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I traded mortgages and mortgage derivatives before, during and after the GFC


thelads
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at 2 of the biggest investment banks, latterly at a hedge fund. I have never discussed that stuff with anyone outside of colleagues and friends. I was wondering if anyone had any questions about it, or if I could give any impressions. I would rather not state the places I worked at, but I can say both banks were heavily involved in that product space and I think I saw more than most.

 

No worries if nobody has any interest.

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LOL! How to pick?

 

There are many possible answers. I guess in terms of public profile, it would be the ABACUS program that got a lot of press. It was CDO/Correlation product. There seems to be a belief it was the only such product around, but each major IB had one, and some were worse than others. I felt that one, and the people involved there got incredibly unfair press. The story pitched was that investors had no idea what they were buying. That is, in almost every case, entirely untrue. With that said, that program was the worst for embedded optionality that people didn't do dilligence on. It was one of the only programs where each tranche issued was entirely callable on its own. It was very complex.

 

The most abusive product was in the simple pass through derivative space. There people used to run simple canned scenarios on CPR's and CDR's etc. Mostly they would run paths of integers. So for example, how does the yield look to a 3CPR, 4CPR, 5CPR on through say 8CPR. There might be 10-20 such scenarios, and some weigthed average of the yields returned. If this exceeded a threshold yield people would invest. Barclays or Lehman (I forget where they guy was, but I remember the guy, very affable Chinese gentleman, who is scary smart and quite nice) created a bond that looked better than average to any such integer path. But the second you deviated from an integer, say from 2CPR to 2.01 CPR, it diverted all cash flow to other classes. So in practice this thing was an absolute disaster. I felt bad for the guy who made it. He was simply directed to structure the thing for maximum possible profit on the retained classes (retained by the bank) and took it literally. He was incredible mathematically, but had no EQ and thought of things like a game. He was sort of lacking in the real world implications.

 

Anyhow, long story short, they sell the bond, a month later the guy who bought it realized he got no cash flow and starts digging into why. It was a large real money manager on the east coast. Considered to be excellent in that space. The PM went absolutely mental, as you would expect. Demanded a head or the bank would be in the box for a year in all assets with this asset manager. Who got the bullet? The structurer. ANd all the profit was ultimately handed back.

 

Going back to abacus, there were worse deals done in the corporate space years before, that acted as inspiration for a lot of these products. Again, I think it was Barclays that did a correlation CDO tranche in the corporate space for IKB in 2002 or 2003. IKB (if I recall the customer correctly) wanted a AAA with 300 bps of spread. So Barclays delivered a blind pool (you don't know whats inside at the start), rated AAA at outset, with infinite substitution by the manager (Barclays could replace any name with any other name). Trade was consumated. I think a week after the trade was closed, barclays swapped out the 3 best names for 3 defaulted names, or close to default. THey marked up over 40% on par within a week. THen went and had a 200k sterling lunch which made the press. Again, the bank was sued, and the profits disgorged.

 

Worst people I came across? There are quite a few. Disturbingly, many are still in finance at very senior levels and did some horrible stuff to get there. I have plenty of stories of mismarking and abuse akin to that on both the sell and the buy side. Most wasnt outright theft, it was fear and cover up. It is still happening today. You have seen a few such stories in credit space. But I am shocked there arent more. If the credit markets were to have an event, I think you would see many many more, and it would look really bad

 

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Interesting story. My general question arelsted to above is how well do the decision or even the creators of these products understand them? Do they actually do diligence and reading/studying the prospectus or run their own models, or do they tend to rely on the reputation or relationships to make a decision.

 

I mean, who can read a 500 page plus prospectus, especially for something that is new/complex and you don't even know what to look for?

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that's a very good question, one of the most important I think. The answer can probably inform how things got so out of control, and how the full ramifications of what was happening was understood so late.

 

So, for RMBS/CMBS/ABS and any derivatives or CDO's of the same(the credit products of the mortgage world, where RMBS had subprime, alt-a, etc) the people who were creating the deals absolutey knew what was inside them. I ran a desk doing derivatives and correlation business. The CDO documents were often closer to 800 than 500 pages. But a lot of that was generic and boilerplate for a given deal or shelf. Meaning that if you were around at initiation of the platform, you worked with external lawyers to draft the whole prospectus, etc. So you know every part. FOr the material economic considerations, in many cases you are creating them yourself. The documents are written to match what you want the security to do. Other features considering contingent risks or events that may occur are distrubuted randomly in many cases. But if you can master one document for a shelf, the rest come much more easily. Akin to looking at your 1st 10k ever. Then your 1st 10k for a given company as opposed to the 3rd or 4th you read. A lot of upfront work. But once that is done you are fine.

 

Now onto customers, most did not read this stuff closely. They read a term sheet, often 1 page of economic details with 3-4 pages of supporting terms. Most deals followed this very closely, but some had hidden problems or options that weren't properly disclosed, which was hugely scummy. The biggest issue, which you correctly are getting at, was that the majority of each of these deals was AAA, regardless of what was in the sausage machine. The majority of buyers there understood the terms broadly, but were clueless about the true risk in the underlying. They bought into the rating. And that was not from a lack of people trying to point them the other way. There were many warnings. But their jobs depended on putting capital to work, and they had built a whole pitch about why it was better to use financial leverage on AAA risk, than take credit or structural risk in other areas (no leverage, B bonds for instance). THe usual happened, where money piled in chasing performance. But when you are running massive leverage, the limits of scale on your equity eat you very quickly. This is what happened to the guys at the BSAM structured credit funds that blew up in 2007. And to Jim Kelsoe at Morgan Keegan. THe latter was almost a case study. If memory serves he was voted Morningstars best fund manager of the decade 2-3 times before 2007, and then lost nearly 100%. And he was a lovely guy. He wasnt a thief. In that case he just drank the Kool-aid and believed the momentum would never stop. It was clear he didn't consider the ramifications of the downside. He had been laughing off worrywarts for years, and just became more and more emboldened. I think that happens in lots of bull markets.

 

With regards to problems at the banks and who understood what, the problem began at the middle management level. When you went to heads of a Mortgage Department, or in many cases, heads of Fixed Income, they really did not understand the products at all, nor what the logistical issues were likely to be in a downmarket. They had been promoted in a massive bull market, and the most aggressive who put growth before risk had done best. In addition, a lot of the smartest people had already left for HF's and prop desks. For example MS in 2006/2007 with it's prop desk. The people in charge by the time things started to go were weak, extremely political and not risk concious. So they got the message they wanted consistently. This is just a hiccup. It will be fine. They would look at historical default rates and recoveries and think things can get no worse. I can't emphasize enough how important it was that the leaders were looking for a specific answer, and their subordinates knew it. I would often (always really) deliver the harsh reality, but it was not well received, and it cost me personally millions in potential pay. That was made abundantly clear. and this includes periods where my small business was making billions, while the rest of the division was hemoragghing. It was incredible to watch. Absolute denial. ANd I know that was true in many other banks.

 

In any one bank that would not be an issue. But when its systemic its bad. When you have a AAA security as 1/4 of your balance sheet, 8% in real capital, and the AAA is handled as 0.2% risk weighting, and in reality it can and will likely lose 100% you have a big bad problem. FInally, when the fed is calling to check in with "banks" and they call the senior leadership, who are also in denial, and in reality just want to make it to January for one last bonus, you have a GFC in the offing. That to me is still misunderstood.

 

So the people who were directly, trading, structuring and managing those businesses did understand. Some people directly above did also. But management, on up the chain had nothing but ignorance and hope. Not a good cocktail in such times. Two more anecdotes may help to illustrate that time a little better too:

 

1) At GS, they had a record negative 1st month in 2007. Their fiscal year ended in November. They had a record positive 2006 and were being very smug. Then the market turned and they were massively wrong sided. The big short they put into Paulson was killing them. They thought they had done a number on him, based on the belief that CPDO's, which had brought corporate spreads to all time tights, were about to become de rigeur in mortgage credit space. They had good reason to believe that, but before they and MS could get their deals away price vol spiked and the rating agencies stepped away (thank god, it could actually have made the GFC a lot worse). SO how did they have a record 2007 as a firm. That one department was down over $1bn in the 1st month of fiscal 2007. The most they had ever made in a year to that point was just around $1bn. The answer was their technology and CFO (Viniar). Every asset was required to be on the same database and modeled appropriately. No multiple rates curves for the US, etc and all that BS. Law of one price and super dilligent infrastucture. By the 2nd week of January, the system was ringing alarms. The underlying of CDO's (subprime BBB's) had sold of 15-20% (CDS) yet the aggregate value NAV of CDO's hadn't budged. Red flag. Viniar simply called the head of the department and head of every desk related to these products in that department to his office. No big fuss, just explain. He got two stories. One he considered BS. Burried the guys who lied to him and threw his and then Blankfeins full weight behind the others. Actually started visiting the desk. Both of them did (I wasnt there but know this happened). Over the next 3 months they were winning 90% plus of most BWIC's for CDS protection. And covered their massive long only to go short. For me the lesson was honesty in leadership, robust systems and no politicing. Strong leadership.

 

2) At another massive bank, still well respected, I was chatting to the chief strategists for both Fixed Income and Structured products. This was Dec 2006. I was super bearish and had a big short on. Biggest in the bank I think. These guys were 20 and 30 years older than me and had been in the industry for a long long time. So I asked a simple question. Is the market in Dec 2006 (for fixed income and credit in fixed income) more levered than it was in 1998. They laughed out load. Nowhere close to 1998. I had expected the answer. It was a prevailing view in the market place at that time. And in a narrow sense it was true. Repo leverage, was much lower for AAA's for instance. But other forms, CDO's and other vehicles, then CDO^2, made it much much much more leveraged. But they couldn't see that. And there was no persuading them. And these were super smart guys. I think they couldn't/wouldnt see it, because if true, their universe was close to its end, as was their lifestyle. Its hard to convince people in that situation. There is a Munger quote to that effect; its hard to convince a man to believe in something when his income depends on understanding the opposite (sorry I know I have butchered that, but I think that was the gist of it).

 

I don't know if the above answers your question. I apologize for not being more articulate.

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Interesting stories. Thanks for posting this.

 

Were you at all aware of the investors (the shorts) buying credit default swaps on subprime mortgages? ie. the guys from the big short.

 

 

 

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Thanks. On your question, absolutely yes. There were a few of us going the same way and so few of the shorts in the beginning. In fact, there is a part of that story that is lesser known, and explains at least in part why Burry got such a hard time. I remember him well, though I doubt he remembers me. The salesperson introduced him as a DR which was unusual, and, to me at least, he asked all the right questions albeit in brief, which was also rare. The way it and he is presented in the movie the big short is completely wrong. As is the depiction of Lippmann at DB. He is not as charming in real life. Very far from that, and he was about to be fired. They interviewed nearly everyone on the street for his job. In a sense he was lucky the crisis didnt begin 6 months later. He would have been out of a job in that case. It did happen to the guy who ran an equivalent book at JPM.

 

So with regard to the thing that was missed. The first CDS contract on credit MBS was done in 2003, as was the first bespoke/correlation trade. Volumes started to take off in 2004, mostly in CRE space. in 2005 interest in Subprime spiked, and there was a huge rush into shorts against BBB/BBB- names in the late spring and summer of that year. THe issue with BBB/BBB- RMBS is that the duration is very volatile (there is a stepdown that can make the duration less than 3, or it can go longer than 12). People buying protection didn't understand this, and entered the contracts thinking duration was constant. They also underappreciated how CDO's were driving marginal pricing. To them it was a cheaper short than puts on homebuilders. This came up a lot. By late fall in 2005 there was a scare and the market blew out in spread terms, and they were sitting on top of big paper gains. Some tried to take profits. Then the dealers began to squezze. They narrowed the durations further. Then the market turned and rallied viciously, went to new all time tights. Guess what dealers did then? Lengthened it to as long as possible, so now the end accounts had huge MTM losses. In many cases there were individual analysts at the hedge funds doing this. To the PM it was an afterthought. Once losses started all hell broke loose. No liquidity at all to exit which further ramped prices. People panicked and took any price. I heard many swear they would never touch the product again.

 

Ironically, Burry had done little to no CDS at that point, and Paulson had done none that I recall. So a lot of people precluded themselves on that basis going forward. I never interacted with Cornwall, but I met them a few years later and was very impressed. The strangest one was Jeff Greene. We just got a call from a broker saying this lawyer or something in california wanted to buy CDS on a bunch of names. That was very strange. The bank didn't want to do it as he didn't seem qualified. So he signed all these waivers (after screaming like a banshee for a while) and did long form ISDA's where he paid the PV of the premium upfront. He used to call all the time on marks as well. But most everyone did that. He was doing it personally though which was funny. Only later did we found out where he had found the idea.

 

Honestly, the most surprising thing about the whole situation was how few people were willing to put the short on. But thats all behavioural finance I guess. My one little pet peeve with the whole big short thing is that they emphasize how shorting BBB/BBB- and A RMBS was the greatest trade ever. It wasn't, shorting the super senior on pf's of that stuff was. Especially if you added a call to your short, which one could do, but most didnt. I think only 3 of us did that. And it only cost an extra 1bp. you could short the same thing as Burry did, but do 10-20x the size, and with less risk. The cornwall guys did something like that via CDO CDS but without the call. Paulson left the call out altogether, but still did the no brainer. I wish the book had considered that, but I guess it would just have been a distraction.

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My pleasure Vox. In the agency space (FNMA/FRMC/GNMA) its as big as ever. That would be IO's, PO's, IIO's. The latter, a huge bet on low rates for a long time is bigger than ever and largely held by HF's or the like. That could be a problem for that market at some point, but not markets as a whole. Though the convexity part of that is huge and could create a lot of feedback vol in the rates market if and when it happens.

 

For credit mortgage products it is largely non existent now, except maybe for the TRS market and CMBX remnants. Single names just don't trade. Post crisis regulation aimed at killing that and has for the most part worked. Which I think is a good thing. Similarly for correlation products in that space and also in corporate risk. The latter has also impacted how much single name CDS can be done in corporates, thus making life tougher for credit hedge funds. You won't see similar outcomes in Mortgage world, or see that be the source of the next crisis I would wager.

 

There is some talk about CMBX as a great short vehicle for the demise of retail. I think the WSJ had an article about that and some guys fund doing it. I read his presentation as well. It is well delivered and polished, though I was surprised that the single biggest risk to the short he suggests is completely ignored. I don't know if he isn't aware of it, or just thought it was a distraction, but it disappointed me that in a 50+ page presentation that he didnt outline what could kill the trade. That should always be front and center I think, and in any event allows for a more informed read by someone new to the space.

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@ thelads - thank you for sharing your experience  and taking time for detailed answers. I very much appreciate the "insiders" look into workings of the machinery. It does appear that the book - " The big Short" captured many essentials of what was happening in these markets at that time correctly.

 

Fascinating!

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@ thelads - thank you for sharing your experience  and taking time for detailed answers. I very much appreciate the "insiders" look into workings of the machinery. It does appear that the book - " The big Short" captured many essentials of what was happening in these markets at that time correctly.

 

Fascinating!

+1

 

Have no questions, but enjoy reading the story :)

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My Pleasure Spekulatius. It was an interesting time for sure. Yes, I think Michael Lewis is an extraordinary writer. He just seems to capture mood, emotion and convey empathy ina way very few can. A colleague of mine from that period worked with him on the book a fair bit actually. He ended up with Eismann in late 2008 having left one of the major banks and ended up ultimately one of Steve's partners. He is actually much more charming and engaging than the character in the film. And the incident in Vegas where he stood up and kept interrupting, that did happen.

 

Actually, come to think of it, (I had forgotten till I started writing this response) I remember meeting Wing Chau that weekend too (the CDO manager he has dinner with). I had met him before. That was another big giveaway. He had worked at some retail banks investment portfolio or something. And a senior CDO salesman pitched him on the idea of going it alone. Basically it was this, go and start up, I'll find some of my investors to seed you as a CDO manager. You take no risk, take in all the fees at new issue, get the residual and live of the income on that. totally asymettric to Wing (though his investors could and would lose). Another thing the story missed was that he was still making millions years after the GFC on some of those residuals/equity pieces of the CDO's as many had no cut off triggers. As per the movie, he loves to gamble.

 

One other answer to the 2nd question on who reads the documents? What I found more remarkable was after prices got crushed, how few still read the documents. There were some incredible opportunities, and a lot of people who had the experience to understand that. But only a few did. Many more came from the outside. I still wonder why that was. I guess burnout....but who knows.

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Yeah, cool thread. Any great stories about excessive partying with brokers / clients? Or were you purely on the quant-side? Actually, did your firms use brokers and if so, what did you think of them? Or was everything marketed directly by inhouse people and if so, any stories about them?

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There is some talk about CMBX as a great short vehicle for the demise of retail. I think the WSJ had an article about that and some guys fund doing it. I read his presentation as well. It is well delivered and polished, though I was surprised that the single biggest risk to the short he suggests is completely ignored. I don't know if he isn't aware of it, or just thought it was a distraction, but it disappointed me that in a 50+ page presentation that he didnt outline what could kill the trade. That should always be front and center I think, and in any event allows for a more informed read by someone new to the space.

 

Great commentary and insight, thanks.

 

What is this single big risk to using CMBX to short retail that you are referring to?

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Thanks. On your question, absolutely yes. There were a few of us going the same way and so few of the shorts in the beginning. In fact, there is a part of that story that is lesser known, and explains at least in part why Burry got such a hard time. I remember him well, though I doubt he remembers me. The salesperson introduced him as a DR which was unusual, and, to me at least, he asked all the right questions albeit in brief, which was also rare. The way it and he is presented in the movie the big short is completely wrong. As is the depiction of Lippmann at DB. He is not as charming in real life. Very far from that, and he was about to be fired. They interviewed nearly everyone on the street for his job. In a sense he was lucky the crisis didnt begin 6 months later. He would have been out of a job in that case. It did happen to the guy who ran an equivalent book at JPM.

 

Maybe I'm being dense, but I got lost at that sentence.  Can you elaborate further on what was wrong?  Or maybe just elaboration on this paragraph in general as it sounds interesting.

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Haha - I had a feeling that question was coming. Oh boy, what to say....what to say....

 

So yes, technically I guess I was sort of quantitative. The products themselves are, and you can't really trade them without knowing the stuff inside and out. I worked as a trader and head of desk, then head of biz and then had some more responsibilities. But I worked with the Quants in every place to develop models and risk systems. It was an edge to know that stuff better than peers, and to see others models. But as I was trading and there was a lot of volume we did interact a fair amount with inter-dealer brokers on hedges (single names and the like) and also with some external marketers in certain geographies (South Korea and Australia). With the latter we just had dinner and a few drinks. It was all very stodgy.

 

With the inter-dealer brokers, we went out maybe once a year. A few of our peers went out more like 1x-2x a week, and they went a little crazy. Though many things were strictly forbidden in codes of conduct, those things were largely ignored when people got out. I only went crazy one night, for a former colleagues "Street" bachelor party. He was getting married the following week. So all his peers went out. Had a great meal then wondered out into the wilds of NYC till it was bright out. Was awesome, we got back in and it was bright out. The fact we did it on a wednesday really made thursday a struggle. Some people went absolutely nuts that night. I believe it led to one divorce, though that was on the cards anyway. You can guess where we ended up. It's on the west side highway around 50th street or so...

 

Beyond that I tended to avoid going out with competitors and brokers. As we were on the sell side and my business covered a wide scope of areas I was working very very long hours. Often 80-90 a week. It wasn't a conventional trading job. And the hours only got more burdensome as the GFC came around and I got more responsibility. In addition to this, 1-2 nights a week you would be required to meet clients for a dinner. Sometimes this was amazing. You do meet really cool and interesting people. I got to get out with John Merriweather one night and it was fascinating. He is totally understated and very likeable. You can see why people followed him. But most of the time it was a grind. I know its crazy to complain about eating at amazing restaurants. But anything thats obligatory, and repetitive and keeps you from home (when you see home rarely) can feel that way I guess.

 

The craziest stuff tended to happen at conferences like the ABS conference in Vegas every year, or the CRE one in Miami every year. There people really went nuts. Again, I tended to be careful, almost a designated driver. There was no upside to getting caught out profesionally in such gatherings. But Vegas the year portrayed in the big short was nuts. I think half the people there or more were on something and it was free love in a few of the night clubs. Not a pretty sight. In Miami, one of my colleagues stole a cop car. Drove it around and somehow didnt get caught. I don't know how he did it. He went on to be very succesful. ANd that is far from the nuttiest thing he did.

 

There are plenty of stories about sales people and how they generated business. I know at one bank a senior sales person in Europe recommended that young sales people use their own money to go to strip clubs and then when a trade was on the line to take it to the next step if required. That apparently is still common, though I only ever heard the stories and never saw it in action. In Asia, its sort of an open secret that that happens. There are some very funny stories around that, though its best I don't post them here I think.

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Hi Maybe for less. With regard to CMBX it is the risk that the loans get bought out of the pool at appraised value or slightly higher. The key here is that there is no size constraint on how much CDS you write on CMBX (or anything else really). So the bet proposed is to short the BBB and BB index of CMBX 7 and 8 (If I recall). Fine, but the outstanding number of bonds in one of those indices (say BB) is only $800mm-$1000mm. The loans themselves in retail are often no more than 10% of the deal. ANd of that 10% less than half is a material problem or likely to be (by his own analysis). So what happens to the thesis if someone buys the mortgages out. No more problem retail.

 

The index he was shorting was at 75 cents on the dollar at the time I think. So if you are on the flipside of his trade, you effectively get 25% of the balance you are long upfront. Lets say you did $3bn. Thats $750mm in equivalent cash (not exactly, but you get the idea). When you buy those problem mortgages out, you will take a hit, but its likely on the order of 30-40%, perhaps a lot less. So call the cost to you $400mm. You are left with $350mm, and where will the index trade with all the problems removed? More insidiously, what happens to those short. The thesis just got neutered. Do they stay in with cash cost of 5% per annum? They probably try to cover. Some would be forced to. So the index could trade at or near par.

 

I know this all sounds hypothetical, but this was Paulsons biggest fear in 2007 with their shorts, and there the buy in neccesary would ultimately be the whole pool of mortgages, making it a moot point. Not the case here. This did happen on a bond in 2009, Amherst did it to JPM, BAML, GS and a few others who were short CDS at 95% upfront. It was a cover story on the WSJ when that happened. So this is doable. For reference, I am told there is one very large fund that is short 2.5bn of the BB or BBB CMBX tranche. I know the people there well. I was shocked when I heard it. As we are in a super low return environment in the credit / mortgage space with way more capital than ideas. So it is not implausible someone would attempt this.

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Sorry racemize, that was poorly conveyed. In the movie, it is portrayed he flew to NY, told them he wanted them to create the product, and that he would do billions. And that the banks had no idea and just laughed. Also, it all took place in conference rooms and everyone was in a suit.

 

So, the product had been around for years. He wasn't the first in, nor the closest to being first in. But that is hardly important, he bet big, and was completely stoic when people played with marks (which they did). Many folded and he didn't. I thought conveying that was enough. You didnt need people in suits (which they werent) in a conference room (which they werent) acting like muppets. I just thought it was unneccesary. Also, for all the thought he put into it, I was just a little surprised that he didn't see the way to express the same view (absolute collapse) with a risk reward ratio of 10-20x to 1 what he was doing. He would still have his fund then. ANd don't get me wrong, I think he is brilliant.

 

to explain the relative risk reward, he was shorting BBB ABX names at 280-320bps per annum for an undefined duration of time. His complaint when spreads went wider was that they only moved them 10 bps when all other indications would say 100 or more was right (and he was 100% right on this), and then, they would use a duration of 2 or less, when it should have been 8 or 9 or more (again he was 100% right). But in these instruments (he was doing single names not the index) the bank was the calculation agent. So they could mark wherever they wanted, unless you could size them up for a new trade on the same name. And he had run out of capacity. In that sense he was tactically poor, even if the strategy was right. He didnt' understand those dynamics. Incidentally, thi is still an issue in some markets today. For instance, in more illiquid names in CDS in EM for sovereigns and quasi sovereigns. You would be shocked.....Back to risk/reward; given his view on utter collapse, which wouldnt take much (house price inflation of -1% would do it for the BBB- universe of 2007 subprime) then he just needed to bet on all the names. It really was all or nothing. the better vehicle was super senior. You could short that at 15-20 bps (the range depending on a few factors) and at most at 21 to 22 if you wanted a call.

 

So, on his bet, if it went wrong for him, he could lose say 200bps on 8 duration of 15% of the face value, and he was levered. For largely the same risk he could have done minimum 10x on the super senior, but with a duration of 2 or less if he had the call. Or put more simply, his downside would be 40bps (20x2) of face value, for the same or similar chance of getting par. So all the mood stuff of him in the office, and banging the drums is cool and all, but it was a shame, because his life would have been so much easier just doing this. I realize this sounds like hindsight, but believe me I felt this way in general (not about him) at that time. I couldn't believe more people weren't doing this.

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Just to clarify on the CMBX example, those are just numbers that I roughly recall. They could be wrong, but the orders of magnitude should be roughly right. To take an extra step, if that hypothetical price dropped another 10-15 pts, the dynamics become that much more powerful for a sneaky buyer to engage in such a transaction. Is it market manipulation? Its very unclear. But I wouldnt bet hoping someone protects me on that basis.

 

One last point, which is small but pedantic, but the auther also mentions an analysis of why someone wouldn't want to own the BBB or BB index at x price and what the yield is. Again, this is not strictly correct. He views it as an unlevered bond. However, you can get substantial leverage, up to 5x depending on who you are, at Libor flat on that index. So he should be looking at the ROE for whoever that guy is at various prices. With that leverage, the economics of the above become hard to avoid. Very hard. The biggest constraints are size, understanding the extent of what needs to be bought to take the perception of risk out and reputational risk. But again, we are in an environment where you are very likely to see someone try in my opinion.

 

For the avoidance of doubt, I wouldn't want to own this index at this price. Not even close. But to propose the short and not address this issue is just concerning to me. I don't mean to take away or criticize what is otherwise an excellent presentation. Nor do I think the author has not considered this. I am sure he has. I just thought it would have been good to address it.

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Yeah I have an opinion. But I would take it with a large grain of salt. The market in auto ABS is bat$hit at the moment, and has been for about 3-4 years, though it seems to be calming down and becoming more rational now. It's again a function of a very low rate world, and horrible spreads in the US in particular for credit world. A great example was from the last Residual I looked at from the santander platform. That was priced to ~7% return on their loss curve. You could easily be negative with a more realistic loss curve. Yet the residual was more than 10x oversubscribed. It was madness. And I believe the company took back a good chunk of this. Even more mad.

 

A large reason (imho) why this happened was that so much money was made from 2009-2014 in the ABS/RMBS structured arena. Then the subprime, alt-a and other products kept amorting away with no new supply. So the proceeds got reinvested into random esoterica like this and mostly into CRE. Because of course, the worst thing you could do is say, the opportunities suck and just give the money back. So here you have a product that in the 1st year really can look like it has a super high yield. But who knows thereafter. It still allows folks to get to the next bonus. I see it as shameful really, an I couldn't do it, but there are 100's of people who will.

 

So, its priced artificially and wrong, and I would wager you are about to see a big hiccup there. Though I don't know that the ramifications will be so big for broader markets. I would however be super nervous about anything dependent on Auto residuals or new car sales, though that seems to have been priced in. I think it varies by country then. the UK is also a bit nuts. Germany and the nordic, in that respect, far less so. But again, please take this with a large grain of salt, I have not been focused on this for a while.

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very nice thread so far! sounds to me like you should write a book too, or lewis should have consulted you as well!

as someone who was on the institutional equity sales side in Tokyo for 17 years (cash salestrading), i can visualize alot of your party stories too as i saw them firsthand! im sure it doesnt surprise you at all to know that when US PMs/traders came out to Asia, they acted even crazier than Vegas or Miami...

 

couple of questions while we're at it:

 

1) did you ever interact with any of the FFH crew? Bradstreet, Lace, Chou etc? what were your thoughts on them?

 

2) what are your thoughts on the student loan market? is that a time bomb that is going to be even bigger than the auto loan mkt?

 

thanks in advance...

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Hi Dr Malone, I am having visions of Tokyo reading what you wrote. you must have some amazing stories. Would love to exchange stories with you some time if you are amenable. I had a friend who spent 10 years there trading rates, who told me one of the funniest stories I have ever heard. I was out in that neck of the woods only twice, though it was an eye opener. I happened to be there for Haloween. It had been a record year. I was given a budget coming in, and we ended up doing 10x that. So it kind of blew their minds. I wish I could take credit it for it, but it was just a great opportunity set. Anyhow, in lieu of payment (as I had a guarantee) related to PNL they sent me out around the globe to educate the salesforce. It was very interesting. My lasting memory of Tokyo was giving a teach in. I had read Liars poker about the japanesse trainees sleeping through training, but I thought it was exaggeration. 15 mins into my presentation the room was asleep. This was fine by me, as I had been taken out for Haloween the night before and felt close to death. But it was just so so funny. I was only in Tokyo 5 days total over 2 trips, but I must say, it was amazing. How was living there? I just went to a nightclub with some of the guys after a wonderful meal, but it was clearly indicated more could be done if I wished. I had just gotten engaged so demured.

 

On to your questions:

1) No - unfortunately not. I am not sure why. I think they did more in the corporate space, but I don't recall ever interacting with them. Funnily enough, in an adjacent business, the corporate correlation business, that I was drafted in to help with and oversee for a period (during a blow up - I had the joyful task of Triage), Berkshire got involved. They were super discreet and did size. Very direct. Wanted equity tranches, that were at over 85 points up front, with short maturity, and of course, no margin posting. That part was always underappreciated. Buffet clearly understood Reg Capital rules as well as anybody. As soon as that was disallowed (under new reg cap rules its just hugely capital inneficient for the selling institution) he stepped away. But this was another source of float. This was also the difference between AIG and MBIA. MBIA is still around as it didn't have to post. No ratings triggers, nothing. AIG was less thoughtful. A small detail, but relevant I think. Furthermore, GS says they were never at risk. Let me tell you, had the government not stepped in on AIGFP/AIG, GS was gonzo in my opinion.

 

2) Great question. I think ultimately yes. What is happening in that space is deeply deeply immoral for large swathes of the loan taking population. I have been reading a lot about it, used to trade the product, and one of my colleagues has helped develop a new lender that is doing quite well. But it is absurd to me that this debt is not dischargeable in BK. There is massive mis selling of education and of loans backing it. It really needs a reality check. Even within the student base that will clearly do well, there is still a lot of misinformation. People paying way more than they need. It is all well documented, but the schools do little to nothing to help. They aren't helpful in informing students coming in. There is tremendous waste.

 

In a simple sense, paying 250k - 300k for any asset that has little to no value is just destructive. No ifs, buts or ands. I think when we see another material recession, and with ongoing automation of many tasks this issue will just grow and grow and ultimately those rules about dischargeability will have to be rolled back. I can tell you that it is primary in most people in that spaces mind. Just anecdotally, from my colleague who started a lender, he believes that is a question of when rather than if over the coming 5 years. But he is also biased and believes like me the system is deeply flawed.

 

With regards to the implications of when or if that should come to pass, I don't think it will have an impact anything like that of mortgages during the GFC. Capital levels are different, and the exposure to this space is not as potentially damaging.

 

Stahleyp - my pleasure. Your question is hard to answer, and again, I would give little weight to my opinion. I am usually wrong. I think it depends on the space with regards complacency. In structured products and MBS the answer is no. While complacent, pricing isnt absurd, leverage isnt crazy and there is little systemic risk. With regards corporate credit risk in the US and the EU to a lesser degree, I think it is far more complacent. Indeed, this would be my big fear for the equity market. As in large part, free terms on credit have allowed massive activity in the PE market and in buybacks, etc. People will point to spreads being at or close to all time lows, and that is true. However, spreads alone tell only part of the story. The quality of the credit giving that spread has declined markedly. Covenants have been neutured. Even in the loan space, which was traditionally much safer, this has happened. Many secured credits now have so many carveouts in covenant terms that they are almost a proxy for unsecured. A great example of this was the BTU (Peabody) 2nd lien notes done in 2015. Allegedly secured. They were at 10 cents inside of 12 months, from Par. In large part, this has been driven by growth in CLO's using faulty logic. It's not as extreme as the relationship was for MBS to MBS CDO's, but using historical default and recovery stats in that arena to project forward is the height of folly in my humble opinion. All of this behaviour and activity points toward delayed default and much lower recoveries. When that starts to cascade, there will be real problems as the liquidity in these markets has virtually disappeared. Also, the marginal price setters are much weaker mentally and financially than those who were in the market 10 years ago. I could write for hours about why. But just look at the proliferation of hedge funds in that space. In the simplest sense, its hard to deliver 10% per year, when the feedstock you are using to earn that is earning 3.5% or less. Then add in "hedging". Most all of these credit funds will tell you they can either hedge away market risk, or time it well. I have been around this stuff for 15 years. I believe those folks are absolutely earnest in what they say, and completely wrong. They are saying what they want to believe. And they tend to ignore all evidence to the contrary. I could give a couple of examples that really illustrate this, but it would totally give away who I am. Happy to do it in a PM if you would find it interesting as long as it is between us.

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