Behind the $4 Trillion in CDOs: Sneaky Banks and Worthless Ratings

The Securities and Exchanges Commission's allegations about Goldman Sachs (GS) fraudulently selling a synthetic collateralized debt obligation called Abacus raise several fundamental questions, starting with: What is a CDO, and why would anyone buy one?

It's a difficult question to answer, so I was happy that an expert in the field agreed to an email interview after contacting me to share her thoughts on my April 14 story on deposit-only institutions.

The takeaway from our exchanges is that CDOs were a way for investment banks to evade their capital requirements, just as asset-backed securities (ABS) played a similar role for savings and loan institutions in the 1980s. ABS and CDOs made lots of money for the people who created them, and both contributed to financial collapse that led to taxpayer-paid bail outs.

The reason? Both created the illusion of safety that was punctured by the collapse of the mortgage market.

That's what Ann Rutledge opined to me in her emails. Rutledge runs R&R Consulting, a Manhattan-based firm whose original mission was "to create a system for dynamically re-rating structured securities (ABSs, RMBSs [residential mortgage-backed securities], CDOs, etc.) to let people see how they actually performed over time, not just how they were expected to perform at origination."

(The other R in R&R Consulting is Sylvain Raynes, Rutledge's husband, who got tossed off CNBC's Street Signs on April 16 after casting doubt on Jim Cramer's objectivity when it comes to his former employer, Goldman Sachs.)

Second Generation of Structured Products

Rutledge, whose help was acknowledged by A.K. Barnett-Hart in her 2009 summa cum laude Harvard College thesis on CDOs made famous by Michael Lewis's latest book, contacted me after reading my story about why we don't need traditional banks anymore. As Rutledge emailed me on April 15: "This is the first time I have seen anyone make the bold but true assertion that the bond market has made the role of banks as lenders redundant."

In trying to define CDOs, Rutledge starts with an explanation of their history. CDOs were a second generation of structured products that Wall Street invented to create capital for savings and loan institutions in the 1980s. (The collapse of S&Ls in the wake of their deregulation resulted in the biggest bailout in American history at that time -- $293.3 billion.)

The first generation of structured products were ABS and RMBS, introduced in the 1980s in response to "liquidity challenges for S&Ls." As Rutledge explained, "asset-backed securities and residential mortgage-backed securities offer borrowers a lower cost of capital by refinancing their business receivables [payments expected from customers] in a 'bankruptcy-remote' off-balance-sheet entity." This means that the S&L could get cash, take the assets off its balance sheet and in the event that the S&L went bankrupt, the assets would be hard for the bankruptcy court to take from the ABS holder.

CDOs Move Debt Off the Balance Sheet

In the mid-1990s, investment banks faced a similar need for capital. Banks used CDOs to move company loans, bonds and other debt off their balance sheets. Banks that issue CDOs purchase the collateral securities, for example, the underlying loans and bonds, and these go into an off-balance-sheet vehicle. But unlike ABS, the securities in CDOs are "more transparent than the business receivables financed with ABSs," says Rutledge. "They already carry a rating, and maybe a price, too."

CDOs turned into a huge market during the 2000s. Rutledge cited statistics from The International Monetary Fund's Global Financial Stability Report indicating that between 2000 and 2009, $4 trillion of CDOs were issued. Between 2000 and 2007, when CDOs peaked, annual issuance grew at a compound annual rate of 29.8% to $993 billion. But as the meltdown ensued, issuance then plunged 89%, to $105 billion, in 2009.

CDOs turned out to be a financial honeypot over the decade for a wide range of CDO ecosystem participants. At the transaction's closing, for example, the company that arranges the CDO makes a placement fee that's a percentage of the deal. That percentage would increase with the riskiness of the CDO collateral. The percentage would be less than 1% for "investment-grade securities and far more than 2% for junk."

Fattening Up on Fees

But banks also made money indirectly because the transaction allowed them to take on more debt and therefore to do more business. Ratings agencies were paid "a small piece of the deal (typically 3.5 to 6 basis points [100 basis points = 1%] of the issue size)," explains Rutledge. "Law firms expected to earn about $1 million per transaction. Other parties such as appraisers and accounting firms conducting due diligence were paid fixed fees."

CDOs generated enormous paydays for all these companies. I estimate that they received fees totaling between $200 billion ($50 million times 4,000) and $280 billion for the $4 trillion in CDOs issued between 2000 and 2009. This is an extrapolation from the typical $70 million in fees from a $1 billion CDO deal. As Rutledge said, "For a $1 billion CDO, one would expect to see $50 million to $70 million distributed through the fee network to bring it to market."

Investors bought CDOs because they earned higher yields than a risk-free Treasury bond. And as long as the ratings were at least AA, many big institutional investors -- hungry for high-yielding paper -- could buy them. Unfortunately, the typical AAA ratings on CDOs didn't signal their real risk for investors. The investors in AAA-rated Abacus, for instance, lost $1.1 billion.

Standards Compromised for Fees

One of the details that Rutledge provided -- the transaction fees paid by CDO issuers to ratings agencies as a percentage of the deal -- helps explain what went wrong with CDOs. As DailyFinance's Abigail Field reports, ratings agencies compromised their standards of objectivity to get those fees. Moody's Investors Service (MCO), Standard & Poor's (MHP) and Fitch Ratings are the three major credit-rating agencies. (The ratings agencies were so compromised that 93% of the 2006 AAA ratings they issued on sub-prime mortgage-backed securities were later downgraded to junk.)

A top concern of CDO investors was that mortgage deals be underpinned by a variety of loans, because diversification is supposed to reduce investment risk. Few wanted deals backed by loans from only one part of the country or handled by only a single mortgage servicer. But some bankers would simply list a different servicer, even though the bonds were serviced by the same institution, or just add another one to the list, and thus produce a better rating.

The New York Times quoted an analyst who explained that his firm was too overworked to catch all these banker tricks. "If you dug into it, if you had the time, you would see errors that magically favored the banker," a former ratings agency executive said. "If they had the time, they would fix it, but we were so overwhelmed."

Rutledge believes that many CDOs didn't deserve their AAA ratings and that if her firm and others that aren't paid by the CDO issuers got paid to rerate CDOs after they were issued, then the true risk of these investments would emerge. The basic problem for the future of CDOs is that unless investors pay for CDOs to be rated objectively, they'll get what they pay for -- an investment that's much riskier than its rating is likely to suggest.