CDOs- how the banks burnt our houses down – Part One

Well we’re deep into the next wave of bank and bail-out propaganda.

Notable so far has been Channel Four covering themselves in glory once again. You can always count on Channel Four as a bellwether of how concerned the well to do chattering class is.  Always to be relied upon to do the corporate world’s work under cover of ‘questioning the received wisdoms’.  Except that the only received wisdoms they ever actually do question are those the well to do find threatening.  I lost count of how many years I was asked personally to make the ‘Global Warming is all a load of rubbish’ film.  Though in fairness to C4 I was also asked by the BBC.  Of course Mr Durkin was delighted to oblige in the end.

Anyway I thought before we get too deafened by pro-banker, ‘how the banks are our only salvation from the ranks of lazy public sector workers, the wilfully unemployed and student spongers’, before we can no longer hear ourselves think I thought I would just remind people of a little of what our noble, innocent and hardworking bankers actually did in the run up to the financial collapse.

Let’s go back to 2004.  Back before the goldfish allowed limit of mainstream attention span and research.

Several very important things happened in 2004.  In 2004, Henry Paulson, soon-to-be US Treasury Secretary, was head of Goldman Sachs and after years of lobbying finally persuaded the ever compliant SEC to do away with the 1975 Net Capital Rule.  That rule was effectively what set maximum leverage limits on Wall Street banks. With it out of the way leverage abuse took off.

That same year. 16th March to be precise, the Fed had a meeting at which the president of the Atalanta Fed, Jack Guynn, said people were concerned that a property bubble was forming with buyers freely admitting they had no intention of occupying the properties they were buying or building on the land, but were counting on ‘flipping’ the properties, selling them immediately for a higher price.  He suggested the Fed should publish a paper laying out for everyone what was going on so that people would understand.

Alan Greenspan, then the Fed chief, ruled that this would not be done on any account because to do so would, in his words “Run the risk… of inducing people to join in on the debate,” and in so doing ” it is possible to lose control of a process only we fully understand.”

There was to be no public debate. And neither was there.   So what was this process Mr Greenspan did not want to people to know about or think they were entitled to an opinion about?  Which brings us to the last of the events of 2004 I want to tell you about.

We have a partial answer to what the Fed didn’t want to have discussed or widely known from no less a person than Henry Paulson writing several years later about the origins of the ‘sub-prime’ debacle.

The turmoil in financial markets clearly was triggered by a dramatic weakening of underwriting standards for US sub prime mortgages, beginning in late 2004 and extending into early 2007

A “dramatic weakening“. Paulson’s italic not mine.

So we have a lifting of any restriction on leverage and suddenly underwriting standards are a thing of the past. Unrelated? I don’t think so.

Higher leverage levels means the banks can ‘invest’ the expected income from one loan to finance another. It means the second loan is entirely dependant on the first one providing the expected income. Which is a tad risky but can mean you make a LOT more loans and potentially, if all goes well, a LOT more money. Of course this only works if you have many more loans in the pipe line,  And therein lay the banks pressing need.

The banks could securitize all they wanted, no leverage limit.  What they needed were more mortgages.  There are only so many AAA rated customers. The answer, of course, was to start selling loans to less than AAA rated customers.  Which required underwriting standards to be lowered a teeny little bit.  And this, in my opinion,  is almost certainly part of why Mr Greenspan felt its unwise anyone outside Wall Street should be allowed to know what is going on.

Starting around 2004 Goldman, under CEO – yes you just knew it would be – Henry Paulson, and the other big banks began to ramp up the creation and selling of CDOs.  For those of you who may not know a CDO (Collateralized Debt Obligation) is one of those financial inventions central to the creation of the crisis of debt we are now in.  They are at the centre of the alphabet soup of financial acronyms.  Like all jargon their main purpose is not to enlighten but to obscure.

I think it worth taking a minute to state as simply as I can what these things are and how they work. It  isn’t actually very complicated. It’s just jargon.

A security, if you remember,  is when mortgages are packaged up and turned into an investment/bond which someone can buy. Securities are how a debt (mortgage) is turned into something that can be sold and bought as an investment. CDOs are a kind of Security.  They are, if you like, one step up in complication from a simple mortgage backed security (MBS).  In fact CDOs often contain mortgage backed securities.

Underneath MBS (Mortgage Backed Securities) , as the name suggests, are just mortgages.  A CDO unlike a simple security, however, does not have to be made of one type of asset.  A CDO is made of a collection of very different underlying assets.  A CDO can have residential mortgages, commercial loans, corporate debt and any number of other things.  Those who made and sold them claimed this made CDOs  less exposed to the risks of just one kind of asset. It also made them much more complicated to assess their actual worth and how risky they really were.

The other thing that made and makes CDOs attractive to those who make them, is compared to MBS, CDOs are secretive.  Whereas you can find out what a mortgage backed security has in it you cannot do this with a CDO. Their details are held as commercial secrets. They are also, if they are a ‘managed CDO’ allowed to change.  That is, things in it can be sold off or added as they go along.

The way a CDO works is that first a special company is created to house it.  That company is called a Special Investment Vehicle (SIV) or  Special Purpose Vehicle (SPV). They are companies in name only. They are very often registered in the Cayman Islands and housed in Ireland.

The CDO creator then puts together all the ‘assets’ , most of which will be debts of some kind or other, that will make the splendid investment opportunity.  The whole pool of assets is then sliced up in to low, medium and high risk slices, with the lowest risk giving the lowest return. Investors can then chose how much risk/return they want.

The U.S. CDO market in 2002 was 49 billion dollars.  In 2003 it was $52 billion. (The figures are from Deutsche Bank and are here.)  In 2004 this jumped up 40% to $73 Billion. $12 billion of this was issued in December alone presaging what was to come. Just two years later in 2006 Bank of America ON ITS OWN created more than this total ($80.6 Billion). That year (2006) globally the CDO market was $551.7 billion.  Most of this increase in 2004 and after was in riskier, higher yielding ‘assets’ and in what was then a ‘new’ invention, synthetic CDOs.

And here we come to the source of the infection.  High Yield/risk and Synthetic CDOs are what Warren Buffet had in mind when he called CDOs “financial weapons of mass destruction.” Because beginning in 2004 CDO’s started to be debased.

Three things started to happen together in the CDO market which  IS a very large part of the financial world and IS the reservoir of infection for our present affliction.  The big banks started to use lower rated securities (those not so AAA rated customers), BB rated, in their CDO’s but ‘wraped’ them in ‘insurance’ bought from the likes of AIG which would pay out IF the asset defaulted. And on the basis of that they argued  the securities and thus the CDO could be rated as AAA. Needless to say the ratings agencies were delighted to bring their renowned turd polishing skills to bear for a fee. Thus polished and insured, here was the huge increase in available raw material for the CDO conveyor belts that everyone had been looking for.

This ‘insurance’ might have been a fine invention, as some of the comely cretins of in the financial world no doubt earnestly believed it was, but sadly there never was enough insurance to cover hundreds of billions of worth of assets. It was a scam. Which is why AIG imploded.

Unfortunately this was just the very tip of the turd pile.

To be Continued.