After having my coffee
with Armond Budish this morning, I found myself in the neighborhood of my
old offices at Roubini Global Economics,
so I popped in to say hi. Nouriel
was there, extremely alert and rested for someone who’d made two trips to Singapore
in the space of one week, and so was Brad
Setser, who, being Brad, wanted to talk about the potential systemic consequences
of a rebalancing of Arab states’ foreign exchange reserves. Apparently the blank
stare he got from me is pretty much identical to the blank stare he gets from
Wall Streeters when he brings up the same issue, which probably means that he’s
on to something very important. As a general rule, systemic shocks come from
somewhere unexpected, which means that something like the currency composition
of Middle Eastern oil monies could actually be much more dangerous than the
subprime mortgage mess over which so much ink has already been spilled.
It didn’t take Brad too long to cut his losses and move on to something I have
a bit more interest in: CDOs, especially those made up of subprime mortgages.
Brad and I are both fans of the blog Naked
Capitalism, and Brad brought up an entry
from Friday in which Yves Smith talks about exactly how
such things are constructed. Smith quotes Eugene
Linden:
In recent years, the money funding these mezzanine tranches has come from
a subset of another securitization called collateralized debt obligation or
CDO. To form a CDO that invests in subprime mortgages, a securitizer will
buy up mezzanine tranches from perhaps 100 different mortgage-backed securities,
and then package them in different tranches similar to the way a mortgage
backed security was packaged in the first place. Thus, some CDO’s can consist
entirely of BBB- tranches of subprime mortgage MBS, but still have 95% of
their value rated investment grade.
Now Linden, if we can believe his blog entry, is chief investment strategist
for a hedge fund that specializes in distressed and bankrupt situations. Which
would mean he’s not a typical innumerate journalist, prone to getting things
very wrong. But Smith is loathe to take Linden at face value. Here’s what he
writes:
From what I have read, it seems more typical for CDOs to have a mix of paper
(unless they are CDO-squared or cubed, which hold only other CDO paper, I
can’t generalize about them), which can include commercial mortgages and LBO
debt along with residential mortgages. One of the reasons to buy a CDO rather
than an MBS is to get diversification.
Brad, too, was confused. If a CDO is comprised of the mezzanine tranches of
lots of bonds all of which are backed by subprime mortgages, how can most of
that CDO be rated investment grade? An investment-grade credit rating on such
an animal would have to come from the supposed diversification benefits of owning
lots of different subprime-backed tranches. And maybe that’s what happened:
the people putting the CDOs together persuaded the credit agencies that because
the subprime-backed bonds came from all over the country, say, they wouldn’t
all go sour at once. And maybe the ratings agencies, who were making shedloads
of money rating these CDOs, didn’t ask too many questions. So maybe it’s true
that people who think they’re holding AA-rated CDO paper are in fact holding
something which should be trading much more like junk.
But maybe it’s not true. After all, ratings agencies might be stupid, but they’re
not normally that stupid. And it’s not even clear that there was remotely
enough mezzanine-rated subprime-backed paper to go around in the first place,
which is why a lot of CDOs ended up making leveraged bets on AA-rated paper
(just like the younger Bear Stearns fund) rather than investing directly in
hard-to-find BBB-rated paper. And it would certainly make a lot of sense, if
only to help boost its credit ratings, for a CDO to diversify its holdings out
of residential mortgages and into, at the very least, commercial mortgages.
In other words, when you start hearing horror stories about CDOs and other
magical pieces of financial engineering, approach with extreme skepticism. Smith
finds quite a few other holes in Linden’s story, as well, which only serve to
make the whole thing more suspect. He’s part of a wonderful vanguard of bloggers,
including Tanta at Calculated
Risk, who are very good at seeing through the hyperbole of media reports
to the often much less sensational realities underneath. Both Smith and Tanta
are very worried about the effects of the housing market on the market in mortgage-backed
securities and thence to the credit markets in general. But they don’t exaggerate
for effect, and they call out people who do. And that’s something all of us,
trying to pull a signal from all of the noise, should be very grateful for.