"The market-sensitive risk models used by thousands of market participants work on the assumption that each user is the only person using them." - Avinash Persaud, April 2008.
This quote came to my attention via Felix Salmon's Market Movers via Reuters, and it encouraged me to develop our thought process from an earlier piece we put out, entitled Static Measures for a Dynamic Environment.
The point: in a changing environment, one has to proactively adapt modeling assumptions (such as recovery rates and correlations) to reflect those changes.
As Operation Securitization got underway, escalated and then came to an abrupt, sudden halt, each input into the model needed to have been updated due to the gargantuan size of the market -- and its subsequent influence and impact on trading levels -- and the systemic risk is brings with it. For example, the growth of the collateralized loan obligation market (CLOs) from 2001 through 2006 continued hand-in-hand with the growth of the leveraged loan market. With CLOs constituting the majority of demand for these (typically broadly-syndicated) bank loans (roughly 60-65%) the demand base grew in tandem with the supply source. But we saw no adjustment in either recovery rate assumptions (for loans or CLO-issued notes) or in correlation (between loans and CLOs or between loans or between CLO tranches) on the basis of, or necessitated by, this dual, dependent growth.
Surely if the CLOs stop buying, with the demand source halted, loan recovery rates must plunge downwards. And that's what's happened. Indeed performing leveraged loans have recently oscillated between trading levels of 50% and 65%, well below historically realized recovery rate levels for defaulted corporate loans! (70-80%)
We've described this phenomenon in more detail in The Corporate Loan Conundrum. Also, The Elephant in the Room describes our astonishment that certain recovery rate estimates to this day remain unchanged.
The system-wide (systemic) mass-production of securitized tranches helped undermine the value of each in the crisis. The greater the supply, the lower the recovery when things don't work out, and the more correlated they become. And so the banks -- the lemmings -- acting in unison for the most part, created lemons (there are notable exceptions who are still around).
Separately, while my "lemons" are securitized tranches, Brad Setser took the initiative back in 2007 of Turning lemons into lemonade. His lemons are different: they are mortgages; his lemonade being securitized notes.
His article is thought-provoking for many reasons. Here are two: (1) it brings to the fore the economic principle of lemons (think second-hand cars), a principle which relates nicely to the government's purchasing of "toxic assets," and (2) it reminds us of the correlation question: increased correlation improves the quality lower tranches. Why, then, in this market of increased correlation, are the lower tranches of securitized notes not being upgraded? Well, it's a loss-loss scenario for them: correlation, like volatility, increases precisely in the tough times, during which defaults are high. During these times the lower tranches die a quick or slow death in any event, depending on the deal. Superfluous then?