Sigh... the biggest problem is not (toxic) bank assets

As strange as it may seem, banks' shitty assets are their smaller problem. Like the AIG saga is showing, the real problem is the size of their liabilities.

Thanks to the CDS market, the big financial institutions have taken to making very, very, very large bets on supposedly highly improbable events (ie, they's get a fee upfront and would commit to make a big payout if the unlikely event, say the bankruptcy of Lehman Brothers or AIG, happened). CDS were initially created as a risk-mitigation instrument, and they can certainly be used that way (for instance, if a transaction depends on a large payment by Lehman Brothers, it may be useful to buy the additional protection to guarantee the amount of that payment from someone else, typically a highly rated entity like AIG (used to be), should Lehman fail). But they turned out to have two great advantages:

• they were a totally unregulated way to release regulatory capital: since you don't take the risk on Lehman anymore, you can re-use the amount you'd have normally needed to set aside for that exposure (apparently the regulators forgot to note that you took exposure on someone else instead for that amount, even if that someone else was highly rated); by using capital more than once, you can boost your returns;

 

• they were a totally unregulated way to make bets: you did not need to have an actual need to hedge a position to purchase (or sell) them, which allowed you to bet mutliple times the amounts you could have under normal regulations on a given risk. By taking risks that were considered extremely low (like AAA rated risk) in high enough concentrations, you could make good income for (what was perceived as) no risk - or at least for no cost in equity;

So lots of financial players started taking those huge bets on supposedly unlikely things happening - with commitments to pay huge amounts should these things actually happen.

For those players, the CDSs are not assets, they are potential liabilities. They booked the upfront fee right away, are maybe getting a smallish yearly commission as income, and have this potentially huge payout to make if something bad happens to some company or asset.

Again, to get an idea of what kind of leverage we're talking about, read this article about John Paulson in last week's Economist:

Another motivating factor for Mr Paulson was the alluring asymmetry of shorting credit. The most you can lose is the spread over some benchmark rate. Yet if the bond defaults, the gains can be mouth-watering. He targeted BBB-rated tranches, the lowest in subprime securities. With credit spreads so low because of a liquidity glut, his possible upside as a buyer of protection using credit-default swaps (CDSs) was as much as hundred times the potential downside. One $22m trade is said to have netted him $1 billion when Lehman Brothers went bust.

And well, there were three problems:

• One was that these unlikely things were not that unlikely (or, in any case, not as unlikely as suggested by the price used to take the risk). People tend to have trouble allocating proper probabilities to rare events, and bankers seem to be no better (go read Nicholas Taieb's Black Swan);

 

• the second was that the "virtuous circle" effect of bubbles further distorted perceptions (asset prices are rising, people borrow more, they buy more assets whose prices go up; they can borrow more to repay earlier loans by backing that with rising collateral, thus reducing default rates, which encourages banks to lend yet more, etc...). All the securities that were seen as not risky at all in a bubbly environment were maybe riskier than they seemed. How could there be only 12 AAA-rated companies in the world, and 64,000 mortgage-backed securities with that same rating?

 

• the third was that the very use of their instruments, and their heavy concentration in the hands of a small number of players actually created new risks that did not exist before. AIG could have survived underwriting a few billion of CDSs, but not 500 billion-worth of the stuff.

And of course it now turns out that, as should have been obvious (and was to people like John Paulson) these CDS were, in more than a few cases, very, very bad bets. And the number of cases is growing rapidly as the crisis gets worse and hits more companies and reduces more assets' values. Which means that those that underwrote these CDSs are faced with large - and mounting - bills.

Thje size of these bills potentially dwarfs the size of the toxic assets they are also saddled with.

And as the risks are increasing (or seen as increasing which may or may not be the same thing), those that underwrote the CDS are seen as increasingly weak, and those that bought the protection, or took naked bets (but how can you tell - this is all unregulated anyway), suddenly worry about their CDS counterparty in addition to worrying about (or hoping for, in the case of naked bets) the underlying insured event to happen. That CDS counterparty being, of course, a (until recently) highly rated financial institution.