Credit Derivatives to blame for write-downs?

[DerivativesTradingDesk]

Blame it on Rio (Risk Ignorant Outlook); blame it on derivatives

The increased usage of derivatives is not the sole reason for the recent spate of debt write-downs by the likes of Merrill Lynch, Citigroup, Countrywide, etc. Invariably, the unmitigated quest for profit, combined with a myopic short-term investment focus, mixed in with whirling devirish volatility and the lack of ability to redistribute risk despite the incomprehensible array of hybrid derivatives products, were the "perfect storm" for calamity.

Derivatives have become a bewildering, complex, sometimes nonsensical financial instruments, whose intrinsic value is only on paper, vacuous, as the underlying cash or security has been so sliced and diced and tranched and mezzanined and senior this and equity that to the point that the best minds and quants at MIT, Stanford and the leading IB's on Wall Street could not price or value them with any certainty

The "Chinese Wall", or should I be more politically correct and say, the "firewalls" that once existed to separate banks, brokers and insurance and assurance entities before the Glass-Steagall Act was effectively repealed in the late 90's, has made for some very questionable bedfellows, passing around mortgage-backed securities like appetizers to each other and leaving the crumbs of the feast to be cleaned up by the wait staff.

Think Fannie Mae.
Not only how they failed in their accounting for derivatives "off-balance sheet" by not marking-to-market, but the tawdry business of "making markets" in mortgage-backed securities, in effect selling the products and buying them back in unrecognizable, grotesque form, and stating them in the journal entries at original value, P&L reflecting inordinate profits.

If only I could do that with my own bank account.

I wouldn't have time to write this article, for I would be in a villa somewhere on a tropical isle.

c. 2007 Phil Green

 

[dzolotar]

I would only add let's blame cars for accidents, and matches for fires while we at it... What is the first thing we learn in Stats about correlation and causation?

 

[kean]

smart people think they can out smart each other. at the end, their best ideas collapsed....allas now you see this credit crunch things.

 

[dzolotar]

I don't mean to get all worked up about, but let's just keep the score straight. There are a few things that have contributed to the current liquidity crisis in the market place, but I don't think anyone at this point will dispute the fact that the overriding force was one and simple. Greed. People who would have never otherwise afforded a house "smelled" the opportunity to make a quick buck and went ahead with it, and their slighly more intelligent mortgage brokers helped them. Everything else was consequential. Did derivatives, credit agencies, and a huge amount of leverage created as a result contribute to this? No doubt. But let's not mix all into one pile. Credit agencies didn't fully deliver on its duty, derivatives multiplied the leverage, but does it really mean blame it all on them?
Speaking of outsmarting the smartest... Since derivatives is a zero sum, there must be someone on the other end of the sorry long.

 

[Andy Nguyen]

Speaking of outsmarting the smartest... Since derivatives is a zero sum, there must be someone on the other end of the sorry long.

You mean this US hedge fund makes 1,000% return betting against subprime - QuantNetwork - Financial Engineering Forum ? :D
Agree with the zero sum thing. It's always the story of Wall Street.

On another related note, Bloomberg market magazine this month ran a story on John Paulson hedge fund whose bet that the housing market will pop net his fund 2.6B in fee this year. Now that's outsmarting the smartest.

 

[John]

It is a combination of factors that contributed to the meltdown in subprime and other high-yield credit market.

1) The development of multi-layer structuredproducts, such as CDO of ABS (underlying collateral are various forms of mortgage ABS, which in term are structured products themselves, even CDO tranches, sometimes of mezzanie ones), CDO square,

2) rating agencies' lack of insight into the true risk carried by the collateral backing these structured deals, [note: in many instances the rating agencies are not neccesarily the best people to evaluate these deals; e.g. in CMBS, the agencies might not have access to full individual commercial loans and the obligors ability to run their commercial properties]

3) investors' over-reliance on the ratings due to their own inability to analyze these complex deals (again, multi-layer structured, with intricate waterfalls, triggers, credit enhancement via interest derivatives (swaps, caps, etc., and opaque collateral information), [note: the dynamics are starting to change, as investors are demanding more disclosure about collateral backing the deals, and making demands to have some of these loans replaced (buyer's market)]

4) mortgage originators & brokers lowering underwriting standards (many instances commiting frauds to get mortgage approved; one example is to inflate assessed value of homes to hit the required loan to value ratio)

5) The investment banks, many of which themselves own subprime mortgage originators, were all too happy to supply these 'highly-rated' structured papers to mis-informed investors.

6) hedge fund managers, turned into CDO managers, in a zeal to increase asset under management, thus management fees.

Now, it is neccesary to make distinction between cash structured products (ABS, CDO ABS, etc.) and the synthetics (CDS, credit indexes, etc), which we normally think of as credit derivatives. The latter (pure credit derivatives) merely reflects the credit riskiness of the former (cash structured products). So it is a zero-sum game in the synthetics side, but not in the cash structured products side, many of which can and are considered a form of credit derivatives.

 

[Vic_Siqiao]

smart people think they can out smart each other. at the end, their best ideas collapsed....allas now you see this credit crunch things.

yes, its funny thing

 

[kean]

They miscalculate the borrowers as a general public. When they package these loans...mortgage in particular, they thought economy is positive and inflation is under controlled. So, the default rate must be low, so the CDO deals are great. The problem is implicit inflation rate is high that causes mortgage costs to go higher. This follow by the exaggerated rating on these loans. Borrowers can't pay their loans and then they defaulted. Please do not forget that credit cards also represent a big chunk.

More people defaulted their loans caused those people who bet on the other side of the CDO deal also defaulted. At the end, banks have to write down all these debts. Some hedge funds closed shop.

This problem is m"e"n made.