I'm a fiscal conservative (and a social moderate), but I'm slowly, creakily becoming more convinced that our free market needs a bit more regulation. That concept was anathema to me just a couple years ago. But, to the big boys, the ones who won't deal unless there's more than $100 million on the table, the free market is an opportunity to collude, cheat, lie, and hedge against forces in the free market that eventually--but slowly--follow their maneuvering with mute regulations. These financiers move ahead of the market that they help mold and shape behind them like dumb, brown clay. But what happened with the mortgage industry, especially at the very top with mortgage-backed Credit Default Swaps (CDS) and Collateral Debt Obligations (CDO), was truly a once in a lifetime collusion that generated multi-trillions of dollars of imaginary money based on an industry-wide hallucination that the US taxpayer made real by bailing the IDIOTS out.CDSs and CDOs are a type of bundled bond certificate. The definition and concept of these debt instruments are so arcane that the overwhelming majority of Ivy-Leaguers that packaged and traded them had no idea what collateral was in them. Yet trades of $10 Billion at a pop were as common on Wall Street as Italian suits. At the time of the crash, 2007-2008, even the hundred million salaried CEOs couldn't answer the most simple questions about CDOs, and the risk their firms were running by owning them.
In a nutshell a CDS is this: a loan company finds hundreds of buyers that DON'T HAVE TO BE QUALIFIED, and sells them exotic floating-interest only adjustable rate mortgages. Mortgage companies then repackage several sets of hundreds of loans from across the country. The mortgage company then sells this package of thousands of loans to the big investment firms. The firms then merge and repackage these loans into bonds that represent tens of thousands of mortgages across the country. They push these mortgage-backed bonds to the rating agencies (Moody's and S & P) as CDSs, which are then given a rating from Triple-B to Triple-A. These CDSs can now be sold in the market to hedge funds, municipal retirement funds, collegiate holding funds, and international pension funds. The bonds have been repackaged so many times, that even the most savvy investors cannot clearly determine the particulars of the mortgages in each bond.
A CDO is even more complicated AND SLEAZY. A CDO is made up of all the lower and lowest rated CDSs. For example, a Triple-B rated CDS is more difficult and expensive to sell, because of its ostensible inherent risk. A CDO basically launders those low rated CDSs. Yes, launders them like a freaking Mafia drug front. So, you take all these poorly rated CDSs, shuffle, and repackage them with other poorly rated CDSs, and suddenly you have a new bond vehicle that receives a new rating from a lowly Triple-B to a stellar Triple-A. Just keep repackaging and reshuffling and eventually you can kluge together a combination of the worst possible double-reverse-negative-amortizing-40-year-floating-post-adjustable-rate-mortgages into an investment vehicle that receives a Triple-A rating and can be sold in the billions to other large investors. Meanwhile, at every step in the laundering process, Goldman Sucks and Merryl Stench and Lehman Fu**ers and the others each take a percentage of the overall value of the bond. These commissions quickly arrive at Carl Sagan's favorite number, billions-and-billions.
So what happens when people begin to default on the underlying mortgages, like they did in the thousands, especially in states like California, Florida and Arizona. AHA!! Nobody, not one intermediate institution believed that mass default was possible. Wall Street was particularly insistent that defaults, at rates that would hurt CDOs, was simply not possible. It had never happened before and all their foolproof analysis proved that that was impossible. The rating agencies too, the gatekeepers in the middle, also ran calculus showing that a bond with tens of thousands of mortgages couldn't default at once. At the most, everyone on Wall Street saw a 5% default rate as the worst possible scenario. And yet, if you dug into the CDOs, you'd discover that most of them were NOT heterogeneous; instead, they were comprised of all the crappy exotic loans made within a few months on the same types of homes to people who couldn't afford them, and they were all going to reset within a few months of each other. But nobody, with all their arrogant and condescending intelligence could know for sure that most exotic loans from 2004 onwards were made to folks who didn't need proof of employment, proof of collateral, or even proof of citizenship. Strippers in Vegas had 5 multimillion dollar homes. Strawberry pickers with $14,000 annual salary were living mortgage free in $750,000 homes. The mortgage rates were beginning to reset ad infinitum in summer of 2007.
You know the rest of the story folks. This is a must-read book. And if you'd like to compliment the top-down view with a bottom-up perspective I recommend http://www.goodreads.com/review/show/...
The Big Short takes a neat perspective. Michael Lewis, instead of simply documenting the nuclear build-up, reveals Wall Street through the handful of contrarians that were trying to bet against the CDOs. Each of these handful of men have a very odd beginning and has some unusual attribute that led them, either by genius or character flaw, to see that this was the Mother-Of-All-Scams. In 2004, in fact, there wasn't even invented yet a vehicle to short the CDSs and CDOs. The concept of shorting a bond that was deemed un-defaultable was not even considered by Wall Street. All trading instruments (equities, bonds, T-bills) must have a shorting vehicle--that's what balances the price between 'puts' and 'calls,' and provides the institutional brakes on the price of a commodity. Without a shorting vehicle, in essence, CDOs had no down-side jeopardy. The book describes the numbers, the risk-split, and Value of Risk (VaR) that these bonds were given, and they were RIDICULOUS! What's even more galling, when the big investment firms finally invented a CDO 'shorting' instrument, and sold them off in the billions, when the crash finally occurred, the firms couldn't cover the spread. What's that mean? It means that even though the shorts were sitting on a legal transaction, the firms could only pay a percentage, and they could only pay that percentage with government help. That means YOU were on the hook, not only to bailout Wall Street, but to pay off the smart folks who tried to apply the brakes to CDOs.
The government bailout is another story entirely, and not covered in depth by The Big Short. But suffice it to say that's it's ugly and controversial enough that it forces me back to my free market position that I almost gave up in second paragraph, first sentence. The government dicked up with the bailouts, and didn't let these BIG SLEAZY, OILY Wall Street investment firms take a bigger hit. And now, 19 April 2010, Goldman Sachs is under SEC investigation for CDO manipulation, while Goldman announced last Thursday that it has allotted $5 point something billion dollars in employee bonuses.
I was going to continue this rant and provide my investment advice/philosophy for the next 10-15 years, but I'll spare you. If there's enough people interested, I'll continue in the comments sections. Have a wonderful day.