Showing posts from June, 2010

The Goldman Case – 4: CDSs and Synthetic CDOs

The CDO at the center of Goldman case is a synthetic CDO.
According to the New York Times, a paper that has won many awards for educational reporting – that would be reporting that educates the public:
During the later stages of the boom, banks began offering so-called synthetic CDOs. Instead of combining bonds, these combine credit default swaps written against specific bonds or pools of bonds. Credit default swaps were developed as a kind of insurance on financial instruments, albeit in an unregulated form. Essentially, one party swaps the risk of holding debt with another by paying a fee to that swapholder in return for a promise that a certain amount of money would be paid in case of default.According to Wikipedia:
In technical terms, the synthetic CDO is a form of collateralized debt obligation (CDO) in which the underlying credit exposures are taken on using a credit default swap rather than by having a vehicle buy assets such as bonds.
According to Investopedia, a synthetic CDS is:

Of Labor and Women’s Rights in Europe

Today’s Financial Times published a joint commentary piece by the prime ministers of the UK and Sweden under the heading Reining in Europe’s deficit is just the first step. As you can infer from title, it was an economic manifesto put together “to ensure that Europe thrives and prospers”. It had “four clear steps”.

The first step was cutting back. “We have to accept that there are things we can no longer afford,” the authors said. Note the wording. First, a reference to things that we cannot afford, which everyone knows to be true. Then the “no longer”, slyly inserted; we are now talking about the things that “we” used to be able to afford but now, we have to accept, we cannot. Here, the two gentlemen of Europe are not talking about private jets. They are talking about retirees affording to live with some dignity. It is that, that “we” can no longer afford.

The second one was fixing the financial system.

Then came the third step:
The third step is creating the conditions for growth. Europ…

So How Should We Respond to Regulatory Failure?

Mark Thoma poses the question on his blog. Specifically, he notes:
I keep reading arguments that start with the fact that regulators have been imperfect in the past and use it to argue that we should eliminate (or substantially reduce) the amount of regulation that is imposed. However, just because regulators missed things in the past like Bernie Madoff, the financial meltdown, and the risks that BP was taking does not imply that regulation ought to be reduced or eliminated.Agreed. And the conservatives beating the anti-regulation drum are getting tiresome. Let's do a 30-second review of regulatory failure and the financial crisis.

There were structural reasons for the failure:

1. We have a confusing hodgepodge of regulators (OTS, OFHEO, FDIC, SEC, OCC, Fed, etc.). Is it any surprise that regulatory issues fall through the cracks between their respective walled fiefdoms? Or that their regulatees go "regulator shopping," trying to find a sympathetic ear, with such a plethora…

The Goldman Case – 3: Recapping CDOs

Recall that our purpose, when we got together as a group of investors, was making money. “A group of investors” has no other purpose.

I said the way to go was arbitrage.

Some of you were not clear on that point. You thought we were going to buy mortgages with the idea of selling them later – presumably for a profit. Where is arbitrage?, you asked, echoing the confusion of some of the country’s best quants.

“Friends”, I recall saying to you. “Let us set aside the not so small matter of being short in cash and focus on basic finance. A mortgage is a bond. Bond prices increase when interest rates decrease. Are we saying that we are buying the mortgages because we know interest rates will go down? If so, why bother with mortgages which have prepayment and relatively high default risks? Why not simply buy a bond – or a pool of bonds?

“No,” you responded. “We do not know which way the interest rates will go. And yes, we are short in cash. And now that you mention it, why indeed bother with mort…

The Shape of Things to Come in Spain

Fundamental misunderstanding, when it comes from animals, is funny; we find the animals’ innocence in terms of “not getting it” endearing. Hence, the “animal jokes”. You’ve probably heard the old one about the horse turning to the jockey and saying: what are you hitting me for, there is no one behind us?!

Fundamental misunderstanding from people is not funny. It reeks of pathos, which is depressing.

It must have been over twenty years ago. I was waiting for a friend at the headquarters of then Citibank in New York. The bank had recently increased the minimum withdraw from its ATM machines from $20 to $40. A young woman came to withdraw what must obviously have been $20 and could not. She made a scene, complaining aloud to the bank staff, threatening that she would take her business elsewhere.

If she were a horse, the episode would have been funny. But as she was not, it was not: the spectacle of a young woman who thought she had money until she came head to head with the mass of finance …