Posted tagged ‘credit default swaps’

Getting It Wrong And Ready To Do It Again

July 30, 2014

Presidents are prisoners of the times. Events happen, often following a period of neglect and sometimes following stimulation. Today, our country is neglecting its infrastructure while many Congressional voices try to “stimulate” growth through lower taxes. Hmmm.

I wonder how that will work out?

George W Bush’s presidency offers several cases in point. Inheriting a budget surplus, the Bush Administration, at the first signs of a slowing economy, championed an across the board income tax reduction.

Whether the tax reduction did anything but make the rich richer is hard to say. The economy, in any case, rebounded and bloomed through the rest of the Bush years, that is until it imploded.

Credit default swaps and collateralized debt obligations certainly were not Bush Administration recommendations.  They were instead manifestation of Wall Street greed without regard for the country or their customers.  These financial instruments were like viruses and their unregulated use grew out of control practically taking the world’s entire banking system down.

Once the patient (our economy) was on its back, it became apparent how unprepared the “small” government was. Liquidity became the issue. Banks no longer trusted each other and lending dried up.

Corporations were faced with bleak prospects and watched their stock prices plummet. As a consequent, corporations slashed budgets and associated headcount. Unemployment jumped.

As the dust settled, one could see the economy was working, albeit much less robustly and with far more unemployed. The lesson there for anyone to see was that productivity could be increased simply by removing unneeded overhead. Corporations were operating more efficiently.

Immediately the talking heads turned to how to reduce unemployment. A worthy task, but the how to accomplish it meant everything. Stimulus.

The economy needed to be stimulated with more liquidity.   The only source capable enough and willing to help was the Federal government. After authorizing about $800 billion (reflecting  each Congress members’ favorite pork barrel project), it was time to move on.

Progressives argued the stimulus needed to be increased and conservatives argued it was already wasteful and too large. Hmmm.

About this time, the unfortunate legacy of the Bush tax cuts was catching up with the front page. Debt and unbalanced budgets became the political pros mantra. And single focus issues are political red meat.

Slash federal and state employment and while at it, cut benefits and pensions too, were many politicians favored recommendation.  Many States and even federal agencies followed this path.

Unemployment swelled with public sector workers joining the private sector, recession idled, unemployed.

The unemployment level topped out about ten months after President Obama took office. Standing at 10.1% unemployed, the nation took a deep breath. What more needed to be done?

The stand off between progressives and conservatives may have strangely been a good dysfunction. No more damage could be unintentionally done. It was now up to Adam Smith’s silent hand to reallocate resources to their most productive places.

Five years later there are abundant signs that the economy is strong and resting upon fundamentally firm underpinnings. No particular place in our economy is red hot. Housing is ok but not great. Manufacturing is growing but not that fast. Banks are profitable but not apparently risking their financial health on murky trades. And, the service industry is perking along meeting the needs of the rest of the economy. (It is true also that income inequality rivals the gilded age but that was true before the 2008/9 recession.)

The GOP got it wrong prior to the recession and got it wrong on how to get out of the recession. Democrats got lucky since the financial implosion took place on Bush’s watch. It could have just as easily waited until President Obama was in office.

The Democrats also got it wrong by not looking for “efficiencies” in spending. How can the country get a bigger bang for its buck?

The GOP seems locked into a non-spending mindset (except for defense), while Democrats are quite happy to spend without thinking about productivity. Both parties got it wrong in the past and seem ready to get it wrong again.


JP Morgan Chase Dots The “I”

May 11, 2012

Today, JP Morgan Chase announced a $2 billion loss from one of its security desks that invested in instruments tied to the economy and possibly European sovereign debt.  For JP Morgan, $2 billion is a lot but hardly a lot considering the size of the entire company.  Why is there such a fuss?

From early reports this was 2008 deja vu all over again.  The goal was juicy profits.  The problem, they claimed was poor oversight.  Those pesky credit default swaps which can generate delightful profits (at someone else’s expense) also can cost enormous amounts if the bet goes the other way.  Again, who should care, these are big boys.

The first question is (a) where did JP Morgan get the to money make these bets in the first place, and (b) if these bets lost the announced $2 billion loss, where would the money come from to cover these losses?

As long as the answer is (a) investors’ funds, and (b) investors’ funds, the issue is closed.  Oh, yes dead as long as these investors knew of the risk.  The question is do these conditions apply to this situation?

JP Morgan has been championing the case for less government regulations and in particular with sophisticated instruments such as credit default swaps.  The risk with CDS is that they are a gamblers delight.  CDSs require a buyer and a seller, and can be bought on anything even if the buyer or the seller has no interest in the object upon which the credit default swap applies.

It seems sensible, for example, that if you owned Greek sovereign debt and were worried that the Greek government might not pay, you might want to buy an “insurance like” contract that said “for X amount of money, we will pay you Y amount should Greek debt default.  X is relatively small compared to Y.

The problems should be obvious.  Will the Greeks actually default? Will worries over the possible failure hurt economic growth elsewhere?  Will the CDS seller be able to pay all the parties that bought these contracts Y amount?  Or, more basically, how many people who don’t own Greek sovereign debt might have an opinion (like the EU will bail them out, or the Greeks will default) and just wanted to bet as if this were the Kentucky Derby?

If you think the worst of situations like this, would some bank try to influence European Union policy depending upon whether they stood to gain on default or not.

The Obama Administration has been trying to impose rules starting with the simplest.  “Just how many bets are there outstanding?”   And, “show me once more that only funds being bet are funds that can afford to be lost (that is from willing investors)”?

The financial sector, lead by the big Wall Street banks have fought this every step of the way.  They have used the time honored techniques of lobbying Congress (read money).  Hope now rises again that Congress will reject the banks argument and allow the regulatory process to put some constraints in place.


February 28, 2011

Here’s one way to do it.  You own a small business which in turns owns a building you partially use.  You go to the bank for a loan and bank says you are already over extended with your building mortgage payments.  What do you do?

You say no problem.  You sell off the building, pay off the mortgage and ask for the loan again.

What you do not tell the bank is that you have signed a 20 year lease with the person to whom you have sold the building.  In all likelihood you have incurred the same amount (or more) liability leasing as when you owned.  In fact accounting rules require businesses to “capitalize” leases which have long term obligations.

So what’s this about?

Big banks like Bank of America, JP Morgan Chase, and Citibank would never let someone get away with a slight of hand like this.  Yet when it comes to their own books, they have been quite creative and equally as misleading.

The game big banks play is to “net” their assets.  Let’s say BoA has a trillion dollars in assets surrounding collateralized debt obligations (like with subprime mortgages).  They decide that if they could lover this amount, they could lend more and therefore make more earnings.  No one seems ready to buy these CDOs.

How to do this?

Magic.  Let’s buy some credit default swaps which insure against these CDO’s defaulting.  BoA will pay the CDS issuer some amount of money each year in return for the CDS issuer agreeing to make BoA whole in case the CDO defaults.  In the minds of the big banks, they have reduced the liability of these CDOs to practically zero and therefore they record zero on their liabilities side of the balance sheet.

In a perfect world, this practice might make prudent sense.  In our actual world, CDOs are of unknown value and the ability of CDS issuers to pay up is very questionable.  The practice of using CDS is not risk free.

So as a user of one of these banks, you should know just how much they are exposed to the unknown.  Today you can’t, but hopefully tomorrow government pressure will force banks to reveal all their assets and liabilities and not allow the practice of netting.


Laying Blame

January 28, 2011

There are 633 riveting pages.  The 2008 Financial Crisis is a mystery no more.  The icing on the cake, the crisis could have been prevented.

As crisis go, this was not your average one.  It had a lot of moving parts.  There was the government-gone private Fanny Mae and Freddie Mac.  These twins would buy mortgages from just about anyone.  They were golden because they came backed by Federal guarantees.  Private businesses backed by Federal money.  Hmmm.

Of course there was money in it for banks when they granted mortgages.  As soon as they granted a mortgage, the bank could sell the mortgage to Freddie or Fanny.  This gave the banks new money to grant another mortgage and pocket the fees associated.  No risk and money in the pocket.  Hmmm.

Investment bankers saw some new angles.  Why not bundle these mortgages and sell bonds that promised to pay the equivalent of your money mortgage payment to bond holders.  The original bank had already collected its fees and was collecting more fees for providing local service.  Freddie and Fanny, as well as other lenders could sell their mortgages to the bundlers who would issue bonds.  The bonds issuers, of course, made fees too.  Hmmm.

The investment bankers struck another idea.  What would they do with mortgages that were a little questionable?  Eureka,   Why not bundle a mixed bag of mortgage backed bonds into what they called a collateralized debt obligation.  They would get ratings agencies (Standard and Poor’s, Moody’s, etc) to rate these CDOs.  The highest rated would carry the lowest return, the riskiest the highest return.  The beauty of this approach was that the assigned ratings would be all slight variations of good ratings (whether they really were or not).  Hmmm.

Other creative investment bankers hit upon “slicing and dicing”.  Here they created CDOs that contained pieces of high rated CDOs and pieces of lower rated ones.  The idea was that by mixing (homogenizing) all types of CDOs, risk was spread out and no one would be too exposed.  Sounds like a free lunch.  Hmmm.

The investment banking community could not have done all this if there were not a ready market.  Money was available around the world chasing attractive returns.  Banks and investment firms around the world lined up to by these CDOs.  Why not, home prices kept going up.  Everyone was doing it.  Hmmm.

Not everyone was convinced that home price would go up forever.  Further, the creators of CDOs began to become worried.  They could not sell all of their CDOs.  What was not sold was parked on the banks books.  This required the financial institutions to reserve money they might otherwise have used to generate more income.  How to get these obligations off their books?  Hmmm.

The answer came in the form of credit default swaps.  CDSs are sort of insurance.  Their beauty is that they are not official insurance so they are not regulated.  CDSs are bets that some obligation will default.  One side bets they will default, the other side bets they will not fail.  Their attractiveness is that one side pays the other side money now on the bet that in the future the obligation will default.  Bird in the hand…?  Hmmm.

Before anyone could react the financial sector was awash in CDSs.  Holders of CDOs claimed they had mitigated their risk by purchasing CDSs.  CDS issuers did not have to report the issuance of a CDS since these instruments were not regulated.  And no one check to see what might happen if the CDS issuer could not pay.  Hmmm.

This arrangement grew while house sales continued to grow and feed new mortgages.  When the housing bubble burst, the flow of fresh fees dried up.  In addition, weak housing sales translated into job losses and the onset of a recession.

The next domino was mortgages defaults.  Mortgage backed bonds lost value.  CDO’s became less valuable and in time, CDSs were called on for payment.  Suddenly everyone could see the king had no clothes.  Hmmm.

Banks and financial institutions are one thing if they are anything.  They are distrustful to a fault when their greed is not satisfied.  If there was a chance they would lose money, they would first shut down their money lending operations and attempt to be the last man standing.  The world economy soon felt the impact.  It was not pretty.

At this point the term “too big to fail” gained new life.  Governments around the world bailed out banks and investment firms.  The rest is history.

The conclusion that this crisis could have been prevented should be no surprise.  The report should have said “the crisis should have been prevented”.  The nature of banking and investing is well known.  The fallibility of humans is equally well known, the free lunch trips most everyone.

Dishonestly filled out mortgage application forms, predatory mortgage interest terms, no (or limited) retained mortgage liability (when sold), and unregulated and non-transparent insurance-like instruments all could and should have been regulated.  If already regulated, they should have been enforced.

Greed and hot money cannot be regulated.  They are part of human nature.  The minority report which purports the crisis could not have been prevented does everyone a disservice.  Everyone that is except the banks, mortgage originators, rating agencies, and investment firms.

EU, Wall Street, and ENRON

February 22, 2010

Today’s Wall Street Journal headlines that the EU is worrying about practices that some countries used to conceal the actual amount of debt they were carrying. By concealing the correct amount of debt, these countries (read Greece, Italy, Spain, Portugal and maybe Ireland) could avoid the politically unpopular actions of deceasing spending or increasing taxes. (Sound familiar?) These countries were essentially “cooking the books”.

We are now just emerging from a near global melt down of the world’s financial system because an awful lot of the large global banking and investment community cooked their books. They bought and sold collateralized debt obligations (CDOs) (making juicy profits in the process), and then many doubled down by laying off their risk by purchasing or selling credit default swaps (CDSs) (generating again fat juicy profits). CDSs are an unregulated form of insurance that is suppose to mitigate risk associated with contracts a bank or firm owns. Wall Street was clearly using them to artificially make their books look better so that they could leverage their actual assets even further. When the housing bubble burst and the economy soured, too many people began to default on their mortgage payments. This caused banks to have to lower their book’s CDO values (and therefore their overall asset value), try to raise more capital, and ultimately to call on their CDS partner to pay up. Surprise, surprise, these issuers of CDS did not have enough money to pay. In the midst of this chaos, in stepped Uncle Sam to help save the US banking and probably the world’s banking system (at tax payers’ expense).

ENRON played a game that also cooked the books. They created off shore corporations for the sole purpose of parking “debt” (that was being used to generate earnings), and claimed that these off shore entities did not need to be consolidated in the official ENRON books (even though they were consolidating the earnings!). No one called them on this practice and after much borrowing, ENRON imploded.

There is always the possibility that any business or firm can fail. Someone may build a better mouse trap or modernity may simply make something no longer necessary, and in both cases a company could fail.  Accordingly, debt and debt leveraging practices, long known, have been established with prudent limits to confine and minimize the occasion of failures. ENRON, Wall Street, and now the EU are examples where entities knowingly pushed limits, no one called them out, and found themselves way over the line.

All these examples contain the smell of seeking a free lunch, greed, and ineffective oversight. Government regulators failed, and private accounting and rating firms were complicit. The Obama Administration can learn from these three events and take steps to prevent a reoccurrence. Well, at least until some new greedy entrepreneur offers investors a “new” free lunch and regulators are fast asleep.


August 8, 2009

The Bureau of Labor Statistics released unemployment figures yesterday and the indications were positive. Although there was another monthly loss recorded, it was less than the previous month and fit a perfect upside down bell curve. Barring any surprises you can predict when the monthly results will go positive.  Should everyone celebrate this news and move on to the next issue?

Relatively speaking, the jobs news is very positive. Unfortunately, however, it tells only a small part of the whole story and not a terribly meaningful part on top of that. The news we need to be hearing is the birth of a significant number of new “good” jobs. These are jobs that pay well, are reasonably secure, and produce goods and services that create value. Flipping hamburgers has its place in the world but that does not represent what I am talking about.

The naked truth is if we want to see prosperity again and our children to have a chance at a better life than ours, we need to be celebrating entrepreneurs who create value by mining (solar energy would count), growing, or manufacturing. These entrepreneurs need to be backed by sensible venture capitalists (read wise use of money) and a pool of capable labor talent. Unfortunately, this recent Labor Department statistics has not changed the number high school graduates or the number of them who are functionally illiterate. These statistics, also, have not changed the number of university trained science, math, and engineering job candidates either.

The take home message is “when the jobless numbers turn positive, the game is not over”. America needs to improve the quality of its labor pool and at the same time, allocate its capital to value creation.  There may be a role for CDOs and CDSs but that is not where real value is created and is a sink hole for the capital needed elsewhere.

The AIG Disease

March 16, 2009

Every time there is a call for moderation or even a revocation of bonuses awarded to financial services companies’ top executives, I hear the moans of we need to “reward” these top performers or “else they will go someplace else”.  I am inclined to hold the door open and tell them to not let it hit their backside.  But I’m not a financial sector employee, past or present.

I have a guess, however, why these lame sounding excuses are made,  They mask a fundamental flaw in the structure of most of these very large banks, investment companies, and insurance firms.  The flaw is simply that these firms have grown to large and are spending more energy keeping themselves going than looking after their customers’ best interest.

The consequence of their paralyzing size is that the scramble for year over year earnings increases becomes more inefficient everyday.   It requires these companies to “book” more business from either acquisitions of other companies or the sale of new products (CDOs and credit default swaps are examples of new products).  Managing these mega companies becomes more detached each day from the art of running a financial company.

As a consequence, smooth talking, hard driving executives who “do the deal” and bring new revenue to the firm were prized.   In normal times it was felt these prized assets must be rewarded generously in order to motivate them further and to protect against their departure for other firms.    But these are not normal times and we have the additional benefit of hind sight and can see that these deals were reckless at best and criminal at the worst.

The real rot does not lie with these traders but with the senior management that has set the tone at the top.  A simple rule of the street is that the top boss always earns more than anyone in his firm.  These traders brought in billions, they earned many millions, and the top boss made the most while no one was minding the store.

There is nothing inappropriate for executives who are essentially on duty 24/7 running global companies to earn generous remuneration (compared to the average earner).  The question is always “how much”.  Bonuses (pay at risk) must truly be tied to performance, both up and down, and come with sufficient horizon that a company does not reward this year only to find out next year that performance was not what it seemed.  I would think that while Government should not regulate pay in the private sector, they could look a lot harder at anti-trust implications of large or multi-purpose financial institutions and move aggressively to break up these companies with unjustified remuneration plans.