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re: Just finished reading 'The Big Short' - questions
Posted on 11/21/12 at 10:47 pm to rickgrimes
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 11:07 pm to foshizzle
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:
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?
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 11/21/12 at 11:13 pm
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