How Wall Street Bankers Helped Create the Current Credit Crisis

By Martin Hutchinson
Contributing Editor

Prior to the beginning of the current financial crisis last August, many of you had probably never even heard of collateralized debt obligations (CDOs).

So how did these obscure, tottering towers of debt precipitate a crisis that has since prompted the U.S. Federal Reserve to take such drastic action and brought down long-standing Bear Stearns Cos. Inc. (BSC)?

Under a CDO, a group of long-term loans, mortgages or bonds is assembled and then sold to a shell company [called the Special Purpose Vehicle, or SPV], with only modest capital. The resulting SPV then issues short-term commercial paper, which it pays from income generated on the longer-term debt it holds. If everything goes according to plan, profits are made because the SPV is earning a higher rate of interest on its long-term credits than it is paying on its short-term debts.

Why would banks do this?

Under modern regulations, banks are forced to maintain certain capital ratios. If a bank can remove $1 billion of assets from its own balance sheet, that frees up about $80 million of capital that had secured those assets and use it for other purposes.

The bank has to use some of that $80 million to initially capitalize the SPV, but since the SPV is not held to the same standard of capital requirements, the bank can do so with only $20 million to $25 million. The remaining $55 million to $60 million can then be used to secure more loans or buy more assets, increasing profits.

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Thus, CDOs enable banks to increase their business – as well as their profits – with the same amount of capital.

Investors buy the commercial paper issued by the SPVs because they offer an attractive yield. And the SPV is left with a profit, since it makes a higher return on its long-term assets than it pays out on its short-term liabilities.

It sounds simple. So, why doesn't it work?

When Things Don't Go as Planned

The most fundamental reason is the SPV's huge liquidity mismatch. 

Its long-term assets have terms of 20 to 30 years, whereas the short-term assets it's selling turn over every 90 days, and sometimes as often as 30 days. If the SPV can't find a market for its short-term commercial paper at a yield it can afford with the income from its long-term assets, the SPV has to find money from another source – or declare bankruptcy.

The only reliably available source for money the SPV has is the bank that originally sponsored it. If the credit markets freeze up the way they have of late, the bank has to lend money to the SPV to keep it afloat. If the liquidity crisis persists, the bank might face this choice: Either bring the assets back on its own balance sheet, or allow SPV to go under.

And that's just one problem scenario. But trust me, there are others.

Commercial paper debt is rated by agencies such as Moody's Corp. (MCO), Standard & Poor's and Fitch Ratings Inc. A pool of long-term debt secures the SPV's short-term debt, and it was assumed that since those assets comprised a wide variety of borrowers, only a few would default at any one time. That would mean that commercial paper secured on, say, the top 50% of the assets would be very low risk, and it was typically granted a "AAA" rating.

However, as we've now learned, in most cases those long-term assets were subprime mortgages. And many of those subprime and Alt-A loans that were securing the commercial paper held by the SPVs were made to borrowers by banks that never bothered to verify income or determine the borrower's true financial position. If you don't check the borrower's income, you know nothing about his ability to repay the loan.

The downturn in the housing market dramatically increased the default rate, which in turn affected the income stream the SPVs were able to realize from their long-term debt. The "AAA" rating of the commercial paper was worthless due to the riskier assets securing it.  No amount of clever analysis will give you an accurate credit rating on loans where the borrower has been allowed lie about his finances.

The Future of CDOs

I think CDOs will disappear. If banks have to lend to the SPV in difficult markets, there is no justification in taking the SPV's assets off the bank's balance sheet. Several banks, such as Citigroup Inc. (C) have had to move assets back onto their own balance sheet. And it no longer makes sense for a short-term investor to buy commercial paper from an SPV now that the true risk of such an investment has been exposed.

With the two main rationales for CDOs removed, it seems unlikely they will survive, except in small niches of the market where special circumstances make them desirable.

CDOs were always an unsound idea, and now they have contributed to the current financial crisis by forcing banks to bail them out, tying up money that the banks need for other purposes. But it could have been only a moderate problem – especially with the Fed pumping liquidity into the markets with hundreds of billions in short term loan facilities – if not for other factors, such as truly lousy credit quality in the home mortgage market, which made the credit crisis fallout that much worse.