My head feels like mush.? I have been struggling over creating a CDO pricing model with the following features:
- A knockoff of the KMV model, using equity market-oriented variables to price credit.
- Uncorrelated reduced discrepancy point sets for the random number generator.
- A regime-switching boom-bust cycle for credit
- Differing default intensities for trust preferred securities vs. CMBS vs. senior unsecured notes.
Makes my head spin, but at least the credit model is complete.? The rest of the model can be done tomorrow.
Ugh, so what was I going to talk about?? Oh yeah, the short term lending markets.? So the ECB makes a splash by showering temporary liquidity on the short end of the market.? That will reduce Euribor-based rates, but not US dollar-LIBOR based rates.? Check with Dr. Jeff for more on that.? Now, Dr. Jeff and I might not agree on the significance of this move, because I discount temporary injections of liquidity.? What will happen to liquidity conditions when the temporary injection goes away?? My view is that they will go back to how they were before the temporary injection.? The only way that would not be so is if the temporary injection somehow changes the willingness of parties to take risk, and I think most large investors can see through the temporary nature of the injection.? The ECB can keep short-term Euribor down for a while, but unless they make some of the injection permanent, conditions will revert.? People and institutions can’t be fooled that easily.
Topic two: the WSJ article on the credit crunch.? The author posits two disaster scenarios:
- A financial guarantor going down, or
- Many money market? funds? “breaking the buck.”
Here’s my view:? The financial guarantors have been too profitable for too long.? There will be parties wiling to recapitalize them, though not necessarily at values that make current equityholders happy.? They are not going broke; the major firms will be recapitalized.
Regarding the second fear, a few money market funds will break, but the wide majority of money market funds won’t.? Most short term debt managers are highly conservative, and don’t take inordinate risks.? To do so would threaten their franchise, which would be stupid.
Things are not good, don’t get me wrong, but it would be very difficult to destroy most of the investment markets on the short end of the yield curve.? Away from that, the actions of the ECB will only have modest impacts on USD-LIBOR.
David — The central banks are not trying to fool anyone about the nature of their intervention. Your comment is making me realize that I am doing no better on trying to explain this than the Fed did.
Stock investors are starting with the presumption that more permanent liquidity is needed. The Fed does not agree. Many of the authors I cited point out that the money is there to lend, but is not getting to the right places.
Let us suppose that the Fed had cut another 25 bp’s. It would have had no effect on banks’ willingness to lend to each other and would have been no help to those with “suspect” collateral. Some of the lending is with banks not subject to FAS 157, we should note.
The central banks instead have chosen a targeted approach to a temporary problem. You can expect to see it repeated as often as necessary until the situation becomes more normal.
It is working better than the discount window initiative, and with the same objective.
On another front — we all look forward to your CDO pricing model!
Jeff
Hi Dave
Sounds like you have your work cut-out for you on the credit model. I have a question that I haven’t heard discussed about leverage. On looking at the Fitch Deratives website, there are three Citi SIV’s that were rated. They were described as having 15 X leverage. Now that Citi is going to bring these assets back to their balance sheet what happened to the leverage?
Could they have wound it all up since August? Are the SIV’s still alive but have an additional CDO in them that would act like an IOU?
Thanks for such a cogent blog.
Louie
What a model tease…
Curious: what tool do you use to price CDO (matlab? Excel not enough?)? Will you be sharing it? it sounds really cool…
Jeff,
I don’t think you and David are too far apart, except on one point. David is taking the view that the ECB injection is a one time, temporary action, as they stated, and hence not a permanent injection, which he seems to think (and I agree) would be a positive step, and bullish for financial assets also.
You are taking it one step further, and assuming that the ECB is willing to make another temporary injection after this one, if necessary. And another after that, if necessary. I’m sure I must be paraphrasing somebody here, but if something temporary keeps on being done, then it becomes permanent. Hence, you and David seem to agree, except on the assumption of whether this is a one time action.
Personally, I think that both the ECB and Fed need to do a lot more, especially injections of the permanent variety, but unfortunately they haven’t called and asked me for my view, so I’ll react to them, rather than vice-versa. LOL
Steve
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Dr. Jeff: When I say, “fool” I don’t mean that the Fed is trying to hide what they are doing, but that they are hoping to do something and reverse it all out, changing the system to a new state in the process with no net action. So far, I seem to be wrong.
Mr. Harper: My model is in Excel, and is the property of my prospective employer. I had to do the thing by hand, with few tools to aid me, so it is more crude than I would like. I might reveal some results here, but I’m afraid I can’t reveal the model in detail.
Louis — the leverage comes back to Citi. Sad that they were playing accounting games by keeping assets off the balance sheet, but that is what they did. Now they get to realize the pain from bad lending decisions.