Category Archives: Derivatives

GSE 2.0 Scare Tactics: False Claim That No Government Guarantee = No Thirty-Year Mortgage

The propaganda strategy for selling the public on the creation of supposedly new improved GSEs is becoming more apparent. Recall that we had an initial skirmish a month ago, when the Center for American Progress published a plan to reform Fannie/Freddie and the housing finance system. It would create an FDIC-like insurance fund to stand behind private Fannie/Freddie like entities that will offer reinsurance with an explicit Federal guarantee on mortgage-backed securities. These new firms can also be controlled by banks.

This plan, which was very similar to ones presented by the Mortgage Bankers Association, the Federal Reserve and the New York Fed, t was clearly an Administration trial balloon; the CAP is the mainstream Democrat think-tank, with close ties to Team Obama. But after the CAP proposal got some resistance, the Treasury’s report, which came later in the month, went the route of presenting three alternatives rather than a specific plan. But we argued at the time that this seeming change was merely a tactical move, to present the Administration as fair brokers in a politically fraught process, and that it still favored what we called the GSE 2.0 plan.

We think the idea of reconstituting the GSEs in somewhat improved form a terrible idea because it preserves the bad incentives of a public/private system and launders housing market subsidies in an inefficient and unaccountable way through the banking industry.

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A Straightforward Criminal Case Against Wall Street CEOs and Senior Executives

Various people who ought to know better, such as the New York Times’ Joe Nocera, haven taken to playing up the party line of the banking industry and I am told, the SEC, that we should resign ourselves to letting senior financial services industry members get away with having looted their firms and leaving the rest of us with a very large bill.

It is one thing to point out a sorry reality, that the rich and powerful often get away with abuses while ordinary citizens seldom do. It’s quite another to present it as inevitable. It would be far more productive to isolate what are the key failings in our legal, prosecutorial, and regulatory regime are and demand changes.

The fact that financial fraud cases are often difficult does not mean they are unwinnable. And a prosecutor does not need to prevail in all, or even most, to serve as an effective cop on the beat.

Contrary to prevailing propaganda, there is a fairly straightforward case that could be launched against the CEOs and CFOs of pretty much every US bank with major trading operations.

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Michael Lewis: Will Defamation Charges by His “Big Short” Villain Stick?

One of the dangers of framing stories as Manichean tales is the purported bad guys can take offense and try to get even. And if you do it in a book, the threshold for liability is low enough that they might indeed be able to inflict some real pain.

Michael Lewis, author of the bestseller The Big Short, along with his publisher, W.W. Norton and his source Steve Eisman, were sued today in Federal court for defamation by one Wing Chau. In case you are one of the five people in America who is interested in finance but has managed not to read The Big Short, there is a scene in the book in which FrontPoint’s Eisman, who is Lewis’ main subprime short hero, has asked to meet someone who is on the other side of his trade. That “someone” is a CDO which in practical terms means a CDO manager. Eisman and two of his employees have dinner with Wing Chau, who is the head of the CDO manager Harding. Needless to say, Lewis’ account makes it clear that he regards Chau as very much part of the problem.

Now we’ve written a LOT about CDOs; in fact, our book ECONNED broke the story of Magnetar and demonstrated how its CDO program, which it used to establish a risk-free short position, drove the demand for a large portion of the subprime market in the toxic phase. And we have taken issue with Lewis’ characterization of the shorts as heros.; Knowingly or not, the strategy that reaped them billions also distorted normal market pricing signals on a massive scale, not only allowing the subprime mania to continue well beyond its sell-by date but also by actively promoting the creation of the “spreadiest” or very worst mortgages.

Our reading of Lewis’ plight is that Chau’s claims seem to be a stretch, given that the facts are less on his side than a reading of his suit might suggest. But as we will discuss later on, litigation on books is so plaintiff friendly that even a weak claim can succeed in court.

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On the Problem Rising Oil Prices Pose for Central Banks

Ambrose Evans-Pritchard of the Telegraph voices his concern that central banks are going to misread the impact of rising oil prices and therefore make the wrong interest rate decision. Bear in mind that Evans-Pritchard called the 2008 oil spike correctly, deeming it to be a bubble, and was also in the minority then in arguing that deflation was a bigger risk to the economy than inflation.

One leg of his argument is that oil price increases slow economic growth. That’s hardly startling; indeed, this concern has been echoed widely in the last few days. For instance, as David Rosenberg notes, courtesy Pragmatic Capitalism:

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Bernanke Blames the Global Financial Crisis on China

They must put something in the water at the Fed, certainly the Board of Governors and the New York Fed. Everyone there, or at least pretty much everyone who gets presented to the media, seems to have an advanced form of mental illness, namely, an pronounced inability to admit error. While many in public life suffer from this particular affliction, it appears pervasive at the Fed. Examples abound including an overt ones like an article attempting to bolster the party line that no one, and hence certainly not the central bank, could have seen the housing bubble coming, or subtler ones, like a long paper on the shadow banking system that I did not bother to shred because doing it right would have tried reader patience Among other things, it endeavored to present the shadow banking system as virtuous (a necessary position since the Fed bailed it out) because it was all tied to securtization and hence credit intermediation. That framing conveniently omits the role of credit default swaps and how they multiplied the worst credit risks well beyond real economy exposure levels and concentrated them in highly geared financial firms.

Another example of the “it is never the Fed’s fault” disease reared its ugly head in the context of the G20 meetings.

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Guest Post: The Price of Oil – Where the Outrage?

By Payam Sharifi, an economics Graduate Student at the University of Missouri-Kansas City

Here in the United States, discussions of our troubled times revolve around any of the following: the housing crisis, the federal debt, unemployment, the fiscal health of particular states, and sometimes even income inequality. Overseas, discussions can include these topics, as well as the plight of the Euro. One issue that I personally feel has gotten the short end of the stick is that of commodity prices, and in particular food and oil. There is a special significance to this issue: its ramifications affect nearly every human being in the world. As seen in prices on the NYMEX and other markets, oil and food prices are beginning to soar again, with the price of WTI futures hitting $90/barrel and Brent crude going over $100/barrel. This issue ought to be discussed again with a renewed interest – but the media and much of the populace at large have simply accepted high food and oil prices as an unavoidable fact of life, without any discussion of the causes of these price rises aside from platitudes. For example, a recent AP report quoted an opinion that gasoline was going to hit $4/$5 a gallon in 2011, but did not mention the possible relevance of speculation in the futures market. It seems that everyday observers (as well as even the financial media) find this issue so complex that they shrink from discussing it. I will now give my opinion on these issues, buttressed by what I have learned from a recent interview with commodities trader Daniel Dicker. His new book “Oil’s Endless Bid” is due out in April.

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Shoddy Anti Derivatives Reform “Study” From Firm That Falsely Claimed Top Academics as Advisor

t’s high time that reporters start lifting the veil to look at exactly who is behind the “research” put out by think tanks. Even drug company research, which many members of the public now know to view with some doubt, at least has an actual investigation of some sort underpinning it (the doubts about them usually involve study design and/or interpretation of results). Think tank end product should be taken with even more salt, since it too often is the intellectual equivalent of a CDO: taking junk ideas and dressing it up in a structure and a brand name so that most people will regard it as AAA-rated thinking.

A piece by Andrew Ross Sorkin at the New York Times is an all-too-rare and badly need hard look at the less than savory process of creating impressive-looking arguments in favor of special-interest serving policies.

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Why are Half of the FCIC Interviews Being Withheld?

The FCIC has made a great show of being transparent, but if you are going to make that your signature, you can’t engage in halfway measures. Lambert Strether, in an e-mail titled “A data conversion effort that shows FCIC’s “Resource Library” is farcically bad and obfuscatory” noted:

Obviously, any independent evaluation of the material is not at all a priority with these guys. Yes, they’ve made it easy enough to DISTRIBUTE, and no doubt there will be an iPhone app any day now. Yay. But as far as making it easy to EVALUATE, which takes data you can interchange and manipulate and search, everything they have done makes that harder. Every single thing.

More tooth gnashing from Lambert here and here.

Another mystery is why so many interviews are being withheld.

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Paulson Denies Culpability in Crisis, Yet Even Bear Turned Down His Deals

The release of the first batch of FCIC interview reveals interesting finger-pointing among some of the major players. We’ve argued (and in ECONNED, provided a considerable amount of supporting analysis) that the subprime shorts drove the demand for bad mortgages. There is no other explanation for the explosion of demand for “spready,” meaning bad, mortgages that started in the third quarter of 2005. As Tom Adams and I describe in a recent post:

Signs of recklessness were more visible in 2004 and 2005, to the point were Sabeth Siddique of the Federal Reserve Board, who conducted a survey of mortgage loan quality in late 2005, found the results to be “very alarming”.

So why, with the trouble obvious in the 2005 time frame, did the market create even worse loans in late 2005 through the beginning of the meltdown, in mid 2007, even as demand for better mortgage loans was waning? It’s critical to recognize that this is an unheard of pattern. Normally, when interest rates rise (and the Fed had begun tightening), appetite for the weakest loans falls first; the highest quality credits continue to be sought by lenders, albeit on somewhat less favorable terms to the borrowers than before.

In other words: who wanted bad loans?

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Is the Proposed NYSE-Deutsche Börse Merger All It’s Cracked Up to Be?

The financial media is duly falling in line and giving a thumbs up to the proposed merger between the New York Stock Exchange and Deutsche Börse. Mayor Bloomberg contends it is both good for New York City and provides customers better service in an era of increasingly global equity trading. Industry analysts approved. Not surprisingly, stocks of other exchanges are up based on takeover speculation.

Your truly is wary about concentrations of power in the financial arena, and consolidation of stock exchanges has the potential to go in that direction. One critic of the deal was former Goldman Sachs co-chairman John Whitehead. Admittedly, some of his objections sound quaint, echoing the hand wringing of the 1980s when the Japanese acquired trophy assets such as the Rockefeller Center. From Bloomberg:

“I speak out rarely, and this is one time when I can’t hold myself back,”

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Questioning Goldman’s “Market Making” Defense

The notion underlying the Volcker rule is that too big to fail institutions have a government backstop and therefore their activities should be restricted to the types of intermediation that support the real economy. The taxpayer has no reason to fund “heads I win, tails you lose” wagers. Various firms, most notably “doing God’s work” Goldman, has tried to play up the social value of its role, whenever possible wrapping its conflict-of-interest ridden trading activities in the mantle of “market making”.

A big problem in taking about market making versus position trading is that, Goldman piety to the contrary, the two are closely linked. Even though all the major dealer banks created proprietary trading operations to allow top traders to speculate with the house’s capital, plenty of positioning also takes place on dealing desks. While dealers are obligated to make a price to customer (well, in theory, it’s amazing how many quit taking calls in turbulent markets), they are shading their prices in light of how they feel about holding more or less exposure at that time. And the dealing desks, just like the prop traders, are seeking to maximize the value of their inventories over time.

A Goldman discussion of risk management presented yesterday (hat tip reader Michael T) gives reason to question that much has changed on Wall Street regarding the role of position taking, now taxpayer supported, in firm profits.

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Krugman, Commodity Prices, and Speculators

Paul Krugman was gracious enough to acknowledge our past differences on the matter of commodities speculation, which was specifically about oil markets. It was the subject of a long running argument conversation between his blog and mine in spring 2008, which I recapped in ECONNED.

In brief, Krugman contended that the skyrocketing oil prices of early 2008 were the result of fundamental factors (and we pointed out that we were puzzled by his stance, since he, unlike the vast majority of Serious Economists, has been willing to call some past bubbles in their making). As he reiterates on his blog today, if the prices exceed the level dictated by supply and demand in the real economy, a standard microeconomic analysis would expect there to be inventory accumulation, aka hoarding.

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Satyajit Das: Derivatives Regulation Dance

By Satyajit Das, the author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.” Cross posted from Wilmott

A question of values …

Derivative contracts are valued on a mark-to-market (“MtM”) basis. This requires valuation of the contracts based on the current market price.

OTC derivatives trade privately. Market prices for specific transactions are not directly available. This means current valuations rely on pricing models.

There are significant differences in the complexity of the models and the ability to verify and calibrate inputs. More complex products used sophisticated financial models, often derived from science or statistical methodology. There are frequently differences in choice, exact factorisation and even numerical implementation of the models. Different dealers may use different models.

Some required inputs for the models are available from markets sources. The nature of the OTC market and the limited trading in certain instruments mean that key input parameters must frequently be “estimated” or “bootstrapped” from available data. In certain products, the limited number of active dealers means that “market” prices are sometimes no more than the dealer’s own quote being fed back after being collated and “scrubbed” by an external data provider. This is referred to prosaically as “mark-to-myself”.

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FCIC Report Misses Central Issue: Why Was There Demand for Bad Mortgage Loans?

By Tom Adams, an attorney and former monoline executive, and Yves Smith

In common with other accounts of the financial crisis, the Financial Crisis Inquiry Commission report notes that mortgage underwriting standards were abandoned, allowing many more loans to be made. It blames the regulators for not standing pat while this occurred. However, the report fails to ask, let alone answer, why standards were abandoned.

In our view, blaming the regulators is a weak argument.

A much more sensible explanation can be found by asking: what were the financial incentives for such poorly underwritten loans? Why would “the market” want bad loans?

All the report offers as explanation is that the “machine” drove it or “investors” wanted these loans. This is lazy and fails to illuminate anything, particularly when there are other red flags in the report, such as numerous mortgage market participants pointing to growing problems starting as early as 2003. Signs of recklessness were more visible in 2004 and 2005, to the point were Sabeth Siddique of the Federal Reserve Board, who conducted a survey of mortgage loan quality in late 2005, found the results to be “very alarming”.

So why, with the trouble obvious in the 2005 time frame, did the market create even worse loans in late 2005 through the beginning of the meltdown, in mid 2007, even as demand for better mortgage loans was waning?

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