What is a synthetic subprime CDO?

Six months ago I was asked to explain what a synthetic CDO was.  Well buddy, the sky is blue because bankers in Wall Street…. I sort of did my best and drew a few diagrams and we got about halfway there and came to a halt. I understand roughly how a synthetic CDO works, I think, but the sheer fuckery implied in such a thing is not easily imparted to someone who does not follow finance. Then another one of my buddies asked me the same question and I thought maybe I could gin up a couple of diagrams that other people might find useful as well.

The trouble with descriptions on paper is that it is hard to build a mental model in your head. I have had a go at doing so below.

I have built these based on what I’ve read in books like The Big Short (Michael Lewis) and The End of Wall Street (Roger Lowenstein). I am not directly familiar with CDOs and have never read a CDO prospectus. I have taken some liberties with the structure of mortgage bonds, simple interest, etc to simplify everything as much as possible. This is a super simplified diagram that I hope will prove useful.

An illustration of the steps that lead to the creation of synthetic CDOs:

Step 1: Get mortgages

Banks lend money to people to buy houses. Some loans are more risky than others. Not all loans get paid back. ‘Sub-prime’ loans, the primary cause of the crisis, are riskier loans to less reliable borrowers.

When you repay a loan, you must repay principal (the loan sum, e.g. $500,000) and interest (the interest, e.g. at 3% per annum, that accrues on the principal. I.e., you pay 3% of $500,000 per year in interest).

If a loan is not repaid, the bank takes the house and sells it to get payment for the loan. Sometimes the house does not sell for a high enough price for the bank to get its money back, and the bank reports a loss.

Step 2: Make mortgage bonds

Once a mortgage has been written, if you are a bank and no longer want to take the risk of that loan not being repaid, it is very hard to ‘sell’ a mortgage to another bank or investor. If you package up (say) 1000 mortgages into a mortgage bond, however, they can now be sold and a bank can rid itself of the risk by selling the mortgage bond to someone else. The bank gets some money, and those other investor/s who bought the mortgage bond, earn interest on the mortgages and take the risk of not being repaid their principal.

Mortgages in a bond are ranked from highest (AAA) to lowest (BBB-). Investors at the top get the lowest rate of interest, but also take the lowest risk and have the highest likelihood of being repaid, for reasons I’ll explain in a moment. A bond could be worth $100m or more, so one investor does not own the whole thing. Little pieces of the bond are owned by dozens of investors. Some investors will hold only AAA, while others will hold BBB-, for example.  This is a sample mortgage bond, with just 5 ‘tranches’, or levels.

Simplified mortgage bond. Actual mortgage bonds could have up to 13+(?) tranches.

Note the 7% figure in the BBB- level. This is the level of losses required before the BBB- holders will be wiped out. Now, imagine that this bond contains 1000 mortgages. 10 of those mortgages (1% of 1000) fail and the mortgages are so bad that once the house is sold the investors in the bond recover no money. Investors in the BBB- tranche of the mortgage bond take 1% losses. However, because the BBB- tranche becomes worthless with just 7% losses, BBB- investors have actually lost 1/7th, or ~14% of their investment.

Many finance books use a ‘waterfall’ analogy, with the ‘waterfall’ (cash; mortgage + interest repayments) falling on AAA holders first, before excess spills down to AA, and then A holders, and so on.

Ratings agencies decided which parts of a bond were how risky, e.g. did a tranche have a AAA or BBB- level of risk?

Step 3: Package multiple mortgage bonds into a Collateralised Debt Obligation, or CDO

In order to sell more mortgage bonds of crappy mortgages, Wall Street packaged parts of numerous mortgage bonds (100 or more) into a kind of ‘super bond’ called a CDO.

Due to flaws in the rating agencies (S&P, Moody’s, Fitch), Wall Street was able to ‘game’ the ratings agencies models and get many BBB- securities re-rated as AAA. See the below diagram:

BBB- magically becomes AAA.

In this diagram, the BBB- tranches from 5 mortgage bonds (top) are piled into a CDO (bottom left). The ratings agencies would then re-rate as much as 80% of this BBB- debt to AAA (bottom right).

CDO creators were able to convince ratings agencies that BBB, or lower rated debts, were somehow not BBB at all when they were piled into a CDO. Quoting Michael Lewis in the Big Short, up to 80% of low-grade debt could be subsequently re-rated as AAA, or highest quality.

So you have a CDO composed of junk (BBB-) being sold as gold (AAA). AAA debt was more highly priced so banks made a lot of money via this practice.

Now in the original mortgage bond, the BBB- tranche takes losses first. Once the first, say, 7% of losses (people not repaying their mortgages) are taken, the bottom BBB- tranche is wiped out. However the re-rating of the debts in the CDOs created an illusion.

In this image, a regular mortgage bond takes 4% losses, wiping out just over half of the BBB- layer:

This is what 4% losses in a regular mortgage bond might look like, if the BBB- tranche becomes worthless at 7% losses. (not to scale; bonds could have up to 10 ‘tranches’ [layers] or more.)
In the above diagram. We’re assuming that the BBB- tranche is wiped out with 7% losses. So 4% losses (40 mortgages out of 1000) wipe out most – 4/7ths – of the triple B tranche, as intended. However, since so much of the higher-rated tranches in CDOs were actually disguised triple B tranches from mortgage bonds, 4% losses in a CDO might look more like this:

This is what losses on a subprime CDO (which was actually all BBB- that got re-rated) might look like.

Instead of losing just 4% of the bottom tranche, a CDO might lose 4% from all or most tranches, because they were all disguised BBB-. If there were 13 tranches and all were BBB-, 4% losses in the original mortgage bonds could be a 52% loss to the CDO. Quoting Michael Lewis again, 4% losses in mortgage bonds happen in good times.

Due to the way they were structured, very small losses could hurt higher tier investors also.

This is just for illustration. In reality CDOs were far more complex. Next up, is the ‘synthetic’ CDO.

Step 4: You can’t get enough mortgages to feed the demand for CDOs. Enter the ‘Synthetic’ CDO. 

There weren’t enough mortgages to go around to feed the creation of CDOs. So Wall Street started creating ‘synthetic CDOs’ from the payments from investors betting against CDOs. To keep this short I assume you know what a credit default swap is, but I am going to use an ‘insurance policy’ analogy to describe them.

Situation 1: This is how ‘The Big Shorters’ (Mike Burry et al) and the CDO market originally worked. Investors bought ‘insurance’ (credit default swaps) against a regular CDO defaulting. Companies like AIG Insurance’s sold these types of ‘insurance’ products:

The regular CDO and investors betting against them. (click to enlarge)

The typical interest payment to CDO owners (orange) might have been something like ‘2% above LIBOR’ (London interbank offer rate) but I have just called it 3% for simplicity.

Scenario 2:

At one point, AIG FP stopped writing insurance. Now Wall Street banks and other investors started writing the ‘insurance’ risk, and Wall Street used the ‘insurance’ payments to create synthetic CDOs to feed demand:

Synthetic CDOs were just somebody elses insurance payments, packaged up to look like a bond. (click to enlarge)

Read the diagram. Unlike a normal CDO, there is no property or mortgages underlying these ‘synthetic’ CDOs. This has a few implications. If the investors buying the insurance policy (credit default swaps) go bankrupt, CDO investors lose everything. Additionally, in this situation there is no property that can be sold to recover the losses, because there are no mortgages.

I couldn’t tell you if that was fraud, as I am not a lawyer. But it looks pretty outrageous.

The greatest concern is actually a bit more abstract – with synthetic CDOs and credit default swaps, there is no limit to the risk (defined as total maximum amount of loss) that can be placed in the financial system. For example, no matter how bad the loans in the USA got, there is always a certain maximum amount of risk. For example say the population is 300 million people. There is a vague, but fairly firm, limit to the number of mortgages you can write for this many people. Just for illustration, there couldn’t be more than, just say, 400 million homes and, say, 800 million home loans. If each loan is $300,000 on average, the total maximum amount of money that can be lost on the loans is something like $240 trillion, plus interest (this ignores the secondary effects of the resulting economic collapse, which would undoubtedly cost much more). Admittedly this is an outrageous sum, and far more than was lost in the GFC. But at least with a mortgage you know the upper limit on your risk, and there is a property that can be sold to reduce some of the losses.

However, with synthetic CDOs you can create as much risk as you like because the number of homes and borrowers is not a constraint. This is why many crisis commentators and post-crisis books take an apocalyptic tone – because the world really could have been looking at financial Armageddon.

I hope you found the diagrams useful.

I have no financial interest whatsoever in any of the above mentioned products or companies, directly mentioned or implied. This is a disclosure and not a recommendation.

Q1 2018: 10foot is up 70% FYTD

As we prepare our upcoming quarterly review, we are pleased to announce that the 10foot portfolio has returned approximately 70% since last quarter and now has an unaudited total net asset value (NAV) of $16,830 versus an initial value of $10,000 at inception.

There has also been a change in the structure of the fund, via deployment of a special purpose vehicle (‘Portfolio SPV’) which now holds the 10foot portfolio. A separate SPV (‘Website SPV’) was created for the purpose of holding the 10footinvestor.com properties, which as you know, are in the process of heading to IPO. The Portfolio SPV has significant – to date unrecognised – intangible assets, primarily in the form of the portfolio manager and their world-class expertise and connections. These are difficult to value. However employing the latest financial techniques like Discounted Cash Flow methodology, modest growth assumptions and a technical change from reporting NTA to NAV, we are now able to ascribe a value to these and thus, the net asset value of the Portfolio SPV is significantly higher than was previously reported to the market. We regret and apologise that it has taken so long to ascribe a fair value to holders’ assets.

Importantly, the Portfolio SPV will begin paying management fees to the Website SPV, 10footinvestor.com. As a result, 10footinvestor.com will soon be drawing its first revenues and progress beyond the pre-revenue stage of development, which should make it easier to finalise the IPO process and unlock a fairer equity valuation for holders. A preliminary valuation suggests 10footinvestor.com could be worth as much as $60 million instead of the $40 million previously disclosed to the market.

A signing bonus of 10 million options in 10footinvestor.com with an exercise price of $0.001 was issued to the Portfolio SPV in return for awarding the management contract to the Website SPV. As a result, we expect the forecast strong growth in the NAV of the portfolio SPV to continue for the foreseeable future. In FY18 we are forecasting investment returns of 120% followed by approximately 100% in FY19 as the IPO process completes.

We will soon be issuing a supplementary report detailing our newly revalued assets, and depending on investor interest, may consider re-opening the fund to further investment. We are available to answer client queries at 10footinvestor@gmail.com, or via our twitter handle, @10footinvestor.

And if you believe all that, I have a $60 million IPO I’d like to sell you….

Corporate Fuckery-O-Meter™ rating:  Off the charts.

More thoughts on NGE Capital, Mayne Pharma, and Crowd Mobile

I originally intended this as another scuttlebutt post but commentary on Mayne and Crowd quickly got too in-depth, so I pivoted. Might have a formal scuttlebutt post in the next couple of weeks.

Here are some thoughts on a possible pump and dump in Crowd Mobile, the regulatory environment at Mayne Pharma, and my surprise when I discovered two friends of mine had actually met David Lamm years ago:

Edit: I have made a small addition to the end of the Crowd Mobile piece below, if you’re interested.

Mayne’s regulatory woes

Now, the reason Mayne shares have fallen so far is, I think, a combination of the perception that the Teva acquisition is a dog (which I addressed in my Buy thesis), and the regulatory issues. There is a huge, entirely correct movement to crack down on pharma shenanigans in the USA, but my view on regulation in general is that Mayne is small enough to sneak beneath notice. For example it sells opiates (a hot issue), but not many. It does however sell methylphenidate (think ‘Ritalin’; similar in effect to amphetamines) and butalbital (a barbiturate) which are drugs of concern and account for 17% of GPD revenue. Methylphenidate is chronically overprescribed in the USA (for ADHD especially), which is a key issue but change is hard to achieve in this area and on balance I think risks to these sales are low.

Mayne also gets new patents for ancient generic drugs (another key issue) by changing their formulation, but only has ~3 drugs (its Specialty Brands Division). Plus many of its reformulations (e.g. turning a tablet into a gel, or a delayed action tablet) can convincingly be argued to add value. Thus I think the company will avoid notice, but broad-based reform (if any) will still have a potentially serious impact on its future if Mayne loses the ability to reinvent drugs in this way.

There are also Mayne-specific problems where the company is accused of manipulating the price of Doxycycline Hyclate tablets. Mayne sells both a generic version of these as well as a specialty brand, ‘Doryx’. As I understand the accusations, Mayne won’t avoid notice here because it and Mylan were at the time (I think) the only generic suppliers of Doxycycline. However, as I hinted at in my thesis, the regulators are going to have a tough time proving wrongdoing. It’s not hard to match prices without colluding if there is only a small number of suppliers – and this sort of ‘soft collusion’ is not necessarily illegal.

Revenue is unlikely to be severely impacted (though I note the company has already mentioned legal fees and a possible sales impact, implying prices may be falling). This is because generic Doxycycline sales account for less than 4% of Generic Product Division (GPD) revenue (it’s not even mentioned):

source: Company prezzo, click to enlarge

There are several nuances to the regulatory aspect as there are Mayne-specific (eg doxycycline price fixing) allegations and larger industry concerns (patents, overprescription etc). My overall view is that Mayne generally avoids the attention of regulators over the next few years, and maybe even benefits from the fast-tracking of patents and generic approval. Mayne also stands to benefit from the shocking leverage present in the sector – many players are tapped out and may have to divest drugs, especially if interest rates rise. Mayne has relatively modest debt and with any luck can benefit from forced selling. In my initial thesis I wrote that I would prefer Mayne not to acquire and to focus on generating cash, but that would be a missed opportunity if there are quality portfolios coming on sale at forced divestment prices. I would prefer to see management go for bite-sized acquisitions – another Teva-like would be a warning.

So I may have to amend the thesis somewhat. Mayne is historically an acquisition machine and they’ve done pretty well, but I maintain a generally jaundiced view of debt and acquisitions. Fortunately I have not paid through the nose for the uncertainty.

A pump and dump in Crowd Mobile? 

An anonymous account that 10foot has just discovered on Twitter, @stockswami, has stated his belief that there is a pump and dump underway in Crowd Mobile shares. Now, firstly, swami is an anonymous account and the author appears to have a strong agenda. He is perpetually calling out tiny ASX companies, regulators, and various market players accusing them of stock manipulation, incompetence and a garden variety of other things. On balance his critiques seem well worth listening to, but readers should approach all anonymous accounts (including this one) with a critical eye.

This alleged pump and dump interests me because 10foot owns shares of Crowd Mobile (ASX:CM8). I have never been in this situation before and I was originally quite sceptical because Crowd Mobile is an established business and does not seem like the usual piece of shit that individuals try to manipulate. However, if I tie together a few pieces of disparate information it is possible to see his point.

I’ve commented previously on Crowd CEO Carosa’s salary package as being pretty outrageous (~2% of market capitalisation last year, due to the equity awards). Carosa also makes additional money via Crowd Mobile contracting with his companies Dominet and DJ Carmichael, a brokerage firm of which Carosa is a director and 5% shareholder. Multiple reports from Carmichael feature on CM8’s website. On their own, none of these connections are problematic, plenty of executives make money, both morally and immorally, by contracting to their companies at fair or unfair rates.

Next, Crowd Mobile seems quite self-promotional. I was surprised to see a little while ago that both CEO Carosa and Crowd Mobile shared my purchase thesis for Crowd both on Twitter and on LinkedIn. Company promotion is not unusual among small caps and I figured that if the CEO was comfortable publicising my criticism of the company and his salary, then by inference the company has nothing to be worried about. However, by inference, we also saw that the CEO was handed half a million in equity last year at low prices, so if you took the cynical view and wondered who gets paid the most if the share price goes higher….

Heuristic: Strongly promotional companies are usually better off avoided as they can be more concerned with looking good than actually doing the work required to achieve their goals.

Then I spotted this article yesterday which made me consider the possibility of a pump quite strongly. It is a blatant puff piece that nevertheless does a pretty good job explaining the investment opportunity and the company’s future opportunity in digital influencing. If you read the disclosure “S3 Consortium Pty Ltd does and seeks to do business with companies featured in its articles. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity…”.

Paid or unpaid? Did Crowd pay for it? Did DJ Carmichael (the broker) pay for it? The more important question is, what should I do in this situation? I hate market manipulation with a fiery passion and I don’t want anything to do with a company that may be manipulating/ being manipulated.

(As a side note, I have noted that 10foot companies typically enjoy a 7%-10% rise in the weeks after I buy them, which is concerning although I am uncertain if it’s anything to do with me. Something to keep an eye on.)

Should I sell just to clear my conscience? That would result in potential financial loss (or missed gains) for no reason on the fear of a pump that may not exist. No, the solution is one which I originally got from Howard Marks: Have a firmly held view of intrinsic value and make your judgement based on that information.

I have a fair opinion of what Crowd Mobile is worth in a range of circumstances, depending on the rate of growth in Q&A and decline in Subscription. If overall cash earnings stay flat, my view is that Crowd is worth more than today’s prices. I won’t say how much more in case it spoils my ability to sell – I haven’t fully thought out my exit strategy as I wasn’t expecting to need it for a couple of years yet. But consider yourself forewarned, there is a good chance of me selling in the near future if my estimate of intrinsic value is exceeded. Something to keep an eye on.

Edit: I re-read this post and realised I sounded very negative on Crowd in this, which was not my intention. I think Crowd is an OK company coming out of some tough times, that was convincingly undervalued when I bought it. Obviously, I have little reason to complain if somebody campaigns its share price higher for me.  I don’t have any specific belief that the company is doing anything wrong, but I can definitely see how someone might construe that people are attempting to pump its share price. I am staying the course and will be making my investment decisions based on the company’s progress and my estimate of its intrinsic value.

David Lamm and NGE Capital

A friend of mine told me recently that he and a colleague met David Lamm years ago, though Lamm wouldn’t remember them. If they recall correctly it was as he was looking for initial investors for Kentgrove Capital, his private fund. They distinctly remember a discussion among themselves afterwards where they openly wondered if Lamm would be around long enough, as an independent fund manager, to become a fixture in the Australian investment industry. This was not a reflection on Lamm himself – just their thoughts on how difficult it is to get started as a fund manager. Both were openly stunned when I told them that Lamm had returned 15.6% p.a. over the past 7 years at Kentgrove, progressed to buying an LIC, and was also one of the major shareholders in Godfrey’s.

Obviously they don’t have a clue about Lamm, or they would have invested in his fund. But I’m wondering if their initial doubts and subsequent respect (both friends have independent records of significant, sustained outperformance) could suggest that Lamm has ‘got what it takes’ to succeed where many managers have failed. There seems to be a definite ‘hill’ with fund managers whereby, if they get to the other side, they’re probably going to be around for the long haul.

Obviously I want to invest with a winner and, just maybe, Lamm is one of those.

I own shares in NGE Capital, Crowd Mobile, and Mayne Pharma.  This is a disclosure and not a recommendation.

Do you have a preference for reading multi-topic longer pieces like this one, or would you have been more engaged by individual pieces on Crowd Mobile and Mayne? Please let me know your thoughts via comments, email, or twitter @10footinvestor as I’m currently working to improve the readability of the site.