The making of CDO koolaid

(Guambat is not speaking here of his childhood summer drink of choice, but of the poisonous "brand" of the recent vernacular.)

Delighted by colourful pictures, Guambat was attracted to the illustrations Barry Ritholtz extracted from a WSJ article to describe, pictographically, how CDOs based on subprime mortgages were created. You have to go to Barry's post to get the full flash treatment, but the images he put up are these:







Jumping over to the article, Wall Street Wizardry Amplified Credit Crisis by By CARRICK MOLLENKAMP and SERENA NG, Guambat gained a bit more understanding (or sense of it, anyway) as to how it was that the spread-the-risk-a-mile-wide-and-an-inch-deep theory of risk management that the recent credit boom was supposedly based on failed of its purpose when taken from the drawing board to the production floor.

From Guambat's limited mental resources, it looks like risk was sure enough spread, but greed got distilled to the point of poison. These were his take-aways from the story:

Norma [a cute name for an abnormal Collaterilized Debt Obligation - CDO] illustrates how investors and Wall Street, in their efforts to keep a lucrative market going, took a good idea too far. Created at the behest of an Illinois hedge fund looking for a tailor-made bet on subprime mortgages, the vehicle was brought into existence by Merrill Lynch & Co. and a posse of little-known partners.

A CDO, most broadly, is a device that repackages the income from a pool of bonds, derivatives or other investments. A mortgage CDO might own pieces of a hundred or more bonds, each of which contains thousands of individual mortgages. Ideally, this diversification makes investors in the CDO less vulnerable to the problems of a single borrower or security.

The top underwriter of CDOs from 2004 to mid-2007, Merrill had generated hundreds of millions of dollars in profits from assembling and then helping to distribute CDOs backed by mortgage securities. For each CDO Merrill underwrote, the investment bank earned fees of 1% to 1.50% of the deal's total size, or as much as $15 million for a typical $1 billion CDO.

To keep underwriting fees coming, Merrill recruited outside firms, called CDO managers. Merrill helped them raise funds, procure the assets for their CDOs and find investors. The managers, for their part, choose assets and later monitor the CDO's collateral, although many of the structures don't require much active management. It was an attractive proposition for many start-up firms, which could earn lucrative annual management fees.

One of the investment bank's clients, a hedge fund, wanted to invest in the riskiest piece of a certain type of CDO. Merrill worked out a general structure for the vehicle. It asked N.I.R. to manage it.

Norma was established as a company domiciled in the Cayman Islands. N.I.R., as its manager, would earn fees of some 0.1%, or about $1.5 million a year.

Norma belonged to a class of instruments known as "mezzanine" CDOs, because they invested in securities with middling credit ratings, averaging triple-B. Despite their risks, mezzanine CDOs boomed in the late stages of the credit cycle as investors reached for the higher returns they offered.

For Norma, N.I.R. assembled $1.5 billion in investments. Most were not actual securities, but derivatives linked to triple-B-rated mortgage securities. Called credit default swaps, these derivatives worked like insurance policies on subprime residential mortgage-backed securities or on the CDOs that held them.

Many investment banks favored CDOs that contained these credit-default swaps, because they didn't require the purchase of securities, a process that typically took months. With credit-default swaps, a billion-dollar CDO could be assembled in weeks.

In principle, credit-default swaps help banks and other investors pass along risks they don't want to keep. But in the case of subprime mortgages, the derivatives have magnified the effect of losses, because they allowed bankers to create an unlimited number of CDOs linked to the same mortgage-backed bonds.

In its use of newfangled derivatives, Norma contributed to a speculative market that dwarfed the value of the subprime mortgages on which it was based. It was also part of a chain of mortgage-linked investments that took stakes in one another.

Such cross-selling benefited banks, because it helped support the flow of new CDOs and underwriting fees. In fact, the bulk of the middle-rated pieces of CDOs underwritten by Merrill were purchased by other CDOs that the investment bank arranged, according to people familiar with the matter. Each CDO sold some of its riskier slices to the next CDO, which then sold its own slices to the next deal, and so on.

But the system works only if the securities in the CDO are uncorrelated -- that is, if they are unlikely to go bad all at once. Corporate bonds, for example, tend to have low correlation because the companies that issue them operate in different industries, which typically don't get into trouble simultaneously.

Mortgage securities, by contrast, have turned out to be very similar to one another.

Most importantly, though, Norma offered high returns: On a riskier triple-B slice, Norma said it would pay investors 5.5 percentage points above the interest rate at which banks lend to each other, known as the London interbank offered rate, or Libor. At the time, that translated into a yield of over 10% on the security -- compared with roughly 6% on triple-B corporate bonds.

Beyond that, rating firms say they had reason to believe that the securities wouldn't all go bad at once as the housing market soured.... all three rating companies gave slices comprising 75% of the CDO's total value their highest, triple-A rating -- implying they had as little risk as Treasury bonds of the U.S. government.

Ratings companies say their March opinions represented their best read at the time, and called the subprime deterioration unprecedented and unexpectedly rapid.

Guambat recommends you read the whole story, if you can, because it is full of the personalized touches, anecdotes and characters that WSJ stories do so well.

Guambat has no experience in the credit industry and only knows what he's read here and there. But even Guambat noticed some time ago that this credit swapping derivative Frankenstein was up to little good as he blogged on about Credit Default Swaps, CPDOs and other creatures from the black backroom.

Guambat reckons that the credit crunch is not so much the result of poisonous risk (such as the poor schleps stretching for a subprime piece of the American Dream who are blamed for this mess) as it is about the fee-for-all stampede of the bulls of greed who ply their trade on Wall Street.

Guambat offers this bit of pictograph to illustrate the matter: