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A Collateralized Debt Obligation (CDO) is a bond, and like many financial instruments the issue is how it is used and regulated, not the instrument itself. This is an attempt to simply explain with a little history and example.

Back in the 1970s the concept of CDOs took off with Mortgage Backed Securities (CDOs) created by FannieMae and FreddieMac. They allowed mortgages to be bundled and sold like bonds to institutional investors--Pension funds etc. They were safe and a good idea. Everyone benefited. The bonds paid interest with acceptable risk, and since banks did not hold the actual loans anymore they were able to make more loans. This resulted in more people being able to buy homes. The problems came much later, when a good idea began to be abused. As an example let's look at another initially good idea, that was twisted into something entirely new and damaging: Junk Bonds.

Way back in the 1970s Michael Milken started working at Drexel, Buhrnam, Lambert, one of the premier Wall Street investment banks. He had a great idea. He had found that certain Junk Bonds were actually good investments. In those days bonds became "Junk" when their credit rating dropped below investment grade. A company that fell on hard times might see their credit rating drop to "Junk" and thus their bonds became less valuable.

Here's an example: Company A issues a block of bonds (debt) through an investment bank. At the time of issue Company A's credit rating is Single A so the bonds are sold at par (100) with a quarterly interest payment of X% for a period of 15 years. Two years later their credit rating drops to Triple C due to poor company performance and changes in their sector of the economy. The interest payment on the bonds stays the same, but in order to compensate a buyer in the market the bond will sell for less than par (100). The amount under par is calculated to return roughly the interest rate the bond should now be paying based on the "Junk" credit rating, plus the initial principle invested in the bond. A buyer comes along and buys the bond at 78 and intends to hold it to the end of its term. So over 13 years the buyer will collect the lower than the market interest rate, but then get 100 for the bonds he paid 78 for when they mature. If the company defaults he loses on the 78 he paid for the bond--maybe all of it. In the event of bankruptcy Bonds (debt) are paid before Stock (equity). If the company fails, chances are he will collect some of the 78 he paid.

Back to Michael Milken. In the 70s Milken found that the Junk Bond market consistently undervalued many companies' bonds. The Junk rating pushed the price of the bonds too low, and a smart investor could buy the bonds of companies that were actually a pretty good risk and because the bonds traded way below par; holding them to maturity could be an investment with a very good return. The companies he found were "fallen angels" and an investment portfolio based on these companies began to return gains similar to stocks. This is what made Milken initially successful and made the Junk Bond market the specialty of Drexel as an Investment Bank. One key thing here to point out: Investment Banks at this time did not issue Junk Bonds. In order for a company to issue debt as bonds they had to have a Triple B rating or better. There was no market for Junk Bonds regardless of the interest rates tied to them. Junk bonds were all bonds from companies whose credit ratings had fallen after the bonds were issued. The mentality of the bond investor preferred safer investments. Principle should never really be at risk, and income was the primary goal. Thanks to floating interest rates and "innovation" in the credit markets, firms like Drexel and Salomon Bros. helped bonds trade more like stocks. Ultimately this is what Wall Street firms wanted people to do--TRADE--buy and hold strategies don't make as much money for Wall Street brokers.

Michael Milken made a great deal of money for his clients. His clients were very appreciative. Many of his clients were S & Ls. He gave them some really good investments in the 1970s that helped improve their bottom line. When he decided that he could create an entirely new market on his own he went to his friends. The next step was that Drexel began selling bonds that were "junk" when they were issued and Milken already had buyers for those bonds. "The Predator's Ball" was a meeting that Milken convened every year as he assembled his investors (S & Ls and others) with his corporate raiders in need of funding (Carl Ichan et al.)The market he created helped fuel the takeover mania of the 80s depicted in Oliver Stone's Wall Street and the reality was that many companies were bought and chopped, jobs were lost, and ultimately many Wall Streeters became rich while the economy went into the tank. The crash of '87 and mini-crash of '89 and then the S & L crisis and Milken's prison term seemed to deliver some kind of verdict on the times. Alas, not. It should be pointed out that Milken ultimately, like a virus, destroyed his host: Drexel, Burnham, Lambert died in the S & L crisis.  Moving to the present, clearly the abuses are more prolific and systemically profound.  

In recent years, due to changes in laws (Gramm-Leach-Bliley 1999) and a general attitude of Free Market Uber Alles these CDOs were stuffed with the worst kind of crap. I like sausages, and I know they are not good for me, but many Mortgage CDO Sausages were stuffed with shit instead of meat scraps and pig lips. This was because of the overall environment and the lack of regulation. In addition, in '04 the Mortgage CDOs from Freddie and Fannie amounted to about 40%, in '07 it was significantly less than that because everyone wanted to play this game and many filled their CDO sausages with fraudulent loans. The worst thing about it was the Rating Agencies played along and they kept rating the garbage as BBB investment grade similar to Arthur Andersen finding Enron as solvent in 2001. If you really want a single point of failure its the Rating Agencies--Moodys, Standard and Poor, Fitch, etc. They did not want to lose the business so they gave bonds ratings that the issuers wanted.

Credit Default Swaps (CDS) allowed bad loans to continue, because it allowed a CDO holder to "hedge" against loss. The problem there was that the CDS market was unregulated and they (AIG and others) wrote way too many CDS, that they could not possible cover in the event of a significant uptick in defaults.

Unfortunately this is one of the other things that seems to come to pass--if you screw up with enough company you get to go free. Michael Milken stood alone, and he was taken down alone. The current financial mess is the responsibility of many and unfortunately in practical reality-no one. This is our problem--our financial system has cancer from CDOs that metastasized into cancer cells. We can operate, but it may kill the patient.

One last ominous throwaway warning--we are a democracy with a large middle class, yes this is still true. The historical examples pretty clearly show that in our case when the crisis starts to break society, dictatorship will come from the RIGHT and not the LEFT. If Obama fails, we're screwed.

Recommended and interesting recent Wall Street history:

Junk Bonds:
Predator's Ball

Mortgage Backed Securities & Trading:
Liar's Poker

Michael Lewis' Most Excellent Recent Essay:
The End

Originally posted to FrankCornish on Wed Apr 01, 2009 at 05:27 AM PDT.

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Comment Preferences

  •  TJ (9+ / 0-)

    I don't know what the answer is, but I'm filled with trepidation.

    You may find yourself in a beautiful house with a beautiful wife and you may ask yourself, "How did I get here?"

    by FrankCornish on Wed Apr 01, 2009 at 05:28:32 AM PDT

  •  Then let's make certain (2+ / 0-)
    Recommended by:
    FrankCornish, OnlyWords

    Obama doesn't fail. FDR's New Deal stopped the groundswell of the KKK that would have taken us down the same road as Italy and Germany. Our only saving grace right now is that the modern-day GOP is a rump of a rump of a party.

    Thanks for the background, BTW.

    Radarlady

    •  The GOP is hurting, (2+ / 0-)
      Recommended by:
      mataliandy, radarlady

      but irrationality is forever out there stalking, waiting for an opportunity to return. Sauron is out there in spirit, and as always, that's what really scares the shit out of me.

      You may find yourself in a beautiful house with a beautiful wife and you may ask yourself, "How did I get here?"

      by FrankCornish on Wed Apr 01, 2009 at 05:48:26 AM PDT

      [ Parent ]

      •  I know (2+ / 0-)
        Recommended by:
        mataliandy, FrankCornish

        but, the two entities that did the most to build the totalitarian states in Europe in the 20th Century are both pretty weak right now: the major right-leaning political party  of the nation in question and the largest organized religious entity therein. Both Italy and Germany were relatively new democracies, and so were dealing with the chaos of multiple parties, a problem we don't have currently, but very well could, if the GOP collapses altogether. The Catholic Church was heavily involved in propping up both the Fascists and the Nazis. I'm speaking here of the Catholic Church as a political entity, not a spiritual one, as there were good individual laypeople and priests who opposed the Fascists and the Nazis. We have a weak analog to this in the RR, which is also out of favor. So, there are some similarities between today and then, and some differences. I realize there are those who will scream Godwin at me here, but, one needs to be aware of the historical currents of any given time to understand it.

        As always, to keep our democracy healthy requires the vigilance of its citizens.

        Radarlady, not concetrating nearly hard enough on her day job...

        •  I'm not at my day job yet... (0+ / 0-)

          but I should be. Thanks.

          RR? Radical Right?

          You may find yourself in a beautiful house with a beautiful wife and you may ask yourself, "How did I get here?"

          by FrankCornish on Wed Apr 01, 2009 at 06:31:39 AM PDT

          [ Parent ]

          •  Religious Right (1+ / 0-)
            Recommended by:
            FrankCornish

            I've used that since I was reminded (here) not all Fundies are politically active. That individual was correct. There are still conservative Christians in America who see their primary role in this world as conversion, not passing laws, on those who don't agree with them, to force outward conformity to their specific interpretation of what constitutes "Christian" behavior.

            Radarlady

  •  CDS's are the problem (5+ / 0-)

    When people can bet on whether a company will fail with no skin in the game, that's a problem. They should be banned.

    •  I agree, (2+ / 0-)
      Recommended by:
      radarlady, rmonroe

      you should only be able to buy a CDS if you own the underlying bond.

      You may find yourself in a beautiful house with a beautiful wife and you may ask yourself, "How did I get here?"

      by FrankCornish on Wed Apr 01, 2009 at 05:40:37 AM PDT

      [ Parent ]

      •  What if you own the stock and want (1+ / 0-)
        Recommended by:
        FrankCornish

        to hedge that? Or have a contract with the company and want to hedge that? Or have any other kind of exposure to the company's industry and want to hedge that?

        I'm in the pro-Obama wing of the Democratic Party.

        by doc2 on Wed Apr 01, 2009 at 05:49:55 AM PDT

        [ Parent ]

        •  I'm not sure what the right answer is... (1+ / 0-)
          Recommended by:
          radarlady

          you bring up good points. At the very least companies who issue them should be regulated like an insurance policy--which is essentially what it is.

          You may find yourself in a beautiful house with a beautiful wife and you may ask yourself, "How did I get here?"

          by FrankCornish on Wed Apr 01, 2009 at 05:53:16 AM PDT

          [ Parent ]

          •  Exactly! If it was regulated like insurance CDS (1+ / 0-)
            Recommended by:
            FrankCornish

            could have been good things. They'd have been backed up by actual money like insurance must be...
            and mostly they couldn't be used as gambling by those with no ownership or potential loss. For sure we should not have paid off the pure gambling IOU's with our tax money

            There sure is a gap between amount of CDS and the bonds they cover. From What Cooked the World's Economy? It wasn't your overdue mortgage.

            About $2 trillion in credit derivatives in 1989 jumped to $8 trillion in 1994 and skyrocketed to $100 trillion in 2002. Last year, the Bank for International Settlements, a consortium of the world's central banks based in Basel (the Fed chair, Ben Bernanke, sits on its board), reported the gross value of these commitments at $596 trillion. Some are due, and some will mature soon. Typically, they involve contracts of five years or less.

            snip
            At almost $600 trillion, over-the-counter (OTC) derivatives dwarf the value of publicly traded equities on world exchanges, which totaled $62.5 trillion in the fall of 2007 and fell to $36.6 trillion a year later.

            Now I would like to ask some paranoid questions.

            We know AIG had sold many CDS.
            We know AIG paid much of the bailout money to other firms we bailed out
            We know some of the other firms had these bad bonds that defaulted. I'm sure they had CDS on them

            Is that what AIG gave them money for? The same money we loaned them money for? But it was a loan so not really a double payment if we get paid back...just strange.

            Here is where the paranoia begins. We know that many hedge funds bought multiple CDS on bonfs they didn't own just to gamble and maybe win if the bonds lose.
            But we know many of the firms we bailed out owned private hedge funds whose books we don't have access to. (Like Goldman has their secretive Global Alpha)

            So what I wonder is...did some of the companies actually recoup their losses many times over at our expense...with the big profit going into their hedge fund and not the institution? They'd do far better if the bonds defaulted than if they did not.

            My paranoia gets worse. The bush administration wanted the failure of mortgage bonds and to let everyone profit from the sale of the bundled predatory loans. I can't think of any other way to interpret their 2003 actions

            From Spitzers article (a few weeks before his arrest)
            Predatory Lenders' Partner in Crime
            How the Bush Administration Stopped the States From Stepping In to Help Consumers

            He notes

            In 2003, during the height of the predatory lending crisis, the OCC invoked a clause from the 1863 National Bank Act to issue formal opinions preempting all state predatory lending laws, thereby rendering them inoperative. The OCC also promulgated new rules that prevented states from enforcing any of their own consumer protection laws against national banks. The federal government's actions were so egregious and so unprecedented that all 50 state attorneys general, and all 50 state banking superintendents, actively fought the new rules.

            Not just sub-prime which has it's place, but predatory loans. Those are almost certain to fail. That is really, really strange.
            Who wouldn't buy cds on those?

            (And credit card debt is also bundled and sold as bonds...and some issuers have that nasty habit of spiking the interest rate (with or without cause) on lower income people when they get to a high debt so they are almost certain to default.)

            I am now a conspiracy theorist or at least a conspiracy wonderer. When there are billions and billions of dollars to make and no regulation and secretive funds and rules that ensure default...hey I get suspicious.

            As Rachel says...I need to be talked down. Please
            (PS Can the rating agencies be sued?)

            •  I don't think it is so much a conspiracy, (0+ / 0-)

              as it was a group of people saw where the bread was buttered and they got in line for theirs.

              There is so much of it however, it would be a monumental investigation to get to the bottom of it. Its one of those things that pushes one more toward a more Revolutionary option...

              If a group of people are so greedy, and so sure they will get away with it, the options are very limited, not terribly pretty, and hard to control once they start.

              You may find yourself in a beautiful house with a beautiful wife and you may ask yourself, "How did I get here?"

              by FrankCornish on Wed Apr 01, 2009 at 08:06:29 AM PDT

              [ Parent ]

            •  There is only so much money (2+ / 0-)
              Recommended by:
              joynow, FrankCornish

              The CDS will fail, there isn't enough money to cover all of them. Now Citi and Goldman maybe getting paid from AIG under previous contracts, but the money will run out.
              The solution would be either

              1. the fed makes more money thus devaluing the currency or
              1. the treasury borrows more  to cover more bailouts like they are doing with AIG

              If the Fed makes more money, foreign investors will run away. The treasury cannot borrow a lot more money as percentage of GDP.
              Those who paid AIG for CDS were stupid. No way all this money is going to be paid. A lot of people will lose money, kind of like a stock market crash, it depends who exits first and who is left holding the bag. But the CDS bag is too big for taxpayers to hold it. More money for more bailouts is unsustainable.

  •  sigh (3+ / 0-)
    Recommended by:
    radarlady, Seeds, FrankCornish

    my take on this is that we are between a rock and a hard place.  From our perspective it looks like the banks are getting away with this huge con.  Unfortunately, I think there is a lot more going on here than they are telling us.  It is deeper than just a few big banks and AIG.  It is a global cancer and has the potential to bring down governments.  Iceland anyone?  Read between the lines in the news and you will find that there are already several countries that are bankrupt and if allowed to fail could become a domino effect for others.  I don't believe that Obama wants to keep shoveling money into these banks, but he found he has to since it has global implications.  

    Nature's laws are the invisible government of the earth - Alfred Montapert

    by whoknu on Wed Apr 01, 2009 at 05:39:29 AM PDT

    •  Exactly, (2+ / 0-)
      Recommended by:
      radarlady, whoknu

      He's a smart guy, and I still believe his heart is in the right place. If this is the direction he is following I think he has his reasons.

      You may find yourself in a beautiful house with a beautiful wife and you may ask yourself, "How did I get here?"

      by FrankCornish on Wed Apr 01, 2009 at 05:41:58 AM PDT

      [ Parent ]

      •  It looks pretty bad from here (2+ / 0-)
        Recommended by:
        radarlady, FrankCornish

        but I believe it is never as it seems.  It must have been pretty bad for Bushie to get up off the couch and start shoveling money into Wall Street.  I don't think he did that willingly.  

        Nature's laws are the invisible government of the earth - Alfred Montapert

        by whoknu on Wed Apr 01, 2009 at 05:53:31 AM PDT

        [ Parent ]

    •  re: "between a rock and a hard place." (2+ / 0-)
      Recommended by:
      FrankCornish, whoknu

      I just pictured that scene from Armageddon when Bruce Willis and Ben Affleck saved the earth by landing on that asteroid to blow it up but all those space boulders were flying around.

      Republicans are liars, by deed or proxy. There is no such thing as an honest Republican. Just those who do the dirty work and those who don't.

      by chicago jeff on Wed Apr 01, 2009 at 05:47:35 AM PDT

      [ Parent ]

    •  Don't worry. CDS are sold on bankrupt countries (1+ / 0-)
      Recommended by:
      FrankCornish

      and there is great profit to be made.

      The likelihood of failure (for the countries or institutions or anything) is reflected in the cost of the CDS appropriately called the spread just like other forms of gambling.
      This article goes into these spreads and how to read them. It includes the pretty Blooomberg charts. As you can see the examples shown include the spread for Bear Stearns, Citi, Iceland and AIG from a few months ago. The spread chart shows the risk of defaulting. The higher the risk of them defaulting the more you pay.
      And yes they sell them on countries. Here is a chart indicating how various countries were doing as of December.
      Here is a blurb

      Germany, Japan, and France all have lower default risk than the US at the moment.  It now costs $60 per year to insure against US default for the next five years.  While this may not seem high, it was at $8 earlier in the year, and $36 one month ago.

      Don't know what it is now. Don't want to

      I'm very sure I don't like betting on these things because if you only get big money if they fail you might not be motivated to try to prevent failure and you might do what you can to increase the odds of failure.

      •  Funny that Lebanon improved the most (1+ / 0-)
        Recommended by:
        joynow

        although our debt is a large percentage of GDP (maybe over 100%). But I bet one reason for this is that the Central Bank prevented every bank in Lebanon from dealing with CDSs (IIRC).

  •  Both political parties have a hand (1+ / 0-)
    Recommended by:
    FrankCornish

    in the financial disasters of the last three or four decades, but I think it takes an ascendant 'deregulatory' mentality to turn the real predators loose. S&Ls were mostly on Reagan's watch and now this even bigger disaster was a product of Bush days.

    I do have a problem with CDOs in principle though -- if bank income is determined by how many loans they issue and they cannot take a loss if those loans fail, the incentive structure would seem to guarantee trouble. At the least they should be forced to hold the riskiest loans that they issue. The buyers of packages should be able to fill their own packages -- kind of like being able to choose your fruit at the supermarket rather than having the store box it up with the bad ones on the bottom.

    We have only just begun and none too soon.

    by global citizen on Wed Apr 01, 2009 at 05:46:52 AM PDT

    •  All true, (2+ / 0-)
      Recommended by:
      ssgbryan, global citizen

      the Democratic house is far from clean. Going forward, regulation has to be put in place, and CDOs must be securely regulated. They worked quite well for decades, its only recently that the system went nuts. Again, I think the failure came from attitude, deregulation, and the Rating Agencies. The Rating Agencies should not be private companies and all their findings should be made public.

      You may find yourself in a beautiful house with a beautiful wife and you may ask yourself, "How did I get here?"

      by FrankCornish on Wed Apr 01, 2009 at 05:51:47 AM PDT

      [ Parent ]

    •  Er, no. Nobody knows at origination which (1+ / 0-)
      Recommended by:
      FrankCornish

      loans are good and which are bad with any certainty. That's why we're in this mess. The private sector is not going to structure or buy CDOs levered like they were in the past, they have learned that lesson. Legislation would be superfluous at this point.

      I'm in the pro-Obama wing of the Democratic Party.

      by doc2 on Wed Apr 01, 2009 at 05:51:58 AM PDT

      [ Parent ]

      •  Interest only mortgages are a pretty good clue, (0+ / 0-)

        as are mortgages on very modest properties that cost an amount that only a couple percent of the population can afford (and which cost half as much five or so years before and have had no improvements) are another.

        Somehow you need to reward and protect reasonable prudence. That was not happening in CDO-world and 10 or 20 years from now under existing rules it will happen again.

        We have only just begun and none too soon.

        by global citizen on Wed Apr 01, 2009 at 06:12:17 AM PDT

        [ Parent ]

      •  Legislation is never superfluous (0+ / 0-)

        with these rat bastards.

        Capitalists are ALWAYS looking for ways to game the system.

        They don't really have a choice, if they fail to do so, they fail in their #1 priority, which is to make a profit.

  •  Well, so did disco . . . . (1+ / 0-)
    Recommended by:
    ssgbryan

    Back in the 1970s the concept of CDOs took off

    In retrospect, it seems like we squashed the wrong craze (as odious as that whole disco thing was . . . .)

  •  Another interesting read (1+ / 0-)
    Recommended by:
    FrankCornish

    is Barbarians at the Gate, telling the story of the RJR/Nabisco LBO.

    http://www.amazon.com/...

    I believe it was HBO that made a movie of this book, too. Also quite good.

  •  Respectfully, (1+ / 0-)
    Recommended by:
    FrankCornish

    You miss a few points. Mike Millken, as smart as he is (and was) did masterfully promote an existing vehicle (high yield or "junk" bonds) that allowed borrowers to effectively go around the onerous covenants that banks embedded in loan agreements and, by terming out the debt, create more permanent capital to leverage. This opened up a greater flow of capital targeted to his neighborhood on the risk/return curve.  Where he erred was in an overzealous organization of a too small capital base, which resulted in moral hazard and, ultimately, the use of material, non-public information that illegally disadvantaged honest market participants.

    CDO's are simply another form of securitization.  CDS overlayed on the structures, and the illusory AAA ratings they extracted from a hopelessly conflicted set of private rating agencies enticed generally lazy (and greedy) creditors into buying the tranches.

    The entire US subprime and Alt A market would not have existed at a fraction of its size had this underwriting analysis not been disintermediated from regulated institutions to the wild west markets of structured finance and the ratings process corrupted.  The designed absence of regulatory oversight remains the central issue in OTC derivatives.

    Personally, I remain insensed that there are way too many structured finance players who have not yet been called to task.  Forget the CEO's. They didn't understand it anyway.

    "Those dunes are to the Midwest what the Grand Canyon is to Arizona and the Yosemite is to California." - Carl Sandburg

    by Critical Dune on Wed Apr 01, 2009 at 07:38:02 AM PDT

  •  You Left Out a Key Point (1+ / 0-)
    Recommended by:
    FrankCornish

    You're analysis is right on, but you left out a key point that totally poisoned the CDO market.  Originally, Fannie & Freddie packaged "whole loans" and sold them off, so that there was diversification, similar to a mutual fund.  If a homeowner defaulted, it didn't matter too much to the CDO portfolio, and if it did, it would only affect that one portfolio and reduce its value in the secondary trading market.

    However, in the late 90s somebody came up with the foolish idea of "slicing and dicing" these mortgages by putting a couple of percent of a mortgage into, say, 50 different pools.  Thus, defaults from one home now automatically reduced the value of 50 different CDO pools, not just one.

    Moreover, trying to "cure" a defaulted loan in the past, when a CDO had whole loans, was easy.  You (the loan servicing company) simply had to go to the fund that owned it and ask for permission to modify the loan to prevent foreclosure or default, and you could get an answer very quickly.

    However, with that loan now spread around into 50 different portfolios, which might have been traded 50 times each, nobody really knows where that loan is right now and even if you did know where it all was, you couldn't know which, if any, of the 50 "owners" of the loan might have the right to decide whether to re-set it, or not.

    It's really the "slicing and dicing" that has caused the serious problems now, because every one of the CDOs out there has an unknown number of problem loan "pieces," and nobody really knows what they're worth.

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