July 17, 2010
Four Instruments

Michael Lewis’s new book, The Big Short, is a story of discovery—discovery by a small group of investors (Lewis estimates there were “more than ten, fewer than twenty” such people in the world) that the financial world was perched on a precipice and about to crash violently to the rocks below. And they subjected their insight to an empirical test: they bet on it. (And won, of course.)

Some observers called the housing people; some noted the absurdity of the mortgage products (alt-A, no-income, option ARM, etc.) being pedaled to naïve homebuyers in the subprime mortgage market. But few perceived the extent to which institutional investors and even Wall Street itself had taken a long position in the subprime mortgage market. And it was no ordinary long position, but one multiplied many times over by derivatives, e.g., synthetic CDOs (many of these stamped “triple-A”). And it was a position made all the bigger by leverage, with investment banks allowed debt-to-equity ratios as high as 40-to-one.

A recurrent question in Lewis’s book is who was on the long side of the bets his protagonists (who were principally hedge fund managers Steve Eisman, Michael Burry, Charlie Ledley, Jamie Mai, and several associates) were making. That is, if they were shorting the subprime mortgage market—by buying credit default swaps on mortgage-backed securities and CDOs—someone had to be on the long side. (And they didn’t believe it could be the “smart money” firms selling them the credit default swaps, i.e., Goldman Sachs, Deutsche Bank, etc.) Discovering who that was, and how the financial system had become so extraordinarily fragile is the story of Lewis’s book. The drama is punctuated by various revelatory moments where one or another of Lewis’s protagonists peels back another layer of the mystery, perceiving some previously hidden aspect of the financial instruments and practices that had evolved to render the system so vulnerable. The end-result is a rather eye-opening view not just of the financial crisis but of human nature.

Not a complete explanation, but a significant degree of illumination, of the financial crisis, arises from consideration of four financial instruments that figure prominently in Lewis’s story:

1. Mortgage-backed securities (MBS)
2. Collateralized debt obligations (CDOs)
3. Credit default swaps (CDS)
4. Synthetic collateralized debt obligations (synthetic CDOs)

Let’s take each in turn.

1. Mortgage-backed securities (MBSs). Mortgage-backed securities are simple. They’re like mutual funds, only rather than stocks pooled together to yield dividends and capital gains or losses, they’re mortgages pooled together to yield interest and principle. How to securitize mortgages was a vexing problem in the financial industry for years. The problem, apart from default risk, was prepayment risk—the risk that falling interest rates might compel mortgage-borrowers to refinance, leaving lenders with prepaid mortgage balances to reinvest at now-lower rates.

So, the question was how to structure pools of mortgages in a way that would make them marketable to investors on a large scale. The answer was tranches, i.e., dividing investors into classes according to willingness to absorb default and prepayment risk. In the “senior tranche”—about 80 percent of investors in a security—investors would get the lowest risk and lowest return. In lower tiers they would get higher risk and higher returns. And in the lowest tranche of all, the mezzanine level, they would get the highest return but also the preponderance of default and prepayment risk. So in the event of default by some portion of mortgage-borrowers whose loans are included in an MBS, mezzanine level investors would be fully cleaned out before losses start to accrue to investors in the next higher tranche, and so on.

The ratings agencies generally stamped securities marketed to senior tranche investors as triple-A (i.e., as safe as Treasury bonds), those marketed to mezzanine level investors as triple-B, and those marketed to investors in between at intermediate grades. Tranching thus enabled the creation of a liquid market in mortgage-backed securities.

Nothing necessarily very amiss here. Arguably this is Wall Street performing its legitimate function of efficiently aggregating and allocating savings and distributing risk. Of course, when MBSs are backed largely by subprime loans, that’s a problem. But most MBSs weren’t backed by subprime loans. It seems that if Wall Street ingenuity had extended no further than MBSs, the catastrophe might have been averted.

2. Collateralized debt obligations (CDOs). One step beyond securitization of loans is securitization of securitizations of loans. This is essentially what a collateralized debt obligation (CDO) is—a sort of fund of funds, but rather than pooling together different mutual funds or hedge funds, it pools together different asset-backed securities, e.g., different mortgage-backed securities.

As Lewis explains,

Its logic was exactly that of the original mortgage bonds [or mortgage-backed securities]. In a mortgage bond, you gathered thousands of loans and, assuming that it was extremely unlikely that they would all go bad together, created a tower of bonds, in which both risk and return diminished as you rose. In a CDO you gathered 100 different mortgage bonds—usually, the riskiest, lower floors of the original tower—and used them to erect an entirely new tower of bonds.

So why create a new configuration of securities that were already on the market? Well, the problem with ordinary mortgage-backed securities is that they

…are too near the ground. More prone to flooding—the first to take losses—they bear a lower credit rating: triple-B. Triple-B-rated bonds were harder to sell than the triple-A-rated ones, on the safe, upper floors of the building… there were huge sums of money to be made, if you could somehow get them re-rated as triple-A, thereby lowering their perceived risk, however dishonestly and artificially. This is what Goldman Sachs had cleverly done. Their—soon to be everyone’s—nifty solution to the problem of selling the lower floors appears, in retrospect, almost magical. Having gathered 100 ground floors from 100 different subprime mortgage buildings (100 different B-rated bonds), they persuaded the rating agencies that these weren’t, as they might appear, all exactly the same things. They were another diversified portfolio of assets! [p. 73]

So a key motivation behind repackaging mortgage-backed securities into collateralized debt obligations was simply to make money. Since triple-B MBSs were “too near the ground” and thus unattractive to investors, investment banks packaged them into CDOs, making an argument about “diversification of risk” that convinced ratings agencies to rate them A, double-A, or triple-A. The result was a new higher-grade product confected entirely of lower-grade product.

One could argue that CDOs nevertheless embody the same idea as MBSs, and thus, like MBSs, increase the efficiency of intermediation—only on a grander scale. But Lewis’s protagonists didn’t see it that way:

A CDO, in their view, was essentially just a pile of triple-B rated mortgage bonds. Wall Street firms had conspired with the rating agencies to represent the pile as a diversified collection of assets, but anyone with eyes could see that if one triple-B subprime mortgage went bad, most would go bad, as they were all vulnerable to the same economic forces. Subprime mortgage loans in Florida would default for the same reason, and at the same time, as subprime mortgage loans in California.

And they calculated that to “wipe out, entirely, any CDO made up of triple-B bonds, no matter what rating was assigned it,… all that was needed was a 7 percent loss in the underlying pool of home loans” (p. 129). Thus they concluded that the CDOs were simply “fraud.” But since “the market appeared to believe its own lie,” and thus “charged a lot less for insurance [credit default swaps] on a putatively safe double-A-rated slice of a CDO than it did for insurance on the openly risky triple-B-rated bonds,” it was “also a stunning opportunity.”

3. Credit default swaps (CDSs). Lewis’s protagonists shorted the subprime mortgage market primarily by buying credit default swaps (CDSs) on MBSs and CDOs. Credit default swaps are insurance contracts on bonds. If you own a bond and want to hedge your risk, and someone is willing, for a fee, to assume that risk, then it’s hard to see a problem with purchasing a credit default swap. In this function a credit default swap is a straightforward insurance product.

But Lewis notes two other ways of looking at credit default swaps. First, since purchasing one requires no financial exposure to the underlying asset (unlike with ordinary insurance), and since credit default swaps are tradable in secondary markets (again, unlike standard insurance contracts), credit default swaps can be instruments of pure speculation.

And secondly, and more bizarrely, one could think of a credit default swap

…as a near-perfect replica of a subprime mortgage bond [or mortgage-backed security]. The cash flows of Mike Burry’s credit default swaps replicated the cash flows of the triple-B-rated subprime mortgage bond that he wagered against. The 2.5 percent a year in premium Mike Burry was paying mimicked the spread over LIBOR that triple-B subprime mortgage bonds paid to an actual investor. The billion dollars whoever had sold Mike Burry his credit default swaps stood to lose, if the bonds went bad, replicated the potential losses of an actual bond owner. [p. 75]

In other words, through creation of these insurance products that, again, (a) can (like MBSs and CDOs) be traded in secondary markets, and (b) require of the buyer no financial exposure to the insured asset, a kind of clone security is generated. For every MBS or CDO, there can be an analogous CDS with exactly the same financial characteristics, i.e., the same risk and same payoff triggered by the same events. This is a curious, even eerie, property for a financial asset to have, since, unregulated as they are, any number of these can be generated from only one underlying real (non-derivative) security. So the original MBS provides a kind of genome from which financial engineers can generate any number of copies. This opens up a new universe of financial activity.

And how well do credit default swaps square with Wall Street’s storied function of aggregating and allocating savings and efficiently distributing risk? Obviously, purchasing insurance on an asset one doesn’t own and that one can sell to another party, preferably when its price has risen, has little to do with hedging risk. Still there’s a long-shot argument to be made that selling vast quantities of credit default swaps, as AIG did, gains for the seller greater financial wherewithal for its other, more orthodox, insurance activities. (As I say, it’s a long-shot argument.) But it’s in their odd property of mimicking mortgage-backed securities that credit default swaps depart furthest from any conventional notion we may have of finance and its role in the economy.

4. Synthetic collateralized debt obligations (Synthetic CDOs). Here’s where the story takes its oddest turn. Since credit default swaps mimic the asset-backed securities they insure, in the sense that the parties on each side of the transactions transfer the same “premiums,” incur the same risk, and realize the same payoff or loss depending on the outcome of the reference event, logically one could combine credit default swaps, rather than MBSs, into one security and call it a CDO. That would be a synthetic CDO. Thus a synthetic CDO is a CDO composed not of asset-backed securities (and thus loans, ultimately), but of credit default swaps (which are just insurance contracts, not loans at all).

I mentioned revelatory moments—moments where one or another of Lewis’s protagonists peals off another layer of the mystery of who was on the long side of their bets. I’ll quote in full what is perhaps the book’s most dramatic passage (italics in original). Steve Eisman is finally face-to-face with someone on the other side of his bets, a synthetic CDO salesman named Wing Chau. Chau says:

Eisman hadn’t imagined that the investment bankers would have taken the credit default swaps he and others had purchased and packaged them into CDOs—that his shorting of the subprime market was adding more fuel to the inevitable fire.

Goldman Sachs and Deutsche Bank had been selling Eisman credit default swaps for years. Initially Goldman and Deutsche had intermediated between Eisman and (unbeknownst to Eisman) AIG, a situation that ended in 2005 when AIG realized it was selling many credit default swaps on MBSs backed largely by subprime loans. (Unfortunately at that point it was too late. The seeds of AIG’s destruction were sown.) Now Goldman and Deutsche were intermediating between Eisman and synthetic CDO confectors like Wing Chau.

And why would the investment banks and CDO confectors have created these new instruments, synthetic CDOs? Because mortgage lenders had run out of “Americans with shitty credit” to lend to and thus the “raw material” with which to generate the mortgages needed to create the MBSs. The thing is, at this point it didn’t matter. They didn’t need more “Americans with shitty credit.” They just needed the credit default swaps, which as noted earlier mimic MBSs and could be regenerated, on the basis of those MBSs, any number of times over. And from the CDSs they could confect CDOs, which likewise could be regenerated using CDSs (like those Eisman and others were bringing into existence through their shorting activity) any number of times over. Since the synthetic CDOs seemed diversified, and ratings agencies had neither the incentives nor the capabilities to properly assess their risk, they tended to be certified A, double-A, and triple-A. And so these assets could be passed to institutional investors in exchange for portions of the colossal quantities of savings that had accumulated around the globe.

There’s no possible pretense that synthetic CDOs somehow enhance Wall Street’s storied function of efficiently aggregating and allocating savings and distributing risk. The money investors pay for synthetic CDOs is apportioned between synthetic CDO salespersons and investment banks. Money received by purchasers of CDOs is just “premium” payments from the owners of the credit default swaps. Period. No money is lent to anyone. No risk is hedged. It’s just gambling, straightforwardly. The mortgages are just a physical reference, like horses in a horse race or a ball on a roulette wheel.

The moral of the story is that humans as a whole are unscrupulous and generally will go wherever they can go. And they aren’t necessarily very knowledgeable about the landscape into which they venture or how their activities shape it. Development of the derivatives products described here was, in a micro context, rational, as was that of the subprime mortgage products devised in the mortgage market. But of course these instruments helped create a catastrophe. Human ingenuity and energies are wonderful things. But to benefit from them, we need to subject them to the scrutiny of our rational self.