Category Archives: Derivatives

Ilargi: Oil Shock – More Than A Quantum Of Fragility

Yves here. We’ve written that the sudden decline in the price of oil has the potential to deliver some nasty financial shocks, given that shale companies and even the majors have been financing exploration and development with debt.

But while concerns about fragility are well warranted, we wanted to make sure a mention made in this article is not treated with undue alarm. It points out that the BIS is concerned that an unprecedented portion of CDOs are now made of leveraged loans.

The problem is that the term “CDO” has been used inconsistently in the financial media. The CDO that you learned to hate in the wake of the crisis and blew up AIG, monoline insurers, and did a lot of damage to big banks were more formally called “asset backed securities CDOs” or “ABS CDOs” But that was too much of a mouthful, so they were referred to as “CDOs” in the press. There were two periods when that type of CDO existed, the late 1990s, and from the mid 2000 to mid-2007. Ina both cases, that market was a Ponzi, used to make the unwanted parts of subprime securitizatons saleable by making them into financial sausage, with some better assets thrown in, and then re-tranched again. The Ponzi part came about from the fact that these CDOs also had unsaleable parts, which were either put into first generation CDO sausage (CDOs allowed a certain portion of CDOs to be included) or sold into CDO squareds (which were hard to sell).

But the more mainstream type of CDO was one made of credit defaults swaps on corporate credits. That was the original CDO done in the famed JP Morgan Bisto deal in the mid-1990s. Indeed, when I first started researching subprime (ABS) CDOs, and just called them “CDOs” some experts assumed I meant the corporate loan type, since that was prevalent. During the crisis, possibly to make sure no one confused these CDOs with the ones that were blowing up, they were increasingly called CLOs, or “collatearlized loan obligations.” They were also legitimately less risky than the subprime CDOs, since their value didn’t suddenly collapse when a certain level of loan losses was breached.

The cause for pause is that CLOs, which are indeed a type of CDOs have traditionally been made mainly or entirely of investment grade credits. It now appears that junk credits predominate. While their structures and diversification will keep ABS CDO-type total wipeouts from happening, they could still deliver some nasty surprises.

Chicago Public Schools’ $100 Million Swaps Debacle Demonstrates High Cost of High Finance

I’ve been late to write up an important series published by the Chicago Tribune earlier this month on a costly swaps misadventure by the Chicago Public Schools. Like all too many state and local government entities, the Chicago Public Schools were persuaded to obtain $1 billion of needed ten-year financing not through the time-and-tested route of a simple ten year bond sale but the supposedly cost-saving mechanism of issuing a floating-rate bond and swapping it into a fixed rate. An impressive, expert-vetted analysis of the deal by the Chicago Tribune estimated that the school authority has in fact incurred $100 million in present-value losses on that $1 billion bond issue.

Nomi Prins: Why the Financial and Political System Failed and Stability Matters

Yves here. We’re delighted to be featuring a post by Nomi Prins, a former Goldman managing director turned critic of the way the financial services industry has become a “heads I win, tails you lose” wager with the entire economy at stake. Many readers are likely familiar with her through her books, such as Other People’s Money: The Corporate Mugging of America and It Takes a Pillage: An Epic Tale of Power, Deceit, and Untold Trillions, as well as her regular TV appearances.

Matt Stoller: Why Is Alan Greenspan’s Lawyer, Scott Alvarez, Still Controlling the Federal Reserve? (AIG Bailout Trial)

Yves here. This important post explains why Scott Alvarez, the general counsel of the Federal Reserve Board of Governors, needs to be fired. His responses to the plaintiffs’ questions at the AIG bailout trial weren’t simply evasive; they reveal a deep, almost visceral, dedication to defending the very policies that nearly destroyed the world economy as well as a salvage operation that favored financial firms over the real economy. We have embedded the transcripts from the first three days of the AIG bailout trial, which cover Alvarez’s performance on the stand, at the end of this post.

Alvarez was brought to the Fed by Alan Greenspan. As a staff lawyer, he helped implement bank deregulation policies such as ending supervision of primary dealers in 1992, refusing to regulate derivatives in 1996 (I recall gasping out loud when I first read about the Fed’s hands off policy), and implementing the rules that shot holes through Glass Stegall before it was formally repealed in 1999. Among those measures was giving a commercial bank, Credit Suisse, waivers to take a 44% stake one of the biggest investment banks, First Boston, in 1988 and assume control in 1990.

Alvarez also has a poor record as far as representing broad public interest in his tenure as General Counsel, which started in 2004. The Fed did an even worse job than the bank-cronyistic Office of the Comptroller of the Currency in enforcing Home Ownership and Equity Protection Act, a law that put restrictions on high-cost mortgage lenders. The Fed was also one of the two major moving forces behind the disastrous Independent Foreclosure Review, an exercise that promised borrowers who were foreclosed on in 2009 and 2010. The result instead was a fee orgy by the supposedly independent consultants, capricious and inadequate payments to former homeowners, and virtually no disclosure of what was unearthed during the reviews.

Yellen has said she wants to make financial stability as important a priority of the Fed as monetary policy. That means, among other things, being willing to regulate banks. Scott Alvarez is too deeply invested in an out-of-date world view to carry that vision forward. If Yellen intends to live up to her word, Alvarez has to go.

AIG Bailout Trial Bombshell II: Fed and Treasury Cornered AIG’s Board into Taking a Legally-Dubious Bailout

As we said in our companion post today on the AIG bailout trial, former AIG CEO Hank Greenberg may have a case after all. Mind you, we are not fans of Greenberg. But far too much of what happened during the crisis has been swept under the rug, in the interest of preserving the officialdom-flattering story that the way the bailouts were handled was necessary, or at least reasonable, and any errors were good faith mistakes, resulting from the enormity of the deluge.

Needless to say, the picture that emerges from the Greenberg camp, as presented in the “Corrected Plaintiff’s Proposed Findings of Fact,” filed in Federal Court on August 22, is radically different. I strongly urge readers, particularly those with transaction experience, to read the document, attached at the end, in full. It makes a surprisingly credible and detailed case that AIG’s board was muscled into a rescue that was punitive, when that was neither necessary nor warranted. And the tactics used to corner the board were remarkably heavy-handed.

AIG Bailout Trial Bombshell I: Paulson Rejected Chinese Offer to Invest “More Than the Total Amount of Money Required”

Hank Greenberg may have a case after all.

Nomi Prins on the Credit Derivatives Systemic Risk Bomb

Yves here. Former Goldman managing director turned journalist Nomi Prins spoke on RT about unresolved systemic risk issues, most importantly, credit derivatives.

Regulators Punting on “Too Big to Fail” Problem of Repo, Looking to Install Yet Another Bailout Vehicle

The post-crisis era is rife with band-aid-over-gunshot-wound approaches to deep-seated weakness in the financial system. Perversely, because the authorities were able to keep the system from falling apart, albeit via a raft of overt and covert subsidies to the perps, they’ve reacted as if all that needs to be done is a series of fixes rather than more fundamental interventions. One glaring example is a critically important funding mechanism, repo, for firms that hold large inventories of securities and/or enter into derivative positions, such as major capital markets firms like Goldman, Deutsche Bank, and Barclays, as well as hedge funds. Here, the authorities have been giving way to industry demands that will assure that repo, which was bailed out in the crisis, will be bailed out again.

Summer 2007 Deja Vu: Banks and Short Sellers Dump Risk on Chumps Via Complex Products

NC contributor Michael Crimmins flagged a Bloomberg article yesterday that described the proliferation of complex synthetic structures, depicting it as return to some of the bad risk-shifting of the blowout phase of the last credit bubble.

The amusing bit is the headline was toned down after the post was launched (you can tell by looking at the URL, which almost certainly tracks the original). The current version is the anodyne “JPMorgan Joins Goldman in Designing Derivatives for a New Generation.” But the very first paragraph flags the troubling resemblance to the last hurrah of the pre-crisis credit mania:

Only Now Does Influential Bank Group Complain That Low Volatility is Producing Too Much Risk-Taking

The spectacle of banks wring their hands about how low volatility is leading them as well as investors to take on too much risk bears an awfully strong resemblance to a child who has killed his parents asking for sympathy for being an orphan.

How Much of a Short Position Did Paul Singer Take in Argentina? And Who Were the Bagholders?

With the Argentine default, we are seeing a replay of a strategy that established Naked Capitalism readers will remember from the crisis: use a complex structure to disguise risk so that short sellers can place their wagers at far lower prices than they would be able to otherwise. And that raises the interesting question of how large a net short position Paul Singer, the instigator of the litigation that has undone Argentina’s restructuring deal and put the country in default, took against Argentina, as well as the relationship among the parties that put on the positions on behalf of short sellers.

Ilargi: In The Lie Of The Beholder

Yves here. Ilargi uses strained messaging in response to recent market upsets, the Argentine default, and the failure of Banco Santo Espirito to address one of NC’s pet topics, propagandizing. Most people think of propaganda as the deliberate crafting of false or misleading messages, or the simple Big Lie. However, there’s also the variant of the deeply vested partisan. As Upton Sinclair stated, “It is difficult to get a man to understand something when his salary depends on his not understanding it.” And a lot of those salaried-by-the-status-quo folks have access to media megaphones.

Regulators Reject Living Wills of 11TBTF Banks, a 100% Fail Rate

Mirabile dictu, it looks like Elizabeth Warren’s grilling of Janet Yellen on the Fed’s failure to make progress on Dodd Frank resolutions, also known as living wills, has had some impact. From the Wall Street Journal:

Financial Interconnectedness and Systemic Risk: New Fed Report Flags 7 Behemoths

Yves here. This post addresses a topic near and dear to my heart: the importance of financial interconnectedness, or what Richard Bookstaber called “tight coupling” in his book A Demon of Our Own Design. Tight coupling occurs when the processes in a system are so closely linked that when certain types of activities begin, they propagate through the system and cannot be halted. Or as Bookstaber put it in 2011:

Non-linear systems are complex because a change in one component can propagate through the system to lead to surprising and apparently disproportionate effect elsewhere, e.g. the famous “butterfly effect”….
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