Part Three
What I have argued so far tries to describe how the system was poisoned and why it ‘froze’ as suddenly as it did. What I want to argue now is far more important. I want to show how Securitization and the Shadow Banking System, will, by necessity of their design, always accelerate towards the point of their own poisoning, crash and wreak. The devastation this rains down on our lives and societies, is, I want to show, inevitable and built in. If I am in any way correct, then the conclusion is, that attempting to ‘fix’ the system with regulatory tinkerings, back to any semblance of how it was, will put us back on the same path again. We will start towards a next crash: one even bigger than the present one. I believe our leaders and their financial masters are already pushing us on to that path.
Addiction – the need of greed
Financial experts love to talk about managing risk. They will often say that is what finance and banking is all about. It is buying and selling risk. Handling it, taming it, mastering it. But while that may indeed be what bankers do they are all too often driven by greed. And greed often overwhelms them and their cleverness.
The desire to create more securities, to buy and sell and bet on them, grew. The drug took hold. Sub-prime became a legal high. So did Alt-A and Option ARM’s and exotic, synthetic combinations and derivatives of them all. All delivering a jolt of risk and a legal high.
But like most synthetic drugs the process of making them can be long and delicate. A recent Fed paper on the Securitization and the Shadow Banking System found that
“Typically, the poorer an underlying loan pool’s quality at the beginning of the chain (for example a pool of sub prime mortgages originated in California in 2006), the longer the credit intermediation chain that would be required to “polish” the quality of the underlying loans to the standards of money market mutual funds and similar funds.” (P. 14)
The authors found six or seven levels of “polishing” might be required to turn sub-prime to AAA rated security. And remember these are now securities with the extra zing of contained risk added in. Risk you could get very, very high on.
Now I want to take a step back. It all sounds so good, so plausible, so ‘manageable’ that you just know that something is too good to be true.
Let’s return to reality shall we. All of this, no matter how clever or polished, ultimately rests on and derives its worth from, a pool of mortgages, which, if all the borrowers pay up, can still only give the known and finite return. Money lent out, money paid back with interest. The interest is the profit. And NOTHING, but nothing, you do will increase this amount. Sure, you might make more money betting on them with CDS contracts, but you can’t bet on them unless someone buys them in the first place. And if you are the one buying the actual securities – and someone has to – then at every step in this ‘polishing’ process some one has to be paid to polish, and each time a little piece of the total possible profit is spent.
Normally when you buy something, if you then have to do something to it, you expect to be able to sell it for more. Like you spend money doing up the kitchen so you can sell the house for more. But here you are having to spend money from your profit just to make them pass as AAA rated.
The worse the mortgages the more you will have to spend. And at the end of it you have a security, which is insured up the wazonga and is still dodgy. Why go to such expense and such lengths to make things so mediocre, unless you had some other very good reason for doing so? Why do it? Why would anyone buy them?
It’s no good saying, because its risky you’ll get a better return. Remember that return can still only come out of the profit from the interest on the underlying loans and some of that has been spent already for “polishing”.
In short, these dodgy securities don’t make a great deal of sense if you are buying them as an investment in order to get profit from the regular payments. Too much has been eaten away, what’s left is still risky over the life of the mortgage and you are reliant on the insurers to pay up if it all goes pear shaped. But they do make sense if you think of them as money.
First, as money, no one intends to hold these risky things for long. Everyone intends to get them to spend them. In which case going for risky ones that offer a higher return seems quite attractive. Neither you nor the person who accepts them from you as payment intends holding them. This works fine in a bubble market where everything is very liquid and deals are being done every day. And in the bubble years we did all hear of the ‘appetite for risk’.
Those creating the sub-prime based securities could justifiably say people wanted them. There was an appetite.
The second point is more important. These may have always been poor earners as long term investments but as long as they were polished, rated and accepted by all as AAA then they were as good as any other as a piece of cash.
You use the debt-turned-to-money to take on more debt. You then put your new debt to work in some new money making venture.
Welcome into the warm, hydraulic embrace of leverage.
Leverage
You pay to have some new cash printed and polished. You use it to take out a large loan. You invest the loan. And it is the profit from this new investment that pays for and makes sense of the costs of all that polishing. This new investment, far removed from the original mortgages is what it has all been building towards. What it has all been about.
It is the profit you will make from the investment, made with the loan, given to you on the basis of the securities, made from the underlying mortgages. This is the real logic of the whole system. NOT getting a feeble return from a few poxy mortgages.
Mortgages were merely the feed-stock for a system (called Securitization) whose purpose was to create new money in order to feed into, in turn, another machine called Leverage.
Securitization plus leverage, lubricated by an unlimited new source of money. That was the machine. It’s what they are trying so hard to kick start again.
The thing to note is that the Securitization of sub-par mortgages does NOT make sense unless you have leveraged loans to bring in the profit. Is it any wonder that Henry Paulson while at Goldman from around 2000 onwards lobbied relentlessly for limits on leverage to be relaxed or lifted. And is it coincidence that when leverage was lifted in 2004 when Mr Paulson was now US Secretary of the Treasury that sub-prime took off?
I am not saying leverage was the cause of sub-prime. I am saying it was the other necessary part which had to be married to securitization for the bubble to inflate as it did. Securitization required leverage. Leverage enabled it. Together they brought the debt-to-money machine to life.
You started with a debt/mortgage. Turned it into currency. Used that to get another loan, i.e. turned it back into debt which you then invested it in another enterprise hoping to bring in more cash. And along the way that new loan you took on, using ‘money’ made from the earlier debt – will probably be securitized and entered into the same process. Confused? Don’t worry. So were half the people in the market, but it didn’t matter to them. They were turning water into wine and getting drunk on it.
Because from that one loan/mortgage has sprung another debt. Both now need to perform. If they do, the bubble grows and you will get twice as rich, twice as fast.
The securitization machine provided an endless supply of new money. It made sense to acquire the stuff because with it you could expand your own loan book. This is why the German Landesbanks bought so much of it. It was, to them, capital, which allowed them to go on a borrowing and lending spree of their own.
Anyone who wanted to grow aggressively and lend massively became the purchasers of as much of this stuff as they could get hold of. RBS was one. Buy it. Sell it on, use it as collateral. It was all good, as long as the bubble grew and leverage allowed returns to cover the costs.
But for the bubble to keep growing and the profits continue to pay for the costs and risks of the sub-prime securities leverage had to get higher and higher. The rate of acceleration of growth of the whole market had to increase. The graph had not just to climb but steepen. The problem is a line can’t get steeper for ever. Eventually it goes vertical and then there is no more. Markets call this a parabolic blow-off. After which because there is no more acceleration, the whole thing collapses back under its own weight.
That was the moment when everyone suddenly recognized the risk in every account and when Lehman could not repo any of its ‘assets’. The promise was revealed as a lie and everything stopped – dead.
The point after all this, is that the securitization system requires this leveraged acceleration of greater and greater risk and return. It will always be drawn to it, as a function is drawn to its underlying attractor. It is written in.
Conclusion
The most common argument heard about the ‘crisis’, is that something simply broke down/went wrong/ran amok. The break down caused a systemic malfunction of an otherwise fine system. Thus what we need to do is ‘fix’ whatever caused the breakage in the first place and adjust things so the same thing can’t happen again. Fixing it will require a few trillion of cash injections. And then a combination of better ‘regulation’ and a few technical adjustments such as a bit more capital here and a bit better ratings there.
The argument I have offered you is totally different. It says that we have NOT, will not, CANNOT and SHOULD NOT fix the present financial system back to its former state.
For the simple reason that the present catastrophic situation we find ourselves in, was not due to a break down in the system, but is an inevitable consequence of how that system works in the first place.
Financial crashes and systemic insolvencies are built-in to the securitization/leverage system. So if we restore it to how it was – ‘fix ‘ it – we will have keep having these deflationary crashes.
The Savings and Loan crisis cost about $350 Billion to bail out, or 6% of US GDP at the time. This crisis so far, has cost about $2.35 Trillion or 16% of US GDP. Anyone remember all the pious, mea culpa, ‘lessons have been learned’ after the S&L crisis? Yeah sure!
According to Fed itself, what the Securitization of the Shadow Banking System does is,
“…converting opaque, risky, long-term assets into money-like and seemingly risk less short-term liabilities.” (Introduction)
“seemingly risk less”.
“Seemingly”.
Let’s not get fooled again.
Brilliant as always, Golem. Here's to a brighter, better different future!
Coming from you that is high praise indeed.
Thank you.
Bravo! An excellent trilogy putting the situation into layman's terms.
A few questions if I may (probably stupid ones but ones which I cannot quite make sense of).
You have described what happens to loans etc once it enters the great securitization/leverage machine but can I take a step back to the loans themselves. As I understand it banks can create loans out of thin air and then borrow to ensure that they comply with their minimum core capital ratios (is this correct?) If so, then the only loss they would suffer if a loan goes bad is from the amount they have borrowed. Therefore, does this mean that the system will never truly collapse as it just means that periodically the person left holding the parcel (due to securitization/leverage) will be forced out of the game (like Lehman was), deleveraging will occur before it all starts again?
If that is the case then by blackmailing governments for bail outs etc are they just trying to stop as many of them going under instead of being worried that the whole system is under threat?
I think youre accurate in describing the motion and logic of the thing (thank you). however im less swayed by the substance abuse/drug addiction and greed metaphor.
Some of these guys were just trained and zoned in to search out the way to work the options available to them and some just got lucky.
Excellent trilogy Golem. Though I'm still struggling with some of the finer points of your argument, my intuition is screaming loud and clear that the shadow banking system is broken and unworkable in its current form. Your trilogy has added words to my vocabulary and I thank you for that.
As IanG has already pointed out, it is not possible for 'business as usual' to continue much longer. Once interest rates rise, even a small amount, then there will be a deluge of defaults that might be enough to force the old system to change.
Would we survive without a shadow banking system? In the age of globalisation is international trade still possible without it?
Well, I have Adam Smith's excellent book. Perhaps I ought to read it.
Morning Dylan,
I am sure you are right that for many it was just as you describe. A job at which some were very good and others unlucky. Just the pressure to do better than the next bloke would be enough to drive the whole thing.
I suppose all I am arguing is that there were also others, perhaps those further up, who should have and perhaps did see a larger picture and knew the risks, but did nothing to reign it in.
I think some of them were greedy. For wealth or more likely power.
I agree the machine will wreak even without greed. But I am not inclined to be so charitable as to think them all reasonable and just men 'just doing their job'.
thesleeperawakes,
Simple questoins to ask hellish to answer. For me at least.
First when you say they can just conjure a loan out of thin air and borrow to meet capital requirements, am I right in thinking you are ndescribing how banks will borrow on the interbank market in order to extend a loan (the wholesale funding model)?
If that is what you mean then you are correct. Although in the whole pool of loans the bank will likely have also loaned out against all depositis as well.
So if the loan goes bad, as you say, for a loan based on wholesale funding, the loss will be on that borrowing. The main looser will indeed be the person holding the security.
Does that mean the sysytem will survive while those holding the most securities are forced out? Difficult to answer.
If what you are getting at is did Paulson and the bankers exagerate the systemic danger in order to balckmail congress and the EU, then I tend to agree. But it's not clear cut, I don't think.
Banking would have survived. Indivual banks would have survived. New banks could have been cpitalized and the ATMs would have still run. Althougth government set up banks may have had to 'seize' large parts of the system from the hands of the dead banks. Visa would have agreed after making a few noises.
BUT there would have been a systemic crash in the sense I described. The promise which animates the whole shadow/securitizing system would have been destroyed by the sheer volume of non-exchangeable securities and the number of institutions holding them. So many banks and finds would have gone into cardiac arrest than everyone holding securitized paper would have suffered. Even paper that wasa actually performing.
In that sense the bankers were correct there would have been a systemic seizure. BUT both the banking system and banks and AT's and people's savings would have survived.
Wealth would, however, have been massively wiped away from the wealthiest.
Make no mistake it would have been an epic, history changing moment. BUT WE WOULD HAVE SURVIVED.
They claimed the disaster would have been such that the rule of law, freedom and democracy would have been at risk. Anarchy would overtake us all is what they argued. I think they were giving voice to their frears for their own wealth and power and dressing it up in terms designed to frighten the cowards who lead us.
I argue that all those things they say would have been at risk, have been mortally damaged but by the actions taken to 'save' the financial system.
The arguments and fright tactics, will, I think, be heard again before two years are out.
I join others in commending an excellent set of posts. Well done Sir!
All signs now seem to pointing towards another round of bailouts within the next five years. How will we manage this? How will our governments fund it? More cuts to services? Further erosion of the social safety net? Probably. What with the fetid bunch of overtly corrupt and self-interested blackguards that make up our political class.
Over the last two generations we've allowed our elected representatives to subjugate our interests time and time again. Subjugation not just to the moguls of finance but to those of energy and arms as well. Your excellent analyses make the former more clear now than ever. The affronts to human dignity in the gulf of Mexico, Iraq and Afghanistan are evidence of the latter.
It is sad that it will take suffering on a grand scale once again to kindle the fires of rebellion against those who wield power by virtue of obscene wealth. It is sad that we have to reach a nadir of justice once again before those who are capable will be spurred into action. But you, Golem, and those like you who speak out for justice and fairness, who question that which is regarded as absolute truth, are facilitating the emergence of new generation of leaders. A new class of informed citizens who will break down the tenets of wisdom, the rules of political life handed down from our 'betters'; who will spread these principles among the people until the tipping point is reached and the people will stand for no more.
I have to believe this because the alternative is despair.
Keep up the good work.
JamieGriffiths,
Thank you.
Bail outs within five years? I think five months is more like it. At least if you count a major bout of fiscal incontinence (QE) as a bail out.
I think QE is fast approaching here and the US. From the new school year to Spending round here in the Uk in Octboer and teh Mid term elections in the US in Novermber will be the crunch time.
A real actual bail-out of bank directly is also becoming more likely. US Commercial property is killing the regional banks faster and faster and getting to a critical juncture. SO too for the Option ARM's and Helocs at the major banks. These latter have only lasted this long because of the very low rates. But even low rates can't stop the reset and recast for ever. So many of those properties are so far in negative equity that they couldn't re-set even if the debtor wanted to .
We have been talking abou tthese debts for 18 months being proved wrong again and agin about when they would blow up. Maybe there is yet another trick to stop them exploding. But if there is a trick it will sure as hell cost money. So it's either bail them out or let them explode and then bail them out.
Me? I live on optimism! I'm the good vibe man.
From today's news, please dechiffre 'QE lite' for us: "Only using the proceeds from the (rotten) mortgage portolio…" Means we would like buy treasury bonds if and when we have the means…? An attempt at masking the intervention as sterilized? Why these proceeds only, and not any money lying around?
Good vibe man? Golem hammers out a fugue in a sombre minor key before going off to slay another bank.
I'm with two minds regarding Option ARMs and HELOCs. On one hand I would like them to explode, because this would send a very loud warning shot over the heads of our indecisive leaders. On the other hand, what happens to thousands of American families when their lines of credit are frozen?
Could Option ARMs fail in a spectacular fashion? The process may be more pernicious, with banks steadily increasing the number of repossessions.
Good morning Mr Eirik,
I take it you are referring to the lead story about the FOMC decision?
They are saying it's not quite QE, QE-lite as you suggest, because they are simply recyling money that was already in the system in previously purchased securities. So a mortgage backed security bought from one of the big banks or from one of the agencies (mainly Fannie or freddie), matures but instead of withdrawing the cash the FED will now inject it back into cirulation by buying up another wilting asset.
So is this QE or not? Or more importanty is it inflationary or not. They aren't exactly thesame question are they? I'm guessing that's part of what is bothering you.
The Fed is right its not newly printed up money. So it is QE-lite in that repect.
It is, however, a clearU-turn in policy which is an unambiguous signal that all the 'we're in recovery' talk was as premature and silly as we thought. This is as clear an admission of double dip as we are giong to get from the Fed. For the moment at least.
OK so it's not new money. They are not increasing the total amount of all money printed. BUT by putting it back into circuation they are inflating the amount of money in actual circulation. Which is more germain to inflation fears than the total amount in existence.
And it's A LOT. $150 billion "or more" they said. This isn't just what happened to mature this week is it? $150 billion is cash accumulated in an account. Which means it is a war chest they have been saving specifically for this sort of spending. They might need more, though $150 billion is quite a bail out is it not? let's not get too blase about out hundred billions.
Putting $150 billion back into the pot is inflationary and more important it is a bail-out. Had they taken this money OUT of circulation they would have reduced the Fed's bloated balance sheet and lessened thei liabilities. They could have paid it back to the Treasury who could have made it available to bail out local and state government's to help them NOT have to close so many scholls or fire so many teachers for AMercian children. BUT NO.
Instead they are going to put that tax-payer cash back on the hook for the bankers.
My guess is it will be used to buy up commercial property securities to help the regional banks and the commercial sector which is reaching critical now. OR, if the big banks have shouted louder than the commercial/regional lobby, then it wil be used to catch the rain of knives falling from Option-ARM re-sets and HELOCS which do finally seem to be doing what we all thought they would do a year ago. Low rates put it off this long but can't hold it off forever.
That's my take of it Mr Eirik. Hope it helps a little.
Morning RichGb,
thanks for your comments as always. I agree about the Heloc and Option-ARM misery. Some who lose their homes you can't help but feel for. What was their crime but to be too ready to believe those who told them it was fine to take on more debt. You'd be a sucker not too. Others I feel little sympathy for. They wanted to ride the gravy train and didn't care if it was socially good or not. They wanted theirs and that was all. I have seen pages of examples of scammers and specualtors using fake buyers to get property after property. I just can't find in it me to weep for them.
I think you are right the drowing tide of reposessions will rise . But this is less about staving off reposessions for ordinary people and more about banks faacing another round of losses coming right up. Is it commerical losses at the regionals or Heloc and ARM's at the majors? I don't know.
But this autumn is when I think we'll start to get a little more clarity.
But then again Rich I have been wrong so many times over the last 18m months. This hovering, stuttering, not-quite-a-rally, but not quite a headline-grabbing-drop either, has gone on far longer than I thought it could. Which is a reminder that I am an outsider and still a learner.
I have to go out for most of the day now. Back much later. Bye.