We talked the other day about municipalities and the Libor shenanigans. Quick recap:
1) Municipalities wanted long-term fixed-rate debt.
2) They got it indirectly by selling long-term floating-rate debt and buying interest rate swaps from banks.
3) At first, this was cheaper than issuing fixed-rate debt.*
4) Later, though, sometimes it turned out to be more expensive than having issued fixed-rate debt, or at least more expensive than it should have been, because municipalities pay a floating rate based on weekly reset auctions of their debt and that rate tends to track an interest rate called the Sifma swap rate,** while they receive a floating rate based on a percentage of Libor, and in 2007-2008 those rates diverged in weird ways.
5) Specifically, banks messed with Libor.
6) You can imagine tons of derivatives counterparties who could get screwed without politicians getting that worked up about it, but poor beleaguered Nassau County is not one of them.
Anyway an informed reader wrote in with some comments, of which this was my favorite: Read more »
If you’d like some non-real-time insight into the London Whale, may I highly recommend this oral history, by Edinburgh sociologists Donald MacKenzie and Taylor Spears, of how investment banks came to price and trade and hedge things like the index CDS that the Whale dabbled in? It made me tear up a little. It is let’s say somewhat technical but it’s not really about math or derivatives, it’s about how people experience their lives in derivatives departments of investment banks.
The main discussion is about the relationship between certain derivative pricing formulas and the credit crisis, and in particular about why ratings agencies did a bad job of rating asset-backed CDOs. The authors attribute these mis-ratings to a cultural problem, in which the people building and rather ABS CDOs were credit-analyst banker type rather than quant types who derive their views from market prices and efficient market assumptions: Read more »
BreakingViews has a couple of posts up about one of my favorite things in the financial universe, Credit Suisse’s habit of paying its bankers in structured credit instruments that take pages to describe. How’s that going? Great:
Three years ago, around 2,000 employees were forced to take some $5 billion of the riskiest assets from the Swiss group’s balance sheet as their bonuses. Now, recipients are being offered the chance to buy more. What once seemed like a punishment has turned into something of a perk.
Investors in the “Partner Asset Facility” already sit on a paper profit of around 80 percent, thanks to a recovery in the value of the original portfolio. That gain is essentially safe, since most of the assets involved have been liquidated or sold down and the funds are sitting in low-risk, low-return investments. The snag is that beneficiaries can’t get to the payouts until 2016.
To ease the pain of waiting, Credit Suisse is giving participants another bite. They have a chance to plough some of their paper profits back in, buying up to $1 billion of risky assets, including mortgage securities, from the bank’s books. Over a third of participants opted in to a similar offer late last year. Some of the purchases are to be funded by leverage, leaving perhaps half to come from willing PAF holders.
Phrases like “risky assets, including mortgage securities,” are always a bit of a minefield, but the sense is clear enough, which is that a whole lot of senior people at Credit Suisse are pretty keen to take money that is basically theirs, which is currently held in the form of basically cash, and invest that on a ~2x levered basis in, er, “risky assets, including mortgage securities,” which let’s just stipulate have a higher risk and higher return than cash.
Remember how a week ago people went around bothering themselves about Bank of America’s derivatives? Specifically how if they get downgraded, as seems plausible, they will have to come up with a zillion more dollars for derivative collateral? And how earlier this week they did the same for Morgan Stanley?
Anyway we talked about it a bit and I put up a table that I figured I’d update when it was complete and now it is so here it is. Also a JPMorgan downgrade, which looked hilariously unlikely 25 hours ago, looks more likely so I guess this is relevant even where it wasn’t before. So here is how much cash various banks will need to stump up – to post as collateral on OTC derivatives or to clearinhouses, or to pay on termination of trades – if they are downgraded two notches:
Hi! Would you like to talk about the London Whale? Sure you would. The amount of misunderstanding of our poor beleaguered beluga is staggering, so I figured we could try to embark on a voyage of discovery together. Maybe we’ll figure it out. Along the way we’ll talk a tiny bit about the Volcker Rule. I am going to try to talk very slowly and simplify things so if you are pretty financially sophisticated you could skip this post (I’ve linked to some better things to read at the end), or just get really angry at me in the comments. Also this post is terrifyingly long, sorry!
So. You are JPMorgan. People come to you and give you money, because you are a bank, and they want you to hold on to their money for them. You pay them interest so you need to invest their money to earn interest – ideally you earn more than you pay so you can make money and pay bonuses and stuff. You invest that money, broadly speaking, by lending it to other people who want to do things with it. Some of those people are buying houses, some of them are running businesses. Those are the main ones. (Some are buying cars, or educations; others are running countries, or municipalities. Ignore that.)
Now a tangent, which is long but important. Some of the money that you lend to people running businesses, you actually lend to people running businesses – like, they come to you and ask you for a loan and you give it to them. Some of it you don’t, because you don’t have enough good loans to make – not enough people come to you for loans because they’re not building factories because Obama or whatever, or people do come to you for loans but it’s for terrible things so you say no. So you have “excess deposits,” deposits that you haven’t loaned out, and you invest those. You invest those in securities – that is, loans that someone already made and packaged into bonds to be bought and sold on the market. Since you are by hypothesis JPMorgan, you do this investing of excess deposits through your Chief Investment Office, or CIO, which is staffed by cetaceans. You can tell how much of this investing JPMorgan does because they disclose it on page 33 of their Form 10-Q filed with the SEC yesterday: Read more »
I occasionally entertain myself thinking about this set of puzzles:
(1) It is good for financial regulators and probably, let’s say, the world, if creditors are slow to pull money out of banks that run into trouble. In particular you don’t want everyone to want to move first and get their money out well before there’s a problem, because them getting their money out creates, or let’s say at least exacerbates, the problem.
(2) Banks also want that, since going bankrupt for no reason seems sort of harsh.
(3) But creditors want their money back – and being first out the door is a good way to ensure that that happens.
And since, when things go pear-shaped, there’s always some risk either that the rules won’t let the creditors move as fast as they want, or that the rules will change, it’s good to get your money out before there’s a problem. The best way to do that is just to keep your money to begin with, or only to give it to people who won’t get into trouble, but failing that, you want to get your money back when there’s a hint of trouble but things are still mostly fine. For some reason credit ratings used to indicate that state, since they worked so well last time, so a downgrade from nice investment grade to less-nice-but-still-investment-grade is a good time to check in with your money and see if it might miss you and want to spend a bit more time with you.
On the other hand, if you are a bank and you agree to terminate or collateralize lots of contracts upon a downgrade, you tend to have to come up with lots of cash at exactly the wrong time. So it is probably smart practice to mostly not agree to that sort of thing. But life being what it is you can’t win them all, so you agree to have some trigger-on-downgrade collateralization in some of your contracts, and you just push for those triggers to be as few and as far away from your current ratings as possible.
Financial news is very serious business and you should probably fret more than you do about the economy and the banksters and the muppets and the homeowners and so forth. Some things, though, are best viewed as purely aesthetic triumphs, and your reaction should just be an appreciative whistle. This starts slow but stick with it, it gets wonderful:
Our results are impacted by the risk of counterparty defaults and the potential for changes in counterparty credit spreads related to our derivative trading activities. In 1Q12, we entered into the 2011 Partner Asset Facility transaction (PAF2 transaction) to hedge the counterparty credit risk of a referenced portfolio of derivatives and their credit spread volatility. The hedge covers approximately USD 12 billion notional amount of expected positive exposure from our counterparties, and is addressed in three layers: (i) first loss (USD 0.5 billion), (ii) mezzanine (USD 0.8 billion) and (iii) senior (USD 11 billion). The first loss element is retained by us and actively managed through normal credit procedures. The mezzanine layer was hedged by transferring the risk of default and counterparty credit spread movements to eligible employees in the form of PAF2 awards, as part of their deferred compensation granted in the annual compensation process.
We have purchased protection on the senior layer to hedge against the potential for future counterparty credit spread volatility. This was executed through a CDS, accounted for at fair value, with a third-party entity. We also have a credit support facility with this entity that requires us to provide funding to it in certain circumstances. Under the facility, we may be required to fund payments or costs related to amounts due by the entity under the CDS, and any funded amount may be settled by the assignment of the rights and obligations of the CDS to us. The credit support facility is accounted for on an accrual basis. The transaction overall is a four-year transaction, but can be extended to nine years. We have the right to terminate the third-party transaction for certain reasons, including certain regulatory developments.
Oh man, if I could write like that. If I could do that*! Read more »
One way I like to imagine the world is that there’s sort of a constant amount of financial risk and entropy tends to increase, so that as time goes by everyone increasingly ends up facing the same financial risks as everyone else (though quantities and leverage vary) and idiosyncratic risk is a rare and beautiful flower and so I dropped a good portion of my net worth on Mega Millions this morning because what else can you do? Entropy increasers could include index funds, or converging bank business models, and I guess you could profitably ponder the fact that the big banks are now living on DCM fees until M&A comes back and what that could mean for a model of “we need to split up the big banks to avoid too-big-to-fail risk.”*
One thing it could mean is get the hell away from banks. So for instance you could quite reasonably be worried about putting all of your money in collateral accounts with the banks who are your derivatives counterparties because hey MF Global just lost all the collateral you put with them, and so you are, reports the Journal based on the Fed’s Senior Credit Officer Opinion Survey on Dealer Financing Terms: Read more »
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