Thursday, June 10, 2010

The Goldman Case – 3: Recapping CDOs

Recall that our purpose, when we got together as a group of investors, was making money. “A group of investors” has no other purpose.

I said the way to go was arbitrage.

Some of you were not clear on that point. You thought we were going to buy mortgages with the idea of selling them later – presumably for a profit. Where is arbitrage?, you asked, echoing the confusion of some of the country’s best quants.

“Friends”, I recall saying to you. “Let us set aside the not so small matter of being short in cash and focus on basic finance. A mortgage is a bond. Bond prices increase when interest rates decrease. Are we saying that we are buying the mortgages because we know interest rates will go down? If so, why bother with mortgages which have prepayment and relatively high default risks? Why not simply buy a bond – or a pool of bonds?

“No,” you responded. “We do not know which way the interest rates will go. And yes, we are short in cash. And now that you mention it, why indeed bother with mortgages? Why not just buy regular bonds?”

“Glad you asked,” I said. “Expecting to make money without initial investment and without knowing the future is a great expectation. Fortunately, in the age of speculative capital, the cause is not lost as the statement of our problem is the definition of arbitrage: making risk free profit without initial investment. But one has to know the game, and the game cannot be played with the Treasuries or corporate bonds. We need the relatively inefficient mortgage market. Even then, the plan is complicated and you must pay attention to understand it.”

“Tell us how”, you cried in unison, excited at the prospects of getting rich with no effort and no money down.

I explained the plan in easily digestible parts:

  • We have to borrow money, but it must be at rates below the current mortgage market; it would be madness to pay 8% to get mortgages that pay 6%.
  • Low rates are available in the commercial paper (CP) market, but only large corporations like Microsoft and IBM have access to that market.
  • We cannot pass ourselves off as a large industrial corporation. Fortunately, we do not have to. What matters in the CP market is not the size per se but the credit rating. Since our ratings, as a group of investors, can never be AAA or its short-term equivalent, A1/P1, we shift the focus from ourselves to the product; we make the product to be AAA.
  • Of course, in a million years, a pool of mortgages will not qualify for AAA rating; they're just too damn risky and triple-A means no default risk. So we will need to be innovative. We'll call it financial innovation! (Smiles all around). That is where the CDO structure comes in. You know the routine. Pool the mortgages and force a class system to the pool where the super senior tranche is protected against historical default rates.
  • We take the CDO to the rating agencies and ask for AAA rating. They need revenues and will play ball. In fact, they will tell us what we need to do to get AAA rating. They might, for example, ask that we sign up a bank as a “liquidity provider”, or strengthen the loan covenants, but these are technicalities and you do not have to worry about them.
  • Triple-A is the key to the CP market. We could now borrow at 2% to and buy mortgages that yield 6%. That's the golden goose of finance if there ever was one. We'd be the king of the world, the master of the universe.
Note the function of a CDO: it is an arbitrage vehicle – and nothing more. There is nothing more in finance as practiced by financiers and taught in schools.

Arbitrage is the anima mundi of modern finance, the single pillar on which the “whole intellectual edifice” of finance rests. It is at the core of everything that is taught at Chicago, Wharton, Stanford, Harvard and London business schools. It is the foundation of everything that the best of brightest of Europe and Asia vie to learn at INSEAD and Heyderabad.

Options, futures, swaps and all derivatives are priced from arbitrage. Relative value trading is based on arbitrage. Rise of the hedge funds, advent of prop trading, onset of globalization and the push for deregulation are all driven by arbitrage. Securitization? Due to arbitrage. Rise in markets volatility? Arbitrage. Synchronization of markets? That, too.

And yet, not a single one of the students and professors who study finance can define arbitrage, much less recognize the specific form of capital that is engaged in it.

In order to be company he must display a certain mental activity. But it need not be of a higher order. Indeed it might be argued the lower the better. Up to a point. The lower the order of mental activity the better the company. Up to a point.

The finance professor, the financial journalist, the think tank “scholar” and the PhD candidate constantly exalted and promoted the advantages of securitization and CDOs without realizing that these innovations were merely the prerequisites for the operation of speculative capital. To the extent that the innovations provide local collateral benefits, such benefits are accidental and incidental. What is more, they must always be in line with the immediate needs of speculative capital.

In our example, what happens after the first CDO? To continue the arbitrage, we would need more CDOs, i.e., more mortgages. Mortgages are provided by banks and mortgage bankers. So they are pressured to do more. At some point, the pool of the eligible people who could afford houses is drained. But that is no excuse to stop the arbitrage. We, the group of investors, cannot simply allow our golden goose to sit idle just because there are no eligible home buyers. Why, that would be hampering the American dream.

So the pressure doubles on banks and mortgage bankers to loosen the standards. They comply, because they, too, make money from issuing mortgages. At some point, that, too, ends. It is clear that no more life is left in the mortgage market. Nay, more than that: it is clear that a train wreck in the form of a housing collapse is coming towards us.

What do we do?

Après moi, le déluge, said Louis XV, the king of France. What a rogue peasant he was. We make money from the deluge. The Jew of kings had it right – Jews always have it right – that you buy when there is blood in the streets.

When there is no blood, we will see to it that there is. It’s business, you know. Nothing personal.

We, the group of investors, have shot the housing market in the US multiples of times. The blood will soon be running in the street. How can we make money from it?

The game plan is not immediately clear. What is clear is that we would need more financial innovation. We would need synthetic CDOs. We would need credit default swaps.


Thomas GER said...

Not directly to this article, but I think this article in the NYT touches upon issues you are also dealing with:


Nasser Saber said...


I just read the article. Lorenzo Bini Smaghi has just discovered some of the intricacies of the international banking which he is proudly sharing with his audience. But what is he saying?

1. "Government bonds have become a kind of currency that is crucial to institutions’ dealings with each other."

2. "In the last 30 years, banks have drawn more and more of their funding from so-called securitization, packaging loans into securities that could be traded on open markets."

3. The volume of interbank lending using such collateral— known as “repos” — is big, Mr. Bini Smaghi said, though there is a lack of data on how big. It is crucial to functioning of the banking system.

Etc., Etc. The man is saying nothing. He is describing what every competent operations manager in a New York bank knows.

The question before us is: why all this is taking place -- or has taken place? That is, why things are the way they are. It is answer to that question that separates men from the boys, so to speak.

I have covered securitization, government bonds and repos in several places on this blog. Read part 9 of the "Anatomy of a Crisis, for example at for a comparison of explaining why repo trading is so critical to banking vs. simply saying so.