The sub-prime and alternative-A loans that gave rise to theses new bodies of derived investment vehicles in no way met the standards of the loans that were pooled and sold to Fannie, Ginnie, and Freddie. The borrowers lacked the necessary credit worthiness, there were little (if any) down payments required, and the loan-to-value approached (or exceeded) 100% of the properties—there was no cushion available to the lenders in the event of a downturn. Even at advancing more money than the properties were worth, everything was honky dori as long as payments were being made timely, interest rates stayed low, the required mortgage payments didn’t increase, the properties continued to appreciate in value, and the investors (in the CDO’s) were content to let things ride and not try to cash out. Well guess what? ALL of those pre-requisites went away. Poof, the houses of “cards” began to tumble and collapse!
I should have caught the distinction in the shift of wording from “Mortgage Backed Securities” to “Collateralized Debt Obligations” because there is a huge terminological difference in “the terms of art”—phrases/words having a unique and defined meaning in a specific context. I must warn my readers I’m speculating on what happened; but at least in the following context, it begins to make sense to me.
In a Mortgage Backed Securities scenario one could ultimately identify the property’s mortgages making up the investment pools. Even in arrears, default, or foreclosure; this is true. They could be identified; thus some value could be attributed to investor units. If, in the case of the Collateralized Debt Obligations scenario; the “investments” entitled the investor(s) to future cash flows from “X” amount of $’s of debt as a fungible commodity like bushels of corn, pounds of pork bellies, or shares of a particular class of common (or preferred) stock that was NOT true - because all properties are not equal. The late Arthur Rubloff stated: “in real estate; the three most important things are location, location, location.”
Were these critical distinctions (and risks) disclosed to the investors on the front page of the offering circular/prospectus in red ink (hence the term “red herring”)—as required of all initial public offerings under the 1933 Securities Act? Did the 1933 Act even apply to all these derivative offerings? Did the investors really know what they were buying? How many pearls and how much lipstick were used in the marketing of these “pigs” to the investors? Answers to such questions will eventually come from the litigation flood which I guarantee will follow. Will “deep pockets” or Caveat Emptor—let the buyer beware—rule? I’m Fred Cederholm and I’ve been thinking. You should be thinking, too.