The CDOs that Disappeared

Not much talk about CDOs these days. Guess we're all glad that's over, right?

Wrong. Oh, how wrong.

The CDO debacle is quietly devastating our real estate market. How? Well, the story goes something like this...

Mr. Potter (I'm in the Christmas spirit) wanted to turn the quaint, snow-covered town of Bedford Falls into a profitable slum called Pottersville. So, he decided to offer every resident a low interest rate home loan they couldn't refuse. Not just the well employed, everyone.

To make money off the un-and-under-employed, he needed a special lending program (don't call it a scheme). So he invented one. He would pool and "securitize" their mortgages. His reasoning was clever, after all, there are strength in numbers. If he grouped a bunch of high risk borrowers into a pool, he could improve the creditworthiness of the whole lot.

Yes, yes, he knows it's a scam. Don't bother him now, he's thinking!

"Let's see," the old man grumbles, "If I pool Uncle Billy with that Sam Wainwright character and old Mr. Gower, we'll, surely, at least one of them will pay me back. Hmmmm, did I just say... surely? Eureka!! I'm rich! I just created AAA paper from a suicidal, drunk old man. I must be brilliant. I'm going to give myself a raise in the morning."

Potter invented the CDO. In doing so, he spun AAA credit from a bunch of junk-quality borrowers, like this: Potter's securities get diced into tranches, one rated AAA, one BBB, and one CCC. An investor purchasing the AAA Tranche of the Pottersville CDO gets the right to hold the last mortgage to default, it might be Billy, or Sam, or Mr. Gower. The BBB investor paid Mr. Potter less, and owns half of the last two performing mortgages. The CCC buyer paid Potter the least, but gets no mortgage cash flow if only one mortgage goes bust. Alchemy at work.

So, what's the problem? Let's count them:

Problem 1) The CDO "securities" trade on the open market and the collective market is smart, not dumb like the original investor.

2) As soon as Billy defaults (we all knew he would), the CCC buyer gets knocked out. That security becomes worthless, it sells for say, 2 cents on the dollar (a pretty realistic figure right now). The problem with Problem #2 is Problem #1. The market is smart enough to know that the AAA tranche also has turned into BBB. And shucks, that BBB paper now sells like it is CCC. Even though the AAA & BBB buyers haven't lost interest cash flow (yet) the price of their paper has plummeted.

3) Impeccably dressed bond insurers have a bigger problem: they charged a rather low premium to insure AAA paper, paper, that is now BBB with an AAA stamp on top. They look the other way. Maybe their problem will go away? It has to go away. That rock solid "insured AAA" paper is backing their pension fund.

4) The CDO remains obligated to pay all three investors. How are they going to manage that? Simple, raise variable mortgage rates on the performing loans. Ooops, after doubling his monthly payment, looks like we lost Mr. Gower to foreclosure. Darn it. Guess that AAA-stamped security is junk too (always was). Hey wait a minute... I know, let's triple Sam's payment and it's all fixed! HOT dog!

As crazy as those problems sound, they're nothing compared to Mr. Potter's grand scheme, a scheme never shared with the dupes who bought his toxic yellow sludge. Potter still has the money they paid him. And Henry Potter just decided something, it's time to buy.

Mr. Potter buys 2/3rds of the mortgages back for oh, 7 cents on the dollar. He leaves the "AAA" sludge for some other sucker, still priced at 42 cents/$1 it's way too high. Potter knows Sam is struggling. He's gonna put the screws to Sam in a minute.

Potter puts his lot of foreclosures up for sale. How does he price them? To sell, of course. As Potter sells off, home prices in Pottersville plunge. And finally, the stress on Sam is too much, he goes under. Potter buys up every house in the town for pennies, then puts them back up for sale.

At least there is one good thing: the CDO debacle is over. They've all been sold off, the losses are booked. Nightmare over.

Or... is it?

Mr. Potter still has homes to sell. Yes, he's ruined Bedford Falls, but he doesn't care. He only has $7,000 in Billy's modest $100,0000 house, now priced to move at $39,000. He's got $14,000 in Sam's $200,000 four bedroom, slap a $59,000 sign on that one. You see, old Mr. Potter can sell at unbelievably low prices and still make a killing.

That's what happens to CDOs that disappear.