The Subprime Mortgage Pool: An Upside-Down Pyramid of Wine Glasses
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.
…First there was a fellow named Larry Fink, who in 1983 worked with a team at First Boston Bank on behalf of Freddie Mac. Fink came up with an invention called a collateralized mortgage obligation (CMO), designed to work with a pool of low-risk mortgages that conformed to Freddie and Fannie standards.
Author Satyajit Das claims that “Michael Milken, the junk bond king, created the first CDO [collateralized debt obligation] in 1987 at now-defunct Drexel Burnham Lambert Inc.”14 He expanded Fink’s idea to work with a pool of junk bonds. It quickly turned into a humongous winner . . . until becoming a world-record-breaking loser.…
Here was the idea. Let’s gather together these marginal subprime mortgages into big pools. But when we slice up each pool into securities, unlike at Ginny Mae, we’ll slice them up unequally. We’ll chop up the pool so that risk and the rate of return varies by slice. We’ll design some of the pieces so that they are very secure while others will be far riskier. The more secure pieces will get lower rates of return and the very risky pieces will get much higher rates of return.
How is that possible? First and foremost, you’ve got to add some continental charm and sophistication to your nomenclature. Instead of slices, the derivatives industry adopted the French word for slice—tranche. Sounds more secure already! Next comes the imaginative financial engineering.
Imagine a pool of a thousand subprime mortgages—a large collection of loans backed by homes whose buyers have less than stellar credit ratings. They might not have made a down payment on their home—they might not even have a job. Every month most of them, actually nearly all of them, will still make their mortgage payment. People don’t like to lose their houses, even if they can’t really afford them. Every once in a while, someone in the pool will default, but the historical record shows that more than 85 percent of the people will keep on paying. So this large pool as a whole will generate each month a robust flow of income from the mortgage payments.
The clever derivative folks figured out that you can create securities from that pool that have very different amounts of risk. Here’s a very simple example.15
Let’s slice that pool into three tranches of securities—high, medium, and low. We give the securities in the high tranche (called the senior tranche or super-senior tranche) first dibs on all the interest payments coming out of the pool. To really protect the investors who buy securities from this highest tranche, you can set it up so the senior tranche would get interest payments even if the default rate were several times the historical average for subprime borrowers. So by giving senior tranche first claim on all the interest payments from the entire pool of subprime loans, you’ve taken away much of the risk for the investors who bought senior tranche securities.
Your middle tranche (called the mezzanine tranche, naturally) would be slightly less protected; it would have to absorb losses if the default rate hit maybe two times the historical average. Securities drawn from the mezzanine tranche would have more risk than the senior tranche but would still be much safer than investing in the pool as a whole.
Finally, you’ve got your bottom tranche (called the equity tranche because equity—aka corporate stock shares—in case of bankruptcy, also has the lowest and last claim on assets). This tranche takes the first hit on defaults. It is saddled with the bulk of the risk of the entire pool.
Since the risk varies for each tranche, the rates of return also vary. The senior tranche, being the safest, would get a lower rate of return. The mezzanine would get a higher rate, and the equity tranche would get an enormous rate of return—20, 30, or even 40 percent per year (so long as defaults on the underlying mortgages stay low)—because it was shouldering nearly all of the risk for the entire pool.
Here’s a visual analogy.16 Imagine a wine bottle and an upside-down pyramid of wine glasses with three levels. The top layer has seven glasses, the middle has two, and the bottom just one. The wine bottle is the pool of subprime mortgages. The wine in the bottle is the sum of all the interest payments from the subprime mortgages. Each wine glass in our upside-down pyramid represents a financial security that is sold to investors. Each row is a tranche. You start pouring the wine (interest) from the top down to pay the investors. The senior tranche is the top row and it gets the first servings of wine. The middle row, the mezzanine tranche, gets served next, and the bottom glass in the equity tranche is last to be served.
If some of the subprime mortgages backing the CDO default, there is less wine to be poured for all the glasses, but the top glasses are first in line to get filled to the brim. If the wine runs out before it reaches the bottom-tranche glass, too bad—that’s the risk you take when you buy that glass.
So far so good, but not good enough. To build a massive global market for the top tranche of wine glasses, you need to get high ratings from one of the three major ratings agencies: Moody’s, Standard and Poor’s, or Fitch’s. If you could get one of them to give you AAA ratings for the senior tranche, you could market it to pension funds, insurance companies, banks, and the like. Big, big money.
That is precisely what happened. Derivative houses were able to convince the rating agencies that the top tranche was supersafe and should be rated AAA, virtually as good as you can get without being backed by the federal government. How they pulled this off is a longer story that we’ll return to later. But for now all we need to know is that the derivative bankers secured AAA ratings for the top tranche. They also secured decent investment-grade ratings for the mezzanine tranches. The lowly equity tranche, however, got stuck with junk-bond status. From the start, the derivative dealers called it “nuclear waste” and “toxic waste.”
In theory this makes some sense. Our top row of wine glasses is protected by the two rows below it. It would take many failures within the wine bottle for there not to be enough wine to fill the top tranche of glasses. However, the creators of these securities also wanted there to be as many wine glasses in the top row as possible, and they wanted them rated AAA—which is what happened. They were remarkably successful in getting AAA ratings for the entire top row—up to 80 percent of all the securities in a CDO. Nice work.
Here’s the kicker: Not only were the senior tranches rated AAA, but they came with a higher rate of return than other sorts of AAA securities (like GE or AIG AAA-rated bonds). So the top row of glasses became hot commodities for investors from the northern tip of Norway to the eastern shores of Wisconsin. A massive global market opened up for derivative dealers.
Let’s pause to admire the true alchemy of this financial engineering. You take a bunch of subprime mortgages from marginal borrowers, and you put them in a big pool (your wine bottle). You divide up the pool into securities (your wine glasses), but you don’t divide them up equally. Each tranche (row of wine glasses) gets a different rate of return based on how much risk it assumes. Because the top tranche assumes relatively little risk, it gets a lower return, but also gets rated AAA—and it has a higher interest-rate coupon than other AAA securities. Kind of amazing, given that none of the mortgages in the pool either on their own or bundled together could possibly earn such a rating. After all, each mortgage in the pool is risky, far below Freddie Mac standards.
Yet with a bit of French vocabulary and fancy wine pouring, our financial engineers turned a very large chunk of the pool (75 percent or more of it) into AAA-rated securities. It’s a miracle. This new derivative, which generically is called a collateralized debt obligation (CDO)17—which includes all the tranches—turned about three-quarters of the sow’s ear into a highly profitable silk purse.18
What about the risky equity tranches—the bottom row of glasses that might stay dry? You would think no one would want to drink from a glass labeled “toxic waste.” You would be wrong. The potential high returns for the equity tranches were so alluring that often the originating bank held on to them, or sold them at a profit to speculators who lined up for them. They even pawned them off on pension funds. The largest investment houses and banks (like now-defunct Bear Stearns, Merrill Lynch, and Wachovia, and others who survived) engaged in a highly successful and profitable campaign to unload billions of dollars of subprime equity tranches onto state pension funds covering public employees.19 According to “The Poison in Your Pension,” a Bloomberg Markets report issued in July 2007, state pension funds purchased 18 percent of the riskiest CDO equity tranches, but only 4 percent of the higher AAA-rated tranches.20 You can bet there now are some empty wine glasses in those pension funds.
For a while the wine flowed freely. During the housing boom the mortgage-default rate was extremely low, even for subprime borrowers. And with home prices rising, subprime-mortgage holders expected to get most of their money back even if the house had to be foreclosed and sold. So for aggressive investors, at least in the short run, the equity tranche seemed more than worth the risk. If defaults started to inch up, the banks figured they would be the first to spot it and could unload the toxic waste before it polluted their books. And as we’ll see in a bit, you could even buy derivative insurance to reduce the risk of the equity tranches.
If your eyes are glazed over from all this wine, just remember one important point: this was a money machine for the derivatives industry. The alchemists walked away with billions of dollars in fees for organizing the pools, creating the securities, marketing them, trading them, and collecting the big returns from the equity tranches. We don’t know what percentage of bank profits came from these derivatives, but we can be sure that it was high—amounting to tens of billions of dollars. Traders got enormous bonuses. Their bosses got a nice piece. Many golden parachutes—those robust executive retirement packages—were stitched together with CDO profits.
This wasn’t just wine. It was Dom Perignon.
- Richard Tomlinson and David Evans, “The Ratings Charade,” Bloomberg Markets Magazine, July 2007, at www.bloomberg.com/news/marketsmag/ratings.html.
- For an entertaining introduction, see the video, “Crisis Explainer: Uncorking CDOs,” by Marketplace senior editor Paddy Hirsch at http://vimeo.com/1876936. Also, Portfolio.com provides an animated flow chart, “What’s a C.D.O.?” at www.portfolio.com/interactive-features/2007/12/cdo.
- Adapted from Paddy Hirsch’s video noted above.
- CDOs can also be constructed from pools of credit card payments, student loan payments, car leases, or any other cash flow—the riskier the better.
- For more complex versions, see an excellent set of videos by David Harper posted on YouTube including “Synthetic CDO that Fails in Subprime Securitization,” at www.youtube.com/watch?v=-8vmzvfEuk0.
- David Evans, “Banks Sell ‘Toxic Waste’ CDOs to Calpers, Texas Teachers Fund,” Bloomberg, June 1, 2008, at www.bloomberg.com/apps/news?pid=newsarchive&sid=aQWoYszGR6w0. Many pension funds have rules that allow them to buy some lower-rated (but not junk) securities, so that these are, at most, a small percentage of the total pension holdings. Derivative dealers found ways to package the toxic waste with government bonds so that it would seem that the investment was protected, and so could get these equity tranches rated above junk status. More recently, the ratings have been lowered to junk and so those investments are now off-limits to pension funds.
- David Evans, “The Poison in Your Pension,” Bloomberg Markets, July 2007, at www.bloomberg.com/news/marketsmag/pension.html.
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