"Because We Had An Unfunded Liability To Pay Off"


Let's talk CDO's: Collateralized Debt Obligations.

Take a bunch of loans such as no-money down mortgages to people with horrible credit ratings and slice them into pieces and re-package them as CDO tranches rated from NR (not rated) all the way to AAA.

How do you turn a C credit into a AAA? In the traditional sense, you can't. But this isn't your daddy's bond world, this here is modern "financial engineering". The way you construct these faux ratings is by dedicating interest and principal payments from all of the loans first to the top rated tranche, then the second, and so on down to the "equity" tranche. Each tranche's rating, therefore, does not represent the average ratings of the obligations held by them, but depends on the expected cash flow, based on the way the tranches are built. The expectations themselves are based on historical data, i.e. if similar loan pools have shown a 5% historical default rate, then the CDO "engineer" will base his tranches on this assumption, plus a bit more as a safety factor, and the ratings agencies will do the same.

As default rates came down in the past few years, engineers could produce a greater proportion of the AAA to BBB rated tranches and less of the "toxic" equity tranche remainders, which acted as rubber bands stretching and shrinking to accommodate the higher or fewer defaults vs. the expectations.

Pause for a visit to engineering class (the "real" one, not the financial kind):

In sophomore year Statics I had a superb professor, Dr. Chang, a dour Chinese gentleman educated in Berlin who managed to combine harsh German authoritarianism with thinly disguised Chinese contempt for us "lesser" cultures. His "real life" problems went something like this: "Meeester Schmidt (he meant Smith), let'z assume vee HANG you worthless body from a noose attached to a cantilever I-beam and then vee slice your scrawny throat..vat is ze bending moment of ze beam?" Yet, this abusive Nazi had more teaching awards than he could hang in his office...I guess because his lectures were memorable, to say the least. One of the first things he taught us was:

"You may interpolate from a set of data with reasonable safety, but you will never, ever extrapolate - under penalty of death. Not the death of your own miserable selves, but of the hundreds of innocents you will kill when the bridges you design collapse. Eees that per-fe-ctly CLEAR or should I bring my dog to class next time to convince you?"

...Yawhol, Herr Doktor, wherever you may be.

You DO understand how extrapolating default experience from the recent past into the future is extremely dangerous, YESSS?? If not, you need private tutoring - probably by the prof's dog.

There is more: CDO's are not only constructed from mortgages - any debt obligation will do. How about debt to finance highly leveraged buy-outs by private equity funds? Fine. Bank loans? Great. Commercial real estate loans? Super....you get the idea. It becomes pretty clear where so much money to finance ridiculously risky lending has come from - it has been borrowed under the thinnest of the false pretenses, disguised as highly rated CDO's, often from unsuspecting pension funds and other such "professionals" who buy the said CDO's based on the boiler-plate ratings.

Why? In the words of a pension fund manager: "Because we had an unfunded liability to pay off" and we needed the extra yield. But it is not all that much extra after all the fees for the "engineers" and their salespeople are taken out - about 10 basis points (0.10%) over straight AAA bonds.

Oh, it gets worse: in order for CDO's to actually produce spreads over the equivalently rated straight bonds AND generate fat fees they are leveraged, sometimes up to 13 times the original amount raised. Anyone care to guess in which currency are (were) cheap loans available? Yes, Yen. As in carry trade.

Bring ze noose and ze cantilever beam, Meester Schmidt, you vill need ze practice.