Newsworthy Math

What Was Wrought

CDO’s (collateralized debt obligations), see this for my introduction to these, depend on underpriced low grade debt. If I can get a 20% discount on debt that has a 10% chance of defaulting, then I should just buy this all day. All I need is enough risky debt (and some confidence in these percentages, but that’s a story for another day). But as CDOs became more and more popular low grade debt was getting used up. Even worse, as demand for it grew its price rose. CDOs were changing the entire ecosystem of low grade debt. There wasn’t enough of it and it was too pricey. There was no profit left. What to do?

One compelling answer was to simply issue more of it. Brokers could persuade people to take on deceptively structured mortgages, that could only get paid back if house prices rose forever. Lousy business plans were funded by people whose sole investment in the debt was they commission they got for issuing it. Dogs were being offered credit cards. These guys made the Glengarry Glenross salesmen seem like saints.

But there’s only so much new low grade debt that this can create and only so low you can go. Enough of it was issued to ruin the economic lives of people who thought they were just buying a house, but not enough to feed the maw.

Alchemy

What there was plenty of was collateralized debt. Some was graded AAA, some graded B. Why not buy these crappy debts and create CDOs? So, we start with $100 of debt that someone was misled into borrowing. We structure that to create $60 worth of grade B debt. Get enough of that and you can create another CDO, with $50 worth of single B tranches, and so on. $100 of crappy debt turns into $300 worth of crappy debt. (I’m making up all these numbers, but the principle is correct.) These were the synthetic CDOs. George Soros (that vicious communist) says pretty much that in April 23rd’s Financial Times.

So why was so much money lost? Why were trillions of dollars needed to prevent an economic meltdown?  It wasn’t because people took out trillions of dollars of mortgages they couldn’t afford. It happened because people got paid, and very well paid, for turning $100 worth of debt into $300 of debt. So they did it again, and again. What did they have to lose?