Archive for October 2008

Halloween costume

October 30, 2008

L is dressing like a penguin.  Her penguin is dressing like a pirate, and L. and the stuffed penguin pirate are going to trick or treat together.  It should be cute.

Who’s next?

October 28, 2008

Article –

Competitive Forces May Push Life Insurers To Federal Funds

The car companies have a case too.  🙂

Maybe it was the ratings agencies, after all

October 21, 2008

Why the CDS Market Didn’t Fail – Finance Blog – Felix Salmon – Market Movers –
Some useful quotes:

This bears repeating: if you take credit risk by writing credit protection, your position is marked to market daily, and is margined daily. Compare that to the behavior of banks, say, which took billions of dollars of credit risk by holding super-senior CDO tranches and didn’t — couldn’t — ever mark them to market. It’s hardly a surprise that the banks have been stunned by the magnitude of their losses, while writers of credit protection were forced to face their deteriorating positions on a daily basis.

But hang on, I hear you say, what about AIG? What about the monoline insurers? Weren’t they undone by CDS? Yes — and they’re the exception which proves my point. AIG and the monolines had something no other writer of credit protection had: a triple-A credit rating. As such, they were the only sellers of credit default swaps who didn’t need to put up collateral as the market moved against them.

More complex? Yes. More opaque? No. In fact, credit default swaps, being much more liquid than most debt instruments, are thefore also more transparent than most debt instruments. Try to sell a CDO tranche, these days: you can’t. There’s no two-way market in such things. But if you want a price on a credit default swap, that’s very easy to obtain.

I agree with this

October 19, 2008

The Weekend Interview –

I think if you have some principles and know what you’re doing, the market responds. They see that you have some structure to your actions, that it isn’t just ad hoc — you’ll do this today but you’ll do something different tomorrow. And the market respects people in supervisory positions who seem to be on top of what’s going on. So I think if you’re tough about firms that have invested unwisely, the market won’t blame you. They’ll say, ‘Well, yeah, it’s your fault. You did this. Nobody else told you to do it. Why should we be saving you at this point if you’re stuck with assets you can’t sell and liabilities you can’t pay off?'” But when the authorities finally got around to letting Lehman Brothers fail, it had saved so many others already that the markets didn’t know how to react. Instead of looking principled, the authorities looked erratic and inconstant.

Don’t be wishy washy. The problem is, of course, they were wishy washy, and now everyone is arguing that saving Lehman would have reduced the crisis. Saving Lehman might have just made a worse crisis next. But we don’t have that counter-factual, so how to know?

The linked post perfect describes how **cked up things were

October 17, 2008

Interfluidity :: CPDOs, Model Risk Spread, and Banks under Basel II

The post was written in 2006.

Banks were buying AAA rated synthetic bonds that had 2% higher yields than regular AAA bonds. You cannot buy such securities and expect not to have big risk; it fails the basic smell test.

Here is how the security is supposed to work

A CPDO issuer accepts principal from investors, and commits up front to a coupon and principal repayment schedule. The issuer puts the money in a leveraged portfolio that includes high yield, risky debt (or credit derivatives), earning a yield higher than would be required to cover coupon payments to investors. In the most benign scenario, after a while, the CPDO portfolio earns enough extra money to trade in the risky debt for a risk-free portfolio of government bonds sufficient to cover the coupon and principal repayments promised to investors. Thus, the CPDO issuer has temporarily taken on credit risk to earn the promised excess spread, and then quickly locks in gains by putting investor assets into ordinary AAA bonds.

But what happens if something goes wrong? Suppose that while the CPDO holds its leveraged, risky portfolio, credit conditions deteriorate. Then the portfolio loses value, and the issuer’s ability to meet the agreed-upon payment schedule becomes uncertain! Wouldn’t this possibility translate into lower-than-perfect ratings by rating agencies? You might think so. But the CPDO-issuer makes a promise that offsets this risk. The CPDO-issuer promises that if the risky portfolio loses money, the CPDO will double-down, increasing the degree of leverage as required to make up for the loss and meet the structure’s promised payment schedule to investors.

But that is impossible. Anyone who has any finance common sense knows that this is (much) risker than a regular bond. It is simply a fancy way of betting that the credit spread will not shrink too much.

Well, that makes me feel better. You? Let’s give the devil her due: This is a very model-tested approach. CPDO-issuers have carefully reviewed credit-spread history, and have come up with rebalancing-and-releveraging schemes that should nearly always manage to recoup losses. If there is no structural change in the bond markets, if the markets behave as models say they behave, then the likelihood that a CPDO will experience a sufficiently long sequence of adverse events to prevent the doubling-down strategy from recouping losses is very, very small, comparable to the probability of a default on an ordinary AAA-rated bond….

… From a Fitch report on these instruments:

[The evolution from earlier principal-insured products (“CPPIs”) to CPDOs] …is mainly driven by Basel II: under the revised international capital framework, bank investors are likely to need a rating on both principal and coupon for their credit investments. [1]

The security may have been profitable for a while, but the 2% spread indicates that it must be risky. The rating is high, because the underlying names are high credit quality, and because the credit spread had never widened that much.

Today, the security is defaulted, and is pays 0.10 on the dollar. No-one should be bailed out by the government on that security. They took their 2% spread already, and now they should take their lumps.

More and more, I am feeling like the regulation was screwed up–there is no way to get around this though. It is an arms race-the faster you impose rules, the faster smart people can figure out ways around them, and make a lot of money doing so.

Fleet Foxes and Wilco

October 17, 2008

Wilco & Fleet Foxes Sing Bob Dylan

I have given many, many exams.

October 17, 2008

And each one causes me some stress.  Will the students be able to solve the problems?  Is it too hard?  Is it too easy so that everyone gets the same grade?  Do they have enough time? 

But the shoe is now on the other foot.  We have our midterm in our Chinese class this weekend, and I am scared.