I have this growing conviction that some of the people working in financial markets are something akin to black hat hackers.
They continuously probe the system for bugs and weaknesses and then exploit them for profit.
This "collateralization with obfuscation" exploit where it's impossible to calculate the risks of bundled investment packages should have been "patched" with legislation after the 2008 crash but wasn't.
So, unsurprisingly, they go after it again.
Remember the Gall-Mann amnesia effect: expert believing news articles on topics outside of their field of expertise even after acknowledging that articles written in the same publication that are within the expert's field of expertise are error-ridden and full of misunderstanding
While the article mentions the 2008 financial crisis, it does not mention that CLOs existed prior to the crisis and performed well during that time, much better than other securitized products.
> The CLO asset class has performed strongly, according to a recent report from S&P (“Twenty Years Strong: A Look Back At U.S. CLO Ratings Performance From 1994 Through 2013”), with few negative rating actions on senior notes due to underlying collateral deterioration, few defaults, and minimal loss rates since the agency started rating the asset class in the mid-1990s... Looking at the default statistics, of the over 6,100 ratings issued by S&P on over 1,100 U.S. CLO transactions, only 25 tranches have defaulted and had their rating lowered to D as a result. Based on this, S&P calculated a 0.41% default rate, or just over four tranches for every 1,000 it has rated.
The reason is that the collateral is higher in the capital structure than debt so defaults are much less likely and recoveries in case of default are higher.
I don't like how pop-financial articles talk about risk and debt. Companies aren't "risky" like a crappy car is risky. It's not that they cut corners and put lives at risk. Leverage and debt are normally conscious decisions made by the company. There is some optimal debt level that they strive for. The higher the debt, the higher the cost, but the greater return you can make. So like anything it's a trade off. I also resent the fact that any company with a non-investment grade debt rating is written off as unworthy of credit.
Thank you for saying this. In all honesty, the leverage loan (and thereby CLO) issues we are seeing now aren't really an issue of complexity. It's really an issue of how underwriting standards are deteriorating as more and more parties compete for these leverage loan deals to put into their CLOs. Companies can also fall into the trap of, "well I'm able to raise debt at these terms so I should be able to afford it." I will admit that complex securitization structures can obfuscate this risk, but the underlying financial risk comes from the cyclical properties of the collateral asset class (i.e. the credit cycle), not from the structure itself.
Underwriting standards are definitely deteriorating and debt covenants are just crazy in some cases so in all likelihood, recoveries should be lower during this credit cycle. That said, a capital structure is a capital structure and loans are still up there.
> Remember the Gall-Mann amnesia effect: expert believing news articles on topics outside of their field of expertise even after acknowledging that articles written in the same publication that are within the expert's field of expertise are error-ridden and full of misunderstanding
This trope is tired and very annoying each time I see it come up.
I'm an expert in Programming Computers (at least, that's my job, so I assume I'm an expert). So I laugh at WashPo or New York Times, or Bloomberg whenever they make simple computer-related errors in their article.
But guess what? I'm not paying Wash Po for my computer news. I'm paying ACM or IEEE actually for computer news. But ACM / IEEE have no news on financial markets. (Bloomberg is an expert newspaper in the realm of finance).
ACM / IEEE don't have many articles on politics. Washington Post is far better at describing the daily political issues in the capital.
Al Jazeera gets American news incredibly wrong sometimes. But I'll trust Al Jazeera on middle-eastern news over almost any American-based paper (aside from Wash. Po, which has a solid foreign politics / world politics section).
Throw in a few "Conservative" newspapers for the conservative slant on issues, and you can get a decent balance of news from a variety of sources.
I don't expect general Newspapers to be an expert in my field. I read newspapers to learn about things OUTSIDE of my realm of expertise. Believe it or not, newspapers have "specialties", and they're quite good if you read them based on what they're actually an expert in.
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Honestly, I don't read too much NY Times, so I dunno what they're an expert in. Financial news is definitely a Bloomberg thing IMO.
Bloomberg, FT, institutional investor, CFA, abnormalreturns.com does a decent job of aggregating. Sometimes Barron’s is ok. Blogs and podcasts can be better. It’s always good in finance to think “does this guy have an agenda or bias to push?” when a famous investor is being interviewed.
Individual blogs are good if you know the individual author and trust them well. Basically, a blog is great to follow a specific person you trust.
But individuals still only have expertise in a narrow field. I'm not going to be reading Herb Sutter's blog for Java-programming news, or "The Old New Thing" (Windows-blog) for even Linux-ARM news. I read Herb Sutter for C++, Old New Thing for Windows-specific stuff.
To get more information from a wider variety of sources, you end up reading Newspapers. You learn to trust the editor, a non-expert but someone who tries to promise quality of their writers follows a certain code. Even within a newspaper, different editors handle different sections (the OpEd section of WashPo is less factual than other sections)
As long as you understand the trust model of various sites or newspapers, things are good. Some amateurs on "Seeking Alpha" or "Medium" are pretty darn good with their analysis, you just gotta learn their names and follow them specifically.
I guess one problem is, if you rely on other people for money, they might believe you incorrect information and discount your opinion because you're not published in WSJ et al.
A financial product that is said to be a strong and will never fail according to some commercial analysts. Although other experts seem to disagree. (Deja vu)
Trading CLO's has been expanding. One could argue far beyond a point where there is enough safe companies to lend to. That must mean the risk for CLO's is growing (Deja vu again)
Continues low interest rates make people look for better returns on their investments and people selling products to fill that need. They may forget to make sure their clients understand that there are no save investments in the market at current Fed rates. (Can we say deja vu)
CLO's now cover leveraged loans, meaning loans with no collateral other than future profit. Like people taking out mortgages on for-rent properties. (Deja vu, deja vu)
Back in the 2008 financial crisis I read articles about what went wrong, but I am not sure I understood exactly what was going on so well. I filled in details mysefl by guessing. Maybe someone can clarify this?
When they combine a number of risky assets into a single asset, they factor in an assumption that a number of these will fail. Others will not and given the payoff of those, the net investment pays off.
I don't know much about finance and how they do these calculations, so I'm going to say something dumb here, and maybe someone can tell me if they are being this dumb (or dishonest) when the calculate these things. Forgive the "explain it like I am 5" description.
There is a naive way of combining these probabilities which high school students probably know. However, this assumes the outcomes in question are not correlated. For example if you flip two coins, the probability of each coming up heads is .5 and they are not correlated, so the probability of getting two heads on two coin tosses is .25.
Of course, if the events are correlated, then that formula doesn't work any more. For example, if there is a new Quantum Coin Toss Manipulator (because we all know it would have to be quantum) that makes all coins flips near it come up the same, then the probability of getting 2 heads when you do two coin tosses is no longer .25 but instead it is .5. And, if you do 100 coin tosses, the probability is still .5 of getting all heads.
Back to the CDOs or CLOs. The chance of individual components failing is clearly not completely independent. Economic conditions such as a big recession presumably will have similar effects on the different components. So the naive formula does not apply.
Hopefully they are not being that naive or dishonest, but it seems like it would be pretty tricky to estimate the correlation and correspondingly difficult to estimate the true risk. Is it that case that they are just not good at estimating the correlation in the risks of these different assets?
Correlations in finance tend to be unstable. Take two equity stocks in the same sector and one year the correlation could be 0.8 and another year it could be 0.3. Obviously, there are relationships between rates, cost of equity, debt, etc. As Howard Marks says, “the seven worst words in investing are ‘too much money chasing too few deals’” So I think a better question to ask then what are the correlations between these assets is to ask “what’s driving CLO issuance, and is that sustainable?”
A 20 year history doesn't invalidate the facts at hand.
The CDOs in the 2008 crisis were designed for uncorrelated risks, but in a real estate bubble driven by too-lax lending standards, the risks were all too correlated.
Before the downturn this was stated by the New York Times, numerous finance blogs, and this golden quote:
"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing."
Chuck Prince, July 10th, 2007 (then Citigroup CEO)
Another component to this is that the marketing materials in CLO products always highlight zero default history, even through 2008, but what if the government didn’t backstop AIG, the banks, GE, etc? Safer tranches were saved from default as a product of action by Paulson and the fed before there were more defaults rather than the perceived risk control imo.
There is an important difference. The people working in financial markets have lobby power to change laws and create more weaknesses.
So, it will be more like if black hat hackers paid part of the salary of the IT-Ops that have to patch the software. Half of the server will run on unpatched Windows 95 and there will be long discussions on why updating is not a good idea because of made-up-reasons.
The legislation you're talking about is the "Dodd–Frank Wall Street Reform and Consumer Protection Act". After failing to defeat it with constitutional challenges, the Republicans gutted it in 2018 with the "Financial CHOICE Act".
The banks are going after stuff again because the protections were removed, not necessarily because they've found a new way around them.
This is so mind-boggling stupid... We deserve whatever happens next for allowing this crap to keep happening... I'm sick to my stomach reading about this...
> Leverage: Leverage results from using borrowed capital as a funding source when investing to expand the firm's asset base and generate returns on risk capital.
I don't think that leverage is necessarily an issue, and it isn't black hat either. It's a normal part of any economy. The problem is scale. After the last two economic issues that we had to deal with, I have a sense that far too much of our economy runs on leveraging, in order to keep growth going. This isn't just happening with these C.L.O.'s, but with credit card debt, mortgage debt, medical & student loan debt, etc. on the personal level, and a whole slew of debt options for businesses. This is all necessary for the capital owning class to maintain their wealth, which is fed by a sea of debt: without economic activity to pay for goods, many things will lose value rapidly.
I've seen these leveraging games blow up twice in my life. I get to listen to people who claim to know economics tell me that it isn't going to happen this time, that it's different, but you are right. We didn't alter our economy in some fundamental way. We didn't create reward structures for building an economic system that would prevent this issue from happening so often, nor did we create a punitive structure for those who benefit and thus try to make it happen. Instead, we allowed those who benefit from these processes keep far too much of their ill-gotten wealth.
It's going to happen again, and my guess is that once again the middle class and poor will be punished for it. If a billionaire loses 90% of their wealth, it wasn't real anyways. When a middle class person loses 90% of their paycheck, or your more common millionaire loses 50% of their wealth, they can be completely devastated. I know, because I already saw it happen twice in my life.
The actual black-hat hack is and was regulatory capture. Sure, with good regulation perhaps the economy runs a bit slower, but all of our growth is based on an engine that burns through billions of barrels of oil a year (yet another debt/leverage to pay off) so perhaps that's for the best.
Leverage is there because of the near zero interest rates for some kinds of loan. While those exist, people will invent new ways to create unhealthy leverage, and you'll be in an arms race trying to stop them all.
That said, the GP wasn't about excessive leverage. It's about legalized scams, what is a very different problem, with much harder solutions.
You're not wrong, but many other industries behave similarly. I think of FAANG's massive A/B testing the same way: constantly probe to find legal ways to get people addicted to their content or to surreptitiously convince them to make bad decisions via advertising.
And it's also really funny to see Google take the deliberate strategy of being a nanometer less evil than Facebook, just so the media doesn't probe too deeply into Google. It's like how McDonald's and Walmart take all the heat, while Burger King and Target are virtually just as guilty of the same practices but remain off-radar.
The more of an asset class is owned by passive investors (now approaching 50% for US equities), the greater the reward for the type of behavior you point out. It's effectively leverage: any "bug" found gets multiplied across the portion of passive investment affected.
Well, passive credit is far worse than passive equity. At least in equity, you are buying more of the largest companies, in credit, you are buying more of the larger issuers of debt...
I think though the institutional problem behind why this happens is compensation and bonus structures.
It is even more foundational in the sense that one guys that manages to land a deal is literally valued $100m to a company which seems like a good cost-to-company argument for a $10m bonus, netting in $90m. Simplistically, at least.
Everyone's trying to beat the market. When the market is doing well, it gets harder and harder to beat, without taking on more and more risk, which always looks smart in the short run because everything's going so well! Until it isn't.
I forget, is it Big Banks, Big Tech, Big Pharm, Big Oil, Big Agriculture, Big Telecom, For-Profit Prisons, or the Military Industrial Complex that is most in charge of legislators? I can never seem to remember which one is really running the country.
Very rich people and (to the extent that they are lumbering hive minds driven by their own rules to persue profit at any cost) corporations have undue influence at most levels of US government. Thats pretty obvious to most of us watching from afar. If you wanted a pithy term to sum this up you could go for 'big money'. The US has ostensibly good democratic structures and systems but they have to a very large extent been 'captured' by the rich and powerful, as the parlance goes.
The operative part in "Big ___ owns the system" is the Big, not the ___. The political system is an arena in which entrenched and monied interests set the agenda and dictate the terms of debate. Issues concerning society at large are crowded out.
> They continuously probe the system for bugs and weaknesses and then exploit them for profit.
Well .. yes? If you can figure out a product and sell it to people, why not? You could make an argument that the customers don't understand the risks of the product, but these aren't being sold to the unsophisticated public but to other people in the finance industry who ought to know better.
Sibling comments are saying investors couldn't know better because they were either lazy or the information was obfuscated, but the truth is the rating agencies are PAID to review the risk and assign a simple letter system that summarizes how risky the investment is in a general sense. Too bad they were too worried about losing their customers and decided to slap an A on what should easily be a CCC
IIRC the issue leading up to 2008 was because demand for CDOs grew to such a level that underwriters were struggling to honestly supply enough debt in the upper tranches (i.e. low risk), which introduced market pressure for agencies to overrate risky assets to pad out new CDOs. Makes me wonder, how does the current market size for CLOs compare to CDOs in 2008? Does the same pressure apply here or is the supply of highly rated assets sufficient to meet market demand?
I don't think that the investors who got burned by CDOs in 2008 didn't understand the mechanism of transmission of losses in these structured transactions. They simply grossly underestimated the underlying risk they were exposed to (the assumption that the real estate market in the US was diversified and that it wouldn't all go down at the same time). Plus the quality of the underwritting had gone down the drain, but I am not convinced it was documented as such.
But even if it was all documented, we are not talking about millions of pages of paper. A typical documentation for one of these structures is 200-500 pages, of which a lot is mostly irrelevant. An investor taking a significant position in one of these structures ought to read the relevant parts. But even highly paid professionals can be lazy too.
The darker side of the problem is that staff and decision makers at institutions have no skin in the game so to speak. They are not the owners, and are highly unlikely to see the long term downside of their decisions. They hope that by the time the music stops playing, they won't be around to have to deal with the consequences.
Some token measures like deferred bonuses or long vesting stock options have been done, but ultimately this just pushed out the horizon a bit. So you have to take care no to be part of a cockup in 5 years instead of 1 year.
I don't disagree that incentive structures drive poor long-term decisions but that's separate from "omg complex 100000 page prospectus". Misaligned perspectives exist whether there's a prospectus or not.
You are right of course, I was just trying to provide an explanation as to why institutional clients aren't more diligent.
They are often not particularly skilled either, as those who can see through the game are on the other side of the trade. Working at a pension fund is not a sexy or exciting proposition by any measure, so talent tends to go elsewhere.
It's the same situation as bright researchers going to finance where they get paid multiples of what they'd earn in their own field.
Once you sign your soul to the devil, it is very difficult to get out. I'm speaking from experience.
The AUM of CLO CEFs are minuscule vs overall CLO market. The two highlighted in that article's graph have a combined AUM of less than $600mm while the overall CLO market has more than $600bn outstanding. CLOs are not being sold directly to retail and it's very misleading to bring up CEFs without mentioning the size of these funds.
It's true the total CEF AUM is small, I don't think it is misleading because they still are being sold to retail at the end of the day even if the AUM is less than $1B. MLP's also started small too. The overall leveraged loan market for retail investors is much larger though as far as I am aware.
Presumably he means a noise-laden prospectus detailing the financial instruments in use for a particular fund. If you have a money manager, are you paying him/her to read that paper, and it's not millions of pages.
They look something like this...think of it as a set of rules for what the manager does with your money:
1) We invest you stocks/bonds rated <N> and above
2) We exit positions under <XYZ> circumstances
3) We enter positions under <ABC> circumstances
4) Past performance by following rules 1-3 is N%
No one failed to read these in the past, instead they focused on the potential profit, which blinded them to the potential downside. This is an investing 101 lesson, that continues to be taught to money managers each time their profit chasing occludes their risk management.
If you, a regular working class citizen, were burned by this(perhaps in your 401k), then it's worth reading the prospectus your fund manager sent you. When you see the list of funds included in your fund, you should have received a prospectus for each of those as well. Look for which funds make up the majority of your funds holdings, and read those prospectuses. If you find(and are uncomfortable with) one of those funds being a triple-leveraged ETF backed by 30-year mortgages, then you should talk to your fund manager about that.
Part of the impetus for the 2007 crash was that investment companies like AIG were making complicated and obscure financial instruments that hid lots of risk, while also being the agency everybody looked to to grade the risk of financial instruments. They rated their own mortgage debt products as low-risk based on fraudulent analysis.
That's been the rule since Reagan/Thatcher, yes? I'm not keen on it either but unless there's a change from the top and some actual consequences for both individual and collective lack of ethics that's how it will remain.
I personally mark Enron and AA's downfall as the last major case in which individuals paid a price for unethical behavior while acting as agents of a corporation.
Reading this made me speechless. One thing is that the same story repeats again (I am only curious if someone is playing against CLO now as "The Big Short" guys did.)
But this...
"They buy a little of the debt of risky companies at a discount, and then buy a much larger amount of insurance on that debt [...]. These wiseguys then do everything they can to force the company into a bankruptcy filing. [...] Since the insurance payment exceeds by far the overall cost of the discounted debt, the hedge fund profits handsomely."
Isn't this insurance fraud? It looks for me like this: I am buying a crappy car, I am somehow able to insure it for a large amount of money (exceeding car value), then I am putting this car on fire and grab insurer money.
The Commodity Futures Trading Commission labeled a similar case as "possible market manipulation", so there definitely is something very fishy going on this type of markets. I'm talking about the "manufactured credit default" of US house-builder Hovnanian. From here [1]:
> A “manufactured default” of a US housebuilder that caused uproar in the credit derivatives market has been called off, after Blackstone-backed hedge fund GSO and Solus Asset Management settled a legal dispute over the trade.
> GSO had agreed to refinance some of housebuilder Hovnanian’s debt at a favourable rate, on the ususual condition that the company miss a payment on some of its bonds. GSO had hoped to profit from credit default swaps that would pay out if Hovnanian defaults.
The Hovnanian deal eventually fell through in later 2018, but only last week did the industry's regulatory body (the International Swaps and Derivatives Association) propose some measures to combat this type of actions.
I think it's interesting. In the case of Hovnanian, you have two companies who are making bets against each other on whether Hovnaian will survive. Hovnanian has no involvement in the CDS market on their own debt. And yet they were able to take the CDS market and turn it into funding, which allowed a company that was in financial trouble to continue to exist and provide jobs.
Solus was free to offer Hovnanian funding with more favorable terms and the agreement to not default. And if GSO and Solus want to go back and forth offering better and better terms then in the end you have a viable company that's leveraged CDS to get additional funding at good terms.
I think a much sketchier case is what Aurelius did to Windstream. There you have no benefit being created on the back of CDS engineering, you just have a hedge fund who drove a viable business into bankruptcy against the wishes of the primary bondholders.
Conceptually, the CDS market is useful. If I do a bunch of business with a company and them going bankrupt would cause me financial problems then I can use CDS to hedge against that possibility. I don't know how you can prevent this kind of engineering though. I think it's easier to prevent what Aurelius did to Windstream. But the GSO/Hovnanian deal seems much harder to regulate.
Maybe instead we just decide that it was actually a good thing and going forward people should be aware that it's a possible outcome? The risk of default isn't just the risk that the company on its own defaults, but also the risk that the company defaults and can't find outside funding. If people are expecting that eventuality then the CDS market should settle in a spot that prices in the possibility of CDS buyers or sellers offering refinancing.
These shenanigans provide a real economic benefit to companies at the risk of long-term damage to an established market. High yield and distressed CDS is more or less a joke right now because of this stuff and the only thing restricting this from higher quality names is no one is big enough to play games at that scale. Without a credible market, the "financing opportunities" for companies will disappear.
In an already inefficient market, it's also very hard to price the possibility/structure of these games as it's not like the company can publicly shop around deals for this. In the case of the HOV deal, issuing new bonds to game CDS deliverables was unprecedented and IMO just total nonsense.
> I am only curious if someone is playing against CLO now as "The Big Short" guys did
Absolutely they are. The heroes of The Big Short weren't doing anything particularly unusual or special. They were just using credit instruments to bet that they'd be more foreclosures than the market was predicting. There'll be equivalent hedgies doing the same with corporate debt now.
> Isn't this insurance fraud?
No because it's not actually insurance as others have said. They're using similar credit instruments to bet against corporates that the Big Short folk used to bet against mortgages.
Is what they're doing ethical? Probably not though you have to be careful. If you look at the Windstream example linked in the article, I'd argue that the hedgie is using ethically questionable methods to expose, and take advantage of, ethically questionable corporate practice. Not entirely clear who the villain is with that one. Probably both parties.
The article treats the Windstream example like a smoking gun for market manipulation but the cited evidence is a little softer than he's suggesting. All the link really provides is Windstream's claim that Aurelius forced them into bankruptcy, which the judge evidently didn't find to be compelling. Windstream proposed a recovery plan for any default caused by the Uniti spinoff and Aurelius didn't agree to the plan. That doesn't prove that Aurelius shoved Windstream in front of a train, only that they didn't pull them off the tracks.
It's not insurance fraud (or fraud of any kind). Fraud is theft by deception. Your car fire example is fraud because to get the payout you have to lie to the insurance company about why the car caught on fire. Car insurance contracts quite explicitly exclude coverage for intentional damage, so if you tell them you set it on fire on purpose, they won't pay you.
In this instance, the "insurance" is actually a credit default swap (CDS). CDS contracts do not exclude "coverage" in cases where the "insured" provokes the company into default. There's no need for deception to make the scheme work, meaning it's not fraud.
The CDS contracts are put together by an industry association called ISDA, with a lot of input from very sophisticated market participants and their very expensive lawyers. It was most likely a conscious decision to make the contract work that way. Anybody who got burned by this directly either knew it was possible or should have known it.
For car insurance you need to buy a car. For debt insurance, not really. I think the editor meant "debt options" but used the word insurance because he was targeting a non-sophisticated audience.
Real life is a little bit different though. How many option sellers are you going to find if the company is easy to drive to bankruptcy?
> Real life is a little bit different though. How many option sellers are you going to find if the company is easy to drive to bankruptcy?
Well, right now, "somebody" is selling long dated OTM put options on some ETF's that are filled with +95% junk rated bonds and/or CLO's, with some of the strikes having +100k OI for pennies on the dollar (ex. HYG60P12202019), which in normal times might be easy money from selling… I'm sure the big boys have better ways of getting exposure as well.
Even though a CDS contract has the look and feel of insurance, it is carefully written to not be insurance legally, which would attract an additional regulatory burden (only regulated insurance companies can sell insurance, pretty much any financial market participant can sell credit protection against some debt).
CLOs are comprised of loans made to small businesses. Small businesses are inherently risky. CLOs exist because they are a relatively inexpensive form of long term funding. Let’s ponder the type of people who start and operate small businesses and whether or not they get access to competitive bank financing...
Once upon a time, seeing entities willing to write loans to small business was worth celebrating. Amusing that once we find out it’s Wall Street stepping in to facilitate this at a scale the government cannot, it is dangerous gambling.
There is absolutely no problem in making risky loans. But there are many problems with packaging those loans together and selling them to a third party that can't calculate its risk level claiming it's low risk.
An important clarification here: CLOs are sold to multi billion dollar asset managers (technically referred to as QIBs, entities that manage at least $100mm in Assets Under Management or more - the vast majority of the structured products business is dominated by large fund managers).
It is the highest tier of investor "suitability" recognized by the SEC. It's their job to understand these products and they have armies of people for it. It can take weeks to "market" these transactions and plenty of opportunities to sit down with bankers and CLO managers to get smart on the space. There is also a ton of supporting technology and research, all of which is available for free on S&P, Moody's, Fitch, Kroll and Morninstar's websites.
If you cannot sell this stuff to a QIB, who can you sell it to?
You probably think of a locally owned dry cleaner or coffee shop when you hear the term "small business." I know that's what I think of when I hear the term. But in the context of lending, the definition of "small business" (usually lumped together with mid-sized businesses under the umbrella term "SMBs") is usually something like <$50MM in annual revenue, or <100 to <500 employees, depending on who you're talking to. They can be quite large compared to what most people think of when they hear "small business," but they're small when compared to large enterprises.
This categorization speaks less to the size of the businesses themselves, and more to the scales that these banks operate on. After all, $50MM annual revenue or 500 employees seems pretty darn big to me!
> Those investors include Japanese banks as well as investors in hedge funds, mutual funds and pension funds (in other words, you and me).
I laughed. You and me, NYT reader who is rich enough to have a 401k.
> The existential question remains: Why do investors fail to learn the harsh lessons about risk, even though the consequences of them still remain so fresh?
I hate to be that guy, but at what point can I blame the Fed for near-zero interest rates that have motivated traders to seek higher gains? I appreciate that people are being more vigilant about reporting on this, but I’m starting to think blaming it on the traders is the easy way out. It seems especially easy when we can draw obvious comparisons to 2007-8 (CDO => CLO, that’s just one letter changed it must be the same thing!). And it sounds like even if these traders weren’t trying to force overleveraged companies into bankruptcy, those companies must be in a precarious enough position that it could happen on its own. Am I mistaken?
Negative rates won't send traders out of business. There are still plenty of trades to make in a negative rate environment. In any case, I'd be interested to hear your argument on why small negative rates are good for the economy in general.
Not the poster but the theory is that it discourages deflationary behavior of funds sitting around and keeping demand down.
Personally I suspect that it is overly risk boosting and encourages economically perverse behavior but it apparently hasn't proven disastrous yet in the locales that have tried it.
Higher interest rates would disallow for a world where so much corporate debt is out there (RTFA and Janet Yellen's quote), and thus disallow for a world where an exploit for higher gains is to buy out insurance policies on investment instruments in companies with too much debt and attempt to force them to go bankrupt.
Sure, other problems will exist, more around the lack of easy credit.
> Small negative rates are probably required to suck some money out of the speculative economy.
Please explain, as this comment comes off as purely speculative.
> A trader who doesn't seek higher gains is a shark that stops swimming and dies. There's no need to blame interest rates for this.
Pension plans (including the Japanese one mentioned) have return targets that need to be met in order to make sustainable payments. Their targets remain the same regardless of where rates are but are much harder to hit when rates are low and encourages managers to invest in riskier investments.
The article is conflating two distinct issues - CDS warping incentives, and CLOs.
CDS is primarily relevant to bonds that trade on the open market. CLOs are packaging private loans made by banks, not bonds. To treat them as relevant to each other demonstrates the author has no clue what they are talking about.
Does anyone understand the logic of this statement? I can't make heads of tails of it, which lowers my trust in the article overall. If people are arbitraging derivatives priced differently to underlying asset then that seems pretty benign to me? Is there something else going on here?
One backdoor risk is exacerbated by a tactic of some all-too-clever hedge fund managers. They buy a little of the debt of risky companies at a discount, and then buy a much larger amount of insurance on that debt — so-called “credit default swaps” — to theoretically hedge their risk. These wiseguys then do everything they can to force the company into a bankruptcy filing, which contractually triggers the insurance payoff on the debt. Since the insurance payment exceeds by far the overall cost of the discounted debt, the hedge fund profits handsomely.
What's the relative size of this market, particularly the high-risk segment in comparison to the size of the subprime mortgage segment and associated CDOs in the 2008 crisis?
Without a sense for whether the order of magnitude is similar, it's hard to draw conclusions on the level of systematic risk.
Wow thanks. That certainly makes things more acute!
I suppose businesses are structurally different from home buyers in a number of ways: for example when a business goes bankrupt (correct me if I'm wrong) creditors are paid out to the extent they can be. Whereas when a home owner goes bankrupt I believe they can get out of their obligations entirely.
CLOs are not inherently good or bad. The difference is in how they are structured and priced. On the benefit side, CLOs have effectively permanent financing in place which takes the liquidity run risk off the table (and thus is more systemically stable) than loans funded with bank deposits.
If you put this is context of long-term economic stagnation where the kind of predictable growth modernity brought over two hundred years is no longer there, then for people that are expected to generate large returns have a large incentive to take on riskier investments that might give an growth upside.
Eric Weinstein argues [1] that what we are experiencing is a long-term stagnation of western economy, and arguably any economy that is not catching up. This is in his estimation the cause of many of our issues.
Here's a heartwarming tale of a man who got a call from a debt collector with a fake note threatening to rape his wife. It started his years-long crusade to bring down the loan sharks responsible for selling fake debt with his name on it..... https://www.bloomberg.com/news/features/2017-12-06/millions-...
There are a number of errors in this article, and there are important things that articles like this fail to mention:
- the loans aren't made by the banks and then shifted, they are more often sold to investors without the bank assuming any of the loan themselves (it's called loan syndication). The bank simply acts as the role of arranger.
- the Japanese investor base is mostly in the most senior part of the capital structure
- for similar credit ratings CLOs have far lower default rates than for equivalent corporates. It's something like 2-3% in the B and BB rated tranches through the crisis
- the average piece of CLO equity returned something like mid-single % digit returns if held through the whole of the financial crisis
- the paragraph on credit default swaps is a distraction. No CLOs use credit default swaps, and certainly no one sells credit default swaps which reference CLO tranches. This happened prior to the financial crisis through synthetic-CLOs but these don't exist anymore. Sometimes investors in CLOs use credit default swaps against an index of credits (like XOVER for instance), but this doesn't really work as a CLO hedge
The facts are that many lessons have been learned since the crisis and people aren't doing the same things they did back then.
What can be said is that there is a race to the bottom in terms of loan covenants diminishing, but this is driven by larger demand for loans than supply resulting in borrowers achieving looser document terms. The drivers of this are often the law firms that work on behalf of the borrowers who promise being able to achieve looser and looser language with a view to winning the business. Unfortunately the lenders have a weak hand in this situation as they are many chasing few assets and find it difficult as individual institutions against a syndicating bank and borrower who have full information and can play lenders off against each other.
A lot of good comments. I just wanted to point out that the last line in this article states 'Why do investors fail to learn the harsh lessons about risk, even though the consequences of them still remain so fresh?' Speaking about the past market problems, if no one is held accountable why should change occur?
A major issue in 2008 were loans made with no credit standards and investors were being sold what they thought was AAA credit risk when in reality the borrowers behind the securities were people with little income make the mortgage payments they were obligated to. The article at hand does little to prove that a similar phenomenon is going on with corporate bonds. Would be interesting to know whether the corporates spoken about here are public or private companies since, if they are public, any going concern can easily be analyzed via a company’s SEC filings.
There’s no doubt that the structure of this product is similar to products which caused the financial collapse, but are all the other systemic issues present? I don’t think the author addresses that.
1. It's important to distinguish between liquidity risk and solvency risk. Liquidity risk is needing to sell an asset that is fundamentally sound and not being able to get a fair price, or any price at all (as happened in 2008/2009 - no/few buyers and many sellers). Solvency risk is the asset goes bad and there's a permanent impairment.
Simplistically:
liquidity risk = broken leg (painful and needs immediate treatment, but recovery over time likely)
solvency risk = horrible cancer
2. CLOs are made up of bank loans, which are generally the most senior obligation of a company, and are the least risky. Bonds, preferred equity and common equity get hit before the loans are impaired. During the period from 1998 through 2016, defaulting loans recovered 66% of their value while bonds recovered 40%. [0]
3. CLOs generally made it through 2008/2009 without any major issues. The structures held up as designed, but prices fell along with other structured products since there were few buyers and many sellers.
If you were able to hold, you did reasonably well. Over the 20 year period from 1994 through 2013, there were 6141 CLO tranches, of which 0.41% defaulted (no AAA or AA defaults) and had a 0.04% loss rate. [1]
4. What has changed since 2008 is that loans are becoming a larger portion of the total value of the business (loan-to-value). This means that if the business goes bad, there's less of a cushion for the loan and recovery rates will be lower.
I don't know how much lower, but some of the junior tranches in a CLO could be impaired in a severe downturn. It's hard to really know, but I _think_ things would need to be worse than 2008 (or the same level of crisis, for a longer period) for AAA tranches in general to be permanently impaired.
5. Accounting plays a role here. If you are required to mark-to-market, then the market clearing price is what the asset is worth, regardless of fundamentals. If there's a panic, you may be a forced seller if you don't have sufficient reserves to get through the disruption and your mark-to-market loss becomes a permanent loss. This applies to any asset class, not just structured products.
6. I don't understand why the article brings up CDS gaming. It's a real issue, and one that is being worked on, but it's not even a rounding error compared to the size of the corporate debt universe. [2]
quote from the FT article:
"Isda’s method of “fixing” CDS has always been akin to “patching” software after hackers exposed weak points. When one window closes, traders simply find a new one."
[0] "JPMorgan Default Monitor 4Q16"
[1] “Twenty Years Strong: A Look Back At U.S. CLO Ratings Performance From 1994 Through 2013”
These are good points. I would add that generally there's not a problem with having lots of risky debt in the system, as long as it's held by investors who are aware of and can handle the risk. The reason that CDOs led to the financial crisis, was that there was lots of risky debt being packaged as AAA and held by investors (i.e. systemically important banks and insurance companies) who couldn't handle losses on it. So the big questions about CLOs should be: who's buying the AAA debt, is it being mis-rated, and if so, can the holders handle losses on it. In general, I think the rating companies reacted to their vast and obvious failings in 2008 by tightening rating criteria across the board, even in structures such as CLOs which did okay during the crisis. Is it possible they're still being too optimistic? The thing about the rating models is that they're very sensitive to correlation assumptions that are difficult to observe empirically. Also, they tend to have a blind spot about things like fraud. Is it possible that junk-rated corporate defaults could end up being much more highly correlated than the models assume? There are transmission mechanisms that can cause high correlation. For example, an uptick in defaults in one sector could lead to a tightening of credit standards across the board that could lead to rollover risk. (Most of these companies are highly dependent on being able to rollover maturing debt.) Or fraud in underwriting standards could be much more pervasive than assumed. (This one seems unlikely, but who knows.)
The 2018 crisis was caused by CDOs - packaged mortgage debt which is going to default, mixed and dressed up as very safe debt, then sold on to some poor sucker (including you in your pension).
The article is saying that people are buying CLOs - packaged corporate debt which is going to default, mixed and dressed up as very safe debt, then sold on to some poor sucker (including you in your pension).
TLDR: History repeats itself, first as tragedy, then as farce.
Debt from multiple issuers is pooled and sold by pieces to investors with different risk profiles. The more risky layers will be the first touched if there are problems, but pay better in the best case. High risk (variation in expected returns), high (expected) return.
The idea is the "good" part of product (the AAA layer) is very safe... according to the model. But it may not be so safe after all if things don't go as expected.
I see a lot of comments in the article on how this is just a scare piece, but it bears remembering just how big of a crisis the 2008 financial collapse was.
Stagnant wages in the 90s gave rise to credit cards and personal debt-as-a-feature capitalism, which was immediately blown out of the water by 2008. people lost their homes because the credit system keeping them afloat basically collapsed. businesses started shedding employees and shuttering doors, while banks across the world began a series of spectacular failures.
Not just banks and auto makers, but capitalism itself looked to be slowly collapsing under its own weight of the hubris of mankind. Its really stunning to look back at some of the absolutely bombastic thing we said and did in the service of not people who were displaced and destitute after this collapse, but in the service of trying to keep capitalism going for ten more years. At some point we started bribing people to participate in the market that just made them homeless with "cash for clunkers." This was an asinine program designed to "boost the economy" by paying people to destroy their already running vehicles under the guise that they caused too much pollution.
This didnt work. It could never work, and so we switched tactics toward simply bailing banks and auto manufacturers by cutting trillion dollar checks and printing more cash. Nobody who caused the financial collapse was ever arrested, save perhaps Bernie Madoff for his high treason of swindling the plutocracy. At the last few months of the term of George W Bush, a round of "stimulus checks" were cut and sent back to americans. The idea here was that americans would buy new televisions and sneakers. The reality for many, including me, was that money went to savings or closing out credit card accounts we didnt need.
And here we are, once again, at the brink of another 10 year cycle. Things seem fine but theres hand-wringing from the usual suspects about systems of credit and debt so complex they cannot possibly exist outside a PhD thesis.
Why would they fix the problem. Every crash is a redistribution of wealth.
When there's a recession, if you're wealthy and have diversified assets you can buy everything at a discount rate during a stock crash and sell when the recession recovers. Meanwhile, the poor and middle class often find themselves unemployed, their savings accounts massively depleted and in a constant crush for cash.
If you're wealthy AND you have the ability to create risk in the market, then even better. You can actually help trigger more "stock discounting" events, and dominate any emerging technology company with your bootstrapped companies while everyone is dying for credit.
It's a kind of extortion on a national or even global scale. "Nice economy you have there. Shame if anything would happen to it."
Nassim Taleb's suggestion is to simply deny institutions the option of growing large enough that their demise would threaten the system. Once an entity gets too large to fail it should be split so that the remaining pieces can fail individually without dragging entire system with it. This would get rid of the moral hazard "heads I win, tails someone else loses".
>Nassim Taleb's suggestion is to simply deny institutions the option of growing large enough that their demise would threaten the system.
If we are specifically talking about the financial institutions, then good luck getting in on some of the biggest deals over banks without the same constraints.
I love the idea of breaking up google. I don’t think it will happen though as they have a lot of political power, much more than the users whom they extort.
Exactly why it makes sense to limit corporation size. Honestly, I think things would be much better off with a progressive tax on the number of employees and contractors a corporation has.
Anything up to 10000 is 0%, and after that, the brackets go up to 80% (for 1 million or over).
The 2008 financial crisis affected everyone, including the wealthy. In terms of reported net worth, young (<40) White, Asian or other Minority college grads were affected the most with a decline of 54.1% of wealth, compared to that of young African-American or Hispanic non college grads (15% decline).
That's not to say the pain felt was greater or even the same as those with less, but it is simply not true that somehow the wealthy remain unscathed from financial crisis. It doesn't even make sense at face value considering they have a large percentage of their wealth in the market and likely have a higher risk tolerance. In fact financial crisis reduces wealth inequality precisely because it affects the wealthy capital owner more
I think parent poster is talking about wealthy people, not college grads with good jobs. They're talking people who can see a market opportunity and invest a few spare million, then make a 100% profit when the market rebounds a few years later.
mean while, all their existing investments plummets. Unless you see them pull out of their investments prior to the crisis, there's very little evidence to support this claim that a financial crisis is good for the wealthy.
If the wealthy has any choice, they would overwhelmingly choose not to have a financial crisis.
These wealthy people don't have a crystal ball and we're likely highly invested in the market at time of crash.
> The top 1% had an average income of $1.26 million in 2014, a 19.1% decrease compared to $1.56 million in 2007, according to an analysis of tax data from researchers at the University of California, Berkeley, and the Paris School of Economics. It’s even worse news for the top 0.01%, whose average income fell to 27.4% from 2007 to a mere $29 million in 2014.
Talking about taxable incomes for the top .01% is silly. You should google the paradise papers or just do some basic reading. Wage workers have incomes that are a function of their job, the top .01% have income from a variety of sources and probably have tax specialists to help them adjust their income up or down to be most favorable given prevailing economic situation.
> You should google the paradise papers or just do some basic reading
Saying "you should google ..." is not a source. If you want to provide a source for your claim about some group, back it up. You're not making meaningful contribution to the discussion.
Yes, the very wealthy have a variety of sources of income (e.g. stocks) and those dropped greatly in value. Unemployment peaked at maybe 10% during the crisis. So some percentage of people lost jobs while the wealthiest who have most their wealth in capital that dropped 30%.
Ironically, having tax exempt investments hurts when your portfolio drops in value as you won't be able to write those off.
You are talking about the middle class. I am talking about people with more wealth than Bill Gates. The people who don’t have accountants and advisors, only own a one or two properties and maybe a million or so stashed for retirement; these people suffered more than Soros or Buffett.
The risk is social, the profit is private. Same as 2008. The entire sector needs to be completely rethought of, and regulated aggressively if they are to provide any public good.
Right, and doesn't the echo of CLO and CDO give the whole thing a feeling of intent? "How could we make a thing similar to 2008 happen and capitalize?" E.g.:
"Randal Quarles, who oversees Wall Street supervision and regulation at the Federal Reserve ...takes comfort from the fact that Wall Street banks are offloading risky loans to investors."
If those "investors" are pension funds or even 401ks, isn't this just a clever way of looting them disguised as a market phenomenon?
Also:
"That’s not the way the markets are supposed to work."
The wealthy disproportionately have their money invested in equities. The ultra wealthy are also typically highly concentrated in specific companies, think Jeff Bezos and Amazon. They tend to lose more when the market crashes.
The wealthy are able to wait out recessions without having to panic sell their equities and in the end they become even richer because inevitably the bull market that comes after the crash will make them come out on the top. All the while collecting dividends. Working class people who don't own equities don't gain anything from bull markets such as the one that's been going on for last 10 years.
I am not sure that's the case. I read that when you look at the top billionaire list through times (80s, 90s, 2000s, now), there is a lot of turnover. Over long economic cycles, the fate of the companies that made people rich can evolve in both directions.
Let's say I'm a billionaire. There's a market crash. A lot of my money is tied up in the market, but luckily, a lot of it isn't. A lot of it will be safe investments or shares in profit-generating companies that issue dividends. So, while the commoner is destitute, while I may have lost 50% of my wealth, I have safe money (and passive income) I can use to pour into the market buying post-crash cheap investments. Also, because my cost of living is minuscule compared to my income, I don't have to panic-sell during the crash.
When the market bounces back four years later, I'm now 1.5x wealthier than I was before the crash (thanks to all the cheap investments), and all I had to do was move some money around.
Don't forget that wealthy people also own a lot of real estate and are rentiers so they have plenty of passive income sources to easily cruise through a recession while buying up cheap stuff which will go up in price heavily once economy gets back on track.
Yes, they lose more.
They lose proportionally less. They're not winding up on the streets. It's disingenuous to pretend that it has anywhere near the impact on their lives as it does the other 99.9% of the participants in the economy.
They definitely can end up in the streets. Some of the wealthiest people suffered the most during past crashes, most killed themselves before taking the streets. Read Devil Take the Hindmost.
Edit: I’m not going to search through this book to find sources that fit some criteria you’re looking for. Get off HN comments, read a book, and learn some financial history lessons.
I haven't read it, but I have a feeling we're not talking about the same people. I'm not talking about successful investors and millionaires. I'm talking specifically about net worth north of $200M in today's dollars. Not the people who jumped from their windows during the Depression. The ones who bought their stock and waited it out.
Edit: I've now read a few reviews and summaries of Devil Take The Hindmost. Its subtitle is "A History Of Financial Speculation," and it appears that its subject matter is not focused on ultra-wealthy persons with diversified portfolios being ruined by market corrections, but specifically speculators and frauds. At a glance, it doesn't look particularly relevant to this conversation.
Batista is currently under arrest and has been sentenced to 30 years in prison for bribing disgraced Rio de Janeiro governor Sérgio Cabral, in order to secure public contracts, according to Wikipedia[0].
I'd prefer an example that isn't somebody who wound up in prison.
Citing an entire book as a source is quite frankly a ridiculous suggestion. You are suggesting that the poster should spend hours proving your position for you when you wont spend a few minutes.
My criteria didn't change. I was talking about people who were ruined by the market, and your example seems to be someone who was ruined by his own crimes.
I would like to know of one ultra-wealthy individual who ended up possessing nothing and was made homeless; I don't intend this to be callous but while committing suicide is a tragedy but it does't mean some rich person was going to end up homeless. Being homeless means you're at a point where no one can or will take you in, and I have a very hard time imagining a hedge fund billionaire in that position.
IMO schools should stand surety for students. Would solve many, many societal problems by putting their skin in the game, rather than using government subsidized loans that can't be defaulted.
>They lose proportionally less. They're not winding up on the streets.
Yes, but the implication of OP is that these ultra-wealthy are crashing the system so they can then buy up everything around them. Where is the data to support this? The rich suffer during a recession too; no one is claiming they end up on the streets.
Have you checked the Oxfam reports? When you take a look at the last years, there is very clear trend. If it continues like this probably in few decades the richest one percent will own as much as the rest 99%.
I believe we're thinking of different definitions of the word "suffer." The qualitative difference to which I refer is that for one class of people, the "suffering" is restricted to numbers on ledgers going down, and for another class of people, said suffering can literally involve ending up on the streets.
Furthermore, someone else in these very comments is claiming the ultra-wealthy can wind up on the streets as a result of market forces.
Correct. Profiteering off of chaos is a business model. Except now the ultra-rich are moving from financial instability into political one. The more chaos, the better, and with political instability you can also gain power, not only money.
The article has nothing to do with wealthy-vs-poor...but your argument is "the rich are better prepared to deal with a market downturn". Jimmy: the rich are better prepared to deal with everything.
With all the talk about the wealthy coming out on top or not...are we actually clear on who these people are? I'm inclined to think that the people that come out on top are the traders and their bosses who pick up the bonuses. Well, provided they're not the ones left with worthless assets :-)
Yay, diversification. They have stable investments they can draw from to purchase the now-insanely-discounted investments in the market, and come back in a much stronger position than before the crash.
So, no, you sell at a stable rate to buy at a discount rate.
Real estate was down in line with equities in the last crisis, so switching from one to the other was not selling a "stable" asset to buy a "discounted" one.
This has to be one of the most backwards comments I’ve read on HN. Read Devil Take the Hindmost and educate yourself. The wealthiest people in modern history lost the most and some drove themselves to absolute poverty. Many couldn’t even mentally handle the extreme quality of life change so they killed themselves.
Because Flat Earth levels of incorrectness should be pointed out. Or maybe we should just grab our pitchforks and make up other random conspiracies to justify how everything works rather than read history books?
