Where’s my money?

Noah Millman gives us an insider look at the financial debacle, both dense and revealing. Millman tells us that he thought CDSs played a positive role in resolving a credit problem in 2002.

Everyone knows what happened to the stock market in 2002. The corporate debt market situation was not as well-reported because it was of less interest to individual investors. But it was of enormous importance to the future of these companies, and to the world economy. Many of these companies had huge debt loads and substantial near-term refinancing needs. And it wasn’t clear they were going to get that refinancing, as investors were not eager to buy bonds from companies that might be the next Enron or Worldcom, and banks were not eager to lend more when they were increasing their provisions against their existing holdings.

Millman explains that at that time, the US markets were flooded with cash because of the easy money policies of Alan Greenspan’s Fed. He doesn’t mention the money flooding in from China. Banks made the loans to these overextended entities because of the floods of cash, and, Millman explains, credit default swaps played a significant role: “… by 2002, the credit derivatives marketplace had matured to the point that banks could use it as one input into their decision making process about when to lend.” He points out that CDSs could be used to hedge risk. If the bank wanted to lend $50mn, and the customer wanted $100mn, the bank agrees, and buys protection for $50mn of the debt. With this hedge, the apparent exposure of the bank is the $50mn it wanted to lend.

And who would write that default swap? Maybe a hedge fund making a bet that credit would outperform equity (so-called “capital structure arbitrage”) and was therefore writing credit-default-swaps and shorting stock as a hedge. Maybe an insurance company taking advantage of wide spreads to take additional corporate credit exposure in its investment portfolio. Maybe a foreign bank that isn’t part of the lending syndicate for the utility looking to diversify geographically.

These, of course, are examples of use of naked CDSs. Millman explains how the CDS market could be used get rid of other parts of their portfolios through special purpose vehicles coupled with a CDS, and other similar deals. All of these involved sales of additional kinds of debt instruments into an apparently insatiable demand. Millman explains that the only way this could have happened was that all of this debt was highly rated by the rating agencies.

Millman offers the same explanations for the value of CDSs discussed here. This plan worked in 2002, and confirmed for him the value of CDSs. He goes on to a description of the excesses that led to the current crisis, with an astonishing example. Again, well worth reading. But let’s take a look at the bigger picture.

The problem Millman describes is that a lot of borrowers like utilities and telecoms had weak balance sheets, loaded with debt, and nobody, especially banks, really trusted the bad balance sheets and the related statement of income. Instead of selling stock and improving their equity position, even at the cost of selling when their stocks were low, these companies wanted to borrow more money. Instead of just saying no, Wall Street and mega-banks moved more and more debt onto the sorry balance sheets of their customers.

This seems like a bad idea. If the balance sheet looks debt-heavy, doesn’t that suggest that there was a lot of risk in lending? If the income statement can’t be trusted, as Millman suggests, how does a lender think its borrowers can raise the money to pay the debt? Everyone who looked at the financials must have seen this, but it didn’t seem to matter. There wasn’t an increase in interest rates, so what was the compensation for the perceived increased risk? There wasn’t any.

I can think of two explanations. One is that there was so much money floating around that borrowers didn’t have to pay more. The reluctance to lend Millman ascribes to the banks was just not there. Another is that the CDS market gave a bad price signal, maybe because CDS players were not estimating credit risk, but instead were relying on their ability to hedge whatever the risk was.

In any event, rather than deal directly with the perceived risks they were taking, lenders moved the risk onto their CDS counterparties, who in turn hedged it with tactics like “arbitrage” CDOs, described by Millman:

Equity investors in such vehicles were basically borrowing for term from the various classes of debt investor to purchase a portfolio of corporate risk, and could change the composition of that portfolio (subject to a variety of ratings agency restrictions) to capitalize on market moves of various kinds. By 2002, this CDO market had already become synthetic, which meant that a variety of investment banks could create such structures on the fly designed around the precise risks investors wished to access (in terms of the underlying portfolio and the degree of leverage in the structure).

Arbitrage CDOs hedging CDSs were going to solve an over-leverage problem? Millman’s picture may be wrong, but it reflects recent US capitalism: debt is the financing mechanism of choice. Equity involves real risks, and it takes a long time to produce results. Wall Street doesn’t like either. At least the risks associated with debt don’t matter, we learned. It can be shifted onto others. Like the Treasury.

And for Millman, this from Robert Pinsky’s translation:

…I went along

The seventh circle’s margin alone, and passed
To where those doleful people sat. Their woes
Burst from their eyes, their hands were doing their best

To shield them from the torments, shifting place
From here to there — one moment from falling flames,
The next, the burning ground: just like the ways

Of Dogs in summer when they scratch…