Okay, this is wonky. I’ve been avoiding writing about securitization for awhile because it can even get the best of people that know financial markets. You may remember that some one asked me where the next bubble lurked and I said commodities. Now, that’s actually a dangerous place for a bubble because commodities are things you eat and things that make your house light up and your car run. The housing bubble pretty much wiped out middle class wealth in the west. What would a commodities bubble burst do in the right markets? Well, think Mad Max or at least The Grapes of Wrath. Conversely, it could lead to a massive drop in key prices like that of oil. Imagine that one!
Here’s some interesting finds from FT Alphaville on the securitization of commodities. It’s titled “The subpriming of commodities” for effect.
It’s always been common practice for commodity inventory to be financed by banks by being pledged as security for the loans in question.
The problem comes if such enterprises, instead of using the inventory for general business purposes, are encouraged to stockpile for the sole purpose of liquidity provision and the opportunity to punt on the underlying commodities themselves. It’s a process which arguably artificially pumps up demand for the underlying inventory.
Bundle all those loans together, meanwhile — ideally into a product that can be sold to buyside investors seeking exposure to commodities — and suddenly you’ve got a direct source of funding for an ever-more speculative game.
When it comes to the larger players, meanwhile, this arguably transcends ‘trade finance’ even further — especially if it involves the setting up of a large number of special purpose vehicles to accomplish the process.
Here, for example, are the thoughts of Brian Reynolds, chief market strategist at Rosenblatt Securities, regarding what’s going on:
A little more than a year ago we picked up on a trend that we termed the “sub-priming” of commodities. Wall Street has been increasingly been doing structured finance deals wrapped around commodities, and this has added a bid for them while also making them vulnerable to downdrafts.
We know that many equity investors think (or at least hoped) that, after the disastrous record of wrapping pipeline and telecom assets in the 1990’s and sub-prime housing in the last decade, financial market reforms such as Dodd-Frank would have eliminated structured finance as a macro driver. When Dodd-Frank was proposed it envisioned standardized derivatives being placed on exchanges and clearinghouse. We felt it would encourage more non-standardized, exotic, and opaque structures to be created, and in the two years since it was enacted that’s what seems to have happened.
Important trends indeed. Yet, as Reynolds also notes, they’re also very hard to quantify given they mostly occur off-balance sheet:
This process is virtually impossible to quantify. We know that’s a disappointment to equity investors who are used to dealing with voluminous information, but that’s the nature of structured finance. Many structured finance deals are private in nature. As such most people, even those in the credit markets, did not know the full extent of the structuring going on in the 1990’s or the last decade until those firms, which were trapped by “Special Purpose Vehicles” (SPVs), such as Enron, WorldCom and Citigroup, became forced sellers. But over the last year we’ve heard more and more anecdotal evidence of Wall Street increasingly structuring commodity deals, such as structured notes and swaps and even using commodities as collateral.
In Reynold’s opinion — even though he’s not a commodity expert per se — this activity significantly increases the risk of a sharp drop in oil in the coming year, especially since structured finance transactions usually come with caps and floors, which act as important support and resistance levels.
That’s an interesting analysis for oil or copper. However, what happens if the commodities in question happen to be food? The only place this used to happen significantly was the gold market. Actually, it’s understandable for oil too. But is Wall Street so hungry for financial innovation that they’re willing to bet the world’s food supply on it? Yes, of course. They’ve already done it several times. History teaches us that it drives the prices up to unreasonable and unsustainable levels that take all kinds of people down when prices collapse.
Here’s an interesting bit on a contango that happened in the wheat market that already led to a food price crisis in 2007-2008. This one had the Goldman Sachs brand all over it. Last year, a similar situation occurred with the Oil Market and the same player.
On Monday, April 11, Goldman Sachs told its clients to sell commodities, and the market reacted with a $4 tumble in the price of West Texas Intermediate (WTI) crude oil and sell offs in other commodities.
On Thursday, April 14, the leaders of the “BRICS” nations (Brazil, Russia, India, China and South Africa), meeting in Sanya, China, continued to press for a new world monetary system that has a much lower reliance on the dollar, and called for stronger regulation of commodity derivatives to dampen excessive volatility in food and energy prices.
We are in another commodity price run up, like that experienced in the 2005-2008 period. Such commodity price frenzies have devastating consequences for the world’s poor who, in some instances, already spend half of their income on food. Today, in the U.S. itself, the rise in the price of gasoline to more than $4 per gallon threatens an economy still struggling to free itself from the still lingering effects of the last bursting bubble.
It appears that the Western economic systems have become ever more volatile over the past decade. That is, bubbles, followed by severe contractions, are appearing more often and with increased severity. This is in stark contrast to the dampening of the business cycle we observed, and celebrated, in the 1980s and 1990s. So, what changed?
In Harper’s last July, Fredrick Kaufman wrote an article entitled The Food Bubble, which explained the reasons for the run up in agricultural commodity prices just prior to the ’08 financial meltdown and worldwide recession. The popular business media gave the article short shrift. But, most of what Kaufman observed as the causes of the commodity price run up in the ’05-’08 period is now being repeated, a short three years later.
I’m finding all this interesting as I watch Jamie Dimon squirm on the big hedge loss reported by JP Morgan. That’s the $2 billion mark to market loss that makes me thing we’re on the verge of 2007 redux. Specifically, the market concentration is incredible because “the whale” created a huge problem for tons of hedge funds. Also, the regulator appeared to be asleep at the switch. You remember are old friends the Credit Default Swaps?
99 per cent of all CDS trades live in an information warehouse called DTCC, to which the regulators of the banks have access in however much detail they want!!! What kind of regulator doesn’t go and look at the that, when the mere public, aggregated info shows this?
Go check out the accompanying graph.
Anyway, I’m not going to get long winded and all financial economist on you, but sheesh, how many times does history have to repeat itself in markets before we get some one to do something useful? I’m just reminded of all the little canaries that died on the way to the big 2007 blow up that people ignored. How many canaries have to die this time out before we get another big one
I should’ve stuck to my research agenda, but no, I just had to go look at business headlines. There’s a debate on at The Economist over “Who benefits from financial innovation?” Nobel Prize winning Economist Joseph Stiglitz is arguing that financial innovation hasn’t been boosting economic growth but his position (which is mine) is currently in the minority.
The right kind of innovation obviously would help the financial sector fulfil its core functions; and if the financial sector fulfilled those functions better, and at lower cost, almost surely it would contribute to growth and societal well-being. But, for the most part, that is not the kind of innovation we have had.
In terms of that big question up there, the answer is found today on Bloomberg.com. If you answered “what is the vampire squid”,you’re absolutely right. The more relevant question appears to be what did that cost us? For that, I can only answer a lot and there’s more to come. Here’s the headline: Secret AIG Document Shows Goldman Sachs Minted Most Toxic CDOs.
Well, there’s your financial innovation for you.
So, the fun thing about the story is that the unlikely hero is Darrold Issa (Republican) member of the House Committee on Oversight and Government Reform who “placed into the hearing record a five-page document itemizing the mortgage securities on which banks such as Goldman Sachs Group Inc. and Societe Generale SA had bought $62.1 billion in credit-default swaps from AIG.” Oddly enough,it appears that Issa may have not really known exactly what he had just disclosed. It didn’t really attract any attention at the time. Luckily, some one who knew something eventually looked at it. This was essentially a list of the deals that made AIG insolvent. These were also the deals that the government basically bought when it rescued AIG.
The document Issa made public cuts to the heart of the controversy over the September 2008 AIG rescue by identifying specific securities, known as collateralized-debt obligations, that had been insured with the company. The banks holding the credit-default swaps, a type of derivative, collected collateral as the insurer was downgraded and the CDOs tumbled in value.
The public can now see for the first time how poorly the securities performed, with losses exceeding 75 percent of their notional value in some cases. Compounding this, the document and Bloomberg data demonstrate that the banks that bought the swaps from AIG are mostly the same firms that underwrote the CDOs in the first place.
Here’s an even more interesting analysis from a legal standpoint. I know the deal was shady, I just have never known exactly if shady=unethical=illegal. The devil is truly in the details placed into public record by Issa.
The identification of securities in the document, known as Schedule A, and data compiled by Bloomberg show that Goldman Sachs underwrote $17.2 billion of the $62.1 billion in CDOs that AIG insured — more than any other investment bank. Merrill Lynch & Co., now part of Bank of America Corp., created $13.2 billion of the CDOs, and Deutsche Bank AG underwrote $9.5 billion.
These tallies suggest a possible reason why the New York Fed kept so much under wraps, Professor James Cox of Duke University School of Law says: “They may have been trying to shield Goldman — for Goldman’s sake or out of macro concerns that another investment bank would be at risk.”
Okay, so we know who we’re speaking of when Cox says the New York Fed, right? That would be Treasury Secretary Timmy-really-in-the-well-this-time Geithner. Bloomberg is going as far as to label his actions a cover-up. I frankly think that looks like a mild charge. Interestingly enough, an earlier version of the information was released by AIG but the counterparty names were redacted at the time. Chris Dodd’s committee had requested the information. Without the names–or more truthfully the frequency of ONE name in particular–you can’t really see much of a conspiracy.
What this detailed list shows–because the names are now out there along with the deals–is that the very same folks that underwrote the original toxic securities were the same folks that went to AIG to bet against them. It doesn’t look like they were hedging or placing insurance on their risk which would be natural and understandable transactions. It appears they fully knew the securities were bad and were preparing to make money by placing offsetting bets. This activity could only be determined if you saw the names of the counterparties next to the deals themselves. So, the appropriate document to list the information on would be a Schedule A. AIG released a schedule A for several years during the crisis, but without some of the most relevant details. We know now that this was at the request of the NY Fed (aka Tim–I’ve got GS on speed dial–Geithner).
In late November 2008, the insurer was planning to include Schedule A in a regulatory filing — until a lawyer for the Fed said it wasn’t necessary, according to the e-mails. The document was an attachment to the agreement between AIG and Maiden Lane III, the fund that the Fed established in November 2008 to hold the CDOs after the swap contracts were settled.
AIG paid its counterparties — the banks — the full value of the contracts, after accounting for any collateral that had been posted, and took the devalued CDOs in exchange. As requested by the New York Fed, AIG kept the bank names out of the Dec. 24 filing and edited out a sentence that said they got full payment.
The New York Fed’s January 2010 statement said the sentence was deleted because AIG technically paid slightly less than 100 cents on the dollar.
Before the New York Fed ordered AIG to pay the banks in full, the company was trying to negotiate to pay off the credit- default swaps at a discount or “haircut.”
Read that date. We’re talking November 2008. If you read further into the Bloomberg article you’ll see that the names were withheld also during 2009. Issa put the names out because he wanted to show U.S. taxpayers where their money went. It’s unclear to me if he understood then or maybe even now that by putting out the details of the deals, he’s basically provided information that let’s us know how deeply Goldman Sachs was in on the financial innovations that blew up the economy. Not only that, it appears they knowingly may have been loading some of those innovations with assets they knew would explode and that they were actively placing bets on that outcome at AIG. As of the end of January, 2010 meeting, Geithner and the NY Fed still didn’t want the details released. No fucking wonder!
Janet Tavakoli, founder of Tavakoli Structured Finance Inc., a Chicago-based consulting firm, says the New York Fed’s secrecy has helped hide who’s responsible for the worst of the disaster. “The suppression of the details in the list of counterparties was part of the coverup,” she says.
E-mails between Fed and AIG officials that Issa released in January show that the efforts to keep Schedule A under wraps came from the New York Fed. Revelation of the messages contributed to the heated atmosphere at the House hearing.
Tavakoli also says that the poor performance of the underlying securities (which are actually specific slices or tranches of CDOs) shows they were toxic in the first place and were probably replenished with bundles of mortgages that were particularly troubled. Managers who oversee CDOs after they are created have discretion in choosing the mortgage bonds used to replenish them.
“The original CDO deals were bad enough,” Tavakoli says. “For some that allow reinvesting or substitution, any reasonable professional would ask why these assets were being traded into the portfolio. The Schedule A shows that we should be investigating these deals.”
So, check this out.
Neil Barofsky, the special inspector general for the Troubled Asset Relief Program, who delivered a report on the AIG bailout in November, says he’s not finished. He has begun a probe of why his office wasn’t provided all of the 250,000 pages of documents, including e-mails and phone logs, that Issa’s committee received from the New York Fed.
Okay, now, follow closely as I connect the dots to this one: U.S. Treasury loan plan may exclude TARP watchdog.
If you were Timothy Geithner, would you want Neil Barofsky poking around any more programs? Wouldn’t you be highly interested in controlling TARP oversight? No wonder Treasury officials and others have been after Barofsky for some time. (Here’s an outline of their actions and attempts to remove independency by Glenn Greenwald at Salon from last summer. )
Geithner basically knew the vampire squid was a huge contributor to the fall of AIG. It looks like he may have actively encouraged covering-up that information. It also looks like GS actively securitized mortgages it knew would fail eventually and made huge counterbets based on that information using AIG as its personal bookie. Then, when AIG couldn’t cover the bets, GS refused to negotiate any deals (they must’ve known something like a bail out was forthcoming). Then knew exactly what was in those securities so they knew their real value. Geithner made AIG pay GS 100% of the value when it appears they were worth around 35%. When AIG tried to report the counterparties, the NY FED told them to withhold the information. (Yet, post Timmy, the NY FED appears to have released everything to Issa’s committee. During Timmy’s time, remember, everything was heavily edited and Barofsky appears not to have gotten the same information.) They also were told not to provide details on the mark downs. Timmy must’ve known that Goldman was betting against the toxic assets they had created. Not only that, it looks like Goldman was actually shorting themselves! AND these guys were Obama’s major contributors. Giethner must’ve been part of the packaged deal.
I got one thing to say now. A lot of folks should be doing a perp walk on this one. This looks like fraud. If this is the kind’ve financial innovation these folks voting on The Economist poll want, then they should just as well turn their life savings over to Bernie Madoff right now. I just wish they’d stop giving the likes of him mine too.
(I hope I’ve explained this adequately, cause this sure is one fucking twisted tale.)