closure under oath, yet the Senate unanimously confirmed
him later the same day. It was time to short CDOs, since the
value added by the SEC’s Cox seemed likely to shrivel.
The CDO Comics
When I read prospectuses for CDO and CDO-squared deals,
I felt as if I were reading comic books. There seemed to be a
lot of collateral damage at the outset, and deals were rife with
conflicts of interest and structural issues so profound the deals
were unratable.
To use an extreme example, if you only use subprime-backed fraud ridden mortgage loans as collateral for residential mortgage-backed securities, the RMBSs might lose
60% or more of portfolio value. If the AAA tranches have
less than 20% subordination, more than half of the principal value of the AAA tranche will be wiped out, and all of
the “investment-grade” tranches below the AAA tranche will
be wiped out. If you use the RMBSs’ “investment-grade”
tranches rated AA, A and BBB as collateral for a new CDO,
all of the collateral of your CDO will vaporize. If you use
tranches of this defective CDO in yet another CDO called a
CDO-squared, you are starting out with doomed collateral,
so the entire CDO-squared is a disaster on the day the deal is
brought to market.
In practice, flawed securitizations mixed some risky but
higher credit quality loans, Alt-A or even some prime collateral in an RMBS. That way, when tranches of the RMBS
were used for a CDO, it was less obvious to investors that they
were getting a dirty deal, and it was less likely the SEC would
investigate this nonsense for securities fraud.
For a better understanding of this scenario, let’s consider
the following example. If you could mix in 30% risky subprime loans into an RMBS deal that includes some risky Alt-A
and prime loans, total losses would probably eat through the
BBB-rated tranche, and possibly imperil the A and AA rated
tranches. Then you could take doomed BBB-rated tranches
from a number of RMBS deals and combine them with A
and AA rated tranches to create a CDO. The CDO’s collateral would be a mess. All of the BBB-rated RMBS tranches
would disappear, probably along with some or all of the single
A and AA rated RMBS tranches.
If you buy the AAA tranche of this CDO, and it has around
25% subordination, your principal is probably in jeopardy,
and all of the tranches below it are in trouble. If you then
use the “investment-grade” tranches rated less than AAA to
make a CDO-squared, every tranche of the CDO-squared is
compromised.
One does not need to read hundreds of pages of prospectuses or perform complicated modeling to know that. Warren
Buffett looks at every investment as if it is a business, and
the only “business” these RMBS, CDO and CDO-squared
securitizations have are the cash flow generating loans backing them. If a business cannot generate cash to pay its bills, it
will fail. If the loans do not do well, the securitizations backed
by them will fail. Moreover, the portfolio is the only source
of revenue for the securitizations. If the portfolio comprises
damaged collateral, the value destruction is permanent.
Credit derivatives enabled gaming and opacity. The documentation of many CDOs is dense with all sorts of cash flow
tricks, and the contracts for the credit derivatives embedded
in the CDOs are not included with the prospectuses. The ratings are completely meaningless.
SIV-Lites: Doomed from the Start
In January of 2007, I noticed that U.S. institutional investors
curtailed their buying of CDOs. But investment banks had
created new types of structured investment vehicles called
“SIV-lites,” or structured investment vehicles with less protection (or “lite” protection). SIV-lites invested in the overrated
AAA tranches of CDOs backed by subprime debt, and the
rating agencies rated these vehicles AAA. In turn, these vehicles issued faux AAA rated asset-backed commercial paper.
These new entities seemed like corporations, but the only
“business” they have is investing in assets, and those assets
have to provide “earnings.” These doomed entities started out
with very poor earnings quality and no possibility for earnings
growth.
As the collateral in the structured investment vehicles inevitably took massive downgrades, the vehicles had to liquidate their wasting collateral, and investors lost a significant
amount of their principal. Mutual funds, bank portfolios,
insurance companies, local government funds and private investment groups (among others) lost billions. Canadians heavily invested, and our North American neighbors lost billions.
Since these assets carried high ratings, European and Asian
investors also took losses.
Despite their “efforts,” investment banks were still stuck
with tens of billions of unsold CDOs. They reduced exposures by buying bond insurance (usually in the form of a
credit derivative), buying credit protection from hedge funds,
and doing a variety of leveraged sales. As bond insurers like
Ambac, MBIA, FGIC and others were downgraded or failed,
