Abandon all hope of really understanding, ye who read the best-selling books explaining the meltdown.
Why say that? Because they can’t seem to get even the basics right.
I just read the second wildly incorrect explanation of how a simple CMO structured finance deal works, and, like the first one, it was in a popular non-fiction book that purports to tell the reader what happened in the much more complicated mortgage market meltdown, and why.
The one I’m reading right now is Michael Lewis’ “The Big Short.” I know, it came out months ago, but what can I say? There are lots of them, and I already know Michael’s schtick pretty well.
Michael is a gifted raconteur. I used to love his satire columns on my Bloomberg, especially when he went off in a serious rant in the “voice” of a 30-something Entitlement King, AKA hedge fund manager.
I enjoyed his first book, Liar’s Poker, and have a copy somewhere still, I think.
I knew at the time that he was just repeating stories as they were told to him sitting out in one of the outer provinces of the Salomon empire (just as distant as Britannia was from Rome in 75 AD). Still, I worked with a number of the people in the book directly, and saw antics that were just as outrageous, with serious money always spicing up the action.
He’s a good story teller. I can read and enjoy his descriptions of people and their interactions.
The Big Short got a serious burst of publicity when it came out, including some spots that most authors wouldn’t even have the temerity to dream about (60 Minutes segment, for example). It even recently got into the Congressional Record as several Congressmen and Senators extolled its virtue as the defninitive way to learn the truth.
I could tell from the exerpts I read and the interviews that I would find the book very one-sided and superficial, so it wasn’t until I saw US Senators discussing how to fix our financial system and his book in the same breath that I decided I had to read it.
I wasn’t even ten pages into it when Michael described the first CMO bond with the analogy of a multi-story building in a flood, with the first tranche getting the first prepayments from the borrowers (like the ground floor of a building in a flood), the second tranche getting prepaid next, and so on. He explained, getting it completely backwards, that the buyer of the first tranche to be paid gets the highest yield, that the second takes a lower yield, and the last tranche the lowest yield of all.
During his couple of years at The Brothers, the yield curve was positively sloping, and spreads were wider on “spread product” the farther out the curve you went. It makes me wonder whether he ever sold a mortgage bond during his time in London. There weren’t many buyers outside the US for those first 100 or so CMO deals, so it could well be that he simply mis-remembers.
Strangely enough, a much earlier book about the meltdown, Charles Morris’ Trillion Dollar Meltdown got the fact correct that virtually every CMO time-sequenced structure paid more yield to longer duration bonds, but he told his readers that the longer dated bonds got more yield because they were taking more credit risk.
Unfortunately, just like Michael, Charles said that about Agency CMO’s, where every penny of principal is guaranteed by the Agency (and lately the taxpayer).
Michael…. if you get the chance to fix this with a second printing, you can save your clever image by using it to describe the treatment of credit losses in a non-Agency structure like those the subprime, alt-A and “private label” MBS used. Then your “ground floor” would be what we called the “equity” or “residual” piece of the deal, that took the first loss. The first floor could be the BBB- bonds, the second floor the BBB (flats) and the third floor would be the BBB+ bonds, and so on. Then you would just have to explain how the people in the Penthouses, (AAA bonds) received all the principal payments for the first few years and how the Penthouses were sometimes split into time tranches or even one more level of credit-tranching (super-senior).
This kind of stuff makes it hard for me to read the literature. I don’t expect any of them to understand synthetics CDOs, credit default swaps, hedging, spread duration, or the inherent fallacy of the copula function default analysis applied to incredibly similar bonds based on large (relatively) consistent sets of underlying debts (residential mortgages). I don’t even expect them to try to explain CPDO’s (Constant Proportion Debt Obligations – the only structured finance invention even more absurd than CDO-squared deals).
But explaining a sequential CMO from fully-guaranteed Agency MBS?
Come on! By 1990, those were called “plain vanilla” deals, and they were. Twenty-seven years after they were introduced and accepted in the market, I would think that authors starting with those as the basic first structured deals would get it right.
FWIW, I’ll share my definitions for CMO’s and tranches from my manuscript. I included them to help the reader by appearing as sidebars the first time the term was used, and then gathered into a limited glossary.
CMO, or Collateralized Mortgage Obligation — A multi-tranche mortgage bond deal that distributes the cash flows from a pool of mortgages to the bonds according to a set of rules for that distribution. The mortgages are said to “collateralize” the bonds.
Tranches – from the French trancher, to cut. In a securitization, tranches are prioritized (cut) by maturity, allocation of interest, or in order of credit priority. When divided by credit gradations, some deals will even take the most senior AAA rated bonds, and prioritize the credit one more time to create “super senior” AAA tranches.
Of course the flood of books out on the meltdown subject range from bad to worse. Michael’s writing is entertaining, and Charles is a journeyman who just didn’t have access to the people who really understood when he set out to write his book. The real meltdown was still a year or more in the future, as well. I honestly don’t know if Morris fixed his fundamental error describing the grandaddy of structured finance whe he re-issued the book as the Two Million Dollar Meltdown.
Some books on the topic are easy to spot for what they are and why you can’t believe them…. the Meltdown by Thomas Woods was a tissue of politically-motivated lies put out to blame the Community Reinvestment Act and Barney Frank for the problem. George Soros’ Credit Crisis of 2008 was just another round of his peculiar self-serving view of the markets as the playground for him and others of his economic class to act out their neuroses and biases.
Other books of the “true confessions” variety are out. Unfortunately, how a Lehman Brothers emerging market bond trader knows anything about the mortgage desk and its internal doings is beyond me. I spent two decades on mortgage bond desks at five firms. I can count the number of interactions with the emerging markets crew on zero fingers. Even when we worked on the first-ever Argentine mortgage bond, they didn’t consult us, and we didn’t consult them.
I do have high hopes for 13 Bankers. I’ve found I make a nearly daily visit to the authors’ blog, and the interviews that they gave after the book was published seemed to have real solutions for the underlying problem. Maybe that will be my entertainment next weekend.
Happy 4th. Remember, it wasn’t all about taxes when we cut our ties with Mother England. The East India Company monopoly was taking more from us than the tea tax took.
Today’s Tea Party would do themselves and the country a favor if they paid attention to the whole picture. John Hancock was a smuggler already liable to be hung before he joined the patriots.