Friday, January 30, 2009

Bad Bonds Or Bad Prices?

In response to my last post about sharply lower CDO issuance a reader had this to say: "There's no such thing as bad bonds, only bad prices".

At first glance the comment makes perfect sense: bonds should be priced to adequately balance reward (yield to maturity) with risk (danger of default). One could reasonably argue that this goes on all the time in the primary market where new issues find willing buyers, and in the secondary market where existing bonds are priced according to continuously changing perceptions of creditworthiness. In plain words, Mr. Market supposedly makes sure the credit shop runs smoothly. And yet, as we well know, the real world very often refuses to follow such nicely constructed theoretical models.

For one thing, the random walk theory of super-efficient markets replete with monkeys and dartboards is utterly and completely fallacious. Any experienced professional will readily admit it, given a modicum of honesty and/or enough booze. For proof just ask 100 people what they prefer: a 50% chance of a $1000 gain or a 100% chance of a $500 gain. Obviously they should not care, since the two are mathematically identical - but human reality is a whole different ball of wax. Look it up...

For another, electrons have no morals. Let's ponder the structure of the more "innovative" forms of finance - for example, CDOs. In today's society debt is essentially a moral obligation, since we no longer demand a pound of flesh, run debtor prisons or engage in heavy-handed gunboat diplomacy. As such, the degrees of separation between borrower and lender are crucially important; they define the moral bond that binds the two in the financial contract. For once a debt has been originated, pooled, securitized, chopped into tranches and sold as tens of thousands of tiny pieces, neither borrower nor lender have any idea of each other's existence as anything beyond electronic entries in a data bank. No Daisy, we're not in Kansas any more and lending no longer runs through the folksy Bailey Building and Loan.

In other words, bond structure matters a whole lot and impacts pricing accordingly. I have a rule of thumb based on the exponential scale: each additional degree of separation between borrower and lender makes pricing a bond ten times more difficult. Putting it another way, a AAA tranche of a CDO based on 5,000 separate mortgages from five dozen neighborhoods split amongst a couple hundred insitutional investors who manage the money from several million investors/lenders is an absurdity in itself and should never have existed - as anything other than a lottery ticket, maybe.

A famous architect once said: Form follows function. In finance, back when I was taught it the hard way, the equivalent was KISS: Keep It Simple, Stupid. Put both together and you have the basic design parameters for an honest and solid financial structure. Stray too far away and you get nothing but highly unwholesome alphabet soup: CDO, CDS, SIV, CPDO..

Conclusion: Yes, there ARE bad bonds, plus other financial instruments of mass delusion. They are the ones that went from AAA to worthless in one go, plus plenty of others that are still causing huge stress in our economy - for example CDS. They were, and still are, beyond proper pricing for the very simple reason that they cannot be priced.


  1. For proof just ask 100 people what they prefer: a 50% chance of a $1000 gain or a 100% chance of a $500 gain. Obviously they should not care, since the two are mathematically identical

    No they are not, although your linked example is correct.

    If you offer me a SINGLE TIME 1000€ at 50% change I either get 0 or a 1000. If you offer me 500€ at 100% I always get 500€. Big, big difference. Your example only stands if you offer me, REPEATEDLY, infinite times the same option (then, on the limit, they are the same). But for a single offer, there is a mighty difference.

    I supposed you read "gut feelings"? Or was it "predictably irrational"? Well, in one of those this example is there.

    But your reasoning stands.

    So much for fuckin' Homo economicus.

  2. From previous thread cotton said:

    "I am leery of any and all mob mentalities."

    Once again, in order to gain perspective, we must learn from history. Our own history shows that the British Empire sent their military over to quell the mob actions of the Revolutionary's.

    The reason, money of course. The Empire must expand or implode and they needed to scam money off of the hard working early Americans.

    We have the same insidious global empire today that has sucked us dry. We are now at collapse and when the people lose it all there will be another Revolution.

    Joe M.

  3. Nice post. Bad bonds are, in effect, financial lies, tangled webs designed to deceive. And the proximate reason we can not now get ourselves untangled is that the people who over saw the creation of these "bad lies" are the same folks who are being charged with addressing the carnage wrought be these weapons of financial mass destruction.

    Until that changes the present condition will persist and grow worse. Someone has to, as they say, bust a move. I posit that if it is going to come, it will have to come
    from the the people. I think we are on course for it to start what with the sort of treatment of the citizenry we are seeing at the state level, where the authorities are simultaneously acting very aggressive in tax collection and derelict in refunding monies owed to taxpayers.

    Recall that the American Revolution occurred over taxes.

  4. Edwardo, how did you manage to multiply yourself exponentially that way ?
    Maybe the way all of those bonds managed to multiply themselves exponentially, all over the globe ? lol
    After exponential multiplication, we are now set to see exponential reduction, perhaps. Whittling ourselves, and the economy down to nothing but...
    pounds of flesh ?

  5. No revolution this time around. No one cares enough to put up a united front. This time it will be anarchy.

  6. CDOs are "bad bonds" for a very simple reason. They are leveraged on the downside (investors below super senior are exposed to the default of loans worth several times the value of their investment), but not on the upside, because they pay a fixed return.

    This means that from a theoretical view accurate pricing of the fixed return is essential in order for the investor to have an ex ante expectation of gain. Somehow, I don't think that this is how the product was explained to investors.

  7. ""I am leery of any and all mob mentalities."

    They are an effective, but extremely blunt, tool. If the mass has a well-defined demand (i.e. "Free Mandela")then a mass protest is appropriate.

    But I'm of the opinion that what we have here in the U.S. is a complicated cluster%$@$ and that the citizenry is in no way united in a defined complaint or solution.

    Imagine a mass demonstration at the Seattle Center over "the economy". The guy next to me wants more Medicare spending. I say "No way! Unsustainability!". Another guy screams "Abolish the Fed!". I wander over and say "Sounds good. What your proposal for the new system?". He screams "You're one of them, aren't you?". My jaw drops. Then I hear chants of "We demand gay marriage!". And I scream back "Dudes, this isn't the time for this. This is about the economy." Soon I'm surrounded by people accusing me of being a Republican. I scream "BACK OFF! Look, there's a highly integrated matrix of thermodynamic realities...". I wake up in Harborview after being flown by a Life Flight helicopter due to massive head trauma. I start rapidly pressing the button on the morphine drip.

  8. Great post Hell. Let's hope the Obama Administration holds the same value to honesty than you.

  9. the bonds could have worked, or course. it would have been possible to keep track of which mortgages went into which pools, and how they were divided into tranches, and where the note for each mortgage was, etc. But they would have needed masters degrees in library science, not business administration. Of course, they did not keep track of these things, so the securities resulting are worthless. GIGO.

    Jason B

  10. Dink,

    I agree with you. Mob mentalities ARE effective and have their place. I mentioned this in conjunction with MLKjr in the last comment section.

    That was a "mob" mentality (insomuch as they were united in common purpose), but that mentality was instrumental in raising them to a level of equality. After which EVERYONE was to be judged by the content of their character (the dissolution of the mob mentality after its singular stated goal was thru)

    What we're experiencing today as the financial crisis is the unassembled mob mentality gone terribly wrong. Too many people played follow the dollar, and now they're all at or over the cliff... like the proverbial lemmings.

    On one hand the only solution was the original one-- don't identify with the mob mentality, don't chase the same dollar (or fraction of a penny as was the case) as everyone else. And instead? Follow a more individual value system, and appreciate the "little" things in life (there's plenty of those to go around)

    Though... we're in the mess (some more so than others), and no sense not cleaning up after the many footed mob.

    But just how are we gonna pay for the broom?!

  11. Anonymous is right. It is theoretically possible to track each loan to each pool, tranche and therefore figure out what the value of the CDO is. It is the brokers refusal to do it, not setting up the appropriate information retrieval infrastructure, that makes the CDO _irreversible_.

    In other words, I fully believe it is possible to do a CDO right. Just that nobody did it. Everyone assumed that CDOs would be priced fairly by the market mechanism, which cannot and will not work without the ability to keep track of which loan went into which CDO.

  12. "or engage in heavy-handed gunboat diplomacy."

    What would you call the invasion of Iraq? or don't dry-land invasions count? or isn't a million dead and four million homeless heavy-handed enough in your book?

  13. The problem with CDOs is not one of record-keeping.

    The problem was in the structure itself, which attempted to turn lead into gold.

  14. The problem was in the structure itself, which attempted to turn lead into gold.

    Exactly, they rolled up SubPrime, Liars loans with a sprinkle of AAA and sold it to the world.

    The straw that broke the camels back. Worm in apple also comes to mind.

    Joe M.

  15. @Cotton

    "the unassembled mob"

    As I interpret it, we are in complete agreement. There needs to be a unified purpose for the protest. And it would be difficult to have unity on such a complicated matter. Also, the action demanded should hopefully be rational and viable. Locally, the Boeing union keeps striking for job security. Dudes, c'mon! The people you're protesting to are administrators, not gods controlling the future.


    Glad to have you back and Fighting The Power :)

    @ Edwardo

    Wow, gold is flying. $1K by next week? Hopefully my cash can still be traded for whiskey in case I need to give up my teetotaling ways soon.

  16. Hell,
    Nobody in his right mind, definitely not economists, would assume that people make decisions based only on expected losses. Add to your example a choice of $1,500 gain with 80% probability and loss of $3,000 with 20% probability. The expected gain is now $600 - but few people would chose this offer over either one you use in your example. The expected utility is not perfect, but it is certainly better than the assumption of risk-neutral expected value preference.
    You are making reasonable points, but you are creating a straw man to argue against.

  17. "There needs to be a unified purpose for the protest"

    There will be, it's called destitution. Just like what happened in France after John Law completed his dirty deeds.

    Joe M.

  18. I agree with Cottonbloggin (I think it was you stated this in the last comment section) that what is going on over the Internet, for example, in places like Hell's blog represent what is really new, and revolutionary.
    Think about it.
    Here we are, all of us contributing GRATIS to adding on to each other's knowledge in a democratic manner where nobody is boss.
    In a small not giga structure.
    Things are already changing, we just are not necessarily looking in the right places.

    I don't like the word "mob".
    It is different from a crowd.
    The people in the French demonstration on Thursday were from many different areas, but they came together for a common cause, and believe you me, if the French can do this, then sure as hell the Americans should be able to also.

    I like what you wrote about turning lead into gold, Hell.
    Does that mean that you have perhaps been reading the Merchant of Venice ?
    I have my fingers crossed on that one...

  19. @Debra

    "they came together for a common cause"

    I'm still not clear on what the common cause was. Please elaborate.

  20. I am afraid I don't understand you Hellasious. Yes, CDOs are bad in that their risks were mis-stated. I would say it is a risky structure and would never get an AAA ranking.

    But on the other hand, don't you think this financial mess would be more contained, if in response to mortgages turning bad, we traced it to some CDOs, and devalued only a few of the CDOs, rather than the whole stinking thing as an asset class. If book-keeping was better, and we didn't just give up, it would be possible to mitigate that damage.

    In any mess, there are the people who throw their hands in the air and cry "chaos". Then there are those with a more analytical mind that say, "Hmm, it is some small things fault. Let's fix that."
    I am on the side of the those who have that analytical mind.

  21. Dink, they came together to express their sentiment that the economic situation can't continue.
    French unemployment is 10 times worse than American unemployment (I think...)
    There just is very little available work (in spite of what some people say). And no investment.
    At least, shall we say, work that enables you to eke out an existence. To eat three times a day. To stick a roof over your head.
    I think that in the States you are laboring under the impression that we live in a welfare state in France.
    This is quite simply, NOT TRUE.
    Economic conditions in France are rather precarious, and this for EVERYBODY.
    It's not because employers (and employees) are paying out large chunks of money that ressources are being redistributed. I sometimes think that all this money is going toward bolstering up the INSTITUTIONS that are in charge of redistributing, for example. But by the time the money has gone through all the bureacratic channels, there isn't any left...
    In many ways, precarity in France is every bit as present as it is in the U.S. There are a lot of people on the streets, in shelters, etc.
    And the people who are the worst off in France are the young, and the over 45's.
    In these brackets, unemployment explodes.
    One of the disadvantages of what has become the vestiges of a welfare state, is that solidarity structures are minimal.
    The churches are an enormous source of solidarity in the U.S.
    Not so in France, where the "everyman for his own" mentality is very prevalent.
    Very individualistic, the French.

    One last fact that needs to be addressed : our current obsession with money leads us to conclude, very naïvely, that problems will be solved by simply throwing money at them.
    This is quite simply not true...
    Money can't buy imagination.

  22. @Debra

    Thanks for the response. I tend to idealize Western Europe and hadn't realized that so many were in such dire straights. If the purpose of the march was to let the media/gov know that the people didn't feel the media/gov were aware of the issue then a demonstration seems reasonable.

    My impression is that the US media/gov is aware there is a problem, but knows it does not have a long-term solution that will be acceptable to the majority of the population. So they're offering short-term patches (TARPs, etc.).

    How do you tell a real estate agent who made 500k in 2007 or a person whose been retired for 10 years via pension/SSA that their lifestyle was unsustainable and now they need to become wind turbine technicians?

    Paradigm shift, indeed.

  23. @Anders Brink

    Everyone assumed that CDOs would be priced fairly by the market mechanism, which cannot and will not work without the ability to keep track of which loan went into which CDO.


    The CDO's themselves could not have worked *unless* they were opaque!

    It's a *deliberate, essential, design feature* to stop the market from discovering the real worth of these products before buying them!!

    *Precisely* because nobody can see whats inside the bag, the buyer will just have to assume that the AAA rating is fair. This saves the sell side a lot of time otherwise wasted on convincing the buyers about the soundness of the collateral.

    The faster the turnover, the bigger them bonuses.

  24. Tiago's right.

    The long-term expectation value is achieved only in the limit of infinite time and for an infinite starting bank account.

    The other issue with CDO bounds is that they are effectively leveraged! Leverage is an amplifier, both up and DOWN. right now the consensus is that the economy is in down mode. why would any rational person buy a leveraged bond that will amplify the losses? - unless it is at a verrrrry low price suffcient to imply a significant posative return despite the probable losses including the leverage effect, sufficient to warrent the very high risk of this investment??