Structured Finance 101

I never believed in things that I couldnt see

I said if I cant feel it then how can it be

No, no magic could happen to me

And then I saw you

I couldnt believe it, you took my heart

I couldnt retrieve it, said to myself

Whats it all about

Now I know there can be no doubt

You can do magic

You can have anything that you desire

Magic, and you know

Youre the one who can put out the fire

You Can Do Magic — America



Today’s post is the first of a two part analysis series describing the mixture of magic and alchemy that is structured finance. Part II, Systemic Risk in the Housing Market will be posted tomorrow. I will answer any questions you might have in the comments section.


Structured Finance

Structured finance is an innovation of the finance industry on Wall Street. It is a method of redistributing risk based on complex legal and corporate entities such as corporations, limited liability companies or some other kind of legal entity capable of entering into contracts. The shares or other interests in structured financial entities are derivatives that obtain their value from an underlying asset. Any asset that has a regular cashflow can be pooled through structured finance to create an asset-backed security. This cashflow can be split among various parties and valued based on the risk of repayment. For instance, the most common form of structured finance utilized to inflate the Great Housing Bubble was the collateralized debt obligation or CDO. A CDO derives its value from the underlying, asset-backed securities which in the Great Housing Bubble were generally bundles of mortgage loans. Mortgage loans have a steady cashflow stream as each homeowner pays their mortgage obligation, and these loans are collateralized by residential real estate. In the event of default on the mortgage held by a CDO, a house can be put through foreclosure to satisfy the mortgage debt and thereby return capital to the CDO.

In any asset-backed security, assets are bundled together to reduce risk and make the asset more attractive to investors. In contrast, if an individual buys a mortgage loan from a lender in order to receive the interest payments, this investor assumes all the risk of default. The default risk might be low, but if one party must bear this risk, the investor significantly discounts the security to compensate. However, if this individual investor buys a small share of a large pool of mortgage loans, the investor reduces their risk exposure significantly and thereby their discount for purchasing it. The value of the security is increased by pooling and thereby lowering the risk. Also, for an individual investor to purchase a mortgage loan requires a significant equity investment as mortgage loans are often in the hundreds of thousands of dollars. If a number of mortgage loans are pooled and sold off to many investors as shares or interests in a financial intermediary like a CDO, the equity requirement can be lowered considerably thus opening this type of investment to a broader investment community. It is the spreading of risk and the lowering of equity thresholds that makes structured finance such an appealing investment tool.

Collateralized debt obligations, like other asset-backed securities, are divided in segments known as tranches (rhymes with launches.) These tranches are typically titled: senior, mezzanine and equity based on their risk exposure. There is no single structure or formula for a CDO, and many contain numerous subdivisions resulting in more segments than the three described. Similar to the lien order of mortgage obligations, these tranches are paid in order of priority. The senior tranche is paid first, the mezzanine tranche is paid next, and finally the equity tranche is paid any remainder. Since these obligations are paid in order, the senior tranche has the least risk exposure and lowest returns, and the equity tranche has the highest risk and greatest potential for return. To further lessen risk (and make the transaction even more complicated) insurance policies are often issued to insure the buyer of a senior tranche against loss. These policies known as credit default swaps were a very lucrative business during the Great Housing Bubble. It was such good business that many insurers took excessive risks and lost a great deal of money when house prices declined.

Structure of a CDOThe real magic of structured finance is its ability to take assets of low investment quality and turn it into something viable. George Soros aptly titled his book, “The Alchemy of Finance.” Like the alchemists of medieval Europe, modern investment bankers try to turn lead into gold. The syndicators who create and manage collateralized debt obligations assess the risk of loss on the underlying asset and break it down into three categories corresponding to the three tranches. The equity tranche in a CDO assumes the expected risk of loss. For example, if subprime loans expect an 8% loss from defaults, then the equity tranche will be 8% of the CDO. The syndicator typically keeps this equity tranche as part of their incentive fee, but practically speaking, the discount would be so steep it is hardly worth selling. If defaults losses are less than 8%, they see tremendous profits, and if it is over 8%, they see nothing. The Mezzanine tranche assumes the risk beyond the expected risk. If the average default loss is around 8%, and the highest default loss ever recorded is 24%, the mezzanine tranche exists to take on this risk. There is a very good chance they will see most or all of their money because the average default loss is being absorbed by the equity tranche. The senior tranche is supposed to have no risk from default loss. The line between mezzanine and senior is at or beyond the highest default loss rate ever recorded. This is not to say there is no risk, but it would take an unprecedented event to see any losses in this tranche – something like the collapse of The Great Housing Bubble.

Syndicators of collateralized debt obligations go to the open market to raise sufficient capital to buy the necessary securities and cover their fees. Since there is very little risk to the senior tranche holders, they require a lesser return on their investment. Although they own 76% of the CDO and receive 76% of the cashflow, they will pay more than 76% of the capital costs of the syndication (close to 85%) and still receive their required rate of return because the underlying subprime loan pool is paying in excess of the return required by senior tranche holders. The mezzanine tranche has more risk, and they will require a higher rate of return more closely approximating the interest rate on the underlying subprime mortgage. The remaining cost of the syndication is raised by the mezzanine tranche. The equity tranche raises no additional capital, and it is generally kept on the books of the syndicator as a bonus.

One can argue that structured finance creates greater efficiency in our financial system because capital is freed to pursue other objectives. Although, it can also be argued, as Warren Buffet has, that derivatives, the product of structured finance, are “financial weapons of mass destruction.” Both arguments stem from the same characteristic of these securities: excessive debt. When the loan that became part of the collateralized debt obligation was originated, this money was created out of nothing by the originating lender. This is how all money is created in a fractional reserve banking system. As long as there is sufficient cashflow, debt creation is normal; however, when excessive debt is created and available cashflow cannot service this debt, the system experiences the very serious problem of insolvency which can lead to monetary deflation – the disappearance of lender-created money into the ethers from which it was created.

If an individual investor wanted to buy a mortgage loan, it would be purchased with equity rather than lender-created money. However, once packaged into a CDO, the senior tranche is often purchased by an investment banker or another lender which also created this money from nothing. Since the equity tranche raises no capital, the mezzanine tranche may be the only money in the structure not created by a lender out of the ethers. With so little “real” money in the deal, there is very little buffer between what would be a loss of invested capital and a banking loss of created capital. There is a tipping point where the debt service exceeds the cashflow, and when this tipping point is reached, the entire debt structure may collapses in a deflationary spiral. The structured finance products such as collateralized debt obligations and their derivatives are highly leveraged instruments with a very sensitive tipping point. Monetary deflation was a major concern to the Federal Reserve as the Great Housing Bubble began to deflate.

The use of structured finance techniques in the syndication of collateral debt obligations was not by itself a problem causing The Great Real Estate Bubble. This was part of the infrastructure for delivering capital to the mortgage market which began with the creation of the secondary mortgage market. In the aftermath of the crash of house prices, collateralized debt obligations received a bad reputation as dangerous securities unworthy of the safe, “AAA” ratings they received from the companies that evaluate the creditworthiness of financial instruments. The advantages of structured finance did not disappear because of problems with the market or the ill-advised ratings these securities received. Collateralized Debt Obligations did not go away, and they have continued to be an integral part of the capital delivery system providing money for buyers to purchase residential real estate.



99 thoughts on “Structured Finance 101

  1. granite

    I would like to know who these “syndicators” are. Have they escaped the debacle?

    What were their “worst case” assumptions in their spreadsheet models? No drop in prices?

    They created the Kool Aid and should drink it themselves!

  2. IrvineRenter

    The syndicators who created the CDOs all made great money in their up-front fees just like everyone else during the bubble. They were all hoping for a fortune based on a lower than anticipated default loss as this would leave money for the equity tranche they kept. That part of the plan obviously did not work since many CDOs are seeing losses all the way up into the senior tranche.

  3. ice weasel

    I’m with Buffet on this. This is alchemy at its worst. It’s merely another way to siphon and skim money that isn’t really there and leave someone else holding the sack. Great scam if you’re on the right end of it. Not so much if you’re left holding the bag of crap.

  4. ConsiderAgain

    Agree on the idea that this tiered package does not deserve a AAA rating. I believe there is a place for these vehicles, but how they are represented and rated is key. Junk bonds for example were represented as such.

  5. IrvineRenter

    These can be constructed in a way that deserves an AAA rating if they can accurately determine the risk of loss through default. The problem with CDOs during the housing bubble was they failed to properly value the underlying mortgages and the collateral which backed them up (the houses.) This caused them to grossly underestimate the potential for default loss. Basically, the breakpoint between the Mezzanine tranche and the Senior Tranche was misplaced, thus the senior tranche has risk it was not supposed to.

  6. George8

    There is a tipping point where the debt service exceeds the cash flow, and when this tipping point is reached, the entire debt structure may collapses in a deflationary spiral.

  7. ConsiderAgain

    Isn’t AAA the highest rating? How would one differentiate the rating between a CDO containing senior & mezzanine tranches only, and a CDO containing all three?

    For example,
    the bi tranche contains 65/35% (senior & mezzanine) and
    the tri tranche contains 65/33/2% (senior/mezzanine/equity)

    To create a true AAA rated CDO wouldn’t the equity portion have to be tiny, on the order of

  8. IrvineRenter

    A CDO does not get rated as a whole, the individual tranches are rated and sold. The senior tranche is supposed to be AAA, while the Mezzanine tranche might be BBB and the equity tranche is junk status.

  9. awgee

    I can’t help but wonder how many folks think, when they become informed on CDOs, “What does this have to do with me? I didn’t invest in any of these CDOs or tranches or mortgage backed securities or anything.”

  10. George8

    My question got dropped. Here it is:

    IR, can you illustrate with example why “…when this tipping point is reached, the entire debt structure may collapses in a deflationary spiral.” ?

  11. Surfing in Newport

    What is missing here is that structure financing made it possible for otherwise conservative funds to get hit by the bubble. AAA rating means that money market accounts, retirement funds, etc… can invest. So when you really look at who is going to get hit by this, it’s easier to say EVERYBODY with two exceptions: Wall Street (they always get their cut), and landowners.

    On the positive side, for those in So. Cal. land, it was the CDO that reduced the gap between conforming and non-conforming loans.

  12. Alan

    From my reading on Calculated Risk, the problem was not the CDO. In a properly functioning market, CDOs sound like they should work fine.

    The problem was the greed of the banks writing the CDOs. The banks making fee’s selling CDOs (Morgan-Stanely) promogulated new and lax lending guidelines for dispensing as many loans as possible. Previously conservative mortgage lenders couldn’t understand how lax the guidelines were and knew that this was a setup for borrower defaults. Combine this with inflated appraisals and you had a recipe for disaster. As evil as I think Mr Mozilla was (and I think he should be prosecuted and go to jail just like Mr Ken Lay), he was actually a shill for Morgan-Stanely, following their written loan guidelines to a tee in order to maximize their fee’s.

    If the lending guidelines hadn’t been allowed to become so lax (stated income, no skin in by borrowers, whatever appraisals) in order to maximize fee’s we might not be in this mess.

  13. Walter

    One small point, CDOs don’t reduce risk, they just allow you to spread it out over many investors, wrap it up with insurance products and cut it up such that you can chose the amount of risk you are willing to take. If they reduced risk, i.e. made the mortgage less likely to default, now that would be magic and worth a nice big fee. (Not that they did not take a nice big fee anyway).

  14. IrvineRenter

    Banks create money out of thin air. There is very little “real” money backing the loan a bank makes. Each time a lender extends credit, it creates money and adds to the total money supply. This is appropriate if the asset used as collateral has value as this system allows the growth in money supply to match the growth in financial assets produced in our economy. When too much money is created, it leads to inflation, and when money disappears, it leads to deflation. This is where CDOs come in.

    When debt is piled onto an asset like a house, what happens if the house loses value? The lender created money to match the houses value, and if this lender has to foreclose to get its money back, they may not get enough. If the amount of money the lender recaptures through foreclosure is less than the total amount of the loan they created, the money supply has just decreased. The decrease in our money supply is deflation, and since this is happening all over, our money supply is shrinking along with the value of homes. Since the structure of a CDO has such as small amount of “real” money backing it (usually only the mezzanine tranche,) it does not take much in the way of losses to wipe out the buffer between losses and deflation. The senior tranche in a CDO is often lender-created money, and when the senior tranche starts to lose money — which is happening right now — you have deflation.

    Don’t worry. Ben is running the helicopters and printing money as fast as the economy is losing it…

  15. IrvineRenter

    The problem with lax underwriting and inflated appraisals is the main topic for tomorrows follow-up post.

  16. IrvineRenter

    CDOs do not change the risk profile of the underlying security (as you pointed out, that really would be magic;) however, they do create a structure whereby securities can be constructed that really do have less risk. The senior tranche in a property constructed CDO has very little risk. In theory even if the default loss was much greater than expected, the senior tranche would not lose money or see a decreased return on its investment. Unfortunately, when the default loss is much, much greater than expected — as was the case lately — then the senior tranche experiences losses it was never supposed to see.

  17. Walter

    True the the senior tranche has less risk, but all that has happened is the risk was shifted to other tranches. Just wanted to make the point that the overall risk still remains. At the end of the day, someone is going to be left holding the bag.

  18. tenmagnet

    At $1.499M this house appears to be incredibly overpriced.
    Can’t even fathom someone paying $1.7M for it back in ’05.

  19. lendingmaestro

    Who is the idea who came up with the idea to offset the fireplace to one side? Better yet, a corner fireplace. It looks absolutely hideous and destroys the room’s functionality.

  20. gjw

    The average American will be left holding the bag, a very small bag indeed. The resiliency and intestinal fortitude of the American people is being put to the test.
    A question and concern is how great will the impact be? There is now a statistically significant number of people that have been affected negatively by the credit trouble and what will this group and there families do in the years to come with their housing needs? Has this credit debacle shifted the attitude of a generation away from buying to renting permanently? How great will the change in behavior be towards personal financial management and commitment of this group?
    As people are now abandoning their houses (financial commitments) before the dreaded “last resort” stage kicks in, simply walking away and hoping that they can re-capture their credit position when all this blows over. Hoping that they will be looked upon by a future lender as a victim of a terrible mistake or accident, not their fault.
    This credit shift is re-defining the financial management ability of families in America in other words families are receiving an education in money, credit, and risk that they missed out on in school.

  21. buster

    I don’t think the structure itself is a problem. It’s just the mis-pricing of risk. If the risks were appropriately priced, the interest rate demanded would have been so high as to act as an impediment to the housing bubble.

  22. lendingmaestro

    Hmmm……were 100% purchase loans included in AAA tranches just because the borrower had 780 FICOS? How about option arms? Fannie and Freddie possess a false sense of security as well. They are both seeing huge losses in their portfolio’s as well.

  23. Alan

    Exactly, the greedy wall street shills rewrote lending guidelines in order to maximize the number of loans written to maximize their fees. The ratings agencies and monoline insurers never knew what hit them. These companies were looking at loss ratios on historical loans based on conservative lending guidelines to estimate risk of these new loans which weren’t based on conservative lending standards (no stated income crap, 10% or more down, no inflated appraisals).

    Or as Mr Buffet says, when you dress up Cr#p, it’s still Cr@p

  24. skek

    In theory, and based on historical results, the senior tranche did deserve a AAA rating. I think two factors combined to create the problem — the structured finance innovations and the mortgage product innovations. Each one alone would not have resulted in the financial catastrophe we are witnessing. The structured finance vehicle is actually a very important tool for greasing the mortgage machine to continue lending. It seems to me that the problem was there weren’t enough qualified borrowers to borrow all the money Wall Street wanted to lend, so creative mortgage products were created to “find” new borrowers. Unfortunately, nobody went back and re-evaluated the structured finance vehicles to assess the risk, and as we’ve seen, default rates on many types of creative mortgage products are well in excess of historical norms.

  25. IrvineRenter

    I think you are exactly right. Tomorrow’s post goes into detail analyzing what went wrong and why.

  26. skek

    There were a number of brakes on the system that failed. To your point about the senior tranches — if the insurers who insured these senior tranches had done so responsibly, they could pay their obligations. As it is, the insurers also overextended themselves and will likely default on their obligations, resulting in losses at the senior level where none should have occurred.

    The “system” works, in theory. Unfortunately, in reality, everyone was blinded by the dollar signs and drove the system to an irresponsible extreme.

  27. Stupid

    Old, but interesting link

    “Consider municipal bonds. According to S&P’s long-term data the 10 year default rate on an A rated municipal bond is 1%; while a corporate bond’s default rate is 1.8%; and a CDO’s is 2.7%. An A rated muni has the same chance of default as a AA/AA- rated corporate and a AA+ rated CDO. When municipal bonds default the expected recovery rate is 90% compared to 50% on corporate and CDOs.”

  28. FairEconomist

    The problem is that the ratings need to be based on the *real* chance of default. They used the % failure if the model is right. The *real* chance is:

    (% failure if model is right)(chance model is right)
    (% failure if model is wrong)(chance model is wrong)

    Apart from the first number, these numbers are difficult or impossible to estimate. With any complex model, though, the chance that the model is going to be wrong is probably too high to ever justify an AAA rating unless there’s a very conservative estimate for %failure given the model is wrong.

  29. skek

    Good point, FE. I have a client who likes to describe business and financial projections as based on a “95% confidence interval.” I think they are right about half the time…

  30. Alan

    Nellie Gail home seller who went through 40 open houses over a 1 1/2-year period without a single offer finally sold his house Saturday during an auction that drew five bidders, including one online, his agent said. But Paul Beyer, the owner of the five-bedroom, Mediterranean-style house in the Laguna Hills enclave (pictured right), ended up accepting nearly $900,000 less than his original asking price of $2.09 million.

    If Nellie Gail drops from 2+M to 1M then the high end in Irvine is toast..

    Hear that iPop… Nellie Gaile for $1.2M what are you waiting for!

  31. IrvineRenter

    It isn’t just the chance of default, it is also the loss experienced if a default occurs. It is the default loss that is critical. Subprime loans have always had high default rates, but in a bull market, the default loss was always low because the value of the collateral was increasing. When you combine high default rates with a declining value of the collateral, then you get massive default losses like we are seeing now.

    The problems we are seeing in CDOs are really problems stemming from the valuation of the collateral underlying the mortgage loans that make up the CDO.

  32. lawyerliz

    If the pricing was accurate, nobody would have made the loans in the first place. It would have cost so much the interest rates would have been very high.

    Also, on some of those vehicles composed of second mtges, the losses will be extreme, down to 10 cents on the dollar to zero, for the so called AAA tranche too.

  33. IrvineRenter

    Hopefully, people will read tomorrow’s post to connect the dots between CDOs, mortgages and the value of the underlying collateral. CDOs and the secondary mortgage market in general are essential to providing low-cost capital to the housing market. Without them, mortgage interest rates would almost certainly be higher, and there would be markets where loans would simply be unavailable. Getting a mortgage to obtain a home at a reasonable interest rate should be of interest to anyone in the home market.

  34. kis

    Most risk assessments involve some type of VaR (value at risk) techniques, such as monte carlo simulation using expected +/- variations for the various variables. The trick I see is that they were probably using historical housing default rates for various credit scores, historical housing price depreciations in down markets, and the reset rate of return rather than the teaser rate.

    What occured, of course, is a systemic problem that the historical norms could no longer be applied when you skip requiring a down payment, skip due diligence on the origination side, and creating an inflationary housing bubble by influxing too much cash in too short a period.

    So their models are totally hosed. And this is creating a credit crisis because nobody knows how to price or measure these instruments now, so nobody is buying unless the spreads are high enough to counteract the uncertainty risk.

  35. ipoplaya

    Say it ain’t so! Even Bimmer sales are down:

    “SAN FRANCISCO (MarketWatch) – BMW Group said Monday its U.S. sales fell 1.8% to 24,190 in February from 24,642 vehicles in the same month of 2007. Sales of BMW brand slid 6.7% to 20,775 from 22,274 but MINI brand bucked the general trend with sales surging 44.2% to 3,415 from 2,368 during the period.”

  36. Surfing in Newport

    Here’s a concept. If CDO are investments like other bonds, then the dividing line between tranches should have been based on the average Rent to Value of the mortgages. Could have simply asked the appraiser to make this assessment at the same time. It’s the fundamental’s of the company that determine the rating of a corporate bond, shouldn’t the same apply to mortgage securities?

  37. IrvineRenter

    That is exactly the same conclusion I come to. Not to take away from tomorrows post, but I believe using the income approach in appraisals rather than the comparative sales approach would solve the problems in the CDO market. The value of the underlying collateral would be tethered to cashflow rather than the irrational exuberance of buyers.

  38. buster

    I always wondered who is holding the BIG bag in the MBS/CDO fiasco. From what I’ve read, there are trillions out there in flakey paper. The US and European banks have written down a lot, but nowhere near this amount.

    I mean, yeah we all hear about these huge losses. But a $14 billion loss is mice nuts compared to all the flakey paper that is supposedly out there. Who bought the bulk of this stuff? Who is sitting on the trillion dollar white elephant and why haven’t we heard more about it?

  39. CapitalismWorks

    The underlying valuation was based on cashflow, the cashflow generated by buyers and predicated on their credit. The value of the underlying collateral (the home) played a smaller in smaller role over the course of the bubble. Traditional lending is based on both the value of collateral (LTV requirements) and the buyers ability and willingness to pay (DTI, FICO).

  40. CapitalismWorks

    Ipop, I believe that is the same house referenced in the Lasner link…

    Nellie Gail lots are vastly superior to anything in Irvine. Being able to measure lot size in terms of acres instead of square feet is great. That said the location south of the Y, makes these homes far from perfect substitutes to high-end Irvine homes.

    The elementary school is good, the high school is bad

  41. CapitalismWorks

    The problem was the varacious appetite for anything that produced some yield by a market that took a hiatus on doing homework. Blaming the banks is like people trying to blame the fast food companies for their fat A**es!

  42. Formerbanker

    IR, you say: “The problem with CDOs during the housing bubble was they failed to properly value the underlying mortgages and the collateral which backed them up”. I am sure you are aware that valuation methods for SFR’s are pretty straightforward, and the primary method is the sales comp approach. Under USPAP, there is little room for appraisers to have the flexibility to say, ‘hey, I am going to value this home at 20% under the sales prices of the most recent three comps because I think the market has been increasing too much in 2003 – 2007 and it can’t be sustained’. That’s just not go to fit into the sales/market approach, income approach, or cost approach. Most large companies went to very automated valuation approaches to validate values as well. I think the problems, instead, are pretty basic: 1) underwriting stopped focusing on one’s capacity to pay a loan from cash flow and readily available liquidity! Mortgage loans became collateral based loans only, period. So, even if probability of default (i.e. ability to make payments as scheduled) was high, the loss given default (due to collateral protection) was extremely low, as another commenter pointed out- and presto! The risk levels assigned by the rating agencies were wrong from day one for these pools. By the way, thank FHLMC and FNMA for leading the charge on easy underwriting – many banks just continually adjusted their underwriting to be as easy as these agencies allowed to fit into conforming standards! 2) This century, the majority of loans were underwritten, originated and sold by finance companies (like countrywide) to subsidiaries of bank holding companies to be packaged/securities – and they were not as near as closely regulated as your traditional banks and thrifts, in my opinion.

    As I’ve noted in prior posts, please don’t underestimate the impact of investors and analysts touting stocks to even small investors had on underwriting. While common sense would tell those in charge of credit risk policy that reigning in LTV’s in markets that have seen rapid appreciation (20%+ for a few years), or verifying income available to service debt, would be good strategies in 2004, 2005, etc. such credit risk managers would be out of jobs because their tightening credit standards would literally take the companies out of the market- and I mean really out- vulnerable to be acquired – because investors had no tolerance for a bank with earnings less than 20% YOY growth in 2002 – 2007. Greed – not only the banks’ greed – but every individual who shorts stocks for fun, every Joe Schmo who moves $ around to companies with highest EPS growth rates (or shops mutual funds doing the same) – fed the fuel. Most investors didn’t and don’t care about risk adjusted return – they only cared about short term return and EPS growth in the short term, because they’re in it for the short term.

  43. kis

    Who is sitting on the trillion dollar white elephant and why haven’t we heard more about it?

    The ‘beauty’ of the MBS/CDO market is that this exposure has been spread far and wide. Some of it will be borne by homeowners who will lose equity yet will still make good on their mortgage. Some of it will be borne by car/retail/contractor companies who lose business because more cash is going into the reset mortgage payments. Some of it will be borne by banks who realize losses in unloading their REOs. Some of it will be borne by bank stockholders who write down their CDO losses(writedowns apply directly against retained earnings). Some of it will be borne by the various CDO tranche holders in the form of reduced return. Etc etc etc.

    Answer – for good or bad, its been diffused across the economy as a whole.

  44. Surfing in Newport

    I suggested GRM because this method would have the benefit of increasing interest rates during a bubble and decreasing them as it deflated. This would serve to reduce volatility in the market which is better for everybody. And fundamentally, a bond rating is based on the ability of the underlying assets (P&E or right to tax) to produce income to make the payments. So to the extent that a property can be rented to make the payments, it reduces the risk of the applicant not having the income in the future to make the payment.

  45. ipoplaya

    It does not appears to be the same house CW based on the pictures or the listing history…

  46. Stilldoubtful

    I have always wondered when home prices started coming down, would the economy follow. Now everyone has been waiting for home prices would fall, would you want to even buy now? That is the question. When today’s home prices still take up 30 – 50% of your income. Will the economy be there for you keep making the payment.

    Warren Buffet owns every type of company out there, and if he is saying today we are in a recession and it is very slow out there —

    “By any common sense definition, we are in a recession,” Buffett said. “Business is slowing down. We have retail stores in candy, home furnishings and jewelry; across the board, I’m seeing a significant slowdown.”

    Buffett also said the slowing economy and the housing slump are hurting his Berkshire Hathaway Inc (BRKa.N) (BRKb.N) insurance and investment company, whose 76 operating units sell such things as bricks, carpeting, ice cream, paint, real estate brokerage services and underwear.

    I think home prices are going to fall faster than expected as even renters will wait and see if the economy will improve to pay for that mortgage.

  47. Iblis

    I hope that tomorrow’s post apportions some of the blame to home buyers who were willing to bid prices through the roof.

    Capitalism, like democracy, requires a certain amount of informed, rational participation from the public.

  48. CapitalismWorks

    Look at the pictures again. I swear that is the same hideous front balcony in both pictures!

  49. ipoplaya

    You are correct CW. I tracked down the address and they are one and the same… Guess the $850K was the starting bid price and a new listing to boot.

  50. zaleriana

    The senior tranche of a given CDO is whatever investment grade rating (necessary only b/c w/o investment grade, what’s the point?) the senior tranche deserves. Lately, it has been mostly AAA, b/c that’s the market with the most liquidity, but it is not necessarily so. Also, many senior tranches only get their AAA ratings as a result of purchased insurance.

    The real problem is not the structure of the bonds or the CDOs, but rather the liquidity “created” by the availability of additional capital. The additional capital looking for a home (so to speak) started a negative feedback loop with the loosening of lending standards, which begat more loans and even looser standards. The distancing of the loan originator from the underlying risk also helped things along, but the same is true for Fannie and Freddie loans, so it’s not strictly a CDO/MBS structure problem.

    If everyone really wants to get upset, look into CDO-squared–which take the subordinated pieces of one CDO (IR’s Mezz piece) and re-package them into a new CDO which again gets an investment grade rating for its senior piece. Even then, it’s not a structural problem, it’s an underwriting problem from both the rating agencies and, more importantly, the buyers. When everyone chooses to ignore changing circumstances, then there is a siginificant risk of loss.

  51. tonye

    “The value of the underlying collateral (the home) played a smaller in smaller role over the course of the bubble. Traditional lending is based on both the value of collateral (LTV requirements) and the buyers ability and willingness to pay (DTI, FICO).”

    But in this market, the WILLINGNESS of buyers to pay is a function of the LTV. If they sense they are upside down and they are seeing a reset of their rates then they incentivized to walk away. This has little to do with FICO scores. At some point, the temporary hit on credit is seen as preferrable than carrying an albatross around the neck forever.

  52. Nitpicky Engineer

    Not to nitpick your comment (which is a good one IMO) but the term you should use is “positive feedback”, which in engineering terms is feedback that exaggerates the initial signal. Negative feedback is used to correct or reduce the output, whereas positive feedback increases it without limit (or until the device maxes out). Example: positive feedback is what causes a PA system to squeal.

  53. tonye

    I guess I’m lost. I though banks could only lend from their deposits. The way I see it, you and I go deposit money with our bank in a savings or CD account and that money gets loaned.

    What is different?

  54. tonye

    Nice house…. but then I saw the commute. This would force us on the toll side of the 73 everyday ( we get off/on at Bison ). So you gotta add 20 minutes (25 miles) each and 90 bucks a week for toll roads for both of us. That’s a lot of gas and tolls.

    No thanks.

  55. CapitalismWorks

    I figure anything south of the Y should be discounted about $60K, due to the amount of mortgage that all those tolls could carry. Never thought about the additional gas though…

  56. ipoplaya

    I ran numbers for a south of the Y commute, assuming use of the 73, and at 7% mortgage rate, you are talking about $175K in mortgage for two commuters.

    I figure $145/week in tolls are additional gas. That is $628 per month in after-tax dollars. On a similar after-tax basis, that is roughly equivalent to $175K in mortgage at 7% flat.

    Figure anything for value of the additional commute time, extra wear-and-tear on vehicles, etc. and the difference should be $200K+ for two people communting to Irvine.

  57. ipoplaya

    This head cold is killing me. Please forgive all the darn typos today and likely tomorrow as well…

  58. ipoplaya

    Marxism isn’t evil, just plain dumb and wrong. It’s an impossibility that flys in the face of basic human nature…

    Hey, wonder why it was called MarxEngelism? Engels was maybe the bigger thinker and doesn’t get squat in terms of pub!

  59. IrvineRenter


    In a fractional-reserve banking system like ours, banks are allowed to loan more money than they have on deposit — a lot more. The ratio fluctuates, but it is often 100 times or more. So for each dollar they have on deposit, they can loan $100. Banks have the ability to create money out of nothing in this manner.

    Check out this video:

  60. Emma Anne

    Gosh, what an . . . ordinary looking house. Almost $2 million in 2005, huh? And the listing includes many !!! and at least one spelling mistake, just like the more moderately priced houses.

    “BANK OWNED!!!”

    How exciting.

  61. Emma Anne

    I am trying to understand why this deflation is a bad thing. If banks created $$$ when the asset grew in value it seems right that the $$$ ought to disappear when the asset goes down in value. But the term “deflationary spiral” is sufficiently scary that I suspect I am missing something.

  62. CapitalismWorks

    Mine was back of the matchbook (and my wife stays at home), but your numbers sound just about dead on.

    BTW, have you tried snorting salt water? In know it sounds crazy (apparently it was also featured on Oprah). There are some kits at the drug store.

    Seriously, if you haven’t done this before, YOU MUST!!!

  63. IrvineRenter

    The problem with deflation is that it is very difficult to stop once it gets going. When there is deflation, cash becomes more valuable, and people stop buying and hoard cash. If people stop buying and stop circulating money, asset prices fall, and the economy slows down dramatically.

    Krugman on deflation:

  64. profette

    That’s a fantastic post, IR. It’s very clearly written (not an easy thing to do given the topic). I look forward to tomorrow’s reading.

  65. Walter

    If you own a money market fund that has any of these CDOs in them I would keep on your toes. There is a risk of loss of capital. Although, up to this point, if this has happened, the fund companies have made investors whole. At least that is my understanding.

  66. tonye

    Thanks for the info.

    I also googled “create money out of thin air” and it was a real eye opener.

    Now all I need to do is to make “The Bank of Tony”, deposit 100K in it, and go banking. I figure I can raise a million and I’m in business.

    Besides a corporation, what else do I have to do to become a bank? Are there “Type S Banks”… ;-D

  67. skek

    You jest, but that’s exactly what is being done. We work with several entities who have “created” private banks — they take on a few wealthy clients and oila! — a license to print money. OK, so it’s not that simple — but close to it. There’s a niche industry out there advising folks who want to create their own business banks.

    Maybe that’s the business venture that gets spun out of this site? First National Bank of IHB? Me likey.

  68. MalibuRenter

    Regarding the 95% confidence interval problem, I do a lot of simulations models, not for real estate, but for other types of finance.

    Simulations are invaluable in showing what the primary drivers of risk are, for the items included within your model. There is a subtlety of building good simulation models: getting the exact right chance of something occuring is extremely difficult. However, if your model is somewhere near correct, you get to look at the outlier simulations and see what happened.

    If I had been doing real estate simulations, I am completely certain that two of the risks in my model would have included real estate appreciation far below historic norms, and difficulty refinancing.

    For the field I do work in, one of my variables is spread to treasuries. I already knew how much damage my clients would have if their rates moved strongly out of line with historic credit spreads. For the models I did, the relationship didn’t stay permanently out of line, and we looked at how long they could tolerate the problem. The model says they will be fine for 2+ years. That’s plenty of time to make adjustments, or watch the market correct itself. There’s a big difference between mild to moderate pain and serious credit problems.

    Still, the type of analysis I do is not the standard. There are a lot of public and private entities that get very accustomed to certain costs and availability of credit. That’s fine for the base case, but you should look at what happens when those things change.

  69. MalibuRenter

    People hoard cash as long as there is something with a decent return, or at least a safe inflation hedge. If the inflation is high enough, or the real returns go far enough negative, people start to spend. However, especially in the modern economy, it’s very hard to keep all of the investments with negative real returns. For example, municipal bonds have departed from their historic returns.

  70. lendingmaestro

    please clarify just what makes a borrower prime or sub prime for me then. Can you also review the qualifications for receiving a AAA or AA rating?

  71. lendingmaestro

    Can you please clarify just what makes a borrower prime or sub prime for me then? Can you also review the qualifications for receiving a AAA or AA rating?

  72. MalibuRenter

    Most equity investors are longer term. However, there is enough turnover to make the stock prices move considerably. There is a huge amount of trading caused by stock analysis. Every time a new analyst report comes out, new people pay attention to that stock, and are motivated to buy or sell. The short term investors churn their x% of market cap for a stock over and over. The long term investors might trade out of a stock every few years.

    A few firms have management which tries to get long term investors. They tend to believe that investors with a long term view will have the least tendency to jump in and out of the stock, whip executive stock option values around, etc.

  73. No_Such_Reality

    The CDO was based on the cash flow of the mortages however the underlying asset for the default case was not.

    If a mortgage would have needed to be justified on a rental parity basis or have the buyer bring the extra capital, the impact on the housing bubble never inflating would have been far more severe than requiring 20% downpayments and prices would literally have stall about 2001 when people didn’t have the additional cash reserves to qualify for mortgages above the rental value.

  74. No_Such_Reality

    Let me translate what Malibu said.

    In a deflationary spiral, people horde cash because the other stuff is all going to be worth less tomorrow. Except when inflation runs wild and holding cash for tomorrow will make it worth less than the stuff that is going to be worth less.

    In other words, people horde cash until everything grinds to enough of a halt that they spend it all buying a dozen eggs because tomorrow they won’t even be able to buy a dozen eggs.

  75. No_Such_Reality

    Most were rational. Here’s their thought pattern.

    I have nothing.

    I can buy with nothing.

    I can live in a big nice new house for basically nothing using an option ARM, or at least, less than renting a two bedroom apartment in Irvine.

    I will loss nothing when they foreclose because my credit was already shot.

    and if I’m right and housing goes up, I’ll make more in six months than I can at a regular job.

    if I’m wrong, I stop paying and live like a king for 6-9+ months before they kick me out.

    If you don’t have anything but a marginal credit score, that looks pretty rational to me.

  76. tonye

    Hey. Who does a private bank get created? Maybe I can make a killing selling the package on TV… ;-D

  77. tonye

    Try drinking a couple of hefty sniffers of good tequila. I think Trader Joe’s still carries Sauza Hornitos.

    I can’t do it anymore because I gotta lose molto wait. :~P

  78. Woodbury Renter

    Here is where you are striking near the heart of it. Irrational belief in mathematical models without understanding their underpinnings. As LTCM was the first to discover, confidence intervals and resulting Value at Risk models work off of the concept of the normal distribution, which itself assumes that the results in a given sample are independent of each other. Unfortunately financial collapses have demonstrated over and over that in financial markets there is self propagating CONTAGION driven by fear. This destroys the concept that the default risk of the most senior tranche was “less than x percent because the likelihood of default was more than 2.5 SDs from the mean. blah, blah, blah. You know your model is wrong when outcomes that you predict can only happen once in 10,000 years happen every day for a week. Unbelievably you will hear some of the true believers say that it is “amazing that we lived to see such a rare occurrence”. Uh, no – we just lived to see how wrong your model is.

  79. zoiks

    The topic of how much losses the holders of the various sorts of mortgage securities are experiencing comes up often. It’s relatively easy to conclude that it’s probably higher than the $100 billion or so that some people have claimed.

    First off, as everybody knows, the Case-Shiller HPI has indicated a 9% loss nationwide in housing prices for the year 2007. Let’s first assume that this is effectively a statistic on the *average* home price. (I haven’t seen that claimed yet, but neither have I seen otherwise. It seems illogical to me that it would track the median, but I could be wrong.) Second, let’s assume that as go the SFR’s (which is what the CS HPI tracks) so go the condos (which the CS HPI does not track).

    Then we can say that 9% of the US aggregate home value at the start of 2007 has departed for greener pastures. The Fed’s data indicates an aggregate home value of 20.6 trillion (9.6 of that being mortgaged, so in a fashion, owned by the bank) at the beginning of 2007. We can conclude that around 1.85 trillion of total home value “vanished” by December 2007.

    Determining how much of that 1.85 trillion is distributed to the mortgages’ net values is difficult. But it’s a reasonable zeroth order estimate to say they would fall in the same ratio (which would leave the aggregate percentage home owner’s equity unchanged), for example. This doesn’t mean the losses have been realized, but it’s an estimate of what will be realized. That would bring us to a loss of about 860 billion on the mortgages so far (actually, to the end of 2007).

    So, at least with that back-of-the-envelope estimate, we could be nearing 1 trillion in mortgage losses as we speak. I’m not saying it’s accurate, but it should be in the ballpark. I realize that I’m conflating securities value with the net principal, but hey they should move together to a large degree. Percentage losses on home values =~ percentage losses on mortgage securities.

  80. Lost Cause

    Marxism isn’t an invention, any more than evolution is an invention. Where do you read your propaganda pap?

  81. RichW

    I’ve been thinking about the ‘risk pooling’ aspect of structured finance, which I perceived as one of the selling points. However, such a model makes implicit assumptions about the types and distributions of failures (defaults) of the component mortgages comprising the pool.

    If the failures are independent then the pooling can attain its goal of spreading the risk amongst the different investors.

    However, if there is broad and correlated mispricing of assets, then the later drop in asset prices, and failures of the component mortgages, are also going to be correlated. This is where we are now. In essence, the supposed benefit of risk pooling was not attained, and an investor in such products is no better off than one who makes a concentrated bet.

    An analogy is in information theory of communications, and the use and design of codes to detect and correct errors. This is often done with multiple layers of codes designed to attain different results and mitigate different effects. One layer of coding is designed to handle ‘impulsive’ noise spikes that have some (known) random distribution over time, but are short-lived (localized); another layer of coding is intended for ‘fading’ events where there is a longer interval of lost signal. The analogy here could be that the risk-pooling is designed for independent and infrequent noise spikes (failures), whereas what we are seeing are prolonged intervals of signal fading (correlated failures that occur in ‘clumps’). Just like any problem of mathematical modeling, failed assumptions lead to broken models, a la LTCM.

    BTW, Thanks for all the informative posts!

  82. belle waring

    I dissent on the more houses–less analysis call. these posts are very clear and informative, and I have learned a lot from them. of course, mcmansion schadenfreude and wtf pricing posts will always be the ihb’s…hmm, I was about to say “money shots”, but let’s go with “bread and butter” since this is a family blog.

  83. zaleriana

    Yeah, you’re right N.E., but see:

    When talking economic/finance, I think of it as a “negative” “feedback loop” rather than a “negative (or positive) feedback” “loop”. Sure, it’s typical of well-despised MBA-speak non-sense–co-opting a sort-of-understood term from another field and then using it in an almost perfectly incorrect way, but it is fairly broadly used. And it even makes a certain amount of sense when parsed as I do.

  84. zaleriana

    There are lots of ways to “qualify” for a AAA rating. You can get a AAA rating for a pool of written-off credit card receivables. There could be a AAA tranche of out-of-the-money recourse second mortgages. Except for the illegality of the underlying debt, the mob could get a AAA on racketeering proceeds.

    You can get to AAA with quality of assets, quality of credit risk for the underlying borrower, appropriate structure, credit insurance or other ways. The most misunderstood in this discussion is the structure. If you have subordinate tranches sufficient to absorb the default risk, then anything can (and should, even with tough underwriting/rating) have an investment grade piece. Maybe the AAA piece should only be 10% of the overall issue (which means it is very unlikely to ever get done), but you can structure any pool of cashflows to provide an investment grade piece.

    The problem was everyone structuring RMBS in the 2002-2007 period was way, way over-optimistic when determinig default rates–they used historical default rates during a period that had no precedent as to the looseness of credit and the acceleration of asset pricing. It was entirely foreseeable, but no one wanted to see it–just like the internet bubble, (almost) everyone wanted to believe that there was a new paradigm that allowed a decoupling of price:rent (for housing) or price:earnings (for internet companies).

    So you got CDOs with (as a made-up example) 85% in the AAA tranche, 10% in a BBB- and 5% equity, when good underwriting would have had 60% or 65% AAA, 10-15% BBB- and 20-30% equity. But if it’s done that way, it’s toxic from day one (who wants to plan for a 30% loss?) and whoever tried to structure it to reality gets cut out of the deal and future deals for being “unhelpful” and keeps that reputation (or even have it amplified, however unfair) after being proved “right”. And this is a world where, unless you have lots of risk capital (e.g. GS, with their big bet against RMBS in ’07, and a couple of hedgies), the only way to make money is by being in the deals–so you can’t afford to say “No” to too many people. Never forget that “No” is a big reason that business-types hate even their own lawyers–they forget the help and only remember the deal that didn’t happen b/c of the guy who said “No”.

    On the other question, Prime v. Alt-A v. Subprime has been detached from reality for a while. I’m not sure anyone can provide a definition of who fits what category that actually correctly categorizes everyone who borrowed/will borrow from 2004-2009. Maybe if real underwriting returns, but not right now.

  85. Iblis

    Yes, for a small number of buyers that would be rational. For anyone with equity, a good credit score and maybe a job (i.e. – something to lose) it was a ridiculous, irrational gamble.

  86. CapitalismWorks

    Apparently Cause is the only thing that is lost. Of course Marxism is an invention. Evolution is based on scientific inquiry and observation. Marxism is a utopian concept designed to address perceived problems with civilization.

  87. djd

    Unbelievably you will hear some of the true believers say that it is “amazing that we lived to see such a rare occurrence”.

    I’m reminded of a (probably apocryphal) bit of dialog which supposedly occurred at a Soviet ministry (MiniMedMech?) when news of the Chernobyl disaster arrived:

    “I thought you said that the chances of a serious reactor accident were one in a million?”

    “Yes, and this seems to be it!”

    The parallel between the Great Housing Crash and Chernobyl & other industrial disasters works on multiple levels: the so-called “Normal Accident” can occur because it is generally believed to be (practically) impossible. (NB: that last is my commentary and may not be the view of Charles Perrow, who coined the term “normal accident”.)

  88. djd

    To be excessively pedantic, there’s the theory of evolution, which is the invented bit – it posits the existence of a natural process called evolution. The process exists (or not) independently of the existence of the theory. This raises the potentially interesting question of whether economic activity could practically conform to an economic theory as yet unwritten (can the theory be descriptive instead of proscriptive?).

    I’d also like to take this opportunity to repeat one of my favorite economics jokes: “Capitalism is without a doubt the worst possible economic system, except for every other one that’s ever been tried.”

  89. Formerbanker

    Please show me some information that shows most equity investors are long term. I’m not being a wise-guy, I really am interested in your source(s). And how do you define long term…I consider it to be 5 years or longer.

Comments are closed.