The CDO shuffle

By Felix Salmon
August 27, 2010
cartoon and which includes the phrase "cheerfully feckless". So, go read ProPublica's latest CDO piece right now.

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It’s impossible not to love any story about the insanity of high finance during the bubble years which not only goes into hugely geeky detail but also comes with a cool cartoon and which includes the phrase “cheerfully feckless”. So, go read ProPublica’s latest CDO piece right now.

It’s long, of course — and for good reason: it’s full of juicy details. For instance, did you know that Wing Chau, the CDO manager who was one of the prime villains in The Big Short, ran one CDO called “888 Tactical Fund”?

More substantially:

ProPublica found 85 instances during 2006 and 2007 in which two CDOs bought pieces of each other’s unsold inventory. These trades, which involved $107 billion worth of CDOs, underscore the extent to which the market lacked real buyers. Often the CDOs that swapped purchases closed within days of each other, the analysis shows.

That $107 billion — an enormous number — was more than enough, at 20% of the total market, to provide the marginal demand that the market needed to keep prices frothy and bonuses high.

Essentially, the CDO business, in 2006 and 2007, became a con game. Ostensibly, independent managers were picking bonds with the aim of maximizing risk-adjusted returns for their investors. In reality, they existed only to provide a veneer of independence for bankers desperately trying to offload toxic waste that nobody wanted:

“I would go to Merrill and tell them that I wanted to buy, say, a Citi bond,” recalls a CDO manager. “They would say ‘no.’ I would suggest a UBS bond, they would say ‘no.’ Eventually, you got the joke.” Managers could choose assets to put into their CDOs but they had to come from Merrill CDOs. One rival investment banker says Merrill treated CDO managers the way Henry Ford treated his Model T customers: You can have any color you want, as long as it’s black.

It wasn’t just Merrill, either. Goldman was in on the game too:

The firm wrote a November 2006 internal memorandum about a CDO called Timberwolf, managed by Greywolf, a small manager headed by ex-Goldman bankers. In a section headed “Reasons To Pursue,” the authors touted that “Goldman is approving every asset” that will end up in the CDO. What the bank intended to do with that approval power is clear from the memo: “We expect that a significant portion of the portfolio by closing will come from Goldman’s offerings.”

The whole thing is summed up quite elegantly in that cartoon and also in a damning infographic:

merrill.tiff

ProPublica isn’t the only entity looking closely at all these smelly deals. The SEC is, too:

Asked about its relationship with managers and the cross-ownership among its CDOs, Citibank responded with a one-sentence statement:

“It has been widely reported that there are ongoing industry-wide investigations into CDO-related matters and we do not comment on pending investigations.”

None of ProPublica’s questions had mentioned the SEC or pending investigations.

One can only assume that Citi has received Wells notices about all this — and has decided that they’re not material enough to disclose, even though they’ve clearly had the effect of making Citi go very quiet indeed on the subject.

So go read this story, and all its sidebars: it’s great stuff. If I had to quibble, it would be only over this:

But the strategy of speeding up the assembly line had devastating consequences for homeowners, the banks themselves and, ultimately, the global economy. Because of Wall Street’s machinations, more mortgages had been granted to ever-shakier borrowers. The results can now be seen in foreclosed houses across America.

That is a slightly separate issue from the CDO Shuffle. Insofar as new CDOs were buying tranches of old CDOs, they weren’t buying new mortgages which would ultimately end in foreclosure. But ProPublica gets the big picture spot-on:

Nearly half of the nearly trillion dollars in losses to the global banking system came from CDOs, losses ultimately absorbed by taxpayers and investors around the world. The banks’ troubles sent the world’s economies into a tailspin from which they have yet to recover.

Well done to ProPublica for holding the perpetrators’ feet to the fire.

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