The following is an excellent excerpt from the book “ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism” by Yves Smith from Chapter 9: “The Heart of Darkness: The Shadow Banking System Self-Interest” on page 259 and I quote:
“Anyone involved in these transactions probably understood the implicit logic, even if no one acknowledged it. But there is a remarkable absence of anyone who could be pinned with liability. Magnestar officially had no legal relationship to these deals. The investment bank packager/structurer was off the hook as long as he made reasonable disclosure (and remember, the standards are much lower here than for instruments that fall in the SEC’s purview). The rating agencies get off scot-free, thanks to their First Amendment exemption (discussed in chapter 6). The lawyers involved in the deal are responsible only to their clients, meaning the structurer/packager, and cannot be sued by unhappy investors. The only party on whom liability could be pinned is the CDO manager, who does have a fiduciary responsiblility to all investors, not just the sponsor. But the fact that the party who in theory had the most to lose, Magnetar, approved their investments, would seem to exculpate the CDO manager.
Now let us look at what the Constellation program meant for the subprime market as a whole. The Wall Street Journal reported its total program at $30 billion, but industry participants contend the amount was higher. A member of one of the firms that packaged Magnetar’s deals remarks:
“You cannot over-estimate all the places Magnetar touched. That Lehman was involved doesn’t surprise me. If you had told me of a major broker/dealer who had an active CDO underwriting group that *DIDN’T* work with Magnetar. . . that would surprise me. At their peak, they were the 8000 pound gorilla. Spreads on BBB/BBB-subprime RMBS [residential mortgage backed securities] would breathe out past where their arb made sense and they’d line up eight more deals. Rinse and repeat. The credits didn’t matter nor really did the managers they contracted. To them it was pure structured arb. When the math of spread vs. structure vs. offer for BBB CDO protection lined up, they would reload the trade.”
Industry sources believe that Magnetar drove the demand for at least 35%, perhaps as much as 60%, of the subprime bonds issued in 2006. And Magnetar had imitators, including the proprietary trading desks at the major dealers; thus, their strategy is arguably the most important influence on subprime bond issuance in 2006-2007.
But how does the math work? Remember, these deals are resecuritizations. And notice how the dynamic has flipped. Before, CDOs had been created as a way to make the lower-rated bits of structured credits more platable to investors. But that logic was increasingly turned on its head. Suddenly, CDOs were popular, and the mezz variety was in particularly hot demand. And Magnetar was creating mezz CDOs.
But the BBB layer is a very small constituent of the original subprime bond deal, only 3%. Let’s make some simple (and actually, conservative) assumptions.
What most commentators have missed, but the industry understood full well, was the massive leverage involved. Even though Magnetar provided only the equity layer, a mere 5%, perhaps even less, doing so made the “higher” 95% of the CDO possible. We will use $30 billion for the size of their program. It extended from mid-2006 to mid-2007, but the bulk of the subprime mortgages referenced in the deals were probably 2006 vintage. This seems particularly likely given that in 2007, investment banks that were long subprime inventory were desperately unloading it into CDOs, and many of those bonds were 2006 issues.
So to make the calculation simple, we’ll assume 20% was comparatively benign stuff and exclude it from this computation. That is consistent with Lazard Asset Management’s finding that by the second half of 2006, over 80% of the assets of mezzanine CDOs were subprime, up from a mere 60% in the first half of 2005. We are assuming that 80% of the remaining assets in the CDO was synthetic, which means only 20% of the subprime component was actual BBB tranches of subprime bonds.
Further assume that 80% of the subprime component of these CDOs was 2006 vintage BBB subprime tranches. You get:
($30 billion x 80% x 20%) / 3% = $128 billion
Although this is just a back of the envelope calculation, $128 billion is 28% of the total of $48 billion in subprime mortgage backed securities issued in 2006. This calculation assumes that 20% of the BBB subprime demand generated that was excluded from the estimate of 2006 subprime mortgage demand.
We have ignored the fact that, of the 2% of supposed semi-decent non-subprime stuff circulating in the second half of 2006, as much as half, or 10% of the total, could be and often was lower rated tranches of mezz CDOs. Including that would intensify the impact of Magnetar’s deals. When you allow for the concentrated effect of BBB CDOs in the remaining 20% non-subprime, plus the fact that the program size was probably higher than the $30 billion reported in the Wall Street Journal, it is entirely plausible that Magnetar deals account for 35% of 2006 subprime issuance, or more.
How can that possibly be? It was leverage, spectacular leverage. If you look at the non-synthetic component, every dollar in mezz ABS CDO equity that funded cash bonds created $533 dollars of subprime demand.
Is it any wonder than anyone in the United States who had a pulse could get a mortgage?
And we’ve only discussed the cash bond component. Remember, 80% of the deals are assumed to be synthetics, meaning they consisted of credit default swaps against (“referencing”) particular subprime bonds. The total synthetic component in this example was $30 billion x 80% x 80%, or $19.2 billion notional amount of credit default swaps on BBB tranches.
That may not sound as sexy until you work through the implications. This $19.2 billion is in addition to existing subprime bond exposures. The resulting losses never would have occurred without the use of credit default swaps. On top of that, anything that happened with those BBB tranches was hugely geared. The synthetic component created demand for subprime loans by a less direct mechanism, by compressing credit spreads. That is a fancy way of saying they lowered interest rates.
Credit default swap spreads and cash bond spreads are linked via arbitrage. If credit default swap spreads tighten, that is tantamount to having the price of the credit default insurance drop. The protection writers (guarantors) receive less, and the protection buyers pay less. When that happens, spreads on the related bonds drop, which lowers the cost of borrowing.
Now, price is supposed to be a function of supply and demand. We have two parties, a protection buyer and a protection seller. At first blush, it is not obvious why having a lot of new credit default swaps on subprime, thanks to the synthetics in Magnetar’s deals, would compress spreads and hence lower subprime borrowing costs.
The trick? The use of the CDO brought new protection sellers to the table.
Historically, the CDS protection writers on CDOs were AIG and the monolines, who provided guarantees only on AAA tranches. The CDS protection buyers were hedgers or shorts. Even though the new ISDA protocol had opened up shorting on the lower-rated subprime and other mortgage bond tranches, that market was not very deep.
Many players were interested in being short the lower rated subprime bond tranches, but they were not willing to pay very much. They saw it as a dangerous wager to pay a lot to be short subprime debt. Even if these speculators felt they were certain to be right in the long term, the cost of funding the bet could erode the profits considerably if it took a while or the market to crumble. But if there was a way to coax–or more accurately, hoodwink–more guarantees into the market at favorable prices, that would not only increase market depth at current pricing but could even squeeze spreads even tighter.
When a CDO consists largely or entirely of synthetic assets, the investors in the CDO are effectively protection sellers, or guarantors. So if the investors bought synthetic, or largely synthetic, CDOs instead of CDOs that contained bonds, that was tantamount to additional supply on the protection seller side. And we had new entrants, all of whom convinced themselves that they were not at risk in acting as guarantors. The correlation traders who speculated with the lower-rated tranches matched their exposures. The AAA investors, increasingly investment banks and European banks, were either hedging their positions with insurance companies, primarily the so-called monolines, or convincing themselves that the inventory piling up on their balance sheet was just a temporary problem and would soon be sold. Their participation tightened credit default swap spreads, and then, by arbitrage, supbrime bond spreads as well, finally lowering rated for subprime borrowers.
Thus the much celebrated subprime shorts were one of the primary cause of the financial crisis. Their use of credit default swaps greatly inflated the level of subprime exposures, and the eventual losses, well above what they would have been otherwise. And the parties on the other side of this trade were in large measure the capital markets players, such as investment banks and European banks, who held AAA CDO inventory, and insurers of various sorts. These institutions were all highly levered and therefore fragile. All suffered or will suffer terminal losses; the survivors owe their existence to massive taxpayer bailouts, central bank subsidies, and regulatory forbearance.
Now it is impossible to know the exact impact of increased CDO creation due to subprime shorts, but there is every reason to think it was considerable. Incremental demand in an overheated market will have a disproportionate impact, and the housing market was already looking frothy in 2005, as commemorated by a June 2005 article in The Economist. Mortgage industry graybeard Lew Ranieri, who effectively created the mortgage-backed securities industry at Salomon Brothers in the 1980s, dates the toxic phase of subprimes to roughly the third quarter of 2005 through early 2007, and points to a sudden shift in demand and attitude toward the riskiest assets. That coincides almost exactly with when ISDA made credit default swaps on asset-backed securities and exposures like CDO trances possible, in June 2005, after allowing for the lag required for the new hunger to result in more mortgage creation.
And while we have focused on CDOs and subprime, the salient characteristic of the runup to the credit crisis was the spectacular underpricing of risk. Very risky bonds and loans showed abnormally low interest rates. The ABS CDOs weren’t the only place heavily synthetic structures were in use.
Commentators who have looked at the role of structured credit have concluded, contrary to popular perception, that it was the credit mania that drove asset bubbles in housing, commercial real estate, and corporate takeovers. As former Goldman Sachs managing director Nomi Prins wrote:
“Wall Street pushed lenders. Lenders pushed borrowers. That’s how it worked. Don’t let anyone tell you otherwise. If you can borrow at 1 percent and lend it out at 6 or 8 or 13 percent, you can make money. Even the squirrels in my backyard can make money at that play.”
In early 2007, the BX started flashing warnings. These subprime indexes started falling, along with other instruments and companies exposed to subprime. But the rest of the credit market remained unimpaired, at least for the moment.
That changed in August 2007, the first acute phase of the credit crisis. Spreads in the interbank markets, the bulwark of banking liquidity, jumped (rising spreads mean higher risk perception; lenders demand more interest). Asset-backed instruments having nothing to do with subprime, like commercial paper (short-term debt, typically 90 to 180 days) backed by credit card receivables, saw buyers evaporate.
Remember our discussion of bank conduits earlier in this chapter. The riskiest type, the structured investment vehicles or SIVs, often contained subprime debt, along with other sorts of loans. Suddenly no one wanted to have anything to do with vehicles tainted with subprime exposures. But these conduits were mini-banks, dependent on short-term funding, so investor distaste meant they could no longer replace maturing IOUs (in this case, commercial paper) with new borrowings.
If these off-balance-sheet vehicles had lived up to their name, the unraveling might have played out differently. One would have expected these entities to have liquidated or negotiated with investors on a case-by-case basis. But investors in SIV paper demanded that their bank sponsors stand behind them. And that put a question mark over Citigroup, which had been very active in SIVs. Suddenly, no one was certain where the daisy chain of exposures led. The subprime crisis had morphed into a classic bank panic.
The next run occurred in the new nonbank credit market, repos. If SIVs liquidated (and some did), then a lot of asset-backed paper might be dumped on the market, producing fire-sale prices.
Before the crisis, repo haircuts had been near zero. Figure 9.3 shows what happened to the repo haircut on an index composed of nine types of bonds, primarily structured debt.
Another tabulation, in Figure 9.4, shows that the haircuts on AAA tranches of asset-backed CDOs, which in April 2007 had been a mere 2% to 4%, skyrocketed to 95% by August 2008, before the Lehman crisis. That effectively means no one would lend against this paper.
What happened? Assume you are a bank or a big broker-dealer. Half of your funding comes from repos, or out of a $100 balance sheet, $50. If you are a traditional bank, you might have $10 of equity. But in this modern world of fancy finance, you’re likely to have a balance sheet more like that of a broker-dealer, with less equity, say $3 or $4.
If your repo haircut on that $50 rises by 20%, you are suddenly $10 short. Your friendly pawnbroker will now only lend $40 against collateral that recently provided you with $50. To get that missing $10, you either need to increase the right hand side of the balance sheet by selling common stock to raise new funds, or shrink the left side by liquidating assets. Investors, even the rich Middle Eastern sorts, were cool on making investments in financial firms as of late 2007, so the only course of action was asset sales. But the larger haircut suggested the value of assets was already in doubt, and selling them (or others) would push prices down even more. The impaired value of collateral would not only be validated, it would get worse. And you as bank or broker-dealer are now insolvent, which is finance-speak for bankrupt.
When large numbers of repo borrowers suddenly had their access to the repo ATM restricted, and they still needed the dough, their only option was to sell something to make up the shortfall, which in this case could be just about anything. That scramble for cash transmitted stress from the structured credit market, where the increase in repo haircuts was large, to all sorts of unexpected places. One widely observed phenomenon during the month after the Lehman bankruptcy was sudden downdrafts in markets that should not have been affected much by the upheaval, like gold. It was obviously a large sale by someone under stress, presumably a hedge fund.
Remarkably, the authorities only partially understood what was happening. The Fed made a series of cuts to its benchmark borrowing rate, the Federal funds rate, and also to its discount rate (effectively, an emergency lending facility). The Fed thus saw this as a liquidity crisis, believing that the panic was an overreaction and the underlying assets were still good quality. If the Fed made it cheap to borrow, so the logic went, banks could fill that $10 hole until cooler heads prevailed.
But this was not a liquidity crisis, it was a solvency crisis. It wasn’t that lenders to banks and various holders of fancy financial paper were now irrationally panicked; they understood that they had been irrational, profligate lenders. They knew this was going to end badly; the open questions were who was most exposed and how badly. And the problem was bigger than the banking system that the Fed and central bankers could readily reach.
Increasingly desperate measures confirmed that this meltdown was no mere liquidity crisis. The Fed and Treasury increasingly launched an alphabet soup of facilities that, after the initial Term Auction Facility, were aimed not at banks, but at trying to prop up the impaired nonbank players and particular markets under stress: commercial paper, asset-backed securities of all sorts, even the better grades of the now-toxic dreck that the hedge funds so eagerly bought (as long as a bank, not a hedge fund, was the owner).
Late in the game, in 2009, the Fed made an effort to intervene in the repo market, realizing only then that it was not only a major factor in the crisis but also rife with conflicts of interest. For convenience, lenders and borrowers do not deal with each other directly but go through a clearing bank that among other things values the collateral and advances funds while transactions are being booked. The biggest of the clearing banks are J.P. Morgan and Bank of New York. It is the clearing banks that decide what haircuts to apply, and that means a clearing bank can damage a rival when it is wobbly.
And that may have happened with Lehman. The bank’s largest creditors sued its clearing bank, J.P. Morgan alleging it struck the fatal blow to the ailing investment bank by withholding $17 billion of cash and securities the Friday before it collapsed.
The Fed’s plan to address the problem by creating a central utility appears designed to deal with that problem. But it also has a second effect: it makes it much easier for the Fed to backstop the repo market, and that is likely the real goal of this plan.
Now let’s take this one step further: where did the lending boom come from, exactly? As you may recall from the last chapter, the Fed and Treasury would have us believe that the “savings glut,” a.k.a., the Chinese, was the culprit. And the Chinese, along with other central banks in trade surplus countries, did play a role in this drama, through their continued appetite for AAA securities, along with others predisposed toward AAA paper (recall that starting in 2001, foreign central banks became the major actors in buying U.S. treasury and agency paper).
The average global savings rate over the last 24 years has been 23%. It rose in 2004 to 24.9%. and fell to 23% the following year. It seems a bit of a stretch to call a one-year blip as “global savings glut,” but that view has a following. Similarly, if you look at the level of global savings and try deduce from it the level of worldwide securities issuance in 2006, the two are difficult to reconcile, again suggesting that the explanation does not lie in the level of savings per se, but in changes within securities markets.
At the same time, other data do lend support to the notion that the shadow banking system was the main culprit in the meltdown. Bank lending has contracted far less than its murky twin. Although global corporate lending did fall from its peak of $2 trillion in 2007 to $1.5 trillion in 2008, that level was on par with 2006. Between the second and third quarter of 2008, U.S. bank credit increased 1%, and between the third and fourth quarter, banking industry consultants Oliver Wyman estimated that it contracted by 0.5%.
By contrast, while $1.8 trillion of asset-backed bonds were issued in 2006, only $200 billion were floated in 2008, and issuance through mid-2009 was “minimal.” Similarly, Credit Suisse pegs the contraction in “shadow money” in private debt securities since 2007 at $3.6 trillion, or 38%, due primarily to the substantial increase in repo haircuts, plus a dearth of new issues and a fall in prices.
It is easy to be overwhelmed by the vast panorama of financial instruments and strategies that have grown up (and blown up), in recent years. But the complexity of these transactions and securities is all part of a relentless trend: toward greater and greater leverage, and greater opacity.
The dirty secret of the credit crisis is that the relentless pursuit of “innovation” meant there was virtually no equity, no cushion for losses anywhere behind the massive creation of risky debt. Arcane, illiquid securities were rated superduper AAA and, with their true risks misunderstood and masked, required only minuscule reserves. Their illiquidity and complexity also meant their accounting value could be finessed. The same instruments, their intricacies overlooked, would soon become raw material for more leverage as they became accepted as collateral for further borrowing whether via commercial paper or repos.
But even then, the bankers still needed real assets, real borrowers. Investment bankers screamed at mortgage lenders to find them more product, and still, it was not enough.
But credit default swaps solved this problem. Once a CDS on low-grade subprime was sufficiently liquid, synthetic borrowers could stand in the place of subprime borrowers, paying when the borrowers paid and winning a reward when real borrowers could pay no longer. The buyers of CDS were synthetic borrowers that made synthetic CDOs possible. With CDS, supply was no longer bound by earthly constraints on the number of subprime borrowers, but could ascend skyward, as long as there were short sellers willing to be synthetic borrowers and insurers who, tempted by fees, would volunteer to be synthetic lenders, standing atop their own edifice of risks, oblivious to its precariousness.
Institution after institution was bled dry. Yet economists and central bankers applauded the wondrous innovations, seeing increased liquidity and more efficient loan intermediation, ignoring the unhealthy condition of the industry.
The firms that had been silently drained of capital and tied together in shadowy counterparty links teetered, fell, and looked certain to perish. There was one last capital reserve to tap, U.S. taxpayers, to revive the financial system and make the innovators whole. Widespread anger turned into sullen resignation as the public realized its opposition to the looting was futile.
The authorities now claim they will find ways to solve the problems of opacity, leverage, and moral hazard.
But opacity, leverage, and moral hazard are not accidental byproducts of otherwise salutary innovations; they are the direct intent of the innovations. No one was at the major capital markets firms was celebrated for creating markets to connect borrowers and savers transparently and with low risk. After all, efficient markets produce minimal profits. They were instead rewarded for making sure no one, the regulators, the press, the community at large, could see and understand what they were doing.
Magnetar and its imitators made unbelievable profits by finding a nexus of spectacular leverage, eager demand, and camouflaged risks. Whether you like the results or not, their novel use of an arcane instrument was exceptionally clever. If the world had been spared their cunning, the insanity of 2006-2007 would have been less extreme and the unwinding milder. But the hedge funds were not the only ones who fed this strategy; the other institutions who carried out the same correlation trade strategy and European bank staff padding their pockets with negative basis trades are just as culpable.
Viewing the underlying problem as one of bubbles misses the true dynamic. When borrowed funds pump up asset values, the unwind damages financial intermediaries, and that has far more serious repercussions than the loss of paper wealth alone. Leverage offers a strategic point at which regulators can intervene. Regulators can tackle debt levels surgically by barring certain types of instruments and practices. But this effort can take place only if authorities do not cede control of the financial system to the inmates. Unfortunately, to a large degree, that has already happened.”
(MOST ALL OF THESE PROBLEMS WERE CAUSED BY THE FACT THAT THEY DID HAVE OFF-BALANCE-SHEET ACCOUNTING, WHICH MADE IT POSSIBLE TO PUT THE DERIVATIVES IN THE SECOND SET OF BOOKS, WHICH WERE NOT REGULATED AT ALL BY THE GOVERNMENT SO YOU ARE VIRTUALLY TURNING THE BIG INVESTMENT BANKS LOOSE TO CHEAT ALL THEY WANTED TO AND COVER IT UP, MAKING IT POSSIBLE TO PAY THE CEOs HUGE SALARIES FOR DOING CORRUPT WORK, CAUSING THE TAXPAYERS HUGE AMOUNTS OF MONEY, THROUGH LOSSES.
LaVern Isely, Progressive, Overtaxed, Independent Middle Class Taxpayer and Public Citizen Member and USAF Veteran