Here’s an email I received late yesterday from a friend, "R," who was in the CDO business from way back when to right through the past few years.

"R" writes:

"I’ve been paying attention to your macro economic call lately and you’re right on.  Three anecdotal stories for you that you can use on Kudlow.  (PLEASE don’t mention my name).

1. XXXXXX and I were talking in 2003 about how shaky these low FICO, high LTV, 2/28 ARM’s that were being created were. People in the know knew then those loan products were going to be a problem in the future. Way back in 2003, it didn’t make sense.

2. In early ’05, XXXXXX tried to hook me up with a HF he knew that wanted to play the CDO issuer game. I talked to the guy and told him that at the risk of talking them out of hiring me, I wouldn’t do it. I thought that game was topped-out even back then. A bit early, but perhaps the right call.

3. I was talking to CDO managers in mid-’05 that were saying how rich sub-prime MBS was and how wrong everyone was for buying that stuff at the spreads they were. To a man, they all agreed they were paying too much for the risk, they all believed that HPA [ED: home price appreciation] was going negative soon. But, sadly, they had to buy the stuff because they needed to accumulate collateral for their CDO issuance. Fuck, we all knew we were overpaying, even back in 2005. We knew it was essentially a bet that home price appreciation was going to continue at levels that couldn’t be sustained. No way that could keep going on.

Everyone was saying the same thing: Home pricing cannot continue appreciating at the same rate, and the second this thing turns, we are FUCKED.

Is it really any surprise to anyone that the mortgage business got too far ahead of itself?  To me, the only surprise has been it took so long for all of this to happen."

So what was the prime motivating factor?:

"The answer is quite simple: DEAL FEES. I gotta keep buying collateral, in order to keep issuing these transactions as a CDO manager. Its my job: I gotta keep accumulating collateral, and I gotta issue the liability against that collateral.

In 2005, we all said "I hate the real estate market, I hate the credit spread, but my job is to keep doing this: Buying Collateral and issuing CDOs. Everyone was the buying this shit to do any deal. The greed went thru the whole chain, from the home owner buying a property they couldn’t afford right up to the CDO manager buying subprime paper."

Why did these managers keep buying this bad junk?:

"Well,
nothing is "bad junk" — it’s just priced wrong. No one believed the
under-performance of these MBS loan pools would ever be so severe.
Everyone knew in the back of their minds that the possibility existed,
as did the possibility that residential real estate prices would move
LOWER someday.

But no one wanted to be the first to acknowledge
it fearing that they’d miss the opportunity to participate in big fees,
big alpha, etc. . . ."

Thanks, R. Great insight from inside the belly of the beast.

>

UPDATE: August 24, 2007 3:49pm

R asked me to add the following:


"I hate the fact that I’m getting pulled into this, but I’m seeing the need to clear a few things up. 

1. To Fred or MS, I "had a spine" by walking away from an opportunity to start up a CDO management business at an established hedge fund company in ’05.  Everyone was going the same way on that trade, the collateral sucked, and HPA was maxing out.  What I told Barry about were my observations from daily interactions with buyers of sub-pime HEL’s as collateral for their CDO transactions.  My role then was on the sell-side.  Minds far smarter than mine were eager to accumulate this collateral.  Fraud?  Nothing fraudulent at this stage of the proccess.  If there was fraud, reading an offering memorandum and monthly remittance reports cover to cover or spending hours of cash flow modelling on Intex wouldn’t have shown it.  Oh, and where was the fraud?  My opinion; mortgage brokers possibly lying about and jamming loans into the wrong people to get fees from the lenders.  My view on the relative value of sub-prime HEL’s during this time period was not nearly as upbeat as others in a world where EVERYONE else was a buyer. 

2. Eclectic, it’s not quite as disgusting as you might think.  Everyone knew the bet they were making; a combination of HPA and continued positive loan performance would continue sans interruption.  It was a market call, similar in concept to the market calls most of you reading this make each day in your chosen financial markets and products.  It was a bet that the collateral was going to continue doing what it was supposed to.  It’s a bit annoying when the "talking heads" claim that institutional investors and HF’s buying these products don’t know what they own.  Bullshit.  They know.  They own a bet on Average Joe’s house staying equal or going up in value and his continued ability to make his loan payments. 

3. Stuart got it right, unfortunately.  In a capitalist society, one sells what people want.  And they wanted sub-prime HEL’s with HUGE credit spreads such that the arbitrage was bigger.  How is that huge credit spead possible?  Lower quality loans; low FICO’s, low LTV’s.

Thanks Barry.  I really want these folks to read this extra detail in an effort to clear up mis-understanding."

Category: Credit, Derivatives, Hedge Funds, Real Estate

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

53 Responses to “CDO Insiders: “We Knew We Were Buying Time Bombs””

  1. peter from oz says:

    eichmann used the same defence
    rgds pcm

  2. Eclectic says:

    Human psychological momentum…

    It’s when willfulness serves merely as a subconscious substitute for the analysis that might or might not support rational optimism.

    As my readers know, I content that both optimism and pessimism can arise from willfulness. Optimism or pessimism in turn may be justified, and can both arise from rational analysis of fact, but neither one, when directed by willfulness alone, ever can.

  3. T says:

    Disgusting.

    “Its my job: I gotta keep accumulating collateral, and I gotta issue the liability against that collateral.”

    Get another job then.

  4. SPECTRE of Deflation says:

    Barry thank you for providing us with these insights from folks in the trenches, as well as your own commentary on this Blog. Where you find the time to do all you do is nothing short of amazing. Once again a big THANKS!

  5. ari5000 says:

    So why the f– is the government trying to bail out behavior that was known to be sheer stupidity????

  6. Justin says:

    “Money, so they say, is the root of all evil today…” Pink Floyd

    The Blame Game, has just begun. Really folks, 99% of us would have stayed in the cdo queue. What? Stop smoking those expensive cigars, are you crazy…

  7. Inferno says:

    Maybe the time bomb is going to blow up sooner than we think. Has anyone seen this?

    http://market-ticker.denninger.net/2007/08/whitewater-wednesday.html

    About half way down the page there is a black chart, it starts a story about 1 billion or so dollars worth of SPY covered calls that were made a day or two ago. Barry, sorry in advance if we are not allowed to post links to other sites on your blog.

  8. Stuart says:

    Just like the greedy hedge fund managers motivated by their commission models, all chasing yield and pushing the envelope further and further. All the same. Those 2/20, 2/40, 4/50% commissions MUST change. They are as a single source, one of the primary culprits for he mess we’re in.

  9. Hey ! I can see the bottom ! It’s WAY down there !

  10. Greg says:

    Is this any different than the real estate brokers / mortgage brokers / NRA / homebuilders etc? They’ve taken a lot of heat (and rightfully so!) on this site and others. The CDO markets and their enablers should get more stick, just to be fair – Wall Street is just as crazy as Main Street, but more sophisticated about the mechanisms.

    But it comes down to the same thing: it’s pointless to blame the people selling something for selling. If other people are buying it, they’ll keep making more of it. Caveat emptor and all that. And although shorting technologies have improved, it is still easier to be right than it is to remain solvent in the face of irrationality.

    The hysterical thing about the ‘financial innovation’ spin Greenspam and others put on it is this: the CDOs and other variants provide a way to break the usual laws of supply and demand. Here’s the innovation: it turns out you can keep reselling the same sausage! (Get more casings!)

    But the rules of supply and demand for derivatives eventually break down when the underlying asset markets do.

  11. Officer, the invisible hand made me do it !

  12. wyler says:

    Has anyone seen this? . . . SPY covered calls . . .

    Inferno, don’t know if you looked at the thead on the associated forum, but it appears difficult to support any conclusions regarding the meaning of that trade (or even if was actual rather than an error) based on the limited amount of data available.

  13. jeff clark says:

    Am I the only one who sees this whole subprime phenomenon as the “helicopter in disguise”?

    As I see it, the Fed has needed to battle deflation by creating inflation.

    Rather than spill cash out into the streets by helicopter, where all the folks – both good and bad – get a shot at scooping it up, the Fed spills out credit to a lot of scammers and fraudsters via the mortgage market.

    With this scheme, they undercut deflation in three ways: getting liquidity “out there”, producing a “wealth effect” of rising RE values, and they lower unemployment in the finance and construction industries. Not bad.

    The next step in the “helicopter” scheme is to accept the paper at the Discount Window i return for cash. Thus voila!, the helicopter without the helicopter.

  14. costa says:

    Barry love the site. Can someone please explain what “credit spread” means, I am asuming it is not the same as bid/ask spread?

  15. dblwyo says:

    Costa – there’ll be better & more technical answers but basically it’s the difference between the interest rate on the CDO or underlying collateral and a lower-risk instrument. So if you’re buying junk to make up your CDO and paying a high price (= low interest rate) you AREN’T being compensated for that risk. BUT, as Barry’s very interesting post shows, the market got wrapped up in speculative fever where the goal was to make the next deal not to price it correctly. BtW – let’s suppose this is not just sub-prime but ALL the various assets that were turned into structured debt products. That part about sub-prime being only 2% of the total mortgage market goes away and then we get to all the other stuff that was based on bonds, buyouts, etc. etc. We’ve seen the tip of the first iceberg.

  16. Bob_in_ma says:

    “Great insight”???

    That’s like getting a description of the workings of a concentration camp from a guard and complimenting him for his accurate description of the atrocities committed there.

    When they realized what was happening, why not come up with a product that actually had value?

    Wall Street is a complete, unproductive joke and essentially a 10% tax on the financial system, it’s basically legal graft.

    Any business remotely involved in the deal making there just needs to be taxed at some very high rate, 50%+.

  17. Royce says:

    Short term gain outweighs long term risk for these guys. Unless they were to be held personally liable, there’s no downside to taking a risk with other people’s money. The worst that happens is you get fired or your firm goes under. Meanwhile, every year your bets pay off you’re banking a huge wad of cash from your bonus.

  18. SINGER says:

    that’s the thing…success was predicated on a continuing appreciation of home prices…

  19. Fred says:

    OT: I eagerly await your spin on the Durable Goods blowout numbers.

    July Durable Goods Orders…rose 5.9%…vs. street at 1.0% (prior revised to 1.9% from 1.4%)

    July Durables Less Transportation…rose 3.7%…vs. street at 0.6% (prior revised to -1.2% from -0.5%)

  20. Stuart says:

    guns and butter

    replaced by

    guns and boeing.

  21. Sure thing, Fred:

    July Durable Goods orders rose a huge 5.9% headline vs the consensus of 1%.

    They were up 3.7% ex-transports vs. the expected gain of .6%. (That’s big)

    The ex-transports gains were led by computers, electronics (led by semi’s), machinery, primary and fabricated metals; Auto production ramped up in June and July and the peripheral industries benefited from this and it is not excluded in the ex-transport #.

    With this said, Non Defense Capital Goods ex Aircraft — you know, PURE CAPITAL SPENDING component, rose just 0.5% after a 0.8% decline in June. I would call that evidence of a still sluggish Capex spending corporate sector.

    As much as we can pull apart those numbers, the bottom line is this data is old news. Those orders took place in a much different credit market world than we live in now. The cost of financing new projects and spending plans is now higher and thus the return on investment hurdles are greater.

    (Hey, you asked!)

  22. Fred says:

    Thanks Barry. I do appreciate that.

    I have noticed a modest pick up in business capex forecasts (TECD, HPQ, CSCO) on top of the large telcom spending plans.

    Thanks for acknowledging this shred of positive data.

    BTW….have you ever seen estimates of the savings to consumers with a 75 bps cut in the Prime Rate (helos, ARMS, etc)?

    I imagine it is not mice nuts.

  23. michael schumacher says:

    Damn BR beat me to it……LOL

    After a two week break to sun himself (with Angelo-of CFC “fame”) Hank Paulsen fires up the presses again with what he has deemed “excess tax receipts” (how can we be running a deficit when we have had over $84 Billion in excess tax receipts just laying around since July 24th??)

    Here is the latest installment of find the fish, I mean money…….

    http://fms.treas.gov/tip/auctions/tio-announcement-359-08242007.pdf

    “only” 3 billion today and Ben has been quiet so far today.

    And to “R”…..I’ve worked in companies that I have uncovered massive fraud and reported them. Have a fucking spine…I’m sure your paycheck was “augmented” by the fact you participated but now have a moral quandry about it??……You know George Tenet wrote a book…….

    Ciao
    MS

  24. Fred says:

    As an aside, isn’t parsing back all these layers of spending similar to your inflation views — inflation is inflation , as spending is spending??

    Can you have the manicured numbers both ways? (don’t include food and energy, and don’t include defence and aircraft?)

    Just asking.

    ~~~

    BR: Yes and no. But if you want to know what the organic corporate CapEx is, you have to pull out a few things: the government Defense spending (since they can spend anything anytime) and Aircraft orders, as they are also an odd duck, non-correlated to the rest of capital spending.

  25. wunsacon says:

    >> Short term gain outweighs long term risk for these guys. Unless they were to be held personally liable, there’s no downside to taking a risk with other people’s money.

    Here’s another phrase to describe Wall Street behavior: “public risk, private profits”.

    Usually, the investors know less than the money managers. For example, in the case of pension funds investing in hedge funds, the ultimate bag holder is the eventual pensioneer, who has no idea that s/he is investing in CDO’s and, even if s/he knew, wouldn’t be able to stop it.

    So, “public risk, private profits”.

    Hmmm….However, when the money manager doesn’t just view the risk as “risk” but as an eventual calamity, then, that phrase is too nice. It’s not just a shifting of “risk”. The money managers are making what they believe to be bad investments. They’re breaching any fiduciary duties and probably committing fraud.

    It’s the Smartest Guys in the Room without the “F— Grandma Millie” talk.

  26. wunsacon says:

    Fred, how do you see a rate cut resulting in cuts to borrowers? First, the vast majority have yet to have their rates reset up anywhere from 3-7 points. A .75 cut is not going to help them. Second, I would expect — I’m betting — that a rate cut comes along and drives up commodities further. I’m not sure they’ll have more discretionary spending after that. They’ll still be in the same hole. Third, because I expect more inflation, long term rates — which drive mortgage rates — should stay where they are or move higher.

    Well, that’s my take…

  27. Greg0658 says:

    Do Durable Goods Order #s point to USA internal consumption vs ordered for export?

    Do Durable Goods Order #s point to country of manufacture?

    This USA main street financial illiterate is just wondering.

  28. Fred says:

    I don’t follow you wunsa…the Prime is currently 8.25%….most HELOs are tied to prime, so they will drop by .75 bps or 9%.

    ARMS are set to 2, 10, or 30 yr treasuries (4.24% – 4.9% base rates)…how do you get a 7 point jump (unless they are paying zero %)?

    I’m not saying it will be a breaze (or should have happened at all), but consumer rates coming down have NOT been factored into the “death spiral funeral durge” sung around here.

  29. Marcus Aurelius says:

    When I leveled with the CEO of the builder I worked for in ’05 about the consequences of the industry running up prices – and the peril of doing so – he tried to get me to buy a larger house. His argument: If you buy more house than you can actually afford, it’ll go up at least 5% per year. In 5 years, you will have made 25% percent on your investment. When I told him that there weren’t enough qualified buyers to sustain that kind of appreciation, his eyes glazed over. When I asked him to think of the position I’d be in if home prices fell for those 5 years, he said it would never happen. Keep in mind, I was speaking to the numbers, and he was riding on an all time profits high – irrational exuberance and self-delusion guided his vision of the future.

    Today, his company is a shell of its former self. Prospects are dim. A publicly traded company, his stock is worth 10% of it’s peak price (The stock price has recently rallied from its all time low of 5% of its historical high, but there’s no reason to think the company will be a going concern in the next few years).

    The bottom line is that this person is still my friend, I am welcome at his home, and care deeply for him and his family. Nonetheless, I do not believe he should be bailed out – he had fair and unbiased warning of what was coming, and he chose to bet the farm. I do feel sorry for the employees and former employees who bought stock in the company and now live with the loss of their investments.

    No matter what anyone says, fundamentals are important. All of the slippery maneuvers in the world won’t salvage a company, or an economy, built on poor fundamentals.

    I am neither bull nor bear, as I’m no longer in the game, but we will all pay the price of ignoring the fundamentals. I look at this as an observation, not an opinion.

  30. In every bubble, the smart guys ALWAYS know they are getting away with murder.

    But the money is too good to stop.

  31. michael schumacher says:

    fred-

    consumer rates went down on some loans yesterday…….almost a 1/4 on retail loans

    but I’m sure you missed that too….

    Ciao
    MS

  32. Fred says:

    Mr Ciao:

    You have a PERSONAL vegence for me and my opinion, for which I could care less.

    It clearly illustrates your moral fibre. For obvious reasons I will (continue) ignore your incessant commentary/blather.

  33. michael schumacher says:

    No fred I don’t have anything personal against you….you made personal comments and attacked me several months ago….I’m sure you recall.

    I don’t forget things like that.

    I also can’t stand people who just make statements, like 90% of your input is.

    you have quite the ego to accuse me of attacking you…..

    For the last time…..IF you don’t like it IGNORE it…you’ve said as much but seem unable to accomplish it. Please show us all that you can at least do what you say.

    Ciao
    MS

  34. Steve C says:

    “I am neither bull nor bear, as I’m no longer in the game, but we will all pay the price of ignoring the fundamentals. I look at this as an observation, not an opinion.”

    Marcus, From that statement it appears you are mainly in cash or low-risk bonds which tells me you are closer to a bear than you think. I hope if equities fall far enough you will get back in the game and buy equities.

  35. SPECTRE of Deflation says:

    Jeff Clark, you ain’t the only one:

    Is hyperinflation coming or am I way off base here?

    I understand it as an unchecked increase in the money supply (FED injections and/or rate cuts) or drastic debasement of coinage (weaker U.S. dollar) which is often associated with wars (Afghanistan and Iraq), economic depressions (credit/real estate bubbles) and political or social upheavals (last approval rating figures for Republicans or Democrats was < 30%).

    Are gold coins/bullion, I Savings Bonds and foreign currencies hyperinflation proof? What foreign currency (certainly not any in an emerging market)? Emerging markets appear to be too leveraged to the U.S. Are there any other type of investments?

    Anyone read the book written by Peter Schiff called “Crash Proof”?

    Comments on any of this? Thanks!

    Posted by: Pat Gorup | Aug 20, 2007 7:14:04 PM

    Whew that is the question. What if we have had our hyperinflation, but this time is was in all asset classes? Wild speculation, lots of juice for the game [liquidity], alchemy of the bond universe and on and on.

    Further we had a period of disinflation while we experienced this hidden hyperinflation. The disinflation was in all things consumable or things we wanted.

    Once the asset classes return to the mean, which they must, all that is left is the debt. This is where we are today.

    If they monetize the debt we get Zimbabwe style inflation. Otherwise it’s to be deflation where cash will be king, and debt of all types will be abhorred. IMHO.

    Neither choice is very appetizing.

    Posted by: SPECTRE of Deflation | Aug 20, 2007 8:13:46 PM

  36. fiat lux says:

    Officer, the invisible hand made me do it!

    Winner: Best comment of the morning.

  37. Stuart says:

    “Anyone read the book written by Peter Schiff called “Crash Proof”?”

    I thought it was pretty good and would recommend it. It’s written for the average Joe. Effective metaphors and analogies. Simple explanations and pretty much called the housing market downfall. Folks who don’t like his message that he has been preaching for some time now won’t like his book as it’s much the same but in more detail and support. Personally, while I want to believe he more pessimistic than what will turn out to be the case, the direction of long term rates, and various markets are IMO correct. There’s a chapter about what Wall street doesn’t want you to know that I found particularly good. Hey, if you’re on Kudlow representing an asset management company, collecting fees as a percentage of the assets you manage, you’re simply not ALLOWED to say anything that will diminish that assets base. Explains why 7/8 guests are bulls-always. Anyhow, most of the content I was already versed in, yet I enjoyed the book and found the content from Peter’s style of writing interesting.

  38. Greg says:

    Costa: you asked what credit spread is. While this is simplistic, it is the difference in annual percentage terms between risk-free lending and other lending. Assume that lending to the US, British or whatever government is (in their home currency) risk free (they could print more money to pay you).

    Say 5% for argument. If banks charge an individual (a bank, a homebuilder, a coffee shop, whatever) 7%, the credit spread is the difference between the rates – in this case, 2%.

    It is (from the lender’s perspective) the extra interest they get for lending to that borrower instead of lending to a risk-free borrower on comparable terms. It should reflect the risk that they will not get repaid by that borrower (in full or on time).

    The credit spread for a given type of borrower (say, AA-rated corporates) is often calculated off of a given benchmark or term to make comparison easier. In theory, the spread can be calculated from credit default swaps, etc., but the idea is the same. So you might hear ‘credit spreads have widened to XX’ for a certain group of borrowers.

    There are lots of caveats: the terms are rarely exactly comparable, interest rate and other risks can affect the calculations (if the terms are not exactly comparable), and there are other more complicated risks. Some will quibble about whether a risk-free borrower exists, etc, etc.

    But in simplistic terms, it is the ‘premium’ paid due to credit risk over other risks.

    Hope this helps.

  39. MarkTX says:

    I was just headed to the Public Library to find some books like Crash Proof, Empire of Debt, Legends Of wall Street, The Great Wall Street Swindle, etc…..

    First I checked online to have a starting point….

    Plenty Of Suzie Orman available…..yuk!

    Anyone other books (yet) on the CDO/leverage/debt/mortgage time bombs

    thanks in advance!!!

  40. michael schumacher says:

    second best quote of the day via the over ambitious NAHB:

    “We were getting some signs of stabilization in July. This was certainly a positive number,” said Bernard Markstein, senior economist at the National Association of Home Builders. “If we could wipe out the events of the last several weeks, we would be rejoicing.”

    even though the way they report numbers basically omits the last several weeks(because of the inconsistency in permits vs. starts) they still can’t manage to spin this with any believability……..

    Ciao
    MS

  41. Valdan says:

    I came across the following from Gary North.

    http://www.lewrockwell.com/north/north561.html

    This is a very succinct overview of what the hell is going on now. With so many good minds out there, why is our policy made by idiots and crooks?

  42. David Merkel says:

    Bad things happen to securitization markets whenever the amount that can be clipped through securitization persistently exceeds 2% of the amount securitized. That creates a flood of loans to be securitized. That happened with home equity loans around the time of LTCM, with manufactured housing in the late 90s, and more recently with subprime and Alt-A.

    The lure of free money brings out the worst in people, particularly investment bankers. Then again, it brought out the worst in marginal borrowers, who should have intuitively known that they could not afford the houses that they were financing.

  43. costa says:

    Greg and dlbwyo Thanks that makes sense now.

  44. Marcus Aurelius says:

    Posted by: michael schumacher | Aug 24, 2007 11:50:23 AM

    The recent spike (if you can define a nubbin as a spike), in new home sales is largely due to the recent announcement that the sub-prime debacle had been contained. Based on comments from friends, I think that this announcement was interpreted, by some, as the equivalent of the housing bubble being crisis-proof.

  45. angryinch says:

    It’s a little disingenuous to continue using terms like “homeowner” and “homebuyer” to describe the folks who took on these toxic mortgages over the past few years.

    When you take out an I/O loan with no money down, you have no equity and you aren’t building any either. What exactly do these folks “own” and what did they “buy”? Seems more like they were buying a call option on future appreciation at best.

    Much more accurate are the terms “homeower” or “ho’moaner”.

    Or perhaps the less-pejorative “renter”. Whether you are renting from an owner or renting from the bank, it’s a difference without a distinction.

  46. Stuart says:

    Speaking of time bombs. Read this and you will know one of the reasons why the major money center banks are NOT loaning each other money-on the hook for $891 million. (8th paragraph into the article)

    JOHN PARTRIDGE and BOYD ERMAN
    Thursday, August 23, 2007
    The freeze-up in short-term lending that is battering Canada’s Coventree Inc. is spreading fast in the U.S. and Europe, raising concerns about slower economic growth and the strain on banks that have agreed to back the commercial paper that suddenly nobody wants to buy.

    Thursday, the list of Canadian companies that have said they can’t get the money they are owed after purchasing so-called asset-backed commercial paper (ABCP) from Coventree and other sources again got longer.

    Among those that revealed exposure were the Greater Toronto Airports Authority, which has about $249-million of ABCP, some run by Coventree. Société générale de financement du Québec, the investment arm of the Quebec government, said it holds $137-million of non-bank ABCP, about 40 per cent of its cash, sold to it by National Bank. As well, Air Canada said it had $37-million of ABCP, out of $1.4-billion in total cash, and Russel Metals Inc. said it is owed $11-million.

    The concern now is that companies whose cash balances are locked up in Coventree investments may be forced to delay spending, slowing economic growth. The problem would be compounded if companies that borrow directly in the commercial paper market to fund day-to-day operations are unable to find buyers. But bond salesmen say well-regarded borrowers are able to find takers for their short-term IOUs, though at a higher interest rate than a few weeks ago.

    “It doesn’t take much of a hesitation on the part of businesses and spending or hiring to begin to show up in the economic data,” Ted Carmichael of J.P. Morgan Securities Canada Inc. warned in an interview. “As long as the commercial paper market remains seized up, the risks that the economy could slow down quite sharply are rising in both the U.S. and Canada.”

    So far companies caught with Coventree paper have said they have access to cash to keep operating, either through banks or what’s available elsewhere on their balance sheets.

    The crisis, which began to spread in mid-July when Coventree customers started to balk at buying paper backed in part by U.S. mortgages amid a housing slump there, has become a global problem. Issuers similar to Coventree have found buyers have vanished, with the Federal Reserve reporting that outstanding U.S. commercial paper fell 4.2 per cent in the past week, the biggest drop since 2000.

    As a result, commercial paper investors who are due money are looking to banks to bail them out in accordance with backup agreements. Fitch Ratings estimates that banks have $891-billion (U.S.) of commitments to commercial paper investors who bought asset-backed commercial paper.

    The problem for holders of Coventree paper is that banks balked at backing the securities, citing an out available only in Canada, and now under the so-called “Montreal proposal” the market has been effectively brought to a standstill while players look for a solution. As a result, nobody is getting paid.

    Even if there is a solution, Coventree’s future looks bleak. The company said Thursday that it is battening down the hatches as its market remains largely frozen and its revenues dwindle. The company said it again couldn’t find buyers for millions in paper, meaning that, since the start of the turmoil, Coventree’s trusts have been able to roll over just $613-million (Canadian) of the $5.5-billion in notes that have come due, and that businesses accounting for almost all the company’s revenue were basically stopped.

    Shares of the Toronto-based structured finance company plunged 35 per cent on the Toronto Stock Exchange Thursday to close at $1.91. The stock hit an all-time high of $16.30 just over a month ago, but has now lost more than 85 per cent of its value in the past two weeks, slashing its total stock market capitalization to just $32-million.

    The market for the products that Coventree created is unlikely to ever return, some commentators said.

    “The commercial paper market, in terms of the asset-backed commercial paper market, is basically history,” Bill Gross, the California-based manager of the world’s biggest bond fund, told Bloomberg News.

  47. Lord says:

    The first dictum of selling -
    Don’t sell what you think people need, sell what people want to buy.

  48. Stuart says:

    sorry, that last post should say
    on the hook for $891 BILLION.

  49. John says:

    R’s story highlights that too much of Wall Street is “What can I sell to make money” instead of the more noble “What can I do to help the client so I can earn money?”

    If individual sellers — and buyers — of bad product were to eventually suffer the consequences of their actions (as elsewhere in life), this would be acceptable. The problem is that because of leverage, a relative few put the entire financial system at risk causing many others to get punished. And too often the guilty simply walk away with millions of dollars.

  50. Bob says:

    What nobody is discussing is that the same kinds of BS assumptions have been going in to financing the current COMMERCIAL real estate bubble, including the distribution of those loans through CMBS conduits. Everyone seems to think that commercial R/E will be immune to the kind of crisis going on in residential. It won’t be.

    Oh, and to all of you holier-than-thou critics of the pariah we know as “R,” maybe you should try walking a mile before throwing your stones. Let’s say you’ve invested heavily in your career, sacrificed your family life for years with 60+ hour work weeks, and are now getting compensated for it. Which one of you would walk up to your boss and say, “No one else is stopping, but I think we should.”? You’d be out of a job and your wife would leave you. It sounds good to say you would throw yourself on the grenade; it’s a lot harder to do it.

  51. Stuart says:

    About those new home sales. Lets wait for the revisions before the goose bumps get too big.

    http://bp1.blogger.com/_pMscxxELHEg/Rs8dHkD6oGI/AAAAAAAAA0g/S2p71rELLDo/s1600-h/New+Home+Sales+Revisions.jpg

    from calc risk.

  52. R says:

    I am the author of the original email Barry posted:

    I hate the fact that I’m getting pulled into this, but I’m seeing the need to clear a few things up.

    1. To Fred or MS, I “had a spine” by walking away from an opportunity to start up a CDO management business at an established hedge fund company in ’05. Everyone was going the same way on that trade, the collateral sucked, and HPA was maxing out. What I told Barry about were my observations from daily interactions with buyers of sub-pime HEL’s as collateral for their CDO transactions. My role then was on the sell-side. Minds far smarter than mine were eager to accumulate this collateral. Fraud? Nothing fraudulent at this stage of the proccess. If there was fraud, reading an offering memorandum and monthly remittance reports cover to cover or spending hours of cash flow modelling on Intex wouldn’t have shown it. Oh, and where was the fraud? My opinion; mortgage brokers possibly lying about and jamming loans into the wrong people to get fees from the lenders. My view on the relative value of sub-prime HEL’s during this time period was not nearly as upbeat as others in a world where EVERYONE else was a buyer.

    2. Eclectic, it’s not quite as disgusting as you might think. Everyone knew the bet they were making; a combination of HPA and continued positive loan performance would continue sans interruption. It was a market call, similar in concept to the market calls most of you reading this make each day in your chosen financial markets and products. It was a bet that the collateral was going to continue doing what it was supposed to. It’s a bit annoying when the “talking heads” claim that institutional investors and HF’s buying these products don’t know what they own. Bullshit. They know. They own a bet on Average Joe’s house staying equal or going up in value and his continued ability to make his loan payments.

    3. Stuart got it right, unfortunately. In a capitalist society, one sells what people want. And they wanted sub-prime HEL’s with HUGE credit spreads such that the arbitrage was bigger. How is that huge credit spead possible? Lower quality loans; low FICO’s, low LTV’s.

  53. Stuart says:

    whattaya mean unfortunately??? LOL

    Speaking of bombs, ahem, has anyone taken a gander at the TED spread lately. It’s spiked to levels not seen since 1987. Yes, I know there’s more than a few metrics of risk, but this one is ominous in its foreboding of what’s coming down the pipe.