Titolo

1000 Alitalia in one shot: so' forti 'sti Amerikani .... (II)

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I admit that I have carefully read only the first part of the story. The have had only a quick look at the second part. I have the impression that Michele is partially missing the main point.

The core of the picture that he is outlining is that OTC derivatives are the main culprits for what is currently happening. Surely he knows that he is not the only one supporting this argument. I remember that George Soros and, in Italy, Guido Rossi were also blaming the size of OTC derivative market (OTC Credit Default Swaps on the top). They say: derivatives are non trasparent and allow dealers to cheat (each other ? or the public opinion ?). I dare say that the first point has been already addressed by OTC derivative dealer since several years through collateral agreements. The  counterparties of  OTC deals agree to check jointly, on a daily basis, the evaluation of the  contracts they have traded (note that these contracts are not all long or all short but somewhat balanced) and the one which is net debtor will provide some cash collateral in order to mitigate counterparty (i.e. credit) risk. In case two dealers are pricing the same contract in two different ways they have a strong incentive to check their pricing models.

OTC derivatives look much like a scapegoat rather than a culprit. The current crisis is mainly related to something else: asset backed securities and the like (which in their more sophisticated forms include derivative components as well). Together with leverage well beyond safe levels. What were doing regulators in the meanwhile ? Looking at the bright side (conspicuos profits that banks were gaining until one a half year ago, you know money is always right). What were doing rating agencies ? Making money through commissions generated by new and new issues of ABSs (that were eventually repackaged into new things and new ABS backed securities). Where did rating agencies indipendency go ? Gone (at a fair price though). Almost everybody was on board. Well, a proper explanation require much more time and words. But this is the substance.

What else ? The main director of  the bailout is going to be Mr. Paulson. Actually it seems they are deciding to give the key of the stable to the wolf himself. No doubt he is a smart guy. No doubt about who he will favour when facing the choice between taxpayer interest and Wall Street (i.e. Goldman Sachs) interest. I suppose that in comparison the well known conflict of interest of Mr. Silvio Berlusconi will pale. One question arise. If the money of all can be used to back heavily a few, what can be said when the most will try to seize the richness of the few ?

 

We essentially agree, Amadeus, but let me try to clarify in three steps.

First, I agree with you that,

The current crisis is mainly related to something else: asset backed
securities and the like (which in their more sophisticated forms
include derivative components as well). Together with leverage well
beyond safe levels. What were doing regulators in the meanwhile ?
Looking at the bright side (conspicuos profits that banks were gaining
until one a half year ago, you know money is always right). What were
doing rating agencies ? Making money through commissions generated by
new and new issues of ABSs (that were eventually repackaged into new
things and new ABS backed securities). Where did rating agencies
indipendency go ? Gone (at a fair price though). Almost everybody was
on board. Well, a proper explanation require much more time and words.
But this is the substance.

I thought this is what my example and all the "violations of the standard model" I describe are  meant to say. If, after all those words, I did not succeed, I should reconsider my writing.

BUT, and this is the second point, without the use of a very large amount of OTC derivatives ($60 trilion only in CDSs) the whole packaging and siphoning around of ABSs would have been much harder, if not impossible. First because a lot of that took place in the form of derivatives and, second and more important, because all the (pseudo, ex-post) insuring of the underlying risk would have been impossibile.

Finally, and it is my third, without the "smart pricing" of derivatives, the economically unjustified "profits taking" activity that has turned the now so needed capital reserves into mansions in the Hamptons, airplanes and trophy wifes, would have been impossible. And most of the collapses we are witnessing would have not happened.

I am not trying to make the OTC market the culprit of the whole story! Far from me. When I write that all three conditions are needed for such a mess to happen, I strictly mean it: what a triple witch decade this is! 

Finally, one must accept that some observations are correct even if they force us to agree with characters we do not find particularly admirable, e.g. Mr. Soros. You mention all these good measures taken on the OTC markets: correct. Still, after the fact it is easy to see that they must have been pretty ineffective if hundred of billions in CDS contracts are being defaulted upon. Evidently the various parties had not carefully and daily checked the credit worthiness of the various counterparties, no? Again, the OTC market is not the culprit but it is hard to deny it is one of them. 

Thanks for your reply. You prefer to emphasize some market features (OTC derivatives and CDSs) that you consider potentially dangerous. I think that such potential danger exists but what has happened has less to do with sophisticated and more with simple instruments that have progressively turned into sophisticated ones (Sogen has been damaged by an employee who were trading simple index futures). As I said previously there is a widespread attitude toward reciprocal control in OTC markets, aimed at reducing counterparty risk. I allow to your main argument that in the CDS OTC market it is spreading the opinion that the outstanding amount of such contracts is much greater than the actual amount of bonds (which are the standard CDS's underlying assets) issued by the companies/banks which are the targets of such derivatives. You should consider that such outstanding amount does not net out offsetting positions and that someone could buy protections on his loans as well.
Actually this means that the picture is somewhat worse and maybe is not an unlikely product of unlucky events.
Let's start from the beginning. In the '90s the big (american) investments banks were making profits because of two main reasons: they were actually smarter in pricing and trading derivatives (were they had competitive advantages) and they were ready to exploit the bull bond market which was driven by the "secular" fall of interest rates after inflation was eventually curbed. When such conditions come to an end, because interest cannot turn negative they were looking for new revenues. In the meanwhile their competitive advantages were reducing. Here came the dotcom/tech bubble. They gained big commissions and fees by bringing into the market the new companies, helping mergers and takeovers spurred by the bouyant market. They did not take big risks and the stocks were placed into the market. At the end the losses were borne by the investors. The bubble bursted and then, to fight the recessionary winds, Mr. Greenspan cut the interest to historical low levels. This provided the fuel for the next trip. Low rates spurred mortgages. Unfortunately they are booked and accounted on an accrual basis. Then came the IB who turned the flows into present value through securitization. Origination of new securities took place starting again to pour commissions into IB pockets. Mortgages were tranched into securities segmented according to their riskiness which was related to some kind of preferred rights to reimbursement over the mortgage pools that were given to the best rated securities. Rating was the new trick and rating agencies were called in to help the new business. They provided bright ratings. Initially it made sense: only (or mainly) prime mortgages were addressed. But when prime mortgages were exploited they cannot do without securitization commissions any more and they started to look at more risky loans. Actually the true lenders were strictly tuned because they needed new business as well and they were transferring the risks! Rating agencies started to close their eyes. They simply required to slightly increase the risky tranches of the subprime mortgage pools. But the commission hunger was endless. Someone devised new ABS backed by...other ABSs (unsold tranches...), CDO backed by ABS, CDO squared backed by ABS on ABSs. Insurance companies provided their guarantee and rating agencies endorsed. This time the rubbish was sold only partly. It remained in the books of the IBs (and other banks as well). Here one little explanation is needed. According to regulatory constraints banks are due to set aside their capital in a fixed proportion of their loans for credit risk. Securities are different. They fall under market risk and the main banks are allowed to calculate the riskiness of their portfolio and the capital required according to their own internal model (though validated by the regulators). Such models usually allow a substantial reduction of required capital. Here you have the unprecedented leverage. You simply need to turn credit risk into market risk through well suited and well rated securities (you do not strictly need CDSs even if you can find them somewhere). When the market was quiet the volatility of such securities was very low and the calculated risk and capital were small. They were rated and priced as if the house market was going the grow forever. Some (willing ?)confusion was added by the fact that the rating labels provided by the agencies were exactly following the same patterns used for corporate bonds. They eventually said that some misunderstanding was possible: the same letters do not have exactly the same meaning...

The story can go on, but it's late and I need to stop here.

OTC derivatives look much like a scapegoat rather than a culprit. The
current crisis is mainly related to something else: asset backed
securities and the like (which in their more sophisticated forms
include derivative components as well). Together with leverage well
beyond safe levels. What were doing regulators in the meanwhile ?
Looking at the bright side (conspicuos profits that banks were gaining
until one a half year ago, you know money is always right). What were
doing rating agencies ? Making money through commissions generated by
new and new issues of ABSs (that were eventually repackaged into new
things and new ABS backed securities). Where did rating agencies
indipendency go ? Gone (at a fair price though). Almost everybody was
on board. Well, a proper explanation require much more time and words.
But this is the substance.

Gia', ma la colpa a ben guardare non e' neppure loro:

- Le rating agencies facevano quello che uno si aspetta da ogni entita' privata, cioe' massimizzare i profitti per il loro azionisti: fidarsene come se fossero imparziali e' da ingenui se fatto da investitori privati, e pura follia se fatto da istituzioni pubbliche come la BIS (su questo, vedi l'opinione che esprimevo poco piu' di un anno fa).

- I regolatori, poi, facevano quello che gli era stato detto di fare, guardando al proprio cortile e ignorando quello accanto. Ad esempio, se la FED per statuto non era responsabile per la supervisione ne' delle banche d'investimento ne' delle assicurazioni come AIG (o MBIA e Ambac, altri disastri in attesa di succedere di cui ora tutti sembrano essersi dimenticati), non le si puo' far carico di essersi addormentata al volante.

Le responsabilita' semmai ricadono su chi definisce i compiti e i poteri dei regolatori, cioe' dei rappresentanti democraticamente eletti a Presidenza e Congresso: i quali in questi giorni, sia a destra che a sinistra, si atteggiano invece ad autentici difensori del pubblico interesse nello stile del capitano Renault di Casablanca ("I'm shocked, shocked to find that gambling is going on in here!", salvo intascare un secondo dopo i proventi delle sue vincite - are you listening, Robert "Citi" Rubin?).