Weekly Insider (Lux Summit and Mortgage Math Made Easy)
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Here’s simple way to look at stuff. First: a mortgage is LBO on a house. Or think of an LBO like mortgaging a company. Second, remember there’s a difference between say fire insurance and mortgage insurance. Third, a stone house less likely to burn then a wood house, and thus similarly a AAA rated mortgage is in theory less likely to burn than a BB-. Unless the stone in theory turns out to be wood. And the AAA in theory turns out to be BB-.
Imagine this: you buy a house. Then you buy fire insurance from AIG. If it burns down, you collect cash. AIG knows the chance of a scorched house: let's say 1 in 100 (1%). If your house is worth $1 Million, they wouldn’t price your premium below $10,000. (1%x1 Million). They would price your premium at something more like $20,000. And they'd be sure to insure a bunch of different homes in different areas, instead of 5 in a row which could all burn if 1 burns. AIG is pretty good at that.
But AIG was pretty bad at this scenario. You buy a house. A hedge fund buys a bunch of mortgages: your mortgage and other mortgages too. This is a CDO (collateralized debt obligation). Let’s say 10 of these mortgages have total value of $10 Million. The hedge fund manager buys insurance in case you don't pay. This is a CDS (credit default swap). Like the assumptions about your house burning down, AIG also makes assumptions about you not paying your mortgage. Let’s say they think there’s a 1% chance of someone a collection of 10 of these AAA rated mortgage not paying. That's would be (1% of 10 Million) or 100k premium--but remember they’re on the hook for an exposure of 10 Million. The chance of everyone not paying their mortgage is low, Moody’s says so. AIG trusts Moody’s. Moody’s trusts the models provided by the people who packaged the mortgages together. Everyone trusts the homeowner will pay his mortgage. But if the price drops, or the homeowner actually can't pay--well, the homeowner might not pay the mortgage. Others might not either. So a 1% chance of something bad happening zooms to 100%. It happens. And in aggregate, the odds of all those mortgages going bad may be around 20%. AIG is on the hook for $10 Million. Do this 8,500 times and that's $85 Billion!
Here’s simple way to look at stuff. First: a mortgage is LBO on a house. Or think of an LBO like mortgaging a company. Second, remember there’s a difference between say fire insurance and mortgage insurance. Third, a stone house less likely to burn then a wood house, and thus similarly a AAA rated mortgage is in theory less likely to burn than a BB-. Unless the stone in theory turns out to be wood. And the AAA in theory turns out to be BB-.
Imagine this: you buy a house. Then you buy fire insurance from AIG. If it burns down, you collect cash. AIG knows the chance of a scorched house: let's say 1 in 100 (1%). If your house is worth $1 Million, they wouldn’t price your premium below $10,000. (1%x1 Million). They would price your premium at something more like $20,000. And they'd be sure to insure a bunch of different homes in different areas, instead of 5 in a row which could all burn if 1 burns. AIG is pretty good at that.
But AIG was pretty bad at this scenario. You buy a house. A hedge fund buys a bunch of mortgages: your mortgage and other mortgages too. This is a CDO (collateralized debt obligation). Let’s say 10 of these mortgages have total value of $10 Million. The hedge fund manager buys insurance in case you don't pay. This is a CDS (credit default swap). Like the assumptions about your house burning down, AIG also makes assumptions about you not paying your mortgage. Let’s say they think there’s a 1% chance of someone a collection of 10 of these AAA rated mortgage not paying. That's would be (1% of 10 Million) or 100k premium--but remember they’re on the hook for an exposure of 10 Million. The chance of everyone not paying their mortgage is low, Moody’s says so. AIG trusts Moody’s. Moody’s trusts the models provided by the people who packaged the mortgages together. Everyone trusts the homeowner will pay his mortgage. But if the price drops, or the homeowner actually can't pay--well, the homeowner might not pay the mortgage. Others might not either. So a 1% chance of something bad happening zooms to 100%. It happens. And in aggregate, the odds of all those mortgages going bad may be around 20%. AIG is on the hook for $10 Million. Do this 8,500 times and that's $85 Billion!
Labels: AIG, CDO, debt, hedge funds, LBO, Lux Executive Summit, mortgage crisis
posted by Josh Wolfe at
4:00 PM
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