The CDS (credit default swaps) are actually just an insurance mechanism (you insure against failure of a debtor to repay). Only when you insure a risk that you do not have in your book, do you make a gamble. And it is not the primary goal.
The CDO (collateral debt obligations) are a risk and reward sharing agreement where everything is laid bare right at the start, no optional clauses, even if the risk-reward trade-offs are not homogenous between the tranches (tranche is slice, in french, I dunno why it is so, may be the first CDO's were "cooked" by a french chef). It is in concept no different than age-old practice of companies having preferential dividend shares, multiple-vote shares, golden shares, death-pill shares, etc, etc...
There are two Ponzi schemes in effect in the present crash, but they are not where you think. The first is simply the fractional reserve banking system itself. Techno just posted a diary which pretty much justifies it a mean of growth to get where we stand now (a mature industrial civilization), I doubt it will still be adequate for the post-peak contraction.
The second scheme is a classic ponzi bubble of selling an overvalued good for yet more money, to "some yet greater idiot": more and more bankers, brokers, realtors (all fee-earning), and yes even borrowers (who made capital gains refi after refi), where lured into a system of easy money that lasted until there was no more fools to bring in to keep the prices going up. And the last of the fools where simply those of the lesser quality (the subprime borrowers), and they were brought in as a last resort to keep the scheme running for another cycle because the guys before them didn't want to be the loosers. Pierre
He was refering more to a (demographic) age pyramid.
He was? Where? I don't see any implication that demographics are involved.
It is in concept no different than age-old practice of companies having preferential dividend shares, multiple-vote shares, golden shares, death-pill shares, etc, etc...
The differences:
least risky tranches at the top and the more risky tranches with commensurate premiums towards the bottom
it's drawing loans like an age pyramid, except you don't sort by year of birth but by year of default (death). Early years bottom, already defaulted->equity tranche, future years (not yet defaulted) --> up in the senior tranches.
This extra value when siphoned off repeatedly from the overall mortgage pool required an ever larger base of sub-prime mortgages in the new pyramid shape, thus increasing the systemic risk further
Here actually he gets plain wrong, or he's trying to push a point to a laymen audience the wrong way. Once a given loan fund is built to be sliced in new CDO, no more loans are added to it. New loans -> new wagon of funds, tranches, etc... You don't feed new risky loans in a sold out fund.
The nexus that connects the CDO and subprime, is that CDOs enabled bad loans to be dumped on the market. There are not enough buyers for all bad loans if they are all rated junk. The CDO, by putting "watermarks", enables packagers to pretend most of the fund is safe and find buyers for it. So they siphoned Wall Street money into McMansions where realtors shoved illiterate borrowers. And everybody took a fee in the process. And to keep on the promises that borrowers could refi, they had to find more borrowers to keep the prices going up. The ponzi scheme is here, and not in the building of the tranches.
The differences:(snipped)
Totally agree. 1) The behavior of rating agencies was fraudulent, close to Arthur Andersen in the Enron case, and they will face consequences. But this is not intrinsic to CDO slicing, the greed and the low rates have turned US real estate financing into a giant fraud, and the fraud just used the fashionable instruments of the time 2) and 3) Yup, it's a political thing, and the politicians will use the RA as a fuse when they are equally guilty. Pierre
but by year of default
So the tranching is done a posteriori, the loans are not pre-sorted?
Say you have a CDO with three loans and three tranches. One of the loans default now, it is automatically assigned to the last tranche owner who now have a foreclosed house, right?
The problem in valuing such CDOs being that in a crisis, like a bursting of the housing bubble, the probabilities of individual subprimes loan takers to default become highly correlated rather than independent events ; if one underestimated that correlation, one overvalued the senior tranche of the CDO, which is why some end up being hit unexpectedly, having to pay premiums they didn't think they'd have to. Auferre, trucidare, rapere, falsis nominibus imperium; atque, ubi solitudinem faciunt, pacem appellant.
Assuming the institution holding the loans bought CDO when defaults happens they get both the house and the CDO pre-decided payment, right?
And then, defaults are cumulated by value of coupon and capital lost to determine what tranche they hit.
Ok so it's not purely time of default based, and capital lost plays a role according to you, so not exactly what I understood from linca.
I guess the devil is in the details of each CDO but it's hard to judge what's going on. My questions resolve around wether the holder of loan+CDO can make money in case of default or not (payment of CDO + payment from selling the house > original price of loan + original price of CDO).
http://en.wikipedia.org/wiki/Collateralized_debt_obligation
My questions resolve around wether the holder of loan+CDO can make money in case of default or not
I don't think this is possible. Actually, the holder of a CDO tranche security will never get a house back. The fund has a contract with a realtor for day to day management of the pool of houses, and when there is a default, this manager will arrange for a refi settlement, a foreclosure, a rental, or an auction to try to make the best money out of it. But in any case, it is only money that is funneled back to the owner of the security. There is a default as soon as the coupon (interest payment) is not 100% of what is was meant to be (there can be partial payments) and/or the nominal has lost value (because it is already known that a house has been auctioned off for less than what had been loaned for it, and the borrower is bankrupt).
So for the owner of a risky tranche will never make a capital gain. In the extremely unlikely event that a defaulted house becomes fund property, is rented while the market is depressed, and may be sold at a gain much later, the excess money will be used to offset other losses in the fund. And if there was a total surplus (which would require the housing market to skyrocket next year), the remainder would go to the funds sponsors (a bank), not the CDO holder.
Because remember: a CDO belongs to the realm of "fixed income" securities, like a bond, and the nominal paid at maturity is agreed at the beginning. There is a coupon to pay a premium for a risk of default, but rarely a performance bonus !! this is in the realm of corporate/venture stock only ...
Note that a local boost in housing is not impossible: if a godzilla hurricane destroys all of florida and 10 million have to be relocated, funds that are geographically focused (on other areas) would benefit. But for the banking system as a whole, it's still a disaster, whatever happens now. Pierre
Thanks for the precisions!
This is the structural un-sustainability of CDO securitization, irrespective of the state of the economy...
I am still puzzled with what drove new CDO buyers to enter. There hadto be something promising - or was there no profit chain, only fear of loss?
It possible that the excitement with CDOs coincided with the first problems of subprime mortgages. Someone may have figured out that a way to get rid of "junk" packages (or to mitigate a subprime fallout temporarily) was to unwrap the pyramid potential of CDOs. On the other hand, I heard that CDOs were rarely traded... Was there only a frenzy of buying new CDO items?
There is no pyramid to unravel in CDOs themselves, the pyramid is in housing. Just a debt-fueled asset bubble, and the repackaging makes it very hard to know who is hit (or hit worst, as everybody will be hurt eventually).
And it's not a subprime thing either. Supbrime just happens to be the first bubble to burst, but there is more than one bubble in the US today. Presently a large proportion of traded US corporate bonds are junk rated, and it's only the easy refi that kept them from defaulting. It will come next, in 2008, and it will be even bigger than subprime. And there will be CDOs too, and again, they are not the pyramid, they are just spaghetti on top of it ... Pierre
CDOs, which are debt instruments, are built as a pyramid. The bonds are packaged into different tranches of securities. At the bottom is the equity tranche backed by the riskier debt or loan collateral. On the top of the pyramid are the "super senior tranche" first, followed by the triple-A rated tranches. Those senior tranches are backed by investment-grade debt or high-quality loans. In between are the mezzanine tranches, which offer a bit of a mix of the pros and cons of both extremes. Naturally, the equity tranche at the bottom of the pyramid is the one with the potential highest risk and reward, which is why it offers the highest yield. The senior tranches on top of the pyramid pay the lowest yield because they are safer, being backed by higher credit-quality assets and benefiting from the "cushion" offered by the equity tranche that gets hit by losses first in the event of credit downgrades affecting the collateral. Typically hedge funds get involved in the CDO market for two main reasons. The first is to obtain returns. In such cases they act as CDO investors, buying almost always the rewarding equity tranche. The second reason will lead them to issue CDOs in order to obtain a new source of funding. In these cases they are the collateral managers, those who gather and buy the assets for the collateral pool. They obtain funds by issuing the notes sliced into the various tranches that are offered to the market. Hedge funds in such cases are no different from the corporations that issue bonds on the capital markets for their funding needs.
Typically hedge funds get involved in the CDO market for two main reasons. The first is to obtain returns. In such cases they act as CDO investors, buying almost always the rewarding equity tranche. The second reason will lead them to issue CDOs in order to obtain a new source of funding. In these cases they are the collateral managers, those who gather and buy the assets for the collateral pool. They obtain funds by issuing the notes sliced into the various tranches that are offered to the market. Hedge funds in such cases are no different from the corporations that issue bonds on the capital markets for their funding needs.
This is from Bloomberg.com, no less:
Bundling mortgages into asset-backed bonds and then agglutinating those bonds into collateralized debt obligations sliced into different flavors of risk always smacked of a sophisticated pyramid scheme. As the foundations crumble, even the apex of the CDO market is looking shaky.
This book has a big chapter on CDOs (No 20), and this chapter:
4. Liquidity, the Credit Pyramid and Market Data 4.1 Bond liquidity 4.2 The Credit Pyramid 4.3 Survey and engineered spread data 4.3.1 Survey data 4.3.2 Engineered data 4.4 Spread and rating
And here you can find some technical info about "Fortis Bank Pyramid CDO, a Euro 268mm ABS CDO". Is this an apt name for some financial product?
The following reference is more rhetorical, but still informative:
[All buyers] liked the extra yield this stuff provided and chose to ignore the dubious basis on which A credit ratings were obtained or the fact that these instruments were not traded and so could not be marked to market. They were worth what the issuers said they were worth - until they tried to sell them. The sheer scale of these ponzi activities is indicated by the fact that in the first quarter of this year alone US$251 billion worth of CDOs were issued and including US$121 billion of credit default swaps - instruments by which banks sell risk to each other.
The sheer scale of these ponzi activities is indicated by the fact that in the first quarter of this year alone US$251 billion worth of CDOs were issued and including US$121 billion of credit default swaps - instruments by which banks sell risk to each other.
The first link is wrong in its description of CDOs, BTW : the seniority of the upper tranches comes not because they are backed by safer securities, but because it is supposed they'll have to pay premiums only if all the backing debtors default, which is supposed to be very unlikely (and which may prove to be false in the case of subprime CDOs) Auferre, trucidare, rapere, falsis nominibus imperium; atque, ubi solitudinem faciunt, pacem appellant.
"They were worth what the issuers said they were worth - until they tried to sell them."
A Ponzi scheme means essentially that you give the first entrants high returns with the money invested by later entrants ; this is not the scheme of CDOs at all : CDOs are insurance contracts. Auferre, trucidare, rapere, falsis nominibus imperium; atque, ubi solitudinem faciunt, pacem appellant.
The lack of CDO trading was especially emphasised at the moment of BNP Paribas crisis. CDO valuation was anything but effective. Banks and hedge funds would have normally sold junk CDOs away, but they were scared reveal the real value of CDOs; and the real value of CDOs was opaque because they were rarely traded. That was the reasoning so shortly ago.
I'm guessing the first few iterations of the high-risk tranches would have posted impressive returns, and this would have been enough to persuade hedge funds to funnel money at them, starting a mini-Ponzi stampede, which would in turn have made CDOs as a whole look more attractive - especially with unrealistic risk ratings.
All it's going to take is proof that someone somewhere moved money from Tranche A to pay off a high return on Tranche B in the hope that money would come in to cover Tranche A at some point, sooner or later, and you have a classic Ponzi.
I'll be surprised if no one tried this.
And the 'real value' of anything is given by the market, anyway, in our utilitarist world. Auferre, trucidare, rapere, falsis nominibus imperium; atque, ubi solitudinem faciunt, pacem appellant.
Each mortgage refinancing gave the old loan - and the CDOs covering them - immediate and safe profit, while shifting the risk to a new loan - and new CDOs.
Wall Street was probably betting on continuous refinancing. In that case subprime loans in CDOs were very attractive because they were "guaranteed" to be refinanced soon, ending all risk.
Here we see a classical element of a pyramid scheme: profit of one item is based on a generation of new items.
Exponential branching appears to be missing on the mortgage level, though typically greater size of new loans alone may be generating a commulative effect. The "slicing and dicing" routine with CDOs probably make a pyramid "complete", through a mathematical model is welcome.
Pyramid elements are floating around, and they make the CDO scheme very unstable. Like in a straight pyramid scam, looks excitingly fine until a logically unavoidable limit is met. In the CDO case, the limit is met when the real estate inflation and refinancing tricks must stop. More generally, broad economic models conspiciously lack clear acknowledgment everything of positive feedbacks, as Michael Hudson notes. We are left then with Ponzi/pyramid frazeology with every hurting runaway boom and bust.
... but the profit is not generated by the refinance of the loans ... indeed, the investment grade tranches are protected from pre-payment risk, as well as default risk.
What the refinance of the loans did was obscure the systematic risk faced by the holders of the higher return junk grade tranches. Utsukushikereba sore de ii
But it can be said that the profit is "in effect" generated by the refinance: the books are closed for the old loan and in parts of the related CDOs. Those parts in CDOs get a final profit margin, "at expense" of new CDO items.
Although the profit before refinance is supposed to be small (since interest is low until refinance is "forced" by high interest rates kicking in after a fixed time period), the tranching trick may give the lower CDOs higher than the nominal profit: If I understand right, the lower tranches are first to take any gain or pain. In this picture, it is the senior tranches that look like total suckers: they get meager profit in good times, and they are not really protected in bad times anyway. But I may need to learn (if I would dare) all details of CDO slicing to be sure.
That is, to be precise, reserve banking is not intrinsically a Ponzi scheme ... provided the credit contract created by the bank is sound, the credit money is sound.
What is required to prepare reserve banking for the post-peak loss of ongoing extensive growth, to be replaced at best by periodic waves of technology driven intensive growth, is a return to low and stable cash rates and regulation of banking operations to require prudent behavior.
Or, in other words, all those prudential regulatory schemes instituted in financial centers after the Great Depression, which have been progressively stripped away since the 60's. Utsukushikereba sore de ii
A Ponzi scheme (or Ponzi financing, as in Minsky's theory) is a scam initiated by an entrepreneur seeking investment. Mr Ponzi himself did this that way: he promised and initially gave high return for investment, which attracted much more investment, so that for a while he was able to give high returns from the investment growth alone. But of course, he had top cut and hide at some time.
Ponzi financing may occur not only as a designed scam, but from enterpriser's desperation as well. I call the Russian GKO scheme because the initiative came from the Russian government (for whatever reason), not from investors.
The situation of "too much money chasing too few assets" has different flavor. Here the initiative comes from eager investors. The mild term for this run is "asset inflation". I would avoid to use "Ponzi" or "pyramid" terminology here. I do not actually know how to call this stronger.
In a narrow sense, a pyramid scheme is a scam with a defined structure (mathematically, an exponentially growing tree graph) of cash contributions and flow. Here there is no formal distinction between investors and enterprisers - everyone plays the same role if only the game can continue indefinitely. Ironically, the current situation with all investors borrowing and all entrepreneurs investing is very analogous in this respect.
More generally, to incorporate the cases like CDO (presumably) a pyramid scheme can be defined as any designed or emergent financial structure with something organized within an unsustainable pyramid "geometry", as Liu describes. That would be the general idea.
The first paragraph should end: But of course, he had to cut and hide at some time.
The last paragraph should better by typed as More generally, to incorporate the cases like (presumably) CDO, a pyramid scheme can be defined as any designed or emergent financial structure with...
And the stronger characterizations of "asset inflation" can probably be "bubble" or "overheating".
Prudential finance involves debt that can be serviced by the income from the financed activity even if income flows from the funded project fall short of projections ... how prudent is a matter of how bad things can turn and still service the finance.
The trap that CDO are heir too is, rather, a debt-farming shell game. If the top tranche of a CDO is considered an investment grade asset, and so allows participation in non-investment grade activity by those limited to holding investment grade assets, and the low risk premium = high price of the investment grade tranche(s) more than compensate sofr the high risk premium = low price of the junk grade tranche(s) ... then instead of the classical small town bank looking on the interest on mortgages (and small business loans) as its bread and butter, mortgages become a way to generate ongoing commissions on origination, selling the mortgages on in order to be able to originate more.
Of course, market pressure will invariably push the finance sector into non-prudential behavior until a series of events realises the systematic risk that has been lying dormant ... unless a regulatory authority imposes a market penalty for engaging in non-prudential behavior. And it is the reaching for those short term gains (ignoring their attendant long term pains) that has driven the ongoing stripping of prudential regulation from financial systems around the world. Utsukushikereba sore de ii
