Broadening the Frame by Matt Carlson

Four Financial Instruments (The Big Short)

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 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 bubble; 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 (discussed below)—many of these stamped “triple-A.” And it was a position made all the larger 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 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. 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 an eye-opening view of the financial crisis and, arguably, of human nature as well.

A considerable degree of illumination of the financial crisis arises from consideration of four financial instruments that figure prominently in Lewis’s narrative:

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: 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—mortgage-backed securities—in a way that would make them marketable to investors on a large scale. The answer was tranching, 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, for example, 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 as intermediate grades. Because willing buyers could be found for products sorted in this way, tranching enabled the creation of a liquid market in mortgage-backed securities.

There’s nothing necessarily amiss here. Arguably, this is Wall Street performing its legitimate function of efficiently aggregating and allocating savings and distributing risk. Of course, when MBSs contain large percentages of subprime loans, that’s a problem. But if Wall Street ingenuity had stopped at MBSs rather gone on to create more exotic financial instruments, the financial crisis of 2008-09 almost certainly wouldn’t have occurred.

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 one 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 perform the role of aggregating and allocating savings and efficiently distributing risk—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” for those with a mind to short the housing market.

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 you may wish to buy a credit default swap from that party. 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, say, health, auto, or fire 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 second, and more bizarrely, one could think of a credit default swap “…as a near-perfect replica of a subprime mortgage bond. The cash flows of Mike Burry’s [one of Lewis’s protagonists] 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 [the London Interbank Offered Rate, a rate leading banks charge each other for short-term loans and thus a benchmark rate for debt instruments] 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 the 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 created. 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 were, any number of these could be generated from only one underlying real (non-derivative) security. So the original MBS provides a kind of genome from which financial engineers could 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 have had of finance and its role in the economy.

4. Synthetic collateralized debt obligations. Here’s where the story gets strange. 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). 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 payoffs or losses, depending on the outcome of the reference event—one could in principle combine credit default swaps rather than MBSs into one security and call it a CDO. That would be a synthetic CDO.

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. (They bought credit default swaps from such firms as Deutsche Bank and Goldman Sachs but didn’t suspect that these firms, not normally associated with the “dumb money,” could be the ultimate counterparties in these transactions.) I’ll quote in full what is perhaps the book’s most dramatic passage (italics in original). Steve Eisman (another of Lewis’s protagonists) is finally face-to- face with someone on the other side of his bets, a synthetic CDO salesman named Wing Chau. Chau says:

“’I love guys like you who short my market. Without you I don’t have anything to buy.’

Say that again….

That’s when Steve Eisman finally understood the madness of the machine. He and Vinny and Danny had been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the triple-B tranche of subprime mortgage-backed bonds without fully understanding why those firms were so eager to accept them. Now he was face-to-face with the actual human being on the other side of his credit defaults swaps. Now he got it: The credit default swaps, filtered through the CDOs, were being used to replicate bonds backed by actual home loans. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. Wall Street needed his bets in order to synthesize more of them. ‘They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,’ said Eisman. ‘They were creating them out of whole cloth. One hundred times over! That’s why the losses in the financial system are so much greater than just the subprime loans. That’s when I realized they needed us to keep the machine running. I was like, This is allowed?’” (p. 143)

To fill out the story, 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 composed largely of subprime loans. (Unfortunately, at that point, it was too late. The seeds of AIG’s destruction were sewn.) Now Goldman and Deutsche were intermediating between Eisman and synthetic CDO confectors like Wing Chau.

And why would the investment banks and synthetic CDO confectors have done this? Because mortgage lenders had run out of “Americans with shitty credit” to lend to and thus 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 above, mimic MBSs and could be generated and regenerated any number of times over. And from the CDSs, they could confect CDOs, which, likewise, could be generated and regenerated 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 over recent years. 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.

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 institutional investors pay for synthetic CDOs is apportioned between synthetic CDO salespersons and investment banks. Money received by purchasers of synthetic CDOs is just “premium” payments from the owners of credit default swaps. Period. No money is lent to anyone. It’s gambling pure and simple. The mortgages are just a physical reference, like horses in a horse race or a ball on a roulette wheel.

The development of the derivatives products discussed here was, in an unregulated environment, logical, as was that of the subprime mortgage products in the mortgage market. But obviously, these instruments helped cause a catastrophe. Human ingenuity and energies are wonderful things. But to benefit from them, they must be overseen by our more rational self.