Links 11/09/08

How the Thundering Herd Faltered and Fell Gretchen Morgenson, New York Times. There is a thread in this story of Merrill’s demise which is either new information or inaccurate, and any readers who have insight are encouraged to speak up. Morgenson focuses on the role of CDOs, and says Merrill was writing more synthetic CDOs than the kind with underlying assets. That is already odd, since no previous reporting on Merrill that I saw said anything like that, and synthetic CDO issuance was much less in aggregate than the kind with underlying assets. The piece then says that with synthetic CDOs, Merril would keep the super-senior tranche and sell the rest. Again, this sound odd, since a reader once commented that synthetic CDOs were in most if not all cases created to hedge or otherwise transform an existing book of exposures. In other words, they were a custom product made for a specific buyer. The idea of selling tranches is not consistent with that construct.

Brazil oilfield may house ‘100bn barrels’ Financial Times

John Maynard Keynes: Can the great economist save the world? Nick Fraser, Independent

More Pain to Come Even if He’s Perfect Joseph Stiglitz, Washington Post

Global diversification – an Australian perspective John Hempton

Obama backs crackdown on tax havens Guardian. Ooh, the hedgies will howl! And aren’t the Isle of Man and the Channel Islands Crown dependencies? Wonder what the Queen will do.

Ben Stein Watch: November 8, 2008 Felix Salmon

Deloitte – A Culture of Non-Compliance? re: The Auditors. This is no surprise. I’ve seen some pretty egregious behavior first hand on M&A deals

Antidote du jour:

If you have not had enough cute for one day, you can also check out the Shiba Inu Puppy Cam (hat tip Felix Salmon)

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  1. ndk

    Can unilateral action by any single country to limit tax havens and regulatory arbitrage really have much impact? I’m sure tempted to suggest that it could, after seeing some of the provisions in the Stop Tax Haven Abuse Act. It certainly isn’t toothless; I’m particularly impressed by Section 102.

    Capital moves fast, though, and money laundering is a time-honored activity that people have gotten very good at. I worry that anything enacted by a single country will be ineffective, particularly without diligent enforcement.

  2. Anonymous

    Regarding the synthetic CDO story, I used to work at a bank which structured a fair number of synthetic CDO^2 – synthetic CDO tranches were bought from other banks and used as the paper underlying another layer of structure.

    At this bank, these products were indeed intended for sale to clients, and this was a highly profitable activity.

    Regarding retaining the super-senior tranche, this was not something that happened where I worked but was not unheard of. The idea was, IIRC, that the SS tranche is of such low risk that it’s perfectly safe to hold on to it and hence avoid the costs of selling it on.

    Banks would also usually hold on to the equity tranche, but for a different reason – it was almost certainly going to suffer badly. Furthermore, purchasers liked having a buffer zone between them and the bottom, as it aligned the incentives of the issuing bank with their customers somewhat.

  3. River

    Re: Obama Crackdown On Tax Havens…

    Tax havens and smuggling have a lot in common. We all know how government operations aimed at shutting down smuggling have faired. In many cases the profits are so large that the enforcers are corrupted.

    Smugglers take advantage of variations in laws between countries. Nothing short of one world government and a single code of laws would be effective against smuggling. I submit that the same is true of tax havens.

  4. Richard Kline

    Pandino: “OhBoyOhBoyOhBoyOhBoy: Cooookkieeeeees! Can uss haz some? . . . Wook? Haz _TARP Nuggies_???? WHHEEEEEEEEEEEE!!!! Santa luvvs wee sad markie bearss, YESS!”

  5. mft

    Concerning the Guardian article on Obama’s tax haven offensive: this is poor reporting by the Guardian, not even mentioning the British overseas dependency of the Cayman Islands, the principal target of the legislation proposed in Feb. 2007 by Obama, Coleman and Levin. And so far as I know (please correct me someone if this is wrong) the Isle of Man, Jersey and Guernsey are of little importance for US offshore tax haven hanky-panky. These islands are mainly used by expatriate Britishers to deposit their earnings in offshore accounts at British banks which are nevertheless able to make payments in the UK. Expatriate Britishers cannot operate normal, onshore UK accounts because of anti-terrorism/moneyaudering legislation since 9/11. I think most of them are not liable for tax in the UK.

  6. eh

    Obviously the big problem isn’t the existence of tax havens, but instead completely out of control government spending.

  7. russell1200

    re: Merrill

    I don’t think they really wanted the senior tranches. I think they were stuck with them.

    They were booking record profits in 2007. Who was buying record amounts of CDOs in 2007?

    You are selling ‘insurance” on iffy mortgage bonds in 2007 (the default swaps) and no longer paying AIG to cover it. You also have a certain amount of cash flow coming in from the underlying mortgages.

    If the housing market bottomed out (and their have always been some thinking it would) they would have a great 2007 and never look back.

    Obviously that is not what happened.

    My only question is: who bought the junk tranches then? Since CDOs where often made up of some pretty junky pieces to begin with, I am curious who would be buying the junk of the junk.

    I suspect that they gave it away, and just made assumptions that made the accounting look good. But that would be a diff ult trick to pull off.

  8. AnoninCA


    Hybrid CDOs have supersenior tranches too. I suspect that GM is not distinguishing between hybrid and purely synthetic CDOs. It’s my understanding that most CDOs issued after 2005 were hybrid.

  9. Anonymous

    ML was in the business of placing the various tranches of CDOs, synthetic and cashflow, with its institutional clients. Most notably in this regard, if it sold a significant proportion of the lowest-rated tranches (equity, BB, BBB and single A) it would “print” the deal. So, even if the deal had a total notional size of $1 billion, if it had placed, say $150 million of it, as long as the $150m was comprised of high risk parts of the capitalisation structure, it considered the deal done. It then “warehoused” the senior portions of those deals. An internal fight did occur as to how much “super senior” risk could/should be retained but the revenue producers won the day.

    In the case of the synthetics, the risk of the entire portfolio is tranched into several different derivative swaps which assume the losses from the underlying portfolio according to a set of priorities. The middle tranches were credit enhanced by the most junior tranches and the senior most tranches were credit enhanced by the middle and junior tranches. The risk of the underlying portfolio, that was to be transferred through the tranches of risk in the synthetic (Merrilly BUYING PROTECTION in the form of SCDO tranches), could be assumed by Merrill (the assumption of risk here is actually a hedge for the risk already sold through the SCDO protecton) in either cash or derivative form. In the case of cash form, the underlying bond is bought and financed with repo and any interest rate risk is delta hedged with swaps. The result is a replicated strategy for a default swap. IN the case of derivative form, Merrill simply sold protection on the reference portfolio on which it (partly) bought protection in tranched form.

    Now, in Merrill’s case, they fell in love with the “fees” and league table status of the deals they were printing even though they retained lots of “tail risk” in the form of super senior tranches. Risk models assigned a very low probability of loss and also a very low VAR to these tranches and hence the notional amount that could be retained against a modest amount of risk capital was quite large. It is only once the underlying assumptions deviate substantially from the initial assumptions (in the adverse direction, ie market implied default rates increase) do they begin to require substantial amounts of risk capital. At that point, they would have realised that they had a problem but they would also have realised that their positions were to big to place – the act of placing that much risk would drive the losses on the retained risk to unacceptable levels.

    In Merrill’s case, they did this with CDO-squareds in which the underlying were (already leveraged) mezzanine (or middle) tranches of CDOs backed by home equity or subprime mortgages. The models underestimated the volatility of the underlying and hence the loss distributions assumed to “haircut” or determine the amoutn of required risk capital for the super senior tranches greatly underestimated the risk of loss on these tranches and certainly underestimated the mark to market volatility of these tranches.

    Risk management was clearly lacking. The notional sizes involved in the retained super senior tranches was in the tens of billions. Even if one believed the risk was minimal, the nominals should be limited by the prospect of that assessment being wrong since these tranches by their very nature provide a small income compensation for low-probability but HIGH SEVERITY potential events.

    I have written too much.


  10. ruetheday

    Revised deal near for AIG:

    NEW YORK (AP) — American International Group Inc. late Sunday was reportedly near a deal for a revised bailout package from the U.S. government that would make borrowing terms easier for the troubled insurer.
    A proposed $123 billion bailout package would be replaced with a new $150 billion package, according to the Wall Street Journal.

    Details of the arrangement could be announced as early as Monday, when AIG is scheduled to report its third-quarter results, the Journal said. The plan reportedly would replace an $85 billion two-year loan with a $60 billion five-year loan at a lower interest rate.

    The government also reportedly would inject $40 billion into AIG in exchange for preferred stock.

    AIG representatives were not immediately available for comment.



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