A bit lost...

Nonoperational

With all the talk of the financial crisis etc I got very interested in the markets and how the banks (and other funds) do business. There are a few things I can't get my head around so I was hoping someone could give me a few pointers.

I think I get what CDOs are, they are basically asset backed securities whose value derives from underlying assets ie bonds, mortgages etc. After hearing Pat Rabbit et al saying the banks exposure to derivitives is a ticking time bomb I had a look at AIBs 2009 Annual report. I can't quite get my head around a few things. I can understand if you buy for example a CMO and the mortgages are not performing then you can loose out. But...

1) Looking at say this page: http://online.hemscottir.com/ir/aib/ar_2009/ar.jsp?page=188&zoom=1.0&layout=single it seems that by far the biggest derivitive trading is in interest rate contracts. What exactly does this mean? First for a very sill question what is the difference between Group and Allied Irish? Do you add the 2 up to get the total or is it just the larger figure?

Regarding the interest rate contracts, say the group figure is 166 Billion. What exactly does this mean? I can't grasp it? I presume it's not saying that AIB purchased 166 billion worth of derivitives based on interest rates. It's not an exposure figure is it? would it be too simplistic to say that's simply the value of the trades but because interest rates will only likely more 1% or so over the time of the contract then the actual risk to the bank is only a few % of the value of the contract?

And what does the fair value mean?

Finally for now (I doubt anyone wil answer this ramnling anyway!) I see that derivitives are accounted for off balance sheet. So I gather that AIBs liabilities in 2009 were about 190 Billion or so. Is any of this derivitive activity taken into account? Again that's where I'm presuming the Figure of 166 billion for interest rate contracts is not a liability, but I'm not quite sure what it is!



If anyone has a stab at any of those questions I'd be grateful. Is there any book or good resource to get some proper knowledge of trading and finncial instruments?

woodseb

the 166bln is a notional figure - in an interest rate swap you exchange interest payments (fixed for floating for example) on a chosen hypothetical principal amount which is the notional amount

the value of the swap is then the value of the difference between the exchanged payments so the exposure to the bank would be only what it is obligated to pay at settlement, or it could equally be in the money

the bank would choose the notional amount with regard to the amount of assets or liability it wants to hedge - so if it had a 100bln loan portfolio that it wanted to convert from floating payments to fixed it may enter into a 100bln notional swap

I wouldn't pay much attention to what Pat Rabbite says....

dunkamania

Below is a link to Michael Burry's primer on the subprime market. He started shorting the subprime market in 2006 and had to explain to his angry clients what he was doing with their money. (he was supposed to be running a value focused equity fund). Alternatively, check out "the big short" by Michael Lewis

http://www.marketfolly.com/2010/04/michael-burry-scion-capitals-subprime.html

CDO's are sometimes referred to as ABS squared (asset backed securities). Their valued is derived from other ABS's, which in turn is derived from underlying assets.

For example, get 20 ABS deals, and sell them off to investors. Nobody wants to buy the equity piece, say 5% of the deal, which is the riskiest, and first piece to take losses. So you package the equity pieces from all 20 deals into a new security (CDO). Since rating agencies failed to identify high correlation between the assets, they gave the senior tranches AAA ratings, and you are
able to sell the garbage that no one wanted as low risk securities.

Isoaxe

dunkamania wrote: »

CDO's are sometimes referred to as ABS squared (asset backed securities). Their valued is derived from other ABS's, which in turn is derived from underlying assets.

There was even such thing as a CDO squared, an additional rinse and repeat of the process just described. Talk about turning lead into (fools) gold!

RoadKillTs

Below is a link to Michael Burry's primer on the subprime market. He started shorting the subprime market in 2006 and had to explain to his angry clients what he was doing with their money. (he was supposed to be running a value focused equity fund). Alternatively, check out "the big short" by Michael Lewis

Read the Big Short. Excellent stuff. Really smart guy. (with really large balls) :cool:

Edit: Betting on the Blind Side article

mono627

Isoaxe wrote: »

There was even such thing as a CDO squared, an additional rinse and repeat of the process just described. Talk about turning lead into (fools) gold!

There was also a handful of CDO cubed securitisations floating around....they were few and far between, but there was still a few of them created. Whoever bought these must have been a complete idiot because there is next to no way of identifying the underlying risk....a pure punt if I've ever seen one.

EDIT: +1 on the big short by the way, Lewis is entertaining as always.

EDIT 2: Essentially the fair value can be thought of as an unbiased estimation for the price the market will pay for the asset(s). The term is normally used in accounting when referring to goodwill in mergers and acquisitions.

mono627

RoadKillTs wrote: »

Read the Big Short. Excellent stuff. Really smart guy. (with really large balls) :cool:

Edit: Betting on the Blind Side article

Which guy, they all had the massive cojones....