Colin Barr

Following the money in banking, economics, and Washington

How CDO games blinded economists

August 27, 2010: 2:31 PM ET

Are we being too hard on the economic forecasters who failed to predict the financial meltdown?

The question comes to mind in the wake of Friday's takedown of the big banks' subprime misdeeds, by ProPublica and NPR. The piece offers the latest glimpse into the games the bankers played to keep their fees and bonuses flowing as cracks started to show in the highflying U.S. housing market.

The sky fell, but few predicted it

ProPublica and NPR show how the banks created demand for the mortgage paper that was being churned out by so-called collateralized debt obligations, or CDOs. They did so by creating more CDOs that bought pieces of existing CDOs. This had the effect of boosting prices at the time but later helped to accelerate investors' flight from collapsing debt markets, as losses at CDOs that owned stakes in one another rattled through the system.

But that wasn't the only game being played in the markets for housing-related debt, as investor Jeff Miller writes at his A Dash of Insight Blog. Another one involved the creation of so-called synthetic CDOs, which issued debt backed not by actual mortgage bonds but by credit default swaps that would pay out in the event of a default on those bonds.

With the synthetic CDOs, Wall Street gave investors who wanted to bet against the mortgage market a convenient vehicle, financed at least in part by institutional pigeons who didn't know what they were up against. That is the storyline behind Goldman Sachs' (GS) $550 million settlement with the Securities and Exchange Commission last month.

Here's where the link to the forecasters comes in: Few people, from Ben Bernanke on down, appreciated the games being played in the world of mortgage-related securities, and how they would help send the economy into the abyss.

Both the creation of new CDOs to absorb existing CDO debt issuance, and the development of products that allowed investors to bet against the housing bubble, amplified the impact of a housing downturn on an overleveraged financial system. 

It was that link that ended up being the key to the 2008 meltdown, Miller writes. That tie that was certainly overlooked by conventional forecasters, most of whom failed to consider the devastating effects the bubble's collapse would have, first on the Lehman Brothers and Bear Stearnses of the world and then on broader credit availability.

But it was also largely ignored by the Nouriel Roubinis of the world, who have since gained fame for "calling" the crisis -- though the most prominent bearish forecasters actually spent the years leading up to 2008 warning of a dollar meltdown, not a Wall Street collapse.

"The current assessment of blame and credit about forecasting is seriously flawed," Miller writes. "None of those 'getting it right' understood the synthetic market.  They over-estimated the regular market.  Mainstream economists did the opposite."

It will be interesting to look back in a year or so, after the vaunted double dip has either occurred or not, and consider whether there was a similar vulnerability in the economy that everyone is currently overlooking.

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Colin Barr
Colin Barr
Senior Writer, Fortune

Colin Barr has covered finance for Fortune.com since November 2007. Previously he was a writer and editor for TheStreet.com, winning a 2006 Society of American Business Editors and Writers award for "The Five Dumbest Things on Wall Street," and for Dow Jones Newswires. He is a 1991 graduate of Penn State and lives in Port Washington, N.Y., with his wife Meena Bose and their two kids.

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