Best of the Week
Most Popular
1. Gold vs Cash in a Financial Crisis - Richard_Mills
2.Current Stock Market Rally Similarities To 1999 - Chris_Vermeulen
3.America See You On The Dark Side Of The Moon - Part2 - James_Quinn
4.Stock Market Trend Forecast Outlook for 2020 - Nadeem_Walayat
5.Who Said Stock Market Traders and Investor are Emotional Right Now? - Chris_Vermeulen
6.Gold Upswing and Lessons from Gold Tops - P_Radomski_CFA
7.Economic Tribulation is Coming, and Here is Why - Michael_Pento
8.What to Expect in Our Next Recession/Depression? - Raymond_Matison
9.The Fed Celebrates While Americans Drown in Financial Despair - John_Mauldin
10.Hi-yo Silver Away! - Richard_Mills
Last 7 days
INTEL (INTC) Stock Investing in AI Machine Intelligence Mega-trend 2020 and Beyond - 18th Jan 20
Gold Stocks Wavering - 18th Jan 20
Best Amazon iPhone Case Fits 6s, 7, 8 by Toovren Review - 18th Jan 20
1. GOOGLE (Alphabet) - Primary AI Tech Stock For Investing 2020 - 17th Jan 20
ERY Energy Bear Continues Basing Setup – Breakout Expected Near January 24th - 17th Jan 20
What Expiring Stock and Commodity Market Bubbles Look Like - 17th Jan 20
Platinum Breaks $1000 On Big Rally - What's Next Forecast - 17th Jan 20
Precious Metals Set to Keep Powering Ahead - 17th Jan 20
Stock Market and the US Presidential Election Cycle  - 16th Jan 20
Shifting Undercurrents In The US Stock Market - 16th Jan 20
America 2020 – YEAR OF LIVING DANGEROUSLY (PART TWO) - 16th Jan 20
Yes, China Is a Currency Manipulator – And the U.S. Banking System Is a Metals Manipulator - 16th Jan 20
MICROSOFT Stock Investing in AI Machine Intelligence Mega-trend 2020 and Beyond - 15th Jan 20
Silver Traders Big Trend Analysis – Part II - 15th Jan 20
Silver Short-Term Pullback Before Acceleration Higher - 15th Jan 20
Gold Overall Outlook Is 'Strongly Bullish' - 15th Jan 20
AMD is Killing Intel - Best CPU's For 2020! Ryzen 3900x, 3950x, 3960x Budget, to High End Systems - 15th Jan 20
The Importance Of Keeping Invoices Up To Date - 15th Jan 20
Stock Market Elliott Wave Analysis 2020 - 14th Jan 20
Walmart Has Made a Genius Move to Beat Amazon - 14th Jan 20
Deep State 2020 – A Year Of Living Dangerously! - 14th Jan 20
The End of College Is Near - 14th Jan 20
AI Stocks Investing 2020 to Profit from the Machine Intelligence Mega-trend - Video - 14th Jan 20
Stock Market Final Thrust - 14th Jan 20
British Pound GBP Trend Forecast Review - 13th Jan 20
Trumpism Stock Market and the crisis in American social equality - 13th Jan 20
Silver Investors Big Trend Analysis for – Part I - 13th Jan 20
Craig Hemke Gold & Silver 2020 Prediction, Slams Biased Gold Naysayers - 13th Jan 20
AMAZON Stock Investing in AI Machine Intelligence Mega-trend 2020 and Beyond - 11th Jan 20
Gold Price Reacting to Global Flash Points - 11th Jan 20
Land Rover Discovery Sport 2020 - What You Need to Know Before Buying - 11th Jan 20
Gold Buying Precarious - 11th Jan 20
The Crazy Stock Market Train to Bull Eternity - 11th Jan 20
Gold Gann Angle Update - 10th Jan 20
Gold In Rally Mode Suggests Commitment of Traders (COT) Data - 10th Jan 20
Disney Could Mount Its Biggest Rally in 2020 - 10th Jan 20
How on Earth Can Gold Decline During the U.S. – Iran Crisis? - 10th Jan 20
Getting Your HR Budget in Line - 10th Jan 20
The Fed Protects Gamblers at the Expense of the Economy - 9th Jan 20
Last Chance to Get Microsoft Windows 10 for FREE! - 9th Jan 20
The Stock Market is the Opiate of the Masses - 9th Jan 20
Is The Energy Sector Setting Up Another Great Entry? - 9th Jan 20
The Fed Is Creating a Monster Bubble - 9th Jan 20
If History Repeats, Video Game Stocks Could Soar 600%+ - 9th Jan 20
What to Know Before Buying a Land Rover Discovery Sport in 2020 - 8th Jan 20
Stock Market Forecast 2020 Trend Analysis - 8th Jan 20
Gold Price at Resistance - 8th Jan 20
The Fed Has Quietly Started QE4 - 8th Jan 20
NASDAQ Set to Fall 1000pts Early 2020, and What it Means for Gold Price - 8th Jan 20
Gold 2020 - Financial Analysts and Major Financial Institutions Outlook - 8th Jan 20
Stock Market Trend Review - 8th Jan 20

Market Oracle FREE Newsletter

Nadeem Walayat Financial Markets Analysiis and Trend Forecasts

US Banking Crisis Explained

Companies / Credit Crisis 2008 Sep 28, 2008 - 09:12 AM GMT

By: Money_Morning

Companies Best Financial Markets Analysis ArticleShah Gilani writes: How Complex Securities, Wall Street Protectionism and Myopic Regulation Caused a Near-Meltdown of the U.S. Banking System - [ In Part III of his three-story investigation of the credit crisis,Money MorningContributing Editor Shah Gilani details how the very complexity of the global financial system brought us to the brink of a total meltdown. In a special addendum tomorrow (Thursday), the former professional trader and hedge-fund manager will detail a banking-system overhaul that would immediately end the credit crisis - possibly without a single penny of taxpayer money.]


There's no time to beat around the bush. Let's flush out the three credit-crisis catalysts that have remained hidden for too long, thanks to Wall Street protectionism and myopic regulation. Those catalysts - which brought us to the brink of a financial meltdown - are structured collateralized debt obligations, credit default swaps, and the horrific offspring of the two - credit default swaps on structured collateralized debt obligations.

An asset-backed security (ABS) is a type of tradable debt security that's derived from a pool of underlying assets. We could be talking about a pool of mortgages, of automobile leases, or loans made to various borrowers. We're using the example of residential mortgages, though the example is exactly the same for commercial mortgages, automobile leases or bank loans. Here's how it works.

Anatomy of Mortgage Loan

A mortgage company makes home loans in your county, as does your local bank branch. Then an investment bank comes along and buys the mortgages from the mortgage company and from the bank. It only wants to buy the mortgages made to prime borrowers who are paying 6% interest on their mortgages. Once it acquires those loans, the investment bank securitizes the mortgages, meaning it pools them into a tradable package it can sell to investors.

This particular pool is known as a "closed pool," meaning no more mortgages will be added, though some may leave the pool if the underlying borrowers pay back their mortgages early because they sold their homes, or refinanced them, or if underlying mortgages are in default and the "servicer" allows them to be removed from the pool.  The only income coming into the closed pool results from the monthly interest and principal payments being made by the homeowners.

In our example - because all the mortgage loans were made to so-called "prime" borrowers with strong credit - you might have an investment grade (A+) security that pays 6%, because all the mortgage holders are paying 6% and the payments are being passed through to the investors. That's it. There are very good, though not exact, methodologies to value this particular security, primarily because it is uniform in that all the mortgage payers are prime borrowers who all are paying 6%.

Asset-backed-securities become infinitely more complicated when they are sliced and diced into structured collateralized instruments. They generally fit into two main categories:

  • Collateralized debt obligations (CDOs), which include all manner of residential and commercial mortgage-backed securities.
  • And collateralized loan obligations (CLOs), which are pooled bank and investment-bank loan portfolios.

CDOs and CLOs are created from "closed-pool," asset-backed securities. They are collateralized by the underlying assets - hence the prefix - but they are also " structured. "
In our example above, our asset-backed mortgage security was rated A+ and pays the investor who buys it 6%. If I want to create higher-yielding securities that I think I will be able to sell a lot more of, I will pool mortgages from subprime borrowers.

Because subprime borrowers are, by definition, higher-risk borrowers, the mortgage companies and banks charge them higher rates of interest to offset the greater risk that they represent. If I pool these mortgages, their ratings would be " junk " - or close to it - which will be a problem as I try and sell these securities to investors all around the world.

That's where the magic of financial engineering, better known as structuring , comes into play. I can divide up the closed pool of subprime mortgages and structure the pool into layers, or tranches . What I'll do is divide up the pool into multiple tranches, or slices. I'll structure the cash flow payments from all the mortgages so that if the 1st or 2nd tranches run into trouble, I'll take cash flow payments from the lower tranches to keep up with all the payments to the holders of the 1st and 2nd tranches.

For someone trying to peddle these asset-backed securities, this is a stroke of genius. In our example, since I'm now pretty much guaranteeing that the 1st and 2nd tranche security holders are going to get paid, maybe I can get the Big Three debt-rating companies - Standard & Poor's , Moody's Investors Service ( MCO ) and Fitch Ratings Inc. - to give my 1st and 2nd tranche CDOs' investment grade ratings. Maybe I can even buy insurance from a monoline insurer like AMBAC Financial Group Inc. ( ABK ) or MBIA Inc. ( MBIA ), and get my top tranches a coveted "AAA" rating. Wow, I could sure sell a lot of this high-yielding stuff with an investment grade rating!

That's just what happened. And they did sell a lot - a whole lot.

Those Troubling Tranches

As I said in Part II of this investigative series , CDOs - on an individual basis - are difficult to value. Indeed, "legend has it that constructing the cash flow payments on the first theoretical 3-tranche CDO (the simplest type of CDO) took a Cray Inc. ( CRAY ) supercomputer 48 hours to calculate.

The problem starts here. There are so many of these tranched securities out in the marketplace - and on the balance sheets of banks, investment banks, insurance companies, hedge funds and all manner of other unsuspecting investment entities worldwide - that when subprime borrowers began to default, it wasn't long before the lower-tier tranches ran out of money to pay the so-called 1st- and 2nd-tier "AAA"-rated securities. The problem escalated quickly and almost all of these securities were downgraded . That's not a surprise. Nor is it the whole story, for it leaves a key question unanswered.

What happened to the lowest-level tranches?

Those tranches were "ugly" to begin with because I started by pooling subprime mortgages (the high-risk borrowers). Then I made them "toxic" by "stripping out" their cash flow to support other tranches. This toxic waste was so bad, no one would ever rate it and only greedy hedge funds or crazy speculators would buy it for its high yield. Or, maybe, I think so much of my creation that I'll keep this piece for myself, or maybe I'll have to because no investor will ever buy it.

This kind of stuff is out there. There's a lot of it. And only an act of God will bring these securities back from the depths where they now reside.
With their collateralized premise and structured nature, CDOs are very difficult to value - especially since no one trusts anyone else's "internal valuation model." Since everyone is afraid of these securities because no one really knows what they're actually worth, no one wants to buy them.
However, when an institution - such as a Merrill Lynch & Co. Inc. ( MER ) - gets desperate enough to sell a portfolio of these securities at 22 cents on the dollar, then everyone else who has to " mark-to-market " their assets now has to value similar securities of their own at 22 cents on the dollar. That causes massive write-downs at banks, investment banks, insurance companies, and other financial institutions. And these companies write down assets and watch their losses escalate, they are forced to raise additional capital to meet regulatory requirements .

CDS - Controlled Dangerous (Financial) Substances

It's a vicious cycle - one that's eroding our faith in our banks, and worse, banks' faith in other banks. As a result, banks have ceased lending to each other out of the fear that the next round of write-downs and losses may imperil some of the trading partner banks that they used to lend billions of dollars to every night.

Not anymore.

It would be bad enough if that were the only problem facing the securities market. On top of these overly engineered structured securities I've just discussed, we also have credit default swaps with an estimated notional value of $62 trillion out in the marketplace. A credit default swap (CDS) is a financial derivative that's akin to an insurance policy that a debt holder can use to hedge against the default by a debtor corporation, or a sovereign entity. But a CDS can also be used to speculate.

In Part II of our investigation , which ran Monday, I explained how problematic credit default swap pricing is and how the indexes against which the value of these swaps are determined are tradable themselves as speculative instruments and how the whole complex is driving the financial system into an abyss. That's essentially what led to the collapse of the otherwise healthy insurance giant, American International Group Inc. ( AIG ). [For the latest news on AIG, check out this related story elsewhere in today's issue of Money Morning .]

Unfortunately, I don't see the U.S. Treasury Department's much-needed rescue plan being effective without actually addressing the problems facing both the CDO and the CDS markets. The Treasury Department's initiative will create more problems than they attempt to solve and will eventually saddle taxpayers with so much debt that they risk sinking the dollar, and worse, the U.S. government's investment grade rating. That would be calamitous. [For the latest news on the federal government's banking-system bailout plan, check out this related story elsewhere in today's issue of Money Morning .]

Tomorrow (Thursday) in Money Morning , in an addendum to this piece, I will outline a proposal that I'm calling the Money Morning Plan because it potentially heralds a new dawn in the credit crisis, addressing the problems from the bottom up, and not from the top down. Although this plan is straightforward and elegant in its simplicity, we still opted to present it as a separate story in order to provide you with the focus, the detail and the explanations we feel this strategy merits.

If the Treasury Department wants to immediately triage the gushing wounds that are bleeding our banks and financial system dry of readily available credit by purchasing and warehousing illiquid assets with taxpayer money, it won't be long before the U.S. financial system begins to hemorrhage somewhere else.

The free market caused these problems under the noses of undistinguished regulators.

The free market - with the oversight of good governance practices mandated by effective regulators, who should not be empowered to kill entrepreneurial capitalism - will once again rise to the occasion and prove America's robustness and indefatigable spirit.

[ Editor's Note : Contributing Editor R. Shah Gilani has toiled in the trading pits in Chicago, run trading desks in New York, operated as a broker/dealer and managed everything from hedge funds to currency accounts. In this special three-part investigation, Gilani has drawn upon the experiences and network of contacts that he developed through the years to provide Money Morning readers with the "real story" of the credit crisis. But this financial inner-sanctum insider will take this story one step further. Tomorrow (Thursday), Gilani will detail a plan that will spare the taxpayers, save the dollar and preserve the United States' pristine credit rating . It's a perspective on the near-financial meltdown that you'll find nowhere else but in Money Morning . If you missed earlier installments of Gilani's investigative series, Part I appeared Friday , and Part II ran Monday .]

News and Related Story Links :

By Shah Gilani
Contributing Editor

Money Morning/The Money Map Report

©2008 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email: customerservice@moneymorning.com

Disclaimer: Nothing published by Money Morning should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investment advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication, or 72 hours after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Money Morning should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

Money Morning Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules