What really happened.... a virtual tale

Something happened to our economy in this country in September of 2008. Something happened that was so unusual, on such a large scale that it prompted the head of the Federal Reserve and the Secretary of the Treasury of the United States to decide that drastic measures were necessary to avoid an unprecedented economic collapse. I have already established that it wasn’t the housing industry collapse. The numbers just don’t add up. It is beyond argument that the sub-prime mortgage debacle would only directly contribute some 42 billion dollars in bad debt which could not possibly create the need for an emergency injection of federal funds that wound up totaling almost 2 trillion dollars and counting. As I stated before, if it was the sub-prime mortgages that caused the whole problem we could have cleared that off the books by simply paying them all off with a small fraction of what we have already spent. What we are actually talking about here is the difference between a cause and a catalyst. The sub-prime mortgage collapse was a catalyst for the collapse. The cause of the collapse is much more complicated.

The answer to the riddle is not simple. I have already touched upon it briefly in a previous post but want to delve into the subject in a little more detail now. I personally started looking into this issue several years ago because the numbers simply didn’t add up in my own mind. I have spent quite a bit of time since then studying; poring over books and articles that seemed alternately needlessly complex and ruthlessly simple. I would like to try to break it down into terms that are easy to understand but I am aware that may not be possible. Still, I think it is worth the effort to make the attempt.

The first financial instrument one has to understand to make sense of this mess is a Credit Default Swap or CDS. A CDS is simply a way of selling debt by insuring it. CDS’s were basically invented in the early 1990’s as a means of freeing up capital. The germination for the idea for CDS’s came to fruition when JP Morgan Financial Services was in the process of trying to figure out how to loan money to Exxon in 1994. At the time Exxon was facing punitive damages stemming from the crashing of the Valdez in Alaska. Facing large damages and falling stock prices Exxon was in something of a financial bind at the time. Ordinarily, such situations are handled by high interest loans as banks feel they deserve more profit for making riskier loans. Even though Exxon was a huge conglomerate and showed little possibility of financial collapse as a result of the upcoming high fines they were expecting they didn’t have enough cash on hand to handle paying such fines without selling off something which would have only served to drive their stock prices even lower and make the loans riskier. JP Morgan came up with a rather unique solution to the problem. They loaned Exxon the money, some 5 billion in all. However, JP Morgan didn’t want to tie up all of their capital on one loan that may or may not be the last money Exxon needed to weather the storm after the accident so they were interested in selling off portions of the debt to other investors. The problem with this line of thinking was that there were very few financial institutions able to withstand such a large debt on their books.

JP Morgan executives then sold the risk on the loan to the European Bank of Reconstruction and Development which basically cleared the debt off of their books while they made also made a percentage for brokering the transaction. The whole process started a chain reaction of ideas within JP Morgan and the rest of the financial institutions around the world as they studied the feasibility of making loans while at the same time avoiding holding the debts on their books. It seemed eminently profitable to find a way to broker deals for such loans while at the same time avoiding holding long term debts on their books which unavoidably cut into the capital they had available to make the loans to begin with. This is much the same fascination that the middle ages had for alchemy. Just substitute the term “debt” for iron and “asset” for gold and you have the general idea. What could be better to a financial institution than the ability to instantaneously turn a debt into an asset?

It wasn’t long after this that another artificial construct along the same lines began to come into favor in the mortgage industry. Collaterized Debt Obligations are structured credit products that were supposed to increase the availability of credit by leveraging the amount of money available for such loans. In short, a CDO in the context of this discussion is a bundle of home mortgages that is sold as an asset. If you think this seems a little like magic you are not very far from the truth. Lending institutions have always been limited to loaning out a factor of the money they have in reserve (their depositor’s savings) in case the loans go into default. It is really a matter of common business sense that any financial institution can only lend out a finite amount of money because it has to hold a small percentage of these loans in the form of capital to support such loans in the event of defaults. Obviously, there are rules and regulations to this effect and the Federal Deposit Insurance Corporation that guarantees depositor’s money is officially responsible for enforcing such restrictions in this country.

With the advent of CDO’s, lending institutions could bundle up groups of mortgages and sell them as assets to insurance companies, pension funds, hedge funds, and investment banks. While the lending institution thereby only made a percentage of the total value of the loan, it was an instantaneous profit while it simultaneously cleared the loan from their books. This freed up their committed reserves so that they could then lend the same reserve out again and again. It is worth remembering that a mortgage based CDO is actually a bundle of debts. While this bundle of debts certainly has a marketable value it is still a bundle of debts with risk associated with just like the individual loans had as single home mortgages. However, CDO’s are by definition a chain in that each CDO is actually only as strong as the weakest mortgages in the bundle but this is a consideration that seemed to escape the notice of most of those so enamored of the use of CDO’s. In most cases the mortgage company retained the responsibility for servicing the loan and actually collecting the money but they no longer owned the loan and were only working for a fee after the mortgage was actually sold. This was also to play into the collapse of the market once it started but I will get back to that a little later.

Naturally, there had to be some way of valuing CDO’s. If you are holding a group of debts and you want to bundle them up into something you can sell, you must first decide what the value of the bundle will be. Who would be best qualified to ascertain the value of such an instrument? Since no one has the necessary prescience to know for certain about such things it fell to the creators of such instruments to value them as well. This is quite a bit like asking a farmer to tell you how much his cow is worth before you pay for it. In actuality the system for valuing CDO’s turned out to be just as fruitful as my example with the cow with the inevitable result that CDO’s were almost universally overvalued from the very beginning. CDO’s are divided into tranches which is a French word for “slice.” The tranches were rated according to the best estimate of the likelihood of the mortgages bundled to go into default. The highest rated tranches (AAA) were of course worth the most money on the market with the lowest rated tranches following accordingly. You will probably be amazed to know that the vast majority of CDO’s were somehow valued as AAA. Unfortunately, these tranches often contained sub-prime and other alternative mortgages that were well understood to be higher risk loans. When the crunch came and loans started to default it suddenly became clear to everyone that no one really knew how much this would devalue the CDO’s they were holding.

Of course there were people who wanted to be sure that the CDO’s they were buying were worth what they were valued at. As my dad used to say, it is virtually impossible that everyone was born yesterday. Credit Default Swaps or CDS’s became widely used to hedge investors bets against CDO’s. Basically the creator of a CDS agrees to stand good for the amount of the investment. In other words, if a CDO is valued at 10 million dollars you could buy a CDS that would hedge your investment by agreeing to pay you the 10 million in case the CDO itself went into default. This was a good idea but a practical impossibility as the upshot was that if a few loans in the bundle went bad there would have to be a determination of how much the total value of the CDO accordingly dropped. Again, this would call for an estimate of the value by the people who created it in the first place. Going back to the farmer analogy this would be the equivalent of the cow suddenly going blind at which point you would have to go back to the farmer who priced it in the first place to decide how much it is worth now that it is blind. The difference in the value of the blind cow and the healthy cow would be paid by the insurer to the holder of the CDS. Unfortunately, the people who originally bundled the CDO’s and sold them were not as honest as your average farmer and most of the CDO’s were in essence for this analogy full of cows with varying degrees of infirmity and potential collapse.

If all of this seems farfetched and ridiculous you are probably not a financial consultant. However, if you recently lost a large portion of your 401K this is the market you were investing in whether you realize it or not. If this were the end of the story we could all shake our heads in wonder and go about our business a little wiser and less financially able but it gets worse. The creator of the CDS who insured the value of the CDO didn’t do this free of charge. The normal matter of business was for the creator of the CDS to be paid a nominal fee for insuring the CDO. As long as the CDO held its value the fee was clear profit for the creator of the CDS. You may have heard of a company called AIG which was one of the companies that the government had to bail out when the market started to slide. As it turns out, they were the biggest insurer of CDO’s in the world at the time. You may or may not be surprised to know that many of the creators of the actual CDS’s were offshore companies under the management of AIG who actually had virtually no funds in reserve to pay for such defaults should they occur. Getting back to our analogy of the cow, if you bought insurance on the cow when you bought him at the farmer’s price and the cow died a couple of months later you would expect that the money you had been paying for insurance was a safeguard against the death of the cow. This would be true as long as the insurance company didn’t go bankrupt before you could file your claim. In our example, this is exactly what happened. As long as they were collecting money these companies were very profitable. When they started having to pay it out, they went under. There are of course rules and regulations for selling insurance in this country. Unfortunately, since the whole derivatives market is outside of any regulatory oversight these rules were not observed in setting up companies to sell CDS’s. Getting back to our analogy; this simply meant that the same farmer who chose the value of the cow before he sold it to you had his brother in law down the road who grows tomatoes set up a company outside the legal strictures of the United States and sell you insurance on the cow. Never mind that there was no money in the company to cover the loss of the cow, the brother in law made money and you got to feel secure in the mistaken belief that you were covered in the event of the untimely death of your new purchase.

All of this led to a market wherein lenders made money off of volume instead of quality. In other words lending institutions soon learned that the real money in the mortgage industry came from bundling mortgages into CDO’s and selling them, not in slowly over a period of 15-30 years making interest off of the loans themselves. The market for CDO’s boomed fantastically and lending institutions felt the pressure to make more loans. It wasn’t that people were suddenly so stupid that they began buying homes they couldn’t afford; it was the fact that lending institutions were aggressively pushing such loans because it didn’t matter if the loan was sound; all that mattered was that the loans could be sold as CDO’s and the money rolled in.

Unfortunately, this is still not the end of the story. The actual dollar amount of CDO’s in the home mortgage industry at the height of the collapse was estimated to be somewhere in the neighborhood of 6 trillion dollars. While this is a formidable number we must remember that this covers all home mortgages in the US, and only a small percentage of them were ever under the threat of foreclosure so we are still talking about numbers that could not possibly crash the whole economy. However, financial consultants being infinitely clever they managed to leverage this market to numbers as high as 350 trillion according to some estimates.

Mortgage CDO’s were taking over the financial markets of the world. The demand was so great that they had to find a way to create more of them than the housing market could possibly support. This was done by creating credit derivatives based upon CDO’s. In other words, a CDO could be created based upon the profit from an existing CDO. It was strictly an artificial construct in that it was not based upon anything but the profit from something that did exist but it could be created and sold on the market and the market was booming so much that people didn’t seem to care that what they were actually buying. It showed a profit as long as the original CDO it was based upon did and everyone was happy. While this sounds more like sleight of hand than finance it is not unusual in the financial markets. I would give you an accurate farmer analogy here but I don’t know of any farmers that would either buy or sell things based upon cows that don’t actually exist; that seems to be a business that requires a much higher degree of education to get into.

The real magic in the creation of a CDO based upon a CDO is that it only takes a fraction of the actual money to create it while it pays the same amount of profit. One hundred to one leveraging was not out of the norm in such markets by the time it went through a couple of such transformations. In other words such a CDO could be created for 50,000 dollars and sell for 5 million dollars as long as the market was increasing and everyone made a profit. Unfortunately, the leveraging worked just the opposite direction when the market started to go down. The CDO would begin losing money at the same rate that the original one it was based upon had with the noticeable exception that it didn’t have any assets at all that could be sold to get your money back. It was basically worth the cost of its creation, assuming of course that you could find someone stupid enough to buy it. Although there seemed to be plenty of people in that category when things were going good almost no one was interested when things started to go the other direction.

Getting back to the cow analogy let’s attempt to follow this logic. The farmer sells you a cow that he has chosen the value of beforehand. Don’t bother to ask how he valued the cow; this is much too complicated for you to understand. Besides if you are worried that you might be buying a blind or sick cow his brother in law who grows tomatoes and runs an offshore insurance company will sell you insurance that covers your investment for a nominal monthly fee. As long as the cattle market goes well your cattle investment goes well and you get statements every month explaining how much money you are making. Everyone is doing wonderfully in this little arrangement, so much so that the farmer soon sells all the cows he has. Since everything is going so well there is still a large demand for cattle, such a large demand that the farmer hits upon the idea of selling you a virtual cow. It isn’t really a cow, it doesn’t have skin, or hooves, or even meat that you could eat if all else fails but he tells you it is just like having a cow in that you get to make the same profit that people who own real cows make and he doesn’t have to go to the trouble of actually feeding or taking care of the cow. Naturally, the virtual cow business is a vast improvement for the farmer since he makes the same amount of money without all the expenses and sweat associated with actually taking care of a cow. It isn’t long before the money invested in virtual cattle far exceeds the number of real cattle.

Unfortunately, for everyone in this cattle business someone decides to actually eat one of the cows one day and discovers that it is too sickly and weak to eat. This immediately brings into question the original value of the cow and it sends a shock wave all the way through the system. Everyone starts to question the value of their own cattle, more especially the people who suddenly realize their virtual cattle aren’t worth the paper they exist on and they certainly aren’t good to eat because that would require they actually existed in the first place. There is a colossal fire sale on cattle of every description but there are no buyers. After all, everyone knows better than to buy more virtual cattle now and the people who made the money off the original sale of cattle have long since taken their money and gotten out of the business. The farmer’s brother in law has gotten out of the insurance business as well since without reserves he knew with the first sign of trouble in the cattle business he was getting ready to be forced pay out everything he had recently made and he doesn’t want to have to go back to growing tomatoes.

Unfortunately, the virtual cattle business was so profitable and so many banks, investment houses, and mutual funds made up of working people’s 401K’s that it will collapse the whole economy if the government allows the chips to fall. The only thing to do is to throw money at the market in the hopes that the cattle market will return and the magical alchemy of virtual cattle starts to go up again because there isn’t enough money in existence to actually pay for the virtual cattle losses if the market stays down. Meanwhile, the inventors of the virtual cattle industry and the virtual insurance industry that it fostered simply have to bide their time and wait for the market to come back. After all, the billions of dollars that just disappeared from the working people’s 401K’s will be enough to allow them to muddle through the next few years.

All of this sounds a little unbelievable. It does explain why both the Secretary of the Treasury and the head of the Federal Reserve were able to convince Bush that something major had to be done. While our GDP hovers around some 14 trillion dollars a year it is hard to see how we can afford a 350 trillion dollar bill to come due. The fact of the matter is that we have not solved this issue to date. There is no government oversight of the system that created this monstrosity of a problem. While some people are making the first attempts at setting one up one of the first orders of business of the new Republican Congress is to defang the new regulations by pulling the funds necessary to set up a regulation industry for the derivatives market. As long as the housing industry goes up this whole byzantine system works in that everyone makes a profit. The farmer who sold virtual cows made a very large profit and he would like to get back into the business but not if the government is going to regulate it. If you want to find out who these farmers are just watch who supports this new effort to cut away at regulation of the industry.

There is a scene in the Matrix where the hero is offered the choice of taking the red pill or the blue pill. One will open his eyes to the world as it exists, the other will allow him to go back to living in ignorant bliss. I don’t think it is an exaggeration to say that we are facing the same choice right now in this country. Either we will open our eyes and take the time to understand what just happened or we will go through it all over again. The problem with living in ignorant bliss is that it doesn’t last forever and we may not be able to print enough money to pay off the next installment when it comes due.