Collateralized Debt Obligation derivatives

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This clip, from the excellent documentary INSIDE JOB, explains in easy-to-understand terms how Collateralized Debt Obligations, or CDO derivatives, were instrumental to the global financial meltdown in 2008.

[youtube]http://www.youtube.com/watch?v=QXw5MaaXjLY[/youtube]Discuss.

CDOs are terrific, in theory. They spread the risk, and provide mechanisms for greater participation in the housing market.

But their utility depends upon a few important restrictions:

1) Debt must be properly rated. Because mortgages were a source of steady interest income for banks, there was increasing pressure by banks upon credit rating agencies to ensure that everyone was rated "A", so that they could continue to issue loans. When ninjas (no income, no job, no assets) are able to get mortgages, the credit rating system is well and truly broken.

2) Asset backed debt must be properly secured. When lenders are providing borrowers with debt up to 125% of the equity in a property, the concept of security interest is lost.

3) Someone must exercise prudential supervision of the financial system.

Central bankers like Alan Greenspan believed that, left to their own devices, people in the marketplace are going to make deals that are in their own interest, and that government does best when it steps back and leaves the market to it. But when banks started slicing and dicing, and buying up each others packages of mixed debt assets, nobody was looking at the overall health of the system. Each player would model their own risk, but nobody was looking at the health of the entire financial system.

So, in the end, you get Howard Davies' inevitable progression:

Sub Prime: Nobody expects the housing market to collapse--but when it does, suddenly the cash isn't coming into the system, so you get a crisis in:
Liquidity: The single biggest market in the world is the liquidity market. When banks stop lending to each other, then system fails. Banks fail for one reason, and one reason only--they run out of cash. Bad loans and losses don't bring down banks. But no cash in the till does. So when banks run out of cash you get:
Unravelling: Small bank failures can be managed. But when a big one falls (and make no mistake, we're talking about Lehman Bros.) then the house of cards starts to give way. If a big bank goes down, you get:
Meltdown: Capitalism stoppped--it truly ground to a halt, on September 15, 2008. Oh, certainly business was still transacted--but the machinery of moving capital ceased to exist for about 4 days. The US Government drew a line in the sand, and it was the wrong line. And so government was compelled to resort to:
Pumping: When a major infrastructure collapses, it is government's responsibility to step in and ensure that the failure is remediated. It doesn't matter whether it's a transportation, information or financial infrastructure, the infrastructure is essential to a modern society. So governments started pushing new money into the economy to restore liquidity to the system.

Now, purists will suggest (and not without reason) that capitalism without bankruptcy is like Christianity without Hell. (I think that one was actually said by Paul Mason), and the proper response in a liquidity collapse is to allow the players like Northern Rock, RBS, Lehmans and most of the US Savings and Loan industry to be liquidated, and get the rest of the system to absorb the shock. The problem with that supposition is, of course, that in that event there would have been no surviving banks in the United Kingdom, Ireland, Iceland or the United States. J.P. Morgan would have failed, Goldman Sachs would have failed.

Can we contemplate a US economy in which there are no credit cards? Can we contemplate that there is insufficient currency in existence to monetize the entire US economy? Can we contemplate a circumstance in which every depositor to the Federal Reserve collapses?

One of my brothers holds a masters in econ and a bachelors in CS - he writes software for the operation of a market maker.

The way he puts it is, "A lot of people allowed themselves to believe a lot of things that they knew to be untrue. Because they were making money."

Interesting video, but it left out one key fact, Government forced banks to make the loans.

That is a deliberately deceptive statement. You know full well that the number of loans mandated by government is a tiny fraction of the banks' collective subprime exposure.

The Bush administration did mandate certain loans--but the Bush administration never ordered banks to lend homeowners 125% of their equity. The Bush administration never put pressure on credit rating agencies to downgrade their screening criteria.

On the other hand, the banks did put pressure on the Federal Reserve, the Bush administration and on Congress to keep the system largely unregulated and to permit the creation of derivative investment vehicles that were not properly rated for risk.

Not only were CRA loans a small fraction of subprime mortgages, CRA-mandated mortgages are actually some of the best performing subprime mortgages.

You know full well that only FDIC insured institutions are regulated by the community reinvestment act. Countrywide, for example, was not an FDIC insured institution and thus not compelled by CRA regulations.

So why did they make so many liar loans? Because there was money in it.

If you want to fault something, fault the privatization of fannie and freddie. They were acting as a profit-seeking entity when they started purchasing subprime mortgages from lenders, and they did so strictly because they knew that the worst case scenario would be that they would merely be rendered a public entity again.

It was the fact that fannie and freddie were willing to buy those loans that made it profitable for everyone else to make and sell them.

It was the idea that, one way or another, the feds would save their asses if their hedges didn't.

or maybe the key fact wasn't really such a key fact after all.

But thanks for letting us know that somebody still believes that horses**t, Inuyasha.

I think i may have lost a bet.

Government is to blame for our financial mess, not so much because government mandated bad loans (it did to some extent). Rather it is that government did not prevent by proper regulation and law the betrayal by the banks and insurance companies betrayal of fiduciary integrity. Some of the banks and insurance companies made a business (and a profitable one at that) of covering the down side of some bad loans and in effect laying off bets of what happened in the market place. They turned financial capitalization into a legalized casino.

In order to grow an economy must have engines of credit, but this has to be soundly regulated so credit is granted to people who have a good chance of paying back what they borrow.

ruveyn

You can't legitimately blame Bush for this, the roots of the problem goes back decades and was exasperated under Presidents Carter and Clinton.



Sorry, but I'm not the one misinformed.

The Community Reinvestment Act, coupled with several affirmative action laws (so that minorities could get loans from banks), forced Banks to make loans to people that didn't have the financial means to afford to pay said loans. In fact that was one thing ACORN was heavily involved in.

Earlier this week I noted that I had changed my mind on the Community Reinvestment Act.

Contrary to my initial conclusion, the evidence is overwhelming that the CRA played a significant role in creating lax lending standards that fueled the housing bubble. Once I realized this, I had to abandon my suspicion that the anti-CRA case was a figment of the rhetoric of Republicans attempting to distract attention from their own role in the mortgage mess.

So I laid out the facts and arguments that had convinced me to switch sides in the CRA debate. It was a long series of posts that generated hundreds of responses and counter-arguments. Felix Salmon’s response is here, Barry Ritholtz’s here, Mike Rorty's here, Ryan Chitum’s here, and Matthew Wurtzel’s here. All of my posts are here. Henry Blodget's earlier post on the CRA, with which I largely agreed until recently, is here. If you carefully run through these posts and the accompanying comments, I think you'll see that every argument raised by the "Defend CRA at all costs" crowd has been refuted.

Read more: http://www.businessinsider.com/the-cra- ... z1SVxGg0nF

This is an article from someone that was originally saying the same thing you are saying now, it may actually cause you to change your stance.

Anyways the article failed to mention that a year after Bush pushed for more lax standards (2002), he backtracked and realized he had made a mistake.

The Bush administration in 2003 tried to change the system, to no avail. Congressman Barney Frank, (D, MA ) was in the forefront of stopping the Bush proposal to take control out of Fannie and Freddie and put it into a third overseeing organization. Frank too has emerged in the current crisis as one of the major critics of the administration.
http://www.americanthinker.com/2008/09/ ... e_got.html

[youtube]http://www.youtube.com/watch?v=H9juJr8CSY4[/youtube]

"Creating lax standards" and "forcing banks to make bad loans" are two entirely different things.

That's what I love about you. No matter how blazingly stupid and indefensible your position is, you just double down.

It's also hilarious to see that someone out there still thinks that AmericanPooper can be used as supporting evidence with a straight face.

Actually, I was waiting for you to say that:

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, which opened the door for interstate banking and encouraged a new wave of banking M&A, made the ratings under the CRA a test for determining whether acquisitions would be allowed. That same year, the Fed refused to allow a Hartford, Connecticut bank to acquire a New Hampshire bank on fair housing and CRA grounds.

This was the first time the Fed had ever taken this kind of action, and it had profound effects through the banking sector. It sent a strong signal to the banks that the Fed would closely scrutinize lending practice, limiting the ability of banks to grow or make acquisitions if they were found to have insufficient low income or minority lending. Banks immediately responded by lowering down payment requirements and using more flexible income criteria.


Read more: http://www.businessinsider.com/the-phon ... z1SW5jhXqN

Unless there is a new definition of lax standards, that looks awfully like forcing someone to do something they don't want to do.

So Countrywide made and sold liar loans because they were afraid they wouldn't allowed to acquire FDIC-insured banks if they didn't?

Ever heard of "Carrot and Stick?"

Anyways are you referring to the same Countrywide that gave Chris Dodd and Kent Conrad special discount loans?

[youtube]http://www.youtube.com/watch?v=hsoM1chZElk[/youtube]

&

[youtube]http://www.youtube.com/watch?v=1GoK0539Gl4[/youtube]

Oh and this is fun:

[youtube]http://www.youtube.com/watch?v=k4tK0h5QZs0[/youtube]

And this:

[youtube]http://www.youtube.com/watch?v=rWbKKydgj_o[/youtube]

Around 4 minutes in is interesting, and explains why I'm so concerned.

You didn't answer the question.

Actually I did answer the question.

Carrot means you give them an incentive like money, tax write-offs, etc.

Stick means you punish them in some way for not doing what you want them to do.

You understand what I'm saying now?