By Tom Adams, who spent over 20 years in the securitization business and now works as an attorney and consultant and expert witness on MBS, CDO and securitization related issues. Jointly posted with mathbabe
Volcker Rule
Last week, the rules for the Volcker Rule – that provision of the Dodd-Frank Legislation that was intended to prevent (reduce?) proprietary trading by banks – were finalized. As a consequence, there has been a lot of chatter among financial types around the internet about what the rule does and doesn’t do and how it is good or bad, etc. Much of the conversation falls into the category of noise and distraction about unintended consequences, impacts on liquidity and broad views of regulatory effectiveness.
Citigroup
I call it noise, because in my view the real purpose of the Volcker Rule is to prevent another Citigroup bailout and therefore the measure of its effectiveness is whether the rule would accomplish this.
As you may recall, Citigroup required the largest bailout in government history in 2008, going back to the government well for more bailout funds several times. The source of Citigroup’s pain was almost entirely due to its massive investment in the ABS CDO machine. Of course, at the time of Citi’s bailout, there was a lot of noise about the potential financial system collapse and the risk posed by numerous other banks and institutions, so Citi as the main target of the TARP bailout, and ABS CDOs as the main cause of Citi’s pain, often gets lost in the folds of history.
The CDO Market
In the years leading up to the financial crisis, Citi was an active underwriter for CDO’s backed by mortgage backed securities. Selling these securities was a lucrative business for Citi and other banks – far more lucrative than the selling of the underlying MBS. The hard part of selling was finding someone to take the highest risk piece (called the equity) of the CDO, but that problem got solved when Magnetar and other hedge funds came along with their ingenious shorting scheme.
The next hardest part was finding someone to take the risk of the very large senior class of the CDO, often known as the super-senior tranche (it was so named because it was enhanced at levels above that needed for a AAA rating).
For a time, Citi relied on a few overseas buyers and some insurance companies – like AIG and monoline bond insurers – to take on that risk. In addition, the MBS market became heavily reliant upon CDOs to buy up the lower rated bonds from MBS securitizations.
As the frenzy of MBS selling escalated, though, the number of parties willing to take on the super-seniors was unable to match the volume of CDOs being created (AIG, for instance, pulled back from insuring the bonds in 2006). Undeterred, Citi began to take down the super-senior bonds from the deals they were selling and holding them as “investments” which required very little capital because they were AAA.
This approach enabled Citi to continue the vey lucrative business of selling CDOs (to themselves!), which also enhanced their ability to create and sell MBS (to their CDOs), which enabled Citi to keep the music playing and the dance going, to paraphrase their then CEO Chuck Prince.
The CDO music stopped in July, 2007 with the rating agency downgrades of hundreds of the MBS bonds underlying the CDOs that had been created over the prior 24 months. MBS and CDO issuance effectively shut down the following month and remained shut throughout the crisis. The value of CDOs almost immediately began to plummet, leading to large mark-to-market losses for the parties that insured CDOs, such as Ambac and MBIA.
Citi managed to ignore the full extent of the declines in the value of the CDOs for nearly a year, until AIG ran into its troubles (itself a result of the mark-to-market declines in the values of its CDOs). When, in the fall of 2008, Citi finally fessed up to the problems it was facing, it turned out it was holding super-senior CDOs with a face value of about $150 billion which were now worth substantially less.
How much less? The market opinion at the time was probably around 10-20 cents on the dollar. Some of that value recovered in the last two years, but the bonds were considered fairly worthless for several years. Citi’s difficulty in determining exactly how little the CDOs were worth and how many they held was the primary reason for the repeated requests for additional bailout money.
Citi’s Bailout is Everyone’s Bailout
The Citi bailout was a huge embarrassment for the company and the regulators that oversaw the company (including the Federal Reserve) for failing to prevent such a massive aid package. Some effort was made, at the time TARP money was distributed, to obscure Citi’s central role in the need for TARP and the panic the potential for a Citi failure was causing in the market and at the Treasury Department (see for example this story and the SIGTARP report). By any decent measure, Citi should have been broken up after this fiasco, but at least some effort should be made from a large bank ever needing such a bailout again, right?
Volcker’s Rule is Citi’s Rule
So the test for whether the Volcker Rule is effective is fairly simple: will it prevent Citi, or some other large institution, from getting in this situation again? The rule is relatively complex and armies of lawyers are dissecting it for ways to arbitrage its words as we speak.
However, some evidence has emerged that the Volcker Rule would be effective in preventing another Citi fiasco. While the bulk of the rules don’t become effective until 2015, banks are required to move all “covered assets” from held to maturity to held for sale, which requires them to move the assets to a fair market valuation from… whatever they were using before.
Just this week, for example, Zions Bank announced that they were taking a substantial impairment because of that rule and moving a big chunk of CDOs (trust preferred securities, or TRUPS, were the underlying asset, although the determination would apparently apply to all CDOs) to fair market accounting from… whatever valuation they were using previously (not fair market? [Yves here: see post on Zions for details]).
Here’s the key point. Had Citi been forced to do this as they acquired their CDOs, there is a decent chance they would have run into CDO capacity problems much sooner – they may not have been able to rely on the AAA ratings, they might have had to sell off some of the bonds before the market imploded, and they might have had to justify their valuations with actual data rather than self-serving models.
As a secondary consequence, they probably would have had to stop buying and originating mortgage loans and buying and selling MBS, because they wouldn’t have been able to help create CDOs to dump them into.
Given the size of Citi’s CDO portfolio, and the leverage that those CDOs had as it relates to underlying mortgage loans (one $1 billion CDO was backed by MBS from about $10 billion mortgages, $150 billion of CDOs would have been backed by MBS from about $1.5 trillion of mortgage loans, theoretically), if Citi had slowed their buying of CDOs, it might have had a substantial cooling effect on the mortgage market before the crisis hit.
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To be fair to the historical record, UBS was just as big an offender in this regard as was Citi.
And if Glass-Steagall had not been repealed in 1999 would the Volker Rule even be necessary or subject to discussion?
And lest we forget, it was this same Paul Volker who when heading the Federal Reserve jacked up interest rates that caused the severe recession of the early 80s and uttered: “The standard of living of the average American has to decline” (Volcker) said “I don’t think you can escape that”. [1979]
And by most accounts, we have not escaped that…
The Volcker Rule epitomizes what Jesse [Le Cafe Americain] has termed the Credibilty Trap:
“A CREDIBILITY TRAP IS A CONDITION WHEREIN THE FINANCIAL, POLITICAL AND INFORMATIONAL FUNCTIONS OF A SOCIETY HAVE BEEN COMPROMISED BY CORRUPTION AND FRAUD, SO THAT THE LEADERSHIP CANNOT EFFECTIVELY REFORM, OR EVEN HONESTLY ADDRESS, THE PROBLEMS OF THAT SYSTEM WITHOUT IMPAIRING AND IMPLICATING, AT LEAST INCIDENTALLY, A BROAD SWATH OF THE POWER STRUCTURE, INCLUDING THEMSELVES.
THE STATUS QUO TOLERATES THE CORRUPTION AND THE FRAUD BECAUSE THEY HAVE PROFITED AT LEAST INDIRECTLY FROM IT, AND WOULD LIKE TO CONTINUE TO DO SO. EVEN THE IMPULSE TO REFORM WITHIN THE POWER STRUCTURE IS SUSCEPTIBLE TO VARIOUS FORMS OF SOFT BLACKMAIL AND COERCION BY THE SYSTEM THAT MAINTAINS AND REWARDS.
AND SO A FAILED POLICY AND ITS SUPPORT SYSTEM BECOME SELF-SUSTAINING, LONG AFTER IT IS SEEN BY OBJECTIVE OBSERVERS TO HAVE FAILED. IN ITS FAILURE IT IS COUNTERPRODUCTIVE, AND AN IMPEDIMENT TO RECOVERY IN THE REAL ECONOMY. ADMITTING FAILURE IS NOT AN OPTION FOR THE THOUGHT LEADERS WHO RECEIVE THEIR POWER FROM THAT SYSTEM.
THE CONTINUITY OF THE STRUCTURAL HIERARCHY MUST THEREFORE BE MAINTAINED AT ALL COSTS, EVEN TO THE POINT OF BECOMING A PAINFULLY OBVIOUS, ORGANIZED HYPOCRISY.
So was Lehman sacrificed because they couldn’t save both Lehman with 600 billion in default and Citi with 1.5 trillion possible default? And they chose to save Citi because it was partially owned by Saudi Arabia? The excuse has always been that Lehman was just too big to cover and they couldn’t find a buyer, right?
I think in part they sacrificed Lehman because they were drinking their own Kool-Aid. I think they saw it as a bunch of guys playing a game. Oops, you loose. If you can’t take the heat GET OUT!
But when they saw the whole pack was in trouble, they knew they had to do something to preserve their own butts. I don’t buy into large conspiracy theories. These were just a bunch of fraternity brothers sending a signal that yes, we can indeed be killed. Then they moved, when the whole pack was in line.
so what you’re saying is the dude who said you have to keep dancing till the music stops was also THE Deejay!
If these guys and women who do this sort of thing would get a life — and spend their time on Youtube drinking red wine and checking out real music, rather than sitting at a desk cooking up complex frauds that sound as bad as Karoke night — then there’d be no need for a Volcker Rule and no bunch of milliion dollar lawyers trying to defraud us all over again.
Why does God make people like this? I have no idea, but if I had to theorize i’d say because he’s a practical joker with a tin ear and no regard for beauty.
Thank you for this very informative article, and particularly the last three paragraphs. If the Volcker Rule works out in practice, it seems to me to be a very constructive step in the right direction.
However, I have read elsewhere that Paul Volcker has disowned the Volcker Rule. I have great respect for his intellect and am wondering what he can see that we cannot?
What can he see ? Perhaps the ability of banks to find a different way next time to lose stupefyingly large sums of money.
Never underestimate the ability of investment bankers to find a way round the rules. That is why we need to get them as far away from retail banking as possible.
I am not sure I understand why the super senior tranche was so risky comparatively – I thought the idea was that the super senior tranche was less risky (ignoring a situation where the creator of a CDS wants to assert super-seniority over the less senior). Anyway, I guess there is a simple explanation, but I am not sure it is so obvious – at least to me.
Would you explain – thanks.
Look at the last paragraph for the reason. There was a re-concentration of risk into the CDO’s, unnoticed at the time because it was assumed that the mortgages in the MBS’s were essentially uncorrelated with respect to failure risk.
Remember that at the time the Real Estate industry’s statement that “the NATIONAL average House Price OVER A CALENDAR YEAR has never fallen SINCE COMPREHENSIVE RECORDS STARTED BEING KEPT (in 1979)” had been bastardized into “House Prices never fall”, so the loss rate to the lender on a mortgage was assumed to be very small under any scenario.
When the Real Estate slide gathered pace, the lower tranches of the MBS’s got wiped out completely. If a CDO was based on such tranches, it would be completely worthless so ALL the tranches would be wiped out.
Wow = I surely missed something. I guess I still do not understand that the entire CDO would be worthless – certainly there was still some value in the CDO albeit much reduced. I guess I am having a hard time understanding this – for one would think that the senior tranches were indeed senior. I guess though if the cash flow disappeared although not the asset value, the CDO’s would for many investors be reduced. I always wonder how one could ever strucure a AAA tranche from a bunch of D mortgages. So, this would show one cannot do this and many understood that one could not. But, a friend of mine said the Lehman stuck these senior tranches into off balance sheet vehicles because Lehman thought these were valuable. I guess I may not understand how these worked. Maybe few did, since they were so hard to explain. Thanks for trying to educate me.
cool post but I wish it had footnotes.
1. When exactly did AIG stop selling insurance on super-senior tranches? I thought, via my vague recollection the FCIC-conducted interviews with AIG officials, was that AIG stopped selling the insurance in late 2005.
http://fcic.law.stanford.edu/resource/interviews
2. You write: “The market opinion [valuation of super-senior CDOs] at the time was probably around 10-20 cents on the dollar.”
What’s your source for that price estimate? It strikes me as too low, but I’ve got no source for believing super-seniors had bidders in the high-40s, low 50s.
3. Where do the super-seniors (what’s left of them) get valued today — 80s, 90s ?