So, was there any money in the system?
ewhac said about the Eisman piece, "I still don't get it. Is he talking about a genuinely non-existent loan, fraudulently created to sell a CDS against? Or is he using the concept of a loan as a rhetorical stand-in for another CDS, in an attempt to describe swaps insuring swaps insuring swaps?"
No, he's talking about a genuine loan on a tenuous (in fact non-existent) promise to repay.
A CDO is a bundle of debt obligations with assets backing them; the assumption is that you can sell them short on the expectation that they'll produce long-term. When Eisman buys a credit default swap (an insurance policy on whether or not a BBB tranche bond obligation between two other parties will default), he gives Goldman Sachs an entry on their books that they can bundle as a new debt obligation vehicle (called a Synthetic Credit Debt Obligation) they can then sell-- and it has the exact same risk pattern as the original policy, because it's a meta-policy on the original risky mortgage-based "asset backed" CDO. When Sachs sells it, the CDO buyers who buy it either didn't know or didn't care what it was; it was just a CDO they could pass on without too much due diligence. Why should they care? Sachs thought it could make the game go on; they thought Sachs was good for it all.
That's why Eisman was so shocked at the CDO's cavalier attitude. He didn't care what he was buying and selling so long as he took his cut. The CDS had the same risk as the mortgages on which it was built, but the CDS dealers were able to take the debt obligations those CDSs represented and sell them as CDOs. This was that color photocopier rolling off $100 bills that Karl Denniger wrote about.
Since actual payoffs on CDSs were extremely rare until the crisis hit, as long as nobody blinked the system could go on forever. Eisman promised to keep paying the CDS's monthly fee-- but he was betting it would default. Sachs promised to pay off the CDS's full value if the BBB tranche of the large CDO (between two other institutions, neither Eisman's or Sachs) on which Eisman had played the CDS defaulted-- and Sachs was betting it wouldn't.
I don't know who's more foolish here: Sachs, for betting that it could keep this game going, or Eisman, for betting that Sachs would have enough money to cover his and every one else's CDOs. I think the shock comes in that paragraph because Eisman realizes just how big the game is all of a sudden, and just how bad it'll get.
Eisman was blinking hard, in disbelief, even as he kept playing the game. But he did keep playing, you'll notice.
When the paper credit market began to contract-- when the demand for real cash emerged and no one could meet it-- this unlimited capacity for leverage struck and the whole world blinked at once.
What's really telling about all this is that the market handwringing about the "complexity" of CDOs making it hard to understand what happened. But that's not true. As Michael Lewis's article points out, for the past year lots of people understood the problem. They just didn't care because it wasn't really their money. It was other people's money, of which they took a cut simply for being the conduit. I don't believe any longer that this was a problem that only a privileged few could understand. It's easy to understand. It was pure criminal greed.
As Brad Delong put it back in September, answering the question "How did we get here?": Well, because the investors and creditors did not do their due diligence and check that the banks that were the ultimate holders of derivative securities had done their due diligence and checked that the financiers who had created the derivatives had done their due diligence and checked that the purchasers of the securities had done their due diligence and checked that securitizers had done their due diligence and checked that the lenders had done their due diligence and checked that the home buyers had done their due diligence and checked that they could afford their mortgages if house prices stopped going up.
Catastrophic failures of risk management at seven different points along the chain--any one of which would have kept us out of this current mess.
No, he's talking about a genuine loan on a tenuous (in fact non-existent) promise to repay.
A CDO is a bundle of debt obligations with assets backing them; the assumption is that you can sell them short on the expectation that they'll produce long-term. When Eisman buys a credit default swap (an insurance policy on whether or not a BBB tranche bond obligation between two other parties will default), he gives Goldman Sachs an entry on their books that they can bundle as a new debt obligation vehicle (called a Synthetic Credit Debt Obligation) they can then sell-- and it has the exact same risk pattern as the original policy, because it's a meta-policy on the original risky mortgage-based "asset backed" CDO. When Sachs sells it, the CDO buyers who buy it either didn't know or didn't care what it was; it was just a CDO they could pass on without too much due diligence. Why should they care? Sachs thought it could make the game go on; they thought Sachs was good for it all.
That's why Eisman was so shocked at the CDO's cavalier attitude. He didn't care what he was buying and selling so long as he took his cut. The CDS had the same risk as the mortgages on which it was built, but the CDS dealers were able to take the debt obligations those CDSs represented and sell them as CDOs. This was that color photocopier rolling off $100 bills that Karl Denniger wrote about.
Since actual payoffs on CDSs were extremely rare until the crisis hit, as long as nobody blinked the system could go on forever. Eisman promised to keep paying the CDS's monthly fee-- but he was betting it would default. Sachs promised to pay off the CDS's full value if the BBB tranche of the large CDO (between two other institutions, neither Eisman's or Sachs) on which Eisman had played the CDS defaulted-- and Sachs was betting it wouldn't.
I don't know who's more foolish here: Sachs, for betting that it could keep this game going, or Eisman, for betting that Sachs would have enough money to cover his and every one else's CDOs. I think the shock comes in that paragraph because Eisman realizes just how big the game is all of a sudden, and just how bad it'll get.
Eisman was blinking hard, in disbelief, even as he kept playing the game. But he did keep playing, you'll notice.
When the paper credit market began to contract-- when the demand for real cash emerged and no one could meet it-- this unlimited capacity for leverage struck and the whole world blinked at once.
What's really telling about all this is that the market handwringing about the "complexity" of CDOs making it hard to understand what happened. But that's not true. As Michael Lewis's article points out, for the past year lots of people understood the problem. They just didn't care because it wasn't really their money. It was other people's money, of which they took a cut simply for being the conduit. I don't believe any longer that this was a problem that only a privileged few could understand. It's easy to understand. It was pure criminal greed.
As Brad Delong put it back in September, answering the question "How did we get here?": Well, because the investors and creditors did not do their due diligence and check that the banks that were the ultimate holders of derivative securities had done their due diligence and checked that the financiers who had created the derivatives had done their due diligence and checked that the purchasers of the securities had done their due diligence and checked that securitizers had done their due diligence and checked that the lenders had done their due diligence and checked that the home buyers had done their due diligence and checked that they could afford their mortgages if house prices stopped going up.
Catastrophic failures of risk management at seven different points along the chain--any one of which would have kept us out of this current mess.