Risk – the devil inside
Whenever someone buys a security they do so because they want the promised return on their money. What they don’t want is the Risk that goes with it. Risk and return are the light and shade of finance. You can’t get one without the other. But the promise that you somehow can, is what the Shadow banking system is all about. They dazzle you with fantastic returns and promise that somehow the risk has stayed in the shadows.
To recap, Securitization takes the risk of default and quantifies it. Once the risk is quantified, away goes the vagaries of a life and in comes a statistical probability. You then spread that probability out so that no one investor/buyer will suffer the whole loss. But – the risk has not gone. At most it has been diluted into a large pool. Namely the market.
Now when securitization started there was the pretense that all the mortgages being securitized were ‘conforming’ mortgages. That is, they were the kind bank managers used to authorize. Solid ones. Ones that WOULD be paid. The kind only famine, war or being run over would interfere with. AAA rated, mate!
In this sepia toned, one-in-a-hundred world, risk was factored in right at the start. Although the risk hadn’t really gone away, it had only been absorbed into the market, that was OK. Like pollutants into a river, the amount was known and the flow of the market as a whole would always, it was thought, be enough to flush it away.
But there are only so many truly AAA mortgages to be had. At some time in the 80’s the God-lets chaffed at this restraint to their power and ambition. They wanted more. They had the clever water to wine trick and wanted to see how far it could be pushed.
Why not take on a riskier loans? There was an untapped pool of debtors just waiting to be told ‘Yes, you can afford it’. At this point sober old-school bank managers saw their stock plummet. What the financial world wanted in their place were oh-so-smart young things who could square the circle of lower quality, higher risk debts, but still, somehow, AAA rated. There were two ends to be met now.
The market still had to be convinced that every securitized debt was still guaranteed by the market’s promise to buy. And for that to be true, they all had to be AAA rated. And yet at the same time they had to be based on debts that were lower than AAA quality.
Nothing that a business school MA couldn’t solve.
AAA – but not quite
The answer was of course simple – insurance. Get someone to wrap your bundle of somewhat-less-than AAA quality debts, in a gold foil promise to pay-out, up to the full face value of the bundle should it ever happen that the debts themselves didn’t quite meet expectations. The insurer, for their part, would get a small premium to cover the risk. In market parlance the insurer bought the little bit of ‘risk’ for a fee. Add this simple and clear step into the process and suddenly less than solid gold debts could be securitized. Tinnier debts could be thrown into the smelter to mix with the gold. And the impurity would be covered by a wrap of 24 carat insurance.
This innovation opened quite a few doors. It let a whole class of new players into the shadow system who ‘wanted’ to siphon off a little bit of the securitization elixir for themselves. Insurers, CDS issuers and speculators of every stripe. The latter were attracted by another aspect of the less-than-gold nature of the debts now being securitized.
You see in the simple version of securitization every security is the same as any other. Which is boring. But once not all AAA securities are as equal as others then power-dressing shirt-sleeves can be rolled up and serious barrow-boy-age can ensue.
Two things make securities not all equal. First there is the business of cutting the securities up vertically so to speak: into Senior, Mezzanine and Junior. The idea was to create differing levels of risk and return. Senior has lowest risk and lowest return. Junior the highest. All within the AAA rated security, of course. When you created the security out of your pool of mortgages you spread the risk out evenly. All you are doing now is reversing that a little.
The way you do it is if you imagine three buckets arranged so that as the top, senior one, is filled it spills over into the Mezzanine below it, which when it fills over-flows into the Junior one at the bottom. As the income from the whole security flows in, it fills the top bucket first. You can see that the top bucket will always fill and any short-fall will effect the bottom bucket first. Of course it’s not really quite that simple, you can get more involved structures of percentage flows going to all three etc.
The point is that you can now create differing levels of risk and return and cater for different appetites. But all, you understand, within the safe confines of the AAA rated, securitized world of high finance. Risk – but without any. Like diet drinks or heroine without the diseases – otherwise known as Coke. Armed with these possibilities you can open up a whole market in risks and bets (CDS) on those risks.
The world of securities and now derivatives, grew.
Then multiply this by the advent of those securities, which weren’t AAA to start with. CDS bets on what will happen to certain tranches of securities without even buying them. It might even be worth making such ‘risky’ tranches for someone, just to allow someone else to make CDS bets on them, don’t you think?
Risk Returns
Of course while all these innovations were expanding what could be included in securities and what could be done with them, risk had been there all along; The quiet shadow cast by all this dazzling innovation. Getting deeper as the innovations got more dazzling.
Remember at the start, the idea was that the risk was always marginal relative to the whole market. A little pollution dripping into the river never hurt anyone. But even though each security adds only a small risk of its own, everyone is doing it. Is there a point when the absolute level of pollution begins to poison the stream? No one asked.
Is the risk really mixing in to the whole flow and being diluted everywhere equally? Perhaps not if people are now specifically buying the tranches in which the risk and return has been concentrated. But no one worried.
While the river kept growing and a flood of new securities added to the flow, who could take time out from making money to worry about such hypotheticals? The bankers became lulled by their own terminology and hype. They’re called Securities for Christ sake! They were ‘managing’ the risk. They were trading it and making money from it. They were even buying it themselves. Like people who can play with fire and not get burned. So clever.
But the amount of risk was growing. And like all pollutants that flow out of sight and are allowed to slip out of mind, they accumulate somewhere unseen. And the risk did. The fact was, the risk was being ‘bought’ by, and was accumulating in, the accounts and balance sheets of people and players IN the financial system, in the market. Which meant the risk was accumulating with the very people who WERE also the market’s promise to buy.
It’s not as if there were two different groups of people. Over here, the people accumulating the risk. Over there, the people whose willingness and ability to buy WAS the market’s promise and guarantee of liquidity. They were the same people. The Market’s promise to pay was being poisoned. But no one was noticing.
Remember the market’s promise of liquidity – that the ‘currency’, the securities – will always be exchangeable, depends on there always being someone willing to buy. But an increasing number of those people were also starting to accumulate the risk that had been ‘taken away’. Would they really be willing or able, even to buy when other people wanted to sell, if it came to a moment of panic and doubt?
Well now we know the answer. When it came to a moment of crisis everyone suddenly saw the risk was all around. No one wanted to buy because everyone knew that everyone else was as poisoned as they were. And no one wanted to buy a bit of someone else’s poison to add to their own. Liquidity didn’t peter-out. It froze in a day, an hour, moment. It only takes a second for a promise to break. And without the market promise there was no market.
The market had poisoned its own promise. Without it, there was no worth behind the currency. It was all just empty promises and printed paper.
But this is not actually the worst of it. The devil is more subtle than that.
THIRD AND LAST PART TO FOLLOW.
Thanks for this. You make it very clear. Ive been reading about the "Magnetar Trade" which sounds a lot like what youve been describing here.
http://www.propublica.org/article/the-magnetar-trade-how-one-hedge-fund-helped-keep-the-housing-bubble-going
Hi, Golem XIV,
I cannot resist quoting this piece of financial logic behind rising markets today:
“It’s a sign of how long this crisis has been reverberating around that we now enter a week that could see fresh quantitative easing from the Fed,” Jim Reid, a strategist at Deutsche Bank AG in London, wrote in a report. “Bad news is interpreted as increasing the probability of imminent QE, a kind of win-win for risk assets.”
I repeat: “Bad news is interpreted as increasing the probability of imminent QE, a kind of win-win for risk assets.”
Who is crazy here? The markets for being moved by such motives, Mr. Reid for imputing such motives on the market, or the Fed for giving in to financial black-mail (again)?
I note that Mr. Reid is not referred to as an economist, but as "strategist". So I guess he's not describing something actual, but rather making the case for QE to serve DB or it's customers interests.
Then again, the distinction has been blurred for a long time.
Mr Eirik,
The financial players are ina win/win situation. Things really do improve they profit. Things get worse, they get another round of free money and make a profit. What's not to like?
This is the situation they lobbied for. It is the situation our governments agreed to.
It was clear as day 18 months ago at least that this is what would happen and it has. NO ONE can say it was unforseen.
Dear Golem XIV,
Please do not let me disturb you in completing your magnum opus, but if you can expand on:
"It’s not as if there were two different groups of people. Over here, the people accumulating the risk. Over there, the people whose willingness and ability to buy WAS the market’s promise and guarantee of liquidity"
What permits this observation, this statement of fact? The "raw" data behind? If you get my meaning…
For instance in the case of AIG (insurer), were they also creditors/owners of debt they had insured? I was rather under the impression that they had simply gravely misjudged the % of defaults on loans and and the value of collateral, making it impossible to make good on their written insurance…
And in the case of regular financial instutions, they were the first to catch on to (in the outer trenches of credit-life, as they are handling forclosures) the massive claims that were in the process of being filed against insurers, and they lost confidence that the insurance would be able make up the losses on loans that now were being held in the shadow banking system ?
The shadow banking system had access to liquidity only through ordinary banks (not CB), which they were denied in view of the the heavy losses the banks knew they would suffer on the loans ( possible insolvency). So, they began to tumble…
Because of uncertainty about where those losses would end up finally, possibly with some of the banks themselves, interbank lending dried up when it dawned on them that the counterparty bank could be insolvent depending on its involvement in the sub-prime market.
Tri-partite, I think: Bank, insurance company and "shadow bank" in a "Danse Macabre"
That's how I read the FED-paper: The shadow banking system gained access to CB-funding in the autumn 2008 through black-mail …or else: There would not be any more money in the ATM
Interesting article Golem. I look forward to the next part. I read a comment on Cif some days back that there is a lot more debt so far hidden that will see the light of day sometime soon. Also, another thought about how interest rates will rise, not if but when, we are in for some interesting fireworks when all those hanging on by their fingernails will fall.
For myself, I never bought anything I could not pay for immediately. I am lucky I know and a lot of folk are living from hand to mouth with high property (rents and mortgage). I sympathise and we will see how the ordinary people wil pay (literally) for all this.
Mr Eirik,
I am not claiming that institutions insured their own securities. I don't have to make such a claim. Only that lots of institutions were holding and accumulating risk (risky assets, risky loans insurance for such loans, or counterparty to CDS bets ). Yet these same institutions are those who muct make good on THE promise that underpins the entire shadow banking system and the exchangeability/worth of the securities – namely that no one will ever be saddled with a securitiy that they cannot echange/sell. No one wants to accept a piece of currency and then find people won't accept it as payment. The promise has to hold. If it doesn't, if people think to themselves – I don't want to accept any more of this stuff, because I know from my own holdings how dodgey it is. At that point the securities cease to be exchageable currency and the mnarkets stops. Doesn't slow down. Just stops. AS it did.
Lehman had billions of securities but no one would accept them. The interbank lending system froze. Lehman suddenly had no assets they could sell. The system fell over.
I am advancing a 'way of seeing' what went on different from other 'ways of seeing it'. Both can map on to0 the events. I believe my way shows more closely what happened and why. It also, I claim, makes it clearer what is at stake and the folly of attemtps to 'fix' the system.
A currency has imploded. All the assets denominated in that currency have and are still devaluing. We have massive on-going deflation.
In one currency. The Securitized one. We could have infaltion in the other, sovereign currency. Now that thought cannot even occur in the other way of seeing what has happened.
Please remeber I am thinking this stuff out as well. I am offering these as thoughts not as truths.
Thinking this all through for ourselves, NOT simply accepting receeived wisdoms, is what we all need to do.