A recent article in the Wall Street Journal discusses Norma (Norma CDO I Ltd), which may become a classic study of the origins of the subprime mess. It details the creation of a CDO by Merrill Lynch for a hedge fund client that apparently had no idea of what Merrill was doing, but sure liked the fees.
It shows how everyone down the line was making fees, especially Merrill. The poor greedy clients were to get fees of about $1,500,000 per year on a $1.5BB offering. Merrill got untold underwriting fees and even sold the tranches to their own customers.
The interesting thing is that Norma didn’t really invest in subprime mortgages, but instead in derivatives — credit default swaps. This trick allowed Wall St. to create and sell an unlimited amount of CDOs from a single asset base.
What were they thinking? The “insurance” of the credit default swap was as good as the underlying assets which unfortunately collapsed in value.
Here are the culprits:
- Merrill and other bankers creating fee generating schemes;
- Fisk, Moody’s and S&P giving A ratings to B rated securities;
- Hedge funds having no idea what they were investing in;
- Young MBAs inventing new instruments that had no proper investment basis;
- Greed.
What is the solution? I don’t think you can stop this stuff. Every 10 years or so you see these cycles. No one learns from the past. They’re are all looking to prevent what happened during the last bust but the new boom is based on different facts. What no one learns is that the principles of boom and bust are the same every time. No one saw the real risk involved in the subprime bubble (except maybe Goldman). I think the market is handling this efficiently and quickly.
I highly recommend the article: http://online.wsj.com/wsjgate?subURI=%2Farticle%2FSB119878232873053285-email.html&nonsubURI=%2Farticle_email%2FSB119878232873053285-lMyQjAxMDE3OTI4OTcyODkyWj.html.
