Page 164 - untitled
P. 164
THE CDO MACHINE
Asset management brought in steady fee income, allowed banks to offer new prod-
ucts to customers and required little capital.
BSAM played a prominent role in the CDO business as both a CDO manager and
a hedge fund that invested in mortgage-backed securities and CDOs. At BSAM, by
the end of Ralph Cioffi was managing CDOs with . billion in assets and
hedge funds with billion in assets. Although Bear Stearns owned BSAM,
Bear’s management exercised little supervision over its business. The eventual fail-
ure of Cioffi’s two large mortgage-focused hedge funds would be an important event
in , early in the financial crisis.
In , Cioffi launched his first fund at BSAM, the High-Grade Structured
Credit Strategies Fund, and in he added the High-Grade Structured Credit
Strategies Enhanced Leverage Fund. The funds purchased mostly mortgage-backed
securities or CDOs, and used leverage to enhance their returns. The target was for
of assets to be rated either AAA or AA. As Cioffi told the FCIC, “The thesis be-
hind the fund was that the structured credit markets offered yield over and above
what their ratings suggested they should offer.” Cioffi targeted a leverage ratio of
to for the first High-Grade fund. For Enhanced Leverage, Cioffi upped the ante,
touting the Enhanced Leverage fund as “a levered version of the [High Grade] fund”
that targeted leverage of to . At the end of , the High-Grade fund contained
. billion in assets (using . billion of his hedge fund investors’ money and .
billion in borrowed money). The Enhanced Leverage Fund had . billion (using
. billion from investors and . billion in borrowed money).
BSAM financed these asset purchases by borrowing in the repo markets, which
was typical for hedge funds. A survey conducted by the FCIC identified at least
billion of repo borrowing as of June by the approximately hedge funds that
responded. The respondents invested at least billion in mortgage-backed securi-
ties or CDOs as of June . The ability to borrow using the AAA and AA
tranches of CDOs as repo collateral facilitated demand for those securities.
But repo borrowing carried risks: it created significant leverage and it had to be
renewed frequently. For example, an investor buying a stock on margin—meaning
with borrowed money—might have to put up cents on the dollar, with the other
cents loaned by his or her stockbroker, for a leverage ratio of to . A home-
owner buying a house might make a down payment and take out a mortgage
for the rest, a leverage ratio of to . By contrast, repo lending allowed an investor
to buy a security for much less out of pocket—in the case of a Treasury security, an
investor may have to put in only ., borrowing . from a securities firm
( to ). In the case of a mortgage-backed security, an investor might pay
( to ).
With this amount of leverage, a change in the value of that mortgage-backed
security can double the investor’s money—or lose all of the initial investment.
Another inherent fallacy in the structure was the assumption that the underlying
collateral could be sold easily. But when it came to selling them in times of distress,
private-label mortgage-backed securities would prove to be very different from U.S.
Treasuries.
