It was the Great Financial Crisis of 2008 that left me feeling unsure of my knowledge regarding high finance. Something called ‘collateral debt obligations’ (CDOs) torpedoed the entire financial system, and I had never even heard of them! During my entire life, I have read widely - I consistently read between 65 and 150 nonfiction books …
It was the Great Financial Crisis of 2008 that left me feeling unsure of my knowledge regarding high finance. Something called ‘collateral debt obligations’ (CDOs) torpedoed the entire financial system, and I had never even heard of them! During my entire life, I have read widely - I consistently read between 65 and 150 nonfiction books each year- yet I have never seen a reference anywhere to such a financial instrument. The Crisis left me feeling,” What ELSE don’t I know about?”. Very unsettling.
So, Peter, if you hear about other financial complexities or unstable instruments, you know I’d love to hear your thoughts about them...
The CDO was the apotheosis of the securitization mania which consumed Wall Street in the aftermath of the S&L fiasco of the 1980s and early 1990s. Wall Street firms were literally hiring individuals with PhDs in astrophysics and quantum mechanics to design new investment "products" to sell to an investment community constantly chasing higher and higher yields.
The basic idea of the CDO was that one could take a basket of securities (usually mortgages), break it down into "tranches", and then re-assemble the tranches into a new tradable security. This is why I characterize derivatives as "synthetic" securities.
The problem with these synthetic securities--and ultimately CDOs could be built using anything, including other CDOs--was that the markets for these investment products was fundamentally non-transparent. Unlike with stocks, mortgages, and fixed-income bonds, it was never fully modeled how these synthetic securities would respond to various market dynamics.
That was the problem, and that became the glaring weakness. After Ben Bernanke raised rates repeatedly in 2005-2006 specifically to "cool off" the subprime mortgage portion of the real estate market, not only did new mortgages abruptly dry up, but because the supply of existing mortgages had a large cohort of Adjustable-Rate Mortgages, refinancing of these mortgages also dried up. As the ARM balloon payments began to hit, mortgage default rates skyrocketed.
What none of the CDO models had calculated was the impact of rising default levels on the value of the synthetic securities containing an increasing number of defaulted mortgages. Thus even a relatively small number of defaulted mortgages had an outsized effect on the entire CDO industry. A saying that circulated around Wall Street at the time sums the situation up perfectly: "If you add two tablespoons of wine to a glass of sewage, you get sewage. If you add two tablespoons of sewage to a glass of wine you still get sewage."
When a market cannot rationally derive a market value for any item, the market value of that item immediately becomes zero. Broadly speaking, this is what seems to have happened with CDOs--as the underlying mortgages collapsed, the market value of the overlaid CDOs became indeterminate, which essentially forced the value to zero. Coupled with the liquidity crunch that ensued from having to unwind these fundamentally worthless securities and you have the Great Financial Crisis in a nutshell.
And of course Wall Street has not learned its lesson. While we no longer have to worry about CDOs, we now have "Collateralized LOAN Obligations".
Excellent synopsis. I argued l, had the sewage been properly disclosed, it wasn’t, the credit rating firm’s ratings were bogus, the rates should have been much higher, the implosion might not have been so severe. Same for the recent SVB and other tech banks funding the VC expansion and collapse. I worked on a few of these deals. Had they properly conducted their stress tests, they would have properly reserved.
All the smartest guys in the room jumped on this with their Monday morning skills. What’s any collateral worth? The gold standard of the banks, commercial real estate, is under stress beyond any reasonable estimate. The scamdemic had a lot to do with it.
CDOs were the epitome of the "dark market"--which is a wonderfully anodyne term that means "nobody has any clue how to do price discovery on these assets".
The ratings were essentially sold because there really was no rational basis for rating the CDO securities in the first place. What the ratings agencies should have done is refused to rate the securities at all.
SVB was actually a somewhat different situation. SVB ran into a liquidity crunch because it had plowed a substantial chunk of its capital into low-yield securities, only to have interest rates rise. As China is experiencing on a national scale, when yields rise capital flows towards the higher yields. For banks such as SVB, that meant that their deposit base began to erode as customers move more idle cash into higher-yielding money market funds and similar investments, while the value of their holdings of low-yield securities kept dropping.
Deposit outflow coupled with declining portfolio valuations equals liquidity crunch.
There was nothing "dark" about the securities markets which sank SVB. SVB just failed to act early on to mitigate their losses in a rising-interest-rate marketplace.
I agree, and yes that’s the information released, however, they were a large creditor on a project I shut down. I don’t think they reserved anything against this investment. I was new on this project and my head was spinning getting up to speed, I was not surprised at the outcome.
I haven't looked at the state of the banking industry in a while, but it would not surprise me to find that essential capital buffers still are not in place.
One of the most bizarre aspects of Wall Street's behavior in recent years has been its stubborn refusal to acknowledge changing market conditions and to adapt accordingly.
It was the Great Financial Crisis of 2008 that left me feeling unsure of my knowledge regarding high finance. Something called ‘collateral debt obligations’ (CDOs) torpedoed the entire financial system, and I had never even heard of them! During my entire life, I have read widely - I consistently read between 65 and 150 nonfiction books each year- yet I have never seen a reference anywhere to such a financial instrument. The Crisis left me feeling,” What ELSE don’t I know about?”. Very unsettling.
So, Peter, if you hear about other financial complexities or unstable instruments, you know I’d love to hear your thoughts about them...
The CDO was the apotheosis of the securitization mania which consumed Wall Street in the aftermath of the S&L fiasco of the 1980s and early 1990s. Wall Street firms were literally hiring individuals with PhDs in astrophysics and quantum mechanics to design new investment "products" to sell to an investment community constantly chasing higher and higher yields.
The basic idea of the CDO was that one could take a basket of securities (usually mortgages), break it down into "tranches", and then re-assemble the tranches into a new tradable security. This is why I characterize derivatives as "synthetic" securities.
The problem with these synthetic securities--and ultimately CDOs could be built using anything, including other CDOs--was that the markets for these investment products was fundamentally non-transparent. Unlike with stocks, mortgages, and fixed-income bonds, it was never fully modeled how these synthetic securities would respond to various market dynamics.
That was the problem, and that became the glaring weakness. After Ben Bernanke raised rates repeatedly in 2005-2006 specifically to "cool off" the subprime mortgage portion of the real estate market, not only did new mortgages abruptly dry up, but because the supply of existing mortgages had a large cohort of Adjustable-Rate Mortgages, refinancing of these mortgages also dried up. As the ARM balloon payments began to hit, mortgage default rates skyrocketed.
What none of the CDO models had calculated was the impact of rising default levels on the value of the synthetic securities containing an increasing number of defaulted mortgages. Thus even a relatively small number of defaulted mortgages had an outsized effect on the entire CDO industry. A saying that circulated around Wall Street at the time sums the situation up perfectly: "If you add two tablespoons of wine to a glass of sewage, you get sewage. If you add two tablespoons of sewage to a glass of wine you still get sewage."
When a market cannot rationally derive a market value for any item, the market value of that item immediately becomes zero. Broadly speaking, this is what seems to have happened with CDOs--as the underlying mortgages collapsed, the market value of the overlaid CDOs became indeterminate, which essentially forced the value to zero. Coupled with the liquidity crunch that ensued from having to unwind these fundamentally worthless securities and you have the Great Financial Crisis in a nutshell.
And of course Wall Street has not learned its lesson. While we no longer have to worry about CDOs, we now have "Collateralized LOAN Obligations".
https://www.investopedia.com/terms/c/clo.asp
Lather. Rinse. Repeat. And derivatives markets are larger now than just before the GFC.
Excellent synopsis. I argued l, had the sewage been properly disclosed, it wasn’t, the credit rating firm’s ratings were bogus, the rates should have been much higher, the implosion might not have been so severe. Same for the recent SVB and other tech banks funding the VC expansion and collapse. I worked on a few of these deals. Had they properly conducted their stress tests, they would have properly reserved.
All the smartest guys in the room jumped on this with their Monday morning skills. What’s any collateral worth? The gold standard of the banks, commercial real estate, is under stress beyond any reasonable estimate. The scamdemic had a lot to do with it.
CDOs were the epitome of the "dark market"--which is a wonderfully anodyne term that means "nobody has any clue how to do price discovery on these assets".
The ratings were essentially sold because there really was no rational basis for rating the CDO securities in the first place. What the ratings agencies should have done is refused to rate the securities at all.
SVB was actually a somewhat different situation. SVB ran into a liquidity crunch because it had plowed a substantial chunk of its capital into low-yield securities, only to have interest rates rise. As China is experiencing on a national scale, when yields rise capital flows towards the higher yields. For banks such as SVB, that meant that their deposit base began to erode as customers move more idle cash into higher-yielding money market funds and similar investments, while the value of their holdings of low-yield securities kept dropping.
https://newsletter.allfactsmatter.us/p/reality-check-svbs-collapse-was-a
Deposit outflow coupled with declining portfolio valuations equals liquidity crunch.
There was nothing "dark" about the securities markets which sank SVB. SVB just failed to act early on to mitigate their losses in a rising-interest-rate marketplace.
I agree, and yes that’s the information released, however, they were a large creditor on a project I shut down. I don’t think they reserved anything against this investment. I was new on this project and my head was spinning getting up to speed, I was not surprised at the outcome.
I haven't looked at the state of the banking industry in a while, but it would not surprise me to find that essential capital buffers still are not in place.
One of the most bizarre aspects of Wall Street's behavior in recent years has been its stubborn refusal to acknowledge changing market conditions and to adapt accordingly.
https://newsletter.allfactsmatter.us/p/wall-street-knows-the-crash-is-coming
Lather, rinse, repeat, then run around in circles and scream!