naked capitalism

By Tom Adams, an attorney and former monoline executive

One of the ongoing myths of the financial crisis is that investor demand was what motivated the creation of so many bad securities. Banks, journalists and academics have all described the period prior to the crisis as a period of “insatiable investor demand” for things like subprime mortgages and CDOs. According to the conventional wisdom as retold by Michael Lewis and countless others, this mania-level investor demand is what caused banks and lenders to bundle up mortgage loans and related bonds as fast as they could.

As Yves Smith has noted on a number of occasions, the notion of “insatiable investor demand” is nonsense. Real cash investors were not the ones demanding more subprime loans and the bonds that they got packaged into. The demand was artificial and a form of Ponzi scheme. It came, overwhelmingly, from CDOs.

CDOs were transactions that bought up low rated tranches from mortgage backed securities. Issuers and bankers of mortgage backed securities came to rely on CDOs as the buyer of the low rated MBS bonds almost exclusively by 2006. As soon as the mortgage bonds were assembled, they knew with certainty that a CDO would buy them because the purchase had been lined up, frequently with companies or units effectively controlled by the lead investment bank, even before the loans were made. The issuance of a CDO was a great money making scheme for the banks, adding further to the demand for MBS bonds, because they would finance the MBS that were intended for the upcoming CDO in warehouse lines with the CDO manager. Creating CDOs for the purpose of buying mortgage bonds was an essential part of the banker toolkit in this era.

Even if the mortgage bonds were being sold in faux transactions to captive or friendly “buyers” in the form of CDOs, one would think that at least the market would determine the price of the CDOs when they were sold. In this way, presumably, the cold light of reality would trickle through to the underlying mortgage bonds and mortgage loans. However, if you thought this, you would be wrong.

Real cash investors were not demanding CDO bonds, no matter what the price. In fact, a significant amount of demand for CDO bonds (especially lower rated and hard to sell CDO bonds) came from other CDOs. A substantial portion of the collateral in so called high grade (amazing name, isn’t it?) CDOs was recently issued CDO bonds from other transactions. Many of these deals had up to 40% of mini CDO squareds. So-called mezzanine CDOs (the sort that consisted heavily of BBB rated tranches) generally contained 10% of other, low rated CDo tranches.

In addition, an even bigger portion of the so-called insatiable investor demand came from the banks themselves who had been tasked with selling the bonds. In particular, banks such as UBS, other European banks, and Citigroup, devised a strategy to purchase for themselves the senior most AAA rated portions of the CDOs. They claim that this was an attractive investment strategy. It was also useful as a way of continuing to feed the machine with “buying” for more subprime mortgage bonds.

The only CDO “investor” group that was somewhat independent of the CDO sausage-making factory was correlation traders, who constructed trades that approximated being long one CDO tranche and short another. These buyers were credit-indifferent and most suffered sizeable losses.

Without the demand from other CDOs and banks buying their own CDOs, the insatiable investor demand for subprime bonds would have vanished. The people at the tops of these institutions were in a position to know this but they either ignored it, because the fees from keeping the dance going were too great, or they were too foolish to realize it.

Thus, the myth of investor demand is exposed as nothing more than a fabrication to provide cover for the irresponsible behavior of the bankers.

More and more evidence is surfacing that proves out this story. For example, the Financial Crisis Inquiry Commission elicited some gems last week. At the end of this article from Bloomberg, Nestor Dominguez, the former co-head of Citigroup’s CDO business, is quoted as saying that he continues to believe CDOs provided a valuable service in meeting investor demand for the product. But just a few lines earlier in the article he admits that Citigroup itself was a huge buyer of CDOs, responsible for a good portion of their bailout needs, and thus a major contributor to non arms length “demand” for otherwise unnecessary bonds.

Yesterday, Bloomberg provided further compelling evidence of where the “demand” for CDOs, came from: Citigroup’s liquidity puts. According to the Bloomberg story, the Financial Crisis Inquiry Commission may be making the case that Citigroup used $14 billion worth of liquidity puts to aid in the purchase of CDOs by Citigroup sponsored commercial paper programs. Basically, Citigroup “sold” the CDOs to investors in the commercial paper but, because investors likely balked at the risk in the CDOs, Citigroup provided liquidity puts to the investors. These puts allowed investors to “put” the bonds back to Citigroup if they declined substantially in value. Which they did, causing Citigroup to buy back about $25 billion of CDOs at about a third of their face value.

Why did Citigroup provide these liquidity puts for the CDOs? To help get the bonds sold in a market that would have otherwise been saturated and unwilling to buy any more of the CDOs.

Prior to 2006, AIG and the bond insurers provided guarantees on a large portion of the AAA rated CDO bonds backed by MBS. This insurance helped investors get comfortable with the credit risk in CDOs (we all know how that turned out for AIG and the other insurers). Based on calculations I’ve made from publicly available transaction data, over 65% of the mortgage related CDOs issued between 2003 and 2005 had insurance provided on the senior bonds by AIG and the bond insurers. By 2007, thanks to AIG’s pull back from the CDO market and the size limitations of the bond insurers, this percentage fell to approximately 25%. Citigroup’s liquidity puts were basically a form of bond insurance and thus a way to give investors comfort that they didn’t have to worry about credit. By “selling” the CDOs to the commercial paper programs, subject to a liquidity put, Citigroup completely fabricated demand for CDOs or, to put it another way, became the insurer in AIG’s absence.

The fact that fewer and fewer CDO deals were being insured should have been a sign to Citigroup that people were no longer comfortable with the credit risk of the bonds. Instead, Citigroup and other banks continued to ramp up the volume by “insuring” it themselves. Citigroup, which was one of the largest issuers of asset backed commercial paper, was probably one of the worst offenders for this tactic (hence their massive bailout by the government) but other banks, such as UBS, Calyon, Societe Generale and others, likely used similar tactics.

The reason Citigroup and others were so eager to keep the CDO machine going (and growing) was because the deals were so lucrative for the bank management and its employees. The fees in the CDO business were among the highest in banking and there were all sorts of additional ways of generating fees and income using the CDO technology and regulatory arbitrage. So the bankers were highly motivated to find creative ways to find new “buyers” for CDOs so they could reap huge personal rewards – even mid-level CDO bank staffers were lavished with seven figure compensation packages and the top brass made multiples of that. Of course, it’s easy to make money if you assume that the underlying deals have no credit risk.

Citigroup officials continued to insist last week that they were meeting the insatiable demand of investors when they created more CDOs. Various industry apologists continue to perpetuate the myth of the exuberant buyer of CDOs, mortgage backed securities and sub-prime mortgage loans. In truth, by 2006, there were virtually no natural buyers for CDOs. This “demand” was a complete farce and if the demand for the CDOs was a farce, then the demand for risky MBS and the mortgage loans was a farce too.

The CDO bankers at Citigroup (and the other banks) who pushed their deals into the commercial paper programs, while calling it a “sale”, the bank managers who misreported these risks to the regulators and accountants, and the government officials who fueled the reckless policies with low rates and a total absence of regulatory scrutiny should all be doing the perp walk (http://www.observer.com/2010/wall-street/end-times-investor ). The entire mortgage related CDO business was a sham. However, it had a tremendously damaging impact on the economy by grossly distorting the mortgage market. In many ways, the CDO business came to resemble a Madoff like Ponzi scheme – new bonds were made to satisfy the “demand” of the CDS short sellers (i.e. Magnetar and company) and the CDO salesmen at the banks who had found the ultimate suckers to dump the bonds on – their own bank and, eventually, the taxpayers.

Addendum 4:00 AM, 4/14 (by Yves): Tom’s post does not include a point discussed more than occasionally among the Naked Capitalism team that has been working on CDOs, namely that they were also sold to unsophisticated institutions, generally foreign (the long-standing expression on Wall Street is “X was sold, not bought”). See former credit derivatives salesman Tetsuya Ishikawa’s book, How I Caused the Credit Crunch, for details.