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CDO Insiders: "We Knew We Were Buying Time Bombs"

Here's an email I received late yesterday from a friend, "R," who was in the CDO business from way back when to right through the past few years.

"R" writes:

"I've been paying attention to your macro economic call lately and you're right on.  Three anecdotal stories for you that you can use on Kudlow.  (PLEASE don't mention my name).

1. XXXXXX and I were talking in 2003 about how shaky these low FICO, high LTV, 2/28 ARM's that were being created were. People in the know knew then those loan products were going to be a problem in the future. Way back in 2003, it didn't make sense.

2. In early '05, XXXXXX tried to hook me up with a HF he knew that wanted to play the CDO issuer game. I talked to the guy and told him that at the risk of talking them out of hiring me, I wouldn't do it. I thought that game was topped-out even back then. A bit early, but perhaps the right call.

3. I was talking to CDO managers in mid-'05 that were saying how rich sub-prime MBS was and how wrong everyone was for buying that stuff at the spreads they were. To a man, they all agreed they were paying too much for the risk, they all believed that HPA [ED: home price appreciation] was going negative soon. But, sadly, they had to buy the stuff because they needed to accumulate collateral for their CDO issuance. Fuck, we all knew we were overpaying, even back in 2005. We knew it was essentially a bet that home price appreciation was going to continue at levels that couldn't be sustained. No way that could keep going on.

Everyone was saying the same thing: Home pricing cannot continue appreciating at the same rate, and the second this thing turns, we are FUCKED.

Is it really any surprise to anyone that the mortgage business got too far ahead of itself?  To me, the only surprise has been it took so long for all of this to happen."

So what was the prime motivating factor?:

"The answer is quite simple: DEAL FEES. I gotta keep buying collateral, in order to keep issuing these transactions as a CDO manager. Its my job: I gotta keep accumulating collateral, and I gotta issue the liability against that collateral.

In 2005, we all said "I hate the real estate market, I hate the credit spread, but my job is to keep doing this: Buying Collateral and issuing CDOs. Everyone was the buying this shit to do any deal. The greed went thru the whole chain, from the home owner buying a property they couldn't afford right up to the CDO manager buying subprime paper."

Why did these managers keep buying this bad junk?:

"Well, nothing is "bad junk" -- it's just priced wrong. No one believed the under-performance of these MBS loan pools would ever be so severe. Everyone knew in the back of their minds that the possibility existed, as did the possibility that residential real estate prices would move LOWER someday.

But no one wanted to be the first to acknowledge it fearing that they'd miss the opportunity to participate in big fees, big alpha, etc. . . ."

Thanks, R. Great insight from inside the belly of the beast.

>

UPDATE: August 24, 2007 3:49pm

R asked me to add the following:

"I hate the fact that I'm getting pulled into this, but I'm seeing the need to clear a few things up. 

1. To Fred or MS, I "had a spine" by walking away from an opportunity to start up a CDO management business at an established hedge fund company in '05.  Everyone was going the same way on that trade, the collateral sucked, and HPA was maxing out.  What I told Barry about were my observations from daily interactions with buyers of sub-pime HEL's as collateral for their CDO transactions.  My role then was on the sell-side.  Minds far smarter than mine were eager to accumulate this collateral.  Fraud?  Nothing fraudulent at this stage of the proccess.  If there was fraud, reading an offering memorandum and monthly remittance reports cover to cover or spending hours of cash flow modelling on Intex wouldn't have shown it.  Oh, and where was the fraud?  My opinion; mortgage brokers possibly lying about and jamming loans into the wrong people to get fees from the lenders.  My view on the relative value of sub-prime HEL's during this time period was not nearly as upbeat as others in a world where EVERYONE else was a buyer. 

2. Eclectic, it's not quite as disgusting as you might think.  Everyone knew the bet they were making; a combination of HPA and continued positive loan performance would continue sans interruption.  It was a market call, similar in concept to the market calls most of you reading this make each day in your chosen financial markets and products.  It was a bet that the collateral was going to continue doing what it was supposed to.  It's a bit annoying when the "talking heads" claim that institutional investors and HF's buying these products don't know what they own.  Bullshit.  They know.  They own a bet on Average Joe's house staying equal or going up in value and his continued ability to make his loan payments. 

3. Stuart got it right, unfortunately.  In a capitalist society, one sells what people want.  And they wanted sub-prime HEL's with HUGE credit spreads such that the arbitrage was bigger.  How is that huge credit spead possible?  Lower quality loans; low FICO's, low LTV's.

Thanks Barry.  I really want these folks to read this extra detail in an effort to clear up mis-understanding."

Friday, August 24, 2007 | 06:00 AM | Permalink | Comments (73) | TrackBack (1)
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Comments

eichmann used the same defence
rgds pcm

Posted by: peter from oz | Aug 24, 2007 6:32:27 AM

Human psychological momentum...

It's when willfulness serves merely as a subconscious substitute for the analysis that might or might not support rational optimism.
--
As my readers know, I content that both optimism and pessimism can arise from willfulness. Optimism or pessimism in turn may be justified, and can both arise from rational analysis of fact, but neither one, when directed by willfulness alone, ever can.

Posted by: Eclectic | Aug 24, 2007 7:07:33 AM

Disgusting.

"Its my job: I gotta keep accumulating collateral, and I gotta issue the liability against that collateral."

Get another job then.

Posted by: T | Aug 24, 2007 7:20:07 AM

Barry thank you for providing us with these insights from folks in the trenches, as well as your own commentary on this Blog. Where you find the time to do all you do is nothing short of amazing. Once again a big THANKS!

Posted by: SPECTRE of Deflation | Aug 24, 2007 7:27:09 AM

So why the f-- is the government trying to bail out behavior that was known to be sheer stupidity????

Posted by: ari5000 | Aug 24, 2007 7:54:06 AM

"Money, so they say, is the root of all evil today..." Pink Floyd

The Blame Game, has just begun. Really folks, 99% of us would have stayed in the cdo queue. What? Stop smoking those expensive cigars, are you crazy...

Posted by: Justin | Aug 24, 2007 7:56:34 AM

Maybe the time bomb is going to blow up sooner than we think. Has anyone seen this?

http://market-ticker.denninger.net/2007/08/whitewater-wednesday.html

About half way down the page there is a black chart, it starts a story about 1 billion or so dollars worth of SPY covered calls that were made a day or two ago. Barry, sorry in advance if we are not allowed to post links to other sites on your blog.

Posted by: Inferno | Aug 24, 2007 8:06:10 AM

Just like the greedy hedge fund managers motivated by their commission models, all chasing yield and pushing the envelope further and further. All the same. Those 2/20, 2/40, 4/50% commissions MUST change. They are as a single source, one of the primary culprits for he mess we're in.

Posted by: Stuart | Aug 24, 2007 8:08:03 AM

Hey ! I can see the bottom ! It's WAY down there !

Posted by: Douglas Watts | Aug 24, 2007 8:26:41 AM

Is this any different than the real estate brokers / mortgage brokers / NRA / homebuilders etc? They've taken a lot of heat (and rightfully so!) on this site and others. The CDO markets and their enablers should get more stick, just to be fair - Wall Street is just as crazy as Main Street, but more sophisticated about the mechanisms.

But it comes down to the same thing: it's pointless to blame the people selling something for selling. If other people are buying it, they'll keep making more of it. Caveat emptor and all that. And although shorting technologies have improved, it is still easier to be right than it is to remain solvent in the face of irrationality.

The hysterical thing about the 'financial innovation' spin Greenspam and others put on it is this: the CDOs and other variants provide a way to break the usual laws of supply and demand. Here's the innovation: it turns out you can keep reselling the same sausage! (Get more casings!)

But the rules of supply and demand for derivatives eventually break down when the underlying asset markets do.

Posted by: Greg | Aug 24, 2007 8:28:20 AM

Officer, the invisible hand made me do it !

Posted by: Douglas Watts | Aug 24, 2007 8:30:04 AM

Has anyone seen this? . . . SPY covered calls . . .

Inferno, don't know if you looked at the thead on the associated forum, but it appears difficult to support any conclusions regarding the meaning of that trade (or even if was actual rather than an error) based on the limited amount of data available.

Posted by: wyler | Aug 24, 2007 8:37:44 AM

Am I the only one who sees this whole subprime phenomenon as the "helicopter in disguise"?

As I see it, the Fed has needed to battle deflation by creating inflation.

Rather than spill cash out into the streets by helicopter, where all the folks - both good and bad - get a shot at scooping it up, the Fed spills out credit to a lot of scammers and fraudsters via the mortgage market.

With this scheme, they undercut deflation in three ways: getting liquidity "out there", producing a "wealth effect" of rising RE values, and they lower unemployment in the finance and construction industries. Not bad.

The next step in the "helicopter" scheme is to accept the paper at the Discount Window i return for cash. Thus voila!, the helicopter without the helicopter.

Posted by: jeff clark | Aug 24, 2007 8:38:15 AM

Barry love the site. Can someone please explain what "credit spread" means, I am asuming it is not the same as bid/ask spread?

Posted by: costa | Aug 24, 2007 8:40:32 AM

Costa - there'll be better & more technical answers but basically it's the difference between the interest rate on the CDO or underlying collateral and a lower-risk instrument. So if you're buying junk to make up your CDO and paying a high price (= low interest rate) you AREN'T being compensated for that risk. BUT, as Barry's very interesting post shows, the market got wrapped up in speculative fever where the goal was to make the next deal not to price it correctly. BtW - let's suppose this is not just sub-prime but ALL the various assets that were turned into structured debt products. That part about sub-prime being only 2% of the total mortgage market goes away and then we get to all the other stuff that was based on bonds, buyouts, etc. etc. We've seen the tip of the first iceberg.

Posted by: dblwyo | Aug 24, 2007 8:51:20 AM

"Great insight"???

That's like getting a description of the workings of a concentration camp from a guard and complimenting him for his accurate description of the atrocities committed there.

When they realized what was happening, why not come up with a product that actually had value?

Wall Street is a complete, unproductive joke and essentially a 10% tax on the financial system, it's basically legal graft.

Any business remotely involved in the deal making there just needs to be taxed at some very high rate, 50%+.

Posted by: Bob_in_ma | Aug 24, 2007 8:53:46 AM

Short term gain outweighs long term risk for these guys. Unless they were to be held personally liable, there's no downside to taking a risk with other people's money. The worst that happens is you get fired or your firm goes under. Meanwhile, every year your bets pay off you're banking a huge wad of cash from your bonus.

Posted by: Royce | Aug 24, 2007 8:58:21 AM

that's the thing...success was predicated on a continuing appreciation of home prices...

Posted by: SINGER | Aug 24, 2007 9:07:12 AM

OT: I eagerly await your spin on the Durable Goods blowout numbers.

July Durable Goods Orders...rose 5.9%...vs. street at 1.0% (prior revised to 1.9% from 1.4%)

July Durables Less Transportation...rose 3.7%...vs. street at 0.6% (prior revised to -1.2% from -0.5%)

Posted by: Fred | Aug 24, 2007 9:25:57 AM

guns and butter

replaced by

guns and boeing.

Posted by: Stuart | Aug 24, 2007 9:32:10 AM

Sure thing, Fred:

July Durable Goods orders rose a huge 5.9% headline vs the consensus of 1%.

They were up 3.7% ex-transports vs. the expected gain of .6%. (That's big)

The ex-transports gains were led by computers, electronics (led by semi's), machinery, primary and fabricated metals; Auto production ramped up in June and July and the peripheral industries benefited from this and it is not excluded in the ex-transport #.

With this said, Non Defense Capital Goods ex Aircraft -- you know, PURE CAPITAL SPENDING component, rose just 0.5% after a 0.8% decline in June. I would call that evidence of a still sluggish Capex spending corporate sector.

As much as we can pull apart those numbers, the bottom line is this data is old news. Those orders took place in a much different credit market world than we live in now. The cost of financing new projects and spending plans is now higher and thus the return on investment hurdles are greater.

(Hey, you asked!)

Posted by: Barry Ritholtz | Aug 24, 2007 10:00:37 AM

Thanks Barry. I do appreciate that.

I have noticed a modest pick up in business capex forecasts (TECD, HPQ, CSCO) on top of the large telcom spending plans.

Thanks for acknowledging this shred of positive data.

BTW....have you ever seen estimates of the savings to consumers with a 75 bps cut in the Prime Rate (helos, ARMS, etc)?

I imagine it is not mice nuts.

Posted by: Fred | Aug 24, 2007 10:07:13 AM

Damn BR beat me to it......LOL

After a two week break to sun himself (with Angelo-of CFC "fame") Hank Paulsen fires up the presses again with what he has deemed "excess tax receipts" (how can we be running a deficit when we have had over $84 Billion in excess tax receipts just laying around since July 24th??)

Here is the latest installment of find the fish, I mean money.......

http://fms.treas.gov/tip/auctions/tio-announcement-359-08242007.pdf

"only" 3 billion today and Ben has been quiet so far today.

And to "R".....I've worked in companies that I have uncovered massive fraud and reported them. Have a fucking spine...I'm sure your paycheck was "augmented" by the fact you participated but now have a moral quandry about it??......You know George Tenet wrote a book.......

Ciao
MS

Posted by: michael schumacher | Aug 24, 2007 10:13:07 AM

As an aside, isn't parsing back all these layers of spending similar to your inflation views -- inflation is inflation , as spending is spending??

Can you have the manicured numbers both ways? (don't include food and energy, and don't include defence and aircraft?)

Just asking.

~~~

BR: Yes and no. But if you want to know what the organic corporate CapEx is, you have to pull out a few things: the government Defense spending (since they can spend anything anytime) and Aircraft orders, as they are also an odd duck, non-correlated to the rest of capital spending.

Posted by: Fred | Aug 24, 2007 10:13:16 AM

>> Short term gain outweighs long term risk for these guys. Unless they were to be held personally liable, there's no downside to taking a risk with other people's money.

Here's another phrase to describe Wall Street behavior: "public risk, private profits".

Usually, the investors know less than the money managers. For example, in the case of pension funds investing in hedge funds, the ultimate bag holder is the eventual pensioneer, who has no idea that s/he is investing in CDO's and, even if s/he knew, wouldn't be able to stop it.

So, "public risk, private profits".

Hmmm....However, when the money manager doesn't just view the risk as "risk" but as an eventual calamity, then, that phrase is too nice. It's not just a shifting of "risk". The money managers are making what they believe to be bad investments. They're breaching any fiduciary duties and probably committing fraud.

It's the Smartest Guys in the Room without the "F--- Grandma Millie" talk.

Posted by: wunsacon | Aug 24, 2007 10:19:32 AM

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