The emperor's clothes

April 29, 2010 in Finance

One of the problems with the latest mess is that the financial press and more specifically financial bloggers have built up a considerable amount of “[wall] street cred” through accurate and intelligent reporting on the financial crisis. In one sense, it’s amazing that they were able to gain such a foothold (I humbly include TGR) by doing nothing more than explaining what was happening on Wall Street without holding any punches – it really speaks to how limited/timid traditional financial reporting was. Most of the discussion centered on new but relatively simple concepts like “capitalization”, “liquidity”, “debt” and – for the most daring – “CDOs”.

But now the ABACUS deal has thrown a wrench in the process. We have reached a point where the nuances of these structures are so fine that the casual observer/blogger/reporter is oblivious to their significance. But we have also established an oligarchy of financial journalists/bloggers who form the authority on the ongoing recession. The problem arises when we collectively rely on those authorities for information they are not qualified to distribute. In that sense the internet is serving very well as a means of collecting and aggregating information (such as ABACUS pitchbooks) – and very poorly as an echo chamber of bad commentary and groupthink (such as ABACUS analysis). It’s not the first time this has happened – I’ve gone to task with the community a few times before. But now it is reaching a critical mass.

I began to think this more specifically last week when the NYT ran a bunch of silly stories claiming to expose Goldman Sachs’ fraudulent ways to the tune of just $2mm in some cases (none of which were, in fact, fraud and none of which were, in fact, remotely outside normal or healthy business practices). A friend in the know confirmed that he thought the stories were pure linkbait, and was surprised they did not anticipate the traffic caused by the GS hearings (the site went down).

Most recently, we have this post from James Kwak, who is quite esteemed in the economic blogging community. In it, he declares that ABACUS was not a CDO nor even a synthetic CDO. No, it’s a synthetic synthetic CDO. The distinction is more than redundant – it is wrong. But it has not stopped Kwak from using it as the basis for his ongoing argument, as here.

But Kwak was himself basing his argument on this post from Steve Randy Waldman, who hasn't got his head around this ABACUS thing. How can be there be no equity tranche? The term “synthetic” should be the tip off, but no – this must be a synthetic synthetic, since in his experience no synthetic tranche works this way.

Unfortunately for their attempts to obfuscate this deal, in my experience, all synthetics work that way. The reason the synthetic market arose in the first place was so that banks could avoid holding un-sellable parts of the CDO capital structure on their balance sheets – through synthetics, they can choose to hold/sell only the tranches they want exposure to. And most importantly, the distinction between “funded” and “unfunded” is silly – it is merely a choice between purchasing the tranche as a bond or as a derivative, with slight risk implications (different convexity profiles) and large balance sheet implications (namely holding risk on or off the balance sheet).

To be fair, there is a difference between the ABACUS deal and the classic textbook synthetic CDO. In the latter, CDS is sold on all of the issuers in the reference pool and noteholders agree to take responsibility for certain tranches of that insurance. In the ABACUS framework, CDS is sold on certain tranches of the reference pool and noteholders take responsibility for their entire insurance swap. The distinction is largely arbitrary; the textbook case is used because it has a more direct analogy to cash CDOs.

So the “synthetic synthetic” label really bothers me. It means that a) we have sufficient understanding of what’s going on to see that the whole capital structure isn’t represented but b) we lack sufficient understanding to communicate that observation without introducing another layer of abstraction. One wonders how many pages it would take these bloggers to explain the CDO squared civil lawsuits that are surely on the horizon. Is it some basic need to re-establish the blogging hierarchy by claiming that “my post will explain this confusing product” but actually cloaking it in further mystery? I would have thought such tactics belonged solely to Goldman Sachs...

I’m getting increasingly nervous about the stock we put in the ability of these “experts” to disseminate real information when it comes to non-macro factors. I dislike the extent to which the public has outsourced reasonable discourse to this hegemony. It’s time to notice that the emperor might not be wearing any clothes.

Here ends the rant. Please note this is not an argument in favor of any specific position on ABACUS (my opinions lie pretty in line with the consensus); merely a call for clarity.

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