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Author: JonBeer Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 36080  
Subject: Re: Completely OT, but gotta ask Date: 9/26/2008 2:50 PM
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**WARNING MASSIVELY LONG AND POSSIBLY INCOHERENT**

Hey Rimpy,

In answer to your questions, yes I was very intimately involved in the whole "Structured Credit" market. I was a salesman at a major international bank up until November of 2007 when it became apparent to management that they'd lost a ton of money with some bad positions (only hundreds of millions, but given we were pretty small in this area that was plenty!). They moved quickly by basically firing the lot of us, so that was fun. I was actually having my best year ever, double my previous best, so was a bit of a shocker to be out on my ear with no bonus when I'd been expecting a very chunky one.

I should stress that we weren't really involved in all the dodgy mortgage business that was going on, we were simply working with Corporate debt - i.e. bonds companies issue to fund their operations. People like GE, Ford, Caterpilllar, JP Morgan, and European and global companies as well. Our most lucrative product was called a Synthetic CDO (Collateralised Debt Obligation) which was manufactured using CDS (Credit Default Swaps). Sorry for all the TLAs (Three letter acronyms!).

You can skip this paragraph if you want, it's pretty complicated and not necessary, but I think it gives a flavour of some of the stuff that was going on...Basically we would set up a special company to sell protection on maybe 125 different company's debts and collect a premium for doing so. It then gets a bit complicated... Investors (pension funds, insurance companies - AIG was a big investor - and foreign banks) give you money, maybe a total of about a billion dollars. This money is used to buy a "safe" asset such as a bond made up of Credit Card receipts which is known as the Collateral. The collateral is put into the special purpose company you create and it then uses that as backing for selling protection on all the companies who's debt it's insuring. The income stream from that insurance goes back to the vehicle. Now, the investors have bought specific bits of the investment, depending on their risk tolerance/greed. Some buy the AAA pieces which are meant to be tremendously remote from risk of losing any money, but they only paid you Libor+20bps or so, so if Libor is around 3% you get 3.2% on your money. Others take the riskier parts depending on what they're looking for - the clever part is that unlike a "normal" CDO, with a synthetic one you don't need to sell the entire capital structure. You can construct it so that there are only AAA and A pieces, so if you can't find buyers of the rest, you don't need to cut the prices to shift them! It's amazingly complicated to explain how you do it, but trust me, you can.

Anyway, the fun part is that these were not, by any means, the most ridiculous bubble-type instruments. Oh no. For those the prize has to go to CPDO - which stands for Constant Proportion Debt Instruments, but you don't need to know that at all. Basically these are massively levered instruments which sell protection on an entire index of CDS. The Indices are extremely popular with investors looking to get exposure to a whole parcel of companies at once. They're very liquid and were being quoted at the time in 1bp markets (0.01%) on sizes of up to $1 billion a side. That's astonishing. Anyway, the CPDOs took on this risk, and borrowed a ton of money to do it. If the trade moved against them, then the CPDO simply doubled down. And again. And again. Eventually they were up to about 15x levered, so for every $10 million you invested, you would have risk of up to $150 million - luckily though you could only lose your initial investment. And they were rated AAA by both major rating agencies! And, when the synthetic CDOs were paying just Libor+20bps for AAA risk, you got Libor+200! That's a massive increase. So obviously, a lot of people bought these. And they all got basically none of their money back as the credit indices they were tracking widened out more than anyone believed was even close to possible. Ooops. Black Swan event! I'm proud to say that the Synthetic CDOs I sold are nowadays selling for about 40 cents on the dollar, so have outperformed :)

With regard to the mortgage market - we were at one point asked to sell bonds made up of so-called NINJA loans (No Income, No Job or Assets) or Liar Loans where the person getting the mortgage has not provided any evidence of their income. I am pleased to say that I actively advised my clients NOT to buy any of those, or the CPDOs even though I would have earned good commission from selling them. It was very very obvious to me, and I think even to some of the people who bought them, that these things were no good. So why, you ask, did they buy them? A few of the major reasons:
1) A pension fund or insurance company needs to generate a certain yield on their investments to survive and these products were the only ones in 2006/2007 that would give them the required yield. Probably a consequence of interest rates being too low for too long, and besides, all your competitors are buying this stuff, so you're not going to get fired for doing so as well.
2) House prices can never drop. And if house prices never drop, then it doesn't matter if the buyer defaults, because you get his house.
3) Company debt won't default any more - financial innovations and the surge of money from China and the middle east will allow everyone as much money as they will ever need. To be fair, corporate defaults were probably at their lowest level ever, but that was a result of all this money being unwisely thrown around, not the reason for it.
4) People didn't realise quite how low lending standards had become, for both companies and mortgages.

Ok, so, once things started to go south - and there's still discussion about what triggered it all, we'll likely never know, but I imagine it was when defaults started trending up sharply on mortgages, and home prices in certain hot areas started declining - then because of the massive leverage everyone had it all went bad very quickly. The end result of that of course, was me losing my job :)

I now have another one, but now I'm even more involved in the mess than before. I'm working for a smaller shop entirely on commission and it's far more exciting. I am now involved in the mortgage backed securities market, the Auction Rate market (that would be a whole other diatribe...) and the Loan market. CDOs of mortgages (normally called ABS CDOs, or RMBS CDOs) are now generally trading anywhere from $0 to $60 depending on how old they are (anything done in 2006 or 2007 is mostly worthless) and what they've got inside them. It's impossible to look at a company's disclosures of their mortgage assets and give an accurate value because you simply can't know what they own exactly - but I think it's fair to say that very few of them are marking their books at levels where they could actually sell those assets. That's one of the reasons there's so much fear in the market - no-one knows what exposure other people have, and often people aren't sure what exposure they themselves have, as a result, they're all trying to hold onto as much cash as possible in case they need it. That's caused the inter-bank markets to seize up - which is one of the things the Fed has been trying to control by injecting hundreds of billions into it on a regular basis. Sadly it's not really working, and things are as bad as, if not worse than they've been in living memory. If banks can't borrow from each other, then they don't have the easy access to funds which makes it safe for them to lend to consumers or businesses. If consumers and businesses can't borrow from the banks, then they not only can't expand, or hire more people, or buy a bigger house/car, but there's also a much bigger chance of them going bankrupt. If people can't re-finance their mortgage, or companies can't re-finance their debt, then they'll default on it. If that happens, generally the people who lent them money in the first place will take a loss. As a result, they'll have less money to lend to anyone else, and will raise their lending standards to even more impossible heights, causing more defaults, etc etc. It really is a vicious spiral.

So the question remains "Where now?". Both in the sense of where are we now? And where are we going now? I think we are not yet through this mess. Washington Mutual died last night, all the big investment banks have either died, been taken over, or become banks themselves, the world's biggest insurance company has died, I think Wachovia will likely disappear, and maybe Morgan Stanley. There's still a great deal of pain to come. I don't see any of the big financial companies making anything like the money they used to for the next few years (though it will come back eventually). The economy won't be in a good way any time soon. Second Quarter GDP was just revised down to 2.8% and frankly I don't believe that number at all. We're in a recession, and have been all year, and probably will be for another year. I am cutting back expenditure in my household significantly (no funky new small form factor PC for me....) and trying to preserve capital in the stock market. I think that I'm actually net short the market now, and have been for a while.


So where do we go from here? At some point things will turn around, but I don't think yet. I don't think people have marked down their books enough, I think a lot of companies have too many employees. I am convinced that a lot of local governments will be feeling very significant pain soon, and some of them will be going bankrupt. Property prices will continue to fall because it's very hard to get mortgages of any size at decent rates. Eventually though, things will return to normal, probably sooner than I think, because I'm a bit of a Bear by nature. At some point there's going to be the most tremendous money making opportunities as property and shares will both be cheap. Given ongoing earnings though I don't believe we're there yet.

In terms of anecdotes about my friends/colleagues - a lot of them still don't have jobs having lost them at the end of last year, or beginning of this one. Many are going back to school, I think there'll be a lot of new graduate in a couple of years with fresh MBAs! Those who are still employed, or like me who've found other jobs, are expecting incomes to be much lower this year. Very few people expect big bonuses this year unlike last, so spending all around is down and likely to stay that way. We all talk a lot about the market and what's happening, I'm normally the most pessimistic to be honest, but I've also been the one making money off my shorts this year :)

The bailout plan is both brilliant and terrible I think. It all depends on the execution and as always the devil is in the detail. If they buy the assets at current market levels then the taxpayer will probably make a profit (no guarantee though!) but the people they buy it off will probably go bankrupt. The problem with the banks right now is not that they can't sell these assets - it's that if they sell the assets where they are now they'll realise massive losses and probably some will go bankrupt because they don't have enough capital. In my mind, what's necessary is a massive injection of capital into the banks (taking big equity stakes obviously) and let them deal with the assets themselves, after all, they know them better than anyone. Once they have sufficient capital they'll be able to lend again and take realistic write-downs on their books. Unfortunately that doesn't seem to be the plan, and in the absence of any government plan then total panic will set in again in the market. I know that the week of LEH and AIG I was not the only one running around with their hair on fire, and the situation would be that bad again if people thought that no government action was coming, or worse, that government action was ineffective and they'd done everything they could.

So in conclusion, we need a bailout, not because its a good idea, but because it's the least bad idea we have. Not doing anything is a much worse idea - "sticking it to the bankers" although satisfying is pretty counterproductive. The bankers will be mildly inconvenienced, but Joe Sixpack in Oklahoma will lose his house and his pension....

Sorry this is so long and incoherent, I haven't had time to put my thoughts together succinctly and pithily, so this brain dump will have to do for now!

Regards
Jon
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