Just what the world needed -- a web-comic explanation of subprime mortgages and CDOs.
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Subprime Primer
19 Mar 2008 02:42 pm
Comments (6)
This is why I don't blog. Everything good has been said already. And this link has been done before many many times.
I have this on my del.icio.us page on February 15 along with 52 other people.
Quibble: for the most part, insurance wasn't used to get high ratings on CDOs. Most CDOs have "natural" triple-A at the top of the capital structure (under the rating agencies' faulty assumptions, of course).
What was much more common was to have a monoline either take the "good", "super senior" risk directly without issuing notes, or (as a CDO arranger) to keep the bonds yourself and have a monoline guarantee them, so you could get double default accounting treatment and arbitrage the coupon/premium spread. Not necessarily a bad idea in principle, but it fell down on a) the assumptions about subprime default rates and underwriting quality were horribly wrong, and b) the monolines were piling up on exactly the same risk as the banks were shedding, so a default on the underlying was likely to cause a default by the monoline as well. If the monolines' exposure to structured finance hadn't been concentrated in the worst of the worst, they'd never have got into trouble and the writedowns we've seen would have been much less severe. But, of course, there's no appetite for insurance of good credits.
A small clarification to my own comment. The "guarantee" often came in the form of a credit default swap.
Oh its true, its true it is horribly true. Ok now quick, blame game! I choose...broker!
A couple things in defense of RSG Hedge Fund:
1) Investors actually want the traunches. The weirdest thing about mortgage bonds is that they can get paid off early, since the home owner can pay the full mortgage whenever they scrape enough together. If you're a large institutional investor doing long term planning, you don't like that, because you want stability and the ability to plan when your payments come in over a long time. You also don't like getting a bunch of principle back without the interest it was going to garner in the future, at a time when interest rates are lower than when the bond was issued. The traunches were not a con, but rather a clever way of making mortgages more predictable in their payment.
2) People didn't wake up one day and all do this to the entire market. They slowly started doing it over time, and most funds gave these subprime mortgages a few years to show whether or not people actually paid them back. For several years people did pay these mortgages, and so they looked like a relatively safe bet, so funds extended their exposure in them. Then people stopped paying. But I honestly don't know how Wall Street was supposed to know the real risk of default, and assume that default in the future would be significantly higher than it had been so far.
Comments closed April 02, 2008.
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Heads in the Sand
Wait a minute......so the people who were ultimately the final investors (institutional money managers).......believed whatever they were told and didn't bother to actually use tiny portions of the money they were managing to actually test any of their own assumptions (the assumptions that everybody else shared as well?).....Oh wait, the investors thought they were big brains too, that they understood the underlying investments too (in fact, most of the investors often insisted they understood the investments better than anyone else, and if you thought you knew better, you could go f--- yourself).
Posted by burritoboy | March 19, 2008 3:19 PM