Confidence Game - Christine Richard [126]
Others were spotting flaws in CDOs, too. A report by a group of Harvard Business School researchers released in June 2007 concluded that investors buying the highest-rated pieces of CDOs had been “grossly undercompensated” for this risk.
The top layer of a CDO was, in fact, an economic-catastrophe bond, similar to catastrophe bonds sold by insurance companies to protect themselves against a highly unlikely event such as a series of category five hurricanes hitting the Florida coast in a single season. The investor in catastrophe bonds sold by a property and casualty company receives a relatively high return on the bonds—compared with other investment grade-rated securities—but if the extreme event occurs, the bond investor will be completely wiped out.
Investors in CDOs, or economic catastrophe bonds, settled for an exceptionally low return even though they faced a similar risk of a total loss.
“The manufacturing of securities resembling economic catastrophe bonds emerges as the optimal mechanism for exploiting investors who rely on ratings for pricing,” Harvard researchers Joshua Coval, Jakub Jurek, and Erik Stafford wrote. “We argue that this discrepancy has much to do with the fact that credit-rating agencies are willing to certify senior CDO tranches as ‘safe’ when, from an asset-pricing perspective, they are quite the opposite,” the report concluded.
THAT THE CATASTROPHE was well under way was obvious as O’Driscoll at Credit Suisse tinkered with the final results of the Open Source Model. Ackman planned to send the loss forecasts for MBIA and Ambac to the Securities and Exchange Commission and the New York State Insurance Department. He also planned to make the model available on the Internet so that those with an interest and enough computing power could use their own assumptions to project the bond insurers’ losses.
Just after midnight on January 29, 2008, O’Driscoll messaged Ackman: “Should be done in the next few hours.” They met at Pershing Square’s offices the next afternoon to go through the final results. The model was predicting losses many multiples of what MBIA and Ambac had told investors they expected. Ambac would lose a minimum of $11.61 billion, and MBIA would pay claims of $11.63 billion, the model forecasted.
Those viewing the model would be able to see the names of all of MBIA’s CDOs of asset-backed securities (ABS) and CDOs from 2005 to 2007. The collateral underlying the CDOs was identified by CUSIP (the unique number from the Committee for Uniform Security Identification Procedures that identifies every bond), as well as by collateral type, par outstanding, and its original and current ratings.
The losses projected on some of the individual securities were staggering. An Ambac-insured CDO-squared called Class V Funding IV, one in a series of Citigroup deals, was expected to cost the bond insurer $1.3 billion on a guarantee of $1.4 billion. An MBIA-insured CDO called Broderick 3 was expected to result in $758 million of losses on a $1.2 billion guarantee. Both of those guarantees had been taken on at the super-senior level, an indication that they were supposed to be even safer than triple-A-rated bonds.
The Open Source Model produced performance projections for all 524 ABS CDOs created between 2005 and 2007, indicating they would result in probable losses for the entire market of $231 billion, with super-senior tranches alone losing $92 billion.
This disastrous outcome was the result of a basic flaw in the assumptions used to securitize mortgages. Credit-rating companies insisted on diversification: a range of loan originators and servicers, wide geographical distribution, and various loan sizes. Ideally, the diversity protected investors from being exposed to loans that would all come under pressure for the