Elaine Meinel Supkis
A recent rash of bank failures is wreaking havoc on a large but little-known corner of the credit markets, in a development that could mean more write-downs for banks and higher borrowing costs for companies everywhere.Geeze, when Lehman Brothers became the Lameman Sob Sisters, one of the most ugly little details was the fact that all that paper they held which they sold as great investments were worth literally less than a dime on the dollar. Some were only a penny on the dollar. Even when a homeowner goes belly up, most often, the property does have some value! Usually, about 60% of the loan. Imagine if homes that were collateral for $500,000 sold for only $5,000 or even just $500? Only if there was some great catastrophe!
Even as some lending markets begin to recover from last month's demise of Lehman Brothers Holdings Inc., the securities firm's default -- together with those of other U.S. and European banks -- is causing new dislocations in the multitrillion-dollar market for complex investments known as synthetic collateralized debt obligations.
Sort of like all those fancy houses in the Galveston area. One middle class community was totally wiped out, leaving only cement floors outlining where the house once stood. This is what has happened to all CDOs of whatever tranche and type.
The Lehman mess has not been settled at all. The bidders at the credit default auction who were supposed to collect the debris and then resell it...HAHAHA...knew this junk was as marketable as popsicles in a January blizzard in Nome, Alaska. But they had to buy something because the government enticed them somehow. How? Well, I would think that the $700 billion lollipop was waved in front of them?
With all this pious talk from the gnome community about 'transparency' and 'trust'...well, this doesn't go particularly far, does it? This is like being in a poker game where the young ladies are asked to play strip poker while the gnomes put on more and more layers of coats and hats and even veils and masks.
Synthetic CDOs are magical things. They have no reality. But they exist. They are devious creations created by some of the most devious minds on earth. The search for the Holy Grail of untraceable, finger-printless, opaque, dark pool money machine was perfected a mere 10 years ago and it was unleashed upon this earth to exploit the Japanese carry trade's funny money 0% lending! See? When we talk about all these strange unicornic creatures created by the gnomes, we must never forget the ultimate reason: to exploit this amazing, once in the last 500 years event! Never, in modern times, has any major export/industrial nation run itself on a 0% system!
So the problem was, how to shimmy this good thing into the real economic world and thus, use it as a basis for building great wealth without lifting a finger or making anything exportable. Before we descend down the particular deep pit into the Outer Darkness, first, let's visit the Bionic Turtle:
This illustrates a partially-funded synthetic CDO typical of the failed structure in the subprime meltdown. "Partially-funded" refers to the fact that only a fraction of the reference portfolio is collateralized (e.g., 7% to 15%); the investors purchase securities only on this funded tranche. "Synthetic" refers to the fact that credit risk is transferred not with a sale of loans to the SPE/SPV, but by the purchase of credit protection with credit default swaps (CDS).He tries! He tries his best! Explaining this mess, do note with his graph, how the arrows all move contrary-wise. And how they basically dump all 'risk' onto others while absconding [to the bottom of the graph] with the real loot. Which is ALWAYS LESS THAN !0% OF THE VALUE OF THE DEALS! And the cherry topping this melange are the juicy fees earned, building, slicing and dicing these deadly deals!
After searching the web, I found this interesting magazine that is all about credit. Just 4 short years ago, they ran an enthusiastic article about the wonders of Synthetic CDOs and how they magically grow EXPONENTIALLY! Wow!
Balance-sheet and arbitrage CDOs can be structured as cashflow or synthetic instruments, although an increasingly popular formula among originators is to combine the two into so-called hybrid CDOs. The cashflow CDO, which formed the bread and butter of the market in its formative years, is a structure in which CDO notes are collateralised by a portfolio of cash assets purchased by the originator. In other words, in this classical structure the CDO owns the physical bond, loan or other security referenced by the instrument.A number of danger signs in this early article! First off, there is NOTHING LEGAL about these deals! Gads! How do we spell, 'ILLEGAL'? Legal means things are set in ink, signed by actual humans who can go to prison for fraud, for example. It means it leaves fingerprints, a trail, something physical. Instead, since these bizarre new thingies were NOT LEGAL, this meant the sellers and buyers could make up whatever stories they wanted with each other since no one ever expected to be hauled before a judge or examined by the SEC.
The volume of traditional cashflow CDOs has been eclipsed in recent years by synthetic products, sometimes referred to as collateralised synthetic obligations. In a synthetic CDO, no legal or economic transfer of bonds or loans take place, with the underlying reference pool of assets remaining on the balance sheet of the originator. Instead, the CDO gains exposure to credit risk by selling protection to others through a CDS, which functions very much like an insurance contract. In other words, the CDO is still being paid for bearing credit risk, just as it would do if it physically owned a bond or loan.
From the perspective of originators, there are a number of clear benefits associated with synthetic CDOs. One of these is that risk transfer via synthetic structures allows bank originators in the CDO market to ensure that client relationships are not jeopardised. That is an especially relevant consideration in the market for CLOs, given that deal documentation in the syndicated lending market often prevents the transfer of loan ownership. Even where loan transfer is permitted, CDOs would often need, in theory, to secure the written permission of each borrower in order to construct a cashflow, which would amount to an impractical burden.
With that Republican idoit, Cox, in charge of the SEC, no one was ever allowed to interfere with deals. And indeed, more and more deals were done 'off the books' and in other obviously crooked ways. This was encouraged by Greenspan who claimed this was pure capitalism and not pure Ponziism. When these things took off, interest rates were at 1% and the search for places where higher rates could be charged was on. These Synthetic CDOs were all about removing obvious risks from the high-interest rate pools.
Business deals or home lending to risky people who were not good clients was the only way one could charge very high interest rates. But everyone buying these things were frightened about bankruptcy of these same, risky borrowers. So they needed come scheme to remove this threat. This is where the Synthetic CDOs were so very clever: they pretended that they could SELL the risks and thus, insure it!
The sales of these risks turned out to be a great way to feather many a gnome's nest. The fees and the sales and resales of these seemingly innocent things was a great way to make a buck for two years! Then the bad news began to come in: the bad risks were very bad risks. And were defaulting at record rates! And the people who supposedly were going to pay for these losses so that the original owners of these tranches would not be hurt, were unable to pay or unwilling to pay up!
A Deutsche Bank report on synthetic CDOs traces the strong growth in investment-grade CDOs back to 2000, by which time – notes the Deutsche report – “the credit default swap market was expanding at a seemingly exponential rate. We estimate the outstanding notional amount was growing at about 75% per annum and that the market totalled about E800 billion. Between the US and Europe, about 150–200 names were actively traded.”The fantasy that the risk was separate from the credit was a fool's game. It was cynical. The people who cooked this up knew it was a con. This is why it was not LEGAL. Namely, no one responsible wanted their nasty little names attached to any deals. Goldman Sachs and JP Morgan's top dogs didn't want to be barking in the pen after a trial. Paulson had to drop his lucrative business when he saw what was coming. He knew two years ago, all hell would break loose so he got himself installed as Treasury chief so he could be in control of the main banking entity that matters when things go crashing down.
Since then, liquidity in the CDS market has continued to grow at breakneck speed, with some estimates suggesting that by the end of 2004, the CDS market will be worth some $4,800 billion.
For investors there are a number of important attractions associated with exposure to the CDS market rather than to cash bonds. CDOs made up of CDS allow investors to buy ‘pure’ credit because the structure separates the credit risk component of from the other asset’s risks, such as interest rate and currency risk.
He is NOT some nice guy who is sacrificing himself for humanity. He has hundreds of millions of dollars of Goldman deals at stake here and he wants to protect this stuff. Indeed, he is frightened of being arrested for fraud. But Congress doesn't want to arrest him. They want him to catch the falling knife of the Synthetic CDOs. He promised them, he would. Alas! This is all attached to that super-monster beast, the Derivatives Beast. Who isn't just synthetic paper but all sorts of oddball deals like currency/interest rate swap games and credit default swaps. These goofy, stupid gnomes let this creature grow to be bigger than the entire planet earth! Illegally!
A synthetic CDO is a collateralized debt obligation (CDO) in which the underlying credit exposures are taken on using a credit default swap rather than by having a vehicle buy physical assets. Synthetic CDOs can either be single tranche CDOs or fully distributed CDOs. Synthetic CDOs are also commonly divided into balance sheet and arbitrage CDOs, although it is often impossible to distinguish in practice between the two types.Tweedle Dee and Tweedle Dumb. Can't tell them apart. And they are not physical. They are metaphysical with a vengeance. Any time we see something that is full of mysteries like this, full of outright contradictions or suspend the laws of gravity, we are seeing magic, not reality. Like, magic TRICKS. Now onwards to tonight's news:
(Bloomberg) -- Investors are taking losses of up to 90 percent in the $1.2 trillion market for collateralized debt obligations tied to corporate credit as the failures of Lehman Brothers Holdings Inc. and Icelandic banks send shockwaves through the global financial system.Every one of the queer, strange, bizarre things cooked up by these crooks this last decade are collapsing! Not one of them is useful, sane or good. Whenever we see this sort of thing in the real, physical world, we usually decide, this is a crime. Drunks driving down the wrong side of the road, smashing into everything are criminals and liable to be arrested if they survive.
The losses among banks, insurers and money managers may spark the next round of writedowns on CDOs after $660 billion in subprime-related losses. They may force lenders to post more reserves after governments worldwide announced $3 trillion in financial-industry rescue packages since last month, according to Barclays Capital.
``We'll see the same problems we've seen in subprime,'' said Alistair Milne, a professor in banking and finance at Cass Business School in London and a former U.K. Treasury economist. ``Banks will take substantial markdowns.''
The utter and complete failure of EVERYTHING these guys cooked up shows determined criminality. Just like Enron collapsed into bankruptcy, thus showing the underbelly of their conspiracies and illegal deals, so it is here: how on earth can these things be legal if they are so lethal?
Recently, China had several scandals over children's milk, toys and things. Lead or melamine was poisoning and even killing children. This was a crime and the government moved to punish the people responsible. Namely, they have committed suicide or are in prison. So it is here! All the bankers and dealers who invented, created and sold this obviously illegal business should be punished!
You don't need a law saying, 'Do this or that and you get arrested.' The mere fact that all of them have conspired to create TOTAL and UTTER economic destruction on an epic scale is grounds for arrest! Terrorists are supposed to scare us and this is illegal, whatever tools they use to scare us. So it is with these guys! They are terrorizing the entire planet. They are destroying our nation and many other nations as certainly as bombers blowing up buildings or shooting officials! Send them to Gitmo!
Here is proof that the Fed under Greenspan had plenty of warning about all this. A report written in 2004:
This graph is a classic 'hockey stick' graph. There should be a big sign attached to all such graphs: DANGER! DANGER! UNSUSTAINABLE GROWTH!!! Any realistic adult looking at such a graph should scream, 'Oh my god! Oh, my god! We must stop this, now!' Not, 'Oh my, look at that! We found a magic way to make something grow very, very fast!' This irritates me no end. I saw such graphs years ago and began to howl about it. No one listened. This is because humans WANT to have things grow to infinity as fast as possible if they can do it. This delights them, not terrifies them!
Out-of-control growth pleases us immensely. So the only way to stop this is to train our youth to fear this graph. Whenever they see such a graph, they must immediately raise alarms and show anger and fear, not happiness. The Credit Magazine guys thought the exponential growth was great! Not hideous. So we have a philosophical problem here that has to be addressed by the schools. Pronto. And we must force Congress to look into this matter, too. For they are making our debts grow the same rate!
Michael S. Gibson∗
Revised, July 2004
CDO tranches are sensitive to the business cycle
Because CDO tranches are sensitive to correlation, and correlation of defaults is typically driven by the business cycle, the correlation risk of CDO tranches can also be characterized, and measured, as “business cycle risk.” Using the model described in section 3 above, and interpreting the common factor as business cycle risk that is common to all credits, I can compute the exposure of each of the tranches of the hypothetical CDO to business cycle conditions. Speciﬁcally, I can compute the expected loss (EL) on the CDO tranche as deﬁned above, conditional on a certain value of the common factor.This is so sad, actually. Mr. Gibson thought that these CDOs would lose 64% value? HAHAHA. More like 98%. And far from a once in 25 years' shock, all the tranches and rubbish collapsed totally and completely in less than 10 years! And because the economist writing this study for Greenspan is not all that wise, he looked straight at his graph showing EPXONENTIAL growth and didn't scream, 'Ach, mein Gott! Herr Grünspan! Achtung! Ungefährlisch!' Nope. Instead, he did recognize that something wasn't quite right and worried that in a recession, somethings might not work.
Table 10 shows such a calculation. Three diﬀerent business cycle conditions are considered:
boom, trend growth, and recession. These correspond to setting M , the common factor driving defaults, at its 10th, 50th, and 90th percentiles, respectively. The table shows both the dollar amount of each tranche’s conditional EL in the boom, trend growth and recession scenarios, and the conditional EL as a percent of the tranche’s notional amount.
The equity tranche, in a ﬁrst-loss position, expects to bear defaults of about half its notional amount in a trend growth macroeconomic scenario and expects to lose its entire notional amount in a recession.
The mezzanine tranche, in a second-loss position, suﬀers no losses in a boom and minimal loss in a trend growth scenario, but suﬀers most of the portfolio’s EL in a recession.
In this sense, mezzanine tranches are leveraged bets on business cycle risk. Recall the hypothetical CDO’s mezzanine tranche. Its par spread is 315 basis points, compared with 60 basis points on the reference portfolio. In exchange for this higher return, the mezzanine investor is exposed to a loss of 64 percent of principal in a recession scenario, compared with 7.6 percent on the reference portfolio.
The senior tranche expects to suﬀer very little loss, even in a recession scenario. Figure 5 shows the expected loss on the three tranches across a full range of macroeconomic shocks (1st to 99th percentile). Beyond the 96th percentile common factor shock, corresponding to a less than 4-in-100 or less-than-once-per-25-years shock, the senior tranche begins to see its principal signiﬁcantly eroded by additional losses. While the senior tranche is not exposed to “recession risk,” it could be said to be exposed to “depression risk.”
But he didn't think these things would CREATE a recession or even worse, a depression! He thought they might not be good in such climates. But didn't put two and two together and realize they would be the actual TRIGGER, the CAUSE of a depression. We see this clearly today. Today, all the central banks are in hysterics because of this stupid deal making. They haven't the faintest idea, how to unwind this without much of the wealth squirreled away in banks, vanishing in a horrid flash. Boom.
One of the things this paper has is a bunch of useless formulas. One is this simple thing: M T M [mark to market] = Fee − Contingent. This is what has failed. There is no market and the mark is way off the mark. Like, into the rough. And the whole point was to gain the Fee! After the pay-out. Elsewhere, the good professor talks about the Default hazard rate which he pegs optimistically at just 1 percent per year. Instead, it is a classic all or nothing matter. All the schemes floated at the same time and when one fell, they all collapsed. This is why we like to compare this with Ponzi schemes: critical mass means the whole thing collapses in a cascade. This is why Ponzi schemes are illegal.
Synthetic CDOs are popular vehicles for transferring the credit risk of a portfolio of assets.Again, this darkness! Things can't be 'observed'. Now you see it, now you don't! The biggest tricks in the trade of all stage magicians is to show you only part of what is really going on. The various machines, mirrors, cloth curtains, etc, are all there to mislead, conceal and confuse. The closer you look, the more you are deceived. This is because all good magicians use 'patter' to control people's perception of reality. Talking is magical. And it works! It can twist reality into a pretzel even though the dough is not tied in a knot.
Using a pricing model for CDO tranches that does not require Monte Carlo simulation, [Elaine: HAHAHA]I analyze the risk characteristics of the tranches of synthetic CDOs. In a hypothetical CDO, the equity and mezzanine tranches contain 10 percent of the notional amount of the CDO’s reference portfolio but 70–90 percent of the credit risk.
This implies that credit risk disclosures relying on notional amounts are especially inadequate for ﬁrms that invest in CDOs.
A basic result is that equity and mezzanine tranches are leveraged exposures to the underlying credit risk of the CDO’s reference portfolio.
I explore several implications ofthis result. First, event though mezzanine tranches are typically rated low-investment-grade, the leverage they possess implies their risk (and expected return) can be many times that of a low-investment-grade corporate bond. Second, a mezzanine tranche’s risk and leverage depend on the riskiness of the CDO’s reference portfolio and the tranche’s credit enhancement. Third, because the equity tranche contains a large fraction of the CDO’s total risk, risk transfer is limited when the CDO originator retains the equity tranche.
CDO tranches and other innovative credit products, such as single-tranche CDOs and ﬁrst- to-default basket swaps, are sensitive to the correlation of defaults among the credits in the reference portfolio. Because correlation is unobservable, diﬀerences of opinion among market participants as to the correct default correlation can create trading opportunities as well as “correlation risk” to be managed. Finally, the paper shows how the dependence of CDO tranches on default correlation can also be characterized and measured as an exposure to the business cycle, or as “business cycle risk.” A mezzanine tranche, in particular, is highly sensitive to business cycle risk.
(Reuters) - The United States has plundered global wealth by exploiting the dollar's dominance, and the world urgently needs other currencies to take its place, a leading Chinese state newspaper said on Friday. The front-page commentary in the overseas edition of the People's Daily said that Asian and European countries should banish the U.S. dollar from their direct trade relations for a start, relying only on their own currencies. A meeting between Asian and European leaders, starting on Friday in Beijing, presented the perfect opportunity to begin building a new international financial order, the newspaper said.Oh boy! The Chinese were the oldest magicians. When Europeans first invaded China, they were amazed to see some of the street tricks. A fad grew from 1700 till today, trying to do these tricks in the West. Las Vegas depends on the magic community to awe and confuse patrons. The Chinese have a long history with the business of paper money. They invented it, after all! I will write a little history about that tomorrow.
Leaders from East Asian countries agreed Friday to have the fund set up by the middle of next year.Asians are groping for some way of dealing with this. Yet they are doing this with Japan! HAHAHA. Good luck. So long as Japan clings to the 0% system, they are endangering everyone. Right now, the carry trade is violently unwinding. But the hope is, in Asia, to rewind it and get the trade going again. This is a futile effort if the US is at 0%, too! A problem! For all of Asia has the biggest trade surpluses with the US. We are their profit center! So they are united in this regard. And so, this deal won't work if we can't bend to their will and resume consuming.
Members of the Association of Southeast Asian Nations, Japan, China, and South Korea will be allowed to dip into the money when faced with a financial emergency.
Japan, China, and South Korea agreed to provide 80 percent of the funds, and Southeast Asian nations will give the rest.
"The pressure they're under now I think is more related to just a panic, the ongoing panic in financial markets. And, I think, the thinking is the $80 billion could be used as sort of a backstop for the regional authorities, that when they do experience pressure, to fend it off," he said.
The comments to this entry are closed.