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Treasury Plan Must Tackle CDOs and CDS or Fail

Shah Gilani — Wed, 24 Sep 2008 13:59:48 +0000

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.

And Then There’s This… Tuesday, June 24, 2008

Ed Steer — Tue, 24 Jun 2008 17:53:02 +0000

In Far East trading on Monday, both gold and silver rose gently until later in their trading day. From there they began an equally gentle decline (dollar related?) that lasted all through London trading until the moment the Comex opened. Then it was lights out as the bullion banks pulled their bids and the floor price evaporated in a heartbeat.

By the time the smoke had cleared less than half an hour later, gold was down about $27 and silver got creamed for around 75 cents…both with monstrous volume. This is the most blatantly obvious bear raid I’ve seen since the one we had a week ago Monday…LOL!!! I’ve seen bigger price declines in both metals in a single day, but not in such a short time period. The gold cartel finally gets the magic 10/10 “Waterfall Award”…because it’s as straight a line as you’ll ever see. But silver spoiled the show, and I felt compelled to dock the boyz a bit because they didn’t get the price down more than a dollar (even thought the chart was just as pretty as gold’s)…so the boyz over at Scotia Mocatta and HSBC (USA) Ltd. (HBA.PD) only get a 9.9/10. Options expiry on the Comex is tomorrow at the close of business, so they’ve got a couple more days to get it right.

It’s a good bet that virtually every long that was placed last week by speculators and the tech funds got stopped out by the raid yesterday morning. Even Dennis Gartman, who had placed another bet on Friday (and maybe added to his position early on Monday morning if he was really unlucky), got blown out. This is the third time in the last couple of months that he’s been taken out within days (if not hours or minutes) of placing a long bet on the gold market. As one well-known NY gold commentator said yesterday; “Some of gold’s friends will find this amusing…but that is foolish. The question is, what is present in the market which causes this very well informed and alert technical/momentum player to go long immediately before unheralded and massive selling hits the market?” Right in front of options expiry is never a good time to go long either precious metal. The Cartel pulled this very same trick before options expiry in March, April, May…and now June. Dennis, try July 1st…right after first day notice for delivery into the July contract…and do not buy on margin!

With last week’s break-out in both metals now firmly and thoroughly crushed, I’m sure that the powers that be would love both gold and silver to go to sleep over the summer months. Both metals are now safely below their respective 20- and 50-day moving averages once again. We’ll have to see what happens, but I wouldn’t bet any money that these metals will cooperate, as the bullish triangles still look like they are about to bust out to the upside…like they tried last week. Let’s see what July brings once month end and quarter end are out of the way.

The 200-day moving averages still lurk below…although not too far below…and from here it would be a virtual non-event if they were taken out. The cartel can do it any time they want. If you don’t believe me, please review yesterday’s gold and silver charts…or the previous Monday’s. One more day like either of those would be all that it would take.

Open interest numbers for Friday trading in gold and silver showed that gold o.i. rose 2,572 contracts and silver o.i. fell 299 contracts. If all trades that occurred on Monday are reported in a timely manner, the gold open interest numbers for Monday should be quite something…and should make the COT this Friday.

I mentioned in my report on Saturday that Friday’s Commitment of Traders report “was a yawner.” However, I neglected to point out the concentration ratios of the ‘eight or less’ traders in the Commercial category that Ted Butler gave me. These traders are, of course, the market making bullion banks. As of last Tuesday’s cut-off, these banks were short 78.6% of the entire Comex silver market and 82.8% of the entire Comex gold market. Once again, here’s the LBMA members list. The first eleven names that are on that list are the ‘market makers’. I would be prepared to bet some serious coin that the ‘8 or less’ traders (for both gold and silver) will be found almost exclusively in this eleven name list…and that they are all the same firms. The link is here.

In gold news I see that Australia’s gold production is down 7% year/year…and Vietnam suspended gold imports to tame the trade deficit. Vietnam has already imported 60 tonnes of gold so far this year…a 100% increase over the same period last year. Lastly, Dubai reported an 18% rise in gold sales in May.

And also of extreme interest was the action of the HUI yesterday, which finished in positive territory despite the crucifixions of both monetary metals. Although I don’t wish to look a gift horse in the mouth…after eight years of involvement with GATA (Gold Anti-Trust Action Committee)…we (including this writer) have a tendency to be suspicious of such counterintuitive stock moves whether the precious metals prices are falling (or rising). It wouldn’t be the first time that the boyz loaded up on cheap shares while everyone else was unloading theirs, so they can use them to sell into (and blunt) any upcoming major precious metals stock rallies…especially at the very peaks…like what happened in March just before the gold price got creamed, where the shares sold off heavily (and counterintuitively) the day before the top. But hey…maybe they’re just trying to make a buck on the upcoming rally!

After all this commentary I only have one story today. It’s entitled “Asia Clearing Union to Introduce Euro Alongside U.S. Dollar to East Payment Settlement”. This basically gives the euro equality with the US dollar. The story is linked here.

It took everything that the President’s Working Group had in their little bag of tricks to keep the house of cards from falling over yesterday…dollar up, US futures markets spun positive, Japan’s huge opening loses blunted, gold and silver crushed. They tried the same with oil and got stuffed. But ominously, the Banking Index (KRX) got creamed again on the continuing woes of MBIA and Ambac (ABK). It hit a ten year low with yesterday’s close. The 3-year chart is linked here…and it’s ugly.

See you tomorrow.

Source:And Then There’s This… Tuesday, June 24, 2008

And Then There’s This…Tuesday, May 13th, 2008

Ed Steer — Tue, 13 May 2008 12:12:06 +0000

Early on Monday morning, both gold and silver had smallish rallies going into the Hong Kong open, but that’s where it ended, as selling pressure took metal to their lows of the session until the New York traders showed up for work.

Silver rallied nicely and gold followed behind rather reluctantly. But both rallies came to an end at precisely the same time…just minutes before the NY lunch hour…and that was it for the day.

Silver punched through its 20-day moving average with ease ($17.35@Kitco) on the spike just before it got sold off hard by some not-for-profit seller, and closed at its 20-day m.a. The 50-day m.a. for silver is about 90 cents higher at $18.08. Gold closed about $12 below its 20-day m.a. Based on all of this, it will be interesting to see what’s in store for silver and gold today.

Friday’s open interest in both metals went their separate ways again…gold o.i fell 8,051 contracts despite the fact that it regained all its losses and ended up on Friday’s close. Silver o.i rose 1,954 contracts. Once again, don’t look to me for answers about this, because I don’t have any. The COT on Friday was strange enough as it was. This Friday’s report will be interesting as well, and the cut-off for that is at the end of today’s trading. By the way, I was interviewed by Al Korelin last Friday, and if you wish to listed to what I had to say, the link is here.

Two stories again today…the first from the International Business Editor of The Telegraph in London…Ambrose Evans-Pritchard. It’s entitled “The global slump of 2008-09 has begun as poison spreads.” The link is here.

The second piece is from my good friend James Turk over at goldmoney.com. It contains all the usual excellent graphs…is headlined “An Update on the Dollar”…and is linked here.

Please be assured that the financial powers that be, especially in the US, will do everything they possibly can to keep the Gold price below that US$1,000 level for as long as humanly…or inhumanly…possible. – Bill Buckler, the-privateer.com – 10 May 2008

Yesterday…MBIA, AIG and ResCap all had bad news…but the Dow was up 130 points nevertheless, so everything is fine. I see over the weekend that the Indonesian government said they might do the right thing and bow out of OPEC. No surprise there, as it’s been a net importer of oil for a number of years. Now let’s see what these clowns under the ‘big top’ have in store for us today!

See you tomorrow.

Casey Research correspondent-at-large Ed Steer is a keen observer of the financial scene and a board member of GATA.org.