Tuesday, 11 November 2008

How it all works

Here’s one, extremely interesting, story about why it is not a bad idea to short financial stocks. It is also probably the best written analysis of the present financial crisis, the problems with rating agencies and how synthetic CDOs work. Written by Michael Lewis, who wrote Liar's Poker. If you only read one thing today ...

Edited highlights:

In my entire life, I never saw a sell-side guy come in and say, ‘Short my market.’ ” And short Eisman did—then he tried to get his mind around what he’d just done so he could do it better. He’d call over to a big firm and ask for a list of mortgage bonds from all over the country. The juiciest shorts—the bonds ultimately backed by the mortgages most likely to default—had several characteristics. They’d be in what Wall Street people were now calling the sand states: Arizona, California, Florida, Nevada. The loans would have been made by one of the more dubious mortgage lenders; Long Beach Financial, wholly owned by Washington Mutual, was a great example. Long Beach Financial was moving money out the door as fast as it could, few questions asked, in loans built to self-destruct. It specialized in asking home¬owners with bad credit and no proof of income to put no money down and defer interest payments for as long as possible. In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $720,000.

...

In retrospect, pretty much all of the riskiest subprime-backed bonds were worth betting against; they would all one day be worth zero. But at the time Eisman began to do it, in the fall of 2006, that wasn’t clear. He and his team set out to find the smelliest pile of loans they could so that they could make side bets against them with Goldman Sachs or Deutsche Bank. What they were doing, oddly enough, was the analysis of subprime lending that should have been done before the loans were made: Which poor Americans were likely to jump which way with their finances? How much did home prices need to fall for these loans to blow up?

...

All that was required for the BBB bonds to go to zero was for the default rate on the underlying loans to reach 14 percent. Eisman thought that, in certain sections of the country, it would go far, far higher.

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“Where are the rating agencies in all of this? And I’d always get the same reaction. It was a smirk.” He called Standard & Poor’s and asked what would happen to default rates if real estate prices fell. The man at S&P couldn’t say; its model for home prices had no ability to accept a negative number. “They were just assuming home prices would keep going up,” Eisman says.

...

“You have to understand this,” he says. “This was the engine of doom.” Then he draws a picture of several towers of debt. The first tower is made of the original subprime loans that had been piled together. At the top of this tower is the AAA tranche, just below it the AA tranche, and so on down to the riskiest, the BBB tranche—the bonds Eisman had shorted. But Wall Street had used these BBB tranches—the worst of the worst—to build yet another tower of bonds: a “particularly egregious” C.D.O. The reason they did this was that the rating agencies, presented with the pile of bonds backed by dubious loans, would pronounce most of them AAA. These bonds could then be sold to investors—pension funds, insurance companies—who were allowed to invest only in highly rated securities. “I cannot fucking believe this is allowed—I must have said that a thousand times in the past two years,” Eisman says.

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That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. “They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,” Eisman says. “They were creating them out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans. But that’s when I realized they needed us to keep the machine running. I was like, This is allowed?”

...

“We have a simple thesis,” Eisman explained. “There is going to be a calamity, and whenever there is a calamity, Merrill is there.” When it came time to bankrupt Orange County with bad advice, Merrill was there. When the internet went bust, Merrill was there. Way back in the 1980s, when the first bond trader was let off his leash and lost hundreds of millions of dollars, Merrill was there to take the hit. That was Eisman’s logic—the logic of Wall Street’s pecking order. Goldman Sachs was the big kid who ran the games in this neighborhood. Merrill Lynch was the little fat kid assigned the least pleasant roles, just happy to be a part of things. The game, as Eisman saw it, was Crack the Whip. He assumed Merrill Lynch had taken its assigned place at the end of the chain.

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