One of the Financial Weapons of Mass Destruction
By 2002, Warren Buffett began warning that our financial system was riddled with financial weapons of mass destruction — certain forms of derivatives. No one listened. In 2016, he repeated that his concern regarding derivatives is continuing. What follows is an explanation of one of the dangerous derivatives he’s worried about, the CDO (collateralized debt obligation).
The first step in demystifying this forbidding term is to break it down:
* Collateralized means there is a lien on some property (collateral) that can be seized if the loan goes into default
* Debt obligation is an indication that it’s a loan
In other words, a collection of loans backed with liens. A mortgage is a good example of a physical asset. The lien could also be on an abstract property right: a business could pledge all its future income from its billings (assignment of accounts receivable).
The CDO concept was started in the 1980s and, when bankers were assembling it honestly, proved a satisfactory investment for decades.
A major factor of investing is always reducing risk. Here’s how the CDO initiated a new way of apportioning risks in a group of individual investments:
* The investments were stacked like the floors of a tall office building; and
* Each floor was called by the French word ‘tranche’ meaning slice and given rankings of AAA, BBB and so on.
T he tranches were not ranked in order of safety. AAA did not contain the best of the prime mortgages.
The genius in the innovation was just that, none of the investments in the pool of assets are individually rated according to safety. The AAA tranche is not composed of the mortgages held by people with the highest credit scores.
Rather, the upper floors give those investors the first right to the cash flow from the entire pool. Therefore, there’s no need to allocate according to likelihood of repayment. The assets were treated like aggregates, a heap of gravel where the characteristics of the individual items were not important.
The rest of the money collected that month would flow like a waterfall down to the lower trenches.
The assets in the pool could be diversified to include many types of debt: car loans, loans to small businesses and so on. The strength of diversity meant that if there was a downturn in one industry, there would be investments from areas where there was no downturn.
The investors who took the risk of the lowest tranches, got a higher interest-rate for assuming that risk.
About 2002 when, as noted earlier, the pool of qualifying mortgage applicants dried up, securitizing banks began using the CDO to disguise toxic mortgages in the residential mortgage backed security (RMBS). In a CDO, the creating bank did not have to evaluate individual mortgages. According to the Financial Crisis Inquiry Report (p.127), by 2004, mortgage-backed securities accounted for more than half of the collateral in CDOs.
But soon the market for the lower tranches dried up. Our ingenious bankers had to come up with a way to sell them- or at least make it appear that they were being sold so the profits would flow through to banker paychecks. We review their cunning solutions next.
Acknowledgement: Image by Myriams-Fotos on pixabay
Originally published at https://jandweir.substack.com.