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Friday, January 11, 2008

CDORant: From The RantVault...

Note - from June 24th 2009, this blog has migrated from Blogger to a self-hosted version. Click here to go straight there.

From time to time my adoring public sends me snippets of current and past wisdom; the current wisdom is usually from other writers, but the past wisdom is usually from these very pages. Sometimes the past wisdom stuff highlights points in time at which your beloved GT has been subseuqently proved by history to have been an idiot, but most of the time it's a hearty "You were right, O Brainy One".

Once a prediction is over with (for good or ill) I tend to forget it - except if it's DavNet or News Corpse. But considering all the hand-wringing over the current 'credit crunch', it really does warrant revisiting past wisdom: was it foreseeable? Here's some past genius... almost 4 years old - I have not even corrected the numerous typos: 

Usually the vendor-finance loan book is periodically "packaged" as "Collateralised Debt Obligations" (CDOs) and issued as a bond-like instrument; in order to have these "bonds" rated highly, vendors can purchase "default insurance". So you can have a segment of a risky loan book coupled with some default insurance, and thanks to an AA rating, get top prices for them (and of course this counts as "earnings". This is particularly popular for US banks (and GSE's like Fannie Mae and Freddie Mac) for their mortgage books.

The resulting bond includes an instrument (notionally) which shifts default risk to the insurer; insurers are happy because they get to collect all that lovely premium.

Where it comes undone, is the assumption of independence of default risk across the entire CDO - that is, the default insurance premium is calculated as if the risk of default of one loan within the CDO is independent of the risk of any other loan within the batch.

Think for one second about that: in a world where mortgages are increasingly being extended to less and less creditworthy individuals (have you seen the commercials on TV lately?), the "correlation" between defaulters is likely to be much higher than zero. Things that make one sub-prime borrower default are highly likely to make other sub-prime borrowers do likewise: rising uneployment or slower real wage growth are felt overwhelmingly at the lower end of the creditworthiness spectrum.

Folks who run banks don't care a damn about anything that happens to their book, so long as it happens after they leave. The people who take their place can use the previous incumbent as the fall guy, or initiate an "inquiry" which exonerates everybody... behaviour typical of bureaucracies.

We are at the "Wile E Coyote" stage now; people are borrowing floating-rate money to refinance fixed-rte obigations, and are adding to debt on top of that in order to fund the gap between the lifestyle they can afford and the one they think they ought to have. Banks andother financial intermediaries are in no way discouraging this, because so long as everybody is pedalling and inflation is depreciating debt over time, things have a chance of working out just fine.

People are relying on inflation to bail them out - as it bailed out an entire generation of mortgage holders in the 1970s. These are the current 60-somethings who are the genesis of the national mindset that property is a "slam dunk", and who have passed that investment whackery on to their kiddies, who are currently engaged in financial-suicide-by-property-speculation. They don't realise that it was massive inflation and incredibly low fixed mortgage rates that made their parents' homes such a stellar investment. And in the 70s, debt ratios were nowhere near where they are today... we are beyond redemption now, and all that we can do is prepare ourselves for the reckoning.

Money and Growth, August 29 2004