"Sayonara, Sucker"

So you are a mortgage banker in 2006 and looking at making a loan to a family that clearly can’t afford the house or is clueless to the risks of such a transaction. You understand the basics of CDOs (But you are also clueless as to the theory behind the Gaussian copula function developed by J.P. Morgan banker David X. Li to value CDOs – and 99.999999% of the Mensa membership can’t explain a Gaussian copula function either. Dr. Li recently admitted he can’t either.) and if the borrower defaults on the loan, so what? You look at the Bart Simpson calendar on your desk (or maybe you have a poster on the wall) and you fully understand your employer will not own the risk - - it will be securitized and sold to the Royal Bank of Bulgaria (a name which might be what Oscar Wilde called “a triple oxymoron”). Then you have the Bart Simpson moment, you grin and think to yourself - - “Sayonara, Sucker”.

What is a CDO you ask (Collateralized Debt Obligations)? British author John Lanchester does a masterful job explaining this and much more in his book I.O.U: Why Everyone Owes Everyone and No One Can Pay (2010). His explanation of banking, how banks work (or don’t in some cases), and the implications behind leverage ratios of 75 to 1 should be required reading for everyone. His take on CDOs is outlined below:

I have several times read explanations of how the CDO geniuses managed to turn poor people who struggled to make their mortgage payments into a source of funds as stable a U.S. Treasury bills. I can understand the explanation with at least part of my brain. The answer was that the cash pouring in went into the equivalent of a series of buckets, the top bucket being an AAA tranche of CDOs, and then, when that was full, spilled over into the AA tranche, then down into the BBB and beyond. If the flow of cash slowed down, well, it would be tough luck on the people holding the lowest buckets, which would be the first to dry up – but then, they were being compensated for that risk by the sexily high yield on the CDOs. The bucket at the top, of course would never run dry. As long as any money at all was coming in, that bucket would fill up first. That was the idea, and, as I’ve said, a part of my brain follows the explanation. But a larger part is still left reeling with incredulity at the idea that anyone could be so clever/stupid as to believe that human fallibility could be engineered into nonexistence. They had forgotten Murphy’s Law, an important principle of engineering – and not at all the same thing as Sod’s Law, which is the facetious idea that the worst thing always happens (in French, le loi de l’emmerdement maximum). Murphy’s Law is an engineering principle, and it states that if something can go wrong, it will. So the idea that something will go wrong has to be built into a machine – how to monitor it, how to fix it, and what to have in place as a backup when it fails. The designers of the CDOs forgot Murphy’s Law. That, to civilians and outsiders, is one of the things which strikes you hardest about this new type of CDOs. You can follow the basic principles of swapping and securitizing debt and stay with the thought that the various inventions were all brought in with the intention of spreading risk and freeing up capital – but there was a point at which people got carried away and the momentum behind this wave of innovative financing went too far.