The Finger Pointing Continues (GS & AIG)

Market Ticker - Karl Denninger
View original article
January 09, 2010 10:20 AM

It just never ends, does it?

Jan. 9 (Bloomberg) -- Hank Greenberg, former chief executive officer at American International Group Inc., said Goldman Sachs Group Inc. is responsible for the collapse of the insurer during the economic crisis, the Wall Street Journal reported.

Oh really?

A Goldman spokesman disagrees:

“Mr. Greenberg appears to base his views on news reports rather than facts,” Lucas van Praag, a Goldman spokesman, said in an e-mail to Bloomberg News. “It is interesting that he doesn’t mention the devastating conclusions about AIG reached by the company’s own auditors.”

Well now that's interesting.

How about this: They're both right.

Let's go back to the basic mathematics of lending again, shall we?

We shall start with a basic lending transaction.  We'll simplify the terms - it's a 10 year loan to be paid at maturity, thereby exactly matching the characteristics of a 10 year Treasury Bill.  We will further presume that a Treasury Bill has an actual zero default risk (perhaps overly optimistic, but you have to benchmark it somehow.)

This deal has a risk of default of 10%, and if it defaults the recovery on the collateral posted will be 80 (that is, 20% of the face value will be lost), both amortized and realized over the entire life of the issue.

It therefore has a risk premium of 10% X 20%, or 2%.  (Before people start carping about prepayment that obviously occurs when a loan defaults and is recovered, along with the potential for calling of debt, etc, I've already included this in the above recovery, default and characteristic definitions above - in actual practice the computation is significantly more complex but we're after the fundamental realities of lending - and credit default swaps - here, not the nuances of how bond issues price.)

If the 10 year Treasury Bond has a yield at that moment in time of 4% then this deal must price at no less than 6%, or the person making the loan is a fool.  We can therefore assume that a bank with lots of smart Harvard MBA types will discern this risk and will be unwilling to lend at less than the aforementioned 6%.

The person seeking the loan, in a market where many people have money to lend, will be able to negotiate some price for the money that is very close to 6%.  In an infinitely efficient market the price will be 6%, with it rising only as inefficiency in the market (constraint on the number of lenders, for example) or worse, outright collusion between lenders to screw the borrower, prevents him from shopping it effectively.

This analysis is overly simplified, for one primary reason - any single loan will either default or not default.  That is, probability when applied to a single event is a crappy investment proposition, because if you take the bet and lose on the first trial the loss may cripple you. 

But banks make lots of loans, not one loan, and in a basket of these loans of sufficient size the losses will exactly balance the risk premium over the term of the loan.  That's what "Risk Premium" IS!

Ok.

So now we take this basket of loans and we "tranche" it.  There's a 2% margin to be "absorbed" in here, and the way we do it looks like this - we assign as a matter of contract losses so that the first 2% of the face value is absorbed by the "equity" tranche.  If we're wrong about the risk the mezzanine tranche gets the next chunk of loss of face value - say, another 2%.  The "Senior" pieces of the issue are protected, and thus until these losses occur they don't lose anything.

This is the "magic" of securitization - it is the shifting of loss so that you create what looks like an alleged "risk free" transaction for the senior tranche components.

But did you really?

Well, no. 

See, the blended premium on the deal - that is, the interest rate that can be returned when blended across the entire transaction and all tranches - cannot exceed that 6% above.  It in fact has to be less, since the bank that handles doing the securitization will not work for free and neither do the ratings agencies that analyze it.  The money to pay everyone in the middle has to come from the cash flow on the deal itself.

So if the equity and mezzanine tranches actually protect the seniors as represented, yet the yield on them fairly represents the risk they are absorbing then the Seniors must yield LESS THAN the Treasury rate!  If that happens you won't be able to sell them, since anyone seeking a risk-free "AAA" bond will simply buy a Treasury instead.

If the Seniors yield the same or greater than the Treasury rate then either (1) the subordinate tranches cannot actually provide the protection touted or they are unmarketable as they fail to provide sufficient yield to compensate for the risk being taken.

So far we have established that one of two things must be true:

1. The buyer of these "securitized" debt instruments is a sucker.  He is purchasing something that has a yield that fails to compensate him for the risk he is assuming.  The shortfall is in fact the source of the profit that the bank that securitizes the debt and the ratings agency that rates the debt makes!
   
   
   
2. The seller of these securitized debt instruments is misrepresenting the risk contained in them - that is, they are through some device (whether intentional or not) claiming that the risk is less than is actually present, thereby allowing the deal's blended interest rate to be above the risk-free rate of return plus the risk premium.
   

It is not possible, mathematically, for there to be any other explanation.  Someone is getting rooked in these deals in each and every case - they have to be, whether it is because the buyers are fools or the sellers are committing fraud.

It gets better.

Now let's say you put together these packages as a bank and sell off the Senior Tranches.  The 10 year Treasury Rate is 4% at the time and the Seniors "price" at 4.5% - 50 basis points "better" than Treasuries.  They sell instantly to people who believe they are "risk free" due to the credit enhancement provided by your securitization, exactly as they should (heh, it's a 50 basis point "free lunch", right?)

But now you have a problem.  The mezzanine and equity tranches are unmarketable.  Why?  Because their interest rate isn't high enough to compensate for the actual risk present (and that must be present in order for the credit enhancement to actually work!)

So what do you (or some buyer) do?  You buy a credit-default swap to protect against the possible loss in the mezzanine or equity tranche you wish to purchase.

Let's presume that the mezzanine tranche is offered with a 10% yield.  The buyers discern that this is insufficient to compensate for risk - that they're being asked to subsidize the (above-market) return you offered to the Senior Tranches (smart cookies they are!)  So you find "someone" who will write a CDS against that mezzanine tranche for 500 basis points - that is, 5%.  Voila!  Now the "blended return" of the two is 5%, which is one full percent (100 basis points) over the "risk free" rate but it is allegedly risk-free!  You now can sell all of these mezzanine securities and you do, to people who believe they are getting a full 100 basis points of yield over Treasuries for a risk-free transaction.

But wait a second!  We just invented financial perpetual motion, didn't we? 

Indeed - and the laws of mathematics say what just happened is impossible.

So how did we pull that off?

Quite simple, really: The guy who wrote the CDS doesn't have the money to pay in the event of default!

So again we have someone who gets rooked.

How did this go on for so long and not blow up instantly?

The entire thing is a Ponzi scheme from top to bottom!

Let's reduce the CDS part to a simple example - I offer to sell auto insurance to everyone in the United States for $100/year, full coverage.

You buy it immediately, on the first day it is offered.  You have "insurance" and I have the money.  You tell your friends and suddenly I am awash in orders for insurance at 1/10th the going rate.  Why it's a miracle, right?

It sure seems like it for a while.  You wreck your car the second week you have your policy, and I pay you.  That's easy - there's so much money coming in that I can afford to cover the pay-outs initially.

But eventually the rate of new policy sales slow down as the market for suckers saturates.  Unfortunately all those existing policies are still in force, and people keep wrecking their cars!  Soon I run out of money to pay, and the vast majority of people who bought those policies discover that they were participants in a giant Ponzi scheme - they didn't buy actual insurance, they were participating in a pyramid structure that could only pay claims so long as the new money flowing in came in fast enough to cover all the people who wrecked.

This is the essence of all of the so-called "financial innovation" of the last twenty years.  Every bit of it. 

It all comes back to the bottom line: a large enough batch of lending transactions that are properly priced for risk cannot yield more than the risk-free rate in actual performance. 

It is mathematically impossible.

Further, the more complex the transaction is - that is, the more transformation, slicing and dicing that goes on - the less yield will be realized compared to the actual risk.  This is due to the inescapable fact that nobody works for free, and is exactly identical to the laws of thermodynamics which state that for each and every transformation energy takes from how it is generated or stored to it's final means of use some is inevitably lost.

Any violation of these laws of mathematics inherently must involve some element of Ponzi Finance - that is, the subsidization of actual return through the requirement that ever-increasing amounts of "new money" flow into the transaction stream. 

This fundamental reality is inescapable.  The entirety of the "Internet Bubble" and the "Housing Bubble" rests in this fact, along with all other credit bubbles through time. 

PONZI SCHEMES ARE UNLAWFUL IN EACH AND EVERY INSTANCE.

Our Government has sought to cover up, obfuscate and misrepresent to The American People (and indeed to the people of the world) this fundamental fact, and we have not only refused to recognize and dismantle the Ponzi basis of this bubble, we are continuing to try to re-inflate it!

This effort will fail because as a matter of mathematics it must fail, and the sooner we recognize this and hold those responsible to account the sooner our economy can in fact recover.