Collateralized Debt Obligations, The CDO Menace

-By Dan Scott

When the discussion turns to financial instruments people’s eyes glaze over due to the complexity of the issue. However, in this case what you don’t understand or rather what you don’t know can hurt you. Congress and the Whitehouse at this point have focused on a plan that supposedly will solve the credit lock threatening the economy with Recession. The problem is the solution proposed doesn’t address the cause but the symptoms. The upshot is while this solution will work it will only do so in a very short time frame, leaving the underlying problem unresolved and festering. Unfortunately, it may take the fall of Wells Fargo, Citicorp and HSBC who literally own TRILLIONS of dollars in CDO derivatives to finally bring Congress and the Whitehouse to their senses. Bears Stearns and Lehman Brothers already paid the price of inaction. I’m not optimistic about any of the current batch of politicians in power actually acting proactively, their track record speaks otherwise.

The Bush Administration for years has been warning about the potential of the lending abuses by Fannie Mae and Freddie Mac. Unfortunately, their warnings have been too technical, understood by only those in the financial arena. Combined with the incompetence of Rep. Barney Frank (D) and Sen. Christopher Dodd (D) the problem was not resolved and in fact the solutions were repeatedly rebuffed. Even Sen. Barack Obama in 2005 failed to grasp the issues when reforms were repeatedly requested, he dutifully voted the Democrat Party Line as an Order Taker against reform. He opposed CHANGE in the favor of the STATUS QUO. His response thus far in 2008 is more Order Taking. What was his response about going back to Washington to work out a bipartisan compromise? He said to paraphrase, I can fly to Washington for the vote and then return in time for the debate. A leader is involved in negotiations, an order taker settles with the results.

During the VP debate, both Joseph Biden and Sarah Palin attributed the current credit lock mess to the greed of Wall Street. Nice simple sound bite, an easy group to demonize and as usual the sound bite is wrong. The sound bite should have been the Democrats with their meddling have once again damaged the economy. Unfortunately, as we listened to the rapid fire stream of talking points from Biden, few if any of them reflected reality. It is so easy to make unfounded assertions and it’s very time consuming to debunk them all that it is not possible in a debate format to rebut a laundry list of myths and falsehoods, and that’s why talking points work. All truths are assertions of facts, but not all assertions of fact are truth. Selectively recounting the facts to sell an agenda is lying or commonly referred to as “sales talk”. Joe Biden was nothing more than a slick used car salesman selling a lemon.

Many months ago back in February, bloggers were discussing the issue of mortgages and CDOs. Of course the MSM ignored the significance of the issues regarding the proposed $150 billion bailout discussed at the time given their pushing the Democrat Party line for the primaries and elections. The MSM kept quiet about the coming mortgage crisis and now also with the ensuing CDO crisis because they knew who was to blame. Even as far back as 1999, the MSM knew there was a problem and refused to push Democrats every time the issue of reform came up. Surprise, surprise, the MSM being the mouthpiece of the Democrat Party selectively reported the facts and thus lulled the public into a false state of complacency through their emphasis of the news.

Here are some facts the MSM has been mostly mum on explaining the mortgage crisis and why it hurts you. In order for Fannie Mae and Freddie Mac (FMs) to purchase a home mortgage two things must happen. First the FMs set out the conditions under which they will purchase a home mortgage from a bank. If the loan doesn’t meet the conditions the bank can’t sell the loan to them. In order for the FMs to buy your home mortgage from a bank, they have to get the money from somewhere, it doesn’t appear out of thin air. The FMs sell a financial instrument called Collateralized Debt Obligation in the open market to investors (the so called greedy people on Wall Street) to raise that cash. Think of the CDO as bond representing hundreds of mortgages packaged together with the inducement of receiving an income. Literally trillions of dollars of CDOs have been sold by the FMs to on the market. The value of any CDO is based on the value of the home mortgages so when people default on their mortgage, the value of the CDO drops because the interest income that was supposed to be paid out to the investors has also dropped. The more mortgages that go into default the lower the value of the CDO. To protect against this the investors turned around and bought an insurance policy to protect themselves against inordinate mortgage defaults (called derivatives). The problem for the financial markets is this, when too many mortgages default at the same time thus causing a run on those companies who issued the insurance (derivatives) they are forced into insolvency and can’t meet their obligations. When this happens, the entire system which is based upon trust collapses in a cascade of financial institution defaults.

The investors trusted the FMs because they were a Government Sponsored Agency (GSA) but instead were duped by them. The FMs were busted on rigging the books which is where Franklin Raines comes into the picture, a supporter and advisor for Barack Obama. As you can see it took me a lengthy paragraph to debunk the sound bite that it was the greed of Wall Street that got us into this mess when in fact it was the arrogance of the Democrat Party’s social engineering imposing their world view at the expense of the markets. Without the markets, you and I can not get loans to buy houses, cars and business can’t get loans to stock the store shelves or invest in new equipment.

However, it wasn’t just bad mortgage policy by the FMs that got us here, the straw that broke the camel’s back was the rapid rise of energy prices from 2006 to current time. The rise in oil prices was so fast that the economy didn’t have time to adjust and compensate thus throwing people out of work. The debacle in the mortgage market ran a parallel path with the run up in energy prices. People were loosing their jobs thus making it difficult for them to pay their mortgages. What really occurred was high gasoline prices and the initial mortgage defaults happened together to push the economy over the edge by starting a bank run to create a credit lock.

Nancy Pelosi and Harry Reid promised to lower gasoline prices in the 2006 elections, did they deliver? NO, they foolishly insisted on keeping the drilling ban restricting supply and thus driving up the cost of oil. When the fast run up of energy prices rippled through the economy, it cascaded against the low wage unskilled earners. Without a job, you can’t pay the mortgage, this is why renting is a far better option for people at the low end of economic ladder. If you loose your job and can’t pay the rent you move in with someone else, there is very little long term financial consequence. However, when you own a home and can’t meet the monthly payment, there are severe financial consequences and ten years of a bad credit record insuring high interest rates for them in the future. As we have repeatedly noted, the financial meltdown was totally avoidable if reforms were put in place back in 2005 on the FMs. Without those reforms more people with low FICO scores were holding mortgages than there should have been. People with low FICO scores are normally the first people who experience layoffs during a slowing economy. People with FICO scores from 590 to 630 are 51% to 31%, respectively, likely to default on their obligations. Being at the bottom of the economic ladder they tend to work in areas that are highly subject to the contraction of discretionary spending. What Democrats in their hubris overlooked is as you climb the economic ladder you become more able to handle the consequences of home ownership, they put the cart before the horse. Contrary to demonizing the banks for giving people loans they couldn’t afford, it was Democrats who literally set these people up for failure via the Community Reinvestment Act.

After the failure of Bears Stearns, Charles Schumer caused the bank run on Indymac by publicly questioning the solvency of Indymac. As you know most banks have 90% of their assets in loans (that’s how they make their money) and about 10% in cash. It doesn’t take much of run to push a bank into insolvency under the accounting rules when you have a 10 to 1 ratio to maintain. Once the public was spooked by word of Indymac’s potential failure (under the rules), a herd mentality set in causing runs on bank after bank. As each bank’s failure was breathlessly reported by the MSM fear was reinforced to pull more deposits out of other banks. Banks were forced to conserve (hoard) cash and could not lend to other banks to make up their cash shortfall. Thus the credit lock.

Connecting the dots:

California’s attorney general is reviewing a request by former employees of IndyMac Bancorp Inc to investigate whether a New York senator triggered the bank’s collapse by releasing confidential information.

In a letter to Attorney General Jerry Brown last week, 51 former IndyMac workers wrote: “From the day (Schumer’s) letter was made public on June 26 until the closure of the bank, a run on the bank took place and the failure became inevitable.”

At this all the FDIC can do is continue to supply money to spooked depositors as they withdraw their cash to a point when these people will regain faith in the system. WaMu and Wachovia were just more victims of a spooked public with which the FDIC had to deal. The solutions which would address the mortgages losses at their source – LOWER the price of energy by domestic drilling which will: a) the futures market will react to drive down the price of oil, in turn lowering the cost of gasoline, b) lower the cost of living so people can make there payments so they are less likely to default, c) expand the economy to increase job creation and d) bring in billions of dollars into the Federal and State Treasuries without the burden of extra taxation. Secondly, a de facto moratorium on new home construction by requiring 20% down and a high FICO score in the 700s. Together, with a coordinated policy insuring the mortgages to support the CDO valuations seems to be the only solution, otherwise it’s let the house of cards fall and then rebuild from the ashes. Will the politicians listen and do the right thing? Not really, just look at their track record and what they have been voting on in Congress. One only needs to listen to Nancy Pelosi’s speech before the procedural vote to realize they won’t, as she promised there would be an investigation into the causes of the current crisis specifically by the very people who caused it like Rep. Barney Frank. Like we are really going to get to the truth of the matter with such people!
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Dan Scott calls himself a “Member of the Global Capitalist Cabal preaching Capitalism and personal responsibility as the economic solution to world poverty.” He is also a member of the 14th Amendment Society — victimhood is a liberal code word for denying the civil rights of others. He is also a proud member of the Global Warming Denier Cabal, insisting that facts not agendas determine the truth.

Dan can be seen on the web at http://www.geocities.com/fightbigotry2002/ as well as http://www.geocities.com/dscott8186/saidwebpage.htm, And can be reached for comments at dscott8186@yahoo.com.