Monday, December 29, 2008

Lehman Bankruptcy: Crisis Management Through Crisis Export?

Although Lehman bankruptcy has long past us (feels like an era way for many of us if only for the fact that so very much has happened since, doesn't it?), I think it's nevertheless valuable on many levels to understand it in the correct context. For those of you who'd like to retrospect, CNN Money has an excellent in-depth review of the Three Days That Shook The World.

There's one unmistakable take-away from the analysis: US government definitely, specifically wanted Lehman to go down. They couldn't prevent the BoA and Barclay's talks of a buy-out, of course. But whenever parties involved in the rescue effort went to them for help, you could almost see the glee in their collective eyes when they said "no". Why is that?

In retrospect, FSA's refusal to approve the Barclay's deal was a devastating, decisive event. Why did they? The official explanation is that Barclay's was not strong enough to take over all of Lehman. But they surely could've asked the US government for some assistance and, between US and UK government backing, there surely must've been a way to make the deal happen. We don't know whether UK government did ask US for some corporative effort. Nor do we know whether FSA acted on request from the US government. But we do know for a fact that US didn't do anything.

But even then, all hope was not lost:

But Lehman's ordeal that Sunday night was far from over. First came a tantalizing ray of hope with the word that the Federal Reserve Board agreed to expand the collateral that investment banks could pledge to the Fed as part of both the Primary Dealer Credit Facility - the name given to the historic measure that allowed investment banks to borrow directly from the Fed window after the demise of Bear Stearns on March 16 - and the Term Securities Lending Facility, a $70 billion "collateralized borrowing facility" created on Sunday by banks to enhance liquidity in the marketplace.

When the Lehman executives started to hear on Sunday afternoon that these windows of emergency financing were opening up, they called the New York Fed to see if it were true. If the Fed allowed Lehman to pledge its shaky collateral to the discount window "we might get a reprieve," one Lehman banker said. But the Fed told Lehman, according to this Lehman banker, "'Yeah, we're doing that for everybody else but you. We're going to let you guys go.'"

Now let's take a look at what Lehman bankruptcy has changed.

Since the subprime crisis first broke out in August 07, it had been a US crisis. Everybody else was still looking pretty, especially the Old Europe. But after Lehman bankruptcy, it became a global crisis within a week. All of a sudden, we learned that European banks were in even deeper trouble than their US counterparts. The invincible Euro and GBP started tumbling, along with Ruble and Won and whatnot. Iceland went bankrupt. Basel II became the Biggest Joke in Financial Regulation...well, you know the rest.

Lehman bankruptcy marked the globalizaiton of the crisis.

But, as I said before, the beauty of this crisis is that it's global. If it had been a US crisis, any single one of the subsequent bailouts -- the AIG bailout, the $700B bailout and the Citi baliout -- would've been devastating to the USD and treausires. Another beauty is that everybody has fiat money. The two combined means that everybody can print as much money as she needs without worrying about currency exchange or inflation -- not until the economy revives.

I'm usually not the one who starts conspiracy theories. But the links here are too strong to deny.

Here's another passage from the CNN Money article to finish this off:

McDade and Lowitt, on Lehman's behalf, made one last-ditch effort to convince Paulson that taxpayers should bail out Lehman. They went back down to the Fed and walked the Treasury secretary through a doomsday presentation that Lehman had put together foretelling the likely global consequences in various markets - foreign exchange, swaps and derivatives, among others - if Lehman were allowed to fail. After McDade finished, Paulson told him, "You're talking your own book. We've thought this over."

"That's exactly the point you idiots", Paulson silently laughed to himself.

Sunday, November 23, 2008

I'll Sell You All the CDS on Citi, Suckers

CDS spread has gotten an undeserved attention as some sort of prophetic leading indicator during this crisis. Is there something special about CDS buyers and sellers that make CDS spreads more insightful than anything else? NO, of course not.

If you think the 40 bps CDS premium on US is ridiculous (for up to 5 years anyway), then I have a surprise for you. Citi CDS was going for 470 bps last Friday. This is close to imminent default range. It's much worse than the usual junk credit.

All the bad news and gloomy speculations about Citi notwithstanding, the simple fact is that

1. Citi deposits will not be endangered. This is hugely political. Governments around the world cannot afford to let it happen, or else they'd be stoned to death by the revolution.

2. Citi bonds will not default. Although Paulson maintains that he didn't think the decision to let Lehman go down was a mistake, everybody knows (Paulson included) it was a critical mistake in transforming a financial crisis into a full-blown global, economic crisis. I think we've learned the lesson by now. The world cannot deal with another CDS settlement of a big company. Not Citi, not GM.

Beyond the above two points, everything else is in play, including wiping out equity.

But, before you get too excited about the parallel between Citi and Bear/Lehamn/AIG, think about the following:

1. Unlike the situation weeks before Bear/Lehman, even for weeks for Morgan Stanley, no bank is stopping trading with Citi. Remember, some banks stopped trading with each of them WEEKS before the trouble became public. It's a very easy decision for them to make, with negligible downside compared to the risk IF they seriously think there's a real risk. But no, nobody stopped trading with Citi, as of the past Friday.

2. Unlike Bear/Lehman/MS, Citi is a real bank with real deposit base. I don't know about the off-balance sheet toxic asset in Citi that everybody suddenly seems to know. But the crucial difference is that Citi is not an investment bank. As long as you believe humanity is not quite stupid enough to march off the cliff, Citi will survive - with pain, maybe, but they will survive.

I think it's quite clear by now that the emerging market crisis of last month is mostly aritificial and technical. They are vulnerable for sure. But there's no structural deficiency in BRIC world in the same order of magnitude as in the developed world. China will be hurt by decrease in demand in goods. India will be hurt by decreasing demand in offshoring. Russia will be hurt by slumping oil price. Brazil will be hurt by slumping oil price (ethenol) and FDI. But none of them is nearly as severe as the chronical, structural deficiencies of future-mortgaging and over-consumption in the developed world. As demonstrated by the 4 trillion Yuan plan announced by Beijing, they are at a point where they CAN create enough demand domestically to get through a temporary glut.

What does this have to do with Citi? My point is the world, not just the US government, will not allow Citi to go down. The US government may not have enough credibility, with Paulson changing his mind every week. But the world ganged up together is a credible threat to the shorts.

And, dare I say, with its truly global franchise, Citi is in a better position to benifit from emerging markets while most other banks, much more concentrated in US and Europe, are exposed to the long struggle ahead of us in the develped world.

If you want to say Citi is too big to manage, that's fine. But it still does not negate the fact that Citi is truly too big to fail -- not just to US, but to the world.

I don't know what will happen to Citi stock. But if you want to buy Citi CDS, I can sell you as much as you want.

Wednesday, November 19, 2008

Public Ownership Is A Fraud

Michale Lewis' epic piece "The End" makes a great read, even if you don't agree with all of his points or accounts. To me, the central theme is that the beginning of the end of Wall Street was Salomon going public. By going public, the wealth of investment banks is transferred from the public to the previous private partners, while the risk goes the opposite way. This is indeed the single most critical, systemic discourse between risk and reward in our financial system.

I'll take that one step further and say the very notion of "public ownership" has become a farce in modern economy.

1. First of all, few shareholders nowadays intend to "own" it for a long time to begin with -- holding a stock for over a few years is considered an indication of old age, I guess.

2. Secondly, for the few old-fashioned shareholders with the real ownership mentality, they have very limited visibility to what's going on in "their" company. Quarterly report is a mockery of transparency for all modern companies large enough to cross the IPO threshold. This is especially true for financial companies, considering the notion of "off balance sheet", the myriad of derivatives, and the increasingly nonsensical accounting rules (I'm surprised few have criticized FASB in this mess yet).

3. Thirdly, even if transparency becomes real and meaningful via some drastic change in law and regulation, shareholders have little use of it. You can vote once a year in shareholders' meeting and hope the board would exercise oversight for you, just like what you do with politicians. Well, you know how well that's been working out. If you think I'm being cynical, just look at the trend in executive compensation over the last few decades.

4. Even if shareholders care, can get visibility, and have an effective board, the obscenely high executive compensation, and especially the most insane, illogical, anti-owner notion of golden parachute, still provide enough cushion for irresponsible and incompetent behavior for at least some executives. Heads you win, tails you don't lose. Risk-reward breakage. Disaster is guaranteed.

We've seen this farcical notion of public ownership blowing up on our collective face in steel, air carrier, banking, telecom, insurance, auto, technology, air carrier, banking, insurance, auto... Now even GE is in trouble. Every time we find a few culprits, scapegoats to satisfy our frustration, then carry on the same fraud, only to see it blowing up somewhere else a few years down the road.

Time to take a step back and survey the history, folks. Do we want to continue this fraudulous public ownership or go straight to state ownership? Most of our mortgages and banks, some insurance, and autos it looks like, are already state-owned. Or worse yet, tax payers just pay and don't own anything.

Public ownership was once a great idea. And it worked when life was simple and scale was manageable. But today's world is different. We need to either drastically rethink corporate governance model in public ownership or revert back to private ownership. The other alternatives are state ownership or even worse, like what we're heading into now, fantom public ownership with tax payers taking on the ultimate risk without any reward.

I don't think Wall Street is dead. There'll be smart and hardworking people setting up private-ownership investment banks soon, because the future state-owned banks cannot possibly compete and be financially viable without constant stimulus, bailout, and suffocating regulation.

Out of the ash, an Old Wall Street will re-emerge.

Thursday, October 30, 2008

Supply and Demand Have Little Relevance to Commodities Price

Commodities price is driven by supply and demand. This is as true as the law of risk and reward.

Except the law of risk and reward hardly applies for the last few years. As such, so does the law of supply and demand since the commodities bubble started last year (arguably earlier) and ended a few months ago. If you need any proof, here're two pieces of news, randomly selected sources from a blind google search (not intending to target the sources in any way), to illustrate my point:

1. On 04/29/2008, disruption in Nigeria causes oil price to surge $1.50 to a then-record of $119.93. interesting.

2. On 07/18/2008, disruption in Nigeria causes oil price to drop $5.31 to $129.29. interesting...wait, WHAT?

The oil run-up of last year bothered me a great deal. So I decided to make an effort in making sense of it. Back then everybody was talking about supply and demand, peak-oil production, Saudi's exaggerated oil reserve, etc. etc. But I couldn't understand how these slow-moving variables could possibly cause the insanely fast-moving price. Then I read about how a new breed of speculators have joined the market and driven up price. That makes perfect sense, just as explaining why water boils by saying the temperature is 100C -- it provides absolutely 0 information. Why did all those speculators all of a sudden swamp into commodities?

Then somewhere along it hit me. Real negative interest rate. When the real interest rate is negative, it doesn't make economic sense to hold cash. Real assets that people need have a much better chance of holding value through inflation. (I know, I can't be even the millionth one realizing this.) With real estate out of question last year, commodities was a logical place to park your money. And it's a self-fulfilling proposition and yet another positive feedback -- the higher the commodities price, the higher the inflation pressure, and therefore the higher the commodities nauseam.

Did supply and demand have anything to do with the equally dramatic burst of the commodities bubble since July? No more than the run-up. I have a theory on why but it's off-topic so I'll leave it out. And the last leg of plunge was no doubt a part of the Great Unwind by hedge funds and banks, primarily triggered by Lehman CDS settlement.

It's primarily inflation, both real and expected (but probably not the nominal, systematically understated CPI), in relation to interest rate. Similar commodities bubbles driven by negative real interest rate have happened before. But this time it's amplified by the massive amount of concentrated capital, from individuals, corporations, and governments, created through years of internationalization, as well as the dramatic increase in capital flow and leverage through fantastic progress in capital markets and regulations such as securitization and Basel II.

Over the longer term, years and decades, there's no reason to believe the law of supply and demand will break down. But in the shorter term, in a market swamped by speculators who never intend to take delivery, supply and demand have little relevance.

In the very short term, minute-to-minute and day-to-day, supply and demand will have relevance, but only in a nominal and deceiving way. Imagine a fallen autumn leaf in water, a very smart one with a PhD in fluid dynamics, with access to a massive cloud of blades running Linux and models coded in A+. She can explain every minute movement from the molecular level up. Supply and demand. But there's a problem. When demand goes up 1%, sometimes the price goes up 0.1%, sometimes 10%, and sometimes even -1%. She doesn't understand. But Reuters reporters call her anyway and dutifully report on how supply and demand drove the price in their obligotary end-of-day headline.

Enough with cynicism. What will happen to commodities?

On 10/3, right after the passage of the Bailout Pork package, I said commodities would have another long-term run-up. On 10/13, I said the market would have an intermediate-term bottom "before or around 10/21". In retrospect, I was a bit early on both accounts, as I am usually. I didn't see the delay effect of the Great Unwind of forced hedge fund liquidation and bank deleveraging. But I wasn't too far off.

I still stand by them today, only with more conviction. Bernanke's Fed has totally lost its mandated independence from politics. He'll be bullied by Washington and Wall Street into keeping the interest rate below real inflation. The next President, no matter who, will probably not have the political will to call Uncle Ben to tackle inflation until it's too late (this is a change from what I said in my 10/3 article), unless the economic appearance improves drastically in the next few months (unlikely). So we'll have yet another asset bubble, in commodities, and commodities-driven inflation, starting from somewhere between yesterday and mid-2009.

The inflation driven by housing bubble in the last few years was stealth. Those who hitched a ride, the homeowners, didn't complain. Those who missed out, the homeless and the renters, complained but were completely drawn out by the party noise. But commodities-driven inflation will be direct and apparent. So my hope is it wouldn't last too long. And that would be a good thing for society.

Until the good thing happens, enjoy your ride on commodities.

Tuesday, October 28, 2008

Stop The US vs China Nonsense

People love enemies. Enemy gives us a sense of purpose, a uniting force. Just look back at the cold war era. Did we obsess endlessly about politician's extra-marital affairs or bicker bitterly about a few billion dollars' pork barrel in spending bills? No, of course not. Let's kill the enemy first. Politicians and media know this very well. Every President must fight at least one war. This is Politics 101. If oil price stays high and Putin stays in power forever, it'd make the job so much easier for US politicians.

Unfortunately, oil has crashed (for now) and Russia looks shaky (for now). China will have to do. It's not ideal, but not bad, either. For one, it's big, unlike Venezuela or North Korea (and Iran somehow just doesn't have the credibility). Even though it's still weak, it's been growing fast. Menacing enough. Secondly, the "communist" label is perpetually handy. Never mind the fact that true Marxists/Maoists/Communists have long been completely pushed out of the political spectrum and exist only at the fringes of common society in China, and many aspects of rule-of-the-jungle capitalism there make most of the self-proclaimed "capitalists" in this country look like socialists. Ignore all that, preface "China" with "communist" and you're done.

The current crisis, of course, makes finding an enemy all the more urgent. China presented itself at the perfect time. First of all, China looks like the only country relatively unscathed by this mess. Even better, their newspapers started calling for abandoning USD as the hard currency. There, done, crisis is over (in the sense that the 300 point drop on the Dow last Friday was a huge relief).

This stupidity must end. US and China need to work together even more closely, at least in economy and finance, to face the numerous post-crisis challenges. Yes, I think the crisis is over and the short-term bottom is behind us. Now we have to solve the difficult problems of global recession, long-term inflation, and structural flaws of international financial system.

First of all, China will not be greatly damaged by this crisis and it's good news for everybody, just as it was when China effectively stopped the contagion of Asian financial crisis in 1997. There are several reasons for my assertion:

1. China's financial system remains relatively arcane and closed to the rest of the world, which turned out to be their biggest blessing this time.

2. Chinese government and central bank have very strong balance sheets as cushion and ammunition against shocks.

3. High savings rate provides cushion. Low leverage lessens the shock.

4. It's true that housing bubble is bursting in China, banks have (potentially significant amount of) bad assets, and some companies do have exposure to the international financial market. But none of these comes even close in relative magnitude to those in developed world. The housing bubble is fundamentally different from those in US and Europe in that the chain-reaction multipliers of subprime and structured finance are completely absent. By all measures, the bad asset problem in Chinese banks in 1999 was much bigger. Yet they got through it fine.

5. It's true that Chinese economy will suffer if the demand for export decreases, especially if it's prolonged. But the domestic market has expanded greatly in recent years with the emerging middle class. There's still ample need for infrastructural improvement to create demand, and the government has the firepower to finance it. Furthermore, China has been diversifying their export destinations in recent years with some success. As long as world demand stabilizes in no more than a year, they'll probably be ok.

6. Contrary to the common misconception, Chinese economy is NOT an export economy. It's much more appropriate to call it a value-added import-export economy. This is a key difference between the Chinese economy and Japanese. Since Japan migrated towards the higher end of value chain in the 70's and 80's, their export relies less and less on importing raw materials (with the notable exception of oil). China, on the other hand, still heavily relies on imported raw materials and components. In my opinion, this is the most important reason why China got through the 1997 Asian financial crisis fine while the currencies of virtually all their competitors' were massively devalued overnight. Chinese economy is much more exchange-rate neutral, except RMD-USD, than most of the world thinks.

And it's a good thing that China doesn't get pulled under by this mess. The economic inter-dependency between US and China is even greater in the post-crisis world. It is to China's self-interest to prevent turmoil in world economy, and to keep the status quo in international trading and USD's position in many more aspects than changing it. Here's why:

1. China has been arguably the biggest beneficiary of the status quo in international trade over the last twenty years or so. Any significant change would take them a long time to adjust and pose challenges and uncertainties.

2. USD's fall from international hard currency would be devastating for China, almost as much as for the US. It'd take them at least a decade to make the transition. This may be the long-term hope for China, France, Germany, Russia, Japan, or Iran. But none of them is ready for it, and will remain unready for years. Yes, there was an article in the English edition of China Daily on "US plundering the wealth of the world". But I find the ensuing hysteria here, excuse my blunt choice of words, laughable. If you actually read the English edition of China Daily regularly, as opposed to occasional glance over second-hand digests and commentaries, you'd find quite a bit of views and opinions not reflecting the government official view or policy. I know this is a surprise to some in the western world but the limit on dissenting views in China has been slowly creeping outward since the 80's. Perhaps more relevant to this case, the Chinese government has been slowly learning the art of public opinion manipulation in the international arena. My reading is this article is more of their gesture to Sarkozy and, indeed, much of the rest of the world. It's the Chinese government's version (in the international arena) of US presidential candidates' "I feel your pain and frustration." No, they don't, in both cases.

3. A devalued dollar (against other major currencies) is bad for China as it almost certainly translates into higher commodity prices, besides the direct impact on their foreign exchange reserve. The dynamic here is quite different from the relative exchange-rate neutrality against other currencies I mentioned above.

On both sides of the (other) pond, there're persistent political forces trying to make an enemy out of the other side. And the leader-wannabes in both countries invariably put up the hawkish face during campaign (internal campaign among power brokers and political elites in China's case). But, also invariably, they come to recognize the interdependency between the two countries soon after coming to power, despite real and important issues and differences. It's a pathetic political circus.

Politicians need enemies to make their lives easier and get them more power. Do we?

Sunday, October 26, 2008

USD Carry Trades?

Yen is the carry trade currency. You know, you borrow Yen, pay next-to-nothing interest, swap it for Australian dollar, get high interest return on AUD. You own the license to print money, unless and until Yen goes up in value. Then you may need/want to unwind -- sell AUD, buy JPY, which drives up JPY, which makes more people need/want to unwind. It's a positive feedback which, despite of the word "positive", means it's destabilizing. Bad. Dangerous. Crash. Crisis. Bad bad bad.

Another possibility you may need/want to unwind the carry trade is increase of risk aversion -- people want to hoard cash. Again, destabilizing positive feedback.

Our financial system is full of positive feedbacks. It's so full of inherent instability it's a wonder it hasn't blown up completely ten years ago. Until we redesign it to eliminate such instabilities, it will blow up again. I believe it's possible to eliminate such instabilities; the key is to eliminate windfalls (spread it out), encourage long-term behavior and discourage short-term speculative behavior. But human society will not have enough political will to make such drastic corrections, not until we suffer greatly. The current crisis does not inflict enough pain.

Let's get back to carry trades.

Why is JPY the currency of choice for carry trades? First, the interest rate is low and the Japanese government wants to keep it low so that cost of financing to the industry is low. It's a saver society. You can have 0 interest rate and inflation and the Japanese society would still save. Secondly, the government wants to keep the currency cheap so as to encourage export. The Japanese domestic market may be big enough to support a decent economy, but not the second biggest economy in the world. JPY-based carry trades help them achieving this goal. In return, they subject themselves to the whims of international speculators, with added misery in a worldwide recession scenario.

This is exactly what we saw last Friday. Bad economic news from Japan. Yen surged, causing more pain for exporters. No surprise there.

But we also saw something else last Friday. USD is about the only other currency that strengthened across the board. Why is that? People think US economy will bounce back fast? USD is once again gold? Or even though USD is not gold but everything else stinks even more? If you believe any of that, I have some wonder organic matter that cures cancer.

This is another round of unwinding and deleveraging. The panic about emerging markets hit. People want to get out, unwind and deleverage. How? Unwind their USD carry trades.

Around end of last year and early this year, when Fed aggressively cut the rate, I asked an FX trader friend of mine whether he'd seen any sign of USD-based carry trades. It made sense. The real interest rate in USD is negative (lower than real inflation) so it doesn't make sense to hold cash in USD. The government wants to devalue USD and keep it low for awhile; it's the easiest way out of the massive external as well as internal debt. So you borrow USD, swap it into Latin American currencies, Euro, Canadian dollar, whatever.

He didn't see any concrete signs of such trend.

Last Friday I asked him the same question again. He said yes.

Emerging markets are fine if it weren't for their currencies being destroyed. Their vast needs for infrastructure improvement and fundamental transformation of entire populations can generate enough demand for sustaining at least another twenty years of worldwide, healthy growth. But what we have instead is the currencies of the two biggest economies being used to pump up their economy beyond hot, suck the lifeblood out of them, then leave them withering in rubles.

I don't think Sarkozy's Statism is the answer. But I at least agree with him that the current international financial regime is fundamentally broken.A system of traders and speculators but no investors is destined to be traded into oblivion.

Friday, October 24, 2008

Perpetual Mortgage: A Better Way Out

Unless and until the housing market stabilizes, which is a less stringent test than bottoming out, pressure on economy and especially financial market will not subside. This seems a fairly broad consensus now. So there're many answers offered. Presidential candidates and Congress are busy in a race to the bottom, dreaming up all kinds of economically nonsensical, legally borderline or even outright unconstitutional, socialist and/or totalitarianistic ways of "helping homeowners".

As far as I'm concerned, we're selling our collective soul to the devil by embracing government bailout and intervention in panic, without questioning or thinking it through.

I have a better idea than forcing/coercing banks to "modify" mortgages: offer homeowners the option of converting existing mortgage into perpetual mortgage.

Here's how it works.

Say you bought a house on $200K mortgage and are now in danger of default and the house is worth only $150K. You can convert into a perpetual mortgage with a principal of the original amount, $200K. You're still the homeowner, enjoying the tax deduction and all. The lender is still the lien holder. The differences with traditional mortgage are

1. You pay only interest. Assuming the same interest rate , your monthly payment drops by about 15% depending on the rate.
2. Your equity on the property remains 0 as long as you don't sell it.
3. If you sell it at a profit, you don't get an immediate windfall. Instead, you get a reverse mortgage from your original lender on the profit. This reverse mortgage can be sold in case you want to cash out.
4. If you sell it at a loss, you don't take an immediate hit. Instead, you carry a loan on the difference.

The idea is to soften the blow to homeowners when the market goes down, and to give people the option of forfeiting wealth accumulation for maximum lifestyle. The choice is yours to make.

Allow me to remind you of three simple facts about traditional mortgage model:

1. Many people are not ready to deal with the 50%, 100% leverage from housing price on their down payment. As a result, when housing goes up, people make unrealistic assumptions about their networth and financial future; when housing goes down, people go panic and/or desperate. Forcing such huge leverage on unsuspecting, unprepared public ultimately forces the risk on the society as a whole -- it becomes a political/social problem, exactly as we're witnessing now.

2. Such leverage is inherently destablizing at the macroscopic level. When economy runs into headwind, the housing market is likely to go down. But homeowners are also likely to lose their jobs. Positive feedback, exactly as we're witnessing now. Perpetual mortgage spreads out the profit/loss on the house so that both homeowners and lenders have more buffer to cope with it.

3. Most mortgages are never paid off. They either get prepaid (sold or refinanced) or foreclosed. Both are among the biggest risks to lenders, thus adding to the interest rate. Perpetual mortage largely eliminates the delusional assumption that it will be paid off on schedule. It also reduces both by A) discouraging flipping, and B) easing foreclosure danger.

It's not a cure-all. But it should make it less painful for many homeowners and lenders while limiting governmental intrusion on capitalism.

Note that this is very different from renting from the bank. You own the house, participate in its appreciation as well as depreciation, enjoy the tax benefit etc. Banks can also impose the same down-payment requirement, although this is impossible when converting existing mortgages. It also differs from "interest-only" mortgages in that, in case of a downturn, homeowner pays the depreciation over a period of, say, 10 years. The original lender is obliged to offer this loan.

Sunday, October 19, 2008

CDS Exchange = Assured Systemic Shock

Friday I submitted a Proposal on Transforming CDS. I encourage you to read it if you hold just a passing interest in the current financial crisis. But the talk of moving CDS to exchanges has been gaining momentum, touted as the cure by SEC Chairman Chrisopher Cox.

If the man who advocated for deregulation of all things financial, and who was appointed to head SEC for the purpose of making it irrelevant, touts The Cure for the crisis that his agency helped create, we need to be automatically suspicious.

But let's go beyond philosophy, go into details and make a concrete case.

Exchanges reduce counterparty risk by being the sole counterparty; in turn, they protect themselves by imposing margin requirements on their client accounts. So far, in almost everything exchange-traded, this mechanism has succeeded. But this does not make it a fit for CDS due to its inherent high leverage on the seller side.

Say I sell on the exchange $1B CDS on XYZ, which is a decent credit and premium is $10M per year (100 bps). The exchange finds you as the buyer. Since you're liable for the $10M annual premium payment, it requires you to put up collateral of $10M. No problem.

But how much collateral does the exchange require me to post? Obviously the amount should be tied to the notional, NOT PREMIUM, since my liability is tied to the notional -- a fraction of it, but the fraction could range from 0.1% to 91%, as illustrated by recent Fannie and Lehman CDS auctions. 100% of notional? There's no way any seller could afford to sell under such collateral requirements, not at a price buyers would buy. Remember, my collateral would be 100 times of my annual proceeds from this transaction. Even 10 times premium would be too high for the seller. Even at 2 times sellers would cry for pain.

But 2 times premium is 2% of notional, and assuming recovery of 40% (another laughable character of CDS standard models), 1/30 of the seller's liability in case of default.

There may be some remedial measures, such as increasing collateral ratio as the credit deteriorates. But, unlike naked equity options, the payout for CDS is by nature sudden-death, a jump event. The day before Lehman bankruptcy, Lehman CDS was trading at 20% upfront. The next day, you're looking at 80% payout.

Convergence between collateral and potential liability on CDS sellers is not possible. Recovery rate upon default is an unsolved problem. Putting CDS on exchange forces the exchange to take the recovery risk.

Who fills the hole? The Exchange. What happens if The Exchange fails? Complete, certain failure of CDS market. In contrast, the fallout from Lehman bankruptcy we've seen so far is less than 100% in both probability and scale.

If we let the old players and the old guards design the new system, the exchange would be guaranteed by the government, with the exchange taking the profit in good times and the government taking unknown, undetermined risk of recovery rate for no return when disaster strikes. And the collateral requirement of sellers would be pathetically inadequate. Future systemic failure is assured.

Will the society allow this travesty to repeat itself?

Friday, October 17, 2008

Proposal on Transforming CDS: Credit Insurance Trust

The latest round of eruption of year-long financial volcano has thrust CDS into almost bar-conversation vocabulary. The common sentiment seems to be total hatred or disgust. Eulogies for CDS have already been published. Others are calling for change in how CDS is traded and/or treated in accounting. Common proposals include

1. Regulate CDS as what it is, insurance.
2. Trade CDS on exchanges so as to minimize counterparty (seller) risk.
3. Move CDS on balance sheet.

But the cost to the seller -- capital reserve in 1 and 3, margin collateral in 2 -- would be prohibitively high if the capital/collateral cushion is to be enough to meaningfully reduce counterparty risk. Such high cost to the seller translates to high premium for the buyer. Result: dramatically reduced market size. In other words, CDS is still dead.

Few people would shed a basis point of a tear on such news today, I suspect. But let's not forget CDS can serve a legitimate and important function: hedge. Yes, there are real, meaningful hedges using CDS. If you hold a bond or otherwise are exposed to credit risk of somebody, there's nothing like CDS that can provide direct, fast, efficient, and clean hedge in time of need.

Credit derivatives are NOT financial weapons of mass destruction. They merely have the capacity of being such powerful tools. But whether it serves good or evil depends on people. Blaming financial products strikes me as profoundly misguided and ignorant, even dishonest.

No, credit derivatives didn't cause this crisis. WE -- the government, some market players, some mortgage lenders, and some home buyers -- caused this crisis. We didn't use the powerful tool of credit derivatives properly.

And while we're on it, let's make one point very clear. The reason why we failed to use it properly is not due to lack of understanding of the risks; rather, it's because the system -- regulators, laws, and corporate governance -- has incentivized decision makers at all levels to ignore the risks and focus on short-term gain. Calling regulators and Wall Street executives stupid or incompetent might feel good. But it wouldn't be correct at the overall level.

It's the system that's skewed and flawed. The magnitude and duration of decision makers' risk and reward are misaligned; sometimes even the sign is wrong. If we only focus on a few individuals' misjudgment or unethical/criminal behavior, we run the risk of missing the deeper, greater cause -- the systemic flaws. In doing so, we only set ourselves up for a repeat in the future.

So I'd like to focus on addressing the systemic flaws here, and only on CDS. Let's first take a look at what makes CDS unique -- forget about the standard pricing model or how it's been treated so far, focus on the economic idea behind it.

1. CDS by nature is an insurance.

2. However, there is one important distinction between CDS and traditional insurance products. The latter can be "hedged" via diversification. It's very difficult to hedge CDS this way because, by definition, it deals with low-probability, high-weight events among a small population. This is the most fundamental flaw of CDS as we know it today. It goes right into the well-known fact that statistical applications (not the theory) loses relevance as you migrate towards the distribution tails. No company is big enough to provide meaningful insurance of such risks on a meaningful scale, especially since the company is a credit risk itself. As to governments playing any role, I hope the governments' involvement in this crisis has thoroughly disgusted everyone so let's not even go there.

3. CDS differs from most of other derivatives in that it is inherently highly leveraged. This makes CDS the key ingredient of the chain reaction.

If you understand the above three fundamental characters of credit default protection, you'd realize regulation or accounting gimmicks could not possibly address the real cause of the problem, short of killing the market altogether. The real solution must address all of the three fundamental characters while avoiding throwing the baby out with bathwater.

In addition, just as nobody should, in the legal sense, moral sense, or from societal considerations, reap a windfall from tragedies, as is the case for all traditional insurance, nobody should reap a windfall from default through CDS. The social utility of insurance is to lessen the impact of tragedies as opposed to encourage speculative or reckless behavior. You may be tempted to ban naked CDS based on this consideration. But naked CDS has its legitimate use, since all exposed to a credit risk do not hold the bond.

More importantly, since CDS settlement is by definition a zero-sum game, there is absolutely no reason the society as a whole should be greatly damaged by it aside from the fact that the reference entity has just defaulted. If we cannot find a way out of this PURELY artificial problem without sacrificing its beneficial functions (or going into state capitalism as we are), then I don't know how we deserve the top spot on the food chain.

My proposal is to set up a private, non-profit Credit Insurance Trust (CIT). To begin with, let's call it what it is, Credit Insurance (CI).

1. Those who want to sell CI must contribute capital, the amount of which is tied to the total amount of notional they can sell. The relationship between contribution and allowable notional is determined by auction, e.g., $1 contribution gives you a permanent, revocable, transferable license to sell up to $1000 notional CI (hold you protest on such outrageous leverage -- read on). Licensees are subject to trustee approval. Licensees are seller agents for CIT, which is the legal seller of all CI. Licensees can buy additional licensed amount at prevailing auction price, subject to the total cap set by the Board of Trustees.

2. Board of Trustees is elected annually by CI buyers. The vote is weighted by notional outstanding bought.

3. CIT invests the fund in long-dated treasuries (or other "riskless" securities the BOT deems appropriate).

4. CI premium goes to the Trust. Licensees take a haircut, ranging from 0 to 5 bps. The better the credit, the bigger the haircut. This discourages speculative selling on poor credits. The returned premium goes into a separate fund -- let's call it CITIF -- which also invests in "riskless" securities, but with maturity no longer than one year. Furthermore, CI on a credit cannot be sold once the credit quality deteriorates beyond certain level. This prevents agents from selling garbage while making fees via private arrangements. Existing CI contracts can always be transferred, however, with registration to CIT.

5. Returns on CIT and CITIF investment pay for the administrative cost first. Excess goes into CITIF; deficit comes from CITIF. It's to the BOT's interest not to let CITIF run dry.

6. CI buyers must invest all of the settlement windfall into CIT, which is done automatically as part of the settlement process. In return, they become holders of CIT's interest-only, non-compounding, annual coupon, 10Y bond. In other words, each settlement is automatically a CIT bond issuance. Coupon payments of such bonds come from the accumulated funds in CITIF, set in arrears and capped at 20%, after administrative expenses. CIT bonds can be auctioned at issuance (buyer cash out) or traded on secondary market.

This may seem a bit complicated, and will get more so when put in the international context. Price of CI depends on the valuation of CIT bonds, the pricing of which would be quite interesting. But it has numerous advantages:

1. While credit default risk may have proven too high-weight for any particular company to bear, by definition such risks can be handled, and statistically "hedged" in the same sense of traditional insurance, at the macroeconomic level. This setup solves the fundamental flaw pointed above.

2. There's no economic incentive for speculative selling by the agents. Speculative selling of CDS is the biggest systemic flaw currently. This setup cuts off the chain reaction mechanism from the root.

3. Contrary to the destabilizing effect of CDS, this setup serves to stabilize the system and benefits everyone involved, therefore by extension the society in general. It will also lower the systemic correlation, which is extremely beneficial to many other credit derivatives, e.g., certain types of CDO.

4. Speculative buying is also greatly discouraged. As a credit worsens, the haircut by seller-agents decreases, discouraging them to sell protection on the credit. Also, buyers' payout is directly tied to the future health of CIT; it's to their interest to keep it well.

5. It aligns risk and reward perfectly. In essence, the insurance is backed by the pool of premiums, not by the promise of any single entity. Licensees make the fee for their service and providing the initial funding to the Trust.

6. CIT's fund is guaranteed to be perpetual. The only way it goes bankrupt is for its "riskless" investment to go sour. In such worst-case scenario, the government would have defaulted. The biggest risks cannot be hedged, period (one example is Earth being demolished by Vogons).

7. Buyers can remain anonymous until settlement. This is important to protecting their interest. But anonymity in this framework will not have the side effect of its current form because the net position on each credit can be easily calculated on the seller side, which is completely public.

8. Last but not the least, this setup is in fact extremely simple. It heavily relies on the market, minimizing reliance on government intervention or artificial, arbitrarily set rules and prices.

Let's run some numbers. Say CIT total fund is $1B. Based on auction price of license amounts, $1T notional can be sold. Average premium is 100 bps (1%), or $10B, per year going into CITIF. Average haircut by licensees is 2 bps, or $200M per year. In an EXTREMELY bad year, 10% of covered credits (by notional sold) default. That's $100B. Buyers still get 10% coupon for the first year. Since in such dreadful times people would want to buy more protection, and premium would have increased, future coupon on CIT bonds will likely increase. (I've omitted investment income and expense for simplicity.)

Everybody wins.

Thursday, October 16, 2008

Resession Will Not Be Deep

In Aladin, Lago, Jaffar's sidekick parrot, has one of my favorite cartoon slapstick bits: Why am I not surprised? I think I'll have a heartattack from not being surprised!

News came out today that Bernanke thinks there'll be a recession. And it's supported by retail sales number. The market had a heartattack from not being surprised.

I mean, is it news to anyone that we'll have a recession? We've been in one for a year. And we surely haven't seen its end yet.

But all this talk of DEEP, WIDE recession is nonsense. Human intuition is based on linear extrapolation. Gloom and panic are always at the height just before the bottom. But in the height of panic people have forgotten one key difference: the government finally got it this time.

Bloomberg had an interview saying "Bailout Is Big, Bad, Ugly, the Only Answer: Jane Bryant Quinn". I agree with Jane on everything except the "only" part. NONE of the government rescue efforts since last August was the only choice, especially the massive liquidity injection of the past few weeks, the $700B bailout and the latest comedy of banks being forced to accept government money for peanuts in return. But, be it as may, this latest mafia drama will break the logjam because it finally stumbled on one of the root problems. It will take some time for the massive liquidity and capital to flow down the money supply chain. But it will. It must. Banks need to make money, even if they're not allowed to fail.

The other root problem, housing price, has been helped by several give-away legislations, and will no doubt continue being helped by the new president and congress. These bailouts are equally morally suspicious and objectionable as the bank bailouts. But, again, they will work. As a result, housing price may still go down somewhat, but much slower than withoutthe help.

Government supported housing price plus government supported banks. Everybody is riskfree! It's a riskfree world! How can banks not lend and buy risky assets as long as there's no chain reaction on 10/21? In a few months, as the money flows down the pipe and banks begging everybody to borrow (they would do a Paulson if they could), how can companies not hire and expand?

And, remember the $400B write-downs by US banks and $300B by European banks? They're write-downs, paper loss. As soon as the housing price stabilizes and CDO market volume recovers, $350B of it will become write-ups. Bank quarterly numbers will go up so fast and furious, it'll feel like the good'ol times again.

This recession will be anything but deep.

So will we get out of this mess without paying any price? Of course there's a price. The price is prolonged inflation and massive debt for future generations.

Inflation will be mostly driven by commodities bubble, credit bubble, and housing bubble. Yes, we may very well have yet another housing bubble in front of us.

But what's the problem if we can keep the bubble going in perpetuity?

The only problem is we can't. At some point people will stop buying our debt and stop using our currency to settle trades. Sure, Saddam threatened to settle his oil in Euro and look where he is now. But unfortunately we got in so much trouble in Iraq, the lesson we intended to teach others has turned into encouragement, for Chavez at least. Yes, people have no alternatives since Euro is in even worse shape now. But desperate people find desperate solutions. Just as we've been doing unimaginable, desperate things to avoid the crisis, the world will find unimaginable, desperate alternatives if necessary. You can only count on others being suckers for so long.

The fantastically flawed and effective bailouts we've seen in the last few weeks have hastened the day of reckoning, or at least made it much harder to avoid or delay.

But that's our children's problems. For now, enjoy the new, riskfree world. Be bubbly.

Wednesday, October 15, 2008

Can I Buy My Own Bond? CDS?

I wonder if it's legal for companies to buy their own debt on the secondary market or CDS on themselves from another party. If it is, I have some fantastic business models to sell to VCs.

1. You sell $1B bond, then proceed to wreck havoc of the company, for example by taking ridiculous amount of bad risk. Rumors start flying around. Stock plummets. CDS spread shoots up. Your bond plummets. You use $700M of the $1B proceeds of prior bond issurance to buy back all your debt from the secondary market, even though it's not callable. You keep the $300M cash.

2. You buy naked CDS on yourself from somebody, with notional say twice as much as all your outstanding debt. If you ever go down, you'll get such a windfall that you'll snap right back out of Chapter 11 looking prettier than before you went in. In other words, you cannot fail. Technically, you could still fail after the CDS sellers fail to pay you. But we all know now that big CDS sellers are not allowed to fail; our government would call their CEOs into a room and hold guns to their heads and ask them to accept huge sums of money for peanuts in return and the CEOs, after reading the fine print in big bold fonts, would try their personal best to fein indiginity while signing and to hold their laughter long enough to get back into their limos. Therefore you cannot fail, no matter how badly you screw up.

So let's do circle time. I buy CDS on me from you, you buy CDS on you from her, she buys CDS on her from me. As Borat would say, NIIIIICE!

But these are brutes. There're more subtle varieties.

1. You buy CDS on yourself, then casually give out some hints of pending trouble -- insider selling, unintended leak to a reporter while drinking, etc. CDS spread shoots up. You sell or unwind your existing CDS for a 100% profit. Insiders buy low. Company turns out fine. CDS spread goes back down. Repeat as necessary.

2. You're a holding company. One of your subsidiaries is in trouble. Or maybe you decide it's in a dead-end market but can't find a good price to sell. You buy CDS on the sub. You force it down. You get paid, wealth transfer from bankrupt sub to parent.

Monday, October 13, 2008

When Senior Bond Is Very Junior

Many people are baffled by how Lehman senior debt has been trading after they filed for Chapter 11 protection, as I illustrated in a previous article. Turns out Robert Waldmann at AngryBear has an excellent analysis on the same topic, only earlier.

But, after some more research, I realized it's more general than Lehman selling CDS protection on itself, although the irony makes it more interesting. Generally speaking, in bankruptcy code, derivatives counterparty claim can go right through Chapter 11 protection and force liquidation. Chicago Fed in fact had a research paper in 2004 (thanks to SeekingAlpha reader analyzing the original rationale behind and the unintended consequences -- cliche of the month? -- of this exceptional treatment of derivatives.

So, what does it mean? If you buy senior debt from a company with significant activity in the derivatives business, your senior bond is in fact subordinate to all such counterparty claims. In case of Lehman, it's not hard to imagine how counterparty claims could easily eat up all that's left. I'm just surprised the market thinks there would still be around 10 cents on the dollar left when all counterparty claims are settled.

If you think only financials are involved in significant derivatives trading, you'd be wrong. Virtually all big companies today are neck deep in this business.

This is arguably one of the biggest stealth dilutions (to bond/eqquity holders) in today's capital markets. The other one would be off-balance-sheet but that belongs to another day.

Market CDS spreads often imply significantly higher default probability than historical data suggest. There're a plural of potential justifications for this apparent "discrepancy". But I tend to think a big part of it is not that market is implying higher default probability. It's lower recovery that market has been trying to say all along.

So, how did such bonds ever get the "senior" label? Did the rating agencies take this into account when rating them?

These are $700B questions, in court. (Not that I'm trying to be dramatic, it's just that anything less than $700B doesn't carry any weight nowadays...)

Lehman CDS Net Settlement Only $6B -- REALLY?

The whole world financial market has been in cryogenesis for weeks due to the known unknown of Lehman (LEHMQ.PK) CDS settlement on 10/21. But Saturday DTCC came out with a bombshell revelation: The settlement will net to a measly $6B.

Well, according to "calculations so far performed by the DTCC", that is. Anybody care to hint how far this "so far" is? 10%? 50%? 90%?

Secondly, the overall net is meaingless. Let's say A owes B $600B and B owes C $594B. The total net payment is $6B. A still fails, which may trigger another round of CDS settlement. Let's say that one nets to precisely $0. Are we supposed to be suckers again and take comfort in that?

Thirdly, the settlement on 10/21 includes virtually all credit derivatives involving Lehman -- CMCDS, fixed recovery CDS, Nth to Default, CDX, CDO.

There're many other reasons why the DTCC announcement cannot be taken at the face value. But the above are the most important ones and I'll stop here.

The important thing is for the government and the market not to be fooled into a false sense of complacency by this press release. The logjam in worldwide financial markets for the past few weeks is because of the Lehman CDS settlement. Banks know how much they're liable for. But they don't know how much others are, including their hedge fund clients.

Unless government forces disclosure on Lehman settlement exposure, we can only assume the worst -- another bank or two going down and propagating the chain reaction. The opacity has been the single most important reason why the inter-bank market has seized up and hedge funds have been forced to liquidate by the double whammy of prime brokerage margin calls and investor withdrawal.

Government must take the pending storm seriously and force all financial institutes to disclose their net liability or windfall on 10/21. For those with huge liability and whose failures are likely to cause chain reaction, the government must provide immediate backing -- buy preferred stock or force debt-to-equity conversion -- so that it's clear to everyone that the chain reaction will be stopped.

The CDS settlement is a zero-sum game. However big the total payout may be, somebody else will get exactly equally big windfall. So there's no reason for the world to go down on 10/21. However, if left unforced, narrow self-interest, greed, and distrust will make people choose certain demise. We need full disclosure, now.

At a time opacity is causing and fanning panic and distrust, the DTCC press release is not helpful. It merely adds smoke to the scene.

10/21: The Bottom

Let's cut to the chase. On Oct 21, somebody A will have to pay somebody B $C in cash to settle CDS on Lehman. Estimates on C range from 100 billion to 600 billion (a recent DTCC press release claims that the total net payment on Lehamn CDS is only $6B but I'll write about how misleading that is later). Group A will almost certainly include AIG, the biggest net seller of CDS, and many hedge funds, who have been using CDS selling as their cheap (HA!) financing source for the past few years. Besides single-name CDS specifically on Lehman, other credit derivatives such as CMCDS, CDS options, or Nth to Defaults, CDX indices and bespoke CDOs with Lehman in it will also settle, partially or in full.

This will be arguably the biggest cash-exchange day in human history to date. I don't care how much tax-payer's money the government will use to bail them out, somebody will fail.

Group B includes two types. One has Lehman bonds. They will be made whole by the settlement although Lehman bonds changed hands at 8.625 cents on the dollar at today's auction. The other doesn't have Lehman bonds. They bought naked CDS on Lehman. They will have a HUGE windfall -- for every dollar notional, they'll get over 91 cents. If they could collect, that is.

Back to the more immediate concern. Who is A?

You could pore over the CreditFixings' auction info and guess. I think a lot of people did just that Friday. They pounced on MS, GS, CS, and DB, who happen to be the biggest Physical Settlement Sellers (meaning they sold CDS on Lehman). JPM shot up the whole day, which happens to be the biggest buyer.

But I don't know how productive this guessing game is. The dealers could be placing orders and requests for their hedge fund clients. Short of serious insider info, there's no way of knowing how much of those requests are for themselves vs clients. More importantly, physical settlement will almost certainly be just a small portion of the overall settlement size. Today's auction had $5.7B sell orders. Cash settlement will most likely be at least 10, maybe 100 times bigger than that. People learned the lesson from Delphi. Furthermore, it'd be very unusual for banks to have a huge net position on CDS, with the possible exception being their proprietary desks and funds. Again, most likely suspects are AIG and hedge funds.

Now you know what the government bailout of AIG is for, the initial $85B and then the additional $37.8B (suspiciously precise isn't it?). Don't be surprised if the number goes up again before 10/21. Will tax-payers get the money back after 10/21? Fat chance. Is the money really for saving AIG or making sure others who bought CDS on Lehman will get their windfall? Take your pick.

On to hedge funds. They knew how much they would need to pay since Lehman bankruptcy. Reportedly JPM, GS, and MS have issued massive margin calls to their hedge fund clients, which is consistent with their sell requests (except JPM who, being the clearing bank for Lehman, may have bought protection) at the ISDA auction and my suspicion that a big part of their requests are on behalf of their clients. Some hedge funds are forced to cash out. And since Thursday some apparently went shorting in desperation, trying to make a quick buck before the doomsday. The 900 point surge Friday 3PM in half an hour showed how nervous and desperate they are.

In the meantime, of course, hedge fund investors must be withdrawing as fast as they possibly could, adding to their misery. Bankruptcy law will be the golden profession for many years to come.

WaMu CDS settles on Nov 7. Its impact is expected to be much smaller, although nobody can be sure, as for all CDS. We may get some rough idea on its auction date, 10/23. If there're high-profile bankruptcies on 10/21 (banks, AIG), then market would be spooked and all eyes would turn to WaMu; otherwise it'd likely be a non-event in comparison.

If there were bankruptcies of anything other than hedge funds on 10/21 (or 11/7, though less likely), then we could be in a serious chain reaction. But governments all over the world would band together to stop it. Governments may be stupid and inept, but they're not suicidal. Fed window will stay open late on 10/21. For banks (or AIG) who cannot post enough collateral, Paulson will be ready to buy stocks in a heartbeat. If the initial $250B runs out that day, they can let foreign sovereign funds to buy perferred stocks. It's a wonderful world.

Moreover, I suspect the pending doomsday is a big reason why banks have shied away from lending to each other over the past few weeks. Nobody knows how much anybody else owes on that day. Coming 10/22, assuming no banks fail, it'd be a huge cloud gone. Back to business as usual, or as usual as it gets nowadays.

Hedge funds' fire-sale exit may be creating a very rare buying opportunity in many financial markets (stocks, bonds, commodities, maybe even dreaded CDOs and mortgages). Two days ago I wondered if the bottom is near. Now I'm convinced the bottom will be around 10/21, if not earlier. The way back up may be painfully fast or painfully slow. But the crisis is essentially over unless we let the chain reaction take place.

Then we'll only have to deal with the massive debt, recession, and inflation. Piece of cake.

Saturday, October 11, 2008

The Wonderful World of Self-Insurance

I came across this gem, written by Oussama A. Nasr way back in 2003 (oh the good ol' times), on self-referencing derivatives, part 1 and part 2। Be sure to read both. Thank me later. You're welcome.

I assume by now everybody in the trade knows about the trick of shorting the stock while buying CDS. Much more effevtive and capital-efficient than just shorting the stock. But that's child's play. Any self-respecting player would short the stock, buy the bond to hedge himself, and buy CDS -- not from anybody, but from the reference entity itself. This way, if the company goes down, you come out ahead with your shorts and CDS while your bond gets 100% recovery (or more); if it doesn't go down, you unwind short and CDS, and make your money on the bond (not nearly as fun as when the company goes down, for sure).
Does it make sense to buy insurance from the guy whose life is insured on it? No, you say? But no to that, sucker। In the wonderful world of bankruptcy court, it does make sense. Because CDS counterparty claim is above senior debt. You get your claim even under Chapter 11, when senior debt holders cannot cash out.

Lehman senior debt is trading at 15 cents on the dollar। Why is that? Presumably, when Lehman exits Chapter 11 in a year, housing markets will have stabilized somewhat, 20% will have defaulted -- ok, 40%, which is NOT going to happen even in the worst form of subprime, but you still get 60% recovery. Lehman may be holding some equity tranches of mortgage CDOs, which is worth precisely 0 unless Paulson buys it with tax-payer money, and some mezzanines, which is worth precisely 0 unless Paulson buys it with tax-payer money. But these CANNOT be the bulk of their asset. So why 15% today?

My guess is that Lehman has sold a lot of CDS on Lehman over the years। As buyers of such CDS claim their payout, recovery for senior debt holders will be diluted.

Just my wild guess। Don't bet your money on it.

Oh, BTW, in case you haven't read the articles I mentioned at the beginning (yes, read them both), companies can jack up their balance sheet and capital adequacy without getting a penny। They borrow $100M from you, give it right back plus interest minus some. But they look very strong as far as regulators and accountants are concerned -- $100M more tier-2 capital.

I'm not saying this is what's happened. Again, just my wild guess and don't bet your money on it.

Wednesday, October 8, 2008

The End Is Near! The Bottom Is Near!

The past two days in stock market have been interesting, revealing, and puzzling.

What happened was no panic selling. Two Friday's ago, after House rejected the Bailout Pork Package, was panic selling. Prices drop like crazy, indiscriminately across the board, then rebound. But what happened in the past two days was steady, guided, sustained downward pressure. I'm sure all chartists have noticed it. And, in the closing minutes, you could almost see two forces fighting, Monday around Dow 10,000, Tuesday around S&P500 1,000. Both times the seller side won at the finish line.

Some big money is exiting the stock market in an organized, well planned, and determined fashion. This is not panic nor desperation. I don't know who the big money is, hedge funds, mutual funds, pension funds. For some reason some people somewhere need a big pile of cash. Not immediately, but in some near future.

When they're done, we'll have a bottom. It could be tomorrow or next week. But it won't be two months away.

Last April/May, I saw the subprime blow-up coming in August, no later than Sept. This April, when the market rallied after Bear Stearns bailout, I called it a sucker's rally and said the bottom would be after Sept at the earliest. Admittedly, I didn't see the full scale of chain reaction from mortgage to CDS to monolines to ARS to CP to Libor to money market funds to bankruns to disappearance of stand-alone investment banking to worldwide seizure. My crystal ball was foggy beyond CDO.

But now, I don't see any crisis ahead of us in the foreseeable future. There may be another bank or two failing. There will be many hedge funds closing -- perhaps the peculiar pattern in the last two days was a prelude to it. There will be long-term inflation.

But all the risks I mentioned above have been priced in. We have thought of all the terrible scenarios. (Heck, even CDS on US is selling at around 40 bps -- to put it in perspective, CITIC CDS spread is around 30 bps, meaning CITIC is considered a safer credit than US sovereign debt.) We're hopeless. We're ready to take the loss and move on. This means the bottom is near. I'm not sure about the prospect of strong economic recovery or bull market. If there is a recovery ahead of us, which is questionable after inflation adjustment, most likely it'll be slow -- let's hope it won't come in the form of yet another asset/credit bubble. I'm too young for death from heart-attack.

Despite all the gloom and doom, the world is not coming to an end. Factories are still churning. Trucks are still moving. Girls are still walking around in their pretty dresses. Funny thing about financial crisis is that, when it REALLY hurts, people will wake up and fix it. And it's much easier to fix than a real crisis, e.g., mass-scale drought. Even Europeans will come together and fix it. All the cash in exile will not be parked in gold-pressed platinum bars. And let's not forget the imminent surge in capital worldwide arising from lowered capital requirements, lowered interest rates, and massive, multi-national capital injection.

Yes, there will be inflation, maybe worldwide. But this is the biggest reason for people not to sit on cash. For many people, I suspect the stock market in the next year or so is their best and last chance to beat or barely keep up with the inflation over many years.

Tuesday, October 7, 2008

It's Capital, Not Liquidity, Stupid

I wrote an article over the weekend on how all the massive, desperate liquidity injections by the Fed have failed, and indeed created a short-term liquidity cash burden at the top of money supply chain, banks. Today, I'm seeing a lot of the old, predictable battle cry: "Lower rates! Inject more liquidity!"

I feel compelled to repeat myself.

While liquidity has been a persistent symptom since the start of the crisis last August, it was never the cause. The cause has always been the Incredible Shrinking Captial caused by a combination of:

  1. deteriorating housing market;
  2. over-leveraging while ignoring systemic risk such as counterparty risk in CDS and elevated correlation in CDO;
  3. and positive feedback loop between declining price and loss of capital base created by mark-to-market accounting.

Take a look around. US banks are buried with short-term liquidity cash, so much so that NY close overnight repo rate is almost zero. Does this mean US banks value each other's credit risk as equivalent to treasuries? Of course not. They just know their counterparts will have unlimited supply of short-term liquidity cash tomorrow and that's enough. Why don't they use the cash to start lending to people who need it, such as municipalities, companies, homeowners, and consumers? They can't. The cash is short-term liquidity supply, not their capital. If they use it to expand the asset side of the balance sheet, they run into two big, familiar problems that have burned them, their counterparts, and a few former counterparts:

  1. capital requirements, which everyone has already been struggling to meet, and
  2. risk of inability to roll the short-term debt to finance the long-term asset.

Sure, the Fed is their personal Santa now. But everyone knows at some point it has to suck out this massive excess liquidity. How do you roll the debt then? When will it happen? With every government agency changing rules of the game everyday for the last several weeks, often without any rationale except just for the heck of scaring people (as one official said of the short ban), nobody is willing to take the risk this close to Christmas and bonus time.

Hence the irony: on one hand we have a bunch of sickly banks sitting on an unlimited supply of liquidity, choking the money supply chain from the very top; on the other hand we have the rest of money supply chain dying for liquidity.

Now the Fed is considering buying commercial papers directly. What a concept. Why don't we just get rid of banks altogether and go to the Fed for a mortgage?

The Bailout Pork Package, for all its ills, at least has the diagnosis right: banks need capital injection. But the mechanics of it is too complicated -- what to buy, whom to buy from, at what price, how to set the price, who to manage it. By the time the doctor cuts to the tumor, some patients may have died from an overdose of pain killers.

We need to inject capital, not liquidity, into the banking system FAST. Once banks have enough cushion on top of the minimal capital requirements, they'll start opening up the money supply chain. After all, it's not like banks hate profit.

There are many ways to inject capital fast. Buffett's Goldman Sachs model is one. Immediate shift to capital ratio based on mark-to-history is another. Even emergency lowering of capital requirements is much better than this madness of blind liquidity injection.

It doesn't take a rocket scientist to figure out these solutions and at least give them a serious thought. Why haven't we seen any sincere push for any of them?

Buffett's GS model dilutes equity and may hurt executives' pay this year, nothing like the instant gratification of the Bailout Pork Package.

Amending rules involves no money flow, thus no direct, immediate profit.

I hate to be a cynic, at least when writing here. If there's a better explanation, I'm open.

Monday, October 6, 2008

Liquidity Part of the Problem, Not the Solution

This is mostly the result of my efforts trying to make sense in my own head of what has been happening for the past few dizzying weeks. Some parts are nothing more than my own guesswork. All are based on public info I've been reading. I decided to share it here hoping readers could help put together a better picture. Critiques and alternate explanations are sincerely welcome.

1. First of all, it's clear that the latest round of the crisis, starting with the Fannie (FNM) bailout and Lehman bankruptcy, is different from the Bear Stearns crisis in March. Bear's was first and foremost a liquidity crisis (there was a serious capital issue behind it but that was not the direct trigger). Fannie and Lehman failed not for lack of liquidity, but due to capital insolvency. Fed data show that Lehman never went to the discount window to get liquidity. Fannie, Freddie (FRE), and Lehman fell because the market had decided they were insolvent, thus refusing to extend any credit or do any business with them.

This is a subtle but important distinction. The fact that Fannie, Freddie, and Lehman failed despite plenty of available liquidity from the Fed proves beyond doubt that all the liquidity-based emergency measures by the Fed and other central banks, including the $630B from the Fed last Monday, were wrong-headed. Besides not solving the problem, in fact they created a false sense of security. In retrospect, if the Fed didn't open up the discount window to investment banks and bail out Bear Stearns, maybe Lehman would've been scared into de-levering much more aggressively.

2. The underlying trigger this time is not subprime. Subprime and Alt-A mortgages are to a significant degree known problems, thus not capable of triggering another round of panic and crisis. The current trigger is the prime mortgage market. This is evidenced by the sudden collapse of Fannie and Freddie. They had little exposure to subprime or Alt-A. Yet their delinquency rates shot up in August. This forced the market to reevaluate its assumptions about prime. If you've experienced an earthquake, you know how it feels when the assumption that the ground beneath your feet is solid and stable is no longer valid. You stop taking anything for granted. You re-examine everything. You panic.

3. The report of interbank lending seizing up has been greatly exaggerated. Libor rates, as quoted in London, have indeed been very high for the past two weeks. So have interbank rates in New York at 11a.m. But the New York overnight repo rate has been very close to 0 for the last week. What does this mean? It's the European banks that have been in trouble lately. US banks, buried to the eyeballs with the massive liquidity injection from Fed and knowing their counterparts in the US are in the same ironic dilemma, are quite willing to lend out the cash for some return, no matter how small.

This ironic dilemma faced by US banks, even before the Bailout Pork Package, is yet another proof of the ills of the Fed's wrong-headed rescue.

Does this present arbitrage opportunities? Surely it does, and with it comes the danger of contagion, this time from Europe. We shall see this week how it plays out. For now, the Libor has become little more than a symbolic benchmark (well, except for those paying for debt indexed off Libor). Interbank lending in Europe has seized up and become irrelevant since banks could go to their central banks, or to the Fed, through some arbitrage channel.

By blindly providing liquidity (as opposed to capital), central banks of the developed world have made credit risk irrelevant. It's a panic response to the panic. Whereas the original panic valued credit risk at infinity, the panic response made (temporarily) credit risk 0 -- but only for banks, the privileged few direct recipients of liquidity injections.

Will this massive pile of short-term liquidity cash trickle down the money supply chain?

Not a chance until the banks have capital relief, which is the real problem. They cannot use the short-term cash to expand the asset side of the balance sheet. Would they trust each other any better? No, they know all this impressive-sounding short-term cash doesn't solve the problem for their counterparts, just as it doesn't for themselves.

But I say this hold-up of cash at the top-end of the money supply chain is actually a good thing. Some people are suggesting lowering capital requirements, as opposed to temporary relief from mark-to-market and some sensible form of capital injections (of which the Bailout Pork Package is not), should be the fix.

Couple that with the massive liquidity now available and guess what will happen? Banks would be out on a shopping spree for all kinds of junk. It'd be Credit Crisis 2.0 before you know it.

The Fed must suck out the senseless excess liquidity, and fast, before Paulson starts using his infinite power and swapping cash (capital cash, that is) for junk.

Sunday, October 5, 2008

Mark-to-Market vs Mark-to-History

By now it should be no question that the Fair Value Accounting rule has driven some firms into a death spiral, and been an important amplifier in the financial nuclear chain reaction we've been witnessing.

To illustrate the point, as if it needs more illustration, let's consider a sudden cut-off of gasoline supply. The cause of the cut-off is such that we can be reasonably sure of its revival, but can't be sure when. The Lambo you just bought last year is worth little on the spot market.

"That's fine," you say to yourself, "I'll just park it for now."

Unfortunately, it's not fine. You used it as part of the collateral on your new Starbucks shop. WaMu texts you at 4pm asking for more collateral. "Or else c u in court," it says, "Sorry, must do MTM." But you happen to be tight on cash. You look around the house and come to the conclusion that the only option is to give up. You let your 10 Starbucks employees go. The next month five of them go delinquent on their mortgages. And these happen to be the last straw that pushes WaMu under the 6% capital ratio stop.

WaMu's insistance on Fair Value Accounting ultimately caused its own demise in this fictional scenario. It's stupid. It's unfair to everybody involved. It's self-inflicted damage, mutually-ensured destruction.

However, supporters of Fair Value Accounting also have a point. Imagine the same scenario above, with one of the following variations:

  1. The cause of the gasoline cut-off is such that we can't be sure it could ever revive.
  2. WaMu thinks that you will default soon regardless because it knows your Starbucks is in trouble. It'd have to sell the Lambo on the market afterwards since it doesn't intend to park it at its own expense and take the risk on it.

It's simply not the regulators' job to judge the market outlook or intention of the company. And, if the company management, when given the option of suspending mark-to-market accounting, comes out saying "we don't intend to sell these mortgages anyway", how can anybody trust them? This is not even a swipe at honesty of corporate manangement. Unexpected events may force companies to change strategy with little warning.

But the solution is so simple it's puzzling why it hasn't been discussed widely and considered sincerely. Just ask companies to report both mark-to-market and mark-to-X on financial assets. The market will have to decide how much of which to use to evaluate the company, and price its stock, bonds, CDS, etc accordingly.

Take Lehman as an example. Its rapid collapse caught most people by surprise, at least before 9/11, the Thursday before its demise. While some hedge funds had been shorting Lehman for months, I'm not sure even they believed Lehman would go down so quickly, especially after the Fed window opened up after the Bear Stearns bailout. If Lehman had the option of dual reporting, people would've valued it somewhere between the two numbers, perhaps even closer to the mark-to-X number.

Trust and confidence can be a self-fulfilling prophecy. If people hadn't been afraid of Lehman's capital solvency, to a large degree due to artificial, nominal paper losses imposed by Fair Value Accounting, they would have continued doing business with it, albeit with somewhat heightened prudence. And Lehman could've survived -- if it had survived till the credit market stabilizes, it would've survived, looking pretty sitting on massive gains as most of the previous Fair Value Accouting write-downs are eventually recouped. The AIG (AIG) bailout may not have been necessary as a result. And tax-payers could've saved a cool $700B (probably more).

The X in mark-to-X could be the moving average market price of the asset, or assets of similar nature, over the last, say, one year after forward discounting. Many details must be carefully considered, of course. But I'll not dwell in them here.

This dual reporting approach has an interesting self-correcting effect if capital requirement is based on mark-to-history. In a bull market, the effectively higher capital requirement, due to time lag and lower-than-market price basis, limits the risk growth while in a bear market, effectively lower capital requirement offers relief and time to adjust. The latter is especially critical in a disaster scenario.

This dampening effect contrasts with the destabilizing effect of positive feedback of mark-to-market: companies are allowed to take on more risk based on paper gains in a bull market, reaching the height of risk just as correction is due, and forced to delever in a bear market, just when they can least afford to do so.

Even the most fervent defenders of mark-to-market admit its destabilizing effect under severely adverse market conditions. Mark-to-history capital requirement coupled with dual reporting can substantially eliminate the negative effects while retaining the positive ones.

Friday, October 3, 2008

Bailout Pork Effect: Short-Term Rally, Long-Term Disaster

Defeat of the Paulson bailout plan in the house last week was nothing short of a remarkable victory of democracy. All of our political leaders were for it, future ones included, showing more unity than the Chinese Communist Party. The mainstream media were so politically aligned with the Government, they put Xinhua to shame. Yet individual voter-tax-payers, with hardly any meaningful organizing effort, fought for their self-interest and won against all odds. Wow.

If only we had done it five years ago on Iraq war and the Patriot Act, today's American citizens would be hailed as a shining example of independent citizenry of a strong democracy for centuries to come.

Unfortunately, we hardly had time to throw a party before the Senate pulled an old political trick and forced the hands of the House and the voter-tax-payers on the same plan. Only with $170 billion added pork to punish the rebelion act. That ought to teach the citizenry a lesson about respecting the Leaders.

There's no doubt SOMETHING must be done, and quickly, to stop this financial crisis from spreading to the wider world and becoming an economic crisis. The question is what that SOMETHING is. There've been many ingenious ideas floating around the internet. The Leaders have supposedly even considered some of these alternatives. Yet they chose the most costly (to tax payers) possibility and gave us two choices: are you for action or gridlock?

It's the same false choice as the one five years ago: are you for freedom or terrorism?

I used to pull this trick on my kids sometimes: who would you like to wash your hands, mom or dad? They started realizing the Possibility Universe is far larger than what I presented, somewhere around six years old. And I actually felt a bit guilty.

The Leaders have been doing this to us. And we never have the intellectual and/or political capacity to see through the same old trick. And they never have any guilt, I'm afraid.

But, we have to face reality at the end of the day -- would that be Friday?

If the Bailout Pork Package is passed, I'm willing to go with the conventional wisdom that the markets (stocks, bonds, derivatives, USD, commodities, gold) would have a broad rally, with the only exception being the treasuries as money exits the bunker and goes to work. Not too shabby huh?

Well, with $700B you'd expect more. Much more, and much more long term. But long term will be ugly.

First of all, the government has totally abandoned fiscal discipline. Well, it's abandoned it for a long time but now the world cannot pretend it didn't know any more. Foreign investors will have to stop playing suckers and buying the treasuries. They wanted to sustain the pretend game as much as we do. But now we finally killed the chance. Even a pretend game has a limit, beyond which the players simply cannot pretend any more. With the double whammy of hugely increased debt and higher interest, maybe CDS on US is not such a dumb idea (nah, it's still a dumb idea for, if...when US defaults, whoever sold you the CDS will not be around to pay).

Secondly, whereas inflation was a strong possibility in summer 07, now it's a certainty. Excess liquidity (credit) is easy to suck out as long as the Fed is determined to (which they weren't when they had a chance to deflate the housing bubble). But what the Bailout Pork Package puts into the economy is not just liquidity, but a massive amount of capital. Excess capital will stay around in the system for much longer. Capital chases return. Excessive capital chases excessive return. Excessive return at the macroscopic level can come from only two sources: asset bubble or inflation. In this case, it will be both.

Which leads to the third long-term effect: commodities bubble (yes, again, the real one) driven by negative real interest rate. The only reason that can explain the commodities bubble until a couple months ago is negative real interest rate. Supply and demand may have the right sign during some periods, but cannot possibly account for the magnitude of the surge. Amount of speculative money is an ontologically flawed argument since it by definition cannot explain why there were so much of it. When the real interest is negative, it does not make sense to hold cash (and cash there will be a lot of it now).

Real assets is one of the best places to park this massive amount of capital windfall, especially through continuously rolled futures since you don't pay the storage cost. What kind of real asset? Housing (mortgage) was the obvious choice when real interest rate became negative during Greenspan years, and especially after the massive rate cuts in 01. But now people will be careful touching mortgages for at least a few years. The only outlet left is commodities -- gold, oil, metals, rice, corn, who cares what it is. Never mind that there will only be so many taking actual delivery, demand will only increase so much and supply will only decrease so much by the mot exaggerated estimates. The $1T+ excess cash must be parked somewhere and earn some return.

While the effect of the housing bubble on inflation could be indirect and delayed, the impact of commodities is direct and immediate, as we learned with pain earlier this year. As I mentioned above, it will be commodities bubble and inflation.

Early in the year I expected the first thing the new president, whoever it may be, will do is to call up Uncle Ben and tell him to raise rates and kill off inflation. Yes, there will be short-term pain. But he could always blame that on his predecessor, however well deserved it may be, and take credit for the long-term benefits to the economy. I believe this is the main reason why the bubble contracted in the last two months.

Now, however, no matter how much the new president wants to play the game and Uncle Ben wants to be a good political lapdog, they cannot possibly do enough to kill the pending inflation without causing another crisis.

Yes, taxpayers may make money when the $1T+ toxic asset the Leaders will be buying for us matures or gets sold. But only before inflation adjustment.

Five years ago, the Leaders of both parties committed this once-great country to the Iraq war, with unspecified amount of lives and money for unspecifiedlength of time. "Imminent! Danger! We must act! Now! Don't ask questions! We don't have time for that! Just give me the power and money! Trust me!" Even if future Leaders were willing and capable, they cannot escape the commitment.

Now, the same Leaders will commit this country to years of inflation and generations of massive debt. "Imminent! Danger! We must act! Now! Don't ask questions! We don't have time for that! Just give me the power and money! Trust me!" Even if future Leaders were willing and capable, they cannot escape the commitment.

I'm still holding out hope that this Bailout Pork Package will somehow miraculously be defeated and some better alternatives will be considered with sincerity.

Nah, we don't have time for that. Let's just trust the Leaders. It's not like we have any other choice.

Don't we?

Sunday, September 28, 2008

Bailout Should Have No Strings Attached

Bailout or not, the devil is, of course, in the details. Details like, at what price?

Jake at EconomPic offered an excellent insight on how the bailout plan may result in banks waiting for others to sell to the government first, thus exacerbating the logjam. It goes like this: whoever sells to the government first establishes a price, then others are better off selling at the price in the open market, avoiding penalties such as regulation, compensation cap, and equity dilution.

I'd like to expand on this arbitrage argument, but from another angle. The above analysis means there'll be a premium for selling to the government as opposed to the open market. Based on this argument, one could argue that, the fewer strings attached to the bailout, the smaller the taxpayer premium. I assume this is the argument behind Paulson's objection to any and all costs to the banks opting in the bailout.

As much I resent the bailout idea, this is a valid argument.

But another factor makes the argument even stronger: cost of carry. Whoever decides not to sell to the government or buy from the open market will have to pay cost of carry and take the risk. Risk is obviously very high, even after the bailout provides a backstop, but it's equal for everyone. The cost of carry to a large degree depends on the financial health of the bank. The more desperate the bank, the higher the cost of carry.

Therefore, shaky banks are more incentivized to sell to the government, while healthy ones could afford to hold out more and/or longer in order to avoid the bailout penalty. In other words, many strings attached to the bailout would only result in the taxpayer bailing out the the most shaky banks. This is exactly the opposite of what it should achieve: save the healthy and let a few sick ones perish.

Now this sounds really bad. The bailout idea itself is bad enough to begin with. Now it should not have any strings attached?!

Yes, I mean, no, no strings attached. Just with a bit of the usual bureaucratic delay. But since it's such unnerving times, I say we should specify the delay -- say, one week?

But it doesn't mean taxpayers must be suckers. This is how I would design it: I buy from banks at market price (e.g., average price of the day) plus some nominal premium, say, one week Libor plus 10 bps.

How would this help? The moment the government announces this execution plan, the market will thaw, because there will be people able to buy from the market, pay the cost of carry for a week, and then sell to the government. Who can afford to take advantage of the 10 bps premium? Those with enough liquidity and healthy balance sheet. The desperate ones could sell to the government and/or the market. The only difference is that government is slower. If you can afford the delay, you get to make the extra 10 bps.

The result is the best of the bunch will join the rescue, while the worst ones will provide liquidity and upside pricing pressure to the market, depending on their desperation.

If we have to do a bailout, this is the least costly, most sensible way of pricing it.