Subprime deconstructed

Leverage -
Lets say you buy a house for 500k, you pay 10% downpayment and you get leverage 450k. So for 50k investment (capital) yo own a 500k (asset). Now we are restricted from using that same asset and pledging it get a new loan (ie, we cant go to another bank and ask for another loan using the same property as collateral). But in most banks, hedge funds - there was no such check.

So fat-greedy-greek-man (als soros) has 100m (capital). He buys an asset (bonds/shares) for 100m. He now takes the asset and pledges it to Bank A for new cash of 100m. Fat-greedy-greek-man now takes the 100m of new cash and buys another 100m of assets. He takes the new assets and pledges it to Bank C for another 100m. So on and so on. He does this 10x. So for 100m capital, the fat-greedy-greeek-man has now a portfolio of 1 billion. So a 10% move in his portfolio gives him a 100% return on his capital. The beauty of leverage.

Now leverage here would have been fine if it was only among the hedge funds...hell fat-greedy-greek-man could go bankrupt for all i care. BUT, banks became greedy.

Greed -
Bank A has a CEO, Mr-Dammit-i-want-to-be-the-fat-greedy-greek-man (Mr Dammit, for short). Mr Dammit says lets grow our hedge fund business (giving liquidity and leverage to hedge funds). This business is given the cool name - Prime Brokerage and it makes tons of money for the bank. Then Mr Dammit's greed twinkles and he says if hedge funds are making so much money, we should start our own hedge fund within the bank. This business is called proprietary trading (the business i am in BUT i manage responsibly, i promise). So Bank A - got 100m of capital from fat-greedy-greek-man, they use this 100m and lend the asset to bank b for new cash 100m, buys new asset and pledges again and again. He makes tremendous profits and Mr Dammit is happy as he is now making as much as fat-greedy-greek-man. Bank B CEO, Mr I-Cant-be-a-Loser (Mr Loser for short) sees Mr Dammit making so much and says....i wanna be like Mr Dammit. So Mr Loser uses the 100m tat Mr Dammit gave him and borrows money from Bank C, buys new asset, pledges and borrows more. He aslso does this 10x. You get the picture....

So if fat-greedy-greek-man leveraged 10x on his 100m, he has a 1billion portfolio. And if all the banks he borrowed from leveraged 10x as well, we now have 10 billion portfolio at stake. 100m has now become 10 billion.

That was the story of leverage which then led to the story of the CDO?

A CDO is a collateralised debt obligation - fancy words that just means that it is a portfolio of assets that have underlying collateral. The easiest and oldest loan in the bank's books is property loans to retail clients. In the old days, Citibank would underwrite a loan and do a proper due dilligence on the asset value, the ability of the borrower to repay his loan and the legality of his ownership (title and so on). But we are in the world of financial engineering and as we get more sophisticated, more risk/leverage is needed to make the same returns - hence the Subprime CDO was born. Subprime is a loan term to lending to the financially distressed and poor. It is the most risky retail lending that can be done.

The story of the Subprime CDO?

LeRoy Johnson is sitting on his crack-head girlfriend's porch drinking a bottle of 4D. A man, John Smith, who is a real estate broker comes up and says politely, "Sir, if you dont me asking, how much rent you paying on this house?". LeRoy says 300 bucks a month. John Smith tells him "I got a wonderful deal for you". For 250 a month, and no downpayment plus a 5000 upfront bonus, you can own this house. He pulls out a paper and tells, LeRoy sign here. Then tells LeRoy, round up your ho's and homies, they can get the same deal. John Smith, rounds up 100 borrowers who all sign for house loans worth 200k each telling them the bonus will be on the way. He now has a portfolio of USD20m.LeRoy just got paid 5k to borrow money for a house he does not even know. John Smith does not check the ASSET VALUE, the BORROWER's ABILITY TO PAY nor does he perform LEGAL DUE DILLIGENCE.

John Smith now takes his 20m portfolio and goes and has dinner with Jacky Lee. Jacky Lee is a beautiful Chinese American mortgage sales Manager at Shittibank. She is in a frustrating marriage and loves to have dinner with John Smith. Jacky Lee has also been very stressed at work as she has failed to meet her sales target that month. John Smith calls her and says i got a 20m loan portfolio for you. Jacky Lee is so happy she gets her boss (Shittibank) to agree to pay the 2% brokerage fee to John Smith. So John Smith sends her the forms and 2 weeks later he gets his check of USD400k (2% fees) in the mail. He calls and after a night at the motel with champagne and nudity, he tells Jackie Lee "See you next month" and Jackie dreamily replies "Be Looking forward to it".

Jackie Lee, the following Monday, compiles the 20m loan portfolio in a nice tidy package with a Citibank stamp and calls Amanda Stevens, her friend from their college sororiety days who now works at GOLDIE SAX as an investment banker. She tells Amanda she has got a new loan portfolio to sell to Goldie Sax. Amanda is thrilled and says lets meet. So after a night at the motel of whipped cream with strawberries and nudity, Jackie Lee says "See you next month" and Amanda dreamily replies "Be Looking forward to it:".

Jackie Lee does not check ASSET VALUES, the BORROWER's Ability to PAY nor does he perform LEGAL DUE DILLIGENCE. Jackie lee becomes a top performer in Shittibank and is given a huge pay rise and a 1yr bonus payment.

Amanda now has 20m of Shittibank's loans and she add this to a pool of 180m of other subprime assets. She now has a nice portfolio of 200m to sell. So she does financial engineering and places the 200m in a CDO portfolio and splits the asset into 3 tranches. She calls a big meeting at Aspen for her insurance clients and there she gets the rating agency to confirm that tranche 1 is a beautiful risk free AAA asset. The rating agency makes this claim citing Amanda's brilliance by making tranche 1 super senior to the other trances. This means, that tranche 1 will only lose money if more than 40% of the borrowers default. But the rating agency tells the insurance companies "Dont worry though, based on our superior models, default rates have never been more than 8% per year, hence our confidence in giving Tranche 1 the AAA rating. The insurers all clap and sign up (especially as they want to be invited to Aspen the next year).

Amanda, the Rating Agency and the insurers do not check ASSET VALUES, ABILITY TO PAY and no LEGAL DUE DILLIGENCE is performed.

Amanda then calls a meeting in Paris for all her asset management clients and the same Rating Agency guy tells the asset management company, Tranche 2 is rated AA1 (one notch lower than our AAA rating) and you will only lose money if more than 15% of the underlying borrowers default. But dont worry, based on our superior models, default rates have never exceeded 8%. Everyone stands and claps and signs up as they love the Paris meetings.

Amanda, Rating agency and Asset Managers do not perform....ASSET.....you get the drill.

Now finally Amanda calls for a meeting in Macao for her hedge fund clients. The rating guy is still around and tells the hedge fund guys, Tranche 3 is fantastic as you are going to be paid 15% to take the riskiest tranche in the whole portfolio but dont worry you only lose money if more than 8% of borrowers default. After a night of champane, cream, strawberries, and nudity, the hedge funds all sign up. Hell, wouldn't you its Macao.

Again not one person has checked ASSET VALUES.....blah blah....by the way Amanda gets a 1m bonus and drives a maserati.

So there you have the story of Leverage and the story of the CDO and when those two worlds collided, we have the Crisis we are now facing - the lack of ACCOUNTABILITY driven by GREED and the ease of LEVERAGE gave rise to 10years of continued growth gloabally and now we will face at least 2 years of hard times.

So where are we now -

1. LeRoy got shot in a drive by and is now claiming Medicare and has stopped paying for his crack-head girlfriend house.
2. His crack-head girlfriend is now thrown out of her house
3. LeRoy's ho's and homies are all in the same boat
4. John Smith used his collected fees and bought a ranch and fishes regularly
5. Jackie Lee has been fired from Shittibank as her last portfolio of 100m subprime loans went bad and she could not sell it to Amanda. She does not talk to Amanda anymore and has lost contact with John Smith.
6. Amanda met John Smith after being fired in a downsizing from Goldie Sax. She runs the ranch with John Smith.
7. The rating agency guy is waiting to see whether all rating agencies will be regulated and he may lose his job plus may be charged in court
8. The insurance companies are losing tons of monies on these structures and know that its gonna be a long time before they go to Aspen again
9. The asset managers will soon see massive outflow of funds
10. 60% of hedge funds will lose their clients and business. The balance 40% will become even stronger and rule the financial world
11. MR Dammit has been fired
12. Mr Loser is waiting to be fired
13. Fat-greedy-greek-man writes a book, supports presidents and is a regular on talk shows. He has 70% of his money in cash. He is smiling