Were Some CDOs Tranches Losers From the Start?

James Hamilton of Econbrowser, in “CDOs: what’s the big deal?” weighs in on the question of what went wrong in the CDO market. He makes a point I haven’t seen stated as clearly anywhere else, namely, some CDO tranches may have been been likely to lose money from the get-go:

The benign view of CDOs is that they represent an important technological improvement that allows for better pooling of risk. I would characterize the main concerns as centering on whether in the process existing financial arrangements have accurately priced aggregate risk.

First let me clarify what I mean by aggregate risk. Some risks are inherently undiversifiable. One can understand that point most clearly with Robert Lucas’s elegant asset-pricing model. Suppose that the entire economy consisted of one big potato farm. All financial assets would then ultimately be nothing more than claims against future potato production, and there is no way they can credibly promise to deliver more potatoes than are actually available. If there is a bad harvest, people will be hungry, and no clever set of financial instruments can possibly insure you against that.

An example of the kind of aggregate risk I have in mind is thinking through what would be the consequences of, say, a 20% decline in average U.S. real estate prices, and what that might mean for default rates.

Let me next clarify what I mean by mispricing of this risk. I am not concerned about whether those who are bearing the aggregate risk (i.e., setting themselves up to be the guy who has the fewest potatoes when times are bad) earn a higher expected return to compensate them for the risk. Rather, my concern is whether they may have invested in assets with a negative expected return. For example, if you purchased an asset with an 85% chance of a 15% return (which you’ll earn as long as a recession does not occur), and a 15% chance of a -100% return (you’re wiped out if it does), then your expected return would be -2.25%.

The specific kind of example that comes to mind is New Century Financial Corporation, which was pushed into bankruptcy from a substantially more modest aggregate shock than the one I am concerned about here. The concern about mispricing is that if loans were extended that should not have been, the magnitude of both the real estate boom and its subsequent bust are amplified substantially relative to what they would have been with accurate pricing of aggregate risk.

But who would be so foolish to have invested hundreds of billions of dollars in extra risky assets with negative expected returns? The logical answer would appear to be– someone who did not understand that they were accepting this risk.

Now for purposes of discussion, Hamilton posits that the buyers of the riskiest CDOs might have ponied up hard dollars for a likely money loser. This is one of the reasons the so-called equity tranches of CDOs (and most asset-backed securities) are commonly called “toxic waste” or “nuclear waste.” They are dubious at best.

Now you might be asking, how could investors be so dumb? The buyers were institutional investors, after all. These guys are supposed to be pros.

There are two possible causes. One is that the sellers of this paper knew it was lousy, but also knew that with high yield paper in high demand, there would be buyers for it (let’s call this the “lipstick on a pig” theory, or Pig).

The second is that while they may have known they were hyping the paper, the sellers also had overestimated its value (this is the “believing your own PR” theory, or PR).

Now I’ve witnessed both Pig and PR in operation. In the early days of the OTC derivatives business (the early 1990s) one of the two biggest dealers was known among professional traders to take customers whenever they could. And we don’t mean take a little, we mean sell customers (generally big corporates) custom derivatives which were guaranteed money losers (and not small numbers either). How could they do that? They were structured to require no cash payment (mind you, that practice wasn’t unique to these bad deals, but you’d be amazed how the due diligence standards drop when no one has to cut a check).

Fooling yourself about the value of merchandise, or PR, also happens all the time. Consider buy-side M&A. Every study every done says most acquisitions fail (the estimates generally range from 60% to 75%) and the single biggest reason for deals not working out is that the buyer overpaid. Now admittedly, there are a lot of perverse incentives at work (everyone does better, including the acquiring CEO, even if the deal doesn’t turn out well). But it is amazing to watch how the participants will tweak the models to make the deal work. They fall under a peculiar spell, and act as if they believe that changing numbers in an Excel spreadsheet will influence reality. The financial model becomes more real than the business it is meant to represent.

Now if PR happens in M&A, with pretty simple math and line items in a spreadsheet that readily be compared with real world measures (target past performance, analyst report, forecasts by industry experts), imagine how easy it is to do with highly complex financial structures and pools of assets that are often heterogeneous?

Mind you, I’m not defending the people who designed and sold CDOs. But the abstractness and complextiy of these deals makes it way way too easy for everyone to con themselves. And here, I imagine the biggest con was in the way the rating agencies and packagers analyzed subprime risk. They used historical subprime data as a basis for forecasts, but those past subprimes had little in common with the paper being originated. Early subprime lending was done on a cautious basis, with a fair amount of borrower scrutiny, and more conservative loan terms (most importantly, lower loan to value ratios). If you have explosive growth in a risky asset category, almost without exception it is done by lowering quality standards. But that adjustment appears not to have been made.

In addition, even if the historical subprime data was applied to a comparable set of borrowers and deals, my impression is that the data was still questionable. The market started only in the mid 1990s and went into retrenchment in 1998, then came back in 2002 and grew rapidly. There is no data on how these loans perform in a serious down cycle like the 1991-1992 recession. And I have a sneaking suspicion that no attempt was made to create proxies for that severe a downturn.

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  1. Scurvon

    It started with the subprime sales people – huge commissions that were not tied to the long-term health of the loan. The majority of the lenders were new companies that had never faced a declining real estate market – they underestimated the risks. The investment banks saw huge fees and pursued these to excess. Like the subprime salespeople, noone would come after these guys to take back their bonuses because loans fell apart. A year ago, it was hard to find anyone anywhere (subprime, investment banking, research, academia, etc.) that thought real estate might go down. And now we find ourselves in the great unraveling.

  2. Anonymous

    We first got wind of what was going on in this business back in 2003, when Household International coughed up more than $400 million to settle claims it had defrauded subprime mortgage borrowers. The sales people in the local offices were cooking up inflated appraisals, falsifying borrower signatures, lying to borrowers about what their APR and monthly payments would be–anything to close a deal and get the commission and meet the monthly sales quota. A lot of people argued that the fraudulent mortages should have been undone–but that would have blasted a big hole in the MBS business, and the Attorneys General approved a settlement that punished the company somewhat but didn’t begin to undo the damage done to the borrowers. Few people understood the whole MBS business at the time, but now a lot of things are becoming clear. If the AGs had taken a tough stance against Household and its abuse of mortgage lending four years ago, the bubble might have been burst before it got so big.

  3. Yves Smith

    I continue to be amazed that the press and regulators will acknowledge that there were “excesses” in subprime lending, but no one seems willing or able to get to the bottom of it. Some of the factoids I’ve seen, for example, Lew Ranieri saying that 50% of the subprime borrowers could have gotten prime loans, and that 50% of these loans were “refi” meaning they weren’t going to buy housing, but were to pay off other consumer debt, says that despite the fulminating of the industry, this product was only nominally about getting low-credit-quality borrowers into housing.

    With all that said, proper modeling would have allowed for the fact that these loans were really crappy. Remember, there is a market for the debt of bankrupt companies, so there is a price for even really weak credits. But no one wanted to admit how bad this paper was. Not only would that shrink the universe of investors considerably, but it would also create a paper trail that would show that it was widely known that many loans were being extended to people who had no realistic hope of meeting their obligations.

  4. Anonymous

    I agree, Yves. The subprime bubble was driven as much by demand for these “high yield, low risk” securities as it was by the housing market itself.

    “Loan officers” were flogging these high-interest subprime loans to borrowers because there was demand for them upstream, from investors.

    And you are right that many subprime borrowers could have qualified for better terms, if they had understood the business better. I was amazed at how many of the Household Finance borrowers had decent credit histories back in 2001-2002. Hardly anybody says the word “subprime” to the borrower!

    High yield and low risk makes about as much sense as “light beer that tastes great.”

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