More Puzzling Over Crisis Mechanisms

Posted on by

In case you haven’t figured it out, Ed’s post on Sweden highlights an important and troubling development. It seems that central banks have locked themselves into “if the only tool you have is a hammer, every problem looks like a nail” behavior with the move to negative rates. Since they are best able to dispense liquidity, well, it is liquidity you will get. The assumption, as has become conventional wisdom among the economic elite, is that the reason Japan stayed mired in borderline deflation is that it wasn’t aggressive enough with quantitative easing and fiscal stimulus. The Japanese have a rather different view, since their economy actually did show good growth in 1996, but then they got into “it’s all over” mode and raised taxes. The Asian crisis didn’t exactly help either. Their assessment, which they have oft repeated, is their big mistake was not cleaning up the banking system sooner. The Japan mess had a different dynamic (it made no sense for banks to lend because there was so much money on offer relative to willingness to borrow, at least among banks that were worthwhile credits that spreads on lending were close to nil and banks could not recapitalize on such thin spreads. Not exactly a problem we have here).

Now to my pet issue. I feel as if I am in blind man and elephant mode, and that we observers of the crisis are collectively in that fix. Which raises an interesting philosophical question: if blind men who encountered an elephant realized the strange critter was bigger than any of them could dimension individually, could they have come up with an adequate description of an elephant among themselves?

The immediate question was triggered by the Michael Lewis piece on AIG, in which he pointed out that AIG quit writing CDS on subprime in very early 2006. The most superheated phase of subprime lending was third quarter 2005 to end of 2006. Although crappy subprimes were being sold in 2007, the volume fell off as the product got a bad name.

Sales of product involving subprimes involved credit enhancement. So if AIG, the biggest stuffee, dropped out, what replaced them? Lewis suggests “Wall Street took the risk”. It’s a throwaway comment, and I don’t think it’s accurate, or at best only partially accurate.

Here are some obvious places the risk could have been absorbed. If readers can provide any feedback (as in do they know of a marked increase in any of these approaches in 2006 v. 2005), it would be very useful. I have another idea I’ll volunteer later, but am curious as to any datapoints re these possibilities:

1. Originator takes more risk, via agreeing to cure a higher level of defaults in the pool. In theory, this can take place via substitution, but in practice, it means the originator takes a loss (swapping good paper for bad). Thus this means the credit enhancement ultimately depends on originator credit quality. This seems a pretty weak form of enhancement, and in theory worsens the appeal of the deal to the originator, but if everyone was punch drunk on risk, maybe no one noticed such niceties.

2. Other insurers step in, like MBIA and Ambac

3. Foreign stuffees. Landesbanken bought a ton of this paper, but I am not certain how much it would have done re the credit enhancement (getting the needed ratings)

4. Overcollateralization. That effectively means making the equity and mezz tranches bigger, in terms of total value, relative to the rest of the deal. Any evidence that that happened?

And a separate question: who was buying the equity layer of CDOs? I have read the investment banks retained it (the sense I had was this was sort of free money, they made enough whether the equity bit paid off to be indifferent). However, i have also seen it argued that hedge funds were big buyers, the theory being that the CDOs overpriced the AAA layers, hence the equity was cheap. Any sense (or better yet, estimates) of how much CDO equity went to hedge funds? This stuff had amazingly high embedded leverage.

One reader did say that the CDO structures shifted to leveraged super senior CDOs (remember CDOs took the mezz portion of subprime deals, which means they are signing up to be hit early on with the effects of defaults. Having some one else take first or early losses enhances credit for everyone else) and they kept the super senior layer. I hate to be a bit dense, but I don’t see how taking the LEAST risky bit helps in risk absorption.

And my impression was keeping the super senior layer was a bit of an accident, as in they couldn’t sell enough, but figured what the hell, this is decent paper, we can keep it (they could repo it for no haircut until everybody got nervous re subprime). That’s the sense the media gave re Merrill, which retained a lot of super senior CDO paper.

OK, now to my pet theory as to where a lot of the risk went: synthetic CDOs. Remember, synthetic CDOs are composed from the cash flow of CDS written on other risks. Presumably a lot of those CDS were subprime deals, either the original MBS or the CDOs they went into (again, remember CDOs generally contained a lot more than subprime RMBS, they were a big home for collatearlized loan obligation tranches, but the subprime deals were particularly helpful in making those structures work).

So what exactly is “the cash flow from CDS” mean? Um, you are the insurer. You are taking the periodic CDS payments and will have to pony up if the credit goes bad (or with a higher tranche, bad enough so as to breach a threshold level).

Synthetic CDO issuance was nearly as large in aggregate as cash CDOs.

Does that add up? One clue would be if synthetic CDO issuance picked up considerably in 2006 v. 2005, that would suggest it was primarily a way to lay off risk (as opposed to the professed reason, “there was so much demand for this paper, we had to create synthetics to meet demand”. I am of the “stocks are sold not bought” school as far as funky paper is concerned).

And if so, who in their right mind was signing up for this stuff? Particularly the equity and mezz tranches, which is where the serious risk assumption was taking place.

Thanks! If you aren’t set up to comment but have ideas or info, please ping me at

Print Friendly, PDF & Email


  1. lambert_strether_openid

    Who in their right mind was signing up for this stuff?

    Collective accounting control fraud? You might call it the "Murder on the Orient Express" theory. (To put this another way, maybe the $15 trillion bailouts were the purpose of it all. SUCCESS not FAIL. Well, depending on how you look at it.)

    Foily, I know, but if we're asking questions like this…

  2. Entirely

    Yves… your questions are getting quite complex! I'll do what I can to help you out…

    First… who owned the CDO equity? The answer is **VERY** rarely the investment bank who underwrote the deal. There were cases (most notably the Goldman Sachs Abacus deals) where an investment bank acted as both issuer and underwriter, but most frequently the bank was acting in an agent role for an issuer who kept the equity in their own deal. The bank did the business for the u/w fees, not because they wanted to keep the equity cashflows from a hyper-levered pool of sh*t.

    But then there is the real culprit… and it has amazed me that no one in the MSM has caught on to this. Until 2006, the paradigm was largely what I illustrated above — i.e., an asset manager decides to issue a CDO, contracts a bank to underwrite it for a fee, and then keeps the equity tranche and earns the ongoing management fees for the deal. In 2006 however, one hedge fund in particular (a large on in IL… no, not that one) came up with a **MASSIVE** trade. They saw CDO equity for what it truly is — non-recourse financing at insanely attractive terms — and decided they wanted to put the trade on in as much size as possible. I'd speculate that no less than 70% of the ABS CDO issuance done in the last three quarters of 2006 was driven by this single program. The hedge fund would contract out the manager and retain the equity. At the same time, they'd buy protection (2x – 3x) on the BBB- tranches of the same deals. They'd buy the protection from the bank underwriting the deal and then that bank would then recycle that new CDS contract into the next ABS CDO they were underwriting. The trade from the hedge fund's perspective was simple… and ended up being a home run precisely because they were so right. As they correctly figured it, the CDO structure and the collateral it was buying was leverage on top of leverage on top of leverage… all supported by highly questionable and perfectly correlated assets. They would clip the massive coupon from the levered equity they retained until the deal blew up… and then they'd make $100-00 on the protection they bought on the BBB- tranches in the same deal. And the true devious beauty of the trade was the fact the ultimate protection seller ended up being another CDO — largely removing the counterparty risk as the cash accounts were fully collateralized.

    The structure of CDO equity was in general so juicy that you'll waste your time looking for people who lost money owning it. The cashflows were so front-loaded most of the basis was paid off before the structures started to collapse. Sure, some people lost some money, but the grand total is missing far too many zero's to be relevant.

    As for who became the bag holders once AIG figured out they'd been playing poker for three years and still hadn't spotted the sucker, the market has largely identified the three most bloated corpses — UBS, ML, and Citi. Other banks who've announced CDO losses also had the trade on, but not nearly in the same size.

    But here it gets a little bit complicated… and it hits on one of your other points. I'll divide the big banks into two groups: a) the true idiots; and b) the guys who at least tried to manage the risk.

    For group "B", include ML, JPM, First Boston, DB, et. al. They liked the fees associated with CDO underwriting and they liked having the outlet for bonds generated by their underlying mortgage machines. They also liked the idea of running a "free money" neg basis book where they funded themselves at LIBOR and could own super senior AAA CDO bonds at 1mL+60bps. BUT, they realized they couldn't justify from a risk perspective owning that much of a single trade so they bought protection via CDS on the CDO tranches from one of the monolines. They'd pay 30bps for the protection, which still made the neg basis position 30bps of "free money" and in exchange they were funding AAA assets with the benefit of a AAA monoline wrap.


  3. Entirely

    So now that the world has blown up, it is in fact the monolines who "own" the risk, but the world has realized they simply don't have the money to make good on the claims. As another example of possession being 9/10th of ownership, the real risk has been shifted back onto the banks. They have a valid claim via the CDS, but their counterparty can't pay it. Some monolines have already gone out of business on the back of this debacle… the others will eventually follow.

    Which brings us to group "A"… For color here, you should read the report put together by the SNB about the drama at UBS. For those into the minutae, it really is a page turner. Some banks, UBS and Citi in particular but also other European monsters, fell in love with the full size of the neg basis potential and convinced themselves paying for the protection wasn't worth the trouble. UBS in fact loved the trade so much they bought the super senior CDO tranches underwritten by *OTHER* investment banks… its competitors. The banks who funded themselves the cheapest were oddly the ones who put this trade on in the most size… truly piggish, but for banks that funded at LIBOR minus, the neg basis portfolios across all assets became a HUGE source of revenue and in a BASEL 2 world, a very efficient AAA one at that.

    I hope this helps,

  4. Yves Smith


    Wow, this is great. My instinct has been that understanding the CDOs is key to understanding the crisis, since they were leverage on leverage vehicles. The risk of everything else pales compared to this. And all sort of assets went into CDOs, which also appears to explain why you saw such tight risk spreads across so many types of credit.

    OK, now I did understand even before the business re the equity being very front-loaded.

    I still need to unpack this a bit more:

    1. You are basically saying the monolines filled most of the gap left by AIG's exit from subprime MBS, correct?

    2. Hedgie gets enormous cash flows for a while on equity layer. Buys protection of 2-3X on BBB-tranche (shouldn't someone have had the brains to see what a scam this was? The equity layer being there is phony). Was this 2-3x coverage equal to the value (in some abstract sense, say at an assumed 30% rate of return) on the equity, or were they overhedged.

    3. CDS is rolled into another CDO (cash or synthetic?) Is this hedgie rolling the CDS into his own deals, or are these going into other deals?

    4. Were the deals in this program only with "real" underlying collateral? If so, who was doing the synthetics? Were they coming out of this and other programs? The reason I am somewhat obsessed with the synthetics is the issuance of them was huge, almost equal to cash CDOs (or so I have read).

    I am clearly old fashioned, if the super senior tranches were obviously so awful ex ante (I'm dubious of anything with too many parts, so I am prejudiced, needless to say) the IBs shouldn't have been selling them either.

    If you are game, I have a paper from a very obscure firm that figured a fair bit of this out, but I could use some third party input as to where it might be off or incomplete enough to be misleading. If so, please e-mail me. Thanks!

  5. Entirely

    Sure… send it along. I'm more than happy to help if I can.

    A few things:

    1) cash v. synthetic CDOs. treat these interchangeably. believe it or not, the reason for the rise of synthetic CDOs was the voracious appetite for the product. so much so, the mortgage machine couldn't keep pace with the demand for supply. the macro hedge funds who saw the folly of the ponzi scheme were more than happy to line up on the other side of the CDS contracts to buy protection to feed the machine.

    2) it amazes me to this day how long it took the conventional wisdom to realize these bonds (i.e., the super seniors, or anything rated AAA for that matter) were not "money good". For the longest time, everyone — from Dick Bove to the Wall Street Journal to the risk officers at the banks themselves — explained this away as a "liquidity problem". No one really got the fact that these things weren't going to return 100 cents on the dollar.

    For CDOs, the vehicle of that realization is the height of irony. In every way, it was Wall Street itself that killed its own golden goose with the introduction of TABX. Everyone knows about ABX… not much has been written about TABX. TABX was "tranched" ABX… a product borrowed from the corporate world. Basically, MarkIT took BBB and BBB- tranches of ABX and credit tranched them in much the same way a CDO did. Well, on the first day of trading, the "AAA"-like slice traded down to $60-00. I think that's when people realized there was a problem…

    3) You hit the nail on the head when you point out that CDOs were applied to *EVERYTHING*. Banks have generally withstood the hit from ABS CDOs. The writedowns have been taken and most banks are at least partially reserved for the remaining exposure they have to the monolines. But at the same time, the super-senior exposure held by banks off CLOs, CRE CDOs, and TruPs CDOs is still held very much in the context of $100-00. You should read the piece S&P put together re: Assured and their TruPs CDO exposure… its eye opening.

    I suppose the jury is still out on whether or not super senior CLOs and TruPs CDOs are money good. If they're not, the world is in for another VERY LARGE round of pain.

    3) Yes, it was the monolines and the dumb banks that stood in for AIG once AIG bowed out. But since the monolines are going to get tapped out LONG before they bear the full brunt of their contractual liability, it is really the banks left as the bag holders. Strangely, CDOss were one sector where the traditional bag holders — i.e., the insurance companies — didn't fund the AAA risk. Almost universally they stopped at the first layer of leverage. It was almost as if the CDO was created due to a bottleneck in the ability of the insurance companies to soak up all the volume.

  6. Yves Smith

    Aha, great clarification, thanks!

    You need to send me your e-mail address, if you don' t mind, since it does not show up on your profile ( so I can send you that paper.

    The TABX is an important detail. I had understood that the illiquiidty had allowed the mark to model fantasy to stand well beyond what should have been its sell-by date, but had thought the creation of the ABX was the trigger.

    I hate to continue to be dense, but how did the banks assume the risk? To get the stuff rated AAA (or the various AAA flavors) you needed some type of third party credit enhancement. What did they do to get the agencies to sign off? I get that they retained the super senior (how much would that have been of total deal value? I had thought there were other takers for other AAA paper) but that still does not explain how they got the AAA ratings if the credit enhancement wasn't coming from AIG or the monolines. (I'm assuming if they wrote CDS they would have laid them off. Did they weirdly not hedge the risk on these deals?)


  7. VG Chicago

    Very encouraging! LOL

    I think we're a done deal as far as recovery or relevance goes. This is a permanent state of affairs. And it's not just the US, but the entire Western World.

    To illustrate, let me use (yet again :) myself as a case study. As some of you know, I am a shrink extraudinaire, doctor to the stars (except Michael Jackson), and I also teach all sorts of psych classes to the future shrinks of this world (and God knows, they'll be needed).

    Anyway, as I have made a name for myself in this racket, I am now receiving teaching job offers in Eastern Europe that actually offer better salaries than what I get right here in the "Leader Nation of the Free World".

    SO, Vinny's weighing in his options. But heck, when somebody can earn more in Eastern Europe than in the USA, I'd say there's gonna be trouble… for the USA…

    Vinny G. (oh, pardon me, "Dr. Vinny G." :)

  8. Mr. S

    Yves – One of the things that popped out in Entirely's post (very, very informative and helpful by the way) was the part about synthetics creeping in. The last big Lewis piece in Portfolio, "The End," had this excerpt, which squares quite well:

    "That’s when Eisman finally got it. Here he’d been making these side
    bets with Goldman Sachs and Deutsche Bank on the fate of the BBB
    tranche without fully understanding why those firms were so eager to
    make the bets. Now he saw. There weren’t enough Americans with
    shitty credit taking out loans to satisfy investors’ appetite for the end
    product. The firms used Eisman’s bet to synthesize more of them.
    Here, then, was the difference between fantasy finance and fantasy
    football: When a fantasy player drafts Peyton Manning, he doesn’t
    create a second Peyton Manning to inflate the league’s stats. But when
    Eisman bought a credit-default swap, he enabled Deutsche Bank to
    create another bond identical in every respect but one to the original.
    The only difference was that there was no actual homebuyer or
    borrower. The only assets backing the bonds were the side bets
    Eisman and others made with firms like Goldman Sachs. Eisman, in
    effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all.
    “They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t
    afford,” Eisman says. “They were creating them out of whole cloth. One hundred times over! That’s why the
    losses are so much greater than the loans. But that’s when I realized they needed us to keep the machine
    running. I was like, This is allowed?”

  9. AmericanGoy

    I learned more about how the market (and the real world) works in this small article than during my 4 years at a university.

    Kudos to Yves and the commenters.

    To Vinny – leave now before Stroger gets even more of his family into Chicago, and before Daley uses taxpayer money to pay all his cronies in the construction business as they make shoddy Olympics buildings…

  10. Ginger Yellow

    "Sales of product involving subprimes involved credit enhancement. So if AIG, the biggest stuffee, dropped out, what replaced them?"

    At the triple-A level, for RMBS that didn't go into CDOs (and a fair part of the stuff that did), the SIVs. The SIVs that were launched in 2006 had much higher proportions of subprime (and recent vintage subprime at that) collateral than the older SIVs, which had a larger stock of better quality but higher yielding assets from before the great spread tightening. Rhinebridge (IKB's SIV) had something like 90% subprime collateral, versus maybe 5%-10% for older SIVs. Cheyne had a similarly high proportion. Naturally, these were the first SIVs to collapse.

  11. joebhed

    Thanks to all for putting the other article on Goldman and Barclays more clearly in perspective as well.

Comments are closed.