CDOs are the topic of the week - possibly the month - among economics bloggers, with rapidly-spreading prophecies of some sort of crash, as the Bear Stearns business continues to work its way out.

The BIS speaks: misjudging the degree of correlation in a portfolio, even slightly, can make your predictions of portfolio risk all but useless.

And, following on from yesterday's post, Felix Salmon worries that the wrong end of the stick is being got:

CDOs are securities – not derivatives – which are very, very rarely traded. As a result, they're often "marked to model" rather than being marked to market. That seems to be the problem that Patterson's column is concerned about, and it's silly for him to be complaining about derivatives in this regard.

It's true that the troubled Bear Stearns funds did invest in some derivatives – mainly bets on the direction of the ABX.HE index of subprime bonds. Those investments rose and fell in value very transparently, and were by far the easiest part of the Bear portfolio to unwind.

So let's not start blaming illiquid derivatives for Bear Stearns' problems. Right now, illiquid derivatives are the least of anybody's problems.

Risk 20 is now at the printers and will be reaching subscribers soon. Look out for our interviews with leading derivatives players of the last two decades - Robert Merton, Myron Scholes, Lee Amatis, Connie Volstad, Allen Wheat and many others. Also the Derivatives Dustbin - which big ideas have fallen flat in the last 20 years? As well as a special set of Risk Awards - due to be presented at the anniversary event next week.

The continually-fascinating question: why are the world's economies so much less volatile now than they were before the 1980s? Better central bankers, says Brad DeLong.

There have been plenty of crises --

Saddam Hussein’s invasion of Kuwait in 1991 shocked the world oil market. Europe’s fixed exchange rate mechanism collapsed in 1992. The rest of the decade was punctuated by the Mexican peso crisis of 1994, the east Asian crisis of 1997-98, and troubles in Brazil, Turkey, and elsewhere, and the new millennium began with the collapse of the dotcom bubble in 2000 and the economic fallout from the terrorist attacks of September 11 2001.

So far, none of these events — aside from Japan starting in the early 1990s and the failures of transition in the lands east of Poland — has caused a prolonged crisis.

The reasons? Good luck, clever central bankers, and longer-term capital in the markets.

Mark Thoma adds his own list:

Better technology, e.g. information processing allowing better inventory control and management

Better policy, e.g. inflation targeting

Good luck so that no big shocks hit the economy

Financial innovation and deregulation

Globalization leading to dispersed risk

Better business practices

Increased rationality of participants in financial markets

Demographic shifts

And one of his commenters notes that we heard all this back in the 1960s, too, and look how that ended up.

Another hedge fund - Galena Street, run by Braddock Financial in Denver - is closing down after taking losses in the subprime market, the WSJ reports (via Calculated Risk). United Capital has suspended redemptions from four of its funds in an attempt to arrest a surge for the exits.

(Update - 6 July: Braddock Financial, which runs the Galena Fund, writes to say that they are also suspending redemptions in order to manage an "orderly and voluntary liquidation".)

Knock-on effects? Right here - with the Swedish state pension funds which invested not only in the two collapsed Bear Stearns funds, but also in Amaranth and Latitude. Ouch.

(The market isn't exactly jumping all over those Bear Stearns funds, by the way. The FT writes: "Investors in the worse-hit of two stricken Bear Stearns hedge funds are offering to sell their holdings for as little as 11 cents on the dollar but still finding no buyers, according to unfilled trades on Hedgebay, a secondary market for funds.")

And, from poor decision making to crime: two indictments in New York for insider dealing on options. It's a rising trend, Bloomberg reckons. (see also here and here. I wonder if this is a followon from the SEC's massive data trawl last year?)

UBS has lost its CEO, Peter Wuffli; though his ally, chairman Marcel Ospel, wanted to step down in his favour, the board said no. So Ospel (who's 54) is staying at his desk for another three years, deputy CEO Marcel Rohner has been moved up to CEO, and Wuffli has left.
Felix Salmon is dissatisfied:

There are three big questions here. Firstly, if UBS has "systematic management succession planning," what on earth is the CEO doing relinquishing all his duties overnight in what is clearly a surprise announcement?

Secondly, if the board of directors holds its chairman in so little regard that it is happy to overrule him on something as big as this, why do they want him to serve for another three-year term?

And thirdly, is firing a 49-year-old CEO really the best way to "institute generational change"?

Answers: first, UBS did have a systematic succession plan (Ospel out, Wuffli up); the board just didn't like it. Second, good question. Obviously Ospel has redeeming qualities - for one, clearly, the ability to knuckle under and do what the board tells him rather than resigning. Third... well, third isn't too important - Rohner is 42 years old. Does that count as a generational shift? More important is the ultimate successor for Ospel. He'll be at least 57 at the end of his next term; if Rohner moves up, that'll be a real shift.

The unanswered question is: Ospel made his succession/retirement proposal a year ago, and the board's only just turned it down. What's happened in that time to make Wuffli suddenly less appealling? The best candidate is the Dillon Read Capital Management failure. Salmon says this doesn't seem enough to fire Wuffli - and I tentatively agree - but the board could well see it as reason enough not to promote him. And Wuffli would then have had little option but to resign. Up or out.

Ironic, really. Ospel, who wanted to leave, is browbeaten into staying; Wuffli, who wanted to stay, is given the push. There is a literary precedent...

Following the expanding and continuing US crisis, the FSA has looked at the UK's subprime mortgage market. Details of their findings: here. Short form: not very impressive. Subprime customers have been sold unaffordable or unsuitable mortgages; firms haven't been monitoring their customers properly; policies are unclear or non-existent - all the hallmarks of an industry going after short-term commissions and hence riding for a fall. Five subprime firms are now facing enforcement action. (And it's not as though this is a few unrepresentative bad apples; the FSA looked at eleven firms representing half the total market.)

This is, basically, an example of why you need regulation. The main political motive for regulating the subprime market is very likely to protect subprime borrowers, not lenders - but, as it turns out, by not following rules designed to protect their customers, the lenders have been storing up trouble for themselves as well in the form of (potentially) lots and lots of non-performing loans. Self-interest doesn't always work to stop lenders - or indeed anyone else - doing stupid, self-destructive things.

Forbes notes the drop in lenders' share prices after the news came out.

Robert Waldmann points out a neglected potential source of carbon credits...

European carbon emissions credits cost over 20 Euros per ton of CO2.
Hardwood pulp wood costs about $8 an English ton in Mississippi so about $8.80 per metric ton. Carbon could be sequestered by burying the wood in the desert in permafrost or sinking it deep in the ocean. How much would this process have to cost to make it a less attractive option than reducing carbon emissions in Europe ?

A few points come to mind: first of all, sinking it in the ocean probably isn't too practical, as a) wood floats and b) the ocean floor is not a dead zone; even if you tethered baulks wood to big concrete blocks, say, it would rapidly get eaten or rotted away, and the carbon would return to the atmosphere.
This is also a problem, to an extent, with other means of sequestration. Buried wood rots. Wood dumped in the desert may not last long either - certainly, if it's left out in the open, decay organisms will get to it. The desert isn't as dead as it appears. Buried in permafrost, wood will last a long time - as long as the permafrost lasts, that is. But do you really want to construct a sort of immense reverse mining industry in the Canadian Arctic? Because the polar regions are really the only place you can leave wood lying around and not expect it to rot.

I've taken a look at his maths. Wood is roughly 50% carbon by dry weight. So a tonne of wood give you 0.33t of water, 0.33t of carbon and 0.33t of everything else - for $24. Meanwhile, one tonne of CO2 emissions - for €20 - represents 270 kg of carbon (the rest is oxygen), which you could buy in the form of 0.81 tonnes of wood, costing you €4.76.

The numbers look good, but I suspect the storage issue is the problem. Not insoluble - but not easily brushed aside either.

Standard & Poor's has put 612 (repeat: 612) classes of subprime-backed RMBS on watch for a downgrade - all from late 2005 and 2006. And things are going to get worse:

At this time, we do not foresee the poor performance
abating....New data reveals that delinquencies and foreclosures continue to accumulate at
an increasing rate for the 2006 vintage. We see poor performance of loans,
early payment defaults, and increasing levels of delinquencies and losses.

As a result, Doug Duncan, chief economist for the Mortgage Bankers Association (MBA), is expecting as many as 600,000 home owners will get into trouble with perhaps half of them actually losing their homes.

Both are worth reading in full. Nouriel Roubini comments:

the financial fallout (to residential MBSs, mortgage related CDOs, ABX indices and even to broader corporate credit spreads) of the worst housing recession in decades is only beginning.

In the latest issue of Risk, Nicholas Keifer looks at the probability approach to estimating default probabilities. Conclusion: generally useful, but careful around extreme cases. Discuss the paper below.

Also: Moody's have followed S&P and downgraded a large number of mortgage-backed securities.

The FSA has been making much of its shift from "rules-based" to "principles-based" regulation - noteveryone is in favour, though. On Tuesday I talked to a couple of partners at Allen & Overy, Bob Penn and Calum Burnett, who spent almost two hours explaining their distaste for the move.

Key quotes:
"We are losing the idea of consultation - policy is just being laid down by the FSA in a range of documents such as speeches, Dear CEO letters and discussion papers"

"The big benefits will come to larger firms - the smaller ones are not resourced or sophisticated enough, and have insufficient contact with the FSA, to get to grips with what the principles mean for them."

"A lot rests on the attitude of the FSA to enforcement - it's hard to predict at this stage what their approach will be. Recent consultation, policy and discussion papers are changing to be more prescriptive as to how the FSA think principles translate into real-life situations - for example, the recent papers on funds of alternative investment funds and treating customers fairly. They appear to be putting firms on notice of their expectations of them through informal channels which have not been necessarily subject to rigorous internal review. It's potentially quite a worrying development."

"The FSA's sending very divergent messages - implementing detailed rules (particularly under MiFID and the Capital Requirements Directive) while trumpeting the movement to principles-based regulation. The timing with MiFID is unfortunate."

"Detailed MiFID requirements are very much at odds with what the FSA is trying to do with principles-based regulation. The FSA is effectively hamstrung, but they can't do anything about it."

...is another way of saying "Russian roulette bonds" - they tick along very nicely most of the time, until something goes wrong, then they blow the contents of your skull all over the wallpaper.
Via Alea, a paper discussing pricing of negatively-skewed structured instruments - which give a steady yield most of the time, only to fail in times of severe economic stress (a drawback often ignored - see extensive discussion here). Key insight:

We show that many structured finance instruments can be characterized as economic catastrophe bonds, but offer far less compensation than alternatives with comparable payoffs profiles. We argue that this difference arises from the willingness of rating agencies to certify structured products with a low default likelihood as “safe” and from a large supply of investors who view them as such.

Also today, from CFO.com - that credit crunch we are all waiting for doesn't seem to be getting much closer - speculative-grade default rates just fell again!

The cliché in this case is "awash with liquidity" - one that Risk has managed to avoid so far. Robert Schiller asks - what does this phrase actually mean?

Traditionally, "awash with liquidity" would suggest that the world's central banks are expanding the money supply too much, causing too much money chasing too few goods.

But if that were the problem, one would cause all prices - including, say, clothing and haircuts - to rise...
Another interpretation is that people are saving a great deal, and that all this money is chasing investment assets, bidding up prices...
But, once again, the data do not bear this out. The IMF's world saving rate has maintained a fairly consistent downward trend since the early 1970s... True, savings rates in emerging markets and oil-rich countries have been increasing since 1970, and especially in the last few years, but this has been offset by declining saving rates in advanced countries.
Another interpretation is that "awash with liquidity" merely means that interest rates are low. But interest rates have been increasing around the world since 2003...

Read the whole thing to see his conclusion - it's meaningless but significant, if that makes sense; it doesn't convey anything specific about liquidity levels per se, but it does imply that the market is starting to suspect a bubble... (via Economist's View)

As global warming surfaced in US politics last year, the response for both parties was obvious - make more ethanol out of maize. (Making ethanol out of maize, while not a terribly good way of cutting carbon dioxide emissions, is a popular American pastime, because maize is grown and fermented in Iowa, a state with tremendous power in picking presidential candidates...)
But James Hamilton points out that moving to maize ethanol will mean volatile fuel prices: the maize harvest is unpredictable, and about one year in five will see a bad crop that could seriously affect availability. In severe cases, according to a study he quotes, the government might have to impose rationing.

Food prices naturally are quite volatile because unpredictable and uncontrollable variation in weather can produce a bumper crop one year and a big shortfall the next. Usually consumers are able to mitigate somewhat the consequences of the volatility of supply by switching between foods depending on what is most cheap or expensive at the moment. However, whereas the demand for food is relatively price elastic, the demand for gasoline is quite inelastic... Very inelastic demand means that having a stable, reliable source for fuel is a very high priority for consumers. Having the supply for such a commodity depend on something as volatile as U.S. corn production does not seem like such a brilliant idea.

However bad this is for the economy as a whole, it sounds like a good time for soft commodity investors - and especially those who market and sell maize derivatives...

Bill Gross, founder of Pimco, is on top form today - see his recent market commentary, which touches on the abnormally low taxes paid by the very, very rich (whom he refuses to call "high net worth individuals"):

What pretense to assert, as did Kenneth Griffin, recipient last year of more than $1 billion in compensation as manager of the Citadel Investment Group, that "the (current) income distribution has to stand. If the tax became too high, as a matter of principle I would not be working this hard." Right ... Far better to admit, as has Warren Buffett, that the tax rates of the wealthiest Americans average nearly 15% while those of their salaried and therefore less incented assistants just outside their offices are nearly twice that. Far better to recognize, as does Chart 1, that only twice before during the last century has such a high percentage of national income (5%) gone to the top .01% of American families.

and moving on to the subprime crisis, which he predicts will affect the rest of the economy in short order:

the worm started to turn, however, when institutional investors – many of them foreign – began to see the ratings downgrades in ABS subprime space. Could the same thing happen to levered structures with pure corporate credit backing? To be blunt, they seem to be thinking that if Moody’s and Standard & Poor’s have done such a lousy job of rating subprime structures, how can the market have confidence that they’re not repeating the same structural, formulaic, mistake with CLOs and CDOs? That growing lack of confidence – more so than the defaults of two Bear Stearns hedge funds and the threat of more to come – has frozen future lending and backed up the market for high yield new issues such that it resembles a constipated owl: absolutely nothing is moving.

Perhaps I was a little hasty in describing Amaranth as "simply an example of what happens when a highly directional trade goes wrong". Look at this:

Commodity Futures Trading Commission Charges Hedge Fund Amaranth and its Former Head Energy Trader, Brian Hunter, with Attempted Manipulation of the Price of Natural Gas Futures

Complaint Also Alleges That Amaranth Advisors L.L.C. Tried to Cover Up the Conduct by Making False Statements to the New York Mercantile Exchange (NYMEX)

UPDATE: here it is. Also, the full complaint (43-page pdf).

Meanwhile, previous Amaranth posts:
The authors of their own destruction
Interesting reading for Friday
Fawcett: I saw Amaranth coming
More light on Amaranth
Amaranth - news roundup

A paper from Darrell Duffie at Stanford discusses the pros and cons of the credit risk transfer business...

If credit risk transfer leads to more efficient use of lender capital, then the
cost of credit is lowered, presumably leading to general macroeconomic benefits
such as greater long-run economic growth...An argument against credit risk transfer by banks, particularly in the case of CLOs, is that it leads to greater retention by banks of “toxic waste,” assets that are particularly illiquid and vulnerable to macroeconomic performance.
Further, a bank that has transferred a significant fraction of its exposure to a
borrower’s default has lessened its incentive to monitor the borrower, to control
the borrower’s risk taking, or to exit the lending relationship in a timely manner.
As a result, credit risk transfer could raise the total amount of credit risk in
the financial system..

Long, but worth a read.

It's also gratifying that he concludes by quoting this article from our May issue:

Dealers are correct in their assertion that they have a much broader base of clients to whom they can lay off equity correlation risk, says BlueMountain's Siderow. But in his opinion, there remains a big open question over this evolution: "How many of these newer players truly understand correlation risk, and will they stay in the market at a time of great stress?"

If newer, perhaps less savvy, players do bolt for the exit door at a time of market stress, some of the major players are waiting in the wings to snap up equity tranches when correlation levels bottom out. As one correlation trader puts it, a number of major hedge funds are "still kicking themselves" for not buying cheap equity tranches during the correlation crisis of 2005. "I know for a fact that they would dive in and put their capital to work massively if we see that kind of dramatic price action again," he says.

Yet more on Amaranth... The Federal Energy Regulatory Commission called in Amaranth's head energy trader for a little chat earlier this year; after a morning of interviews he left to get some lunch, and proceeded to exit the room, the building, and the country in quick succession, according to the FERC's chairman.

"Brian ended the interview when he and his attorney became aware that the FERC had misrepresented the agenda," said Hunter's spokesman. He certainly did. He now has 25 days to talk the FERC out of fining him, fellow trader Matthew Donohoe and the fund itself $291 million in profits, plus other civil penalties. He's suing to get the case removed from their jurisdiction, as we reported last week.

According to the FERC:

This case involves manipulation of the final, or “settlement,” price of the NYMEX Natural Gas Futures Contract on February 24, March 29 and April 26, 2006, by selling an extraordinary amount of these contracts during the last 30 minutes of trading before these future contracts expired, with the purpose and effect of driving down the settlement price.

Investigators in the Commission’s Office of Enforcement found that Amaranth had previously taken positions in various financial derivatives that were several times larger, and whose values increased, as a direct result of the fall in the settlement price of the natural gas futures contract. Thus, for every dollar lost on its sales of the futures contracts, Amaranth would gain several dollars on its derivative financial positions.