Collateralized debt obligation

Today I am republishing part of a series of articles I wrote back in May, 2008. Since then Wordout has added hundreds of new readers, and I hope they find this further insight helpful.
This was before Fannie and Freddie, before Lehman and the whole October surprise. But the general gist of it still applies.

Image by MotherPie via FlickrCrisis? What Crisis?

The subprime mortgage crisis is a problem for all of us. Whether you’re in Asia, Europe, Africa, one of the Americas or Australia, you’re already affected. Rising costs in everyday things like gas, food and clothes are worldwide. And the subprime crisis is right in the middle of it.

CDOs were first created in 1987 by Drexel Burnham Lambert. If you remember the stock market crash of 1987, you might recall that afterwards there were several investigations into the marketing of “junk bonds”. DBL was famous for their part in that. So CDOs were not really all that new, but generally they weren’t used with mortgages. Researching at RiskGlossary.com, we find:

CDOs are mostly about repackaging and transferring credit risk. While it is possible to issue a CDO backed entirely by high-quality bonds, the structure is more relevant for collateral comprised partially or entirely of marginal obligations.

Marginal obligations. That’s polite for bad loans. The way it would usually work is this: Lots of “marginal obligations” would get bundled together with a few reasonable ones and a very few highly rated ones. That bundle would be bundled with other bundles, created with a similar mix with the added dividend of several low quality bundles and at least one with a high rating. That mega bundle would get a high rating. Then the bundles would be “pooled”. Then these pools would be pooled. Then you take slices from bunches of these pools and and that makes a CDO.

If the CDO has at least one top rated, AAA pool slice, then the CDO has that rating. A quick slang primer: “Money good” is highly rated and everyone believes it’s guaranteed profit with no risk. “Toxic Waste”, well, you get the picture. What was happening was that there was alot of toxic waste being sold as money good, and at least some of the people knew it. But not the investors.

By now, which was around 2005, the investors weren’t just from overseas. The housing boom was so historic that it spawned television shows well into 2007. People who had never invested in anything felt fine investing in a house, or two. And those who didn’t join in the housing frenzy? If they held shares in money markets, their managers were happily buying up pieces of these CDOs.

Breakfast In America

By 2005 you could buy a house with no money down and resell it a year later for twice the price. For some reason everybody thought prices would only go up. And since anybody could get a loan, many did. By 2005 the average home cost 4 times the annual income of the average family. For most of our history, it’s been only 2 times the income.

But many who were able to get a loan were having trouble making the payments. Prices had skyrocketed, causing monthly mortgage payments to increase. It soon became obvious that just because someone could get a mortgage didn’t mean they could pay it off. The CDOs were supposed to spread the risk out so thin that no investor would be damaged if it performed badly. With so many CDOs filled with toxic waste, there were few that weren’t damaged, magnifying the risk.

People were getting loans, buying the house, moving in, and then defaulting on the first payment. It was a trend in 2006. The first to notice that anything was wrong were the biggest managers of all these CDOs. They noticed that even though the computer software showed acceptable risks, the actual performance was not what was projected by the computer models. Looking into the details, they found that far more defaults were occurring than the computer predicted.

Crime Of The Century

As defaults piled up, property prices started declining. This was bad news for many homeowners. Many of them had already taken out ‘equity’ in their homes, in the form of a home equity loan. In essence, they’re making two house payments. With a basically flat economy, that can only last for so long. If you have a picture in your mind of some kind of lower class person just out to rip off the rest of us, you need to rethink. Most are hard working people trying to make a good life for their families.

By 2006 it was common to find people who had gotten mortgages they weren’t even looking for, sold to them by a guy who simply knocked on the door one day and offered them the American Dream. I personally know at least one person who, although he qualified for the best terms, was convinced by the local bank to take a much more expensive loan. Unethical standards were applied across the board, from the local level to the international level.

As the loan defaults continued, credit tightened up. The 1st to go was the NINA loan. With no notice at all to local mortgage companies, the larger banks and investment firms simply stopped buying them. Suddenly, billions of dollars which had been riding a fast moving gravy train were just stopped. Some banks went quietly of business. Some were bought, or “merged” with another bank to stay alive. (Sound familiar?)

It’s not just the locals though. Bear Stearns proved that. At every level the fabric has fallen apart. We’re only just beginning to see how deep the hole is. The Fed has been trying hard to keep the financial system working here in the US. Their counterparts in Europe and Asia are doing the same. For instance, during the same week that Bear Stearns was “rescued”, the Fed pumped about 200 billion dollars into the US economy. Since then, the Bank of England is having to take a look at how deeply their economy is affected. So far, they’re into it for about 100 billion dollars. The International Money Fund estimates that the total losses worldwide could reach 945 billion. If so, I’d consider us lucky. That would represent only a 1% loss of the original 70 trillion.

Even In The Quietest Moments

Right now, it’s quiet. The Fed has come in and done their thing. One of the big guys has fallen. It’s all out in the open… sort of. Remember I said at the top that no matter who you are, you’re affected? Well, here’s where we find out how. This is the part that the Fed is really fighting against, and I hope they win. I doubt that they will, but I hope.

You see, the housing and mortgage markets were performing so well that many traditionally safe investment funds began buying into these mortgage backed CDOs. They were rated AAA, money good. But they are filled with toxic waste. They are a time bomb, ticking. As long ago as April 2007, it’s been a certainty to some at the top. From Market Watch dated 4/4/2007:

…a Reuters article quoted a spokesman for a UK asset management firm, “I do think a massive default cycle is about to start in the CDO market. It’s mad. Sub-prime will create massive defaults.” “The event that will destroy the CDO market has already happened. But it will take another year to trickle down. They [holders of the CDOs] don’t realize what’s going to happen.”

The holders of those CDOs are everybody who is invested in just about any type of funds. I don’t personally own any shares in any funds, it’s never been my ‘thing’. But most people I know who have anything invested are investing at least some of their savings in funds. In a twist of irony, these are the investments we normally think of as safe.

Famous Last Words

So it’s good for us guys who have no funds, right? Not really. Think about the magnitude of the problem for a moment. Put it into perspective. The Fed pumped 200 billion dollars into the economy. That’s about 2000 dollars for every family in America(based on 3 per family and 300 million people). Did you see anything change? Did gas prices go down or up? Did your mortgage or your rent get paid any easier? Did you feel it at all?

That chunk of change, 200 billion dollars, didn’t do a thing for you did it? Trust me, it’s a drop in the bucket. That money went to keep banks from going under. And why were they needing the help? Because of the bad loans they made intentionally. The only other alternative was to let them go under en masse, and that’s not permitted anymore in the US. That’s the promise of the recession we’re in, that there will be no depression. But it will probably last long, and be hard.

I’m going to end Crunch Week on that note, and maybe this thought: Several years ago, it became known that there was about twice as much fixed income savings in the world as was thought. All that extra savings was in the hands of countries who had historically been poorer. Through the use of what would evolve to be unethical strategies, most of that savings has been transferred somewhere in the form of debt, which is what the savings really represented to begin with. If the IMF prediction above is accurate, is the end result is that somebody will have profited over 35 trillion dollars when this is over? And if so, then who was that masked man?

Many thanks to ThisAmericanLife for publishing the podcast which I used as source material for most of this and the last post, “The Global Mortgage Ripoff”. I didn’t even come close to covering everything they did, so if you want more information on this subject, I highly recommend listening to the entire recording. Just hover your mouse over the little yellow SnapShot and hit the play button that appears. The audio lasts about an hour.

I am Jon, and that’s my 2 cents.

To read all of the Crunch Week series, use these links:
How Much Money Is There
Bear Stearns – The BS Timeline
The Global Mortgage Ripoff
The Promise Of Recession

Today I am republishing part of a series of articles I wrote back in May, 2008. Since then Wordout has added hundreds of new readers, and I hope they find this further insight helpful.
This was before Fannie and Freddie, before Lehman and the whole October surprise. But the general gist of it still applies.

Image via WikipediaThere Is No Spoon

Earlier, we looked into how much money there is in the world. If you took the time to watch that video, you probably came out of it with the only conclusion that was possible, which is this: There is no money in the world. There is only debt, promises to pay, IOUs. It’s hard to wrap your head around that, though, so it’s easy to look at all that debt the way we’ve been trained to: as if it were real money. Remember the main difference between “real money” and “Federal Reserve Notes” is only the difference between assets and debt.

But how, you might ask, if banks can create all the notes they want by creating debt, how could a bank ever go out of business? How could a banking behemoth such as Bear Stearns, be taken over for just a fraction of its current valuation? Well, they can only create those notes by creating debt. If there’s nobody left trying to get a loan, the bank simply has no way to create more debt. That’s essentially what happened to Bear Stearns. Nobody wanted their notes anymore.

Over most of the course of human history, the accumulated savings in fixed income securities of the world had built up to about 36 trillion dollars. Then, in the last several years, that figure nearly doubled to about 70 trillion. This is more than all the money spent by all the countries in the world in one year.

Much of this new wealth was stored up overseas, insane profits made recently by historically poor countries, cash made from the sale of oil and high tech items. The people in charge of managing all this new cash wanted to increase the returns on their investments. But they didn’t want to lose any of it. Normally, they would invest in treasury notes, or government secured bonds, something safe.

Think about it, there’s suddenly twice as much money to invest, and there’s just not that many great investments around. As if that wasn’t enough to cause the money managers to scramble, before he left, the great Alan Greenspan released a statement, which basically said that the US Federal Reserve funds rate would remain extremely low indefinitely, which made the treasury markets look much less attractive.

Mortgage Backed Securities

So these guys started looking for something that was still reasonably safe, but still more profitable. All they needed to do was beat the 1% from the Fed on Treasury notes, so even the low mortgage rates, around 5% on average, were very attractive. But these guys couldn’t manage a mortgage from around the world. Something new needed to be created.

So the Mortgage Backed Securities were created, and the global pool of money managers loved them. Individual mortgages were bundled together, and those bundles bundled and so on until enough mortgages were bundled together to sell for millions of dollars. That’s thousands of mortgages per package. For awhile, things were great.

But no market is endless. Eventually, everybody who could afford and qualified for a mortgage had bought one. By 2003, the market was starting to slow, but the demand for these types of securities was still insane. So looser guidelines were instated, making loans easier to get for slightly less qualified borrowers.

These new guidelines determined the loan an applicant could get, but in the end, literally anybody should have been able to get a mortgage. That was the so-called NINA loan, which is short for No Income No Assets, which means that there was no check run on you at all, except verifying that you had a credit score. (There were cases of loans made to dead people.)

Common Cents

Naturally, this makes absolutely no sense in the common use of the word. Why were the banks doing this? They were writing loans to people knowing in advance that these loans would default. Common belief is that the US housing market will never have a correction, that real estate values would only rise. Common sense says that no market can sustain endless growth. Corrections are a natural part of the cycle, like storms with the heat of summer.

So how did it happen? With all the computers and brilliant people on staff, why did they keep creating this bad debt? The answer is insidious. They were monitoring. They were watching these mortgages like a hawk, and all the data they had was positive. The projected foreclosure rates were capped at around 8-12% of these bad loans. The problem was, the computer programs used to analyze that data were wrong. The analysis used was the same as for the old-fashioned, Income Verified, Assets Verified, fixed-rate mortgages, and not for these new variations. In some areas the mortgage rates are now expected to go beyond 50% foreclosure rates.

This isn’t the end of the story. It actually gets a bit worse. So far we’ve seen that there isn’t really any money anywhere there are banks. We’ve also seen how the global pool of “money”, really just a collection of IOUs, doubled in less than a decade, creating a new investment market in the form of (mostly American) home mortgages. Click back to Wordout to learn how the crisis was guaranteed to happen by the use of neat little things called Collateralized Debt Obligations.

I am Jon, and right about now we are knee-deep in it.

To read all of the Crunch Week series, use these links:
How Much Money Is There
Bear Stearns – The BS Timeline
The Global Mortgage Ripoff
The Promise Of Recession

For those interested in where we’re going with this, and too impatient to wait, click this link to an audio file which can explain it to you. The audio lasts about an hour, and covers the topic here today and the continuation for the next post at Wordout.

Tag: Collateralized debt obligation

The Promise Of Recession, Again

Global Mortgage Ripoff Revisited