And yet another terrifying piece, this time in the Financial Times (via memeorandum):
But now, at long last, one shard of reality has just emerged to piece this gloom. In recent weeks, bankers at places such as JPMorgan Chase and Wachovia have been quietly sifting data trying to ascertain what has happened to those swathes of troubled CDO of ABS.
The conclusions are stunning. From late 2005 to the middle of 2007, around $450bn of CDO of ABS were issued, of which about one third were created from risky mortgage-backed bonds (known as mezzanine CDO of ABS) and much of the rest from safer tranches (high grade CDO of ABS.)
Out of that pile, around $305bn of the CDOs are now in a formal state of default, with the CDOs underwritten by Merrill Lynch accounting for the biggest pile of defaulted assets, followed by UBS and Citi.
The real shocker, though, is what has happened after those defaults. JPMorgan estimates that $102bn of CDOs has already been liquidated. The average recovery rate for super-senior tranches of debt – or the stuff that was supposed to be so ultra safe that it always carried a triple A tag – has been 32 per cent for the high grade CDOs. With mezzanine CDO’s, though, recovery rates on those AAA assets have been a mere 5 per cent.
I dare say this might be an extreme case. The subprime loans extended in 2006 and 2007 have suffered particularly high default rates and the CDOs that have already been liquidated are presumably the very worst of the pack.
Even so, I would hazard a guess that this is easily the worst outcome for any assets that have ever carried a “triple A” stamp. No wonder so many investors are now so utterly cynical about anything that bankers or rating agencies might say these days.
Krugman has the following analysis:
Why is this important? A recurring theme of those who believe that the financial system can be rescued with fancy financial engineering — a group that, sad to say, apparently now includes the Obama administration — is that the losses on toxic assets aren’t really as bad as people say; that lack of liquidity and “irrational despondence” have led to an undervaluation of these assets, and that if we can just calm things down and get cash flowing again all will be well.
Not so much, it seems.
With every passing day, it becomes clearer and clearer that the Krugman/Roubini wing, which has been more right than wrong throughout this mess, is right, and everyone else is wrong.
And not to beat a dead horse, because I know I mention this every couple of days, but I am consistently amazed that no one seems to be going after Moodys and S&P and the other ratings agencies, who are as complicit in this mess as anyone. After Enron, Arthur Andersen went under, and so far this makes Enron look like a walk in the park, yet to my knowledge nothing is happening to the ratings agencies right now.
*** Update ***
And how about those ratings agencies? They would have done a better job using a Magic 8-Ball to rate the CDOs. (“Signs point to junk!”)
Pretty much.
lilly Von Schtupp
I keep telling myself that in time there will be criminal investigations. Not just for the ratings agencies, but for certain government regulators too, that smug Cox guy comes to mind. For me, this would all be easier to take if I believed people were going to jail for it. Maybe we should just do what Bill Maher suggested and blow up a few bankers during half time at the super bowl.
cleek
the market will take care of the ratings agencies.
and that’s only 75% snark (Moody’s 12 mo)
Zifnab
But who’s going to sue Moody’s or S&P? If my multi-billion dollar business has a triple-A rating and your multi-billion dollar business has a triple-A rating and his (formerly) multi-billion dollar business just went bankrupt, depriving him of money to do much of anything, why would either of us sue the people claiming we have solvency?
Imagine graduating from college with a 4.0 average, only to find out everyone else in the class had 4.0 averages too. Are you going to sue your teacher and throw your own grades into further doubt?
DougJ
Very interesting.
Despite what idiots like McMeghan say, the mortgage default crisis has been vastly amplified by the insane CDO market.
robertdsc
Geithner should quit in disgrace. I fear he’s going to kill this Presidency.
Dave
Why doesn’t the government, through FDIC or the SEC or some other arm, rate these things? Since the banks aren’t paying the government (as they do the agencies), we’d get a much better idea of what these things are worth from the get-go.
garyb50
I just keep getting the feeling things are so bad, so corrupted & toxic, that too much truth would just cause total collapse.
The Grand Panjandrum
@DougJ: Not only amplified, but made possible by the bundling. Had this paper not been written, and the derivatives not been sold, the mortgage companies would not have had the liquidity to feed the sub-prime beast.
Fwiffo
I’m eternally skeptical of a ratings system that shares a scale with soft drinks at McDonalds. There’s AAA, AA and A. Shouldn’t it be A, B, C, etc.? No, they’re better, even better and the bestest. Large, Extra Large and Super Size. The ratings are about marketing and have no meaning beyond that.
Dennis-SGMM
Gee, it’s almost as if everyone involved, including the rating agencies, colluded together to assign astronomical values to sketchy financial instruments with the only goal being to maximize the amount of their commissions.
That would be wrong,
Rome Again
@Zifnab:
You are assuming a solvency rating actually means the entity is solvent.
Josh Hueco
Kinda like three, four, five, six, and seven diamonds? Not that I’m comparing Wall Street to a whorehouse, mind you.
Zifnab
@Fwiffo: The A-Class securities are the highest rated. There are B-Class and C-Class securities as well, which compose the mid-market and junk bond market equities.
There are also + / – ratings attached to the equities to add additional nuance. It’s not quite as bad as you think. But most of the assets you hear about in the news are attached to large cap high security investments. If a bunch of B or C rated bonds blew up in everyone’s face, it wouldn’t even be a surprise.
@Rome Again: I’m assuming the solvency rating continues to convince people the entity is solvent. It’s an increasingly tiny fig leaf of modesty, I admit, but I’d rather have an A-rating right now than no rating at all, regardless of how solvent I am.
miss water whiskers
CPAC update: Jesus Money and Coke machines
Dennis-SGMM
@Fwiffo:
I’ll take a share in that Vente-rated bond, Garçon.
Comrade Darkness
@DougJ: Not only amplified, but made possible by the bundling. Had this paper not been written, and the derivatives not been sold, the mortgage companies would not have had the liquidity to feed the sub-prime prime alt-a, option payment, commercial real estate, Trump condos, rolled auto loan, furniture at no payments for twelve months!, credit card beasts.
Amended for broader accuracy.
Dennis-SGMM
@Comrade Darkness:
1. Create an inelastic demand for newer, bigger, stuff.
2. Make sure that people’s self-esteem is tied to said stuff.
3. Keep wages stagnant so that borrowing is the only way to get the stuff.
4. Profit!
Comrade Darkness
And then we pick up the pieces and get back to square one. Better than the slow death by 400 trillion in worldwide CDO and CDS cuts. This also has the severe downside of giving the perps time to get theirs and get out. (saw an estimate of 683 trillion yesterday. guess no one really knows, given it’s unregulated)
I’d willingly go hungry for a day cuz the atm was out of money to watch some of these thieves go down, big time. No problem.
kwAwk
The article really says nothing that we already didn’t know. Because of the falling prices of houses and the bad economy we are seeing higher default rates on individual loans which is making these mortage bundles pay off at a rate that is lower than the planned rate, which means they default on the terms of the mortgage backed security.
When the cdos default and are liquidated there is no market for these cdos, thus you only get 5% to 32% back when you try to sell them in today’s market. This is nothing that we haven’t known for a year now.
But don’t confuse for a second that just because a CDO has a market value of 5% of face value now, that only 5% of the loans in the bundle are paying off long term. That is completely separate issue. To believe so would mean you believe that 80%+ of the morgages are in default, which is simply not the case.
Nobody would argue that this situation isn’t bad with these securities, and we’ve known this for quite some time. The question becomes do we take the irrational stance on price setting of the market or do we try to take a more rational long term approach that says if we can get the economy back on track then we can tamp down the losses a bit.
Do we try to save the American brand by working through this crisis in the private sector, or do we just wipeout the shareholders and trash the perception of America being the best place to invest just for expediency.
I’m seeing parallels to the surge in Iraq, where some people were so invested in a particular course of action and in being angry about how we got into Iraq that they couldn’t see that the best course of action going forward wasn’t to leave Iraq immediately. Just as in this case some people are so angry and so bent on wiping out the shareholders that they may be missing the notion that wiping out the shareholders may not be the best solution going forward. Some bloggers seem to almost cheer on a daily basis as he watches private capital being destroyed.
Redhand
Very true. I’m for reform, . . . and retribution.
Comrade Darkness
@Dennis-SGMM, the really interesting thing about this is the nation-wide real-world test we are running of what really is elastic and inelastic.
Beer is down. Imagine that!
Liquor IS quicker…
>Profit!
It sure looks like a grand conspiracy, but I don’t give them credit for being that smart. I think it just worked out that way as the each party gains each inch of power and milks it for maximum profit and there is no offsetting legislation. Then this is where we end up.
Cheap credit isn’t just sinking consumers. It’s sinking everybody. It sank the rich, but leveraged investment banks already, remember.
chrome agnomen
this cranky bastard says, just take all their money away and make them go to court to get it back. encourage people to save by paying an interest rate that at least equals the inflation rate, and prevent any financial entity from becoming of such size that it is ‘too big to fail’.
i think that most people with any sense of morality would admit that if there is no real penalty for outright stealing vast sums of money, then almost anyone would do it. how much more likely, then this to occur among a class of people with no scruples.
Napoleon
@Fwiffo:
PS, the various grades of A are investement grade, but some are better then others
It is an A, B, C system. It goes AAA,AA, A,BBB,BB,B you get the idea
Whoops I see this was covered upthread
Dennis-SGMM
Just how do you propose that we ("We" being the taxpayers) work through this crisis in the private sector? The financial component of the private sector seems to be a black hole: trillions have been poured in by Congress and the Fed and not a glimmer of light has come back out. As for wiping out the shareholders, I’d say that the current value of banking stocks has pretty much wiped them out already.
Zifnab
@chrome agnomen: Well, that’s the joke. Individually, none of the major firms were really "too big to fail" so much as they were "too in debt to fail". You have a company like AIG with billions of dollars in policies outstanding that they had absolutely no way to cover. That doesn’t have anything to do with AIG’s size and everything to do with how it was leveraged. Same with Lehman and Bear Sterns and Merrill and the rest of them.
Even a small company can cause a big mess if it’s got a million dollars in obligations and only $10k cash on hand.
georgia pig
@kwAwk:
A voice of sanity. Everyone keeps assuming that there is another option, that somehow we can avoid being Japan. Some might say that Japan actually succeeded or, as you say, emerged with an intact brand. I sometimes feel as if we on Apollo 13 and some of crewmembers don’t understand that we can’t (1) proceed on to the moon or (2) simply get out and walk home.
liberal
@kwAwk:
Except that, of course, the best course of action was to leave Iraq immediately.
Dan
From the FT article:
The ratings agencies might be the next to become zombies – the market knows not to trust them. Not as satisfying as a criminal investigation, but could end up being a rough sort of justice nonetheless.
MaryKaye
John, One of the interesting stories about this disaster is well told in this month’s edition of Wired Magazine written by Felix Salmon. The ratings companies, apparently, could not wrap their heads around the risk. And, it would appear that they didn’t understand the risk because they refused to acknowledge the flaws in the way the risk was calculated. David X. Li’s Gaussian copula function was first published in 2000. Investors exploited it as a quick—and fatally flawed—way to assess risk. This isn’t to set the blame on David Li’s shoulders. Rather, it’s a story of what happened to David Li’s idea.
You don’t have to be a quant to grasp the nature of the towering error that was made. If you are a quant the nature of the error is breathtaking.
gex
We’ve just demonstrated that we are highly irresponsible. This was all BS. All that wealth was just numbers created by models that had nothing to do with actual value.
What good does it do to tell the world they can invest with us, and we will make them good no matter how the investment turns out? Seems like that’s just saying American taxpayers will give the world two $10’s for a $5 whenever they ask.
qwerty42
Well the AAA ratings would be investment level stuff. The kind of things pension funds go for (usually they are required to do this). So maybe some retirements are much less secure than they might seem. By now, though, that should be showing up in reports.
J. Michael Neal
Someone would have had the liquidity to create a disaster. There were a number of things that amplified it, and turned it into an epochal event, but the underlying cause was not securitization, or even the quantification of risk. Purely and simply, there were too many dollars and not enough places to invest them. If it hadn’t been mortgage securities, it would have been something else.
With most non-English speaking countries building their entire economies around exporting goods to English speakers, the whole system was built upon the United States exporting dollars for goods. Those dollars don’t disappear, and they can’t be spent directly in the home economies. They must be reinvested back in the economy from whence they came. What you got was classic inflation: too many dollars chasing not enough goods. It’s just that the goods in question were financial instruments of some sort.
The only way in which more rigid standards on mortgage lending would have alleviated the underlying crisis is if it had brought on a recession sooner than actually happened. The only realistic solution is that the US stopped buying stuff, plunging itself into a recession, and taking all of the exporting countries with it. It wouldn’t have been as severe as it is, maybe, but it would have happened.
Perry Como
@Hilzoy: Been there, done that.
Elie
–So if I deduce correctly, many on this site think that Geithner/Obama administration is handling this whole thing incorrectly.
What should they do? (seriously) and what would be the consequences of that? Do you actually believe that full nationalization or whatever you think is going to work, is going to work at the level that we can truly avoid bad consequences? Do you think that by just calling the chips, its ok to risk civil unrest and all else that follows from a catastrophic and fast collapse?
What Geithner/Obama is doing IS risky — playing out –dragging out the reality of this catastrophe. They are trying to control what they can of the hard, hard landing that is certain. I don’t think they think the landing is going to be avoided — only hopefully slightly managed, ala Sullenburger — crashing the plane in the water rather than on a runway. Either way it crashes but which way do you think you can get the most survivors? And even that is no sure thing…
I’m not saying that Geithner/Obama are right or wrong. I don’t really know and probably many here don’t truly either. We are going to crash. No avoiding it from what I am able to grasp. Just when, how hard and what is the damage going to be.
They both know that this is their baby. That is as it should be. That is why I think they will do the best they can. Those above who scream to fire Geithner. Get real. Oh yeah, lets grab an outsider like – uh – let me guess – KRUGMAN to come in and fix it. I’m sure that he (or anyone else other than Geithner) will fix it up and we can avoid a crash landing and everyone will go home happy and relieved.
I am going to have to trust the team Obama put together and hope for the best. Not sure that anyone can offer a way out of this without substantial pain and perhaps for a long time. If someone thinks some other appointment or other expertise will give us that, I would be pleased to hear it and think that we should march in the streets to get the administration to listen. If you can’t say that person x, or action x that you have in mind can indeed give us that, then I think you need to acknowledge that and go back and sit down and sweat with the rest of us strapped in our seat belts screaming in the back…
J. Michael Neal
Krugman is starting to bug me, again. I agree with him that nationalization is the way to go, but he’s being childish in his inability to see that there is an alternative viewpoint, and that things aren’t entirely clear cut.
Let’s say we do nationalize, in a way that is essentially receivership for the banks. The common stockholders get wiped out, and the debt holders take large haircuts. One consequence of this is that there will be another seizure in the credit markets, as everyone who has to realize losses gets paralyzed.
Who are those bondholders? A lot of them are insurance companies and pension funds. I think one aspect of the stress testing is going to be figuring out whose head is on the chopping block. I can see a possibility that the taxpayer, in other guises, is going to turn out to be one of the major bagholders, through various vehicles. Sure, it might be primarily the rich, but quite possibly not. We’ll see.
Further, one thing that is clear is that a number of foreign governments are headed for big losses, either directly or through sovereign wealth funds. Like it or not, handing huge losses to them is a foreign policy, as well as an economic policy, issue. Hillary Clinton will get to go to a bunch of countries, and tell them that the United States is wiping out their investments. That should go over well.
In the end, I think that receivership is the way to go. It’s downsides are probably not as great as the downside of not just clearing things up. However, pretending that this isn’t a huge trade-off, with important arguments going the other way, is foolish. In this sense, Krugman, Roubini, et al, are being very, very foolish. It’s easy for them to lob hand grenades since theyaren’t the ones with the responsibility.
buermann
If you go after the ratings agencies they’ll downgrade you, and since everyone is still pretending to believe the rating agencies in order to not be downgraded themselves, you’ll be sunk.
priscianus jr
"Moodys and S&P and the other ratings agencies, who are as complicit in this mess as anyone…"
More than 15 years ago, looking at decisions to build megaprojects that cause extreme social dislocation and environmental damage (and thus the typical fobbing off of economic externalities upon the general public) — which represents a major factor in today’s global economy (investments are international, not local) — I realized that the rating of bonds is probably the biggest single factor in determining whether such projects go ahead or not. Not whether people want them, not the true costs, not whether there are better alternatives, but the rating of the bond, whether the investors would make a sufficen treturn to justify their investment. At that point I came to the conclusion that the bond rating agencies are MORE complicit in this mess (i.e. the modern global dis-economy) than anyone. Except of course that they are not really separate players, objective judges a they are supposed to be, but while wrapped in the cloak of the highest moral concern for the life savings of the world’s widows and orphans, are completely in cahoots with the banks, governments, and other investors and mega-contractors. If you want to know how this works, concretely, one book I can recommend is ean-Francois Lisee, In the Eye of the Eagle, Toronto Harper Collins 1990.
lilysmom
Can you imagine going through all this with John McCain and his genius team in the White House? Gaahhkk
Jason F
Is FT still using long-scale billions (that is, one billion equal to a million million)? Because quite frankly, $450 billion (with one billion equal to a thousand million) in CDOs doesn’t seem like that much. We threw roughly twice that amount at the banks with TARP, so if all we are talking about is less than half a trillion dollars in toxic assets, we should be fine.
Now, if by "$450 billion," FT means what most of us (particularly Americans) would think of as "$450 trillion," then we are well and truly fucked. But as others have said, we’ve known that for a long time.
priscianus jr
Elie,
What should Geithner/Obama do? Good question. I came across a posting today that is very much to the point:
http://baselinescenario.com/2009/02/12/rahm-emanuel%E2%80%99s-and-david-axelrod%E2%80%99s-new-dilemma/Baseline is one of the best sites to be reading in these troubled times.
J. Michael Neal
These aren’t all the toxic assets, merely one of many classes of them.
Elie
#35 —
I think like you — its weighing tradeoffs..there are no good solutions at this point – meaning none without significant down sides and the honest argument acknowledges that. N
Jon H
@Jason F: "Is FT still using long-scale billions (that is, one billion equal to a million million)? Because quite frankly, $450 billion (with one billion equal to a thousand million) in CDOs doesn’t seem like that much"
But that’s only for a year and a half’s worth of CDOs.
Wile E. Quixote
@Dennis-SGMM
Why don’t we just condemn the banks? Citibank is trading for $1.66 a share, the company’s market cap is 9.05 billion. If you were to condemn city and tell it’s shareholders that they’d be paid the 1 year target estimate, which is probably too high at a cost of $6.45 a share, you’d be out 36 billion dollars. Then once the government owns it open up the books and liquidate it.
Now this just leaves you with the problem of dealing with the bondholders who I think are going to have to come to the realization that they’re fucked too.
jenniebee
How about we start thinking about this in terms of sound business and economic principles and not in terms of fucking superficial marketing wankery, mmkay? That would be an excellent step-fucking-one.
Jeebus, it’s like a country of drunks who worry that going to AA might hurt their image.
NutellaonToast
How is it POSSIBLE that recovery rates are only 5%? These CDOs are all backed by houses. Housing prices have gone down, but not by 95%! That doesn’t make sense to me. What am I missing?
Elie
Thanks # 40 — great link –
I also want to add, that I think that its essential that we listen to whatever credible experts and expertise there is out there (Roubini and Krugman). We need to be informed and also to have this discussion among ourselves. I just wanted to express my opinion that in the end, its Obama’s hand on the tiller and his selection of Geithner was a necessity born of the need for speed and familiarity with the system (such as it is, working or not) rather than a "perfect" policy expert who could have been made in different circumstances. He got that in Geithner being familiar with the Fed and the Treasury as well as private banking sector. An outsider would have had to spend much more time just ramping up — time that we donot have.
Steeplejack
@NutellaonToast:
I’m not an economist, and most of the current crisis leaves me baffled, but I’ll take a shot at this.
The whole genesis of the crisis is that the CDOs are so leveraged (up to 30:1, I have read) that they aren’t really "backed by houses." So, at best, $1 of a given CDO might be backed by 3 cents of "house." But I think that with all the slicing, dicing, re-tranching and re-leveraging it’s probably even worse than that.
My follow-on conclusion is that the real reason Geithner and the goverment seem to be dithering on what to do is that each time they peel back a layer of the onion the new reality revealed is geometrically worse than the previous (awful) reality.
It’s not just a question of "Hey, fuck Citi, let ’em fail." It’s that Citi going down would probably pull down a host of "counterparties" all over the place. It’s like some financial Rube Goldberg contraption from hell.
Chris Andersen
Really, I don’t know why anyone is all that surprised at Geithner’s foot dragging. He’s a banker. Bankers are, by nature, conservative. Expecting him to accept the idea of putting the banking system into receivership (it’s NOT nationalization) is about as foolish as those who thought the big shit pile could ever be turned into gold.
Geithner will have to be dragged to the table of receivership (it’s NOT nationalization). Hopefully the continuing poor economic news will do the trick.
NutellaonToast
"The whole genesis of the crisis is that the CDOs are so leveraged "
Wait, it’s the HOLDINGS that are leveraged? I thought it was the institutions buying more than they had? Now you’re telling me the leverage is built into the fucking assets themselves? THAT’S INSANE!
gwangung
Now, you’re starting to get it.
Now multiply that by at least an order of magnitude….
And we’re screwed no matter what we do. It’s gonna be a very, very hard landing–so lets look for the least damaging solution, even if it means the bankers get off relatively easily…
TenguPhule
Yes.
It was both at the same time.
Yes.
Yes, Captain Obvious.
Steeplejack
@Chris Andersen:
LOL! I can’t believe you are saying this with a straight face. The crisis we’re in now was caused in large part by bankers gambling like drunken prospectors in the Klondike Saloon.
I think Geithner is "foot-dragging" because the "problem" facing us is so apocalyptically huge that for at least half of every day he is afraid that there is no solution, and he has to fight the urge to go back to bed and pull the covers over his head. The other half of the day, the only solutions he does see are so awful that he has to fight the urge to go back to bed, etc.
Dennis-SGMM
@gwangung:
Real panic would set in if someone revealed how many dollars in "assets" are lost for every dollar defaulted on in a mortgage.
J. Michael Neal
You’re missing the basic structure of the securities. They aren’t backed by the mortgages directly. They’re backed by parts of the bonds derived backed by the mortgages. However, they aren’t backed by the full bonds, only by the lower tranches. The lower tranches are the first ones wiped out in the case of defaults. They could only be sold as combined instruments, the CDOs, since the risk of default was so high. In theory, the risk was lowered by pooling a bunch of different bonds’ lower tranches together, since it meant that a lot more mortgages had to default in order to impair them. That worked great so long as different defaults were independent events, which was just as long as house prices were going up. When they started falling, they stopped being independent.
Steeplejack
@NutellaonToast:
Ding! What Gwangung said.
TenguPhule
Kill the current bankers.
Find new bankers.
Profit.
NutellaonToast
I love how everyday I wake up thinking we’re totally fucked and then something happens later on that makes me realize it’s even worse than that.
Every…fucking…day.
ThatLeftTurnInABQ
I made the same observation over on the ObWings thread linked to in the update. If some of the "bagholders" have nukes, and/or are located in geopolitically sensitive parts of the world, that complicates matters. What happens if one or more of those countries takes a big enough financial hit to delegitimize the govt., and they face a choice between using extreme nationalism to get their cred back or being overthrown?