Our financial institutions have been running a game on the American Public for the past 15 years. This shell game could not have been carried out with out the enabling support of the government (both parties) and its financial watch dogs. Collateralized Debt Obligations (CDOs) are financial creations that almost no one understands but every Financial Institution has sold for scandalously large profits. For a quick tutorial on these little understood financial vehicles, go to Wikipedia at http://en.wikipedia.org/wiki/Collateralized_debt_obligation.
If anyone out there remembers the collapse of the Savings and Loan Industry back in the 1990's, you will remember that our government set up the Resolution Trust Administration to deal with that problem back then. The situation was very similar to today's problem, in that real properties were secured by shaky mortgages and those bad mortgages caused the collapse of the Savings and Loan Industry. Through the Resolution Trust, our Government effectively bought the properties at their true fair market price and sold them. The Savings and Loans were saved, though some investors and Savings and Loan Institutions did suffer financially.
When today's crisis started, I asked myself why today's government could not do the same. If there are bad mortgages why not have the government buy them at fair market, take over the properties and sell them. I foolishly thought this might save the mortgage banking industry. I was wrong. I overlooked the introduction of the CDO within the past 15 years. Everyone should make themselves aware of this Financial Device since it will have a gigantic negative impact on every taxpayer and resident of the United States.
The essence of the CDO is to separate the interest earned on a mortgage or other debt vehicle from the mortgage agreement itself, making those interest payments a new salable commodity. This seeming magic was performed in several stages and over a period of a dozen or so years.
First, in the day of the friendly local banker, a citizen took out a mortgage and paid that friendly banker until the mortgage was paid off. If the citizen had a problem he could go to his local banker and work out a solution.
Second, came the day of the wholesaler. Mortgages were bundled and sold to either private investors or Fannie Mae, and the bank received money that it could lend again and the investor received a mortgage at a discounted price as a term investment. The homeowner entered into an endless cycle of frustration tracking down the unfeeling institution that bought his mortgage and seemed to be located on the far side of the moon. Homeowners have complained of this phenomenon for years and have been rewarded for their patience and complaints with the CDO.
Third, came the day of the Collateralized Debt Obligation. To make a long story short, a CDO separates the ownership interest of a debt from its interest income. It has been used in relation to mortgages, student loans, credit cards, and car notes. The holder of the instrument (e.g. mortgage) keeps the mortgage in its own name and sells the interest due on the mortgage to a third party. That third party then bundles the interest with the interest from other mortgages and creates a new investment instrument. Because the new investment is not based on the mortgage itself, it can be sold to investors for whatever price the investing market will bear, often making this investment worth much more than the original mortgages. Since the mortgage itself is not purchased, no messy requirements conforming to local State banking laws are required. At a time when other investments were paying very low returns, this device seemed a gift from God. For cases involving the ownership issue see: http://thebellwetherdaily.blogspot.com/2007/11/cleveland-federal-judge-dismisses-32.html. Also see UNITED STATES DISTRICT COURT NORTHERN DISTRICT OF OHIO EASTERN DIVISION, IN RE FORECLOSURE CASES: CASE NO. NO.1:07CV2282, 07CV2532, 07CV2560, 07CV2602, 07CV2631, 07CV2638, 07CV2681, 07CV2695, 07CV2920, 07CV2930, 07CV2949, 07CV2950, 07CV3000, 07CV3029, JUDGE CHRISTOPHER A. BOYKO.
The natural and, in hind sight, foreseeable effect of this development was that the banks and the others participating in this CDO device sought every mortgage they could get their hands on. The prime qualifier for the mortgage was its rate of interest. The higher the interest rate, the better the return and the greater the profit derived from the CDO. You must remember that the CDO has been separated out from the mortgage through a device called a swap. The CDO administrators pay the holder of the mortgage to swap them the interest from the mortgage without actually purchasing the mortgage. All this was done free of oversight and regulation. The CDOs insisted that they were securities independent of the Banking laws (See 'thebellwetherdaily' above). This fiction has resulted in some unusual court battles in the Federal Courts.
This pressure for high interest mortgages flowed down to the mortgage originators. They could place every high risk mortgage they could write. As a result they wrote as many risky mortgages as they could. It has been argued that in the early days of this century, any mortgage could be written no matter how unqualified the person.
This brings us up to the present bailout. The question is who is being bailed out. Clearly it is not the homeowner that has one of these mortgages. Clearly it is not the originating or successor bank that actually holds the mortgage. If the purpose were to bail out the mortgage originator or legal holder in due course, the regulators could copy the Resolution Trust that bailed out the Savings and Loan debacle of the 1990s. But don’t expect that to happen this time. The real parties being bailed out are the CDOs and those that invested in them. Some of the largest Financial Institutions and private investors in the world today are being bailed out by the US Taxpayer. If our government only covered the actual bad mortgages as it did in the old Resolution Trust days, the local banks that made the mortgages would not close, the flow of credit would be re-established, but all those holding an interest in the CDOs would go belly up on their investment. It must be remembered that the actual mortgage and the CDO are separate. The mortgage stays a mortgage and is owned by the originating bank or holder in due course. The CDO is an investment device and is owned by the investors. In many ways the CDO is actually a legal fiction.
It is my firm opinion that the reason the treasury balked at buying up the supposed toxic mortgages was not because of their toxicity but because the purchase of those mortgages only helped the originating bank and holders in due course. The purpose of this bailout is to help those who created this CDO device and have made incredibly high profits from it, and are now at risk of losing their substantial investment. Even worse these companies were set up overseas and no taxes were paid to the IRS. Now our government is asking the average taxpayer to bail out some of the wealthiest institutions and individuals in the world only because those institutions and individuals are wealthy and influential. All the goals that have been announced, such as saving the mortgage industry, free flowing credit and the reputation of the Financial System could be accomplished by the same remedy as the Savings and Loan Resolution Trust. But such a solution would not save those who brought you the CDO, the true beneficiaries of our government's benevolence.
If you wish to know the next bailout, my best prediction is CDOs based on Corporate Notes and Bonds. For information, see Bloomberg at the following address: http://www.bloomberg.com/apps/news?pid=20601087&sid=a5x0jMKZf4yc.