
Banks to sell first post-crisis managed synthetic CDO - uijl
https://www.ifre.com/story/2220833/banks-race-to-sell-first-post-crisis-managed-synthetic-cdo
======
ThrustVectoring
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, under the
assumption that this would make any risk the banks take dissipate away
harmlessly. In the EU, this took the form of leverage limits based off the
credit rating of the asset, with the highest rated asset commanding the
largest leverage limits.

These regulations combined in a very unfortunate way in the transatlantic CDO
trade. The CDO part isn't the important innovation, though; as long as the
above structure persisted, _something_ would be found to take advantage of it.
Anyhow, the short of the crisis is that American banks would sell their risky
assets into concentrated positions of systematically important banks,
particularly ones outside of the narrow American regulatory purview. On the
other side of the Atlantic, they accidentally applied a _massive_ incentive to
figure out a way to slap an AAA rating on stuff, and the market delivered that
in spades.

The cherry on top of this entire system is that when American banks make
loans, this cash gets transferred and winds up sitting in some money market
fund somewhere. These funds are searching for short-term dollar-denominated
yields, and the best way to get that is to lend money to European banks
secured by AAA-rated assets. After all, with the generous leverage limits
bestowed on them, they can borrow a _hell_ of a lot of money.

~~~
coliveira
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.

~~~
JumpCrisscross
> _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.

~~~
vijayr02
Again, only true for regular (non synthetic) CDOs - this is where the issuer
is a dumb (or managed) vehicle that buys loans and tranches them up. The best
example today would be Mortgage Backed Security (MBS) tranches / Asset Backed
Security (ABS) tranches. AS you say, if the intermediary is suspect the
structure can become suspect - but this can be fixed by appropriate
structuring and security.

In a synthetic CDO the cash raised from CDO issuance is invested in collateral
(more often than not, chosen for highest return rather than real safety), and
the investment return is generated by selling protection on CDS - the terms of
this CDS may not always be very clear. If you have sold protection to Lehman
for example and they go bust, your structure is in limbo, without a single
underlying having defaulted.

------
nickles
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], a misallocation of
investments that ultimately leads to economic contraction.

CDOs attempt to manufacture safe assets from riskier ones. Various debts are
pooled, then the pool is divided into 'tranches'. Each tranche has a different
rating, indicating riskiness of the tranche, according to the tranche's claim
on distributions. A higher rated tranche will get paid before riskier
tranches, allowing investors to choose their risk tolerance. Riskier tranches
have higher yields commensurate with a greater risk of not being paid.

In theory, this structure is sound, provided that the debt being pooled has
known characteristics. During the financial crisis, ratings fraud contributed
to the breakdown of CDOs [2]. Lenders made unsound loans and lied about the
characteristics of the collateral and the borrowers. Ratings agencies (Fitch,
Moody’s and S&P) then rated this debt as being less risky than it actually
was, due to having false information and perverse compensation incentives.
Additionally, structurers assumed that diversifying geographically would
prevent correlated defaults on individual debts (which was not the case).
These assumptions led to CDOs having unsound risk pools. More exotic products,
like CDO squared (CDOs composed of CDOs), further amplified problems.

Similar products (e.g. CLOs) have been in high demand, as there is a genuine
need for safe assets. Ideally CDOs can be produced without succumbing to the
issues they faced during the financial crisis. The current interest rate
environment exhibits suspicious behaviors, including negative yielding
sovereign debt and investment grade/high yield spreads [3][4] roughly as tight
as they were prior the financial crisis. Increasing the supply of safe assets
may help lead to a rates environment that would previously have been
considered normal.

[0] [https://voxeu.org/article/safe-asset-shortage-rise-mark-
ups-...](https://voxeu.org/article/safe-asset-shortage-rise-mark-ups-and-
decline-labour-share)

[1]
[https://en.wikipedia.org/wiki/Malinvestment](https://en.wikipedia.org/wiki/Malinvestment)

[2] [https://macromarketmusings.blogspot.com/2010/01/academic-
vs-...](https://macromarketmusings.blogspot.com/2010/01/academic-vs-wall-
street-economists.html)

[3]
[https://fred.stlouisfed.org/series/BAMLC0A0CM](https://fred.stlouisfed.org/series/BAMLC0A0CM)

[4]
[https://fred.stlouisfed.org/series/BAMLH0A0HYM2/](https://fred.stlouisfed.org/series/BAMLH0A0HYM2/)

~~~
morley
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 The Big Short would have been more interesting if it made that
argument, rather than merely "CDOs are evil."

EDIT: I was reacting to the movie adaptation; I haven't read Michael Lewis's
book.

~~~
tialaramex
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?

~~~
darawk
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 was that
people didn't understand them.

~~~
wpietri
In that assets are only created for people to purchase with informed
understanding, I don't think "they were great but nobody understood them" is a
possible thing.

The clearest example here is shares in a Ponzi scheme. Those are definitely
assets, and they are definitely not fine. They are made to _not_ be
understood. The same is more subtly true of the previous wave of essentially
fraudulent mortgage-backed securities. But I think the same is also true of
any hard-to-understand instrument engineered to look like a good deal at first
glance.

You also ignore systemic risk. For many years before the 2008 collapse,
cognoscenti knew that a lot of risk had gone _somewhere_ , we just didn't know
where. But we sure found out! Saying that "all assets are fine" is sort of
like saying "all chemicals are fine". It's technically true, in that dioxin
and DDT don't _intend_ to be harmful. But if the evidence shows that people
can't use them responsibly, then a ban in a totally reasonable outcome.

~~~
darawk
> In that assets are only created for people to purchase with informed
> understanding, I don't think "they were great but nobody understood them" is
> a possible thing.

It isn't the case that nobody understands them. We understand them just fine
now. This is how civilization learns. For a long time we didn't know how to
price options - now we're quite good at it.

> The clearest example here is shares in a Ponzi scheme. Those are definitely
> assets, and they are definitely not fine. They are made to not be
> understood. The same is more subtly true of the previous wave of essentially
> fraudulent mortgage-backed securities. But I think the same is also true of
> any hard-to-understand instrument engineered to look like a good deal at
> first glance.

Ponzi schemes are designed to defraud unsophisticated investors. These assets
serve a useful purpose and work just fine as long as their risks are properly
understood, which they now are.

> You also ignore systemic risk. For many years before the 2008 collapse,
> cognoscenti knew that a lot of risk had gone somewhere, we just didn't know
> where. But we sure found out! Saying that "all assets are fine" is sort of
> like saying "all chemicals are fine". It's technically true, in that dioxin
> and DDT don't intend to be harmful. But if the evidence shows that people
> can't use them responsibly, then a ban in a totally reasonable outcome.

The evidence does not show that for these assets. You could make a similar
case about basically any dangerous but useful technology. When dynamite was
first invented i'm sure a lot of people died messing with it. That doesn't
mean we should ban it, it means we need to figure out how to handle it and use
it safely. We now understand these assets pretty well. I'll bet you basically
whatever amount of money you want that the next crisis will not come from
these assets.

~~~
wpietri
I'm not persuaded. There's no such thing as "understand just fine now". Ponzi
schemes have been understood since the 1920s, but people keep falling for
them. More sophisticated investors can get taken by more sophisticated tricks.
Having worked for financial traders, I know just how pleased people can be to
have pulled one over on people they see as adversaries.

I agree it's possible that these assets could be fine now, either because
people have truly learned a lesson, or just because of the "once bitten, twice
shy" reaction that takes a few decades to wear off. But the principle by which
you declare them fine, namely that all assets are fine, is definitely wrong.

~~~
darawk
> I'm not persuaded. There's no such thing as "understand just fine now".
> Ponzi schemes have been understood since the 1920s, but people keep falling
> for them. More sophisticated investors can get taken by more sophisticated
> tricks. Having worked for financial traders, I know just how pleased people
> can be to have pulled one over on people they see as adversaries.

You could make this argument about literally anything. You're not really
saying anything specific to CDOs here, so I can't really give you a more
specific response.

> I agree it's possible that these assets could be fine now, either because
> people have truly learned a lesson, or just because of the "once bitten,
> twice shy" reaction that takes a few decades to wear off. But the principle
> by which you declare them fine, namely that all assets are fine, is
> definitely wrong.

All assets are fine _if you understand their risks_. Sometimes we deem certain
people or groups insufficiently responsible to handle the risks of certain
assets. Non-accredited investors are not allowed to invest in private
companies. The United States bans "contracts for difference", etc..

I think the problems with CDOs are extremely well understood at this point by
everyone in that market. It has been one of the most studied issues of the
last decade in quantitative economics. That isn't to say that it's impossible
that there's some lurking risk we don't yet get. There absolutely could be.
But the probability is much lower than basically any other complex asset
class, precisely because this is the one that blew up last time.

If you want to go hunting for latent risk, CDOs are literally the last place
you should look. Our economy is chock full of astoundingly complex financial
instruments. If you are worried about CDOs because they blew up last time, you
are really really missing the point.

If we used your system for banning assets, we'd have banned the stock market
in 1929. We'd have banned tech stocks in 2001. Argentina would have basically
banned all money by now.

My point is: just pointing at the fact that something blew up once is an
insufficient argument that it is not worth the risk. The pattern of "new thing
blows up in our face" is quite common across things that turn out to be
incredibly valuable and useful. The question at hand is whether we understand
it sufficiently well now to use it safely. And the answer is pretty
unequivocally yes. We know what we did wrong with CDOs and we know how to
correct for it.

~~~
wpietri
You seem to be arguing with quite a lot of things I didn't say. E.g., I don't
have a "system for banning assets".

I do agree that, "All assets are fine if you understand their risks," is
moving in the direction of a reasonable principle. So you're making progress.
Once you start to grapple with intentional information asymmetries, willful
misleading of buyers, and engineering for complexity as a way of hiding risk,
you might really get somewhere. I doubt you'll get far enough to prevent the
_next_ crash or anything, but definitely somewhere.

------
csense
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?

~~~
qeternity
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.

~~~
Craighead
Weird, why would indiscriminately layering traunches of risk to fool ratings
agencies not be considered the problem?

------
dilippkumar
I have questions:

1\. What/Who's debt is being packaged?

2\. What happens if the debt holders don't pay?

3\. How are rating agencies rating these?

4\. Who is buying these?

------
zelias
Time is a flat circle

------
ChickenTicklerz
Hey! It's 2008 again!

------
foogazi
Is it time to invest in ZeroHedge ?

~~~
dirtydroog
The Russians will never give you a slice.

------
overcast
What good is our species having the ability of written language, if we never
learn from our past mistakes.

~~~
tenebrisalietum
You will always have the haves and have-nots. You will always have tribal
borders.

The haves will gain and use knowledge and technology to make their lives and
those of their tribe easier and it will benefit them more than those of the
have-nots.

So written language containing the body of science and technical knowledge
benefits them always. The effect on the entire species is unimportant to those
with comfortable, limited lives.

Other non-technical written language to create a world of mystical morality to
keep the other side in check also benefits the haves.

Until the human species changes into something new where competitive behavior
is not a base need/instinct, nothing will ever change.

You can't escape this.

~~~
overcast
So basically the evolutionary gift we've received, is being wasted on us.

~~~
ficklepickle
100%. We have a powerful conscious mind that we use to rationalize our primate
biases. It used to bum me out, but I've developed a more zen-like outlook. It
just is. Everything just is.

------
Pigo
As long as corporate welfare is there to bail them out, I feel like we're at
least partly to blame for expecting something different.

~~~
snarf21
I'll bite. So how do we fix it? Most people just want to live their life and
not fight the powers that be. Only when things get _really_ bad to people
stand up in numbers. Voting for change is just living "Animal Farm" in real
life.

I'm not trying to be snarky or cynical. I'm really not sure how we exit this
spiral.

------
umichguy
Reminds me of all the scenes from the movie "The Big Short."

~~~
onlyrealcuzzo
For anyone interested in the growth of CDOs (and the composition of them)
leading up to 2008 -- here's some charts:

[http://fcic.law.stanford.edu/resource/staff-data-
projects/cd...](http://fcic.law.stanford.edu/resource/staff-data-projects/cdo-
charts)

Basically, by 2006, CDO originations were ~$250B. It took about 4 years for
originations to get that large, and by 2008, there was probably less than
~$600B total.

GDP was ~$14.7T.

If history repeats itself, this is the beginning of the end. Not the end. But
anything can happen. Who knows?

