BY MATT HUTCHINS
Investors across the nation began tallying their losses this week from one of the worst months on record for world markets. As the individuals whose assets have been diminished realize the extent of their losses, the courts and the new administration in Washington will be called on to scrutinize the actions of banks, insurance companies, and investment funds. Across the news media, it is common to hear talk of the sub-prime bubble and how losses in the housing market initiated the current crisis, but this narrow view of the recent collapse is akin to blaming a light bulb for an explosion in a house filled with gas by a leaking pipe. For sure, the two factors are interrelated, but prudent savers who resent the losses they have suffered should not think that the whole crisis originates in loose lending to sub-prime deadbeats. The rapid fall of home prices and its effects on the economy at large cannot be accurately understood without unpackaging the many reasons banks were unable to understand the risks involved in the purchase of mortgage-backed securities. A culture of overconfidence which permeated the financial services industry caused experts to feel certain they were protected from loss, while in fact their blindness was precipitating an economic Chernobyl.
Over the last ten years, a multi-trillion dollar web of off-the-books structures allowed small amounts of capital to be leveraged into huge portfolios of assets that produced unprecedented profits. One of the basic tools used was the securitization of debts to form Collateralized Debt Obligations (CDO). A CDO is a security, much like a bond, which guarantees a fixed rate of cash flow over the life of the instrument. Instead of owning a specific asset or debt in a company, a CDO works by bundling the cash flows from a number of debts into a portfolio. Different degrees of risk are combined in levels called tranches, such that high-risk debts pay higher cash flows and low-risk debts guarantee a lower return. Together, the debts are given an aggregate rating which then allows purchasers of the instruments to estimate their risks.
Beginning in the 1980’s, Wall Street investment banks like Lehman Brothers taught banks around the world how to package these CDO’s and move them into off-balance-sheet trusts that could market the debts to other institutions. Once these structured investments were moved off the balance sheet, the bank would enjoy the double benefit of minimizing the collateral assets devoted to the debts and appearing to be carrying less risk than before. These activities were very profitable due to their high degree of leverage, and in order to continue expanding their activities in this area and selling CDO’s to Wall Street, banks had to keep underwriting more consumer loans which could be bundled together and sold. The housing market was more than ready to feed at this trough of easy credit. The easier it became to market the CDO’s to Wall Street, the faster the banks sought to write consumer mortgages.
The firms holding mortgage backed securities conducted sophisticated analysis of the instruments to understand what risks they were exposed to, and where they felt there was too much risk in the debts they carried, they sought to diversify or transfer risks by writing credit derivative contracts. Credit-default swaps (CDS) were the most significant form of derivative used; a CDS works by the exchanging a fixed stream of payments for the guarantee that any losses which occur in the event of default or other “credit event” will be covered by the seller of the contract. The interesting feature of a CDS is that because it results in a fixed stream of payments, multiple CDS’s can be repackaged into a CDO, now called a Synthetic CDO, much like the underlying assets. The underlying risks can thus be sliced and redistributed among parties who are seeking different types of risks to balance their portfolio. The party holding the assets could hedge against their own risks, and risk loving CDS sellers could make a profit by exposing themselves to the possibility that there will be a credit event in the underlying securities. One result of this sophisticated derivatives market is that the risks taken by one party would quickly be distributed across the market, and each individual’s highly diversified portfolio would be unlikely to fall in value so long as the entire market was rising.
A further wrinkle is that CDS contracts could be written between parties who did not actually own the underlying assets. The proper functioning of the market required that traders be able to perform “arbitrage” of risks and gain a profit by taking offsetting positions that formed a spread across which profit could be generated. Traders who perform arbitrage trades help the market prices reach a proper level by shifting supply and demand to where they are needed. Perhaps it is for this reason that the Chairman of the Federal Reserve, Alan Greenspan, steadfastly argued to keep the CDS market unregulated, stating that it performed an essential market function and should not be impeded.
The complicated hedging and diversification activities of firms was a rational exercise in a booming market, but the unregulated nature of CDS contracts permitted the speculators to quickly outnumber the fair traders. Much like a futures market, most of the fluctuation in CDS prices now has nothing to do with the market participants’ actual exposure to risks, but rather it has become a forum for speculation on the creditworthiness of institutions across the economy and financial system. So long as the underlying weakness of the core financial institutions was hidden by broadly spread and off-balance-sheet risks, massive leveraging went unnoticed. Firms failed to build into their risk models the possibility of a system-wide failure. There were general indicators though, that the cycle would reach its limit soon. For example, compared to the historical average of 155% of GDP, by 2008 the proportion of debt to economic production had ballooned to over 350%. That means that the total borrowing in the United States was more than triple the annual economic output of the entire nation.
Once the massive leveraging began to slow down, overheated markets which had become addicted to credit went into withdrawal. Soon the banks which held mortgage-backed securities had to mark down the value of their assets. Where these assets had been put forward as collateral to get credit, the creditor institutions called on their debtors to increase the amount of assets advanced as collateral, an action known as a “margin call.” This cycle swept across the financial system, expanding exponentially, until core institutions were soon destabilized. Bear Stearns, Lehman Brothers, and AIG were all brought to their knees by an inability to meet these margin calls. Although they sat at the core of the global credit system, as soon as the cracks began appearing in the surface and a ratings downgrade became imminent, CDS market rates to protect debt shot up and the firm was left with no credit available at precisely the moment they needed it most.
So, while the housing market was the center of a large proportion of the lending which created the over-leveraging of the world economy, the underlying cause of the boom in housing was easy access to underwriting. Now that the damage from housing markets has destroyed core institutions and huge amounts of debt are triggering credit-default swaps, financial institutions around the world are scrambling to reduce their debts to ensure that they too will not be sucked into the vortex of margin calls. Unfortunately, since the CDS market is unregulated, there is no way to know how many of the trillions of dollars of outstanding obligations will be triggered nor who will be required to pay. This is the house of cards our government is trying to support, and these are the forces that are causing the credit-fueled world markets to slow to a crawl.