Log in

No account? Create an account
entries friends calendar profile Elf Sternberg's Pendorwright Projects Previous Previous Next Next
So, was there any money in the system? - Elf M. Sternberg
So, was there any money in the system?
ewhac said about the Eisman piece, "I still don't get it. Is he talking about a genuinely non-existent loan, fraudulently created to sell a CDS against? Or is he using the concept of a loan as a rhetorical stand-in for another CDS, in an attempt to describe swaps insuring swaps insuring swaps?"

No, he's talking about a genuine loan on a tenuous (in fact non-existent) promise to repay.

A CDO is a bundle of debt obligations with assets backing them; the assumption is that you can sell them short on the expectation that they'll produce long-term. When Eisman buys a credit default swap (an insurance policy on whether or not a BBB tranche bond obligation between two other parties will default), he gives Goldman Sachs an entry on their books that they can bundle as a new debt obligation vehicle (called a Synthetic Credit Debt Obligation) they can then sell-- and it has the exact same risk pattern as the original policy, because it's a meta-policy on the original risky mortgage-based "asset backed" CDO. When Sachs sells it, the CDO buyers who buy it either didn't know or didn't care what it was; it was just a CDO they could pass on without too much due diligence. Why should they care? Sachs thought it could make the game go on; they thought Sachs was good for it all.

That's why Eisman was so shocked at the CDO's cavalier attitude. He didn't care what he was buying and selling so long as he took his cut. The CDS had the same risk as the mortgages on which it was built, but the CDS dealers were able to take the debt obligations those CDSs represented and sell them as CDOs. This was that color photocopier rolling off $100 bills that Karl Denniger wrote about.

Since actual payoffs on CDSs were extremely rare until the crisis hit, as long as nobody blinked the system could go on forever. Eisman promised to keep paying the CDS's monthly fee-- but he was betting it would default. Sachs promised to pay off the CDS's full value if the BBB tranche of the large CDO (between two other institutions, neither Eisman's or Sachs) on which Eisman had played the CDS defaulted-- and Sachs was betting it wouldn't.

I don't know who's more foolish here: Sachs, for betting that it could keep this game going, or Eisman, for betting that Sachs would have enough money to cover his and every one else's CDOs. I think the shock comes in that paragraph because Eisman realizes just how big the game is all of a sudden, and just how bad it'll get.

Eisman was blinking hard, in disbelief, even as he kept playing the game. But he did keep playing, you'll notice.

When the paper credit market began to contract-- when the demand for real cash emerged and no one could meet it-- this unlimited capacity for leverage struck and the whole world blinked at once.

What's really telling about all this is that the market handwringing about the "complexity" of CDOs making it hard to understand what happened. But that's not true. As Michael Lewis's article points out, for the past year lots of people understood the problem. They just didn't care because it wasn't really their money. It was other people's money, of which they took a cut simply for being the conduit. I don't believe any longer that this was a problem that only a privileged few could understand. It's easy to understand. It was pure criminal greed.

As Brad Delong put it back in September, answering the question "How did we get here?":
Well, because the investors and creditors did not do their due diligence and check that the banks that were the ultimate holders of derivative securities had done their due diligence and checked that the financiers who had created the derivatives had done their due diligence and checked that the purchasers of the securities had done their due diligence and checked that securitizers had done their due diligence and checked that the lenders had done their due diligence and checked that the home buyers had done their due diligence and checked that they could afford their mortgages if house prices stopped going up.

Catastrophic failures of risk management at seven different points along the chain--any one of which would have kept us out of this current mess.

Current Mood: annoyed annoyed

5 comments or Leave a comment
From: norikos_author Date: November 29th, 2008 06:39 am (UTC) (Link)


I find myself speechless. As described, this seems to be the same thing, in principal, as check kiting -- after all, as long as none of the banks try to _cash_ the checks you're kiting, you're fine....

And nobody realized that building an entire market on a classic scam was, just maybe, a bad idea?

elfs From: elfs Date: December 2nd, 2008 04:47 pm (UTC) (Link)

Re: ....

What I want to know now is, where's my damn perpwalk!?
ewhac From: ewhac Date: November 30th, 2008 10:32 am (UTC) (Link)
Thank you. That's a bit clearer. I'm still having trouble visualizing where all the pieces on the chessboard are, and how they connect to each other, but it's a bit clearer now.

When this crisis started emerging in earnest, a turn of phrase came to mind, one intended to counter the Fountainhead-thumping Objectivists.who continue to espouse laissez faire, government-is-the-problem, unregulated "free market" dogma. Your quote from Brad Delong simply reinforces it:

Caveat Emptor Does Not Scale.
elfs From: elfs Date: December 2nd, 2008 04:51 pm (UTC) (Link)
I think the real tragedy here is that the risk was divorced from the reward. The CDO dealers created a demand and Sachs responded by creating investment vehicles that had only fantasy backing. But the CDO dealers didn't have to care because as long as they got a cut-- as long as they took their wealth out of the system first-- there was no risk to their long-term well being. It was every one else's money. Their only risk was to be caught out in the open, mid-transaction, when the pants fell and we saw who was still holding and who had only a smoke-filled hole.

And even then, separating corporate finances from personal finances, complete with "performance rewards" in the tens of millions, let a lot of people walk away from the wreckage very, very rich.
_candide_ From: _candide_ Date: December 1st, 2008 01:18 am (UTC) (Link)
Oh, but wait ... it gets worse.

Credit default swaps are akin to insurance. You pay a premium, and if the debt-based financial instrument catastrophically loses value, you receive payment, like a claim after an automobile accident.

Now, here's where the problem enters in: Credit default swaps are themselves financial instruments. Which means you can buy and sell them, causing the laws of supply and demand to inflate their value. So, how much are they really worth?

Well, that's where the quants, the, "geeks bearing equations," come in. They model all of this stuff. Or at least, they try to. In reality, they were told to shut by the head sales trader because the traders were making $3,000,000 each on CDS so who gives a shiite what you geeks and your models say.


See, I was at the Society of Industrial and Applied Mathematics Conference on Financial Mathematics and Engineering last week. We heard from a few people who work in the financial industry. They talked about what they saw before the meltdown. Waaaaay before. In fact they faulted themselves and fellow, "geeks bearing equations," not for their models being wrong, but for not speaking up about what the models were saying. (Do you really want to go to the VP, 2 levels above the head sales trader, and tell that VP the bad news about the risky, overvalued instruments the company is holding?) But I digress….

One fellow (whose name & ties I will not mention) alluded to a Certain Large Insurer which decided to model its credit default swaps like its life and auto insurance policies. Now, see, there's a problem with that. I can't turn around and sell my auto-insurance to Elf. You can do that with credit default swaps. Moreover, nobody is going to go out, buy life insurance, then commit suicide so that they can collect the policy. They'd be a little too dead to benefit. However, a trader can go out, buy a credit default swap on an instrument she owns, then short-sell that instrument (thanks to the elimination of regulations that prevented short-selling except under specific conditions). Or worse: traders can purchase credit default swaps protecting instruments they don't even own.

Life-insurance doesn't even work anything like Credit Default Swaps, yet that Certain Large Insurer modeled the two the same. Is it any wonder that they had no idea how bad their risk-exposure was?
5 comments or Leave a comment