I first read Michael Lewis back in the 80s with Liar’s Poker, where he covered the initial bond trading explosion. His new book, The Big Short, is back in the same territory, covering the subprime mortgage blowup in 2006-2008, and it’s a very readable story centering on a handful of traders who got the idea early that they should start betting against this market. If only to have a quick reference for later, I want to jot down a few notes on the various trading vehicles.
First off, note that any cash stream can essentially be thought of like a bond. A mortgage is a cash stream from the borrower to the lender. The risk on a particular mortgage is that the borrowers won’t be able to re-pay, but since the penalty for not paying will be to lose the house, most borrowers with some skin in the game will try hard to re-pay. Back in the 80s they came up with the idea of bundling mortgages together, and making bonds out of them, called collateralized debt obligation (CDO). That worked OK for awhile, but in the 2000’s real estate boom, in part to keep the party going, we saw the massive increase of subprime loans (where there was little to no downpayment, and perhaps no income verification either).
But it wasn’t until about 2005 that some smart traders decided they needed a vehicle to bet against mortgage bonds, and in particular mortgage bonds on subprime mortgages. Now it’s apparently very hard to short a bond, but bankers were able to come up with the next best thing, which was called the credit default swap (CDS). The CDS is like an insurance policy on a mortgage bond – to hold a CDS you pay a yearly insurance premium (usually a percent or two of the amount of the bond) to the issuer, and if the underlying mortgage bond defaults (because individual loans in the bond are not being repaid), then the issuer pays out to cover the losses. Note that the issuer of the CDS is potentially on the hook for the entire value of the underlying bond.
Now we can see that in fact one can look at the CDS as a cash stream of insurance premium payments, and since the chance of a pay out is the same as the chance that the underlying bond will default, it means that you can create a CDO made out of CDS policies (called a synthetic CDO). And if your assumption was that the underlying mortgages would always be repaid since real estate always goes up, then you’d be presumably happy to buy synthetic CDOs as well as regular CDOs, seeing them as equally risk-free.
The other important factor here is that as long as you can find an issuer, anyone can buy a CDS. Thus the volume of trading of these things was not limited to the number of home loans being made! For awhile AIG was a big issuer of CDS’s, but after awhile they saw they might run into trouble with them, and others stepped in. Also note that most purchases of these things were brokered by the big banks, and they liked the fact that there was not a transparent market – i.e. they could charge a nice profit for being the middleman. They also, of course, had some of their own money in these holdings.
So, The Big Short tells the story of some investors who bought CDS’s, and what happened next. Funny enough, while they were convinced that the underlying mortgage bonds would go bad, several of them were very worried that they would not be paid off, because they could see that the issuers would be losing a lot of money. Thus typically they did not hold the CDS’s until the end, but sold them at a big profit to desperate buyers who had the underlying bonds and saw that they were in big trouble.
This books gives me some idea of why the banks are so opposed to regulations, but that doesn’t mean the rest of us need to listen to them!