Summer Rerun: Extreme Measures II: Gillian Tett at the Financial Times

This post first appeared on August 27, 2007

Recently, we’ve noticed a new theme among economics writers: Extreme Measures.

Commentators have looked toward the end of the road we are on and fear it leads to a precipice. Hence the calls for radical course correction.

Paul Krugman and Bill Gross of Pimco, each of whom proposed large scale rescues of homeowners at risk of default, were the first cases we noticed.

But what really caught our attention was Gillian Tett of the Financial Times proposing drastic measures, albeit to deal with a different, but equally serious problem, namely, that markets are seizing up due to subprime risk.

Normally, risk does not pose an overwhelming problem to financial markets; au contraire, it’s their bread and butter. But in this case, the risks have been sliced and recomposed into other instruments and distributed around the world. No one is certain who has subprime exposure, and because these subprime loans are often components of very complex, illiquid instruments, no one is sure how much (or more to the point, how much less) they are worth.

Let us stress, we cannot say enough good things about Tett. We’ve sung her praises before, and consider her to be the best source on the markets (although her FT colleagues John Authers and John Dizard are also insightful). So to see her offer up an idea that while it may be directionally correct, is badly misguided in its details, is worrisome indeed.

It suggests that someone as knowledgeable and plugged in as she is thinks we really are in a mess but can’t come up with a realistic way out.

Here’s what she said:

One is the fact that nobody quite knows exactly where the subprime losses truly lie…

But the second problem is that nobody knows the real value of these instruments either…

Common sense would suggest the best way to deal with these two problems would be to take two steps: namely inject more transparency into the system, by encouraging institutions to reveal their exposures, and then encourage financial institutions to create a proper market to trade the assets, and thus determine a price…

Right now, it is probably relatively easy to guess at what a simple subprime loan might be worth.

However, working out the values for associated derivatives, or derivatives of derivatives, of these loans, is far harder…. investment banks say it can take entire weekends for their computers to value instruments such as collateralised debt obligations…

So is there any solution to all this? One option would be to simply wait and hope that eventually a new wave of bottom fishers will emerge….

More specifically, some policymakers now suspect that one key to rebuilding confidence would be to find ways of ripping apart some of these fiendishly complex structures, so that the constituent components can be clarified and traded again. Structured products, in other words, may need to be restructured into less . . . er . . . structured formats.

This endeavour will not be simple. Nor will it be painless. After all, if you unwind CDOs, say, it tends to trigger securities sales, further depressing prices. But high finance is a world where innovation is supposed to pay, and presumably it is not beyond the wit of the financial wizards who created these complex products to invent ways of taking them apart.

Uum, there are at least three big problems with this idea.

First, let’s go over, at a very high concept level, what a CDO is. You take a bunch of financial assets that pay income, like mortgages but can and more often does include tranches of mortgage backed securities and God knows what else. You put them a legal entity. You then set up rules for how principal and interest payments are allocated to expenses (oh yeah, investors have to pay to keep the puppy running) and to the various classes of holders (those called “tranches”). You do some voodoo to make sure the tippy top tranche gets an AAA rating (that usually involved overcollateralization, the purchase of insurance from a third party insurer like Ambac, or credit default swaps).

So you have different holders with different economic interests in this entity. To unwind it, you have to pay them out, either in cash or collateral, or perhaps via paper in a new entity.

To do that you have to make a determination as to what those classes are worth relative to each other. That means you have to value them, at least on a relative basis.

But the whole problem that we were trying to solve to begin with was that no one is certain to value this paper. But unwinding it presupposes some sort of valuation.

The second issue is that unwinding these vehicles would be a nightmarish task. If it takes a weekend to value some of them, how long would it take to come up with a restructuring plan? Now because absolutely no one gets to see the documents on these deals (I am not making that up, the regulators can’t demand them) I can’t be certain, but I assume any modification in terms would require a waiver or other approval from the investors (God only knows what the threshold for approval is and what voting rights the various classes have. A buddy sent me a link to the indenture of one REMIC, which is the most plain vanilla version of tranched MBS; the underlying assets are mortgages. It required the consent of 2/3 of the investors in each class to change the terms). Per the relative value question we raised in 1, you get into the ugly question of “class warfare,” that the different classes can have divergent economic interests.

And you have another wrinkle: fooling with the CDOs ripples back to the credit default swaps market. Some complaints and threats of litigation arose during the Bear Stearns subprime-related hedge funds crisis, alleging that Bear was self-dealing by removing or modifying mortgages from certain instruments. It appeared the issue was these moves improved the credit quality of the CDO, which would lead to losses on the part of CDS holders who would benefit if the CDO did worse, not better. (Note that Tanta at Calculated Risk dug deeply into this issue and was frustrated, both at the lack of specificity of the charges by the allegedly wronged parties, and by reporters not having a good enough grasp of the terminology. Bottom line: someone who knows this area pretty well was still largely in the dark). So you might even have CDS holders suing to block unwindings.

So that is a long winded way of saying that getting any unwinding approved is a huge task.

Third is who pays for this? Any restructuring is, per all that has preceded, a very big undertaking. It will take a lot of investment banker and law firm effort, maybe even (quelle horreur) rating agency time. None is a charitable organization.

I don’t see how anyone makes enough dough for this to be worth their while. And if they did, it would be at the expense of the poor investor chumps who are already under water.

But Tett was on to something with her notion of trying to get bottom feeders to start acquiring CDO tranches. But what could be done to facilitate that?

The problem with my notions is that they are likely still too small to make enough of a difference, yet would require clever regulatory footwork, or blackmail, to get the needed cooperation.

As Tett stressed. the barrier to anyone making headway is the lack of knowledge of who holds what and what those deals consist of.

Now if I were a bottom fisher, I’d want to have some decision rules as to what sort of paper might be attractive. Since I’d be doing price discovery, I’d look only at deals that didn’t have too much embedded leverage (that would rule out CDO squared and cubed, and there might be quick screens you could do on regular CDOs). To do that, you need deal documents (you can’t do this bit with a spreadsheet, you’d screen for certain structural elements and then start analyzing the subset that looked promising). “Qualified investors” can obtain them, but it’s a nuisance to ring around to get them (and you may encounter resistance if you don’t have an existing brokerage relationship with the firm that handled deals you’d like to screen. Note that the high barriers to getting these documents make it impossible for third party analysts to play a role).

Thus it seems that a minimum requirement is for the regulators to compel the underwriters, who are all investment banks, to disgorge their offering documents.

Now let’s assume I found a few deals that looked like they might have some tranches that I’d be willing to make offers on. How would I find people to whom to make such offers? Golly gee, that very same underwriter who developed the deal documents (well technically it was the entity who made the offering that is legally responsible, but let’s not kid ourselves as to who was pulling the strings) would know who bought the paper initially. And if someone wanted to trade this paper, the very first place they’d go first is the bank that handled the offering initially.

You see where this is going. Yes, the paper that was retranched (typically the BBB to B layers) are likely to have disappeared into other entities that will make it hard to trace. But most of the value of these deals was in the AAA tranche. That is unlikely to have retraded, and if it did, it is quite probable that the originating investment bank executed the trade. My belief is that equity tranches don’t trade, so the likelihood is that they are with their original holders.

That means that the Street, collectively, probably has a handle on where a fair bit of this paper sits, more than press reports would lead one to believe (mind you, the CDS written on CDOs, and then sometimes bundled into synthetic CDOs, are another matter entirely, but what we are talking about here is starting a price discovery process that hopefully moves up the food chain). So why are they not letting on that they know more than they pretend to know?

Aaah, the Street has a lot to lose with price discovery. Remember, in the first stage of the Bear subprime-related hedge fund collapse, the Wall Street firms first seized the collateral. Then they realized that if they liquidated the funds, the prices realized would not only be lousy but it would force a remarking of similar paper. That means they’d have to mark down the value of similar collateral, much of which is rumored to sit with hedge funds, which would require them to put up more cash or collateral, which in most cases would require them to sell assets, which would lead to downward price pressure on whatever they sold, leading to further markdowns on collateral and more forced sales. Hello meltdown.

So the Wall Street firms decided the better course of action was to gang up on Bear and make it solve the problem.

Now this remedy is probably inadequate. Even though a big chunk of the value of the initial CDO lies in the AAA tranches, enough of that probably trades for dealers and interested buyers to have decent marks on it. It’s the lower rated tranches that show the effects of embedded leverage more (meaning they are harder to value), and were more often resecuritized (which makes the next-gen instruments vastly harder to value and difficult to locate).

But this discussion nevertheless highlights the basic dilemma: the parties who are in the best position to facilitate price discovery have every reason to impede that process. And I doubt that the regulators have enough will to force them to cooperate.

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  1. Dirt Rat

    You also failed to mention that a great many of these subprime loans were made for 125% to 200% above actual market value, thanks to over-inflated appraisals. That was the actual market value for when times were good. (Eliot Spitzer was beginning to investigate WaMu and First American Title over this problem shortly before he resigned.)

    So if I have a mortgage/note for 150% of value and that actual market value has dropped to, say, 60% of previous value, how much would you be willing to pay for that note? That is the underpinnings of what a lot of these tranches are based on. You’re right, it’s not a pretty picture that you want to see in full daylight.

  2. Sundog

    Fall 2007? (Don’t want to use up a valuable FT click to read the source from Tett, though I should.)

    Lovely contrast by YS here between conventional wisdom at the time (dispersion of risk) and what brought it all down in Fall 2008.

    YS: But in this case, the risks have been sliced and recomposed into other instruments and distributed around the world. No one is certain who has subprime exposure, and because these subprime loans are often components of very complex, illiquid instruments, no one is sure how much (or more to the point, how much less) they are worth.

    This is an extraordinarily provocative piece on any number of levels; really a classic NC post. I imagine I could write hundreds of pages in response and be nowhere near exhausting the issues raised.

    YS: But this discussion nevertheless highlights the basic dilemma: the parties who are in the best position to facilitate price discovery have every reason to impede that process.

    For “price discovery” one might substitute numerous alternatives. Is it relevant that people in Laredo, Texas gather near the river to partake of the spectacle as gunfire and grenade explosions erupt across the border? Border cities love to cite their low rates of violent crime; they are less likely to talk of the corruption and cognitive dissonance which is the heart of the problem on both sides of the border.

    Cheers for continuing the summer reruns!

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