You can't create something out of nothing.
Yet another in the series of what I learned in the recent financial crisis:
Conclusion 6: You can't create something out of nothing.
But that is not so obvious as it at first may seem.
Let's take a look at a great conjuring trick called CDO Squared.
Here's how it works. Imagine you are a banker (just for a few minutes I promise) and you are sitting at your desk in some ridiculously tall tower wondering how you are going to convince your boss to increase your bonus this year. As you look out of the window you see the little people on the street. To you they look like ants, running around doing their business. Little do they know what you are planning in your tower.
You think to yourself. "Those little people are so unreliable, but one thing I know is that on average I can count on some of them to be responsible. Now, hmm... my bank needs to look really responsible. After all we have a great logo and a big fancy building, so how can we get those responsible people in the crowd to represent us?"
You keep thinking (remember you are a banker - they hired you because you were good at it) and then you happen on an idea. "How about if I get a load of mortgages together and sell a product in tiers so that some of it is really very secure and guaranteed by the reliable lot and some is less reliable. I can find different institutions willing to take different risks to buy this product depending on the security that they are looking for."
Meanwhile the guy on the floor above you is about to have an even bigger brainwave based on your brainwave. He is going to get a bunch of your products (called CDO's) together and sell them off to create yet more reliable debt.
There is only one problem. Each of these mortgage holders only has one house. So in effect the bricks and mortar product can only be sold once (that is the underlying base value of a house). Remember that has been sold in the first CDO. The CDO of a bunch of CDO's tries to make something valuable out of the rest of the pot.
In a crisis situation this "A rated product" becomes worthless because it was made out of peoples upside in the housing market - which itself has crashed.
And guess who ended up buying those CDO Squared's? The guy opposite you in the other tower, while someone else in your tower bought some of his. Talk about a house of cards.
I wonder if you can guess what this model is based on?
Conclusion 6: You can't create something out of nothing.
But that is not so obvious as it at first may seem.
Let's take a look at a great conjuring trick called CDO Squared.
Here's how it works. Imagine you are a banker (just for a few minutes I promise) and you are sitting at your desk in some ridiculously tall tower wondering how you are going to convince your boss to increase your bonus this year. As you look out of the window you see the little people on the street. To you they look like ants, running around doing their business. Little do they know what you are planning in your tower.
You think to yourself. "Those little people are so unreliable, but one thing I know is that on average I can count on some of them to be responsible. Now, hmm... my bank needs to look really responsible. After all we have a great logo and a big fancy building, so how can we get those responsible people in the crowd to represent us?"
You keep thinking (remember you are a banker - they hired you because you were good at it) and then you happen on an idea. "How about if I get a load of mortgages together and sell a product in tiers so that some of it is really very secure and guaranteed by the reliable lot and some is less reliable. I can find different institutions willing to take different risks to buy this product depending on the security that they are looking for."
Meanwhile the guy on the floor above you is about to have an even bigger brainwave based on your brainwave. He is going to get a bunch of your products (called CDO's) together and sell them off to create yet more reliable debt.
There is only one problem. Each of these mortgage holders only has one house. So in effect the bricks and mortar product can only be sold once (that is the underlying base value of a house). Remember that has been sold in the first CDO. The CDO of a bunch of CDO's tries to make something valuable out of the rest of the pot.
In a crisis situation this "A rated product" becomes worthless because it was made out of peoples upside in the housing market - which itself has crashed.
And guess who ended up buying those CDO Squared's? The guy opposite you in the other tower, while someone else in your tower bought some of his. Talk about a house of cards.
I wonder if you can guess what this model is based on?