A CDO Sub-Primer

[Mr. Massett explains why the media explanations of the mortgage crisis explain nothing.]

When the US credit markets began to blow up last year, every newspaper in the country served up two explanations for the mess: “sub-prime mortgage” and “collaterized debt obligation,” or “CDO.”

A sub-prime mortgage sounds bad on the face of it, so no problem there. But CDO has no obvious meaning. Only a few days ago I watched an NPR journalist try to figure it out from the words themselves (“let’s see, ‘collateralized’ refers to ‘collateral,’ so there must be a thing like a house or a car someplace, and ‘debt’ means, well, debt, and an ‘obligation’ means, um, you have to do something, right?”) The usual fudge is to drape the riddle with adjectives like “opaque,” “complex,” and “hard to understand,” as if these were explanatory principles. The phrase “complex and opaque financial instruments known as CDO’s” doesn’t tell you anything, really, but at least it sounds bad. Dern near as bad as a sub-prime mortgage. Moving right along, in other news…

The trouble is CDO’s were never meant for the average investor, or the average journalist. They are Wall Street inventions designed for the big players, investment banks like Citi or Merill or Bear Sterns. To understand them you have to think like an investment bank. This is no harder than thinking like a Martian.

Imagine you are on Mars, preparing to give birth to a CDO. Here’s what you do: first of all you — you being an investment bank — buy up a ton of loans. They might be car loans or credit cards loans or whatever, it doesn’t matter. In recent years the popular loan to grab was a mortgage, especially a sub-prime mortgage, because there were so many sloshing around, and because the criminals who’d written them were eager to sell them along and get them off their books.

You, the investment bank, don’t care if these are dodgy loans. You have a way to turn pig’s ears into silk purses. It works like this:

You are going to issue bonds — these are the “collaterized debt obligations” or CDO’s — tied to the pool of loans you’ve bought. The bonds aren’t ownership of the mortgages, merely a claim on the income stream. Nothing exotic here, banks have been doing this sort of thing forever. (There is no special reason for the name except somebody figured “CDO” would sound better than, for instance, “Unfathomable Ocean of Ob-Securities.”)

Now, say your pool of 2,000 mortgages pay interest at an average rate of 10% and have an average default rate of 10%. (I use these numbers only because they’re simple.) The thing is, you’d expect bonds written on them to have the same rates: 10% interest, 10% chance of going belllyup.

But not so. CDO’s can have risks and rewards that are different — and wildly different — from the underlying pool of loans.

How is that possible?

Well. Aha. The beauty of CDO’s is that they are related not only to those mortgages, but to each other. Watch, Martians, and marvel:

You are going to create 3 types of CDO’s. These are called “tranches” in financial circles on account of it sounds French. Who cares what you call the things? Let’s call them Papa, Mama, and Baby CDO.

Baby CDO is written so it will have to eat 80% of the defaults on the mortgages.

Mama CDO will have to suffer the other 20%.

And Papa? Gee. Papa looks to have zero exposure to default. This means Papa will get a AAA credit rating. Voila: the silk purse. (You may not care to pay out 10% on a AAA bond, maybe you can away with 3 or 4% and use the remainder to goose the rates on Mama and Baby. Baby is risky but if it pays 15% interest there will be buyers. )

Note that you don’t have to write only 3 types of bonds. You can write as many different “tranches” as you like, and you can structure them any way you want. Do you see the genius here?

Maybe not. But if you really were an investment bank you’d know there’s a huge institutional market for bonds. Mutual funds, hedge funds, pension funds, college endowments, and so on, are always out prowling for fixed income. You can take your CDO’s to these buyers and say “Sweetheart, your prowling days are over. What do want? 10 — year AAA at x%? I can write you that. Some spicy short-term Bbb at z%? Done. Whatever you want: done, done and done.”

This makes life much easier for everyone. This is why a CDO can be a Good Thing.

What went wrong?

A lot. Obviously, Moody’s and the other credit-rating agencies got the risk on the mortgages wrong. Can you blame them? They estimated the default rates based on the last 30 years of data. What else did they have to go on? Some folks blame the mortgage lenders. But hey, they were able to borrow at very low rates (for which you can blame the Fed if you want) and once they ran out of decent folk to lend to they began lending to bums — and why not, since they knew they could sell the mortgages on to investment banks, who were going to turn them into CDO’s based of course on the Moody’s ratings? The blame diagram starts to look like a circular firing squad.

And maybe CDO’s really are too complicated, at least in the sense that if a buyer gets scared and pries open the hood to see what’s making that rattling noise he finds 300 pages of tiny print referencing 2,000 mortgages to people he doesn’t know, and there’s no way in hell he can sort it all out in 10 minutes, which is exactly how long he has to make a decision, so he opts to sell right now, only every one else has decided to sell right now and there’s no market. Maybe CDO’s will have to go away. On the other hand, this might be an excellent time to write CDO’s linked to sub-prime mortgages because we know the real risks now, don’t we? I think so….. but I’m not an investment bank.

Of course there was more to the credit blow-up than just mortgages and CDO’s and cheap money. I completely forgot to mention Credit Default Swaps. And fair value accounting rules. And off-book securitization vehicles. And much else. It really is Mars out there. In recent years a lot of Wall Street trading strategies have been designed by “quants,” meaning computer geeks steeped in calculus. I just got an invitation to the “Quant USA Congress” scheduled for July in New York. Among the topics to be discussed (on a stack of bibles, I am not making this up):

• Taking the advantages of Black — Litterman back to a constrained mean — variance framework in a geometric setting.
• Defaultable displaced dynamics.
• What is hidden in TABX that is not in the ABS remittance reports?

No wonder journalists are at a loss, eh?

If you’re interested, there are books that make more sense than the daily papers. For the big picture, try James Grant’s Money of the Mind. This is a history of credit in America from the Civil War to the l980’s. Did you know there was a financial meltdown in the early l920’s triggered by bonds written against — of all things — mispriced mortgages? Grant says Wall Street has a short memory: people avoid the mistakes their parents made but repeat the follies of their grandparents.

If you just want to understand CDO’s, try Charles Morris’ The Trillion Dollar Meltdown. This is a quickie, available in every airport bookshop in America right this minute. The guy is a banker, though, and knows what he’s talking about.

You can get the gist of Richard Bookstaber’s A Demon of our own Design: Markets, Hedge Funds, and the Perils of Financial Innovation by reading the title a few times. Bookstaber’s a quant, and while no actual calculus apperars in the book, this ain’t Mars Lite anymore.

Larry Massett is an HV Producer.