Yesterday, at Bear Stearns, bad things were happening. 650 people lost their jobs, trekking one at a time down the stairs to the exit from the entire floor that HR had occupied for the day's meetings, as the rest of the staff waited to hear what was happening. And they won't be the last, writes the LSE's Willem Buiter this morning.

...following the massive overexpansion of the financial sector just about everywhere during the past decade, there is now likely to be a retrenchment... through lower employment, lower profits and lower valuations.
From the point of view of the efficient allocation of resources in the medium and long term, the relative (probably even absolute in the short run) contraction in the size of the financial sectors of the advanced industrial countries is a desirable development...

Buiter, of course, can afford to take this Olympian view - it's not as though the LSE is planning to start having severance interviews in the senior common room any time soon. But the general point is a good one - it's easy to become suckered into thinking that the financial sector's troubles will necessarily be mirrored, in both nature and scale, in the rest of the economy. This probably won't happen (with the exception of sectors heavily and directly dependent on it, which basically means US autos and residential construction).

Last week's bout of optimism about commercial property may have been a little premature. Though the numbers are still good, some CMBX tranches have more than doubled, and Bloomberg is starting to talk about a bubble.

For anyone who's confused, Calculated Risk explains - What is subprime? One of the best summaries I've seen so far...

It almost feels like summer in London. The sun's out, the air's warm (by English standards), the national sports team is getting thrashed, and the European Central Bank is once again pumping liquidity into the money markets.
Whatever the central banks did this summer, it wasn't enough - spreads are back out again and volatility's rising. Nouriel Roubini is unhappy about it (again). In a link-laden post he writes:

There is now increasing evidence that the liquidity and credit crunch in international financial markets is back to its summer peaks of August and, in most dimensions, even worse than in the summer...The reasons why the massive liquidity injections and policy rate cuts by central banks have miserably failed are clear... we are facing a credit/insolvency problem in addition to a liquidity crunch and central banks’ monetary policy is impotent in dealing to credit problems...

...the odds now favour a US recession that slows growth significantly on a global basis. Without stronger policy responses than have been observed to date, moreover, there is the risk that the adverse impacts will be felt for the rest of this decade and beyond...

The warnings are growing louder - the next big financial problem will come from the US credit card business. Even at the beginning of October, the Federal Reserve (via Calculated Risk) was warning that credit card debts were rising - possibly as a result of the drying up of home equity loans. Delinquency rates are rising too.
Problem is, with the drying up of every form of available consumer debt, US consumer spending (heavily dependent on easy credit) could dry up too. A consumption slowdown will mean a hard landing recession, predicts long-standing (and accurate) bear Nouriel Roubini. Not good for anyone... but, as we pointed out on Risk News, the picture's unlikely to be as bleak anywhere else as it was in subprime.

By contrast, said Anthony Thompson, Deutsche's head of US collateralised debt obligations and asset-backed securities (ABS), the commercial mortgage-backed security (CMBS) market was likely to hold up well, for several reasons.

"I don't think CMBS will be the next to fall. Subprime mortgages were the wrong loan to the wrong borrower at the wrong time - no other market has that risk. Commercial mortgages were aggressively sold at tight spreads, so we have seen some widening this year, but CMBS investors are relatively savvy with some skin in the game. They are real gatekeepers of risk."

Suggestions that UBS may be dramatically underestimating its exposure to subprime come from Citigroup (ironically...)

While UBS have the second highest ABS CDO exposure, they have taken one of the lowest writedowns.
Clearly, UBS are not marking their assets at current market prices, and are still heavily relying on marked to model prices...

And the Citigroup CDO liquidity put gets attention from Peter Cohan:

Fortune has added a new phrase to my vocabulary: liquidity puts. In an interview with Citigroup Inc. (NYSE: C) Chairman Robert Rubin, liquidity puts are defined as the right of Collateralized Debt Obligation (CDO) holders to sell back the CDO to its issuer at the original price. The liquidity put is responsible for the $25 billion worth of CDOs on Citi's balance sheet...

you might think the existence of the put would make it impossible for Citi to get those CDOs entirely off its balance sheet. But in fact Citi found a complex accounting rationale for doing exactly that, and the CDOs jumped entirely to somebody else's balance sheet. All that remained in Citi's realm was this sticky little matter of the puts - which, as we shall immediately see, ultimately worked to get these CDOs right back to their creator, Citi. Last summer, with the whole world suddenly unwilling to finance CDOs, the holders of the liquidity-put CDOs began to return them to Citi. And that's where they now reside...

Some quick links today - Bloomberg catches up on some more unfortunate SIV investors - the Jefferson County, FL, school board?

``Municipalities shouldn't be playing like they're expert investors, squeezing the last penny out of SIVs,'' Mason says. ``They're making a giant jump into a new product area which has unknown, unforeseen risks.''

Michael Lewis is ready for his closeup at Citigroup:

Before I can responsibly accept the job as Citigroup CEO I needed to ask myself: Am I really qualified?... This led to several seconds of sometimes painful introspection. But once they'd passed I had both my answer (Yes!) and another, even better question: What, exactly, are the qualifications of a Wall Street CEO? Clearly, the boards of directors who hire them don't know, as they keep having to fire them. The qualities and attitudes and skills necessary for the job must be inferred, from the CEO's themselves. Examine these special people closely and you can see why they are so hard to replace. To wit:
-- The Wall Street CEO must possess an extraordinary ability to be paid huge sums of money each year without losing composure.
This isn't as easy as it sounds...

And the FT poses an interesting question: are you a shower of foreigners or a pack of whimpering dogs? Rating agencies are the former, according to various MPs; banks are the latter, according to private equity player Guy Hands.

(Rather quaintly, the FT wrote "some MPs noted 'they’re all foreigners' amid other insults". I'm not sure that calling someone a foreigner is really an insult. Maybe it is if you're English.)

Supposedly, the headline above is one of only two things you really need to know about economics. (The other is "there's no such thing as a free lunch"). A recent study of CEO compensation (summarised here) points out a problem with option grants - asymmetric returns. In very simple terms, a CEO who holds a lot of more or less at-the-money options can either play a low-risk or a high-risk game. If he plays low-risk, he'll fail small - and his options will become worthless - or win small - and make a moderate amount. If he plays high-risk, he may win big and make millions, or he may lose big - in which case, though the company is seriously damaged, he himself loses no more than he would from losing small.

It's that asymmetry, write the authors, that produces high-risk behaviour by CEOs who hold plenty of options.

...the basic purpose of options has been to promote managerial aggressiveness in top executives, even if they sometimes led them "to undertake large-scale risky investments that tended to deliver extreme company performance." What was not envisioned... "was that the extreme performance delivered by option-loaded CEOs was more likely to be in the form of big losses than big gains."

Of course, it's worth noticing, as James Surowiecki does, that the same asymmetry exists even in non-option-based pay packages:

...the perverse effects of performance pay are exacerbated by the fact that big bonuses are often based on short-term performance. Stanley O’Neal, who was recently forced to resign as the C.E.O. of Merrill Lynch, made eighty-four million dollars in 2005 and 2006, a figure based in part on the huge profits that Merrill booked as a result of its forays into the subprime market. Last week, thanks to those same forays, Merrill announced giant losses and writedowns that obliterated most of those profits. O’Neal, however, won’t be giving any money back.

It's not a problem confined to the financial world. "As matters stand now," wrote Lt-Col. Paul Yungling of the US Army earlier this year, "a private who loses a rifle suffers far greater consequences than a general who loses a war". Or, one might add, a CEO who loses several billion dollars.

As the Carina CDO starts to liquidate its assets (an event which apparently caught S&P completely by surprise) it's worth looking at the problem with forced liquidations; not only are you, by definition, selling when you don't want to, but other predatory traders may make matters worse by shorting. Via Alea comes a model of predation risk, that predicts price overshooting (or rather undershooting) during a forced sale.

Sean Park has an idea for a new market - completion risk for large projects:

Building work on the stadium is set to begin up to three months ahead of schedule in April or May, with completion in 2011 to allow for test events, the Olympic Delivery Authority (ODA) said.
I suspect that if you had a market in construction cost and completion date, both would go bid very quickly at £496m and May 2011…and it would be a good bet... It is unlikely that they have accounted for things outside those which have historically contributed to delays and cost overruns. Indeed, there is no way of “scientifically” accounting for these possibilities, and I further suspect if they were to add an arbitrary 50% or more haircut to at least provision for some unknown eventuality, they would never be allowed to do so (by the customer, the accountants, the insurers, etc.) However if there was a traded market price any interested party would be able to hedge this risk...

Very interesting post on the FT's Alphaville blog. Deep within Citi's recent 10-Q, the news that the bank bought $25 billion of CP issued by subprime CDOs.

Most CDOs, of course, don’t normally issue CP. Traditionally, CDOs issue straight tranches of rated bonds. But Citi made CDOs issuing CP good business pre-crunch. You might say that commercial paper CDOs are a scion of the SIV world - using CP issuance to supplement their normal debt issues and create a more dynamic, flexible portfolio, benefiting from low yielding CP.

But also just like SIVs, CDOs need to keep refinancing that CP to pay off upcoming redemptions. But where they differ is that CP issuing CDOs mitigate that rollover risks by using their arranging banks’ as underwriters on all new CP issues. Whatever CP they can’t sell, agreements are in place as backup that ensure banks will buy.

And just like with SIV CP investors, over the summer, CDO CP buyers have dried up.
Money market funds - formerly among the biggest players in the CP markets - are loathe to touch anything containing MBS.

So Citi - unable to place CP on subprime CDOs it arranged as far back as 2005 - is having to buy it instead. Right when it can least afford to do so.

Ouch. And, the writer reckons, this is waiting to go sour on Citi any moment now...

Italian banks are largely insulated from the US subprime crisis. (Good!) But their derivatives operations are still under investigation - reportedly, UniCredit, Intesa SanPaolo, Banca Popolare, and BNP Paribas - according to this report.
No details on the investigations yet.
Background on the problems at Banca Italease here and here.

Banks are now expecting a total of $200 billion losses from the subprime crisis. Will this mean a second wave of writedowns? Yes, according to various observers - Mervyn King reckons it'll take months for the full extent of the damage to be revealed; the IMF's Simon Johnson predicts a second phase of anxiety and possibly further credit tightening.

The FT's John Plender has an idea of what to blame - the Basel rules, which allowed banks to shift assets into a shadow world of off-balance sheet finance, and which put too much weight on complex modelling techniques. Basel II may be an improvement, he says. Or it may not. Alea points out other links in the same vein.

And, briefly:
Investment strategies compared.
Gisele Bundchen - short the USD. Strategy's record so far: good. Annual earnings in 2006: $33 million.
Stan O'Neal - long the US subprime residential mortgage market. Strategy's record so far: catastrophic. Annual earnings in 2006: $48 million ($160 million in retirement package).

Should Merrill Lynch be approaching Ms Bundchen to fill Mr O'Neal's shoes? Well, she'd be cheaper. In more than one way.

Brad DeLong has been reading Riccardo Rebonato's The Plight of the Fortune Tellers and rather likes it:

Rebonato's hammered-home point that the 99.9% value-at -risk for a weekly return distribution cannot be determined. You would need 200 years of data from an unchanging return distribution...The four-part classification of transactions:

* Sold lottery tickets
* Bought insurance
* Sold insurance
* Bought lottery tickets

is very useful, and I wish that he had expanded on it more...All in all, a highly recommended book.

A better understanding of rare events wouldn't go amiss within the industry either - David Viniar, for example.

Meanwhile, correlation funds are noticing the opportunities presented by high volatility. Risk Books' latest publication explores the latest generation of volatility products - Volatility as an Asset Class looks at the gamut of vol products now on offer, covering trading strategies, theory and pricing.

We've been hearing rumours (and more than rumours) of job cuts in the investment banking world for some time now. This week, a lot of the departures seem to have been at the top of the business - Stan O'Neal, of course, and also Michael Raynes and Nestor Dominguez at Citi.

Citi's Chuck Prince, of course, continues to be in the frame - as chairman and chief executive, he bears ultimate responsibility for the bank's misfortune. The FT points the finger elsewhere in the credit department...

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