Who Owns Troublesome CDO/CMOs?

There is an interesting article in July Bloomberg Mag ("Toxic Debt")about who owns the CDOs and CMOs now causing so much trobule at Bear Stearns, and possibly elsewhere.

Its only in the dead tree version, so there is only so much I can link to. If you pay for a Bloomberg terminal, you are entitled to the mag as part of your sub (just ask for it). There were four stories in the magazine:

The Subprime Sinkhole

Subprime Money Trail

The Ratings Charade

The Poison in Your Pension

Here is a short excerpt:

"Worldwide sales of CDOs—which are packages of securities backed by bonds, mortgages and other loans—have soared since 2003, reaching $503 billion last year, a fivefold increase in four years. Bankers call the bottom sections of a CDO, the ones most vulnerable to losses from bad debt, the equity tranches. They also refer to them as toxic waste because as more borrowers default on loans, these investments would be the first to take losses. The investments could be wiped out. . .

Because CDO contents are secretive, fund managers can’t easily track the value of the components that go into these bundles. “You need to monitor the collateral in your investment and make sure you’re comfortable there will be no defaults,” says Satyajit Das, a former Citigroup banker who has written 10 books on debt analysis. Most investors can’t do that because it’s extremely difficult to track the contents of any CDO or its current value, he says. About half of all CDOs sold in the U.S. in 2006 were loaded with subprime mortgage debt, according to Moody’s and Morgan Stanley. Since CDO managers can change the contents of a CDO after it’s sold, investors may not know how much subprime risk they face, Das says."

Two things struck me about the magazine coverage: First, the CMO issue is far more widespread than many people realize. Apparently, cheap money made a highly leveraged reach for yield ever more appealing. Lots of surprising players seem to have got sucked in.

Second, the incongrously "fun" graphics Bloomberg used throughout — they reminded me of a comic book, which is so contra-indicated by the seriousness of the subject matter (maybe they wanted to add some levity to a serious subject).

Its really noticeable in the magazine, but it here are the two graphics I pulled from the online PDF:




Graphics courtesy of Bloomberg Magazine

I’m taking Betty and Veronica down to Pop’s Sweet shop after the bell if anyone wants to join me . . . 


The Poison in Your Pension
David Evans
Bloomberg Magazine, July 2007

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What's been said:

Discussions found on the web:
  1. Jack Stevison commented on Jun 26

    That’d be swell. I hope the soda jerk remembers to give me extra syrup this time. I gave him an extra dime for it last time and I got the usual amount.

    Inflation, eh?

  2. James commented on Jun 26

    I think the leagal problem I see in the future and what will anger congress is: the ratings agencies and major banks sold a lot of the worst stuff to pensions. The rating system they used will be based on really poor models. I also believe that the pension fund stuff will prove to just somehow work out as the worst of the worst. The is except for the stuff that gets dumped on Fannie and Freddie.

    Its similar to the Anderson accounting scandal in that the bond ratings have become corrupted.

    So this is very similar to what we saw with Enron. Illegal accounting practices analogus to the conspiracy to sell off high risk debt to pensions. Conspiracy between GS/BSC and all to influence the ratings till they sell bundles for a profit.

  3. REW commented on Jun 26

    I don’t pay for the NYT subscription but apparently dame Gretchen has a story today about how Bear tried to offload about $550 million of their bad loans by selling them to Everquest Financial (for cash and mostly equity), which Bear was going to take public later this year. Yesterday Everquest withdrew its offering.
    I wonder how many investors would have lapped up that IPO without knowing the extent of their holdings.

  4. fatbear commented on Jun 26

    From someone with no Bloomberg access, thanks. This brings me to the main point I’m pondering – who the hell winds up holding the bag?

    Approaching is a meltdown caused by a search for fees on the Street. (After all, the CDO paper we’re talking about here – derivatives and leverage trash, not the useful MBS, etc. – serve no real purpose other than fee generation. Or do they?)

    If that’s the case, the 1st penultimate hit is on the clients (the re-org fees will keep paying for those Tribeca condos), most likely big banks, pension funds, the CBOC, and edu endowments. And the 2nd is the stockholders of Bear, GS, MS, etc., once again mainly pension funds, etc., but probably not CBOC. And the 3rd is Ambac & MBIA, but they are overstretched themselves with risk/capital ratios somewhere in the stratosphere (like 90:1 or so). So where?

    I guess the the last hit is Ms & Mr Sixpack – and who do they blame? Bush? Greenspan? Clinton? Some incoherent “they”?

    It’s not only going to hit the financial system, it’s going to be at the top of 2008 politics – along with gas prices and the Chinese owning everything (while killing us with poisoned food and bad tires).

  5. P. K. commented on Jun 26

    Selling these CDO’s to pensions—One could say this is yet another in a long list of things that are systematically and methodically transitioning the U.S. from “Bedford Falls” to “Pottersville”…..if one is cynical enough.

  6. S commented on Jun 26

    So a pension fund manager is paid zillions of dollars for buying CDOs and other complext paper just because they have a certain credit rating attached to them?

    Doesn’t the manager have a ficuciary duty to periodically monitor creditworthiness or assess the value of the underlying collateral?

    Lawyer’s saliva glands are working overtime on all fronts associated with this mess.

  7. ECONOMISTA NON GRATA commented on Jun 26

    Who will wind up holding the bag…? It ain’t gonna be me…! That’s something that I can assure you of. It shouldn’t be you either, if you’ve been reading posts in this blog and other like minded blogs.

    What is going on in the CDO market is part and parcell of the unsustainable structure of the financial markets. If my scenario pans out, “there will be blood on them there streets…”

    Things are bad and they’re only going to get badder… Anyone that tells you otherwise is either a fool or they’re getting paid for it.

    Best regards,


  8. Neal commented on Jun 26

    Bloomberg had an article out on May 31 where they described the “rating” agencies as being integrally involved in assembling these CDO packages and that the majority of their revenue comes from that service. They cannot be said to be independent evaluators of quality, rather their goal is to maximize the amount of receipts of the issuer.

  9. Neal commented on Jun 26

    Another point from that Bloomberg article was that the bust rate of ordinary Baa corporate bonds is 2% in 5 years, wheras the bust rate of the CDO Baa grade is 24% in 5 years. The Ba grade bust rate was 25%, not much different. (Baa is the lowest “investment” grade, Ba is less than investment grade).

  10. KP commented on Jun 26

    The answer is we(non-hedgefund managers) end up paying for it. Either directly via our affected investments(401k’s, pensions,etc) or indirectly via inflation and/or high interest rates.

  11. Isaac commented on Jun 26

    A: Taxpayers.

  12. dark1p commented on Jun 26

    yeah, my butt hurts already.

  13. RW commented on Jun 26

    Who owns this stuff? You’d be surprised (or maybe not). Take a look in a nice, conservative investment grade bond fund some time (remember even the lowest level debt tranche immediately above the most risky equity tranche can receive a BBB rating).

  14. fatbear commented on Jun 26

    Guys, I’m looking for insight here – that’s why I posed the “who winds up holding the bag” question. I am as protected as I can be, and I’m sure most who read here are likewise. What I want to know is where the pressure point is, what will break and descend into a bottomless pit – banks? brokers? MBIA et alia? condo market here in the city? (Homebuilders are a foregone conclusion; likewise the mortgage originators. Not to forget MEW-dependents like autos and consumer durables.)

    As BR has pointed out, the ratings outfits are heavy into “who, me” coverage. And Congress has already cast it’s beady eye on money managers (yes, I know it’s only the hedge guys so far, but watch).

    As for money mangers watching over their CDOs, from what I read the content of most CDOs is hidden, in the sense that the derivatives are so far removed from the underlying issue that only the syndicator knows for sure what’s in each, and perhaps not even them as some are CDOs of CDOs of underlying, etc., not to mention that the tranches are sometimes synthetic and/or of such a composition that the info takes lots of time to bubble to the surface. (Have you ever tried to do mortgage servicing? Clarity can come, but usually 30-60 days later.)

    So let’s assume the institutional pension funds are screwed; edu endowments too; big banks perhaps; brokers if like BS their capital isn’t sufficient (BS just put up 25% or so to cover only the first two funds). This could make LTCM look like small fry.

    And how will that breakdown echo through society? Are we looking at 1929 again? How does Peak Oil work into this? China and $1.2Trillion of our debt? I could go on and on and on….

    Where does it end?

  15. esb commented on Jun 26

    With respect (or disrespect) to Betty and Veronica, why not just take the two litle lovlies directly to the barn and skip the milkshakes, smiles and liplicking first step?

  16. RW commented on Jun 26

    I have no idea who is going to get hit or how badly; I mean that literally — could be a tempest in a tea pot or a perfect storm that forces a bailout bigger than LTCM and Resolution Trust combined — but if nothing else the situation amply illustrates the distinction between uncertainty and risk; i.e., the relative lack of transparency in many of these derivative products and/or the models that regulate them creates a potential margin of error so great that calculating risk becomes nearly impossible: I mean there could be tranches in the pile that are worth par, others a hedge fund would love to acquire at 60 cents on the dollar; others, possibly even rated higher, that no one would want at half the price; and others still that are pure toxic waste, going to zero unless someone was foolish enough to buy them on margin (using 10:1 leverage on something that is already levered 10:1 as a matter of structure creates a pretty explosive mix).

    There are two kinds of events, probably longitudinal in nature, that will send me to my bomb shelter (figuratively speaking): One is the rating agencies downgrading a growing list of securities (that process is starting now) and changing methodology as a partial result so downgrades accelerate; the other is a forced sale of securities that creates a palpable market price significantly lower than par or NAV on multiple issues (some more collapses on the order of the Bear Stern’s funds will do that I think). I would have included SEC probes and/or other federal intervention in that list except I think those will primarily be focused on either preventing the two events I have previously described or, barring that, attempting to circumscribe their impact.

    FWIW. I am not a professional in this field and some of this is frankly out of my league; I’m just trying to understand it well enough to continue investing and also avoid being burned to the ground.

  17. Winston Munn commented on Jun 26

    The CDO was the idea of Michael Milkin – hey, if you can’t trust a convicted financial felon who can you trust?

  18. Joe Klein’s conscience commented on Jun 26

    Is anyone here old enough to remember Gerald Tsai, Fred Carr and Fred Mates? That is what this market reminds me of. Blind speculation and suckers.

  19. ken commented on Jun 26

    Bill Gross said that Pimco bid on a lot of the BS CDOs in the low to mid 90s price range and did not win a single bid.

    He says they regularly buys CDOs and will continue doing so.

    He says an investor must look at each deal and do their own valuation and credit risk analysis by drilling down and taking a good look at the collateral.

    Pinco seems to be in the market to buy up more if only someone would start selling.

  20. Philippe commented on Jun 27

    The story of CDO’s is straightforward if one goes back to the prima facie debtors and their financial status together with the collateral attached.
    Banks and speculative funds have blurred the reality through debts virtual representation (derivatives expression, mix of assets and debts which are no longer connected) the outcome is through price assets reconciliation and the ordeal is to reconcile debts, collateral and prices.
    They are more casualties than broadcasted, the banks as lenders, the banks which went through the securitisation of assets (it is to be proved that they could syndicate the whole assets with no recourse on them), the banks which have been taking a second leverage on these assets (Bear and Stern « hedge » funds, they are more than Bear and Stern cases) and ultimately the investors have been a casualty through funds and or direct purchase of CDO’s and they have been so, since long.
    Since (2006/2007) these are pending issues to be resolved and none of the debts originators, issuers, debts managers have been able to tackle the problems and it is only through real liquidation of the underlying assets that the aftermath will be known.
    It is quiet probable that a FOUR TRILLION USD exposure (total amount of loans outstanding, granted to the real estates and commercial real estates) is not going to find a peaceful issue through assets repricing.

  21. wally commented on Jun 27

    I really don’t whether rating agencies ‘participated’ in assembling CDOs or not, but it does seem that the vogue now in rating is to use ‘models’. Of course, that is the same thing the government agencies do to hone their reporting of unemployment, housing sales, price increases, etc. Invariably a model will rely to some degree on extrapolation of past statistics to predict the future. Invariably an extrapolation of past statistics will miss the ‘turns’.

  22. Francois commented on Jun 27

    “And how will that breakdown echo through society? Are we looking at 1929 again? How does Peak Oil work into this? China and $1.2Trillion of our debt? I could go on and on and on….

    Where does it end?”

    It ends with a renewed interest in the concept that the neocons have tried so hard to trash in the last 2 decades…it’s called “public interest”.

    There are organizations in the socio-economic ecosystem that should not be and CANNOT be converted into “profit centers”. Rating agencies are among these organizations. (So should health care btw, but as a doctor, wtf do I know about that right?) It is that simple.

    But for that to happens, you need and well-informed and well-connected investors “citizenry”. And a Congress plus executive that is either responsive to their needs, or forced to be so.

    Right now, the only ones that have access to the lawmakers and the executives are the very well-heeled and politically connected. They basically write the laws, and they have the added benefit of an Executive that hates the very notion of “public interest”.

    After all, why is it that shareholders protections are so weak and getting weaker? Shareholders don’t have highly organized think-tanks, unlimited donations to “advocacy” groups that only serves as mouthpieces for very narrow interests groups which only goal is to capture an ever bigger portion of wealth at the expense of the rest of the investors/shareholders.

    Why is it that people with less than millions in assets can’t invest in hedge funds or other vehicles outside of mutual funds? To “protect” them? From what?

    Why as an individual with 401k, am I forced to invest long-only, in a ridiculously narrow list of MFs chosen by God knows who? And don’t get me started on “disclosures”.

    Please note the trend behind this: There are more possibilities than ever to invest globally, yet, as individuals w/o big wealth, the institutions (Gov, Brokerage houses, Lobbies) have made sure that they will not make it easy on the little guy.

    But they sure have and keep on make it very lucrative for themselves.

    Where is it going to stop? The day there is a wave of market dislocations that will inflict lots of pain to a lot of people.


  23. Iqbal Latif commented on Jul 6

    <<"Worldwide sales of CDOs—which are packages of securities backed by bonds, mortgages and other loans—have soared since 2003, reaching $503 billion last year, a fivefold increase in four years. Bankers call the bottom sections of a CDO, the ones most vulnerable to losses from bad debt, the equity tranches. They also refer to them as toxic waste because as more borrowers default on loans, these investments would be the first to take losses. The investments could be wiped out. . . >>

    Something is amiss here. The CDO graph represents a picture where nearly 15% or even less forms the ‘toxic waste portion, the one which is not investment grade. Now if we see the total market of CDO’s at 503 billion $’s, and even the whole 15% of the toxic waste defaults we are here looking at 80 billion $ say 100 billion $ spread as follows..

    32% Banks and brokers.. equals 32 billion $
    22% Asset managers….. equals 22 billion $
    19% Insurance………. equals 19 billion $
    18% Pension funds…… equals 18 billion $
    10% Hedge funds…….. equals 10 billion $

    BSC Hedge fund has already taken a 3 billion $ hit, may others have gone belly up. In all likelihood the toxic waste of CDO risk is very well spread and most likely it may dawn that there might be no contagion. In a world
    where assets have grown to 145 trillion $ the amount of toxic waste portion of CDO’s is very negligible.

  24. undergroundman commented on Aug 7

    503 billion “last year” alone (I am not sure which year was referred to). You have to add the sales from the previous years, which are still floating around.

    So a hedge fund buys a CDO. The borrowers default. Does the hedge fund get the house?

    These securities are backed by hard assets, after all. Now, I realize that house prices are tanking, but how bad are they tanking and how big of a factor will house prices be?

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