Deutsche Bank Ignored Its CDS Problems Until They Went Away
bloombergview.com
bloombergview.com
What happens when this level of genius in small groups is cut loose on financial markets where "Make money is the only goal"? You get these space shuttles. They are so complex because that's all these people ever think about.
Snapchat is world changing and the work of brilliant computer scientists? Did I miss something? I can only hope that your post was intended to be sarcasm.
The space shuttle we have is, to paraphrase [1], made from piss-soaked snowflakes and we are crossing fingers that it isn't all going to melt in our hands overnight.
Sometimes it does dissolve in our hands and at that point, that's when the extensive hordes of ancillary staff roll out to lick butt.
So when you think that you're playing with wooden blocks, you're right, but you're probably doing it a bit better than piling them up randomly for the highest margin to support a massive hierarchy of unnecessary staff. And you're right, it is pretending. But it makes money, and that's all they care about at the end of the day.
Good luck for you still have hope of doing an honest job.
In practice AIG managed to get itself into a situation where the Fed needed to give it $182.3 Billion dollars to keep it afloat.
That's $182.3 Billion, not Million. https://en.wikipedia.org/wiki/Aig#Liquidity_crisis_and_gover...
I got lost somewhere around the first appearance of the word tranch,
Deutsche bank sold lot's of this type of insurance.
If the markets had turned and some large companies had gone bankrupt they would not have had the means to pay the people who bought this insurance.
Basically they took very low quality insurance and re-packaged it as high quality insuarance.
So why weren't the banks charged with illegally selling insurance products and/or violating insurance regulations? Because fuck you, peon.
Imagine an empty company loans 100 companies $1 each.
To get the $100 to loan, that company sells bonds to 2 investors for $50 each.
One investor is senior and one is junior.
What this means is that if any of those 100 companies default and don't pay back their loan, then the junior investor loses money.
The junior investor loses money until their entire $50 is lost, and only then does the senior investor have to suffer loses.
The senior investor therefore only has losses if more than $50 of the total $100 loans is lost.
This is basic credit tranching in funded format.
Unfortunately things get a lot more complicated when instead of $1 loans, we have $1 credit default swaps, which instead of loaning someone $1, you promise to pay them if a 3rd party company defaults.
This trade is DB buying protection from a company on a very senior tranche of this type of trade, but they are buying it leveraged, so for example they buy $100 of protection from a company that has $10 of cash inside (provided by the third-party investors), with a promise to pay more if the tranche deteriorates.
As far as rationale, the primary purpose of these trades is to offload super senior risk from DB's balance sheet, which they accrued through doing a different type of trade.
What I don't get is who paid for that risk in the end. I suspect it was the government which bailed everyone out with public money so that the doomsday scenario was never realized.
The difference, of course, is that with software the opaqueness is pure cost. Whereas in the financial markets the opaqueness is often a profitable resource from somebody.
For those who want to understand it , these might possibly help(These are only personal notes.):
[part 1]https://medium.com/finance-and-economics-studies/read-note-o...
[part 2]https://medium.com/finance-and-economics-studies/asset-backe...
A former Kansas Fed president called them "horribly undercapitalized", with a leverage ratio of 1.63 percent:
http://www.reuters.com/article/2013/06/14/us-financial-regul...
Banks like Deutsche aren't in the business of taking large directional derivative bets. They are market makers so the quasi totality of these 72 trillions are offsetting positions, which are mostly collateralised, i.e. each counterparty has to post assets to match the evolution of the value of the derivative in order to keep the credit exposure minimal.
With such a massive book, there will be residual risks all over the place but 72 trillion is a meaningless number for assessing them.
And anyway notional tells you nothing about the risk or exposure. 1bn of 30y is a lot riskier than a 1bn of 1y etc.
1 - End customer trades do sometimes get torn up. Also trade compression services between street counterparts also result in bulk tear-ups from time to time. But still the vast majority of trades are legacy and largely offset each other.
Not everything is always perfectly hedged. And when it's not, there are mark to market issues. And, the market isn't always liquid. Levine is in fact writing about a market that "froze up".
One of my favorite anecdotes (pg 212) from The Big Short involves Deutsche. It was perhaps embellished a bit for the book. It involved credit default swaps:
In early July, Morgan Stanley received its first
wake-up call. It came from ... Deutsche Bank ...
the CDS (sold to) Deutsche Bank had moved in
Deutsche Bank's favor
Deutsche: Triple-A-rated subprime CDOs ... were
now worth ... 70 cents on the dollar
Morgan: Our model says they're worth ninety-five
Deutsche: our model say's they're worth seventy
Morgan: Well, our model says they are worth
ninety-five, repeated the Morgan Stanley person
Deutsche: Dude, fuck your model. I'll make you a
market. They are seventy---seventy-seven. You have
three choices. You can sell them back to me at
seventy. You can buy some more at seventy-seven.
Or you can give me my fuckimg one point two
billion dollars.
So, while 72 trillion is indeed a "meaningless" number, quite often the "residual risks" you mention will greatly exceed the equity in the big investment banks. Notably, Deutsche has in the past been considered to be very over-leveraged.
The banks smartly foisted off some of their "residual risks" onto muppets and companies like AIG, who stupidly accepted the business. But AIG wasn't liquid enough to pay off. If the Fed hadn't bailed out AIG, who then bailed out their counter-parties, the fallout would have utterly destroyed the world's financial system.
As it was, we came pretty close to everything crashing down. IIRC at one point the Fed had to provide liquidity to e.g. Verizon, because the banks weren't willing to. Sheesh.
Perhaps rather than total notational outstanding, a more meaningful number is the amount of real assets this is all backed by. According to the IMF we have $600 trillion in gross notional derivatives backed by a $600 billion in real assets, i.e. 1000x systemic leverage:
http://www.imf.org/external/pubs/ft/sdn/2012/sdn1212.pdf
One can imagine this to become just a tiny bit problematic once collateral chains start breaking, such as when "AAA-rated" AIG failed :)
Also, interestingly, from the piece I quoted, a lot of these derivatives get to be created without any collateral being posted at all:
"Another important metric is the under-collateralization of the OTC market. The Bank for International Settlements estimates that the volume of collateral supporting the OTC market is about $1.8 trillion, thus roughly only half of exposures. Assuming a collateral reuse rate between 2.5-3.0, the dedicated collateral is some $600 - $700 billion. Some counterparties (e.g., sovereigns, quasi-sovereigns, large pension funds and insurers, and AAA corporations) are often not required to post collateral. The remaining exposures will have to be collateralized when moved to CCP to avoid creating puts to the safety net. As such, there is likely to an increased demand for collateral worldwide."
Not for bilateral derivatives that can always be netted, even in bankruptcy, which make up the bulk of the notional outstanding. If you read the ISDA Master Agreement[1], derivatives can always be netted as there is a provision that exempts derivatives from the usual bankruptcy automatic stays to stop literally this exact threat you posited [2]. Even beyond the bilateral case, the multilateral cases are increasingly cleared through central clearinghouses[4]. But even when they aren't, multilateral nets can still be pushed through, in one of two ways: 1) even when Lehman failed, there were some multilateral nets that greatly reduced the exposure, under mutual agreement by all creditors, and 2)The Dodd-Frank Act, since 2009, has also greatly helped this, giving the FDIC and Fed enhanced powers under the Orderly Liquidation Authority[3], which allow them to multilaterally net to reduce contagion risks even if there is no such master agreement that a priori would have let them do so[5].
[1] http://en.wikipedia.org/wiki/ISDA_Master_Agreement
[2] A Dialogue on the Costs and Benefits of Automatic Stays for Derivatives and Repurchase Agreements, by Duffie and Skeel, alternatively see [3], or [4]
[3]The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences by David Skeel.
[4] The Risk Controllers by Peter Norman.
[5] Even pre Dodd-Frank, when there wasn't a law that let this happen, usually the creditors come together and fix things, a la LTCM "bailout"[6], which was funded entirely by the creditors and unwound in an orderly fashion through multilateral netting. Bear Stearns and Lehman Brothers were the only creditors that stiffed everyone else, by refusing to participate, and that was partly why they got fucked in 2009 since the other bankers remembered their unwillingness to help out in 1998, and reciprocated.
[6] I hate that this is called a Bailout. No taxpayer funds were spent. The creditors (i.e. big banks) bailed out one of their own by pooling together money and fixing their shit. The only governmental involvement was that the Fed president called the CEOs of the big banks and said "yo fix your shit before it spreads", and they did. That's not a bailout in the sense of "taxpayers bailed them out". They bailed themselves out.
But when I read this article, I can only say one thing: Why?
Why is Wall Street spending all this time and energy in creating all these different securities? I suspect that any excess "profits" or "returns" to be had from them accrue 90% to the bankers and 10% to the muppets funding them. So why do the muppets keep playing this game?
In this case, the sucker would actually have been DB's investors if the worst case ever did happen. (They would have gone under like many other banks - the bailout saved them.)
In this case the investors they sold protection to (hedge funds) got better prices than they ordinarily would have, because of the risk hidden in the conduit.
1) The way you get to sell products to investors is by promising some sort of alpha: "My fund is less risky, my derivative pays more for the same risk, etc."
2) But magic does not happen in the financial markets (and when it does is through the old stories.. diversification, transferring the risk to those of broader shoulders, etc.)
3) So what you do is HIDE THE RISK. There are many ways to do that, and they usually involve COMPLEXITY. Complexity and opacity are your friends, as they confuse investors who don't realize there is a hidden risk somewhere there, or a scenario you haven't told them (but put on page 350) where if A B and C happen, then he will lose a lot of money.
I'm not joking here.. sometimes complexity is good as it allows you to e.g. reduce mismatches in your risks (your income is in USD and expenses in EUR, your debts are long term and assets short term, etc.). However, the ultimate purpose of most complex products is that they allow you to sell stuff that appears better than it really is. And IT WORKS. Everytime. Against millionaires and against folks buying silly combos of insurances plus deposits (forgot their names).
I've been rereading my copy of Taleb's Antifragile. He keeps hammering similar points over and over: complexity, risk, opacity, susceptibility to Black Swans, etc.
I think I'd be depressed if I worked on Wall Street and the better part of my compensation resulted from peddling all these confusing products.
Still, as you point out, sometimes complexity is good. I do understand that.
And then we wrap it up all with a bow by allowing finance people to alternately claim that a) they are so smart they deserve to personally make millions to billions, and b) they couldn't possibly be held accountable for systemic fuckups, because nobody could possibly have known. I'll accept one or the other, but the combination is incredibly dangerous.
The primary purpose of these trades is to offload super senior risk from DB's balance sheet.
Super senior risk is the risk that DB retained when it (very profitably) sold various other tranches on a group of assets (typically CDS on a bunch of corporate and sovereign credits).
This type of risk is very difficult to sell as the return is very low and most entities they might buy unfunded protection from are likely to not be able to pay in the event that the swap pays out.
Offloading that risk through a swap to a conduit like this allows DB to release (expensive) capital/reserves that would otherwise need to hold.
Fail early, fail hard, then go fix it. Don't go off operating in an undefined state.
Quite a lot of financial strangeness can be answered with "where else are you going to put your money?" Western treasury bonds are the safe option, but they're close to negative yields. Spending $1.01 at auction to buy a bond which nominally costs 95c and pays back $1 in five years doesn't look great. So there is a huge demand for "riskless" positive-yielding investments.
That's why London (and elsewhere) property continues to shoot upwards in value way beyond the ability of the inhabitants to afford it. That's why Switzerland has negative interest rates. And so on.