities now claim surprise that many non-prime ARM borrowers are facing payment shock because of the increase in short-term interest rates over the past few years. Apparently driven by the prospects of high fee income and substantial spreads on non-prime ARMs, mortgage originators persuaded many relatively unsophisticated borrowers to take out these mortgages; then, investors willingly purchased them when they were securitized. Many of these mortgages are now in default, some of the lenders are bankrupt, and the mortgage-backed securities are trading at deep discounts to face value.
Given these widely held expectations of rising interest rates, it is difficult to avoid the judgment that these ARM loans were poorly underwritten at the outset. It was imprudent for mortgage brokers and lenders to approve borrowers who likely could not service the loans when rates rose, and it is surprising to me that sophisticated capital-market investors willingly purchased securities backed by such poorly underwritten mortgages.
William Poole
President, Federal Reserve Bank of St. Louis St. Louis Fed | Page Not Found
Tanta, nice work. Curious though, just who was lending the money to the hedge funds for the leverage, and who is on the hook for the shortfall when the margin calls roll in and a fund is under water? I read that BSC made the lenders whole, but who were these lenders exactly? I assume many of the hedge funds that missed the exits won't be able to satisfy their lenders requests.
Hehe.. yes, well I would guess the people incorporated on Mars (or Deleware or Samoa or wherever) as No Liability Corporations will not be paying it back... they'll just close shop and wander off with all the money they made.
I mean the poor schlub who decided to literally borrow from a Japanese bank as him/herself to pay off a higher interest debt.. that schlub.
Should have just formed an LLC, shorted the Yen, and gone long SP500 futures (and crossed their fingers).
It's Capital, which would be the correct term, correct?
If you're an investor, it's probably capital. (I don't think it's Capital unless you're a German investor.) If you're a lender, it tends to be equity. I'm just using it in the balance sheet sense. Part of my problem is that I am used to dealing with on-balance-sheet securitizations, which is where the idea of OC as equity came from.
barely, as far as I can tell everybody and his pet kitty supplied part of the loans to the Bear fund. Last I saw, the reports were that Fund 1 managed to unwind without losses to the lenders by "refinancing" some of its loans with Bear's repo facility. It looks like real lenders lost real dollars on Fund 2.
So? That's what you get for making subprime loans to hedge funds.
The past real estate resessions losses caused the S&L debacle. This time it is different. For the most part the S&L's and mortgage brokers sold off the mortgages to Wall Street. The Street then repacked them and sold to Hedge Funds.
The unregulated Hedge Fund industry will absorb a portion of the losses. The bigger losses will be the Wall Steet Houses and the large Money Center Banks that have lend to these Hedge Funds to margin their CDO's.
As was seen in the Bear Stearn Hedge Enhanced Leverage Fund. When the losses pile up the Hedge Fund goes under. The equity vaporizes and the remaining losses are put to the margin lender; i.e. other Wall Street Houses and Money Center Banks.
It was these Investment Bank's that packaged these CDO's that are now essentially being putted back to them. They will end up eating there own garbage.
As these Hedge Funds stop withdrawals the ponzi-like scheme comes to an end. Not enough money coming in to pay the investors exiting.
The cycle feeds on itself. Less lending, higher rates, greater losses. Fewer investment in hedge funds. The real impact is the spillover to all the Leverage Buyout Deals. Fewer deals fewer takeovers lower stock prices along with lower home prices.
Another outstanding contribution (although it is a bit short - heh).
One point that might be considered for some future work:
If Jhon Doe defaults on a $250K, 100% LTV, ARM that winds up with a loss severity of let's say 20%, then someone gets to lose $50K of real money, yes? Then somerwhere, after all the "risk reduction" hedging etc., one or more people still get to lose $50K, right?
But, in the mean time, Wall Street Geniuses (tm) got to make lots of fees to slice and dice the various cashflows, create the CDS protection, etc.
It seems to me that someone also gets to pay the WSGs lots of money to do this service. Therefore, the total loss is going to be a more than just the $50K. Any idea how much this pain will be and how it is going to be spread?
Tanta has many lucrative days ahead of her serving as an expert witness for the defense. Few judges and absolutely no jurors will be able to tolerate the migraines that will come from attempting to parse the bewildering complexity of terms and interdependent relationships of structured finance. Even the eyes of $600-an-hour plaintiffs' attorneys will begin to glaze as she drones remorselessy on about distinctions without differences, equity vs. capital, and so on and so forth. By the end of the second week of her testimony, everyone from the bailiff to the court reporter will be eyeing the exits and fervently whispering their deepest, most heartfelt wish: dismissal, dismissal, DISMISSAL. ;>0
Tanta, that is just an excellent tutorial. As much time as I've spent studying this situation (over half of my work time over the last year), in several dozen clear paragraphs you explained a number of things I still had not grasped: especially the triggers and the conflicts over down-ratings. Thank you very much for the time and effort you put into this lesson. I do appreciate it.
PS -- My excuses for repeating these thanks, which I first posted in the comments to a different blog entry. Well, most of the blog entries here at CR are really very good.
eli-the problem with your theory is that the yen carry trade has been a viable and profit making adventure for around 2 decades. currently you can buy 1.21 yen per usd. it threatens to unwind but never does. thus everyone and their mother (literally Japanese mothers) are borrowing yen to invest abroad mainly for interest differentials. if the yen weakens further they get extra bang for their buck via currency exchange. and fyi, their interest rate is 0.5% while US treasuries are 5.25%, quite a differential. Japan is THE largest holder of US treasuries and some have accused Paulson of an unofficial deal with the japanese to keep it this way b/c his GS makes easy money off it and it helps keep our interest rates down. never mind that the tradeoff is the gutting of US manufacturing. Wall st, hedge funds US and japanese, japanese banks are the biggest exploiters of this trade. this has also funded cdo investment by hedge funds in a big way which could be why we're seeing some slight yen strengthhening rel. to the usd. i agree with you that if this unwinds it will devastate many current trade positions incl our stock mkt which is why one must pay attention to it at all times.
barely-all the other major investment banks lended to the 2 BSC hedge funds and i wouldn't be surprised if there was some carry trade in there too.
Financial engineering is complex, like hardware engineering or genetic engineering. Journalists at the smaller local papers generally are English majors.
Could you explain where all the money came from to give to these hedge funds? That repo facility part? Isn't that the Federal Reserve creating money out of thin air.... money is created by making a loan?
This time isn't quite so different. The banks may have sold off a lot of mortgages into securitization, but they ended up buying (back) large amounts of MBS. Furthermore, their exposure to RE developers is huge. In fact, bank exposure to RE overall as high as it's ever been -- higher than Texas banks to the oil business in the 80's (and none of them survived).
To my knowledge, Bear Stearns has a very large prime broker operation, which I would assume has grown in magnitude along with the hyper growth of the hedge fund industry over the past decade or so.....
How much of this hedge fund leverage has been extended by Bear Stearns and their prime broker subsidiary over the years? Is there any mention anywhere regarding BSC credit exposures to any of these potential financial landmines, particularly those leveraged hedge funds invested in mortgage/asset-backed-related securities?
Lastly, who else runs large prime broker operations? Goldman? JPM? Any credible help or feedback would be much appreciated.
Tanta,
"downgrades of the lowest tranches will prevent the deals from "stepping down," or redirecting the cash-flow of principal to the lowest-rated tranches."
lama, it's basically to guarantee that there remains principal balances of the lower tranches to write off.
The deal steps down only when it is projected to have significantly more principal balance in the subs than will be needed (with the OC) to cover projected remaining losses. If you allowed the subs to receive principal when loss projections are high enough to result in a downgrade, you'd risk amortizing them too fast. So it's really a question of speeds at this point (prepayment speeds and slope of the cumulative loss curve). You speed up (or maintain the speed) of the amortization of the top tranches while slowing down the amortization of the bottom tranches.
Tanta i just got home from hanging out in the CVS parking lot and i think u need to clarify what the effect of a downgrade is to an issuer, ie explain how an issuer earns ROE. maybe then there will be no more 'what's the big deal, most subprime bonds haven't been downgraded' comments. and to annoy the people who whine about long posts, maybe add in a discussion about 6 pack vs OC structures. oh boy that would be a sweet ubernerd!
ps i refuse to join the yahoo club. i'm a misunderstood genius, not a 'yahoo
A lot of the huge growth in hedge fund investing has come from pension funds using fund of fund managers The FOF guys go to pension funds and say we will pick the best hedge funds to invest in, all you have to do is commit $x mms to us. The original leaders in venture capital funds, then LBO funds, and now hedge funds were some of the biggest University endowment funds, and they had a spectacular track record. The private pension funds jumped next, followed by the public pension which have the largest dollars to invest, and now will take the greatest hit. The smartest money, the guys at Yale, are already scaling back. As usual, the little guy, the guy who works for the state will take the greatest hit.
Make that 121 yen to one USD... its 1.21 yen to the penny.
Carry works because of two things:
1) BOJ makes certain JPY:USD exchange rate is 'stable'... not 'flat line' like RMB:USD but sufficiently predictable within a range. It becomes a defacto peg in that respect. If dollar falls vs yen then BOJ jumps in & buys USD denominated assets - primarily treasuries & agency debt - changing supply/demand and pushing dollar up, yen down relative to each other.
That eliminates the currency arbitrage risk in the carry trade... then it becomes a traditional 'yield curve' carry... borrow short at low rates and lend long at much higher rates. So what if they are in different currencies as long as those currencies exchange rates are 'stble' relative to each other... BOJ assures that.
The second part is...
2) ZIRP - BOJ maintains a very low short term interest rate environment. Almost everyone on earth pays higher interest rates than BOJ so almost everywhere else makes for a possible carry end point.
However some destination currencies are better than others - those that are appreciating or have higher interest rates than USD assets would normally be best but only if the BoJ is expected to intervene to stabilize the yen exchange rate like with USD. Usually they don't because they aren't big trade partners... US is.
Where do the dollars come from allowing the BoJ to intervene by buying our debt? Our CA deficit with Japan, plain and simple.
Why does the BOJ do intervene? Because a weak yen insures they will be able to continue to export to us resulting in the large US CAD with Japan. So what if Japan faces internal deflation - sell the stuff to the US instead. They've been doing that for a loooong time.
If Japan stopped 'defending the dollar' OR went away from ZIRP... then the Japanese carry trade would end. It doesn't require BOTH happen, just one or the other to end carry.
And we haven't even started to discuss the PBoC intervention...
These guys can only continue to get paid by picking good hedge funds. In this environment, they will pull their investment in a fund as soon as possible if the performance is weak. This only accentuate the cash crunch that Tanta describes. It really is the perfect storm setting up!
zero interest rate policy-you have to remember, i'm not a financial guy and i've only been posting here for not even a couple wks. i will miss certain acronyms.
IMO a yen mortgage would be a terrible idea. The yen should be stable till a "Black Swan" type of event(Tokyo earthquake, big time hedge fund liquidations etc). At that time the yen could easily appreciate 20% or much more in a week. IMHO a yen mortgage would involve steady small profits for several years until there was a catastrophic loss.
I fish with my bil quite a lot... he's a poet. If we went fishing in Jamaica that's how it would be... with some details maybe cut from the video. LOL.
The best succinct explanation I've seen is published under the auspices of the San Francisco Fed - the document describes itself :
"The use of this strategy by investors is puzzling,
as the theory of interest parity conditions implies
that it should not generate predictable profits.This
Economic Letter explores this puzzle by first describ-
ing the structure of a carry trade transaction.It then
reviews research documenting the payoff proper-
ties of carry trades and discusses how these strate-
gies can be linked to the swings in exchange rates
observed over recent years. Finally, it presents some
evidence on the size of carry trade strategies."
Banker - I hope that your birth palce means you're a Red Sox fan.
"it is meant to be the price the fund would take if it had to liquidate the asset or unwind a position today"
I'd just like to quibble with this. There is nothing that forces hedge funds to mark at the bid. And with illiquid assets the bid can be significantly lower than the mid or last.
a, I was just trying to get to the point of marking a portfolio. So by "today" I didn't mean to imply "today's bid," I really just meant "present market value." If you're marking your position as of quarter-end, you don't use last quarter's value or a projection of next quarter's value.
["People clearly understand that there will be costs when they finance a home," said Dan Hanson, managing director of Countrywide. "Home buyers look to us for information, so we've decided to recommit ourselves to educating people about the cost options that work best for their unique situations. By presenting our customers with a menu of options, they can make an informed choice that's right for them now and into the future. And, the best choice in the long run isn't necessarily the one with the least out-of-pocket costs, but rather the one that brings the best total value over the life of the loan."]
Of course everyone clearly understood those advertised "Zero Cost Loan" programs actually cost money. Why wouldn't they. And of course the lowest cost loan isn't the best one. It's always the loan with the lowest payment...
Your blog entries are far more enlightening than anything in the financial press. That's the first really lucid of how CDO's work (and of the phrase "mark to model") that I've run across.
hi, you've got great posts in your site. gotta give you credit for that. found me some articles too in your site i think are worth bookmarking, thanks. keep it up.
"Could you explain where all the money came from to give to these hedge funds? That repo facility part? Isn't that the Federal Reserve creating money out of thin air.... money is created by making a loan?"
I'm sure not Tanta, but as far as I know, the money is created by the prime brokers, because they're banks.
That's why it's good to be a bank.
The Fed doesn't quite create money on its own---it's more that it encourages or discourages the private banks to do so.
Banks supposedly need a certain amount of money "on deposit" with the Federal reserve. This money doesn't earn interest. But what it means, is that a certain significant and large multiple thereof is allowable for them to loan out.
And when they loan it, that's when the money is created.
The "Fed funds rate" is the rate that it takes Fed member banks to borrow from each other (or who knows whom) for this Federal Funds, i.e. the amount necessary for deposit at the Fed.
Obviously private banks want to put as little as possible there. If they earn 7% on the loans they make and pay 3% on Fed Funds, why that's practically a license to print money.
Lever up boys.
So basically the investment banks (who are all core members of the Federal Reserve System ) created the money out of thin air by twiddling some numbers on their computers to say that hedge fund Big Swinging TanTans, LLC now has One Billion Dollars (use pinky), and at the same time our friends Boldman Hacks, also has an interest-earning 'asset' of 1 billion pinky flinching American pesos.
It's because they're a bank of the Federal Reserve system which makes this legal, instead of engaging in the Federal felony of counterfeiting.
And then the payment is to abide by the Fed's rules.
Hi..You have mentioned in your article Leverage, Ratings and Forced unwind that rating downgrades of the lower tranches of CDO "can seriously boost the cash flow up above". That makes sense but what that also would mean that subordination or support for the upper tranches would reduce(or atleast they will be under greater risk of lower subordination) and so the chances that the higher rated tranches will be paid off will reduce(even though the CDO is structured so as to direct cashflows in case of a ratings downgrade of lower tranches it does not protect the higher tranches from writedowns as and when the losses do reach the upper tranches)so a ratings downgrade of lower tranches(or a subsequent wipeout can actually reduce the chances of the upper tranches getting fully paid off.
What do you think?
Honestly, I don't know if this is an UberNerd post or an UnterNerd post.
I wondered what was going on - seemed the internet was slowing down. Now we know - its bandwidth was under the control of Tanta's fingers.
the TANTA at the bottom is a bit superfluous, no?
A lot of money being "invested" in these things comes from the Yen carry trade, I would imagine. I guess that's leverage on both sides.
But I actually don't understand the Yen carry trade. Can someone explain it to me?
This is as far as I've gotten. Players in the US borrow Yen for essentially zero interest rates. They then buy dollars (incidentally keeping the dollar strong and the yen weak) and invest those dollars in instruments such as those discussed by Tanta.
My question is: who do they buy the dollars from? And why doesn't it all come out in the wash? Who is selling them the billions of dollars involved?
"Honestly, I don't know if this is an UberNerd post or an UnterNerd post."
3175 words, I'm not smart enough to know the difference in a UberNerd and a UnterNerd post, so maybe you could write up a couple of job descriptions.
Fractious little group you are this morning. Maybe some of you need to go outside and play. With a big red rubber ball.
Anybody think it was too long?
We have not succeeded in solving all of your problems. The answers that we have found only serve to raise a whole new set of questions. In some ways we feel we are as confused as ever but we believe we are confused on a higher level and about more important things.
-- Unknow
Today's a unique morning Tanta. Can you figure out why we're all inside today?
do people understand the concept of warehouse leverage for a mortgage lender ie NEW?
i'm going outside to play with my balls.
Because your 12-year-old children are happily devouring a 700-page novel that they stood in line at midnight to buy, while you whine about a 300-word blog post?
Oh, sure, bacon dreamz, suggest that I should have made this longer by talking about warehouse haircuts.
Nope, this happens a Sunday every year in July...
Because you're celebrating Pi Approximation Day by refusing to leave the house?
Arbogast,
I suggest you immediately halt this line of questioning..
If you start wondering about things like "so they borrow yen to buy dollars and then buy other paper with the dollars", you're head will explode (very messy).
It's one of those confusing things where.. Oh, you know... No one wants Yen so it's easy to borrow and use to buy things.. But then that means someone wants it if they trade you for it.
Or how about.. Oh you know, China saves money and they use all that cash (Yuan and dollars from exports) to buy Treasuries to keep the Yuan devalued vs the Dollar. Who wants Yuan then? If you know China's just dropping it for Dollars?
Try to draw diagrams of where the money flows. Maybe the Fed is just printing Dollars, buying up Yen and Yuan, and just burning them?
Maybe it makes sense for whatever part of the system is sopping up Yen,Yuan... Because, one day.. That paper will be worth a lot vs the Dollar.. One would guess.
which whine is best with that Pi?
Sorry, your time is up. It's the last few holes of the British Open, which obviously is 6 hours ahead of the US...
Holy Mother of Accountant, you're suggesting my post is too long while you are watching golf?
I watched a golf tournament once. That's like 67 years of my attention span I'll never get back.
Tanta u do suffer from terseness. ur posts are way too short!
Watching golf you can multitask, easily. By the way it a very close tournament. Lead changes almost every hole.
Tanta,if you think golf is bad,try the fishing channel.
Fishing channel on mute is the best
Who needs the fishing channel when she has Haloscan?
I'm going to incorporate this info into a fairy tale I wrote for my kid named "Bear Stearns and the Three Hedge Funds".
Similar to how smugglers have worked since the beginning of time... you put the bad stuff in the bottom of a box mixed in with good stuff, in the back of container, 1 of 1000 on a ship, 1 of 100 at a port.
All the inspectors and captains know its out there, just convencing each other its not on their boat.
Too early in the a.m. for the Blended Scotch analogy.
Tanta,
I loved it....Thank you
"Whether that "diversification" is helping any, insofar as some of it involves commercial RE and LBO notes and other perfectly "uncorrelated" risk-free no-brainers, is another question"
Tanta-yesterday i recomm everyone listen to Fin. Sense's Online interview with Richard Arbogast, a man of your ilk, an MIT PhD economic graduate who gives us a glimpse into the wonderful world of Wall st. derviatives. one of his pts was that in times of crisis things normally with a -1 correlation coefficient (maximally uncorrelated) can become +1 perfectly correlated). one ex. he gave was hi yield junk bonds normally correlate (move together) with Treasuries so everyone was buying junk and shorting Treas. to take advant. of the spread. when the 1987 crash hit, everyone sold junk and BOUGHT Treas.(flight to quality) thus imparting a double whammy hit. i wonder if that is whatt is happeening now? he also said that the mere fact of grouping these seemingly uncorrel. components into a cdo which on the face of it suggests diversification really forces a correlation in a selloff. ex: the Blockbuster bonds get hit equally to the Chrylser bonds when the entire cdo tanks. i think you'd find the listen worthwhile.
before the subprime collapse, i was thinking about starting a subprime conduit. i was going to call it, 'ABS of Steel' to reflect the awesome safety provided by the tranching of risk...Billy Blanks was going to be head of marketing...
also to reflect the fact that i have abs of steel.
Arbogast-i'm not an expert but i assumed they could just get dollars in the foreign exchange mkts or just go to the banks and exchange. its not just US investors either. everyone pokes fun at the Japanese housewife driving alot of the trade so there must be some truth to that as well as japanese bank, hedge funds, and their mothers. i've also often wondered how i could get my hands on some yen for the same purposes. i wouldn't just dismiss this though as some arbitrary anomaly with no significance. its extremely significant to our world wide imbalances and should be watched carefully. if it starts to unwind as we started to see Friday it could be an indicator of bad things to come.
idoc, I listened to it and ordered the book. It was a great interview.
Carry trade:
Borrowing in YENs is in a fact shorting the YEN.
Those who engage in carry trade are either japanese who already have YEN and sell it to get higher yield (say in NZ
or
Hedge funds in the US who borrow in YEN, sell it to get US$ and use the $ to buy assets in the US.
Great post as usual, Tanta, but one minor suggestion. You appear to be using "equity" to mean two different things in this paragraph:
The first equity appears to mean investor equity, which drops by 25% because the entire $5 loss comes out of the investor equity, regardless of margin requirements. The second equity appears to mean the total holdings of the fund, no?
I think most people here can figure this out, but it took me a couple minutes.
bacon dreamz
You want to join the Yahoo club I think you qualify. LMAO
The "official" community has been warning about this structured credit "complexity" risk for years (e.g.,
http://www.bis.org/publ/qtrpdf/r_qt0506f.pdf and recent issues of the IMF's Global Financial Stability Report). I guess it's welcome to the Rodney Dangerfield club...
albrt, you're right, that was a less than fully effective way of putting it, wasn't it? All I can say in my own defense is that I was watching a golf tournament at the time and so got distracted. I'll fix . . .
Tanta/Arbt-ok you guys are losing me here. "The first equity appears to mean investor equity, which drops by 25% because the entire $5 loss comes out of the investor equity, regardless of margin requirements. The second equity appears to mean the total holdings of the fund, no?
Tanta pls take me thru the calc of "20% drop in the EQUITY of the fund."
Sergio needs an up and down from the pot bunker to win. Otherwise a 4 hole playoff. Great tournament either way.
idoc, Tanta's mind was temporarily elsewhere when that sentence was written. Refresh and try the new version. God help me if I screwed it up again . . . I'm listening to the Beach Boys, and being compelled to join in the chorus of "Don't Worry Baby" at a falsetto register about 3x outside of my so-called "singing voice" tends to require a lot of my energy . . .
Kevin, what is the Yahoo club? u mean the billy blanks fan club? i founded that shit...
Isnt the essence of the carry trade borrowing at a low rate in Japan and investing in a higher rate elsewhere? The arbitrage being in interest rates more than in currencies. A game that very few are positioned to play.
idoc,
It makes sense, on the surface, going out and borrowing a pile of Yen for 2% to, say, pay off some dollar denominated debt that's costing you 8% a year.
For simplicity's sake (who is this simplicity person?), let's say you got 1Dollar for each 1Yen that you borrowed. (the benefit being that you lowered your APR to 2% from 8%).
What happens if the Yen starts to rise (for whatever reason) versus the dollar? If you have to pay off the Yen debt with Dollars that you earn in the US.. this could (for lack of a more sophisticated way to say it) start to suck real quick. In 12 months, you could easily need to pay $1.20 for each 1Yen. So.. while saving that 6% spread APR.. you just added 20% to your total debt.
Now, it can work both ways.. and the value of the YenVSDollar can change as rapidly as it wants.
Who knows what'll happen over the next few years.. but I'm guessing it'll get very interesting.
Reputation and the Non-Prime Mortgage Market
One aspect of recent developments was odd and has turned out to be the source of much difficulty in the non-prime market. The steep yield curve during much of the 2002-04 period reflected investor expectations that short-term interest rates would be rising, which they in fact did. Yet, many mortgage-market participants apparently did not anticipate this increase. Of course, I would not expect average homeowners to be able to read the yield curve, but I find it odd that apparently sophisticated investors in non-prime mortgage-backed securities now claim surprise that many non-prime ARM borrowers are facing payment shock because of the increase in short-term interest rates over the past few years. Apparently driven by the prospects of high fee income and substantial spreads on non-prime ARMs, mortgage originators persuaded many relatively unsophisticated borrowers to take out these mortgages; then, investors willingly purchased them when they were securitized. Many of these mortgages are now in default, some of the lenders are bankrupt, and the mortgage-backed securities are trading at deep discounts to face value.
Given these widely held expectations of rising interest rates, it is difficult to avoid the judgment that these ARM loans were poorly underwritten at the outset. It was imprudent for mortgage brokers and lenders to approve borrowers who likely could not service the loans when rates rose, and it is surprising to me that sophisticated capital-market investors willingly purchased securities backed by such poorly underwritten mortgages.
William Poole
President, Federal Reserve Bank of St. Louis
St. Louis Fed | Page Not Found
Thank you Tanta ... I need this after a relatively short night "shot-gunning" beers... practice makes perfect.
---non-prime market---
Beware terminology shift
It's the last few holes of the British Open, which obviously is 6 hours ahead of the US...
Who won? Who won? uh...Who's winning?
IMO, the only more boring than playing golf is watching it. Leave trajectory analysis for the rocket scientists.
If you have to pay off the Yen debt
Bahahhahahhha hahahhahhaha
no one is planning on paying off yen debt...
thanks for making my afternoo
Albrt,
Concur with use of Equity-
People misuse the term in the times, bloomberg,cnbc, ft
It's Capital, which would be the correct term, correct?
Tanta, nice work. Curious though, just who was lending the money to the hedge funds for the leverage, and who is on the hook for the shortfall when the margin calls roll in and a fund is under water? I read that BSC made the lenders whole, but who were these lenders exactly? I assume many of the hedge funds that missed the exits won't be able to satisfy their lenders requests.
no one is planning on paying off yen debt...
thanks for making my afternoon
Hehe.. yes, well I would guess the people incorporated on Mars (or Deleware or Samoa or wherever) as No Liability Corporations will not be paying it back... they'll just close shop and wander off with all the money they made.
I mean the poor schlub who decided to literally borrow from a Japanese bank as him/herself to pay off a higher interest debt.. that schlub.
Should have just formed an LLC, shorted the Yen, and gone long SP500 futures (and crossed their fingers).
Anyhoo, you're welcome for making the afternoon.
For those too lazy to get the latest HP thingee
Harry Potter and the Deathly Hallows - Wikipedia, the free encyclopedia
After reading it, the plot is no less complex than presented here.
Does anyone know when the "prime" borrower loan pools of 5X - 6X income Negative Amortization loans begin to tank?
It's Capital, which would be the correct term, correct?
If you're an investor, it's probably capital. (I don't think it's Capital unless you're a German investor.) If you're a lender, it tends to be equity. I'm just using it in the balance sheet sense. Part of my problem is that I am used to dealing with on-balance-sheet securitizations, which is where the idea of OC as equity came from.
barely, as far as I can tell everybody and his pet kitty supplied part of the loans to the Bear fund. Last I saw, the reports were that Fund 1 managed to unwind without losses to the lenders by "refinancing" some of its loans with Bear's repo facility. It looks like real lenders lost real dollars on Fund 2.
So? That's what you get for making subprime loans to hedge funds.
The past real estate resessions losses caused the S&L debacle. This time it is different. For the most part the S&L's and mortgage brokers sold off the mortgages to Wall Street. The Street then repacked them and sold to Hedge Funds.
The unregulated Hedge Fund industry will absorb a portion of the losses. The bigger losses will be the Wall Steet Houses and the large Money Center Banks that have lend to these Hedge Funds to margin their CDO's.
As was seen in the Bear Stearn Hedge Enhanced Leverage Fund. When the losses pile up the Hedge Fund goes under. The equity vaporizes and the remaining losses are put to the margin lender; i.e. other Wall Street Houses and Money Center Banks.
It was these Investment Bank's that packaged these CDO's that are now essentially being putted back to them. They will end up eating there own garbage.
As these Hedge Funds stop withdrawals the ponzi-like scheme comes to an end. Not enough money coming in to pay the investors exiting.
The cycle feeds on itself. Less lending, higher rates, greater losses. Fewer investment in hedge funds. The real impact is the spillover to all the Leverage Buyout Deals. Fewer deals fewer takeovers lower stock prices along with lower home prices.
This was great and very informative. Thanks Tanta
"Kevin, what is the Yahoo club? u mean the billy blanks fan club? i founded that shit..."
Its a club for those of us that Tanta probably wishes didnt own computers. Watch your knuckles I think she went to get the ruler.
So if I buy the downgraded stuff for say, 9 cents and held it to term, I could actually make out okay?
Thanks, David.
Kevin, for the record I am perfectly thrilled that Yahoos own computers. It keeps them out of the parking lot of my local CVS.
OK Finished the post. Great one.
I still can not quantify where we are, how bad is all this going to get. But I suspect that I am not the only unable to quantify what is going on.
Tanta, So... WHo is everyone and their pet kitties? LEH, BSC, CIT, GS, MER... all of the above and then some?
Better yet, how did you determine it and is it something that I can see?
Tanta,
Another outstanding contribution (although it is a bit short - heh).
One point that might be considered for some future work:
If Jhon Doe defaults on a $250K, 100% LTV, ARM that winds up with a loss severity of let's say 20%, then someone gets to lose $50K of real money, yes? Then somerwhere, after all the "risk reduction" hedging etc., one or more people still get to lose $50K, right?
But, in the mean time, Wall Street Geniuses (tm) got to make lots of fees to slice and dice the various cashflows, create the CDS protection, etc.
It seems to me that someone also gets to pay the WSGs lots of money to do this service. Therefore, the total loss is going to be a more than just the $50K. Any idea how much this pain will be and how it is going to be spread?
barely, that was in the original press coverage from back in June.
My understanding is that most of these cases involve syndicates of lenders behind the prime broker. Lenders have diversification issues, too.
Tanta has many lucrative days ahead of her serving as an expert witness for the defense. Few judges and absolutely no jurors will be able to tolerate the migraines that will come from attempting to parse the bewildering complexity of terms and interdependent relationships of structured finance. Even the eyes of $600-an-hour plaintiffs' attorneys will begin to glaze as she drones remorselessy on about distinctions without differences, equity vs. capital, and so on and so forth. By the end of the second week of her testimony, everyone from the bailiff to the court reporter will be eyeing the exits and fervently whispering their deepest, most heartfelt wish: dismissal, dismissal, DISMISSAL. ;>0
Tanta, that is just an excellent tutorial. As much time as I've spent studying this situation (over half of my work time over the last year), in several dozen clear paragraphs you explained a number of things I still had not grasped: especially the triggers and the conflicts over down-ratings. Thank you very much for the time and effort you put into this lesson. I do appreciate it.
PS -- My excuses for repeating these thanks, which I first posted in the comments to a different blog entry. Well, most of the blog entries here at CR are really very good.
Alan
eli-the problem with your theory is that the yen carry trade has been a viable and profit making adventure for around 2 decades. currently you can buy 1.21 yen per usd. it threatens to unwind but never does. thus everyone and their mother (literally Japanese mothers) are borrowing yen to invest abroad mainly for interest differentials. if the yen weakens further they get extra bang for their buck via currency exchange. and fyi, their interest rate is 0.5% while US treasuries are 5.25%, quite a differential. Japan is THE largest holder of US treasuries and some have accused Paulson of an unofficial deal with the japanese to keep it this way b/c his GS makes easy money off it and it helps keep our interest rates down. never mind that the tradeoff is the gutting of US manufacturing. Wall st, hedge funds US and japanese, japanese banks are the biggest exploiters of this trade. this has also funded cdo investment by hedge funds in a big way which could be why we're seeing some slight yen strengthhening rel. to the usd. i agree with you that if this unwinds it will devastate many current trade positions incl our stock mkt which is why one must pay attention to it at all times.
barely-all the other major investment banks lended to the 2 BSC hedge funds and i wouldn't be surprised if there was some carry trade in there too.
Tanta, I love your posts.
Financial engineering is complex, like hardware engineering or genetic engineering. Journalists at the smaller local papers generally are English majors.
Could you explain where all the money came from to give to these hedge funds? That repo facility part? Isn't that the Federal Reserve creating money out of thin air.... money is created by making a loan?
Tanta-my 15 yo has had his nose buried in that same book for the last 24 h. actually kind of peaceful...
T-, thank you for the easy-to-follow example/well-illustrated explanation.
Nice closing, Bubba vs. Buffy, too. I hate it when schmucks/sharks end up eating their own.
frank,
This time isn't quite so different. The banks may have sold off a lot of mortgages into securitization, but they ended up buying (back) large amounts of MBS. Furthermore, their exposure to RE developers is huge. In fact, bank exposure to RE overall as high as it's ever been -- higher than Texas banks to the oil business in the 80's (and none of them survived).
To my knowledge, Bear Stearns has a very large prime broker operation, which I would assume has grown in magnitude along with the hyper growth of the hedge fund industry over the past decade or so.....
How much of this hedge fund leverage has been extended by Bear Stearns and their prime broker subsidiary over the years? Is there any mention anywhere regarding BSC credit exposures to any of these potential financial landmines, particularly those leveraged hedge funds invested in mortgage/asset-backed-related securities?
Lastly, who else runs large prime broker operations? Goldman? JPM? Any credible help or feedback would be much appreciated.
Thx in advance.
RUD
Tanta,
"downgrades of the lowest tranches will prevent the deals from "stepping down," or redirecting the cash-flow of principal to the lowest-rated tranches."
Why is that?
Thank you great one.
Hey y'all! Need a laugh today? Some housing slump video clips on utube...
Ft Meyers home auction coverage on local news - Hilarious!
YouTube - FLORIDA HOUSING CRASH 50% OFF
P Schiff vs Bulls - LMAO!
YouTube - Real Estate Predictions 2007
Re: Tanta, if you think golf is bad,try the fishing channel.
Recommended: Fishing with John
"dry humor... at it's finest"
Dryfly:
Could be this is for you...
...
lama, it's basically to guarantee that there remains principal balances of the lower tranches to write off.
The deal steps down only when it is projected to have significantly more principal balance in the subs than will be needed (with the OC) to cover projected remaining losses. If you allowed the subs to receive principal when loss projections are high enough to result in a downgrade, you'd risk amortizing them too fast. So it's really a question of speeds at this point (prepayment speeds and slope of the cumulative loss curve). You speed up (or maintain the speed) of the amortization of the top tranches while slowing down the amortization of the bottom tranches.
Idoc,
Do you know how I can get a Yen-denominated mortgage in USA? - I would be interested in playing the carry trade for me, too.
Joe
Tanta i just got home from hanging out in the CVS parking lot and i think u need to clarify what the effect of a downgrade is to an issuer, ie explain how an issuer earns ROE. maybe then there will be no more 'what's the big deal, most subprime bonds haven't been downgraded' comments. and to annoy the people who whine about long posts, maybe add in a discussion about 6 pack vs OC structures. oh boy that would be a sweet ubernerd!
ps i refuse to join the yahoo club. i'm a misunderstood genius, not a 'yahoo
Schahrzad Berkland,
A lot of the huge growth in hedge fund investing has come from pension funds using fund of fund managers The FOF guys go to pension funds and say we will pick the best hedge funds to invest in, all you have to do is commit $x mms to us. The original leaders in venture capital funds, then LBO funds, and now hedge funds were some of the biggest University endowment funds, and they had a spectacular track record. The private pension funds jumped next, followed by the public pension which have the largest dollars to invest, and now will take the greatest hit. The smartest money, the guys at Yale, are already scaling back. As usual, the little guy, the guy who works for the state will take the greatest hit.
currently you can buy 1.21 yen per usd
Make that 121 yen to one USD... its 1.21 yen to the penny.
Carry works because of two things:
1) BOJ makes certain JPY:USD exchange rate is 'stable'... not 'flat line' like RMB:USD but sufficiently predictable within a range. It becomes a defacto peg in that respect. If dollar falls vs yen then BOJ jumps in & buys USD denominated assets - primarily treasuries & agency debt - changing supply/demand and pushing dollar up, yen down relative to each other.
That eliminates the currency arbitrage risk in the carry trade... then it becomes a traditional 'yield curve' carry... borrow short at low rates and lend long at much higher rates. So what if they are in different currencies as long as those currencies exchange rates are 'stble' relative to each other... BOJ assures that.
The second part is...
2) ZIRP - BOJ maintains a very low short term interest rate environment. Almost everyone on earth pays higher interest rates than BOJ so almost everywhere else makes for a possible carry end point.
However some destination currencies are better than others - those that are appreciating or have higher interest rates than USD assets would normally be best but only if the BoJ is expected to intervene to stabilize the yen exchange rate like with USD. Usually they don't because they aren't big trade partners... US is.
Where do the dollars come from allowing the BoJ to intervene by buying our debt? Our CA deficit with Japan, plain and simple.
Why does the BOJ do intervene? Because a weak yen insures they will be able to continue to export to us resulting in the large US CAD with Japan. So what if Japan faces internal deflation - sell the stuff to the US instead. They've been doing that for a loooong time.
If Japan stopped 'defending the dollar' OR went away from ZIRP... then the Japanese carry trade would end. It doesn't require BOTH happen, just one or the other to end carry.
And we haven't even started to discuss the PBoC intervention...
As a follow up to fund of fund managers:
These guys can only continue to get paid by picking good hedge funds. In this environment, they will pull their investment in a fund as soon as possible if the performance is weak. This only accentuate the cash crunch that Tanta describes. It really is the perfect storm setting up!
Tanta,
As we say in MA, "Light dawns on Marblehead."
Marblehead is a seaside town with a nice sunrise.
"Lastly, who else runs large prime broker operations? Goldman? JPM? Any credible help or feedback would be much appreciated."
Try Morgan Stanley
Morgan Stanley - Prime Brokerage
then Goldman, as the top two.
BearStearns would likely be a very aggressive third or fourth place vying for a piece of this market with everyone else. . .
dryfly-so whats a couple of decimal pts, eh? what is ZIRP?
joe- i don't know if you can get a yen denom mortgage for prop in USA. i did find this link:http://answers.google.com/answers/threadview?id=438095
Hmmm that Yen denominated mortgage is looking more expensive by the day... YEN just about to crack 121 and looks to be headed south in a hurry...
alongwith the nikkei(-1.5%)
idoc-zirp (your joking right?)
Nice summation, Dryfly
I've been theorizing that Putin and Abe need to sit down, sing cumbaya, and have japan's export capacity shifted to Russia...
zero interest rate policy-you have to remember, i'm not a financial guy and i've only been posting here for not even a couple wks. i will miss certain acronyms.
lama,
I grew up in Marblehead and my family still lives there. One of the great places on the planet. Maddies, mmmmm
Nice explanation of 'carry trade,' dryfly. Thank you.
IMO a yen mortgage would be a terrible idea. The yen should be stable till a "Black Swan" type of event(Tokyo earthquake, big time hedge fund liquidations etc). At that time the yen could easily appreciate 20% or much more in a week. IMHO a yen mortgage would involve steady small profits for several years until there was a catastrophic loss.
(I currently own some OOTM Dec yen calls)
When you think about the New Home sales numbers this week consider last week's NAHB sentiment survey and then look at the concensus numbers again.
I take the under.
Recommended: Fishing with John
"dry humor... at it's finest"
Dryfly:
Could be this is for you...
ecoshift - outstanding. I had to watch them all.
I fish with my bil quite a lot... he's a poet. If we went fishing in Jamaica that's how it would be... with some details maybe cut from the video. LOL.
re arbogast at 11:34 am on the carry trade.
The best succinct explanation I've seen is published under the auspices of the San Francisco Fed - the document describes itself :
"The use of this strategy by investors is puzzling,
as the theory of interest parity conditions implies
that it should not generate predictable profits.This
Economic Letter explores this puzzle by first describ-
ing the structure of a carry trade transaction.It then
reviews research documenting the payoff proper-
ties of carry trades and discusses how these strate-
gies can be linked to the swings in exchange rates
observed over recent years. Finally, it presents some
evidence on the size of carry trade strategies."
The document is at:
http://www.frbsf.org/publications/economics/letter/2006/el2006-31.pdf
It is tough to read - and I think there is an element of doubling down that they miss. Brian Setzer at Roubini has also talked of it.
Most of these financial strategies are tough to follow - but its worthwhile understanding them.
Tanta of course has a talent for making housing stuff readable and understandable. Few people have that skill.
-K
sk - I read Setser almost everyday & read the fed paper you linked to once. Those are excellent sources.
And I agree - economic theory would suggest that currency arbitrage should erase any sustained gain available through carry trade.
Except no ones told the BOJ that... or if they did tell them they aren't listening.
I also agree VERY strongly with your point that its a tough act to copy. Kids, don't do this at home.
Golf, fishing. If you want adventure TV, go here
Banker - I hope that your birth palce means you're a Red Sox fan.
"it is meant to be the price the fund would take if it had to liquidate the asset or unwind a position today"
I'd just like to quibble with this. There is nothing that forces hedge funds to mark at the bid. And with illiquid assets the bid can be significantly lower than the mid or last.
a, I was just trying to get to the point of marking a portfolio. So by "today" I didn't mean to imply "today's bid," I really just meant "present market value." If you're marking your position as of quarter-end, you don't use last quarter's value or a projection of next quarter's value.
Mozilo came up with his newest latest con job:
["People clearly understand that there will be costs when they finance a home," said Dan Hanson, managing director of Countrywide. "Home buyers look to us for information, so we've decided to recommit ourselves to educating people about the cost options that work best for their unique situations. By presenting our customers with a menu of options, they can make an informed choice that's right for them now and into the future. And, the best choice in the long run isn't necessarily the one with the least out-of-pocket costs, but rather the one that brings the best total value over the life of the loan."]
Of course everyone clearly understood those advertised "Zero Cost Loan" programs actually cost money. Why wouldn't they. And of course the lowest cost loan isn't the best one. It's always the loan with the lowest payment...
Shameless.
Tanta,
You continue to crack me up.
Thanks
Tanta,
Your blog entries are far more enlightening than anything in the financial press. That's the first really lucid of how CDO's work (and of the phrase "mark to model") that I've run across.
Isn't the yen carry trade the same thing as "selling USD denominated CDO's to the Japs"?
hi, you've got great posts in your site. gotta give you credit for that. found me some articles too in your site i think are worth bookmarking, thanks. keep it up.
jay
board and batten
Tanta,
I found your explanation on how CDO's work more clear than I have been able to find anywhere else so far. I really enjoyed the article.
great posting. keep it up!
"Could you explain where all the money came from to give to these hedge funds? That repo facility part? Isn't that the Federal Reserve creating money out of thin air.... money is created by making a loan?"
I'm sure not Tanta, but as far as I know, the money is created by the prime brokers, because they're banks.
That's why it's good to be a bank.
The Fed doesn't quite create money on its own---it's more that it encourages or discourages the private banks to do so.
Banks supposedly need a certain amount of money "on deposit" with the Federal reserve. This money doesn't earn interest. But what it means, is that a certain significant and large multiple thereof is allowable for them to loan out.
And when they loan it, that's when the money is created.
The "Fed funds rate" is the rate that it takes Fed member banks to borrow from each other (or who knows whom) for this Federal Funds, i.e. the amount necessary for deposit at the Fed.
Obviously private banks want to put as little as possible there. If they earn 7% on the loans they make and pay 3% on Fed Funds, why that's practically a license to print money.
Lever up boys.
So basically the investment banks (who are all core members of the Federal Reserve System ) created the money out of thin air by twiddling some numbers on their computers to say that hedge fund Big Swinging TanTans, LLC now has One Billion Dollars (use pinky), and at the same time our friends Boldman Hacks, also has an interest-earning 'asset' of 1 billion pinky flinching American pesos.
It's because they're a bank of the Federal Reserve system which makes this legal, instead of engaging in the Federal felony of counterfeiting.
And then the payment is to abide by the Fed's rules.
Hi..You have mentioned in your article Leverage, Ratings and Forced unwind that rating downgrades of the lower tranches of CDO "can seriously boost the cash flow up above". That makes sense but what that also would mean that subordination or support for the upper tranches would reduce(or atleast they will be under greater risk of lower subordination) and so the chances that the higher rated tranches will be paid off will reduce(even though the CDO is structured so as to direct cashflows in case of a ratings downgrade of lower tranches it does not protect the higher tranches from writedowns as and when the losses do reach the upper tranches)so a ratings downgrade of lower tranches(or a subsequent wipeout can actually reduce the chances of the upper tranches getting fully paid off.
What do you think?