The making of a market crisis

http://www.iii.co.uk/articles/articledisplay.jsp?section=Planning&article_id=7245300&catEnforce=YourStories

by Peter Temple
23.07.2007

The American consumer's addiction to using their home as an ATM machine had to come to grief somewhere. Most investors might have assumed that, when it happened, it would be nothing to do with them. In reality, the interconnectedness of financial markets means that home loan defaults in America can threaten large hedge funds, in turn provoking rumbles on Wall Street, weakness in the dollar, and a backwash into the FTSE.

Add to this the fact that some large UK banks have exposure to mortgage lending in the US and the conclusion is that we really do need to understand exactly what is going on here.

The problem starts with so-called sub-prime lending. For the uninitiated this might normally mean lending to the self-employed, those with adverse credit histories and other higher risk individuals. In the US, this has been taken to a new level with aggressive marketing bringing in individuals who might not normally participate in the home buying market, and their being given loans many times their income on the flimsiest of pretexts. When rates rise, and times get tougher, defaults become inevitable.



Collateralised debt obligations

For the next stage of the problem we need to reflect on the ingenuity of Wall Street in creating new financial instruments. Home loans in general, and sub-prime mortgages in particular, were repackaged into bundles known as collateralised debt obligations (CDOs) and sold to investors in search of high yield. The theory was that while some loans might go bad occasionally, this had always occurred with a predictable frequency that could be offset when incorporated into the terms of the bond that was backed by the bundle of loans.

Not content with this relatively simple idea, the next stage is for the packaged mortgages in CDOs to be sliced into different tranches, each with different degrees of seniority. Those lower down the pecking order stood first in line to take the brunt of defaults, when they occurred, and offered higher returns in the meantime to compensate. Higher-grade slices offered lower yields, but less exposure to default.

Now add to this the fact that lots of hedge funds bought stuff like this using massive amounts of leverage and it's possible to see the genesis of a financial crisis. The problems are compounded by the fact that the different classes of security created in the collateralised debt obligations are virtually impossible to value accurately. And what's more, there is no liquid market in them.


The issue of valuation

It's not a small problem. In the US, approaching $1,000 billion of a collateralised debt obligations based around residential mortgages was issued in 2006 alone. Not all carries a risk of default, but a fair proportion does.

Let's look at the issue of valuation in particular. Typically buyers of 'toxic debt' like this would go back to the investment bank responsible for the original issue and ask them for a price when seeking to value their holdings. Issuing banks, of course, would be reluctant to admit that their creations had dropped sharply in value, so the whole edifice begins to take on a slightly unreal quality. Everyone with any sense knows there is a problem, but no-one is prepared to admit (or even really knows) quite how large it is.

What is now known is that two hedge funds run by investment bank Bear Stearns have all but collapsed as a result of the crisis. Some more may follow as reality takes hold. Other hedge funds have actually profited from the misfortune of their competitors. But that doesn't mean the whole affair is simply a gigantic zero-sum game.

The concern among central bankers and other policymakers is that the large scale mispricing of assets like this - which looks like it is what has happened here - will not be corrected in an orderly manner. Writing down of large tranches of CDOs to their correct price might necessitate the forced sale of more liquid bonds to shore up cash reserves. A subsequent sell-off in bonds would have a knock on effect on equities. Result: we all end up with higher bond yields, and lower share prices.


Peter says

The moral of this particular story is that financial markets never learn that complexity, leverage and illiquidity are rarely a good combination. CDOs have worked well for a while, but most observers with any knowledge of the history of financial markets could have seen the current crisis coming a mile off once US interest rates began to rise.

The bundling of mortgages, held to be a strength because of the diversification of risk of default, turns out to be a weakness. With a low-grade corporate bond (a so-called 'junk' bond), for example, buyers at least know what they are buying. They can analyze the company's accounts, and form a view on the true risk of default under a range of scenarios. If default happens, they can fight for representation at meetings of creditors, determine how a restructuring might be engineered, and maybe come out not too far out of the money.

Buy a slice of a CDO based around residential mortgages from an investment bank and none of this is possible. The amount you recover is a function of how prudent the original mortgage lending has been, the earning power of the mortgagees, and the value of the underlying property. History suggests, in fact, that the underlying property is little more than a house of cards.