The Big Short_ Inside the Doomsday Machine - Michael Lewis [39]
There was also a third, even more mind-bending, way to think of this new instrument: as a near-perfect replica of a subprime mortgage bond. The cash flows of Mike Burry's credit default swaps replicated the cash flows of the triple-B-rated subprime mortgage bond that he wagered against. The 2.5 percent a year in premium Mike Burry was paying mimicked the spread over LIBOR* that triple-B subprime mortgage bonds paid to an actual investor. The billion dollars whoever had sold Mike Burry his credit default swaps stood to lose, if the bonds went bad, replicated the potential losses of an actual bond owner.
On its surface, the booming market in side bets on subprime mortgage bonds seemed to be the financial equivalent of fantasy football: a benign, if silly, facsimile of investing. Alas, there was a difference between fantasy football and fantasy finance: When a fantasy football player drafts Peyton Manning to be on his team, he doesn't create a second Peyton Manning. When Mike Burry bought a credit default swap based on a Long Beach Savings subprime-backed bond, he enabled Goldman Sachs to create another bond identical to the original in every respect but one: There were no actual home loans or home buyers. Only the gains and losses from the side bet on the bonds were real.
And so, to generate $1 billion in triple-B-rated subprime mortgage bonds, Goldman Sachs did not need to originate $50 billion in home loans. They needed simply to entice Mike Burry, or some other market pessimist, to pick 100 different triple-B bonds and buy $10 million in credit default swaps on each of them. Once they had this package (a "synthetic CDO," it was called, which was the term of art for a CDO composed of nothing but credit default swaps), they'd take it over to Moody's and Standard & Poor's. "The ratings agencies didn't really have their own CDO model," says one former Goldman CDO trader. "The banks would send over their own model to Moody's and say, 'How does this look?'" Somehow, roughly 80 percent of what had been risky triple-B-rated bonds now looked like triple-A-rated bonds. The other 20 percent, bearing lower credit ratings, generally were more difficult to sell, but they could, incredibly, simply be piled up in yet another heap and reprocessed yet again, into more triple-A bonds. The machine that turned 100 percent lead into an ore that was now 80 percent gold and 20 percent lead would accept the residual lead and turn 80 percent of that into gold, too.
The details were complicated, but the gist of this new money machine was not: It turned a lot of dicey loans into a pile of bonds, most of which were triple-A-rated, then it took the lowest-rated of the remaining bonds and turned most of those into triple-A CDOs. And then--because it could not extend home loans fast enough to create a sufficient number of lower-rated bonds--it used credit default swaps to replicate the very worst of the existing bonds, many times over. Goldman Sachs stood between Michael Burry and AIG. Michael Burry forked out 250 basis points (2.5 percent) to own credit default swaps on the very crappiest triple-B bonds, and AIG paid a mere 12 basis points (0.12 percent) to sell credit default swaps on those very same bonds, filtered through a synthetic CDO, and pronounced triple-A-rated. There were a few other messy details*--some of the lead was sold off directly to German investors in Dusseldorf--but when the dust settled, Goldman Sachs had taken roughly 2 percent off the top, risk-free, and booked all the profit up front. There was no need on either side--long or short--for cash to change hands. Both sides could do a deal with Goldman Sachs by signing a piece of paper. The original home mortgage loans on whose fate both sides were betting played no other role. In a funny way, they existed only so that their fate might be gambled upon.
The market for "synthetics" removed any constraint on the size of risk associated with subprime mortgage lending. To make a billion-dollar bet, you no longer needed to accumulate a billion dollars' worth of actual mortgage