...Archive for April 2010

A knife fight is not a mediation

The excellent Ezra Klein has ruined his electoral career for nothing. That’s a shame; I’d vote for him. Ezra writes:

If an investment bank is structuring a trade for two clients, it has an obligation to serve its clients. That is to say, it needs to structure the trade they want to be part of and disclose all relevant information necessary for them to evaluate the trade. But if the firm, or the employees structuring this trade, think that one side is going to win and the other is going to lose, I don’t think they have an obligation to warn the losers… The SEC’s case against Goldman simply says that they failed to disclose relevant information that one side needed to decide for themselves whether going long on the Abacus deal was a good or bad trade. That is to say, the issue isn’t whether Goldman acted in the client’s best interest but whether they made it unnecessarily difficult for the client to act in his own best interest.

Goldman wasn’t structuring a trade between two clients, as far as IKB and ACA were concerned. It was working to form a business entity called ABACUS 2007-AC1, LTD and underwriting an issue of securities by that entity. The only clients formally involved were IKB and ACA, and they were on the same side of the deal.

If this had been an adversarial deal, Goldman would have had no obligation to inform the side that wasn’t paying it whether they were making a good trade. But if this had been an adversarial deal, Goldman would have been advising one party or the other. Both parties could not have been its customers.

Imagine you are trying to buy a house. It is contentious. Disputes arise over price, warranties, settlement terms, etc. You would hire an agent, and the other party would hire an agent. Those agents would be different people. The hazards of relying on the same advisor in a difficult negotiation are obvious.

IKB/ACA may have been “sophisticated”. They may have been dumb, or corrupt, or unlucky. But, in an adversarial negotiation with John Paulson, they would not have shared the same agent with him. A knife fight is not a mediation.

The whole issue is that IKB/ACA did not know that they were in an adversarial negotiation and that the other guy had Goldman Sachs as its agent. They thought Goldman Sachs was working for them, underwriting securities of a special purpose entity it was putting together to satisfy investor interest. If IKB/ACA had been negotiating a very complex $192M custom trade with John Paulson, there would not have been a “flipbook” and a “prospectus”, just sign the dotted line. There would have been conference rooms and long hours and thousand-page paranoid contracts scrutinized and initialed in triplicate.

There is no circumstance where an investment bank “structures a trade for two clients” whose interests are opposed when the terms are anything but standard. I mean, really. Think about it. It’s Orwellian — Goldman calls a practice that is absurd on face “market making”, and suddenly it’s normal except for technical questions about who picked what securities or who should have suspected something.

What happened here is nothing like what a market maker does. A market maker takes the other side of client-initiated trades, and then lays off the risk. ABACUS was initiated and sold by Goldman Sachs, at a hidden party’s request. Goldman was unwilling to make a market for Paulson at a price he would have accepted, so it manufactured an entity willing to do so. Investors in that entity were not informed that they were dealing with an active, involved adversary. And Goldman has the nerve to call both sides of the arrangement “customers”.

This was a high finance version of the same pump-and-dump schemes you get by e-mail. Paulson needed buyers for what he was selling. Goldman sent around the flipbook until it found some, and without revealing that a hidden counterparty wanted to dump. This is not an ethical practice. I don’t know whether it’s illegal. But if really smart, well-intentioned people like Ezra can’t quite see that it’s disreputable, if it seems like a he-said, she-said technical kind of thing, we are in deep trouble.


P.S. For this deal to be okay, Paulson’s role would have had to be disclosed plainly and in writing. His name need not have been mentioned, although it would not have remained hidden for long. But Goldman would have had to reveal that a party wishing to take a large short position had initiated the deal and would be involved in its design. Goldman would also have had to make clear, in writing, that this party was its client.

Like many Goldman apologists, I suspect that by the time the deal closed, some of the ACA guys probably knew or had guessed what was going on. Maybe the IKB guys knew too. That doesn’t matter. Individuals taking bonuses for deals at ACA and IKB were not the “investors”. ACA and IKB’s shareholders were the investors, and ultimately British and German taxpayers. Goldman had an obligation to put important facts in writing. By not doing so, Goldman created plausible deniability for employees at ACA and IKB who had a personal interest in closing the deal. The wink-wink/nudge-nudge act mitigated career risk, helping to enable corrupt stupidity. Informal disclosure does an end run around risk managers at both firms, who would have expected discussion of an active, adversarial counterparty in the documents they reviewed. Even if some people at ACA knew, the deal might never have gotten done had ACA or IKB formally known. $192M deals that become $1B deals should be fully documented, in ink.

Update History:

  • 28-April-2010, 10:10 a.m. EDT: Changed “sharing the same agent” to “relying on the same advisor”.
  • 29-April-2010, 7:00 a.m. EDT: Shortened first link to Ezra Klein’s piece. Removed one “really” where there were two in last sentence before postscript.

Goldman and “hope”

On Friday, Goldman published a letter called Goldman Sachs: Risk Management and the Residential Mortgage Market . Here’s a bit of it:

In a “synthetic” CDO, two parties enter into a derivative transaction, which references particular assets. By the very nature of a synthetic CDO, one counterparty must be long the risk (i.e., hoping to benefit from an increase in the value of the referenced assets), and the other counterparty must be short the risk (i.e., hoping to benefit from a decrease in the value of the referenced assets).

I have made this point before, but I will bore with repetition. Both in theory and in practice, there need be no identifiable party “hoping to benefit from a decrease in the value of the referenced assets”. Historically, in the vast majority of deals, there was no such party. Does anybody wish to dispute this as a factual matter? Mr. Blankfein?

Synthetic CDOs began as a tool for balance sheet management by banks. In these deals, a bank issues a synthetic CDO whose reference portfolio is composed of debt that the bank actually holds. The bank retains the first-loss “equity” tranche, but sells mezzanine and senior tranches. It may or may not retain the risk of the “super senior” tranches.

Banks derive two advantages from this arrangement:

  1. They limit losses with respect to their loan portfolio. When all senior tranches have been sold away, banks total exposure to loan losses is limited to the size of the first-loss tranche, usually a very small fraction of the total assets. It is as if they have bought insurance on their loan portfolio, but the policy includes a small deductible. When banks retain the risk of “super senior” tranches, the structure becomes analogous to an insurance policy with a small deductible and a lifetime cap that is less than the total value of the loans. In either case, banks effectively lay off some of the risk of their porfolio.

  2. Banks don’t need to hold regulatory capital against debt that is insured by a CDO with sufficient collateral to guarantee that insured losses will actually be covered. If investors in a CDO require a smaller premium than a bank pays to holders of regulatory capital, the bank profits by shifting credit risk to the structure (either by redeeming excess capital or, more likely, by using the capital to make new loans). This is called “regulatory capital arbitrage”.

As long as the yield investors demand is not too high, banks gain from issuing synthetic CDOs. If investors and rating agencies pay more attention to the correlation structure of portfolios than the characteristics of the underlying debt, the ability to cheaply lay off risk to CDOs might encourage banks to make riskier loans than they otherwise would. Like a John Paulson, banks doing these deals would try to cram the riskiest debt they could into reference portfolios. (Rating agencies are said to be particularly attentive to the debt selection process in bank balance sheet deals.) But in no sense do banks, the short counterparty, hope the deals go bad. Their best case scenario by a long shot is that every penny of debt gets paid, so that they earn a good yield on the equity tranche.

During the 2000s, for a lot of familiar reasons, AAA debt with a yield premium to Treasuries could be sold very easily, so entrepreneurs began structuring synthetic CDO deals based on debt they did not actually hold. In these deals, arrangers sold credit protection to investment banks, who may then have been economically short the credit, depending on how they were initially positioned. If investment banks retained those unhedged short positions, then there would, as Goldman alleges, have been a party “hoping to benefit from a decrease in the value of the referenced assets”. But investment banks were market makers and underwriters for these deals; they were not typically speculative counterparties. If you don’t believe me, here’s Goldman:

Goldman Sachs did not engage in some type of massive “bet” against our clients. The risk management of the firm’s exposures and the activities of our clients dictated the firm’s overall actions, not any view of what might or might not happen to any security or market…We maintained appropriately high standards with regard to client selection, suitability and disclosure as a market maker and underwriter. As a market maker in the mortgage market, we are primarily engaged in the business of assisting clients in executing their desired transactions. As an underwriter, the firm is expected to assist the issuer in providing an offering document to investors that discloses all material information relevant to the offering.

A market maker takes reactive positions dictated by customers who seek liquidity. The essence of market-making is accepting a risk that one might not otherwise choose in exchange for a fee or a spread. Since another party forces ones positions, and that other party might know something that the market maker does not, market makers usually strive to avoid carrying “inventory”, risk that accumulates as a byproduct of taking the other side of customer trades. The business of market-making is the art of hedging, of laying off risk forced onto the market maker by her customers. For large, complex positions, it is rarely possible for a market maker to find a single party to take the other side after it has assumed the risk of a client-initiated bet. [1] The market maker’s expertise is decomposing risk forced upon it by clients into smaller, more easily marketed positions, and neutralizing that risk via arms-length exchanges.

In synthetic CDO deals prior to 2006, the investment banks that served as market makers and took the initial short position on the CDO credit usually strove to be neutral or long the deals. They did as market makers do, and laid off their initial exposure by hedging, statically when possible, dynamically when necessary. Investment banks also frequently went long the deals they issued by retaining exposure to the super senior tranches. Out there, somewhere in the world, there may have been parties that stood to gain from events that would also have harmed CDO investors. But there was literally no one “hoping to benefit from a decrease in the value of the referenced assets” in totality. If you die, a whole bunch of people whom you don’t know and who don’t know you might benefit from buying your crap cheaply at your estate sale. There are even professional estate sale vultures, who make a business of taking the other side of estate liquidations. But it’s quite a jump from dispersed market interest to a claim that there is someone out there hoping to benefit specifically from your death. Dispersed market interest by estate sale junkies is not “material” to how you conduct your life. But if someone in particular really hopes you will die so that they can take your shit, you’d want to look over your shoulder.

I won’t go so far as to say that Goldman is lying, when it claims that “[b]y the very nature of a synthetic CDO”, one party hopes to benefit from an increase and another party hopes to gain from a decrease in the value of the referenced assets. But I will say that that the statement is factually wrong, and that Goldman knows very well it is factually wrong. If we are generous, we might categorize the statement as a sloppy simplification, a rhetorical imprecision that happens to flatter Goldman Sachs.


[1] If a position is not client-initiated, but initiated by the bank in response to some other party’s wishes, then the bank is not acting as a market maker but as an agent for the initiating party. An investment bank is free to act as an agent for a client when it trades at arms-length in public markets. But it may not act as an agent of a client while transacting with underwriting clients, unless it discloses the nature of the relationship. This failure to disclose is the essence of Goldman’s ethical foul in the ABACUS deal. It is also, I think, why Goldman is fighting the case so hard. Goldman gains competitive advantage by letting underwriting-driven demand take on customer risk that Goldman itself is unwilling to accept. There is, in the lingo, a synergy. But it is also an unethical practice, in violation of Goldman’s duty to its underwriting clients. I think Goldman is fighting so hard because it benefits from this synergy and wants to keep it. Goldman wants to normalize the practice, and rhetorically attempts to do so every time it protests that market makers don’t disclose the identity of counterparties. When Goldman is shifting risk that it did not wish to bear or hedge to an underwriting client, it is not acting as a market maker. Rather it is acting as an agent for a client wishing to take a position, while imposing the burden of liquidity provision on uncompensated and uninformed underwriting clients. When a bank arranges and underwrites deals to meet its own hedging needs, or especially to take an opposing speculative position, that is also ethically questionable if not plainly disclosed.

Deconstructing ABACUS

Goldman’s controversial “ABACUS 2007-AC1″ synthetic CDO turns out to be a very complicated deal. This is not your grandfather’s vanilla mezzanine RMBS synthetic CDO. It is, in some sense, a supersynthetic CDO.

There’ve been some excellent posts dissecting the deal, including…

Also, the formal prospectus is now available, as well as a marketing “flipbook“.

In what way was ABACUS a “supersynthetic CDO”? Despite notionally having seven classes of investors, just two classes of notes were actually sold. When I read this at Alea, it blew my mind. The only notes that were sold were AAA debt, from senior (but not “super senior”) tranches. I didn’t understand how this could work. CDOs turn low-class debt into AAA gold by segregating losses. Senior notes are made safe by shifting losses to junior tranches, and remain safe until the junior tranches are wiped out. I had seen synthetic CDOs with unfunded senior classes, in which case the issuer retains some risk if the CDO fails catastrophically. But if there are no junior tranches, who takes the first loss? Who stands in the line of fire to protect AAA noteholders?

I spent some time squinting over the prospectus to understand. But there is no clearly stated explanation. On the contrary, there is a lot of language like this:

On (i) each Payment Date and (ii) any other Business Day on which Currency Adjusted Notional Principal Adjustment Amounts are paid by the Issuer to the Noteholders, the Class SS Notes will be senior in right of payment to the Class A-1 Notes, the Class A-1 Notes will be senior in right of payment to the Class A-2 Notes, the Class A-2 Notes will be senior in right of payment to the Class B Notes, the Class B Notes will be senior in right of payment to the Class C Notes, the Class C Notes will be senior in right of payment to the Class D Notes and the Class D Notes will be senior in right of payment to the Class FL Notes.

That sounds like the standard CDO waterfall. But in reality there was nowhere for the water to fall, because no B, C, D, or FL notes were sold. If losses were allocated to any investor, they would be allocated to AAA tranches. So what was going on?

The ABACUS prospectus doesn’t say. But there is a hint. Rather than buying credit default swaps on the aggregate reference portfolio, then dividing the cash flows among the tranches based on seniority, the CDS payments are calculated separately for each “series” of notes (where the series are subdivided by class). In other words, each class of notes writes its own distinct insurance policy.

As best as I can tell, there are two distinct levels of abstraction in the ABACUS deal. First there is the reference portfolio, a hypothetical portfolio of debt. Then there is a notional CDO, a hypothetical entity that we imagine to have purchased (or synthesized) the reference portfolio. We pretend that this notional CDO is “fully funded”, with a $1100M SS tranche (“super senior”), a $200M Class A-1 tranche, a $280M Class A-2 tranche, a $60M Class B tranche, a $100M Class C tranche, a $60M Class D tranche, and a $200M FL tranche (“first loss”). In reality, no one has purchased any of the reference portfolio, and the notional CDO, which would have required $1.8B $2B of investor interest to build, was never constructed. Instead, the notional CDO forms the basis for a thought experiment: Given any performance scenario for debt in the reference portfolio, we can compute the loss that would have been experienced by holders of the various tranches. So, we could write a kind of swap (somewhat different from an ordinary credit default swap), whereunder a “protection buyer” pays a predetermined, fixed spread and a protection seller pays the losses that a hypothetical holder of a tranche in the notional CDO would have experienced.

Effectively, the seven tranches of the notional CDO serve to define seven new kinds of bets that one could take on the reference portfolio. Since these bets are designed to mimic the experience of investors in a real CDO, S&P and Moody’s were able to associate ratings with these bets. However the bets themselves — highly customized variants credit default swaps — are not securities.

For a regulated entity that wished to hold AAA debt, securities had to be constructed based on these bets. The actual “ABACUS 2007-AC1″ legal entity offered synthetic securities designed to mimic the experience of tranches in the notional CDO. It did so in the usual way, just as a commodity ETF or “vanilla” synthetic CDO would: The entity accepts money from investors, and uses those funds to purchase ordinary, low-risk debt. (In this case, the low risk debt was not so ordinary; it was itself a synthetic security. But we’ll set that aside.) The entity then takes a side bet. Investors’ earnings are interest on the low risk debt adjusted by the gains or losses they experience on the side bet. The net effect of all this is that buyers of “notes” from the entity experience outcomes that are almost exactly as if they had invested in a tranche of real CDO. However, notes synthesized this way do not need to be backed by a funded CDO structure (cash or synthetic). In fact, the scheme completely eliminates all constraint on the quantity of funding invested in a given tranche, and severs any relationship between the quantity of funding and the characteristics of the securities. Goldman could have sold $1 worth of Class A-1 notes or a $1T dollars of Class A-1 notes, as long as it was able to make itself comfortable with taking the other side of the Class A-1 side bet. It happened to sell $0 worth of Class C notes, but it could have sold any quantity, without altering the characteristics of the notes or the structure of the notional CDO.

Once you “get it”, the scheme is not very difficult to understand, and it is clever. But it is not clearly described in either the ABACUS pitchbook or prospectus. I don’t know why the three-level structure is not clearly diagrammed (reference portfolio -> notional CDO -> funded entity that replicates the experience of arbitrary tranches in the notional CDO). “Notional CDO”, by the way, is my term. It is nowhere in the prospectus or pitchbook. The distinction between the notional CDO and the actual funded entity are blurred in the documentation. Perhaps the structure of this sort of deal would be obvious to insiders, or perhaps there are clearer descriptions elsewhere, in documents that have yet to be made public. Both Alea and David Harper have pointed out that this structure is similar to a “bespoke” or “single-tranche” CDO. Effectively ABACUS describes a hypothetical cash CDO with seven tranches, then chops it up into seven “single-tranche” CDOs, only three of which were ever actually invested. But in none of the documents is it represented as a bespoke CDO.

A remaining issue that has not received much scrutiny is how the deal was priced. IKB earned LIBOR + 0.85% on its Class A-1 tranche, prior to any credit events. Both ACA and IKB earned LIBOR + 1.10% on Class A-2 notes. In a cash or more vanilla synthetic CDO, the above-LIBOR cash flow to CDO investors is determined by the credit spread on the underlying debt, potentially plus a “basis” if demand for insurance has pushed the market price of protection above the underlying’s credit spread. Effectively, cash flows into the structure are market determined. (The allocation of spread between the tranches is an internal matter among the CDO’s investors.) With ABACUS or a bespoke CDO, there is no market in the tranche-specific credit default swaps and no security with an observable credit spread that can serve as a basis for pricing. So the price of protection must be negotiated between the protection seller (the ABACUS SPV and its investors in this case) and the protection buyer (usually the deal’s sponsor) without a very clear benchmark. Disclosure of the fact that there was an adversarial counterparty on the other side of the deal would likely have affected the character and perhaps the outcome of those negotiations. Since investors may have believed the ABACUS deal was offered and underwritten at Goldman’s initiative, it’s unclear whether there were active negotiations at all, or whether ABACUS investors simply accepted spreads computed by Goldman on the theory that as customers of a reputable bank they would be given reasonable prices. (“Fair” prices would have to be modeled, and modeling a fair price of a bespoke CDO tranche might be within the competence of an investment bank but beyond the competence of even “sophisticated” institutional investors.) Sponsors of bespoke CDOs often hedge their exposure in public markets, so ABACUS investors need not have suspected that there would be an identifiable counterparty, who was also a customer of Goldman’s, negotiating against them on price. Alternatively, Goldman undoubtedly had more efficient means of hedging its exposure that it otherwise would have, since it could just lay off the risk on Paulson. So Goldman might have been able to offer unusually good pricing to ABACUS investors. We cannot say a priori whether ABACUS investors ended up receiving better or worse pricing than they would have had Goldman underwritten this deal on its own initiative and hedged its exposure. But investors did not have the opportunity to negotiate price in full awareness of an adversarial counterparty, so the fairness of the spreads investors received merits further examination.

To summarize, ABACUS defined seven “side bets” based on the performance of the reference portfolio. Under each bet, one party would insure the losses of a hypothetical tranche of a notional CDO in exchange for fixed payments from the other party. The ABACUS legal entity synthesized securities based on two of those side bets, and sold those synthetic securities to IKB ($150M) and ACA ($42M). But as Alea points out, the largest “investment” — by ACA via ABN-AMRO — was not actually a purchase of notes from the ABACUS SPV, but an unfunded side bet. ACA/ABN took a $909M “long” positions in one of the seven side bets, with Paulson (via Goldman Sachs) on the other side. This was an unfunded CDS-like arrangement that occurred some time after the ABACUS legal entity was formed and funded.

I think in judging Goldman Sachs’ behavior, the fact that the ACA/ABN “investment” was a side bet arranged after the deal closed is important. The SEC’s main allegation, that Goldman was less than candid about Paulson’s role during the selection of the reference portfolio, would have affected all parties, IKB, ABN-AMRO, and ACA, both as noteholders and bond insurers (side bettors). But the question that I find most interesting is whether or not Goldman mistreated investors by virtue of a conflict between its roles as market maker and underwriter. That conflict directly affected only IKB and ACA as purchasers of newly underwritten notes. The ACA/ABN “wrap” of the super senior tranche occureed after the ABACUS LLC had been underwritten, so Goldman was only a counterparty to ABN/ACA at that point in time.

Update: Correction: IKB invested the A-1 tranche, not ACA as originally stated. Many thanks to commenter gennitydo for pointing out the error.

Update 3-May-2010: Yves Smith publishes a note from an anonymous correspondent claiming that ABACUS was just a failed underwriting of a vanilla CDO, not several “singe tranche CDOs” as described above. I think her correspondent is mistaken, and stand by the post as written.

If ABACUS had been constructed as a vanilla synthetic CDO, but the junior tranches had been left unfunded, Goldman would have been on the hook for that risk (as well as the risk of the super senior tranche and the unfunded portion of the Class A-1 and A-2 tranches). Goldman would have lost at least $708B on the deal if that had been the case, probably much more, depending on how worthless the super senior tranche turned out to be. Goldman could have synthesized the full reference portfolio and then dynamically hedged its exposure to the whole unfunded portion of the structure, but that would have been an elaborate and inefficient means of reaching an economically identical result. The prospectus notes that the structure would sell CDS by series of note, where series are within-tranche groupings, which it would not have done if it were synthesizing the full reference portfolio. ABACUS was built from single-tranche CDO’s, with Class A-2 notes covering a 21% – 35% slice of a notional CDO built from the reference portfolio and Class A-1 notes covering a 35% – 45% slice, while the unfunded but eventually insured super senior tranche was 45% – 100%. No one funded or ever bore the risk of the 0% – 21% bit.


Many thanks to the indispensable jck of Alea for great comments on an early draft of this post. All the dumb mistakes are mine; the smart stuff is jck’s benign influence.

Update History:

  • 26-April-2010, 6:45 a.m. EDT: Corrected misstatement of which parties invested which tranches, with thanks to commenter gennitydo.
  • 3-May-2010, 3:00 a.m. EDT: Added update re a purported debunking of this description published at Naked Capitalism.
  • 3-May-2010, 3:45 a.m. EDT: While reviewing the piece after its alleged debunking, I notice that I am arithmetically inept. It would have taken $2B, not $1.8B to fully fund the structure. Corrected in the text with the old value scratched.

Synthetic securities are not so strange

Synthetic securities are not so strange. Many retail investors own them.

If you hold a commodity ETF or a equity ETF that tracks its benchmark via futures, you hold a synthetic security. Like a synthetic CDO, commodity and equity ETFs are investment vehicles that hold very vanilla “collateral securities” (like Treasury bills), but simulate exposure to some other thing by taking positions in derivative markets. For example, if you were to purchase the PowerShares DB Agriculture ETF (DBA), you would hold an interest in an entity that holds T-bills and takes futures positions in commodities like corn, wheat, and sugar. Despite the fact that this entity is synthesized in part from “zero-sum” derivatives, your shares of DBA constitute “securities” in every common sense: They are standardized, transferrable, claims on a business entity. The fund holds assets (the T-bills) that serve to secure claims that may arise against it in the course of doing business. Shares are limited liability instruments; investors can not be held liable for amounts beyond what they have invested.

It is possible to borrow and sell short shares of DBA, but at the fund level, the statement “for every long there is a short” is no more true of DBA than it is of IBM. It is true that the long futures positions held by the ETF are necessarily matched by short positions by some other investor. Formally, the short counterparty is likely a single clearinghouse. But the clearinghouse is just an intermediary; in an economic sense, the positions opposite DBA are held by a wide variety of market participants whose motivations may include both speculation and hedging, who may or may not have information or strong beliefs about future price movements.

The fact that DBA is “synthetic” may or may not have economic significance. If you review the prospectus of a synthetic ETF, you will be informed of various risks relating to the structure of derivatives markets. But the ETFs are intended simply to offer exposure to a basket of commodities more efficiently than a fund that physically warehoused the goods would. Commodity ETFs track the experience of an entity holding real goods with varying degrees of accuracy, but most investors view their positions as simply being long the commodity.

There are lots of important differences between a commodity ETF and a synthetic CDO. Synthetic CDOs are usually leveraged. Some synthetic equity ETFs are also leveraged, although they manage leverage very differently. Unlike ETFs, claims on synthetic CDOs are divided into multiple tranches, which is intended to create different classes of shares that are more or less speculative. The derivative positions held by synthetic CDOs are usually over-the-counter credit default swaps, and are likely to be less liquid than the futures positions held by a typical ETF.

I don’t mean to overstate the analogy. A synthetic CDO built from credit derivatives on the hard-to-digest bits of mortgage-backed securities is very different from an ETF that provides exposure to commodities. To the degree that it is important to draw inferences about the nature and intentions of a fund’s counterparties, one would conclude that the CDO and ETF trade with very different populations. A synthetic CDO is constructed in a manner intended to provide stable and predictable cashflows to more senior investors. Commodity ETFs are volatile all around.

However, the statement “a XXX transaction necessarily included both a long and short side” is as true for commodity ETFs as for synthetic CDOs. That statement may or may not have some economic significance. But it does not in itself imply that there are one or a few counterparties taking concentrated speculative bets specifically against the holdings of the fund.


This piece is inspired by comments of James Kwak, despite his poor taste in pundits. It is also intended as a bit of an answer to Arnold Kling, who wonders whether claims on a synthetic CDO could be considered securities.

L’affaire Goldman in price/information terms

I have found it helpful to pull away from the details of the Goldman/Paulson/ABACUS deal and think through the issues abstractly. In the unlikely event that others will find it helpful, I present the tale below…


Let’s suppose there is a trader, whom we’ll call “Trader X”. Trader X wishes to take a very large position on a bunch of related and correlated financial instruments. But Trader X has a problem. The size of the trade he wants to make is large relative to ordinary turnover in the asset. The market would almost surely move against him before he executed more than a fraction of his trades. Market-makers are very sensitive to the balance of order flow. If Trader X starts calling dealers and executing trades, they would observe one-sided flow and quickly adjust the price until trades on the other side were attracted and the flow returned to balance. This “adverse price action” would significantly reduce the profitability and increase the risk of X’s trade. It would also reveal his information or belief about future price movement to the market, enhancing market efficiency perhaps, but reducing his edge.

Trader X’s problem is well-known: sporadic large trades are known as “block trades”, and naively executed block trades are inefficient and expensive. If Trader X was buying and selling stock, he could make use of various tools that have been developed to circumvent this problem, “dark pools” that try to match big buyers and sellers without revealing strategic information about either party, to one another or to the market at large. Unfortunately, block trading platforms haven’t yet evolved for what Trader X wants to buy. The instruments he wants are similar and correlated, but not quite as standard as stocks, and “block trades” like his are sufficiently rare that even if the infrastructure existed, he’d be unlikely to find a counterparty quickly. Trader X could try to trade strategically and build a position over time, but given the thinness of the market that would take too long, the opportunity will disappear. Trader X is in a bind.

So, he goes to Investment Bank Y and explains the situation. Bank Y has many connections in the investing community, and could “shop the deal”, looking for a large investor to take the other side of the trade. But other investors are like market makers: they view strong demand to as an indicator of a counterparty’s information, and fear getting ripped off. Bank Y can find investors to trade with Trader X, but they would demand a large price premium over current quoted prices in order to take a position opposite a trader who acts like he knows something (whether he does in fact or not). If Trader X could persuade counterparties that he had no information — if it were clear his motivation was to hedge a risk, rather than gamble on a price change — then other investors might be willing to take the trade, and maybe he could find competitive bidders and get a decent price. Unfortunately, that just isn’t the case. Trader X is widely known to be a speculator, and by revealing the trade he wishes to make and the money he is willing to throw at it, he would reveal both his beliefs and his strong commitment to those beliefs. Other investors without special information would be wary of trading against such a certain counterparty, and would not offer favorable terms.

Bank Y asks Trader X what the ideal solution to his problem would be. Trader X thinks for a moment and says, “Ideally a counterparty would naturally appear who happens to want the opposite side of my trade. If they were buying while I was selling, order flow would be balanced, and we could transact at current market prices.”

Bank Y considers for a moment, and comes up with an idea. “Suppose we start a little investment company up, something like a mutual fund devoted to the kind of positions you want to trade. Since you want to take a ‘short’ position, we’ll find a manager enthusiastic about the prospects of the ‘long’ side and help him start this little fund. There are lots of reputable money managers in the world, with a wide variety of views, so we can find somebody excited and capable of running this fund. We have lots of connections among investors, and we are in the business of drumming up interest in new investment vehicles, so there’s a reasonable chance we’ll find people to fund the strategy at a scale large enough to match your trade. Once we do, there will be a natural buyer of what you want to sell, and you can enter the market without impacting prices. In fact, since both you and this fund will use us as market makers, we’ll just cross the trades internally at prevailing prices, and neither you nor the fund will have to worry about adverse price action.”

“Hooray!”, says Trader X, “You guys are fabulous.” And it all worked out just exactly as Bank Y described.

Let’s suppose that this has all just happened, and asset prices have not moved at all. There has been no collapse of some gobbledygooky RMBS/CDS/CDO market. Today, everybody is happy. No harm, no foul, right? Was this little strategy okay?

Trader X has profited compared to all of his feasible alternatives. He acquired a position he desired very efficiently. Bank Y has earned a fee. But let’s consider the situation of the investors in the new fund, whom we’ll refer to as “the Investors”.

The Investors, as of this writing, hold a position they are pleased to hold at prevailing market prices. However, the Investors would not have taken the position at all had it not been for the intervention of Bank Y.

Let’s call the difference between the prevailing market price and the price Trader X would have had to pay a direct counterparty to take the other side of his trade “the Premium”. If Bank Y had simply shopped X’s trade to the Investors, they would have demanded the Premium. (If they would not have, why go to the trouble of starting the investment fund?) So, the net effect of taking the indirect route was a transfer of the Premium relative to the other feasible opportunity. Under the “full disclosure” scenario, the premium would have gone to the Investors. Under the “little investment company scenario”, Trader X keeps the Premium. The Premium is the value of the information not revealed, conditional on the trade getting done. (It is a maximum bound on that value if the trade would not get done at all under full disclosure.)

Note that this redistribution of wealth does not depend at all on how the investments ultimately perform. It doesn’t matter whether, in the future, Trader X is vindicated and the Investors go broke, or the Investors make a killing and Trader X moves back in with his mom. The Investors suffered an opportunity cost (and Trader X enjoyed a benefit) at the time the trade occurred, based on how the transaction was architected. Trader X might be an idiot or a genius. The Investors might have been duped, or they may have invested only after extensive due diligence (which revealed everything except the confidential involvement of Trader X). Whatever. We want to consider the only the events leading up to the trade, before market fluctuations confuse the issue. Did Bank Y behave ethically when, by withholding information, it got a deal done and caused a transfer of wealth to X?

If Bank Y had plainly represented itself as an agent of Trader X, perhaps there would have been no problem. Bank Y acted very effectively in Trader X’s interest, but in a manner that can fairly be described as adversarial with respect to the Investors. But if Bank Y had disclosed the relationship, the Investors might have inferred Trader X’s intentions and demanded the Premium (unless Bank Y actively misled them, which I’ll presume is bad). So was it okay for Bank Y to be a secret agent of Trader X while engaging in its conventional business of marketing a new investment fund?

In the story as I’ve told it, the undisclosed information was clearly material — the Investors would have received the Premium or would have preferred not to do the deal had the circumstances of the trade been plainly presented. When an investment bank is acting as an agent, to what degree can it withhold material information from other parties in order to benefit its client? And what is the relationship of an investment bank to those to whom it is marketing a new investment product? Clearly it is something less than fiduciary. Potential investors seem something less than “clients” as well. Are they simply adversarial “counterparties”? Perhaps they are “customers”? In any case, what duties are owed them?

I think I’ll just let these questions dangle. What do you think?


This exercise came from thinking through the excellent comments to the previous post, especially those of JKH. Thanks always to interfluidity‘s exceptional readers.

Goldman-plated excuses

My first reaction, upon reading about the SEC’s complaint against Goldman Sachs was to shrug. Basically, the SEC claims that Goldman failed to disclose a conflict of interest in a deal the firm arranged, that perhaps Goldman even misdirected and misimplied and failed to correct impressions that were untrue but helpful in getting the deal done. If that’s the worst the SEC could dig up, I thought, there’s way too much that’s legal. Had you asked me, early Friday afternoon, what would happen, I would have pointed to the “global settlement” seven years ago. Then as now, investment banks were caught fibbing to keep the deal flow going (then via equity analysts who hyped stocks they privately did not admire). The settlement got a lot of press, the banks were slapped with fines that sounded big but didn’t matter, promises were made about “chinese walls” and stuff, nothing much changed.

But Goldman’s PR people have once again proved themselves to be masters of ineptitude. Haven’t those guys ever heard, “it’s not the crime, but the cover up”? The SEC threw Goldman a huge softball by focusing almost entirely on the fibs of a guy who calls himself “the fabulous Fab” and makes bizarre apocalyptic boasts. Given the apparent facts of this case, phrases like “bad apple” and “regret” and “large organization” and “improved controls” would have been apropos. It’s almost poignant: The smart thing for Goldman would be to hang this fab Fab out to dry, but whether out of loyalty or arrogance the firm is standing by its man.

But Goldman’s attempts to justify what occurred, rather than dispute the facts or apologize, could be the firm’s death warrant. The brilliant can be so blind.

The core issues are simple. Goldman arranged the construction of a security, a “synthetic CDO”, which it then marketed to investors. No problem there, that’s part of what Goldman does. Further, the deal wasn’t Goldman’s idea. The firm was working to serve a client, John Paulson, who had a bearish view of the housing market and was looking for a vehicle by which he could invest in that view. Again, no problem. I’d argue even argue that, had Goldman done its job well, it would have done a public service by finding ways to get bearish views into a market that was structurally difficult to short and prone to overpricing.

Goldman could, quite ethically, have acted as a broker. Had there been some existing security that Paulson wished to sell short, the firm might have borrowed that security on Paulson’s behalf and sold it to a willing buyer without making any representations whatsoever about the nature of the security or the identity of its seller. Apparently, however, the menu of available securities was insufficient to express Paulson’s view. Fine. Goldman could have tailored a security or derivative contract to Paulson’s specifications and found a counterparty willing to take the other side of the bet in full knowledge of the disagreement. Goldman needn’t (and shouldn’t) proffer an opinion on the substantive economic issue (was the subprime RMBS market going to implode or not?). Investors get to disagree. But it did need to ensure that all parties to an arrangement that it midwifed understood the nature of the disagreement, the substance of the bet each side was taking. And it did need to ensure that the parties knew there was a disagreement.

Goldman argues that the nature of the security was such that “sophisticated investors” would know that they were taking one of two opposing positions in a disagreement. On this, Goldman is simply full of it:

Extensive Disclosure Was Provided. IKB, a large German Bank and sophisticated CDO market participant and ACA Capital Management, the two investors, were provided extensive information about the underlying mortgage securities. The risk associated with the securities was known to these investors, who were among the most sophisticated mortgage investors in the world. These investors also understood that a synthetic CDO transaction necessarily included both a long and short side. [bold original, italics mine]

The line I’ve italicized is the sole inspiration for this rambling jeremiad. That line is so absurd, brazen, and misleading that I snorted when I encountered it. Of course it is true, in a formal sense. Every financial contract — every security or derivative or insurance policy — includes both long and short positions. Financial contracts are promises to pay. There is always a payer and a payee, and the payee is “long” certain states of the world while the payer is short. When you buy a share of IBM, you are long IBM and the firm itself has a short position. Does that mean, when you purchase IBM, you are taking sides in a disagreement with IBM, with IBM betting that it will collapse and never pay a dividend while you bet it will succeed and be forced to pay? No, of course not. There are many, many occasions when the interests of long investors and the interests of short investors are fully aligned. When IBM issues new shares, all of its stakeholders — preexisting shareholders, managers, employees — hope that IBM will succeed, and may have no disagreement whatsoever on its prospects. Old stakeholders commit to pay dividends to new shareholders because managers believe the cash they receive up front will enable business activity worth more than the extra cost. New shareholders buy the shares because they agree with old stakeholders’ optimism. The existence of a long side and a short side need imply no disagreement whatsoever.

So why did Goldman put that line in their deeply misguided press release? One word: derivatives. The financially interested community, like any other group of humans, has its unexamined clichés. One of those is that derivatives are zero sum contests between ‘long’ investors and ‘short’ investors whose interests are diametrically opposed and who transact only because they disagree. By making CDOs, synthetic CDOs sound like derivatives, Goldman is trying to imply that investors must have known they were playing against an opponent, taking one side of a zero-sum gamble that they happened to lose.

Of course that’s bullshit. Synthetic CDOs are constructed, in part, from derivatives. (They are built by mixing ultrasafe “collateral securities” like Treasury bonds with credit default swap positions, and credit default swaps are derivatives.) But investments in synthetic CDOs are not derivatives, they are securities. While the constituent credit default swaps “necessarily” include both a long and a short position, the synthetic CDOs include both a long and a short position only in the same way that IBM shares include both a long and a short position. Speculative short interest in whole CDOs was rare, much less common than for shares of IBM. Investors might have understood, in theory, that a short-seller could buy protection on a diversified portfolio of credit default swaps that mimicked the CDO “reference portfolio”, or could even buy protection on tranches of the CDO itself to express a bearish view on the structure. But CDO investors would not expect that anyone was actually doing this. It would seem like a dumb idea, since CDO portfolios were supposed to be chosen and diversified to reduce the risk of loss relative to holding any particular one of its constituents, and senior tranches were protected by overcollateralization and priority. Most of a CDO’s structure was AAA debt, generally viewed as a means of earning low-risk yield, not as a vehicle for speculation. Synthetic CDOs were composed of CDS positions backed by many unrelated counterparties, not one speculative seller. Goldman’s claim that “market makers do not disclose the identities of a buyer to a seller” is laughable and disingenuous. A CDO, synthetic or otherwise, is a newly formed investment company. Typically there is no identifiable “seller”. The investment company takes positions with an intermediary, which then hedges its exposure in transactions with a variety of counterparties. The fact that there was a “seller” in this case, and his role in “sponsoring” the deal, are precisely what ought to have been disclosed. Investors would have been surprised by the information, and shocked to learn that this speculative short had helped determine the composition of the structure’s assets. That information would not only have been material, it would have been fatal to the deal, because the CDO’s investors did not view themselves as speculators.

I have little sympathy for CDO investors. Wait, scratch that. I have a great deal of sympathy for the beneficial investors in CDOs, for the workers whose pensions won’t be there or the students at colleges strapped for resources after their endowments were hit. But I have no sympathy for their agents and delegates, the well-paid “professionals” who placed funds entrusted them in a foolish, overhyped fad. But what investment managers believed about their hula-hoop is not what Goldman now hints that they believed. Investors in synthetic CDOs did not view themselves as taking one side of a speculative gamble against a “short” holding opposite views. They had a theory about their investments that involved no disagreement whatsoever, no conflict between longs and shorts. It went like this:

There is a great deal of demand for safe assets in the world right now, and insufficient supply at reasonable yields. So, investors are synthesizing safe assets by purchasing riskier debt (like residential mortgage-backed securities) and buying credit default swaps to protect themselves. All that hedging is driving up the price of CDS protection to attractive levels, given the relative safety of the bonds. We might be interested in capturing those cash flows, but we also want safe debt. So, we propose to diversify across a large portfolio of overpriced CDS and divide the cash flows from the diversified portfolio into tranches. If we do this, those with “first claims” on the money should be able to earn decent yields with very little risk.

I don’t want to say anything nice about that story. The idea that an investor should earn perfectly safe, above-risk-free yields via blind diversification, with little analysis of the real economic basis for their investment, is offensive to me and, events have shown, was false. But this was the story that justified the entire synthetic CDO business, and it involved no disagreement among investors. According to the story, the people buying the overpriced CDS protection, the “shorts” were not hoping or expressing a view that their bonds would fail. They were hedging, protecting themselves against the possibility of failure. There needn’t have been any disagreement about price. The RMBS investors may have believed that they were overpaying for protection, just as CDO buyers did, just as we all knowingly and happily overpay for insurance on our homes. Shedding great risk is worth accepting a small negative expected return. That derivatives are a zero-sum game may be a cliché, but it is false. Derivatives are zero-sum games in a financial sense, but they can be positive sum games in an economic sense, because hedgers are made better off when they shed risk, even when they overpay speculators in expected value terms to do so. (If there are “natural” hedgers on both sides of the market, no one need overpay and the potential economic benefits of derivatives are even stronger. But there are few natural protection sellers in the CDS market.)

Goldman claims to have lost money on the CDO it created for Paulson. Perhaps the bankers thought Paulson was a patsy, that his bearish bets were idiotic and they were doing investors no harm by hiding his futile meddling. Perhaps, as Felix Salmon suggests, the employees doing the deal had little reason to care about whether the part of the structure Goldman retained performed, as long as they could book a fee. It is likely that even if Paulson had had nothing to do with the deal, the CDO would still have failed, given how catastrophically idiotic RMBS-backed CDOs were soon revealed to be.

But all of that is irrelevant, assuming the SEC has the facts right. Investors in Goldman’s deal reasonably thought that they were buying a portfolio that had been carefully selected by a reputable manager whose sole interest lay in optimizing the performance of the CDO. They no more thought they were trading “against” short investors than investors in IBM or Treasury bonds do. In violation of these reasonable expectations, Goldman arranged that a party whose interests were diametrically opposed to those of investors would have significant influence over the selection of the portfolio. Goldman misrepresented that party’s role to the manager and failed to disclose the conflict of interest to investors. That’s inexcusable. Was it illegal? I don’t know, and I don’t care. Given the amount of CYA boilerplate in Goldman’s presentation of the deal, maybe they immunized themselves. But the firm’s behavior was certainly unethical. If Goldman cannot acknowledge that, I can’t see how investors going forward could place any sort of trust in the firm. Whatever does or does not happen in Washington D.C., Goldman Sachs needs to reform or die.

Revaluing China

It’s odd that I’ve ended up something of a China dove. My entrée into the fin/econ blogosphere was as a commenter at Brad Setser’s website, where some of my rantings verged on sinophobic. But somewhere along the line, I came to the conclusion that faulting China for America’s problems is a bit pathetic. While the jury is still out on the long-term wisdom of its dash to wealth, there’s a solid case that the China’s economic policies have served it well. The United States was and remains the world’s most powerful nation, not a fainting virgin. If China’s economic choices were indirectly harmful to the United States (they were and are), it was within the United States’ power to craft a response that would neutralize those effects. It is not China’s fault that the US did not look after its own interests. The United States’ self-destructive tolerance of unbalanced trade was relentlessly pushed by domestic groups — Wall Street and Wal-Mart — and was given plenty of cover by the economic establishment prior to the “Great Recession”.

Although I hold the United States responsible for its imbalances, I have no patience at all for the argument that “profligate Americans” were the root of the problem. American families responded quite reasonably to the price signals they encountered in goods, credit, and housing markets under an assumption that markets are stable and reasonably efficient. In making those assumptions, they were following the endlessly repeated advice of “experts”. Sure, you can toss out anecdotes about ugly Americans buying Hummers and taking cruises with cash-out refis. America has its share of credit-loving conspicuous consumers. But most families put their cash-out refis to more ordinary and defensible uses, as a supplement stagnant incomes. Absurd and unsustainable price signals (ungodly cheap imports, incredibly easy credit, monotonically rising home prices) were the failure for which the US must take reponsibility, and the blame for those falls squarely on the shoulders of lobbyists, politicians, and economists. It was a technocratic elite that fucked up, not Jane and Joe Six-Pack.

All of a sudden, though, part of that elite wants to make amends by forcefully confronting China. I think that’s a mistake, see here and here, or read Ryan Avent. The United States needs a comprehensive, nondiscriminatory balanced trade policy, not a bilateral trade spat with China.

But suppose the China hawks are right, that China’s mercantilism is uniquely harmful and must be forcefully addressed. The usual demand is that China let its currency appreciate sharply against the dollar. A depressed exchange rate functions as both a tariff on foreign goods and an export subsidy. The (accurate) case against China is that its currency policy amounts to protectionism in disguise. However, it is the real, not nominal, exchange rate that matters in this story. Most China hawks are agitating for a change in the nominal exchange rate, so that instead of buying 6.8 Yuan, a dollar should only be able to purchase 6 or even 5.5 Yuan. That approach has advantages: it would be a clear, visible change that can be implemented quickly. Holding wages in the US and China constant, a nominal appreciation becomes a real appreciation. However, there is another way that China’s real exchange rate could adjust: Chinese wages could rise more quickly than American wages while the nominal exchange rate stays put.

The US should prefer real appreciation via wage growth in China to appreciation via a sharp change in nominal exchange rates. Economically, the two approaches are similar, but politically they are quite different. The danger that the US might try to “inflate away its debt” is a live issue in China. A big nominal appreciation of the CNY implies huge paper losses on China’s hoard of dollar assets. That might create resentments, as China’s relatively modest losses on other US investments have. If China were to engineer a real appreciation while keeping the nominal exchange rate stable, it could avoid an accounting loss on its enormous investment. Avoiding such a loss is in the interest of both China’s economic managers and the United States.

It’s uncomfortable to make a policy recommendation based on what a cynic might claim to be deceptive spin. The economic effects of a revaluation via rising Chinese wages or via a nominal appreciation are similar. One could argue my suggestion amounts to colluding with China’s leaders to hide the degree to which they and we have expropriated wealth from China’s underpaid workers. (China’s workers are underpaid in international terms, for work of comparable productivity.) A nominal revaluation would render transparent the cost of China’s past subsidies to Western consumers and its own export tycoons. A wage-based revaluation would hide it.

But there is also a sense in which the paper losses that a nominal reval would occasion are misleading. The wealth represented by China’s reserves might never have been earned without its policy of exchange rate management. China’s development, in a broad sense, is much more valuable than its stock of reserve assets. Despite suffering a direct expropriation of international purchasing power from the policy, most Chinese are arguably better off than they would have been in the absence of that “theft”. Outrage over paper losses on reserve assets would be like shareholders in a business getting mad over a phenomenally profitable promotion because it involved selling goods at a discount.

Further, the US has not — yet — “inflated away” the value of a dollar in terms of domestic purchasing power. China’s reserve assets can be traded for roughly the same American goods and services as they could have on the day that they were purchased. America has changed over the past decade much less than China has. China’s workers have grown dramatically, incredibly, more productive, thanks to structural changes in their economy. So perhaps the most accurate way of accounting for these changes is to let the wages of Chinese workers increase to match that productivity growth, rather than restraining wage-growth but cheapening internationally-traded goods.

I don’t think there’s a clear case that one story is “truer” than any other. But I do know that a future in which the US and China are warm friends looks far better than a new cold war based on avoidable grievance. My first-best prescription for the US is to avoid singling out China at all, while using nondiscriminatory capital controls (or else “import certificates“) to unilaterally enforce a balance of trade. But if we must single out China, we should prefer revaluation via higher wages to nominal appreciation. If we are not stupid about how we frame the issue — if we don’t throw around accusations of sweatshops and slave labor as an offensive sort of cudgel — we might find that China’s leadership is more open to wage appreciation than currency appreciation. Higher wages balance the cost of reduced international competitiveness with the benefit of increased domestic demand. Giving ordinary people more money always has a political upside. Rising wages don’t attract self-defeating flows of “hot money”, like gradual nominal appreciation does. And China’s leadership, with its laser-focus on stability, prefers gradual experiments to bold, dramatic adventures.

As Joseph Wang used to point out (see e.g. his comments here), ultimately, the stability of America’s middle class depends upon the emergence of a wealthier middle class in China and other emerging countries. That’s what we should all be working towards.

Capital can’t be measured

Simon Johnson and James Kwak are absolutely right. Sure, “hard” capital and solvency constraints for big banks are better than mealy-mouthed technocratic flexibility. But absent much deeper reforms, totemic leverage restrictions will not meaningfully constrain bank behavior. Bank capital cannot be measured. Think about that until you really get it. “Large complex financial institutions” report leverage ratios and “tier one” capital and all kinds of aromatic stuff. But those numbers are meaningless. For any large complex financial institution levered at the House-proposed limit of 15×, a reasonable confidence interval surrounding its estimate of bank capital would be greater than 100% of the reported value. In English, we cannot distinguish “well capitalized” from insolvent banks, even in good times, and regardless of their formal statements.

Lehman is a case-in-point. On September 10, 2008, Lehman reported 11% “tier one” capital and very conservative “net leverage“. On September 25 15, 2008, Lehman declared bankruptcy. Despite reported shareholder’s equity of $28.4B just prior to the bankruptcy, the net worth of the holding company in liquidation is estimated to be anywhere from negative $20B to $130B, implying a swing in value of between $50B and $160B. That is shocking. For an industrial firm, one expects liquidation value to be much less than “going concern” value, because fixed capital intended for a particular production process cannot easily be repurposed and has to be taken apart and sold for scrap. But the assets of a financial holding company are business units and financial positions, which can be sold if they are have value. Yes, liquidation hits intangible “franchise” value and reputation, but those assets are mostly excluded from bank balance sheets, and they are certainly excluded from “tier one” capital calculations. The orderly liquidation of a well-capitalized financial holding company ought to yield something close to tangible net worth, which for Lehman would have been about $24B.

So Lehman misreported its net worth, right? Not according to the law. From the Valukas Report, Section III.A.2: Valuation — Executive Summary:

The Examiner did not find sufficient evidence to support a colorable claim for breach of fiduciary duty in connection with any of Lehman’s valuations. In particular, in the third quarter of 2008 there is evidence that certain executives felt pressure to not take all of the write‐downs on real estate positions that they determined were appropriate; there is some evidence that the pressure actually resulted in unreasonable marks. But, as the evidence is in conflict, the Examiner determines that there is insufficient evidence to support a colorable claim that Lehman’s senior management imposed arbitrary limits on write‐downs of real estate positions during that quarter.

In other words, the definitive legal account of the Lehman bankruptcy has concluded that while executives may have shaded things a bit, from the perspective of what is actionable within the law, Lehman’s valuations were legally indistinguishable from accurate. Yet, the estimate of net worth computed from these valuations turned out to be off by 200% or more.

Advocates of the devil and Dick Fuld will demur here. Yes, Lehman’s “event of default” meant many derivatives contracts were terminated prematurely and collateral on those contracts was extracted from the firm. But closing a marked-to-market derivatives position does not affect a firm’s net worth, only its exposure. There may be short-term changes in reportable net worth as derivatives accounted as hedges and not marked-to-market are closed, but if the positions were in fact hedges, unreported gains on other not-marked-to-market assets should eventually offset those charges. Again, the long term change in firm net worth should be zero. There are transaction costs associated with managing a liquidation, but those would be minimal relative to the scale of these losses. Markets did very poorly after Lehman’s bankruptcy, but contrary to popular belief, Lehman was never forced into “fire sales” of its assets. It was and remains in orderly liquidation. Last July, more than 9 months after the bank fell, Lehman’s liquidator reported that only a “fraction” of the firm’s assets had been sold and the process would last at least two years. Perhaps the pessimistic estimates of Lehman’s value were made during last year’s nadir in asset prices, and Lehman’s claimed net worth looks more reasonable now that many assets have recovered. But if Lehman’s assets were so profoundly affected by last Spring’s turmoil that an accurate September capitalization of $28B shifted into the red by tens of billions of dollars, how is it plausible that Lehman’s competitors took much more modest hits during that period? Unless the sensitivity of Lehman’s assets to last year’s markets was much, much higher than all of its peers, Lehman’s assets were misvalued before the asset price collapse, or its competitors assets were misvalued during the collapse.

We get lost in details and petty arguments. The bottom line is simple. The capital positions reported by “large complex financial institutions” are so difficult to compute that the confidence interval surrounding those estimates is greater than 100% even for a bank “conservatively” levered at 11× tier one capital.

Errors in reported capital are almost guaranteed to be overstatements. Complex, highly leveraged financial firms are different from other kinds of firm in that optimistically shading asset values enhances long-term firm value. Yes, managers of all sorts of firms manage earnings and valuations to flatter themselves and maximize performance-based compensation. And short-term shareholders of any firm enjoy optimistic misstatements coincident with their planned sales. But long-term shareholders of nonfinancial firms prefer conservative accounts, because in the event of a liquidity crunch, firms must rely upon external funders who will independently examine the books. The cost to shareholders of failing to raise liquidity when bills come due is very high. There is, in the lingo, an “asymmetric loss function”. Long-term shareholders are better off with accounts that understate strength, because conservative accounting reduces the likelihood that shareholder wealth will be expropriated by usurious liquidity providers or a bankruptcy, and conservative accounts do not impair the real earnings stream that will be generated by nonfinancial operations.

This logic inverts for complex financials. Financial firms raise and generate liquidity routinely. Many of their assets are suitable as collateral in repo markets. Large commercial banks borrow freely in the Federal Funds market and satisfy liquidity demands in part simply by issuing deposits that are not immediately withdrawn. For large financial firms, access to liquidity is rarely contingent upon a detailed audit by a potential liquidity provider. Instead, access to liquidity, and the ability to continue as an operating firm, is contingent upon the “confidence” of peer firms and of regulators. Further, the earnings of a financial firm derive from the spread between its funding cost and asset yields. Funding costs are a function of market confidence, so the value of a financial firm’s real future earnings increases with optimistic valuation. For a long-term shareholder of a large financial, optimistically shading the firm’s position increases both the earnings of the firm and the “option value” of the firm in difficult times. It would be a massive failure of corporate governance if Jamie Dimon or Lloyd Blankfein did not fib a little to make their firms’ books seem a bit better than perhaps they are, within legal and regulatory tolerances.

So, for large complex financials, capital cannot be measured precisely enough to distinguish conservatively solvent from insolvent banks, and capital positions are always optimistically padded. Given these facts, and I think they are facts, even “hard” capital and leverage restraints are unlikely to prevent misbehavior. Can anything be done about this? Are we doomed to some post-modern quantum mechanical nightmare wherein “Schrödinger’s Banks” are simultaneously alive and dead until some politically-shaped measurement by a regulator forces a collapse of the superposition of states into hunky-doriness?

Yes, we are doomed, unless and until we simplify the structure of the banks. When I say stuff like “confidence intervals surrounding measures of bank capital are greater than 100%”, what does that even mean? Capital does not exist in the world. It is not accessible to the senses. When we claim a bank or any other firm has so much “capital” we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely “true” model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank. There is a broad, multidimensional “space” of defensible models by which capital might be computed. When we “measure” capital, we select a model and then compute. If we were to randomly select among potential models (even weighted by regulatory acceptability, so that a compliant model is much more likely than an iffy one), we would generate a probability distribution of capital values. That distribution would be very broad, so that for large, complex banks negative values would be moderately probable, as would the highly positive values that actually get reported. If we want to make capital measurable in any practical sense, we have to dramatically narrow the range of models, so that all compliant models produce values tightly clumped around the number we’ll call capital. But every customized derivative, nontraded asset, or unusual liability in a bank’s capital structure requires modeling. The interaction between a bank holding company and its subsidiaries requires multiple modeling choices, especially when those subsidiaries have crossholdings. A wide variety of contingent liabilities — of holding companies directly, of subsidiaries, of affiliated or spun-off entities like SIVs and securitizations — all require modeling choices. Given the heterogeneity of real-world arrangements, no “one-size-fits-all” model can be legislated or regulated to ensure a consistent capital measure. We cannot have both free-form, “innovative” banks and meaningful measures of regulatory capital. If we want to base a regulatory scheme on formal capital measures, we’ll need to circumscribe the structure and composition of banks so that they can only carry positions and relationships for which we have standard regulatory models. “Banks’ internal risk models” or “internal valuations of Level 3 assets” don’t cut it. They are gateways to regulatory postmodernism.

Regulation by formal capital has a proud and reasonably successful history, but has been rendered obsolete by the complexity of modern financial institutions. The assets and liabilities of a traditional commercial bank had straightforward, widely acceptable book values. For the corner bank, discretionary modeling mattered only in setting credit loss reserves, and the range of estimates that bank officers, external auditors, and regulators would produce for those reserves was usually pretty narrow (except when all three colluded to fake and forbear in a general crisis). But model complexity overwhelms and destroys regulatory capital as a useful measure for large complex financial institutions. We need either to resimplify banks to make them amenable to the traditional approach, or come up with other approaches more capable of reigning in the brave new world of banking.


Some sources: Yves Smith has been phenomenal on the Lehman bankruptcy. Regarding estimates of the hole that appeared in Lehman’s balance sheet, see “$75 Billion Needlessly Lost in Hasty Lehman Bankruptcy Filing?” and “So Where, Exactly, Did Lehman’s $130 Billion Go?“. Neither Yves nor I remotely buy the “hasty bankruptcy” explanation, see my comments above, the previously cited article, and the always acerbic Independent Accountant. Comments on the pacing of the Lehman liquidation are from the CNBC video embedded in Yves’ piece. The $24B estimated tangible for Lehman is computed by taking its September 10, 2008 shareholder equity and subtracting intangible assets reported on Lehman’s last available balance sheet.

My discussion of financial firms’ incentive to lie was informed by the investor/blogger/super-cop John Hempton, see “Don’t believe what they say” and “Bank solvency and the ‘Geithner Plan’“.

This essay also owes something to Frank Partnoy’s excellent “Make Markets Be Markets” presentation.

Update: Somehow I managed to get the date of Lehman’s bankruptcy wrong. Takes talent, I know. Thanks to commenter mindbender for setting me straight!