By David Goldman
White House economic advisor Larry Summers, a former Treasury Secretary and President of Harvard University, had brief career as a part-time pitchman for a hedge fund. His activities may bear on his ability to serve the country with maximum effectiveness. According to sources who attended meetings with him, Summers traveled to Asia during July 2007 with a pitchbook recommending the AAA-rated tranches of collateralized debt obligations to Asian sovereign funds and financial institutions, in his capacity as a Managing Director of the hedge fund D.E. Shaw.
In July 2007 the AAA-rated tranches of mortgage-backed securities backed by subprime collateral were trading at around 90 cents on the dollar. Now they are trading at less than 40 cents on the dollar.
The AAA-rated tranches of CDO’s, of course, are the “toxic assets” that the US government now is proposing to buy from banks to unclog their balance sheets. D.E. Shaw, ranked fourth by size among hedge funds with about $30 billion in resources, owns an unspecified amount of such structured products. Late in 2008 it suspended some redemptions by investors seeking to cash out, and continues to “gate” redemptions. Although D.E. Shaw’s investments are proprietary, the perception of the investment community is that the firm is stuck with big positions in such “toxic assets” that it cannot sell. The overhang of hedge fund redemptions on the market artificially depresses the price of structured product, which in turn has forced massive writedowns on the part of banks.
According to my sources, Summers enthusiastically urged Asian investors including sovereign funds to purchase such instruments just weeks after the collapse of a Bear, Stearns hedge fund whose failure triggered the collapse of the whole structured market. I do not know precisely what was in Summers’ pitchbook, but if I were a member of a Congressional committee responsible for the oversight of economic policy, I would very much want to know what was in it.
Larry Summers is a highly-honored economist and an honorable man, and I do not believe for a moment that he has done or would do anything dishonest. Nonetheless, perceptions are important. America’s foreign economic relations are of paramount importance to its recovery prospects, and the involvement of foreign governments will only increase. Foreigners already own $4 trillion or so of American debt instruments, and the credibility of American public officials is not a minor issue.
At very least, Dr. Summers should explain what happened.
At the same time that Summers was pitching Asian investors, a case could be made, and was being made, that AAA structured product would turn toxic. Many people made this point at the time. I claim no special prescience, but I was one among many market participants sounding the alarm at the time. In July 2007, I circulated a report to the clients of Asteri Capital, the hedge fund for which I served as strategist, entitled, “The Trillion-Dollar AAA Asset Bubble.” I wrote the following:
In the course of the most ambitious re-leveraging of corporate balance sheets worldwide, most of the funding is provided by investors who believe that they are taking no credit risk at all. Most LBO’s are financed by Collateralized Loan Obligations (CDO’s) or Collateralized Loan Obligations (CLO’s), who sell most of their debt to Aaa/AAA investors. This cognitive dissonance is the source of the last several weeks’ volatility in credit markets.
Investment-grade securities backed by CDO’s have taken the brunt of the decline in credit devaluations during the past six weeks, the first time in history that the safest part of the capital structure suffered the most in a generalized credit widening. More than a trillion dollars of Aaa/AAA-rated securities have been issued via Collateralized Debt Obligations during the past three years, the fastest-growing fixed income asset class. Triple- and Double-A securities backed by sub-prime collateral suffered extreme losses overnight, with the ABX 2007 AAA index falling by a point to 95-16 from 96-16 on July 13, and the AA index falling by 3 ½ points to 87 from 90-16.
First loss tranches of CDO’s backed by corporate credit did not widen at all during the violent spread widening of June and July – again, the first time in history that the bottom of the capital structure did not suffer in a general credit market decline.
Rating agencies and investors drastically mispriced the risks across the CDO capital structure to begin with. As corporate balance sheets are re-levered through LBO’s and other acquisitions, default risk is pushed out towards the back years – favoring first loss tranches over investment-grade tranches of credit CDO’s.
Re-pricing of the Aaa/AAA universe represents a more potent macroeconomic threat than sub-prime mortgage losses as such. Financial intermediaries, including banks, money market funds, special investment vehicles as well as hedge funds bought top-rated securities with enormous amounts of leverage. If the levered bid for Aaa/AAA paper dries up, funding for leverage will dry up.
Aaa/AAA-rated debt backed by corporate collateral does not merit the rating, for the present leverage wave is unlike anything we have seen in the past, making long-term default risk unpredictable.
On July 18, I went on Larry Kudlow’s CNBC show to warn the public about the AAA asset bubble:
KUDLOW: I want you to give us a little primer–briefly–with key bullets so we can all understand it. On this credit situation, all right, the Bear Stearns story did interfere with the market today. Look, some people are arguing that these credit and debt markets are unraveling. They’re coming unglued. What is your take?
Mr. GOLDMAN: They’re not coming unglued, but the leverage machine has broken down. We’ve had a de-coupling of stock markets and credit markets. The price of credit risk in high yield and crossover has almost doubled, while the stock market’s up several hundred points in the last few weeks. Never has this happened before.
Mr. GOLDMAN: A lot of the reason is because this massive amount of leverage going into M&A, LBOs and so forth is being financed by structured credit. Three-quarters of it is being bought by people who thought they were taking no credit risk at all.
KUDLOW: Turned out to be a whole lot less than AAA paper. That’s part of the Bear Stearns story, is it not?
Mr. GOLDMAN: Exactly. Bear Stearns said we’re going to buy AAAs, lever them up 10 times, give you 12 points, you can’t go wrong. They were wrong. But that’s what the entire financial system is doing.
KUDLOW: There’s the ABX Index. Now that’s the BBB index. Now, that thing’s dropped about 50 points, OK?
KUDLOW: That’s a huge–but the prime rate of ABX index is only down about 5 percent. Mr. GOLDMAN: That’s right, but you lever it up 10 times. That’s a 50 percent loss, and AAs are down 15 points. Nothing like that has ever happened before. And banks and their–various other levered institutions are sitting on considerable losses. They don’t have to mark them to market. But the availability of leverage going forward for the marginal deal is going to be much tougher, and that means that that’s at least one factor you have to take into account in the stock market as a drag.
KUDLOW: When the private equity buyout boom started several years ago in earnest, in big time, I mean, private equity, equity was the key word. It seems like now equity has given way to lots of debt, and the debt is highly leveraged. So they’re becoming leveraged buyouts. They’re not equity buyouts. Is that part of the problem?
Mr. GOLDMAN: That’s exactly the problem, Larry. The rating agencies and the financial system said we can go on autopilot. If you find someone to take the first few losses of it, first, say, quarter of the losses in a high-yield LBO kind of situation, 75 percent of it is risk free, it’s AAA. We don’t have to worry about it. The market in the last six weeks has said, `Wait a minute. We might have a problem.’ And the ability of the financial system to digest this so-called AAA stuff that the Street has been cranking out through credit structures has now broken down.
Paul Volcker was asked in Congressional testimony Feb. 3 why it was that the economists of the Federal Reserve failed to anticipate the financial crisis. He responded that economists in general were not trained to anticipate such problems. No-one should blame Larry Summers for pitching the wrong side of the biggest trade in the past generation. He’s an economist, not a banker or a trader. But he has a responsibility as a public official to account for any baggage he may have brought in with him. The right thing to do would be to make public his July 2007 D.E. Shaw pitchbook.