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

[thelads]

Hi LC, Sorry - only just saw your question. No - I no longer work or live around there unfortunately. But I do visit from time to time if you are up for grabbing a drink or coffee.

[thelads]

Stahleyp - one more thing I somehow forgot to mention. I have done a little research on the EM credit space, though I don't work in that area. That to me is one very much to watch. The growth there has been astonishing for the last 15 or so years. The market went from close to non-existant (as a tradeable space) to quite large. The growth has been nearly 15 fold in the last 15 years. With the credit market in developed world just about doubling. There is nothing inherently wrong with this in principle, as some of this was credit activity moving from banks to markets.

 

However, the structure of the market is really really poorly developed. Again, this is just an opinion, but the quality of credit understanding and analysis done by the major players in that space is very poor quality. People do not understand what they own. In many cases, the fund managers in the space are old sovereign and rates traders from the 90's. Guys who traded Brady bonds. Very savvy traders, but they are not credit experts or analysts and as a result aren't great at judging people in that space. Beyond that, as most of the growth has been in investment grade or close space, there has been little or no distress by volume. Little pockets here and there (Argentina, some stuff in Asia). But few if any distressed funds dedicated to that space exist. As a result, when things do go wrong, for bondholders, prices can go from par to 90 and take months. The next stop can be 50, 30 then 10. Its amazing. There are just no players to step into the void in between. It looks a lot like the credit markets in the US and EU did in the 80's. To give you an idea of the lack of understanding at some of these places, one guy I met ran research for Latin america at a prominent and very well respected EM mutual fund in NYC. He covered over 300 companies across several countries. Nice guy, and very hard working. But he had no idea on the companies he owned, and didn't really understand the distinctions in jurisdictions. It's sort of stunning when you press on this. I met many others in the space and this is consistent. Anecdotally, the best person in the space I met worked for Elliot, which is hardly a shock.

 

I mention this only because I wonder what happens to these markets when fund flows reverse for a period of years. That space could, and I think should be an absolute cluster Fu$k and could be ripe for opportunity. You saw a brief forestaste of this in some parts of the Brazilian market. But fund flows have still supported that.

[dr.malone]

thank you for your reply. i'm not at all surprised to hear the jpnse passed out during your presentation! if its one thing they are deprived of, its sleep and something else that begins with the letter "S".

 

and yes, Halloween is most likely the biggest party scene globally in Tokyo. They shut down the streets of Shibuya and Roppongi as its just mass chaos. The cos-play scene originated in Tokyo and they just take it to another level!

 

i loved every day living there. the food is the best in the world, and the entertainment scene offers you, as you said, anything you want to do...we'll chat later offline i'm sure. lol

 

i'm sure your friend knew tom hayes...its a small circle of gaijins in tokyo...esp in rates and FX. equities had alot of the old school BZW and Jardine guys there. alot of british warrant traders too...

[Seahug]

thelads - really appreciate the insight you are sharing

 

If you have an opinion on the GSEs, I would be really be interested to hear it. I own FNMA prefs, about even on this a 5% holding. Given lack of concrete progress and a string of legal losses, I just ignore this position. However, since this is your area, I'd be grateful if you can contribute something.

 

Cheers!

[thelads]

Dr Malone, would love to chat offline at some point. I don't think my friend in Rates knew Tom Hayes, he had left a little before Tom had arrived. But some other expats knew him. I met a few of them out one night, but don't remember any names, or much of anything else to be honest. LOL! Yeah - that party on Haloween was absolutely mental. I actually met one of my favorite musicians that night in one of the few things I remember. It was absolutely crazy. I still can't believe that happened.

 

Seahug, Thanks for your question. I don't have much of an opinion on what is likely to happen there. From the arguments I have heard, it would be appropriate to reverse the sweep. But this is entirely political and I have no idea how long the case could take to play out, or if Trump's administration will roll things back. It's something that has been discussed a lot in the HF space in NY. In the last 4 years its been a part of nearly every idea dinner I attended and most other gatherings. There are very strong opinions on this on both sides, but it's mostly PM's and analysts regurgitating whatever they heard from the last lawyer they spoke to. I wish I had a better answer for you, but I don't and adding to the cacophony with a baseless opinion. Apologies for not being more helpful. Just for the sake of anecdote, when the GSE's were collapsing, the people with the absolute worst opinion on outcome where agency mortgage traders, bar none. So I am very reticent to opine strongly here.

[Seahug]

Thanks, thanks.

 

Most everything now is noise and attempts to read between the lines. It's not a good use of time to follow daily. I'm tempted to sell but I just know it will shoot up a couple of months after. Hate this event driven cr_p.

 

Cheers!

 

 

[Jurgis]

Great posts, thelads.

 

Considering your area and your thoughts about US and EM debt, do you have an opinion about MCO as stock? One of the bearish lines on it is that the debt issuance is toppy here (as you said, there's been debt explosion). On the other hand, the bulls say that there are still secular tailwinds in debt move from banks to market (as you mentioned too). Thoughts?

[rukawa]

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.

 

What is the call feature?

[thelads]

Hi rukawa- the call feature was simply putting in a 2 year call as the "bond" issuer. In CDO world it was not uncommon to have bonds issued with calls across the structure. This allowed the manager of the CDO to refinance the structure if spreads dropped or the pool delevered (through the underlying credits improving a lot). So the people who bought such assets were open to having a call in what they bought. This was not the case for the underlying instruments which, in almost every case, had no such feature. Indeed people would have balked at one being put in.

 

It is relevant in this case because your choice was to short an 8 year or potentially longer instrument (or potentially shorter due to the step down possibility) at 280 - 300 bps, or, in the bespoke/CDO form at 15-22bps with only a 2 year duration (if you were wrong) or very long, if you were right. In both cases your max upside was par.

 

Hope this answers the question

[thelads]

Hi Jurgis. Great question. I'm not sure my opinion will have much, if any value on this topic. I used to interact a lot with each of the ratings agencies. It's an amazing business. Memory may serve me poorly, but as I recall they get paid differently depending on what product is being issued. Structured products were the highest paying, with sovereigns being lowest paid. But that's from memory and may be wrong.

 

As long as debt is outstanding, issuance or restructuring is high, they will do well. I think EM traded debt is bubble like. But it could go further. Europe is still dominated by bank debt and that could become tradeable. And China could develop a large tradeable market, currently that's mostly private. So I don't think I would bet against them. Even in a major decline there will be restructuring, and, if the last 30 years is a guide, the response to too much debt will be .... more debt and QE or something akin. That doesn't eliminate path risk, but does leave room for growth.

 

They still have a huge advantage in that for the banking system at least capital rules are still based around ratings. Capital efficiency in that guise is omit back in. For the sake of illustration take Italian banks and the large NPL stock that must be moved on at some point. It is quite possible that a large part of this ends up in a structured vehicle, where a majority of the financing package for buying/funding such NPLs is rated ABS, or something similar. ECB QE in a sense favors this or could do more so going forward.

 

Even in the financial crisis, and post it, Moody's was getting paid to rate re-Remics and their brethren while being sued. Volumes can drop in the short term but they are guaranteed a long and steady stream of business. Even in a downmarket they get a share of restructuring.

 

One last example, let's say you want to modify a small part of a securitization after issuance, like remove a swap or cap (because it's fully valued or someone wants fixed now instead of floating). It has no effect on anyone else, and you own 100% of the tranche. Want to do that and keep the rating. Need Moody's approval. And it ain't cheap. They literally read for 20 mins, or less. 1 dude. Then bill 15-30k. It's incredible. And good luck haggling on price

[racemize]

Do you have any concerns regarding the size of the derivatives market in general or for any of the banks?

[thelads]

It's been a while since I worked at one of the big banks. It seems from the outside to be orders of magnitude better than it was in 2007, and the controls and logistics have improved. It's harder to get esoterics on the books, as reg cap rules have cut off a lot of the silliness. You have much more control over counterparty risk, which was one of the biggest issues. So I would have to say no, not really.

 

There are individual area's that are points of small concern. Not in the sense of a big crisis, but in terms of getting messy quickly and causing some headlines. For instance, the amount of exotics in rates world (effectively selling options, but liquid enough not to get dinged on a reg cap basis) has gotten very big as people try to add yield by selling optionality. In addition, with the amount of IO and IIO product in agency mortgage space, big moves in rates, or in the curve could become a bit of a feedback loop. That could cause some losses at banks as they run huge inventory in that area too, and hedging that stuff is always imperfect. In periods like this of low yield and return, the dealer desks tend to start taking short cuts in hedging and so they can get run over as the market dynamic changes. It tends to happen periodically in that product. That plus some of those Interest Rate products could feed on each other in a big sell off as a boatload of duration would get added. This would be a bad quarter for some banks and Annaly and the like. But probably nothing more. Not a big crisis.

 

Something similar, though very very small is happening with some credit options. But it's tiny. It could cause a problem for a couple of funds who are aggressively selling vol there too, but not the bank.

 

So of the things I know of, I don't think so. But with these banks you just have no idea. Really none. The figures published on gross notionals just don't inform anything. You don't know the effective leverage, degree of non-linearity or what correlation could be. It isn't mentioned. So there could be something I am missing. Also, there is a good degree of latittude in how many of these things are marked. It varies by bank. But some are really horrific. DB had something like 120+ different rates curves for the US in it's system across groups. That's madness. True story, in 2007, there was a CDS contract I saw at the bank I was at. There were 5 entities in the bank that traded independently (Prop Desk, Insurance biz, Bank, IB and another). All 5 were marked differently. Same coupon. Same everything. It was scary. And that was not alone. I thought that was far less frequent till I saw the DB story. In 2009, I was tasked with looking at a bunch of businesses with a variety of exposures. There was one large, but slightly exotics rate book. They hadn't moved the mark at all, and there were market proxies that were clearly much much cheaper. I argued to drop the price, but the response was not a happy one. And it was never budged. Not even by a bp. So when the tough gets going, in my experience, senior management plant their heads firmly in the sand. I don't think that behaviour has changed, so you should have fair warning if something starts to happen, allegations are made and the defense is weak. But as I say above, if something were to happen I think it would be a quarter problem and knock the share price, not a systemic event.

 

Hope that is some kind of answer. Sorry if it doesn't really get to the heart of the issue.

[CorpRaider]

Any thoughts on Canadian real estate and likelihood of impact in US.  I just wonder if there's not some potential for contagion if and when their RE bubble pops.

[Jurgis]

Hi Jurgis. Great question. I'm not sure my opinion will have much, if any value on this topic. I used to interact a lot with each of the ratings agencies. It's an amazing business. Memory may serve me poorly, but as I recall they get paid differently depending on what product is being issued. Structured products were the highest paying, with sovereigns being lowest paid. But that's from memory and may be wrong.

 

As long as debt is outstanding, issuance or restructuring is high, they will do well. I think EM traded debt is bubble like. But it could go further. Europe is still dominated by bank debt and that could become tradeable. And China could develop a large tradeable market, currently that's mostly private. So I don't think I would bet against them. Even in a major decline there will be restructuring, and, if the last 30 years is a guide, the response to too much debt will be .... more debt and QE or something akin. That doesn't eliminate path risk, but does leave room for growth.

 

They still have a huge advantage in that for the banking system at least capital rules are still based around ratings. Capital efficiency in that guise is omit back in. For the sake of illustration take Italian banks and the large NPL stock that must be moved on at some point. It is quite possible that a large part of this ends up in a structured vehicle, where a majority of the financing package for buying/funding such NPLs is rated ABS, or something similar. ECB QE in a sense favors this or could do more so going forward.

 

Even in the financial crisis, and post it, Moody's was getting paid to rate re-Remics and their brethren while being sued. Volumes can drop in the short term but they are guaranteed a long and steady stream of business. Even in a downmarket they get a share of restructuring.

 

One last example, let's say you want to modify a small part of a securitization after issuance, like remove a swap or cap (because it's fully valued or someone wants fixed now instead of floating). It has no effect on anyone else, and you own 100% of the tranche. Want to do that and keep the rating. Need Moody's approval. And it ain't cheap. They literally read for 20 mins, or less. 1 dude. Then bill 15-30k. It's incredible. And good luck haggling on price

 

Yes, this is great. Confirms what I knew, but adds some specific insights/details on EM and Europe and their revenue on mods.

 

You remember it correctly that they are paid differently based on product category.

 

Thanks.

[thelads]

Hi CorpRaider,

 

Thanks for the question. I do believe that Canadian property is a bubble, and an obscene one at that. I don't know timing on it, but I would wager it's getting very very close to the end, if it hasn't already turned.

 

However, I don't know of any direct linkages or feedthrough mechanisms that will lead to problems in the US or elsewhere. That's not to say they don't exist, but I don't know them. From the little I do know I don't see the potential for the same fallout for banking in North America, or alone the world. The CHMC would take a big hit. The banks would be far less profitable for a long time with increased premiums after that. They would get badly hurt on the uninsured portion and their consumer loan books. Some may go or get bailed out. But I think it will be largely focused on Canada. I don't see the daisy chain as we had emanating from the us.

 

I do wonder, when this happens if it has a large psychological impact on people. Is it the straw that breaks the camels back in terms of fanciful/hopeful assumptions and beliefs? Things change fast when the marginal players shift from optimism to pessimism. But who knows. I'm sorry I don't know more about the topic. But I do think the CMHC part, while awful for Canadian taxpayers, is good in limiting likely fallout.

 

You didn't ask on this, but I think it's related so I'll mention it. It confuses me a little when I see people bucket Canada, Australia and Sweden together in the crazy bucket. I think the latter is very different from the 2 former, both of which are nuts. But each of those markets, while expensive have very different financing structured for buying and societal systems in place in the event of something going wrong. Also many different drivers, though Chinese capital flight is material in 2 of them of course.

 

More generally I just wonder about the world we are in. In Germany you can get a 10 year fixed mortgage, with amort over 30 years, at a rate of 0.7%. People tend to size what they buy to monthly outgoing. So with rates so low this has enormous impact. I think many if not most people taking on mortgages here to buy (not for cheap debt for other purposes) just have no idea how exposed they are. I look at Japan and what happened there post 1989. It's still a disaster. People look at the US, Ireland, and think things always snap back quickly. But that's not the case. What happens to prices with rates at 3-4% and stagnant incomes? You may not have mass foreclosure. But you will have huge negative equity. People trapped in their homes. There are worse fates. But this has bigger economic consequences. Affects flow of capital, confidence and spending and labor mobility. Perhaps this doesn't happen. But I struggle to see why it isn't likely.

 

Sorry for the last bit. Just my 2 cents. And it's probably worth a lot less than that!

[Green King]

Hi rukawa- the call feature was simply putting in a 2 year call as the "bond" issuer. In CDO world it was not uncommon to have bonds issued with calls across the structure. This allowed the manager of the CDO to refinance the structure if spreads dropped or the pool delevered (through the underlying credits improving a lot). So the people who bought such assets were open to having a call in what they bought. This was not the case for the underlying instruments which, in almost every case, had no such feature. Indeed people would have balked at one being put in.

 

It is relevant in this case because your choice was to short an 8 year or potentially longer instrument (or potentially shorter due to the step down possibility) at 280 - 300 bps, or, in the bespoke/CDO form at 15-22bps with only a 2 year duration (if you were wrong) or very long, if you were right. In both cases your max upside was par.

 

Hope this answers the question

 

So are you saying the call feature effectively lower the pricing on the short because if something goes wrong the CDO manager can buy it all back effectively squeezing the shorts?  But in the Systemic market event, they could not since no one would have had the money to and you rip their face off.

 

Or are you saving you can short super senior with a synthetic put @ a few hundred to one pay off? If the underlying goes to zero.

[thelads]

Not exactly. These were bespoke CDO tranches. In nearly every case there was no manager. Just a set portfolio. Where there was a manager he often just did portfolio selection and limited substitutions, but as the issuing/creating bank we controlled the call. In nearly every instance we were shorting the tranche.

 

The theory of the correlation business was you would delta hedge with the underlying. So a pure CDO issuing business sells all the liabilities, gathers its fees and that's the end of the story (until they start retaining risk - because "pricing was bad" - code for, we fucked up). Our business was more like an options business. You can look at the tranches in a CDO or in tranches as options on the amount of loss. So that's the theory.

 

I thought the market was insane. It went from zero to hundreds of billions in 3 years and to me at least the liquidity seemed ephemeral. If that was the case hedging would be futile and you would still lose. The ability to hedge would drop over time leaving you very exposed. As a result we just shorted. We were very up front with customers on this. Would I buy it? No. but they were coming to us. We would give them similar risk to what they would but in a standard CDO, or other bespokes. But we would give it cheaper or with a better pool. We had an open best offer on either or often both of those variables as we had a strong directional view.

 

The call was risk reducing for us as, if we were wrong, we were paying premium for only 2 years. We had capped our duration in the event we were wrong.

[Green King]

Not exactly. These were bespoke CDO tranches. In nearly every case there was no manager. Just a set portfolio. Where there was a manager he often just did portfolio selection and limited substitutions, but as the issuing/creating bank we controlled the call. In nearly every instance we were shorting the tranche.

 

The theory of the correlation business was you would delta hedge with the underlying. So a pure CDO issuing business sells all the liabilities, gathers its fees and that's the end of the story (until they start retaining risk - because "pricing was bad" - code for, we fucked up). Our business was more like an options business. You can look at the tranches in a CDO or in tranches as options on the amount of loss. So that's the theory.

 

I thought the market was insane. It went from zero to hundreds of billions in 3 years and to me at least the liquidity seemed ephemeral. If that was the case hedging would be futile and you would still lose. The ability to hedge would drop over time leaving you very exposed. As a result we just shorted. We were very up front with customers on this. Would I buy it? No. but they were coming to us. We would give them similar risk to what they would but in a standard CDO, or other bespokes. But we would give it cheaper or with a better pool. We had an open best offer on either or often both of those variables as we had a strong directional view.

 

The call was risk reducing for us as, if we were wrong, we were paying premium for only 2 years. We had capped our duration in the event we were wrong.

 

I am sorry I am extremely slow and I want to know this for sure.

Is this right?

 

Payoffs

Is it like this

At Par 20 to 30 bps negative carry with call duration 2 years

At .5 Par you make 5000/20 250X of outlay

In years 2 still at par you call back you CDO and loses 40 bps. Call back costing you BPS extra.

You can do this because you are the dealer. People assume the housing market was going to move up.

Who is taking the other side? this is LTCM like trades. I am assuming only AAA would want these.

[thelads]

Yeah that's about right. I know, the economics look obscene.

 

In terms of people who took the other side, you would be surprised. A few hedge funds would do it vs delta because I "sold it cheap". Various financials. Some were sold through levered notes (that had knock ins to contribute more money). Monolines did a good bit, and bank prop desks weren't far behind.

 

The bank prop desk thing may seem weird. But you must understand that between the banks there was no posting below certain thresholds. So between say GS and BOA, that threshold could be on the order of 6bn. So no initial margin, and usually no variation margin. This is in large part why there was such a massive surge in growth in bank prop desks in the early mid 2000's, the roe was almost infinite. But it was bound to end in tears. It also made the cascade and linkages so much worse. As people really could and did have wildly different Marks on things, with few repercussions.

 

I would also add, that I know how nuts this looks. Who wouldn't do this, right? Trust me, I was considered, and for a period treated like a lunatic. People thought I was betting the farm because I did as much size as humanly possible. The notional I did was enormous. Many billions. Risk management and the head of fixed income ultimately stopped me, much to there later regret. But back then I couldn't understand how they would think that. I still can't quite fathom it. Though it's obvious in retrospect.

[Green King]

Thanks. That made my day. I laughed hysterically for a bit. I guess this is how you print great numbers in a bull market.

 

[thelads]

Exactly. Those prop desk, and others on the other side were eating like a chicken and ultimately shit like an elephant. I used that phrase once in a meeting with senior management and the internal prop desk (who paraded around like peacocks) and was swiftly rebuked. Though none of those people was around a year later to say I told you so to. Glad you got a laugh.

 

I used to oscillate between laughter and tears

[Green King]

I hear you. I went through a similar emotional rollercoaster last year at a start-up.  It was really hard to get things done correctly when people in charge didn't what they were doing, acted like they knew everything and took credit for everything that worked out well.

 

It also looked like risk management in your case didn't understand risk. It has never been about notional risk or losing money but more about blow-up risk.

 

Thanks for the contribution, this Thread was something that I would not have experienced otherwise.

[thelads]

Hi GreenKing. I'm very very sorry to hear about your experience. You are absolutely right. It is all about risk management. Where that fails, all is lost. In the banks case, it was incredibly weak, and unfortunately for them they had just replaced some greatly knowledgeable and adept risk managers with salespeople at the helm. The risk management department just folded like a cheap suit. I always feel for risk departments, as they have responsibility without authority, unless senior management takes their role seriously.

 

I also had a similar experience at a fund more recently. It amazes me still just how poorly people can behave with bad incentives, and moreover, how smart and informed people can become tyrannical with a little power and nobody to rebuke them. Of course quality of decision making just craters.

 

For what it's worth, as painful as that situation was, it will probably end up being very valuable as an education in what not to do as an organization or as a manager when you start your own thing later on.

[Patmo]

Hi thelads, great thread, thanks for that.

 

I don't have much in the way of questions, but I am curious about what was ultimately the outcome of the GFC for you. It appears you suffered for a while for having a measured view (for lack of better wording) and being a black sheep of sorts. What happened once it turned out you were right, and do you feel it was worth it? Also, what are you up to nowadays?

[thelads]

Hi Patmo,

 

Thanks for the kind words. I came out of things fine I guess. I stayed on the sell side until January 2010. It was clear at that point the nature of risk taking done on that side was going to be heavily regulated away from what I ultimately wanted to do. I wanted to act and behave as an investor and that wouldn't be possible there. In a sense I was fortunate in that my job was stable and I was still paid ok. But I never got paid big money, nothing close to related to what I was promised or comparable with PNL. this was mostly down to multiple changes in management and a takeover at the company. I was also promised other things in terms of business control etc. it wasn't all about the money for me. I liked where I worked and the people and I felt more comfortable when I controlled the risk than those in charge. So I just split and moved to the buyside.

 

I was lucky that my performance in the past gave me the leverage to get a guarantee in compensation,  though it was ultimately unnecessary. We did well in that fund for the time I was there. We understood what was happening with regulatory capital much better than our peers, and surprisingly the banks. We did some really cool trades too. The up shot of that was good pnl, and more importantly we did well when others did poorly. Particularly in 2011 which was a bloodbath for our competitor and a relative heaven for us.

 

However, that year they paid me below my contractual rate (on % of pnl) though more than I had ever earned before. Still it was offensive as I had the best return profile in the fund, and was a large contributor to results and reputation which was driving money in. I had promised my wife after the sell side that If I ever got lied to on pay again I would move on. Once they do it once, they will do it again. They were upset to see me go and promised a lot to keep me. But I had promised the new place I would go and I keep my word. I should have stayed. I left a lot of $$ in deferred comp.

 

The next place was a nightmare. It seemed a great move at the time, and many were envious I got the gig. I knew many of the people there and they had been trying to recruit me for years. So I felt comfortable. But the place was just entering a big decline and was horribly managed. I spent a year there.

 

In that time the old place was asking me back. I was pretty unhappy at the new spot so I headed back to help "fix a problem area" with the promise of a new biz as compensation. They knew me and trusted me as a safe pair of hands. Unfortunately the situation to be fixed was worse than I imagined. Worse. The appetite to deal with it just wasn't there. It was the damndest thing. So I warned and warned. Produced some results to show likely outcomes, but was chastised. I even found out they went outside of the company to tell people I had "lost the plot". It was kind of sick in a way and deeply disappointing. Not to mention an enormous waste of time. In any event. The pm lost his ass.

Over 20% in less than a year. Quite a few lost their jobs. I was sickened by the whole thing. I was offered a very good job and excellent retention economics, but I had seen enough. The guy who lost a ton was still around and if anything had more influence. So I kind of felt the place was destined for the glue factory. So I quit. Quite a few of the best people have done so since and I don't like

The long term prospects for that business. Which is a shame as many of my friends are still there.

 

I know work at a different fund that is value focused, and am enjoying it tremendously. I get to look at lots of things and people are open minded. So work wise I am the happiest I have been in a long time.