CDO’s- The Garbage Dump Of Securitization

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When CDO’s were first introduced I thought maybe I just did notunderstand. You take junk that nobody wants, dump it into a box,mix it all together and out comes AAA paper. Magic. When I was veryactive in the early stages of developing CMBS, we always knew therewas an issue of what to do with the low level paper and how do yousecuritize loans that did not have any real cash flow. If thiscould be solved then the volumes and profits would increasesubstantially. CDO’s to the rescue. As one of my capital marketsfriends recently commented, the definition of a good banker is onewho dreams up ways to get around whatever the latest rules and regsare.

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Despite the massive losses suffered by CDOs’ and their sponsorsover the past two years, I hear that they may be making a comeback. That would be terrible. A CDO is by design, an instrument ofassured deception and destruction. If the loan was made to a solidcash flowing asset, and if there was true debt cover in stressscenarios, then the paper would be in a true CMBS pool. The onlyreason to have a CDO is to have a place to dump the risk and thejunk, otherwise there is no need for it.

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What always amazed me was the ability of the I banks to convincerating agencies that a large pool of garbage could be transformedinto high quality paper and rerated based on the clearly falsebelief that not all of the pool will default and be bad and that byhaving a lot of different assets- diversity- the risk was changedinto good cash flows. That is the ultimate –yes Virginia therereally is a Santa Claus story.

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Then we saw indexes of CDO’s, CDS issued against CDO’s, and amarket that was pure fantasy having nothing at all to do with thequality of the cash flows of the underlying assets. It was designedto do what it did. Fool the rating agencies and the mass ofinstitutional investors into believing what may have been theultimate ponzi scheme.

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While I never trust Congress to ever get it right, and while Iam still a strong believer in the free market and freedom toinnovate, Wall St cannot be trusted to behave responsibly. When Istarted in Wall St in 1965, it was a very different world. We hadour excesses and scams, but the current generation of bankers issummed up by what a friend of mine in the business said to merecently. “I want to get that consulting assignment from themso I can get inside and figure out how to rip their face off”. The kids with the computers have no idea what theramifications are of what they are doing. They are just trying tofind another way to confuse the rating agencies and the buyers, andto make a bigger spread. If we are to avoid the next crisis, weneed some way to prevent the return of CDO’s or their nextiteration, and other financial products which have no true economicvalue enhancement purpose. I am not in favor of the governmenthaving this role. The financial instrument has got to be tied tothe asset and cash flows emanating from that asset. The only realsolution is to make bonuses deferred and tied to the product onesells, creates or trades, and to only pay based on three and fiveyear outcomes. Only then will there be an economic incentive to actbetter and not just to maximize profit for the period to the yearend bonus. Your view changes completely if you have to beresponsible in your wallet for your actions.

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Joel Ross

Joel Ross began his career in Wall St as an investment banker in 1965, handling corporate advisory matters for a variety of clients. During the seventies he was CEO of North American operations for a UK based conglomerate, and sat on the parent company board. In 1981, he began his own firm handling leveraged buyouts, investment banking and real estate financing. In 1984 Ross began providing investment banking services and arranging financing for real estate transactions with his own firm, Ross Properties, Inc. In 1993 Ross and a partner, Lexington Mortgage, created the first Wall St hotel CMBS program in conjunction with Nomura. They went on to develop a similar CMBS program for another major Wall St investment bank and for five leading hotel companies. Lexington, in partnership with Mr. Ross established a hotel mortgage bank table funded by an investment bank, and making all CMBS hotel loans on their behalf. In 1999 he formed Citadel Realty Advisors as a successor to Ross Properties Corp., focusing on real estate investment banking in the US, UK and Paris. He has closed over $3.0 billion of financings for office, hotel, retail, land and multifamily projects. Ross is also a founder of Market Street Investors, a brownfield land development company, and has been involved in the acquisition of notes on defaulted loans and various REO assets in conjunction with several major investors. Ross was an adjunct professor in the graduate program at the NYU Hotel School. He is a member of Urban Land Institute and was a member of the leadership of his ULI council. In 1999, he conceived and co-authored with PricewaterhouseCoopers, the Hotel Mortgage Performance Report, a major study of hotel mortgage default rates.