The Big Short_ Inside the Doomsday Machine - Michael Lewis [100]
Inside Morgan Stanley, there was apparently never much question whether the company's elite risk takers should be allowed to buy $16 billion in subprime mortgage bonds. Howie Hubler's proprietary trading group was of course required to supply information about its trades to both upper management and risk management, but the information the traders supplied disguised the nature of their risk. The $16 billion in subprime risk Hubler had taken on showed up in Morgan Stanley's risk reports inside a bucket marked "triple A"--which is to say, they might as well have been U.S. Treasury bonds. They showed up again in a calculation known as value at risk (VaR). The tool most commonly used by Wall Street management to figure out what their traders had just done, VaR measured only the degree to which a given stock or bond had jumped around in the past, with the recent movements receiving a greater emphasis than movements in the more distant past. Having never fluctuated much in value, triple-A-rated subprime-backed CDOs registered on Morgan Stanley's internal reports as virtually riskless. In March 2007 Hubler's traders prepared a presentation, delivered by Hubler's bosses to Morgan Stanley's board of directors, that boasted of their "great structural position" in the subprime mortgage market. No one asked the obvious question: What happens to the great structural position if subprime mortgage borrowers begin to default in greater than expected numbers?
Howie Hubler was taking a huge risk, even if he failed to communicate it or, perhaps, understand it. He'd laid a massive bet on very nearly the same CDO tranches that Cornwall Capital had bet against, composed of nearly the same subprime bonds that FrontPoint Partners and Scion Capital had bet against. For more than twenty years, the bond market's complexity had helped the Wall Street bond trader to deceive the Wall Street customer. It was now leading the bond trader to deceive himself.
At issue was how highly correlated the prices of various subprime mortgage bonds inside a CDO might be. Possible answers ranged from zero percent (their prices had nothing to do with each other) to 100 percent (their prices moved in lockstep with each other). Moody's and Standard & Poor's judged the pools of triple-B-rated bonds to have a correlation of around 30 percent, which did not mean anything like what it sounds. It does not mean, for example, that if one bond goes bad, there is a 30 percent chance that the others will go bad too. It means that if one bond goes bad, the others experience very little decline at all.
The pretense that these loans were not all essentially the same, doomed to default en masse the moment house prices stopped rising, had justified the decisions by Moody's and S&P to bestow triple-A ratings on roughly 80 percent of every CDO. (And made the entire CDO business possible.) It also justified Howie Hubler's decision to buy 16 billion dollars' worth of them. Morgan Stanley had done as much as any Wall Street firm to persuade the rating agencies to treat consumer loans as they treated corporate ones--as assets whose risks could be dramatically reduced if bundled together. The people who had done the persuading saw it as a sales job: They knew there was a difference between corporate and consumer loans that the rating agencies had failed to grapple with. The difference was that there was very little history to work with in the subprime mortgage bond market, and no history at all of a collapsing