Why the CDO market melted down

Anna Katherine Barnett-Hart wrote a paper while a student at Harvard that Michael Lewis used as inspiration for his new book, The Big Short. Yes, she’s that good.


We read through it, and what’s great about it is the clear-eyed illustration of how the CDO market metastasized and turned into such an out-of-control monster.

So, they’ve provided an handy, easy to understand explanation of what happened, and why. Here’s the opening graphic, which no doubt makes things perfectly opaque. As it turns out, that was the intent. CDOs make balance sheets look healthier even as they were deliberately used to mask the riskiest assets. Read on.

Incomprehensible, isn't it? And SPVs make the rest of it look intelligible.

The Story of the CDO Market Meltdown:

Leveraged debt and the current debt crisis

Credit default market . NY Times.

Image from NY Times article, Arcane Market Is Next to Face Big Credit Test, an article which is getting huge circulation among financial blogs as it is makes public to the world at large what the financial blogs have been saying for months, that the coming debt crunch could make subprime seem small.

Few Americans have heard of credit default swaps, arcane financial instruments invented by Wall Street about a decade ago. But if the economy keeps slowing, credit default swaps, like subprime mortgages, may become a household term.

Sudden Debt has a clear explanation of this impending debt market crisis.

The investment bank factories synthesized a whole array of artificial goods, ultimately far removed from the income streams of the underlying assets:

1. CDOs and CLOs, i.e. tranched bonds made up of loan packages.
2. CDSs on the above bonds, i.e. credit insurance policies.
3. Hybrid and synthetic CDOs, i.e. bonds made up of the above CDSs.
4. SIVs that issued their own ABCP in order to buy and hold the above “goods”.
5. CPDOs that were structured to own CDS income streams.

… and more…

The alphabet soup seems thick and opaque, but don’t let the jargon confuse you. Here is the crucial point: almost all of these “securities” were unfunded debt, i.e. money equivalents created from thin air. All they did was to generate more and more “buying power” to boost asset prices higher, from houses in the Inland Empire of California to share prices in New York, London and Shanghai. In case it is still unclear: it was margin debt.

If you are familiar with buying stocks or commodities on margin, you can immediately appreciate what went on, and why all current attempts to avert a wider crisis will fail miserably for as long as the focus is on the symptoms, instead of the underlying illness. Margin debt cannot be “restructured” with falling asset prices. Period.

In other words, this entire pyramid of bizarre financial instruments was created and paid for with borrowed money. A hedge fund borrows ten million to create CDOs, which they then use as collateral to borrow more money to create even more debt instruments. Some hedge funds and investments can be leveraged 30 to 1 or more on this. That means they’ve bought $30 worth of securities on credit for every actual dollar they have. So, just a few mild breezes could easily knock such a house of cards down. Especially when some of what they bought is now worthless or selling for pennies on the dollar assuming a buyer could be found.

But with margin money, the clock is ticking. If the asset value drops below a predetermined level, the borrower is then forced to sell whatever they can to pay back all or part of the loans and can not hold in hopes of the price coming back.

Credit default swap losses may reach $250 billion

Shadow banking system reserves. PIMCO

Bill Gross of giant bond management company PIMCO says losses on credit default swaps could reach $250 billion based on historical default rates.

To put that number in perspective, many Street estimates ascribe similar losses to subprime mortgages, a derivative category substantially distinct from CDS insurance.

With CDS, a bond issuer sells risk to the buyer who agrees to make good on defaults above a certain level in return for an income stream. They can’t call it insurance because only insurance companies can sell insurance, but that’s what it is. But insurance companies and banks are required to have cash reserves to meet black swan events, buyers of CDS are not. He calls this the shadow banking system, a huge, unregulated entity now filled with hidden icebergs of risk and lurking catastrophe.

“Buyers of protection” will be on the other “winning” side, but the point is that as capital gains and capital losses slosh from one side of the shadow system’s boat to the other, casualties and shipwrecks are the inevitable consequence.

This also spells, in his view, an end to the neocon style of capitalism.

Market based, regulation-lite American style capitalism, seemingly so ascendant after the dot.com madness nearly a decade ago, has met its match with the subprimes and the poorly structured and supervised derivative conduits of today’s markets.

Norma hairballs

How a CDO works

A CDO called Norma left ‘hairball of risk’;
Tailored by Merrill Lynch

The WSJ details how a CDO called Norma that sold $1.5 billion in securities to investors in March is now worth a fraction of that – assuming buyers existed for their toxic glop, and none do.

The article also has a hugely informative Flash animation detailing how CDOs are structured. Think thousands of mortgages packed into a bond, with one hundred of those bonds comprising a CDO. In the case of Norma, it was comprised mainly of subprime mortgages because they wanted to goose the return.

“It is a tangled hairball of risk,” Janet Tavakoli, a Chicago consultant who specializes in CDOs, says of Norma. “In March of 2007, any savvy investor would have thrown this…in the trash bin.”

Yet bond rating agencies cheerfully gave this toxic waste their approval. They will no doubt be wallpapered with lawsuits for years and maybe some of those involved in this ever-widening sleazy greedfest will go to prison.

Financial castles of sand

sand castle

The Financial Times has a quite understandable, informative article about the collapsing shadow banking system and how it is impacting real banks and the financial world at large.

How crazy did it get?

Satyajit Das, an author and derivatives industry expert, cites an example where just $10m of real, unlevered hedge fund money supports an $850m mortgage-backed deal. This means $1 of real money is being used to create $85 of mortgage lending.

Little of this was regulated, because CDOs and SIVs are not real banks. While this allowed them to do insane things, it also means that, unlike actual banks, they have no lender of last resort to bail them out.

But they were borrowing from real banks, who now will suffer real pain too.

Most of these vehicles, and the shadow banking sector as a whole, is supported by back-up liquidity lines with “real” banks – promises to lend money that bankers never imagined they would have to deliver on.

The rot is not just in the US. Municipalities in Australia may sue Lehman Brothers after CDOs Lehman sold to them are now worth pennies on the dollar. And a Canadian bail out by a consortium of banks has failed before it got started, just like the US effort (deemed by some as the “Save Citi plan”) also has.

Not only were municipalities buying this now toxic waste as supposedly safe investments, so were pension funds and enhanced money markets, maybe your pension fund…