from Follow the Money

Turning lemons into lemonade

August 30, 2007, 1:29 pm (EST)

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Or perhaps – with a bit of reverse financial engineering – into “apples, pears, strawberries and all the rest.” 

Martin Wolf is the latest observer to note that the US has created a lot of financial lemons that left a sour taste in the mouths of investors around the world.   Lemons that have prompted policy makers around the world to seek a bit more say in how the US regulates its financial markets. 

And lemons in the economic sense as well.   

Buyers of used cars have to worry that the original owner is selling the car because the seller knows that the car has problems – and since the seller knows more about the car than the buyer, the risk that the seller is trying to pass on a lemon inhibits transactions.   Buyers of used securities apparently have similar concerns about a lot of complex financial products.  Martin Wolf writes:

What is driving this is “asymmetric information”: buyers believe sellers know more about the quality of what they are selling than they themselves do. This seems to be precisely what has now happened to trading in certain classes of security. The crisis is focused in markets in structured credits and associated derivatives. The cause seems to be rampant uncertainty. Investors have learnt from what happened to US subprime mortgages that these securities may be “weapons of financial mass destruction”, as Warren Buffett warned. With the suckers fled, the markets have frozen. The people who created this kind of stuff distrust both the instruments and their counterparties.

That distrust is one reason why the stock of outstanding money market instruments has shrunk by close to $250b -- an amazing number -- over the past three weeks. 

I suspect – and I am certainly not an expert on this, only an interested observer – that a lot of this complexity is central to a certain part of the securitization process. 

After all, the idea behind a CDO is that by combining a whole bunch of different – and hopefully uncorrelated – payment streams, you can create a new security that is less risky than the original securities.    All the payments go into a common pot, and someone – the holder of the equity tranche – agrees to take all of the losses.  

The holder of the equity tranche is betting that nothing much will default.   If all goes well, they win big.  They want correlated good performance.  But their losses are also capped in the event of highly correlated poor performance.    The equity tranche can only be wiped out once.  If a lot of different payments streams going into the CDO go bad at once, some of the tranches protected by the equity tranche are at risk.   Consequently, those holding the higher rated tranches are effectively betting that the payment streams are not correlated.   Credit magazine -- drawing on JP Morgan -- explained it this way:

"JPMorgan explains default correlation trading as analogous to a cat walking blindfolded through a room filled with mousetraps. If the cat has only one life, he would prefer the traps to be located in clusters. The cat will lose his life whether he hits a single trap or a cluster. At least with the traps in clusters, there will be paths between them. The same is true of a lower-rated tranche of a CDO: the holder of such a tranche would prefer high correlation, or clustered traps.

If the cat is a more traditional cartoon cat, one with nine lives, he is happy for the traps to be scattered evenly round the room. He can afford to hit a few traps, but does not want to hit a large cluster which would wipe out all his nine lives. Likewise investors with senior tranches prefer low correlation."

Avoiding correlation means bringing different things together.   Subject, of course, to the constraint that freshly minted CDOS will be composed, in aggregate, out of the debt that the economy is creating.  If households are borrowing a lot, well, some CDOs likely will have a lot of household debt.   

Back to lemons.   The initial theory was that combining different payment streams together produced an ensemble that was worth more than its constituent parts (presumably because there was more demand for higher rated paper than lower rated paper, so creating a big set of highly rated tranches maximized value).   But if investors lose faith in the technology that created the jumbled set of payment streams – and start to worry, for example, that even a combination of mortgages and leveraged corporate loans could prove to be correlated because of a broad decline in lending standards– well, you have a mess.  Gillian Tett:

"all this complexity is coming back to bite us with a vengeance. For as policy makers scramble to shore up confidence in the money markets, they face two crucial challenges.

One is the fact that nobody quite knows exactly where the subprime losses truly lie, since these credits have been sliced into millions - if not billions - of securities and scattered between all these modern investment vehicles. Hence the Bank's baffling diagram.

But the second problem is that nobody knows the real value of these instruments either. For many have never been traded, but simply stuffed into these vehicles and left there, seemingly unnoticed - until now, when investors are panicking about potential losses."

Each CDO is in some sense unique, as it is composed of a unique set of payment streams.   But many unique securities also seem to contain some exposure to subprime – or to the debt issued to finance the recent leveraged buy out boom – so many unique securities share exposure to a common set of risks.   

Those who might be tempted to buy worry that they sellers are selling the true duds – the pools with the worst combination of underlying instruments.  They don’t want to overbid for a security that could turn out not to work as well as expected.  On the other side, those holding pools that they like are reluctant to sell what they still think is a good asset at the distressed price they can get in the market. 

The result: Nothing moves.    That is a particular problem for those who borrowed to buy these securities.   They need to raise cash to assure their creditors that their creditors won’t be stuck with the lemons.   And that either means taking a big loss on the potential lemon – and selling at below firesale prices – or selling other, higher-quality, securities.

Gillian Tett reports that parts of the official sector think the solution is to unpackage existing pools.   

"More specifically, some policymakers now suspect that one key to rebuilding confidence would be to find ways of ripping apart some of these fiendishly complex structures, so that the constituent components can be clarified and traded again. Structured products, in other words, may need to be restructured into less . . . er . . . structured formats." 

But Yves Smith has noted that unpackaging the payment streams of existing CDO likely will prove bloody difficult.    

... [Y]ou have different holders with different economic interests in this entity. To unwind it, you have to pay them out, either in cash or collateral, or perhaps via paper in a new entity.  To do that you have to make a determination as to what those classes are worth relative to each other. That means you have to value them, at least on a relative basis.

But the whole problem that we were trying to solve to begin with was that no one is certain to value this paper. But unwinding it presupposes some sort of valuation. [emphasis in original]

In all probability, prices need to fall a lot more – meaning more people need to be forced to sell at almost any price --  before it becomes profitable to buy up the tranches of a bunch of different lemons (or all the tranches of a single lemon) and try to assembly the tranches of those lemons into something that is easier to understand, easier to value and thus easier to trade.

Taking apart what has already been joined together and creating a simpler, cleaner, more standard product sounds hard.

Not joining different payment streams together initially seems a lot easier.    Rather than turning apples and pears into lemons, it probably is now easier just to take the apples and pears directly to market.   

That raises another issue.  

There may not be a lot of demand out there for certain “used securities” initially assembled out of what has turned out to be quite risky housing debt.    But there also isn’t much demand out there for newly minted subprime debt that is fresh off the mortgage broker to investment banker MBS assembly line.

Two problems intersect.  The first is the information asymmetries that now dominate the secondary market for complicated financial “products.”    The second is that the US securitization assembly line was churning out of freshly made clunkers for much of the past two years – but that problem was masked (to really mix metaphors) by demand for clunkers from folks who thought they had figured out how to buy a lot of different clunkers, mix them together and somehow create a smooth (financial) ride …

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