We’re All Naked, No One is at The Wheel, and How Much Was That Check Anyway?

Recently I encountered data showing the US derivatives holdings are at the greatest level in history (yes now, in Oct, 2010 – not in Oct, 2008).  Now Americans my ask “why,” they may ask say ” how could this happen, “why aren’t these things illegal?”  I’d wager that almost half of Congress might still think that, and that is the problem – they still don’t even understand what they just regulated! Many people still seem to think that the phrase ‘toxic derivatives’ somehow refers to something akin to a perishable good, perhaps some bad fish from the market.

The ideas I most often encounter, generally, fall into two categories:

  • They were perishable; at one point they were (the derivatives) edible, and later – not so much.
  • The banks were making crazy outlandish bets, and missed. (Close, but they didn’t know it)

These weren’t crazy bets (well, they were, but not in the sense you would think) in that there was no ‘swing for the fences mentality’ – they (most of them) were just looking for cash flow, not upside, and were oblivious to the risks (they confused minimal probability with minimal ramifications). It just so happens, in the latter part of the sub-prime bubble (say late ’06 – ’07), that these derivatives weren’t perishable – they weren’t meant to be consumed.  But, not for the reasons you might think.  You see, the houses that were sold during that time (for the most part) ought not have been sold.  You heard me.  People who weren’t qualified and didn’t know what they were spending, or at what terms, bought real-assets at prices that did not reflect their true value.  We’ll get in to more detail shortly but remember this key point: When a homeowner goes bankrupt the primary lessor (1st mortgage) will get the property and may fare well in foreclosure, the secondary lessor (2nd mortgage) – not so much.

For your derivatives, would you like ‘paper’ or ‘plastic?’

Derivatives are so named because, as an asset class, their prices are determined by the prices of another asset (derived from).  There are many derivatives in our lives; the jet fuel hedging of the airlines, a farmer selling his crop a few months before harvest (he’s really selling a contract to buy his crop at a later date), a ‘put’ option on a stock position, a CDS to hedge a bond position, and even your own insurance policy.  The notion that derivatives are, in and of themselves, some form of toxic, or treacherous, device is simply wrong.

All the types of derivatives that I have described (really all that exist, but let’s keep it simple) represent an obligation. They are a contract promising purchase or delivery of an asset, at (or up to) an agreed upon date, if certain conditions are met (time and price).   Now, understand that a ‘Credit Default Swap’ represents a contract insuring the value of a bond (perhaps mortgage-backed) and that the swap buyer will make regular premium payments to the seller of the insurance.  If the bond were to default the company who sold the insurance bares [theoretically] the risk of the entire value of the bond (say $1mm).  [If an insurance company insures your house they collect premium from you, and in exchange if something covered by your insurance destroys your home the insurance company owes you a new home (essentially) – the bear the risk of the entire value of your home]

A few things to understand:

  • CDS were usually created to insure entire bond offerings, often in denominations of $1 Billion
  • In 2005 the CDS market was in its’ infancy, and the public was convinced they could do know wrong in housing
  • As a consequence, there weren’t many buyers of CDS’s and prices were low (they thought risk was low)
  • Therefore, there were many willing sellers (like AIG)
    • Remember, the sellers get paid steady premiums (as if they owned a bond)
    • If the bond defaults – the CDS seller has essentially bought the farm
    • I have read quotes that in 2005 Bear Sterns was willing to insure $1Billion in Mortgage Backed Securities for $20Million/year (2%)
  • Even after people (AIG) got the drift, realizing that they were carrying much more risk than they thought ($200Million in premium income came with $10Billion in liabilities) – they did not unwind the trades
    • In the above example, even if AIG had never owned any MBS they would have $10Billion in exposure by selling the insurance.
  • Why would they sell the insurance?
    • They’re AIG, they sell insurance
    • They did not understand that entire mortgage bonds could become worthless – almost no one did

A few large buyers came into the market to buy CDS (like John Paulson), and they were not hedgers (no one was back then).  They wanted to capitalize on the impending catastrophe in real estate and they saw this cheap insurance not just as a tool to do it, but as evidence that the crisis was coming – the price of risk was very low.  In their effort to bet against the most toxic of mortgages, there simply not enough new horrible mortgages to bet against.  Enter financial innovation and exactly what Warren Buffet meant when he called derivatives “financial weapons of mass destruction” – The synthetic, sub-prime, mezzanine, negative amortizing, adjustable rate, stated income Collateralized Debt Obligation.

I’ll explain.  We know that a person who sells a CDS gets premium income, and we know that people who buy CDO’s (the bonds) earn income as well.  Now if there weren’t enough of these new bonds to go around, that means that there weren’t enough bonds for people who wanted to own them and for people who wanted to bet against them (at this point, every new issue was matched with buyers of the bond and the swaps – and then they sold the swap liability to AIG [as if AIG sold the swaps themselves]).  There was also another issue; AIG had been a big hole to shove CDS liabilities (all the risk) in to, now there was a need to find more people to take the other side of the CDS trades (sell the insurance).  Naturally, the banks kept some for themselves (as if they didn’t own enough of the bonds).  And then they did what was brilliant – they realized they could take CDS contracts (which pay a premium to the seller) and bundle them together into a kind of synthetic bond.  Every CDS calls for someone who will take the risk of the bond and for someone to sell that risk to them, just like a bond.  The great thing is they could pick any other bond to buy a CDS on, then they put the insurance contract into this ‘synthetic’ (it’s made of insurance contracts) bond, and those insured bonds could already have had insurance (CDS) sold against them.

What I am saying is that we’re now creating risk out of thin air – let’s see how:

  • Here we have a $1Billion mortgage-backed bond (XYZ) and there has been $1billion in CDS insurance sold against it (for $20Million/year)
  • There are no new bonds to insure.  I create a new bond called ABAC – ABAC has no mortgages in it to produce cash flow
  • I sell CDS insurance on XYZ to ABAC.
  • ABAC has now insured XYZ for $1Billion, in exchange for $20Million/year in income
  • ABAC (a bond) is sold to investors [desperate for yield, and knowing their bond is made synthetically], their bond yields them $20Million per year

Now let’s stress test our new model:

  • Home prices stop rising
  • Some adjustable rate mortgages reset, other homeowners are unable to refinance  as planned because their homes haven’t risen in price
  • Homeowners begin to default
  • The $1Billion of mortgages in the XYZ mortgage-backed bond default
  • ABAC and XYZ bond holders lose $2Billion – $1Billion in assets create $2Billion in losses
    • That’s a bubble

Why we haven’t really regulated derivatives?

The first notion I want to put forward is that of ‘arbitrage.’  Arbitrage is the practice of simultaneously buying and selling the same asset to capitalize on a difference in price.  We’ve already discussed that derivatives derive their price from the price [movement] of other assets.  Now, realize all derivatives and/or derivative exchanges are not treated equally under Fin-Reg.  This creates an opportunity for arbitrage – Regulatory Arbitrage.  In this practice let’s say that there is an exchange that is strictly ‘regulated’ for derivatives under Fin-Reg – then we could create a derivative that trades on an unregulated exchange, and whose price is derived from the price of an asset on the ‘regulated’ exchange.  We know have an asset (derivative) that is technically unregulated provides the full exposure of the ‘regulated’ exchange, just without any of those pesky rules.

We still can’t price these things?

To the true issue with this notion of ‘toxic assets,’ we can’t price them – more importantly, in the height of the prices it was difficult to price the bonds that the CDS’s insured; making it impossible to price the insurance.  Stock options are one of the most known types of derivatives, and they came into use in the 1970’s after the development of the Black-Scholes option pricing model.  Today you still see wild irregularities in the option prices of stocks that trade sporadically (like many of the bonds on which CDS are traded), and traders will tell you that option-pricing is an imperfect science – perhaps more an art than a science.  This is a problem when it comes to derivatives as a whole. Theoretically in stocks there can only be so many options contracts as there is stock to be delivered (I’ve seen rare exceptions in ETFs, this year UUP issued more shares following an extremely large call position being purchased), and that limits the potential losses to, says, the market cap of the stock.  In the example of synthetic CDS we learn that we can lose more money than there are assets, by orders of magnitude.  There is no specifically adopted ‘derivative pricing model,’ and if there were it certainly isn’t standardized (firms may not agree on what one asset [or liability] is worth).

Perhaps the greatest danger is that derivatives allow us to create more financial risk that what exists in the world – if there were only derivatives on ‘actual’ assets, bubbles would be infrequent, harder to inflate, and collapse more slowly.  Now imagine you made an investment, but you couldn’t track its price regularly, and you’re surprised to find that after many months you find one day that your investment is worth 30% less than what you thought it had been the day prior.  This was the issue with many of the illiquid bonds those infamous CDS contracts were based on; they traded infrequently, they were believed to be default-proof, almost no one knew what the bonds held, and therefore it was almost impossible to value the bond.  Remember we said that the people who sell the CDS insurance (AIG) look a whole like owners of the those bonds, and the people who bought the ‘synthetic’ bonds knew they were really selling insurance – but those guys thought they were selling blizzard insurance to people in Ecuador – and did so happily.

In Reality….

The fact of the matter is we (as human beings) ignore ‘unlikely’ events in our models, and then manage to be surprised when something “unexpected” happens that lies outside our model.  It’s how insurance companies work, for example; do you think insurance companies have enough capital to pay out all of their policies at any given moment should they all be called simultaneously?  Of course not.  Do you have enough money to pay all of your creditors should they call your ‘marker’ right now?  You don’t have to answer that, but you see my point – when the tide recedes you’ll see whose swimming naked.  The problem today is, almost everyone’s naked and even the people in the water don’t realize that everyone around them is naked too.


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