A Quality CDO Analogy From Matt Taibbi

Matt Taibbi’s latest tome on Goldman Sachs is harsh enough that it actually played a role in Dick Bove’s downgrade of $GS stock today.  I wanted to focus on a specific analogy Taibbi used to explain CDOs, because I think it’s an excellent one, although it could use some slight tweaks to make it even better.  Taibbi writes:

“A normal CDO is a giant pool of loans that are chopped up and layered into different “tranches”: the prime or AAA level, the BBB or “mezzanine” level, and finally the equity or “toxic waste” level. Banks had no trouble finding investors for the AAA pieces, which involve betting on the safest borrowers in the pool. And there were usually investors willing to make higher-odds bets on the crack addicts and no-documentation immigrants at the potentially lucrative bottom of the pool. But the unsexy BBB parts of the pool were hard to sell, and the banks didn’t want to be stuck holding all of these risky pieces. So what did they do? They took all the extra unsold pieces, threw them in a big box, and repeated the original “tranching” process all over again. What originally were all BBB pieces were diced up and divided anew — and, presto, you suddenly had new AAA securities and new toxic-waste securities.

A CDO, to begin with, is already a highly dubious tool for magically converting risky subprime mortgages into AAA investments. A CDO-squared doubles down on that lunacy, taking the waste products of the original process and converting them into AAA investments. This is kind of like taking all the kids who were picked last to play volleyball in every gym class of every public school in the state, throwing them in a new gym, and pretending that the first 10 kids picked are varsity-level players. Then you take all the unpicked kids left over from that process, throw them in a gym with similar kids from all 50 states, and call the first 10 kids picked All-Americans.”

This is a good analogy, although in reality we need a few minor adjustments:  it’s not really like taking the top 10 kids from the rejected unpicked batch from all 50 states and calling them “All-Americans,” – they don’t get even better, they’re just rated AAA too -  it’s like calling them varsity as well.  And the (flawed/faulty/crazy) logic behind it, with the mortgage CDO analogy, went something like “they’re all from different parts of the country, so they won’t all suck at the same time.”  Or, “They all suck in a different way, so they won’t all suck at the same time – that’s what our model says.”

In any case, I think Taibbi’s gym-class pick analogy is one of the best I’ve seen to describe CDO-squared to the layman.

-KD

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