Confession of a CDO insider @The Eye of Sauros

The infamous CDO hit again the news headlines... I had been running the Orc race with Investment Banks in the CDO business on the arranger’s side for a while and I know that sooner or later they will come back along with other structured products and financial weapon of mass destruction and bring the Armageddon. Regarding the CDO of subprime RMBS (Residential Mortgage-backed Securities), the dust from 2007 and the subprime crisis has not settled yet and we still don’t have a precise view on their value (if any…) and the final outcome yet. It will depend on the house price, interest rates, unemployment rate, behaviour of the borrowers but as well to a large extent on the governmental policies whose impact is very difficult to assess. OK, OK, I said nothing new there. Regarding the hotter topic of short sellers of the underlying collateral of the CDO and involved in their asset selection at the same time, I guess in the near future a few other cases will be revealed as I’m afraid this kind of practice was not rare. For instance, Magnetar was known for buying the first-loss piece of the CDO for which they selected the assets, banking outrageous fees, hedged the single names in the portfolio and go massively short of other pieces of the same CDO (mezzanine tranches). The process ultimately gave them an incentive to pick the worst assets in the CDO…

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Sauros wrote:

my personal experience shows that after a move with such the amplitude as the one we saw on March 16th after Goldman, either the bull trend reasserts straight and we’ll see shortly a consequent rally cancelling Friday’s drop or the markets hesitate, stand still and ultimately resume their fall with strength. I also want to see how the DAX reacts around its 20-SMA moving average.

+100 points up on the DAX today, that's precisely the kind of reaction I referred to in the post.
BTW it looks like the 20-SMA held

Sauros, great post. I just recently learned about the mezzanine tranches of CDO's in my finance class. Seems like Paulson & Co took candy from a baby. I would not be surprised if we start to hear many more reports of this nature in the future. Even though, I am a young Fund Manager I am starting to understand the pitfalls that go along with regulation and finance. Correct me if I'm wrong, but I feel that IB's and Financial Institutions will always find a way (through creation of new, exotic, and unregulated products) to pick pennies up in front of the steam roller.

Batman wrote:

Sauros, great post. I just recently learned about the mezzanine tranches of CDO's in my finance class. Seems like Paulson & Co took candy from a baby. I would not be surprised if we start to hear many more reports of this nature in the future. Even though, I am a young Fund Manager I am starting to understand the pitfalls that go along with regulation and finance. Correct me if I'm wrong, but I feel that IB's and Financial Institutions will always find a way (through creation of new, exotic, and unregulated products) to pick pennies up in front of the steam roller.

Thanks Batman. I think CDO should be taught in a "History of Finance" class
Afterwards, it looks like the SEC, after it missed Madoff, wants to shoot an elephant and they try to do Goldman...
All is about greed: a few years ago the CDO business was the cow to milk and that precisely what the bankers (including myself I'm afraid) used to do, Goldman's case is just an instance of this.

After the crisis, most of the banks have been focusing on "flow" business (vanilla products), but the problem is the margins tighten as the market becomes more and more competitive and the appetite for yield is coming progressively back. What is likely to happen is that more and more structured products will be proposed again in order to feed this appetite and increase the margins and only the Lord of Trading knows what the guys will be able to invent...

Now trust my long experience as a structurer, the more the product is structured, the higher the margin (meaning the cost for the investor) and most of the value-added of the structured product goes not to the investor, but to the structurer...