American Unemployment Rate Approaches 10%

[Admiral Yi]

There is one  thing that I don't get.  Assuming there is something about securitization (tax advantages?  balance sheet advantages?  it's just what they do?) that led the investment banks to participate in the subprime bubble and stay out of previous bubbles, that still doesn't explain why they decided to double down with CDS's.  Default insurance is not a brand new financial product.  Why did they bet the house on subprimes, and not on, say emerging market debt?

[alfred russel]

There is one  thing that I don't get.  Assuming there is something about securitization (tax advantages?  balance sheet advantages?  it's just what they do?) that led the investment banks to participate in the subprime bubble and stay out of previous bubbles, that still doesn't explain why they decided to double down with CDS's.  Default insurance is not a brand new financial product.  Why did they bet the house on subprimes, and not on, say emerging market debt?

Did anyone double down on CDS besides AIG? Before they went bust, AIG did disclose what they were doing, and that was taking advantage of the "arbitrage" opportunity of MBS paying higher interest rates than less risky assets. Essentially they decided that MBS were virtually risk free, and they were going to put all their eggs in that basket (the CFO communicated to an analyst in a conference call that they saw very little chance to lose money). One way they did this was purchasing CDS, which would provide significantly higher returns than purchasing the assets. Another was through securities lending. CDS is getting a lot of publicity, probably because derivatives are the boogeyman of our times, but AIG lost more through securities lending (they would lend, or "temporarily sell", their securities to other companies and use the cash to invest in MBS, rather than treasuries or other relatively riskless assets as is typical).

I don't know to what extent the banks doubled down, or whether they were just holding some product in the course of business which went bad and general business conditions helped to conspire against them.

[Admiral Yi]

I don't know.  Lehman went bust on commercial real estate.  What about Merril and Bear Sterns?

[alfred russel]

I don't know.  Lehman went bust on commercial real estate.  What about Merril and Bear Sterns?

I can't tell you.

[Hansmeister]

There is one  thing that I don't get.  Assuming there is something about securitization (tax advantages?  balance sheet advantages?  it's just what they do?) that led the investment banks to participate in the subprime bubble and stay out of previous bubbles, that still doesn't explain why they decided to double down with CDS's.  Default insurance is not a brand new financial product.  Why did they bet the house on subprimes, and not on, say emerging market debt?

Because there was an implicit guarantee by the gov't (thru freddie mac and fannie mae) that they could always sell it at no risk.  Basically, the high-risk subprime morgages became the surefire way to make a profit.  People make the argument that since the two entities didn't own that much of the subprime market it is wrong to blame them for the failure, which is nonsense.  As long as there was the believe that they would always buy them up, they didn't actually have to own it to affect the entire market.

Why did they take such a radical step? because in the late '90s the gov't decided that the only way to get financial institutes to lend to minorities to increase their homeownerships was to remove the risk to the lender. 

You'd be happy to know that the very person who designed the financial instruments to expand subprime mortgages while working for FM has been appointed the head of the Federal Housing Authority by Obama.  Since then the FHA has picked up the slack for the two failed institutes, building up the next housing crisis.

[Admiral Yi]

That *might* explain some of the appetite for MBS's, but it doesn't explain the appetite for CDS's.

[alfred russel]

That *might* explain some of the appetite for MBS's, but it doesn't explain the appetite for CDS's.

The main reason there was an appetite for CDS's is because that provided an effective way to speculate on a company's solvency. If you think GM is going to run into financial distress, you can short the stock and make a 50% profit, or you can buy a CDS and make a 1000% profit.

In terms of being "insurance", there was some of that going on. AIG disclosed it was helping companies achieve "regulatory arbitrage." Basically European regulators were uncomfortable with the banks holding MBS, but were okay so long as they were protected by CDS written by AIG. But "insurance" uses such as that was not the primary use: the notional value of CDS's written exceeded the value of the debt they were written on. They were primarily ways to speculate.

[alfred russel]

Because there was an implicit guarantee by the gov't (thru freddie mac and fannie mae) that they could always sell it at no risk.  Basically, the high-risk subprime morgages became the surefire way to make a profit.  People make the argument that since the two entities didn't own that much of the subprime market it is wrong to blame them for the failure, which is nonsense.  As long as there was the believe that they would always buy them up, they didn't actually have to own it to affect the entire market.

Why did they take such a radical step? because in the late '90s the gov't decided that the only way to get financial institutes to lend to minorities to increase their homeownerships was to remove the risk to the lender. 

You'd be happy to know that the very person who designed the financial instruments to expand subprime mortgages while working for FM has been appointed the head of the Federal Housing Authority by Obama.  Since then the FHA has picked up the slack for the two failed institutes, building up the next housing crisis.

There was an implicit guarantee that the US government was going to stand behind Fannie and Freddie's debt, but there was never a guarantee that Fannie and Freddie were going to stand behind nonconforming debt, even if they did buy a portion of it. The ratings agencies and the buyers of the debt screwed up, and to the extent the mortgage companies and investment banks should have been doing do diligence, they screwed up too. 

[Admiral Yi]

The main reason there was an appetite for CDS's is because that provided an effective way to speculate on a company's solvency. If you think GM is going to run into financial distress, you can short the stock and make a 50% profit, or you can buy a CDS and make a 1000% profit.

In terms of being "insurance", there was some of that going on. AIG disclosed it was helping companies achieve "regulatory arbitrage." Basically European regulators were uncomfortable with the banks holding MBS, but were okay so long as they were protected by CDS written by AIG. But "insurance" uses such as that was not the primary use: the notional value of CDS's written exceeded the value of the debt they were written on. They were primarily ways to speculate.

I meant an appetite to sell CDS.  Sorry I wasn't clear.

[alfred russel]

The main reason there was an appetite for CDS's is because that provided an effective way to speculate on a company's solvency. If you think GM is going to run into financial distress, you can short the stock and make a 50% profit, or you can buy a CDS and make a 1000% profit.

In terms of being "insurance", there was some of that going on. AIG disclosed it was helping companies achieve "regulatory arbitrage." Basically European regulators were uncomfortable with the banks holding MBS, but were okay so long as they were protected by CDS written by AIG. But "insurance" uses such as that was not the primary use: the notional value of CDS's written exceeded the value of the debt they were written on. They were primarily ways to speculate.

I meant an appetite to sell CDS.  Sorry I wasn't clear.

If you are in the business of providing financial services, why wouldn't you write them, provided they were at the right price and didn't put your institution at risk?

AIG determined that MBS were essentially risk free, so why wouldn't they write as CDS contracts as they could, considering they didn't have to set up a reserve, their AAA rating was a significant part of their collateral, and the risk was substantially off balance sheet and the rating agencies were apparently not concerned. I don't think anyone was as far out on a limb as AIG was, but the same principles apply.

[Admiral Yi]

Well yeah, IF their assumptions were all correct CDS's were a fabulous line of business.  My whole point is their assumptions were boneheaded.

[DGuller]

Well yeah, IF their assumptions were all correct CDS's were a fabulous line of business.  My whole point is their assumptions were boneheaded.

Sometimes stupidity is not only the simplest explanation, but also the one most correct.  Sometimes you get so caught up collecting the nickels that you lose track of the steamroller creeping up on you.  Pricing tail events is extremely difficult, and it's all to easy to get false comfort in models that are more precise than accurate.

[Admiral Yi]

Pricing tail events is extremely difficult, and it's all to easy to get false comfort in models that are more precise than accurate.

How was the subprime meltdown a tail event?  That's the line the AIG CEO was pushing and I just don't see it.

[DGuller]

Pricing tail events is extremely difficult, and it's all to easy to get false comfort in models that are more precise than accurate.

How was the subprime meltdown a tail event?  That's the line the AIG CEO was pushing and I just don't see it.

I guess I was speaking more from the point of view of the AIG financial products quant.  They thought they were selling "insurance" that would almost never be cashed in.  That makes it pricing a tail event.  Even if they were right, they were being too careless doing that.

[Admiral Yi]

FYI just read a book review in the NYT and Bear Sterns, Lehman, and Merril were all big into CDS.