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Just finished reading 'The Big Short' - questions
Posted on 11/21/12 at 9:53 pm
Posted on 11/21/12 at 9:53 pm
I am an engineer and don't have a finance background, so I have a few follow up questions based on the book. I hope the MB can help me answer them:
1) I don't think I completely understand the concept of 'synthetic' CDOs. The way Michael Lewis explains this it seems like you could keep repackaging CDSs that you buy on sub-prime triple B rated bonds into synthetic CDOs, the idea being you use CDSs to replicate the worst of the bonds many times over since the banks couldn't extend home loans fast enough to people with bad credit (and high risk of default) whet their appetite, so to speak.
My question: Is there a theoretical end to creating CDOs like this? Was it ever going to be sustainable? And how in the hell do you keep track of what is in each of them? It is so confusing to even wrap my head around this stuff.
2) Are CDSs and CDOs still legal in their pre-2008 form? Are there any regulations that regulate these securities now?
3) And just to confirm, any institutional investor could have bought and sold CDSs on subprime mortgage bonds back in 2005-07, right....even they didn't own any of the underlying bonds? You could purely speculate on them without having any risk tied up yourself except your premium payments? I think Lewis' analogy was something like being able to buy fire insurance on some random slum prone to fires that you didn't even live in.
That is just incredible that you could speculate with relative low risk like that. Do any regulations prevent people from speculating like this now?
4) Are employees that work at Moody's and S&P's really 2nd rate as Michael Lewis makes them out to be?
1) I don't think I completely understand the concept of 'synthetic' CDOs. The way Michael Lewis explains this it seems like you could keep repackaging CDSs that you buy on sub-prime triple B rated bonds into synthetic CDOs, the idea being you use CDSs to replicate the worst of the bonds many times over since the banks couldn't extend home loans fast enough to people with bad credit (and high risk of default) whet their appetite, so to speak.
My question: Is there a theoretical end to creating CDOs like this? Was it ever going to be sustainable? And how in the hell do you keep track of what is in each of them? It is so confusing to even wrap my head around this stuff.
2) Are CDSs and CDOs still legal in their pre-2008 form? Are there any regulations that regulate these securities now?
3) And just to confirm, any institutional investor could have bought and sold CDSs on subprime mortgage bonds back in 2005-07, right....even they didn't own any of the underlying bonds? You could purely speculate on them without having any risk tied up yourself except your premium payments? I think Lewis' analogy was something like being able to buy fire insurance on some random slum prone to fires that you didn't even live in.
That is just incredible that you could speculate with relative low risk like that. Do any regulations prevent people from speculating like this now?
4) Are employees that work at Moody's and S&P's really 2nd rate as Michael Lewis makes them out to be?
This post was edited on 11/22/12 at 4:51 am
5
Posted on 11/21/12 at 10:21 pm to rickgrimes
The one piece of info from that time that makes me cringe is.....
quote:
To put the CDS situation into even further perspective, the gross domestic product (GDP) of the United States in 2007 -- the total value of all the goods and services generated in the country that year -- was $13.84 trillion [source: CIA]. In the third quarter of that same year, the top 25 banks in the United States held $14 trillion in credit default swaps [source: New York Times]. So even if the United States could liquidate its entire GDP for the year at once, it still wouldn't cover U.S. CDS losses should a series of credit events -- those triggers for CDS payouts -- occur.
Posted on 11/21/12 at 10:47 pm to rickgrimes
quote:
the idea being you use CDSs to replicate the worst of the bonds many times over
Not quite.
A CDS was viewed as insurance, not as a gamble or as an attempt to replicate other bonds.
When you buy insurance from any insurance provider (State Farm, Allstate, etc.) you are paying money to someone else with bigger reserves to help you out when you are in trouble. Not really gambling, but betting that someone else can handle the risk better than you can.
The general concept of a CDS is perfectly fine generally speaking. The problem is that if the guarantee behind it collapses you are in trouble. But there is a first time for everything, and the collapse of US real estate was so large that it overcame even the biggest reserves around.
Posted on 11/21/12 at 11:24 pm to rickgrimes
quote:
1) I don't think I completely understand the concept of 'synthetic' CDOs. The way Michael Lewis explains this it seems like you could keep repackaging CDSs that you buy on sub-prime triple B rated bonds into synthetic CDOs, the idea being you use CDSs to replicate the worst of the bonds many times over since the banks couldn't extend home loans fast enough to whet their appetite, so to speak.
A synthetic CDO is basically a conditional collateralized debt obligation, that is to say, it's a collection of collateralized debts that are not actually debts at the time but will be if certain conditions are met.
From what I remember, the credit default swaps that were being offered by AIG and whatnot were insuring the default risk of triple A rated subprime mortgage bonds (could've been the CDOs comprised of the lesser tranches of mortgage bonds, I'm not sure). On paper, the issuers of credit default swaps were insuring against the default of bonds rated on the same level as U.S. treasury bonds. On paper, buying a credit default swap on that kind of bond would be a sucker's bet; I think the CDS payouts were triggered by a percentage of defaults within a given bond, which was considered unlikely for an investment of that grade. Thus, for the issuer of a synthetic CDO, almost everything out there was hedged on that synthetic CDO being worthless.
I'm not sure what you mean by repackaging CDSs though. Are you wondering why they didn't offer an infinite amount of synthetic CDOs to be purchased by a relatively small number of investors (at the time)?
This post was edited on 11/21/12 at 11:26 pm
Posted on 11/21/12 at 11:31 pm to rickgrimes
Too drunk to reply, but thank you for the phenomenal thread.
Posted on 11/25/12 at 2:58 pm to rickgrimes
1) synthetic CDS are created by buying holding risk free assets (for example treasuries) and layering on risk in order to pick up a risk premium. By buying a treasury and writing (taking on the risk of default) CDS for a specific loan, you have (effectively) perfectly replicated actually holding the assets. Since there are a lot more risk free assets floating around, it is easier to create a synthetic CDO than to originate more loans and create an actual CDO.
There is no theorhetical limit on their creation since there is no need to actually generate the desired loans and you can creat risk free assets by buying risky assets and then buying CDS on them. After doing that, you can write CDS on something else and have one junk bond imitate another.
The reason it got so big was because its hard to keep track of and confusing. The industry clearly needs to be watched when there is a lot of growth, but I don't know exactly how to regulate it.
2) as far as I know they are. The market just isn't demanding them in the way that they were before and no I bank wants to deal in it.
3) That is correct. However, I disagree in their vilification. If you ban naked short positions on CDS, that creates a major market disfucntion. Had it not been for the people going short on the stuff, how much bigger would the bubble have been? People do it all the time with put options and no one has a problem with that. It is not the fault of the buyer, but the fault of the writer.
4) Yes. They aren't idiots by any means, but you have to realize that we are talking about an entire industry of only people in the top 1% (really top 20 basis points) of global intelligence. The guys at the rating agencies are smart, but they aren't paid nearly enough to incentivize the diligence that hedge funds do. Even given the same intelligence, they won't ever be able to beat the street.
There is no theorhetical limit on their creation since there is no need to actually generate the desired loans and you can creat risk free assets by buying risky assets and then buying CDS on them. After doing that, you can write CDS on something else and have one junk bond imitate another.
The reason it got so big was because its hard to keep track of and confusing. The industry clearly needs to be watched when there is a lot of growth, but I don't know exactly how to regulate it.
2) as far as I know they are. The market just isn't demanding them in the way that they were before and no I bank wants to deal in it.
3) That is correct. However, I disagree in their vilification. If you ban naked short positions on CDS, that creates a major market disfucntion. Had it not been for the people going short on the stuff, how much bigger would the bubble have been? People do it all the time with put options and no one has a problem with that. It is not the fault of the buyer, but the fault of the writer.
4) Yes. They aren't idiots by any means, but you have to realize that we are talking about an entire industry of only people in the top 1% (really top 20 basis points) of global intelligence. The guys at the rating agencies are smart, but they aren't paid nearly enough to incentivize the diligence that hedge funds do. Even given the same intelligence, they won't ever be able to beat the street.
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