A question for financial bods

CDOs, AAA tranches, the Great Crash and all that.

The general view is that this entire system failed and failed badly, that all the AAA tranches of the CDOs fell over and that securitisation as even an idea is a bad thing.

My own supposition is that it’s a bit different. And so I’d like to ask those who actually know (Paul B, you being a quant in these sorts of markets, maybe you know?).

I get the impression that most to near all of the AAA tranches of all but the very last of the deals put together are still paying out as they should do. The equity tranches did take all the losses and go horribly bust. But the slice and dice approach did in fact work: most to near all of the AAA tranches turned out to actually be AAA, even in the middle of the worst housing bust ever.

They all dropped in value, horribly, during the crash, causing all that pain to the banks holding them on leveraged terms (and thereby near wiping out their capital etc) but that’s a different problem from the idea that the AAA tranches themselves actually failed as bonds.

These two views are obviously not compatible. So which is the correct one?

40 thoughts on “A question for financial bods”

  1. And so I’d like to ask those who actually know (Paul B, you being a quant in these sorts of markets, maybe you know?)

    I don’t doubt Paul B’s expertise in this area, but it’s perhaps worth pointing out that if he encountered an ancient carpet maker in Marrakech, he’d tell him he was doing it all wrong.

  2. I think you are almost correct. But I have heard that some of the AAA CDO of CDOs did take losses as the correlations between the underlying CDOs was close to 100% since many of the underlying CDOs had the same loans and these went bad.

  3. I do not know the empirical answer but my take is that securitisation works fine (e.g. bonds backed by mortgages and tranched out) as long as the mortgages are not super correlated.

    What does not work, and should not have happened, is ‘securitisation squared’ where you create CDOs from the (already securitised) mortgage bonds and tranche those out, as the various tranches of the bonds are by definition quite correlated.

    But subprime during the crisis also potentially a special case as many of the mortgages were structured badly and inevitably more correlated than they should have been.

  4. The Inconvenient truth

    Tim

    According to an EIOPA consultation on securitisation a in September last year, the worst performing AAA securitisation a in the EU had a 0.1% default rate, in contrast to the US where the figure as 16%.

    For BBB securitisation a the respective figures were 0.2% and 62%.

    Of course what is often overlooked is that the credit rating is a measure of ultimate repayment of principle and no guarantee of mark-to-market volatility prior to maturity.

  5. I remember one AAA bond having a partial default. I can’t remember which one but it triggered a massive panic and a few simple questions like “why did you think default risks from a bunch of mortgages in the same town were uncorrelated when one factory closure would put lots of the mortgagees out of work at the same time?”
    A bit later someone admitted that Californian mortgages were non-recourse which meant that (i) they were not the security that thyey were sold on as and (ii) the mortgages in any one town had a near-90% correlation because they were all linked to swings in local property prices.

  6. It really doesn’t matter, one way or the other. All markets are based purely on confidence. It doesn’t matter what happened, only what was perceived to be happening at the time. One might think, looking back in retrospect & saying markets were being overly pessimistic would be instructive for the next time, but it doesn’t work that way. The root cause of last time round was overconfidence in weak securities, in the first place. But at the time investors didn’t see them as week securities. And they won’t next time, with the next bunch of crap.
    If you want something instructive from the big crash, it’s that so few people called it. That so few people were calling it was why it happened. So just wait until almost all of the experts are telling you it’s not going to happen again. And sell short.

  7. I have never heard of partial default in a CDO. An EoD on a tranche causes acceleration and it’s game over. And if a AAA tranche has a default then all the others must have defaulted too. So there is nothing partial about it. This is all detailed in the CDO prospectus.

    Partial default is unknown outside of sovereign debt markets where countries make up the rules as long as the debt is under local law. So they can default on one bond and not another. Like Russia defaulting on its foreign debt.

    If you mean that recovery was greater than 0% then that is possible especially for senior tranches. But that is not partial default.

  8. Doesn’t this go back to the complexity of the “securities”, I still don’t claim to understand the lingo so I’m being deliberately vague, being greater than anyone could understand in a timely manner?

    My understanding is that most of these creations were, in fact, stable. The base problem is no one knew which assumptions used to group them were actually valid leaving no way to tell the good from the bad.

    One interesting take I have from my first look at CDOs is that the firms, Drexel Burnham Lambert for Imperial Savings Association, that originally created them are out of business. It appears Imperial Savings Association went under during the S&L collapse in the late 80s. If anyone actually knows what happened I’d love a little more detail.

  9. If you want something instructive from the big crash, it’s that so few people called it. That so few people were calling it was why it happened.

    Same with the oil crash. It was all “peak oil” and $200 per barrel before the arse fell out of the industry.

  10. Ordinary people’s money should not be dependent on 24 hour casinos where a proportion of players are trying to short the market and destroy value.
    NB John77 makes a good point (yes really): American no recourse mortgages rendered Collateralised Debt Obligations meaningless as there is no ‘obligation; to repay ‘debt’ by the (sub prime) borrower so making them worthless as ‘collateral’ , so negating all three words in the phrase.
    Do No Recourse Mortgages still exist in the States?If so international sanctions would appear to be in order to preserve the world financial system, which we have become dependent on while being very sceptical of the less immediately powerful EU.

  11. @DBCReed – you are living proof that a little knowledge is a dangerous thing. Non-recourse mortgages are not useless as collateral as they are SECURED.

    All non-recourse means is that if the house is worth 100 at the time of the loan, and the loan amount is 90 (LTV=90%), and the house price falls to 70 at the time the mortgage payer defaults, then the bank takes ownership of the house and sells it and so loses (90-70)=20.

    In the UK the bank would come after the borrower for that 20.

    So in the US the bank gets back 70 out of 90. Which is not zero.

    Sure this is not as good as getting 90, but the interest rate on the mortgage will have priced that risk in.

  12. @TimN
    ” It was all “peak oil” and $200 per barrel before the arse fell out of the industry.”
    And exactly the same information was available before the crash as was available after the crash. It’s the way of looking at the information changed.
    Much the same with the stuff leading to the big crash. The number of actual defaults, initially, were trivial. But confidence….

  13. @ Frederick
    “Sure this is not as good as getting 90, but the interest rate on the mortgage will have priced that risk in.” Except that it hadn’t priced it in and some kid in Wall Street didn’t know that was a risk when he bought it and bundled it.
    When I said partial default I meant that only part of the interest payment due was paid – final recovery of the initial principal was so far in the future that one could only speculate about it.

  14. @john77
    Subprime loans that I am aware of were either at a higher fixed rate or a low starting variable rate. The higher interest rate is where the risk was “priced in.”

  15. Was the risk priced in?

    Subprime mortgages started failing, leading to the crash, and rising unemployment (in short).

    So, what caused the mortgages to start failing?

  16. @ Liberal Yank
    In some states, memorably California, mortgages were non-recourse; in some others they were normal (a debt owed by the borrower with the house as additional security). There was no visible sign that interest rates for California were the necessary amount higher than those in Massachusetts or Manhattan to fund the put option on local house prices.

  17. @john77
    As I stated earlier and no one has questioned “The base problem is no one knew which assumptions used to group them were actually valid leaving no way to tell the good from the bad.”

    Your point was “Except that it hadn’t priced it in and some kid in Wall Street didn’t know that was a risk when he bought it and bundled it.”

    Risk, as it was then assessed, was primarily built into the interest rates based on credit scores. That the risk assessment didn’t include all of the variables doesn’t mean that there was no added cost for the perceived higher risk loans. Obviously interest rates weren’t the “necessary amount higher” for different states but that is different than saying it wasn’t included at all.

  18. @ LY
    I was specifically talking about the higher risk of non-recourse loans versus normal mortgages. as should be obvious from my positioning ” Except that it hadn’t priced it in and some kid in Wall Street didn’t know that was a risk when he bought it and bundled it.” immediately after and in the same paragraph as ““Sure this is not as good as getting 90, but the interest rate on the mortgage will have priced that risk in.””
    I wasn’t therein disputing your point [although I could point out that a lot of us did know which assumptions were valid but no-one asked us until after the house of cards collapsed. As soon as someone told me, an equity analyst, about it I pointed out that mortgages in a single state would have significant correlation.]
    The trouble with conversing with Americans is that they only really understand English 94% of the time and we only find out what the 6% is afterwards. You are arguing that sub-prime mortgages paid higher rates than prime loans, to which I reply – so what? There should have been higher rates for California mortgages vs New England mortgages, whether prime or sub-prime.

  19. Sorry Tim W, mortgage derivatives isn’t my game, and I don’t know the answer to your question.

    My impression from talking to people in the game is that AAA-rated RMBS tranches were mostly OK, but AAA-rated RMBS-backed CDO tranches sometimes were not. Because you can recover some money from a subprime mortgage which defaults, but not enough to cover the mezzanine RMBS tranches behind the CDOs.

    One datum is an in-depth report on AIG, and its CDO CDS business in particular, which concluded that there were real losses as well as liquidity problems.

  20. Tim Newman warns us against supposing that one knows an expert’s business better than the expert does. I’ll do my best to heed Tim’s implied advice.

    However, if I’ve made this mistake I’m not the only one. For example, I was recently more disappointed than surprised to read a commentator here, one Tim Newman, decrying a serious error in Family Law made, in TN’s opinion, by a Family Court Judge.

  21. Bloke in North Dorset

    “So, what caused the mortgages to start failing?”

    According to the one book I’ve read on the subject it was when house prices stopped going up, note not falling. Most of the subprime mortgages relied on remortgaging to a higher price home to cover the cost of the rising interest rates after the initial introductory period, to give the illusion of wealth and allow some equity withdrawal. When that didn’t happen the new rate couldn’t be afforded and the rest, as they say, is history.

    Obviously that’s only one story and from a guy who made $40bn when he bet against the market.

  22. For example, I was recently more disappointed than surprised to read a commentator here, one Tim Newman, decrying a serious error in Family Law made, in TN’s opinion, by a Family Court Judge.

    That didn’t need an expert to point that out. Took a complete cunt to defend it though: you.

  23. Let’s be clear about this then Tim N. You are saying that you know more than the judge does about family law.

    No, I don’t believe I passed any remarks on family law. Perhaps you’re confusing me with somebody else?

  24. Tim N: you wrote that the judge should not have ruled on the question he ruled on. That’s a question of family law, which he carefully explained in his published judgment.

    Perhaps it was an imposter posting under your name.

  25. Most points already covered. Correlations of underlying mortgages going to 1 in distressed situations (like the factory example above)
    CDOs are securitisations of securitisations. CDO squared are Cdos of cdos.
    Cdos were often made up of tranches of Mbs which couldn’t be sold. So they were repackaged as cdos. As an example a bank could have a pool of non investment grade Mbs collateral which could then be tranches from aaa downwards. As You move further away from the underlying mortgage collateral you have less control. Oh and the final point was there was ahem a lack of mortgages going into the pools that actually met the origination criteria; look at the law suits flying around

  26. Tim N: you wrote that the judge should not have ruled on the question he ruled on. That’s a question of family law, which he carefully explained in his published judgment.

    I said:

    1) Justice must be seen to be done. You, being an authoritarian cunt, took issue with this.
    2) The judge used a “balance of probabilities” justification for engaging in speculation that was wholly unecessary. I tried to explain this to you but, being a pompous arse, you instructed me to read the ruling in the mistaken assumption that I had not. This is the problem when you believe you are right 100% of the time and incapable of being wrong.

  27. If you read the judgment you’d know that the judge’s ruling wasn’t unnecessary speculation, it was the whole purpose of the “finding of fact” hearing. See point 14.

    The problem is that you are 100% wrong about this. You’re not arguing with me, you’re arguing with the judge’s understanding of what the hearing was for. And yet you butt into this thread to accuse me of ultracrepidarianism.

    Self awareness really isn’t your thing.

  28. You’re not arguing with me, you’re arguing with the judge’s understanding of what the hearing was for.

    Erm, no. I’m arguing with your assertion that I have claimed to know more about family law than the family law judge. Having misrepresented what I actually said, and with my clarifying what I actually said and showing that your assertion is bollocks, you are now trying to shift the goalposts back to the original discussion. Nice try.

    Self awareness really isn’t your thing.

    So we can add amateur online psychology to the long, long list of subjects in which you are an expert.

  29. And for somebody who accuses me of lacking self-awareness, isn’t it wonderfully ironic that in your defense you end up professing expertise in a legal case you know no more about than anyone else who has read the papers and shown an interest?

    See the difference between you and I is that whereas when I make a comment, I am (usually) happy to be corrected*, implying I do not consider myself an expert in the subject. Whereas you, without fail, dismiss any challenge or criticism of your commentary with glib replies and increasing condescension before you abruptly disappear only to pop up on another thread a day or so later, and never, ever admit you are wrong or mistaken (please feel free to link to an occasion where you have done so if you believe I am misrepresenting you here. But you won’t, because you can’t, because I’m not). Your whole shtick is one of an infallible expert, and it is tiresome.

    *As I would possibly have been in this case had it not been you glibly telling me to “read the judgement”, as if your wisdom in the matter was beyond question. Given your form in resorting to lying, evasion, and misrepresentation when I have previously demonstrated you have been wrong, you must forgive me for taking the assumption that your interventions in any thread in which I am participating is equally insincere.

  30. Bloke in North Dorset,
    ““So, what caused the mortgages to start failing?”

    According to the one book I’ve read on the subject it was when house prices stopped going up, note not falling. Most of the subprime mortgages relied on remortgaging to a higher price home to cover the cost of the rising interest rates after the initial introductory period, to give the illusion of wealth and allow some equity withdrawal. When that didn’t happen the new rate couldn’t be afforded and the rest, as they say, is history.”

    Thanks for the explanation.

    If that’s what was happening then, blimey.

    I may be a little simple-minded about house-buying and mortgages ….. I’ve never seen any short-term benefit in house price increases, and cannot conceive AT ALL why rising prices would help those struggling to pay a mortgage*. Trading-up just seems obvious bedlam.

    * Aside from the semi-nice feeling you get when you know that you can sell your house tomorrow for what you owe. If everything else has gone pear-shaped.

  31. My claim is that the judge has the legal expertise to know what he’s supposed to be ruling on. Your claim is that you know better. So be it.

    When one party to a debate attempts to summarize the debate in his favour (before scuttling off), it is a reasonable sign that he has lost. It is also an example of the very same weasly behavior which marked you out as a dishonest weasel in the first place.

Leave a Reply

Your email address will not be published. Required fields are marked *