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The ABCs of CDOs: How We Got To Today's Financial Mess

By September 21, 2008

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It's hard to believe, but the finance industry gave a major award this past spring to a guy who orchestrated a "financial instrument that was central to this global credit crisis we’re in," according to a newscast on 9 May 2008.

If the financial meltdown hasn't caused your eyes to glaze over yet (and even if it has), you should learn about this guy and some of the nitty gritty behind the crisis that has President Bush calling for a private sector bailout unmatched since the Great Depression.

We Start With CDOs
In May, James Finkel 1 was honored with the CDO of the Year. CDO stands for Collateralized Debt Obligation, and it's a new, and potentially risky, investment security. According to the RiskGlossary, CDOs are "hard to analyze" but are "appealing to investors because of the attractive yields they offer... [the CDO market] more than most, is one of caveat emptor" (emphasis added).

Finkel's CDO that won the award was the Monterey CDO Limited. It consisted of "189 assets" ... and these assets were the lowest-grade slices of different mortgage-backed securities. What's a mortgage-backed security you might ask?

According to the RiskGlossary, a "mortgage-backed security (MBS) is a securitized interest in a pool of mortgages. It is a bond." An MBS doesn't pay interest like you and I think of interest; it "pays out the cash flows from the pool of mortgages." Investors did not think of the MBS as "risky" because "most have principal and interest payments guaranteed by government sponsored enterprises Fannie Mae, Freddie Mac, or Ginnie Mae that explicitly or implicitly have the full backing of the US Treasury."

So what changed? And why did I reference Finkel's winning CDO as dealing with "low grade slices"?

Enter NINA Loans
According to RiskGlossary, in the early 2000s mortgage-backed securities started getting more risky. One of the reason was that the original mortgages were getting more risky due to NINA loans: no income, no assets. Yeah, you read that right. Here's Alex Blumberg, on why he got interested in this story:

[S]omeone will lend you a bunch of money without first checking if you have any income or any assets. And it was an official, loan product. Like, you could walk into a mortgage broker’s office and they would say, well, we can give you a 30 year fixed rate, or we could put you in a NINA...there were lots of loans like this, where the bank didn’t actually check your income...

What Finkel did was take little bits (they call them slices ... do you think that was a conscious reflection of the description of investment banking in The Bonfire of the Vanities?) of different mortgage-backed securities ... put them together (repackage them) ... and then slice-and-dice this new instrument. What's amazing -- and so wrong that it makes my head hurt -- is that some of these new slices were then "rated AAA, rock-solid, good as money." Here's Blumberg again:

If this seems too good to be true to you, you're in good company. Guys like billionaire investor Warren Buffet said the very logic was ridiculous.

The scale of this speculation is frightening. Finkel tells Blumberg that his small office holds a share in 16 million -- 16 million! -- mortgages. And each of those 16 million mortgages has other CDO owners and other investors ... all around the world. Monopoly money. The financial houses were treating this like monopoly money.

And Now, The Bubble
Of course, expanding the pool of potential mortgage holders resulted in exactly what economists would predict: it increased the demand for houses, which pushed up prices. A lot. From Blumberg: "By late 2006, the average home cost nearly four times what the average family made. Historically it was between two and three times."

Another problem was that much of this demand was false, in the sense that the homeowner couldn't ante up when adjustable rates ratcheted up. And as we know, real median household income in the US declined from 2000 to 2006.

Put those two factoids together and foreclosures are inevitable.

Now basic supply-demand theory worked in reverse. As more houses came on the market, the prices started to drop. More foreclosures, bigger drop.

But the defaults weren't just homeowners. The defaults included mortgage bankers, too. Here's how Blumberg describes it:

And in late 2006, early 2007, as prices began their plunge and alarm was spreading across mortgage backed securities desks all over Wall Street, the people on Wall Street... started backing away from some of the riskiest mortgages that they would accept in their pools...

[A] small bank, like Silver State mortgage... would borrow money from a big bank, say Citibank, or Washington Mutual. Silver State would use this borrowed money to buy up a bunch of loans, and then pay back the big bank once it sold the pools to Wall Street. Now these smaller banks were highly leveraged, in most cases 20 to 1. Meaning, in Silver state’s case, even though it only had 5 million of its own dollars, it could borrow 20 times that, 100 million, to buy loans with...

[When these small banks could no longer sell their loans to Wall Street], since they had very little of their own money, (just like the homebuyers whose mortgages they’d purchased) they had no choice but to default on their loan [to the "big bank" like WaMu].

The news show highlights one case -- we don't know how typical it is -- where the mortgage broker falsified the borrower's documents, inflating his income. In the cited example, the mortgage broker made $18,500 on one loan. In this case, the borrower "actually qualified for a Veterans Administration loan at a really good rate, and he had money to put down, but the broker convinced him to take a mortgage that turned out to be much worse, with a much higher commission."

That broker's actions, too, should be criminal. Should be prosecuted. But we know it won't be, because there are too many tales like this and too few courts and DAs. Blumberg calls the practice "ubiquitous."

Only Part Of The Tale
This is only part of the tale. And Blumberg argues that the black hat in this story -- if there is one -- is the "global pool of money," investment advisors from around the world looking for a good return. When Federal Reserve Greenspan said he was going to keep interest rates unrealistically low (1%), they turned to other investments. And according to Blumberg, they loved these mortgage-backed securities, no matter their color or stripe.

The galling thing is that other than any personal losses -- mortgage bankers losing jobs, CEOs getting tossed with not-quite-as-golden parachutes as usual -- the brunt of this folly will be borne by our grandchildren, who will be saddled with a trillion dollars or more of new debt. Probably time to revisit the S&L crisis, too. Who remembers that a Bush sibling (Neil) was involved?

1 Finkel's bio (emphasis added):
Prior to founding Dynamic Credit Partners, LLC in November 2003, he headed the European CDO team at Deutsche Bank, London, and previously was a senior member of the structured products/derivatives group at Bear Stearns. In his career, Jim has originated, structured, distributed, restructured and unwound almost $10 bln of CDO and structured credit products. Jim also has significant mortgage-backed and asset backed experience from his first trading desk position with Nomura Securities in 1992, then with Bear Stearns.


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