Dragons and Credit Default Swaps

- An Easy-to-understand look into the Subprime Mortgage Crisis

Alan Greenspan- Former Chairman of the Federal Reserve

I loved The Big Short. When I first watched it, I felt like I had understood only the obvious aspects of the subprime mortgage crisis, which contributed greatly to the recession. But there was a lot of ambiguity still in my head like what in the hell is a synthetic CDO and why did Steve Carell get that damn haircut? As of now, bad hair has not yet been proven to be the origin of any part of the financial collapse, but the former — well let’s just say the following piece is going to be a major eye opener. I feel it is more than important for millennials to truly understand this so they can let it happen again and make money off of it…that or prevent it all together.

The Mortgage

Our story begins with the Mexican immigrant working in the States as a fruit picker — particularly strawberries. Now you can assume that these strawberries are like any other; there’s no gold or cocaine in them. Hence, it is safe to say the fruit picker doesn’t make large profits from the strawberries. But seeing this is the nation where there are two lands where all dreams come true (Disneyland and DisneyWorld), it was only inevitable that the fruit picker along with his fellow farm workers will want to purchase a $700,000 home (one for each person) after a visit to Magic Kingdom. And purchase they did, sometime in the early 2000’s. Now to understand how this was possible, let’s look at the two sides of a home purchase: the picker or buyer side and the bank side.

First, it is easy to see how the strawberry pickers were able to purchase a posh home — the answer lies in teaser rates on the mortgage. A mortgage is a loan taken out from a bank to buy a home; the banks make money off of mortgages by charging interest rates which reflect economic conditions. A teaser rate or a temporary low interest rate on the mortgage that is increased at a future date, was something that was prevalent and particularly helpful for new homeowners or lower class home buyers. Essentially, banks crafted their mortgage policies to be reasonably affordable for the home buyers so they could capture a market that would otherwise resort to renting a home. But here comes the interesting part — how did the banks finance these mortgages which are subprime or are in theory quite risky investments.The answer can be found in probability.

If you play a game A, where you have a 20% chance of failing and at the same time play game B, where you have a 40% chance of failing, then your overall chance of failing becomes 8% or the multiplication of the two probabilities. It becomes even more interesting when the chance of failing in each game is a function of time or is correlated to an underlying rate— which is exactly what banks took advantage of. To finance these risky mortgages that seemed attractive as long as the teaser rates were low, they bundled hundreds of the home loans in a way such that the overall risk of defaulting or chance that the mortgage payments will stop, decreased. They then sold these mortgage bundles or mortgage bonds to investors who could care less if an individual mortgage failed since they were betting against the overall or systemic risk of the pool.

Thus, these investors believed that the mortgages that these bonds were constructed with were highly uncorrelated — meaning that even if one strawberry picker failed to pay his monthly loan payments to the bank, it would not be a sign that the other fruit pickers would fall into this pattern as well. In other words, as Bob Marley would say, “everything gonna be alright.” Of course, Bob Marley eventually stepped on a rusted nail and died.

Enter the Dragon

So now we are at where the movie begins with 3 entities so far. We have investors who have purchased mortgage bonds from banks expecting to make money from the interest, homeowners who may not be able to pay off their mortgage once teaser rates hike up to standard rates and of course, the banks who are facilitating these transactions with lawyers and outside agencies like Fannie Mae writing these bonds.

Mike Osinski- Software engineer who built the mortgage packaging technology used by banks to build complex financial products

Now enters the dragon — let’s call it JP Morgan. The dragon in this story does not have a clue what a strawberry is and has no reason to pick on the pickers. The dragon is also equipped with some of the best software, top notch mathematical expertise, lawyers who are worth every million they are paid and young investment bankers who are willing to work 24 hours a day to make a fraction of the money their managers make for twice the time spent at work…. Also the dragon has something no one else has — fire, also known as structured products. But we’ll get to that in a sec.

Tranche rhymes with Launch not Ranch

Let’s go back to the mortgage bond the smaller banks provided. Each bond consisted of multiple mortgages with an overall risk agreeable with investors. There is something important that I didn’t address: what happens when the Fed meets (with Greenspan as the chairman at the time) and the interest rates drop? It becomes obvious for the fruit pickers to take advantage of this by refinancing their mortgage. Unfortunately, this means that all the money in the mortgage is instantly paid out and the homeowners receive a new interest rate with a new payments plan. This entails doom for the mortgage bond investor who was counting on cashing in big on interest from the various mortgage payments built into the bond he or she purchased. The fix for this is where all the complications begin, with origins lying in advanced mathematics and physics —

— To reduce the individual or idiosyncratic risk on the overall bond risk, the bank can slice up the mortgage bond into segments called tranches (and if you’ve seen the movie, I’m not yet referring to those of CDOs). The tranches are chiseled into a pyramid like structure with the riskiest mortgages lying in the mud in the bottom tranche, and the top sky-scraping tranches filled mainly with riskless or AAA mortgages. The top most or senior tranches are given debt seniority and paid out first to those investors if the bond is to fail. Thus, the top tranche is safe and the remaining payouts then waterfall down to the middle or mezzanine tranches. The catch is (and this should be logical) that because the bottom tranches in the bond are riskier, they offer higher interest rates and thus, higher returns to investors if the strawberry harvest goes as planned. Before I continue on to the story of the dragons, there is another entity that needs to be mentioned — credit rating agencies like S&P’s and Moody’s that are in competition with each other to attract banks to analyze their mortgage bonds and return them with high credit ratings like AAAs. In fact, it was very important at the time for S&P’s and Moody’s to return with strong ratings on the mortgage backed securities since the eventual investors would be forbidden from looking at riskier securities.


So at this point you might be piecing some things together, but actually it’s the big banks that are really piecing things together! When you’re a dragon with fire, you can weld practically anything solid together, including the mortgage bonds themselves. By following the above model, you can structure thousands of mortgage bonds (each built with hundreds of mortgages and other loans) into tranches and structure them together into a single “safe” Collateralized Debt Obligation or CDO. The dragon in our example, JPM, sold close to $130 Million in CDOs to funds with a lot of money aka institutional investors. To the investors, the dragon’s kill was the best kill, especially when the high lords of credit have rated the instruments with meaty Triple As.

At this point, the story of the poor strawberry pickers is completely lost in the thousands of pages that encompass a single CDO. The I-bankers don’t know what’s in them, the risk managers don’t know what’s in them, the financial engineers or quants don’t know what’s in them and only a few heavily bonused lawyers have read only the majority of the CDO. The basis of the CDO is in complex models and formulas, but if you thought this is where the complexity ends — it doesn’t. Say hello to my little friend, the Credit Default Swap or CDS and with it, another dragon with another name — let’s call it AIG reinsurance.

The Swap

When an investor, say a hedge fund, makes a massive investment in a CDO, it’s also crucial to insure any risk — in this case, the seemingly low chance that a CDO will fail. In theory, if you’re a 50 year old man who loves burgers but also suffers from heartburn, you wouldn’t invest in a 24 hour nurse every Fourth of July. But 35 years later, when you’ve survived a heart attack, it wouldn’t be a bad idea to have a nurse every day of the week. The conundrum arrives when you’re 80 years old, but have never had any major health complications. Should you spend the money on a nurse? No one else your age is doing it unless they have been in the hospital for serious reasons, and you’re not 90 years old where such an investment would make total sense. Most funds during the 2000's were the 80 year old healthy guys, with no one to nurse their losses. Only a few seriously lucky ones realized the utility in the credit default swap.

Essentially, the CDS was a financial product sold like an insurance contract by dragons like AIG who believed in their fellow dragons like the I-Banks. The purchasers of the CDS were investors who didn’t particularly believe in the subprime mortgage backed securities and possibly the entire banking system. These were the outsiders, who were willing to pay regular premiums to the big reinsurance companies in order to protect their investment on the high paying CDO, which they believed could disintegrate given a catalyst. At the time, it was like building a nuclear fortress in the middle of Switzerland. Now you’re probably wondering, it can’t get more worrisome than that. You have billions of dollars in financial products backed by mortgages that people can’t pay back a couple years from now, and the only reason these products keep getting sold is because of sneaky tranching based on computer models. Well, there is something I didn’t mention because it is akin to a massive fiery meteor years away from the Earth but nevertheless headed straight for it. And the catch is, NASA is made up of less than 20 guys who no one listens to. So let’s talk about the Synthetic CDO because it is the grand finale on Doomsday Preppers.

The Big One- the Synthetic CDO

Sometime somewhere a banker (who was probably on drugs in Vegas) thought of a ‘genius’ idea which would later be sold to investors looking to expose themselves to extremely high upsides with exotic risks.

In practice, a regular CDO is really just a segmented bundle of further segmented bundles comprised of anything with regular interest bearing cashflows. In other words, you can create a CDO backed by anything where a person pays out a loan or security through monthly payments to the organization they owe . So of course, this not-so-sober banker decided to issue the formation of a CDO that was backed by the premium payments that flow from the very thing meant to insure the original CDO in the first place! Yes, I am saying that securities were created that were wholly backed by the regular premiums investors paid on the Credit Default Swaps to dragons like AIG. These are what we call the Synthetic CDO. Another way to look at this was Wall Street literally invented securities whose cashflow was structured to feed off of the CDS payments, resulting in bond-like behavior. In layman’s terms, this was some next level magic.

Essentially, you had the CDS which was being backed by a Synthetic CDO, and the Synthetic CDO which was being backed by the underlying CDS or various CDS’s (take a moment to digest that). Because, the cashflows of the CDS mirrored that of the CDO it insured, we are talking about millions to billions of dollars in investments. And all this time, no one has a clue that the Mexican strawberry pickers along with the rest of American homeowners are about to get screwed. But the most interesting and scary part of the Synthetic CDO was what it truly was in theory — investors of Synthetics believed (without telling anyone) that there was a pressing need for investors to insure the regular CDOs they were investing in. Investception? No, in financial mathematics this is called credit exposure and in basic economics this is called taking advantage of information asymmetry. The craziest thing about this is the lower you go in the layers of investception, the higher the returns — with the riskiest tranches of Synthetic CDO’s seeing jaw-falling payouts. And yes, you should just assume tranches when CDOs come up; they are a fundamental part of most CDOs. If you’ve taken a financial economics course or two, then another way to put this is the Synthetic CDOs allowed its investors to gain from the underlying credit exposure using a CDS, without actually investing in the assets themselves (aka the CDOs). If you’ve passed high school, then you can probably understand this — your shorting the housing market and your shorting it Big time.

So what was the catalyst to the collapse of the subprime mortgage system and thus CDOs — a simple but inevitable hike in mortgage rates.

The Lion with Courage

Sometimes I wonder what kind of guts Christian Bale had to accept the role of Dr. Michael Burry (a Vandy med school graduate), who was the mastermind behind the ‘Big Short’. To really understand the psyche of a hedge fund manager like Burry, we need to understand what it is that drives someone to look at the current market and say, “some shit is happening.” First an foremost, this isn’t some common portfolio strategy like convertible bonds arbitrage. This is literally like betting against the entire world’s cluelessness — even supposedly smart guys with Phd’s and MSc’s. These are people who could have sent submarines into the deepest trenches in the ocean or discovered quantum computing before Google but decided to structure asset backed securities for the Goldman Sachs. And now you are the one claiming you know something they don’t?

To me, this is it. It is the epitome of human courage. When you can say with a straight face that you knew things Alan Greenspan nor the White House did. But, then when one thinks about it, and one really has to wonder — how could a lion know something the all-knowing Oz didn’t. How could he beat all the dragons and catch all the rich lords in their game? Maybe, a select few people knew and maybe just maybe, they let it happen. They say wars boost a nation’s long term growth in industry — they never said financial crises don’t do the same for corporations.

Dr. Burry — Founder of Scion Capital

note — -I know this was somewhat of a repetition of the Big Short but I think the movie’s humor and bad haircuts really distracts you from the information. Also, I didn’t quite get the analogies sometimes.

advice — read the book, watch Margin Call as well and take some statistics courses or something.

another note — because of a lack of accounting background, I couldn’t go into the complex tax policies surrounding the securities mentioned above. sorry about that mate.