Questions on AIG, Goldman, and Deutsche

I want to raise a few points on AIG that don’t seem to be coming up elsewhere, but that need critical attention if we are to understand how this disaster came to pass and who else is implicated.

There have been a few reports that AIG stopped selling credit default swaps – the financial instruments that eventually destroyed the company – in late 2005 (the latest timeline comes from TPM). But asset-backed credit default swaps, which allow investors to short CDOs, were not even invented until early 2005, according to a Dow Jones article published on January 27, 2005. The article was titled “New Derivatives Could Boost Asset-Backed Secondary Market”:

A new type of credit default swaps is emerging on the structured finance scene, raising hopes that trading in the asset-backed market could get a shot in the arm…

There is no doubt that there is a slew of market participants waiting to use such derivatives – the decade-old asset-backed market has been mostly a buy-and-hold market, its secondary trading illiquid, lacking the instruments that would allow investors to express a negative view on an asset-backed security.

Currently, the only way to express a relative value view in the ABS market is to sit on your hands and do nothing,” said Gyan Sinha, a senior managing director in fixed income research at Bear Stearns. For example, Sinha said, there is no way to short an asset-backed bond – i.e. bet on spreads, or yield margins, widening. [emphasis mine]

The term “asset-backed securities” is confusing, but it includes CDOs; typically, subprime securities were packaged into asset-backed securities. The article is not available online, but I’ve freed it from its home in a proprietary database and pasted it below.

So what gives? Was it nearly impossible to short subprime before 2005? Was AIG able to write all the contracts that destroyed the company in the space of a year? Am I missing something?

Furthermore, 2006 was the biggest year on record for CDO and CDS issuance. If AIG – the biggest casualty of the engineering binge – sat the market out, does that mean bigger CDS sellers stepped in to fill their shoes?

This Bloomberg story from late 2007 on the invention and standardization of subprime-related credit derivatives is also extremely important, yet I haven’t seen it mentioned anywhere. It describes Wall Street’s efforts to engineer an instrument that would allow investors to short the subprime market. According to the article, all this happened in the winter of 2005, around the same time the Dow Jones article was published.

The Bloomberg article emphasizes how important this invention was for the subprime market:

Those meetings of the “group of five,” as the traders called themselves, became a turning point in the history of Wall Street and the global economy.

The new standardized contracts they created would allow firms to protect themselves from the risks of subprime mortgages, enable speculators to bet against the U.S. housing market, and help meet demand from institutional investors for the high yields of loans to homeowners with poor credit.

Derivatives, or “synthetics,” are “like wearing a seatbelt that allows you to drive faster,” says Rod Dubitsky, director of asset-backed research for Credit Suisse. “The total dollar amount of losses, all these losses you’re seeing, are from synthetics. No question, it changed the game dramatically.”

Note that Goldman and Deutsche led the cartel-like engineering process described in the article. Goldman and Deutsche also topped the list of AIG counterparties; ie, they entered lots of these contracts with AIG, and eventually benefitted handsomely.

So Goldman and Deutsche invented the weapon that eventually led to AIG’s demise and scored them billions in taxpayers’ money?

Again, am I reading this wrong?

Which begs the question: should we really be focusing on the AIG Financial Products division? Isn’t it highly possible that there was fraud and collusion by Goldman, Deutsche, et al, in creating these contracts in the first place?

Cassano looks like a stooge and a patsy next to the banks and hedge funds who profited from these contracts as counterparties.

I agree with the guv – the counterparties deserve much more scrutiny, and need to be held accountable.

Note: I wrote about this material in a past life at subprimer.org, as well.

New Derivatives Could Boost Asset-Backed Secondary Mkt
By Ramez Mikdashi
DOW JONES NEWSWIRES
27 January 2005

NEW YORK (Dow Jones)–A new type of credit default swaps is emerging on the structured finance scene, raising hopes that trading in the asset-backed market could get a shot in the arm.

But there’s still a ways to go before credit default swaps on asset-backed securities will be widely used – the new product lacks standardized documentation, and given the nature of asset-backed securities, it is proving a major task to create documentation that reflects the different needs of investors.

There is no doubt that there is a slew of market participants waiting to use such derivatives – the decade-old asset-backed market has been mostly a buy-and-hold market, its secondary trading illiquid, lacking the instruments that would allow investors to express a negative view on an asset-backed security.

“Currently, the only way to express a relative value view in the ABS market is to sit on your hands and do nothing,” said Gyan Sinha, a senior managing director in fixed income research at Bear Stearns. For example, Sinha said, there is no way to short an asset-backed bond – i.e. bet on spreads, or yield margins, widening.

What’s more, one issue can differ widely from another even in the same sector – in terms of average-weighted life, for example. That indicates the expected maturity of the notes which in turn depends on the assets backing the notes – typically some type of consumer debt – and how fast they pay down.

“It isn’t a very fungible asset class: there is no commonality between different issues. Deals are very specific,” said Sinha.

That makes it impossible for investors to use securities from one securitization as a proxy for another, which makes the market less liquid.

But it’s not just traders and short-sellers who have a keen interest in the new credit derivatives, the booming area of structured finance is also closely watching developments, particularly the managers and underwriters of collateralized debt obligations – vehicles that are based on a pool of debt assets, including asset-backed securities.

In the past few years, partly due to the scarcity of asset-backed bonds that can be used as collateral for CDOs, synthetic CDOs of asset-backed securities have begun to emerge – that is CDOs that are based not on a portfolio of asset-backed bonds, but on a credit derivative that was designed to mimic such a portfolio.

Scarcity of assets is particularly dire in Europe, said Alexander Batchvarov, a managing director in charge of international structured research at Merrill Lynch.

“The CDO investor base in Europe is not satisfied with the volume of cash issuance,” he said, noting that lower-rated tranches of ABS issues in particular are consistently oversubscribed.

“Total ABS issuance in Europe in 2004 was EUR240 billion, with only 3-4% of that as BBB-rated,” he added.

Batchvarov said that bankers are now also beginning to develop structures that will group individual credit default swaps on asset-backed securities.

Documentation To Match Differing Needs

With all these interests to deal with, the lack of uniform documentation standards for these derivatives comes as no surprise. That’s a situation that the International Swaps and Derivatives Association hopes to have resolved by late April.

The documentation “is the only thing that is holding back the development of this CDS market. The 1997-1998 growth of the corporate CDS market is being run in fast forward in the ABS market,” said Bear Stearns’ Sinha.

One of the key hurdles has been the definition of a credit event for an asset-backed security. Credit events that are common in the corporate credit default swap market, such as bankruptcy, aren’t relevant in the asset-backed market – securitizations are typically shielded from bankruptcy because the assets backing them are ring-fenced and their payment streams flow into a trust.

So far, ISDA has settled on three events that would serve as credit events for the new swaps and trigger payment. These are failure to pay, a ratings downgrade or a loss event in which the principal is written down.

ISDA is now tackling the final big issue, which is the settlement process for the swaps. Louise Marshall, spokeswoman for ISDA, said it’s possible that there will be two templates for settlement.

The first template would provide for either cash or physical settlement of the asset-backed credit default swap after the credit event, making it more akin to a traditional corporate credit default swap.

The second approach, dubbed as pay-as-you-go, resembles a total return swap after the credit event, say market participants. In this structure, the maturity of the credit default swap matches that of the asset-backed security. In that scenario, the seller of protection makes the buyer whole for interest shortfalls up to the fixed rate received and principal losses in total on the underlying asset-backed security, said Todd Kushman, a product specialist for derivatives of asset backed securities at Bear Stearns.

“Should there be any remittance of an interest shortfall or a reversal of principal write-down in the asset-backed security that is being referenced, those payments will be paid back to the protection seller,” he added.

While some asset-backed money managers or monoline insurers may prefer the pay-as-you go approach, traders who structure and trade synthetic single-tranche CDOs would prefer a cash-settled CDS-style structure.

These traders “would prefer a valuation process where they could collect bids on the referenced ABS security in order to value and terminate the swap through cash settlement,” said Kushman.

Asset-backed swaps that look like total return swaps are not as user-friendly for building CDOs as the credit default swaps that have a bullet maturity, said Sean Rice, a managing director in global structured products at Banc of America Securities

“Those essentially let you cleanly model portfolios of swaps as they all line up and have the same maturity.”

-By Ramez Mikdashi, Dow Jones Newswires; 201 938 2008; [email protected]