Showing posts from March, 2008

Anatomy of a Crisis: The "Credit Woes" of the Summer of '07 – (8)

So, why CDO and not MBS? What is the difference between these securities?

Considered in isolation, the answer is, very little.

But nothing exists out of context, certainly not when it involves speculative capital that can only exist within a relation.

The critical difference between an MBS and a CDO is this, that an MBS is created to securitize mortgages, but CDO is a created to satisfy an arbitrage relation. Therein lies a world of difference.

The starting point of an MBS is the pool of available eligible mortgages. When all the mortgages in the pool are used up in the creation of the security, no more MBS could be created until the pool is replenished through the arrival of new mortgages. What is more, after an MBS is created, it must be marketed to investors.

In a CDO, the driver of the product creation is the demand, which is endless as long as the arbitrage opportunity persists; the availability of the eligible mortgage pool is secondary. Of course, a CDO cannot exist without mortgage…

Anatomy of a Crisis: The "Credit Woes" of the Summer of '07 – (7)

For arbitrage to be possible, there must be a difference in rates; the larger the difference the bigger the arbitrage profit. Differences in rates are due to either the variation in tenor (time to maturity) or credit quality. To maximize its profit, speculative capital sets to borrow at the lowest short term rate and use it to buy highest-yielding, longest term asset.

The superlatives "lowest" and "longest", nota bene, do not pertain to a logical or mathematical extreme; speculative capital is too pragmatic to chase abstractions. Rather, they connote a practical consideration: speculative capital strives to create and exploit the widest borrowing-lending rate differential doable.

The lowest short term rates are available in the commercial paper (CP) market. The rates are low precisely because the CP market is accessible only to highest rated corporations. Speculative capital is, alas, nomadic, with no corporate lineage and a short engagement horizon. Like a mule, it …

Struggling Not to Name Names

When it was announced a few days ago that Tony Blair was going to teach religion at Yale – he will teach “how religious values can be channeled toward reconciliation rather than polarization” – I thought we had hit the equivalent of Absolute Zero on the absurdity index. You could not possibly top that – or go lower.

Then came the announcement of the Fed's latest design to stabilize the markets. It said, in part:
The Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured ... by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS. The Fed's normal lending mechanism is similar to the way a pawn shop operates. You pledge US Treasuries or other Fed eligible securities and receive cash in return. When you pay back the debt, you get back your securities. The operation injects money into the financial system. The Fed co…

Anatomy of a Crisis: The "Credit Woes" of the Summer of '07 – (6)

The essence of arbitrage is constant. Its form varies from one occasion to the next, depending on the circumstances. So while it is possible to demonstrate the concept of arbitrage with a simple example, the particular form in each case must be elaborated. It is this variation of the form that appears as a new product, a new market or a new strategy and for which financial engineers in the City and Wall Street are eternally given credit.

The critical point to note is that the particular form of arbitrage disrupts the status quo with varying degree of severity. In the heydays of globalization in 1998, the New York Times Magazine devoted a section to globalization under the heading “The Nuke of the 90’s.” An awestruck former Treasury official was quoted as comparing the “global markets” to nuclear weapons and adding: “The global markets are the most powerful force the world has ever seen, capable of obliterating governments almost overnight.”

Hegel said that myth is the expression of impo…

Anatomy of a Crisis: The "Credit Woes" of the Summer of '07 – (5)

Note the "nature" of the $5.

In so far as this sum pertains to a potential loss in lending, it belongs to the realm of credit. In so far it is bought and sold as a commodity with fluctuating price, it is in the realm of market. It is in the latter capacity that it becomes the subject of arbitrage. If, for example, the price of this "$5 value" rises to $6, Arbitraguer would create a riskless position by:

• Selling the call for $6 (+$6)

• Borrowing $20 (+$20)

• Buying ½ share of stock at $25 (– $25)Numbers in parenthesis show the amount of direction of the cash flow, with “+” for inflow. The strategy yields $1 net income no matter what the future stock price, as shown below:

If stock is $60:
• Sell ½ shares for $30 (+30)
• Pay back the $20 debt (– $20)
• Pay $10 to call holder (– $10)

Keep the $1 net income.
If stock is $40:
• Sell ½ shares for $20 (+$20)
• Pay back the $20 debt (–$20)
• Option expires worthless

Keep the $1 net income
The idea of “$5 value” being bought and sold i…

Anatomy of a Crisis: The "Credit Woes" of the Summer of '07 – (4)

Option Player is a piker. He wants to make it big in the markets but has neither Arbitrageur’s acumen nor Lender’s capital. The combination makes him vulnerable to manipulation. Against this backdrop, Arbitrageur and Lender appear at his door. The arbitrageur is a descendent of the Music Man and knows the Alpha and Omega of salesmanship, beginning with sympathizing:

“I understand you are in the market to invest but you are in a jam because you have no money. Indeed $50 is a great sum. Who has that kind of money these days?"

Option Player nods in approval.

Arbitrageur continues: “But look! Perhaps you are not approaching this thing from the right angle. Allow me to show you a way that you could profit from a rise in the stock without owning it. I know it sounds too good to be true but this one is good and true!

“The stock you want to buy is $50. One year from now, it could rise to $60 or fall to $40. Here is my offer. One year from now, if the stock is $60, I would pay you $10, which …

Anatomy of a Crisis: The "Credit Woes" of the Summer of '07 – (3)

To arbitrage credit, speculative capital must first bring it into its orbit, make it “game.” The idea develops gradually from the practical consideration of trading. The arbitrageur is the personification of speculative capital. In that capacity, he is a practical man, interested only in profit and loss. When he sees a new opportunity, he rushes in to exploit it without giving much thought to the theory. “How could practical man think?”

What follows is the fascinating story behind the creation of the foundation on which the entire financial markets in the industrial world rest. If also offers a lesson in the limits of empiricism, however intuitive and obvious, of the kind the central bankers routinely practice.

Let us go then together to the scene of the discovery of credit as a tradable product, where Arbitrageur has gone to Lender to borrow money for a sure-fire, cannot-miss trading strategy. For simplicity, we assume interest rate is zero. This assumption does not affect the logic …