Banks to sell first post-crisis managed synthetic CDO • Hacker News Board

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

#81

Post by AnimalMuppet » Thu, Jan 30, 2020, 2:10 AM UTC

luckydata wrote: post #33

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…

I think the author understands CDOs just fine, what you probably want to miss is that the system is built on manufactured trust in what is an extremely corrupt environment. CDOs are not safe because ratings are a joke, as evidently proven by the facts that led to our last recession.

"What you probably want to miss" sounds very much like an accusation of bad faith. That's frowned upon on HN.

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

#82

Post by AnimalMuppet » Thu, Jan 30, 2020, 2:12 AM UTC

qeternity wrote: post #66

csense wrote: post #64

Hopefully by now, everyone knows a bunch of banks bought CDO's, and then in '08 they collapsed, or nearly did, and took the world economy with them. If you run a bank, and you know this product is dangerous and causes banks to fail, why in the world would you buy one of these products? Maybe you told your brother-in-law to take a massive short position on your bank?

They didn’t collapse because of CDOs. They collapsed because GSEs had pushed the real estate market to ridiculous levels. The GFC was a classic case of government interference creating market distortions.

Even if true, that's not very comforting. The real estate market is once again at ridiculous levels...

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

#83

Post by luckydata » Thu, Jan 30, 2020, 3:41 AM UTC

AnimalMuppet wrote: post #81

luckydata wrote: post #33

Earlier quoted context omitted.

I think the author understands CDOs just fine, what you probably want to miss is that the system is built on manufactured trust in what is an extremely corrupt environment. CDOs are not safe because ratings are a joke, as evidently proven by the facts that led to our last recession.

"What you probably want to miss" sounds very much like an accusation of bad faith. That's frowned upon on HN.

“I couldn’t help but notice...”

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

#84

Post by riffraff » Thu, Jan 30, 2020, 7:51 AM UTC

djannzjkzxn wrote: post #62

riffraff wrote: post #40

Earlier quoted context omitted.

one interesting fact the movie didn't mention about CDOs, IIRC, is that the repackaging makes sense only with the assumption that the underlying assets are independent variables. I.e. if you have 2 independent bonds which will default with 50% probability you can combine 4 outcomes into a single one and issue two tranches. The senior one should be payed back 3 times out of 4 (it's enough if one bond pays back) and th…

Assets don’t need to be completely independent for their combination to provide an improved risk-adjusted return. In fact, all asset prices are correlated, but we still diversify. I don’t think the financial crisis happened because nobody heard of conditional probability. Derivative structuring is one of the places where people who are good at math go to get rich. Here is an old paper from 2001 that talks about how r…

sure, I didn't mean to imply that lack of basic understanding caused the financial crisis, but watching the movie (the Anthony Bourdain skit) and not having any knowledge of this stuff the first thing you'd think is: how could the soup be rated higher than the fish leftovers?

Understanding the probability bit explains that the trick depends on different modeling, not just on repackaging.

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

#85

Post by coliveira » Thu, Jan 30, 2020, 4:15 PM UTC

vijayr02 wrote: post #71

ThrustVectoring wrote: post #61

Earlier quoted context omitted.

Collateralized Debt Obligations themselves aren't a leveraged product. The originating bank issues loans and then sells on the assets. The various tranches are sold for cash and receive varying priority of cash-flow from the original loans. All the leverage is outside of the CDO itself - either European banks buying a dollar's worth of "AAA" assets with 98 cents of borrowed money, or some company writing a credit-def…

This is not a regular CDO - this is a synthetic CDO. The 'synthetic' means that the issuer may not (and most likely does not) hold the risk being tranched (loans in your example). Instead it generates return by selling CDS protection on certain market defined risks (hence the word synthetic, in the sense of being a derivative exposure). This makes a big difference: 1. Since individual tranches can be created on deman…

I see people repeating the mantra that CDOs are Ok, because they're theoretically sound and the only problem was with the regulatory issues until 2008. Given this and the apetite for risk in an environment of low returns, I wouldn't discard the possibility that these assets have once again risen to unsustainable levels. After all, the opacity of such arrangements is one of their problems. We may not learn the truth until it is again too late.

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

#86

Post by AnimalMuppet » Thu, Jan 30, 2020, 5:16 PM UTC

luckydata wrote: post #83

AnimalMuppet wrote: post #81

Earlier quoted context omitted.

"What you probably want to miss" sounds very much like an accusation of bad faith. That's frowned upon on HN.

“I couldn’t help but notice...”

Where are you quoting from? It's not in the comment you were replying to, nor anywhere upstream that I could find. And, wherever it is, why do you think it justifies assuming bad faith?

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

#87

Post by pyrale » Thu, Jan 30, 2020, 10:45 PM UTC

darawk wrote: post #26

tialaramex wrote: post #25

Earlier quoted context omitted.

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?

I've read the book. And all his other books. They're fun, but they're not a great source for serious understanding. The book and movie does briefly explain all this, but it paints a picture that the instruments themselves were inherently toxic, which was not the case. What was toxic were the assumptions that went into modeling their risk characteristics. The assets (like all assets) themselves were fine. The problem…

In order for the instrument not to be toxic, it would have to live in an ecosystem where these flaws are not systemically induced.

This industry has been failing systemically often enough to consider the product a liability.

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

#88

Post by kangnkodos » Thu, Jan 30, 2020, 11:22 PM UTC

coliveira wrote: post #85

vijayr02 wrote: post #71

Earlier quoted context omitted.

This is not a regular CDO - this is a synthetic CDO. The 'synthetic' means that the issuer may not (and most likely does not) hold the risk being tranched (loans in your example). Instead it generates return by selling CDS protection on certain market defined risks (hence the word synthetic, in the sense of being a derivative exposure). This makes a big difference: 1. Since individual tranches can be created on deman…

I see people repeating the mantra that CDOs are Ok, because they're theoretically sound and the only problem was with the regulatory issues until 2008. Given this and the apetite for risk in an environment of low returns, I wouldn't discard the possibility that these assets have once again risen to unsustainable levels. After all, the opacity of such arrangements is one of their problems. We may not learn the truth u…

One of the key problems back in 2008 was that AIG was issuing something equivalent to insurance to everyone. Different investment banks were helping their customers to make big bets, and if things went south, they had "insurance" from AIG.

In hindsight, AIG wasn't charging enough for this "insurance", and didn't have sufficient reserves to cover their losses if real estate prices across the whole country went down at the same time. Almost no one seriously considered that as a possible scenario at the time.

So the important questions are:

- Who is providing "insurance" this time around?

- Is the company providing "insurance" charging enough?

- Does the company providing "insurance" have enough reserves to cover losses if we have another situation where everything goes south at the same time?

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

#89

Post by kangnkodos » Thu, Jan 30, 2020, 11:48 PM UTC

vijayr02 wrote: post #71

ThrustVectoring wrote: post #61

Earlier quoted context omitted.

Collateralized Debt Obligations themselves aren't a leveraged product. The originating bank issues loans and then sells on the assets. The various tranches are sold for cash and receive varying priority of cash-flow from the original loans. All the leverage is outside of the CDO itself - either European banks buying a dollar's worth of "AAA" assets with 98 cents of borrowed money, or some company writing a credit-def…

This is not a regular CDO - this is a synthetic CDO. The 'synthetic' means that the issuer may not (and most likely does not) hold the risk being tranched (loans in your example). Instead it generates return by selling CDS protection on certain market defined risks (hence the word synthetic, in the sense of being a derivative exposure). This makes a big difference: 1. Since individual tranches can be created on deman…

Yes. Most people missed the importance of the word synthetic. In order to explain it, let me make an analogy.

You think IBM is going to go up in price. (It should with the new CEO from Red Hat!)

You can send $100 to investment bank A which turns around and buys a regular share of IBM.

Or you can send it to investment bank B which offers a synthetic share of IBM. Investment bank B doesn't actually buy a share of IBM but collects bets from different people who think the price of IBM is going to go up, and other people who think the price of IBM is going to go down.

With investment bank A, your money may go up or down a little, but there's not much chance that investment bank A will go out of business.

On the other hand, with investment bank B, there are several different ways the investment bank could go out of business. It might not balance out it's up and down bets correctly because it's confident that IBM is going up. Or many of the other customers may be unable to pay up. Or maybe investment bank B made a deal with AIG to make sure that investment bank B would not lose money on the deal, but AIG was unable to pay.

With synthetics, there are additional risks which are more difficult to quantify.

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

#90

Post by BoiledCabbage » Fri, Jan 31, 2020, 1:20 AM UTC

kangnkodos wrote: post #88

coliveira wrote: post #85

Earlier quoted context omitted.

I see people repeating the mantra that CDOs are Ok, because they're theoretically sound and the only problem was with the regulatory issues until 2008. Given this and the apetite for risk in an environment of low returns, I wouldn't discard the possibility that these assets have once again risen to unsustainable levels. After all, the opacity of such arrangements is one of their problems. We may not learn the truth u…

One of the key problems back in 2008 was that AIG was issuing something equivalent to insurance to everyone. Different investment banks were helping their customers to make big bets, and if things went south, they had "insurance" from AIG. In hindsight, AIG wasn't charging enough for this "insurance", and didn't have sufficient reserves to cover their losses if real estate prices across the whole country went down at…

That's again missing for forest for the trees.

The whole point is that those questions above cannot be answered ahead of time. The synthetic securities are so complex and intertwined that the risk cannot be safely calculated w.r.t. the amount of money being invested in them until after the fact.

Nobody can say if anyone is charging enough for insurance because nobody can quantify the risk accurately. Noone can say if the company has enough reserves because they we don't know how correlated that risk is or how large it is. If I'm shorting a stock I know exactly how much is at risk (within a reasonable margin of error), because these are complex contracts meant to balance out other complex contracts all with extremely high leverage any imbalance can spiral out of control. And any unexpected large change can destroy the entire financial system.

There are more degrees of freedom than can be well quantified in way something can go wrong.

It's not that people didn't think to ask and answer those questions above, it's that with the complexity of the system and the scale of money involved and leverage used they can't be answered with confidence. Only the appearance of confidence.