Baseline Scenerio -- Structured Finance For Beginners

The Baseline Scenario
Structured Finance for Beginners
Posted: 29 Mar 2009 04:00 PM PDT
For a complete list of Beginners posts, see Financial Crisis for Beginners.
This is more of an advanced beginners topic - I already covered CDOs (collateralized debt obligations) in my first Beginners article - but I imagine that most of our readers are already familiar with structured products. At least, many people know that first a bunch of securities are pooled together, and then they are “sliced and diced,” in the common media parlance I find incredibly annoying. But Joshua Coval, Jakub Jurek, and Erik Stafford have a new paper, “The Economics of Structured Finance,” which does a brilliantly clear job of describing what these securities are and why they were so widely misunderstood, with the results we all know.
The paper is 27 pages long, not counting references, tables, and figures, and if you are comfortable with probabilities and follow it carefully you can understand everything in it. I will provide a summary to whet your appetite. I am not going to use numerical examples because the examples they use throughout their paper are so good.
The key to CDOs is that they could be used to manufacture AAA-rated securities out of underlying securities (like mortgages) that were not even close to AAA. (”AAA” is a bond rating, meaning that the security in question had about a 0.02% chance of defaulting in a given year.) This is well known. But although these new, synthetic securities had expected default rates comparable to traditional AAA-rated securities, they had other properties that were unlike their traditional brethren, having to do with (a) correlations between the underlying assets and (b) sensitivity to underlying default rates. (a) is the probability that, if one mortgage inside a pool defaults, the other mortgages will also default; (b) is the degree to which small changes in those default rates can affect the expected value of the manufactured AAA securities. This meant that these CDOs were much more sensitive both to errors in estimating their characteristics, and to macroeconomic changes, than most people realized.
If you didn’t follow that I’ll go over it again more slowly.
In a simple, “pass-through” securitization, each investor in the pool of mortgages has an equal claim to the mortgage payments. Therefore, the expected loss for each security is exactly the same as the average default rate of the mortgages.
In a CDO, the investors have unequal claims. By creating some junior tranches (”tranche” is French for “slice,” in case you were wondering) that absorb the first losses, you create a large senior tranche that is buffered and suffers no losses until all of the junior tranches are completely wiped out. This is why the senior tranche can get a AAA rating; the estimated chances are pretty low that enough people will default to wipe out the junior tranches. In a CDO-squared, you take some of the junior tranches of ordinary CDOs, pool those, and then create tranches out of that pool. The amazing thing is that you can then create not only a senior tranche but a mezzanine (middle) tranche of your CDO-squared that has the expected default rate of a traditional AAA bond, even though it is made out of junior tranches. (There are very clear examples of all of this in the paper.)
However, this only works well if the default probabilities of the underlying mortgages are not highly correlated. Assume in an extreme case that defaults among the underlying mortgages are perfectly correlated: either none default or they all default. In this cases, the tranches do nothing for you: if all the mortgages default, then the senior tranche gets wiped out along with the junior tranches.
Furthermore, the performance of AAA-rated tranches is highly sensitive to the default rates of the underlying mortgages. Conceptually, this happens because the amount of protection provided by the junior tranches is not that much bigger than the expected default rate; so if the actual default rate is just a little higher than expected, a much larger proportion of the protection will get eaten up. In the example in the paper, an increase in defaults from 5% to 7.5% can knock a AAA-rated tranche of the CDO-squared down to a BBB- rating.
The conclusion is probably apparent to many readers at this point. The underlying mortgages were more highly correlated than people thought, both because they often came from the same types of developments in the same regions (California, Nevada, Florida), but also because everything in the economy became highly correlated. And as the economy got worse, default rates climbed higher than estimated based on historical data, because all the historical data came from a period when housing prices only went up. While this would only have a “linear” impact on a simple pass-through securitization (double the defaults, double the losses), it had a “non-linear” impact on AAA tranches of CDOs, and especially of CDOs-squared.
Finally, there is one more misunderstood characteristic of CDOs. Securities with the same expected payoffs, and hence the same rating, can have different characteristics. In particular, they can differ in their degree of correlation with the rest of the economy. The authors cite catastrophe bonds (which default only, for example, if a hurricane hits South Florida) as securities that are uncorrelated with the economy. Because of their lack of correlation, they are more desirable than other securities with the same rating, and hence have lower yields (higher prices). Senior tranches of CDOs are just the opposite: they only go bad if the economy as a whole goes bad; that is, they are highly exposed to systemic risk, which almost by definition is difficult to quantify. Because of this high degree of correlation, investors should have demanded higher yields (lower prices). But because investors by and large thought that all AAA securities were comparable, they didn’t demand high enough yields, and the issuers (investment banks) made the difference.
The bottom line is that all AAA securities are not created equal - even if they have the same estimated probabilities of default. And treating AAA tranches of CDOs and CDOs-squared as if they were AAA corporate bonds played an important role in the growth of the structured finance market and, as a result, the overall asset bubble that is collapsing around us.

Gaming the Legacy Loan Auctions
Posted: 29 Mar 2009 03:00 PM PDT
My colleague Ilya Podolyako is back with a comment on the Geither Plan to buy toxic assets, as well as an update to his previous post about the constitutionality of government takeovers of private property. He discusses in particular the possibility (also suggested by one of our readers) that the government could “seize” toxic assets and pay “just compensation,” even in the absence of a bankruptcy or a takeover. Ilya is a 3rd-year student at the Yale Law School and, among other things, an executive editor of the Yale Journal on Regulation. The post below is by Ilya.
PPIP for Legacy Loans = Free Put Options for Banks
I finally got a chance to read through the PPIP plan in detail. I noticed one curious point: under the program as announced, auctions for the legacy loans do not appear to be binding on the contributing entity.
The Process for Purchasing Assets Through The Legacy Loans Program: Purchasing assets in the Legacy Loans Program will occur through the following process:
. . .
Pools Are Auctioned Off to the Highest Bidder: The FDIC will conduct an auction for these pools of loans. The highest bidder will have access to the Public-Private Investment Program to fund 50 percent of the equity requirement of their purchase.
Financing Is Provided Through FDIC Guarantee: If the seller accepts the purchase price, the buyer would receive financing by issuing debt guaranteed by the FDIC. The FDIC-guaranteed debt would be collateralized by the purchased assets and the FDIC would receive a fee in return for its guarantee.
This is quite odd, since, if I read it correctly, it turns the entirety of the program into a put option for participating banks. That is, they could identify certain assets, put them up for auction seemingly risk-free, check the result, and reject anything below their internal valuation without any further capital contribution.
The structure, which seems to be confirmed by the term sheet (”Once a bid(s) is selected, the Participant Bank will have the option of accepting or rejecting the bid within a pre-established timeframe”), amplifies the lemons problem that Simon and James mention in their LA Times op-ed. If the plan revolved around binding auctions, a temporary market for the toxic assets could develop while investors make government-guaranteed “probing” bets on the precise toxicity of the assets for sale. If banks wanted the auctions to recur instead of being a one-time event (perhaps to sell a larger or more diverse set of loans), they might mix in some good assets with the bad ones. This move would assuage concerned investors and probably make it easier for the banks to get approval from their regulators for the particular sale. Investors who were smart/lucky enough to win the good assets with bids below their “worth” to the bank on a medium-term basis would then get to profit from their decision. Other buyers would want to follow suit, at least until the point in time when they would expect a bank to cash out on any previously established confidence with a large offer of only toxic securities that would earn a lot of money even in the absence of future auctions.
By contrast, if banks can selectively reject bids, they could offer an enticing mix of good and bad assets (say, 50/50) and then accept only the ones that grossly overpay for the bad ones. That is, they would get full power to exclude intelligent, accurate price setters from the auction process, undermining the efficacy of the program to an even greater extent than adverse selection would in a committed-sale context. Of course, it is not clear whether the current setup is objectively worse than the repeated-game lure-and-hook scenario, but the question is worth considering.
Updates on the Constitutionality Issue and the “Brute Force” Plan B
I thought I would provide some clarification on how I see the Fifth Amendment applying to the current stage of the economic crisis.
First, contrary to what some have suggested, the constitutionality of government policy is not irrelevant. As long as the courts are open, private parties can file suit either to stop prohibited actions from going forward, or, in a less extreme scenario, to get money damages. True, courts often dodge heated constitutional issues, but in the 1950’s, they saw it fit to prohibit the nationalization of steel mills during a time of war, so the Fifth Amendment is still a force to be reckoned with.
Second, I am suggesting that sudden regulation of previously unregulated entities would constitute a taking, not that all new regulation does. Retroactivity is key here: the Fifth Amendment protects vested interests from being nullified or diminished by new laws, but does not prevent Congress from forcing new entrants to comply with a fresh framework. Furthermore, cases on the topic make it clear that when investors knew ex ante that they were buying into a highly regulated business, new rules would not trigger constitutional scrutiny unless they explicitly contradicted previous administrative promises. For present purposes, this means that even if Congress passes a bill allowing Treasury to seize hedge funds or nationalize large conglomerates at will, the Department will still have to provide “just compensation” to previous owners.
Of course, the extent of this compensation matters a great deal for evaluating the viability of particular administrative actions. As I mentioned in the previous entry, constitutional law clearly includes contractual rights to cash flows in the definition of property. Stock and subordinated bonds fall into this category. Furthermore, there seems to be judicial consensus that, for constitutional purposes, equity has value even when the operating business appears to be insolvent, provided that this business is not actually in bankruptcy proceedings. The approach makes sense: in the face of uncertainty, both junior debt and common stock constitute a call option, and call options have value even if they are deep out of the money. For example, while Citigroup may well be unable to function without government aid right this second, its common stock is trading at $2.62 because of the possibility that the company will survive the crisis intact and generate dividends/appreciate in value in the future. If the government were to nationalize Citi and push the value of the stock to 0 by decree, it would potentially be on the hook for the entire $14 billion market cap.
The application of the takings doctrine to debt is more complicated. Suppose the government takes over Citi and says it will pay only 30 cents on the dollar for its junior unsecured liabilities, which matches the market price for these bonds. The Supreme Court has wavered on the extent of just compensation required for this 70% haircut. The traditional test for regulatory takings in Penn Central emphasizes diminution of value as the takings metric, and one could argue that paying market price for the assets does not diminish their value. On the other hand, unexpected termination of the option on future cash flows does foreclose the valuable possibility of getting more money back. I really don’t know which way a court would come out here. I do know, however, that a failure to give the debtholders a chance to argue for a higher price for their assets (either in court or some special tribunal) would probably incur judicial wrath for breaching either the takings and due process clauses of the Fifth Amendment or the Seventh Amendment guarantee that civil controversies over $20 will be settled by juries.
Again, if investors in AIG, Citigroup, SAC Capital Advisors, or General Motors knew that this kind of executive intervention was possible when they put up their money, the story would be completely different. It is the sudden imposition of new, costly rules that is the problem. This temporal element highlights the difference between nationalization and various versions of bankruptcy: even if Article I, Section 8 of the Constitution did not explicitly authorize a uniform bankruptcy code, it could pass muster under the Takings Clause merely because some version of the judicial power to settle claims on insolvent debtors was in place long before any current investors were born. That is definitely not true of the power to summarily seize any institution that poses systemic risk to the financial system, as evidenced by the fact that Geithner and Bernanke made their plea to Congress this week in the first place.*
There is an upside to all of this - the “brute force Plan B.” If the Public-Private Investment Partnership fails due to a lack of participation by banks, investors, or both, the government could just file suit in a federal district court to take control over any toxic assets it wants. The fact that the judicial branch would oversee the action would preempt any due process or Seventh Amendment challenges. Banks would come in as defendants in the action. Treasury would still be on the hook for “just compensation,” but in the current political climate, juries are likely to be pretty stingy with taxpayer money. Indeed, banks may prefer a quick hand-over of the assets to actually litigating the claim. For the sake of expediency, the government could also attempt to seize the assets first in exchange for their “market value” and litigate any factual questions later. I am not persuaded that this course of action would actually be any faster, since banks could ask a court for a temporary restraining order to block the action. This would move the policy back to litigation square one, but now the executive branch would look like it was avoiding judicial scrutiny instead of trying to maximally honor the constitution in difficult financial times. All things being equal, it is better to get to the judges first.
Thanks to Jesse Townsend for feedback on the constitutional analysis above.
By Ilya Podolyako; posted by James Kwak

You are subscribed to email updates from The Baseline Scenario To stop receiving these emails, you may unsubscribe now.
Email delivery powered by Google
Inbox too full? Subscribe to the feed version of The Baseline Scenario in a feed reader.
If you prefer to unsubscribe via postal mail, write to: The Baseline Scenario, c/o Google, 20 W Kinzie, Chicago IL USA 60610