Just Say AAA
What do you get when you cross a Mafia don with a bond salesman? A dealer in collateralized debt obligations (C.D.O.’s) — someone who makes you an offer you don’t understand.What you see is not what you get or Enron redux.
Seriously, it’s starting to look as if C.D.O.’s were to this decade’s housing bubble what Enron-style accounting was to the stock bubble of the 1990s. Both made investors think they were getting a much better deal than they really were. And the new scandal raises two obvious questions: Why were the bond-rating agencies taken in (again), and where were the regulators?
To understand the fuss over C.D.O.’s, you first have to realize that in the later stages of the great 2000-2005 housing boom, banks were making a lot of dubious loans. In particular, there was an explosion of subprime lending — home loans offered to people who wouldn’t normally have been considered qualified borrowers.Like Enron before it the bond rating agencies gave these bonds AAA ratings giving investors a false sense of security.
For a while, the risks of subprime loans were masked by the housing bubble itself: as long as prices kept going up, troubled borrowers could raise more cash by borrowing against their rising home equity. But once the bubble burst — and the housing bust is turning out to be every bit as nasty as the pessimists predicted — many of these loans were bound to go bad.
Yet the banks making the loans weren’t stupid: they passed the buck to other people. Subprime mortgages and other risky loans were securitized — that is, banks issued bonds backed by home loans, in effect handing off the risk to the bond buyers.
In principle, securitization should reduce risk: even if a particular loan goes bad, the loss is spread among many investors, none of whom takes a major hit. But with the collapse of the $800 billion market in bonds backed by subprime mortgages — the price of a basket of these bonds has lost almost 40 percent of its value since January — it’s now clear that many investors who bought these securities didn’t realize what they were getting into.
And it’s also becoming clear that in addition to failing to appreciate the risks of subprime loans, many investors were fooled by fancy financial engineering — those collateralized debt obligations — into believing they had protected themselves against risk, when they had actually done no such thing.
The details of C.D.O.’s are complicated, but basically they’re supposed to transfer most of the risk of bad loans to a small group of sophisticated investors, who are compensated for that risk with a high rate of return, while leaving other investors with a “synthetic” asset that is, well, safe as houses.But we shouldn't just blame the bond agencies, the Federal Reserve should have known what was going on. In fact they probably did but chose to do nothing because politically connected people were making lots of money and the sub prime market was the smoke and mirrors that made the Bush economy look like something it wasn't - a success.
S.& P., Moody’s and Fitch, the bond-rating agencies, have gone along with the premise, telling investors that the synthetic assets created by C.D.O.’s are equivalent to high-quality corporate bonds. And investors have, in the words of a recent Bloomberg story, “snapped up” these securities “because they typically yield more than bonds with the same credit ratings.”
But the securities were never as safe as advertised, because the risk transfer wasn’t anywhere near big enough to protect investors from the consequences of a burst housing bubble. It’s not quite the metaphor I would have come up with, but here’s what the legendary bond investor Bill Gross had to say about C.D.O.’s in Pimco’s latest “Investment Outlook”:
“AAA? You were wooed Mr. Moody’s and Mr. Poor’s by the makeup, those six-inch hooker heels, and a ‘tramp stamp.’ Many of these good-looking girls are not high-class assets worth 100 cents on the dollar.”
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