Thursday, December 17, 2009

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.

12 comments:

  1. what was the typical profit margin on these CLOs? how much did Potter net after selling the CLO to investors?

    ReplyDelete
  2. Maybe they should make a movie about this.

    That's right, reality does not sell well, lets stick to fantasies.

    Thanks FDR and Happy Birthday to a Man who stood up against tyranny.

    ReplyDelete
  3. Good simple explanation of the CDO scam.

    Making money on the way up then even more money on the way down. Taxpayer subsidized to boot.

    Meanwhile you bankrupt all the government entities then buy up their assets on the cheap too.

    True bankster style.

    ReplyDelete
  4. So the banksters are set for a whole new round of profits on the backs of home-owners and taxpayers?

    Is this the take-home message FDR? Don't bet against the banksters?

    ReplyDelete
  5. "Is this the take-home message FDR? Don't bet against the banksters?"

    Unfortunately, it is. Short what they are shorting, inflated paper notes of all sorts.

    ReplyDelete
  6. FDR, Im in Tulsa oklahoma and here is some headlines in my Newspaper for JUST TODAY!!!:

    1.Official: Up to 135 Tulsa officers could be laid off.
    Up to 120 firefighters could lose their jobs, and some stations might close as part of budget cuts.

    2. 1,000 apply for 50 jobs(at new grocery store)

    3.At least six state agencies are preparing to furlough employees after state officials ordered 10 percent budget cuts across all state agencies.

    Question: Then, I look at the stock market and its OVER 10,000!! I just dont get it????? What im i missing???? I know a few might not want to take there money out of a 401k because you get penalty taxes if you draw your money out before 59 1/2 But still I cant figure out why the markey has'nt dropped like a rock???
    Is there any way the market can keep defying logic like it has and keep rising or is the big fall coming? Would you say you are 70 percent? 80 percent? 90 percent? sure the market will fall before the end of next year?
    Thanks,
    Magnumpi28

    ReplyDelete
  7. "Is there any way the market can keep defying logic like it has and keep rising or is the big fall coming?"

    It's interesting how markets tend to give us the opposite reaction to what is actually occurring. The market is down 40% in two years. That's no small slide.

    The deflation firmly in control of all markets will only accelerate over the next few years. My forecasts are published below.

    ReplyDelete
  8. I am watching the behaviour of the precious metals complex with some interest. After the recent almost unabated rise from $900 to $1200 the "consolidation" or "pause" of the past several weeks seems to have subtly altered the gold market psychology. Someone felt 1221 was a good level to take a not insignificant number of chips off the table. Others say 1100 is now an attractive entry or re-entry point. Although the bullish hyperbole has barely taken a breath the market (so far) appears to be lacking conviction. How fast will many new gold bugs lose interest or faith in a flat, churning or heaven forfend falling market given the craving for instant gratification among the speculating classes?

    ReplyDelete
  9. FDR,I know this is a long list of comments at the link below,but I believe it is the best explanition that I have seen about what the Fed is trying to do pretaining to the stock market and Treasuries.Everything adds up after reading all the comments below this artical.Your comments on this would be appreciated,and everyone here would benifit from reading this also. Artical dated 12/17/2009 www.zerohedge.com/article/dark-gray-swan-no-more-foreign-dollars-which-buy-us-treasuries Thanks for keeping us informed !

    ReplyDelete
  10. Hello FDR,

    Kudos for this superb writing on CDOs. It is extremely clear and easy to understand.

    I was mulling over some of the info that you presented, and I was wondering some things:

    * Would something like this had happened if these less than prime mortgages had NOT been securitized and sold as CDOs to naive, unexperienced and unsuspected parties?

    In other words, would something like this be currently happening if all of these mortgages had stayed as regular loans at "normal" commercial banks like JPM, C, & BAC??

    Thanks.

    ReplyDelete
  11. So as far as stocks go, does anyone want to try and guess what markets will crash the fastest for a short position?

    This rally has all of the characteristics of a B wave (low volume) which would mean that the really nasty C wave is around the corner.

    Now I read that they passed an agreement in Copenhagen where "emerging" countries would somehow cut back on their "pollution," and OUR government will subsidize them! The money would go to funding growth in their countries' technology industries. So not only are they giving them OUR future money, they are also going give MORE jobs to other countries (on our dime). unbelievable
    -OB

    ReplyDelete
  12. FDR, I might have read somewhere in one of your blogs but how are you going short on gold?

    ReplyDelete

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On Nov 2, 2010, I plan to vote (FOR or AGAINST) my incumbent congressman

 
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