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re: Just finished reading 'The Big Short' - questions
Posted on 11/25/12 at 2:58 pm to rickgrimes
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.
2
Posted on 11/26/12 at 10:55 am to TheHiddenFlask
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?
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?
Posted on 11/26/12 at 5:28 pm to TheHiddenFlask
Appreciate the input 
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