Former professional trader and hedge-fund manager Shah Gilani says the very complexity of the global financial system brought us to the brink of a total meltdown. Asset-backed securities such as structured collateralized debt obligations, credit default swaps and the horrific offspring of the two, credit default swaps on structured collateralized debt obligations, are the main culprits, says Shah:

An asset-backed security (ABS) is a type of tradable debt security that’s derived from a pool of underlying assets. We could be talking about a pool of mortgages, of automobile leases, or loans made to various borrowers. We’re using the example of residential mortgages, though the example is exactly the same for commercial mortgages, automobile leases or bank loans. Here’s how it works.

Anatomy of Mortgage Loan

A mortgage company makes home loans in your county, as does your local bank branch. Then an investment bank comes along and buys the mortgages from the mortgage company and from the bank. It only wants to buy the mortgages made to prime borrowers who are paying 6% interest on their mortgages. Once it acquires those loans, the investment bank securitizes the mortgages, meaning it pools them into a tradable package it can sell to investors.

This particular pool is known as a “closed pool,” meaning no more mortgages will be added, though some may leave the pool if the underlying borrowers pay back their mortgages early because they sold their homes, or refinanced them, or if underlying mortgages are in default and the “servicer” allows them to be removed from the pool. The only income coming into the closed pool results from the monthly interest and principal payments being made by the homeowners.

In our example - because all the mortgage loans were made to so-called “prime” borrowers with strong credit - you might have an investment grade (A+) security that pays 6%, because all the mortgage holders are paying 6% and the payments are being passed through to the investors. That’s it. There are very good, though not exact, methodologies to value this particular security, primarily because it is uniform in that all the mortgage payers are prime borrowers who all are paying 6%.

Asset-backed-securities become infinitely more complicated when they are sliced and diced into structured collateralized instruments. They generally fit into two main categories:

• Collateralized debt obligations (CDOs), which include all manner of residential and commercial mortgage-backed securities.
• And collateralized loan obligations (CLOs), which are pooled bank and investment-bank loan portfolios.

CDOs and CLOs are created from “closed-pool,” asset-backed securities. They are collateralized by the underlying assets - hence the prefix - but they are also “structured.” In our example above, our asset-backed mortgage security was rated A+ and pays the investor who buys it 6%. If I want to create higher-yielding securities that I think I will be able to sell a lot more of, I will pool mortgages from subprime borrowers.

Because subprime borrowers are, by definition, higher-risk borrowers, the mortgage companies and banks charge them higher rates of interest to offset the greater risk that they represent. If I pool these mortgages, their ratings would be “junk” - or close to it - which will be a problem as I try and sell these securities to investors all around the world.

That’s where the magic of financial engineering, better known as structuring, comes into play. I can divide up the closed pool of subprime mortgages and structure the pool into layers, or tranches. What I’ll do is divide up the pool into multiple tranches, or slices. I’ll structure the cash flow payments from all the mortgages so that if the 1st or 2nd tranches run into trouble, I’ll take cash flow payments from the lower tranches to keep up with all the payments to the holders of the 1st and 2nd tranches.

For someone trying to peddle these asset-backed securities, this is a stroke of genius. In our example, since I’m now pretty much guaranteeing that the 1st and 2nd tranche security holders are going to get paid, maybe I can get the Big Three debt-rating companies - Standard & Poor’s, Moody’s Investors Service (NYSE:MCO) and Fitch Ratings Inc. - to give my 1st and 2nd tranche CDOs’ investment grade ratings. Maybe I can even buy insurance from a monoline insurer like AMBAC (NYSE:ABK) or MBIA (NYSE:MBIA), and get my top tranches a coveted “AAA” rating. Wow, I could sure sell a lot of this high-yielding stuff with an investment grade rating!

That’s just what happened. And they did sell a lot - a whole lot.

Those Troubling Tranches

As I said in Part II of this investigative series, CDOs - on an individual basis - are difficult to value. Indeed, “legend has it that constructing the cash flow payments on the first theoretical 3-tranche CDO (the simplest type of CDO) took a Cray (NYSE:CRAY) supercomputer 48 hours to calculate.

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More on this topic (What's this?)

How Credit Default Swap Settlements Are Draining Liquidity From Interbank Market (naked capitalism, 10/28/08)

" Credit Swaps Top $33 Trillion, Depository Trust Says" (naked capitalism, 11/5/08)

Plumbing of CDS becoming clearer (Option ARMageddon, 11/5/08)

Read more on Collateralized debt obligation (CDO), Credit Default Swap (CDS) at Wikinvest

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