[letittbe]

More "for dummies"

Mortgage Backed Security
A Mortgage Backed Security is a type of asset backed security where the originator (often Fannie Mae, Freddie Mac, Lehman, Citi or one or two other major players) buys a bunch of “whole loans” (aka residential mortgages). The loans are placed in a big pool and payments on the loans (interest, capital, foreclosure recovery, etc) are pooled as the “income” part of the security. The MBS originators sell “shares” of the security to mutual funds, pension funds and other “buyers”.
Over the 00’s roughly 1 to 2 trillion dollars of MBS were created each year. However, an MBS is not as easy to price as other types of securities (such as commercial paper, munis or government bonds). The value of an MBS depends on the aggregate value of the loans. Each loan is valued based on:
• The size
• The interest rate
• The length of the loan
• The value of the property in the case of foreclosure
In addition, there are numerous costs for servicing the loans (actually gathering and tracking the payments), pushing for recovery in the case of default or foreclosure, selling the properties in the case of foreclosure and many others.
The risk on the security is also complicated because it depends on the individual risk of failure of each loan, plus aggregate risks. The risk factors include:
• The chance of default (borrower will simply stop paying)
• The chance of prepayment (borrower will pay early, reducing interest)
• The chance of delinquency (borrower will miss a payment)
• Average interest rate vs current interest rate (if interest rates go down, prepayment goes up as borrowers refinance. If interest rates go up, delinquency and default increase).
• Credit rating of the borrower
• Payment history of the borrower
The Lehman team, for example, had models that included upwards of 20 different variables which gave the risk of whether an individual loan, or pool of loans would fail. However, these models are only as good as the underlying data. Whole Loans were often bought based on just the size, rate and maturity. This created numerous opportunities for fraud and also more cost for “due diligence” in reviewing the loan packages. The feeling was that loan quality really didn’t matter all that much because the MBS market fed the CDO market and the CDO market was super hot. In other words, Lehman would turn over the loans so fast it wouldn’t matter how good or bad they were.
For further reading:
• http://en.wikipedia.org/wiki/Mortgage-backed_security

Collateralized Debt Obligation
Because an MBS can be made up of horrible quality loans, and no one would buy the MBS, banks came up with the idea of slicing up an MBS into “tranches”. Each tranche can be thought of as a bucket. As Lehman (or the MBS holder) receives money (interest, principal, whatever), they throw the money into the buckets in order of seniority. The first tranche gets all the money until the bucket is full. Then the second tranche gets money. The third tranche gets whatever is left. The belief was that, regardless of the underlying loan quality, enough money would come in to always fill the first tranche, and almost always fill the second tranche. The third tranche was riskiest, but was also priced accordingly (it was cheap and had a high interest rate).
A CDO basically let the rating agency give high ratings to part of an MBS even if the underlying assets were junk. The CDO also created nightmares of level 3 (hard to price or sell) assets for companies like Lehman who often simply kept the 3rd tranche.
For further reading:
• See if you can sneak into an Alvin Hall lecture. He explains this amazingly well.
• http://en.wikipedia.org/wiki/Collate...ebt_obligation

Credit Default Swap

A Credit Default Swap is a contract between two parties that can be thought of as insurance. The term insurance, however, has to be avoided because insurance is regulated whereas a CDS is a private contract and thus, unregulated. The seller of a CDS provides “insurance” against credit related default events on some particular object (security, company, whatever). The buyer pays the seller a premium and then only gets payment if a credit event occurs on the CDS object.

Take, for example, the numerous CDS contracts issued against Lehman. JP Morgan sold CDS protection to the Lehman customers who bought Lehman MBS and CDO products. If Lehman defaulted on payment, or went bankrupt, JP Morgan had to pay out the value of the CDS. Of course, a CDS is often much more complicated than this and can involve stock, debt or other considerations.
Most of the CDS’ that were called in over the fall were tied to either CDO or MBS products, or to the companies that issued the products. Imagine this chain of events, and you can see the leverage factor at play:
• Lehman issues an MBS for 10 Million.
• Lehman turns the MBS into a CDO and sells the first tranche to say… AIG. The second tranche goes to…call it “failed Euro Bank”.
• AIG buys a CDS from JP Morgan (counterparty to $58 trillion in swaps!) to protect against the CDO going bad.
• Failed Euro Bank buys a CDS from Citi (counterparty to $38 trillion in swaps!) to protect their part of the CDO.
• Hedge Fund “TBNL” buys a CDS against Lehman going bankrupt from BofA (counterparty to ANOTHER $38 trillion in swaps!).
We now have seven companies (Lehman, AIG, JP Morgan, Citi, Euro Bank, TBNL, BofA) all tied to the same underlying asset. Note that some of these companies (JP Morgan, Citi, BofA) are required to pay massive amounts if the MBS fails. AIG and Failed Euro Bank are also potentially in trouble, especially if JP Morgan, Citi or BofA can’t pay. Hedge Fund TBNL helps cause the problem because Hedge Fund TBNL has no exposure to the underlying asset and is simply betting that it will fail. Add a few dozen Hedge Funds doing the same thing and you suddenly have companies promising to pay 30 or 40 times (or more) of the underlying asset’s value if a credit event occurs.
Speculation exists that the government deal around Bear Sterns was actually to keep JP Morgan from having to pay out many trillions of dollars in CDS payments.
For further reading:
• http://en.wikipedia.org/wiki/Credit_default_swap
• http://asecondhandconjecture.com/ind...nd-nightmares/
• http://nickgogerty.typepad.com/desig...ment-risk.html

[asypecresty]

Words, words, words, NAKED, hu-hu, hu-hu, words, words, ASS-et, hu-hu, hu-hu, words, words, words, ASS-ume, words, words...

Hey Beavis, what is this Bullshit, there is no timeline, just some stupid porn story?

[Siffidiolla]

Thanks for that stuff, Asher.

-Arrian

[Rchzygnc]

Originally posted by Chemical Ollie


Canada still has a European Queen Starchild is an exception.

[8Uxtkz7F]

Originally posted by Nikolai
So where's your name on that list Asher? I was on the 12-man team that wrote the software for Lehman to trade CDS and MBS trades.

[Proodustommor]

Originally posted by Asher

I was on the 12-man team that wrote the software for Lehman to trade CDS and MBS trades. Weren't you trying to get that done right before they started having business problems?

JM

[VanDerSmok]

Originally posted by Nikolai
I won't pretend I understand what that really means.:P Does it mean you made a computer program/frame work that managed/kept overview of how the values was secured in the firm? If I understood it right from your post CDS and MBS is two different ways to insure the values, right? Or am I completely in the wrong direction? There's literally dozens of instruments Lehman and other banks use, CDS and MBS trades are just two. I was working on the application that the traders used inside Lehman (it was also used by other banks, like Deutsche Bank, under contract). They had a frontend they used to display all of the information associated with the deal (which is a lot, our database was many terabytes in size). The meat of the program was in the server-side processing. The volume of traffic our servers saw was incredible, and then it had to interact with dozens of risk systems (compute clusters that analyze risk factors in each trade, and accept/reject the trades). Then it had to flow from desk to desk for approvals inside Lehman. Finally the trades had to get pushed outside Lehamn to the counterparties and government clearing houses.

It was very complicated and complex program with many other systems it communicated with.

Essentially, any time a Lehman trader needed to make a trade, they loaded up our program and actioned the trade through the program. They're all "paperless" trades. It was called a "trade capture and workflow system".

[Toscoropreark]

Apologies for the encoding if it's displaying weird for anyone -- if you switch the character set (in FF, View -> Character coding) to "Western" it should work.

Edit: Although for some reason, this post is best viewed in Unicode

There's a lot more to to the doc if anyone is interested. Here's the section on legislation:

The government has played a huge role in setting up, financing and regulating the capital markets. Over the years, critical pieces of legislation have fundamentally changed the way that money moves. In other cases, regulations from the SEC or other groups have had similar effects. This section highlights a few of the major items related to the current crisis.

Community Reinvestment Act
The CRA was passed in 1977 as a way to encourage banks to lend more to inner cities, minorities and other areas that were/are traditionally “underserved”. Of course, the areas were underserved primarily because of the high risk of default and low rate of return. Therefore, the CRA had a stick in the form of “regulatory oversight”. That is, any bank attempting to merge with or acquire another company had to have a positive CRA rating. The banks looked on the CRA as a “charity tax” and donated money, gave risky loans and performed other non-business savy acts as a way to get approval for big mergers.

Two important things about CRA that have to be included as part of the story:

• Housing prices tracked inflation in a flat line until after CRA, when prices started to decouple from inflation. This effect may not be causal, but it is definitely correlated since the CRA predates the other legislation and many of the “causes” people point to for starting the housing bubble.

• The CRA wasn’t necessarily the direct cause of the problem but it created the opportunity. The CRA didn’t force banks to give bad loans, but it did suggest that they give more to less qualified borrowers if they wanted consideration for mergers and other regulatory acts. So the banks gave a few bad loans… kind of like the first guy who sold a Tulip in Holland. The first price probably wasn’t unreasonable, but it opened the door and created the market. Throw the deregulation efforts of the 80’s on top of it, and you get a massive mess very quickly.

The first MBS (from Bear, consisting of Fannie/Freddie secured Alt-A and subprime loans issued under the CRA) creates a demand. The lack of regulation means Wall Street sees massive dollars in CDO and MBS creation. Banks see massive dollars in originating and selling off loans. Non bank mortgage originators see a “safe target” in poor and vulnerable communities. Borrowers see “Free money” and a chance to get a house they never thought they could afford. So even though it isn’t fair to place all the blame on Jimmy Carter & the Democrats in the 70’s, you can very easily put the CRA in the class of legislation that caused unintended consequences through social engineering.

Yes, CRA only applies to FDIC banks. Yes, most of the sub-prime and alt-a nonsense was created by mortgage companies that weren’t banks, and thus weren’t under CRA anyway. However, most of those mortgage companies only exist because the big banks did the first loans (guaranteed by Freddie/Fannie) under the CRA, and then the investment banks did the first MBS and CDO offerings, creating the demand for crap loans to turn into gold.

So greed was a huge multiplier, but greed only matters if the preconditions exist for greed to have a chance. Some legislation (FHA, CRA) opened the door and other legislation (repeal of Glass-Steagall, etc) encouraged incentives for greed to grow unregulated. I don’t see the story as a simple “this is the thing that caused it all” as much as a “look at all these places where something could have been done”.

Further Reading
• http://bigpicture.typepad.com/commen...erstandin.html
• http://www.ffiec.gov/cra/
• http://en.wikipedia.org/wiki/Community_Reinvestment_Act

Glass Steagall Act
The Glass Steagall Act was passed in 1933 as a response to the great depression. Basically, the US government decided to break up the functions of a bank into different companies. Essentially, investment banks had to be separate from commercial banks. The theory was that this approach would prevent commercial banks from recklessly speculating with depositor money. The separation of “granting credit” from “using credit” was supposed to prevent conflicts of interest that were perceived to have contributed to the market meltdown in 1929. Other parts of the act created the FDIC.

The act was revised in 1956 to further separate insurance underwriting (“protecting credit”) from banking practices. An insurance underwriter could neither be a commercial bank nor an investment bank. This act is why a CDS is called a “swap” rather than simply “credit insurance”. If a Swap was considered insurance, it would be illegal for the investment banks to originate the deals.

Many of the classic “big banks” had to break up into multiple companies or reduce their services and focus on one side or the other. Some banks got around the act by creating superficial commercial banks (e.g. Lehman Brothers Bank) which exist solely for compliance reasons.
The law was partially repealed in 1999 with the passage of the Gramm-Leach-Blilely Act. Other portions were repealed or modified under other regulation throughout the 80’s and 90’s.

Further Reading
• http://www.investopedia.com/articles/03/071603.asp
• http://en.wikipedia.org/wiki/Glass-Steagall_Act

Gramm Leach Bliley Act
This act, also called the Financial Services Modernization Act, repealed parts of Glass-Steagall relating to separation of banking activities. Commercial banks, Investment banks and insurance underwriters were allowed to consolidate. One of the first (and the one that prompted the act) was the merger of Citibank and Travellers Group. Note that this merger has recently dissolved, with Citi splitting of parts of Travelers and selling the rest to Metlife.

The primary argument for the act was that people put money into savings when the economy is bad (benefiting commercial banks) but invest when the economy is good (benefiting investment banks). Neither group was well suited to survive the various “lean times”, however a combined company would get the best of both worlds.
The most interesting part of the act was that any merger had to have a “satisfactory CRA rating”. Essentially, this means that the bank has to convince the CRA auditors that the bank supports community reinvestment. Usually, this process worked as a defacto bribe/greenmail system where big banks would dump tons of cash on groups like ACORN just before a CRA audit. From the bank perspective, CRA money was wasted in high risk, low payout loans to unqualified borrowers.

Further Reading
• http://en.wikipedia.org/wiki/Gramm-Leach-Bliley_Act
• http://banking.senate.gov/conf/
• http://banking.senate.gov/conf/grmleach.htm

Securities Acts Amendments (May Day)
In 1975, the government removed the regulation that fixed commission prices for brokerages. In other words, brokerages were free to compete on price of transaction rather than on services. Much as deregulation of airline fares killed some companies and made new ones, the May Day changes killed some investment banks and brokerage houses and allowed new ones to form. Quite simply, the revenue model changed drastically and banks had to rapidly adapt. This act basically forced a lot of the creativity in capital markets that led to the explosion in the 80’s and 90’s.

For example, Salomon Brothers in the early 80’s made more money than almost all of the other brokerages combined. Since they weren’t competing for fixed price commissions, Salomon made money by creating innovative products and services and essentially making new markets all over the place (including… yes… Mortgage Backed Securities!).

Further Reading
• http://curiouscapitalist.blogs.time....all_repeal_it/
• http://www.ft.com/cms/s/0/30031a6c-8...077b07658.html

2004 Leverage Adjustment
In 2004, the SEC changed the leverage limits for a handful of institutions. Rather than the 12 to 1 cap most financial services work with, Lehman, AIG, Bear, Freddie, Fannie and a few others were allowed to leverage up to 30 to 1. Obviously, removing a hard cap on leverage encourages the firms to make larger and riskier bets.
The reason for the change is a little unclear as the actual decision was made by the SEC and very little information is easily available.

[Xxmlqevq]

I knew it was AC/DC's fault!

[mr.videomen]

They're widely considered to be at least partly heavy metal.

Eg, their wiki:
Genre(s) Hard rock, heavy metal, blues-rock, rock and roll

[feqlmwtuqx]

Thanks for proving the point.

[effebrala]

I never disputed that.

[mirzaterak]

hard rock for sure, but heavy enough to be put in my heavy metal music folder. think most will agree. Like the wikiquote says, lots of metal fans got into heavy metal thanks to AC/DC, and so did I.

[smirnoffdear]

WTF? If this is for dummies it needs a lot less words and more colorful charts and graphs.

[zoneouddy]

Originally posted by MORON
My insufficient google-fu suggest that the article is not in circulation....

should it? It's not confidential but it's part of a rather extensive writeup a team of guys did at work (we do a lot of business with financial services companies).

It's only been "published" by a company-wide email and then who it gets forwarded to that may find it interesting.

[Effofqueeno]

As we now know.

[VINPELA]

Re the OP: as a dummy I can assure you that is NOT the "for dummies" version. Flagrant false advertising.

[Sxedlawb]

I'm just shocked beyond words that they actually accounted for any variables, let alone 20!!

What, were people just not reading prospectusesesses or were these '20 variables' just 20 different shades of pig-lipstick?

[triardwonvada]

I'm sure it's all excellent stuff, but I still think there should be an 'executive summary' for the TLDR brigade.

After all, if my CEO is allowed to run a publishing company without ever needing to understand any detail ....

[secondmertg]