Felix Salmon

Wednesday links get downsized

Felix Salmon
May 6, 2009 22:35 UTC

The End of Car Culture: Nate Silver on the surprisingly large drop in miles driven in the US.

Stress Test Flunkie Bank Of America Up 36% This Week: Yet another case of rewarding failure.

Rattled in Ridgewood: The plight of the former overclass.

Chart of the day: Credit convexity (ultrawonky)

Felix Salmon
May 6, 2009 22:21 UTC


This chart comes from a blog entry by Ann Rutledge, which eventually formed some of the basis for a big National Journal cover story by Corine Hegland. It’s not easy to understand, but essentially the action is in the top right hand corner, which I’ve annotated for the sake of comprehension.

The x-axis, along the top, essentially shows the degree of subordination of a tranche of an asset-backed bond. At the far right is 99%, which means that the lowest tranche accounts for just 1% of the total face value; at the far left is 78%, which means that the lowest tranche is much thicker, accounting for 22% of face value. The y-axis, down the left hand side, is the amount of loss that a bond investor experiences, in basis points. And each line represents the proportion of the pool which goes into default.

What we see in the chart is something pretty interesting. Expected default rates on these structures were always pretty low, in single digits, and at those levels no one ever takes any losses; the holders of the junior tranches make the most money, because they’re getting the highest coupons.

Eventually, when default rates rise, losses rise — and generally, the thinner the tranche, the higher the losses. That’s why the lines generally point down and to the right. (Ignore the horizontal lines along the bottom, for these purposes.) Intuitively, most people looking at the securitization market think that when you have a highly subordinated (highly leveraged) tranche, then it can get wiped out quite quickly once default rates start rising.

But in fact it doesn’t always work that way, and that’s where the convexity comes in. Check out the light-brown line corresponding to a 31% default rate: at the far right hand side of the graph, it actually goes up and to the right. If the lowest (equity) tranche had just 2% of the face value, then it would lose nothing, while if it had 7% of face value, it would lose quite a lot. The reason is that the extra leverage gooses the yield on the tranche so much that the extra income more than makes up for the default losses. As Rutledge puts it in a presentation she gave to the Japan Society:


When you have a thin, high-yield tranche, then, you actually benefit from increased leverage at pretty high default rates. Until, suddenly, it falls apart.

Look what happens when the default rate ticks up from 31% to 32% or 33% or 34%: suddenly the advantage of leverage massively backfires, and losses start skyrocketing. Those kind of default rates were never built in to the models being used to rate and value these tranches, though, and ignorance was bliss: the demand for these securities only ever rose, because people ignored the tail risk on the other side of that 31% barrier.

Because the models said the bonds were so safe — look how well they perform even at a 31% default rate! — they themselves became popular instruments to securitize, in the form of CDO-squareds* and the like. Lots of yield, no risk — what’s not to love? Of course, the problem was the tail risk — and because CDO-squareds were made up only of highly-leveraged tranches, even the most senior tranches ended up going to zero when those default rates ticked over the magic line into the murky world of extreme tail risk.

More generally, however, it just takes one glance at this chart to see that all manner of weird stuff is going on there — that there are artifacts of the securitization process which were not at all intended. Writes Rutledge:

The sensitivity of value to default risk and structure, credit convexity, is an intermediate to advanced level problem in fixed income mathematics that, as far as we know, is not taught in any academic finance program other than ours…

Usually when my students (who typically have five to ten years of deal experience) make these diagrams, they gasp in astonishment at the clarity and stark simplicity of what they have never seen before.

What’s quite clear is that the people buying these tranches — often banks playing the regulatory-arbitrage game — generally had no idea what they were letting themselves in for. They knew that they were getting a high yield, and they knew that the Basel rules allowed them to allocate relatively low levels of capital against these securities. Which was fine, because the securities in question (often triple-A tranches of CDO-squareds) had high credit ratings, bestowed by ratings agencies wielding models they didn’t really understand.

And then it all blew up.

*Update: Or even just CDOs. As Corine Hegland emailed to me:

What the heck is the difference between a CDO and a CDO-squared? Does the financial world understand that when it uses pieces of structured securities to build a CDO, instead of using old-fashioned corporate bonds, that it’s basically building a CDO-squared to begin with?

Neither SIFMA, nor other industry materials, nor the rating agencies maintain this distinction, which makes me think that it gets lost, but it’s important. With mortgages, for example, the first securitization technically created residential mortgage-backed securities, or RMBS, which functionally behave like CDOs; the mezz tranches of the RMBS then went into CDOs, which functionally behaved like CDOs-squared. (and the mezz tranches of THOSE CDOs then went into CDOs-squared, creating CDOs-quadrupled? or just tripled?)


Ignorance is bliss.

We totally knew. We actively gamed the ratings models.

What is befuddling now is that people actually /believed us/.

Stanford should have been shut down in 2003

Felix Salmon
May 6, 2009 16:20 UTC

The Stanford International Bank Ponzi scheme could and should have been shut down as early as 2003: regulators had more than enough information to do so. Fox Business Network has the story, after receiving 237 pages of SEC documents related to Stanford dating back as far as 2002. This one, I think, is the real smoking gun. It’s worth reading in full — it’s not long — but here are a few snippets:

This letter discloses another possible case of Corporate Fraud being perpetuated by the Stanford Financial Group and its owner, banking and real estate mogul Mr. Allen Stanford.

Stanford Financial is the subject of a lingering corporate fraud scandal perpetuated as a massive Ponzi scheme that will destroy the life savings of many, damage the reputation of all associated parties, ridicule securities and banking authorities, and shame the United States of America…

With the mask of a regulated US corporation and by association with Wall Street giant Bear Stearns, investors are led to believe these CDs are absolutely safe investments. Notwithstanding this promise, investor proceeds are being directed into speculative investments like stocks, options, futures, currencies, real estate and unsecured loans…

The questionable activities of the bank have been covered up by an apparent clean operation of a US broker-dealer affiliate… Registered representatives of the firm, as well as many unregistered representatives that office within the B-D [broker-dealer], are unreasonably pressured into selling the CDs. Solicitation of these high risk offshore securities occurs from the United States and investors are misled about the true nature of the securities.

The offshore bank has never been audited by a large reputable accounting firm, and Stanford has never shown verifiable portfolio appraisals…

By the size of the portfolio, this would be one of the largest Ponzi schemes ever discovered.

This letter is being written by an insider who does not wish to remain silent, but also fears for his own personal safety and that of his family.

It’s all pretty unambiguous stuff, and it was received by the SEC in September 2003 — more than five years before Alex Dalmady published his own, similar, analysis. What’s more, the letter was copied to the Wall Street Journal, the Miami Herald, and the Washington Post; none of them seem to have done anything with it.

If Stanford had been shut down in 2003, billions of dollars would have been saved. But no one seemed to care — certainly not enough to do anything about it. Which is quite disgraceful.


Dear Sir,

I am writing to you concerning the ongoing situation with Allen Stanford and the collapse of Stanford International Bank.

I am one of the depositors with Sib that has lost everything I worked hard to scrimp and save over a period of more than 40 years. Because of the freezing of Stanford’s companies I am now left penniless and reduced to having to beg from friends and neighbours.

I have just watched a trailer from a documentary on BBC Panorama, this is the link for you to watch it.

http://news.bbc.co.uk/1/hi/uk/8042349.st m

After watching this I was shocked and horrified to realise that the DEA, and therefore the Bush administration and the United States Government knew about Allen Stanford and had serious reasons to believe that he was acting illegally as far back as 1990. The US chose to do nothing about his behaviour and illegal activities because they wanted to use him to help them find information about Drug Barons and money laundering. In fact the DEA encouraged him to continue to operate, knowing he was perpetrating a crime. The SEC, who were investigating him were called off and Allen Stanford was allowed – with the blessing of the DEA and the US government – to continue to defraud thousands of honest, hardworking, law abiding citizens of not just the USA, but the UK, Antigua and hundreds of other countries.

In law, if a person or party has knowledge of a crime that is being committed and that party stands by and allows the crime to take place and does nothing about it, then they are also guilty of perpetrating that crime. Your government now stands accused of being a willing and knowing participant in the crime carried out by Allen Stanford against the thousands of depositors, who like me have lost everything.

I feel that it is no coincidence that the “protection” being offered to Allen Stanford was taken away so soon after the Bush administration was removed from office and President Obama took over in the White House. Mr Obama strikes me as a genuine, honest, caring man and I would like to believe that if he did have any knowledge of what was happening with Stanford, he decide that he would not be party to such a web of deceit. The SEC was therefore given the go ahead to move in and close Stanford down. If this is correct, it happened too late for thousands of depositors and lives have been ruined.

The DEA, and your Government have been complicit in this crime and as such, your Government now need to step up to the plate, take responsibility for their lack of judgement and make sure that very single depositor that has lost money with Allen Stanford is repaid in full. This is the very least that can be expected from the USA and President Obama. This scandal will not go away until you have done that, and it will leave a stain on the Presidency of Mr Obama. If he does accept that his Country has an obligation to act and recompense the depositors he will continue to be seen as an honest, genuine, caring President. If he chooses to turn his back on me and the other depositors, he will be seen as no better than Allen Stanford.

I would like to ask if the present government thinks the sacrifice of all the thousands of depositors was worth it to catch a few drug lords and acquire bits of information about money laundering? The depositors seem to be viewed as collateral damage and sacrificial lambs, which were given no consideration by your government. The eyes of the world are on President Obama and how he behaves during his new term in office. I trust he will realise how wronged we the depositors have been and takes the necessary steps to right this wrong.

Yours sincerely,

Catherine Burnell
(Depositor at Stanford International Bank, and Patsy to the DEA and the US Government)

The speed of the SEC

Felix Salmon
May 6, 2009 15:09 UTC

On October 10, 2006, Bloomberg ran a long and important story about how insider trading was endemic in the CDS market. Now, 31 months later, the SEC has finally brought its first insider-trading case involving CDS, and it’s a rather small and unimpressive case at that. What’s more, the SEC still doesn’t seem to have nailed down jurisdiction in these issues.

I know that regulatory agencies move slowly, but this only serves to underline the fact that the SEC should emphatically not be the main regulatory agency charged with overseeing the functioning of the financial markets.

Update: The WSJ got there even earlier than Bloomberg, in August 2006.


matched in speed by the FCC

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BofA’s state of denial

Felix Salmon
May 6, 2009 12:56 UTC

The NYT finally gets one of the stress-test anonymice on the record today, in the person of Steele Alphin, BofA’s chief administrative officer, and what he said is flabbergasting:

Mr. Alphin noted that the $34 billion figure is well below the $45 billion in capital that the government has already allocated to the bank, although he said the bank has plenty of options to raise the capital on its own…

Mr. Alphin said since the government figure is less than the $45 billion provided to Bank of America, the bank will now start looking at ways of repaying the $11 billion difference over time to the government.

For one thing, you can’t just repay the $11 billion if you don’t think you need it any more: before any TARP funds are repaid, any bank needs to have weaned itself off the FDIC’s bank-debt guarantee program, among other conditions.

But more to the point, the minimum amount of tangible common equity that a bank requires under the stress-test is not the same thing as the maximum amount of capital, including preferred stock, that a bank reasonably needs to have. The stress-test capital requirements are in addition to regulatory capital requirements, not a replacement for them. And since the government’s preferred stock does count towards a bank’s regulatory capital, then you can’t just repay it on the grounds that it doesn’t count in the stress-test calculations.

It seems to me that BofA is in some weird state of denial here, where a $35 billion capital shortfall can be considered evidence that it actually has more regulatory capital than it really needs. What’s more, the bank now seems to be happy going on the record with this kind of analysis. Which doesn’t instill in me a great deal of confidence in its management.


Li’l help here… I’m very curious to hear how BAC can cover the shortfall by converting a part of the $45Bn they received under TARP.

By my recollection of the 8-K, they didn’t issue convertible preferred stock, but rather plain-old perpetual preferred stock plus some deep out-of-the-money warrants. But even if they did issue convertible preferred stock, how can they force conversion? Conversion is a right of the holder (i.e. Treasury). Sure, some converts have call options that, when the stock price exceeds the the conversion price, are effectively force-conversion options. But this requires two things: a) that the preferreds are callable and b) that the conversion option is in-the-money. Are either true? I thought the preferreds shares (i.e. TARP monies) were only repayable after 3 years, and only then conditional on being repaid with proceeds from a qualified equity issuance. Am I misremembering the terms of the TARP purchases?

A stress test shocker

Felix Salmon
May 6, 2009 04:32 UTC

So much for anchoring. You thought BofA might need $10 billion in new capital? Try $35 billion. Or, in English, lots and lots and lots of money — much more money than the bank could conceivably raise privately.

The first obvious question is “if BofA needs $35 billion, how much does Citi need?”. Which leads straight into the question of how much the other 19 banks need, in aggregate — it’s likely to be a shockingly enormous sum.

The second obvious question is “when will Ken Lewis and Vikram Pandit resign?” — I can’t imagine either of them surviving a forced capital injection of this magnitude.

And the third obvious question is “what on earth does Treasury think it’s doing”, leaking the stress tests in such a ham-fisted way, with each iteration worse than the last.

I don’t blame the banks for being angry. They have hundreds of people making sure that they’re well capitalized; Treasury then sends in a handful of wonks to look over the books and a few weeks later determines that they’re off by $35 billion? That’s quite a shortfall, especially when there’s really no indication that Treasury is better at working these things out than the bankers are.

I fear that in the wake of these stress tests, Treasury will have created an atmosphere of antagonism and mistrust which is going to make it almost impossible to push through the kind of root-and-branch regulatory reform that’s desperately needed. Without the banks’ buy-in, no new regulatory structure is going to work — but right now the banks have every incentive to hide things from Treasury and the regulators, rather than to work with them to strengthen the system as a whole. The stress tests might end up improving the banks’ TCE ratios — but that doesn’t mean they will end up improving the health of the financial system as a whole.

Update: There’s been a bit of confusion about what I was trying to say here, so let me clarify: Treasury might well be — and probably is — entirely correct about the amount of capital the banks need. But from the banks’ point of view, that’s not true: they think that Treasury is being too harsh. Which will make them unwilling to cooperate and will create an antagonistic playing field.


“Which will make them unwilling to cooperate”

The banks don’t want to cooperate? Excellent! It was wonderful to work with them. Shut ‘em down THE NEXT DAY. Withdraw all public funding, withdraw the license to perform the function of banking within the borders of the United States.

BANKERS AND REGULATORS SHOULD BE AT ODDS, NOT DRINKING BUDDIES. Bankers at present do not respect anyone or anything. The chain needs to be yanked – hard. This economic collapse is in fact their fault, and they must be blamed for it, whether they like it or not.

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Why asset managers should ignore credit ratings

Felix Salmon
May 5, 2009 22:08 UTC

Jonathan F (a/k/a my boss) wonders whether Goldman’s decision to ignore credit ratings when it comes to bond-investment mandates might not be counterproductive:

The problem with using market prices as a signal for any market action is that it tends to encourage herding by making any market movement self reinforcing. So if a company’s spread widened (or its stock price fell) then investors would react, say by selling its paper, which would then presumably lead to a further credit downgrade. There was a credit agency (it belonged to one of the big ones) that adopted this approach and was blamed for some of the death spirals (or near death spirals) in bank equities in the autumn of 2002 (Commerzbank, etc).

What he’s talking about is a move from the current system, where investors sell bonds which are downgraded to junk, to a new system where investors sell bonds with high credit spreads. Given the choice, the second one seems fairer to me — it means that companies aren’t at the mercy of credit-rating agencies, especially near the crucial triple-B cusp, and it also makes it much easier for the ratings agencies to make that now-fateful downgrade into the Cs.

Taking a bigger-picture view, it can reasonably be said that the ratings agencies, to a good approximation, are basically just lagging indicators for the credit markets anyway. So if you’re going to be exiting certain credits, better you do it sooner, when they gap out, rather than later, when they’re finally downgraded.

It’s also only a minority of corporate credits which really get actively damaged by wider spreads in any case: essentially, it’s the levered companies with a lot of short-term debt needing to be rolled over in the near future. That includes all banks, of course, as well as quasi-banks like GE — but most corporates fund themselves with a mixture of long-term bonds and bank lines of credit, which aren’t nearly as susceptible to market whims.

A move to judging credits based on their spreads rather than their ratings might also help put an end to ratings arbitrage, where companies try to issue debt not where it makes the most sense, necessarily, but rather where they can do so at the lowest cost without damaging their ratings. Essentially the ratings agencies become not a dispassionate observer of how creditworthy the issuer is, so much as a key constituency to be kept in mind when putting any kind of debt deal together. That’s unhealthy, as we saw in the wake of the structured-credit boom. And it should come to an end in the corporate world, too.

But mostly fund managers should stop relying on ratings in any case. They’re both in the business of judging credit: fund managers who outsource that business to a ratings agency are simply not doing their job. And their clients shouldn’t ask that they do so.


The bigger issue is that ratings of any form (market or funadmental) are used to perpetuate the shell game of taking short term deposits to fund investment in illiquid assets (i.e. the maturity/liquidity mismatch game).

+good point Nate

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Awaiting PowerMeter

Felix Salmon
May 5, 2009 18:38 UTC

The behavioral sociology of measuring energy usage is simple: the more you know about how much energy you’re using, the less you use. Just getting the information cuts most people’s energy usage by somewhere between 5% and 15%, while people with high electricity bills (like me) find it much easier to isolate exactly what is causing those bills and can then work out how best to reduce them through upgrading appliances or replacing incandescent bulbs with CFLs or any number of other routes to energy efficiency.

The problem is in the measurement. There is a natty gadget known as the Wattson which measures home energy use, but it’s expensive, and almost impossible to find outside the UK, for some reason.

Enter Google, which has now announced plans to release free PowerMeter software which will map any individual’s energy use on their phone, home computer, or iGoogle homepage. The little gizmo which plugs in to your fusebox is going to be very cheap, and with any luck will somehow be available for free to anybody who might have difficulty paying for it. (This is part of Google’s philanthropic google.org arm, after all.)

Google’s Dan Reicher mentioned the PowerMeter on a panel at the New Yorker Summit today, and I can’t wait to get one — I anticipate it’ll save me a few hundred dollars a year. His colleagues have already installed it — one of them discovered he was paying for all the washers and dryers in his building. When will I be able to get mine?


After getting Power Meter i have seen the difference, my electricity bill reduced by 10%

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The risks of consolidation

Felix Salmon
May 5, 2009 16:55 UTC

I had a short chat with Nassim Taleb this morning about his new paper with Charles Tapiero, entitled “Too Big to Fail, Hidden Risks, and the Fallacy of Large Institutions”.

There’s a great deal of mathematics in the paper, which is full of equations and greek letters, but the gist of it is explained in pretty plain English:

Societe Generale lost close to $7 Billions dollars, around $6 Billions of which came mostly from the liquidations costs of the (hidden) positions of Jerome Kerviel, a rogue trader, in amounts around $65 Billions (mostly in equity indices). The liquidation caused the collapse of world markets by close to 12%. The losses of $7 Billion did not arise from the risks but from the loss aversion and the fact that costs rise disproportionately to the size of the bank…

Consider the following two idealized situations.

Situation 1: there are 10 banks with a possible rogue trader hiding 6.5 billions, and probability p for such an event for every bank over one year. The liquidation costs for $6.5 billion are negligible. There are expected to be 10 p such events but with total costs of no major consequence.

Situation 2: One large bank 10 times the size, similar to the more efficient Société Génerale, with the same probability p, a larger hidden position of $65 billion. It is expected that there will be p such events, but with $6.5 losses per event. Total expected losses are p $6.5 per time unit – lumpier but deeper and with a worse expectation.

In other words, small mistakes we can live with. Large mistakes we can’t, because when a mistake the size of Kerviel’s is unwound, the costs are enormous — not only to SocGen, which lost upwards of $6 billion, but also to all shareholders globally, who saw the value of their holdings marked down by trillions of dollars thanks to the effects of SocGen’s enormous and chaotic forced unwind.

The lessons here are broader, and apply to the practice of M&A more generally: when industries consolidate, there might well be economies of scale — but at the same time tail risks increase. What happens when a massive amount of technology outsourcing is consolidated in Bangalore, or computer-chip manufacture is consolidated in Taiwan? Efficiency rises — but so does the risk that one disastrous event could have massive systemic consequences.

The solution for banks is relatively simple: just put a cap on their size. (I’ve been suggesting $300 billion.) What’s the solution for other industries, which also naturally tend to consolidate and cluster? I’m not sure, but in an increasingly interconnected and just-in-time world, the risks are greater than ever.

Update: A couple of good comments from dsquared; the first points out that the paper ignores problems of correlation, which is true. But as Rick Bookstaber is more than happy to point out (and Taleb is no fan of Bookstaber), correlations tend to pop up in the most unlikely places, and in general they just make everything more dangerous — not only the systemic risk of lots of small players failing at once, but also the systemic risk associated with one large failure. So add in correlations to Taleb’s model and I think it only becomes scarier.

Dsquared then asks whether we really want to move to a world of “Fewer SocGens, More Barings”. My memories of the systemic implications of the Barings collapse are hazy (maybe John Gapper or even Nick Denton can help out here), but I think the answer might well be yes: while the Barings collapse was bad for Barings, it didn’t have the kind of negative externalities that we saw with Kerviel. But I might be wrong on that front.


Will: I don’t think the players in other industries are as mutually interdependent as they are in finance. If Pratt & Whitney folded tomorrow for idiosyncratic reasons, I think the reaction from GEAE and Rolls-Royce would be more along the lines of “yippee” rather than “we are now surely doomed”.

dsquared makes a good point about correlation, but I think has misunderstood NNT’s point. Banks get into trouble for idiosyncratic or systemic reasons. By definition, a systemic cause will affect the entire industry, whether it’s concentrated or not. But an idiosyncratic event will only affect the entire industry if it affects a single very large bank that is tightly linked to the rest of the industry.

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