What is a CDS? Hint: Credit Default Swap

This is quite a horrifying article from Fortune: The $55 trillion question

It’s pretty relevant to my previous post where I compared these instruments to gambling. This is from the article:

So what started out as a vehicle for hedging ended up giving investors a cheap, easy way to wager on almost any event in the credit markets. In effect, credit default swaps became the world’s largest casino. As Christopher Whalen, a managing director of Institutional Risk Analytics, observes, “To be generous, you could call it an unregulated, uncapitalized insurance market. But really, you would call it a gaming contract.”

There is at least one key difference between casino gambling and CDS trading: Gambling has strict government regulation. When you put $10 on black 22, you’re pretty sure the casino will pay off if you win.


Read this article, it’s very interesting. It makes me why no one has gotten up in arms screaming:

Make Credit Default Swaps (CDS) illegal!

It sounds like they are pretty shady to begin with. If some trader has the ability to write a contract via IM or over the phone that has millions or more of potential payouts in the event something happens that would seem to me to be a very substantial breakdown in corporate controls that would trickle all the way up to the CEO – via the Sarbanes-Oxley. Risk of this magnitude should be disclosed to shareholders and ignoring it seems pretty stupid – even if you think bad things are unlikely.

Another great quote from the article:

The CDS market offers no such assurance. One reason the market grew so quickly was that hedge funds poured in, sensing easy money. And not just big, well-established hedge funds but a lot of upstarts. So in some cases, giant financial institutions were counting on collecting money from institutions only slightly more solvent than your average minimart. The danger, of course, is that if a hedge fund suddenly has to pay off on a lot of CDS, it will simply go out of business. “People have been insuring risks that they can’t insure,” says Peter Schiff, the president of Euro Pacific Capital and author of Crash Proof, which predicted doom for Fannie and Freddie, among other things. “Let’s say you’re writing fire insurance policies, and every time you get the [premium], you spend it. You just assume that no houses are going to burn down. And all of a sudden there’s a huge fire and they all burn down. What do you do? You just close up shop.” (Emphasis added.)

How the Bailout could (should?) work:

I’m not sure why everything has to be so complicated. To me, the solution seems quite simple:

  1. Fund a new government entity with $500bln to $750bln. Let them draw it down with $100-$200bln increments if it makes it easier.
  2. Define a what they are allowed to buy: financial instruments (I think these would be CDOs, but there are so many different things floating around I’m not really sure) that are back by real mortgages. The organization would not be authorized to buy derivatives (since these are basically just a form of gambling in many cases.) Just to be clear: the purchased securities must be backed by real assets (ie: mortgages).
  3. Set the price: This is the hardest part in theory, since the fact that there is no market for these things that is the root of the problem. I think paying full price (as has sometimes been discussed) is stupid. I see three options:
    • Buy them at the last mark-to-market value of the selling firm. In this model, the seller would be required to sell a portfolio of securities that seemed, on the whole, to be reasonably valued.
    • If valuation is in question and probably worth less, pay book value but require additional warrants in the seller. This gives the government (taxpayer) some upside in case the assets are worth less.
    • If the valuation is in question and probably worth more, pay book value + 20% and take some warrants. This gives the seller some more case and still gives the government some upside.

    The big trick here would be setting the warrant coverage, but I’m pretty sure it wouldn’t be that hard.

  4. As a bonus, it would be ideal if the agency doing this could somehow either acquire, unwind, or force, these purchases to re-consolidate loans. This would mean buying up all the tiers of a security across which a number of loans have been subdivided. In this scenario, the agency would effectively roll the securities back up and, in the process, unwind them back to the original loans. Holding a giant portfolio of loans would basically make this new agency fannie/freddie 2.0. No private entities are capable of doing this because of the sheer scale, but the government could – either with money or with legislation or both.

Why would this work?

If these securities are backed by actual mortgages they have some value. It’s unclear what it is, but it is based on how many of the mortgages in the portfolio default. So if the government is able to buy these securities at $0.20-$0.60 on the dollar – which would appear likely since everyone is desperate and there have been open market transactions in this range – it would be a good deal in the long, long term. The problem is banks have to mark to market (ie: reduce the value) of these assets which hurts their capital ratio and forces them to get more money, thus creating a vicious cycle. The government has no such short-term issues (in theory). So if the government can wait 10-30 years and basically hold the mortgages for their effective lives, it should recoup $1 on the dollar (plus interest) minus whatever the foreclosure rate is. This is interesting because it seems to me that a foreclosure rate of > 40% seems really unlikey and foreclosures don’t result in $0 return. So even at a 40% foreclosure rate where foreclosures recouped 25% of the loan value, that would be a 30% off. So $0.70 on the dollar. (And that’s not including interest on the loans that get paid.) That’s not a bad deal if you can be patient.

And only the government has this kind of patience.

Mortgages and Accountability

In my opinion, this entire meltdown that has been going on for the last year or so is caused by one thing: a lack of accountability. This occurs at both a personal level (people who bought houses they couldn’t afford and, hence, got mortgages they couldn’t afford), the people that sold them those houses and mortgages, the banks that underwrote them, and the bankers that cut them up and resold the paper.

Let’s step through this so that it is super clear:

  1. Borrower: Some people seem to want to be sympathetic to people facing foreclosure. (And I guess I’m sorry they are losing their house.) But if you bought a $500,000 house and you make $50,000 a year: YOU ARE AN IDIOT. Yes, I know most cases aren’t that extreme, but a lot of them are. People gambled and bought houses they couldn’t afford in hopes the market would go up. This is called an investment. If you lose money in other investments (like, say, the stock market) no one feels sorry for you or offers to help you out. (Man I wish the government would make my portfolio whole on the bloodbath yesterday.) And, yes, some of the blame goes to predatory lenders (and probably overzealous realtors) who convinced people to buy more house than they could afford and to take on bigger loans than they could afford (probably in many cases without understanding the long-term costs – perhaps believing appreciation would cover it all.) Anyway, anyone that took out a loan that they couldn’t afford is a major part of the problem.
  2. Mortgage Brokers: I think these slice of the pie probably deserves to see many of its members go to jail for fraud, but I doubt it will happen. There corporate masters (to the extent that they had them) also deserve some blame too. As is often the case, the root problem here (again in my opinion) is the compensation model. These guys were compensated for closing loans. So, not surprisingly, they closed as many loans as possible. This was also a sales job, so they didn’t really care (and probably didn’t even understand in most cases) whether someone could or couldn’t pay the loan. All they cared about was getting the loan closed. I’d wager there was a lot of coaching (and wink-wink conversations) where they told borrowers how to fill out the load app so it would get approved. Whoever thought of Alt-A mortgages was an idiot, because that’s the perfect model for abuse by a bunch of ravenous sales people who just want to sell as many (and as expensive) mortgages as they possible can. Especially since once the mortgage is sold there doesn’t appear to be much recourse against the broker (perhaps in the first month or two, but I don’t really know this business.) Hence: no accountability, just hyper selling – not a good combo.
  3. Banks: It used to be the banks were the responsible ones. They underwrite the loans, hence they had final accountability. But those days are gone – thanks to our clever friends at investment banks and the Macs (Fannie and Freddie….). The banks could just sell their loans to an investment bank (slice it up, see below) or Fannie/Freddie. At that point they basically became just another mortgage broker – although I’d wager they made more money in the process. Perhaps they had to be prepared to buy the loan back for a longer period of time, so they had slightly higher risk. They also probably looked at the loan application slightly longer (and more carefully than the mortgage brokers – but only to make sure it conformed so they could sell it. Beyond that they didn’t care, once it was sold it was no longer their responsibility. And guess what? NO ACCOUNTABILITY.
  4. Investment Banks: This is where the fun really begins. These guys are really clever. They are always looking for things to sell and, thus, make fees. This drove the creation of derivatives – which in many ways are really just a complicated way of gambling on real world things. How this is legal and online poker isn’t is a good sign of how retarded our government is. (I’m for legalizing online gambling, just to be clear.) But I digress. So the banks wanted fees, they figured they could buy up mortgages, repackage them, and sell them again in bundles with a slightly higher level of complexity (cough, cough, I mean structure… or value add, or something). They basically broke mortgages up across these instruments (or derivatives, or paper, or CDOs) – which I’m pretty sure most of them actually didn’t understand. They then sold these. It worked great – they made a lot of money on fees. They also created an entire ecosystem around them that consisted of hedging and insuring these things. That worked out great for everyone until housing prices started going down. I will say, on behalf of the investment banks, they did maintain a little accountability… mostly because they were stupid though. They kept some of these CDOs for themselves rather than selling them. Woops. More on this later.
  5. Fannie Mae and Freddie Mac: I’m not going to go back to the root causes of why these organizations were ticking timebombs because that’s a long way back in history. But when the government starts encouraging people to buy houses and backing it up with these organizations who are sort of for profit and sort of for the good of the people – bad stuff is bound to happen. Of course politicians seem to have the memory and attention span of the average fruit fly, so it’s not surprising that they didn’t think this through. These organizations should have been accountable to their shareholders but they were drunk with power and the tacit “the government will save you” stamp on them which allowed them to do some really stupid stuff. Like buy really bad mortgages and encourage everyone down stream to write them. Trust me, if these clowns weren’t willing to buy subprime and alt-a loans, no one would have been writing them. (They share this with the investment banks, but I’ll grant it to the Fs because they started it. I’m pretty sure the i-banks saw the Fs making money, got jealous, and jumped in to the fray.) Anyway, these guys were backed by Congress (the ultimate no accountability organization) and hence could was their hands of any risk. Any they did.

So what’s the punchline:

  1. No one in the entire chain of a mortgage transaction had any sense of responsibility for the mortgage or would be held accountable (except the buyer). Therefore, everyone just wanted to take their cut and pass it along. As long as the musical chairs of a rising real estate market kept going everyone was happy.
  2. I have to believe that in this chain that the value of the mortgage in a final security had to have been stripped down to very little. At each step in this chain people were taking commissions and fees (and the loan servicer took their cut too – but I left them out). This would seem to make them a bad investment. I’m not sure how a loan can return more than it’s original interest as a return – and since so many people took money out along they way, it would seem the actual return would have to have been much less.

What I would really love to see:

The Wall Street Journal or USA Today – if any of you guys are listening (highly unlikely I know) here it is – should do a nice chart showing the flow of a mortgage through the system and how much in fees got eaten up along the way. It would be really interesting to see this. (At least to me.) I’m also pretty sure it would help people really begin to understand what was actually going on and how messed up the system got.

The Bailout

This is a big mess, but I think this article: The Paulson Plan Will Make Money For Taxpayers – is probably right.

I think, however, the article missing the other big issue: short vs. long-term outlook. Obviously, the fed isn’t doing the bailout as an investment, but the very structure of the bailout would appear to be an investment. The government is effectively buying all of these assets. The advantage the government has is that it doesn’t need to make money and no one really cares about its balance sheet (yeah we can debate whether that’s good or not later).

I believe most of these assets will have some value… eventually. How long is open to debate.

So I think this bailout will generate money for the government (directly – I also think it will benefit indirectly as the economy recovers). Hopefully they won’t waste it… but they probably will.

What they should do is basically structure the bailout as a special case U.S. sovereign wealth fund. That might restrict how the use any upside that should come of this.

At the very least it should be packaged and contained so we can track and understand the outcome. IE: in 20-40 years, did the bailout make money? lose money? break even? I’ll given even odds that we won’t even know. Perhaps I’m too cynical.

It’s the ecosystem stupid.

Ok, so everyone is talking about Apple these days. There was a good Fortune article on why Zunes don’t matter, regardless of how good they might be. (The Trouble with Zunes) This got me thinking.

Windows is obviously a very successful product for Microsoft. (Captain Obvious.) The reason it is successful is because it created a very powerful ecosystem – developers, CPUs, hardware vendors, etc. I once saw a really insightful slide (from some analyst – no idea who or where to find it again) that showed how much Dell / HP / Compaq (shows how old the slide was), Intel, and Microsoft, spent on R&D and how nearly impossible it would be to catch up with that. Clearly it was right – no one has caught up. I think it missed the developer angle – the ability to develop interesting applications coupled with the right development tools and a critical mass (of consumers for the apps) is very powerful. And even more difficult to overcome.

Apple seems to get this on several levels:

  1. The basic ecosystem: creating a linked system (a closed one is easiest) that just works from end-to-end is critically important. That’s why ipod+itunes has seized the music space. It’s also why once they get AppleTVs and AppleHomeServers right they’ll control the living room. Unless Microsoft wakes up and recognizes not just the importance of this ecosystem (I think they do) but that the only way to win is through a fully linked-up, coherent ecosystem, Apple is going to win this war too.
  2. Design matters: Not just industrial design, but also interface and system design. And, probably more importantly, it is a heck of a lot easier to design a great product when you control the whole ecosystem. System design – basically how everything that is involved works together – is the hardest parth and is, again, made inherently easier in a closed system. Bill Gates is a great system designer. The problem is that at Microsoft I don’t know who else is. If there is one (or a group) it’s probably either the Office team (brilliant integration of formerly disparate applications to make them so co-mingled it’s hard to imagine them not being a suite) and/or the Xbox team (this is a good system Xbox 360, Xbox live, Xbox first party, and Xbox thrid party.)

Apple (or maybe just Steve Jobs) clearly gets these two things. They also have the inherent power and charisma of Jobs at the top which forces everyone else to at least try to think like him. I’d wager that everyone working on a product team at Apple is always thinking “omg, omg what if Steve comes in here and looks at my product – he better be blown away”. When everyone is thinking like that, you get 100x better outcomes. I’m pretty sure there aren’t many people thinking that way at Microsoft these days.

The third axis of tech power, Google, is somewhere in the middle. They have a lot of really smart people thinking up really smart things. However, I’m not sure they have a lot of system thinkers running around. All their stuff seems like amazing spot solutions with little overall cohesion. That’s why Android (their phone effort) has little (imo) chance to unset the iPhone. If they really got someone in there thinking about the overall system, this could change. It’s not beyond repair in my opinion.

If you want a clear example of this, look at their authentication system. Admittedly they are trying to fix this, but it’s pretty bad right now.

BTW, it’s hard to do this stuff. As an entrepreneur I try to do it everyday. It doesn’t always work out the way I hope – ecosystems (and systems in general) are pretty complicated and it is hard to figure everything out. It’s even harder to do with the limited resources of a start-up.

Duels Comic

Check out the first ever Duels comic:


It’s really cool and gives a great overview of the backstory behind Phyrra, the world of Duels.

Apple TV: Experimenting with Movies

I rented No Country for Old Men this weekend on Apple TV. It was my first attempt at renting. It wasn’t ideal. I let it download for a bit before I started watching it and it still stopped midway through. So I watched some other DVRed stuff before returning and watching the rest. This wasn’t a great experience – it definitely broke the pacing and immersion of the movie.

So I tried again, this time I bought Revolver (a Guy Ritchie movie with Jason Stratham that I’d never heard of before). I let it start downloading. Found 28 Weeks (or maybe Days) Later and left that on while I watched some work. Then I watched Revolver. No issues. (Maybe it wasn’t true HD, the “buy” option is a little ambiguous about what you get – “iTunes Widescreen Format”, what the hell is that?). The quality was pretty good, the movie was reasonably good – although really weird.

I’m not sure it’s ready for primetime, but it is pretty cool. I’m getting ready to move so I haven’t spent much time setting up the configuration I want. I really want to have all this media on my Windows Home Server, but I have heard it is corrupting iTunes stuff in some cases so I’m waiting for a patch to mess with that. Until then I’ll just mess around with the Apple TV directly.

Microsoft and Yahoo: Shotgun Wedding

Microsoft (MSFT) desperately needs to acquire Yahoo (YHOO) to gain a significant foothold in the media world. To me, at least, this is very clear. Yahoo also needs Microsoft, although I’m not sure they know it yet. I think the merger force a level of clarity to both companies that they both sorely need.

Microsoft should restructure into four divisions:

* OS
* Office
* Media and Advertising (Yahoo! and Live)
* Entertainment (Xbox 360, games)

I’m not sure where TV should go, probably Media.

Anyway, they should then appoint Susan Decker from Yahoo! to run the media group. I think they can turn that into a wildly profitable business by combining Yahoo!’s sprawling empire with the many good, but underutilized Microsoft web properties.

If they are really smart they’ll also figure out how to unlock the value of Flicker, delicious, and the various other web 2.0 properties that seem to get lost in the Yahoo! shuffle. In my opinion, this largely arises from trying to hard to tie everything together. I personally think a more loose confederation – both in terms of management/teams and actual presentation to users – could dramatically increase the value of a myriad of smaller Yahoo and Microsoft web properties.

Maybe they’ll also figure out how to unconfuse this giant Live initiative that Microsoft has going. I mean, who names something “Microsoft Office Word Live 2008” …. the rate they are going it will be “Microsoft Office System Word Live 2009” or something. It’s confusing and makes no sense. Maybe Microsoft Word and Microsoft Word Live might work – where one is a license and the other is free with ads or subscription.

Anyway, I could see how this merger could fall into the “putting two rocks together just sinks them faster” category, but I don’t think that is the case. I actually think it could force clarity in a way that creates compelling outcomes. Of course, that requires someone with a strong force of will to run these divisions and make them successful. But at least, divided up this way it’s pretty clear who the competitors are for each group and, in my opinion, a relatively clear direction for each group.

Good luck to them both – I hope they figure it out.

(Disclosure: I own Yahoo shares. So yes, I hope they go up either through a Microsoft acquisition or through something else. I think an AOL deal might be interesting too if they could actually figure it out – but the Microsoft deal is far better.)