Wednesday, March 17, 2010

Subprime Soup

I'm a huge Michael Lewis fan, and his interview on Fresh Air is a good one (as is his 60 minutes piece).

The Planet Money team recently bought their very own toxic asset. They look surprisingly cute in the animation for something that has completely destabilized our economy.

One barrier to getting real reform is that most people's eyes glaze over as soon as you say the word tranche - and yet tranching is fairly close to the heart of the shell game that was built on top of some really poor mortgages.*

If you want to understand most of structured finance in one delicious meal, just buy the spicy beef soup from the Westborough Korean Restaurant, our new go-to take-out place.

The soup is a delicious beef broth with noodles, beef ribs, bean sprouts, and this really spicy red paste - in small quantities the paste is delicious. But if you pick up takeout, then by the time you get the soup home, the paste has settled to the top. The first bowl of soup is going to have more of the red paste than its fair share, and is going to be really, really hot. You'd have to be a little crazy to drink it.

That is tranching, in a nut-shell. Given a pool of "stuff" with a little bit of danger mixed in, tranching just means the Wall Street firms who are dividing the soup up put more of the spicy sauce in some bowls and less in others.

This is generally good for those getting the less spicy bowls - it allows them to make a pool of "stuff" less dangerous.

What do you call those pools that have more than their fair share of hot sauce? Those pools are called 'toxic waste', and that's where our toxic assets come from.

* I believe the true heart of the crisis is not any one financial technique - it is asymmetric risk - that is, the ability of Wall Street bankers to make money when a bet wins and have someone else pay when a bet loses. But in order to get anyone to play a game like that with them, they need to make the game complicated, so that the absurdity of the rules is less obvious. If you slice and dice your securities into enough tranches, it becomes a lot harder to see what you actually own.

Of course, when you actually look, it's an eye opener!

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