Merrill Lynch, CDO’s, risk and experience
Collateralized Debt Offerings or CDO’s are investment vehicles which are a form of sub-prime mortgage bonds. They suffer from the same sickness as bonds backed by sub-prime mortgages. Nobody know what the real risk of default is on these financial instruments. They have become a victim of their own success.
When CDOs were a rare commodity lenders and investors had time to sit down and investigate the pieces that makeup a single bond offering. People were careful and got a good handle on the true risk associated with these financial packages. Because the risk was known, the bonds could be properly priced in the market. This led to liquidity for CDO buyers. They knew what the proper price was and could buy or sell them as they saw fit. But, a good thing always gets over played.
When demand went through the roof, CDO buyers assumed on the old model of known risk and proper pricing. As my Sargent told me very early in my military career, “Assumption is the mother of all fuck-ups.” The volume of deals meant that each deal did not get the risk review it needed. The pieces that made the CDO became different then the original packages. Everybody was buying, but nobody knew what they were buying.
Then, the market said, “Enough. I have enough of these instruments in my portfolio. I don’t want any more.” Like the sup-prime mortgage backed instruments, when the buyers left the market nobody had a good idea as to the real worth of the financial packages that backed the bonds.
Something was going wrong at Merrill Lynch in 2006. O’Neal, the CEO, “replaced the veteran risk managers with a younger, less-seasoned team.” (WSJ, 10/25/07 pp A17). About the same time Merrill’s CDO guru left for a smaller client firm. Two and a half weeks ago a new chief risk officer was appointed. Someone at Merrill was ring the alarm bell over a year ago.
What does it all mean? Merrill Lynch has been preparing for the write-down since 2006. They announced a number and then missed it by a whopping 75%. Either they think that things are worse than they currently seam or they have a great potential to get worse. Remember, though Merrill is the largest player in the CDO market, they are not the only large player.
Couple the CDO and sub-prime problems together and they mean that financial institutions are in a credit squeeze.
What does that mean to you? The US and world economy runs on the easy availability of money at reasonable rates. CDO’s were one form of borrowing that provided easy availability for large borrowers. That’s pretty much closed down for the moment. Mortgage lenders have tightened the availability of credit. Do you get the picture?
Written by Jim Norton, smallbusinessboomers.com
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POSTED IN: Being A Boomer, Finance
1 opinion for Merrill Lynch, CDO’s, risk and experience
Joe
Jul 29, 2008 at 6:51 am
I like what your Sargent told you about Assumption. My Grandfather told me; “Anything that sounds too good to be true, generally IS!!!!
You’re right on with your opinion.
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