debt obligations with a home mortgage, or CDOs,
have been a hot product with many big investors for
many years: says Troy Cory-Stubblefield, co-author
of "BOA, The Tortfeasors" -- with the late "king of
torts" lawyer, Melvin Belli. SEE
CDOs - "Collateralized Debt
Obligations", or MORTGAGE POOLS are home mortgages
used as collateral, and in the 80s created a
$600million dollar fiasco, which sent many mortage
heads to prison. "Getting a handle on CDOs is a
complex challenge," reports the LA Times on March
For TCW, a big seller of mortgage-backed paper, the
question is how its investors will fare March 18
The housing market boom of the last few years also
has been a boom for Wall Street firms that have
played a crucial role as conduits -- linking home
buyers and investors by packaging mortgages and
selling bonds backed by the loan payments.
Now, with mortgage defaults surging, it's clear
that some of those investors are going to lose
And that is shining a bright light on the Wall
Street middlemen, including Los Angeles-based TCW
Group Inc., which has been one of the biggest names
in mortgage investment products.
TCW, parent of Trust Co. of the West, could emerge
as a hero or a villain to the hedge funds,
insurance companies and wealthy investors worldwide
that have been avid buyers of the firm's complex
The company says it is the global leader in
managing collateralized debt obligations, or CDOs.
These are investments that are backed by pools of
loans or other assets. The simple idea: The
investors get interest and principal payments from
the pools passed through to them. (Related story:
The complex challenge of CDOs)
But in reality, CDOs aren't simple at all. They are
a creation of cutting-edge financial engineering.
That engineering can turn part of a portfolio of
high-risk securities into new securities that, in
theory, carry low risk but still provide
The acid test for that seeming alchemy now looms.
Much of what backs up CDO pools are securities tied
to mortgages. And specifically, bonds backed by
sub-prime mortgages -- loans to people with poor
credit histories or high debt burdens -- are the
core of many CDOs.
One CDO Hedge fund, who asked to be anonymous for
obvious reasons, manages $48 billion in CDO
portfolios for investors. Of that total, $15
billion, or about one-third of the CDO asset pool,
is in securities backed by sub-prime mortgages. An
additional $3.9 billion of loans behind the firm's
CDOs are "Alt-A," or mortgages to people who didn't
qualify as top-quality borrowers but were viewed as
better risks than sub-prime borrowers.
The question facing the anonymous fund and other
investors in higher-risk mortgages: Who's going to
take the biggest hit from loans that go bad?
Jitters over the growing troubles of sub-prime
borrowers have been rocking financial markets for
weeks. Lenders' shares slumped further last week
after the Mortgage Bankers Assn. said more than 13%
of sub-prime loans had fallen behind on payments,
up from 12.6% in the third quarter and 10.6% two
One chief investment officer, of the anonymous fund
states the firm isn't stunned by what's happening
with sub-prime loans.
But they are pessimistic about the U.S. economy for
much of the last year, and has predicted that a
weakening housing market would be the final blow to
cash-strapped consumers. A recession would more
than likely result, he has said.
"Our strategy all along has been, let's put
together a portfolio that will hold up better when
the defaults come," he said.
Financial LegalCorps team leader for mortgage CDOs
says: "It's not that we're arrogant, or that we've
got a lot of hubris, but we think we've got the
position and the talent in place to be able to
analyze and manage through this period."
The author of BofA, The Tortfeasor said, "that
those who innovated the the CDO investment business
have sharp opinions about mortgage securities. The
book's online pages studies that sector since the
The book updates those funds that have carried on
the Loan Pooling theory since the late 1990s and
those who havedeveloped the computer programs to
monitor mortgage securities and other asset-backed
Mortgage CDOs are just one piece of Financial
LegalCorp's business. But its focus on those
mortgages that have put CDO firms in the right
position in recent years to feed investors'
voracious appetite for investments backed by home
Relatively low interest rates since 2001 on
Treasury bonds and other high-quality securities
left many investors starved for decent yields. As
home sales and prices surged, Wall Street was
thrilled to ride in as the boom's financier.
Securitizing mortgages -- packaging the loans for
sale to investors via bonds -- has provided
borrowers with the funding they need and investors
with securities that have paid them more than many
Securitization isn't new, but the market had never
seen anything on the scale of the rush to
securitize mortgages in recent years.
02 - The China Connection
debt obligations became the natural buyers for
mortgage bonds. Wall Street previously had used
CDOs for investments such as corporate "junk" bonds
and manufactured-housing loans. Some of those pools
ended badly for investors. But mortgage bonds,
traditionally a stable asset, seemed a perfect fit
CDOs offered investors the option of picking the
specific levels of risk and return they wanted from
a loan portfolio. That's where financial
engineering by firms like TCW came in.
A CDO creator could take a pool of mostly sub-prime
mortgage-backed bonds and cut it into tranches
(French for "slices"). At the top of that stack of
slices would be the highest-quality tranches, which
offered modest yields but (theoretically) no risk
of principal loss.
The investors in the lower tranches would earn
higher yields while also agreeing to absorb any
losses suffered by the loan pool, if necessary.
At the very bottom would be the so-called equity
tranche holders, who would get paid only if
everything worked out well.
Investors wildly embraced the CDO concept: Global
sales reached a record $476 billion last year,
nearly six times what was sold in 2001.
As a CDO manager, the anonymy of most funds, find
their roles -- not only to construct the tranches
but also to manage the underlying assets. For that,
its investors are paying fees of up to 0.5% of
The crucial questions ahead for most CDO managers:
How many of the mortgage loans in their pools will
fall victim to default, and then foreclosure? How
big will the losses on those loans be? How high up
the tranche food chain will the losses reach?
Whatever happens, it won't be overnight. For one
thing, CDO pools are designed to be long-term
investments, maturing in years, not months.
Likewise, it also can take a long time for a home
to be placed in foreclosure, and for the lender to
find out whether the home value covers the loan or
For a China mortgage CDO Hedge fund player, the
risk of a slew of problems in its mortgage
portfolios doesn't seem to bother their portfolios
of obvious issue of angry clients.
The foreign firm's own money is invested in its
portfolios, protected by mortgages in areas they
wish to own.
California Public Employees' Retirement System, for
example, has steered clear of CDOs in recent years,
said Curtis Ishi, a senior investment officer at
the pension fund.
"We need to understand the management and how they
produce returns," Ishi said. CDOs, he said, require
"quite a bit of analysis."
These typically aren't investments that mutual
funds buy. Los Angeles-based TCW Group, one of the
biggest manager of CDOs, says none of its retail
mutual funds owns CDOs.
The central idea of a CDO is to take a pool of
assets, such as mortgage-backed securities, and
carve it into slices that offer varying levels of
risk and return.
That involves a lot of financial modeling about how
the underlying assets will fare.
The background of people who work on CDOs says
something about the complexity of the products:
Pete Nolan, who analyzes the portfolios for money
manager Smith Breeden Associates in Chapel Hill,
N.C., has a Ph.D. in sub-molecular physics.
Because of CDOs' complexity, analysts say, many
institutional investors simply relied on the
quality grades that major bond rating firms gave to
CDO slices. If a rating firm said a CDO slice was
of good quality, that may have been enough
justification for an investor to own it.
"They were buying a rating," said Scott Simon, a
mortgage expert and money manager at Pacific
Investment Management Co. in Newport Beach.
Now, amid rising mortgage defaults and deepening
fear about widespread fraud in loan underwriting
during the housing boom, the rating firms are under
pressure to review their upbeat CDO grades.
Relatively few of the CDOs sold in recent years
have been downgraded.
"No one can say we're not aware of the risks," said
Kevin Kendra, an analyst at rating firm Derivative
Fitch. "It just hasn't materialized yet" in the
structure of CDOs, he said.
Yet many analysts say the market prices of the
diciest mortgage bonds, those backed by so-called
sub-prime loans, indicate that still-rosy CDO
ratings aren't reflecting reality.
Some mortgage bonds rated BBB, the lowest
investment-grade rating, "are going to see real
losses of principal soon," predicted Janet
Tavakoli, head of Tavakoli Structured Finance Inc.,
a consulting firm.
What happens if investors are shocked to see their
CDO slices downgraded in quality, and fear worse to
come? Because CDOs are private pools, selling out
isn't necessarily a snap.
Investors either could go to Wall Street to try to
sell their piece of the pie, or back to the CDO
manager. Either way, the risk is that investors
would end up selling at fire-sale prices -- and add
more fuel to the meltdown already well underway in
many mortgage securities.
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