Cutting Through Merrill Lynch's "Hairball of risk"

Another one from CJR.

Anyone interested in understanding how and why the housing bubble is bursting would do well to read Ryan Chittum's write up on collateralized debt obligations or CDOs.

Read the WSJ piece, too - but Chittum's piece is a great warmup.

As has happened before, the banks have once again run amuck - and we are all being asked to save them from their foolishness.

The WS piece, Wall Street wizardry amplified credit crisis details the sad history of a particular CDO called Norma.

Chittum's piece is the better intro, but essentially, the CDO is pooling mortgages so they can be sold off to investors. If you're willing to take more risk, you can buy a "slice" that will be affected first by losses. More risk averse investors would choose a slice that losses would only affect after they'd burned through the riskier slices (i.e. you get a lower return in exchange for getting screwed last)

Norma sold some $525 million in CDO slices - largely the lower-rated ones with higher returns - to investors. Merrill declined to say whether it kept Norma's triple-A rated, $975 million super-senior tranche or sold it to another financial institution.

Many investment banks with CDO businesses - Citigroup Inc., Morgan Stanley and UBS - frequently kept or bought these super-senior pieces, whose lower returns interested few investors. In doing so, they bet that the top CDO slices, which typically comprised as much as 60 percent of the whole CDO, were insulated from losses.

By September, Norma was in trouble. Amid a steep decline in house prices and rising defaults on mortgage loans, the value of subprime-backed securities went into a free fall. As increasingly worrisome delinquency data rolled in, analysts upped their estimates of total losses on subprime-backed securities issued in 2006 to 20 percent or more, a level that would wipe out most triple-B-rated securities.

Oops.

Y'know what's interesting about all of this?

Here's naked capitalism, doing what we expect - making money. In order to make money they are incurring risk.

What's messed up is that they are masking the level of risk to their investors with these CDOs, and then - then when things go south in a big way - they run to the government for help.

Collateralized debt obligations? More like collective debt obligations.

The cost of their risk is paid by everyone. Socialism - at least when it comes to losses.

When it comes to making money - then it's laissez faire, baby. Hands off, big bro - the market needs room to do its business.

Hah. This is going to get worse - the commercial real estate sector was up to the same kind of shenanigans. I wonder how long it will be before that batch of banks is running to the government looking for a handout.