Monday, July 23, 2007

Those Pesky CDOs and How They're Ruining the Party

You may have read about CDOs in the financial news recently. They're the investment where investors (mostly institutions like hedge funds, pension funds and the like) purchase interests in the stream of payments coming from a pool of mortgages and other loans. Rising delinquency rates among mortgages, especially subprime mortgages, have led to losses for CDO investors. A pair of big losers were two hedge funds sponsored by the investment banking firm, Bear Stearns, which last week announced that the funds had lost all (in the case of one fund) and over 90% (in the case of the other fund) of their investors' money. Less than six months ago, these funds reportedly had more than $1.5 billion in investor money. But now, it appears that anyone that invested in these funds is holding nada, or darn close to nada.

The investors in these two funds have plenty of company. Press reports indicate that lots of investors and maybe some financial firms have lost money in the CDO markets. Lots of it. Chairman Ben Bernanke of the Federal Reserve reportedly said on July 19, 2007 that some estimates of the losses from the subprime lending mess could run up to $50 billion to $100 billion.

Even these days, $50 billion plus is more than lunch money. Many of the losses appear to come from mortgage loans that were poorly conceived. Adjustable payment loans with low initial "teaser" rates offered to borrowers with shaky credit histories, along with little or no documentation of the borrower's ability to repay the loan, created a scenario where the lender (or, more precisely, the investors in the funds that bought interests in CDOs) were speculating on a continuation of rising real estate prices to ensure repayment of their investments. This risk was heightened by funds that used leverage to increase the quantity of high risk mortgages they held--the greater the leverage, the lower the delinquency rate on the mortgages that would be required to blow up the fund. Of course, as long as the real estate market kept rising, things would have remained copacetic. And we all know that once a market starts rising, it never stops. At least, not for a while. A lot of very smart people were involved in creating the subprime mortgage, CDO situation, but the strange thing is that they didn't seem to see this train wreck coming. Or, if they did, they surely didn't do enough to stop it.

Whenever a tamale heats up, it gets passed around because no one wants to be burned. Put another way, chickens are of the habit to come home eventually to roost. It's safe to assume that the investors that have recently been told that they lost 90 or 100 cents on the dollar won't just sit quietly and sip some tea. Lawyers of the plaintiffs persuasion are now surely boning up on the fine points of CDO investments, while lawyers of the defendants persuasion are now surely boning up on the fine points of CDO investments. Well, at least someone will benefit from this mess.

As for Mom and Pop, standing somewhat bewildered behind the counter of their store at the corner of Main and Elm Streets, things will change. Easy credit, especially in the mortgage markets, will dry up, because Wall Street investors will refuse to buy easy loans. With interest rates rising, fixed 15 and 30 year mortgages make more sense anyway. People with weaker credit histories may be unable to get mortgage loans. But if the only loan they could get was a snare that would ruin their finances and wreck their lives, perhaps it's better if they spend a few years building up some savings for a down payment and improving their credit ratings. See our blog on how the right mortgage loan helps you build wealth.

It was the availability of cheap credit that allowed risky mortgage loans to be made, and then packaged into CDOs that were the subject of investment strategies offering little more than a speculation on real estate values. The torrent of cheap credit that flooded the world in the last few years is drying up. European and Asian governments have been raising interest rates. While the Fed has held rates level for the last year, it by all indications is more likely to raise them than lower them. Easy money seemed to come in the last few years from owning real estate or, more recently, investing in blue chip stocks. A lot of people spent their home equity while real estate prices were rising. This almost casual use of home equity-based credit epitomized the adage, "easy come, easy go." But real estate values are flat or dropping in many markets and there's not likely to be much more easy money in the foreseeable future. At the risk of sounding like Ward Cleaver talking to the Beaver, caution and prudence in finances are now advisable. The thrifty squirrel has the best chance of surviving the winter. Store up some extra acorns, and sleep better.

For more detail about CDOs, read our blog at

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