Originally posted by: mshan
I stick to mutual funds, so I don't know a lot about puts, calls, etc.
But if someone makes a bad 10 x leveraged $1 bet and is wrong, isn't his loss $10?
I thought at least one of those Bear Stearns hedge funds, where those mortgages were nominally marked at 100 on the books, were marked down to something like 70 when they actually had to sell them, and that it was the large leverage used in the fund that turned these " moderate" losses into completely worthless (like 3 cents on the dollar)??
It wasn't leverage, it was the fact that the pieces of these bonds were so subordinate in the actual MBS, then were pooled into CDO's, which then the hedge funds bought the lower subordination of.
Look at it this way. An MBS is structured with AAA bonds all of the way down to BBB, BB, B and an "equity" tranche which takes the first portion of losses.
Since it's sometimes hard to find people who want to take a single BB, B, or equity piece in a sub-prime MBS, they took a bunch of these pieces and stuck them in another structure, a CDO.
You take 10 of these subordinate pieces and stick them in a CDO and you do the same thing you did with the MBS, creating a AAA, AA, A, BBB, BB, B, and equity tranche.
So, essentially, you are taking the crappiest portion of a structure, sticking a bunch of them in another structure, then creating a super-crappy portion. Of course, this last portion pays massive % in interest, maybe 15-20%+. This type of return is attractive to hedge funds, who think that a CDO structure pooling protects them.
However, what happens if the crappy MBS subordinate pieces start going down the tubes and you hold a subordinate CDO piece too? You get a downgrade on the MBS, which results in a downgrade to the CDO, which has to be marked to market, resulting in losses.
Essentially you're doubling down on risk thinking the pooling nature of the structure will protect you while you reap a good return. Too bad these toxic waste junk bond tranches didn't have enough protection in them to guard against crappily underwritten mortgages.
Now you're seeing the rollup effect of this. Since nobody wants CDOs, nobody wants to buy subordinate pieces of MBS. Since you can't place sub pieces of MBS, you can't issue MBS unless you put a lot more enhancement in it (reducing the money the company gets out, tying up more capital that could otherwise be lent). That means that you can't underwrite as many mortgages, meaning that subprime borrowers with resetting arms are f'd. People think they'll be able to refi into more secure mortgages, but where are those going to go? People have already been burned once, so once those MBS pre-pay the banks refi'ing them need to hold them on balance sheet, draining capital that could otherwise be used to lend money to other people, spurring on capitalistic growth.
This also happens with CLOs, which are nothing more than less than perfect middle-market corporate debt bundled in pools. Most of this debt is created by LBOs. Since hundreds of billions of companies have been going private through LBO and since that market is limited to a small section of money (read high-net worth investors or private-equity, hedge funds, or large pension fund), your average joe-sixpack is taking the money he got from an LBO and sticks it back into the DJIA. More money chasing fewer stocks = price appreciation.
However, since CLOs are shutting down, LBOs are shutting down. Chrysler, Alliance Boots, First Data, and approx 300billion in LBO debt are starting to fall through. That means that the deals won't go through, meaning that the price-premiums baked into the stocks by the market is also going to deflate, causing repricing in the stock market, aka a correction (like today). Additionally, the i-banks can't spin the LBO bonds off, so they have to hold them, further reducing deployable capital, reducing economic growth.
So, essentially, the last 7 years has been fueled by debt and now the whole system ground to a halt. Oops.