What should we make of CDOs?
By
Bill Bonner Jul 11, 2007
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No population should know what goes into its laws, its sausages, or its CDOs. Most of the time, the subject is of no interest. But once in a while, it pays to be curious. Here, we poke around in the mortgage derivatives market a bit, just to see what we can find out. Collateralised debt obligations (CDOs) and mortgage-backed securities (MBSs) are as much a mystery to most of us as andouilles are to the typical Englishman. But they might be of greater importance. On them, associated swaps, synthetics and various elaborations, rests a derivative market of as much as $500trn in nominal value. Readers who want to know how these instruments work are advised to consult a financial engineer who really knows what he is talking about. What we have learned about them is little more than hearsay and conjecture. Not admissible in court, it nevertheless tells a remarkable tale.
Down on the bayous of Louisiana or out on the prairies of Nebraska, homeowners are feeling the pinch. House prices are falling. Sales are slow. Many homeowners have seen their adjustable-rate mortgage payments leap. Local sheriffs are said to be working overtime, padlocking houses whose owners can no longer afford to pay for them. As foreclosures rise, so do foreclosure sales. Houses are auctioned off on the courthouse steps; some are bringing only half the purchase price. America’s subprime market includes around six million houses mortgaged to nearly 100% of their value. When these houses begin to sell at big discounts, the whole mortgage industry starts to sweat.
Typically, a local mortgage lender gets rid of his mortgage as soon as he can. He makes money by writing mortgages, not holding them. So he sells them and uses the proceeds to write more. The buyers of these mortgages, usually large investment banks, package them into MBSs. These are divided into tranches, based on credit quality, and sold as CDOs. The best tranches are easily marketed to solid investors – pension and insurance funds, for example. Less credit-worthy parts are not as easily sold. They are too risky. So, often, a big financial house will create hedge funds specifically to take on these CDOs. Then, the hedge fund will raise additional money by borrowing it, in order to leverage its returns. One of Bear Stearns’s funds – the High Grade Structured Credit Enhanced Leveraged Fund – controlled $12bn worth of mortgage assets with just $699m capital.
Anyone who would lend to something called the High Grade Structured Credit Enhanced Leveraged Fund deserves what he gets. But given the size and reach of the derivatives market, we could all feel the effects. The whole boom depends on low lending rates. And lending rates are low because so many people are so eager to lend in so many different ways – with much of the money funneled through the derivatives market.
What happened to Bear Stearns’s funds could be happening to many others. As more houses went to auction, the hedge funds and banks who lent the money began to panic. Lenders, notably Merrill Lynch, wanted it back. But just as selling a house on the courthouse steps is a bad way to maximise owner returns, so an auction of hedge-fund assets is a dangerous way to get lenders back to par. With a house, buyers can see what they are getting. People might even buy the places to live in. What was in the High Grade Structured Credit Enhanced Leveraged Fund could be listed on the side of the pack or reported on a 10-Q form. But what they were worth was anyone’s guess. Bear Stearns didn’t want to find out. All of Wall Street seemed to concur: the last thing anyone wanted was the “price discovery” of an open auction.
Complex derivatives have been one of the biggest hits of 21st-century finance. The geniuses who create them probably won’t get their names on any public schools, but they deserve recognition. They didn’t merely package lumps of dodgy mortgage loans. One of their breakthroughs was to separate the mortgage income stream from the risk of loss. A ‘credit default swap’ (CDS) is, in effect, an insurance plan. Holders of CDOs can offload the risk of loss to a third party, paying a premium as though it were an insurance policy. This is why so many risky bonds now sell as though they were Treasury obligations – supposedly, the risk has been swapped out of them. Then quants at Goldman, Bear and elsewhere figured out that the stream of income from the insured CDO holders – the swap payments – could be converted into a ‘synthetic CDO’. This, typically, is sold to a hedge fund too. What is it worth? What is any of this stuff really worth?
The whiz kids who figure out this sort of thing have their formulas. We’d rather hear what Mr. Market has to say. Eventually, he’s likely to tell us that they’re worth a lot less than people think.
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