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Occupied by Wall Street: The Rise of the CDO Squared: A Case Study

September 29, 2011

If you’ll humor me, I’ll illustrate the point I made in my “Occupied by Wall Street: Fixing Perverse Incentives in the Financial Sector” post with a case study. It is at this point widely accepted that the entire system for securing mortgages and insuring investments was systematically scammed before the financial collapse of 2008, much of it very effectively, for almost a decade. This is especially problematic because it is through this mortgage system that housing bubbles (that is to say, the consistent development of overvaluation of property in certain regions at certain times) most directly affect the economy as a whole. That is to say, if someone owes $300,000 on a house that is now only worth $200,000, somebody is gonna lose some money.

The systemic gaming of the mortgage system was incited by a bill named the Gramm-Leach-Bliley Act, also known as the Financial Services Modernization Act of 1999. The Gramm-Leach-Bliley Act repealed part of an older law named the Glass-Steagall Act which was passed in 1933 under FDR, which, among other things, established the FDIC. The part of Glass-Steagall that was repealed by the Gramm-Leach-Bliley Act essentially served to distinguish between and separate the Investment Banking and Commercial Banking sectors of the financial services industry. I will explain why repealing this section is absolutely moronic, and basically served to streamline the systemic scamming of the mortgage sector.

Mind you, I am not trying to say that the mortgage industry itself is a scam- it has just fallen victim to an extreme outbreak of predatory banking, an outbreak largely fueled by banks’ new found ability to bundle mortgages together into investment items called Collateralized Debt Obligations, or CDOs.

A CDO is a collection, usually of around a thousand mortgages, that is separated most often into 3 tranches by evaluating the statistical likelihood of receiving certain percentages of the payments for the mortgages within the CDO; the top tranche, typically around 65-70% of the CDO, is rated AAA by the various ratings agencies, because it is virtually certain that at least 65-70% of the mortgage-holders will make their payments. The next tranche, usually between 15 and 25% of the CDO, is often rated BBB; 15-25% of the mortgage-holders will probably make their mortgage payments, but if they do the holders of the investment see a larger payoff at the end of the process. The remaining 10-15% of the CDO is basically complete crap; it is far from certain that a tranche full of the worst-performing mortgages in the bundle will produce, but if it does, the investors see some handy profits.

There are a few big problems with this system. First and foremost is the central role of investment ratings, and therefore the ratings agencies themselves, in US banking laws. The way that US banking law is currently written, commercial banks are required to have certain amounts of cash on hand for transactions at all times, with a kicker: AAA-rated investments are considered to be interchangeable with currency holdings under the law. And the majority of virtually every CDO is rated AAA. So what exactly does this mean?

This means, in its most basic form, that Commercial Banks are now legally allowed to replace some of their required currency reserves with hypothetical money to be paid out from CDOs that they bundled containing mortgages that they sold. This is a pretty convoluted incentive system for the banks: it gives them an incentive to give out mortgages to unqualified homeowners, because the banks no longer have a good financial reason to ensure that mortgages will pay off in the long run. The banks can just spin the crappy mortgages off with the good ones in huge CDOs, or even hold those crappy collateralized mortgages as some of their cash on hand. But it gets worse.

One of the most staggeringly audacious scams in the system is based on the existence of an investment item called a CDO squared. Remember the incredibly crappy bottom tranches from our CDOs? Nobody wants to buy that crap, so the banks have found an innovative new way to deal with it. They take the crappy bottom tranches from a bunch of CDOs and put them together to make… a new CDO. A CDO squared. And then they bring in the ratings agencies to evaluate their new concoction… and the ratings agencies, the people the government put in charge of making sure that our banks have enough money on hand not to fail, tell us that 65-70% of this new CDO squared is one of the safest possible investments there are. AAA! And then the banks take the bottom tranches of all their CDOs and they keep them as part of their cash on hand. Because the law and the system says that’s ok.

The Gramm-Leach-Bliley act essentially paved the way for the exploitation of mortgages as an investment item when it said that the Commercial Banks previously in charge of mortgages were also now allowed to act as Investment Banks, but the incentive system for mortgages didn’t change; employees still got paid more to give out mortgages than not to, but the lenders were now so far removed from the investment product that the incentives to giving out bad mortgages outweighed the disincentives, giving rise to huge networks of bad mortgages under predatory lenders. For a perfect example of one of these networks, you need look no further than the meteoric rise and fall of Countrywide Financial.

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