CDO/CDS Part VI

Now today we should be discussing the passage of the Health Care Bill in Congress but I will leave that to tomorrow as at the same time I would like to discuss Senator Dodd's regulatory reform bill.

But first I will finish with the CDO/CDS discussion.

In the Cash as well as the Synthetic CDO there were on average 4 names which were very cheap (i.e. yielded much more than their rating would have suggested) which, because of their rating still fit the requirements to achieve the sought after AAA rating. Every financial engineer knew that; any good salesman knew that; and any investor who understood that would fall out of basket of potential clients because they would want to remove those names which would give a stronger investment, at a significantly lower yield.

The investor of choice could be convinced of the validity of the rating agencies; could be made to pay up for a AAA piece of paper; and would crash and burn with their CDO portfolios when the market turned and one or more of the "cheap names" defaulted.

It is an old adage that if something looks too good to be true it probably isn't. If a traditional AAA security like IBM yielded .15% more than the risk-free rate what did the investor buying a AAA CDO yielding .30% think they were buying? Actually the real question should have been what additional risk were they taking on to earn .15% more, and was it worth it?

Lastly, almost as an aside let's talk about AIG and their role in the Synthetic CDO debacle.

The financial engineers were so sure of their statistical analysis that they came to the conclusion that the AAA securities they were creating were so secure that they could actually slice off the top of the structure and create a part of the security called the "super-senior or super AAA". That's how they described it.

The truth was that they were carrying more risk than they wanted to and so they went around and found investors who were interested in taking on that part of the default risk that should never default. The bankers found people like AIG Financial Products and bought insurance for the top of the structure.

Think of it like this. At the bottom of the Capital Structure is the First Loss Piece. Any losses in the portfolio are first attributed to this portion. It usually makes up the first 3%. On top of this is the mezzanine slice, another ~15% and would be rated BBB normally and would take the next losses above the original 3%. On top of this is the AAA piece which would be the next ~67% and would take the next set of loss, and on top of this was the super-AAA, the top ~15% which would take the remaining losses. Strangely the bankers chose to go to people like AIG and pay them .15% to assume the risk of the super-AAA. AIG FP convinced their parent AIG that they were just providing financial insurance. They would get paid .15% on billions of dollars of financial risk which should never be realised. Sound like "something for nothing". AIG FP thought it was as if they were getting paid to insure for flood risk in the desert. Obviously the geniuses at AIG FP had never been to the desert and didn't know that what looks like a dry gully or wadi quickly becomes a death trap when there is a flash flood and that rain occurs more often than they thought and when it does, it's a real problem.

So now the credit crisis starts to bite. the "cheap" names in the portfolio start to deteriorate and so no longer fit the requirements for the AAA rating. When the bottom 3% collapses, then the bottom of the next 15% becomes the bottom of the structure, weakening the mezzanine which means that the top 15% of the super-AAA is no longer super-AAA, but rather just AAA. The flash flood has started. Suddenly names like Ford and GMAC which were part of the "good" names in the pool of 100 are no longer good and they fall outside of the guidelines etc.

Now forget the corporate names, and remember the Sub-prime structures. Same story, except that not only does the bottom 3% disappear, but the next 15% as well, and if the real estate market plunges 50%, so does the CDO. Before an investor can blink their AAA security is A, or worse. A security that was valued at 100 is now trading at 20-if you can find a buyer.

Those mortgages held by the GSE's are crushed. The first-loss pieces held by the investment banks are crushed. The providers of super-AAA insurance are crushed.

Welcome to the Credit Crisis.