The Big Short

April 5th, 2010 by Potato

I just finished reading Michael Lewis’ The Big Short this weekend. It was a pretty quick read, and fairly informative on just what sort of shenanigans were going on in the CDO market of repackaged subprime loans. Even though I’ve been reading about these for something like two years now, I learned more scary facts about them. The book comes off as a really long newspaper article (albeit a rather good one), quoting the people who were there, and retelling the story of the guys who figured out early on what was going on, but there isn’t a central narrative (aside from subprime itself). Not too many of them seemed to grasp (or care about) the societal clusterfuck that would be unleashed if they were right until it was nearly upon them — they were just trying to make a buck on a mispricing of risk.

He has a few very interesting anecdotes about the generation of these financial instruments and the people behind it all, and it does contain a good explanation of what exactly a CDO is if you still haven’t picked that up.

I found it amazing that the raters (Moody’s, S&P) were so complicit in all of this. He makes a good point that our system is not set up to incentivize the “cops”: raters and regulators are paid far, far less well than the traders they’re trying to monitor. As a result, generally the “dumb” finance guys end up in those positions, and they get walked all over by the smart money (indeed, the big bucks in finance draw away some bright minds from physics, math, engineering, and even medicine who might do more societal good in those positions, rather than coming up with complicated computer models of how to redistribute capital). Some of these characters in the book who had figured out that these groups of subprime mortgages were doomed to fail asked the rating agency people to do a better job of rating the paper, since it obviously wasn’t AAA. Of course, they were doing that because they wanted the ratings lowered so they could make money on their shorts, and not out of some altruistic motive, but still. They pointed out things like how high default rates were in a period of rising house prices, and asked what their models said would happen to all this stuff if housing went down, even modestly — the ratings guys said they didn’t test negative numbers when rating the bonds.

I was also surprised to hear of just how dodgy some of these CDOs were created. I knew that they took a pile of mortgages, say 1000 of them, and grouped them together, and then created tranches, or levels. Each level suffers defaults in a certain order: the lowest level takes the hits of defaults first, and if just ~8% of losses occur in the underlying mortgages, that level is wiped out, and it gets some low rating from the agencies (BBB-). The top level has a fair bit of protection, some high number of losses must occur before they’re wiped out, so that stuff gets rated AAA. Then what I found out is that first off, the characteristics of the whole group of loans was only ever described on average: so a group of 1000 loans to borrowers with a credit score of 610 was rated the same as one to 500 borrows with a credit score of 510 and 500 with a credit score of 710, yet the second pool was much more likely to suffer huge losses that would wipe out the bottom few rungs of the bond ladder since any small economic setback would lead someone with a score of 510 to default. Secondly, there was so much demand for these asset-backed securities that the firms started creating synthetic CDOs: they’d take all the lower-level paper (rated BBB) that they couldn’t sell because it was too risky for people to buy, then create a new tower of paper and tranche it out, and again the top level would get an AAA rating, even though it was entirely composed of the low-rated dreck they couldn’t sell individually. The theory was that not all the bad paper would go bad at once, so the top level would have protections similar to the group of 1000 mortgages. Except since this was all the paper that went to nothing with ~8% losses on the underlying pools of mortgages, anything that affected all those mortgages at once, even if just a little, would make this whole tower worthless… the risk models were in no way reflecting the reality of the situation. Then on top of that, when they started running out of mortgages to reshuffle, they made CDOs out of the credit default swaps these shorts were buying, just synthesizing securities out of whole cloth.

There was one anecdote in particular that really blew my mind though: The tale of Option One, which was creating subprime loans that were so bad, people were defaulting in the first month. I had some idea of how bad the subprime lending was in the US. I know that it’s better in Canada, but I’ve always held that it was merely a matter of degree and not of kind, and that as our market got away from fundamentals, a correction would be needed. For a brief instant when I was reading about how bad some of this stuff was, I started to wonder if the “it’s different up here” crowd might actually be right… then I remembered that in Toronto and Vancouver, you can’t buy a house/condo today and expect to make a profit renting it out in the long term (i.e., when rates return to something resembling normal).

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