OK. End of lecture. Back to Joe and Joella.
The happy couple are smoking weed with some buddies, when one of them happens to mention that he’s bought his house—his trailer, that is. Joe and Joella are astonished. This guy (he calls himself Fat Boy) doesn’t have a job or any income or any assets, so who would be dumb enough to lend him money? Fat Boy explains it. Property prices always rise. He’s been lent 105% of the value of the trailer. The idea of that extra 5% is that he can invest in improving the property and/or setting a little aside for interest payments. In practice, Fat Boy laughs, that extra 5% is being inhaled right now and very sweet it tastes too. Joe and Joella ask about interest payments, and Fat Boy says that he’s on something called a ‘teaser rate,’ which is very low. It’ll start going up in a couple of years’ time—but at that point, he says, he’ll probably sell up, take the profits, invest in somewhere bigger. He sketches out the likely outline of his property empire, using the glowing tip of his joint to illustrate some of his larger ideas.
Maybe Fat Boy sounds like an idiot, but he’s not the real idiot here. To understand the degree of insanity that afflicted our financial system just a few years back—and still afflicts it today—we’ve got to trace out what happens next stage by individual stage. So here goes.
Stage 1
Joe and Joella go to Fat Boy’s bank and ask for a loan. To their silent amazement, they get it: 105% of the asset value. Super-low teaser rate of interest. And their trailer—or rather, their pre-manufactured housing unit, in Wall Street jargon—becomes theirs.
Stage 2
Joe and Joella’s loan has been given to them by a recently formed unit of the First National Bank of Pumpernickel Creek: an internet-based home loan subsidiary called EZ Homes. EZ Homes did no real credit assessment of Joe and Joella, because it had no intention of holding on to the credit risk. EZ Homes, in fact, simply took a bundle of its recent home loans and sold the entire package. It did so by creating and selling an asset-backed security—effectively, a bond supported by the underlying mortgage assets and nothing else.
Please note that if this were the end of the financial chain (which it most certainly is not) you would already have a situation in which the end investor has done no or minimal due diligence on Joe and Joella. Boosters of the system liked to talk of risks being ‘dispersed’ by the securitization process, but that language would likely have puzzled our old-style bank manager. Risk is risk is risk is risk. If you make a loan, and know your borrower and check your collateral, you have a decent chance of getting your money back, plus a little extra by way of profit. If you don’t know your borrower and haven’t checked their financial capacity and haven’t ascertained the strength of their collateral, then you haven’t ‘dispersed’ anything at all except your common sense—and the likelihood of making any money for your ultimate investors.
Stage 3
In any case, however, things weren’t as simple as a mere asset-backed securitization. An ambitious Wall Street bank—specifically, the Housing Issuance and Trading unit of Bear Lehman Lynch Sachs & Stanley—acquired a whole load of mortgage products and bundled them in a newly created structured investment vehicle or SIV. Such an SIV might have had a balance sheet looking a little like the one below. (These data are adapted – and simplified – from a genuine financing, in this case Goldman Sachs’ controversial Timberwolf1 issue.)
Assets ($m)
1,000+ mortgage products
Liabilities ($m)
9 AAA-rated floating rate notes (FRNs)
8 AAA-rated FRNs
100 AAA-rated FRNs
200 AAA-rated FRNs
100 AAA-rated FRNs
100 AAA-rated FRNs
305 AAA-rated FRNs
107 AA-rated FRNs
36 A-rated FRNs
30 BBB-rated FRNs
22 unrated income notes
Now this might look a little confusing—actually, it is confusing—but the essence of it is simple enough. Those mortgage products provide a stream of cash flows (which come, let’s remember, from Joe and Joella—and thousands of other borrowers—making payment to their primary bank.) When the SIV receives those payments, it crunches some numbers. If all is well—that is, if the money coming in is sufficient to repay all those various noteholders—they will receive their payouts as expected. If all is not well—if there is a default (ie: the incoming payments prove insufficient)—the noteholders are paid in order of seniority. The AAA-rated noteholders come first. (There are so many tiers of them because of somewhat different details regarding maturity dates and the like.) Once the AAA-rated notes are made whole, the AA-rated noteholders get their turn, and so on down the chain.
Those ratings—the AAA, AA, A, and BBB—are external assessments of risk made by the ratings agencies. (More on them in the next couple of chapters.) The people at the top of the list are safest, because they have the first claim on any payments. The people at the bottom of the list are least safe, because they receive payment only in the event that everyone else has already been paid out. Needless to say, however, those taking the least risk also earn the lowest interest rate; those at the most risky, most speculative end of the deal are (in theory) well compensated for the risk they take. (I say ‘in theory,’ because when in practice these edifices of crappy assets collapsed, those at the bottom of the food chain often received nothing at all.) Structures of this sort are known as collateralized debt obligations, or CDOs.
When you finally understand the CDO structure and grasp the way that cash flows—and risks—cascade down the chain of bondholders, it’s easy to get seduced by the logic of it all. Yet when you stand back and think about it, the logic is extraordinary. Joe and Joella do not look (or smell?) like investment grade borrowers. They have no credit history, no job, no income, no assets and—I don’t want to be snobby about this, but—they live in a trailer park and have nothing to do all day but smoke marijuana with Fat Boy. Yet from that billion-dollar swamp of ultra-high-risk consumer lending, look what Wall Street managed to do: it created $980 million worth of investment grade assets. The ‘AAA’ rated assets were supposedly as safe as Treasury bonds issued by the US government. Even the ‘BBB’ rated assets were supposedly as safe as bonds issued by the governments of Russia, India, and Brazil. Even Fat Boy, as he sat there waving his joint to illustrate his path to Donald Trump style wealth, would have been disconcerted to learn that Wall Street rated around 80% of his loan as being at least as creditworthy as the US government itself. Lunacy.
Stage 4
It gets worse. The Housing Issuance and Trading unit at Bear, Lehman, Lynch, Sachs & Stanley (BLLSSHIT, for short) decided they liked stage 3 so much, they’d do it all over again. They’d create yet another structured investment vehicle—only this one wouldn’t hold mortgage-backed securities on the asset side of its balance sheet, it would hold CDOs issued by structured investment vehicles created to hold mortgage-backed securities.
So what we’ve got now is Joe and Joella’s crappy mortgage being packaged into a mortgage-backed security, then repackaged as a CDO, then re-repackaged as a ‘CDO-squared.’ And at every stage, the original crazy lending decision becomes less and less obvious to the ultimate end investor. That investor would have no way to check out the borrowing capacity of individual borrowers, no way to check the value of the ultimate collateral. The one overridingly crucial job of the fixed income investor is to check the credit quality of the bonds he or she is investing in—and the whole CDO-squared nonsense made that task impossible to perform. Yet all the slick Wall Street salesmen needed to do to secure their sale was to point to the AAA rating bestowed on these bonds by the ratings agencies. A rock-solid rating, and an attractive yield: what could possibly go wrong?
Stage 5
You might think that all this is complex enough, crazy enough, tangled enough—but
you’d be wrong. As it happens, there were Wall Streeters keen to see if they could create a ‘CDO-cubed,’ a CDO of a CDO of a CDO of a mortgage-backed security, backed by the full faith and credit of Joe and Joella—but as far as I know, the whole market blew up before people could be that stupid. Shame.
Nevertheless, there was room for one further twist in the screw before Armageddon arrived. As the mortgage market boomed to a peak of something over $10 trillion, there were investors starting to get anxious about the scale of their exposures. Some of these were motivated by ordinary credit-driven concerns. Others were bullish on the mortgage market but simply had to cap the total volume of their exposures. And so on. There was a huge variety of different motivations.
But there was one common solution for their needs: the credit default swap or CDS. Forget about the intricacies of the terminology. Credit default swaps operate exactly like regular insurance—in this case, insurance against credit risk and default. You pay your premium year after year. If the asset you’ve insured goes bad, then the insurance pays out. So if, for example, you bought a mortgage-backed security full of subprime mortgage assets, you might (when you came to your senses) decide to insure yourself against the possibility of default. It would have been a sensible thing to do. If you’re dumb enough to buy a house in an earthquake zone in the first place, then at least have the sense to insure it properly.
So far, so sensible. The trouble, as ever, was Wall Street. Some smart guys on the Street noticed that the pattern of payouts on insurance schemes (a chain of small regular premiums followed by a potentially large one-off insurance payout) looked very like the pattern of payments on a CDO (a chain of small regular interest payments followed by a large final repayment of principal). Using a little financial magic it proved to be possible to turn those credit default swaps into a ‘synthetic’ CDO. In plain language, all those people taking out insurance against defaults were making bets on one side of the mortgage market, while the synthetic CDO enabled investors to bet on the other side of the market. In effect, that synthetic CDO created mortgage risk out of nowhere. That $10 trillion of mortgage risk was apparently not enough; Wall Street had to artificially create more from thin air. Many of these synthetic schemes were little more than Ponzi schemes, which pretended to offer AAA-rated assets and in practice were lethally weakened by the shoddiness of their underlying assets. The creators of those schemes made a fortune from creating them, lost heaps of money for their investors—and are still, for the most part, in business and thriving today. No one who created such a scheme has been jailed and almost nobody fined.
*
No doubt you’ve read this far with some mixed feelings. Relief to have gotten through it. Pleasure at having (mostly?) followed it. Anxiety that maybe you haven’t quite. Some angry amazement that financial regulators were so dozy that they let all this happen without a murmur. But let’s put all that to one side. This chapter has traced developments in the mortgage market as a means to an end. We’re not so interested in risks that were specific to one financial market at one specific period in history—a market which more or less annihilated itself in 2008.
The crucial issue is this: the way Wall Street sees risk vs. the reality of those risks.
We’ll look at the reality of the risks in the next chapter. But first, the Wall Street view. According to Wall Street, all these MBSs and CDOs and CDSs allowed the credit risk of Joe and Joella’s mortgage to be ground so finely that it was spread like pollen across the entire financial system. Of course, if Joe and Joella failed to keep up with their payments, someone would have to absorb the loss, but in the Joe Schmoe / Jefferson Smith world, the hit was taken full in the face by one single institution, not even a large one. In the new financial system, the losses would be barely noticeable.
That was the first piece of good news—but there was more. In the old days, anyone who took credit risk was stuck with it. There simply wasn’t anything they could do but absorb any hit when it came along. In the brave new world of the last decade, risk-takers could, if and when they chose, become risk-avoiders. Credit default swaps offered a way for people to exit bets they had taken and pass the risk to those whose confidence and whose balance sheets were up to the challenge.
Better still, the technology of financial derivatives allowed every separate element involved in a transaction to be separately priced and, if necessary, sold. Investors could gauge for themselves which risks were acceptable and which were not. Financial markets should be near-perfect mechanisms for evaluating and distributing those risks. In neoclassical economic theory, the dual process of self-interest and market pricing should ensure that risks weren’t just widely distributed, but efficiently distributed too. Borrowers would be able to borrow cheaply (so more factories would get built). Lenders would be able to lend more securely (which would also tend to reduce overall economic costs). The result—in theory: everyone would get just a little bit richer. (Except for Wall Street, which would get very much richer.)
If these arguments had any merit, the basic arithmetic shouldn’t have worried anyone much. In the first half of 2007, global banks made profits of approximately $425 billion. The banking system worldwide had core capital of almost $3,500 billion.2 By mid-2008 the value of subprime mortgage securities had been written down by around $200 billion. The IMF reckoned there were subprime losses of a further $1,000 billion to deal with.3
Now, on Wall Street’s logic, none of this should have been much of a problem. By mid-2008 subprime mortgage losses amounted to less than the profits earned in a single quarter. The losses to come would wipe out another year’s worth of profits. The total losses wouldn’t knock out even half of the banking system’s hefty capital—and that’s ignoring the system’s capacity to rebuild capital by generating profits. Indeed, even that overstates things, because much of those subprime losses ended up outside the banking sector (as insurance companies and other investors got in on the act). So while a few badly managed or weakly capitalized banks might not have been able to ride out the crisis, the banking system as a whole should have emerged just fine. It would be a little like a fashion retailer screwing up its fall and winter ranges, taking a hit, fixing the problem, moving on. No one likes it when tough times come along, but those tough times are part of the price you pay for being in business at all. It shouldn’t, ordinarily, be a big deal. That was the logic. The logic that everyone—almost everyone—believed for years.
And that logic failed catastrophically. When Lehman Brothers failed, its Chapter 11 (bankruptcy protection) filing reported this:4
Assets: $639 billion
Liabilities: $768 billion
Net value: minus $129 billion
Now, evidently you haven’t had a good day at the office if, at the end of it, you have to report that you’re insolvent to the tune of $129 billion. That’s kind of an oops! moment, to put it mildly. On the other hand, that loss represented less than two months of banking profits. It represented a tiny 3.8% of the banking system’s core capital … and bear in mind that it wasn’t only banks that did business with Lehman. It was corporations and insurance firms and hedge funds and a host of others too. In other words, on Wall Street’s logic, Lehman’s bankruptcy should have been barely noticeable in the noise. A big deal if you stood close to the event; a mere pinprick if you were positioned further back.
Yet that pinprick triggered an unprecedented threat of collapse. In the US, and right across the world, governments and central banks stepped in to save the banking system. In the US, the UK, Ireland, and Iceland, you’d be hard pressed to find a single large bank which would not have gone bankrupt had governments not stepped in. In other markets—France, Germany, Spain, Italy, Japan—the consequences were possibly somewhat less catastrophic, but only because the American and British authorities had already thrown their bodies in front of the speeding train. Had it not been for the extraordinary vigor and generosity of American and Brit
ish taxpayers, the major institutions in those other markets would have gone under too. (Of course, if you happened to be one of the taxpayers in question, you can’t claim too much credit. I don’t recall that you were ever given a choice.) And let’s not be vague about what that collapse would have meant. It would have meant that when you went to your ATM, no cash would have come out of it. It would have meant that when nonfinancial firms tried to transmit cash in the ordinary course of their business, no cash would have been transmitted. The Lehman bankruptcy—that $129 billion pinprick—bankrupted capitalism. It was the day the world ended.
Wall Street claimed to have minimized and contained financial risks. In fact, those risks were aggregated, multiplied, and hidden. That was the case in 2008. It is still the case today. The next chapter starts to identify those risks. The chapter after that explains why Wall Street doesn’t function the way ivory-tower economists think it must do.
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