CDO Part IV or A Sow's Ear is, er, a Sow's Ear

So now we have a product which piles assets together and then slices the whole into different pieces which when stacked on top of one another are the total capital structure.

As mentioned, the bottom of the pile, the equity or first-loss piece is understood to be the riskiest, and the top of the pile, the AAA rated piece, is the most secure. Well two things happened at this point.

The original "cash" CDO's, were made up of pools of actual assets such as bonds or loans or other such assets. That was fine as long as there was an adequate pool of assets to draw from. As it turns out, some asset classes such as corporate bonds became somewhat scarce, or too expensive. The rating agencies which granted the AAA ratings used historical default rates of the ratings they themselves had given and created guidelines as to what mix of bonds were required in order to create AAA tranches.

All the investment banks had similar models to find the right mix of bonds to meet these requirements which created excess demand for said bonds which made them more expensive thus lowering the yields which had made the CDO attractive in the first place. One solution was to find different assets-enter Sub-prime mortgages. Another was to create synthetic structures-enter the rise of CDS.

First let's deal with the Cash CDO's and thus to Sub-prime.

Part of the pursuit of happiness in the USA is to own a house, two cars, two kids etc. Credit was freely available, and there was a strong desire by many members of Congress, among them Barney Frank, Chairman of the House Financial Services Committee, to support home ownership for all. The way this was engineered was essentially to set up guidelines which if adhered to by the mortgage originators would make the mortgages they were granting eligible to be guaranteed under either FNMA or FHLC. "If they were adhered to" is the operable phrase here.

The mortgage originators came up with self-qualifying mortgages which were presented in a fashion that made them eligible for guarantees by the federal agencies. Originally these were NINA loans reserved for the most credit-worthy borrowers who could demonstrate good credit histories regarding past mortgages and could demonstrate access to income. Somehow this got twisted into NINJA loans, No Income No Job (or) Assets which were used for the least credit-worthy home buyers, the Sub-Prime market.

Now a mortgage originator is not required to keep the mortgages granted on their books. In fact, what they like to do is grant the loans under documentation which they could present as adhering to the federal guidelines, and on that basis sell the loans on to an investment bank, after taking their 1% or higher fee.

The investment bank is happy to buy these loans as the federal guaranty makes them eligible to meet the rating agency guidelines necessary to get a AAA rating. The final investor WAS happy, because they get a AAA asset significantly cheaper than other similarly rated assets.

But wait a minute. We start out with loans with documentation granting loans to people who have no income, no jobs, no assets, and because they are self-qualifying, don't have to provide any paperwork to suggest they can actually afford the mortgage they are receiving. Forget about the initial Adjustable Rate Periods, the Balloon Payments and any other offers intended to entice people to take out mortgages- they knew they could not maintain the payment UNLESS the real estate market only rose- or if pigs flew.

This is called a pyramid scheme, and this kind of activity has been going on since the creation of the United States (see "The Exchange Artist" by Jane Kamenesky). The fact that the original customers fell for the "free lunch" is nothing new. The fact that the mortgage originators were willing to grant loans and get them qualified for federal guarantees allowing them to pocket their 1% fees and sell them on to investment banks, is disgraceful at best, and actually probably closer to criminal. The investment banks, accepting the guarantees at face value were happy to buy them, pool them, and sell them to investors who were also happy to take the ratings at face value and buy AAA assets cheaply.

The trouble is these AAA securities were being sold as Silk Purses-but they were made out of Sow's Ears, and sooner or later the "silk" will wear off, and all you are left with is a pig.

Tomorrow, Synthetic CDO's.