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.
"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?:
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
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."