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zafonic

Cdo's And Bespoke Tranch Opportunity's

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A question for someone more intelligent than me.

The big banks have developed “Bespoke Tranche Opportunity’s”, essentially CDO’s with a different name.

You would have thought that banks would stay a million miles away from these products given that they nearly brought down the banking sector not so many years ago (and led to the insolvency and closure of some banks).

Despite this, there is clearly an appetite to trade them again and this got me thinking who were the main beneficiaries of the last housing collapse.

Much is spoken in the press about the hundreds of billions of pounds lost by banks and the hundreds of billions of pounds of Government money to bail them out. It is my understanding that most of these losses were on the synthetic credit default swaps on CDO’s, rather than the actual mortgages themselves.

Now a swap is a zero-sum-game, i.e. for every loser there is a winner. So given that the banks lost tens of billions, there must have been an entity on the other side of the trade that profit to the tune of tens of billions. A quick google of “who profited from the housing crash” throws up very few names and those that it does mention are the handful of hedge funds featured in the book The Big Short. BUT, these hedge funds only made a few hundred million each or so (impressive, but that leaves hundreds of billions unaccounted for).

My inference is that, there are a silent group of people who cleaned up to the tune of billions who (understandably) have kept quiet about the riches they manages to earn. Riches that essentially have come through the taxpayers bail-out money.

Another thought is that if you add up the bonuses paid by the banks to staff over the last 15 years or so, this probably broadly equates to the amount of bail out money needed. Is this effectively where all the money has gone (i.e. over bonuses paid based on an over inflated valuation of the banks, which subsequently turned out to be erroneous so they need the “bonus” money back.

Anyone who know more about this subject than me care to share thoughts on who the banks losses went to?

Thanks in advance.

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My understanding is that both parties had their own methods for valuing their swaps. Funnily enough, both claimed a profit and a bonus. I think I read this in the Faisal Islam book (good but has to be read in sections to avoid blood boiling).

So basically, the taxpayer paid for it.

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question

I have no particular knowledge of this subject.

Ultimately the people who "profited" were the house owners who walked away from their worthless houses, and didn't have to pay. But I think there was also the element of a bubble in the fiancial derivatives collapsing, meaning assets were no longer worth what they were previously. People can lose without there being winners. If the housingmarket in the UK collapsed, all the homeowners would be poorer, but no one would be a winner (well, indirectly, non home owners, but that's a different issue)

I agree about the bail out going on bonusses, although I would have said the banks were actually not profit making in the decade or more up to the crash, and it was those bonusses we paid for with our taxes.

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I suspect that there were two groups of winners:

1. Those people who sold houses for prices far higher than would have been the case had the mortgage market not massively overheated (and those allied businesses like Estate Agents and mortgage brokers who participate in this market).

2. Those bankers who would have received annual bonuses and salaries from originating and trading these instruments which they did not have to repay when the whole thing went sour.

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Anything called "Bespoke" is so reminiscent of the days of privilege and special treatment (and something for nothing fraud) - it's a sign of modern day times that it's a banking product.

It also tends to suggest that there's still a long long way down before the crash is fully played out.

Edited by billybong

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^


Now a swap is a zero-sum-game, i.e. for every loser there is a winner. So given that the banks lost tens of billions, there must have been an entity on the other side of the trade that profit to the tune of tens of billions. A quick google of “who profited from the housing crash” throws up very few names and those that it does mention are the handful of hedge funds featured in the book The Big Short. BUT, these hedge funds only made a few hundred million each or so (impressive, but that leaves hundreds of billions unaccounted for).

My inference is that, there are a silent group of people who cleaned up to the tune of billions who (understandably) have kept quiet about the riches they manages to earn. Riches that essentially have come through the taxpayers bail-out money.

Trillions/quadrillions?


http://www.dailyfinance.com/2010/06/09/risk-quadrillion-derivatives-market-gdp/

One of the biggest risks to the world's financial health is the $1.2 quadrillion derivatives market. It's complex, it's unregulated, and it ought to be of concern to world leaders that its notional value is 20 times the size of the world economy. But traders rule the roost -- and as much as risk managers and regulators might want to limit that risk, they lack the power or knowledge to do so.

A quadrillion is a big number: 1,000 times a trillion.

Edited by billybong

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Trillions/quadrillions?

Attempts to regulate the shadow banking industry since 2008 have been half-baked. It would seem to be a simple matter to force disclosure of the loss of value required to wipe out an investment, which would give some idea of the amount of leverage involved at the initial offering. But things are never that straightforward. Credit derivatives are stochastic processes and require a continuous bath of liquidity (noise) to operate successfully. No security can be correctly priced when illiquid.

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The passage below is the best explanation i've found to date. Last para in particular sums up the massive misdirection by Governments.

A CDS is like insurance and sometimes you "win" even though you don't "profit" - you pay a premium for the CDS and payment of that premium may permit you to recover principal (such as bond principal) that otherwise is lost by reason of a bankruptcy.

For example, you buy $1MM of Mega Corp 5 year bonds with a coupon of 5% in April, 2008, and also buy a CDS for the same amount and time period for a premium of $25,000. If there is no default, you earn your interest, minus the premium, and receive back your principal.

In that example, the "profit" would be enjoyed by the seller of the CDS who pocketed the premium ($25K) and did not have to make good the principal ($1MM).

You can also "profit" from a CDS if you bet right, even if you don't have an actual debt exposure, if the market turns in the diretion you bet and if you can then sell the CDS to a third party. In the prior example, say you did not actually own the bonds, you just bought a naked CDS, thinking that Mega Corp may be nearing a problem, and you are right and a year later the market for a 4 year Mega Corp $1MM CDS is $50K, then you sell the CDS to someone looking to cover an exposure for that time period and pocket the $25K profit.

Or you buy up $1MM of Mega Corp. bonds at a discount (selling at a discount due to Mega Corp. credit problems) and tender the bonds and the CDS when they default. You profit based upon the discount, minus the $25K. Etc. One of your risks though is that the counterparty on the contract - let's call them AIG - can't pay what they promised, even if Mega Corp defaults. You then have a $25K bankruptcy claim against AIG, presumably worthless.

In the real world of AIG, the government bail out money - i.e., the 99.9% of the AIG funds that were devoted to purposes other than the bonuses that are apparently the only topic of interest to the demagogues in Washington - went in most cases to counterparties, either to pay off "bad" bets by AIG on CDS and/or to cover collateral requirements under a CDS.

For example, the CDS described above might have had a provision saying that the issuing counterparty did not need to post collateral for the CDS if its credit remained AAA, but if it dropped, say to A, then it would have to post 50% of the contract amount as collateral for its obligation. That situation was arising as to AIG and in some respects created a "run on the bank". Usually at least one side of the CDS had a real economic interest to cover - e.g., the bond buyer described above wanting or needing to hedge its credit bet by purchasing CDS. Sometimes on the other side of the contract was a simple speculator - e.g., AIG - but without the speculator, you would not have had much of a CDS market at all.

Like all futures, options, etc types of contracts, some of the parties need to hedge an actual economic bet (e.g., commodity buy or sell) and other parties are just there to make money as a speculator, or in some cases by buying and selling both sides (arbitrage, i.e., taking advantage of pricing distortions in one or both markets to match off the risks and take the spread as profit). That is winding around a lot of different sorts of issues, but I hope is helpful in answering the question about who profits from a CDS. Think of it like fire insurance; the insurer, if properly run, makes the profit (most of the time) from the conract, but you profit - in reality suffer less of a loss - if you have to cash in on the insurance. Unlike insurance, however, the CDS market was (relatively) unregulated and so it was up to the counterparties to satisfy themselves that the other counterparties could pay up their side if called upon. Since in virtually all cases the players were big institutions that does not seem too much to ask.

And why would the government feel the need to step in to save the bacon of supposedly sophisticated financial players - now that is the $64,000 question worth considering, as a taxpayer and as a matter of public policy. And the related question becomes why isn't Washington trying to explain the use of 99.9% of the AIG bailout money rather than trying to divert your attention to the 0.1% (pre tax) amount for the bonuses.

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