Solving the Financial Crisis When 1+1 Doesn't Equal 2

Recently, several widely respected experts have all said the same thing: all U.S. and European banks are insolvent if they mark everything to market.

How could this be, after so many writedowns and bailouts? Since I have no evidence to support or refute them, my only logical choice is to join them.

My guess is, to forget about CDS/CDOs as they're past, well-known problems. The hidden toxic dump remaining, the next bomb that keeps blowing up may be the highly customized, highly complex, structured deals they've been accumulating over the years. There's no wholesale market for any of them, and decomposing them carries the substantial risk of mismatching due to the various disparities in the current market. And, what about hedging? If Merrill got into a $15B trap doing the simplest CDS/bond basis trade, how can you have any confidence that any hedge/arbitrage/trade will work as expected?

Here lies the biggest surprise to the financial world to date: 1+1 no longer equals 2.

As the industry is still struggling to explain the CDS/bond basis, and is still trying to determine whether to trade it, and how to trade it; good luck with the structured deals. I've seen some of them. It could easily take a highly specialized expert, days to: digest it; break it down to pieces; figure out how it'd behave under different scenarios; and calculate risk based on existing standard models. Except for the fact that over the past year, the assumptions made by many standard models have been proven to be way off base by the market. Now, on top of this, take away 1+1=2.

Portfolio decomposition is THE foundation for synthetics and much of structured finance. If you take this away, you take away a big part of the foundation of financial pricing. But, the world should not be surprised as it happened before with Long-Term Capital. Calling the market stupid is as productive as calling reality stupid, even though you could very well be correct. The market is just pricing in some factors omitted by standard models. I have a model that can explain and quantify these factors but it's beyond this article and beside my point.

My point is this:

• It's futile to expect anybody to price/hedge lots of the structured trades meaningfully, even with the best/purest intentions, and
• Even if there is a liquid market, the pricing mechanism is so different now that many tried-and-true, fundamental assumptions in finance are no longer valid.

It's a wild new world. It may be rational still; we have to assume it so. However, it's so fundamentally different that it'd take some time (at least months, quite possibly years) for the industry to make sense of it. If you think I'm exaggerating, think about the impact of abandoning Libor and the U.S. treasury curve having a credit spread of 50 bps embedded.

What we're going through is wholesale, across-the-board, fundamental re-pricing of every financial instrument in existence. So why are we still debating about which banks are good and which are bad, what their valuation should be, whether to take away bad asset and how to value them, etc., etc.?

Forget about valuation and risk management! It's not possible! It's a new world that we don't understand!

There, feels better already. Now we can calm down and think rationally. Now that we admit we don't know how to price them and cannot possibly know for a long time, the solution becomes apparent: don't price them. Try some of these ideas, instead:

1. Ask banks to do a one-time categorization of assets they deem "hard to price." This hard-to-price pool cannot change in the future.
2. Sweep these hard-to-price assets aside. Get rid of all hedging and stop all trading of this pool. It will be held to maturity except, for perpetuals (e.g., real estate); the bank can decide when to sell (but never buy back into the pool) subject to some hard deadline (e.g. 30 years).
3. Provide a total cost, not including operational/financing costs/hedging costs so far since initial trade, future collateral/margin costs, and any realized P&L due to position changes so far since initial trade.
4. The total cost becomes a nominal addition to the bank's Tier-2 capital base for regulatory and accounting purposes.
5. As assets in the frozen pool mature, the realized P&L with respect to the reported cost is accounted for in Tier-2 capital.
6. The frozen asset can be used as collateral, at reported cost, at the Fed window prior to maturity.
7. Everything else will be marked to market.

The final settlement at maturity is the only sure answer to the perennial question: "What's its worth?”

Currently banks do have some flexibility in which assets to mark to cost. But there're too many restrictions in some regards while too much flexibility in others. By doing it across the board (regardless of whether the asset is owned by the mortgage division, a trading desk, or the financing department) and at the same time, one time only, we eliminate the regulatory arbitrage and uncertainty.

Under this system, banks will have to prove some illiquidity threshold for assets they put in the pool. Expert panels set up by the government will determine such threshold. Other than the illiquidity criterion, banks are free to choose which ones to keep frozen. If they choose assets already marked down, they'd get a one-time boost, which they must disclose in the quarterly report.

The merit of this approach is to provide capital relief to the banks without government subsidy, government guarantee, or some other artificial price intervention. Banks would not be forced to sell assets and/or raise capital in the worst moment. It's the ultimate bailout without spending a penny.

The hope is that, when held to maturity, the macro-economy will recover and most assets will pay off. Nobody is seriously predicting Armageddon after all. In fact, China used essentially the same approach circa 1998 and it worked out beautifully.

Of course, this is not the best solution. The best solution is to let all of the banks fail, use a small fraction of the trillions of bailout money to support deposits and the massive ensuing unemployment, and let the good and capable restart from scratch. We'd have a lean and healthy private partnership Wall Street in no time, where risk and reward were matched in magnitude and duration, owners actually have control, and stupidity/mediocrity has nowhere to hide.

But that's no going to happen, is it?

Disclosure: No positions.

Comments

[Ricard:]

This article, and nearly every article I've read about the alphabet soup (and I have read many in the past two years) is beyond my comprehension. Apparently I am not alone, since barely anyone on what used to be Wall Street understood it either. It sounds like we essentially built the world's most productive economy, and let Wall Street put a chainsaw to it, hack it apart (MBSs), and then push it off a cliff. Wall Street then created CDSs, which were meant to defy gravity, and make those MBSs float in thin air. Why didn't the DEA crack down on Wall Street? Whatever they were smoking to concoct this scenario, it seems to be more potent than any drug selling on the streets.

Every time I read about the trillions in derivatives that have no counter-party, or about how not a single mutual fund, sovereign wealth fund, or pension fund manager, rating agency, or government authority knew what they were buying or selling, I get angry. This doesn't just sound like people making bad decisions...it sounds like the structure of the system was deeply flawed to begin with, as if it was DESIGNED TO FAIL.



I have two questions:

1) If CDSs are supposed to have counter-parties involved, isn't it reasonable to assume that someone (lots of someones, given the drop in the insured assets) made a mint off of these products, and that the profits earned from those people would counter-balance the meltdown in assets? Where is the counter-party holding these CDSs now that the underlying asset is devalued?

2) Please tell me how this system was ever supposed to work. Who designed it, and who authorized it? I cannot believe that GS simply thought it up, and it became so. My understanding of derivatives in mathematics and in finance is that they derive their value from the source, and that their value tends to be dwarfed by the source. Why are derivatives such a massive part of asset values? Why do they dwarf the source?

Thanks again for your time in writing these articles for our benefit.

Feb 02 08:52 PM

[mr freddo:]

I think Ricard has asked two very important questions that I would like Bo to comment on. First, who are the counter parties that have the profitable side of the trade? If I bought insurance on Lehman Bonds but didn't hold the bonds, I should be rich, right?

Second, why do derivatives dwarf the source? My understanding is that the source was just a marker that allowed the casino to take bets. The majority of these derivatives are written to gamble, not to legitimately hedge risk. It is interesting to note that the Senate is now debating whether to eliminate naked CDS's.

I think these questions get to the source of our current problem that makes this crisis different from all others before. Normally, you let a company go broke, liquidate, and move on. But actually having to pay off on the CDS's that were written was never really contemplated by the modelers. A frozen market was never contemplated either. So when a company like GM goes BK, that sets off a cascade of additional bankruptcies of companies that wrote insurance on GM's bonds. Isn't that why AIG fell after Lehman?

Think back to the meeting that Paulson and Bernanke had with Congress to get the TARP money. Behind closed doors, they scared the living hell out of every senator. They reported that our incredible financial system was just days away from collapse.

It's the CDS market that makes things different this time around. We must avoid a market meltdown at all costs so... no more bankruptcies. That is a Japan type solution but it does give us time to sort out this CDS market and put the fire out in a controlled manner. More bankruptcies will lead directly to a cataclysmic destruction of the financial markets.

I'm just an average guy trying to understand this event. Thanks Bo for your insights.

Feb 03 02:52 PM

[Bo Peng:]

Hi Recard and Mr Freddo,
Thanks for your kind comments.

CDS settlement is indeed a zero-sum game. For every dollar someone pays, there's someone else receiving it. But considering the underlying bond default (and not considering the naked CDS for now), then it's not zero-sum anymore. Assuming all bond holders of a defaulted bond are fully protected via CDS and thus make even, then most likely the CDS sellers are the net payers because the premium is most likely less (and often MUCH less) than the payout on default.

As to the size of a derivative vs that of the underlying, there's no forced relationship between the two unless the derivative settlement must involve delivery of the underlying. Most CDS contracts are cash settled after Delphi default. Especially for naked CDS buyers, there's no economic reason to insist on physical settlement.

In my opinion, CDS and CDO and all other "financial weapons of mass destruction" all serve legitimate purposes. They're powerful, useful tools. We didn't use the tools properly. Some abused them. Basel II allowed banks to use them to lower capital requirement and increase leverage. Hedge funds used CDS as a cheap source of financing, which is as legitimate as selling insurance without any regulation. Rating agencies treated subprime backed CDOs the same way as those backed by real companies. While every player in the market shares some blame in this mess, including some home buyers, there's no doubt in my mind the fault first and foremost falls squarely on regulators and rating agencies. I'm surprised the media and even the blogosphere still haven't come to clarity on this regard.

Feb 03 09:48 PM

[Ricard:]

Thanks again for your reply. The reason I've asked you these questions is because I've been reading in the news for two years now the effects of leverage through "shadow banking" and derivatives in general, and not only found it appalling, but also found a lack of informed opinion about the subject that would actually harbor Q&A.

Unfortunately, I've learned nothing new from your answer, as detailed as it is. I am still wondering where the wealth that is/was the CDS holder in this market has gone. It certainly hasn't vanished into thin air.

"As to the size of a derivative vs that of the underlying, there's no forced relationship between the two unless the derivative settlement must involve delivery of the underlying. "

That there is no forced relationship almost equates to abuse, IMHO. I can understand how hedging strategies can minimize the effect, but if it is not anchored to some core tangible asset, the ship that is the derivatives account can easily go adrift. Perhaps with regulation there may be some moderation in the amount of leverage allowed in the marketplace, but for derivatives to be worth more than the actual, tangible economy, seems to be utter nonsense, much more so than efficient market theory. Again, I may not know better, but something about this [derivatives] market simply doesn't smell right.

Again, thanks for entertaining someone on the "outside" of this mess.



On Feb 03 09:48 PM Bo Peng wrote:

> Hi Recard and Mr Freddo,
> Thanks for your kind comments.
>
> CDS settlement is indeed a zero-sum game. For every dollar someone
> pays, there's someone else receiving it. But considering the underlying
> bond default (and not considering the naked CDS for now), then it's
> not zero-sum anymore. Assuming all bond holders of a defaulted bond
> are fully protected via CDS and thus make even, then most likely
> the CDS sellers are the net payers because the premium is most likely
> less (and often MUCH less) than the payout on default.
>
> As to the size of a derivative vs that of the underlying, there's
> no forced relationship between the two unless the derivative settlement
> must involve delivery of the underlying. Most CDS contracts are cash
> settled after Delphi default. Especially for naked CDS buyers, there's
> no economic reason to insist on physical settlement.
>
> In my opinion, CDS and CDO and all other "financial weapons of mass
> destruction" all serve legitimate purposes. They're powerful, useful
> tools. We didn't use the tools properly. Some abused them. Basel
> II allowed banks to use them to lower capital requirement and increase
> leverage. Hedge funds used CDS as a cheap source of financing, which
> is as legitimate as selling insurance without any regulation. Rating
> agencies treated subprime backed CDOs the same way as those backed
> by real companies. While every player in the market shares some blame
> in this mess, including some home buyers, there's no doubt in my
> mind the fault first and foremost falls squarely on regulators and
> rating agencies. I'm surprised the media and even the blogosphere
> still haven't come to clarity on this regard.

Feb 04 10:22 PM