One of the really clever uses of derivatives, and Guambat is sincere here, is to create a book that can be laid off on to other betting types that will put a figure on any type of risk/reward ratio that imaginative minds can concoct. The fascinating part of the game is that people, well, the participants in this game, then internalize these numbers as some kind of truth, some kind of window or mirror into a reality that they have constructed. Guambat has always cherished fairy tales and thus finds the world of derivatives to be endlessly enthralling.
And so it is that the wizards of finance have put a number on the upper limit to the risk that the "subprime fallout" will have on the credit markets. Three banks hope to corner the market in this contagious contango and thereby drive up the value of the shit they're holding long enough to be able to offload it onto the true believers, or their fund managers at least, thereby making a motza. They're following the model that the best systemic means to cope with risk is to share it a mile wide and an inch deep rather than an inch wide and a mile deep, except that they have interchanged the word "shit" for the word "risk" to make it so much more palatable and propitious.
Banks line up $75bn mortgage debt fund, By Gillian Tett in London, Krishna Guha in Washington, and David Wighton in New York
"Citigroup, Bank of America and JPMorgan are on Monday expected to announce plans for a fund to buy mortgage-linked securities in an attempt to allay fears of a downward price-spiral that would hit the balance sheets of big banks.Before coming to Treasury, Paulson was Chairman and Chief Executive Officer of Goldman Sachs.Prior to his confirmation as Assistant Secretary, Mr. Ryan served as a Senior Advisor to U.S. Treasury Secretary Henry M. Paulson.Robert K. Steel retired from Goldman Sachs as a vice chairman of the firm on February 1, 2004.Market meltdown fund launched
A person familiar with the discussions said that US banks collectively were expected to put up credit guarantees worth about $75bn for the fund, named the Single-Master Liquidity Enhancement Conduit (SMLEC).
The concept of an SMLEC first emerged three weeks ago when the US Treasury summoned leading bankers to discuss ways of reviving the mortgage-linked securities market and dealing with the threat posed by structured investment vehicles (SIVs) and conduits.
The Treasury acted as a neutral “third party” in the discussions, and Hank Paulson,Treasury secretary, was strongly in support of the initiative.
Robert Steel, under-secretary for domestic finance, led the US Treasury side of the discussions, with the day-to-day work handled by Anthony Ryan, assistant secretary. The plan is an attempt to address concerns about SIVs and conduits, vehicles that are often off-balance sheet but closely affiliated to banks.
They typically fund themselves in the short-term asset-backed commercial paper market but purchase long-term securities. The gap between short-term debts and long-term assets has created a vicious funding mismatch in recent weeks because investors have stopped buying notes issued by some SIVs and conduits. There are fears some SIVs may be pushed into forced sales, prompting further declines in the price of mortgage-linked securities that could hurt the balance sheets of some institutions.
SMLEC is likely to be unpopular with some banks which have already started trading in distressed subprime securities at knockdown prices."
"It is thought that the SMLEC would buy up sub-prime assets and then repackage them in a way to give investors more confidence. This would also save banks from having to try and sell them at a heavily reduced price, which could have a big impact on balance sheets across the sector."Goldie as political hedge fundFOLLOW UP:This conduit story has been conducive to much comment in the financial tomtoms. The (Newscorp/Fox) WSJ blog, Deal Journal, has a take that "resonates" Guambat, which is hard to do to a thick blog of mass. One comment to that post (by mike harrold (chicago)) in particular stood outside Guambat's burrow sounding like a maiden siren:
By promising to be the lender of last resort to their SIV clients, Citicorp essentially “sold” a put option that has now become “in the money.”
For years Citicorp generated large fees from their SIV-clients. That revenue was effectively overstated because it did not properly account for the probability that the option premium sold “short” would justify the liability assumed by the seller, Citicorp.
Citicorp made money by selling out-of-the-money option premium too cheaply.
By miscalculating the “real” cost of the option they were short, and therefore selling it too cheaply, Citicorp enjoyed what looked to them like a “free lunch.”
Now that the option is “in the money” Citicorp would like its possessors to NOT exercise it so that the underlying collateral’s value will have more time to (hopefully) go up.
As long as one incorrectly estimates the likelihood of a several-standard deviation move in volatility, one will always sell option premium too inexpensively.