Note: In a prior life I was a part of the CDO research group supporting the clients at Lehman's trading desk in NYC. I'm familiar with what happened there.
The article contains a few errors. One, the article claims Lehman owned lots of senior tranches, which lost value when default rates unexpectedly rose. That's incorrect. We could sell that stuff to pension funds and make money on it, so we did, and losses in that tranche didn't hurt us; it hurt the retirees.
Lehman got hit hard because they could not sell the highest risk tranches (referred to as "toxic waste"). But they made enormous fees on originating the CDOs, and the toxic waste paid high interest rates (20-30%), so Lehman reluctantly kept it on their balance sheet and constantly tried to sell it off to other people (most of whom were too smart to take it).
We tried to hedge the risk by shorting the mezzanine tranches (those were between the toxic waste and the senior AA or AAA tranches). If default rates went up, and we hedged correctly, the gains from the synthetic shorts would make up for the losses on the toxic waste subs.
But for a variety of reasons this wound up not working as well as expected. Particularly, the correlation of default rates between subprime and quality debt decreased substantially and unexpectedly, which means these shorts did not generate as much cash as was lost when the equity tranche tanked.
Also, for an amusing tangent, we had bomb-proof windows to the outside world on the trading floors. A fertilizer bomb could go off in Times Square and we'd still be trading. Unfortunately we were not so well protected from the bomb that went off inside the trading floor.
For an amusing tangent to your amusing tangent, Blizzard's offices have bullet-proof windows and doors to prevent disgruntled World of Warcraft players from going on shooting rampages.
The article contains a few errors. One, the article claims Lehman owned lots of senior tranches, which lost value when default rates unexpectedly rose. That's incorrect. We could sell that stuff to pension funds and make money on it, so we did, and losses in that tranche didn't hurt us; it hurt the retirees.
Lehman got hit hard because they could not sell the highest risk tranches (referred to as "toxic waste"). But they made enormous fees on originating the CDOs, and the toxic waste paid high interest rates (20-30%), so Lehman reluctantly kept it on their balance sheet and constantly tried to sell it off to other people (most of whom were too smart to take it).
We tried to hedge the risk by shorting the mezzanine tranches (those were between the toxic waste and the senior AA or AAA tranches). If default rates went up, and we hedged correctly, the gains from the synthetic shorts would make up for the losses on the toxic waste subs.
But for a variety of reasons this wound up not working as well as expected. Particularly, the correlation of default rates between subprime and quality debt decreased substantially and unexpectedly, which means these shorts did not generate as much cash as was lost when the equity tranche tanked.
Also, for an amusing tangent, we had bomb-proof windows to the outside world on the trading floors. A fertilizer bomb could go off in Times Square and we'd still be trading. Unfortunately we were not so well protected from the bomb that went off inside the trading floor.