Welcome to European Tribune. It's gone a bit quiet around here these days, but it's still going.
Display:
Don't some credit derivatives have paiement upon a rate change? i.e., a downrating itself would create a shockwave...

P.S. and there should be a limit of 46 characters to Diary title lengths. So that Re: Title is less than 50 chars.

Un roi sans divertissement est un homme plein de misères

by linca (antonin POINT lucas AROBASE gmail.com) on Wed Jul 4th, 2007 at 09:14:35 AM EST
That is the problem. The credit rating agencies realise this and decide that breaking the rating system is a lesser evil compared to the adjustment that would occur were they to doengrade all these bonds.

To be honest, I hope the SEC takes notice of what the Bloomberg piece is saying, and investigates S&P and Moody's for "alleged distortion of the credit market".

Can the last politician to go out the revolving door please turn the lights off?

by Migeru (migeru at eurotrib dot com) on Wed Jul 4th, 2007 at 09:27:34 AM EST
[ Parent ]
But the SEC might just agree that breaking the ratings is a lesser evil than breaking Wall Street. After all, it's their turf, too...

Pierre
by Pierre on Wed Jul 4th, 2007 at 09:40:29 AM EST
[ Parent ]
The question is how bad is it?. Is this just a moderate adjustment that is being prevented, or a big crash?

Maybe they're just trying to hold out until January 2009, so the crash doesn't happen under Bush's watch?

Can the last politician to go out the revolving door please turn the lights off?

by Migeru (migeru at eurotrib dot com) on Wed Jul 4th, 2007 at 09:48:18 AM EST
[ Parent ]
There is no way they can postpone it so far. On the contrary, I think a 29-like crash before the election is what bushco wants: chaos, state of emergency, raise of the charismatic leader, etc, etc...

Pierre
by Pierre on Wed Jul 4th, 2007 at 09:57:43 AM EST
[ Parent ]
Standard CDS (credit default swap) contracts have a lump paiement upon a default (and the loan with eventual recoveries are transfered to the provider of the derivative security).

But the rate plays a role: as long as the product remains "Marked to Model" (theoretical pricing and not actual quote from a market, which is only available for the most liquid ones, like iTraxx basket and the like, see www.markit.com - nothing is free there).

The "Model" price is a math model of the probability of a default by the time the CDS expires. This gives you a value "averaged over all possible futures weighted by their respective probabilities".

Most of those math models try to extract "implicit" information from the market: notably, when a borrower has issued bond, they have a yield (coupon set a issue divided by price set by market), which has a spread (how many % more than Fed rate is it ??). Risky borrowers have high spreads, which means they must pay exorbitant rates to borrow, thus increasing their riskiness ("on ne prête qu'aux riches")

So the math models computes the risk of default of company ACME in years 1,2,3... based on the spreads of its quoted bonds of maturities 1,2,3 years: actually, you are making a poll of the opinion of traders about if/when ACME will default, except (market quotes + untested math + historical default events to calibrate) replace a lot of phone calls... (+ tricky poll maths)

And the problem is that in the past years, markets have been so in love with risk that the spread range between "sovereign debt" and "total junk" is only a few percentage points.

So basically when the auction at BearStearns & Merril Lynch says that securities traded for 30 to 80 cents on the dollar, it means their spreads are up by 1-20 percentage points. Which means that the new market opinion, according to the models, should now read as: 100% guaranteed total default across the board for all MBS within the next 6 months. Either that, or the calibration is out the window and bankers are now shit scared about risky loans like they haven't been in decades (= total credit crunch)

Most institutions with MBS marked to models should now be basically writing them off, which would require a gov'nmt bail out...

Pierre

by Pierre on Wed Jul 4th, 2007 at 09:55:31 AM EST
[ Parent ]
Just look at how often the topic is mentioned in the business press now. The FT has a major article on the topic almost daily these days.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Jul 4th, 2007 at 10:35:14 AM EST
[ Parent ]
The Fed stopped lowering interest rates and started charging for borrowing - strange notion, eh?  And the Yen carry trade seems to be ending as well.  The US consumer has dutifully consumed and have so many 'assets' that they are bankrupt (Cash Statement.) Investors in the 1,000,000,0000 person Chinese market have discovered - Gadzooks! - 999,000,000 don't have any money and of those that do, a Gucchi rip-off is just as good as a Gucchi.

And on and on and on and on.

The monkeys are no longer in charge of the banana plantation.

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Wed Jul 4th, 2007 at 01:11:58 PM EST
[ Parent ]
What you're saying is regardless of what the credit rating agencies do, isn't it?

Can the last politician to go out the revolving door please turn the lights off?
by Migeru (migeru at eurotrib dot com) on Wed Jul 4th, 2007 at 10:37:26 AM EST
[ Parent ]
Absolutely. It only depends on having a quote for the bond, or bond basket. The more you have, the more it becomes difficult to hide it (one auction with a dozen baskets, 10 bidders, and one quote data point at a single date could still be dismissed as an "outlier"). But as the evidence will pile up, the ratings will become irrelevant to the write off.

Where the ratings matter, is that derating those securities would force a sale by those institutions with a "risk mandate" (e.g. pension funds are not allowed by statutes to detain bonds below a certain quality). Basically, they would have to liquidate their position by the end of the financial quarter, when their reporting is due. And this would provide lots of datapoints regarding the crash...

Pierre

by Pierre on Wed Jul 4th, 2007 at 11:05:30 AM EST
[ Parent ]
Mandated selling because of downgrades will provide "panic mode" data points (i.e. lots of sellers and few buyers), which will feed on themselves in a vicious circle. The unwinding can only be painful, precisely because of these trigger mechanisms, which force transactions to take place and 'shine light' on the whole sorry mess, whose sudden visibility in turn makes the crisis real and feeds it.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Jul 4th, 2007 at 11:11:26 AM EST
[ Parent ]
Can any of you Bears of Financial Brain tell me what the key differences are between a CDS and a Guarantee?

"The future is already here -- it's just not very evenly distributed" William Gibson
by ChrisCook (cojockathotmaildotcom) on Wed Jul 4th, 2007 at 11:28:14 AM EST
[ Parent ]
It's pretty similar, from the point of view of the purpose it serves for "hedging" customers. It's an insurance against default by the borrower, which repays you of the nominal remaining at the time of default (forgoing expected trailing interests, but you can reinvest the premium at the rates available at the time).

And the cost is regular payments, so it really works a lot like those "unpaid lease" insurances that individuals can get for property they let.

But it is different from an asset-backing, in that it is hassle free: you get cash, full stop. No legal action to take to seize the backing asset, no doubt about its future value and liquidity at the time of default, no delays...

The two can coexist: there are CDS on asset-backed loans. But you can't have your cake and eat too. In such cases, the CDS contract says that all you initial entitlements as lenders are transfered to the CDS issuer (that is, they try to recoup the loss they made on a default, by snatching the assets and getting whatever recovery they can - in short, with the CDS, you transfer the hassle to a bank)

Pierre

by Pierre on Wed Jul 4th, 2007 at 11:41:25 AM EST
[ Parent ]
But if, as Pierre suggests, the banks are beginning to get worrying signals from their models even without the credit ratings being downgraded, they will try to quietly reduce their exposure by selling any high-risk debt instruments they do hold. In addition, if they start writing things off, this is bound to show up in their quarterly financial statements. Which will provide more data points.

Can the last politician to go out the revolving door please turn the lights off?
by Migeru (migeru at eurotrib dot com) on Wed Jul 4th, 2007 at 11:40:50 AM EST
[ Parent ]
Exactly. The only way they could conceal this much longer, is if the SEC is complicit and also validates "updates to the in-house models" to shift the baseline as the crash goes.

Note that this will not be easy: I read last week that some (smart shark) hedge funds have shorted the bank stocks, purchased CDS from them without the underlyings (nothing prevents you from doing that, effectively betting on ACME going belly up), and sometimes even shorted the MBS when markets allowed. These hedge funds have officially demanded that the SEC applies regulation swifly and strictly to the big street names (in short: they will not let their preys escape). So there is big money pushing for a crash too, and lobbying power on both sides.

Pierre

by Pierre on Wed Jul 4th, 2007 at 11:48:05 AM EST
[ Parent ]
I read last week that some (smart shark) hedge funds have shorted the bank stocks, purchased CDS from them without the underlyings (nothing prevents you from doing that, effectively betting on ACME going belly up), and sometimes even shorted the MBS when markets allowed.

In other words, fredoiul cannot profit from this any longer, as people with deeper pockets than him and earlier access to information already have ;-)

Can the last politician to go out the revolving door please turn the lights off?

by Migeru (migeru at eurotrib dot com) on Wed Jul 4th, 2007 at 11:50:12 AM EST
[ Parent ]
Fredouille can still give it a try, I just gave the recipe. But it is risky: as always, timing is critical, as if you short too early and wait you pay a lot for margin calls, and some stocks could benefit from (heresy !) ... a bailout !!

Pierre
by Pierre on Wed Jul 4th, 2007 at 11:59:23 AM EST
[ Parent ]

FSA sounds alarm on subprime lending (4 July)

The Financial Services Authority has started disciplinary action against five mortgage brokers for weak "responsible lending" practices in the subprime mortgage market.

The UK financial regulator on Wednesday issued a damning report on the sector, which lends to borrowers with spotty credit histories. Arrears among subprime borrowers are currently running at 20 times those of mainstream mortgage holders, sparking concerns firms have taken on excessive risk in ramping up their lending in this area.


SEC examines subprime market (27 June)

The Securities and Exchange Commission yesterday said it had initiated a broad-based investigation into the troubled subprime mortgage market.

Christopher Cox, chairman of the SEC, told a congressional panel that the regulator was investigating a dozen subprime mortgage issues, including collaterallised debt obligations (CDOs), which are repackaged pools of debt sold to investors.

The SEC is also looking into the secondary market for these instruments.

Asked what had prompted the scrutiny, Mr Cox said "the climate and the environment". He added: "The attention that is being paid generally to problems in this area causes us to be alert to the potential for violations of the laws and regulations that we enforce."



In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Jul 4th, 2007 at 12:24:48 PM EST
[ Parent ]
Funny.  CCox naming the problem "the climate and the environment" and then admitting the SEC is way behind the industry he is in charge of regulating.

Our knowledge has surpassed our wisdom. -Charu Saxena.
by metavision on Fri Jul 6th, 2007 at 07:24:53 PM EST
[ Parent ]
By the way, why would anyone want to enter a marked-to-model swap with the institution that maintains the (proprietary) model? That's naïve in the extreme.

Can the last politician to go out the revolving door please turn the lights off?
by Migeru (migeru at eurotrib dot com) on Wed Jul 4th, 2007 at 11:53:08 AM EST
[ Parent ]
you mean a credit default swap or a regular swap ? I assume it's a CDS you are talking about.

Actually, it is not relevant to the "subscriber of the insurance": most of the time, he wants a hedge. If the rate of payments for the hedge doesn't chew up a too big proportion of the coupons, he'll be happy. He only wants a big name to sell the protection (you don't want your insurance to go belly up, do you ?)

The model is only pertinent to the book value of the contingent claim in the bank's account. Pretty much like the valuation of a portfolio of drivers at an insurer. The problem is that driver insurers have models based on big old historical records where Gauss works very well.

The banks do have a problem: they sold lots of protections for too cheap fees, valuing them a derisory price coming from a fancy model (ACME will default in a credit crunch ? nononon, that can't be). And they thought they were faster than Insurance companies, because models enabled them to roll out new products faster and without waiting for the accumulation of long historical records, etc...

Now the models will either be tweaked or they will make it apparent that lots of cash will be due shortly, and that the hedges of the banks are grossly inadequate. Note that it is only because the swing in the inputs is terrible (from bubble to crunch) that the model can do nothing but confirm the disaster (that common sense could have predicted). We do not know for real how these models would perform in a non-bubble, non-crunch period, because they have never been back tested on such a period.

I take it they are rather poor in that they did not incorporate more indicators that would have raised alarms as early as two years ago in the real estate market.

Also, I think the theoricians will soon discover such realities as "friction" and "inefficiency" in the market. There's plenty of this in an illiquid real estate market (legal costs, janitor costs, realtor fees...)

Pierre

by Pierre on Wed Jul 4th, 2007 at 12:22:06 PM EST
[ Parent ]
The "Model" price is a math model of the probability of a default by the time the CDS expires. This gives you a value "averaged over all possible futures weighted by their respective probabilities".

Most of those math models try to extract "implicit" information from the market...

Implicit information of a model flows from the decision-making structures (schemata) of the model based on the valuation and privileging of the total input stream from what is being modeled.  Baldly, you only see what you're looking for.  

In a mathematical model the problem is compounded¹ by the assumptions of Set Theory as applied in Probability and Statistics.  In the former, a pre-model decision is made to toss all 'unlikely' or low probability occurances into one variable if they are included in the model; in my experience these 'unlikely' occurances are ignored.  

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Wed Jul 4th, 2007 at 12:53:01 PM EST
[ Parent ]
Baldly, you only see what you're looking for.  

It's not that bad. When you have a model (produced by scratching you head), and you miss a few calibration parameters, extracting them from the market is like asking around a closed question (answer: yes/no or a single digit, or which box gets checked). In many cases, this actually works very well, pretty safe, and anyway there's no other way you can cope with the volume dealt everyday (I'm thinking of plain vanilla put/call options here, on stocks or currencies).

Like every closed question, it has a preconception of the world. The answer will not tell you that may be you should take a broader perspective and rethink your model because times are changing. You only realize when the results become unstable with time, or you lose money... And then you make the model smarter (like Local Volatility vs. Black-Scholes after the 1987 crash)

The problem is credit derivatives have had no prior "model testing, low volume phase". The bubble brought the volumes to the top tier of the banking business in 5 years.

Pierre

by Pierre on Wed Jul 4th, 2007 at 01:08:38 PM EST
[ Parent ]
The use of "Bad" is a value judgement which you, not I, applied.  As you said, "...there's no other way you can cope with the volume dealt everyday ..."  That doesn't imply, however, what is not covered in the model can't hurt you.  (For a given value of hurt.)

This is (1) a subject I'm greatly interested in; (2) can bore people for days discussing; (3) getting way off topic.  


She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Wed Jul 4th, 2007 at 01:49:18 PM EST
[ Parent ]

Display:

Top Diaries

Occasional Series