Thu, 04 Dec 2008
While many think that CDOs and other complex instruments contributed to the crisis, the US government has been very enthusiastic in its use of these structures. In fact, if the behaviour of the US government is any indication, CDOs seem to be part of the solution. Let me give a couple of examples.
One of the best is the bail out of Citigroup. If one looks at the term sheet for this transaction, it is clearly a CDO structure:
- First loss tranche (10%) retained by Citigroup. Using typical CDO numbers, this would be all the pieces rated A and below. But if we assume that valuations are generous, then this would be just the equity piece or may be also a bit of the mezannine piece.
- Second loss tranche (1.6%) taken 90% by US Treasury (TARP) and 10% retained by Citigroup. Depending on one's valuation assumptions, this could be the BBB piece, the A piece or the AA piece. This is a thin tranche implying high loss given default.
- Third loss tranche (3.3%) taken 90% by the FDIC and 10% retained by Citigroup. Depending on one's valuation assumptions, this could be the A piece or the AA piece.
- Senior piece (85%) taken 90% by the Federal Reserve and 10% retained by Citigroup. Under good old CDO norms, this is the correct attachment point for a AAA tranche and if you are very gullible, you could consider this a AAA piece. Since the Fed took this piece, you would assume that either they were gullible, or that some valuers there are willing to turn a Nelson’s eye towards this transaction.
Now why is such a complex structure required when most of the parties involved are arms of the government itself and every reasonable person would agree that all pieces are clearly at significant risk? Clearly, the government is now abusing CDOs for the same reasons that Wall Street abused it – to fool oneself or to fool others.
As a second example, consider the terms of the restructuring of the loans to the AIG announced by the New York Fed yesterday. There is an LLC set up to buy CDOs and this has a complex structure.
- There is an equity tranche of a little under 15% contributed by AIG and the remaining 85% (senior tranche) is provided by the New York Fed. Note once again that the attachment point of the senior tranche is once again the magic number of 15% of the old days.
- There is a complex payment waterfall structure in which the Fed receives principal before it receives the interest (Libor + 100 basis points). To me this looks like make believe accounting where the Fed would be able to claim that there was no loss of principal and only the interest was lost.
- The profits are shared between AIG (33%)and the Fed (67%). Since AIG provided all the equity, one can think of this as an implied IO (Interest Only) tranche that is owned by the Fed.
- The term sheet glosses over the fact that the only source of cash for AIG to provide the equity piece of $5 billion is borrowing from the various schemes of the Fed and the Treasury. So the Fed is now playing the role of a prime broker lending to a hedge fund that picks up the equity piece of a CDO. What can the Fed do when there are so few prime brokers still left?
My last example has nothing to do with CDOs and is not a recently designed instrument, but the consequences of some needless complexity in the design is showing up only now. Long ago the US Treasury introduced inflation indexed bonds (TIPS) whose coupons and redemptions are indexed to the consumer price index. This is close to a real risk free bond and is a useful asset class for many investors. It is also useful in creating a market implied estimate of expected inflation (simply subtract the TIPS yield from the nominal yield of an ordinary government bond).
The US Treasury however fouled up this simple and elegant instrument by adding a totally unnecessary complexity when it stated that the redemption will not drop below par even if inflation over the term of the bond turns out to be negative. This adds a European put option exercisable at par at maturity to the instrument. Under normal conditions, this option is far out of the money and can be ignored. If one wanted to be more accurate, one could assume a volatility for the inflation rate, value this put and compute the option adjusted spread (OAS) for the TIPS.
The problem is that these are not normal times. Some people believe that the risk neutral distribution of the CPI at maturity is bimodal with one peak at 80% of current levels and another at 140% of current levels. Black Scholes valuation is hardly appropriate and nobody knows what the true value is. What we do know is that the yields on two TIPS with the same residual maturity have vastly different yields (a spread of 200 basis points) depending on when they were issued and therefore how much of inflation adjustment is already impounded in the principal. Mankiw blog has an excellent discussion on this issue. Econbrowser also discusses this and I have drawn on ndk’s comments in that post for the bimodal distribution mentioned above.
There is an old joke which asks what is the difference between the godfather and the investment banker. The answer is supposed to be that the godfather makes you an offer that you cannot refuse while the investment banker makes you an offer that you cannot understand. The US government is now very clearly in the business of making offers to the rich and well connected that the tax payer cannot understand.