Friday, October 24, 2008

How Did We Get Here, Part 2

After a little break, we can get back to our consideration of the very volatile financial situation that has recently developed. Today, we will bring the story up to the point of the crisis. Next time, we will see how it all unravelled and assign blame. I will close this series with considerations for the future.

(NOTE: I realize that this series is going on a bit long. Well, what can I say? The situation is complex. Given all of the bluster and spewing of the twenty-four hour news cycle, though, I think I am doing pretty fair, no? If no, let me know and I will change directions)

When we last left our story, there were loads of people clamoring for cheap credit in the form of residential mortgages. As with any resource, when it is cheap, people use more of it and the demand skyrockets. No problem...just supply the credit to the people who want it, all while making sure that they are a good risk and that you will get your money back, right?

Well, that's not exactly how it happened. Remember the stringent process for issuing home loans described last time? That didn't exactly hold up too well. Because all of the people who were qualified to get mortgages already had them, mortgage companies had to look for new customers. They found these new customers, all right, but to do so, they had to change the general profile of who they considered "mortgage-worthy."

This definition went from "person with good credit, assets and a job" to "pretty much fucking anybody." Why? The lenders, for their part, had to deal in volume because the margin of profits on their loans were so low in the interest rate regime that was in place between 2001 and 2007 (more on this later, in the blame section).

The borrowers, on the other hand, were motivated either by the potential for profit on their investment or the desire (NOT right...this will be important later) to own a home. This desire, it seems, outpaced the realistic expectation that these people would ever be able to pay the debt back. Already, I'm sure, you can see where problems might arise.

So, where are we? We have lots of unworthy people with loads of debt lent to them by people who were eager to lend to anybody who could reasonably operate a pen to sign the promissory note. How, you ask, did this situation lead to a financial crisis with global implications?

Well, the mortgage companies were not the only ones looking for a way to make a profit in a bad environment. The investment banks were out there as well, so to speak. They, too, had been hit by the bursting of the tech bubble in 2000-2001 and were searching around for somewhere to put the money they had (for themselves and their clients). They decided that residential mortgages were the way to go.

Now, this was not the first time that investment banks dabbled in mortgages. Far from it. Investment banks and their fixed-income (read=not stocks or commodities) trading departments had dabbled in mortgage debt since at least the 1970's. This is where mortgage-backed securities (MBS) come into the picture.

MBS are basically an investment vehicle that are composed of many individual mortages bundled together and traded as one unit. Like other forms of debt securities (bonds, mostly), they bore a period of maturity and an interest rate. When an MBS is sold, the buyer becomes the holder of the mortgage or, in other words, the receiver of the payments from the borrower. MBS's are attractive because they allow investment banks and financial institutions access to another credit market.

This form of debt, like all forms today, are rated by the major rating agencies (Standard and Poor's, Moody's and Fitch). These agencies assess the structure and composition of assets and issue ratings that tell anyone interested how "good" a particular debt is. Here, "good" is defined as "likely to be paid back with interest."

Sounds fine, right? The investment banks, paying attention to the rating agencies, would not take on bad debts and the rating agencies would not recommend unsound investments to their clients (that being the investing public as a whole).

Well, there was a problem. A big problem. The MBS that were being sold were more complex than anyone was willing to admit. Put simply, there were wolves among the sheep. Not all of the MBS were composed of the same classes of debt. They were, in large part, composed of some good debt, some moderate-risk debt and a lot of bad debt.

The problem came when the rating agencies rated these individual MBS highly, as all good debt, when they were anything but. These MBS, or a lot of them, contained ticking time bombs, thousands of mortgages that were risky (at best) and downright suicidal (at worst).

What's more, to further complicate the situation, the MBS were themselves pooled into collateralized debt obligations (CDO) and these were traded just like the MBS were. These CDO's are divided into "tranches," which is just the French word for slice. Each tranche is supposed to be made up of a certain class of debt, which makes managing the risk easier because the relative "goodness" of the debt is a known thing. But here, this was not necessarily so.

Risk has been mentioned before, but it is at this stage (right before we get to the meltdown...don't worry, it is coming) when the idea of risk management comes into the picture. Investment banks (and smart investors in general) never expose themselves to more risk than they feel they can handle.

To do this, they try and offset the risk with other financial instruments. In options trading (what I used to do for a living), for example, there are many spreading strategies to offset the risk of any one contract and insure a profit or at least limit a loss. Those of you who are familiar with the world of sports betting (which I am not...officially) will see some similarities here. In our present case, the buyers of MBS's and CDO's used credit-default swaps (CDS) to manage risk.

Here again, what was usually done does not apply here. CDS's, basically guarantees against another party defaulting on a loan, help to manage risk by passing it along, so to speak, to other parties until many people hold small parts of the risk and no one body is fully exposed. What was different with our persent case is that the investment banks and other entities bought these MBS's and CDO's on leverage (read=credit). So, basically, they were buying huge pools of debt by taking on huge amounts of debt themselves. This is what is called leverage.

With all of this complex debt, leverage, credit and the attempt to manage risk, it is not hard to imagine that something could happen that would destabilize this arrangement. This is so because so much of the arrangement was based on credit and promises, not on real assets and complete assessments of the risks involved.

This brings us to the so-called tipping point. Next time: the tipping, falling and blaming.

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