A Decade Of Fallacy

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by: Alhambra Investment Partners

By Jeffrey P. Snider

Ten years ago yesterday, Bear Stearns sent a letter to shareholders of two specific hedge funds that it sponsored. Whenever anyone brings up the name now, you immediately know where this is going. That wasn't the case in 2007, however. Whatever the world may think of Bear in hindsight, a decade ago, it was a highly reputable firm.

These two particular hedge funds had earlier that year caused a rumble throughout the shadow system. On July 17, 2007, the bank finally declared them all but worthless, total wipeouts. In the mainstream, nobody could quite figure out why apart from invoking the generic idea of subprime mortgages. Everyone knew, or claimed afterward to know, that they were risky, but pinpointing the exact point of failure proved incredibly difficult. Something, something, CDS.

I wrote on August 1, 2007:

The strategy for the hedge funds, in simple terms, was to invest in senior tranches backed by subprime mortgages, hedged by puts against an ABX index. Information on the exact nature of the investments is still hard to come by under the veil of hedge fund secrecy but it looks to be that 90% of the investments were senior or better, meaning that 90% of the assets were AAA rated…

Then the wheels fell off, exactly where the models cannot predict. Despite the falling valuation of subprime CDOs the ABX index stabilized. It seemed that the subprime loans made before the middle of 2006 were performing within constraints - it was the loans made in the third and fourth quarters that were the trouble. This distinction was the reason for the "all clear" signal that Wall Street and the Fed sent shortly after the New Century and Countrywide troubles were made public.

Credit default swaps through the Gaussian copula had been used since 2000 to obtain (meaning infer from market prices) correlation, which had meant up to that point mass production of even subprime MBS. The idea of senior tranches, including super senior, was overcollateralization; a thickness of protection where waterfall losses should never be able to wipe out all the mezzanines and equity pieces above. Yet, it was the senior tranches that were throughout of the greatest concern.

This structure, however, didn't matter to correlation, or implied correlation. CDOs were known to exhibit a skew, or correlation "smile." This irregularity was how pricing at the ends, the equity as well as the senior or any super seniors, would almost always imply greater correlation than in the middle mezzanines. In other words, the market was pricing each piece differently, and the Gaussian copula meant to extract correlation from those prices was giving (often drastically) different correlations for what were parts of the same security.

Traders who traded these things perceived risks more aggressively than the models. The very idea of correlation itself explains why it was divergent at the ends; if correlation rises, the probability that enough defaults occur to wipe out all the tranches, equity first, up to and into the senior parts does, too. A 100% correlation means that no one defaults, or everyone does.

But pricing through CDS meant as an assumption that CDS trading would always be regular and fluid. The experience of the Bear hedge funds started to suggest maybe there were systemic liquidity weaknesses after all. It wasn't liquidity in the same way as anyone then, or now, perceived of it, but that was the behavior nonetheless (balance sheet capacity).

If perceptions of default risk, for whatever reason, started to rise, by virtue of CDO pricing in the correlation smile it would affect the senior and super senior pieces more robustly. The senior tranches, whether subprime, prime, or financial assets other than mortgages, were by far all the largest by par dollar volume. Rising perceived correlation meant systemic pricing problems.

As these irregularities started to pop up in more than just the two Bear Stearns cases, CDS providers like dealer banks, AIG (NYSE:AIG), or monoline insurers began to pull back. They had written CDS freely in the mid-2000s based on the premise they would collect premiums over the life of the contract and never have to pay out a nickel. Suddenly, however, with default probabilities shifting even slightly the whole business had to be re-evaluated. Even though payout risk was still relatively low, you can't go from zero probability to 10% or 20% without difficulty. Leverage is just that relative.

It was, essentially, the start of the death spiral, a self-reinforcing reductive process from which there was very likely no escape. As CDS providers stopped writing them, Gaussian copula mechanisms inferred the changing prices of CDS as rising correlation, hitting the ends (the vast majority) of CDOs harder than the rest - even though the risk of actual loss on each was still minimal (I don't believe that by the end there was ever a single cash loss on any senior tranches). And as senior CDO valuations were questioned, CDS providers grew even more shy, distorting CDS prices and creating still higher inferred correlation, and on and on.

While all that was going on, and what I've written above is but a brief, generalized summary, the FOMC gathered on May 9, 2007, to declare that the worst was over; no big deal; nothing to see here.

MR. DUDLEY. The market turbulence that began in earnest on February 27 is now a distant memory. Risk appetites have recovered, volatility in the fixed income and equity markets has declined, and the U.S. equity market has climbed to a new high.

It wasn't that policymakers were unaware of all this subprime stuff, either.

MR. DUDLEY. Also, note that ABX spreads remain considerably wider than the CDS and cash spreads that they reference. This situation underscores the illiquidity of the ABX market and may partially reflect the lack of a natural constituency of investors who might wish to take the long side of this index, especially when the subprime market is under stress. The problems in subprime mortgages have spilled over into the collateralized debt obligation (CDO) market.

In the orthodox view, it just didn't matter. As Bernanke told Congress two months before, it was for them a subprime problem not a monetary one.

Wall Street took its cues, at least in the short run, from the first quote rather than the second. The 10-year UST yield was on May 8 at a recent low of 4.63%. Treasuries sold off the day of the FOMC meeting to 4.67%, and then proceeded into what today would be characterized as a BOND ROUT!!! In little over a month's time, by June 12, 2007, the 10s were yielding 5.26%. That 60+bps move seemed to confirm what it always confirms for economists and the media; normalcy and sense, the world where Ben Bernanke actually knows something useful.

The bond market, however, as eurodollar futures, had already begun to suspect something was up. The yield on the 10s would importantly go no farther. Though it was still as much as 5.19% by early July 2007, there was by then an unmistakable downward bias (yields). The day Bear Stearns sent its letter to the shareholders of those hedge funds, the yield was 5.08%. Two days later, the 10s would yield more than 5% for the very last time.

Subprime wasn't contained because it wasn't ever really about subprime. This was, and infuriatingly still is today, a monetary story. Call it Milton Friedman's revenge for the things carried out in his name if you wish. It was the official start, as much as there may have been one, of the ongoing interest rate fallacy.