RMBS, CDO & CDS

A couple more questions coming in on the financial crisis.

RMBS - Residential Mortgage-backed Security. What is it? Non-depository mortgage companies do not have a traditional source of money to fund a homeowner when they make a home purchase. Depository mortgage companies (i.e., banks which provide mortgages) do. You put your money into your bank's savings account and they pool the deposits and lend it out to homeowners that want to buy a home. Non-depository mortgage companies don't have deposits to source loans. Instead they go to Wall Street and say give me some money. Wall Street gives them some money and in return Wall Street gets a series of mortgage payments sent to them from homeowners.

Wall Street then does something perfectly fine which has been vilified in the press. It pools these mortgages and cuts them into different segments of risk and sells them off to investors. There are high risk segments and low risk segments. When a homeowner pays his monthly mortgage the low risk investors get the payment first. As each payment comes in you move down the segments. If everyone pays their bills then the guy at the bottom with the riskiest 'tranche' gets his interest payment too. If only 80% of the homeowners pay their bills then the investors with the low risk security still get their money but the investors with the high risk security do not.

On it's own the function of this service that Wall Street provides is allowing money in a bank in Switzerland to help fund the purchase of a home in Oregon. This is useful.

On top of this the ratings agencies were in charge of rating these tranches. The top tranche typically got a very high rating and the bottom tranche or equity tranche (since it's like a stock; debt holders get paid first) got a low rating. Sometimes Wall Street or the investor who bought these securities from Wall Street would purchase 'insurance' to bump up the rating to get a higher bid when they sold it off to investors.

Sometimes they did something else. Which leads us to...

CDO - Collateralized Debt Obligation. Man what a pathetic name huh? What is it? Those bottom tranches sometimes could not be sold off. They were high risk right? Not everyone wants to make a high risk bet. So what did Wall Street do? Something relatively smart that again gets vilified in the press. They took a whole bunch of those equity tranches and pooled them again and recut them into a bunch of segments similar to RMBS. The top tranche gets payment first and the lower tranche gets payment last if at all.  They payments here however are being sources from the equity tranches from a whole bunch of RMBS pools.  Anyway you cut it the CDOs are being sourced from high risk securities.

There's a pretty good diagram here that helps you visualize what's going on.

Again insurance and a rating were attached to the CDOs.  These CDOs are on average higher risk than the RMBS.  Because they are sourcing their interest payments from the equity tranches of the RMBS.  But that's fine.  As long as you treat these as high risk you should be okay.  They can help add a little extra return.  You wouldn't load up on these but you might add 1% to your portfolio of fixed income products.

CDO - squared.  You can naturally keep doing this.  Take the equity tranche of the CDO and pool and repackage.  Nothing inherently wrong with this as long as you understand you are increasing your risks buy owning these.  Something many companies couldn't get their head around.

CDS.  Now we come to the real problem.  Credit Default Swaps.  These are like insurance.  They are also like options which can be used as insurance against stocks.  CDS are insurance on a company or a company's debt defaulting or on other kinds of debt like CDOs and RMBS.  If you own GE debt you can go out and buy a CDS on that debt.  You pay a fee and in return if the debt goes bad (GE can't pay you back) then the counterparty to the CDS you bought will reimburse you.

Why is this bad?  Why aren't they called CDI?  Credit Default Insurance?  Because if they were labelled as insurance they would be regulated.  What does that mean?  Well an insurance regulatory board would say to Mr. CDS underwriter, "You are going to insure that GE bond so I want you to hold some cash on hand so I know that you can actually pay up if the bond goes sour."  State Farm and Allstate and so forth are required to manage the money they have in certain ways so when Joe Blow crashes his car or his home gets flood they can actually pay up.  

The term swap is to get around the regulatory boards.  The monoline companies like Ambac and MBIA used to provide insurance for very secure bonds like municipal bonds that don't default very often.  They insured one type of bond hence the name monoline.  But they moved into CDS because it was very lucrative.  They were really multilines.  The problem was they weren't prepared for homeowners to not pay their bills.  AIG also got into this game and got into the same problem.  Essentially when CDOs and RMBSs went belly up the guys who bought insurance wanted to be reimbursed.  But these companies didn't have nearly enough money on hand to pay up.  Hence the first two companies and gone and AIG had to be bailed out.  

Insurance in inherently a good game.  A certain amount of car crashes happen each year and the standard deviation around that average is tight.  So an insurance company has a good idea of how much it will have to pay out.  When financial problems happen it usually takes down a ton of companies (see the S&L crisis back in the 90s).  It's a bad thing to insure.

The real dumb part of this meltdown is that people bought CDS insurance and thought it would actually protect them when they should have known that companies like AIG didn't have the resources to protect them if a whole bunch of these securities went belly up.  

And CDSs just like options should be used to reduce risk.  But if you want you can also use them to leverage up.  Take a big gamble rather than use these instruments to hedge risk on other investments.  I can buy the GE bond and insure it with a CDS or I can just take a huge gamble on the CDS itself.  Just as I can hedge my holdings of Microsoft stock buy purchasing a Microsoft put option I can also just buy the Microsoft put option in a bet that the stock plummets.  I can make a lot of money on this but I can lose most of it in the blink of an eye.  This again can lead to a quick and painful death of your fund/company.

There is talk now, and I agree entirely, that if CDS contracts are written then the underwriter of the contract must be regulated just as insurance companies are.  Something similar happens in the futures market where people buy insurance on things like interest rates and the price of oil.  The Chicago Mercantile Exchange runs most of the futures trading.  Not once.  Not once has the CME had a futures contract default.  They are very good at managing this kind of thing.  There is a lot of talk about having the CME regulate and run the trading of CDS contracts.  I think this is a good thing.