[Vision2020] CDOs: The Root of the Problem

[Andreas Schou]

I've heard CDOs -- the main sort of security that's the problem here
-- described as "too complex for even Wall Street to understand." But,
actually, after looking into it, it's not terrifically hard to
understand *what* they are, though it's not so obvious *how they
work*. Everybody's talking about them, so I thought I'd do two things
(a) share my understanding of them, and (b) get beat by people
better-informed than myself for being wrong.

In order to construct a CDO, a bank starts with a number of mortgages,
both prime and subprime. These mortgages are pooled together, a simple
way to spread the risk out across the entire security. Next, the pool
is split, with every share of the CDO representing a fraction of both
prime and subprime mortgages.

The pool is then sold in multiple forms: a highly rated bond, a less
rated bond, and an unrated bond. If losses occur, they are assigned
from the bottom up: the unrated bond takes losses first, then the less
secure bond, and then finally the highly-rated bond. The existence of
the low-rated bonds serves to buffer the highly-rated bond against
potential dips in the housing market; they soak up the losses before
they hit the highly rated bond.

As the mortgage crisis progressed, the losses to CDOs slowly climbed
the ladder. The unrated bonds ate tremendous losses as subprime
mortgages began to default, then the low-rated bonds, and then the
highly-rated bonds. Unlike mortgage-backed securities backed solely by
prime mortgages, however, the highly-rated structured CDOs weren't
entirely isolated from the subprime crisis: they were still
collateralized out of a pool containing subprime mortgages. This sent
the financial services sector into a frenzied game of musical chairs
where no one wanted to be the last person to have CDOs on their
balance sheet. Everyone wants to sell. No one wants to buy. Worse,
since the subprime collateralization of the assets has collapsed, no
one is sure how much of the asset underlying the securities (the
mortgages comprising the pool) remains.

Which means that those assets are utterly worthless until either (a)
maturity or (b) until Wall Street establishes some plan for rationally
valuing those assets.

Because the Bernanke/Paulson plan proposes to purchase the CDOs at
close to maturity value rather than by reverse auction, it represents
a socialization of tremendous Wall Street losses. The reason that no
one on Wall Street wants CDOs anymore is that much of the property
collateralizing the securities is no longer attached to the CDO: the
owners have defaulted. This reduces the underlying maturity value of
the assets, especially if the government plans to purchase unrated
bonds structured to absorb losses for the AAA-rated 'straw-into-gold'
bonds.

Does anyone actually want to defend this?

-- ACS