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Banks to sell first post-crisis managed synthetic CDO

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Re: Banks to sell first post-crisis managed synthetic CDO

#51

Post by samsonradu »

boublepop wrote: post #47
nickles wrote: post #13

It has been argued that the current environment of low rates is driven by a safe asset shortage [0]. Many investors (e.g. insurance companies, pension funds) need to match liabilities with assets yielding reliable returns. With a constrained supply of safe assets, this demand drives yields down. Austrian economists argue that the resulting level of interest rates may be artificially low, leading to 'malinvestment' [1…

With the low availability of reliable assets doesn’t that mean that any government could issue like 2% bonds and essentially get near unlimited buyers? Thus financing huge projects like a complete transition to green energy, or large infrastructure projects and at the same time help work against the potential severity of a future crash?

2%? They're issuing ~0% bonds in most of the Eurozone.

I also believe there can't really be a crash when interest rates are very low/at 0%, since the time value of money literally becomes null and debt can forever be pushed further. BUT since there is already existing debt to service - issued at higher interest rates - the debt size has to increase.

Then it works as a trap as the interest rates cannot easily go up without heavy defaults - because there is a lot of debt to service. Also, somehow low interest rates correlate with low GDP growth - max capacity, no room for growth left?

Disclaimer - not an economist, perhaps someone can debunk my theory and explain what I'm getting wrong.

Re: Banks to sell first post-crisis managed synthetic CDO

#52

Post by morley »

tialaramex wrote: post #25
morley wrote: post #17

Earlier quoted context omitted.

Your comment illustrates what I found so frustrating about The Big Short, and people who cite it whenever CDOs are brought up: the filmmakers made no effort in understanding the theory behind CDOs, nor did they attempt to explain the potential benefits. Now... it's possible that the way human nature works, CDOs will always result in companies engage in collective delusion that results in a similar meltdown. I think T…

What potential benefit of CDOs did you feel wasn't explained? The movie is based on a book. Do you feel the book's author (Michael Lewis who has written about mortgage backed securities for years) also doesn't understand the theory behind CDOs? Or that the filmmakers didn't understand the book?

To answer your first question: the benefit of derivatives, of which CDOs are a type, are that they theoretically allow people to _reduce_ risk.

The classic example is a put option. If you think a stock will go down in a future, you could short that stock; but if instead the stock goes _up_, you could be on the hook for an infinite amount of money. Instead, you can buy a put option and get a similar payout if the stock goes down, but if it goes up, you've only lost the money you spent on the option.

Another example is purchasing futures: if you're an airline and you think fuel prices are going to go up, you can buy up a messload of fuel futures, and you'll effectively pay the same price for fuel while everyone else is paying more (which I think JetBlue did in the 00s).

In this case, a CDO theoretically reduces risk by spreading your risk across a huge number of mortgage holders. If you sell someone one mortgage and they default, then whoops! You just lost a ton of money. But if you instead sell 100 different mortgages, you're "diversifying" your risk. Most people don't have billions of dollars to sell thousands of mortgages to make this sort of investment, so CDOs package the mortgages into purchaseable portions.

(Of course, what happened during the housing crisis was that there was a huge, systemic issue that would cause huge swatches of mortgages to default. That part sucked, and the contributors to that catastrophe definitely deserve the ire on them.)

[Disclaimer: I'm relying on my memory of finance classes I took 15 years ago, I'm probably wrong about some details.]

Re: Banks to sell first post-crisis managed synthetic CDO

#53

Post by vkou »

nradov wrote: post #24
nickles wrote: post #13

It has been argued that the current environment of low rates is driven by a safe asset shortage [0]. Many investors (e.g. insurance companies, pension funds) need to match liabilities with assets yielding reliable returns. With a constrained supply of safe assets, this demand drives yields down. Austrian economists argue that the resulting level of interest rates may be artificially low, leading to 'malinvestment' [1…

This is one reason why defined benefit pension plans are a terrible idea with hidden risks for employees, employers, and taxpayers. Everyone pretends things are fine but when investment returns come in below expectations the illusion will fall apart. As a society we should aggressively phase out pensions and replace them with defined contribution plans.

Defined benefit pension plans are a great idea, because you get something out of them, regardless of how long you live.

Even if investing in one makes you take a haircut, compared to a fixed contribution fund, they are still a great idea. For two key reasons.

1. You need money to live.

2. You don't know how long you'll live for.

If I retire with a fixed contribution retirement fund, that is planned to last me 20 years, and I die after year 5, it's of zero consolation to me that ~75% of my fund is still around.

... But if I live to year 21, I've now got zero income. A big fat zero. And I'm also not in a great physical state to work for more money to support myself.

Likewise, if there's a market crash, and a slow recovery two years into my retirement, that 20 years of runway may turn into 12.

Banking on a fixed contribution fund is like playing a game where we flip a coin. Tails, you triple your money. Heads, you lose everything you own.

This game has a positive expected net value for you, but you'd be an absolute idiot to play it at the age of 75.

With a defined benefit pension plan, you're playing a different game. Heads, you add 40% to your money. Tails, you lose half of what you own.

This game has a negative expected net value for you, but if you have to pick between one or the other, it's a much better game to be playing at the age of 75.

The optimal strategy, of course, is to diversify your investments, and have both a defined contribution retirement fund, AND a defined benefit pension plan, with the understanding that one of them may underperform for your situation. (The first if you live too long, the second, if the market in general has a rough time.)

Currently, something like 4-6% of my retirement 'savings' (In the form of social security contributions) are tied in defined benefit pension plans. I'd feel much more comfortable if I could shift my distribution of savings, so that they would be closer to 30% of them. And yes, I expect to take a haircut on them.

Re: Banks to sell first post-crisis managed synthetic CDO

#54

Post by coliveira »

ThrustVectoring wrote: post #50

This is actually fine. While CDOs were involved in the last financial crisis, they weren't the fundamental culprit. That honor would belong to ill-coordinated banking regulations between the US and Europe. In order to provide a public backstop without encouraging moral hazard, banking regulators impose risk-taking limitations on banks. In the US, this took the form of encouraging asset sales into capital markets, und…

These are all incidental issues. The real problem with CDOs and related financial products is that they deal with tremendous leverage without proper transparency. In a leveraged environment, you need to have a framework to understand who owns what and if the counterpart can pay for that leverage. Good examples of such a well regulated market are the options and futures markets. On the contrary, CDOs, swaps, and other exotic instruments give institutions the ability to leverage themselves, but nobody is regulating where the money is to pay counterparts when bets are wrong (and they eventually will be). The result are frozen markets! The only solution the financial world has at this point is to create money to bring liquidity to the markets again. This can only work up to a point, and in fact can exacerbate the results of a financial catastrophe.

Re: Banks to sell first post-crisis managed synthetic CDO

#55

Post by vkou »

lotsofpulp wrote: post #34
Retric wrote: post #27

Earlier quoted context omitted.

Defined benifit pensions can utilize the same investments as defined contribution pensions. The actual difference is who gets the surplus from early deaths, either other pensioners or children/charities etc. Equivalent investments are thus safer in defined benifit pensions at least in terms of a safe retirement. Of course this is all rather dependent on good regulations and equivalent funding. Allow companies to issu…

For taxpayer funded defined benefit pensions, the actual difference is that in the defined benefit pension case, future taxpayers are on the hook for any underfunding and understating of costs in exchange for government employee votes as well as other kinds of fraud. With defined contribution, politicians and senior union officials can’t play those numbers games since there is no lien on future taxpayers.

> With defined contribution, politicians and senior union officials can’t play those numbers games since there is no lien on future taxpayers.

If you run out of money in your retirement, and are eating catfood under a bridge, you're going to ask future taxpayers to pay for your survival, either way. Regardless of whether the reason for it is 'my pension fund ran out of money' or 'I lived longer than my planned X years of runway.'

The fun thing is, if you've invested into both of those things, you are reducing the risk that you end up in this situation.

Re: Banks to sell first post-crisis managed synthetic CDO

#56

Post by coliveira »

morley wrote: post #17
nickles wrote: post #13

It has been argued that the current environment of low rates is driven by a safe asset shortage [0]. Many investors (e.g. insurance companies, pension funds) need to match liabilities with assets yielding reliable returns. With a constrained supply of safe assets, this demand drives yields down. Austrian economists argue that the resulting level of interest rates may be artificially low, leading to 'malinvestment' [1…

Your comment illustrates what I found so frustrating about The Big Short, and people who cite it whenever CDOs are brought up: the filmmakers made no effort in understanding the theory behind CDOs, nor did they attempt to explain the potential benefits. Now... it's possible that the way human nature works, CDOs will always result in companies engage in collective delusion that results in a similar meltdown. I think T…

CDOs and similars are the ideal vehicle for financial fraud. Basically it assumes that certain companies can create pools of loans that have well defined risk, and rewards them for finding as many of these loans as possible. It is clearly in the interest of loan originators to create a high number of loans with lower quality, after all they won't have to keep these loans and are paid only on the origination.

Re: Banks to sell first post-crisis managed synthetic CDO

#57

Post by nradov »

vkou wrote: post #53
nradov wrote: post #24

Earlier quoted context omitted.

This is one reason why defined benefit pension plans are a terrible idea with hidden risks for employees, employers, and taxpayers. Everyone pretends things are fine but when investment returns come in below expectations the illusion will fall apart. As a society we should aggressively phase out pensions and replace them with defined contribution plans.

Defined benefit pension plans are a great idea, because you get something out of them, regardless of how long you live. Even if investing in one makes you take a haircut, compared to a fixed contribution fund, they are still a great idea. For two key reasons. 1. You need money to live. 2. You don't know how long you'll live for. If I retire with a fixed contribution retirement fund, that is planned to last me 20 year…

Most financial risk can't be reduced, only shifted around between parties. The problem with defined benefit pension plans is what happens when the sponsoring entity goes bankrupt and can no longer pay? It's just too risky and the existence of the PBGC actually exacerbates that risk, creating a huge moral hazard at taxpayer expense.

And as for a market crash two years into retirement, only an idiot would be in volatile assets at that stage. The default investment option for most defined contribution plans is a target date fund, which protects against that scenario.

Re: Banks to sell first post-crisis managed synthetic CDO

#58

Post by JumpCrisscross »

coliveira wrote: post #54
ThrustVectoring wrote: post #50

This is actually fine. While CDOs were involved in the last financial crisis, they weren't the fundamental culprit. That honor would belong to ill-coordinated banking regulations between the US and Europe. In order to provide a public backstop without encouraging moral hazard, banking regulators impose risk-taking limitations on banks. In the US, this took the form of encouraging asset sales into capital markets, und…

These are all incidental issues. The real problem with CDOs and related financial products is that they deal with tremendous leverage without proper transparency. In a leveraged environment, you need to have a framework to understand who owns what and if the counterpart can pay for that leverage. Good examples of such a well regulated market are the options and futures markets. On the contrary, CDOs, swaps, and other…

> they deal with tremendous leverage without proper transparency

At least immediately post crisis, these products were super transparent. You have all the underlying loans and their docs in the closing package. Everyone knows who the ultimate borrower is, and how a dollar traces from them to their point in the chain.

As long as these assets are held outside the payments system, the contagion risk is contained. The problem happens when the public doubts the solvency of a payment processor.

Re: Banks to sell first post-crisis managed synthetic CDO

#59

Post by JumpCrisscross »

coliveira wrote: post #56
morley wrote: post #17

Earlier quoted context omitted.

Your comment illustrates what I found so frustrating about The Big Short, and people who cite it whenever CDOs are brought up: the filmmakers made no effort in understanding the theory behind CDOs, nor did they attempt to explain the potential benefits. Now... it's possible that the way human nature works, CDOs will always result in companies engage in collective delusion that results in a similar meltdown. I think T…

CDOs and similars are the ideal vehicle for financial fraud. Basically it assumes that certain companies can create pools of loans that have well defined risk, and rewards them for finding as many of these loans as possible. It is clearly in the interest of loan originators to create a high number of loans with lower quality, after all they won't have to keep these loans and are paid only on the origination.

> it assumes that certain companies can create pools of loans that have well defined risk

No. It says a portfolio of risks can be arranged such that their first cash flows are less risky than their last. This is prima facie true.

What matters, to a point, is less the level of risk than its correlation. (And where you draw the line between privileged and unprivileged flows.)

Putting it another way, if I take a hundred loans to random industries and say “I’ll pay Bob a dollar first and Al a dollar second,” Bob has a less risky asset than Al. If you have enough uncorrelated loans, and Bob’s take is small enough and first enough, it starts to approach the point that the whole portfolio must default before Bob loses money.

In practice, CDOs largely performed through the crisis. Their market values plummeted. But their senior tranches kept paying.

Re: Banks to sell first post-crisis managed synthetic CDO

#60

Post by nradov »

lotsofpulp wrote: post #34
Retric wrote: post #27

Earlier quoted context omitted.

Defined benifit pensions can utilize the same investments as defined contribution pensions. The actual difference is who gets the surplus from early deaths, either other pensioners or children/charities etc. Equivalent investments are thus safer in defined benifit pensions at least in terms of a safe retirement. Of course this is all rather dependent on good regulations and equivalent funding. Allow companies to issu…

For taxpayer funded defined benefit pensions, the actual difference is that in the defined benefit pension case, future taxpayers are on the hook for any underfunding and understating of costs in exchange for government employee votes as well as other kinds of fraud. With defined contribution, politicians and senior union officials can’t play those numbers games since there is no lien on future taxpayers.

Local governments with unsustainable pension costs are likely to choose bankruptcy instead of large tax increases. Bankruptcy judges have the authority to unilaterally cut pension benefits.

For any young attorneys just starting out, Chapter 9 bankruptcy will be a growing and lucrative practice area.

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