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Comment by morley | Hacker News Reader

Your comment illustrates what I found so frustrating about The Big Short, and people who cite it whenever CDOs are brought up: the filmmakers made no effort in understanding the theory behind CDOs, nor did they attempt to explain the potential benefits.

Now... it's possible that the way human nature works, CDOs will always result in companies engage in collective delusion that results in a similar meltdown. I think The Big Short would have been more interesting if it made that argument, rather than merely "CDOs are evil."

EDIT: I was reacting to the movie adaptation; I haven't read Michael Lewis's book.

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CDOs could be more vulnerable to corrupt practices than other systems. The US banking system could be too corrupt to safely employ CDOs in the long-term.

This is difficult to put into theory because corruption is difficult to measure, but I think we've all seen one example already. It wouldn't be the first thing that's great in theory but not in practice.

I've seen the movie and not read the book, and I took away two things:

1. Derivatives can be riskier than the underlying asset.

2. Ratings agencies will lie if it makes a big client happy.

I don't think either 1 or 2 is controversial. And put together, those two truths will lead us right back to 2008.

one interesting fact the movie didn't mention about CDOs, IIRC, is that the repackaging makes sense only with the assumption that the underlying assets are independent variables.

I.e. if you have 2 independent bonds which will default with 50% probability you can combine 4 outcomes into a single one and issue two tranches.

The senior one should be payed back 3 times out of 4 (it's enough if one bond pays back) and the other will be paying back 1 time out of 4 (both need to work out).

But if the underlying things are correlated, they will fail or succeed at the same time, so when you buy the senior tranche your assumption that it's safer is wrong.

OTOH, buying the other one you'd get a good deal: you will pay for 25% chance of getting the money, but get something more than that.

Assets don’t need to be completely independent for their combination to provide an improved risk-adjusted return. In fact, all asset prices are correlated, but we still diversify. I don’t think the financial crisis happened because nobody heard of conditional probability. Derivative structuring is one of the places where people who are good at math go to get rich.

Here is an old paper from 2001 that talks about how ratings agencies were using this math: https://www.jstor.org/stable/4480294?seq=1

The devil is in the details - even if you understand the math, you have a lot of choices to make. Ultimately you are going to have to set parameters on your model where the data to estimate the parameter accurately doesn’t exist. And at that point, math suddenly turns into opinion.

sure, I didn't mean to imply that lack of basic understanding caused the financial crisis, but watching the movie (the Anthony Bourdain skit) and not having any knowledge of this stuff the first thing you'd think is: how could the soup be rated higher than the fish leftovers?

Understanding the probability bit explains that the trick depends on different modeling, not just on repackaging.

I think the author understands CDOs just fine, what you probably want to miss is that the system is built on manufactured trust in what is an extremely corrupt environment. CDOs are not safe because ratings are a joke, as evidently proven by the facts that led to our last recession.

"What you probably want to miss" sounds very much like an accusation of bad faith. That's frowned upon on HN.

“I couldn’t help but notice...”

Where are you quoting from? It's not in the comment you were replying to, nor anywhere upstream that I could find. And, wherever it is, why do you think it justifies assuming bad faith?

I've also seen the movie and didn't take away the message that "CDOs are evil", but rather that the risk was not accurately reflected in the ratings.

The reasons for that are debatable of course, ranging from bankers greed to rating agencies misbehavior and so on.

What potential benefit of CDOs did you feel wasn't explained?

The movie is based on a book. Do you feel the book's author (Michael Lewis who has written about mortgage backed securities for years) also doesn't understand the theory behind CDOs? Or that the filmmakers didn't understand the book?

I've read the book. And all his other books. They're fun, but they're not a great source for serious understanding.

The book and movie does briefly explain all this, but it paints a picture that the instruments themselves were inherently toxic, which was not the case. What was toxic were the assumptions that went into modeling their risk characteristics.

The assets (like all assets) themselves were fine. The problem was that people didn't understand them.

In that assets are only created for people to purchase with informed understanding, I don't think "they were great but nobody understood them" is a possible thing.

The clearest example here is shares in a Ponzi scheme. Those are definitely assets, and they are definitely not fine. They are made to not be understood. The same is more subtly true of the previous wave of essentially fraudulent mortgage-backed securities. But I think the same is also true of any hard-to-understand instrument engineered to look like a good deal at first glance.

You also ignore systemic risk. For many years before the 2008 collapse, cognoscenti knew that a lot of risk had gone somewhere, we just didn't know where. But we sure found out! Saying that "all assets are fine" is sort of like saying "all chemicals are fine". It's technically true, in that dioxin and DDT don't intend to be harmful. But if the evidence shows that people can't use them responsibly, then a ban in a totally reasonable outcome.

> In that assets are only created for people to purchase with informed understanding, I don't think "they were great but nobody understood them" is a possible thing.

It isn't the case that nobody understands them. We understand them just fine now. This is how civilization learns. For a long time we didn't know how to price options - now we're quite good at it.

> The clearest example here is shares in a Ponzi scheme. Those are definitely assets, and they are definitely not fine. They are made to not be understood. The same is more subtly true of the previous wave of essentially fraudulent mortgage-backed securities. But I think the same is also true of any hard-to-understand instrument engineered to look like a good deal at first glance.

Ponzi schemes are designed to defraud unsophisticated investors. These assets serve a useful purpose and work just fine as long as their risks are properly understood, which they now are.

> You also ignore systemic risk. For many years before the 2008 collapse, cognoscenti knew that a lot of risk had gone somewhere, we just didn't know where. But we sure found out! Saying that "all assets are fine" is sort of like saying "all chemicals are fine". It's technically true, in that dioxin and DDT don't intend to be harmful. But if the evidence shows that people can't use them responsibly, then a ban in a totally reasonable outcome.

The evidence does not show that for these assets. You could make a similar case about basically any dangerous but useful technology. When dynamite was first invented i'm sure a lot of people died messing with it. That doesn't mean we should ban it, it means we need to figure out how to handle it and use it safely. We now understand these assets pretty well. I'll bet you basically whatever amount of money you want that the next crisis will not come from these assets.

I'm not persuaded. There's no such thing as "understand just fine now". Ponzi schemes have been understood since the 1920s, but people keep falling for them. More sophisticated investors can get taken by more sophisticated tricks. Having worked for financial traders, I know just how pleased people can be to have pulled one over on people they see as adversaries.

I agree it's possible that these assets could be fine now, either because people have truly learned a lesson, or just because of the "once bitten, twice shy" reaction that takes a few decades to wear off. But the principle by which you declare them fine, namely that all assets are fine, is definitely wrong.

> I'm not persuaded. There's no such thing as "understand just fine now". Ponzi schemes have been understood since the 1920s, but people keep falling for them. More sophisticated investors can get taken by more sophisticated tricks. Having worked for financial traders, I know just how pleased people can be to have pulled one over on people they see as adversaries.

You could make this argument about literally anything. You're not really saying anything specific to CDOs here, so I can't really give you a more specific response.

> I agree it's possible that these assets could be fine now, either because people have truly learned a lesson, or just because of the "once bitten, twice shy" reaction that takes a few decades to wear off. But the principle by which you declare them fine, namely that all assets are fine, is definitely wrong.

All assets are fine if you understand their risks. Sometimes we deem certain people or groups insufficiently responsible to handle the risks of certain assets. Non-accredited investors are not allowed to invest in private companies. The United States bans "contracts for difference", etc..

I think the problems with CDOs are extremely well understood at this point by everyone in that market. It has been one of the most studied issues of the last decade in quantitative economics. That isn't to say that it's impossible that there's some lurking risk we don't yet get. There absolutely could be. But the probability is much lower than basically any other complex asset class, precisely because this is the one that blew up last time.

If you want to go hunting for latent risk, CDOs are literally the last place you should look. Our economy is chock full of astoundingly complex financial instruments. If you are worried about CDOs because they blew up last time, you are really really missing the point.

If we used your system for banning assets, we'd have banned the stock market in 1929. We'd have banned tech stocks in 2001. Argentina would have basically banned all money by now.

My point is: just pointing at the fact that something blew up once is an insufficient argument that it is not worth the risk. The pattern of "new thing blows up in our face" is quite common across things that turn out to be incredibly valuable and useful. The question at hand is whether we understand it sufficiently well now to use it safely. And the answer is pretty unequivocally yes. We know what we did wrong with CDOs and we know how to correct for it.

You seem to be arguing with quite a lot of things I didn't say. E.g., I don't have a "system for banning assets".

I do agree that, "All assets are fine if you understand their risks," is moving in the direction of a reasonable principle. So you're making progress. Once you start to grapple with intentional information asymmetries, willful misleading of buyers, and engineering for complexity as a way of hiding risk, you might really get somewhere. I doubt you'll get far enough to prevent the next crash or anything, but definitely somewhere.

Blaming the problem on "people" is also missing a large part of the problem. The breadth of the crisis meant that it affected a lot of people who had never heard of CDOs, and never should have. People lost their jobs in totally unrelated fields. Companies couldn't grow because credit dried up while the mess was sorted out. People couldn't sell their houses because the entire market crashed. And so on.

Of the people who did know about CDOs, many should have understood them, because they were playing around with sums large enough to affect the economy as a whole. They didn't through a combination of inertia and fraud.

There were systemic effects, where a whole lot of people were making apparently sensible local decisions and nobody understood the entire interaction -- but that's not really a good justification for shrugging shoulders and say, "Well, I guess it's everybody's fault, then".

People should be able to make the "assumption" that they'll be able to work in a functioning economy, without having to become experts in complex financial instruments. If the financial industry can't leave them to make that assumption, they'll vote for a government that will enforce it -- probably clumsily. If the system requires everybody to understand a financial network that most of them can't, they'll forbid it, which isn't good for the economy but is more acceptable to a lot of people than being told that the financial crash was their fault.

> Blaming the problem on "people" is also missing a large part of the problem. The breadth of the crisis meant that it affected a lot of people who had never heard of CDOs, and never should have. People lost their jobs in totally unrelated fields. Companies couldn't grow because credit dried up while the mess was sorted out. People couldn't sell their houses because the entire market crashed. And so on.

Sure, but i'm not sure what this has to do with my point. Should we ban internet stocks because the market was irrational in 2000?

> There were systemic effects, where a whole lot of people were making apparently sensible local decisions and nobody understood the entire interaction -- but that's not really a good justification for shrugging shoulders and say, "Well, I guess it's everybody's fault, then".

Ok, but how does that cash out in any kind of coherent policy recommendation?

In order for the instrument not to be toxic, it would have to live in an ecosystem where these flaws are not systemically induced.

This industry has been failing systemically often enough to consider the product a liability.

To answer your first question: the benefit of derivatives, of which CDOs are a type, are that they theoretically allow people to _reduce_ risk.

The classic example is a put option. If you think a stock will go down in a future, you could short that stock; but if instead the stock goes _up_, you could be on the hook for an infinite amount of money. Instead, you can buy a put option and get a similar payout if the stock goes down, but if it goes up, you've only lost the money you spent on the option.

Another example is purchasing futures: if you're an airline and you think fuel prices are going to go up, you can buy up a messload of fuel futures, and you'll effectively pay the same price for fuel while everyone else is paying more (which I think JetBlue did in the 00s).

In this case, a CDO theoretically reduces risk by spreading your risk across a huge number of mortgage holders. If you sell someone one mortgage and they default, then whoops! You just lost a ton of money. But if you instead sell 100 different mortgages, you're "diversifying" your risk. Most people don't have billions of dollars to sell thousands of mortgages to make this sort of investment, so CDOs package the mortgages into purchaseable portions.

(Of course, what happened during the housing crisis was that there was a huge, systemic issue that would cause huge swatches of mortgages to default. That part sucked, and the contributors to that catastrophe definitely deserve the ire on them.)

[Disclaimer: I'm relying on my memory of finance classes I took 15 years ago, I'm probably wrong about some details.]

Re: The movie adaptation; Here's the Vennett / Anthony Bourdain scene, https://www.youtube.com/watch?v=xbiDrzTd8fE

CDOs and similars are the ideal vehicle for financial fraud. Basically it assumes that certain companies can create pools of loans that have well defined risk, and rewards them for finding as many of these loans as possible. It is clearly in the interest of loan originators to create a high number of loans with lower quality, after all they won't have to keep these loans and are paid only on the origination.

> it assumes that certain companies can create pools of loans that have well defined risk

No. It says a portfolio of risks can be arranged such that their first cash flows are less risky than their last. This is prima facie true.

What matters, to a point, is less the level of risk than its correlation. (And where you draw the line between privileged and unprivileged flows.)

Putting it another way, if I take a hundred loans to random industries and say “I’ll pay Bob a dollar first and Al a dollar second,” Bob has a less risky asset than Al. If you have enough uncorrelated loans, and Bob’s take is small enough and first enough, it starts to approach the point that the whole portfolio must default before Bob loses money.

In practice, CDOs largely performed through the crisis. Their market values plummeted. But their senior tranches kept paying.

The comparative advantage of certain investors (Bob in this case) is useless if the loans are the result of fraud. I can create a fraudulent loan originator and crank thousands of loans that are worthless, simply because borrowers can't or won't pay the loan. These loans can be classified as AAA, but it doesn't matter. This is essentially what happened in 2008. And to complete the picture, nobody knows who is who, because of the widespread fraud, so while some borrowers will continue to pay, there is no way to know how many, and therefore no way to value that asset class. So, again, the problem with the failure of CDOs is not just its theory, but assumptions about the trustworthiness of loan originators.

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