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Financial Weapons of Mass Destruction
Posted By dpacheco On August 16, 2009 @ 3:07 am In Politics & Public Policy | No Comments
As the economy continues its rickety climb back up out of the black depths of the Great Recession, let’s take a look back at some of the financial “innovations” that caused the crash in the first place, courtesy of this excerpt from Les Leopold’s The Looting of America.
(Note: Les Leopold refers to an upside-down pyramid of wine glasses. To find out what he means, read this excerpt first.)
The following is an excerpt from The Looting of America: How Wall Street’s Game of Fantasy Finance Destroyed Our Jobs, Pensions, and Prosperity—And What We Can Do About It  by Les Leopold . It has been adapted for the Web.
To financial engineers, CDO derivatives are gorgeous. They can be twisted and turned into a million tantalizing shapes. One beauty is called a “CDO squared.” You’ve got a bunch of high-risk CDO equity tranches that just aren’t selling. So what do you do? You make more wine. You pour all those bottom-tranche glasses into a new bottle. Then you create another upside-down pyramid of glasses, and sell them, with your wine pouring, from the top down. (The idea is to gather up hundreds of bottom-tranche wine glasses from many different CDOs, so that you’ll have enough wine for a new bottle. In theory, they shouldn’t all go dry at the same time.) With a little bit of guile, luck, and some fancy mathematical modeling that befuddles the all-too-willing rating agencies, you’ve created a high-rated, highly marketable new set of senior tranche securities—all based on the junk of the junk.
Pretty cool. But what if you can’t sell all the bottom tranches of the CDO-squared securities? You guessed it. You form another pool of those untouchables—called a CDO cubed—and tranche away again. If you’re not too tipsy, let’s walk slowly through this winery. You started by taking the bottom glasses of wine from many CDOs and pouring them into a new bottle. Then that bottle of risky CDO wine is used to pour a new upside-down pyramid of glasses—your CDO squared. Then you take the bottom glasses of many CDO-squared pyramids and pour these very, very risky glasses of wine into a new bottle that fills up yet another upside-down pyramid of glasses—the CDO cubed. Anyone buying this stuff is either very drunk or nuts or both. (Fortunately, there are very few cubed CDOs.)
But the real wizardry comes with the addition of one more incredibly seductive derivative: the credit default swap (CDS). (Dear Wisconsin: This is the critical component of the garbage they sold to your school districts.)
Credit default swaps. Warren Buffet called them “financial weapons of mass destruction.” Attach them to your CDOs, spew this potion of toxic tranches all over the globe, and presto: The crash of 2008.
Credit default swaps were added to CDOs to solve a specific financial problem—the time and effort it took to form a CDO, called the “ramp-up.” To form a regular CDO, you have to get legal title to the one thousand or so subprime mortgages (or credit card debts or car leases or corporate loans or bonds). This takes time and a lot of legal fees. You don’t want to tie up your bank’s money for three or four months. In that time, the financial world could turn against you before you can unload the tranches. There must be a faster, simpler way.
There is. The particular swap that solves this problem is viewed most clearly with corporate bonds, the heart of the swap market.
Corporate bonds are in essence a loan to a corporation. You give the company money and it gives you a bond—a piece of paper that says they agree to pay you interest for a period of time. After that, you get your principal back in full . . . provided the company doesn’t fold in the meantime. Each kind of corporate bond gets a risk rating (from the rating companies) based on the financial health and strength of the company. The lower the risk, the better the rating and the less interest the corporation needs to pay to attract investors to purchase its bonds. If the company goes bankrupt, corporate bondholders are first in line to get repaid from the remaining corporate assets. So bonds often retain considerable value even if the corporation goes under.
Now let’s say you bought $100 million of Lehman Brothers bonds back in 2006 when they were high flyers on Wall Street. Even though these bonds seemed solid, you might have desired a bit of insurance, just to be sure. So you asked your friendly banker to write you a credit default swap. For a fee from you (let’s say $500,000 per year for five years—0.5 percent), you could buy full protection for the $100-million principal of your bond in case Lehman Brothers defaulted during that time. You’re willing to pay it, even though it cuts into your interest payments from the bonds, because the credit default swap secures your principal entirely. It makes your balance sheet look less risky and helps your company maintain a good debt rating. You’ve transferred the risk through the swap to whoever sold you the insurance.
Why would someone else take on that risk? Because they are betting that it is unlikely that such a prestigious Wall Street firm would fail, and the $500,000 per year in fees they would collect from you seemed adequate to cover that small risk. And besides, the bank or other investor who is buying your risk gets these nice premiums without putting out any of their own money. That’s a nice return. Everyone is happy.
It turns out that thousands of investors and institutions thought this type of hedging was a spectacular deal. The next step was to marry the credit default swap and the collateralized debt obligation into a synthetic CDO—precisely what the Wisconsin folks bought.
The first synthetic CDOs were invented in 1997 by Bill Demchak and his group at JPMorgan. They were searching for a way to protect their bank from the billions of dollars in outstanding loans they had made to their traditional customers—other large companies, banks, and foreign governments. They didn’t want to sell the loans because that might upset their customers who had long, established relationships with the bank. So Demchak and his group invented a way to get rid of the risk but not the loans. They set up a pool of credit default swaps on three hundred corporate loans that JPMorgan held. Those swaps, not the loans, were put into a special-purpose vehicle—a kind of bank account held separately from their books, often in an offshore bank. JPMorgan paid insurance premiums into that vehicle. They tranched (sliced) that vehicle into securities and sold them to investors. Those investors, not JPMorgan, were on the hook for any defaults in the pool of three hundred loans (worth $9.7 billion) JPMorgan held. The first offering in December 1997 was called the Broad Indexed Secured Trust Offering (nicknamed “Bistro”). It was a stunning success. The tranches were gobbled up in two weeks by insurance companies and banks. Soon the method was copied throughout the financial industry.1
“Bistro” and credit default swaps solved the problem of having to assemble those time-consuming, cumbersome, and costly CDO pools composed of real mortgages. Why? Because a CDO made up solely of swaps can be created instantly. With the help of complex computer modeling, you could design the swap-insurance payments so they more or less mirrored a regular CDO pool of mortgages that already existed elsewhere. Your swap-enabled CDO (the synthetic CDO) would be sliced into tranches and would return the exact same income as a regular CDO that contained real subprime mortgages or other risky forms of debt. You’ve just doubled the number of securities without creating any new pools of mortgages.
This is the heart of fantasy finance. It’s also the hardest part. So let’s slow down and take this step by step.
Imagine that you’re a banker and your bank already has a $200-million portfolio of subprime mortgages. You are worried that some of these risky mortgages might go under. You want protection. And you’d like to make some money through some fancy financial engineering along the way. Here’s one way to do it. (To simplify things we’ll put the wine glasses away and only create two tranches.)
Now let’s see why everyone involved likes this arrangement. The top-tranche investors are happy. They put money into your account and got a decent rate of return from your premiums. But they are the last to lose their money if you tap into the account to cover defaults. They sleep well because they have very little risk, but still a good return. In fact the rating agencies said this kind of top-tranche investment was AAA.
The bottom-tranche investors who put money into your account are happy too, but in a different way. They are happy like a gambler with an adrenalin rush—one who anticipates getting a big payoff at the gaming table. They know the money they invested could be lost to you should the housing market go sour, but they are getting a very high rate of return right now. They are betting that if the investment lasts long enough, they can get back much more than they invested, before something bad happens and you take some, or all, of their investment away.
And of course, you, the banker who dreamed it all up, get a very nice bonus. You get hefty fees from the money that goes into the account for putting the deal together, for setting up the account, for selling the investments, and for managing the whole shebang.
All of this happens without buying or selling any of the underlying mortgages. No time or money had to be spent assembling a new pool of mortgages. This is hall-of-fame financial engineering.
This was also the kind of “exotic and opaque” investment that was sold to the Wisconsin school districts. Without knowing it, the Wisconsin Five bought a tranche just one small step above the gambler’s tranche. They didn’t even get the upside of the gambler’s payoff that should have come with it. (But they sure got the adrenalin rush when they started to lose.) They were putting money up to insure very risky debt held (or bet upon) by the Royal Bank of Canada (RBC). For accepting such risk, their rate of return should have been awesome—that’s the upside. Instead the banks and investment brokers took very high fees and gave all the downside—the highest risks—to the school districts. As the default rate moved closer and closer to the school districts’ tranche, the value of the schools’ $200-million investment plummeted to next to nothing. Any day now, the default rate will hit the point that triggers the release of the $200 million to the Royal Bank of Canada. And since the school districts had borrowed $200 million to place that bet, they will still owe that too as well as the interest payments. They might have been better off investing with Bernie Madoff.
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URLs in this post:
 The Looting of America: How Wall Street’s Game of Fantasy Finance Destroyed Our Jobs, Pensions, and Prosperity—And What We Can Do About It: http://www.chelseagreen.com/bookstore/item/the_looting_of_america:paperback
 Les Leopold: http://www.chelseagreen.com/authors/les_leopold