Monday, 9 February 2009

Synthetic Money Brings the House Down

Here's roughly whats got the banks and big insurers into trouble.

Underneath the lingo, the mechanisms are really, really simple. Thefigures below are just for explanation.

1. Lets say a bank has a portfolio of “sort of ok” loans, and statistics show that defaults on those loans over any 50 year period are about 10% (lets call the loans BBB rated). The first move is that bank sells off the risk of 10% of those loans defaulting - to other people. One way it does this is by using the existing interest payments on those loans to buy credit default insurance on that first 10% of the portfolio. So its first 10% loss on the portfolio is covered.

2. What that leaves the bank with is 90% of the portfolio of loans which, according to statistics and therefore the ratings agencies, will hardly ever go into default. The effect of this is to make 90% of the portfolio a much higher rating. Lets say that 90% is now AAA rated.

That’s it. How to make AAA silk purses out of sows ears.

Regulators, accountants and bank management didn’t look past the AAA rating. They assumed that AAA was AAA, and therefore (a) reduced their other forms of liquid capital and (b) paid themselves a handsome bonus for increasing the amount of AAA assets the bank had.


So now the bank has got this AAA rated stuff made out of BBB stuff, the next thing to do is to do the same trick within the AAA stuff itself. So the bank calls 90% of it the “Super Senior” tranche and sells off the risk of the remaining 10% defaulting.

Now, there’s no such thing as something higher than AAA rated. So insuring the default on the first 10% of losses on the AAA rated (but non Super Senior) tranche was cheap – its just the cost of default on a AAA rated security. Bonuses all round.

(Tea break if you like here – its not complicated this, really)

The first bank now has 90% of 90% of the original BBB stuff as “Super Senior” (that’s 81% of the original). This Super Senior stuff is considered SO safe that banks didn’t feel they needed to insure it.
They referred to it informally as quadruple A rated. (See Note 1 when you've read the rest of this).

The invention of the super-senior tranche, then, was a way of letting banks have their cake and eat it too. They could take a load of not very good debt onto their balance sheets, "fully" hedge (insure) it (with only the it-could-never-default tranche left over) and book all the remaining cashflow as pure profit with no credit risk.

And so the banks took billions of dollars of securities onto their books, and "fully" hedged them while not really hedging most of them at all. This is financial innovation. Bonuses all round.

So far so magical. Of a portfolio of "sort of ok” loans, 81% have now been made so safe there’s no need to insure them, in fact they’re as good as cash, and 9% of them were sold on and either considered as good as cash or insured at rates assuming they were AAA rated. And accountants, regulators, management booked it all as AAA rated, and insurers wrote the insurance etc etc

Now the magic works as long as your original 10% in every 50 year period default assumption was correct. But what happens if theres a likely 30 % default, as is effectively happening now (in large part due to the unprecedented historical levels of debt/corporate and personal made possible by these very structures, and all the other reasons the economies are slowing down).

Of the original 100% loans, 30% will go bang entirely. But 90% were supposed to be AAA rated! Rock solid. Here’s why this pans out so badly: the first (non AAA) 10% of the loans were insured so an insurer takes the hit. That’s ok up to a point, because the risk was in the premium (or it was supposed to be). And so far, with the odd bailout of AIG, this has stood up. Banks in this phase are insured.


There’s another 20% to go….

Of that 20%, 9% were sold on. Either they will go phut in the future as the economy gets worse (so now no-one wants to buy them), or they have already gone phut (in which case a basket case insurer, AIG, is expected to pay). If there’s no insurance there’s an outright 100% loss of a so called AAA rated investment.

That’s the 9% the bank got rid of.

BUT 11% of the loans are still on the banks books as AAA rated but uninsured (because the super senior stuff was supposedly so safe. The banks kept it because to them there was no risk and it paid the interest rate of the original BBB loans.)

And this is the BIG issue.

In this example, 11% of the banks capital, capital it thought was ultra liquid and super safe, is now unsellable, probably worthless, and uninsured. This is not apparent until (a) either there are actual defaults to that level, or very, very importantly, until the ratings agencies decide to regrade it. And that is what is happening right now; things have deteriorated so that the super senior stuff is in for a reassessment. The lower the reassessment, the lower the percentage of it the bank can call as capital – and some of it is going straight to junk. And that re-rating is happening now. The numbers are big, but it gets worse, a lot worse….

Synthetic CDOs?

When bankers saw how much money was to be made by splicing up these loans in the way described above, they wanted to make more loans than were actually wanted in the real world. No matter. They looked at the market rates for credit default insurance and swaps etc and created new markets in those rates (a market in pure rates). A market mirroring the rates (and indeed the ratings), but not arising out of actual loans….a synthetic market.

And there was no theoretical limit to the size of that synthetic market.

Like betting on a particular horse in a horse race, the odds of that one horse winning are public and there’s no limit to the number of bets that can be placed on the horse, even though punters have no ownership or connection to the horse. The actual loans and insurances and swaps etc. were the horse. The synthetic market placed bets based on the odds.

And by the process of selling off 10% and re-rating what was left, they kept creating more and more AAA stuff, more super senior stuff, and effectively cash. And this happened over and over again. So when, in our example above, the bank “created” AAA assets, this effect of creating AAA assets was mirrored and multiplied when AAA assets were made out of the synthetic market, and the accountants, regulators, management booked it etc etc and everyone made a bonus.

Now at this point you might well ask "Were they allowed to do that?". And the answer was yes. At least after 2000, Prior to that it was illegal. (See note 2 below if your jaw isn't above anything sharp).

And in the same way as, in our example, the bank lost 11% of its super senior assets, there are now (synthetic) multiples of that paper that the bank called its capital….and some of it is facing being downgraded by ratings agencies, which is why banks will need to be recapitalised or nationalised – but no-one knows how much will be needed, or even if its doable.

The world was awash in AAA rated paper – and while the dance continued it was effectively cash (and other slightly lesser forms) – created by structures which took low rated stuff and made it into AAA rated stuff; a process multiplied by a synthetic secondary market in pure (flawed) risk, unrelated to real world lending - money conjured out of nothing. And now those markets have shut down all that “money” has simply evaporated in the same way as it was magicked into existence. It sits like a collapsed souffle, contracts which no-one wants to buy, will probably never want to buy and with risks no-one can assess, and with maturity dates for many, many years to come.

Apart from insurers and hapless investors of so called AAA rated bonds who have been and are being caned, this is the bed the banks made for themselves, and us.

(Note 1: A additional twist is that a proportion of the super senior tranches were insured (who knows how much), but the risk was considered so low there was trivial premium. Although right now the problem is that super senior stuff is being re-rated and that affects the capital base of banks, when defaults rise so the super senior tranche is actually affected, the insurers, mainly AIG, monolines and large invesors, will have to pay out. Ironically, this may (I say may because its all so opaque) put capital into the banks (albeit probably with taxpayer support to the insurer) as it would convert lower graded paper into cash. Further, the Special Investment Vehicles (in which many charities and councils are invested) are structured so that on the default of a few large companies the entire amount of their investment is returned to the bank triggering a huge transfer of wealth from mainly unsuspecting investors. The loss to the investors is massive, where the cash ends up is anyones guess because of the structures.)

(Note 2
: In 2000 these activities were not only made legal for the first time (Commodity Futures Modernization Act) but in the same stroke were, believe it or not, actually prevented from being regulated by the authorities, a truly spectacular triumph of interest group lobbying and failure of Government. The legislation was 11,000 pages long and was never even debated by Congress. I think I feel faint.)


  1. Hahaaha[triple A Rated super senior tranche laugh]is now the basis of bank capital .

    It really cannot get better than this.

  2. ....And promicing like noddy money to pay the bearerr a thousand laughs on demand

  3. Bonuses will always motivate people, but they're like a cheap firework - you never know exactly where they'll go.

    Scrap bonuses, pay a decent salary, and watch folk work towards something better for everyone.

    I am a hippy. But I still like cage fighting. Grrrr