Collateral Debt Obligation?turning rotten meat into delicious beef steak

September 24th, 2007

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Back in February this year, in How to dump risk to consumers: securitisation, we mentioned that

With the recent financial ?innovation? of debt securitisation, lenders can now aggregate their loans, and through dicing, slicing, splicing and divesting, repackage it into an ?investment? product.

Back in the old days, the nexus between lenders and borrowers was strong. Before the bank lends you money, it has to know your financial health intimately and ensure that you are credit-worthy enough for a loan. You had to dress in a suit to impress the bank managers enough to convince him or her to give you credit. Indeed, in the old days, accumulating bad debt was bad business.

Today, through the financial ?innovation? of securitisation, the link between lenders and borrowers were broken. It has developed to the point whereby the one who is lending you the money is not the one who has to bear the loss or clean up the mess when you default on the loan. As the loan travels down the chain from the lender to the ultimate owner, intermediaries along the way collect fees and charges. Thus, lenders make profits the moment they make a loan. After that, they pass the risk of bad debt down the chain like a hot potato.

Alas, human avarice knows no bounds. The greed for profits drives lenders to make as much loan as possible, to the point of recklessness. It has come to the point that lending money becomes a sales job?this time round, the lender dress in a suit to ?sell? you home loan ?products.?

After you ?buy? the home loan ?product,? your regular loan repayments are aggregated together with other borrowers? repayments into a tap of cash flow. This cash flow is then sliced into pieces of ?investment? products. The first piece in the queue to receive the cash flow will receive AAA credit rating, while the next in queue will receive lower credit rating (e.g. BBB, CCC, etc). This is stage one of the securitisation process.

Next, comes another bright spark of financial ?innovation.? Since such a securitised ?investment? product is a cash flow, why not aggregate them together and securitise them again? This time, why not aggregate the various BBB-rated (or lower) cash flows from stage one of the securitisation process and then slice them further into many pieces. Again, the first piece in the queue to receive this cash flow will receive AAA credit rating. This securitisation of securitised ?investment? products is called Collateral Debt Obligation (CDO). Somehow, through the magic of financial ?innovation? and ?sophisticated? mathematics, bad credit-rated loans ended up with AAA rating.

This is how rotten meat gets converted into delicious beef steak. Add in appetizing sauces and you may get a delicious meal. But be prepared to have a bad stomach should you eat such poison.

For the average person on the street, when he or she is served a mouth-watering beef steak from the waiter in a high-class restaurant, how can he or she tell that it had been prepared from rotten meat?

There will be more people with bad stomach soon.