Collateralized debt sounds like a damn good idea, and it can be. It’s fairly complicated, but it isn’t rocket science, and it’s really worth knowing enough about to make sense of the news these days.
Bad Debt: 15% Off
Many relatively high risk borrowers need, or would like, credit; many investors would take a small profit provided there’s very little risk; some want to play the odds in the hope of a big payoff.
There isn’t enough high quality debt out there to supply the risk averse, and there’s lots of the dodgy stuff. This is the opportunity. I can buy lots of crappy debt cheap. A percentage of it will fail: some companies and people will not pay off their loans, their mortgages, their credit card debt. But there’s so much of it, that I can get it cheap. I can buy the collateral for much less than what it will actually (probably) pay. Now I can structure a deal.
The Waterfall Model
This is the waterfall: one group (the equity investors) buy the collateral, and sell a tranche (a bunch of bonds) that will get paid first as that collateral pays off, making its purchasers a small profit. (Whoever is doing all the work of setting up this deal, usually a bank, will take a cut of that.) Then they sell a second tranche that will get paid from the money left after the first lot are paid. These purchasers get a slightly higher profit, and the structurer takes a cut of that. And so on. Maybe. The number, size and profitability of the tranches is where cleverness comes into it. It’s surprising how much high grade debt you can make out of low grade debt, about 80% or more, depending on your assumptions about the percentage of that debt is going to default.
If there’s any money left after all the tranches are paid the equity investors get it all. If the deal goes well and only about the expected percentage of debt used as collateral defaults, then these guys make a tidy profit. Everybody wins.
More dodgy credit can be issued, people who need to buy safe bonds get to do so, and people with lots of money get to take a tilt at a high score.
So far the only objectionable thing would be if the quality of the collateral was misrepresented, or if the bankers’ cut was unreasonably large. Below the diagram (not to scale, but accurately representing my graphic skills) is my explanation of what would be really nasty, possibly illegal, and what the SEC is saying happened. (I’m not a lawyer. Please do not sue me.)
The Waterfall of Collateralized Debt.
Suppose I know that the collateral I’m buying is much crappier than I let on. (It’s like the right hand waterfall, while I’m pretending it’s like the left side.) Normally that would be a lousy idea. The amount I get paid selling the various tranches doesn’t cover my equity investment. But suppose I also take out insurance on these thranches failing?
Yes, you can do that. That’s what a CDS (Credit Default Swap) is: insurance against a default. Very clever, and surprisingly legal.
(A future post will try to explain CDSs in a little more detail.)
Since it was decided that it was legal to insure debt, somebody gets to sell that insurance. AIG lost the farm because it sold tons of it, believing it was insuring left hand waterfalls. People bought a tranche and then took out insurance so that if it defaulted they would get paid anyway. AIG sold tons of insurance against things that were much more likely to happen than they (probably, perhaps) realized. It’s a bit like taking someone’s money and pretending to buy their lottery ticket every week. That works really well unless they win the lottery.
I can even take out insurance on debt that I don’t own (no, really), betting on your failure. That’s ungentlemanly at best. But it gets worse.
Suppose I was to structure a deliberately crappy, right hand, deal, sell it as a left hand deal, and take out insurance on it failing? I get the insurance on all the tranches I sell, the people I sell them to get completely screwed, and I get rich. What could possibly be wrong with that?
Well, it might be illegal. Being the bank that takes its cut, knowing the full story, might also be illegal. In both cases it sure as hell should be.
What actually happens with these “structured investments”, legal and illegal alike, is, of course, much more complicated. But that’s the big picture.
The Goldman Sachs case will be worth following.
[...] increasingly popular, because you could create CDO’s (collateralized debt obligations), see this for my introduction to this, they depend on underpriced low grade debt. It’s supply and [...]