[In Part III of his three-story investigation of the credit crisis,Money MorningContributing Editor Shah Gilani details how the very complexity of the global financial system brought us to the brink of a total meltdown. In a special addendum tomorrow (Thursday), the former professional trader and hedge-fund manager will detail a banking-system overhaul that would immediately end the credit crisis - possibly without a single penny of taxpayer money.]
By Shah Gilani
Contributing Editor
There's no time to beat around the bush. Let's flush out the three credit-crisis catalysts that have remained hidden for too long, thanks to Wall Street protectionism and myopic regulation. Those catalysts - which brought us to the brink of a financial meltdown - are structured collateralized debt obligations, credit default swaps, and the horrific offspring of the two - credit default swaps on structured collateralized debt obligations.
An asset-backed security (ABS) is a type of tradable debt security that's derived from a pool of underlying assets. We could be talking about a pool of mortgages, of automobile leases, or loans made to various borrowers. We're using the example of residential mortgages, though the example is exactly the same for commercial mortgages, automobile leases or bank loans. Here's how it works.
Anatomy of Mortgage Loan
A mortgage company makes home loans in your county, as does your local bank branch. Then an investment bank comes along and buys the mortgages from the mortgage company and from the bank. It only wants to buy the mortgages made to prime borrowers who are paying 6% interest on their mortgages. Once it acquires those loans, the investment bank securitizes the mortgages, meaning it pools them into a tradable package it can sell to investors.
This particular pool is known as a "closed pool," meaning no more mortgages will be added, though some may leave the pool if the underlying borrowers pay back their mortgages early because they sold their homes, or refinanced them, or if underlying mortgages are in default and the "servicer" allows them to be removed from the pool. The only income coming into the closed pool results from the monthly interest and principal payments being made by the homeowners.
In our example - because all the mortgage loans were made to so-called "prime" borrowers with strong credit - you might have an investment grade (A+) security that pays 6%, because all the mortgage holders are paying 6% and the payments are being passed through to the investors. That's it. There are very good, though not exact, methodologies to value this particular security, primarily because it is uniform in that all the mortgage payers are prime borrowers who all are paying 6%.
Asset-backed-securities become infinitely more complicated when they are sliced and diced into structured collateralized instruments. They generally fit into two main categories:
- Collateralized debt obligations (CDOs), which include all manner of residential and commercial mortgage-backed securities.
- And collateralized loan obligations (CLOs), which are pooled bank and investment-bank loan portfolios.
CDOs and CLOs are created from "closed-pool," asset-backed securities. They are collateralized by the underlying assets - hence the prefix - but they are also "structured."
In our example above, our asset-backed mortgage security was rated A+ and pays the investor who buys it 6%. If I want to create higher-yielding securities that I think I will be able to sell a lot more of, I will pool mortgages from subprime borrowers.
Because subprime borrowers are, by definition, higher-risk borrowers, the mortgage companies and banks charge them higher rates of interest to offset the greater risk that they represent. If I pool these mortgages, their ratings would be "junk" - or close to it - which will be a problem as I try and sell these securities to investors all around the world.
That's where the magic of financial engineering, better known as structuring, comes into play. I can divide up the closed pool of subprime mortgages and structure the pool into layers, or tranches. What I'll do is divide up the pool into multiple tranches, or slices. I'll structure the cash flow payments from all the mortgages so that if the 1st or 2nd tranches run into trouble, I'll take cash flow payments from the lower tranches to keep up with all the payments to the holders of the 1st and 2nd tranches.
For someone trying to peddle these asset-backed securities, this is a stroke of genius. In our example, since I'm now pretty much guaranteeing that the 1st and 2nd tranche security holders are going to get paid, maybe I can get the Big Three debt-rating companies - Standard & Poor's, Moody's Investors Service (MCO) and Fitch Ratings Inc. - to give my 1st and 2nd tranche CDOs' investment grade ratings. Maybe I can even buy insurance from a monoline insurer like AMBAC Financial Group Inc. (ABK) or MBIA Inc. (MBIA), and get my top tranches a coveted "AAA" rating. Wow, I could sure sell a lot of this high-yielding stuff with an investment grade rating!
That's just what happened. And they did sell a lot - a whole lot.
Those Troubling Tranches
As I said in Part II of this investigative series, CDOs - on an individual basis - are difficult to value. Indeed, "legend has it that constructing the cash flow payments on the first theoretical 3-tranche CDO (the simplest type of CDO) took a Cray Inc. (CRAY) supercomputer 48 hours to calculate.
The problem starts here. There are so many of these tranched securities out in the marketplace - and on the balance sheets of banks, investment banks, insurance companies, hedge funds and all manner of other unsuspecting investment entities worldwide - that when subprime borrowers began to default, it wasn't long before the lower-tier tranches ran out of money to pay the so-called 1st- and 2nd-tier "AAA"-rated securities. The problem escalated quickly and almost all of these securities were downgraded. That's not a surprise. Nor is it the whole story, for it leaves a key question unanswered.
What happened to the lowest-level tranches?
Those tranches were "ugly" to begin with because I started by pooling subprime mortgages (the high-risk borrowers). Then I made them "toxic" by "stripping out" their cash flow to support other tranches. This toxic waste was so bad, no one would ever rate it and only greedy hedge funds or crazy speculators would buy it for its high yield. Or, maybe, I think so much of my creation that I'll keep this piece for myself, or maybe I'll have to because no investor will ever buy it.
This kind of stuff is out there. There's a lot of it. And only an act of God will bring these securities back from the depths where they now reside.
With their collateralized premise and structured nature, CDOs are very difficult to value - especially since no one trusts anyone else's "internal valuation model." Since everyone is afraid of these securities because no one really knows what they're actually worth, no one wants to buy them.
However, when an institution - such as a Merrill Lynch & Co. Inc. (MER) - gets desperate enough to sell a portfolio of these securities at 22 cents on the dollar, then everyone else who has to "mark-to-market" their assets now has to value similar securities of their own at 22 cents on the dollar. That causes massive write-downs at banks, investment banks, insurance companies, and other financial institutions. And these companies write down assets and watch their losses escalate, they are forced to raise additional capital to meet regulatory requirements.
CDS - Controlled Dangerous (Financial) Substances
It's a vicious cycle - one that's eroding our faith in our banks, and worse, banks' faith in other banks. As a result, banks have ceased lending to each other out of the fear that the next round of write-downs and losses may imperil some of the trading partner banks that they used to lend billions of dollars to every night.
Not anymore.
It would be bad enough if that were the only problem facing the securities market. On top of these overly engineered structured securities I've just discussed, we also have credit default swaps with an estimated notional value of $62 trillion out in the marketplace. A credit default swap (CDS) is a financial derivative that's akin to an insurance policy that a debt holder can use to hedge against the default by a debtor corporation, or a sovereign entity. But a CDS can also be used to speculate.
In Part II of our investigation, which ran Monday, I explained how problematic credit default swap pricing is and how the indexes against which the value of these swaps are determined are tradable themselves as speculative instruments and how the whole complex is driving the financial system into an abyss. That's essentially what led to the collapse of the otherwise healthy insurance giant, American International Group Inc. (AIG). [For the latest news on AIG, check out this related story elsewhere in today's issue of Money Morning.]
Unfortunately, I don't see the U.S. Treasury Department's much-needed rescue plan being effective without actually addressing the problems facing both the CDO and the CDS markets. The Treasury Department's initiative will create more problems than they attempt to solve and will eventually saddle taxpayers with so much debt that they risk sinking the dollar, and worse, the U.S. government's investment grade rating. That would be calamitous. [For the latest news on the federal government's banking-system bailout plan, check out this related story elsewhere in today's issue of Money Morning.]
Tomorrow (Thursday) in Money Morning, in an addendum to this piece, I will outline a proposal that I'm calling the Money Morning Plan because it potentially heralds a new dawn in the credit crisis, addressing the problems from the bottom up, and not from the top down. Although this plan is straightforward and elegant in its simplicity, we still opted to present it as a separate story in order to provide you with the focus, the detail and the explanations we feel this strategy merits.
If the Treasury Department wants to immediately triage the gushing wounds that are bleeding our banks and financial system dry of readily available credit by purchasing and warehousing illiquid assets with taxpayer money, it won't be long before the U.S. financial system begins to hemorrhage somewhere else.
The free market caused these problems under the noses of undistinguished regulators.
The free market - with the oversight of good governance practices mandated by effective regulators, who should not be empowered to kill entrepreneurial capitalism - will once again rise to the occasion and prove America's robustness and indefatigable spirit.
[Editor's Note: Contributing Editor R. Shah Gilani has toiled in the trading pits in Chicago, run trading desks in New York, operated as a broker/dealer and managed everything from hedge funds to currency accounts. In this special three-part investigation, Gilani has drawn upon the experiences and network of contacts that he developed through the years to provide Money Morning readers with the "real story" of the credit crisis. But this financial inner-sanctum insider will take this story one step further. Tomorrow (Thursday), Gilani will detail a plan that will spare the taxpayers, save the dollar and preserve the United States' pristine credit rating. It's a perspective on the near-financial meltdown that you'll find nowhere else but in Money Morning. If you missed earlier installments of Gilani's investigative series, Part I appeared Friday, and Part II ran Monday.]
News and Related Story Links:
-
Money Morning Special Investigation of the Credit Crisis (Part I):
The Real Reason for the Global Financial Crisis…the Story No One's Talking About. -
Money Morning Special Investigation of the Credit Crisis (Part II):
The Credit Crisis and the Real Story Behind the Collapse of AIG. -
Wikipedia:
Securitization. -
Wikipedia:
Asset-backed security. -
Money Morning Market Analysis Series:
Inside Wall Street: Why Hocus-Pocus Accounting Will Perpetuate the Capital Markets Credit Crisis (Part I).
-
Money Morning Market Analysis Series:
Inside Wall Street: The Hocus-Pocus Accounting Tricks That Will Perpetuate the Capital Markets Credit Crisis. -
Wikipedia:
Subprime Lending. -
Wikipedia:
Structured Finance. -
Money Morning Market Analysis:
Why Mark-to-Market is Bad News for Shareholders. -
Wikipedia:
Tranches. -
Wikipedia:
Hi-Yield Debt (Junk Bond). -
Wikipedia:
Mark to Market. -
Money Morning Market Commentary:
Sen. Dirksen: Allow Me to Introduce You to Standard & Poor's.
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.
[…] each bank relying on its own internal model to value the “toxic waste” on its balance sheet, investors would no longer be able to compare the financial statements […]
[…] If you missed Gilani's investigative series, Part I appeared Sept. 18, Part II ran Sept. 22 and Part III was published Sept. 24. Gilani's plan was published on Sept. 25 as an open letter to U.S. Treasury Secretary Henry M. […]
[…] Money Morning Special Investigation of the Credit Crisis (Part III): How Complex Securities, Wall Street Protectionism and Myopic Regulation Caused a Near-Meltdown of th…. […]
[…] you missed Gilani's investigative series, Part I appeared Sept. 18, Part II ran Sept. 22 and Part III was published Sept. 24. Gilani’s plan was published on Sept. 25 as an open letter to U.S. Treasury Secretary Henry […]
It is most refreshing to be specifically informed, by way of your three-part series, of money’s sinister roots and tentacles, which, during our times, have been exposed. Thus is revealed, for the first time in history, a lawless, even monstrous and destructive global financial regime.
If this monstrous “device” appears to have been seeded within the United States of America, then its toxic roots and tentacles have easily found “very fertile soil” elsewhere globally in which to “flourish” out of control, as we now see it.
This disgusting “thing” has, throughout its history, always caused desolation to most people because of its gigantic and inordinate “consumptive license” to too few among us.
Although Mr. Gilani will, tomorrow (Thursday), “detail a plan that will spare the taxpayers, save the dollar and preserve the United States’ pristine credit rating”, such a plan will simply go unnoticed by the powers that be.
In fact, all remedies at this late date, however noble and/or meaningless, such as the current 700 billion dollar one, are just like pouring sand into the ocean. Indeed, an exercise to no avail.
The “thing” is already “on the run” to its end.
The thinking and prudent among us, therefore, must prepare hearts and minds for the very “worst”.
Thank you for an excellent analysis and explanation in plain english so this complex issue can be understood.
Too bad that there is not a way to force every Senator & Representative (even Mr Treasury secretary himself) to read your article.
They could certainly learn enough from it so they could make an intelligent decision. As it is, they are going to "vote dumb & blind" like they always have because they rely upon the advice of their lobbiest friend, who has his / her own agenda rather than the facts to present to the lawmakers.
Keep up the good work & maybe we can educate enough of them to serve us better in the future.
Harold Weidner, from Arizona
I agree with what was said ; but if we do have to purschase
these instruments as the fed & pres says then lets do it like a bank fire sale , discount them 25% to start then an additional
50% from that value " not face valve as stated " .. I dont think it shoukld matter wheither it is a foreign country or a us company , no purschase at face/stated value….all of the banks/investment houses have had to sell their instruments at 30 to 20% of face value… also any income derivied sholud be used to pay of the national debt.. then reinstate the regulations & over site rules that were in place in the 80's which both bush's have seen fit to over turn./get rid of or igbnore.. in addition use fanni & freddi to lower instrest rates for all the existing loans to 4.5 % for 3 years then let new loans afterthat float at market… also fanni & freddi should not be returned baxck to the private sector , they should be ketp by the gov being that is where they started & all the income should also be used to pay of the debt…at the same time all the ceo's & managers wich caused this mess should have to work without pay for 3 years to help fix this mess ; if they dont want to then give them the boot with no severance pay/golden parachute .. & if they want a job tell . to try mcdonalds. If i screw up I have to pay for it & no one bails me out…..
I hope / pray somebody in washington has their head on straight & doen't give them all for nought… it would be a shame … if this opportunity was wasted…..
P S forgot to add that seeing as that the banks are selling at a discount when they forclose , would it be eaiser to just write down their existing loans by 25% & lower the instrest rate it would be cheaper rthat the cost of foreclosure & resale at a lower rate / price which they are doing now …..????????????????????????????????????????
[…] you missed Gilani's investigative series, Part I appeared Sept. 18, Part II ran Sept. 22 and Part III was published Sept. 24. Gilani’s plan was published on Sept. 25 as an open letter to U.S. Treasury Secretary Henry […]
[…] else. If you missed Gilani's investigative series, Part I appeared Friday, Part II ran Monday and Part III was published Wednesday. In his “Open Letter to U.S. Treasury Secretary Henry M. Paulson, Federal Reserve Chairman Ben S. […]
[…] you missed Gilani's investigative series, Part I appeared Sept. 18, Part II ran Sept. 22 and Part III was published Sept. 24. Gilani’s plan was published on Sept. 25 as an open letter to U.S. Treasury Secretary Henry […]
[…] How Complex Securities, Wall Street Protectionism and Myopic Regulation Caused a Near-Meltdown of th… […]
Mr. Gilani would do the world a great favor if he would request permission to testify before the congressional committees considering the current "Bail-out Proposal." He must act quickly and use whatever influence he can muster to wangle an invitation to testify. Regards. ~ WEH
An addendum to my prior comment:
Now, in our lifetime, that this ugly financial worldwide “thing” is already “on the run” to its unprecedented end, some readers may be wondering “how” the “thinking and prudent among us” might “prepare hearts and minds” for the very “worst”.
There does exist a most worthwhile and very useful answer to the question.
But requires “deep” thought and reflection.
[…] can find each part of Gilani's investigative series here: Part I, Part II and Part III. To get a free copy of "Crash Proof" courtesy of Money Morning, and learn how to grow […]
[…] each bank relying on its own internal model to value the “toxic waste” on its balance sheet, investors would no longer be able to compare the financial statements […]
[…] else. If you missed Gilani's investigative series, Part I appeared Friday, Part II ran Monday and Part III was published yesterday (Wednesday).] Dear Hank: Here's How to End the Credit Crisis at No Cost to Taxpayers Otra cosa. El autor de […]
[…] complexity of collateralized mortgage-backed securities (CMBS) is beyond any simple explanation, though I offered one a few weeks ago. Second, and exponentially worse is that there is a “multiplier catalyst” in this […]
[…] can find each part of Gilani's investigative series here: Part I, Part II and Part III. To get a free copy of "Crash Proof" courtesy of Money Morning, and learn how to grow […]
[…] Money Morning Special Investigation of the U.S. Credit Crisis (Part III): How Complex Securities, Wall Street Protectionism and Myopic Regulation Caused a Near-Meltdown of th…. […]
[…] Money Morning Special Investigation of the U.S. Credit Crisis (Part III): How Complex Securities, Wall Street Protectionism and Myopic Regulation Caused a Near-Meltdown of th…. […]
[…] complexity of collateralized mortgage-backed securities (CMBS) is beyond any simple explanation, though I offered one a few weeks ago. Second, and exponentially worse is that there is a “multiplier catalyst” in this devastating […]
Thank you from Germany for your informative series on various financial 'instruments'.
While I would not be bold enough to claim that I now truly comprehend the financial crisis, I do feel like getting some ground under my feet in understanding the technical dimension of the disaster.
Thank you!
[…] In the worldview of Geithner, and other like-minded economists, credit, rather than savings, is the central figure in the economic equation. Therefore, the new Treasury secretary sees anything that eases the process of lending to be an effective economic policy. With such a view in mind, the centerpiece of Geithner's plan is the commitment of as much as $1 trillion to revive the collapsed market for securitized debt. In the run-up to the Crash of 2008, it was securitization – more than anything else – that permitted Americans to borrow more than they …. […]
[…] [Editor's Note: Contributing Editor R. Shah Gilani has toiled in the trading pits in Chicago, run trading desks in New York, operated as a broker/dealer and managed everything from hedge funds to currency accounts. In his just-completed three-part investigation of the U.S. credit crisis, Gilani was able to provide insider insights that no other financial writer or commentator could hope to match. He drew upon the experiences and network of contacts that he developed through the years to provide Money Morning readers with the "real story" of the credit crisis. It's a perspective on the near-financial meltdown that you'll find nowhere else. If you missed Gilani's investigative series, Part I appeared Friday, Part II ran Monday and Part III was published yesterday (Wednesday).] […]
[…] else. If you missed Gilani's investigative series, Part I appeared Friday, Part II ran Monday and Part III was published Wednesday. In his “Open Letter to U.S. Treasury Secretary Henry M. Paulson, Federal Reserve Chairman […]
[…] Money Morning Special Investigation of the U.S. Credit Crisis (Part III): How Complex Securities, Wall Street Protectionism and Myopic Regulation Caused a Near-Meltdown of th…. […]
[…] bad enough that the regulators who came before the FHFA were inept, but what is happening now under the FHFA is far worse, and actually has the potential to […]
[…] specific products – structured collateralized mortgage obligations (CMOs) and credit default swaps (CDS) – are “derivative” products that stand out as being […]