How smaller banks would have helped shrink the CDO market

By Felix Salmon
December 13, 2009
new details on how banks would pass CDO risk between each other in an improbably long chain:

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The WSJ has new details on how banks would pass CDO risk between each other in an improbably long chain:

One of Goldman’s trades with AIG involved a financial vehicle called South Coast Funding VIII. South Coast was one of many pools of bonds backed by individual homeowners’ mortgage payments that Wall Street turned into collateralized debt obligations or CDOs.

Merrill Lynch, now part of Bank of America Corp., underwrote the South Coast CDO in January 2006 by stuffing it with packages of home loans originated by firms such as Countrywide Financial Corp., the big California lender.

Once a CDO debt pool is assembled, it is sliced into layers based on risk and return. Merrill sold the safest, or top layer, of deals like South Coast to large banks, including in Europe and Canada.

The banks wanted protection in case the housing market tanked. Many turned to Goldman, which effectively insured the securities against losses. Then, to cover its own potential losses, Goldman bought protection from AIG, in the form of credit-default swaps.

The risk, here, originated with Countrywide. It then got moved to South Coast Funding, whence it moved to Merrill Lynch, and thence to European banks, who sold it on to Goldman Sachs, who in turn passed it on to AIG. When the music stopped, AIG bore the brunt of the losses.

The obvious question here is why the chain was so long: why couldn’t Merrill (or even Countrywide) just insure the mortgages with AIG itself, instead of sending them off on a long and winding road to end up in the same place?

There’s actually a good answer to the question. Countrywide considered itself to be in the originate-to-distribute business, it didn’t want an exploding balance sheet. So it was very happy to sell its mortgages to the likes of South Coast Funding and book the profits immediately. South Coast Funding, in turn, had no real equity of its own, it was just a special-purpose vehicle set up by Merrill Lynch. And Merrill considered itself to be in the moving business rather than the storage business, so it wanted to sell as much of the debt as it could.

Eventually, the bonds ended up with big European and Canadian banks, who were attracted by their triple-A credit ratings: under Basel II, that meant they needed to hold very little capital against them. Crucially, it was these banks, who had no size limits, which were happy expanding their balance sheet as much as they could, so long as that meant extra profits. They even managed to bring their risk down near zero by getting Goldman to insure the credit.

Finally, Goldman was basically in the trading business, insuring CDOs only if and when it knew that it could get someone else (in this case, AIGFP) to reinsure the risk at a lower rate; eventually the European banks got wise to that trade, and started dealing directly with AIG themselves.

There’s a lot of blame to go around here, but right at the heart of it is the fact that there were no limits on the size of banks’ balance sheets. The European banks (and, later, once AIG stopped insuring this stuff, Merrill Lynch itself) would happily balloon up as large as they could with stuff like this, because sheer size was one of the profitable attributes that regulators didn’t mind in the slightest. If there were a cap on size, this chain would have been much harder to construct.

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