Tuesday, 9 February 2016

Financial instruments

Last week I went to see "The Big Short" and enjoyed it for it's entertainment value, however it was remarkably accurate.

The FT has a front page story today [Tuesday 9-Feb-2016] suggesting The Big Short is on again, this time in London, luxury homes are being shorted by hedge funds in a bet on falling prices.

If you are unfamiliar with the back story, the gist of the unsavoury activities that led to the housing crisis was threefold:-

lenders handing out risky [sub prime] mortgages to borrowers with poor credit scores
banks bundling these sub prime mortgages into securities and treating them as if they were not risky
banks and insurers issuing insurance policies against the system’s implosion

The good news is CDO's [collateralised debt obligations] are dead. Pre-crisis, investors were gorging on these bundles of residential mortgages, to be more precise, bundles of bundles of mortgages.

Similar financial devices are still around, including private label CMBSs [commercial mortgage-backed securities] and CLOs [CDOs with regular bank loans instead of mortgages]. The Consumer Protection Act prevents people from issuing these securities to hedge or transfer all the risk, meaning they are still exposed to some of the risk.

Can another Big Short happen?

Well not in the same way, for one thing, the complex insurance products that "The Big Short" guys used to bet against the housing market so-called CDS [credit default swaps] are dead too. That is a good thing but it is now concerning that the solution to the crisis generated the seeds of another.

Essentially the government nationalised the entire residential mortgage market, handing the reins to Fannie Mae, Freddie Mac, and the Federal Housing Authority. Although these entities do not make dangerous CDOs, and you cannot buy a CDS from them, our reliance on them leaves the economy vulnerable.

Are we as safe as we could be from all the lessons learned? I think not.


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