Felix Salmon

Goldman Sachs datapoint of the day

Felix Salmon
Apr 24, 2009 14:28 UTC

Tyler at Zero Hedge has been rooting around in NYSE statistics, and finds that Goldman Sachs traded over 1 billion shares for its own account last week — more than half the principal program trading from NYSE member firms, and more than 20% of all program trading on the exchange. My feeling is that this is a function of the decline of big liquid hedge funds with essentially unlimited funding capacity: Goldman is stepping in to take advantage of the lack of liquidity in the non-bank financial sector.

But how can Goldman take advantage of that lack of liquidity in the hedge-fund world? Just because it has access to unlimited government liquidity itself. Essentially, the US taxpayer is lending at extremely low rates to the world’s largest hedge fund, even as the world’s largest hedge fund is trying to extricate itself from any responsibility to the US taxpayer by repaying TARP funds.

According to Jon Unia, Goldman has made $600 million over the past four months just from the fact that the government has guaranteed a large chunk of the company’s debt — I think that’s the difference between Goldman’s funding costs with the guarantee and the amount it would have had to pay without it. That money alone makes the difference between Goldman making a profit and making a loss. If you add in the pretty artificial profits they’re getting from their NYSE program trading activities, I’m sure the hidden subsidy to Goldman Sachs gets even bigger. And that’s not even counting all the money funneled to Goldman via AIG.

Goldman Sachs claims to be a bastion of free-market capitalism. But that’s not how it’s making its money these days.

Update: Goldman Sachs spokesman Ed Canaday responds:

The NYSE report that Zero Hedge discussed shows Goldman Sachs trading over 1 billion shares in the principal program trading category. What the table doesn’t show, but a deeper look at the numbers reveals is that the vast majority of this total is trades by our quantitative trading desk. This desk is participating in a relatively new NYSE program called Supplemental Liquidity Providers. The NYSE started the program to attract liquidity to the exchange. As an SLP, this the desk makes markets in NYSE stocks. They often do high-frequency trading (which is simply auto-quote market making) where they send out hundreds of “baskets” of stocks at one time. Program trading, as defined by the NYSE report is any strategy that sends out a “basket” of 15+ stocks at one time. I am happy to discuss this with you if that description doesn’t make sense.

On another part of the post, you reference the FDIC-guaranteed debt program (aka the TLGP). I don’t understand how it is the US taxpayer who is essentially lending to GS and the other banks since the FDIC and this program are funded by the banks themselves. I also have difficulty understanding the $600 million savings that is sourced to Jon Unia. Do you know how he arrived at this number?

No, I don’t know where Unia gets his $600 million number, but I don’t believe for a minute that the TLGP guarantees are coming at anything approaching a market rate — not with bank CDS spreads where they are. There’s an implicit subsidy from taxpayers insofar as FDIC guarantees are vastly cheaper than any private-sector insurer would charge for the same service.


Correction: Where you have a blueprint for how to protect the American people, established into law, based on previous experience of dealing with Savings and Loan problems, and where you have experienced regulators involved in crafting that law, you have the benefit of hindsight.*

Hindsight was established in 1980s. This is what happens and laws were put in place to protect the government and its people from being exploited again.

With hindsight, comes responsibility and good stewardship. You cannot always get that from a stock broker, because stock brokers are sometimes programmed differently, by way of incentive and off record discussions. Not all stock brokers are this way, but many are. There should be a clear division between brokerage firms and government funds. Right now, that divisions is awash in trading platforms and automated liquidity experiments, derivatives and toxic debts being put off on the American tax payer – without consequence to sub-level executives who signed their companies into that debt.

This can lead to confusion. Where confusion sets in you have to go back to the law.

After so much indulgence, there is only the law. The weightier provisions of the law, take precedence, after so many narrow violations materialize.

Why Chrysler needs to declare bankruptcy

Felix Salmon
Apr 24, 2009 13:17 UTC

If Chrysler does come to some kind of agreement with its banks — which is by no means a foregone conclusion — then why would it still want to declare bankrutpcy next week? The WSJ gets half of the story when it says that bankruptcy “would let Fiat pick and choose which operations it wants”, but then goes and confuses matters by saying that Fiat is interested in Chrysler “in its totality.”

The answer is that it’s all about the dealers — which are the reason why I said GM should declare bankruptcy as long ago as last July. Detroit is hobbled greatly by its legacy contracts with its dealers, and bankruptcy is the only way of getting out of those contracts. In many ways, I suspect that the dealers have the most to lose from bankruptcy proceedings. Lucky they don’t have a particularly strong and unified lobby, I guess.

Update: Jeffrey Cane, who knows everything, tells me that Chrysler can only file for bankrupcy. It can’t declare bankrutpy, only a judge can do that.


someone tell me how cutting half the dealerships is going to help Chrysler. Dealers pay for all of the transportation getting vehicles to their lots, all of the sales/service training, all the promotional materials, they fund their local ad associations with no money from Chrysler, and fill sold units with no money from Chrysler.

When Chrysler made big money , so did their dealers. The problem isnt the dealers.

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Thursday links go hostile

Felix Salmon
Apr 24, 2009 04:52 UTC

Hostile takeovers: Why don’t they happen in the non-profit space? (Except in Singapore, weirdly.)

Statistics that I don’t believe: In The New Yorker. Never underestimate the ability of even the most storied fact-checking department to go snow-blind in the presence of numbers.

In Defense Of Elizabeth Warren: Carney responds to his misguided colleague.

Systematic Dismantling of the Rose Art Museum Well Underway Even as Brandeis Claims Otherwise: Says the Rose itself, and I believe it.

Bizarre web strategy of the day, Rolling Stone edition

Felix Salmon
Apr 24, 2009 04:29 UTC

I’m ashamed to admit that I never read all of the long and famous Matt Taibbi screed on the financial system which I linked to a month ago. So faced with a plane ride tomorrow, I thought I’d read it then. Except, inexplicably, Rolling Stone has decided to horribly truncate it, and in its place I find this:

For Matt Taibbi’s complete report, including the people behind the crash and a look at those who stand to profit from it, check out Issue 1075 of Rolling Stone.

This is Not Useful: since that particular issue of RS came out, there have been two new issues (one with Lil’ Wayne on the cover, and one with the Kings of Leon), which means the only way I’m likely to be able to check out Issue 1075 is by getting myself to the library. And much as I love Taibbi snark, I don’t love it enough to do that.

I think it’s silly for magazines to truncate their articles online in the hope that readers will then go to the newsstand to buy the physical copy. And that’s what RS did as recently as February, when it was sensibly attacked by Choire Sicha for doing so. Magazines don’t compete with their own websites, they compete with everybody else’s websites.

But at least their was some logic to what Rolling Stone did in February: put the article out in print first, and then only online in full once the next issue hits the newsstands.

The new strategy makes no sense at all: first put the article out in full online, and then truncate it when it’s no longer on newsstands. Huh? What earthly purpose does that serve?

Update: If you want to read untruncated Taibbi, he’s got a classic piece of Friedman-bashing over at True/Slant.


“At least their”… maybe a trip to the library is in order after all.

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A California default

Felix Salmon
Apr 24, 2009 03:41 UTC

Thomas Pindelski  asks:

Given that CA now has the lowest credit rating of all the states, does that make the high rates CA is offering in recent auctions something to avoid, owing to the risk of default, or something to cherish on the lines of ‘too big to fail’.

This is something which came up in conversation today, unsurprisingly, in the wake of my talk to the regional bond dealers. One of them came up to me and indignantly told me that he’d been a muni bond dealer for 38 years, and that of course he knew all about credit risk, as had his forebears before him. To which the natural response is: well, if you’re pricing California debt at these levels, then you must reckon that there’s a pretty substantial probability of default.

The more interesting response was, basically, “my moral hazard trumps your moral hazard”. In other words, it’s true that because California has insured itself against default, there’s moral hazard there: whenever anybody is insured against anything, the likelihood of that thing happening goes up. But at the same time, there’s a bigger moral hazard at play: the federal government will never let California default, it’s too big to fail. And so when push comes to shove, California will get a federal bailout before it defaults on its bondholders.

I suspect, however, that the moral hazard seniority works the other way around: the fact that California’s bondholders are insured means that it’s not too big to fail, and that in fact a payment default by the state would have very little in the way of in-state systemic consequences. (I have no idea what it might do to the monolines, but if they can’t cope with a single credit defaulting, they really shouldn’t be in the business they’re in.) The federal government might step in to mediate the negotiations between the monolines and the state, but it’s not even obvious why it would want to do that.

The more powerful argument why California won’t default is that a payment default is illegal under state law: California’s simply not allowed to default on its bonds. But what are the monolines going to do, sue? If California defaults on say a $1 billion payment which the monolines have to pay, then California owes the monolines $1 billion. If the monolines sue the state and win, then California owes the monolines $1 billion. It’s not clear that they’ve advanced very far. Could they start attaching state assets? I doubt it, somehow.

My hope is that the monolines would get their money back reasonably quickly — the unintended consequences of a default would force California’s dysfunctional legislature to wake up to the pettiness of its actions, and serious fiscal policies might finally be able to be passed. But I can’t say that outcome is particularly probable: the California legislature has shown no signs of being grown-up in the past, or even of moving in that direction.

And indeed the really nasty unintended consequences of a Californian default might well be felt outside the state, with the closing down of the municipal bond market nationally. Once California defaults, it’s hard to see any other state raising private general-obligation funds at any kind of interest rate it would consider acceptable.

Which brings us back to the moral-hazard play: maybe the Feds would bail out California, not for California’s sake, but rather for the sake of the municipal bond markets as a whole. But it’s hard to see where they would get the money, or how Congress would ever approve such an appropriation.

Still, Treasury surely has some kind of traction here — maybe it can tell California that it won’t get any stimulus-bill funding if it’s in default on its obligations. Might that do the trick?


“And indeed the really nasty unintended consequences of a Californian default might well be felt outside the state, with the closing down of the municipal bond market nationally. Once California defaults, it’s hard to see any other state raising private general-obligation funds at any kind of interest rate it would consider acceptable.”

Is this necessarily the case? I would have thought that the bond markets can look at state’s budgets and financial situation and reach educated judgments differentiating most states from California. I.e. states that aren’t running comparably huge deficits, or whose revenues are not so sensitive to fluctuations at the top of the income scale (or in real estate valuation) would not suffer as badly as states like, say, New York. Or are these bonds priced on the assumption that the federal government will step in and print money whenever state governments screw up as badly as California has done?

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Innumeracy watch, Mark Penn edition

Felix Salmon
Apr 23, 2009 22:18 UTC

Mark Penn wrote a very silly column on blogging for the WSJ. He should have left it at that. But no, he had to go and try and defend himself. Which is how he ends up justifying this:

It takes about 100,000 unique visitors a month to generate an income of $75,000 a year

With this:

As far as the $75,000, the Technorati report says that of those bloggers who had 100,000 or more unique visitors, the average income is $75,000. True, it’s not the median, but it is the average.

Now if say a high-schooler or even a first-year undergrad made this mistake, one might be able to bemoan the state of the US educational system, rather than the innumeracy of the individual in question. But if Mark Penn, who has dealt with numbers and statistics his entire professional life and been paid millions of dollars to do so, makes this mistake, then we are probably all doomed.

Even more depressing, in many ways, is the cute little distinction Penn insists on making between the median and the average, for all the world as though he understands basic statistics. Of course he doesn’t: the average income for bloggers who have more than 100,000 unique visitors is going to be skewed towards the income of bloggers with millions of unique visitors, however you slice it.

But in any case, the world has moved on: in my anecdotal experience, the hot new route for anybody who wants to make enough-to-live-on money from their blog is to do so by trying to turn it into a book, rather than by selling advertising on the blog itself. It’s taken a while, but everybody from Christian Lander to Barry Ritholtz is bookifying, these days, with no little success; I think that the amount of time between Postcards from Yo Momma launching and it getting a book deal can probably be measured in nanoseconds.

The blog-to-book trend may or may not last, of course, but Mark Penn will always be innumerate. Maybe that’s the real reason why Hillary lost.


Given the constant displays of breathtaking ignorance displayed by Mr Salmon since he began his attempt to take Reuters downmarket and trash a once-respected brand, this is a severe and disgraceful case of the pot calling the kettle black.

How long before Reuters realise the damage that Mr Salmon’s disgraceful attitude towards work is doing to their brand?

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How special is the US triple-A?

Felix Salmon
Apr 23, 2009 21:31 UTC

A very good comment comes from dWj:

I had never heard until a year or two ago that U.S. Treasuries were even rated, though I have since read on occasion that it’s AAA, and have read the complaint that therefore other AAA rated bonds are rated as “as safe as treasuries”. (This is like saying that, because Einstein had a high school diploma, anyone with a high school diploma has been rated “as smart as Einstein”. The mechanism simply doesn’t make the distinction; it’s a bit of a leap to then say that the mechanism is asserting that the distinction doesn’t exist.)

It’s a good point, well made, but I, for one, have always been well aware of Treasury’s triple-A status, since I first started learning about bonds at the time that Newt Gingrich was refusing to raise the US debt ceiling and a US default was a serious possibility; a lot of discussion ensued, at the time, about the consequences of the US losing its triple-A rating. And since then, many sovereigns have lost their triple-A status, including Japan.

What’s more, Moody’s has indeed been creating distinctions within the triple-A band; the USA is stronger than Spain, but weaker than Finland, if that helps.

Of course more is meant by “risk free” than “zero credit risk” — the reason that Treasuries are considered risk-free and, say, IBRD bonds are not is not because the World Bank is more likely to default on its obligations than the US government. Rather, Treasuries are the most liquid debt instruments on the planet, and when you’re dealing with this kind of level of credit risk, illiquidity risk starts to become increasingly important.

But the fact is that all good things must come to an end — and that includes America’s triple-A credit rating. I have no idea when it will disappear, but empires fall, and so do triple-As. Even for the one country in the world capable of printing as many dollars as it needs.


Triple A rating is meaningless if inflation wipes out earnings. Eventually investors will move away. Risk taking is the only way to increase wealth when investing. Now to the real matter.

The character of those in the industry is of the greatest importance. Trust is not an assurance of prosperity. Rather it is the confidence in knowing you are receiving all the information available and that it is correct. This level of transparency simply is not present.

Corruption prevails all way to the highest levels of most business’. I would submit the same is true for governments. The more we look for technical solutions to our problems, the more we look past the fundamental issue. Consumers should seek out those who act in good faith and have the reputation to back it up. Otherwise don’t consume. I suspect this very principal is in no small measure contributing to our economic catastrophe. Unfortunately this does nothing to alleviate suffering and hardship that this calamity has brought upon millions.

I find no end to my distress over the moral decay so many in this nation suffer from.

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Will there be a wave of municipal defaults?

Felix Salmon
Apr 23, 2009 20:59 UTC

So that went quite well, I thought — in any case I’ve pretty much guaranteed myself an invite back next year if there turns out to be a wave of municipal defaults between now and then.

I got a little pushback, in the Q&A, about my assertion that once municipalities start defaulting in any serious number, the cost of default to a municipality drops sharply — perhaps even below zero. One questioner came back with the obvious response: OK, in that situation the market for all municipalities might end up closing, for a while. But at some point, the market will reopen. And when that happens, municipalities with no history of default will find it much easier to raise funds than those who did default.

My answer to that was “not really”. I gave the example of Colombia and Peru to show that entities which have avoided default in the past don’t necessarily have more or cheaper access to debt capital markets in the present — in fact, they often have worse and more expensive access, just because they have more debt as a result.

Another questioner responded that municipalities weren’t like Latin sovereigns — you can’t really argue with that, since it’s impossible to imagine any municipal issuer behaving like, say, Ecuador. All the same, I said, if the muni market closes, it will close for all borrowers, whether they have defaulted or not. And if and when it opens again, it will open for all borrowers, whether they have defaulted or not. Lenders only really care about future defaults, not past ones, and past default is not necessarily a good guide to future default, especially in the municipal context where default decisions are made by elected officials who will almost certainly not be in power the next time the do-we-default question arises.

Of course, the balance of probabilities is still that there won’t be a wave of municipal defaults. But bondholders generally want more than a balance of probabilities: they want near-certainty. And I don’t think they’ve got that, right now.


As long as Washington is amenable to giving billions of printed dollars to the States, defaults will be deferred. The risk then will be inflation and fiscal irresponsibility as long as Uncle Sam will continue to bail us out. Does any one remember the Weimar Republic?

The U.S. has roughly 40 trillion dollars in unfunded liability for Social Security. The Fed, FDIC and Treasury have given as much if not more in the form of guarantees for the banking and insurance industries. The 11 trillion or so in Treasuries seems small in comparison. This information has not been ignored by China who’s Premier recently expressed concerns about the U.S. honoring it’s financial obligations with China.

How about a U.S. default instead?

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Notes for a speech to the Regional Bond Dealers Association

Felix Salmon
Apr 23, 2009 16:18 UTC

Blogging will be light today and tomorrow, since I’m flying to and from the annual meeting of the Regional Bond Dealers Association in Dallas. They’ve asked me to give a speech: here are my notes.

Like everybody else at this conference, I’m sure, I’m here to talk about risk – the main part of what you all do for a living. You buy it, you sell it, you measure it, you underwrite it. But like most of us, I’ve changed my view on risk considerably over the past couple of years. And it seems to me that one of the biggest mistakes that we all made during the credit boom was that everybody overestimated the demand for risk, when in reality there was much more demand for safety.

I believed along with Alan Greenspan that when it comes to debt instruments in general, and credit derivatives in particular, “These instruments enhance the ability to differentiate risk and allocate it to those investor most able and willing to take it.”

But if you look at what happened in practice, the art of securitization always seemed designed to create ever-increasing quantities of risk-free debt. Banks thought they were selling loans and mortgages to people who wanted the risk, but they weren’t: they were carefully packaging those loans and mortgages into bonds carrying a triple-A credit rating. And people buying triple-A risk don’t want any risk at all.

So what happened to the risk? The answer is that it was essentially modelled away. And one of the most important enablers of that modelling is the subject of my Wired cover story, the Gaussian copula function.

But the story is bigger than one formula.

Consider the very first synthetic CDO: it was called Bistro, and it was issued by JP Morgan in the late 1990s. The bank sold off the risk associated with $10 billion in loans on its balance sheet – this was credit risk which the bank didn’t want, even though it valued its lending relationshipsvery highly. So it kept the loans on its book, and kept the relationships, but sold off the risk by using credit default swaps to structure a synthetic CDO.

But here’s the astonishing thing. The credit risk on that $10 billion in loans managed to somehow get squeezed into a CDO of just $700 million: there was no chance that all the loans would sour at the same time, and JP Morgan managed to persuade Moody’s that the CDO could be just 7% of the size of the underlying loan pool, while hedging all of the credit risk.\

And it gets better: of that $700 million, fully two-thirds carried a triple-A rating. And triple-A, for those of you who remember as far back as 2006, means “no credit risk at all” – it means “risk free” – it means “you’re only taking interest-rate risk”. Which makes no sense when the whole point of credit default swaps is to separate out credit risk from interest-rate risk.

Add in the double-A rated tranches of Bistro, and you have holders of less than $200 million of risky paper taking substantially all the credit risk on $10 billion of corporate loans. That’s less than 2%. And Moody’s happily signed off on this, for two reasons. One was that the business of rating structured-finance vehicles was highly profitable; the second was that their entire business and reputation was based on the idea that they could model credit risk. If they couldn’tmodel credit risk, then they couldn’t rate credit. And so they were backed into a corner, and forced to apply their storied credit ratings to structured products which were simply the logical conclusion of their own models, rather than the result of a fundamentals-based look at a certain credit.

If you take a step back, you can see what’s going on here. You and I and Alan Greenspan all thought that credit derivatives were wonderful things because they moved credit risk out of the hands of people who didn’t want it, like banks, and into the hands of people who did want it.

In reality, however, the appetite for risk was never nearly as great as we all thought. $10 billion of loans becomes less than $200 million of credit-risk instruments, and everybody else reassures themselves that they’ve managed to reduce their credit risk to zero, even as the people holding that $200 million in synthetic CDO tranches are reassured by their own single-A or triple-B credit ratings that theyaren’t taking a particularly large amount of risk either.

And of course you know what happens next: some bright spark invents the CDO-squared, which seems to reduce the total amount of risk even further. You take the mezzanine debt, the triple-B stuff, and you do all manner of securitization magic to it, and it turns out that you can turn most of that into triple-A paper, too!

Because it was all triple-A, no one felt much in the way of need to do any analysis of their own: it’s almost impossible to overstate the power of the laziness of the bond investor. You know this from your own work with municipal issuers: the reason for those monoline wraps is not because the issuers have a lot of credit risk, but because the investors are lazy, and don’t want to do their homework, and reckon they can get out of doing their homework so long as there’s a monoline guarantee. Essentially, they’re outsourcing their own job to the monolines. Which might be reasonable for a small retail investor, but is not a good idea if your job is to invest in fixed-income instruments which carry a higher yield than Treasury bonds.

Of course, we all know how reliable those monoline guarantees turned out to be – and that’s a related story. The monolines, just like the ratings agencies, believed far too much in the power of models.

But things didn’t go completely insane until the technology behind Bistro started being used on asset-backed bonds in general, and mortgage-backed securities in particular.

Once again, we have a situation where everybody is trying to farm off risk to everybody else, to the point at which everybody thinks that someone else has it. For one thing, virtually nobody ever even stopped to worry about credit risk in the MBS market – I know that I didn’t, until it was far too late. I believed what the professionals told me, which was that the only thing a mortgage-bond investor needs to worry about is prepayment risk, and that credit risk is a non-issue.

But even those people who did stop to worry about credit risk were rapidly reassured. Most mortgages were always sold to Fannie and Freddie – and, presto, all that risk magically disappeared. These were hugely profitable corporations, what could possibly go wrong?

Then of course there were the non-conforming mortgages, mostly subprime, which couldn’t get sold to Frannie. How could you securitize those? They all looked very similar, with the same originators and underwriters and loan-to-value ratios and underlying FICO scores and so on and so forth. And so the key aspect of securitization which allowed the ratings agencies to dole out triple-A ratings like so much confetti – diversification – would seem to have been missing.

At least in the Bistro deal, the underlying loans came from a broad and healthy group of companies. When people started securitizing subprime mortgages, the underlying assets were neither broad nor healthy. And so were the seeds of disaster sown.

Common sense says that you can’t start lending money to very risky borrowers without taking on lots of credit risk – but somehow, by the time the loans made their way through the system, almost nobody thought that they were taking on credit risk. Most of the participants in the market thought they had triple-A-or-better debt, and they all believed, without ever really stopping to check, that the enormous amounts of credit risk being produced were being willingly held elsewhere.

And so we come to David Li’s Gaussian copula function. What the copula did was, in effect, nullify the effects of common sense: it blinded bankers and traders and bond investors with quant science. The formula decided that you could measure the degree of diversification in a mortgage pool scientifically, by looking at a single number known as correlation. Correlation was treated as a constant – which was ridiculous on its face – and then the ratings could be derived from it. By plugging in a suitably low correlation number at one end, you could churn out triple-A ratings and healthy bond valuations at the other. And since the trade was so incredibly profitable for anybody who entered into it, no one asked too many questions, and everybody piled in.

Of course, on Wall Street, if everybody is making the same trade, that’s a tried-and-true recipe for bubbles and crashes, which is exactly what we got.

It turns out that while everybody was concentrating on credit ratings, no one spent nearly enough time worrying about model risk. All those models, including the Gaussian copula function, which were used to generate the ratings, turned out to have enormous flaws. For one thing, models generally try to describe some external reality – but in this case, the models were driving the reality, creating feedback loops which were entirely outside the ability of the modelers to comprehend or hedge.

More generally, the models were based on data from a period of time when nothing ever blew up, and as a result they had a tendency to produce results saying that nothing was ever going to blow up. Eventually, you got to the ridiculous situation where the chief financial officer of Goldman Sachs could get on a quarterly earnings call and talk with a straight face about 25-sigma events, as though such concepts had real meaning.

At this point, there might be a couple of you in this audience feeling just a tiny bit smug about all this. Sure, you’ve been hit by the financial crisis – we all have. But you never got into the mortgage securitization space, you never traded correlation, you never got blindsided by a multi-billion-dollar “liquidity put” you never even knew that you had written. In other words, it wasn’t your fault.

But it’s worth asking why the regional bond dealers managed to dodge the bullet. And the answer, I’m afraid, is basically that you got lucky.

For one thing, you don’t have massive balance sheets. JP Morgan, when it did its Bistro deal, was perfectly happy keeping $10 billion in assets on its balance sheet. In New York, at the time, big balance sheets were considered a good thing: they were ways of making lots of money, and even investment banks without a commercial bank attached – Goldman Sachs is the prime example here, but you could look just as easily at Morgan Stanley or Lehman Brothers or Merrill Lynch – had as much as $1 trillion of assets. Why did they need such an enormous balance sheet? No one really asked. But it did make it easy to hide things like super-senior risk.

Remember that the Bistro deal was only for $700 million, which meant that JP Morgan kept $9.3 billion of so-called “super-senior” risk on its own books – unless and until it managed to hive that risk off to AIG. Later entrants to the game, like Citi and Merrill, never bothered to sell much if any of their super-senior exposure, and when suddenly correlations spiked and mortgages across the country started defaulting at the same time, they realized that their models had been flawed, that they hadn’t sold off all their credit risk after all, and that they had hundreds of billions of dollars in risk so well buried in these trillion-dollar balance sheets that no one really knew it was there.

So, congratulations on not being huge. And congratulations too on largely avoiding the securitization/ABS space, which was mainly the province of the big banks with lots of warehousing capacity.

But if the next shoe does drop, it’s likely to be munis, and that’s bread and butter for a lot of you guys. Correlations can go to 1 in any market, not just ABS. And although the locus of the crisis was ABS, there’s no particular reason that it couldn’t have been munis instead.

A lot of people think that municipal bonds are just inherently very safe things, but we just don’t live in a world of “inherently very safe”. I’d highly encourage you all to get out your copy of the last Berkshire Hathaway annual report, where Warren Buffett talks about the risks in the muni market:

The rationale behind very low premium rates for insuring tax-exempts has been that defaults have historically been few. But that record largely reflects the experience of entities that issued uninsured bonds…

A universe of tax-exempts fully covered by insurance would be certain to have a somewhat different loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different. To understand why, let’s go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds – virtually all uninsured – were heavily held by the city’s wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city’s fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it was apparent to all that New York’s citizens and businesses would have experienced widespread and severe financial losses from their bond holdings.

Now, imagine that all of the city’s bonds had instead been insured by Berkshire. Would similar belt- tightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to “share” in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial.

Local governments are going to face far tougher fiscal problems in the future than they have to date…

When faced with large revenue shortfalls, communities that have all of their bonds insured will be more prone to develop “solutions” less favorable to bondholders than those communities that have uninsured bonds held by local banks and residents. Losses in the tax-exempt arena, when they come, are also likely to be highly correlated among issuers. If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow. What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer?

To put it simply: if one muni defaults, that’s nasty for its creditors, including the monolines. And default is much more likely now than it was when most munis were unwrapped – insurance, as any insurer will tell you, is rife with moral hazard.

But if five or six munis default, things get much, much worse. At that point, the cost of default for a wrapped muni issuer plunges, and possibly even goes negative. Once a few munis default, no one’s going to lend to any muni, even the ones which are current on their debt. So why bother staying current? Why not just default and let the insurer, rather than your local taxpayers, take most of the pain?

In other words, there’s a very serious, and pretty much impossible to hedge, risk of snowballing muni defaults.

The fact is that the muni market is still heavily reliant on monoline wraps, which are at heart an artifact of the credit bubble, and of the fact that no one wanted to do homework or admit that they were taking risk. Those days are over now, and the new financial world which emerges from the current rubble is going to be one where investors are forced to face up to the fact that risk is endemic and can’t simply be modelled away.

What’s that going to mean for your business? I fear the news isn’t good. No fixed-income investors have the time to do detailed credit analysis on a regional hospital. That’s something banks do: these things should often by rights be loans rather than bonds. Which implies that we’re going to move back to a world of reintermediation, with less of a role for bond dealers and more of a role for boring bankers who know their clients and do their homework. And more generally, the financial sector is going to be a much smaller part of the economy than it has been over the past couple of decades.

So even if and when the economy rebounds, I wouldn’t expect your business to necessarily rebound with it. Ask yourself how many of your buy-side clients really want to analyze and buy substantial amounts of credit risk, which is the main product that you’re selling. Remember that they can’t be lazy any more, and rely on copulas and credit ratings and monline wraps, they have to do it all themselves. Do you see a business selling to these people? I hope so, because that’s going to be a large part of your job from now on, and I wish you all good luck.


Felix, I’m supporting dWj over here. Sadly you’re creating wide-sweeping realisations without truly understanding what you’re talking about. Just about every paragraph is written convincingly, but the data that supports your argument is mostly false. For example: first CDO late 1990s. Um, no. AAA means only interest rate risk? Um, no. Also this had very little to do with Gaussian copula back in those days. I could go on and on but does it really matter. Anybody who can criticize somehow has an equally unsophisticated, applauding audience.

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