Coninued from part one. If you haven’t read part one and have the time to do so, it helps with this one.
CDS insurance gave some bright sparks an idea.
The insurance is otherwise known as a CDS – Credit Default Swap. The similarity to CDO (Collateralized Debt Obligation) is irritating but don’t let it deflect you. It’s just insurance. When you ‘buy’ a CDS contract you are getting an insurance agreement that says the ‘insurance’ company that sold you the CDS will pay you, if the ‘asset’ the CDS is insuring does not pay up as it should – IE the Collateralized Debt Obligation based mostly on those pesky mortgages.
The essential difference between the insurance you buy for your house and CDS type ‘insurance’ is that anyone can buy a CDS on any ‘asset’ even one owned by someone else. And they can buy as many as they want. It’s as if people down the road and all their friends, could insure your house against fire. Which might seem an odd thing to do…except if they all had the feeling your house was likely to catch fire. Instead of saying they ‘insured your house against fire’, which sounds jolly decent of them, let’s rephrase it to say, they bought an insurance policy which would pay them in the event of your house burning down. Now how safe do you feel?
Seen this way CDS is less like insurance and more like taking a rather unpleasant bet. A bet that your house might burn down. That is the bet many banks made from 2004 onwards. And in 2008 our house did burn down.
Starting in 2004 the sale of CDS began to explode. CDOs even started to have CDS ‘insurance’ included in them. Often in the most senior tranche. That CDS would be described as insurance for the CDO which sounded innocuous. But in retrospect it has been seen for what it was – a bet that the rest of the CDO would fail, built right into it from the start. Several law suits are underway alleging that Goldman Sachs, among others, knowingly created CDOs that would fail (Abacus, Timberworlf and Hudson CDOs are the most infamous) by stuffing them full of very poor quality mortgages. BB rated mortgages/securities that they ‘insured’ up to a AAA rating. And, the law suits allege they did this deliberately IN ORDER THAT those who bought the CDS ‘insurance’ would profit from the CDO’s default. I.E. it is alleged Goldman and other banks conspired with one special class of customer to intentionally defraud and steal from another ‘sucker customer’.
The inclusion of the CDS right in the CDO is what makes a CDO synthetic. So when you hear people refer to synthetic CDOs that is all it means. Synthetic merely denotes that not all the ‘assets’ inside it are simply debts. The explosion of synthetic CDSs meant a lot of them from that point on had the insurance built in. But it also meant one even more stupid and greedy thing.
Some crimes are simple. That perpetrated upon us by our financial class is not. It is epic, deranged and utterly amoral. A perfect description of the suited bankers who performed it in fact.
Some time in mid to late 2006, just as the market in CDOs was exploding to over $500 billion per year, some people at the heart of it already began to smell danger. Janet Tavakoli of Tavakoli Structured Finance Inc was one of the most forthright. As she still is. I mention this just to make it clear that by 2007 at the latest, people on the inside were NOT taken by surprise by what happened. They knew, or at least had been told repeatedly, what was going on and did it anyway for the simple reason that it was making them rich.
The problem was that already in 2006 there were the first signs of a slow down in the housing market and more importantly, the first rumblings of investors getting nervous about the quality of some of the CDOs and their underlying securities. At the same time the banks themselves had built up a massive holding of CDOs and had a CDO-and-Securities selling machine that needed feeding. Jobs and bonuses depended on this machine as did quarterly profits. So how to ramp up sales of CDOs when the housing market was already showing first signs of faltering?
This was a pressing problem not least because the banks needed to get rid of some CDOs they had accumulated on their own books. They also wanted to keep selling more and more even though some of the more informed in the market were feeling apprehensive. The answer of course was to sell to the less well informed, less formally known as ‘the bag holder’. But bag holders will generally not enter a market unless it looks to be booming. So how to keep the boom times rolling?
The answer was to create CDOs which would buy up other CDOs. Starting in 2006 and accelerating thereafter a whole new level of greed took off as the banks started to create CDOs and particularly synthetic CDOs in order to buy up bits of other CDOs they were having trouble selling. Essentially the banks created a fake demand which not only sustained the bubble but made it bigger. And here is the turbo charger that ensured the the bust when it came would be orders of magnitude more serious than anything ever seen before.
A bank created a CDO. In the senior tranche they might include a CDS to ‘insure’ it. The bottom tranche they would sell most often to the more aggressive hedge funds. You remember the ones who took out adverts shouting about how the returns on their funds were better than anyone else’s? Well this is how they made those returns. They bought the riskiest tranches that gave the best returns. Of course when the music stopped, those insitutions who still held them started to rot from the inside out. On the outside, market to model accounting acted like a thick layer of powder and perfume to cover the stench of putrefaction. But underneath they were dying and many are now past the point of rescue which is why you are now seeing them closing.
The top tranche, banks often held on to themselves or sold to other banks. Many of whom were European (German Landesbanks) who were greedy for them. The question often asked is why did the banks keep stuff they knew was rated as AAA but wasn actually barely BB? And the answer is that much as the banks loved to make a killing by buying up BB rated securities, wrapping them in worthless CDS insurance and then selling them on as AAA – attractive as that was, the banks needed capital and assets of their own.
Even though leverage levels were a thing of the stuffy old past, one still didn’t want to be seen as reckless. The more the banks wanted to lend and/or create CDOs, the more they needed an increasing capital base. Year end statements don’t look good if you have no capital holdings and no assets to flourish at investors and regulators. So the banks held on to the senior, AAA rated tranches, and used it as their own capital and level 3 assets. Insane as it is, that is why they held on to so many of them. They were fake, but they looked like AAA assets so the banks kept them and used them as if they were. Which requires, you’ll admit, the complete idiocy or connivance of the ratings agencies AND the regulators.
These were the ‘assets’ they used as collateral in short term loans from other banks and the infamous REPO arrangements. They were thus essential for day to day bank borrowing and liquidity. You can see that as the crisis took hold and the banks realized that they had all pulled the same trick, it’s hardly surpising that none of the banks wanted to accept these AAA rated ‘assets’ any more, and bingo you had the funding crisis which ate Bear Stearns, Lehman Brothers, AIG and Northern Rock.
But I’m getting ahead of myself. Back to the bubble years.
The big banks helped create a whole infrastructure of financial companies whose job it was to be the ‘independent’ guarantors of the quality of the assets going in to the bank’s CDOs. These companies got most of the work from the banks they were supposed to be independent from. See the already linked articles for more detail.
From 2006 to 2009, even as the banking crisis was taking hold, CDOs were being created by the banks, for the express purpose of buying up bits of earlier CDOs that weren’t selling (See good graphic here) – the Middle tranches. These were, in reality very much BB in quality but rated higher. The bank would put up the money to create a new CDO which would buy the BB quality, but AAA rated, bits of an old CDO, and then re-split them again in to new Senior, middle and bottom tranches. Sell the bottom to some thrusting hedge fund manager trying to make it big, sell the top to a pension fund or another bank as AAA rated and the middle to some other CDO that had been created expressly for that very purpose.
By 2007 Merrill, Citi, UBS, Goldman and the others were all selling bits of their CDOs to themselves via other CDOs.
The market in CDOs was growing exactly as the bankers had hoped, synthetic CDOs in particular were exploding (which is further evidence of the extent to which CDO were being insured with CDS). European banks were buying up these synthetic, insured CDOs and stuffing them on their balance sheets. Where they still are today, ticking away under the petrified gaze of the German regulators. These are what blew up Sachsen Landesbank and Hypo Real Estate among many others.
Remember, that the original idea of CDOs is that through their complex slicing and dicing they are supposed to ‘spread the risk’. But by selling them to themselves in a daisy chain of CDOs all looking like new investors in a growing market, but in fact being fake fronts for the same few banks leveraging non-existent assets into even more non-existent assets, what they actually did was concentrate the risks and the worthless paper in banks who could not sustain the losses. Which led, ultimately, to sovereign nations and their tax payers being blackmailed by the bankers into bailing out the losses created by the self same bankers who created the mess in the first place.
But I digress again.
By 2007 in a large group of CDOs investigated by Propublica (who if you don’t know them are wonderful people) found that 67% of the CDO slices were bought by other CDOs created by the same group of banks. CDOs stared to buy pieces of each other reciprocally, ‘A’ buys a slice of ‘B’, ‘B’ returns the favour and buys a slice of ‘A’. The CDO TABS 2007 7 created by UBS had pieces of four other CDOs in it, which all in turn had pieces of Tabs in them. TABS 2007 7 is now liquidated. In fact nearly all its assets were catastrophically downgraded and the entire CDO had to be liquidated less than a year after it was created. No one questioned Tricadia who have gone fromstrength to strength.
It was created by a firm called Tricadia Capital who were responsible for choosing the assets, vouching for their worth and generally looking after the interests of the investors. It so happens that another ‘part’ of Tricadia had already told its (that unit’s) customers that “serious cracks” were appearing in the CDO and mortgage markets, that a serious ‘unwind’ of the CDO trade might be about to ensue but that their firm was well positioned to benefit if that happened. Which means they had already taken out CDS bets, that a ‘serious unwind’ and collapse of CDOs, is exactly what would happen at the very moment that the other ‘part’ of Tricadia was choosing those seriously cracked assets for ‘it’s’ customers to invest in, in the TABS 2007 7 CDO.
Of course the ‘unwind’ did happen, all our houses burnt down, the CDS insurers like AIG couldn’t pay, the bankers via Mr Paulson, told us the sky was going to fall and so we HAD to take tax money and pay all those insurances AIG had written to all those funds and banks, who had written the CDOs, which had now failed, but which luckily they had all insured against just that ‘terrible’ possibility.
And we did. And the bonuses flowed so as to keep those very clever and most valuable bankers from leaving an ungrateful country that might even think of reining in their just rewards.
Here is a wonderful interactive graphic showing the web of banks and their CDOs buying other CDOs which shows you this was not an accident or just a few bad apples. It was and is what modern banking has become. It is why our nations are being bankrupted and the bankers created it.
I know this has been an epic. But at the end of this tale of greed we need to remember this.
The size of the shadow banking world of CDOs and CSOs is vast. Remember mortgages are a debt on a house. That is the real wealth at the bottom. A place for a family to live. Above that is a security. Above that a CDO. Above that CDS. Each layer further removed form the actual thing of worth. Each layer bigger than the one upon which it sits, from which it is derived, because leverage allows each layer to be used as capital for lending out yet more debt. By the time we get to CDS the ‘worth’ is all negative, in that the worth is realized only in the event of the ‘assets’ below it, the CDO, the security and the mortgage, all defaulting. And yet this top layer, is also the biggest layer.
This vast top layer is the wealth of the super rich and their banks. It is what we are bailing out. It is the stuff whose value is hidden in mark to model accounting or in SIV’s off balance sheet and off shore. It is what our nations are being bankrupted in order to save.
One bank Bank New York Mellon will serve as an example. I don’t chose BNY Mellon because they are exceptional and certainly not because I accuse them of any illegal activity what so ever. I chose them because they are typical. Bank of NY Mellon has a large share of the CDO trade in Ireland. It is the market leader in fact.
BNY Mellon has 22.3 trillion dollars under management globally.
For anyone interested in a very different take on the financial crisis, the failure of the policy of bailing out the banks and what it means for us, my book, THE DEBT GENERATION is now finished and shipping.
the first two para's had me laughing hystericly for ten mins and then i sobered up
if i knew that someone was betting that my house would burn down i would shoot them
Just let me see if I understand something: so bank bailouts are not simply covering banks' investments that have gone sour. Bank bailouts are covering the CDS owners, who have bet that the banks' assets (the CDOs) will have gone bad; and they bet many times the value of the assets' fall in value: so the loss in assets has been translated into a leveraged 'win' for a group of insider investors?? That's bloody terrible – I mean even worse than I imagined the situation. Say it ain't so.
I'm right in thinking they have trillions of dollars/pounds/euros of the stuff that they can't pay off and their running day to day like crackheads for the next liquid fix? And they expect us to keep hitting them up?
If they don't get a fix they start twitching and freaking out?
Those dude needs to be kept away from the supply. They need cold turkey.
There's a song it that somewhere. The Cure
24K,
Exactly the metaphor I always think of. There is indeed a song in there. I'd like to hear it when you're done.
Beneke99 it does beggar beleif doesn't it.
Those CDS are a large part of the 'wealth' of those who lord it over us. If we enforced the laws those bits of paper would be worthless in an instant. But if we bend over for them and try to 'save' their system, then they will cash those bets in at our expense and continue to lord it over us.
Our choice.
The Irish bail out could well lead to a domino effect now with Portugal, Spain and Italy to follow with continuing destruction in economies and currencies. The madness of loans on top of loans on top of loans, like a nightmarish Monetary Russian Doll, carries on at increasing pace. Implosion can be the only end result here.
Very good very clear article… Thanks !!
I hope you can persuade some national newspaper ( Guardian?) to print such a clear step-by step- analysis ..or nail it to the door of every bank in Ireland…or Spain… things will only move forwards if/when what has happened/is happening is better understood by the general public…and our elected representatives are forced to acknowledge it.
Andrew,
Thank you. A great many sites in quite a few different countries are now linking to the blog almost every day now: Hungary, Ireland Scotland, America, and this morning Finland.
And can I sent out a special shout to Hypo Real Estate who logged on this morning. Nice to see you lads!
Corbero,
I agree with you. Those who think this will 'fix' European bank insolvency are kidding themselves at our expense. Bailing out the Irish portion of our banks' debts will no more solve the problem than bailing out the Greek portion did.
From Ireland the bond specualtors, who are the same banks who are looking to be bailed out, will simply move on to make a killing in Portugal and then Spain. That's if Italy doesn't cut in the line first.
Excellent article Golem. The hyperlinks punctuate the text like the hammer blows to the end of a stake, 'Washington Blog' style. This will also raise the blog's ranking in the search engines.
How would you like your stake done?
Well done with plenty of garlic!
Indeed Sir, a blinding article. Or rather a sight-enhancing article. I often feel like agent Dave Kujan at the end of the Usual Suspects when I'm reading your blog – sitting on the edge of the desk supping coffee and looking up at that big notice board while all the clues fall into place.
"The greatest trick the devil ever pulled was convincing the world he didn't exist".
Well, quite.
One question: Who's on the other end of the CDSs? I mean, the banks retain the super senior tranche of the CDO for themselves which includes CDS elements which pay out when the CDO goes belly up. But who's underwriting the CDS? AIG was handing them out like sweeties at a panto and they were rescued in the original round of bailouts. But if the banks are covered by their CDS in case of defaults, and it's now the banks who are still desperate for the bailout money (rather than a third party like AIG) can I take it that this implies that the banks were all writing each others' CDS? Or am I misunderstanding something?
Crackerjack pencil on its way to you Jamie!
I hope you're not kidding – they must be worth a small fortune by now.
But seriously – that's mind blowing. I guess we must be talking about different 'parts' of the bank, one taking out CDS for the CDOs it was building and one issuing them for other banks' CDOs on the say so of the ratings agencies? One hand not knowing what the other is doing?
Because anyone with half a brain who had oversight of the whole picture would surely see that what one part of the company was doing was writing insurance for exactly the type of asset that another part of the company was betting against?
I know that this doesn't necessarily imply a conspiracy where government bailouts were factored in early on (I suppose that person at the top would think 'So what? Even if it all goes tits up, I'll still be walking away with a fat pay cheque') but doesn't it still amount to sociopathic behaviour?
Which would be startling, because I've always tried to see the roots of this crisis as being stupidity walking hand in hand with greed. The blind faith in never ending growth blinkering the players to anything but the evidence of very recent history. The jackals only turning up on the scene once the carnage had begun, forcing the debts on to the public purse via the craven political class out of sheer necessity (well, self preservation) and precipitating the sovereign crises. But this is clear evidence as far as I'm concerned of deliberate intent, at the very highest level, to drive the whole system into a wall – at god knows what ultimate cost – for short term financial gain.
Sickening.
Hi Golem, been a long time since my last comment.
I used to work as a market risk controller covering CDS and CDOs in a large bank for many years, and as early as 2004/2005 when we started seeing CDOs coming through, it became evident that soon or later things would blow up.
I've noticed some inaccuracies if I may dare to say so, in your explanation of CDOs and Synth. CDOS. Understand as well that the usual CDO underlying were bonds, not mortgages. But the MBS (Mortgage Backed Securities market was huge- Fanny Mae/Freddy Mac etc… spring to mind).
A CDS's reference asset is a bond. If the issuer of a bond records a credit event, as defined in the ISDA document, the owner of the CDS (long Protection) would go to the seller of the protection (short protection or long Risk if you prefer) and the seller of the CDS would pay the difference between the current bond price and par (notional value of the bond). So if you had a 1m protection on GMAC and GMAC defaulted, you would go to the company that sold the protection and either deliver the reference asset (bond) for 100% of value of that bond (that in the market would sell probably at 40 to 60% maybe) or cash settle. Cash settlement would be more the norm as there are many more CDS than reference assets around!
For banks, originally it was a very good tool to protect against Credit Risk. If you had a big loan on a company, you could buy protection to reduce the risk. It was also an easy way, by selling protection, to have a "synthetic" bond position, without the need to buy a bond on a particular company, and with reduced on no regulatory capital required (at the time). That's how it started on the late 90's. When I joined a big investment bank and started covering those products, (in a risk control & reporting role) in 2001, it was just the beginning of the CDOs.
The CDS market moved quickly from credit risk insurance to a speculation tool. A Market market maker bank would make good money from that. CDOs then came along. The structure is rather complex. A good explanation can be found in this excellent website: http://www.riskglossary.com/.
(Part 1)
Part2:
As one friend of mine who was head of model validation in that same bank told me at that time (that's the rocket science guys!): "if the world knew what sort of b*llsh*t we are doing we would be out of work forever". His words.
A comment regarding investment bank vs retail banks. Please understand I am only a very little fish in a big pond full of very big sharks. I hope I won't be abused for my comments, but sometimes an insider story can clarify things….
Investment banks dealt with the result of the massive mortgage boom, through securitisation of the loans made by retails banks. But the banks causing the problems were all non investment banks. When Halifax (retail bank) went to Ireland few years ago, they wanted to be one of the biggest banks there. They did, by lending money to ANYONE that would ask. The commercial lending went out of control. The losses there are staggering! And mounting. I totally agree about your comment on Ireland.
Securitisation was as a great tool. Banks could lend lots of money, go to Goldman Sachs or whoever, ask to securitise their loan into a CDO structure and sell most of it Hey presto the credit risk was passed to another "sucker" sorry investor. Unfortunately banks started to accumulate a lot of that crap on their books. They just hold other banks risks rather than their own. When things turned sour in the US (main culprit) and Europe the whole thing blew up.
I could spend hours rambling about details, the US retail and commercial mortgages securitisation etc… sorry have no time now.
Lots of people are angry. Including bankers. Many little people like me saw it coming, so saying the crisis came out of the blue is complete and utter b*llsh*t. Some people (few) high up in banks have been ruining the banks, the countries etc… but above all do not forget that the balme is equally shared by the polititians who were (and still are) in bed with the bankers. Through economic policies and keeping interest rates artificially low for so long it fed a lending frenzy that does not seem yet to be ending. Money was cheap (very cheap) returns in interest were ridiculously low, everyone was look for higher returns via higher risk, hence lend to sub-prime boomed…. long story….
Maria41
Hello Maria,
I am always more than delighted to be corrected. Not that I enjoy making mistakes but I am keen to learn. Please never hesitate to correct anything I have misunderstood. Worse than me being wrong ( egg on face I can contend with) I feel ashamed to mislead people who come here.
It doesn't sound as if my mistake was material to the argument.
Would you consider dropping me a private email? I would love to talk to you more in complete confidence. I need to learn and some of my questions require a specialist knowledge.
I quite understand if you feel you can or simply don't wish to. But I thought I would ask.
Either way thank you for this comment and thanks for reading.
Great article now what is best way for us to escape this mess.
I am not trying to be smart and it sounds like there aren't any get out of jail cards, so I accept it's going to hurt, but what is the best route forward?
so when they said the banks were too big to fail, did they mean – not yet?
if I, joe blogs can understand the explanation, even if I cannot follow immediately all Maria has disclosed, surely that nice Mr King must know what he is doing to us? not to mention our teenage chancellor and his buddies?
is there any hope without a revolution?
We have two chances.
1) they on-going disaster finally escapes their containment measures.
2) we revolt and throw them and their political lick-spittles out.
Or both.
Mr King knows and has known since mid ’08. Mr Haldane, also of BoE also knows.
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