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Wednesday, September 17, 2008

How Financial Innovation and Sophistication Wound Up Biting Us All

Let's suppose you, the reader, gets a loan and then let's chart the path of this loan. It's possible that you use a mortgage broker. Then, that mortgage broker finds a bank. That bank likely then sells it to another bank, and then the other bank might even wind up selling that loan to Fannie Mae or Freddie Mac. Then, Fannie/Freddie will wind up packaging your loan and turning the bulk loans into bonds. Then, those bonds are bought up by heavy hitter investors like conglomerate financial services companies, private equity firms, insurance companies, and certain elite investors a la George Soros. Then, some of those bonds might even be insured through hedge financial instruments like credit defaut swap.

A credit default swap (CDS) is a credit derivative contract between two counterparties, whereby the "buyer" or "fixed rate payer" pays periodic payments to the "seller" or "floating rate payer" in exchange for the right to a payoff if there is a default[1] or "credit event" in respect of a third party or "reference entity".

If a credit event occurs, the typical contract either settles by delivery by the buyer to the seller of a (usually defaulted) debt obligation of the reference entity against a payment by the seller of the par value ("physical settlement") or the seller pays the buyer the difference between the par value and the market price of a specified debt obligation, typically determined in an auction ("cash settlement").

A credit default swap resembles an insurance policy, as it can be used by a debt holder to hedge, or insure against a default under the debt instrument. However, because there is no requirement to actually hold any asset or suffer a loss, a credit default swap can also be used for speculative purposes and is not generally considered insurance for regulatory purposes.

In other words, your loan would be spread by as many as six different parties and each party would assume a portion of the risk.

This extreme financial innovation and sophistication served several purposes. First, it creates liquidity. Because each and everyone can touch the loan and sell it right away, they can all move on to the next loan. Second, it spread the risk. This makes sense as long as the market is relatively normal. If you go bad on your loan, each and every party's exposure is rather limited. The mortgage broker is only exposed if there is fraud. The bank's have likely sold it and are only exposed again if there is fraud. The bonds have limited exposure because your loan is one of a batch. The credit swap issuer also has limited exposure because your loan is one of many. It should come as no surprise that the only entity fully exposed is the borrower themselves and that's because they don't have the financial means to participate in these sorts of sophisticated financial transactions.

Yet, this intense innovation wound up boomeranging in this market. That's because in this market your loan was a whole lot of loans. Now, instead of spreading the risk among many, the risk was spread to many. Furthermore, these vehicles are so sophisticated that the holders themselves had difficultly fully understanding of just how much exposure they faced. As such, while in the good old days, you would get a loan and your bank would hold that loan. Then, if you went bad, the exposure was spread equally between yourself and your bank. Now, the whole financial system faced some exposure. This would have been fine if the number of defaults was reasonable. Instead, defaults exploded and now suddenly the exposure wasn't merely in just banks and mortgage companies, but in the entire financial system altogether. Now, banks had exposure to a lot of bad loans. These mortgage bonds were full of bad loans, and the credit swap issuer was insuring a lot of bad loans. The whole entire system had just doubled down their exposure on bad loans.

The tools were so sophisticated and plentiful that it allowed everyone a piece of the pie. When the market was hot, everyone tried to grab theirs. Once it blew up, everyone had their own fair share. As such, the mortgage crisis is now a financial services crisis on the brink of being an economic crisis.

1 comment:

Anonymous said...

No story on this debacle is complete without includinig the key role played by FASB Rule 157, a rule that went into effect last fall requiring assets in portfolios to be classified into three groups, and applying strict rules for valuation of each group.

The crutial aspect of Rule 157 was to require assets to be "marked to market", that is that their value be marked down in the company books at the market price. This is fine where the market is liquid and active, such as for common NYSE-listed stocks, but for assets like derivatives, it is problematic.

When portfolio managers discovered they were holding assets that would suffer from an unnecessarily harsh valuation according to this new rule, they all tried to sell them, and very quickly there was nobody to buy them. Thus, we began the Great Asset Contraction that helped to trigger the present crisis.