This is the structural un-sustainability of CDO securitization, irrespective of the state of the economy...
I am still puzzled with what drove new CDO buyers to enter. There hadto be something promising - or was there no profit chain, only fear of loss?
It possible that the excitement with CDOs coincided with the first problems of subprime mortgages. Someone may have figured out that a way to get rid of "junk" packages (or to mitigate a subprime fallout temporarily) was to unwrap the pyramid potential of CDOs. On the other hand, I heard that CDOs were rarely traded... Was there only a frenzy of buying new CDO items?
There is no pyramid to unravel in CDOs themselves, the pyramid is in housing. Just a debt-fueled asset bubble, and the repackaging makes it very hard to know who is hit (or hit worst, as everybody will be hurt eventually).
And it's not a subprime thing either. Supbrime just happens to be the first bubble to burst, but there is more than one bubble in the US today. Presently a large proportion of traded US corporate bonds are junk rated, and it's only the easy refi that kept them from defaulting. It will come next, in 2008, and it will be even bigger than subprime. And there will be CDOs too, and again, they are not the pyramid, they are just spaghetti on top of it ... Pierre
CDOs, which are debt instruments, are built as a pyramid. The bonds are packaged into different tranches of securities. At the bottom is the equity tranche backed by the riskier debt or loan collateral. On the top of the pyramid are the "super senior tranche" first, followed by the triple-A rated tranches. Those senior tranches are backed by investment-grade debt or high-quality loans. In between are the mezzanine tranches, which offer a bit of a mix of the pros and cons of both extremes. Naturally, the equity tranche at the bottom of the pyramid is the one with the potential highest risk and reward, which is why it offers the highest yield. The senior tranches on top of the pyramid pay the lowest yield because they are safer, being backed by higher credit-quality assets and benefiting from the "cushion" offered by the equity tranche that gets hit by losses first in the event of credit downgrades affecting the collateral. Typically hedge funds get involved in the CDO market for two main reasons. The first is to obtain returns. In such cases they act as CDO investors, buying almost always the rewarding equity tranche. The second reason will lead them to issue CDOs in order to obtain a new source of funding. In these cases they are the collateral managers, those who gather and buy the assets for the collateral pool. They obtain funds by issuing the notes sliced into the various tranches that are offered to the market. Hedge funds in such cases are no different from the corporations that issue bonds on the capital markets for their funding needs.
Typically hedge funds get involved in the CDO market for two main reasons. The first is to obtain returns. In such cases they act as CDO investors, buying almost always the rewarding equity tranche. The second reason will lead them to issue CDOs in order to obtain a new source of funding. In these cases they are the collateral managers, those who gather and buy the assets for the collateral pool. They obtain funds by issuing the notes sliced into the various tranches that are offered to the market. Hedge funds in such cases are no different from the corporations that issue bonds on the capital markets for their funding needs.
This is from Bloomberg.com, no less:
Bundling mortgages into asset-backed bonds and then agglutinating those bonds into collateralized debt obligations sliced into different flavors of risk always smacked of a sophisticated pyramid scheme. As the foundations crumble, even the apex of the CDO market is looking shaky.
This book has a big chapter on CDOs (No 20), and this chapter:
4. Liquidity, the Credit Pyramid and Market Data 4.1 Bond liquidity 4.2 The Credit Pyramid 4.3 Survey and engineered spread data 4.3.1 Survey data 4.3.2 Engineered data 4.4 Spread and rating
And here you can find some technical info about "Fortis Bank Pyramid CDO, a Euro 268mm ABS CDO". Is this an apt name for some financial product?
The following reference is more rhetorical, but still informative:
[All buyers] liked the extra yield this stuff provided and chose to ignore the dubious basis on which A credit ratings were obtained or the fact that these instruments were not traded and so could not be marked to market. They were worth what the issuers said they were worth - until they tried to sell them. The sheer scale of these ponzi activities is indicated by the fact that in the first quarter of this year alone US$251 billion worth of CDOs were issued and including US$121 billion of credit default swaps - instruments by which banks sell risk to each other.
The sheer scale of these ponzi activities is indicated by the fact that in the first quarter of this year alone US$251 billion worth of CDOs were issued and including US$121 billion of credit default swaps - instruments by which banks sell risk to each other.
The first link is wrong in its description of CDOs, BTW : the seniority of the upper tranches comes not because they are backed by safer securities, but because it is supposed they'll have to pay premiums only if all the backing debtors default, which is supposed to be very unlikely (and which may prove to be false in the case of subprime CDOs) Un roi sans divertissement est un homme plein de misères
"They were worth what the issuers said they were worth - until they tried to sell them."
A Ponzi scheme means essentially that you give the first entrants high returns with the money invested by later entrants ; this is not the scheme of CDOs at all : CDOs are insurance contracts. Un roi sans divertissement est un homme plein de misères
The lack of CDO trading was especially emphasised at the moment of BNP Paribas crisis. CDO valuation was anything but effective. Banks and hedge funds would have normally sold junk CDOs away, but they were scared reveal the real value of CDOs; and the real value of CDOs was opaque because they were rarely traded. That was the reasoning so shortly ago.
I'm guessing the first few iterations of the high-risk tranches would have posted impressive returns, and this would have been enough to persuade hedge funds to funnel money at them, starting a mini-Ponzi stampede, which would in turn have made CDOs as a whole look more attractive - especially with unrealistic risk ratings.
All it's going to take is proof that someone somewhere moved money from Tranche A to pay off a high return on Tranche B in the hope that money would come in to cover Tranche A at some point, sooner or later, and you have a classic Ponzi.
I'll be surprised if no one tried this.
And the 'real value' of anything is given by the market, anyway, in our utilitarist world. Un roi sans divertissement est un homme plein de misères
Each mortgage refinancing gave the old loan - and the CDOs covering them - immediate and safe profit, while shifting the risk to a new loan - and new CDOs.
Wall Street was probably betting on continuous refinancing. In that case subprime loans in CDOs were very attractive because they were "guaranteed" to be refinanced soon, ending all risk.
Here we see a classical element of a pyramid scheme: profit of one item is based on a generation of new items.
Exponential branching appears to be missing on the mortgage level, though typically greater size of new loans alone may be generating a commulative effect. The "slicing and dicing" routine with CDOs probably make a pyramid "complete", through a mathematical model is welcome.
Pyramid elements are floating around, and they make the CDO scheme very unstable. Like in a straight pyramid scam, looks excitingly fine until a logically unavoidable limit is met. In the CDO case, the limit is met when the real estate inflation and refinancing tricks must stop. More generally, broad economic models conspiciously lack clear acknowledgment everything of positive feedbacks, as Michael Hudson notes. We are left then with Ponzi/pyramid frazeology with every hurting runaway boom and bust.
... but the profit is not generated by the refinance of the loans ... indeed, the investment grade tranches are protected from pre-payment risk, as well as default risk.
What the refinance of the loans did was obscure the systematic risk faced by the holders of the higher return junk grade tranches. I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.
But it can be said that the profit is "in effect" generated by the refinance: the books are closed for the old loan and in parts of the related CDOs. Those parts in CDOs get a final profit margin, "at expense" of new CDO items.
Although the profit before refinance is supposed to be small (since interest is low until refinance is "forced" by high interest rates kicking in after a fixed time period), the tranching trick may give the lower CDOs higher than the nominal profit: If I understand right, the lower tranches are first to take any gain or pain. In this picture, it is the senior tranches that look like total suckers: they get meager profit in good times, and they are not really protected in bad times anyway. But I may need to learn (if I would dare) all details of CDO slicing to be sure.
