How were the main characters of “The Big Short” not basically dealing in SCDOs themselves, and other questions about the housing market collapse.

by Sporz

Cash CDO

Were these individuals betting against the entirety of the bonds, or only the lower tranches?

They bet against upper tranches too, because those were also too highly rated. In fact often with CDOs you can’t bet against the lowest tranches because they’re held by the structurer.

We see a scene in the Big Short where Burry slides a big-ass binder of “bonds he wants to short” across the table to the Morgan Stanley reps. Does this prospectus specify only specific tranches within those bonds that he’s shorting?

You take a group of debts – mortgages commonly – that have a collectively middling quality. Subprime stuff say. And then we do a waterfall.

The money moves from one tranche to the next. The senior tranche pays first, the middle “mezzanine”, becuase we like opera, tranches next, then the so-called equity tranche, which is last. If the money flows freely, all pay up. If they don’t pay, then we have a problem: the lowest tranches dry up, then the mezzanine, and then the senior tranches.

The last tranche in the waterfall, the “equity” or “first-loss” tranche, typically was held by the structurer to sweeten the deal and have “skin in the game”. The money moves down this waterfall and it dries up from the last tranche first.

These all feel bond-like in their own ways. Most of them get even rated like bonds – the equity tranches are typically “not rated”.

So when Burry slides a big-ass binder of bonds he wants to short: it would have been particular tranches or all of the (tradeable) tranches. He could also have been shorting just plain mortgage pools, which are the basis of many CDOs.

Brownfield Fund’s big revelation was to bet against the upper tranches such as A and AA.

If you think that a particular tranche is overvalued, short it.

If the entire bond is supposed to fail at a certain default rate, then wouldn’t betting against the entire bond be sufficient?

  • If I think the entire portfolio will fail completely (no money to anyone): short all tranches.
  • If I think some of the portfolio will fail, short the mezzanine tranches.
  • You can’t really short the equity tranche.

Or does this have to do with the return ratios (25:1, 30:1, etc. on their money) of different tranches? If so, who exactly determines these repayment ratios? They seem almost arbitrary.

It has to do with how the waterfall works.

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My understanding of a synthetic CDO is that it is essentially a collection of credit default swaps against the MBSs.

Correct. You can mix in other stuff with the synthetic but the defining characteristic is that it’s mostly derivatives like CDS (credit default swaps).

So if Mark Baum and Co. are taking out these credit default swaps against CDOs which are made up of MBSs, aren’t they essentially creating synthetic CDOs of their own?

You can short a bond or a CDO tranche by just plain old short selling. You can also short it by shorting credit: buying a CDS on the thing. Up to them. I’m sure they did both.

You can also do it by structuring synthetic CDOs on debt – you take a short position (buying CDS) on the credit quality of the products, they take a long – you make money when it fails. Big short.

If I were as smart as them I would have done any one of these three: short the tranche/MBS, CDS the tranche, structure a product as a synthetic CDO, these all work to the same effect. You are shorting the credit quality of the reference in any of these ways and make money when it fails.

When mortgages started drying up, even the subprime ones, the SCDO market started taking off to keep the gravy train going. What I don’t understand here is: if the housing market was considered so stable, and these investment banks had to pay premiums on the swaps in their SCDOs, then how did they expect ever to profit?

They already had the CDS and CDO products in place – you can’t get out of a losing bet without losing money and the liquidity of the market was drying up.

They failed to understand (and I make no claim to being smart enough to have done this at the time) that that crash in the underlying prices could happen and collapse the markets in these products. There was a generally held view that the house prices underlying all these products were stable.

Additionally, these people were supposedly the “outsiders and weirdos” who were the select few who were able to see what was coming, and bet against the housing market. They ended up profiting hugely while the investment banks which were doing the same thing on a billion dollar scale ended up collapsing. Was this difference in outcome the result of them not having the equity available at the outset of the collapse to cover their swap positions? I.e. they owed more money to people who they insured swaps for than money owed to them from the reciprocal?

They had the smarter bet. There is always a contrarian in these situations who wins. It’s a random fucking walk. Sometimes you’re George Soros betting against the pound and you win; sometimes you’re…that guy who made a bet and lost everything on Arsenal or the Mets.

They won on the swaps, CDOs, and shorts and they were on the right side of the bet when everyone else was wrong.


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