In these heady days of financial reform and the manic battle of lobbyists, politicians and populists to steer the course of financial regulation, the question of who exactly is to blame for the ongoing economic crisis has returned to the fore. A Senate panel recently interrogated Chuck Prince, former chairman of Citigroup, who fell to the familiar routine of pleading ignorance: “I’m sorry that the financial crisis has had such a devastating impact on our country. I’m sorry for the millions of people, average Americans who have lost their homes. And I’m sorry that our management team, starting with me, like so many others, could not see the unprecedented market collapse that lay before us. [...] investors were reaching for yield, and many people, from investors to traders to rating agencies to regulators, believed that a new era of generally lower risk had begun.” (http://www.npr.org/templates/story/story.php?storyId=125736564) Robert Rubin, former Treasury Secretary under President Clinton and a former Citigroup director, stuck to the same story. “[...] there isn’t a way, in an institution that has hundreds of thousands of transactions a day, and probably something over a trillion dollars a day running through it, that you’re going to know what’s in those position books. And I didn’t know it when I was running Goldman Sachs and you wouldn’t know it sitting on the board of Citi either. You really are depending on the people who are there to bring you problems when they exist.”

Needless to say, there’s something quite unsatisfying about these explanations, though we’ve been hearing them from the beginning from most top-level people. Can one really believe that top management didn’t have at least a faint idea of what was happening? It was making them bank, after all.

From my time in New York far on the sidelines of the financial debate, it became clear to me that there’s generally two levels of analysis in the world of financial economics: the top level, consisting of policymakers–Fed and Treasury officials–and academics, which is also populated by some of the higher ups in the financial industry food chain; and the bottom level, populated by traders and asset managers. Clearly, if you want to know what’s “really going on,” you’d go to the bottom level. This simply stands to reason: finance is a massive heaving machine, just keeping up with what’s going on is a full time job for thousands, so any one group of policymakers or regulators is going to have to operate at several levels of abstraction from the real picture. Meanwhile, the traders actually drive the evolution of the system by adapting to regulatory structures and determining how deals are executed in their relentless search for return; they also produce the financial “innovations” of which we’ve become all too aware. Journalists have at last started to report on this micro-level aspect of the crisis: e.g. the New York Times has recently reported on the widespread practice at structured finance desks of hiring away ratings agencies employees to structure financial products in such a way as to fetch AAA ratings, hiding their true risk. This American Life, easily the best source of reporting on the crisis, has also recently ran a story that rebuts the conventional wisdom that the crisis was an emergent phenomenon that no one could foresee; they were able to see through the smoke screen by simply looking deeply at the actions of a particular hedge fund (see episode #405, “Inside Job”). The SEC’s recent indictment of Goldman Sachs has also shifted the focus to the actions of packagers, securitizers, quants, and sales-people.

Here at the Dark Comedy Hour, we’re kicking ourselves a bit for sitting on a story we’ve been reserving for the much delayed first issue of the Dark Comedy Review that would have broke some of this news (to a non-finance audience of course, for much of the information about the soft fraud that was going on in mortgage securitizations was probably an open secret on The Street). For our fifth post, therefore, we bring you, ahead of schedule, a piece by our own Wall Street insider, a good friend of the site who has a decade of experience working in “structured finance”, a term which refers to the types of practices that have become widely known as the central locus of the crisis–the packaging of mortgages and other loans to make securities, i.e. “securitization”, the practice that gave rise to the famed “Collateralized Debt Obligation” or CDO.

In some realms of social science, one sometimes refers to consulting the “Delphic Oracle”, i.e. actually talking to people involved in the social processes you’re studying. In the case of the financial crisis, the oracle has either been left un-consulted, or has been keeping his silence. Whatever the case, we now bring you a story of the financial crisis straight from the banker’s mouth.

Our Wall Street Insider will remain anonymous for obvious reasons.

-the Archivist

note: We’ve also posted an earlier version of this piece that goes into a lot more detail about the way these structured finance desks worked. For readers especially interested in the potential fraud (legal or illegal) caused by conflicts of interest between banks and ratings agencies, especially the practice of banks simply hiring rating agency employees, check out this version.

A Brief History of the Financial Crisis

A lot went wrong, and I don’t think many people know how close we came to large-scale destruction of the modern financial system. There was a real risk of catastrophic failure on the scale of the 1930’s or the 1890’s. It is easy to be sanguine today. Although things are bad, we have remained within the bounds of normalcy. There are no massive, cascading failures rendering people broke overnight. Instead, we have achieved what is probably the best we can hope for out of a set of bad alternatives.
The second stage of this crisis is playing out in slow motion, allowing us some time to adapt to the changing realities of the economic situation. There will be continued changed in our economy and lifestyle for years to come, most of them negative, but as long as they happen slowly enough we will be able to adjust and eventually return to some kind of prosperity.

I can’t tell the whole story here. That would take many more pages, and much more information than I have available.

Depending on who you listen to, you may hear that the problem is a result of credit derivatives, securitization, Wall Street bonus payments, quantitative financial engineering, failure of government regulators, government sponsored mortgage agencies, credit rating agencies, consolidation of the financial industry, American consumer demand, unscrupulous lenders, the abandonment of the gold standard, the Federal Reserve’s easy monetary policy, and more. In reality, all of those things did contribute in some way. You can take any item from that list and use it as a window into understanding the phenomenon, but you will quickly encounter more and more of these items until you realize that a holistic approach is needed. That is to say, you can not understand or address the problem by focusing on a single aspect of it because it is too big and too complex. You need to understand the dynamic relationship between all of these things.

I will try to explain just a small part of this story concerning the banks involved, and in particular their use of credit derivatives. And I feel compelled to mention that this crisis was not engineered by any conspiracy or cabal. Goldman Sachs has most adroitly exploited the situation to their benefit, but as an organization they are certainly not smart or powerful enough to have created this outcome for their own benefit.

In classic banking, there is a division between retail/commercial banks and investment banks (the division exists as a result of the Glass-Steagall act and other depression-era legislation.) Commercial banking is usually simpler. The bank takes deposits from people in the form of checking and savings accounts, and perhaps a few other ways. It lends those deposits in various forms including mortgage loans, lines of credit, etc.

The bank makes money because it borrows the money at the short-term rate paid to depositors ,and lends the money at a longer term rate charged to borrowers. Typically, there is additional charge referred to as a credit spread. This compensates the bank for taking on the risk that not all borrowers will pay back the money they have borrowed. The bank’s expertise is in judging the borrower’s credit worthiness, as well as the value of any collateral.

Investment banks, on the other hand, primarily make money be providing services to corporations and governments. For example, investment banks arrange for the sale of new stock shares, or bonds, or for the acquisition of one company by another. There are a lot of these types of activities, some fairly esoteric, that investment banks perform and for which they earn large fees.

There are two important things to recognize about the role of the investment banks.

First, they do not take risk in the same sense as commercial banks. While an investment bank often does have its own capital at stake in a stock offering or merger, it does not have to. A commercial bank, however ,can only lend money against its own balance sheet.

Second, investment banks create product for investors. If you want to invest in publicly traded securities, you buy stocks and bonds. The investment banks are the middle-men who create these securities as a way to transfer capital from investors to investments (productuve uses of capital like businesses.)

It is a natural outgrowth of the investment bank to make capital markets. The investment bank matched up the original company that issued bonds (borrowers) with the bond buyers (lenders). The investment bank is therefore naturally well positioned to create a secondary market in bonds that have already been issued.

So, moving away from theory and toward reality, this means that investment banks have big, open floors the size of multiple football fields, and these floors are filled with row upon row of jackass traders working the phones and the screens. These guys are working to match up buyers and sellers of stocks, bonds, and just about anything else that can made into a security and traded. This activity generates a huge amount of profit – far more than the lending activity of commercial banks.

Let’s go back to the early 2000’s. The fed was keeping interest rates low and credit easy in order to counteract the stock market crash (remember dot-coms, enron, worldcom?) and the effects of the Sept. 11 attacks. All around the world, money was getting easier and cheaper to borrow. Because of this situation, the returns from lending were squeezed down close to nothing. By the mid-2000’s, a few years into the easy money cycle, credit spreads had become very tight.

Investors with fixed liabilities to fund, like pension and insurance funds, as well as lenders like commercial banks, need fixed income assets (bonds) with enough yield to meet their liabilities. They are some of the most profitable customers for investment bank capital markets, and these customers needed a new product. They needed more spread.

How do you take an income producing asset and increase its spread, without changing the quality of the underlying promise to pay back the debt? This question has been asked many times, and the answer is always the same: leverage. If you put up part of the money and borrow the rest when buying an asset, you increase the amount of income received per dollar of actual capital. That is financial leverage.

Wall Street investment banks created product to meet this need. Here is a brief and simplified description of the basic innovation they created. It is called a collateralized debt obligation (CDO), and there a million variations on this simple concept.

You take a credit product, like mortgage loans, and bundle them into pools with thousands of other, similar loans. These pools are securitized into mortgage bonds with standard features that can now be traded easily. This process started in the 1970s and can be now be done with just about any type of underlying asset.

Now you can take these bonds and divide them into different “slices”, called tranches. Investors in the junior tranche absorb all the losses from defaults (or generically from any losses) until their investment is wiped out. Only then do investors in the senior tranche start to take losses. This allows you take a pool of assets, potentially real crap assets, and construct senior tranches that are much safer.

It has been my experience that a lot of people, including many of the people actively involved in the production, trading, and marketing of these products, do not understand them very well. Forgive me if a belabor the point, but I feel compelled to go into a bit more detail on how these structures work. I am deliberately keeping the example simplified and devoid of any mathematics or technicalities.

Two people, A and B, both borrow money. Both debts are risky in these sense that there is a chance that A or B may fail to repay the debt.

Bank X, who has either originated these loans or bought them from someone else, packages them together into a security, the AB bond.

Bank X then tranches the AB bond into two parts: junior and senior. Investor C buys the junior tranche, and investor D buys the senior tranche.

Investor C receives a very high coupon, but will lose his investment if either A or B fails to pay. Investor D receives a modest coupon, but will only lose his investment if both A and B fail to pay.

Investor D owns an investment grade investment (determined by a rating agency like Standard & Poor’s, or Moody’s), while investor C owns an unrated (speculative) investment.

Bank X has transferred the risk of lending to A and B completely off its balance sheet by selling to C and D. At the same time, bank X is earning profits, potentially when it originates the loans at A and B, and again when it sells securities to C and D. Bank X can therefore do these transactions all day long, unconstrained by the need to have actual capital to reserve against the loans (it no longer has the loans on its balance sheet!)

Bank X will want to do many, many more transactions like this. Investor D will also want to do more transactions like this one.

To understand D’s motivation, consider that non-tranched bond with the same credit rating will pay only a small fraction of the spread on the tranched product. Tranches contain hidden leverage.

Given this situation, the limiting factors on how many of these deals get done are the number of borrowers like A and B, and the number of high-risk junior tranche investors like C.

Junior tranche investors take almost all the risk, and hold an investment which is unsuitable for most fixed-income investors because it does not have an investment grade credit rating. Most of these investors are hedge funds or similar leveraged investors (this means they take other people’s money, borrow more, and then invest it with little or no regulatory oversight.) Hedge funds exist mainly to take the risk that investment banks do not want, but that arises as a byproduct of the investment banking business. If investment banks could produce senior tranches without producing junior tranches, they would, but since that is impossible they need the hedge funds.

Hedge funds are generally rational investors who evaluate risk using the same criteria as investment banks. Most hedge fund guys used to work at investment banks. They demand a premium for taking unwanted risk off the bank’s balance sheet. Thus, as a matter of logic, the junior tranche owner must get overpaid relative to the amount of risk he takes.

This situation is possible because the senior tranche investor gets underpaid. The profit from underpaying him is split between the bank and the hedge fund. The senior tranche investor, remember, is an insurance company or pension fund or commercial bank, he evaluates risk differently. He cares about the credit rating on the bond relative to the spread he is getting paid. As long as a bond has a AAA rating, he will go for the highest yielding bond regardless of what it is inside it.

An investment bank salesman has clients from both hedge funds and pension funds. He takes both of them out to dinner, although not together. When he is with the hedge fund manager, he makes fun of the pension fund, but not the other way around.

So junior tranche investors are enticed into the market by getting overpaid. What about the actual borrowers? There are a lot of potential borrowers out there (keep in mind the debt could be home mortgages, credit cards, business loans, student loans, aircraft leases, or almost anything else.) However, investment banks are well known for exploiting an opportunity to make money to the maximum possible degree. They always need more.

The majority of the debt used to create CDO type structures was residential mortgage debt. It is worth noting that nearly every major investment bank bought or created a mortgage lending company. These are the very same companies that aggressively pushed loans to expand the market for mortgage borrowing (sub-prime loans featuring low or no downpayments, little documentation, adjustable rates, teaser rates, negative amortization, many other techniques.)

The combination of low interest rates (courtesy of the Fed) and loose lending standards (courtesy of the mortgage lenders) made it very easy to borrow money to buy a house. The mortgage business got so big because it was a critical input to a very profitable trade. Easily available, cheap loans combined with a little propaganda massively increased the amount of borrowing.

For the average person, buying a house became the best use of capital. It offered a highly leveraged investment, which is hard to get as an individual investor. Most houses can be bought with 20% down or less (sometimes much less), whereas buying stocks on margin usually requires 50% of the price in cash. Also, when you buy a financial asset like stocks on margin, you get daily margin calls. That is, if the value of the stock declines tomorrow, you have to put up more cash to keep your leverage ratio at 50%. With home loans, there are no margin calls. As long as you keep making payments, you never have to contribute more capital even if the value of the house drops.

In addition, mortgage debt is tax advantaged. Perhaps even more importantly, home values trended dramatically higher during this period and created a self-reinforcing cycle of easy money, which stimulated demand, which increased prices, which in turn created more demand. This cycle gave rise to the illusion of stability in home prices. As a “real” asset, as opposed to a financial asset, it was believed that home prices would never decline.

In the early part of this cycle, new ways of finding a market for mortgage debt allowed for a more efficient way to get investment capital to credit-worthy borrowers for the purchase of a valuable asset. As time went on, the appetite of the investment banks to do this trade as much as possible created a runaway spiral of self-reinforcing excess.

Here is how the banks ended up screwing even themselves in the process.

Tranching a security is said to create a “capital structure” out of the underlying security. You have the equity, or most junior tranche. You have the senior, AAA rated tranche. In between, you have various mezzanine tranches which may be investment grade or below investment grade. And above the AAA tranche, you have a “super senior” tranche.

The problem faced by the bank is one of distribution. The demand for each tranche is not equal, and it changes over time. The bank may not be able to sell enough super senior tranches to produce all the AAA tranche that it could sell.

The choice is to either sell fewer AAA tranches, or to retain some of the super senior risk on the bank’s balance sheet.

Option one is never seriously considered. Selling AAA tranches is where all the money is. When these decisions are made by traders who are short-term bonus oriented, they are never going to pass up a money making opportunity. So the bank ends up keeping large amounts of super senior in order to produce enough AAA.

Remember, however, that the senior tranche holder is deliberately underpaid for the risk he takes, in order to overpay the equity holder. Also remember that these risk calculations are underestimated because they contain assumptions such as home values never decline.

The bank is now drinking its own Kool Aid.

In economics, there is something called an exogenous shock. Literally, it means simply a shock from outside the system. Something which can not be predicted based on the rational actions of market participants, but which happens randomly. It is a way for economists to say “we don’t know WTF happened.”

No one knows exactly why the bubble burst when it did. Maybe it was related to the price of oil or commodities. Maybe it was a shift in mass psychology. Maybe it was the weather. In very large, complicated systems it is impossible to know, even ex post, why these things happen.

It should be clear, however, that the system was primed for collapse. While the exact mechanism of the collapse can not be known in advance, or even now, a vulnerable system will eventually meet an exogenous shock that will cause it to collapse.

In simple terms, we as a society borrowed a lot and did very little with it. A house does not really help to grow the economy. You can live in it, but it doesn’t produce anything, or invent anything, the way that a business does. We created a sort of artificial wealth by bidding up the prices of our houses. Now that the bubble has burst, we have reverted to something closer to our actual wealth, but it feels like we are poorer by comparison.

There is a certain inevitability to the cycle of boom and bust in dynamic economies. It has been going for centuries, ever since the roots of capitalism and trade, and will probably continue to go on for as long as there is a robust human society.

The bubble in internet and technology stocks of the late 90’s also created false value, but it did give rise to some valuable progress as well. At least some of the investment in those companies created things of real value. I am not sure that the bubble in housing prices has created any value. Using resources to build housing developments we don’t need doesn’t add any value to the overall economy. Hopefully the next bubble will produce something useful.

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Written by Uncategorized & Posted on April 24th, 2010
Tags :: insiders, non-fiction, wall street
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