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FTX going under due to magic beans reminds me so much of Lehman Brothers going under in 2008. That time the magic beans were "mortgage backed securities" that s

FTX going under due to magic beans reminds me so much of Lehman Brothers going under in 2008. That time the magic beans were "mortgage backed securities" that somehow took low-quality debt, mixed it up with some magic, and out came high-quality debt, only it didn't.

kristjansson 4y ago
The problem with MBS was always the zero-sum nature of the alchemy. They took 100 low-quality loans in, and returned 10 high-quality loans, 30 ok-ish loans, and 60 dog-shit loans. No harm no foul, until the dog-shit tranches were marketed as ok-ish, and alchemists believed they we're really creating gold.
- dragontamer 4y ago
  CDOs weren't the problem. You see, mixing together dog-shit __ONCE__ isn't that big of a deal. CDO-squared (CDOs of CDOs) were a problem. If you took those 60 dog-shit loans, mixed them together, and created 10 high quality loans out of them, problems began to occur. Even then, it wasn't the CDO-squared that collapsed the whole thing. It was the CDS: the "insurance" (so to speak) on the CDO-squared that made things go haywire.
  - oliwary 4y ago
    I am fascinated by the number of layers of abstractions built on top of each other in these financial products... Bankers seem to rival programmers in their ability to stack abstractions on top of each other until it is impossible to understand how the underlying system relates to the top layer.
    - pseudosavant 4y ago
      You could say that MBS/CDOs were 'leaky abstractions', and that there were equivalents to 'code smells' to suggest they weren't the golden debt they masqueraded as. I can't think of other professions that develop the same level of abstractions that programmers and bankers create. Layers and layers of inputs and outputs.
      - TheOtherHobbes 4y ago
        You could also say they were deliberate fraud. The number of big-name banks whose actions are questionable [1] - if not actually criminal - is astonishing. [1] As reported by insider papers like the Financial Times.
    - htrp 4y ago
      A structured products desk is basically a microservices team
  - pseudosavant 4y ago
    Nested leveraging is a common theme. Each layer is leveraged and but supposedly protected by another layer's risk management. Go through enough layers and you eventually hit an insurer that has zero chance of being able to cover all of the losses of everyone. It could be CDS of CDOs of CDOs, or coins being backed by other coins. Thankfully the average person is less affected by crypto losses than mortgages, or in the case of the depression, stocks.
  - 6stringmerc 4y ago
    Actually AIG and other bond insurers really got the bailouts too. I remember a guy bragging about helping another firm backdate its books to get bail out money. He was bragging. Still remember his name and how he got his pill head daughter a Cush company paid job in London.
  - bagels 4y ago
    Were the risk models assuming no correlation between the risk of the underlying securities?
- ethbr0 4y ago
  The central MBS problem seemed to be ratings-based-regulation + free-market-unregulated-ratings-agencies. In hindsight, it should have been structured like government insurance servicers: subject to random and regular audits, with $$$ fines if they turn up anything fishy. If you don't want corruption, engineer a system where not being corrupt is more profitable...
- throw474374383 4y ago
  I talked to a banker at the time (from BoA I think) and he said these things came about by the banks re-arranging the structure again and again, running it through the risk and credit rating algorithms and then tweaking and retrying until they got something with a good rating. So essentially that's like finding exploits in the other parties risk calculation algorithms or credit rating algorithms until you find some hack that labels crap as gold. So I think of it as hacking basically. The banks figured out how to hack Moody's algorithms, as it were. Don't forget through all of that madness Moody's was rating utter crap as AAA https://en.m.wikipedia.org/wiki/Credit_rating_agencies_and_the_subprime_crisis https://en.m.wikipedia.org/wiki/Credit_rating_agencies_and_t...
  - jcbrand 4y ago
    If you have a metric, eventually it'll be gamed.
- ThrustVectoring 4y ago
  Mortgage-backed securities weren't exactly the problem, it was merely the vehicle in which a trans-Atlantic banking regulation arbitrage trade was carried out, and the trade accidentally became fully self-financing. US mortgage originators and banks were allowed to take risk if they sold it off onto the capital markets, and EU banks were allowed to take risk as long as it was deemed "safe" by ratings agencies. The truly pernicious part is the self-financing spiral. Banks issued mortgages, which deposit cash in the home seller's account. Seller puts the cash into a money market fund. MMF gets short-term interest by financing AAA-rated securities. EU banks use this financing to buy senior tranches of MBSes. These MBS purchases allow banks to issue more mortgages by freeing up their capitalization. Like, zero-sum alchemy will only generate small frauds and relatively limited losses. You need large amounts of leverage and some kind of self-financing spiral to generate catastrophic de-leveraging events.
NotYourLawyer 4y ago
It feels magical, but that part is actually fine. The senior claims on that combined debt really can be pretty high quality. The junior claims are dogshit though.
- htrp 4y ago
  But you can tranche the dogshit and come out with some high quality senior claims :-D
PathOfEclipse 4y ago
"Certainly more study is needed on this issue. But the degree to which the Community Reinvestment Act (renewed and strengthened in 1995; see attached chart), the Home Mortgage Disclosure Act and the many other planks of the raft of federal regulation which have built up over the past couple of decades has pushed the banking industry into making the loans for which they are now being criticized is far and away the most under covered aspect of this story. " https://www.cnbc.com/id/25195425 https://www.cnbc.com/id/25195425 It's amazing how the government somehow managed to successfully pin all the blame on corporations for problems it helped cause. From wikipedia: https://en.wikipedia.org/wiki/Subprime_mortgage_crisis https://en.wikipedia.org/wiki/Subprime_mortgage_crisis "Lenders made loans that they knew borrowers could not afford and that could cause massive losses to investors in mortgage securities." Of course, it was the government itself that pressured banks to make these loans in the first place. From https://www.appeal-democrat.com/thomas-sowell-government-created-financial-crisis/article_5664ba31-59f2-529c-826e-6bcd5b928f0b.html https://www.appeal-democrat.com/thomas-sowell-government-cre... "All this was an opening salvo in a campaign to get Congress to pass laws forcing lenders to lend to people they would not otherwise lend to and in places where they would not otherwise put their money."
- SantalBlush 4y ago
  That banks extended bad loans under pressure from the government suggests they did so at a loss; otherwise, they would have done it anyway in search of profit. Moreover, Sowell makes bold claims and offers little evidence beyond references to redlining, while the evidence that banks were engaged in unethical and fraudulent practices are backed up by cold-hard data and an abundance of testimony from people within the industry. Sowell's essay is revisionism.
  - deleted 4y ago
    [deleted]
  - JackFr 4y ago
    You understand the borrowers weren’t the victims of the fraud —- in fact they were engaged in it. The banks settled on charges of selling securities backed by loans that they had not sufficiently vetted, of which many turned out bad.
memish 4y ago
Get ready to have your mind blown. Watch this https://twitter.com/HaloCrypto/status/1590417311839981569 https://twitter.com/HaloCrypto/status/1590417311839981569
- jl2718 4y ago
  I was once surprised to learn that, in some cultures, dishonesty is regarded as a skill. After all these years, I’m starting to see their point.
goodcanadian 4y ago
There are already a lot of replies, so maybe it is pointless adding my own . . . My understanding of the problem with mortgage backed securities was that the calculations assumed the risks on the low-quality debt was uncorrelated. If that were true, all of the math works out, and there is no problem with mortgage backed securities. The reality was/is, however, that the risks on those loans were, in fact, highly correlated. The conditions that caused one loan to default also made it much more likely that others mixed up in the pot would also default. In that case, the math was wrong and the magic failed. I suppose we could argue all day about whether that was an honest mistake or deliberate manipulation.
- tdullien 4y ago
  It was broken incentives. Give people a financial incentive to do something that can look like an honest mistake in retrospect, and they will make a lot of "honest mistakes".

kristjansson 4y ago

The problem with MBS was always the zero-sum nature of the alchemy. They took 100 low-quality loans in, and returned 10 high-quality loans, 30 ok-ish loans, and 60 dog-shit loans. No harm no foul, until the dog-shit tranches were marketed as ok-ish, and alchemists believed they we're really creating gold.

dragontamer 4y ago
CDOs weren't the problem. You see, mixing together dog-shit __ONCE__ isn't that big of a deal. CDO-squared (CDOs of CDOs) were a problem. If you took those 60 dog-shit loans, mixed them together, and created 10 high quality loans out of them, problems began to occur. Even then, it wasn't the CDO-squared that collapsed the whole thing. It was the CDS: the "insurance" (so to speak) on the CDO-squared that made things go haywire.
- oliwary 4y ago
  I am fascinated by the number of layers of abstractions built on top of each other in these financial products... Bankers seem to rival programmers in their ability to stack abstractions on top of each other until it is impossible to understand how the underlying system relates to the top layer.
  - pseudosavant 4y ago
    You could say that MBS/CDOs were 'leaky abstractions', and that there were equivalents to 'code smells' to suggest they weren't the golden debt they masqueraded as. I can't think of other professions that develop the same level of abstractions that programmers and bankers create. Layers and layers of inputs and outputs.
    - TheOtherHobbes 4y ago
      You could also say they were deliberate fraud. The number of big-name banks whose actions are questionable [1] - if not actually criminal - is astonishing. [1] As reported by insider papers like the Financial Times.
  - htrp 4y ago
    A structured products desk is basically a microservices team
- pseudosavant 4y ago
  Nested leveraging is a common theme. Each layer is leveraged and but supposedly protected by another layer's risk management. Go through enough layers and you eventually hit an insurer that has zero chance of being able to cover all of the losses of everyone. It could be CDS of CDOs of CDOs, or coins being backed by other coins. Thankfully the average person is less affected by crypto losses than mortgages, or in the case of the depression, stocks.
- 6stringmerc 4y ago
  Actually AIG and other bond insurers really got the bailouts too. I remember a guy bragging about helping another firm backdate its books to get bail out money. He was bragging. Still remember his name and how he got his pill head daughter a Cush company paid job in London.
- bagels 4y ago
  Were the risk models assuming no correlation between the risk of the underlying securities?
ethbr0 4y ago
The central MBS problem seemed to be ratings-based-regulation + free-market-unregulated-ratings-agencies. In hindsight, it should have been structured like government insurance servicers: subject to random and regular audits, with $$$ fines if they turn up anything fishy. If you don't want corruption, engineer a system where not being corrupt is more profitable...
throw474374383 4y ago
I talked to a banker at the time (from BoA I think) and he said these things came about by the banks re-arranging the structure again and again, running it through the risk and credit rating algorithms and then tweaking and retrying until they got something with a good rating. So essentially that's like finding exploits in the other parties risk calculation algorithms or credit rating algorithms until you find some hack that labels crap as gold. So I think of it as hacking basically. The banks figured out how to hack Moody's algorithms, as it were. Don't forget through all of that madness Moody's was rating utter crap as AAA https://en.m.wikipedia.org/wiki/Credit_rating_agencies_and_the_subprime_crisis https://en.m.wikipedia.org/wiki/Credit_rating_agencies_and_t...
- jcbrand 4y ago
  If you have a metric, eventually it'll be gamed.
ThrustVectoring 4y ago
Mortgage-backed securities weren't exactly the problem, it was merely the vehicle in which a trans-Atlantic banking regulation arbitrage trade was carried out, and the trade accidentally became fully self-financing. US mortgage originators and banks were allowed to take risk if they sold it off onto the capital markets, and EU banks were allowed to take risk as long as it was deemed "safe" by ratings agencies. The truly pernicious part is the self-financing spiral. Banks issued mortgages, which deposit cash in the home seller's account. Seller puts the cash into a money market fund. MMF gets short-term interest by financing AAA-rated securities. EU banks use this financing to buy senior tranches of MBSes. These MBS purchases allow banks to issue more mortgages by freeing up their capitalization. Like, zero-sum alchemy will only generate small frauds and relatively limited losses. You need large amounts of leverage and some kind of self-financing spiral to generate catastrophic de-leveraging events.

NotYourLawyer 4y ago

It feels magical, but that part is actually fine. The senior claims on that combined debt really can be pretty high quality. The junior claims are dogshit though.

htrp 4y ago
But you can tranche the dogshit and come out with some high quality senior claims :-D

PathOfEclipse 4y ago

"Certainly more study is needed on this issue. But the degree to which the Community Reinvestment Act (renewed and strengthened in 1995; see attached chart), the Home Mortgage Disclosure Act and the many other planks of the raft of federal regulation which have built up over the past couple of decades has pushed the banking industry into making the loans for which they are now being criticized is far and away the most under covered aspect of this story. " https://www.cnbc.com/id/25195425 https://www.cnbc.com/id/25195425 It's amazing how the government somehow managed to successfully pin all the blame on corporations for problems it helped cause. From wikipedia: https://en.wikipedia.org/wiki/Subprime_mortgage_crisis https://en.wikipedia.org/wiki/Subprime_mortgage_crisis "Lenders made loans that they knew borrowers could not afford and that could cause massive losses to investors in mortgage securities." Of course, it was the government itself that pressured banks to make these loans in the first place. From https://www.appeal-democrat.com/thomas-sowell-government-created-financial-crisis/article_5664ba31-59f2-529c-826e-6bcd5b928f0b.html https://www.appeal-democrat.com/thomas-sowell-government-cre... "All this was an opening salvo in a campaign to get Congress to pass laws forcing lenders to lend to people they would not otherwise lend to and in places where they would not otherwise put their money."

SantalBlush 4y ago
That banks extended bad loans under pressure from the government suggests they did so at a loss; otherwise, they would have done it anyway in search of profit. Moreover, Sowell makes bold claims and offers little evidence beyond references to redlining, while the evidence that banks were engaged in unethical and fraudulent practices are backed up by cold-hard data and an abundance of testimony from people within the industry. Sowell's essay is revisionism.
- deleted 4y ago
  [deleted]
- JackFr 4y ago
  You understand the borrowers weren’t the victims of the fraud —- in fact they were engaged in it. The banks settled on charges of selling securities backed by loans that they had not sufficiently vetted, of which many turned out bad.

memish 4y ago

Get ready to have your mind blown. Watch this https://twitter.com/HaloCrypto/status/1590417311839981569 https://twitter.com/HaloCrypto/status/1590417311839981569

jl2718 4y ago
I was once surprised to learn that, in some cultures, dishonesty is regarded as a skill. After all these years, I’m starting to see their point.

goodcanadian 4y ago

There are already a lot of replies, so maybe it is pointless adding my own . . . My understanding of the problem with mortgage backed securities was that the calculations assumed the risks on the low-quality debt was uncorrelated. If that were true, all of the math works out, and there is no problem with mortgage backed securities. The reality was/is, however, that the risks on those loans were, in fact, highly correlated. The conditions that caused one loan to default also made it much more likely that others mixed up in the pot would also default. In that case, the math was wrong and the magic failed. I suppose we could argue all day about whether that was an honest mistake or deliberate manipulation.

tdullien 4y ago
It was broken incentives. Give people a financial incentive to do something that can look like an honest mistake in retrospect, and they will make a lot of "honest mistakes".