You may well call the CDO the ‘seedy woe,’ for all the wreck it has caused. And it could shock you to learn that this artificial asset returned from its near-death state, as David Faber discusses in ‘And Then the Roof Caved In: How Wall Street’s greed and stupidity brought capitalism to its knees’ (www.wiley.com).
He traces the origins of CDO (collateralised debt obligation) to 1987, in Drexel Burnham Lambert, an investment bank. “Drexel, home of junk (high-yield) bond kingpin Michael Milken, would famously fail in 1990 after Milken’s indictment and the collapse of the junk bond market he had created. But the CDO lived on,” narrates Faber, in a section titled ‘tough to kill.’
Securitisation is often quite helpful for consumers, he observes. “It expands the availability of credit and it helps provide financing for projects that create jobs.” An example is of how the future revenues of films can be securitised to raise money to help produce those films.
When in 2005, ‘the sub-prime frenzy was in full force, and the originators were giving out mortgages as fast as they could and Wall Street was securitising them with equal abandon,’ bankers were faced with a problem – the bottom of the securitisation was becoming a tougher sell. These BBB and BBB- tranches carried a decent interest rate, but it was not proving good enough to lure buyers, recounts Faber.
“The banks didn’t want to stop creating mortgage-backed securities, but they found themselves awash in the riskiest part of the pool that they couldn’t sell and didn’t want to keep. It was a problem. They turned to the math geniuses in the CDO group for a solution.”
What did the whiz kids come up with? Mezzanine CDO, a piece of financial alchemy the likes of which we may never see again, the author notes. The idea, as he explains, was to combine BBB and BBB- mortgage securities that contained different types of mortgages originated in different years, by different mortgage lenders, from different parts of the country.
“All that diversity would somehow allow the investment bank to profess that the chances of being paid back on the CDO were markedly better than on the securities from which it was created. It may sound like a strange argument, but somehow the rating agencies bought it.”
Recommended read, in the open.
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When a country falls apart
How does a financier or an economist understand these phrases, when applied to a country: ‘third world,’ ‘developing nation,’ or ‘emerging market’? In financial terms, of course, answers Robert P. Smith in ‘Riches among the Ruins: Adventures in the dark corners of the global economy’ (www.amacombooks.org). The natural questions are: “What is the country’s balance of payments; how much do they export; what is the per capital income; how well educated is the labour force; how big is the economy; what is the gross domestic product?”
To a tourist, however, those same phrases are understood in more prosaic terms, he continues: “Does the water run; is there reliable electricity; is the food and water safe to consume; does a dilapidated public bus meant for forty passengers instead carry eight people and a few farm animals as it spews out unfiltered exhaust?”
Wondering thus in Nigeria, Smith finds that the country’s personality was ‘immediately evident along the pothole-filled, trash-strewn roadway from the airport where countless sellers hawked pots and pans, vacuum cleaners – you name it – along the roadside.’
And what is the view he gains, as a financial tourist in 1985, from his hotel window at the Holiday Inn in Lagos: “Between repeated knocks on my door by aggressive Nigerian prostitutes, I would gaze out my window to the hotel’s swimming pool below, virtually empty except for a shallow layer of filthy rust-coloured water. On closer inspection I noticed a few dead cats floating on the surface.”
Just the sights that made him think, “This is what happens to good people with bad leaders. Their country falls apart. No one cares anymore.”
Important lessons.
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Leaning on the trade
Don’t push your creditors too far, advise B. Yerram Raju and Ram R. Pujari in ‘The Small Entrepreneur: Starting & growing’ (Excel Books). ‘Leaning on the trade,’ that is, helping yourself to longer credit period than suppliers have offered, is a useful way of overcoming cash flow problems, but there are costs attached to such a practice, the authors caution. One, by stretching the credit period, you will lose the cash discount. “For large orders, this may be significant. However, this is not always relevant if money has to be borrowed in order to pay the bill.”
Also, as a growing business, it is necessary to retain the goodwill of suppliers. For, “by building up a good reputation of prompt and early payments, the owner/ manager of a small firm will have little difficulty in getting bigger credit limits when the need arises.”
Useful reference.
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