Good explanation of how CDO were constructed in today’s WSJ, and why the subprime mortgages were so problematic.

Various CDOs, including Goldman’s, “magnified the impact of toxic mortgages by replicating mortgage securities in debt pools known as collateralized debt obligations as well as CDO derivatives, and also in an index that tracks subprime bonds.”

A $38 million pool of subprime-mortgage bonds created circa June 2006 found their way into more than 30 debt pools. Total losses = $280 million.

Here’s the WSJ:

“The subprime mortgages that caused big losses generally were packaged into CDOs, in which dozens of mortgage-backed bonds were pooled together and slices of the CDOs were sold to investors. Another version of these CDOs didn’t contain actual mortgage bonds but were linked to them via derivatives called credit-default swaps. Through the use of derivatives, banks created many of these synthetic CDOs using the same mortgage securities, all of which would rise or fall in value depending on how the mortgages were performing. With synthetic CDOs, those who had bet that the loans would perform well were on the hook if their performance deteriorated.

In effect, the documents said, Wall Street was “copying and pasting” what turned out to be the worst-performing securities of the mortgage boom. Such activity helped multiply opportunities for hedge funds and traders who wanted to short the housing market, but magnified the losses of those on the other side of the trades. To short a trade, in this instance, is to bet the housing market will turn down.”

I am a sucker for a good graphic:
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courtesy of WSJ
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Source:
Senate’s Goldman Probe Shows Toxic Magnification
CARRICK MOLLENKAMP And SERENA NG
May 2, 2010
http://online.wsj.com/article/SB10001424052748703969204575220300651236446.html

Category: Credit, Derivatives

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.

19 Responses to “CDOs for Dummies”

  1. Rikky says:

    a good simplified explanation for the crux of this mess. it goes to show the banks will always find a way to leverage the $1 you start with into some multiple. you can also see the beauty from the banking side. they create the products, slice em and dice him and sell them off making their intermediary/development fee and also keeping some of the juiciest parts of the vehicles which only they really know outside of the phony investment grades. nice gig if you can get it.

  2. R. Cain says:

    “We are simply providing financial products that deliver the risk exposure the client is seeking.”
    L. Blankfein

  3. globaleyes says:

    globaleyes was always wary of traches. I looked from many angles. No matter how you slice it, every part lacked appeal. Remember, early last decade the world was hungry for yield. We got vapor instead.

  4. forcast says:

    Very good summary, it is even educational
    Thank you Barry

  5. rktbrkr says:

    You Bet your Life, nope not the old Groucho Marx TV show but BP’s self insurance for the gulf oil spill.

    Where are the “Boycott BP” T shirts & bumper stickers, didn’t see any on the net, I guess the free enterprise system in the US must be asleep. Can’t see how there won’t be a populist boycott of BP before long.

    Reuters reported that BP self-insures through its own insurance company, Jupiter, which does not lay off risks onto reinsurers or syndicates at Lloyds of London, according to a spokesman for the company.

  6. ACS says:

    You’re the proud owner of 50% of “Springtime for…” oops, Soundview Home Loan Trust 2006 OPT5. You good sir own of 50% of Soundview Home Loan Trust 2006 OPT5. Madam you are the lucky owner of 50% of Soundview Home Loan Trust 2006 OPT5. You’re pension fund is now the proud owner of 50% of Soundview Home Loan Trust 2006 OPT5. Acme Insurance is now owns of 50% of Soundview Home Loan Trust 2006 OPT5…

  7. farmera1 says:

    So in this case $38 million in sub prime mortgages were magically morphed into $280 million in debt (probably more than that if the losses were $280 million). That is a cool 700% leverage built on less than stellar mortgages (liar loans etc). Now that is creative financial engineering.

    I’ve read that many bonds had 10 times the face value in over the counter derivatives written on them. WOW. And we wonder why this carefully designed system blew up. But the key point is that all of this stuff was designed to make big bonuses for the banksters nothing more nothing less. And these guys were saved by us mere tax payers. The CEOs walked with hundreds of millions of dollars like FULD did from Laymen. What a country.

    Reminds me of the old saying: Steal a loaf of bread get thrown in jail. Steal railroad and get elected to congress or at least retire rich.

    I too had a local broker try to sell me some mortgage based tranches . I didn’t bite ‘ cause I didn’t understand how this could work out. Taking big piles of crap mortgages, pooling them together into bigger piles and suddenly you have a good investment. I’m just a farmer but it didn’t make sense to me.

  8. X on the MTA says:

    See this, totally messes with me because if the synthetic exposure is bigger than the underlying, who wouldn’t the protection writers just get together and take control of the underlying and make good on it’s obligations. Those who bought protective CDS would not mind, and those who bought them speculatively would get burned, but I don’t think it would be unfair since it’s a perfectly legal tactic and it would mean less payouts for the protection writers

  9. Low Budget Dave says:

    I was listening to an NPR podcast this weekend, and the guest (from WSJ) kept using terms like “making a market” and “spreading risk” to describe what Goldman was doing. After about a half hour of this, he had convinced my wife that CDOs were a necessary part of free enterprise. Most people are not really familiar with the term “synthetic”, and do not really understand how completely different derivatives are from CDOs.

    NPR allowed him to keep blathering about how banks “used derivatives” to cover the risk on long term loans they were making. Which I guess is partially true. But if you issue a billion dollars in long term loans, there is no justification to buy ten billion in derivatives.

    The purpose of selling the derivatives is to gamble. The purpose of buying the derivatives is to defraud the seller. I guess that is OK as far as a legal purpose, since these were very sophisticated sellers, but it should have been disclosed.

    I am not a great investor, but if someone offered me a stock called “Let’s Defraud Dave”, even someone as clueless as me would have second thoughts.

  10. peachin says:

    OK, let’s do the test: If It looks like, acts like, smells like, and is talked about like – Bull $hit – well then it is
    We live in a society, that people like to “overide” sensibility – in using synthetic “anything” as representing reality – let’s look at what a texan says about the reality of a pound of sausage:

    http://www.youtube.com/watch?v=f4RNb3tt0LM

  11. mbelardes says:

    I understand the importance and use of a CDO. Some investors want to invest in or have exposure to crappy loans in hopes of higher yields. I understand the use of selling a CDS to increase yield or buying a CDS to protect the underlying bonds. Follow the money (raw dollars) and somewhere someone with shabby credit is getting a loan for a home (or whatever) and if they can make the payments, everyone wins. (Best example is a recent graduate, with new job, no money down, decent income, you see where I’m going…) So the CDO makes sense to me as it has a positive aspect to the capital markets and general economy.

    One of these days, someone is gonna have to walk me through the purpose of buying a synthetic CDO.

    Because this “our clients wanted to buy the risk” and “well, certain client’s wanted more exposure to that market” stuff really doesn’t fly.

    If billions of dollars (trillions really when you look at the derivatives market) are flowing into synthetic securities that are merely used for bets and not actually funding anything of short or long term economic value to planet earth while also putting the integrity of the global financial markets at great peril, you don’t need to be a rocket science or quant genius to see those securities need to be severely regulated or completely restricted.

    Options and Futures are exchange traded and make sense.

    Forward and Swaps are not exchange traded and make some sense still.

    These full on synthetic deals are in a whole new realm of ridiculous rationalizations. I’m smart. You guys are smart. I’m not buying the “oh these are just so complicated that you don’t understand the true benefits.” Rewards? Ha! Finance guys get paid to understand and manage the Risks! We understand the Risk all too well now with these…

  12. dogzilla17 says:

    Seems similar to the chapter on Unit Investment Trusts from Galbraith’s classic ‘The Great Crash 1929′ –just replace Blue Ridge & Shenandoah with Abacus 2007-AC1—eerily the chapter is entitled ‘ In Goldman Sachs we Trust’ …

  13. [...] Wall Street manufactured all those CDOs.  (Big Picture, Crossing Wall [...]

  14. dogzilla17 says:

    Hi Barry — my first post — not sure if earlier one was received– great book & blog/website!!!

    Sounds a lot like Galbraith’s classic ‘The Great Crash 1929′ Chapter on Unit Investment Trusts entitled ‘In Goldman Sachs we Trust’ — just replace Blue Ridge or Shenandoah with Abacus 2007 AC1

  15. NormanB says:

    Why wasn’t this explained before, way before the crash? And how about those blowhards on the Senate Committees (though we all know the glee BR gets when GS is raked over the coals)? Where were they when this crap was happening? Where was the FRB? Where are they when Greek, Spanish, Portuguese, Venezuelan, etc bonds are now being ‘guaranteed’? The CASINO LIVES!!!!!!!!!!!!!!!!

    ~~~

    BR: I don’t get gleeful when Congress acts like jerks. And i don’t dislike Goldie. I merely thought the media was feeding us a diet if steats GS spin . . .

  16. Mikey says:

    Does anyone know where all that option-ARM paper that will soon be resetting in the next two years went?

    Were they too repackaged into CDOs?

  17. jaytrader says:

    Barry-
    The article starts out incorrectly I believe.

    “Even at its peak, subprime lending accounted for a relatively small portion of overall mortgage lending. Yet losses from these mortgages caused deep damage to the financial system.”

    Subprime lending in 2005-2007 was some 40% of new mortagages. This is hardly a small portion. The losses were magnified by the leverage of the CDO’s and side bets.

  18. jimc1004 says:

    I have an even easier way of grasping the concept of “synthetic” synthetic CDOs [derivatives with no actual mortgages sometimes called "CDOs squared"]. Though S-S-CDOs started with mortgages turned into bonds turned into pure gambling, to me they seem pretty analogous to the “investment trusts of trusts” from the 1920s. Stocks had become so popular among the hoi polloi that the investment banks [some with names you already know] theorized that there would “not be enough stocks” for everyone who wanted to buy. So first they developed “investment trusts” which were a holding company which owned “some” actual stocks [actual holdings not published anywhere!], and they sold closed-end-fund shares in this investment trust [which was really just another way [another level] to leverage the stocks which usually had already been bought on margin]. Their biggest selling point was supposed to be the value added by the Wall Street stock picking geniuses. Next they created the “investment trust of trusts” which held mostly the stock of the [first level] investment trust. The most infamous pair of these were developed in the summer of 1929: Blue Ridge [2nd level] and the Shenandoah Corporation [1st level], both inventions of Goldman Sachs’ spin-off trading company. All these trusts were sold well above the net asset value of the underlying securities even at the market top. After the market break they became worse than toxic assets, pretty much worthless. Another example of reverse leverage in action!

    For a more detailed history read the slim but excellent, and very funny, The Great Crash 1929, by by John Kenneth Galbraith.

  19. jimc1004 says:

    jaytrader

    I think that the confusion is between NEW mortgages and TOTAL OUTSTANDING
    mortgages. IIRC, I read at the time of the near collapse [late 2008] there were in the U.S.
    $1.3 Trillion outstanding SUBPRIME mortgages [and about $300 MILLION of THOSE
    in default in early 2009] and about $11 to 12 Trillion PRIME mortgages outstanding.

    Of course both these figures are dwarfed by the CDSs and other derivatives only dimly related to any actual mortgages, which at the same time totaled between $50 and 60 Trillion depending on whose numbers you use [nobody was regulating them OR accurately counting them].

    If it had just been those $300 Million in defaulted sub-prime mortgages causing the collapse then
    the TARP money could have PAID OFF ALL those mortgages [several times] and we could have all skipped making $ Trillions of paper profits in home equity and 401-k balances disappear – to replaced with $ Trillions of props to the To Big To Jail banks and additional ginormous deficits.

    [I'm only partly kidding! Nobody paid off MY mortgage but me, but many folks were swindled, like those pushed into sub-prime loans for additional banker profit when they could have qualified for prime mortgages, including folks already paying off a prime mortgage who refinanced into sub-prime and eventually lost their house.]

    Jim C