Leo Linbeck III

You Wrote:

“To be sure, there were snake oil salesmen, and stupid buyers. But the fundamental problem is that buyers underestimated the covariance of the loans in their portfolio. This underestimation resulted from a lack of understanding of what happens in a financial crisis: a flight to quality.”

and later wrote:

“My fundamental point is that CDSs are not the source of the problem. The residential asset price bubble is the problem, and F&F were the proximate cause. The jury is still out whether CDSs help or hurt the situation. And outlawing them and other derivatives may, by the LOUC, cause more harm than good.”

I would like to add my 2 cents into this, if I may.

I work for a software and information services company that tries to grapple with these issues. My clients are many of the leading hedge funds, prime brokers, fund admins, institutional asset managers, custodians, etc., So, I have seen this from multiple perspectives and have reached out to many contacts I have made to discuss this issue for many years now.

There are TWO big problems we are facing. The first is making its way through the system, subprimes, where now many people have heard of Fannie Mae and Freddie Mac, where as 6 months ago, they probably haven’t.

The second problem is CDS, and this has the potential to pull everything down.

Unfortunately, a big cause of both of these problems is lack of information. Lets start with the subprime mess. Many firms have junk on their books, but how much junk? How do you value it, or measure the risk of it?

Let me explain. my mortgage gets pooled with other mortgages that have the same interest rate and maturity date. This is what we refer to as GNMA or FNMA, and is not a bad thing. But, these GNMA’s have been purchased into structured products such as CDO’s that also get purchased on up into other CDO’s – on and on again. How do you price these instruments, or measure risk? Where does the data come from?

The original issuer of my mtg knows my risk profile as it looked 6 years ago when I got my mortgage; but now? how do you know if I am a dead beat, or where I live (Upper west side? Detroit? Las Vegas?) that may be in a highly impacted area. And, when these products are rolled up into other products, it is impossible to link them.

For example, lets work downward. If I have a CDO, how do I know what is in it? It is in a prospectus in a PDF along with hundreds of other positions – including other CDO’s. No one is going to enter hundreds and thousands of these things into a computer – it just doesn’t happen. There are a few products out there, but they are just scratching at the surface.

So, firms try to price these instruments, or assign risk values to them based on models. And when you scratch at the surface of the model used, you recognize it is just a guess.

The issue comes down to how much junk do you really have on your books and no one really knows. When the giant hedge fund Citadel bought eTrade’s asset back business for .20 cents to the dollar, some one was betting it was worth more, while the other person just wanted it off their books.

This is still being flushed out of the financial system.

The second issue deals with CDS, and in my opinion, it is far worse. For example – Bear Stearns, Most folks believe that the Fed was not bailing out Bear, but was bailing out JP Morgan who had a $10 Billion CDS exposure with Bear, and $55 Billion overall. If Bear tanked, they would have taken JP with them, and in turn, JP would have brought others along with them.

An example of how this works for those not too familiar – Lets say I am a hedge fund, and I have a $10 million loan in the form of a bond to Bear. Bear agrees to pay me 7% interest per year on my loan and at the end of 10 years, pays me back my principle.

Now, I think bear is a little risky and I am worried about my principle, so I go to JP Morgan for a CDS, which is insurance. JP do not think Bear is too risky and charge me 2% (200 bps) to insure my principle. So, I think I have 5% risk free. Bear pays me 7% and I pay JP 2% for insurance.

And then Bear does the unthinkable, they tank. I look at my hedge fund buddies and say ‘no, problem’ we are insured, JP will pay us back our $10 million. In fact, they will pay all $10 billion in CDS that people had with them. That would have been a huge run on them that they could no have withstood. Thus, the fed stepped in. If JP tanked, they would have brought others down with them.

The CDS market is believed to be $40 – $50 trillion and no one really knows what the risk (counterparty risk) really is.

The chicago mercantile exchange has been trying for years to be the exchange for these CDS. They would have had complete transparency knowing the full extant of counterparties. But the banks that today act like exchanges fought tooth and nail because they made heaps of money on the spreads of products.

Again, an informational problem.

So, now there is a flight to safety because know one really knows how much junk they have on their books or what the extent of their counterparty risk is.

However, I should point out that this flight to safety is causing most of asian money to fly to the US. When things get bad, the US is still the safest, least corrupt place in the world. It amazes me that we still have much of the worlds gold here in NY at the fed.