Monday, April 06, 2009

Leverage doesn't kill investors. Bad investments do.

Every one wants to blame the financial crisis on leverage. There was a glib comment on the blog the other day which reflects a common view:

"Sad to see the "cure" for overleveraged, undercollateralized balance sheets to be... more leveraged finance."

No offense to Jonathan intended, as his view probably reflects the majority of opinions among those who follow finance. But I find blaming leverage per se to be a weak argument. Thus I don't see bringing some degree of leverage back into the market as a negative. Furthermore, I don't think that simply blaming leverage will be constructive as we try to construct a regulatory structure to prevent similar meltdowns in the future.

Let's consider the case of a CDO of ABS. To make life simple, we'll assume CDO was constructed from mezzanine bonds from HEL deals. This would be securities similar to the ABX 2007-1 A index, basically the segment of major home equity deals from early 2007 which were originally rated "A."

The HEL deals were structured something like the following (although I'm presenting a simplistic version, the point stands.) I'm assuming $100 million original face, with the underlying mortgages having a 6.75% rate.

  • Senior: 5.75% coupon, $80 million
  • Mezzanine: 6.50% coupon, $15 million
  • Subordinate: 8.00% coupon, $5 million


  • All principal cash flows to the Senior until it is entirely repaid, then to the Mezz, then to the Subs. Interest payments are only made to the mezz and subs if the senior interest obligations have been met. (Don't get hung up on the math right now, it won't be important to my point. If you have questions about ABS and/or CDOs, e-mail me. Accruedint AT gmail.com).

    In a CDO of ABS transaction, the CDO would buy a series of mezz bonds, then repackage them into a similar senior/sub structure. So now let's say we have a $100 million CDO which buys the mezz of 50 different HEL deals, all structured similarly to above.

    The CDO builds its own senior/sub structure as follows:

  • Senior: 5.45% coupon, $80 million
  • Mezz: 6.00% coupon, $12 million
  • Sub: 8.00% coupon, $4 million
  • Equity: $4 million


  • Same deal as above, where the senior gets all principal and interest due before the other pieces. Only once all other classes get their principal and interest does any cash flow accrue to the Equity. One might think of the sub/mezz/senior pieces of the CDO as providing leverage to the Equity. Since the total assets in this deal is $100 million, with equity of $4 million, we have 25x leverage.

    Its easy to see why the CDO of ABS world came crashing down. The ABX 2007-1 A is now trading at $2.5, or a 97.5% loss vs. the original face. So the CDO built on securities similar to ABX would have almost all principal in the deal wiped out entirely. Even the senior most piece of the CDO, which would have been rated AAA originally, would have suffered huge losses.

    But was it the 25x leverage that was the problem? Not at all. Substitute any number for the equity, and the structure still doesn't work, because the underlying collateral is crap. If you are going to try to tell me that leverage caused the meltdown, then you'd need to show me how a different leverage figure would have prevented the problem. Here is an example of a leveraged vehicle that fails at any haircut.

    Now one might say that if the ratings agencies would have required more overcollateralization, these CDOs never would have been created. Perhaps. But again, if leverage isn't the problem with the security, then allowing too much leverage wasn't the ratings agencies' primary mistake. The real problem is that the ratings agencies never considered the binary nature of these structures. If you build a CDO based on all mezz consumer loan ABS, and consumer loans perform poorly, then the whole deal is threatened. We didn't need catastrophic losses on consumer loans to impair the senior-most pieces of these CDOs. Had sub-prime consumer loans suffered a mere 10% loss rate, the CDO would have suffered a 50% loss rate! That would have resulted in the "AAA" rated Senior piece suffering a 30% loss. That isn't acceptable for a AAA-rated asset.

    It isn't like the ratings agencies should have rated these types of CDOs AAA at some lower leverage level. They shouldn't have rated these types of CDOs at all. We talk about toxic legacy assets. These CDOs were toxic from the word go.

    Now consider this. Why didn't the ratings agencies figure that consumer loans could go all go sour at once. Why did they assume that a 10% loss rate was nearly impossible? Or if you want to damn the ratings agencies as mere minions of the investment banks, why were people buying these CDOs? Those investors must also have assumed that the 10% loss rate was nearly impossible. Else they wouldn't have bought the bonds at all. So why was every one so confident?

    We all want to blame some nefarious party, because that would feel better. It is more satisfying to think we were all duped by the evil geniuses on Wall Street. But what if it was as simple as the Fed having succeeded in dampening the business cycle that people started to assume volatility would remain permanently low? What if the fact that previous disturbances that could have had greater contagion (1987 crash, Asian Currency crisis, Russian Debt crisis, LTCM, Y2K, Dot Com bubble, 9/11, etc), didn't. People began to assume the age of crashes was over.

    Now I'd be a fool to say that leverage played no part in the crisis. Clearly financials got over-leveraged. Part of the problem is that with so much leverage, some financials (AIG, Lehman, Bear) didn't have enough time to see if their asset bets would play out. But why they got over-levered was a response to contracting yield spreads. Or put another way, ROA was dropping so in order to get the same ROE you needed more leverage. Spreads were contracting (and thus ROA falling) because there was greater confidence in a more stable economic horizon. As ROA fell, too many fell into a trap of buying poorly constructed securities to get a relatively small amount of extra yield. And before you try to say that no one saw ABS CDOs as riskier, consider that the senior-most ABS deals always yielded 20-30bps more than the senior-most commercial loan-backed CDOs. Every one knew that consumer ABS-backed CDOs were more risky!

    So ultimately, leveraged investing comes down to picking good assets first, then getting the leverage right. The crisis has been brought on by poor asset decisions more so than too much leverage.

    31 comments:

    Nathan said...

    The leverage of an ABS CDO equity is a lot more than 25 to 1 with respect to the underlying mortgages, because the ABS mezz in your example is already effectively levered 5 to 1. So the leverage is really more like 125 to 1. Even the senior position in the CDO is effectively 5 to 1 levered. So maybe the problem is too much leverage after all.

    Advant Guard said...

    Isn't the real issue risk management? An unleveraged bad investment can lose not more than 100%. A leveraged bad investment can lose a lot more than 100%.

    An investor has to know how much he can afford to lose and understand the risks he is taking.

    In this case, the ratings agencies evaluated the risk that one mortgage would go bad because of job loss or illness, and reasoned that having a pool of mortgage should reduce the overall risk. But they ignored the systemic risk of bad underwriting and a period of falling home prices.

    Marcf said...

    Yo AI,

    Weak argument, faulty logic. Look kids, smoking doesn't kill! Take this guy, he was a chain smoker but he got run over by a bus! He didn't die of smoking he died of bus run-over. Quod era demonstratum.

    Sure any leveraged investment (smoking) in real estate derivatives was a shitty investment because real estate is a shitty investment nowadays (the bus).

    Seriously though, take some unregulated banks where leverage was 30x, that means that a 3% down swing in assets will wipe out equity in their balance sheet. This is the main reason why MTM is being suspended as part of Bernanke's shock and awe program.
    Credit money, a fake bank construct based on the money multiplier will take seniority in capital structures when bad debt arises. This is what got Marx all riled up back in 1870, that credit money or fake money would senior equity capital from entrepreneurs and investors. He wasn't anti-capital. He was anti-debt.

    Of course, and more to your point, bad debt doesn't materialize if investments are good, or if they materialize, are innocuous if the default rates are properly anticipated and yields set accordingly. But this is a tragedy of dramatic mispricing, some of these were AAA securities after all.

    The mispricing comes from too much leverage. Narrative inspired by minsky's financial instability hypothesis. As monetary mass increases, so does the volume of configuration space it can finance, meaning we can finance a lot more shit that we couldn't before (subprime bubble). In parralel it pays to lever as assets prices go up and real men lever up. At first, a type 2 ponzi scheme takes hold. As a result, lending standards go down. Securitization made ashes of due diligence and complexity and conflict of interest made sure all of this risk was mispriced ( dummy version: you can't lose man, even if you default, the house will be worth so much more!).

    Clearly all of these steps are a consequence of an out of control monetary mass, born out of out of control credit money expansion born out of securitization.

    Securitization is the main culprit, an innovation designed to bypass the depression era legislation designed to limit .... the amount of leverage in the system.
    So this opinion seems to reflect the arrogance and ultimately ignorance that characterized this pre-delegeraging generation of leaders. They knew better than our forbears. Hopefully the knowledge we are quickly rediscovering won't be so easily forgotten in our internet enabled world.

    Consider this a strike two. One more and I unsubscribe from your feed ;)

    GS751 said...

    You should do a write up on SIV's and how its basically a leveraged carry trade.

    Accrued Interest said...

    To All:

    I'm not saying leverage isn't problematic. I'm just saying we should look at the assets first and the leverage second. What it feels like most commentators are doing is blaming leverage and stopping there.

    What I'm trying to say is that we'd be in a similar situation even if the financial system was somewhat less leveraged. Obviously if there were zero leverage, that would be completely different, but then again, that's not a realistic world is it?

    Look, Goldman Sachs was twice as leveraged as Lehman. Goldman made better decisions about their assets. Lehman was sunk by their assets more so than their debt.

    Accrued Interest said...

    Nathan:

    100% correct on the leverage. But it still tells you that the asset was bad first. Losses were just accelerated by the leverage. Am I making sense?

    Avant:

    Yeah, risk management basically means combining good asset decisions with the right leverage. That's what I'm trying to say. Its more complicated than just saying "leverage is bad" end of conversation.

    Marc:

    Glad you read with such an open mind.

    Josh Kalish said...

    Great post.

    IMHO, one thing that is ignored is that securitization is actually a much better way to pass along the risks to the appropriate parties.

    You can take the big money center banks that are regulated many times over. Banks like WFC have 100b + of loans sitting on their books with only the standard banking leverage behind them. Yet, they will loose most of their value the day they have to mark them properly. Again, it was bad lending, not leverage that has killed these banks.

    Along the lines of the request from gs to write about SIV's. One thing I've never understood is why Citi had to put the SIV's back on its balance sheet. Since the SIV is a separate entity, why did they have to take it on balance sheet?

    ab said...

    Josh:

    I think I can explain this. The biggest reason Citi has to put the SIVs back on its balance sheet is the reputational risk involved in not doing so.

    SIVs (along with vanilla CP conduits) come with an implicit guarantee by the sponsor (in addition to some explicit LOC). If Citi didn't repurchase the SIV paper from investors, those investors would get burned badly and want nothing to do with Citi (or anything it issues).

    By bringing the SIV assets on balance sheet, they can (1) maintain the relationship and (2) potentially sell the assets for a better price when the market turns.

    Not saying this was a wise move, just giving the rationale.

    Zvi said...

    Good point about picking assets to lever up. Turns out that the risk being packaged was systematic, keyed to macro factors rather than to specific risks that could have been diversified via these structures. having said that, leverage was still too high, courtesy of the incentives many had to reach for yield.

    Olive Zeng said...

    To Ai:

    I think it depends. It is not always the case that Asset First and Leverage 2nd.

    I c ur point and ur example. But u r only seeing one side of the coin.

    Put it this way, bad investment decisions r made. But if u r not over-leveraged, it is going to be ok for u. It will hurt but it will not die.

    But if u r making bets for ur living, u should not take too big a leverage because u might get killed in one bad bet even if the rest of ur 99% of the trades r making money, making huge money...

    If u have 100k and me 10 mil(Let me dream for a while if u would not mind), and we two r betting a coin flipping, 50/50. And I ask u, will u bet 1k for a head to come up to win 20k from me if u r right? Of course u wanna do that. But let's change the leverage, will u bet against me for that if i change the minimum of bet to 33k for the game?

    So all in all, it comes to the bet size management when we r talking about leverage, and I do think in some cases, leverage is much more critical than getting the idea right.

    Just my 2 cents.

    Sujan said...
    This comment has been removed by the author.
    In Debt We Trust said...

    AI,

    I think a lot of problems could be solved if we had an integrated CORPORATE bond and bond futures exchange (CDS market).

    No more OTC trading, dark pools of liquidity, and iceberg orders (ok well - not as much anyway. There will always be a search for arbitrage opportunities).

    Bring back pit trading! Bring back open outcry! Imagine having LOCK LIMITS for CORPORATE bonds and bond futures (CDS)- just like you have in regular futures. You say that margin can be a good thing. I agree...within limits. The CFTC imposes strict net worth tests for a reason.

    Maybe I am just nostalgic for the olden days but having bonds exchange driven would introduce a lot of transparency don't you think? If AIG tried pulling similar CDS stunts on the Chicago floor the pit traders would laugh them right out of the exchange (if not beating them into a pulp first).

    GS751 said...

    To In debt we trust:

    Umm idk about open outcry for corporate bonds. I personally think that electronic exchanges are much more efficient than open outcry. All the NYSE specialist will disagree with me because they make their living with the specialist pricing system. The reason there are CDS's is that bond clearing is light years behind clearing of most equities. (accrued Int, I could be dead wrong on this)

    PNL4LYFE said...

    I think you're right that the quality of the assets is the major problem. But to some extent, the asset quality is a direct result of excessive leverage at all points in the lending chain. If every home loan had been made with 20% down (5x leverage), prices would never have grown so far beyond sustainable value. If banks couldn't lever 30x, lending would not have become so competitive that it encouraged recklessness. In other words, higher leverage drives down ROA rather than low ROA leading to high leverage.

    Todd Ryder said...

    Obviously the assets were crap.

    But good investors can sustain losses on crap investments -- IF they aren't over exposed AND levered 40-to-1.

    So again, no leverage = no need for taxpayers' bone marrow (all we have left) financing Paulson/Geithner/Fed bailouts.

    In short, the "shit for brains" Greenspan Fed (depressing yields to effectively zero) created the necessity for 40-to-1 leverage and 40-to-1 leverage, "insured" via CDSes, created "too big to fail!"

    I mean, you seem like an intelligent (experienced bond trader) person?! Which sessions of "basic investor risk assessment 101" did you skip? Apparently all of them...

    Accrued Interest said...

    Wow lots of great comments...

    Josh: I completely agree that securitization is a better vehicle for creating levered credit plays because the leverage is termed. With term leverage, you don't have to worry that your funding will be pulled. Key in this market.

    As to the SIV question, I think ab is right.

    Olive: I'm not saying leverage is irrelevant. But if I buy an asset which loses 50% of its value, it doesn't matter whether I levered it 3-1 or 100-1. I'm wiped out.

    Now the contagion argument is a fair one. More leverage means more players are touched by losses. But here again, I'm not trying to say that leverage not an element in the crisis. Merely that we won't prevent another crisis by limiting leverage but ignoring the problem of poor asset decisions.

    On CDS, its a complex subject, but yes I think CDS exist in part because cash bonds are difficult to trade in large quantities and quickly. And I think an exchange would solve so many problems.

    PNL: It is a vicious cycle, I'll admit. So again, it isn't that the leverage was irrelevant, but to me, its about assets first.

    Snarky Librul said...
    This comment has been removed by the author.
    Green Rookie said...

    But that is crux, isn't it?

    Asset quality is inevitably connected to the contagion of trouble both through the pressure on individual portfolios and through the financial system, in general.

    no?

    Green Rookie said...

    Point taken on: "But if I buy an asset which loses 50% of its value, it doesn't matter whether I levered it 3-1 or 100-1. I'm wiped out."

    Accrued Interest said...

    I guess what I'm ultimately trying to say is this: People complain that the PPIP and the TALF is using leverage to create a problem that was caused by leverage. But in fact if we could successfully restart the market for good assets by allowing reasonable leverage, that is a legitimate solution. The cry of "But leverage was the problem dummy!" is simplistic.

    As readers know, I'm not too optimistic about the PPIP as constructed, but that is because I don't expect the PPIP to buy bad assets at the prices banks are currently holding them. It isn't because I hate leverage per se.

    Todd: Ugh... I can always tell when some new website links me, because we suddenly get these kinds of comments.

    Mark Wolfinger said...

    I run into this situation all the time with people who are learning how to trade options.

    Options reduce the risk of investing in the stock market, but if you hedge a bad investment, the outcome is not going to be favorable. It's the stock (or other asset) that you own that determines the profitability of the trade. Options are tools to help manage risk.

    Too many expect the option strategy, all by itself, to produce profits and pay scant attention to the underlying asset.

    http://blog.mdwoptions.com/options_for_rookies/

    In Debt We Trust said...

    I know corp bonds are relatively illiquid compared to sovereign debt or equities.

    In the equity markets we also have illiquid issues. They are listed on the pink sheets.

    But CDS are arguably a type of bond futures all on their own right?

    If we can trade eurodollar futures, 30 year futures, and fed fund rates futures then why not something equivalent for CDS?

    Yeah. I know its a stretch for some of you here. But keep in mind that CDS were originally scheduled to be regulated by the CFTC before the CFMA removed all such authority.

    Maybe I am too old school for thinking that the pit traders know how to do a better job than the CDS desks. (No offense to anyone here). I just keep seeing that final scene from "Trading Places" in my mind - where the 2 old guys scream for the pit traders to turn back the machines on.

    Dimitry said...

    The fundamental issue with your argument is that leverage and investment asset quality are not i.i.d. It's as simple as that.

    Excess leverage in the system creates conditions where investors are rewarded for chasing sh1tty assets. Moreover, it appears that leverage also seems to affect regulators: the more excess leverage there is, the more rose-tinted their glasses become.

    Accrued Interest said...

    Dimitry:

    But when people snarkily say the TALF or the PPIP is "using leverage to solve a problem caused by leverage" the speaker is implying one or more of the following...

    - leverage was the whole problem.
    - we should aim for no leverage
    - this kind of crisis can't happen in a less leveraged world.

    I'm here to say that none of those things are true.

    Assassin said...

    "Had sub-prime consumer loans suffered a mere 10% loss rate, the CDO would have suffered a 50% loss rate! That would have resulted in the "AAA" rated Senior piece suffering a 30% loss."

    Don't you mean 37.5%? I could be wrong; I don't know much about the topic, and am just trying to follow along by reading examples.

    Jonathan said...

    Wow, AI I have to say I am quite flattered to be on the front page as I've been following your work intensely for ~a year now.

    Heres the problem I have with your post in response to my glibness:

    But was it the 25x leverage that was the problem? Not at all. Substitute any number for the equity, and the structure still doesn't work, because the underlying collateral is crap. If you are going to try to tell me that leverage caused the meltdown, then you'd need to show me how a different leverage figure would have prevented the problem. Here is an example of a leveraged vehicle that fails at any haircut
    Thats the entire point. You expect some of your assets to fail, or the collateral to be bad, or atleast you should. You only lever yourself up if you are absolutely certain you have your probabilities and rates of return squared up.

    The banks levered themselves up, which is all fine and good. And then an outside observer could be forgiven for saying whoah, guys, you have some pretty significant asset/equity ratios here. How sure are you that you won't end up writing some of this down? And the banks say well, its okay, because we have these models, and these models say that only a ten sigma event can cause us to write down by x%, so realistically we're happy with our positions.

    But the point of levering yourself is you have to be -certain- of your return, otherwise you are done. The financial system merely substituted one kind of risk for another-in this case uncertainty of return was exchanged for model risk. And their models blew up.

    In a normal world, you could expect to lose on some of your bets. But in this new world of finance, there was no room for error.

    On the matter of the rating agencies:

    The big issuance machines knew that the "protection" they were buying was worthless. The desk heads at the larger players aren't idiots, as much as the public makes them out to be. Buying "protection" at a few bips on the dollar was considered a necessary expense to make the sausage palatable to some of the larger buy side clients, (pension funds, bumpkin airport, etc).

    At the end of the day: When you have $20 in assets per $1 in liability, you'd better be damn sure that you've locked in your return. Because you write down 5% of that asset and you're insolvent. Leverage is a wonderful force multiplier, but the decoupling of incentives to responsibility in the financial services sector turned it into a Death Star.

    Jonathan said...

    Apologies, last sentence should say $20 in assets per $1 in equity.

    blob said...

    Isn't it the leverage applied to the AAA pieces that's really scary? I mean really - who wants L+15bps returns for being short a put? Only banks and monolines found that model interesting and they found it interesting b/c they were able to operate at 30:1 leverage... L+450 for something they perceive to be low risk sounds a little more palatable. This is the leverage that seems misplaced to me. Now maybe it wouldn't be so much better if the banks were only 15:1 and the structures were L+30bps...

    jrahilly said...

    Hi AI,

    I am a big fan, but I agree with Nathan on the issue of leverage. Your comment that "if I buy an asset which loses 50% of its value, it doesn't matter whether I levered it 3-1 or 100-1. I'm wiped out" is misleading because the underlying asset in your example, the HEL pool, did not lose 50% of its value, it lost 10% of its value. The CDO served only one purpose, other than to generate fees for Wall Street dealers, and that was to provide a financing vehicle for investments in levered assets. That is to say, the CDO structure served only to magnify the leverage in investments in levered assets. When you say "If you build a CDO based on all mezz consumer loan ABS, and consumer loans perform poorly, then the whole deal is threatened," what you neglect to mention is that the threat to the whole deal was posed entirely by the leverage inherent in the CDO. The ABS structure as a whole absorbed the same 10% loss as the HEL pool in your hypothetical example, which is hardly catastrophic given the current economic environment, yet the CDO structure amplified those losses to 50%, which is systemically catastrophic. What I find most interesting in thinking through this problem is the asymmetric impact the CDO structure had on returns. While the leverage in the CDO magnified losses by multifold for debt investors, it clearly would not have magnified gains proportionately for non-equity had the HEL performed well. In retrospect, it is laughable that investors demanded only 20-30 bps more for levered senior paper in CDOs of ABS relative to unlevered positions in CDOs of commercial loans. If losses on commercial loans were double those on HEL, losses to investors in the CDO of commercial loans would have only been 40% of those suffered by investors in the CDO of HEL ABS. These investors may have understood that CDOs of ABS were riskier, yet they did not really understand the risks.

    My question for you is, given that a market for poorly underwritten HEL existed in the ABS space, what economic purpose did CDOs of ABS serve? My sense is that the premise of my question is false, and that in reality, as underwriting standards deteriorated, demand for mezzanine ABS paper was actually weak, and couldn’t be sold directly to investors at spreads that would allow the arbitrage to work. In duping the rating agencies to bless CDOs of ABS with investment grade ratings, and in marketing the CDOs to investors chasing yield, Wall Street created a market for mezzanine paper that otherwise would not have existed. In doing so, they created a market for poorly underwritten HEL (not to mention mortgages and other assets) that otherwise would not have existed. Maybe I am wrong, so my question still stands. Why do CDOs of ABS exist? What say you AI?


    Respectfully,

    John

    Accrued Interest said...

    Jrah:

    Like I said before, I'm not saying you (or Nathan) is wrong. I'm not saying leverage isn't (wasn't) a problem.

    Put it this way. We hear banks report their Tier 1 ratio, or TCE ratio, or whatever other leverage ratio you like. That, in and of itself, doesn't tell you enough about how much risk they are taking. The quality of their assets is just as important, I'd argue more important, than their leverage ratio.

    On CDO's and the "economic purpose," I'm not sure how you define that, but here's my thought.

    I think what you are saying is that ABS CDO and CDO^2 were really just a bank capital game. A way of investing in lower quality securities but still getting this cute AAA rating and thus getting favorable capital treatment. I think that's correct.

    I also think many banks, especially European banks, bought this stuff strictly on rating, and/or on the combination of rating and carry vs. funding. Once the IB had placed the Senior tranches, they just pushed the junior tranches onto hedge funds, often ones the IB itself controlled. Keep the deal flow going.

    I certainly don't deny the problem of leverage. But I think too many people simply think we can solve out economic problems with less leverage. Its about better risk management, and leverage is only one part of that.

    Michael F. Martin said...

    Leverage is about redistributing wealth from the impatient to the patient.

    That is all.