Mort & Hank Talk Economics #5

Collateralized Debt Obligations
Mort and I exchanged news about grandkids and home projects over breakfast a few Thursdays ago. Gina refilled our mugs, left the pot on the table, and cleared the dishes.

“Say, Mort, we’ve talked about the economy and some of the causes of the meltdown. But I still haven’t figured out about CDO’s. Got any thoughts about that?”

“I’ve been thinking about that, too, ‘cuz I have a way to illustrate it that would make some sense. It’s such a big and abstract subject it doesn’t lend itself to easy dissection.”

I sipped my hot black coffee and sat back in my chair. “Go for it, man. I’m all ears.”

“Okay. I’m gonna ask you to remember some of things we talked about the last several weeks, ‘cuz some of it ties together.” He scowled, cleared his throat, drank some water, and began:

“Remember, we talked about the bank managers our dads worked with fifty or sixty years ago in our small hometowns. The guys who knew everyone in town and their finances?”

“Sure, I remember that.” I really did remember, slightly surprising myself.

“Now, suppose that bank manager had a brainstorm that he could virtually eliminate risk in his loans and improve his cash flow at the same time.”

“Okay, I got it. Bank manager’s a smart cookie.”

“Right. Now bear in mind he couldn’t have done what I’m about to propose—this is hypothetical. The regulators woulda been all over’im like white on rice if he tried this in ‘55.”

Okay,” I agreed, “Hypothetically speaking.”

“Yeah, I gotta make it small to have it make sense. Here’s how it works: Bank manager wants to show a bigger revenue stream to the owners of the bank—he has in mind a raise, maybe a promotion to VP. He picks thirty of the bank’s loans to bundle together into a group, which he will then sell to various investors around the county—moneyed folks who are looking for investments. So he takes ten excellent loans—the collateral on them is farms, businesses, crops, machinery—and the loans’ total value is, say $200,000. The value of their collateral is $300,000 plus. They get a AAA rating.”

“I’m with you so far, Mort. Those are loans that are almost guaranteed to be paid back.”

“Right. Now he takes ten more loans that are a mix of pretty good loans and sorta good loans. The value of these loans is also $200,000. Half are to really good farmers and businessmen who’ve proven over time they will underestimate their income for the life of the loan. The other five of this group is to borrowers who have over-extended themselves, but’ll probably be able to pay off the loans. Those loans are not quite as good as the first half. If everything goes well, the collateral value on these will be $250,000. If everything goes bad, the value will be $150,000. This group gets a AA-BB rating.”

“So let me guess. That means on five of those loans, some of the loan officers didn’t do their homework, or the families are in trouble a little—they’re marginal, right?”

“That’s right, Hank.” Mort paused and poured and sipped some coffee. “Our bank manager bundles the last ten loans up and puts them into the third ‘bucket.’ He hopes nobody notices them. Today, we call ‘em subprime loans. By the way, the last ten loans have a collateral value of $200,000 if every single tiny thing goes exactly right. That means the crops have to come in and be sold at the right price, the businessman or farmer has to budget very carefully, he can’t go buying a new car or a new tractor this year, etcetera, etcetera. And if the weather’s too wet or too dry, if there’s a hailstorm, if there’s a disease among the pigs or cattle or chickens, the loans will go into default. Those loans are unrated. We’ll call ‘em XXX so we can identify them later.”

“Right. So now we have a bucket of AAA loans, a bucket of AA-BB loans and a bucket of XXX, unrated loans?” I was doing my best to keep up.

“Yep. The buckets are called ‘tranches.’ The financial guys call ‘em that to try and keep everyone in the dark. It means portions. Oh, by the way, the Wall Street guys labeled those buckets ‘Senior,’ Mezzanine,’ and ‘Equity.’ That way nobody could figure out what the hell they were talking about. What it really meant was Senior CDO’s were good, Mezzanine were so-so, and Equity meant ‘You own ‘em now, so Good luck!’ The total asset value of those loans is $600,000 if our math is right. And there is collateral on all of ‘em also worth $600,000 plus if everything goes right. If enough things go wrong, it’s worth what? $400,000? Our bank manager is the loan originator for which his bank collected origination fees. Now, anybody can sell assets, as a general rule. I can sell my La-Z-Boy, my car, and if I own a note or a race track ticket or an IOU, I can sell all or part of it, can’t I? If I own a hundred acres, I can sell ten of ‘em or all of ‘em.”

“I guess so, depending on the zoning and EPA restrictions and stuff like that.”

“I’m gonna ignore those gratuitous comments, Hank. Remember, this is a hypothetical case, and we hafta keep it pretty simple so you’ll understand it. Quit trying to confuse the issue. In any case, the bank manager has a nominal $600,000 worth of assets to sell. He can find buyers for them, divide ‘em up into parcels, some AAA, some AA-BB, and some XXX, and sell them or parts of them. Let’s assume he does that. To entice buyers, he’s going to discount the loans a little, plus pay the investors the interest every quarter, highest interest on the highest risk loans—XXX, lowest interest on the AAA loans. The AA-BB loans are somewhere in the middle. That’ll be the buyers’ Returns On Investment. Also known as ROI. So Mr. Bank Manager goes around to about a hundred or so potential investors, folks around the county he knows have ready cash—some retired farmers, some widows, some enterprising implement dealers and so on. He ‘lets each of them in on the deal,’ which he has made up into 600 shares at a thousand dollars a share. Their organization is responsible for collecting the annual interest on all those notes he’s bundled up and the mortgagees will pay them off when the notes come due, or so hope the investors.”

Hank went on, “What’s interesting is that our Bank Manager has transferred all the risk to those shareholders who bought pieces of his bundled Collateralized Debt Obligations. He calls them that ‘cuz it sounds better than “a grab bag of mixed loans.” Furthermore, the shareholders are now the owners of those assets and hafta set up methods for collection of the interest and the monthly or quarterly or annual payments on the notes. So the bank is out of the picture. Bank Manager sends a letter to the mortgagees telling them that the new owners of the notes are the Gump County Association of Rich Folks Who Want to Get Richer, Inc. Bank Manager gets a raise and a promotion and a bonus and laughs all the way to the bank. Gets a job on Wall Street. At two million dollars a year plus perks and stock options. Just kidding about the last part!”

“That sounds pretty good, Mort. Why wouldn’t it work?”

“Remember the caveat I put in there about everything having to go perfectly right for those XXX rated loans? Well, everything goes wrong! A year or two after Mr. Bank Manager put together the deal, there was a hard frost in April. Everybody had to go out and replant his corn. Then in June, there was hardly any rain. A lot of the corn got too dry and didn’t mature. Oats crop failed. Then in September a tornado hit the county and wiped out about thirty percent of the debtors’ farms. Then in October, the Congress voted to do away with some of the subsidies farmers had been getting for four generations. I tell you, it was a catastrophe! Those retired farmers and widows lost their pensions and everything. And just like that, property values went down, too. So those investors could foreclose, but what good would it do? They couldn’t get their value out of the property.”

“Well, that sure sounds familiar, Mort. Except for the details, it’s a lot like what we’ve been seeing the last six months.”

“Yeah, multiplied by about ten million.” Mort grinned, swallowed the last of his coffee, put on his cap on and headed for the cashier. “Gimme a call when you wanna go for coffee, Hank.” I said I sure would. I walked to my car shaking my head.