Swaption´s posts

An explanation of the "credit crunch"

2007-10-03T19:39:00.001+01:00

I always belief that I am not a technical person but that I am very good analitically.

I am going to try to explain what created the "credit crunch" (a slang for a general economic condition in which loans are harder to obtain).

CHAPTER 1: SUBPRIME LENDING

Subprime lending is the practice of making loans to borrowers who do not qualify for the best market interest rates because of their deficient credit history. Usually, these borrowers have to pay a higher interest rates on their loans as the default rate (chance of not getting the money back) is higher.

Lenders usually take into account the two scenarios: getting more interest of the same amount loaned versus have a higher risk of losing the money loaned. This creates an equilibrium.

CHAPTER 2: CDOs

Collateralized debt obligations (CDOs) was a financial product been in the market since late 1980s. Essentially, they consist in an heterogenous mixture of debt (loans, mortgages, bonds...) put as a pot, this product is structured in layers (called tranches): senior, mezzanine and equity. The structure of the product works as the folowing, the first to get the hit of a default is the equity, second the mezzanine and third the senior.

Example: An investment of 3 bonds with each valued at €100 with a third in each tranche.
A) Value of the bonds (portfolio) if none default = €300
Senior = €100 Mezzanine = €100 Equity = €100

B) Value of the bonds (portfolio) if one bond defaults = €200
Senior = €100 Mezzanine = €100

C) Value of the bonds (portfolio) if two bond default = €100
Senior = €100

D) Value of the bonds (portfolio) if the three bond default = €0
Nobody gets nothing.

As you can imagine, if you investment in the senior tranche you will receive less interest than in the equity, less risk less money.

Getting the interest for each of the tranches is not an easy job as depending on the assets and relationship among them you get more or less risky senior, mezzanine and equity tranches. The growth of CDO's was due to the development of the Gaussian copula models which allowed to define the interest to each tranche (known as pricing).

The models to price are created by the underwriter (an investment bank) and are reviewed by an independent (a credit rating agency).

CHAPTER 3: Banks start using CDOs

Well, here banks start to think, mmm... we can use these products to get rid of our risk in the subprime lending. We give the money to the borrower, he is our happy client, we take his loan/mortgage and we put in a CDO among other debt instruments, we sell the CDO, we get the money and if the borrower defaults, well is no longer our debt somebody else will take the blow.
This creates what is called a bubble. People were having easy access to the money to buy a house, they were buying the houses, houses were increasing prices, people were seeing prices go up, people were believing it was a good investment opportunity, people wanted to buy more houses, people were requesting more money... so forth and soon.

But well... if the banks are not running with the risk... who is?
Two agents: hedge funds & pension funds.

CHAPTER 4: Uncertainty about the investments in CDOs

Something was going wrong around 2006. The Fed was raising the interest rates what means an increase in the payments for those people with mortgages. As people was having difficulties to pay their mortgage more houses were given to the market in order to sale. Real Estate prices were starting to decline.
This is usually the end of bubbles, economic conditions change so borrowers can´t meet their financial commitments and lenders have to take the asset (house) but as the price has drop they can recover their investment.

However, the value of the CDOs did not change significantly. One would assume that if the subprime mortages were losing value, the CDO should be also losing value, that is true... but the value of the CDO is determined by a model we have seen in Chapter 2. What happens if you input the new subprime mortgages into the model and the output is a similar price as before? The model is working or is it wrong? The longer it takes the more belief grew that the models were not accurate.

That was like a russian roulette... you are hearing the clink, clink... and there will be a bang, but until the bang let´s be quiet.

CHAPTER 5: Clink, clink... baaaaaaaaang!!!

Minor companies were having problems, but at least big names were not affected. Just a few black sheeps in the big herd.

On June 22, 2007, Bear Stearns, the fifth-largest U.S. securities firm, found the bullet.
Two of his funds, the Bear Stearns High-Grade Structured Credit Fund & the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund had troubles.
On July 18, 2007, Bearn Stearing said that its two failed hedge funds had little if any money back after "unprecedented declines" in the value of securities used to bet on subprime mortgages

The message was that it was an isolated case, but within the market everybody knew it won´t be the last one. More minor players were falling and uncertainy grew as Bearn Stearns could not recover as much money as expected from selling his CDOs (some CDO when they reach a certain value must be decommisioned by contract, so the bank had to sell the assets to the markets, the money they got was a lot less of what the models was saying it was worth > conclusion: models were not accurate).

On August 8, 2007, BNP Paribas decided to freeze three of their funds as the valuation was not appropiate. Also, there were rumours that Goldman Sachs was having troubles with some funds.

CHAPTER 6: The "credit crunch"

Imagine the situation, you are bank and you are lending money to other banks, funds, etc. You are hearing about these problems, some players are defaulting... are you going to give money as easily as before? Or you will start looking for more guarantess and receive more interest for the money you are lending to others?

Yes, so everybody took the same option, let´s think it twice, let´s ask for more guarantees and let´s ask for more interest. Nobody was giving money, and as a result the interest rates were rocketing.

You can draw a picture like the below one obtaining the historic rates for Euribor or any other interest rate.

The Central Banks (more or less the government) decided to intervene. If nobody is lending money that will an armageddon, somebody has to put the oil in the market or otherwise the machinery will grip and the whole financial system will collapse.
So the Central Banks started lending money in behalf of the old lenders. You can see big movements in the short term interest rate, these are central banks interventions giving money to the market and lowering interest rates.

On another scenario, more and more CDOs were dissolving and selling their mortgages into the markets. Prices were going down. What was the reaction of the market? We don´t want to hear about buying any product with mortgages inside. A market with lots of sellers and no buyers. Looks great?

CHAPTER 7: Northern Rock fall

The Central Banks were lending money to the markets... well except the Bank of England. The governor of the Bank of England, ervyn King, took a brave approach, those who are suffering now from the crisis are those who run into riskier businesses and must pay the price of being riskier.
Otherwise next time if being riskier does not have a price everybody will play the russian roulette again.

One on those was Northern Rock. The business model was the following:
A) We lend money to our customers to buy their houses.
B) We pack those mortgages and put a nice ribbon on the top.
C) We sell the packet to the market and get money.
D) With the money we do again step (A)

But now, the scenario was different, markets were not willing to buy these mortgages packets. The bank had to go to the market to ask for more money and more to keep the engine running, and then, interest rates start rocketing and it was more and more expensive to get that extra money.

On 13 September 2007, Northern Rock asked the Bank of England for help, it needed extra money for attending its demands. It was not a problem of not having the assets to cover its liabilities, it needed money to cover its short-term payments.

Next day, queues of people were asking for their money in the Northern Rock branches. The bank could be healthy, but if you stay at home and all the customers go and take their money at some point the bank runs out of cash (it invests your money in loans, mortgages, bonds... it does not have your cash in the coffers, banks make money investing your money) and then you lose your money. This is called bank run or run on the bank. Northern Rock had to ask for money, in the meantime their reputation and shares plummeted.

I feel like a piece of shit

2007-09-24T20:36:00.000+01:00

I was preparing a more learned post, but it will have to wait until tomorrow.
I need to sublimate my feelings.
I was not promoted!!! Fuck off!!!
I really do not understand anything, my company usually promotes people twice per year, I was included in the present round with effect 1st October but it was depressing to see that two people with less experience and less time in the company were promoted instead.

What shall I do? How I should react? It is an horrible feeling, it is not going to be the end of the world. I am still trying to make up my mind to make me believe this can have its positive consequences for my career, maybe it will trigger some kind of reaction as it happened two years ago.

Who knows...

The Beast of War - Price of learning in terms of honour

2007-09-23T21:46:00.000+01:00

Sometimes one´s mind can predict the future, this post was started prior Monday the 24th where I felt like a shit.

The Beast of War is movie of a tank crew belonging to a Soviet tank unit in the Afghanistan war which destroys a Pashtun village, the tanks gets separated from the unit and enters a dead end valley pursued by a band of mujahideen fighters.

The tank crew is made up of four Soviets and one Afghan. As night falls and the crew sets up camp, the afghan tank crewman stablishes a relationship with the lectured tank driver about the fundamental principles of the Pashtun people's code of honour: melmastia (hospitality), badal (revenge), and nanawatai, which requires even an enemy to be given sanctuary if he asks.

I remember clearly that when the driver asks afghan why he accepts the put down treatment of the commander. The afghan says is "the price of modernity, we have to put up with it to become a developed nation learning from the USSR".

After that the commander asks to send the afghan to measure the depth of a stream, then using a machine gun, kills the afghan.

I feel like the afghan a little bit, I am here in London to enjoy the benefits of being in the invesment banking industry, however, I feel treated like an inferior being who comes to clean the boots of the Queen's bank employees.

And they used the machine gun next day...

The Largest Trading Floor in the World

2007-09-23T20:54:00.000+01:00

Today I found that the largest single trading floor in the World belongs to UBS. It is its Stamford (Connecticut- USA) trading floor.

According to Advanced Trading the floor has 1,400 seats, 2,000 computers and 5,000 monitors. A nice place for traders, sales, quants, technology support, executives and others (auditors as well?) which include fixed income, commodities, currencies, money markets, derivatives, equities, international trading (¿?), algorithmic trading, direct market access, program trading... Wow!

I wonder how many of these people will lose/have lost their job as a result of the Dillon Read Capital Management shut down (yes, I am a cheeky boy!).

See a gallery of photos in the Advanced Trading photo essay.

Pingue atque peregrinum

2007-09-22T16:59:00.000+01:00

Marcus Tullius Cicero made at least eighty-eight speeches during his career (fifty-eight still survive)

One of his judicial speeches is called Pro Archia Poeta
This speech is on behalf of the poet Aulus Licinius Archias who in 62 BC was accused by a certain Gratius of having assumed the citizenship illegally. The speech, which furnishes nearly all the information concerning Archias, states that he had celebrated the deeds of Gaius Marius and Lucullus in the Cimbrian and Mithridatic Wars, and that he was engaged upon a poem of which the events of Cicero's consulship formed the subject.

I wish to highlight a part of it:
<26> Quid? a Q. Metello Pio, familiarissimo suo, qui civitate multos donavit, neque per se neque per Lucullos impetravisset? qui praesertim usque eo de suis rebus scribi cuperet, ut etiam Cordubae natis poetis, pingue quiddam sonantibus atque peregrinum, tamen auris suas dederet. Neque enim est hoc dissimulandum (quod obscurari non potest) sed prae nobis ferendum: trahimur omnes studio laudis, et optimus quisque maxime gloria ducitur. Ipsi illi philosophi, etiam in eis libellis quos de contemnenda gloria scribunt, nomen suum inscribunt: in eo ipso, in quo praedicationem nobilitatemque despiciunt, praedicari de se ac nominari volunt.

You can read the translation here.
Pay attention to the "pingue quiddam sonantibus atque peregrinum" (though their style sounded coarse and outlandish).

Lol, it seems the problems to learn new languages come from far away in time. My ancestors had the same problems in learning Latin that I have in learning English.

Ground beef or minced beef: Disgusting fact

2007-09-21T03:39:00.000+01:00

I always knew minced beef was not a healthy product, but is perplexing to see how unhealthy really is.

I realised that when you cook it in a pan some water usually came from the frozen beef and messed with my olive oil. But as one my flatmates explained me it is not water... it is bloody fat!

I thought he was pulling my leg, how the hell could that increase in liquid be fat melted by the heat? So I decided to let it get cold to see if it solidified and well... it is fat!!! Look what happened when I tried to clean, the water from the tap could not reap the grease... argh!!

Disgusting... I am going to reduce its consumption definitively.

Responsibility and freedom

2007-09-19T21:33:00.000+01:00

I read in the following link:
La responsabilidad tiene que ver con la libertad o autonomía del individuo así como su capacidad de comprometerse consigo mismo y con otros hasta el punto de responder de sus acciones.

Today I have something to highlight (at least, not always a boring life).
I have fallen asleep. :D

I am not really used to hands of the clocks, I grew up using digital clocks in my childhood. So I got a little problem today...
My present clock has a small rectangle with the digital hour, so I use to pay more attention to the digital, I usually guide myself with the minute hand so it was 8:10h, spare time to arrive to work.
Arrive at the DLR station, the carriage is almost empty O_O'... strange check the hour X:47 a bit late but not so late (why I did not see the hour is explained by the psychology of perception).

Arrive to Bank... where the hell are the crowds??? Is there a strike? Anything? Look again. 9:53 oups...

Funny is that nobody realized I was late, that is because my job requires lot of autonomy... in those situations I wonder why would happen is somebody in my position just eludes responsibility, I know a bunch of people who will not be able to do it, lack of discipline...

On the other hand, if they realized nobody probably would say anything... it happened two years ago in Hong Kong in probably the most embarrassing moment of my life...

The cocktail of life

2007-09-17T22:12:00.000+01:00

- 25% of genetics
- 25% of endowment (education, parents, inheritance, childhood behaviours...)
- 25% stochastic (call it luck or destiny if you wish)
- 25% of your choice

Does it look like a bit gloomy?
Come on! Life is like poker, you do not need the best cards or to win all the hands to beat in the game. ;)

"Cunctator"?

2007-09-16T17:36:00.001+01:00

Quintus Fabius Maximus Verrucosus was a Roman politician and soldier, born in Rome around 275 BC and died in the same city in 203 BC.
He was known as Cunctator ("delayer" in Latin),due to his tactics during the Second Punic War.

His acts were transcribed by Plutarch is his Parallel Lives. Plutarch compared the tactics of Fabius, in the middle of the crisis in Rome, with the ones of Pericles, at the top of the apogee of the democratic Athens. I strongly recommend its lecture, it is definitively worthwhile.

After Rome had a major loss in the Lake Trasimene, where Gaius Flaminius was surprised by an ambush from Hannibal's army, the Senate decided to make Fabius dictator during six months, that meant giving him the absolute power.
Fabius decided not to oppose direct battle to Hannibal, which was a wise move. However, Rome did not agree and he was called several times coward and even traitor. To illustrate the discontent his right hand, the head of equites disobeyed him and went to attack Hannibal almost losing the Roman Army with him.

Six months later, the Senate elected Gaius Terentius Varro & Lucius Aemilius Paullus as consulae, who had the opposite strategy. The output was the disaster of Cannae.

I felt sometimes like being Fabius (with the obvious difference).
Trying to explain what is reasonable with arguments, but people prefer to listen to whom tells them what they wish to hear.
However, I decided not be a Cunctator, they are adults so they make the choices.