Derivatives Detox
Nov 20th, 2008 | By Kathy Graham | Category: Feature #1
ABSTRACT
Janet Tavakoli was one of the first and few voices speaking up about the risks of structured finance, including derivatives. The 2003 first edition of this book was a beacon warning of the dangers that this product line would play in creating the current global financial crisis. Her new book, Structured Finance & Collateralized Debt Obligations: New Developments in Cash and Synthetic Securitization, Second Edition (Wiley, 2008), provides a clear understanding of these products including their proper structures and valuations. This book is a great desktop reference, a fascinating chronological story, a marvelous unveiling of the quagmires to avoid, and a balanced commentary on the major relevant issues encompassing these instruments.
Derivatives Detox©
by Kathy Graham
DESKTOP REFERENCE
The scope of products under the generic umbrella of “structured finance” is huge and still growing. For anyone that encounters these instruments as an investor, banker, financial services provider, money manager, or even a reader of the daily news, Tavakoli’s book offers thorough explanations of all of the following products, their definition and uses, pros and cons, and any moral hazards, topped with good advice:
“If you don’t understand what is going on with your cash flows, you are in serious trouble.”
- Janet Tavakoli on CDO equity structures
· Collateralized debt obligation (CDO)
· Collateralized fund obligation (CFO)
· Collateralized mortgage obligation (CMO)
· Asset-backed securities (ABSs)
· Residential mortgage-backed securities (RMBS)
· Commercial mortgage-backed securities (CMBS)
· Mortgage-backed CDO
· Credit derivative, Credit default swap
· Total return swap aka Total rate of return swap
· Special purpose entities (SPEs) aka Special purpose vehicle (SPV) aka Special purpose corporation (SPC) with/without capitives
· Master trusts, Owner trusts, Grantor trusts
· Real estate mortgage investment conduits (REMICs)
· Financial asset securitization investment trusts (FASITs)
· Multiseller conduits, Single-seller conduits
· Certain domestically domiciled corporations
· Convertible bonds and asset swaps
· Marquee deals
· Credit enhancement
· Monoline and multiline insurance
…and that’s just the first six chapters.
“Super Senior Sophistry” is a chapter describing how the “Frankensteins of Wall Street,” as The Economist dubbed them, created the super senior tranches that are a key driver of a synthetic CDO arbitrage. Others, including The Economist, have wondered how such sophisticated financiers thought that they were holding onto to the safest slices of CDOs by keeping the super seniors for themselves. Tavakoli explains their rationale and then hits the reader with two even more shocking facts: rating agencies don’t rate supers and there’s “no market standard definition of super senior risk” nor is there a standard means of pricing super senior risk.
THE CHRONOLOGICAL CHAIN
Structured Finance & Collateralized Debt Obligations is filled with stories such as the senior super situation. As a historical account of the development of structured finance products, her narrative is entertaining while being extremely informative.
One tale explains the unusually large number of financial geniuses present in the modern world using probabilities of a coin toss. Tavakoli states, “If you have 64 people in a room, each tossing a coin, …the law of probabilities being what it is, one person will flip heads six times in a row. This person will be dubbed a genius. What genius? What cockamamie twaddle! The next thing you know, another firm has signed the lucky person to a two-year contract at a minimum of $1 million per year.”
The Vatican, money laundering, the major investment banks, hedge funds—all play their parts as Tavakoli weaves through the history of structured finance from its roots to now.
Her description of the current great unravel is illuminating. After detailing the subprime mortgage scenario play by play, Tavakoli mentions that though many of the predatory lending practices that contributed to the subprime problem are not illegal, they do employ “truthiness in lending”, which is a term that Comedy Central’s Stephen Colbert defines as “what you want the facts to be, as opposed to what the facts are; what feels like the right answer as opposed to what reality will support.” She concludes by saying, “…if one defines a classic Ponzi scheme as using money from new investors to pay obligations to existing investors, the lending relationship between investment banks and failing mortgage lenders has devolved into just that. In fact, it had devolved into the largest Ponzi scheme in the history of the capital markets.”
From remarks such as these, some might be thinking that Tavakoli is perhaps not understanding the nuances of these products or situations because she is not qualified or perhaps she is just a cynic, seeing negatives where none exist. Those individuals would be wrong on both accounts.
JANET M. TAVAKOLI
Tavakoli has her MBA in Finance from the University of Chicago’s Graduate School of Business. She taught Derivatives there as an Adjunct Associate Professor of Finance for several years.
Her past work experience is equally illustrious, including stints as:
· Executive Director, Head of Financial Engineering, Global Financial Markets Division, Westdeutsche Landesbank, London
· Head, Market Risk Management, Capital Markets Group, Bank One, Chicago
· Head, Asset Swap Trading Desk, Merrill Lynch, NYC
· Head, Mortgage Backed Securities Marketing to Japanese clients, PaineWebber, NYC
· Head, Quantitative Research Marketing, Bear Stearns.
Additionally she’s provided expert reports on many major litigations involving financial institutions to the tune of over $1.2 billion in consolidated litigation total claims.
Tavakoli answers the second concern of some herself, “Despite the caveats, I’m an enthusiastic proponent of structured financial products and welcome the growth of new products in the market.” As for the future, she’s unclear what its composition will be, but does note that “what is needed is effective regulation. Until that occurs, investors will have to fend for themselves.”
QUAGMIRES
Ineffective Guardians: According to Tavakoli, senior management, the regulators, Basel II, and the rating agencies have all contributed to the abuse of these new structured finance products.
Because of “poor understanding of the basic mechanics” of these products combined with market pressures to rapidly grow departments to satisfy client needs, management often has a difficult time assessing what the dynamics behind their group making or losing money truly is. Adding to the fog, investors don’t have the ability to check the accuracy of performance reports given to them by managers, who are paid their bonuses based upon that performance.
As for regulators, Tavakoli wonders why the SEC, the Fed, and others were so missing in action when they should have been questioning a number of glaring oddities that were pointed out by concerned professionals from the beginning. She says that “Basel II is part of a series of failure by various financial regulators” because it “has been ineffective in heading off problems such as the global securitization crisis due to securitizing risky product that was improperly rated.”
Tavakoli’s critique of the rating agencies responsible for improperly rating those products is comprehensive. In fact, it’s well worth buying this book if you are an investor just to understand how thoroughly rating agencies were and appear still to be bungling the basics. Her critique offers ways that investors can protect themselves until effective regulation surfaces.
Fraud: One of the reasons Tavakoli mentions effective regulation as necessary is because it helps break the fraud triangle, which is need, opportunity, and the ability to rationalize one’s behavior. Her approach is common sense based: financial systems need to be systems that people can trust to manage their money wisely but, on the other hand, there are and probably will always be people who try to help themselves to more of other people’s money than is due them. Given the complexities of modern finance and how smart financiers are, effective regulation to decrease opportunity combined with vigilance by all parties is required to keep the system trustworthy.
Gray-area Opportunities: Another area that Tavakoli tackles are those gray-area opportunities, the ones that sometimes are legal and sometimes—and in other places—are illegal. Acknowledging that ethics are a slippery slope because they’re impacted by location and era, she still strives to point out where they occur, even when only ignorance—not intent—causes the possible opportunity to defraud.
BALANCED COMMENTARY
Even though Structured Finance & Collateralized Debt Obligations is a valuable purchase solely because it provides all of the aforementioned attributes, there is yet one more reason to read this book. Tavakoli’s commentary on various money management related topics is extremely insightful because it’s presented in an easy to comprehend manner by someone who understands human nature and complex financial matters.
The limitations and uses of models are one such topic covered. “The irony of the complex CDO market is that the basic principles of sound finance are often violated in ways that models cannot capture,” states Tavakoli. Throughout the book, she constantly explains how the models miss the pertinent facts and what can be done instead to capture the true dynamics of these products.
Portfolio diversification myths and many other subjects are also analyzed, so many that HQ Financial Views has assembled a panel of financial experts (their bios and topics follow) to share their insights - and hear yours - on this book at www.hqsearch.com/blog. See you there!
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Read these four financier’s insights from perusing Janet Tavakoli’s book Structured Finance & Collateralized Debt Obligations at http://www.hqsearch.com/blog…then join in to share your thoughts.
BLOG STAR PEG SWANTON
Fraud: Is it or Isn’t It?
Margaret M. (Peg) Swanton is the president and owner of Tactics, Inc.—a management consulting firm established in 1995. Peg, who has more than 25 years of professional experience, is a University of Chicago MBA and a CPA . She began her professional career by successfully implementing and operating an ERP system at a manufacturing firm. She observed that good information systems combined with good business processes made it possible to quickly identify and stop fraud, waste and errors in the normal course of business.
In the 1990’s, she began working as a management consultant, found fraud on her first project and decided to focus on fighting fraud. Already a CPA, she became a Certified Fraud Examiner. Some of her projects still involve designing accounting and financial reporting systems; others are investigations of fraud allegations or business disputes.
Peg has excellent business analysis and reasoning skills, is able to rapidly identify critical business issues and determine how to resolve them whether the project is the design of a new accounting system or a fraud investigation. She and Tactics, Inc. have a solid history of successfully completed projects – on-time and on-budget. Peg can be reached at 312-987-1800.
Peg’s blog concentrates on the fraud aspects of this current economic situation.
BLOG STAR TIMUR GÖK
The Mother of All Derivatives
Timur Gök is on the faculty of the Department of Finance at Northern Illinois University where he teaches courses in corporate finance, international finance and business economics in the undergraduate, the MBA and the Executive MBA programs. Before joining NIU, he was Director, Domestic Finance at Deere & Company. He began his professional career at the University of Florida, where he taught economics.
He is a former Fulbright Scholar and holds a M.A. degree in Economics from Washington University in St. Louis and an Advanced Professional Certificate in Finance from New York University. He is a member of the American Finance Association and Financial Executives International (FEI) and is the Regional Director of the Chicago Chapter of the Professional Risk Managers’ International Association (PRMIA).
Timur has chosen as his blog topics the history of the “mother of all bombs,” the issue of regulation, bubbles, and bail outs.
BLOG STAR LISA A. GARLING
Musings from a Corporate Banker…
Lisa A. Garling has 15 years of leveraged lending experience with a major international bank in Chicago. She has held senior roles there in credit risk assessment, cross functional team leadership, loan portfolio and relationship management. Her MBA is in Finance from the Kellstadt Graduate School of Business at DePaul University and her BA is in Economics from the University of Michigan. Garling is a member of the Turnaround Management Association and Chicago Financial Women.
Her blog musings focus on the impact past, present, and future that those sophisticated financiers that created the super seniors have had on the traditional banking industry.
BLOG STAR JIM HOLTZMAN
Jim Holtzman has more than 25 years of entrepreneurial financial and operational experience in the software, outsourcing, manufacturing, procurement and telecommunications industries. Jim is charged with leading the finance and administrative team and is responsible for all financial/admin operations at Fieldglass.
Previously, Jim held senior management roles in the areas of finance, operations and marketing at a variety of successful early stage businesses including iPhotonics, Inc. in Maryland and MFS Communications and Cognitive Concepts, Inc. in the Chicago area. Prior to that, Jim served in various roles within the capital markets, banking and leveraged lending sectors. As a founding member of Household Commercial’s leveraged lending unit in Chicago, Jim helped grow their portfolio of leveraged loans to more than $2 billion of outstanding assets.
Jim holds a master’s degree in business administration, with concentrations in finance and accounting from the University of Illinois at Champaign-Urbana. He holds a bachelor’s degree in microbiology from Indiana University at Bloomington, as well as a secondary concentration in chemistry.
The Mother of All Derivatives
Warren Buffett famously called derivatives “financial weapons of mass destruction.” What then should we call a collateralized debt obligation or CDO? How about the “mother of all derivatives” (MOAD) akin to the infamous Massive Ordnance Air Blast Bomb (MOAB), nicknamed “mother of all bombs,” that was the most powerful non-nuclear weapon ever designed when it was tested in 2003? After all, the epitaph may appear well-deserved for a product that has been associated directly and indirectly with much of the $600 billion or so of writedowns and credit losses at some of the largest banks in the world since the beginning of 2007.
To paraphrase the bard, does the evil that derivatives do live after them and is the good oft interred with their bones? As with Caesar, the story is a complicated one.
Here are some things that we know. The homeownership rate in the U.S. jumped four points from 1994 to 2005 and much of that change was due to innovations in mortgage markets, including the combo loan, subprime mortgages and the development of secondary mortgage markets. This also was the time of growing wealth, global liquidity, yield-hungry investors, unscrupulous lenders, crooked mortgage brokers, scheming borrowers, greedy underwriters, complicit politicians, seemingly uncomprehending regulators and rating agencies, and assorted dreamers and schemers joining for the ride. Somewhere along the line, we also had bankruptcy and tax reforms and regulatory innovations. The latter allowed investment banks to massively increase their leverage and to place bigger bets – all to better serve their clients who were frantically scouring the globe looking for higher yields. What is an underwriter to do but to help feed such habits? And not long before the system ground to a halt, an item high on the Washington agenda was a commission appointed to explore regulatory reforms to keep American capital markets competitive with the rest of the world. When the artifice imploded, it was enough to make wise men wonder. Alan Greenspan was “shocked,” just shocked that all this took place mostly on his watch and ended the way that it did.
Where do we stand now? The prognosis for derivatives is not good and the prognosis for the economy is worse. However, the prognosis for politicians and their handmaidens, the regulators, is fair even when the rules are bad and the implementation worse, because they make, implement and oversee the rules.
At the epicenter of our troubles we find CDOs and CDSs – collateralized debt obligations and their cousins, credit default swaps. Some would add the FMS – no, not another derivative, but the free market system itself – to that mix. It is tempting to call for draconian measures and drastic new regulations. But do we want to empower a new army of regulators? No doubt the regulatory system must be overhauled and streamlined. However, it is unlikely that what we need is more regulation, but more effective regulation. “Until that occurs,” as Janet Tavakoli points out, “investors will have to fend for themselves.” But if the bail-out culture takes root, when will they ever learn?
In the meantime, how do we get out of this mess? Well, frankly, another bubble may provide a quick fix. Here is my candidate – a green bubble. It is irresistible in its purity and broad appeal. Just as no one could be against motherhood, apple pie and home ownership, who could be against saving the economy and the earth all at once? So, bring on the government subsidies from Washington to Berlin, from London to Beijing.
Appealing perhaps, but why am I not feeling better? As Mencken said, “For every problem, there is a solution that is simple, neat, and wrong.”
Timur Gök
Fraud: Is it or Isn’t It?
Over the past several months, I have heard many discussions about the current economic situation. Some discussions focused on sub-prime mortgages and derivatives; others on the decline in real estate prices and losses in retirement plans. Regardless of whether the people involved were financial professionals or individual homeowners, the discussion often moved to the topic of fraud − even when I did not mention being a Certified Fraud Examiner. I heard stories about homeowners cheated by unscrupulous lenders and elaborate mortgage schemes leaving lenders with hundreds of thousands of dollars in mortgages and virtually worthless properties. How much of the current economic crisis is due to fraud? Has the level of fraud increased and, if not, why is there so much talk about it?
Before we can discuss whether fraud had increased, we need a definition. Fraud is a word that we use in everyday speech but which has a specific legal definition. Although the legal definition can vary from jurisdiction to jurisdiction, it is the same in criminal and civil court. It is commonly defined as a crime or civil wrong for gain with four elements:
1. a person makes a material, false claim;
2. that person knows that the claim is false;
3. a second person relies on that claim;
4. the second person suffers a loss.
The normal standards of proof apply to fraud − the preponderance of evidence in civil actions or beyond a reasonable doubt in criminal cases. A “false claim” may be misleading and/or missing information rather than just specific statements. Material means important enough to have affected the decision of a reasonable person. A misstatement about an unimportant detail is not fraud. The concept of caveat emptor or “let the buyer beware” means that, if the buyer did not exercise reasonable judgment, a jury may not find fraud. Last, a person can not commit fraud inadvertently or by error. Proving fraud means proving that the act was intentional not accidental or by error. As Hamlet said “Aye, there’s the rub.” Proving intent can be hard. Top executives at Enron defended themselves claiming there was no fraud and, if there was, they did not know about it. They were convicted but the prosecution’s case was long, involved, and costly to taxpayers.
Now that we have defined fraud, we can try to measure it. One option is to use court decisions. On one hand, they give us an independent source of data. On the other, the data are not readily available and risk counting errors. We need data from multiple jurisdictions. Counting errors may result from a person convicted in criminal court and found liable for the same offense in civil court, agreements for restitution with no admission of guilt, conviction or liability under a particular statute but not for fraud, and when victims do not file complaints or seek damages. There is no legal requirement to report fraud and many organization prefer to take their losses quietly out of the public eye. Other options for measuring fraud include collecting data from professionals in the field or by analyzing lawsuits to identify fraud regardless of legal findings. However, while these studies can tell us interesting things, they can not tell us the rate of fraud or whether it is increasing.
So how much of the current economic crisis was caused by fraud? It is hard to tell and may not matter except to those lucky few who can recoup losses. Based on my experiences, fraud occurs when no one is paying attention. Waste and errors also occur when no one is paying attention. What is the difference? Intent. The costs are the same and when fraud, waste and errors are not stopped, costs grow. Many of the new investments were created by slicing and dicing existing and dull-and-boring investments. The highly compensated folks worked on the sexy slicing and dicing operation and ignored the underlying investment. Did they verify that the underlying investment existed or that it was valued properly? Not according to stories I have heard. And they apparently continued doing the same thing month after month. Ultimately, it does not really matter whether it was fraud,waste or error, the solution is the same − make certain someone is minding the store even the “dull and boring” parts.
- Peg Swanton
Musings from a corporate banker . . .
As structurers, traders and newly minted “bankers” with Ph.D’s from MIT were thinking great thoughts, putting together new and more complex deals and rewriting the rules of profitability in the banking industry, corporate lenders remained seated at their desks wearing green eyeshades, pouring over financial statements, calculating leverage and capital ratios and researching client market fundamentals. Credit committees and regulators weren’t impressed by new and more “sophisticated” risk models, and continued to require old school assessment of underlying repayment risk.
In the back room of the bank, where underwriters toil, the profitability of assets acquired to be held on the balance sheet were still calculated to meet regulatory and internal capital hurdles. CDS were primarily used to manage balance sheet exposure, the cash costs and/or revenue of the derivatives were included in the calculation of risk-adjusted return, and ISDA terms were generally required to match the underlying credit documentation. Profitability has been decoupled from risk as complex structures, mathematical modeling and buoyant trading markets convinced investors that risk could be reduced, eliminated, or at least sold off to someone else. No matter that direct credit was providing the fuel for the financial asset firestorm, lending became a loss leader for banks as structuring, trading and capital-friendly derivatives fees generated profitability traditional loans would never match. Chinese walls and management silos segregated the structurers and traders from the lenders, the risk from the return, and compensation and internal investment went to the cash generators, not the capital consumers.
At the same time, new era bankers were suddenly interested in old time leveraged loan assets to feed the seemingly insatiable appetite of the CDO/CLO beast. Like subprime mortgages, if the arranger didn’t expect to hold the loan to maturity, the agencies rated the default risk, valuations could be determined by a liquid trading market, and default protection could be purchased in the CDS market, underlying credit risk was no longer a primary consideration. Market demand drove down pricing, accelerated time to market and created “covenant-lite” deals.
As “a sinking tide lowers all ships”, the sub-prime debacle is bearing down on the corporate debt market. Investment grade borrowers are drawing down underpriced liquidity lines as the CP market shuts down, working capital and inventory financing (often securitized to feed the beast) is unavailable, 5-year credit lines are coming up for renewal and leveraged loans face deterioration and potential default as the recession deepens. All this as bank capital has been eroded by write-offs on assets too complex to value and to oblique to trade.
What’s a banker to do?? One thought — everybody take a deep breath and focus on their strengths. Traditional bankers have the expertise to value and restructure credit. As Denzel Washington said in the 1995 movie Philadelphia, “All right, look, I want you to explain this to me like I’m a six-year-old, okay?”. Combing through all the derivatives, securitizations and obscure documentation to find the value may seem impossible, but the underlying concept, lending money to a borrower at a price and having it repaid when due is a concept you can explain to a six-year old. It may take longer, be more painful and far less sexy for bankers to restructure and workout loans than trying to re-engineer their way out of the crisis, but writing up assets can generate income faster than adding new business in a capital strapped industry.
Experts and pundits are spending countless hours dissecting, analyzing and decrying the current credit market freeze up and ongoing “crisis”. There is lots of blame to go around, and a lot of people are getting blamed –maybe everyone’s time would be better spent crafting a solution that can be explained to six year olds. Where’s a good MIT Ph.D. when you need one???
- Lisa Garling
As a corporate CFO, one of my responsibilities is be a good steward of my organizational money. That means that I have a combined obligation to both manage that money for reasonable returns, while effectively managing the risks associated with that management. The management of risk is also situational.
I am also the CFO of generally earlier stage organizations that frequently have negative cash flows or at least teeter on the brink of negative cash. We balance investment of venture provided funds for maximum operational returns against the ultimate desire to grow into a more mature company that has strong net income and positive cash flows. This balance results in a relatively conservative view of the cash we hold for those operational investment. Cash is our life blood and we must manage both its conservation and its use for growth.
Often I have encountered opportunities to maximize returns on cash in reserve and have decided to take slightly less return in exchange for greater safety overall. This is particularly true in the case of highly complex investment vehicles that offer moderately (and sometimes significantly) greater potential returns on our reserved cash resources.
The base assumption that I use in these instances reflects one of Tavakoli’s key take away elements. Every single investment opportunity is someone’s product that they are trying to sell. At the risk of sounding cynical (and I probably am to an extent), when someone is selling me something, whether it be an investment product, a service (such as those of a rating agency) or anything else, this is a money making opportunity.
While I agree with Tavakoli that there is an opportunity for fraud, I choose to believe that most many outcomes are less about fraud and more about people’s failure to effectively deal with conflicts. In each sale situation, there is an opportunity for conflicts to arise (the desire for the sale outweighs the appropriate review on the seller’s side to ensure that they are selling something that is appropriate for the situation. It is ultimately my responsibility, and that of my team, to ensure that what we are buying is appropriate for our needs and risk tolerance.
My job as CFO is to hire the right people to manage that risk, build appropriate controls to minimize the risks we encounter and then understand the products that we are buying. That means research, research, research! But once the research is done and the experts have been consulted and have opined upon the products and my situation, it is my responsibility and by proxy that of my team, to make the final decisions on what to purchase and use.
I don’t claim to be a deep subject matter expert on CDO’s, synthetics or other highly technical arbitrage products. But I can hire that kind of talent and then my responsibility is to appropriately question the decisions that are made in those camps. It is easy to say “this is coming from an expert and so I can just rely upon that expert’s decisions and it will all be fine.” But realistically those experts, for example, recommended auction rate securities as an investment vehicle. Perfectly safe, until they weren’t. We did not get caught in that fiasco, but it would have been easy to do so. And regardless of the settlement outcomes, the inability to access my cash for a significant period of time could have put me out of business in the meantime.
So one of my responsibilities and that of my team is to not presume the good guys really are good guys. While they may not actually be bad guys, they also may not have my best interests at heart. The inherent conflicts in a product sale results in an added burden of responsibility which resides at home so to speak.
One final note is that issue of gray areas which Tavakoli also pointed out. There is nothing wrong with exploiting the gray areas available to us due to lack of legislation/regulation or just due to the less developed and resulting situationally inefficencies in a market or practice. But there is no need to push the bitter edge of that gray area or you may find that the boundary later moves and you further find yourself hanging out in the cold cold wind. Examples of that are the regulatory changes in tax structures and their own aggressiveness that almost took KPMG down and resulted in substantial scrutiny by the IRS of those who took part in the tax avoidance structures.
There is nothing inherently wrong or bad about taking advantage of limited or new regulations or arbitraging inefficiencies created in rapidly evolving markets. But that regulation will come and narrow the gray area and those arbitrage opportunities will close. It is important to ensure that you remain on the gray side when they move and that we act as appropriate stewards of our organizations’ reserves, particularly with respect to the risks we assume.