8 ms·

Your comment illustrates what I found so frustrating about The Big Short, and people who cite it whenever CDOs are brought up: the filmmakers made no effort in

by morley 7y ago

Your comment illustrates what I found so frustrating about The Big Short, and people who cite it whenever CDOs are brought up: the filmmakers made no effort in understanding the theory behind CDOs, nor did they attempt to explain the potential benefits. Now... it's possible that the way human nature works, CDOs will always result in companies engage in collective delusion that results in a similar meltdown. I think The Big Short would have been more interesting if it made that argument, rather than merely "CDOs are evil." EDIT: I was reacting to the movie adaptation; I haven't read Michael Lewis's book.

vsareto 7y ago
CDOs could be more vulnerable to corrupt practices than other systems. The US banking system could be too corrupt to safely employ CDOs in the long-term. This is difficult to put into theory because corruption is difficult to measure, but I think we've all seen one example already. It wouldn't be the first thing that's great in theory but not in practice.
tialaramex 7y ago
What potential benefit of CDOs did you feel wasn't explained? The movie is based on a book. Do you feel the book's author (Michael Lewis who has written about mortgage backed securities for years) also doesn't understand the theory behind CDOs? Or that the filmmakers didn't understand the book?
- darawk 7y ago
  I've read the book. And all his other books. They're fun, but they're not a great source for serious understanding. The book and movie does briefly explain all this, but it paints a picture that the instruments themselves were inherently toxic, which was not the case. What was toxic were the assumptions that went into modeling their risk characteristics. The assets (like all assets) themselves were fine. The problem was that people didn't understand them.
  - wpietri 7y ago
    In that assets are only created for people to purchase with informed understanding, I don't think "they were great but nobody understood them" is a possible thing. The clearest example here is shares in a Ponzi scheme. Those are definitely assets, and they are definitely not fine. They are made to not be understood. The same is more subtly true of the previous wave of essentially fraudulent mortgage-backed securities. But I think the same is also true of any hard-to-understand instrument engineered to look like a good deal at first glance. You also ignore systemic risk. For many years before the 2008 collapse, cognoscenti knew that a lot of risk had gone somewhere, we just didn't know where. But we sure found out! Saying that "all assets are fine" is sort of like saying "all chemicals are fine". It's technically true, in that dioxin and DDT don't intend to be harmful. But if the evidence shows that people can't use them responsibly, then a ban in a totally reasonable outcome.
    - darawk 7y ago
      > In that assets are only created for people to purchase with informed understanding, I don't think "they were great but nobody understood them" is a possible thing. It isn't the case that nobody understands them. We understand them just fine now. This is how civilization learns. For a long time we didn't know how to price options - now we're quite good at it. > The clearest example here is shares in a Ponzi scheme. Those are definitely assets, and they are definitely not fine. They are made to not be understood. The same is more subtly true of the previous wave of essentially fraudulent mortgage-backed securities. But I think the same is also true of any hard-to-understand instrument engineered to look like a good deal at first glance. Ponzi schemes are designed to defraud unsophisticated investors. These assets serve a useful purpose and work just fine as long as their risks are properly understood, which they now are. > You also ignore systemic risk. For many years before the 2008 collapse, cognoscenti knew that a lot of risk had gone somewhere, we just didn't know where. But we sure found out! Saying that "all assets are fine" is sort of like saying "all chemicals are fine". It's technically true, in that dioxin and DDT don't intend to be harmful. But if the evidence shows that people can't use them responsibly, then a ban in a totally reasonable outcome. The evidence does not show that for these assets. You could make a similar case about basically any dangerous but useful technology. When dynamite was first invented i'm sure a lot of people died messing with it. That doesn't mean we should ban it, it means we need to figure out how to handle it and use it safely. We now understand these assets pretty well. I'll bet you basically whatever amount of money you want that the next crisis will not come from these assets.
- morley 7y ago
  To answer your first question: the benefit of derivatives, of which CDOs are a type, are that they theoretically allow people to _reduce_ risk. The classic example is a put option. If you think a stock will go down in a future, you could short that stock; but if instead the stock goes _up_, you could be on the hook for an infinite amount of money. Instead, you can buy a put option and get a similar payout if the stock goes down, but if it goes up, you've only lost the money you spent on the option. Another example is purchasing futures: if you're an airline and you think fuel prices are going to go up, you can buy up a messload of fuel futures, and you'll effectively pay the same price for fuel while everyone else is paying more (which I think JetBlue did in the 00s). In this case, a CDO theoretically reduces risk by spreading your risk across a huge number of mortgage holders. If you sell someone one mortgage and they default, then whoops! You just lost a ton of money. But if you instead sell 100 different mortgages, you're "diversifying" your risk. Most people don't have billions of dollars to sell thousands of mortgages to make this sort of investment, so CDOs package the mortgages into purchaseable portions. (Of course, what happened during the housing crisis was that there was a huge, systemic issue that would cause huge swatches of mortgages to default. That part sucked, and the contributors to that catastrophe definitely deserve the ire on them.) [Disclaimer: I'm relying on my memory of finance classes I took 15 years ago, I'm probably wrong about some details.]
luckydata 7y ago
I think the author understands CDOs just fine, what you probably want to miss is that the system is built on manufactured trust in what is an extremely corrupt environment. CDOs are not safe because ratings are a joke, as evidently proven by the facts that led to our last recession.
- AnimalMuppet 7y ago
  "What you probably want to miss" sounds very much like an accusation of bad faith. That's frowned upon on HN.
  - luckydata 7y ago
    “I couldn’t help but notice...”
    - AnimalMuppet 7y ago
      Where are you quoting from? It's not in the comment you were replying to, nor anywhere upstream that I could find. And, wherever it is, why do you think it justifies assuming bad faith?
smileysteve 7y ago
Re: The movie adaptation; Here's the Vennett / Anthony Bourdain scene, https://www.youtube.com/watch?v=xbiDrzTd8fE https://www.youtube.com/watch?v=xbiDrzTd8fE
slumdev 7y ago
I've seen the movie and not read the book, and I took away two things: 1. Derivatives can be riskier than the underlying asset. 2. Ratings agencies will lie if it makes a big client happy. I don't think either 1 or 2 is controversial. And put together, those two truths will lead us right back to 2008.
- riffraff 7y ago
  one interesting fact the movie didn't mention about CDOs, IIRC, is that the repackaging makes sense only with the assumption that the underlying assets are independent variables. I.e. if you have 2 independent bonds which will default with 50% probability you can combine 4 outcomes into a single one and issue two tranches. The senior one should be payed back 3 times out of 4 (it's enough if one bond pays back) and the other will be paying back 1 time out of 4 (both need to work out). But if the underlying things are correlated, they will fail or succeed at the same time, so when you buy the senior tranche your assumption that it's safer is wrong. OTOH, buying the other one you'd get a good deal: you will pay for 25% chance of getting the money, but get something more than that.
  - djannzjkzxn 7y ago
    Assets don’t need to be completely independent for their combination to provide an improved risk-adjusted return. In fact, all asset prices are correlated, but we still diversify. I don’t think the financial crisis happened because nobody heard of conditional probability. Derivative structuring is one of the places where people who are good at math go to get rich. Here is an old paper from 2001 that talks about how ratings agencies were using this math: https://www.jstor.org/stable/4480294?seq=1 https://www.jstor.org/stable/4480294?seq=1 The devil is in the details - even if you understand the math, you have a lot of choices to make. Ultimately you are going to have to set parameters on your model where the data to estimate the parameter accurately doesn’t exist. And at that point, math suddenly turns into opinion.
    - riffraff 7y ago
      sure, I didn't mean to imply that lack of basic understanding caused the financial crisis, but watching the movie (the Anthony Bourdain skit) and not having any knowledge of this stuff the first thing you'd think is: how could the soup be rated higher than the fish leftovers? Understanding the probability bit explains that the trick depends on different modeling, not just on repackaging.
samsonradu 7y ago
I've also seen the movie and didn't take away the message that "CDOs are evil", but rather that the risk was not accurately reflected in the ratings. The reasons for that are debatable of course, ranging from bankers greed to rating agencies misbehavior and so on.
turk73 7y ago
The book was excellent.
coliveira 7y ago
CDOs and similars are the ideal vehicle for financial fraud. Basically it assumes that certain companies can create pools of loans that have well defined risk, and rewards them for finding as many of these loans as possible. It is clearly in the interest of loan originators to create a high number of loans with lower quality, after all they won't have to keep these loans and are paid only on the origination.
- JumpCrisscross 7y ago
  > it assumes that certain companies can create pools of loans that have well defined risk No. It says a portfolio of risks can be arranged such that their first cash flows are less risky than their last. This is prima facie true. What matters, to a point, is less the level of risk than its correlation. (And where you draw the line between privileged and unprivileged flows.) Putting it another way, if I take a hundred loans to random industries and say “I’ll pay Bob a dollar first and Al a dollar second,” Bob has a less risky asset than Al. If you have enough uncorrelated loans, and Bob’s take is small enough and first enough, it starts to approach the point that the whole portfolio must default before Bob loses money. In practice, CDOs largely performed through the crisis. Their market values plummeted. But their senior tranches kept paying.
  - coliveira 7y ago
    The comparative advantage of certain investors (Bob in this case) is useless if the loans are the result of fraud. I can create a fraudulent loan originator and crank thousands of loans that are worthless, simply because borrowers can't or won't pay the loan. These loans can be classified as AAA, but it doesn't matter. This is essentially what happened in 2008. And to complete the picture, nobody knows who is who, because of the widespread fraud, so while some borrowers will continue to pay, there is no way to know how many, and therefore no way to value that asset class. So, again, the problem with the failure of CDOs is not just its theory, but assumptions about the trustworthiness of loan originators.

by morley 7y ago

vsareto 7y ago

CDOs could be more vulnerable to corrupt practices than other systems. The US banking system could be too corrupt to safely employ CDOs in the long-term. This is difficult to put into theory because corruption is difficult to measure, but I think we've all seen one example already. It wouldn't be the first thing that's great in theory but not in practice.

tialaramex 7y ago

What potential benefit of CDOs did you feel wasn't explained? The movie is based on a book. Do you feel the book's author (Michael Lewis who has written about mortgage backed securities for years) also doesn't understand the theory behind CDOs? Or that the filmmakers didn't understand the book?

darawk 7y ago
I've read the book. And all his other books. They're fun, but they're not a great source for serious understanding. The book and movie does briefly explain all this, but it paints a picture that the instruments themselves were inherently toxic, which was not the case. What was toxic were the assumptions that went into modeling their risk characteristics. The assets (like all assets) themselves were fine. The problem was that people didn't understand them.
- wpietri 7y ago
  In that assets are only created for people to purchase with informed understanding, I don't think "they were great but nobody understood them" is a possible thing. The clearest example here is shares in a Ponzi scheme. Those are definitely assets, and they are definitely not fine. They are made to not be understood. The same is more subtly true of the previous wave of essentially fraudulent mortgage-backed securities. But I think the same is also true of any hard-to-understand instrument engineered to look like a good deal at first glance. You also ignore systemic risk. For many years before the 2008 collapse, cognoscenti knew that a lot of risk had gone somewhere, we just didn't know where. But we sure found out! Saying that "all assets are fine" is sort of like saying "all chemicals are fine". It's technically true, in that dioxin and DDT don't intend to be harmful. But if the evidence shows that people can't use them responsibly, then a ban in a totally reasonable outcome.
  - darawk 7y ago
    > In that assets are only created for people to purchase with informed understanding, I don't think "they were great but nobody understood them" is a possible thing. It isn't the case that nobody understands them. We understand them just fine now. This is how civilization learns. For a long time we didn't know how to price options - now we're quite good at it. > The clearest example here is shares in a Ponzi scheme. Those are definitely assets, and they are definitely not fine. They are made to not be understood. The same is more subtly true of the previous wave of essentially fraudulent mortgage-backed securities. But I think the same is also true of any hard-to-understand instrument engineered to look like a good deal at first glance. Ponzi schemes are designed to defraud unsophisticated investors. These assets serve a useful purpose and work just fine as long as their risks are properly understood, which they now are. > You also ignore systemic risk. For many years before the 2008 collapse, cognoscenti knew that a lot of risk had gone somewhere, we just didn't know where. But we sure found out! Saying that "all assets are fine" is sort of like saying "all chemicals are fine". It's technically true, in that dioxin and DDT don't intend to be harmful. But if the evidence shows that people can't use them responsibly, then a ban in a totally reasonable outcome. The evidence does not show that for these assets. You could make a similar case about basically any dangerous but useful technology. When dynamite was first invented i'm sure a lot of people died messing with it. That doesn't mean we should ban it, it means we need to figure out how to handle it and use it safely. We now understand these assets pretty well. I'll bet you basically whatever amount of money you want that the next crisis will not come from these assets.
morley 7y ago
To answer your first question: the benefit of derivatives, of which CDOs are a type, are that they theoretically allow people to _reduce_ risk. The classic example is a put option. If you think a stock will go down in a future, you could short that stock; but if instead the stock goes _up_, you could be on the hook for an infinite amount of money. Instead, you can buy a put option and get a similar payout if the stock goes down, but if it goes up, you've only lost the money you spent on the option. Another example is purchasing futures: if you're an airline and you think fuel prices are going to go up, you can buy up a messload of fuel futures, and you'll effectively pay the same price for fuel while everyone else is paying more (which I think JetBlue did in the 00s). In this case, a CDO theoretically reduces risk by spreading your risk across a huge number of mortgage holders. If you sell someone one mortgage and they default, then whoops! You just lost a ton of money. But if you instead sell 100 different mortgages, you're "diversifying" your risk. Most people don't have billions of dollars to sell thousands of mortgages to make this sort of investment, so CDOs package the mortgages into purchaseable portions. (Of course, what happened during the housing crisis was that there was a huge, systemic issue that would cause huge swatches of mortgages to default. That part sucked, and the contributors to that catastrophe definitely deserve the ire on them.) [Disclaimer: I'm relying on my memory of finance classes I took 15 years ago, I'm probably wrong about some details.]

luckydata 7y ago

I think the author understands CDOs just fine, what you probably want to miss is that the system is built on manufactured trust in what is an extremely corrupt environment. CDOs are not safe because ratings are a joke, as evidently proven by the facts that led to our last recession.

AnimalMuppet 7y ago
"What you probably want to miss" sounds very much like an accusation of bad faith. That's frowned upon on HN.
- luckydata 7y ago
  “I couldn’t help but notice...”
  - AnimalMuppet 7y ago
    Where are you quoting from? It's not in the comment you were replying to, nor anywhere upstream that I could find. And, wherever it is, why do you think it justifies assuming bad faith?

smileysteve 7y ago

Re: The movie adaptation; Here's the Vennett / Anthony Bourdain scene, https://www.youtube.com/watch?v=xbiDrzTd8fE https://www.youtube.com/watch?v=xbiDrzTd8fE

slumdev 7y ago

I've seen the movie and not read the book, and I took away two things: 1. Derivatives can be riskier than the underlying asset. 2. Ratings agencies will lie if it makes a big client happy. I don't think either 1 or 2 is controversial. And put together, those two truths will lead us right back to 2008.

riffraff 7y ago
one interesting fact the movie didn't mention about CDOs, IIRC, is that the repackaging makes sense only with the assumption that the underlying assets are independent variables. I.e. if you have 2 independent bonds which will default with 50% probability you can combine 4 outcomes into a single one and issue two tranches. The senior one should be payed back 3 times out of 4 (it's enough if one bond pays back) and the other will be paying back 1 time out of 4 (both need to work out). But if the underlying things are correlated, they will fail or succeed at the same time, so when you buy the senior tranche your assumption that it's safer is wrong. OTOH, buying the other one you'd get a good deal: you will pay for 25% chance of getting the money, but get something more than that.
- djannzjkzxn 7y ago
  Assets don’t need to be completely independent for their combination to provide an improved risk-adjusted return. In fact, all asset prices are correlated, but we still diversify. I don’t think the financial crisis happened because nobody heard of conditional probability. Derivative structuring is one of the places where people who are good at math go to get rich. Here is an old paper from 2001 that talks about how ratings agencies were using this math: https://www.jstor.org/stable/4480294?seq=1 https://www.jstor.org/stable/4480294?seq=1 The devil is in the details - even if you understand the math, you have a lot of choices to make. Ultimately you are going to have to set parameters on your model where the data to estimate the parameter accurately doesn’t exist. And at that point, math suddenly turns into opinion.
  - riffraff 7y ago
    sure, I didn't mean to imply that lack of basic understanding caused the financial crisis, but watching the movie (the Anthony Bourdain skit) and not having any knowledge of this stuff the first thing you'd think is: how could the soup be rated higher than the fish leftovers? Understanding the probability bit explains that the trick depends on different modeling, not just on repackaging.

samsonradu 7y ago

I've also seen the movie and didn't take away the message that "CDOs are evil", but rather that the risk was not accurately reflected in the ratings. The reasons for that are debatable of course, ranging from bankers greed to rating agencies misbehavior and so on.

turk73 7y ago

The book was excellent.

coliveira 7y ago

CDOs and similars are the ideal vehicle for financial fraud. Basically it assumes that certain companies can create pools of loans that have well defined risk, and rewards them for finding as many of these loans as possible. It is clearly in the interest of loan originators to create a high number of loans with lower quality, after all they won't have to keep these loans and are paid only on the origination.

JumpCrisscross 7y ago
> it assumes that certain companies can create pools of loans that have well defined risk No. It says a portfolio of risks can be arranged such that their first cash flows are less risky than their last. This is prima facie true. What matters, to a point, is less the level of risk than its correlation. (And where you draw the line between privileged and unprivileged flows.) Putting it another way, if I take a hundred loans to random industries and say “I’ll pay Bob a dollar first and Al a dollar second,” Bob has a less risky asset than Al. If you have enough uncorrelated loans, and Bob’s take is small enough and first enough, it starts to approach the point that the whole portfolio must default before Bob loses money. In practice, CDOs largely performed through the crisis. Their market values plummeted. But their senior tranches kept paying.
- coliveira 7y ago
  The comparative advantage of certain investors (Bob in this case) is useless if the loans are the result of fraud. I can create a fraudulent loan originator and crank thousands of loans that are worthless, simply because borrowers can't or won't pay the loan. These loans can be classified as AAA, but it doesn't matter. This is essentially what happened in 2008. And to complete the picture, nobody knows who is who, because of the widespread fraud, so while some borrowers will continue to pay, there is no way to know how many, and therefore no way to value that asset class. So, again, the problem with the failure of CDOs is not just its theory, but assumptions about the trustworthiness of loan originators.