Goldman’s Undisclosed Role in AIG’s Distress

Posted on Janet Tavakoli's website:

Goldman wasn’t the only contributor to the systemic risk that nearly toppled the global financial markets, but it was the key contributor to the systemic risk posed by AIG’s near bankruptcy. When it came to the credit derivatives American International Group, Inc. (AIG) was required to mark‐to‐market, Goldman was the 800‐pound gorilla. Calls for billions of dollars in collateral pushed AIG to the edge of disaster. The entire financial system was imperiled, and Goldman Sachs would have been exposed to billions in devastating losses.1

A Goldman spokesman told me its involvement in AIG’s trades was only as an “intermediary,” but that isn’t even close to the full story. Goldman underwrote some of the CDOs comprising the underlying risk of the protection Goldman bought from AIG. Goldman also underwrote many of the (tranches of) CDOs owned by some of AIG’s other trading counterparties.

Even if all of Goldman’s CDOs had been pristine, it poisoned its own well by elsewhere issuing deals like GSAMP Trust 006‐S32 that—along with dodgy deals issued by other financial institutions—eroded market trust in this entire asset class and drove down prices.

By September 2008, Goldman had approximately $20 billion in transactions with AIG. Goldman was AIG’s largest counterparty, and its trades made up one‐third of AIG's approximately $6.1 billion2 in transactions requiring market prices.2 Societe Generale (SocGen) was AIG’s next largest counterparty with $18.7 billion. SocGen, Calyon, Bank of Montreal, and Wachovia bought several (tranches) of Goldman’s CDOs and hedged them with AIG.3

On November 27, 2007, Joe Cassano, the former head of AIG's Financial Products unit, wrote a memo about the collateral AIG owed to its counterparties. Goldman, Soc Gen, Calyon and others required more than $4 billion. Goldman asked AIG for $3 billion of the $4 billion required in collateral calls. (Click here to view the nine‐page memo uncovered by CBS News in June 0092.) By September 2008, Goldman had called $7.5 billion in collateral from AIG.

AIG lists its transactions as negative basis trades. This suggests Goldman earned a net profit by purchasing—or holding its own—CDO tranches and then hedging them with AIG.4 As AIG’s financial situation worsened, Goldman bought further protection in the event AIG collapsed.

SocGen’s negative basis trades totaled $18.6 billion. For example, SocGen bought protection from AIG on two tranches of Davis Square VI, a deal Goldman underwrote. According to AIG’s documentation, SocGen got its prices for marking purposes for Goldman’s deals from Goldman. As of November 2007, Goldman marked down these originally “AAA‐rated” tranches to 67.5%, down by almost one‐third.5
SocGen’s list includes other deals underwritten by Goldman: Altius I, Davis Square II, Davis Square IV, the previously mentioned Davis Square VI, Putnam 2002‐1, Sierra Madre, and possibly more. SocGen hedged this risk by purchasing protection (in the form of credit default swaps) from AIG.
Calyon had $4.5 billion of negative basis trades with AIG. Calyon and Goldman were co‐lead on at least two deals: Davis Square II and Davis Square V. According to AIG’s memo, Calyon got its prices for these deals from Goldman.

Goldman’s list of negative basis trades prominently featured many of Merrill’s CDOs (as underlying risk), and Merrill had its own list amounting to around $9.9 billion (as of November 2007). In Sept 2008, at the time of AIG’s near collapse, Bank of America had just agreed to merge with Merrill, which held $6 billion of super senior exposure to CDOs hedged with an insurer, now revealed to be AIG. Both Ken Lewis, then CEO of BofA, and Hank Paulson received tough questions about the merger, but not tough enough. Lewis later testified that Hank Paulson (then Treasury Secretary and formerly CEO of Goldman at the time of the AIG related trading activity) urged him to be silent about Merrill’s troubles. Merrill later received a $6.3 billion bailout payment from AIG.

Bank of Montreal had $1.6 billion in negative basis trades with AIG, and at least two Goldman transactions (Davis Square I and Putman 2002‐1) made up 6 of its 9 positions with AIG. Wachovia had 6 trades with AIG, all related to Davis Square II, a deal that Goldman underwrote.

Goldman questioned PriceWaterhouse, Goldman’s and AIG’s common auditor, about prices. Goldman wanted lower prices, which meant that AIG would have to produce more collateral. When AIG was downgraded in September 2008, AIG was required to put up an aggregate amount of $14.5 billion in additional collateral to equal the full difference between original prices and market prices. But “market prices” in this illiquid market were influenced by Goldman Sachs.

Goldman was right to question the prices, make calls for collateral, and protect itself. Goldman’s activity was not the same as that of an arsonist buying fire insurance, but its trading activities with AIG and others were accelerants of AIG’s problems.

During AIG’s bailout, Goldman had influence over the decision to use public funds to pay 100 cents on the dollar for these CDOs (the underlying risk of the credit derivatives), but none of the information about the volume of Goldman’s trades with AIG—or the Goldman CDOs hedged by AIG’s other counterparties—was made public.

Goldman’s public disclosures in September 2008 obscured its contribution to AIG’s near bankruptcy and the need to bailout Goldman’s trading partners in AIG related transactions. Goldman’s trading activities played a starring role in the near collapse of the global markets.

*****

1 Goldman’s current and former officers were influential in varying degrees in AIG’s bailout. Hank Paulson was then Treasury Secretary and a former CEO at the time Goldman put on its trades with AIG and underwrote deals bought by some of AIG’s counterparties. Lloyd Blankfein was CEO of Goldman and was influential in the bailout discussions. Stephen Friedman, then Chairman of the NY Fed, also served on Goldman’s board.

2 AIG’s Nov 007 report2 showed Goldman’s positions at $23 billion, but something may have happened before Sept 2008 to reduce that amount. AIG was required to price these credit derivatives using market prices, and if applicable, AIG had to provide collateral if the prices moved against it. Terms varied, but after the downgrade, AIG owed collateral for the full mark‐to‐market value to several counterparties. This is the difference between the original value and the price that Goldman and others put on the credit default swaps.

3 AIG’s other trading partners for the CDSs requiring mark‐to‐market prices included French banks Societe General (SocGen) and Calyon, Bank of Montreal, Wachovia, Merrill Lynch, UBS, Royal Bank of Scotland, and Deutsche Bank.

4 AIG may have used the term “negative basis trade” loosely. Whether Goldman was an intermediary (stood between AIG and yet another counterparty), or whether it booked negative basis trades, Goldman had to manage its risk in the event AIG went under.

5 SocGen’s total margin calls were not available in the November 007 memo2. It is possible that like Calyon—and like troubled Citigroup—SocGen provided a liquidity put on commercial paper (CP) distributed by Wall Street firms to a variety of investors. Calyon agreed to buy the CDO’s commercial paper (short term debt backed by the longer term tranches of the CDOs) if demand in the market dried up when it came time to roll the CP. Calyon hedged the risk of the liquidity puts by purchasing credit default protection from AIG

Bondholders Extract Revenge on Fee-Hungry Bankers

Posted on Bloomberg by David Reilly:

Companies in dire straits often roll the dice in a bid to stave off bankruptcy. The problem is that last-ditch efforts to raise new funds or restructure often come at the expense of bondholders.

Struggling companies, their advisers and lenders should think twice about such strategies after an almost $700 million judgment last month against Citigroup Inc., Bank of America Corp., Wells Fargo & Co. and other lenders, in connection with the bankruptcy of homebuilder Tousa Inc.

With bankruptcies rising, the decision may push creditors in other cases -- those of Tribune Co., Lyondell Chemical Co. and CIT Group Inc., for example -- to pursue more aggressively what are called fraudulent conveyance claims.

The Tousa case has caused the legal and bankruptcy communities to sit up and take notice because fraudulent conveyance claims rarely result in a sizeable judgment. Such claims seek to claw back money for a bankrupt entity by claiming a transaction was fraudulent because, while insolvent, it had transferred funds or assets without receiving something of equivalent value.

Fraudulent conveyance claims are usually settled or fizzle because they face a tough road at trial, essentially requiring a bankruptcy judge to play Monday-morning quarterback.

The Tousa case has turned that thinking on its head.

“This case will undoubtedly embolden people in other cases, like Tribune,” said Douglas Baird, a University of Chicago law professor.

Tribune Creditors

Creditors of Tribune have alleged that fraudulent transfers took place as part of that company’s $8.3 billion going-private buyout. Tribune Chairman and Chief Executive Officer Sam Zell has denied the allegations, telling Bloomberg News, “In this particular case, I don’t think it’s valid, but ultimately it becomes a basis for negotiations.”

Baird said the Tousa decision will make such negotiations tougher. “I can go back to a lender and say that there’s a serious fraudulent conveyance risk here, and they’d say those claims never get anywhere,” Baird said. “If I say that someone just got tagged to the tune of half a billion dollars, this becomes a real risk.”

The Tousa decision also offers a window to some behavior that marked deal-making in the waning days of the credit and housing bubbles.

One example: AlixPartners LLP, the firm issuing a solvency opinion for Tousa, was to receive $2 million for a favorable opinion, and less than half that for an adverse one. Guess how that worked out.

Citigroup, Wells Fargo

Banks such as Citigroup, Bank of America and Wells Fargo, as well as other lenders, are appealing the Tousa decision. Last week, U.S. Bankruptcy Judge John K. Olson ordered them to post bonds of about $700 million while pursuing the appeals.

Tousa is a Hollywood, Florida-based homebuilder that expanded earlier this decade through a series of acquisitions, taking on $1 billion in debt.

In 2005 the company entered into a joint venture to buy Transeastern Properties Inc.’s homebuilding business. Tousa issued unsecured guarantees related to more than $500 million in borrowing by the venture, which quickly ran into trouble.

Tousa faced claims due to its guarantees and in January 2007 agreed to pay more than $421 million. Tousa didn’t have that kind of cash, though, and its business was rapidly souring as the housing meltdown began.

Secured Debt

To finance the settlement, Tousa issued $500 million in new, secured debt on July 31, 2007. This was secured by Tousa subsidiaries that weren’t at risk from the failed joint venture. Those units were home to most of the company’s assets, meaning claims from the new lenders would compete with those of existing bondholders.

Six months later, in January 2008, Tousa filed for bankruptcy. The company’s existing bondholders cried foul.

They claimed the 2007 financing had fraudulently transferred value from the subsidiaries, which didn’t see any money from the deal and weren’t on the hook for the joint venture’s failure. The bondholders also argued that the subsidiaries were insolvent both before and after the new round of financing.

Judge Olson agreed. His decision noted that banks and other lenders involved ignored ample evidence in early 2007 that Tousa was in bad shape and that taking on more debt wouldn’t benefit the company. He also found that:

Layers of Fees

-- Those involved with the financing had big incentives to get the deal done, no matter the risks. Half the chief executive’s target incentive bonus of $4.5 million was contingent on the deal’s completion. So too was a $3.5 million fee for the company’s investment bankers, Lehman Brothers Holdings Inc., along with a $2.9 million financing fee. And Citigroup “saw the proposed new financing as a highly attractive opportunity for fees,” the judge wrote. It ultimately collected $15 million.

-- Citigroup bankers arranging the financing knew early on that Tousa was in trouble. The judge noted that after looking over financial models for Tousa, a Citigroup banker wrote in an e-mail, “I don’t think the downside model should be shown to anyone outside of here. It’s too scary.”

-- The company’s board was warned in a letter from Capital Research and Management Company, an investor in Tousa’s existing bonds, that the new financing could put Tousa into the “zone of insolvency” and that it might be a “fraudulent transfer.”

-- Some lenders swallowed whatever management fed them, failing to question housing-market forecasts. That failure, Olson wrote, “was the result of either gross negligence or a willful decision -- motivated by a desire to generate fee income -- to turn a blind eye toward the obvious reality that Tousa was in a death spiral.”

Now, Tousa’s bondholders have rightfully gotten some revenge, while fee-hungry bankers and lazy lenders have been warned.

Banks don’t just have an asset problem, says Moody’s

Posted on FT Alphaville by Tracy Alloway:

Here’s the Moody’s report that is making waves in financial media circles on Tuesday morning.

The basic premise: The average maturities of new debt issuance by Moody’s-rated banks around the world fell from 7.2 years to 4.7 years over the last five years — the shortest average maturity on record. In graphic terms, that looks like this.

That means banks will face maturing debt of $10,000bn between now and the end of 2015, or $7,000bn by the end of 2012, according to Moody’s.

Now, a debt profile skewed towards short-term maturities can make a bank more vulnerable to market volatility (increases in official interest rates and/or swings in investor confidence) which rather helps explain why banks got into it in the first place. Here’s Moody’s:

Before the crisis, banks tended to issue two to three times more new debt than what came to maturity during a given year, highlighting the rapid asset growth that occurred across banks and systems in recent years and their active management of liabilities to lower funding costs. The trend towards shorter debt maturities reflected banks’ increasing confidence in their market access as well as the availability of alternative funding channels, notably through the use of securitization. It also appears that, presumably for similar reasons, banks have increasingly relied on instruments with option features (step-up, call or put options) that expose the issuer to periodic changes — the risk being an increase — in the rate they pay on their own debt (for the purpose of our graph, we have generally referred to these instruments as medium-term notes, or MTN).

As the above should suggest, the danger here is that investors don’t return in time for banks to refinance their shorter term debt. Uncharacteristically perhaps, Moody’s is actually concerned here. At the very least, the ratings agency says the banks will experience a step-up in funding costs:

Driven by either internal risk management or regulatory considerations, we expect that affected banks will want to extend their debt maturity profiles by replacing some of their short-term debt instruments and MTN-like instruments with new, longer term wholesale debt in the coming months and years. However, spreads on long-term corporate debt are already substantially wider than short-term debt currently, and it is probable that rates will rise in the future when considering the historically low interest rates currently prevailing and some other forces that may also push up rates, such as the imminent exit of government support to the financial sector and the fact that these governments will also compete with banks for debt raising in order to finance their large deficits. Therefore, funding costs would increase from the mere fact of moving out on the yield curve, with the risk of funding costs being pushed up further by the rising tide of benchmark rates.

And just to get really wonky — here’s a demonstration of that increased funding cost:

Suppose, a Baa-rated bank had issued short-term debt under an Aaa-rated government guarantee programme and had been paying a coupon of about 1.3 per cent. It would need to pay a 7.75 per cent coupon for issuing a 10-year bond on its own today — a 645bp increase. The same move by a Ba-rated bank would result in a 929bp increase. Considering that the issuance of Aaa-rated government-backed unsecured debt for banks globally (ex-US) is up 23 per cent, while issuance without government backing is down 22 per cent — you can get a sense of just how much money banks have actually been saving due to the guarantee programmes.

Those government-guarantee programmes around the world will of course expire in coming years. At the same time you will also probably get a wind-down of central bank asset purchases and further regulatory pressure on banks’ capital — all of which means significant upward pressure on banks’ funding costs, at a time when many will still be dealing with copious amounts of bad debt, according to Moody’s.

In other words, the banks don’t just have an asset problem — they also have a looming liability problem.

Back to Moody’s:

Investors have returned to the market in 2009, providing significant amounts of funds, but this should not be confused with a return to a normal operating environment. We believe that the “thawing” of debt and equity markets was largely driven by calculated, opportunistic risk-taking in the context of the extraordinary support provided by government programs and very low short-term interest rates. We would therefore not describe the investor resurrection as a return to strong financial fundamentals in the markets.

In fact, we expect that credit-related losses to continue to cause damage to banks’ financials. In our view, losses are still on a rising trend, mainly because of the delay that exists between the end of a recession and a fall-off in provisions and actual charge-offs.

To use the US banking system as an example, banks have not provisioned for the full amounts of loan and securities losses that we believe they will incur over the coming year, which we expect to reach $470 billion in credit costs by the end of 2010. Approximately only one quarter of this has been recognized to date and we expect earnings to be insufficient to offset these costs during that period, resulting in many banks being unprofitable.

The risk premium on bank debt is unlikely to fall in such a poor credit quality context. If anything, it may actually increase, especially for long-term debt which already commands a significantly higher premium. Additionally, a close look at recent results reported by banks in various systems reveals that asset quality prospects for both consumer and commercial credits remain bleak.

Therefore, credit costs should continue to put banks’ earnings and profitability under considerable pressure, which might cause investors to seek additional risk premia, as governments gradually exit from the direct support they have so far provided. In other words, we see weaknesses on both sides of the balance sheet, and we are concerned that the risks associated with both assets and liabilities may fuel each other, cause losses and undermine investor confidence.

Moody’s — we didn’t know you could be so (bank) bearish.

Was it “Nobody Saw It Coming” or “Everybody Who Saw It Coming Was a Nobody”?

By Richard Alford, a former economist at the New York Fed. Since them, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side. (Guest post on Naked Capitalism)

A number of economists, economic policymakers, regulators, and central bankers have attempted to explain away their failure to both foresee and mitigate the current financial crisis by asserting that no one saw it coming. The inference is that they cannot be held accountable for something so unusual, so extraordinary, and so unforecastable that that no one saw it coming. Robert Shiller, in a November 1, 2008 NYT OP-ED, noted the following example:

Alan Greenspan, the former Federal Reserve chairman, acknowledged in a Congressional hearing last month that he had made an “error” in assuming that the markets would properly regulate themselves, and added that he had no idea a financial disaster was in the making. What’s more, he said the Fed’s own computer models and economic experts simply “did not forecast” the current financial crisis.

However, the Fed and other policymaking agencies cannot honestly claim that no one saw it coming. There is ample evidence that:

• Economist and commentators “saw it coming”; and

• Economists and others repeatedly brought their observations to the attention of the authorities including the Fed, but were ignored.

In fact, the Fed increasingly exhibited a willingness ignoring critics and criticism. The existence of this pattern at the Fed can be illustrated by looking at two presentations by Kohn. The first is from 2003 and the second is from 2005. But first, a return to Shiller’s OP-ED piece:

Mr. Greenspan’s comments may have left the impression that no one in the world could have predicted the crisis. Yet it is clear that well before home prices started falling in 2006, lots of people were worried about the housing boom and its potential for creating economic disaster. It’s just that the Fed did not take them very seriously.

Schiller blamed self-censorship and group think. Shiller reports that while he was a member of the economic advisory panel of FRBNY, he felt the need to use self-restraint and stated that he only gently warned about bubbles in the housing markets.

It is one thing for someone to practice self-censorship. It is another thing all together for an institution charged with a public responsibility to allow and foster an atmosphere in which someone well respected enough to be asked to sit on an advisory board feels as though he or she must temper their statements or pull punches. What was the role of the advisory board, if the members did not feel free to raise and discuss competing views or alternative policy paths? In the context of the dynamics of globalization and financial innovation, why was conformity to a static consensus tolerated and even encouraged?

Furthermore, while the Fed had a responsibility to promote economic and financial stability, Shiller did not. Once well respected economists and analysts highlighted the possible risks the Fed had an obligation to assess those risks. Shiller also reported that the group-think that ignored signs of the impending financial crisis extended well beyond the halls of the Fed:

I gave talks in 2005 at both the Office the Comptroller of the Currency and at the Federal Deposit Insurance Corporation. I argued that we were in the middle of a dangerous housing bubble. I urged these mortgage regulators to impose suitability requirements on mortgage lenders, to assure that the loans were appropriate for the people taking them.

The reaction to this suggestion was roughly this: yes, some staff members had expressed such concerns, and yes, officials knew about the possibility that there was a bubble, but they weren’t taking any of us seriously.

Returning to the Fed, a speech by Kohn in February 2003 indicates that while Shiller was self-censoring, other commentators had been pointed enough in expressing their concerns to merit a response:

In particular, a number of commentators have raised the specter that imbalances are being created in the markets for consumer durable goods and houses–unsustainably high prices or activity–that will produce macroeconomic strains when, inevitably, they correct. These concerns obviously echo those expressed by some observers that monetary policy allowed run-ups in equity prices and capital spending in the 1990s that ultimately proved to be destabilizing.

In a footnote, Kohn went on to say:

Another possibility is that the buildup of debt associated with the strength in household investment will feedback adversely on financial conditions, especially as the boom unwinds. Such consequences could occur even in the absence of a “bubble” in housing prices if households were overextended and lenders had not taken adequate precautions against even a measured drop in collateral values… Moreover, loan-to-value ratios on mortgages have been about flat, leaving ample cushion for moderate housing price declines, should they occur. These observations suggest that widespread credit difficulties with important macroeconomic effects are unlikely when interest rates rise.

Kohn not only acknowledged the existence of the commentators and their concerns and took them seriously enough to present evidence that he thought should lay to rest those concerns to rest. He also suggests that the likely short-lived nature of the interest rate -driven increases in housing prices and real estate investment implied that any resulting macroeconomic or financial problem would be of a manageable scale:

Judging from this analysis, and bearing in mind its inherently tentative–if not speculative–character, it seems likely that as the economy strengthens and interest rates rise in response, household investment and prices are likely to soften some relative to recent trends, but not to break precipitously. Houses and cars would not be providing the impetus to economic activity they often have in past recoveries…

At the Jackson Hole Conference of 2005, a speech by Rajan, the then Chief Economist at the International Monetary Fund, “Has Financial Development Made the World Riskier?” and a response by Kohn allows us to get a read on Fed policymakers reactions to warnings about possible economic or financial dislocations two years later. In the opening paragraphs, Rajan argued that the transformation of the financial sector had made it more efficient, but at the expense of increased risk:

The expansion in a variety of intermediates and financial transactions has major benefits,…However, it has potential downsides, which I will explore ..

… the incentive structures of investment mangers today differs from the incentive structures of bank managers in the past in two important ways. First,… managers have a greater incentive to take risk. Second, their performance relative to other managers matters.

The knowledge that managers are being evaluated against other managers can induce superior performance, but also perverse behavior.

One is the incentive to take risk that is concealed from investors—since risk and return are related , the manger then looks as if he outperforms peers,,, typically the kind risks that can be concealed most easily… are known as tail risks.

Both behaviors can reinforce each other during an asset price boom…An environment of low interest rates flowing a period of high rates is particularly problematic, for not only does the incentive of some participants to “search for yield” go up, but asst prices are given the initial impetus which can lead to an upward spiral, creating conditions for a sharp messy realignment…..

…the most important concern is whether banks will be able to provide liquidity to financial markets so that if tail risk does materialize, financial positions can be unwound and….the real consequences to the real economy minimized.”

The balance of the Rajan paper was a development of these ideas along with the presentation of considerable amount of supporting evidence. He referenced over 50 plus scholarly papers. Rajan never forecasted or predicted the crises which were to follow relatively quickly. However, he concluded:

a risk management approach to financial regulation will be important to attempt to stave off such states through the judicious operation of monetary policy and through macro-prudential measures. I argue some thought also should be given to attempting to influence incentives of financial institutions mangers lightly, but directly.

Kohn was a Discussant, but his response was not so much a discussion or rebuttal of the Rajan theses as it was simply a restatement of his and presumably the Fed’s belief that the greater dispersion of financial risk away from banks necessarily implied lower levels of systemic risk. There was no discussion of the implication of the changes in incentive structures or herding behavior. Kohn dismissed concerns about tail risk citing reduced volatility of output and inflation over the previous twenty years. However, who believes that tail risk has to either manifest itself in a twenty year period, or be non-existent. Furthermore, the factors cited by Rajan had come to dominate the financial sector only during the prior ten years.

No mention was made of LTCM or the Tech bubble. Concerns that low interest rates may contribute to increased risk in the financial system were dismissed on the grounds that those policies contributed to greater stability in output and inflation. Kohn never addressed the point that the shift away from bank-center finance might leave the system short of liquidity should risks materialize.

In short, Kohn’s response to Rajan’s theses was nothing more than a curt dismissal when compared to his detailed response to the specter of imbalanced -induced concerns voiced by the unnamed commentators in 2003. It appears that the perceived need to respond, even if only in words, to well researched warnings by prominent economists had disappeared.

Furthermore, Kohn on this occasion and presumably others, never publicly revisited (to my knowledge) the contingencies which were in part the basis of his rejection of the warnings in 2003. Interest rates had risen very slowly amidst a jobless recovery and a failure of investment spending to propel the economy. Ten year Treasury yields were only about 25 bps higher and monetary policy remained accommodative. Loan to value ratios had started to erode as had lending standards. If Kohn had re-checked the reasons he cited in his in 2003 rejection of warnings he would have found that the conditions he had cited for being sanguine no longer obtained.

In summary, numerous people, including well respected economists and officials saw the grounds for economic and financial crises being laid. Furthermore, these warnings were brought to the attention of US policymakers. Assuming the two presentations cites above are representative, the warnings were at first treated as worthy of a serious response. However, even as evidence of serious imbalances and bubbles grew, the responses to warnings became perfunctory and devoid of serious analysis.

Houston, we have a problem.

Boomers in Denial About Retirement Savings

Posted on CNBC by Christina Cheddar Berk:

No doubt last year’s financial crisis dealt a body blow to many investors, but many Boomers approaching retirement have yet to turn their reaction to last year’s events into action.

Wells Fargo just released the results of its Retirement Fitness survey and looked hard at the investment habits of pre-retirees ages 50 to 59. What did they find?

“There is a sense of denial among the pre-retirees,” said Lynne Ford, head of Wells Fargo Retail Retirement.

Even after suffering significant losses last year, many remain overly optimistic about their investment returns and the ability of their savings to fund their expenses after they stop working.

Only 23 percent of pre-retirees are saving more for their retirement than they were a year ago, the survey found. Most, some 57 percent, are saving the same amount, and 20 percent are saving less.

Perhaps even more startling is the extent to which their savings are falling short of their goals. On average, these pre-retirees expected they would need $800,000 to fund their retirement. However, most had only saved about $300,000.

Despite their inadequate savings, nearly two-thirds of the group lack any formal plans for retirement savings or spending strategies.

Of the 35 percent of those who had a written plan for retirement, only slightly more than half — about 52% percent — say they had updated it in the past year during the market downturn.

According to Ford, the results of the survey cry out for people to take more control over their retirement.

“The bottom line is you have to have a plan and pull it out and retest your assumptions,” Ford said.

Among the biggest mistakes people are making is over-estimating their investment returns and the amount of money that can safely be withdrawn each year in retirement.

In the survey, both those who were about to retire and those who already had said they expected their savings to grow by 8.7 percent each year, on average. However, the compound annual growth rate of the S&P 500 from 1958 through 2008 was only 6.6 percent.

People also under-estimate how long they will live in retirement, she said. A healthy person in their mid-sixties can easily expect to live into their eighties or even nineties. However, few people are prepared to support themselves in retirement for more than twenty years.

Only the strongest survive (and thrive) in the CP markets

Posted on the Sober Look:

Money market funds continue to struggle to put cash to work , searching for product that would comply with pending new regulation, yet provide returns that are above treasury bills. The returns on money market funds continue to be pathetic - about 15-25 basis points annualized.

The better rated banking firms have taken notice of this demand. They now have a choice of funding themselves by borrowing from other banks or via the CP market. (Neither was really available on anything but the overnight basis in the second half of 08).


With the 3 month LIBOR hovering above 25 bp, CP funding is cheaper for banks that can get AA rating on the paper (see the CP yield curve below).





And banks are indeed taking advantage of it, issuing CP and selling it to guys like the Fidelity MM fund. That gives the larger/stronger banks a real advantage over the smaller ones. Community banks have to pay depositors 60 bp on checking accounts and over 105 bp on money market acccounts - and that's their key source of funds. The larger banks can fund themselves with CP at 20 bp. That's a significant competitive advantage.

The new issuance of CP has caused the amount of financials-issued commercial paper outstanding to spike,



source: FRB



driving up the overall CP notional.



source: Bloomberg


This new supply is easily absorbed by money market funds. The CP market has simply bifurcated into those who have the credit quality to issue paper and those who don't - there's little in between. With new regulation, money markets won't be able to buy much "tier-2" CP and there aren't other buyers out there. You are either "tier-1" or you are basically out of the market (some stronger "tier-2" can still place paper, but in limited amounts - maybe 5% of the total). For a while the Fed was buying CP via the CPFF program, but that's winding down:



source: FRB

The survivors in the CP market are some of the strongest institutions or institutionally sponsored ABCP programs. Everyone else has to look for other sources of funds.

Does Financial Innovation promote Economic Growth?

Posted on Rick Bookstaber's blog:

I participated in an Oxford-style debate at The Economists’ Buttonwood Gathering a couple of weeks ago. The proposition for the debate was Financial Innovation Boosts Economic Growth.

On the pro side of the proposition were Myron Scholes, the chairman of Platinum Grove and Robert Reynolds, the CEO of Putnam, and on the con side were Jeremy Grantham, the CEO of GMO and me. This was the first time I had participated in a formal debate, as I suspect it was for the others. When we came out onto the stage, I overheard one person in the audience say, with a British accent, “Well, they obviously have never been in an Oxford debate before.” I don’t know what we did wrong, but it looks like we even messed up our entrance.

The entire debate is available here. It includes five-minute opening remarks by each participant – first Robert for the pro, then me for the con, then Myron and finally Jeremy. This was followed by one-minute rebuttals and then questions from the moderator and audience. It is pretty interesting, but for those who do not want to spend the time watching it, here are the main points I made.

I elected to restrict my discussion of financial innovation and economic growth in two respects.

First, I focused only on the so-called innovative products. I grant that there are some innovations in the financial markets that have been beneficial; Robert Reynolds gave a summary of many of these. I take as a given that electronic clearing, the adoption of telecommunications, the development of futures, forwards and mutual funds have all had a positive impact.

So what do I mean by innovative products? Well, I could just say you know them when you see them. But when I think about innovative products, I think about them in a three dimensional space. I look at where the product fits in the dimension of simple to complex, standard to customized, and transparent to opaque. The things I term innovative products congregate in the {complex, customized, opaque} region.

Second, I focus on the impact of financial innovation over the past ten or fifteen years. I am looking to the past rather than forecasting to the future for two reasons. One is that I do not have a crystal ball, so I cannot project what innovations will occur in the future. Another is that if the future is like the past, then at least the past can provide a guide. Behavior being what it is, absent regulation to bridle our actions, this is a reasonable assumption to make.

So, defining innovative products in this way and looking over the past ten or fifteen years, let’s look at the ways financial innovation might promote economic growth.

Do innovative products improve market efficiency?

If we were in an Arrow-Debreu world, the answer would be yes. But the incentives behind innovation move in the other direction. The objective in the design and marketing of innovative products is not market efficiency, but profitability for the banks. And market efficiency is the bane of profitability. The last thing a bank would want is a competitive, efficient market, because then it would not be able to extract economic rents. So the incentives are to create innovative products that reduce market efficiency, not enhance it.

How is this done? Well, I can quickly think of two ways. First, by creating informational asymmetries, by having products that are difficult for the users to understand an price. And the second is by designing innovative products, which, due to their non-standard nature, allow the banks to extract higher transaction costs.

Do innovative products allow us to better manage risk?

Hardly. They create risk, or, if you don’t want to go that far, they hide risks. They put risks off balance sheet, obfuscate them through complex schemes, create non-linearities and correlations that only become evident in times of large market changes. They also push more risk into the tails, so that in the day-to-day world things look more stable, but in an extreme event the losses are accentuated.

Earlier in the conference, Larry Summers gave an address where he remarked that since the early 1980s we have had a major financial crisis roughly every three years. Whatever financial engineering and the innovations it creates is doing for the markets, it is not tempering risk.

Do financial innovations help meet investors’ needs?

Unfortunately, the answer is yes. Well, not investor needs, but investor wants. They allow investors to lever when they aren’t supposed to lever, take exposure in markets where they are not supposed to take exposure, avoid taxes, take on side bets in markets where they have no economic interest. I go through some of the uses of derivatives for gaming and gambling in my Senate testimony from June.

Do innovative products promote capitalism?

The answer to this is yes and no. We get capitalism when things are going well, and socialism when things are going poorly. I went through this in a recent post.

Innovative products are used to create return distributions that give a high likelihood of having positive returns at the expense of having a higher risk of catastrophic returns. Strategies that lead to a ‘make a little, make a little, make a little, …, lose a lot’ pattern of returns. If things go well for a while, the ‘lose a lot’ not yet being realized, the strategy gets levered up to become ‘make a lot, make a lot, make a lot,…, lose more than everything’, and viola, at some point the taxpayer is left holding the bag.

If we were to look at the sorts of strategies employed by large investment firms and banks, my bet is would see a bias toward short volatility, short gamma, short credit and short liquidity. All facilitated with innovative products – you can’t really do the first two without some form of derivative – and all leading to these sorts of return characteristics.

This was a debate, so we all took the polemic positions. Though the positions were assigned based on our pre-existing views. I am not so extreme as to hold that all innovative products, even those that do fit in the {complex, customized, opaque} corner, are devoid of value. But just because we are able to take some cash flow and turn it into an instrument doesn’t mean we should. Here are three questions we can ask to determine if a new, innovative product makes sense.

Is there a standard, simple instrument that could do the job – either one that already exists or one that can be created.

Is the primary purpose of the new instrument to meet economic objectives (i.e. helping to get capital to the producers or helping producers layoff risks) or to meet non-economic objectives (i.e. gaming the system, making side-bets on the market).

Does the instrument create negative externalities; on the margin does it increase the risk of market crisis, by making the market more levered or complex?