This week Bruce is joined once again by Robert England. Robert is a journalist and author who has written extensively on mortgage finance, banking, retirement policy, and the financial and economic impact of aging population. His most current work is Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance. Previous works include Aging China: The Demographic Challenge to China’s Economic Prospects. Robert is also a senior writer for Mortgage Banker Magazine.
In our minds, we used to think that we would go to the bank, get a loan, make a payment to them until we paid it all off, then they hold the loan the whole time. This was called a portfolio loan. It was not until late 2007 when Bruce heard the term mortgage-backed security and CDO. Bruce wondered if, therefore, at the time this was commonly understood by people who were even in the loan business. Did they understand the path the paper took and how it was disseminated? Robert believes the people involved with mortgage originations understood it, although other people involved in the housing sector probably did not understand it as much. They did not understand that the loans were being put into portfolios while securities were being issued against the portfolio so that investors were the ultimate funders of the mortgage loans and not banks. The money was funded temporarily by the mortgage originator. They would obtain a warehouse line of credit from a bank if they were an actual mortgage banker as opposed to a broker. They would have money just to the point that the loan closed, and then the loan was sold to an investor. For the mortgage originator, the investor was either Fannie or Freddie or a bank that was acquiring the loan. They did not really know what happened to the loan after that. They did not have to know this; they only knew that they were creating loans, and the demand for them kept increasing even though the quality was decreasing.
Out of the mortgage-backed security world came a product called a CDO. This is a collateralized debt obligation, which began to be used as early as the 1980s. It was used to take existing corporate debt and roll it into a pool of loans to issue securities against a pool of corporate bonds. This never became a huge amount of business and was tried later for bonds from developing nations and other kinds of debt instruments. The market would rise and fall and vanish away, so someone was always trying to come up with another way to use a CDO, which is just another form of securitization. The 1999 credential came up with the idea of having a CDO that put together mortgage-backed securities into a pool and issued securities against those securities, so you were securitizing securities.
There was also the concept of a traunch, which Bruce thought was brilliant and a good vehicle if done correctly. In the private-label mortgage-backed securities world, they all had traunches even before the CDO, and every deal had as much of the deal as possible set up as AAA rated. These were credit-rating traunches. About 94% of most MBS deals were AAA rated by the credit rating agencies, such as Moodys and Fitch. They were paid fees to buy the Wall Street firms, and they also rated the CDOs. The huge volume of private mortgage-backed securities and CDOs did not really take off until after 1999. The reason for this was when the committee for banking supervision came up with a concept for having the idea risk-waited capital standards apply to these kinds of financial instruments and to give the credit-rating agencies a job of determining their credit rating, only then did it determine the amount of capital banks would hold against the traunches of the deals. The central bankers never really thought this through and were actually creating a monster here because by giving this role to the credit rating agencies, they had made a big mistake. Ironically, when the idea was first proposed, Moodys Investor Service wrote a letter in response to the proposal and suggested that it not be done and that it would corrupt the credit rating standards and created a moral hazard. Yet, this was ignored, and the various countries, including the United States, adopted the standards in 2001 that gave the credit rating agencies this role.
The same year there was a Gramm–Leach–Bliley Act that also did away with the last of the Glass-Steagall Act and barred the SEC from regulating the investment banking holding companies. The investment banking companies, which were already independent, did not have a prudential regulatory regime since Gramm–Leach–Bliley cast this in stone. There was a battle subsequently with the Europeans over this, and Congress first passed a law allowing a voluntary regulatory regime to be established for the bank holding companies and investment banking firms. All of the banking regulation was based on the idea that banks have deposits, taxpayers are exposed to deposits, and banks hold assets for a long time and therefore we are protecting the taxpayers from losses. However, investment banks do not hold deposits and by the nature of their business should not be holding assets for a very long time but rather should create markets. By adopting a regulatory regime in 2004, the bank holding companies and investment companies were given the incentive to buy and hold assets and the use of tremendous leverage, especially mortgage-backed securities. Risk-weighted capital standards are supposed to discourage banks from picking on assets with high risk, but what they really did was create incentives for banks to take on assets with low capital ratings. The investment banking firms did the same things that banks were doing, which were loading up on the assets.
The money to fund the CDOs came from investors, and it had to rated AAA to attract a lot of money. Two things were going on in the early days of the CDO. There were institutional investors who invested in the CDOs that contained mortgage-backed securities and subprime. Banks were also creating CDOs to get the lower-rated traunches of mortgage-backed securities off their books. They could not sell them, but they were trying to get rid of them, so they would put them into CDOs so it would become AAA rated. The institutional investors had lost interest in the lower-rated traunches of the private-labeled mortgage-backed securities subprime, particularly around 2003. The CDO was a way to recycle those assets that institutions would not buy by turning them into AAAs. You would basically take the worst from one pile, and it magically turned into the new pile of the best. By making it very opaque, some investors who did not understand it could be enticed into investing. These were actually black boxes.
Most of the investors aforementioned were foreign investors. After 2003, the U.S institutional investors were not buying, and the investors who were willing to buy had incentive to buy dollar assets and were looking for bond assets. They had trade surpluses or recycled petro dollars. They had lots of dollar denominated funds, and they needed to invest them in dollar assets in order to avoid currency risks. Therefore, the Asian and European banks and other institutional investors were buying these CDOs without much regard for what was in it, and you could not really know what was in it. They did not quite get the level of risk that was there because they were rated AAA.
Bruce wondered what role the Credit Default Swap played in the world of CDOs. Robert said the Credit Default Swap is a form of insurance in which one side sells credit protection against the bonds or mortgage backed securities that the payments would be made, and the other side buys the insurance. The availability of credit default swap made it possible to create synthetic CDOs on a massive scale beginning around 2005. They had existed before, and people were buying credit default swaps to protect their risks for owning certain traunches of the mortgage-backed securities. They then applied this concept to the CDO, but the synthetic CDO was created entirely with credit default swap. The actual assets were a pool of credit default swaps, and the entity issuing the synthetic CDO was insuring their performance. They would turn around and try to get insurance that would cover their losses if the bonds or notes failed. The provider of that was AIG’s financial products division, which sold all the protection for many years.
There were other companies that did it as well, but not nearly the size. The mono-line bond insurance companies that were looked over by state regulators became involved to their own detriment. When they went out of business, whoever was supposed to obtain the insurance coverage just lost. What happened was the issuers such as Merrill Lynch, Goldman Sachs, and Citigroup were putting together synthetic CDOs and were providing the insurance. In turn, they often could not buy the insurance. Goldman Sachs was able to, but Merrill Lynch and Citigroup increasingly were not able to buy the protection and continued to put together synthetic CDOs without it. They were the designated back holder at that point. They ended up owning all the super senior traunches, which is part of the deal that is made up of the credit default swaps. Citigroup tried to hide these assets on their balance sheet as well as their trading accounts. When the investment banking regulation was adopted, the Wall Street firms obtained a provision that allowed them to model anything held in their trading account on their book if it had not traded recently. However, Citigroup was also putting these assets into structured investment vehicles, which are more black boxes off its balance sheet. These were funded with asset-backed commercial paper, which was then backed in some cases by subprime mortgages. The Citigroup had over $50 billion worth of toxic assets at the time of the crisis. They were telling the public they had practically no subprime exposure.
Usually the person holding the credit default swap had the other side of the transaction, but this was not even necessary to get a credit default swap. One person was buying protection, and the other was selling. Merril Lynch was putting together a deal where they were providing credit protection to the other party that was in the deal. Then, someone such as Kyle Bass comes in and says he can buy, Bruce wondered if he could invest in a credit default swap and not have the other side. Robert responded you can in that you would only take one side, in this case the protection side. You can also bet against some of the various parts of the deal, which is what the hedge funds did. The smart people were buying the protection, and the less smart people were not. The general public did not realize how many bad loans were out there, including investors. They assumed that the deals would function and people would pay their mortgages. They did not see the dangers. However, those with the hedge funds did see the dangers and began to sponsor CDOs in order to create traunches they could bet against. They were selling a product they knew was going to fail, and then they bet against its failure. This was at least what was alleged with Goldman Sachs and the deal that got so much attention in Congress.
What the hedge funds did was slightly different, and it is not clear the extent to which the investment banking firms knew about it or whether the people at the top knew about it. Hedge funds would sponsor CDOs, and they would buy the equity traunch. The banks would then have to sell the AAA and BBB to someone else. There were CDO managers, and the catch funds were not supposed to influence the choice of assets that went into the CDO. That was how investors were assured that this was done with integrity. However, certain hedge funds appeared to influence, but it cannot entirely be proved because it was done in ways where it was difficult to trade. Very often with certain hedge funds, such as Magna Tar based in Chicago, the deals they sponsored and the $50 billion worth of CDOs all failed spectacularly. The CDO managers picked the worst assets out there. The question is whether Merrill Lynch in this case knew what was going on, and this is still going through litigation. Logically, you would think that they had to know something. The people at the top were probably the ones who did understand what was going on at the time. Interestingly, it seems to happen where they may not even understand completely the concepts that are emerging constantly.
You wonder about someone like Stanley O’Neal, who was supercharging at Merrill Lynch the CDO business at the worst possible moment because they thought it was very lucrative. You have to wonder if they were really that foolish and unaware. It is hard to know.
In Robert’s book, it talks about one trader who actually earned more doing one trade than for what Bear Stearns was sold. Bruce wondered if he used a naked short sale to achieve this. Robert said he did and that naked short selling was almost impossible to do with the uptick rule. You could still do naked short selling, but it was difficult to execute. An uptick means that stock has to rise and move up before it goes back down again. The naked short selling is selling shares of stock that you do not own or borrow. This is illegal and is done to manipulate markets to achieve outcomes that the manipulator desires to do. In March 2008, somebody bought an option for $1.7 million that would not pay off unless the chair price at Bear Stearns collapsed within ten days. Immediately after this happened, rumors were circulated throughout the industry that Bear Stearns did not have enough cash even though it had $18 billion in cash. Brokerage firms started pulling their money out of Bear Stearns. Within days, they only had $2 billion in cash and were on the verge of collapse. Over the Bear Stearns weekend in March 2008, the sale of Bear Stearns was negotiated by the Fed. In the initial deal, which was only $2 a share, the person who made the $1.7 million bet made $270 million off the bet. The company was sold for $236 million, which was worth less than the corporate headquarters of Bear Stearns.
Bruce read a quote that stated, “Bear Stearns was vulnerable to runs because, like most of Wall Street, it had been funding its operation from short-term secured and unsecured cash. When these short-term arrangements did not roll over, new arrangements could not be secured. Cash was drained out of the firm.” We now have sovereign debt. In his book Boomerang, Kyle Bass has done his job of doing credit default swaps on Greece. He would pay $1100 for $1 million coverage. Bruce wondered if Robert saw the same setup that really damaged the world’s economic mortgages done and if round 2 might be sovereign. This derives from the same problem with giving assets too low a risk waiting, especially in Europe where soverance requires no euro capital. Originally this was supposed to apply to AAAs and AAs, and in fact it does still apply to lower rated traunches. You could own a lot of these assets and fund them through overnight lending, and confidence in the system would vanish and people would want their cash back. They would demand more and more assets. Effectively, the price of the asset was declining, but it was being affected by cash being drained out of the system.
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