It’s all over the news, we see investment banks all around the world losing billions because of subprime and credit crunch and the sporadic use of the word “CDO” in between. For the finance illiterate this is the most cryptic any news headline can get. In fact, few finance experts actually know what it means. How is possible to lose $8 billion and notice it last minute?
Common agreement is to blame a real estate bubble that provoked billions in loses, and although true, this is only part of the story. The real problem is greed and the use of derivatives and how investment banks, rating agencies and hedge funds tried to utilize them to gain quick profit.
To my friends I’m talking geek speak, so let me explain how this all works using human language.
Let’s suppose you are an online used cars seller “CARS A FULL”. You want to sell 100 Mercedes D this month. This will be a simulated scenario for the sell:
- You go to ebay and search for the model you are trying to sell. See similar sales and come up with an average sell price of $25000 (I have no idea about cars so bare with me). You also see a lot of people asking for a Mercedes D and willing to buy at that price.
- Knowing the average sell price, you call up your dealer and ask for 100 Mercedes. If the dealer gives you a price of $25000 or more, you know it’s not worth the effort to even try this whole sell, they either lower the price or you don’t want the deal.
Pretty simple, this is more or less how you trade stocks. You have an index where you see the average bid/ask price (sell price) of shares, so you know you can buy or sell Microsoft at certain amount. There is no doubt about it, if you were to execute the sell at this moment you know how much money you’ll be getting. It’s an open market and very liquid: you can sell almost instantaneously and everybody sees the price you are willing to buy or sell for.
Now, let’s go back to the online used cars seller example. Imagine now that ebay doesn’t exist. No online site where you can actually see what’s the average price or how many people is willing to buy a Mercedes D. Things get a little interesting. You know for sure people want a Mercedes D, there is definitely market for it but you need to figure out a fair value. You neither want to sell cars at a lost nor set a price too high for anyone to buy them.
What do you do? Well, you hire 5 people that all they do is randomly call customers, potential buyers and recent buyers to try to figure out the current cars’ value.
This is the situation with banks and CDOs. There is no common place where they can all look and see a price. Most of the time, this actually works to their advantage because customers can’t see others banks prices and they can rip customers off easily.
Business is good and several years later your monthly sells has grown from 100 to 2000 cars. But competition is fierce against 200 other car dealers around your area. Not only that, sometimes a couple of cars come defectious and you lose money because you can’t sell those for a profit. Other times the car comes with 0 miles of usage, completely like new but you already agreed to sell them at certain price and you could have made more profit. You need an edge in the business.
You think about it and come up with a great idea. You call up your dealer and put a condition on him: He has to hire an independent rating company that will check the cars and notify of their conditions. Depending on their usage, scratches, miles, defects and so on they can get ratings ranging from AAA to DDD. This will help you to know beforehand which cars are in what conditions.
Now you hire a team of experts that write the “cars model book”. In this book, given the year of manufacture, miles and rating (AAA-DDD) of the car, you can come up quickly with an estimated sale price.
CARS A FULL is rocking, every first of the month you order a couple hundred cars, the dealer gives you a list of car’s ratings and prices. You look up in your cars model book what is a good sell price and either accept or reject the dealer’s offer. Business is good, the idea is brilliant and soon it catches up with other cars sellers. They also start requiring a third party rating agency and create their own “cars model book” to get an idea of what is a “good” price. They all pool customers and other companies to try to see how well their models actually match the market (practice known as mark to market in finance). And this is how most banks operate.
So what went wrong?
Back to our online car seller. As the happy owner of CARS A FULL you wake up a common morning just to see the news: “Manufacturer of Mercedes D mixed engines and a half of them were sent out to dealers with a Honda engine”. You think, this is going to suck for the dealers. CARS A FULL should be in good standing because the cars pass through the third party rating company and they are all AAA. Good to go, we are safe.
This couldn’t be further from the truth. You arrive to the office to find the phone ringing non-stop, your employees going crazy and a long list of complains. It seems half of your last month sales had Honda engines. But this is impossible! Pissed at the madness you decide to open the hood of one of the cars that you were about to ship today. You’ve never bothered to check any car, you fully trusted your dealer and rating agency, but to your surprise you find a Honda inside the Mercedes.
Things get worse. One employee comes running to you with a printed page from the New York Times. It appears that some Mercedes D were shipped with the right engine but they got a defectuous steering wheel that might get stuck during driving if not exchanged. In addition, the only way to detect the steering problem is with special equipment and expertise which you don’t have and can’t get at the time. So not only you have Hondas in your garage but you might have defected steering wheels with no way to tell them apart.
More news come in: “Rating agencies purposely ‘failed’ to detect the issues because of shared commissions with dealers.” Now you know what happened. The dealer wanted to sell the cars, they hired rating agencies to inspect the cars. Dealers wanted to get the better prices with better ratings so they offered commission to the rating agencies for the amount of sales. It was convenient for the agencies to fail to detect these car’s issues.
You are fuming. You call up your dealer who doesn’t pick up the phone. You call the rating agency to find busy signal. You are just starting to realize the consequences, you got more than 1000 cars in your garage to sell and you can’t price them correctly. Your “cars model book” is useless without the correct input data. You need to first find out the situation of every single car in your garage. This is going to be expensive but it’s the only way to get out of the hole, or so you believe. After spending an extraordinary amount of money to figure the cars’ condition, you find out you can’t sell them at the price your book is suggesting. The word has spread on the market and all other online car sellers are in the same situation, all your competitors are in trouble too and nobody wants to buy Mercedes D because they are afraid to get a Honda or a defected steering wheel. Your book is clearly useless at this moment and you can’t figure out a good sell price.
You only have an option, try to sell a couple cars and see what they sell for. (Mark to market). You put some cars out for sale and you don’t see any bids coming in. You know your cars are not worthless but there are no offers at the moment so you have no clue what a decent sale price is. There is no liquidity, you are trying to sell completely blind.
This is the current situation at banks. They got into the business of selling and buying derivatives without checking under the hood. The business was doing great and earnings skyrocketed but they built their business on models with incorrect input. When the news about mortgages defaults broke, they found that their supposedly safe AAA investments were in reality BBB or CCC and they tried to get rid of them as fast as possible just to realize that the whole finance industry was under the same umbrella. Every investment bank wanted a way out but nobody wanted to buy. Nobody trusted anyone and nobody was lending money to anyone. The federal reserve tried to add billions to add liquidity but it hasn’t help much. Nobody wants to buy unknown instruments with high risk and the people selling are selling way undervalued, losing billions in the process.
Whose fault is it? The rating agencies who ignored the warnings? The dealers who looked left while this happened just to get a nice paycheck? Or the seller that didn’t bother to open the hood and sold cars without having some basic knowledge?
They all had their part on it and they are all trying to recover their losses, praying for the Fed to come to their rescue. If things get worse politicians will try to regulate this largely unregulated business, but for now, these are interesting times to be in the financial industry.