Reputation risk and SIV sponsors

This bridge is well known: it's in Newcastle, and if it fell down, it would have a reputational impact on the city. What you build reflects on you: well, if it's beautiful; badly if it's ugly and it fails.

This brings us nicely to structured investment vehicles or SIVs. (This or this are not too bad if you're not up on SIVs and SIV-lites, although take them with a pinch of salt: by 'highly rated' they do not of course mean 'highly likely to return principal'.) Barclays is in the spotlight again after restructuring a number of SIVs it was involved with. While some of the comment has been positive, one cannot help but wondering if what they have build is reflecting entirely positively on them.

Liquidity Dynamics

Three pieces of recent news seem interlinked. Barclays used the Bank of England window to buy in liquidity at a penal rate. The president of Moody's thinks that what we're experiencing is an extreme lack of confidence and lack of liquidity. I have never seen this before. And the CP market is still shrinking.

This highlights the importance of liquidity and suggests that it would be interesting to incorporate liquidity dynamics into models of market returns. A model that just accounts for asset returns is not that useful in many cases if the implicit assumption is that prices can fall but you can still sell. The reality in many securities at the moment is that the holders strongly suspect that prices have fallen but they have no real idea because there is no liquidity.

Extreme value theory might account for the tail of the return distribution well for liquid assets like the S&P 500 future, but it isn't much use by itself if it tells you your ABS can fall by 50%. For many securities a large fall in value implies extreme illiquidity and hence a large measure of uncertainty as to the right mark to market. So the possibility of a 50% fall is not a useful quantification. Instead it would be useful to have a theory that says 'today your ABS is worth 98 +/-1 and you can sell it in a day. In a year at 99% confidence it might be worth 50 +/- 25 and if it has fallen that far, you can sell it in three months'.

Finally, some real liquidity, from the Wild Coast of South Africa.

It's all about funding baby

From the FT:

Standard & Poor’s issued a string of downgrades and negative watch notices on a number of SIV-lite programmes late on Tuesday night.

SIV-lites, a type of collateralised debt obligation that rely on short-term commercial paper to fund senior debt, have come under intense pressure due to falling values in their investments combined with a liquidity crunch in commercial paper markets.

“A vast majority of the portfolio of each of these market-value structures is invested in US mortgage securities,” S&P said.

A few things are becoming clearer. Firstly isn't it amazing the number of structures that have MBS in them? I guess you can think of CDO of CLO paper as a Libor floater, but putting in a money market fund is just bizarre. Putting some in a SIV makes more sense, but weren't SIVs meant to be diversified? Having a vast majority of your funds in anything is not diversification.

Secondly it's fascinating that the price of liquidity is such a dominant factor at the moment. No one much cares if these structures are ultimately money good. What is hurting is how much it is costing to keep them afloat in the current liquidity market. This makes ABCP look like a much worse idea now that it did a couple of months ago.

Finally this is so predictable it is deeply amusing:

Meanwhile, Moody’s said a constant proportion debt obligation run by UBS had been hurt by falls in net asset values and put it on review for possible downgrade.

I'd be interested to know how ABN's CPDO structures are doing...

Update. According to Bloomberg, CPDOs Rated AAA May Risk Default, CreditSights Says. In the immortal words of my friend Sue, no shit Sherlock.

Godot waits for the close.

Vladimir: Subprime?

Estragon: Subprime.

Vladimir: Slime.

Estragon: Triple A.

Vladimir: Exposure?

Estragon: Exposed.

Vladimir: Leveraged.

Estragon: Leveraged and Funded.

Vladimir: Funded?

Estragon: Roll coming up.

Vladimir: Roll that CP.

Estragon: CP?

Vladimir: ABCP.

Estragon: The End.

(Inspired by Long or Short Capital.)

Liquidity Markets

Caroline Baum writing for Bloomberg points out that Bernanke of the FED is an expert on the Great Depression:

Bernanke [...] wrote in a 1983 paper for the National Bureau of Economic Research (``Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression''): [...] ``the financial crisis of 1930-33 affected the macroeconomy by reducing the quality of certain financial services, primarily credit intermediation.''

Translation: Many commercial banks, considered efficient at allocating credit (they have a knack for differentiating ``good'' from ``bad'' credits), failed. The ones that remained solvent wanted to hold liquid assets or, if they were willing to make loans, charged a higher rate of interest.

Then and Now

``It was reported that the extraordinary rate of default on residential mortgages forced banks and life insurance companies to 'practically stop making mortgage loans, except for renewals,''' Bernanke said, citing the work of the late economist A.G. Hart.

Sound familiar? The rate of default isn't extraordinary just yet, but the mortgage market is contracting in leaps and bounds, starting with originations and ending with securitizations. The tentacles of the home-loan market are starting to strangle portions of the debt, equity and even the normally staid money market.

Bernanke is fully sensitized to the collateral damage damaged collateral can cause. Over and over in speeches during his stint as Fed governor from 2002 to 2005, he returned to the subject of the Great Depression, detailing where the Fed went wrong and what the Fed could have done to ameliorate the problems of the banks (provide liquidity or lower interest rates).

This is interesting as we are now in a true market for liquidity. Cash is a rare commodity at the moment and those people who have it are charging through the nose for it. The reason it's rare is that the market has woken up to their lack of knowledge of default probabilities both for securities and for their counterparties. A triple A rating doesn't mean much for ABS, and nor does a AA- give much comfort when attached to a broker/dealer in current conditions. Faced with this ignorance and in many cases plummeting or highly uncertain or both collateral values, the market is making people who want cash pay up for it. One ABCP conduit, for instance, with a (nearly full) guarantee from a very good credit quality sponsor and good quality assets was paying Libor plus 40 for one month CP this week. That's extraordinary if you think you can estimate the joint default probability of the assets and the sponsor and you are charging for that risk. It isn't if you have cash, they don't, they need it badly, and there is no one else they can go to. Then you can charge what you like...

There is no risk

Well not quite. But here's the thing. Roubini Economics Monitor discusses the distinction between risk (in his terms variability in outcomes that can be estimated statistically) and uncertainty (unknown or unmeasurable outcomes). The basic idea in this article is that risk can be priced but uncertainty can't:

Economists distinguish between “Risk” and “Uncertainty”: the former can be priced by financial markets while the latter cannot. The distinction between the two was made by the famous economist Frank H. Knight in his seminal book, Risk, Uncertainty, and Profit (1921). In brief, “Risk is present when future events occur with measurable probability” while “Uncertainty is present when the likelihood of future events is indefinite or incalculable”.

This is all very well but unhelpful as in these terms the financial markets have no risk, just uncertainty. We never know that our modelling is right and we have correctly estimated risk because we don't know what random process the underlying is following. We don't known what lies beneath. We just hope for the best and under ordinary conditions mostly we are right.

Structuring does not add to uncertainty, it just translate an unknown return distribution into an unknown P/L distribution in a deterministic way. Thus while this quote correctly describes some of the RMBS market:

First, you take a bunch of shaky and risky subprime mortgages and repackage them into pass throughs; then you repackage these PTs in different (equity, mezzanine, senior) tranches of cash CDOs that receive a misleading investment grade rating by the rating agencies; then you create synthetic CDOs out of the same underlying RMBS; then you create CDOs of CDOs (CDO squareds) out of these CDOs ... then you stuff some of these tranches into SIVs or into ABCP conduits or [even] into money market funds.

It does not effect the epistemology of the situation. What we are seeing now is a combination of leverage (which again purely deterministically magnifies any modelling errors) and model risk producing a liquidity crisis as people have suddenly noticed how uncertain the value of their securities is. That doesn't mean it wasn't uncertain earlier, just that they didn't know it was uncertain. Those unknown unknowns have become known unknowns, and that is why we have a problem.

Rational Default

(R.I.P. subprime, alt-A, negative am hybrid arms and all those other delightful mortgage market innovations.)

Over on Calculated Risk, Tanta discusses the behaviour of U.S. home owners given the availability of negative amortisation mortgages. (Essentially an option ARM had very low initial payments, so you could buy a large house with one of these even if you didn't have a large income, then if the house went up in value, sell it before the low interest period ended. If it went down in value, you just defaulted and tried again with a different property. The negative am part is that the reason the interest payments were so low was that some interest was capitalised into the loan amount.

It was the policy makers who didn't recognize rampant speculation in the housing market. While we joked about "liar loans" here on Calculated Risk, the policy makers were congratulating themselves on the "ownership society". I'd argue home buyers who used no money down option ARMs were making a rational choice: they were balancing the odds of a big payday with little financial risk - if the property continued to appreciate - with the stigma of a foreclosure on their record. Obviously many home buyers felt the stigma was worth the risk. I see that as [...] a rational choice given the circumstances.

Now this is interesting: undoubtedly some people did behave this way, but was it a common phenomenon? This is a little like the sovereign default problem I discussed earlier: sometimes it is rational to default. However, just as there nations are held back by the stigma of default, so I suspect many people don't default when they rationally should. This is part of risk aversion, a flipside of the phenomenon whereby students don't go to University despite the availability of deferrable student loans whose repayments are based on income: a risk neutral analysis indicates one course of action, but people are not often risk neutral.

Quantitative Hedonics

I'll start with an effective way to create hap- piness. Lays' ketchup flavour crisps and Mouton Rothschild 1985. Yes, I know it sounds like a strange combination but it actually really works. So, if that is practical hedonics, what's quantitative hedonics?

Economists are starting to broaden the idea of cost, in particular talking about the cost of happiness. Quantitative hedonics, then, is an attempt to measure misery or its inverse, joy. The basic idea is easy enough: if you rate your happiness sitting in the garden this morning at 6/10 without an ice cream and 7/10 with one, and an ice cream costs £1, then it costs £1 to increase your happiness 10%.

Nick Cohen in today's Observer discusses an example of this: the cost of aircraft noise. Clearly being overflown makes people miserable. How much should the airlines pay to compensate the people they inflict this on? Obviously one cannot get an unequivocal answer, but even an estimate is interesting.

This view of the world suggests a different way at looking at some problematic modern situations. For instance recently the New York Times had a discussion of babies on public transport. One side took the view that a screaming child make the whole experience miserable for everyone: the other that they had a perfect right to travel with their child no matter how noisy. It would be interesting of debating whether it is acceptable to travel with a screaming infant what the hedonic cost of doing so was. Perhaps if this added onto the parent's ticket their decision to travel might be different?

On days like this...

...with monsters stalking the market it is nice to be long gamma. You have to call current CDS levels on the big 3 broker dealers is an opportunity to sell protection at nice wide levels too...