Bloomberg View’s Mark Whitehouse points to a fascinating report on new evidence showing how badly Wall Street screwed investors in stuffing collateralized debt obligations with toxic assets.
The report, by BlackRock’s Oliver Faltin-Traeger and the Columbia B-School’s Christopher Mayer, finds that mortgage bonds stuffed into CDOs performed dramatically worse than mortgage bonds that weren’t stuffed into CDOs when controlling for variables:
Even if one holds observable characteristics such as initial ratings and yields constant, the bonds in the CDOs suffered ratings downgrades that were 50 percent to 90 percent more severe. As of June 2010, for example, bonds with initial triple-A ratings had been downgraded by an average 11.84 notches, compared to 5.99 for those not in CDOs.
The performance of the re-securitized securities implies that bankers knew that they were actively seeking to put the worst assets they could get away with into CDOs and that they snookered investors into thinking they were much better than they really were. The opacity of a super-complex structure like a CDO made it possible for them to do this, and the ignorance and/or complicity of the ratings agencies enabled it.
This is a significant finding, one that I’d hope would get wider attention in the press. As Whitehouse says:
The research provides strong support for the idea that banks — with the help of pliant ratings agencies — put together the CDOs and sold them to investors in a premeditated effort to get rid of some of their most toxic assets, or to provide vehicles for clients who wanted to bet against the worst possible assets. As the authors put it: “It would have been very hard to randomly choose securities with such poor ex-post performance.”
The surprise in these findings obviously is not that Wall Street screwed people, but in how much worse the securities that made it into CDOs were than the securities that did not. It was creating investments for people and designing them to perform as poorly as possible. It shows yet again how Wall Street’s perverse incentives spurred demand for worse and worse mortgages in the real economy.