There’s a wonderful set of flash based illustrations of how CDOs are put together as an online companion that goes with the must read front page WSJ article this morning: Wall Street Wizardry Amplified Credit Crisis

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Click any of the 3 graphics below to take you to the 6 step process . . .
Cdo_step_1

Cdo_step_3

Cdo_step_5

Very nicely done!

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Source:
Wall Street Wizardry Amplified Credit Crisis
A CDO Called Norma Left ‘Hairball of Risk’;
Tailored by Merrill Lynch
CARRICK MOLLENKAMP and SERENA NG
WSJ, December 27, 2007; Page A1
http://online.wsj.com/article/SB119871820846351717.html

Category: Credit, Derivatives, 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.

16 Responses to “The Making of a Mortgage CDO”

  1. Donny says:

    Meanwhile the markets keep climbing the mountain of worry.

  2. blam says:

    The creator of a subprime residential mortgage-backed security — or RMBS — buys loans from all over the country, often from several different lenders. Several thousand loans go into one mortgage-backed security. Because the security combines the specific risks of all the individual loans into a single pool, its investors as a whole are less exposed to the potential problems of any one borrower.

    The losses begin here because the historical distribution of specific risk on the underlying is no longer valid. “Shifting risk” creates a different distribution of returns because, well, the risk has been shifted.

    Unfortunately, our whole economy is riddled with this elementary mistake from statistics 401. The quality of the mortgage is a function of the qualifications of the borrower and lender, not the other way around.

    Excellent presentation. Thanks

  3. zell says:

    This is the high tech, high finance version of Three Card Monte, no doubt learned by the Wall Street crowd, from N.Y. street hustlers.
    Where’s the bad debt?

  4. justin says:

    Question: was there any taxes being collected during this proccess? If so, I understand why/how the politicians like Chuck Shumer could stand idly by. Oh, my mistake, they didn’t know any of this was going on. Right.

  5. Winston Munn says:

    You read this and it’s natural to think to yourself, “Oh, well, another bank caught in the subprime trap.”

    Quote: “Reuters) – Capital Bank Corp (NasdaqGS:CBKN – News) said it is writing down certain assets estimated to worth $2.6 million to $2.8 million.” End Quote.

    But reading on you find…

    Quote: “‘While Capital Bank has no subprime mortgage exposure, the current housing market is soft throughout the franchise, thereby causing difficulty in the liquidation process of certain nonperforming loans on our balance sheet,’ Chief Credit Officer Mark Redmond said in a statement.” End Quote.

    It might be more accurate to say that with the floor of value collapsing from beneath the collateral, it’s a-l-l subprime, making the corresponding capital based on this value a mirage destined to disintergrate in the desert of contracting debt.

  6. Mike G. says:

    How anyone thought they could rate the final products is pretty sick. By the time the CDO spits out its “BBB” bond, figuring out if it reallyis “BBB” or something else would be a nightmare. I can see why they wanted to get a rating on that garbage, but I am kind of shocked that Moody’s, Fitch, etc. would step in front of that particular train for a fee. Once they sold their credibility, there was nothing left to sell.

    First, they came for the municipal bonds
    So I rated munis
    Then they came for the corporate bonds
    So I rated corporate bonds
    Then they came for the RMBS’
    So I rated RMBS’
    Then they came for the CDOs
    So I rated CDOs
    Then they found all my CDO ratings PURE CRAP and came for me!!!
    But there was nothing left to rate

  7. Don says:

    Excellent article by the WSJ on the creation of a CDO.

    This was just the latest attempt at alchemy–BBB bonds in, and out pops AAA securities as good as treasuries, but paying 5.5 more than LIBOR.

    Funny thing about risk. It’s like mass/energy–you can change its form, or spread it around more, but whatever risk was there at the start of your alchemy is still around at the end.

    And lending money to people w/ a history of not paying it back whilst counting on the uninterrupted appreciation of the asset securing the loan to bail you out–well that’s a whole load of risk floating around that even a wall street quant/alchemist ought be able to see.

    Hubris is a timeless attribute of man, even if financial alchemy is a relatively new phenomenon.

  8. I overheard a great quote the other day:

    “Banks are devising all sorts of new ways to lose money, when all the old ways still work just fine . . . ”

    I can’t recall who said it . . .

  9. michael schumacher says:

    And to think that the I banks thought the could do this FOREVER. Just roll it over month to month and collect the spreads on them.

    No wonder the market gets “surprised” at each and every write-down…….

    With strategy’s like that no wonder they still say “it’s contained”..

    Ciao
    MS

  10. Eric Davis says:

    I think it was stumph, but CNBC was running a clip yesterday with Buffett quoting stumpf, with the losing money quote, One of the usual suspects was trying to get him to say “Banks are a buy!!!,Buy!!! buy!!! BuYa”

    but he wasn’t biting..

    They ran the clip a few times then stopped, since it had important investor info like, “Don’t step in front of the car Wreck that is the big financials”

    A better clip was when he said he had been approached a few times by the big banks, indirectly for deals.

    Melissa Lee: Mr. Buffett, if I can just jump in. It’s Melissa Lee. I’m just curious. Have you been approached by a major financial institution in terms of whether or not you would be interested in buying a stake?

    Buffett: Yeah. Yeah.

    Melissa: You have been? You turned them down?

    Buffett: They sometimes do it indirectly because they don’t like to hear ‘no’ directly. (Laughter.)

    http://www.cnbc.com/id/22398095/site/14081545/
    http://www.cnbc.com/id/22397740

  11. Stuart says:

    Well that was a darn good illustration of the process. Not a chance that the holders are pricing CDOs based on the current ratings illustrated in step 6. Not a chance.

  12. michael schumacher says:

    OT:

    Nice trick that MS pulled on it’s investors by pricing the deal with a range and the investors, knowing full well what was about to be dropped on MS said “ok…we’ll take the range pricing instead of doing the deal here” ( price was in high 40′s)and the crooked specialists over at the NYSE drives up the SP of MS even in the face of a $10 billion write-down.

    Guess what day the deal priced???

    Yesterday’s close…….over 55

    So you see the I banks are still screwing each other in the quest for more leverage and more money.

    i wonder how long the Chinese will put up with that??…probably about late August is my guess…..LOL

    Ciao
    MS

  13. Eric Davis says:

    I hope the I-banks learn something from all this. IMHO, the biggest problem is the lack of integrity in banking, trying to create more and more convoluted instruments to screw borrowers and lenders.

    Which screws everyone.

    But if I’m betting, I’ll bet I’m just being Naive.

    but august sounds good for the big banks. :)

    It does keep pissing me off that the big stinker banks keep catching a Bid.. I can’t believe that they don’t just constantly drag bottom like a boat anchor on the market..

  14. VJ says:

    ANOTHER SHOE DROPS

    Fitch: RMBS Ratings May Be Downgraded

    Fitch Ratings said late Wednesday it placed credit ratings on residential mortgage-backed securities backed by bond insurers MBIA, Ambac, Financial Guaranty and Security Capital on watch for possible downgrade.

    Among those affected are 87 RMBSs insured by MBIA Inc., 64 by Ambac Financial Group Inc., 35 RMBSs insured by Financial Guaranty Insurance Co. and 19 backed by Security Capital Assurance Ltd.

    FORBES LINK

    Horse. Barn.
    .

  15. rickrude says:

    i think Cramer is right, the FED should be held accountable for starting the mess…
    Greenspan comes to mind.