CDO's how come they don't know where the toxic loans are

Posted by: Stuart M on 07 October 2008

From a simplistic point of view:-

CDO = Take say 90 safe mortgages and package them up with 10 sub prime ones. So at worst value = 90% but you get the interest from them. However if the percentage of sub prime mortgages increases so does the risk.

Then
CDO Squared (CDO2) = Take 100 CDO's and repackage

Then CDO cubed (CDO3) = Take 100 CDO2 and repackage.

So if you hold a CDO3 you have to untangle 1,000,000 mortgages.

OK now from a UK consumer point of view I take out a loan and I pay interest and repayments on that to the company I took out the loan from. I assume if packaged into a CDO then the interest gets redistributed (minus a possible cut) to the owner of the CDO, and if that CDO is in a CDO2 the same happens etc etc.

So to redistribute my payments there must be a trace of who owns what so interest payments can be distributed. So what is the problem in knowing where the toxic debt is?

So as far as I can see, if your mortgage is in say a CDO3 and you repay it things must be in place a route for that money to get to the holder of the CDO3 to repay it!

So I must be missing something as why they can't find the toxic debt?

(BTW I do get that accounting rules in play are a part of the problem and mean even if you have 100% good CDO's they have to be valued at market value and if no one want's to but them that is a lot less than their real worth and income stream but affects a banks capitalization)accountancy principle
Posted on: 08 October 2008 by hungryhalibut
quote:
So I must be missing something as why they can't find the toxic debt?

Perhaps it's invisible as well as toxic?

Nigel
Posted on: 08 October 2008 by Happy Listener
True in thought but the whole financial system has been flooded with these highly graded instruments (ratings agencies ought to be cut down for putting A ratings (some AAA) against alot of these.

Problem is the world has been through a massive debt bubble over the last few years, with debt of all kinds (leverage corporate deals, household mortgages, part of banks' commercial loan books), being sold on to others.

The illusion of robustness could only go on so long and it was the US market where their crazy lending arrangements in the sub-prime mkt, hit home hard.

Confidence is everything and if you don't know what another bank is holding, you as a bank aren't going to lend to it. The spiral began.

We have reached the point of financial contagion added to which the stock markets have run scared, increasing the spiral and putting even more strain on collateral and the ability to repair via simple equity raising.

What comes next could be very nasty if those in charge cannot normalise the financial structures and lending profiles we have all previously enjoyed but without stupidities in certain areas.
Posted on: 08 October 2008 by Huwge
Stuart,

I think it is the use of the CDO as a proxy for a corporate bond, rather than the underlying mortgage security that is creating the problem. The value of the CDO as an asset has been miscalculated, because the underlying credit risk was not fully understood. Constant repackaging of the financial instruments make it increasingly difficult to "see" the "real" credit risk.

Then, not only did the financial institution use the proxy asset to match its liability, but it borrowed to pay for it, gambling that the cost of borrowing (or own internal cost of capital) would be offset by the excess yield from the proxy bond versus its traditionally rated corporate bond equivalent.

So, the financial institution has an asset that is no longer matching its equivalent liability, so a deficit on the asset side but also it has incurred additional debt. So, a double whammy.

Huw
Posted on: 08 October 2008 by Adam Meredith
quote:
Originally posted by Happy Listener:
Confidence is everything and if you don't know what another bank is holding, you as a bank aren't going to lend to it. The spiral began.


Which, unfortunately, makes it semi-rational for others who have leant money to a bank, in the form of deposits, to withdraw it. A lot of panic is actually rational response.
Posted on: 09 October 2008 by Happy Listener
Adam,

Entirely agree with your words. It's all about confidence. All banks are de facto insolvent - they exist at the mercy of depositors and the fact that only say 0.1% of depositors want their cash out each day. They are only 'solvent' because of this.

Like Naim having to pay the electric bill by offering up a CD555 in payment!

But the real issue is that banks' accepted capital ratios are around 7% to be classed as strong. There have been regulatory changes in the banking systems within the last few years in the way that banks manage and 'reserve' their capital against losses.

Some are finding these are now having a hard bite, as the worse your loans book gets, the more capital you have to set against such prospective losses. Which in turn makes banks rein back their lending, just at a time when the general market may need lending to continue to allow a softer asset value fall.