dxn/dx = n xn-1

No, not that kind!
The financial kind.

The contents of this document fall into two parts:
excerpts from Frank Partnoy’s F.I.A.S.C.O. and
miscellaneous articles.

Frank Partnoy’s FIASCO

Here are some excerpts from the Afterword
FIASCO: Blood in the Water on Wall Street
by Frank Partnoy.
The main book was published in 1997,
but the above edition includes a roughly 20 page afterword dated January 2009.
Almost all of the emphasis is added by the author of the current blog.


This book is the story of my journey
through the gluttony and dysfunctionality of 1990s Wall Street.
But it also is a story about the roots of the 2008 market crisis.
Today, when I am asked if anyone saw this crisis coming,
I think back to the people I worked with
in the derivatives groups at Morgan Stanley and First Boston,
and my answer is yes.
We invented the products that ultimately blew up the banks.
We created the instruments at the center of the subprime mortgage meltdown.
We fostered a culture of epic greed,
which nearly destroyed the financial system.

Yes, we saw it coming. How could we not?

The final months of 2008 marked the end of an unprecedented saga of excess.
The mania, panic, and crash had many causes.
But if you are looking for a single word to use
in laying blame for the recent financial catastrophe,
there is only one choice.

Without derivatives,
leveraged bets on subprime mortgage loans
could not have spread so far or so fast
Without derivatives,
the complex risks that destroyed Bear Stearns, Lehman Brothers, and Merrill Lynch,
and decimated dozens of banks and insurance companies, including AIG,
could not have been hidden from view.
Without derivatives,
a handful of financial wizards could not have
gunned down major mutual funds and pension funds,
and then pulled the trigger on their own institutions.
Derivatives were the key;
they enabled Wall Street to maintain its destructive run until it was too late.

In what follows,
I will connect the dots from the mid-1990s through the end of 2008.
I will describe how investors and regulators ignored repeated warnings
about the hidden dangers of derivatives.
I will show you how derivatives were at the heart of the collapse.


[The following is a bit of technical explanation
necessary to clearly understand the risks that are described below.]

Remember that a put option is
the right to sell some underlying financial instrument
at a specified time and price.
In the trader’s parlance, or Corvette lingo,
if you bought a put option, you might pay $1,000 today for
the right to sell a Corvette for $40,000 ($40K) sometime during the next month.
You would make money if the price of Corvettes dropped.
If the price of a Corvette dropped to $30K, you would make $10K—
the $40K you could sell a Corvette for, using the put option,
minus the $30K you could buy a Corvette for in the market
(less the $1K premium you had paid).
Whereas the buyer of a put option wants the price to go down,
the seller of a put option wants the price to stay the same or go up—
but definitely, please, don’t go down.
The more the price goes down,
the more the seller of the put option has to pay the buyer.

In our example, if the price of Corvettes had dropped to $30K,
and we had sold put options on 100 Corvettes, we would have lost $900K
($1 million less the $100K premium we had received).
The strategy of selling put options does not carry
the one benefit Morgan Stanley touted for some of the riskier products it sold:
“downside limited to size of initial investment.”
In this case, you could lose more than everything.
A put seller’s downside is limited only by the size of his or her imagination
(and the fact that prices usually don’t fall below zero).


Not long after I left Morgan Stanley in 1995,
David Li, a thirty=something math whiz from rural China,
joined second-tier Canadian Imperial Bank of Commerce.
Li was thinking about the same problem
my derivatives colleagues and I had addressed with
[other deals Partnoy described earlier, namely]
the FP Trust, PLUS, and MX deals:
how can you repackage low-rated assets to create high-rated ones?

At Morgan Stanley,
we had created dozens of collateralized debt obligations, or CDOs,
and we had become quite skilled at
persuading the rating agencies, and investors,
that they should label an investment AAA,
even if the underlying assets were risky.
FP Trust was the classic example:
a risky and high-yielding financial cake
made of crap (Philippine National Power bonds)
with a thin layer of attractive icing (U.S. Treasuries).

But FP Trust proved to be too brazen,
which is why S&P ultimately branded it with a subscript “r” [for “Restricted”].
Even the unsophisticated analysts at S&P
saw through the simple icing layer
and figured out that
they shouldn’t be giving unadulterated AAA ratings
to what was underneath.
Wall Street needed a new way to mix crap together
to make it look like real cake.

The mixing process was key.
One might reasonably assume that crap would be toxic.
But what if you could pool different types of crap,
and then extract the unhealthy parts?
What if the negative characteristics of some fecal material
offset the negatives of others,
magically canceling out any risks?
Like matter and anti-matter.
Crap and anti-crap.

Had I stayed at Morgan Stanley,
the question of how to create a better mixing process
would have captured my attention.
Bankers everywhere were looking for ways to remodel
the relationships among assets in a portfolio.
The key variable everyone focused on was correlation,
the extent to which assets might decline simultaneously.
Just as crap might become safer if pooled [?],
financial assets might become less risky when put together—
especially if you could show persuasively that
any expected declines or defaults on those assets would not be highly correlated.
One bond might default, but if you held a hundred uncorrelated bonds,
not very many would default at a time.

Several people discovered good mixing models,
but David Li found the best one.
It had the most colorful history as well.
Li reframed the mixing problem as an inquiry into death,
something he knew a fair amount about,
and not just because his father, a Chinese police official,
had moved his family to the countryside
to escape the purges of Mao’s Cultural Revolution.
Li knew that statistical research into
what was known as the “broken heart” problem
suggested that
people died more quickly after their spouses died.
In a not-very-touching move,
insurance companies had tried to profit from this phenomenon
by denying coverage and raising premiums for bereaved spouses.

Li saw a straightforward, though perhaps implausible,
analogy to this insurance problem,
through the use of a mathematical formula known as a copula,
a kind of skewed, bell-curve distribution that described the probability of death.
A default by a company or an individual was like a death.
Just as statisticians had modeled
how people reacted when their spouses died using copulas,
Li could use the same math to show how different assets reacted
when one of them “died,” or defaulted.
As Li told the Wall Street Journal,
“Suddenly I thought that the problem I was trying to solve
was exactly like the problem these guys were trying to solve.
Default is like the death of a company,
so we should model this the same way we model human life.”
[The obvious problem here is that spouses are indeed coupled by a web of relationships.
Are companies so strongly connected?]

At first, that idea sounded ridiculous,
especially to the salesmen who would be charged with
dumping the resulting CDO investments on clients.
Human life? Broken heart?
Who was David X. Li anyway?
The first reaction of a typical salesmen,
after they’d asked what the fuck the “X” stood for,
would have been to note that “copula” sounded like “copulate.”
[No wonder, they have the same Latin root, cōpulāt or cōpulāre.]

But once the salesmen learned that the commissions for selling new CEOs
were a hundred times higher than those for most other investments,
they stood at attention.
When they heard these CDOs had high yields and AAA ratings,
all they could talk to their clients about
was the genius of David X. Li and his new copulas.

Li moved up the ladder to J.P.Morgan Chase.
He published his copula model in an academic journal.
(If you want to read the article, it’s called
“On Default Correlation: A Copula Function Approach”
and is in the Journal of Fixed Income, Volume 9 (2000), pp. 45-54.
I can’t recommend it as riveting bedtime reading,
although I like his reference to the “Frank” copula—
no blood relation, I assure you.)

According to the math, huge amounts of risk disappeared
when you pooled risky assets together into a CDO.
[Whenever I read or hear statements like that,
I wonder how many assumptions are needed to support that math,
or, if it relies on statistical modeling,
exactly what was the base data set on which the modeling occurred.]

As a result, a large share of the pooled investment could be rated AAA.
Word spread about this result like a game of telephone.
Mathematicians explained the model to derivatives structurers,
who explained the model to rating agency analysts,
who explained the model to salespeople,
who explained the model to investors.
By the end, the message had warped
from logarithmic functions and negative infinity symbols,
to fat tails and low correlations,
to simply “AAA, pass it on.”

Wall Street derivatives arrangers trolled for risky assets to pool
using the new methodology.
Banks created hundreds of billions of dollars of new CDOs
backed by low-rated corporate bonds, emerging markets debt,
and subprime mortgage loans.
They split the CDOs into levels, or tranches,
based on the seniority of claims.
The tranches were like the floors of a building built in a flood plain.
The lowest floors were the riskiest and would be flooded with losses first.
The middle levels were protected by the lower levels.
The highest floors seemed very safe.
It would take a perfect storm to flood them.
Or at least that was what the mathematical models said.

The ratings agencies, primarily S&P and Moody’s,
were willing to rate many CDO tranches AAA,
even though the underlying assets already carried much lower ratings—
from them.
In their eyes, the models
could magically transform a pool of BBB-rated subprime mortgage loans
into a somewhat smaller pool of AAA-rated CDO investments.
[Talk about turning a sow’s ear into a silk purse!]
These AAA ratings were nearly as preposterous as the AAA ratings for FP Trust,
but the rating agencies’ mathematical models,
including a version of Li’s copula,
better hid the dubious nature of the ratings.
The crap had become cake.
Investors either believed the ratings
or ignored the ratings’ unreasonable bases
(as well as the fact that the banks paid the rating agencies
triple their usual fees for these ratings.)
The CDO business boomed and became the most profitable part of Wall Street.

When mortgage lenders
such as New Century Financial Corporation and Countrywide Financial
saw the insatiable demand for risky loans
they began making too-good-to-be-true loan offers
to anyone they could find.
Many people have criticized borrowers
for taking loans they couldn’t possibly repay.
Much of that criticism is fair, but it ignores the big picture.
The driving force
behind the explosion of subprime mortgage lending in the U.S.
was neither lenders nor borrowers.
It was the arrangers of CDOs.
They were the ones supplying the cocaine.
The lenders and borrowers were just mice pushing the button.

However, the new CDO mixing process had limits.
The models could only convert certain kinds of risky assets
into new AAA-rated instruments,
and there simply weren’t enough of those risky assets.
As bankers structured more CDOs,
they bought up all of the underlying assets
that best fit the profile of the mathematical models.
Once these assets were in CDOs,
they were stuck there and couldn’t be repackaged again.
It was hard to believe,
but the bankers were running low on risky assets.
After low-rated bonds and loans had been pooled once, they were gone,
and therefore no longer available to be pooled again.

It was truly incredible,
but there simply wasn’t enough crap on Wall Street.

This is where derivatives entered the picture.
The major banks recently had begun trading credit default swaps.
Credit default swaps are like life insurance:
one party pays a premium and receives a benefit upon death,
except that as with Li’s model
the death is not the death of a human being.
Instead, the “death” that triggers payment is the default on some obligation,
such as a corporate bond or mortgage loan.

There is no limit to
the number of credit default swap side bets parties can make.
If General Motors has a billion dollars of bonds outstanding,
you can only get a maximum of
a billion dollars’ worth of fixed-income exposure to General Motors.
But by using credit default swaps,
you can increase your exposure to credit default swaps without limit.
If you want a trillion dollars of exposure,
you simply enter into a credit default swap based on General Motors,
and then multiply by a thousand.
It doesn’t matter whether the bonds exist or not.
This a side bet, like gambling on a sporting event.
There might be a limit to
the amount of exposure you can get to a professional sports team
by investing directly in the team,
but there is no limit to the exposure you can get
from betting on its games.

Wall Street saw
they could use credit default swaps to create an infinite amount of crap.
They quickly engineered new repackaging transactions,
using credit default swaps to clone risky subprime-mortgage-backed investments
that, when pooled, generated more sky-high ratings.
These new deals were known as “synthetic” CDOs,
because they had been created artificially,
through derivatives side bets.
Instead of basing payoffs on subprime mortgage loans that
actually existed in the real world,
the banks created an Alice in Wonderland world
and based payoffs on
the multiple virtual realities that were down the rabbit hole.

If you were a homeowner with a risky subprime mortgage loan,
CDO arrangers might put together a hundred side bets
on whether you would default.
Through credit default swaps,
a hundred investors around the world could be exposed to
the risk that you might not make your next monthly payments.

Soon, investors around the world
were buying complex subprime-backed financial instruments:
synthetic CDOs, structured investment vehicles,
constant-proportion debt obligations,
and even something called CDO-squared (don’t ask).
The demand for these derivatives-backed investments
was a tail wagging a very large dog.

Back when I worked at Morgan Stanley [1993-95],
credit default swaps did not even exist.
Yet by 2008, the credit default swaps market had grown to $60T (trillion).
To put that number in perspective,
the entire world’s (yearly) gross domestic product was $60T.
The value of all of the publicly traded stocks in the world was less than that.
During the same time,
the size of the derivatives market overall had increased
from $55T of notional amount in the mid-1990s
to an incredible $600T (again, trillion!).
To paraphrase the late Senator Everett Dirksen,
$60T here, $60T there, and pretty soon you’re talking about serious money.

By 2006,
there were as many synthetic CDOs backed by credit default swaps
as there were actual CDOs backed by real mortgage loans.
By 2007,
insurance companies had joined the banks
as major players in credit default swaps.
AIG led this pack;
it sold half a trillion dollars of credit default swaps,
including swaps based on CDOs.
Because all of these derivatives were unregulated,
no one could figure out who held what.
No institutions disclosed details about their credit derivatives.
Lehman Brothers was a typical example:
it grouped credit default swaps along with other derivatives,
so no one could accurately assess its exposure.

The banks bought staggeringly large amounts of
so-called super-senior tranches of synthetic CDOs.
That term referred to the top floors of CDO “buildings”
filled with subprime mortgage loans.
They were called “super-senior” and were rated AAA,
because the mathematical models said they were senior enough
to be safe from even a Noah’s-era flood.
The banks’ positions were similar to
those in the Corvette example earlier [page 255, ¶3.18].
The banks had sold put options,
except that in this case the options were out-of-the-money,
like a put option on a $40K Corvette that would not be triggered
until the price fell to $30K.

the banks were selling put options based on subprime mortgage loans.
They took in insurance premiums in the form of
periodic swap payments from their counterparties.
In return,
they assumed the risks of a major increase in subprime mortgage defaults.
But the trades were labeled super-senior and rated AAA.
That was a marketing ploy.
If they had been called put options instead,
it would have been more apparent that they had real downside risk.

The rating agencies’ models said these super-senior tranches were so safe
because they had a large cushion protecting them against losses,
in the same way the top half of a ten-story building
would be protected by the bottom five floors.
According to these models,
the probability that a mortgage market decline would go through that cushion,
to damage the more senior tranches, was essentially zero.

What did the banks’ managers and boards of directors think of these risks?
Either they were comfortable with
having shareholders bear the risk of major losses
in the event of a subprime mortgage decline,
or they had no idea what the risks were.
Or perhaps some of both.

In any event,
managers and directors did not warn shareholders
about the massive losses they would incur
if housing prices declined so that
defaults on subprime mortgage loans increased
and became more highly correlated.
They did not tell shareholders they had done the equivalent of
selling put options based on housing prices.
Because so many people had taken out risky mortgage loans—
with teaser rates, interest-only adjustable payments, and no money down—
a decline in the price of their homes would put the homeowners deep underwater,
with little incentive or ability to repay their debts.
Many of them would default at the same time,
which would flood even the top floors of a subprime-backed synthetic CDO.
The banks’ senior officials either hid, or did not understand, this risk.

As long as housing prices remained high, or even flat,
the banks and their employees would earn large profits from the subprime CDO insurance premiums.
But if housing prices collapsed,
the banks would be like a million Victor Niederhoffers
[a hedge fund manager Partnoy described previously who lost his whole fortune]
or a thousand LTCMs.
Anyone who looked closely at the details and understood derivatives
could see that
the impact of a flood of defaults would be truly biblical.
That was why, beginning as early as 2006,
many sophisticated investors, including several hedge funds,
placed big bet against both the subprime mortgage markets and the banks.
Those bets would, almost overnight,
make them some of the wealthiest people in the world.

[Afterword 8.1]
[In the first half of April,]
New Century, the second-largest subprime lender in the United States,
filed for bankruptcy.
Soon after that,
Countrywide, the leading lender, went into free fall.
The savviest hedge funds increased their short positions
and the value of subprime mortgage loans plummeted.
Bank stocks began to decline.

[Afterword 8.2]
In June,
Moody’s and S&P finally had to admit they had been terribly wrong.
Moody’s downgraded the ratings of
$5G (billion) of subprime mortgage-backed securities
and put 184 CDO investments on review for downgrade.
S&P placed $7.3G of deals on negative watch.
One by one, banks began announcing massive losses
from investments backed by subprime mortgage derivatives.

[Afterword 8.3]
Bear Stearns collapsed and was purchased by J.P. Morgan.
Lehman Brothers filed for bankruptcy.
Merrill Lynch sold itself to Bank of America, which also bought Countrywide.
The U.S. government had to rescue AIG, the world’s leading insurance company,
and the handful of banks that were still standing.
By the end of the year,
most experts were calling the financial crisis
the worst since the Great Depression.

[Afterword 8.4]
Without derivatives,
the total losses from the spike in subprime mortgage defaults
would have been relatively small and easily contained.
Without derivatives,
the increase in defaults would have hurt some,
but not that much.
The total size of subprime mortgage loans outstanding
was well under a trillion dollars.
The actual decline in the value of these loans during 2008
was perhaps a few hundred billion dollars at most.
That is a lot of money,
but it represents less than 1 percent
of the actual market decline during 2008.

[Afterword 8.5]
derivatives multiplied the losses from subprime mortgage loans,
through side bets based on credit default swaps.
Still more credit default swaps,
based on defaults by banks and insurance companies themselves,
magnified losses on the subprime side bets.

As investors learned about all of this side betting,
they began to lose confidence in the system.
When they looked at the banks’ financial statements,
all they saw were
vague and incomplete references to unregulated derivatives.
By the time banks voluntarily disclosed
some additional information about their complex positions,
it was too late.
The dominos already had fallen.

[Afterword 8.6]
This story was Victor Niederhoffer’s writ large.
Banks effectively sold
trillions of dollars of put options based on subprime mortgage loans.
They used credit default swaps to make huge leveraged side bets
that the holders of those loans would not default.
Because derivatives were largely unregulated,
most of those side bets were hidden from view.
Without derivatives, the risks associated with subprime mortgages
could not have multiplied and propagated in such sweeping ways.

[Afterword 8.7]
The 2008 crisis might seem complex and inaccessible,
but if you’ve made it through this book it is easy to understand.
As with the options sold by Robert Citron of Orange County
[actually, Citron was the buyer, not the seller, of those disastrous options],
or Nick Leeson of Barings,
or Niederhoffer,
the strategy speared to generate profits with little downside risk.
Until it didn’t.

[Afterword 8.8]
the banks that had prided themselves on ripping the faces off their clients
ended up bearing the largest losses.
Morgan Stanley was right there,
announcing billions of dollars of write-offs.
The subprime risks that originally had appeared to move away from the banks
returned, like a financial boomerang.
This time, the biggest victims were not the banks’ clients.
They were their own shareholders.

[Afterword 8.9]
As with previous fiascos,
many market participants misunderstood the complexity of derivatives.
But don’t blame this mess on David Li.
He understood the limitations of his mathematical copula model
and the downside risks of subprime mortgage loans.
And he warned everyone, too.
Li told the Wall Street Journal in 2005 that
using his model could be treacherous:
“The most dangerous part is when people believe everything coming out of it.”

[Afterword 8.10]
Where were the regulators?
By 2008, Alan Greenspan was long gone.
He had helped plant the seeds of the crisis and then stepped down.
When Congress called Greenspan to testify about his role,
he admitted to some of his mistakes and was publicly disgraced,
his once-great reputations [the Maestro] soiled forever.
Robert Rubin also suffered searing criticism,
in part because he denied responsibility and defended his earlier decisions,
but especially because he had been a director and senior executive at Citigroup through the crisis,
and had pocketed $115M in pay even as Citigroup crumbled.
In contrast, Arthur Levitt, the former SEC chair,
admitted his errors and called for reform.
No one mentioned Brooksley Born, the woman all of them should have listened to.
[Actually, Brooksley Born was not the first CFTC chairman
to have called for regulation of derivatives.
See Gillian Tett, Fool’s Gold, for an earlier example.]

[Afterword 8.11]
Meanwhile, the men on the job struggled in response to the turmoil.
Federal Reserve chair Ben Bernanke and Treasury Secretary Hank Paulson
lost credibility
as they felt their way through various responses in fits and starts.
SEC chair Christopher Cox was criticized for early inaction,
even after he embraced regulation of credit default swaps.
As of this writing, in early 2009,
it appeared that the Obama [44] administration
planned to implement sweeping financial reforms,
but details were not available.
When they consider new legislation,
I hope they think about derivatives.

[Afterword 9.1]
Ultimately, what lessons should anyone draw from my experience?
I believe derivatives are the most recent example of
a basic theme in the history of finance:
Wall Street bilks Main Street.
Since the introduction of money thousands of years ago,
financial intermediaries with more information have been taking advantage of
lenders and borrowers with less.
Banking, and its various offshoots, has been a great [?} business,
in part because bankers have an uncanny knack for surviving
century after century of scandal.
In this way banking resembles politics.
Just as political scandals will continue as long as we have politicians,
I believe financial scandals will continue as long as we have bankers.
And, despite several bank failures, massive pain, and much consolidation,
there is no evidence of the banking profession disappearing anytime soon.

[Afterword 9.2]
It might seem inconceivable, but in a few years
the banks will recover and reemerge.
Memories of the egregious excesses will fade, as they always do.
Bankers will return to recapture their informational and regulatory advantages.
The government’s “Troubled Asset Repurchase Program” (TARP) engineered by Bernanke and Paulson
ensured that banks will survive to fight another day.
And when they do, the cycle will repeat.

[Afterword 9.3]
The main reason Wall Street will return is that we will want it to.
Our financial culture is infused with a gambling mentality.
Even in the midst of crisis, we don’t seem to think we deserve a better chance.
We continue to play the lottery in record numbers, despite the 50 percent cut.
We flock to riverboat casinos, despite substantial odds against winning.
Las Vegas remains the top tourist destination in the U.S.,
narrowly edging out Atlantic City.
The financial markets are no different.
Our culture has become so infused with the gambling instinct
that we afford investors only that bill of rights given a slot machine player:
the right to pull the handle,
the right to pick a different machine,
the right to leave the casino,
but not the right to a fair game.

[Afterword 9.4]
Gamblers are not steady hands.
They either play too much, or not at all.
When the lose faith in the markets, as they did in 2008,
they will not lend or invest.
Instead, they swear “never again,”
and sell at the bottom, when they should be buying.
Investment choices oscillate between the financial equivalents of
stuffing cash in a mattress
and betting on the ponies.
That is not an efficient way to allocate capital,
but that cycle will continue.
It always has.
Cash can remain stashed away for only so long.
Eventually, what economist John Maynard Keynes called the “animal spirits”
will return, and the gambling will begin again.

[Afterword 9.5]
In this book,
I have tried to describe for you
how the most sophisticated part of Wall Street works.
These are the people, the products, and the activities
that have dominated our financial system.
Morgan Stanley is a central player and is one of the survivors.
The bank will do everything it can to rebuild its tarnished reputation:
intensive lobbying,
tear-jerking television ads about our children’s future,
elaborate investments in corporate social responsibility,
and unprecedented charitable and political contributions.
Eventually, that strategy will work.
Morgan Stanley will remain among the most prestigious banks,
and derivatives will return to dominate global finance.
In a few years, some young rocket scientist from the firm
might be ripping your face off.

[Afterword 9.6]

As the derivatives markets have grown,
they have become more volatile and dangerous.
At the same time, lobbyists for investment banks
have persuaded our elected representatives
to reduce the amount of derivatives regulation,
arguing that derivatives are used primarily
for “hedging” and “risk-reduction purposes.”
These arguments—plus healthy campaign contributions—have worked.
The result is that the regulators lack both power and money,
and are doomed to remain several steps behind the finance industry.
Could a $100K a year SEC investigator
ever catch a $2M a year derivatives salesman?

[Afterword 9.7]
At the end of the original of this book, published in 1997,
I wrote the following:
Given the death of regulation and proindustry balance of power,
you don’t need a psychic to predict that
there will be another Orange County-like fiasco sometime soon.
The current path seems clear.
The financial services industry
will continue to pay tens of millions of dollars
to lobbyists and congressional campaigns
to fend off regulation.
Derivatives will continue to cause
billions of dollars in losses by hundreds of derivatives victims,
along the way destroying reputations, twisting lives,
and emptying bank books.
Young salesmen will, as I did, continue to join the derivatives business
and become rich beyond their wildest dreams.
And Wall Street will continue to argue that
there is no compelling reason to regulate derivatives.
So far, this argument has persuaded Congress and the investing public
not to worry too much about derivatives.

[Afterword 9.8]
After reading this book, what do you think?

[Afterword 9.9]
I have just one last thing to add,
for anyone who doubted my claim
obscure financial instruments called derivatives
could cause the collapse of the global financial system.
I told you so.

San Diego
January 2009

Miscellaneous Articles


A Wall Street Invention Let the Crisis Mutate
New York Times, 2010-04-17

Can it get any worse?

Every time you pick up another rock
along the winding path that led to the financial crisis,
something else crawls out.
Subprime mortgages were sold as a way to give low-income people
a chance at homeownership and the American Dream.
the mortgages turned out to be
an excuse for predatory lending and fraud,
enriching the lenders and Wall Street
at the expense of subprime borrowers,
many of whom ended up in foreclosure.

The ratings agencies,
which rated the complex investments that were built with subprime mortgages,
turned out to be only too happy to be gamed by firms that paid their fees —
slapping AAA ratings on mortgage bonds doomed to fail.
Lehman Brothers turned out to be disguising
the full reality of its horrid balance sheet
by playing accounting games.
All over Wall Street,
firms pushed mortgage originators
to churn out more loans
that were doomed the moment they were made.

In the immediate aftermath,
the conventional wisdom was that Wall Street had simply lost its head.
It was terrible, to be sure, but on some level understandable:
Dutch tulips, the South Sea bubble, that sort of thing.

In recent months, though, something more troubling has begun to emerge.
In December, Gretchen Morgenson and Louise Story of The New York Times
exposed the role that some firms, including Goldman Sachs and Deutsche Bank,
played in putting together investment structures —
synthetic C.D.O.’s, they were called
that were primed to blow up.
They did so, reportedly,
because some savvy investors wanted to go short the subprime market.

On Friday, the Securities and Exchange Commission dropped the hammer,
charging Goldman Sachs with securities fraud
for its purported failure to disclose that
the bonds that were the basis for one particular synthetic C.D.O.
had been chosen by none other than John Paulson,
the billionaire hedge fund investor,
who was shorting them.

Oh, and one other thing is starting to become clear:
synthetic C.D.O.’s made the crisis worse than it would otherwise have been.

Remember in the months leading up to the crisis,
when the Federal Reserve chairman, Ben Bernanke,
and Henry Paulson Jr., then the Treasury secretary,
were assuring everyone that the “subprime problem” could be contained?
In truth, if the only problem had been the actual mortgage bonds themselves,
they might have been right.
At the peak there were well over $1 trillion in subprime and Alt-A mortgages
that were securitized on Wall Street.
That’s a lot, to be sure — but it was a finite number.
You could have only as much exposure as there were bonds in existence.

The introduction of synthetic C.D.O.’s changed all that.
Unlike a “normal” collateralized debt obligation,
which contained the bonds themselves,
the synthetic version contained credit-default swaps —
derivatives that “referenced” a particular group of mortgage bonds.
Once synthetic C.D.O.’s became popular,
Wall Street no longer needed to feed the beast with new subprime loans.

It could make
an infinite number
of bets
on the bonds that already existed.

[World without end. Amen.]

And why did synthetic C.D.O.’s become popular?
One reason was that the subprime companies
were starting to run out of risky borrowers to make bad loans to —
and hitting a brick wall.
New Century, a big subprime originator,
went bankrupt in early April 2007, for instance.
Yet three weeks later,
the Goldman synthetic C.D.O. deal, called Abacus 2007-ACI, went through,
because it was betting on subprime mortgage bonds that already existed
rather than bundling new ones.
It didn’t even have to go to the trouble of
repackaging old C.D.O. tranches into new C.D.O.’s,
which was also a common practice.
(Goldman has vehemently denied any allegations of wrongdoing,
pointing out that it lost $90 million on the particular Abacus deal
that is the subject of the S.E.C. complaint.)

The second reason, though, is that
synthetic C.D.O.’s gave people like John Paulson
a way to short the subprime market.
Mr. Paulson’s bet against the subprime market,
which famously reaped the firm billions in profits,
was the subject of a recent book, “The Greatest Trade Ever.”
Boy, I’ll say.

Both Gregory Zuckerman, the author of that book,
and Michael Lewis, who wrote the current best seller “The Big Short,”
make it clear that the heroes of their narratives —
the handful of people who had figured out that subprime mortgages
were a looming disaster —
were pushing Wall Street hard to give them a way to short the market.
Maybe synthetic C.D.O.’s would have been created even without their urging, but it seems a little unlikely. They were the driving forces.

It is important to note that
every synthetic C.D.O. required both investors who were long
and others who were short.
That is,
there needed to be investors who believed the “referenced” bonds
would rise in value,
and others who believed they would fall.
Everyone, on both sides of the transaction, understood that.
What makes it feel like dirty pool is the allegation that
Paulson & Company and Goldman Sachs were actively involved in
choosing the bonds that would be bet on —
knowing they were going to be short.
In its filing on Thursday, the S.E.C. charged that
Goldman never told investors of Mr. Paulson’s involvement.
“Credit derivative technology helped people disguise what they were doing,”
said Janet Tavakoli, the president of Tavakoli Structured Finance,
and an early critics of many of the structures that have now come under scrutiny.

There appear to be other examples of this, as well.
Last week, Pro Publica, the nonprofit investigative journalism outfit,
reported how a big Chicago hedge fund, Magnetar,
helped put together some synthetic C.D.O.’s —
precisely so that it could bet against them.
In his book,
Mr. Zuckerman seems to have stumbled onto Abacus and similar deals.
One banker, he writes, “suspected that Paulson would push
for combustible mortgages and debt to go into any C.D.O.,
making it more likely that it would go up in flames.”
Which is precisely what the S.E.C. is claiming.
But in his quest to lionize his central character,
Mr. Zuckerman rushes past what by all rights
should have been the most shocking revelation in his book.

Mr. Lewis, for his part, recounts a dinner, late in the game,
in which one of his heroes, Steve Eisman,
is seated next to a man who is taking the long position
on many of the C.D.O.’s he is shorting.
They get to talking, and the man says to Mr. Eisman:
“I love guys like you who short my market.
Without you, I don’t have anything to buy.”
He adds, “The more excited that you get that you’re right,
the more trades you’ll do, the more product for me.”

As a reader, it is hard not to love that moment,
rich as it is in irony and foreboding.
The guy on the long side —
who was making investments that
the housing and mortgage markets would remain strong —
is an obvious fool;
Mr. Eisman, on the short side the trade,
is clearly going to be vindicated.
(And, by Mr. Lewis’s account, Mr. Eisman never “helped” a Wall Street firm
pick the bonds for the C.D.O.’s he was shorting,
the way the S.E.C. says Mr. Paulson did.)

But on second reading, the passage isn’t quite so funny.
The people on the short side of those trades were truly savvy investors,
who, unlike so many others,
did their homework and had insights that made them a great deal of money.
But the rise of synthetic C.D.O.’s that they pushed for —
and their ability to use credit-default swaps to short subprime mortgage bonds —
took an already bad situation and made it worse.

And here we are now, all of us, paying the price.

Naked Truth on Default Swaps
New York Times, 2010-05-21

A Secretive Banking Elite Rules Trading in Derivatives
New York Times, 2010-12-12

[This is a major story.
It was the top story on page 1 of the Sunday Times,
featuring the graphic that follows the excerpt.]

On the third Wednesday of every month, the nine members of an elite Wall Street society gather in Midtown Manhattan.

The men share a common goal: to protect the interests of big banks in the vast market for derivatives, one of the most profitable — and controversial — fields in finance. They also share a common secret: The details of their meetings, even their identities, have been strictly confidential.

Drawn from giants like JPMorgan Chase, Goldman Sachs and Morgan Stanley, the bankers form a powerful committee that helps oversee trading in derivatives, instruments which, like insurance, are used to hedge risk.

In theory, this group exists to safeguard the integrity of the multitrillion-dollar market. In practice, it also defends the dominance of the big banks.

The banks in this group, which is affiliated with a new derivatives clearinghouse, have fought to block other banks from entering the market, and they are also trying to thwart efforts to make full information on prices and fees freely available.



JPMorgan’s soap opera makes clear that Wall Street is detached from reality
By Steven Pearlstein
Washington Post, Sunday, 2012-05-20


[T]he damage caused by credit default swaps
goes beyond the issue of moral hazard
and its effect on the cost of borrowed money.
This market also ties up hundreds of billions of dollars of the world’s capital —
capital that could otherwise be used to actually finance real businesses
that could create wealth and jobs and new products and services.

It also represents a massive waste and misallocation
of some of the world’s brightest, most skilled workers
who are lured in part by the outsize salaries and bonuses
that the imperfectly-competitive financial markets now offer.
Imagine how much more vibrant and innovative the economy might be
if all those Wall Street “rocket scientists” were actually designing rockets
and all those hedge fund traders were channeling their entrepreneurial risk-taking
into starting new companies.

For this pundit,

the lesson to be drawn from JPMorgan’s trading blunder
is not that
banks have become too big to manage
or even too big to hedge.
It is that
banking and finance have become
too detached from
the real economy they were meant to serve.

Labels: , ,