Unreal: Banks' Created Fake Demand to Boost Profits and Yearly Bonuses
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That made CDO investors like pension funds and insurance companies increasingly nervous. If homeowners couldn't make their mortgage payments, then the stream of cash to CDOs would dry up. Real "buyers began to shrivel and shrivel," says Fiachra O'Driscoll, who co-ran Credit Suisse's CDO business from 2003 to 2008.
Faced with disappearing investor demand, bankers could have wound down the lucrative business and moved on. That's the way a market is supposed to work. Demand disappears; supply follows. But bankers were making lots of money. And they had amassed warehouses full of CDOs and other mortgage-based assets whose value was going down.
Rather than stop, bankers at Merrill, Citi, UBS and elsewhere kept making CDOs.
The question was: Who would buy them?
The top 80 percent, the less risky layers or so-called "super senior," were held by the banks themselves. The beauty of owning that supposedly safe top portion was that it required hardly any money be held in reserve.
That left 20 percent, which the banks did not want to keep because it was riskier and required them to set aside reserves to cover any losses. Banks often sold the bottom, riskiest part to hedge funds . That left the middle layer, known on Wall Street as the "mezzanine," which was sold to new CDOs whose top 80 percent was ultimately owned by ... the banks.
"As we got further into 2006, the mezzanine was going into other CDOs," says Credit Suisse's O'Driscoll.
This was the daisy chain . On paper, the risky stuff was gone, held by new independent CDOs. In reality, however, the banks were buying their own otherwise unsellable assets.
How could something so seemingly short-sighted have happened?
It's one of the great mysteries of the crash. Banks have fleets of risk managers to defend against just such reckless behavior. Top executives have maintained that while they suspected that the housing market was cooling, they never imagined the crash. For those doing the deals, the payoff was immediate. The dangers seemed abstract and remote.
The CDO managers played a crucial role. CDOs were so complex that even buyers had a hard time seeing exactly what was in them -- making a neutral third party that much more essential.
"When you're investing in a CDO you are very much putting your faith in the manager," says Peter Nowell, a former London-based investor for the Royal Bank of Scotland. "The manager is choosing all the bonds that go into the CDO." (RBS suffered mightily in the global financial meltdown, posting the largest loss in United Kingdom history, and was de facto nationalized by the British government.)
By persuading managers to pick the unsold slices of CDOs, the banks helped keep the market going. "It guaranteed distribution when, quite frankly, there was not a huge market for them," says Nowell.
The counterintuitive result was that even as investors began to vanish, the mortgage CDO market more than doubled from 2005 to 2006, reaching $226 billion, according to the trade publication Asset-Backed Alert.
Citi and Merrill Hand Out Sweetheart Deals
As the CDO market grew, so did the number of CDO management firms, including many small shops that relied on a single bank for most of their business. According to Fitch, the number of CDO managers it rated rose from 89 in July 2006 to 140 in September 2007.
One CDO manager epitomized the devolution of the business, according to numerous industry insiders: a Wall Street veteran named Wing Chau.