Wednesday, November 21, 2007

The CDO Blues

I remember it must have been about late 2005, maybe early 2006. The bank I was working for was advancing loans at a "loan to value" of 80% and in some cases 85%. So if the property or asset was worth $100,000, we'd loan out $80,000 or maybe up to $85,000. I was looking at property prices and I said, "I think we should lower our loan to value to 75 maybe 70%."

The statement was summarily ignored.

Of course, like many things, now I watch various predictions (which weren't terribly hard to make) come true and see the same people with their pants caught down during Dotcom Mania sit there and scratch their heads today.

But the issue of what loan to value banks lent out at had larger effects than just for the local neighborhood bank down the street. It's having an effect throughout the country's banking and mortgage system as there are billions and billions of dollar's worth of CDO's, securities that were essentially mortgages packed together and sold on the second market.

The whole selling point or gimmick of the CDO was that, yes, part of the portfolio of mortgages were sub prime or worse, but the majority of the mortgages were high quality, triple A rated mortgages. The idea was to provide a slightly higher rate of return, but mix in different qualities of mortgages in the mix to lower the risk.

What's sad though, is that say you have a great borrower, low risk and so forth and so on. That may get you a triple A rating, but that doesn't mean you lent out $100,000 on a property that was worth $120,000. Matter of fact, given the over valuation and my now aging recommendation that banks lower their loan to values, it seems these AAA mortgages loan out $100,000, on properties that were only worth $80,000.

What I love though, is the now 20 cents on the dollar people are getting for loaning to a BBB- risk.

Alas, I'll say it again for the cheap seats, there was no lack of economists, analysts and just plain ol' smart people that warned about this. And all of it could have EASILY been avoided if you just had an economist in the house...or rather should I say LISTENED to the economist in the house.

Sadly, it seems in America it's more important not to rock the boat than prevent it from sinking.


Anonymous said...

Unforunately this isn't a new problem!

"A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him."

John Maynard Keynes, "Consequences to the Banks of a Collapse in Money Values", 1931


Anonymous said...

One of the chief causes of the great depression was that there was no line drawn between commercial bank and investment bank.

Are we not eroding the line between the two with the housing/credit crisis?

A Commercial bank makes a loan at 105% LTV with a 3/1 ARM with a 300 basis point discount for the first 3 years. They make these loans, only to bundle them into a CDO and then sell them out on the open market, as Fannie Mae will not buy such a risky loan as this. An Investment bank buys this CDO, and eventually 40% of the loans contained within are defaulted on. Investment bank is stuck holding the bag with a risky portfolio.

At face value, you have the investment banks in a crisis because these large pools of CDOs are now worth 20-30% of their face value, plus they now are participating in a part of the economy they weren't meant to; home loans.

In a CDO, is it the Commercial bank that has to foreclose on the home, or is it the Investment bank?

Also, the Commercial bank is stuck with bad loans they have been unable to get off their books. I think it was an economist from Credit Suisse I heard on Bloomberg on the Economy state that if these banks had to write down to market the value of all their loans, that there wouldn't be enough capital left and the bank would have to shutter and go out of business.

So, revisiting the theme; Have the supposed protections built into the system to protect against a Great Depression been eroded to the point that we could see major bank failures? Or as a junior economist, am I just not seeing this the right way?