Fueling the Flames of Debt

This most simple of financial truths would seem to be a no-brainer. My grandmother knew this and she had only a third grade education. If such a basic monetary tenet was obvious to a farmers wife 80 years ago, it should be a staple of financial practice even in the modern age. Such common sense is how the lights stay on and the bills get paid. As we now see , Wall Street ignored basic financial common sense and the world has been plunged into financial chaos because of it.

In the quest for a fatter bottom line to show their clients, the major financial institutions of Wall Street produced huge amounts of debt. Then they packaged the debts like a loaf of bread and sold that bundled debt under the guise of asset backed securities. This method of creating an asset has been used for many years, this is how corporate and municipal bonds are used as investments. The difference lies in the assets that back the instrument.  A corporate or municipal bond is backed by either the physical property of a corporation or the tax base of a municipality. The consolidated debt obligations that are at the core of todays problems were not so soundly based.

A mortgage backed CDO is comprised of hundreds, perhaps thousands of home mortgages. These mortgages are backed by the homes that the mortgage represents. The mortgage backed CDO’s offer value to the investor via the interest on the mortgage debts. This sounds great, at first glance. The truth is far more complicated than the investment banks touted.

A bond or CDO is only as good as the debtors ability to pay. If a corporate bond is sold based on a Proctor and Gambel debt, the underlying debtor can be researched to ascertain its worthiness as an investment grade obligation. P & G has revenue, market share and tangible assets to back its obligations and a quality assessment can be made of its ability to repay the debt. No problem. Any first year analyst could and would perform the due diligence of a prudent investor and reasonably conclude whether the offering presented value or risk. 

Not so with a mortgage based CDO. A qualitative analysis of a mortgage backed security cannot be performed in any meaningful way. The big banks knew they were holding hundreds of billions in high risk debt, yet they glibly bundled millions of high risk debts together and sold them as highly rated investment grade bonds. The axiom, ” two wrongs do not make a right” comes to mind.