"Sometimes A Cigar Is Just A Cigar."

*

An old and dear friend of mine, Aeneas, wrote to me last week and brought up several very trenchant points about the present “situation" in the risk markets which I would like to share with you:

“It is interesting that so much of the recent discussion in the media has been focused solely on the sub-prime side of things. While this is sizable and serious most seem to be ignoring the impact of the massive risk re-pricing is going to have on the lower regions of the high yield market.

As you point out in your first entry, all of those covenant “lite” etc. deals done have been predicated (as always in a an overheated lending market) on the Ponzi-like need to churn the re-financings to keep some of these deals/ companies afloat. The exposures there are also stashed in a thousand out of the way CDOs which will become painfully clear over time.

This whole episode reminds me somewhat of the Latin debt crisis of the 80's in that all those petro-dollars had to be put to work somewhere which lead to a wide range of over excited lenders doing stupid things on a large scale, the most obvious of which was in Latin America.

This time around, the dollar amount is larger and the diversity of the outlets wider. Adding in the CDOs and derivatives and Mr. Toads Wild Ride is just getting started!"

Aeneas echoes a growing sentiment amongst regulators and market makers - one that we have heard from the lips of Hank Paulson, Ben Bernanke, Bob Diamond and a host of others - the re-pricing of risk is an essential element of any lasting recovery. The problem is that this will be accompanied by enormous pain and, potentially, great disruptions in the market. To date, the media, the pundits, and the Pollyannas who hope to wish this all away, have not had the fortitude to tell the truth, as unpleasant as it may be, so I will. To paraphrase "Old Blue Eyes" - "It's a real good bet, the worst is yet to come!"

And why? Because, as Aeneas noted, we have spread the toxin, oh so cleverly, across the globe - rats in the 14th century have transmogrified into CDOs in the 21st. The time has come to recognise that, once again, we have blundered with our modelling. The rating agencies keep talking about how strong the statistical base is on which the models were built and do not take kindly to the suggestion that, just maybe, the models did not and, of course, could not, factor in the double whammy that has occurred - an incredible growth in CDO and CDS issuance combined with the failure of the tranching mechanisms to properly identify and price risk - because there were no statistics on which to base such a supposition; that is, until now. These models live and die by the probability that defaults will not exceed a certain number in each tranche. In the specific structures that have collapsed this supposition has been demolished by the reality of a massive number of defaults which have drained the structures of their value.**

As is an all too human trait, we are now seeking to place the blame and, of course, the rating agencies are in the cross-hairs. However, the errors should not be laid solely at their feet, as the drivers for this disaster are legion. As Aeneas pointed out there is the "wide range of over excited lenders doing stupid things on a large scale". In addition, there are the legal and tax regimes that have created the gaping maw - which must be fed - that we call "Private Equity". Had we but thought through the process more carefully, we could have foreseen this present state. Every lender/debt issuer/regulator, needs to ask themselves, these two questions:

How could we have thought that we could lend billions, at incredibly low rates, to finance the buying of firms from their shareholders, thus creating highly leveraged entities, and somehow, through the "magic" of new structures based upon new, untested models, make risk disappear?

How could we have assumed that millions of people, who did not meet realistic standards of financial stability, could buy homes, with little or no equity, and somehow not run into trouble when a downturn took place?

The answer, while painful, is simple, we closed our eyes to risk; we failed in our fiduciary responsibilities.

To quote, as I did in my first posting on this Blog, from another portion of Alan Greenspan’s speech to the OCC in October, 1999:

“As I have indicated on previous occasions, history tells us that sharp reversals in confidence occur abruptly, most often with little advance notice. These reversals can be self-reinforcing processes that can compress sizable adjustments into a very short period. Panic reactions in the market are characterized by dramatic shifts in behaviour that are intended to minimize short-term losses. Claims on far-distant future values are discounted to insignificance. What is so intriguing is that this type of behaviour has characterized human interaction with little appreciable change over the generations. Whether Dutch tulip bulbs or Russian equities, the market price patterns remain much the same.

We can readily describe this process, but, to date, economists have been unable to anticipate sharp reversals in confidence. …

Nevertheless, if episodic recurrences of ruptured confidence are integral to the way our economy and our financial markets work now and in the future, the implications for risk measurement and risk management are significant.

This market has enriched the private equity barons, the sub-prime "flim-flam" men and the legions of traders and speculators who have fanned the flames. Some have already paid the price, particularly the sub-prime inveiglers, certain of the CDO creators and salesmen, and even the heads of an i-bank and a rating agency; many more will pay the price in the weeks and months to come – high on the list those lured into debt hoping that the promises they heard were true, and then all of us who rely on the markets for our livelihoods and the funding of our retirements.

We need to find a way to handle the living whilst burying the dead. One important aspect of this is to constantly stress, at every level of our financial institutions, the need for good solid risk and reward skills that are not constrained because of arguments over “the growth of the bottom-line” or “strategic market forces” or "I have this great model that can help us make money and take no risk." We need to remember Freud’s warning applies, undoubtedly in a way he never intended, to risk as well - “Sometimes a risk is only a risk.”

At the danger of appearing to be self-serving, I will end this posting with the ending of Mr. Greenspan’s OCC speech:

“... Boards of directors, senior managers, and supervisory authorities need to balance emphasis on risk models that essentially have only dimly perceived sampling characteristics with emphasis on the skills, experience, and judgment of the people who have to apply those models. Being able to judge which structural model best describes the forces driving asset pricing in any particular period is itself priceless. To paraphrase my former colleague Jerry Corrigan, the advent of sophisticated risk models has not made people with grey hair, or none, wholly obsolete.”

My thanks to Aeneas for his thoughtful and thought-filled commentary; your contribution to the debate, as always, is appreciated greatly.

Now, who will be the next one to comment? Stop lurking and get working!


Cassandra

*This statement, famous but apparently unsubstantiated, was made purportedly by Sigmund Freud in response to a question during his famous Clark University lectures (September 1909). Freud had been describing the latent sexual meaning and significance of dream symbols, when someone asked, "You seem to smoke a lot of cigars, what does *that* symbolise?" and he answered "Sometimes a cigar is just a cigar." I have used this quote, even though no one can find an exact written reference, because it is consistent with Freud’s persistent refusal to analyse his own actions, and, besides, it’s a great bon mot.

** Tranching of credit risk is a conspicuous feature of many securitisations and credit derivatives. In “Credit tranching” one creates a multi-layered capital structure that includes senior and subordinated tranches (classes). For example, a securitisation of commercial mortgage loans might create 10 different tranches, each carrying successively lower ratings and supporting the tranches senior to it. Different tranches within a deal's capital structure present different degrees of risk and have differing performance characteristics. When the deal's underlying assets consist of credit exposures for which default probabilities, recovery rates, and correlations can be reasonably estimated, simulation techniques offer a convenient approach for pricing different tranches and analyzing their risk-return characteristics. (Quoted from "Tranching Credit Risk, Examples with CDOs", Nomura Fixed Income Research. 8 October 2004)

Cassandra's Note: Unfortunately, the modelling & simulation techniques that created and priced these tranches are exactly what have failed in this present sutuation.