The liquidators want $1 billion for investors and the name of the rating agencies’ dealer for a friend. Read more »
Retail clients are not typically paragons of rationality or possessors of Black-Scholes calculators so a good way to make money is to bamboozle them with mispriced derivatives. The classic way banks do this is with structured notes, where you combine a bond worth $75 and an S&P option or whatever worth $15 and sell the combination for $100 because who has time to check your math, really. In the early years of this century life insurance companies came up with a clever variation on this idea. The variation was:
- Combine a bond worth $75 and an S&P put option worth $15.1
- Sell the combination for like $80.
- Hope everyone forgets about it.
This was an amazing plan. You can see why it sold well? You can also see why it did not really work, for the insurers? It totally totally did not work, for the insurers, and yesterday Moody’s issued a report about it saying basically “a lot of life insurers are kind of fucked because of this,” which, sure, but what were they expecting?
Here’s what they were expecting: Read more »
A primary goal of financial engineering is to confuse the bejeezus out of Them while remaining crystal clear to Us. There’s no point to it if it doesn’t in some way confound the expectations of some Other, whether that Other is the tax authorities, bank capital regulators, rating agencies, customers, or markets generally.1 But the worst possible outcome is for a product to be unpredictable to whoever built it, mostly because, if it was any good, they built a lot of it, and if it blows up on them it’ll hurt.
There is an obvious tension here: complicated products serve well to confuse Them but are more likely to end up acting up on Us as well.2 One fruitful approach is for Us to be just a bit smarter than Them. Another approach, lovely when it works, is to build a product that is so beautifully simple that anyone can understand it, but that has one simple conceptual twist that falls right in the particular blind spot of one particular targeted Them.3
You can bracket the question of whom residential mortgage backed securitizations were designed to confound,4 and just take a moment to realize: they kind of screwed the banks that did them, no? I mean, “compared to what” I guess – imagine if Countrywide had done all the lending it actually did, but kept everything on its balance sheet – but the fact that BofA has eighty zillion dollars in putback liability must be discouraging for whoever’s left there on the securitization desk. Like: the whole idea was to put some loans in a box and sell the box to investors; the investors, not you, now own the credit risk on the loans. You own nothing. The loans have nothing to do with you. Sure you signed a piece of paper saying some stuff about the loans, just before you waved goodbye to them, but why would you have read that? Those are just reps and warranties; those are for the junior law firm associates to haggle over. You sold the loans, it’s done, right? Read more »