Friday, November 14, 2008

Toxic Assets

There is a tendency to blame sub-prime borrowers for the current financial mess, even though back-of-the-envelope estimates show that the value of the mortgages that are at risk is small relative to the mortgage market and miniscule compared to the overall financial market.

Via dkos, I came across this Michael Lewis article in Conde Nast; it tries to explain what happened.

Here are the key excerpt:

“Then he said something that blew my mind,” Eisman tells me. “He says, ‘I love guys like you who short my market. Without you, I don’t have anything to buy.’ ”

That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. “They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,” Eisman says. “They were creating them out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans. But that’s when I realized they needed us to keep the machine running. I was like, This is allowed?”

You really should read the whole thing.

“That Wall Street has gone down because of this is justice,” he says. “They fucked people. They built a castle to rip people off. Not once in all these years have I come across a person inside a big Wall Street firm who was having a crisis of conscience.”

But he couldn’t figure out exactly how the rating agencies justified turning BBB loans into AAA-rated bonds. "I didn’t understand how they were turning all this garbage into gold," he says. He brought some of the bond people from Goldman Sachs, Lehman Brothers, and UBS over for a visit. "We always asked the same question," says Eisman. "Where are the rating agencies in all of this? And I’d always get the same reaction. It was a smirk." He called Standard & Poor’s and asked what would happen to default rates if real estate prices fell. The man at S&P couldn’t say; its model for home prices had no ability to accept a negative number. "They were just assuming home prices would keep going up," Eisman says.


CapitalistImperialistPig said...

Yes, but I am still having trouble getting my head around the crucial (bolded) clause. It might be the same problem that I have with string theory;)

Arun said...

CIP, glad you asked, forced me to clarify my thoughts. There are clear analogies to particle physics here; I'll try not to make them. :)

What happens when I short-sell a real asset, say a stock of company A? I borrow the share from B, and sell it to L. Of course, the plan is to be able to buy the share at a depressed price later and return to B.

But for a duration, there is a sort-of doubling of the shares - we started with one owned by B, and for a while there are two shares in existence, the one owned by B and the one owned by L.

The share and virtual share have almost identical properties. E.g., if the share price of company A goes down by $2 in the market, the value of B's holdings and the value of L's holdings both drop by $2.

Of course, shares are tangible assets, and so if the company A declares a dividend, the dividend check will be mailed to the possessor of the real share, in this case, I think L gets the check, if I haven't yet replaced B's share.

Because these are tangible assets, a conservation law holds in the long term.

Here is hypothesis - for derivative securities, the short-sold security held by L is identical in all properties to the security held by B. Or to put it another way, B did not loan me his derivative security, he cloned it.

If company A could indefinitely issue shares without diluting the value of the share, it too would happily "lend" out shares to short sellers. Is the derivative not diluted by cloning?

My hypothesis is yes and no. The "face value" of the derivative is not affected. However, the leverage that underlies the creation of the derivative is multiplied. Which is how about $100 billion of real losses in the mortgage market can roil a $60 trillion derivatives market.

Homework problem: prove my first hypothesis.