The New Vocabulary

I have just begun to read the riveting (for me at least) new book by Cohan, "House of Cards." The book is the story of March, 2008, just a year ago, and the collapse of Bear Sterns. The narrative is almost moment by moment as one rumor leads to fact and some rumors lead to action and no one is able to turn the stampede away from the precipice. It is, as my friend David Worrell used to say, "a buffalo jump."

In the old days, before modern meat processing facilities, the American Indians out on the wide spaces of Montana, would find a relatively level plain which ended in a cliff. They would stalk buffalo and when the herd was in the right attitude, they would cause a stampede towards that cliff. Those in front, no matter how they might try, could not stem the surge behind them and over the cliff they would all go. Other members of the tribe would wait below and harvest the buffalo to feed and clothe their families. An apt analogy, almost.

The problem with this view of the fall of Bear Sterns is that the American Indians intended the consequence, planned the stampede and executed the plan perfectly. Bear Stearns did not intend to fail it just made assumptions about the future that they should have realized were false. The old adage that if something sounds to good to be true, it is probably not true should be hanging on the wall of every home in America and the wall of financial consultants as well - as a warning.

In Cohan's reportage of March, 2008, even his precise writing is a report of chaos. I read slowly, immersed in the deluge of terminology only a trader could understand, but coming through that guantlet, just knowing some of the definitions started to make all this financial horror somewhat clearer. Here follows what I understand.

CDO Collateralized Debt Obligation. One firm takes a number of similar based debts that it is owed and packages them together into an "obligation" which can then be sold. Maybe the average debt term in the package is 6.0%. The packing firm sells the package at 5.8% to the buyer return and keeps the value of the spread between 6.0% and 5.8% as its profit. But wait. There is more to this simple transaction. Trace it back a little further. In order to own the debt in the first place, the packager had to loan money to someone else in return for a promise to pay the load back, with interest at 6.0%.

Make it simple. ILOAN2U, Inc. loans $ 400,000 to Joe Dinner bucket to buy a house. Joe agrees to pay ILOAN2U back with 6% interest every year on the unpaid balance. Simple enough. The proceeds of the loan, the $ 400,000 get split up between a real estate broker, lawyers, loan originators, bankers and, oh yeah, the person who actually sold the home.

Wait, there's more! Where did the $400,000 come from that ILOAN2U just forked over? Yep, you guessed it. ILOAN2U borrowed it!! From where? From a bank where Joe Dinnerbucket and all his co-workers deposit their paychecks. Well, if the bank loaned out the money that Joe and others put in the bank, how much money does the bank have actually in the vault? Answer, not much.

What does the Bank do if ILOAN2U doesn't pay the Bank back when ILOAN2U sells off the "obligation" that it packaged in the paragraph 1 above? Well they used to not worry about that because, you might have guessed it, the Bank bought what are called Credit Default Swaps, which are insurance that debts are repayed.

Who wrote the insurance? Well, one of the big writers of that kind of insurance was AIG. Now you are catching on.

There are a lot of variations on this story, but mostly they are related to the nature of the underlying debt. Could be credit card debts, could be small business loans, could be annuity payments, could be lottery payments, could be car loans, could be business leases on commerical office or manufacturing space.

CMS - Collateralized Mortgage Security
CDO - Collateralized Debt Obligation
RMBS - Residential Mortgage Backed Security
CLBS - Commerical Lease Backed Security
Credit Default swaps
Alt A
Subprime
Hedge Fund
Hedge
Mark to Market
Mark to Model
FASB
Liquidity
Repo Desk
Overnight Funding Sphere: Related Content