I was asked to comment on the Goldman situation on the early show Monday on Bloomberg TV. Thankfully I won’t have to be in their studios at 6:46 AM, but it did leave me searching around for a picture they could put up on the screen.
Though not as successful at having no photos as JP Morgan, I can say that I’ve been photographed relatively few times over the years.
I could make up some story about childhood trauma, but the truth is that I don’t like being in photographs.
The producers are going to have to deal with what I had on hand….. I suggested they say I’m on a gardening holiday, the way they do in the UK, to which end I sent them photos of my garden and myself on my next-door neighbor’s tractor. I hope they do it. Business news is far too stuffy, anyway.
Will my words mean more if I’m wearing a jacket and tie?
They called me because their print reporter Jody Shenn and I talk fairly frequently, with the most recent conversation about whether CDO managers were purposefully reinvesting in garbage.
I pointed out that 2004 and 2005 vintage deals that required several years of reinvestment are trapped by a market where spreads grind narrower.
That is also a problem for amREITs, pension funds, insurance companies, and anyone else who doesn’t have a choice about being invested for the long term, and has to be long the market.
But some will say it must be a good thing when spreads tighten, because that means the bonds you already own gain in value. As far as it goes, they do. But most of the types of investors I mentioned have to pay their liabilities long after the current portfolio matures, so reinvestment is part of the management equation.
Sadly, here’s where the credit cycle works against the bond investor. When everyone is frightened to death and suffering horrible liquidity (eg September 2008 through March 2009), everything trades impossibly cheap. In fact, any truly credit-exposed paper traded to handsome equity return levels during the crisis. You might say that was because there was no leverage, so everything other than government paper basically had to be owned as a pure equity purchase.
But I was talking about the top of the market, not the bottom. As the perception of risk declines and systemic liquidity increases, the higher risk assets (junk bonds, or subprime mortgages, for example) trade to lower and lower spreads vs LIBOR or other near-riskless rates.
Managers who ran deals made out of decent quality loans or bonds in 2004 were faced in 2007 with a situation of either choosing to set the deals on a course for guaranteed insolvency by replacing single-A credits with new single-A purchases, or by taking their chances that BBB or lower credits might not default.
Think of a CDO as a robotic bank. All the rules are set up in advance, and the option of working with borrowers in trouble is basically not among the rules. The reinvestment rules allowed some flexibility in choosing new investments as old ones rolled off, but not much. In particular, choosing to invest at L+50 as your L+120 bonds mature is not an option if the CDO structure requires L+78 to pay the CDO bonds.
Worse yet, most CDO deals are set up to protect the most senior bonds if things get bad (“triggers” are violated). These triggers include the average rating of the debt held in the portfolio, the balance of the portfolio bonds, and the net yield (spread) that portfolio throws off.
If certain triggers are violated (principal or interest coverage being among them), most deals start paying all available cash to the most senior bonds. The issue is that the most senior bonds are also the lowest cost bonds. It would be like a family dealing with a job loss deciding to pay every available dollar to accelerate pay down on a low-cost mortgage while continuing to borrow even more from high-cost credit cards.
In short order they would owe so much that even if the bread-winner got a decent new job, the debt service might be unbearable. In the CDO business we called it a “death spiral”, and very few deals survived, even when the underlying junk bonds or mortgages recovered and began paying on time again.
So, rather than fail the debt-service trigger tests, a CDO manager had to buy the stuff that was yielding more than L+100 in 2007, even if he knew it was garbage with much higher risk.
With the Magnetar and Goldman/Paulson trades going on, an enormous additional load of buying pressure kept spreads tight right through most of 2007 when a “normal” debt market would have been free to begin pricing in the additional risk.
But as we now know, those deals, tens of billions in size, were designed to fail. The collateral damage was the deals and managers and portfolios who were trying to buy good bonds and invest for the long-term benefit of their investors.
But some still think that the winners in the poker game have no blame, only the losers.
I wonder what kind of questions they’ll ask Monday morning.
By the way, I saw an interview with the authors of 13 Bankers. They get most of the joke.