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Duke Study in China (Summer 2008)

Econ/Finance (Fall 2009 -Fall 2010)

Deutsche Bank - FT Offer (8.16.2010)

I recently finished my internship as a Global Markets summer analyst at Deutsche Bank and received an offer to return back full-time. It was an incredible, intense experience and I'm really happy to have been extended a job offer. I'll write more about the program when I have some time.

Synthetic CDOs (4.29.10)

Wall Street and investment bank transactions are generally seen as really abstruse and sort of like a black box. Also, a lot of times when mainstream media covers Wall St. and financial instruments, they tend to just call them "banker magic" or "financial wizardry" and then leave it at that. This doesn't exactly help the problem, so it was really refreshing that, when reading The Big Short by Michael Lewis (referenced about 800 times in the Goldman Sachs congressional hearing), to see a lot of these financial instruments being lucidly explained. Out of derivatives, CDOs, swaps, etc, the king in extremely complicated financial instruments referenced by MSM seems to be the Synthetic CDO. Lewis actually does a really good job explaining them.

It all starts with mortgages. A mortgage is essentially a bond that a person issues. At its most basic, the mortgage that a bank has represents a stream of future cash flows for 20, 30 etc years.

Then in the 1980s, someone came up with the idea of a mortgage backed bond. Because a mortgage is essentially a stream of cash payments from a person, if you take, say, a thousand mortgages and bundle them together, then you have a thousand cash flows coming from a thousand people. The assumption is, because the covariance between individual mortgage risks is less than one, by having a pool of a lot of different mortgages, you're decreasing the overall risk. Just because one person defaults doesn't mean the other 999 will, necessarily.

It's much less risky than owning one mortgage. Also, with a thousand different cash flows, you can split the pool of mortgages into different layers (tranches) and sold as bonds, so people can choose what level of risk they're comfortable with. They mortgage cash flows fill up the safest tranch first (AAA rated and gives the lowest return because its the safest), and the lowest - riskiest - tranch last (usually rated BBB- or lower). The popularity of mortgage-backed bonds led to the decrease of risk for mortgage lenders, because investment banks would buy the mortgages from the mortgage lenders to create the mortgage-backed bonds. The mortgage lenders were passing on their mortgages to investment banks, and since the mortgages were bundled together, the risk for mortgage lenders was decreased - so they could charge more "corporate bond" rates, than "credit card" rates. Financing houses was much cheaper, and everyone was happy- the American dream was easier to ascertain.

The CDO (collateralized debt obligation), operates under the same basic principle as the mortgage bond. A CDO is a collection of different mortgage bonds. The lowest (and riskiest) tranches were hardest to sell, so by collecting the riskiest tranches of different mortgage bonds and pooling them together, Wall St. was able to lower the perceived risk. Unlike the mortgage bonds, that relied on diversification of people to lower risk, mortgage bonds diversified mainly by geography. If you take the riskiest tranch of a mortgage bond made from Florida mortgages, and that of California mortgages - surely you won't have mass defaults in both areas. House prices have never decreased nationally before - they're generally considered a more regional market. Again, because the covariance of different mortgage bonds was thought to be significantly less than 1, by collecting a bunch of the riskiest mortgage bonds together, they were able to decreased percieved risk. Thus, a pool of BBB- mortgage bonds were pooled together into a CDO and given a AAA rating. Wall Street sold a lot of these, and made a lot of money.

So that's a CDO. But what is a synthetic CDO? The problem with CDOs is that they require actual mortgages to be issued. For every billion dollars of subprime loans, maybe only 20 million dollars of BBB tranches were made. That is, to create a billion dollar CDO, you need to have $50 billion dollars of subprime mortgages issued. That is, until Wall St. thought of the "synthetic" CDO - all you needed for those were credit default swaps.

Credit default swaps are insurance against default on a bond. For example, if I bought a $10MM 10 year Lehman Brothers bond, I could pay a certain amount every year (say, 250k), and if Lehman Brothers ever defaults (can't pay its debts), then I would get the amount I was owed. They started off as a way to manage risk. However, between 2003-2006, some prescient investors who were short the housing market like MIchael Burry, Steve Eismann, and John Paulson, used CDSs to take a short view on the housing market. Because these people thought that the housing market would crash, but they didn't know when, they bought CDSs on mortgage backed bonds. To them, this was better than simply short selling a mortgage backed bond, or housing stock, because you didn't have to worry about timing the market (that is, the housing hysteria could go on for a while, the prices of these things could rise more and more, and even though you're right you may lose a lot of money first). So they used CDSs on the riskiest mortgage backed bonds (that they didn't own) because they would just have to pay a fixed rate, and if people started defaulting, the riskiest tranches would become worthless, and they could collect on their CDS protection.

So now you have people going short on mortgage backed bonds by buying CDSs. However, to banks, selling a CDS (which these guys bought) replicates the pay-offs of buying a mortgage backed bond. You receive a fixed payment from the person who bought the CDS, and - just like buying a mortgage backed bond - if the bond defaults, you lose a lot of money, because you have to pay up to the person who bought the CDS. The difference is that you don't need any mortgages to be issued to sell a CDS.

So now investment banks really wanted people to buy CDSs on these BBB bonds. Because the bonds were the riskiest, they received the highest interest payment on them for selling their protection. For protection on these bonds, investors like Michael Burry would pay 250 basis points (2.5%). Then investment banks bundled all of these CDSs together into a synthetic CDO (synthetic because there are no actual bonds or mortgages in it - just CDSs). Under the same assumption of spreading risk by pooling lots of different CDSs on different BBB mortgage bonds, these synthetic CDSs were given AAA ratings, and investment banks were able to sell them to other investors (like IKB and AIG), who were getting only 12-50 basis points for issuing the protection against these AAA rated synthetic CDOs (though it's the same protection!). So by selling insurance through CDSs on a bunch of BBB rated mortgage backed bonds, pooling them together into a AAA synthetic CDO and then getting AIG and IKB (etc) to issue protection on these same mortgages at a much lower AAA rate, investment banks were able to make a riskless profit of around 200 basis points. Also, there was no limit to how many they could make because they weren't based on anything real, like mortgages - but CDSs.

 

 

Chinese Presentation (2.28.10)

Every semester in Chinese we need to give a 10-15 minute presentation on any topic of interest relating to China. I made my presentation (link) last Thursday on the charges against China of manipulating its currency and keeping it artificially depressed. It's a really interesting topic that has been getting more and more attention recently (Paul Krugman alone has written about it here, here, here, here, and here). After I was done, my Chinese teacher - who is from Beijing - said that framing is extremely important, and I just gave the western media angle. She said that on TV in China what they report that is if the government allows their currency to appreciate, every 1% means 200,000 less jobs (or 2 million, I forget).

Deutsche Bank (2.12.10)

I recently accepted a summer internship offer from Deutsche Bank Global Markets (S&T). I'll be in NYC this summer! I'm really happy to have the opportunity, and I am relieved to be done with the interview process.

How Much is Coldplay Worth? (12.23.09)

For my Corporate Finance final paper (link), I proposed a new business model for the recording industry, which has been facing precipitously dropping revenues and record sales this decade as its current business model has been more or less destroyed by the internet.

Trying to think of a new business model was really hard, and, I think, sort of presumptuous. Regardless, I gave it my best shot. The changes I proposed tried to address what I thought were the two main problems the music industry is facing: the expectation of free music because the emergence of p2p programs and bittorrent, and the costless distribution of music made possible by the internet.

To adapt to these changes, I thought that the recording industry should narrow its focus dramatically by eliminating and merging their divisions so they're left with just two - Artists & Repertoire and a new branch that handles anything related to the media and public image. Secondly, create a website similar to Hulu.com that distributes music for free. On each artist's page, there would be targeted AdSense ads, promotions of that artist's upcoming concerts, and a link for donations. The record company would make money off the ads, the artist would keep 100% of the donations, and they would split concert ticket revenues. This seems pretty radical but it's actually not too different from what the television industry has done with Hulu (though that is actually going to a subscriber based system soon, I heard).

To test the validity of the new business model, I looked at the cash flows that a record company could expect to receive from a succesful artist/band. To do this, I chose Coldplay and made a DCF using their historical album sales, projected forward as if they had released their first album next year. As a big fan of Radiohead, I should mention that although Coldplay does have some songs that I like (like this one), I chose modeling them over Radiohead because it was 4am and it was far more appealing at the time to create a DCF from a band with 4 albums/cash flows over 9 years versus one with 7 albums over 20 years. Also, though it pains me to say it, they are a better of an example of a successful band - at least from the perspective of album sales and cash flows.

Anyways, this is what I came up with:

coldplay DCF

Using these assumptions:

coldplay dcf assumptions

 

What I found was Coldplay had a present value of $72m in the old albums based business model, and a present value of $65m under my proposed one. That's pretty good, considering this 10% drop in revenues would most likely be paired with a larger drop in expenses given the record companies would be culling their 7 divisions down to 2. Granted, I did use a ton of assumptions, some being quite generous. So overall, this was more useful as a thought exercise than a serious valuation, but it was still cool to think about. Realistically, I doubt that record companies will start giving away music for free given the success of the iTunes business model.

 

Negative Interest Rates (12.21.09)

In the midst of the economic crisis, Greg Mankiw (former Bush advisor and current econ professor at Harvard) suggested the Fed set a negative target interest rate in this article: Mankiw (2009).

The Fisher Equation for real interest rates is fairly intuitive:

fisher deriv

With r being real interest rates, i being nominal interest rates, and pi being expected inflation. In its more common form, it states that the nominal interest rate is roughly equal to a real interest rate plus an inflation premium.

Already, some people say we have negative real interest rates in some sectors, with the federal funds rate being as low as it can be, as well expected inflation. There was also a period of negative real interest rates in 2002.

On a related note, Warren Buffet has also offered a negative-coupon bond, the Squarz, where you essentially pay Warren Buffet for the privilege of lending him money. You also received the a warrant to buy shares of Berkshire Hathaway at a premium to the share price at the time of its issuance.

Anyways, what Mankiw suggested was actually that, to stimulate the economy in a severe downturn, the Fed set a negative target interest rate: that is, a negative nominal interest rate. So now, by parking $100,000 in the bank, you'd have, say, $97,000 next year instead of $105,000. The obvious problem with a negative interest rate is that no one would want to lend, so they'd just hold cash. To get rid of this incentive, Mankiw suggests the Fed manufacture greater inflation, to, say 10% annually. This would present consumers with the following choices: hold money (-10%), invest at the risk free rate (-3%), invest in a risky security (low negative to slight positive expected returns), or buy a huge new TV.

I thought this was a really creative idea on how to incentivize spending. However, it would not go over well with the public. I was talking to my brother about this and he said that if the Fed ever tried that, he'd move. Apparently his sentiments aren't uncommon, as Mankiw received a ton of hatemail after his NYTimes piece. I would have to agree; there is just something inherently morally unsettling about a system with such a blunt disincentive to holding savings.

 

Nick Leeson (10.27.09)

We were talking about options today and my Asset Pricing professor Emma Rasiel told us the story of Nick Leeson, which I found pretty amazing.

Leeson was a trader for Barings Bank in London in the early 90s. He used to work in the back-office (clearing trades) and did so well there that he was promoted to the front office (making trades). He was a hotshot, so Barings sent him to Singapore to become the general manager of the future's market at the SIMEX, Singapore's exchange.

He was doing quite well there and making a lot of money. Because he was on the trading floor making markets, he only made money off bid-offer spreads (e.g. the lowest sell is $4.04 and the highest buy is $4.02 so you collect $.02), but if you make enough trades you can make a lot of money.

Then Leeson started making speculative trades that weren't approved by Barings. He was doing extremely well at first - he earned £10m for Barings in '92; however, Leeson made bad trades as well and lost money. Instead of owning up to the losses, and because Barings made Leeson a part of both the front office and back office in Singapore, Leeson was able to use an "error account" (numbered 88888, which is good luck in Chinese culture) to hide all of his bad trades from Baring management.

At the time Leeson started hiding his bad trades, he had an enormous long position on the Nikkei 225, Japan's market index. His payoff, relative to the Nikkei 225, looked like this:

nikkei long

 

However, the problem with futures markets is that they require a margin account. That is, they need some collateral. Leeson needed money for the margin account to sustain his long position on the Nikkei 225. One way to earn money immediately is to sell options, that is, to give someone else the right - but not obligation - to buy or sell a stock at a certain price.

So Leeson started selling put options to cover his margin on the long position he had in Nikkei 225. Selling a put option means that, for example lets say McDonalds is trading at $50 now, and I sell someone a 3-month put option with a strike price of $50 and a premium of $5. That means that someone paid me $5 up front for the right to sell McDonalds to me at $50, 3 months from now. So if in 3 months, McDonald's share price falls to $40 dollars, the option is called "in the money" (it has value) and will be exercised. The person who bought my put option will exercise it, and I am obligated to buy his McDonalds shares from him at $50. I lose money,and he/she makes money, because options are zero-sum. However, if in 3 months the price of McDonalds goes up, his/her option is worthless because the market selling price is higher than the option selling price.

So, Leeson sold put options that were bullish on the Nikkei 225 to fund his margin account. This actually increased his long position in the Nikkei 225. So now if the Nikkei 225 went down, he would not only lose money from his initial long position but also from all of the people he sold put options to who want to exercise them. His exposure to the Nikkei now looked like this:

long and put

And when combined, like this (note the blood red):

combined

So now Leeson had a really bullish position in the Nikkei 225. Options are leveraged instruments by nature, and on top of that he had the massive long position, somewhere on the order of several hundred million dollars. If it went up he would make massive profits. If it went down he was going to get killed.

By the end of 1992 Leeson had £2m in losses hidden in account 88888; by the end of 1994, he had £204m.

The End

On January 16th, 1995, with his obscene losses mounting, Leeson placed a massive short-straddle trade on the Nikkei 225. A short straddle trade is when you simultaneously sell a call and a put option. It is essentially a bet on volatility. If the stock doesn't move much, you collect on the premiums; however, if the stock price goes way up or down, people will exercise their calls or puts and, as with selling any option, your theoretical losses are infinite.

Short straddle payoffs:

short straddle option payoffs

So now Leeson had hundreds of millions of dollars on the line saying the Nikkei 225 would go up AND a few more hundred millions that said the Nikkei 225 wouldn't change much.

What happened one day after Leeson placed his short-straddle trade?? On January 17th, 1995, there was a massive Earthquake in Kobe, Japan. Over $100 billion in damage. Predictably, the Nikkei plummeted and volatility spiked.

Nikkei Graph Kobe Earthquake

Ouch.

Cinematic reenactment of Leeson's positions:

 

Leeson fled to Malaysia, Singapore, and finally Germany where he was captured and extradicted. His losses totalled £827 million, twice Baring's working capital. Baring went bankrupt after a failed bailout attempt.

Leeson's case illustrates a pitfall that many people can fall into: being risk seeking on losses, a cognitive impediment that the field of behavioral finance tells us to watch out for. It's bad enough when you're talking about your personal finances, and even worse when its hundreds of millions of dollars that aren't your own. It's also pretty amazing that Leeson could get away with hiding his losses for several years, and that Baring's accountants didn't bother to check up on the £200m or so that were unaccounted for in Leeson's books.

Yoram Bauman (10.26.09)

I found this pretty hilarious.