Just finished reading 'The Big Short' - questions | TigerDroppings.com

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rickgrimes
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Just finished reading 'The Big Short' - questions



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?



This post was edited on 11/22 at 4:51 am



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Notro
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re: Just finished reading 'The Big Short' - questions


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.






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foshizzle
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re: Just finished reading 'The Big Short' - questions


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.






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rickgrimes
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re: Just finished reading 'The Big Short' - questions


Yes, I get what a CDS is. What I was referring to was the synthetic CDO which supposedly comprised of nothing but CDSs.

These are the paragraphs I was referring to from the book:
quote:

And so, to generate $1 billion in triple-B-rated subprime mortgage bonds, Goldman Sachs did not need to originate $50 billion in home loans. They needed simply to entice Mike Burry, or some other market pessimist, to pick 100 different triple-B bonds and buy $10 million in credit default swaps on each of them. Once they had this package (a "synthetic CDO," it was called, which was the term of art for a CDO composed of nothing but credit default swaps), they'd take it over to Moody's and Standard & Poor's. "The ratings agencies didn't really have their own CDO model," says one former Goldman CDO trader. "The banks would send over their own model to Moody's and say, 'How does this look?'" Somehow, roughly 80 percent of what had been risky triple-B-rated bonds now looked like triple-A-rated bonds. The other 20 percent, bearing lower credit ratings, generally were more difficult to sell, but they could, incredibly, simply be piled up in yet another heap and reprocessed yet again, into more triple-A bonds. The machine that turned 100 percent lead into an ore that was now 80 percent gold and 20 percent lead would accept the residual lead and turn 80 percent of that into gold, too.

The details were complicated, but the gist of this new money machine was not: It turned a lot of dicey loans into a pile of bonds, most of which were triple-A-rated, then it took the lowest-rated of the remaining bonds and turned most of those into triple-A CDOs. And then--because it could not extend home loans fast enough to create a sufficient number of lower-rated bonds--it used credit default swaps to replicate the very worst of the existing bonds, many times over. Goldman Sachs stood between Michael Burry and AIG. Michael Burry forked out 250 basis points (2.5 percent) to own credit default swaps on the very crappiest triple-B bonds, and AIG paid a mere 12 basis points (0.12 percent) to sell credit default swaps on those very same bonds, filtered through a synthetic CDO, and pronounced triple-A-rated. There were a few other messy details*--some of the lead was sold off directly to German investors in Dusseldorf--but when the dust settled, Goldman Sachs had taken roughly 2 percent off the top, risk-free, and booked all the profit up front. There was no need on either side--long or short--for cash to change hands. Both sides could do a deal with Goldman Sachs by signing a piece of paper. The original home mortgage loans on whose fate both sides were betting played no other role. In a funny way, they existed only so that their fate might be gambled upon.


Was this manner of creating CDSs and CDOs and synthetic CDOs ever sustainable? It seems to me you are just hacking up and repackaging the same thing over and over again. The whole thing seems so complicated. How do you even know what is in each of these pieces?



This post was edited on 11/21 at 11:13 pm


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Dead Mike
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re: Just finished reading 'The Big Short' - questions


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 at 11:26 pm


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TheHiddenFlask
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re: Just finished reading 'The Big Short' - questions


Too drunk to reply, but thank you for the phenomenal thread.





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matthew25
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re: Just finished reading 'The Big Short' - questions


From another forum:

page 97: "In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $724,000."

And still, nobody goes to jail.






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rickgrimes
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re: Just finished reading 'The Big Short' - questions


quote:

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)?


Yes. The italicized sentence in particular is interesting to me:

The details were complicated, but the gist of this new money machine was not: It turned a lot of dicey loans into a pile of bonds, most of which were triple-A-rated, then it took the lowest-rated of the remaining bonds and turned most of those into triple-A CDOs. And then--because it could not extend home loans fast enough to create a sufficient number of lower-rated bonds--it used credit default swaps to replicate the very worst of the existing bonds, many times over.

So did the IBs game the system as much as they could? Could they have created an even bigger mess?



This post was edited on 11/22 at 2:09 am


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rickgrimes
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re: Just finished reading 'The Big Short' - questions


quote:

Too drunk to reply, but thank you for the phenomenal thread.

Well...were you going to make a follow-up post?






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TheHiddenFlask
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re: Just finished reading 'The Big Short' - questions


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.







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GetBackToWork
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re: Just finished reading 'The Big Short' - questions


The real issue going forward, IMO, is how to manage risk without creating inefficient regulation.

The individual payoffs grew so large, so fast, that any traditional check like reputational risk or concern for the firm was thrown out the window. In the 80's, no one wanted to be "that guy" who brought down the partnership. The dynamics change when the payoff runs into the hundreds of millions, and there is no partnership.

Once the world returns to "normal", there will be another run using some new tactic. As someone else mentioned, because there are so few who understand the ever increasingly sophisticated financial products, they have no incentive to work as regulators. The next time someone hits the wall, even the Fed won't be large enough to fix it. LTCM in 1997 was doable. 2008 was a stretch whose effects still aren't totally written. What happens when the positions can't simply be bought out and there isn't enough capital to "shore it up" anymore?







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rickgrimes
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re: Just finished reading 'The Big Short' - questions


Appreciate the input





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TheHiddenFlask
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re: Just finished reading 'The Big Short' - questions


No problem.

Feel free to ask for any clarification, I wrote that on an iPhone, so proofing wasn't gonna happen.

This is one of my favorite books of all time, so I don't mind talking about it.






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