ARMAGEDDON

In March of 2005, a brilliant investor with Asperger’s Syndrome, Mike Burry,
devised the idea to buy CDSs on SPMBSs. He figured that 75% of SPMs had two
year fixed teaser rates that would provoke thousands of defaults when the floating
interest rates kicked in. Remember, in 1996, 65% of SPMs were fixed rate as
opposed to the 80% that were ARMs by 2007. Burry eventually convinced some
Wall Street firms to underwrite CDSs on SPMBSs. Within three years, that
segment of business would become a trillion dollar business fueled, in large part,
by the rating agencies. Wall Street viewed the SPMBSs as safe, and were happy to
take Burry's money, as well as a few others who were jumping in to buy the swaps.
In fact, the swaps were so inexpensive to buy it is clear that Wall Street did not
understand the risk it was insuring. In May of 2006, Standard and Poor’s
announced plans to change the model used to rate SPM bonds, effective July 1,
2006. Immediately, the creation of SPM bonds shot up, presumably before tougher
standards were employed. Two years later, the top rating agencies testified before
congress that their ratings were merely “opinions” and were not intended to be
relied upon. Perhaps that’s why Fannie Mae and Freddie Mac both had AAA
ratings at the time the U.S. Government took them over, or why Lehman Brothers
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and AIG both had AA ratings within days of their bankruptcy and bailout. (In case
you’re wondering, the sarcasm is intentional.)
Back to the second quarter of 2005, credit card delinquencies reached an all time
high. So even though home prices were booming and mortgage prices low, people
were struggling to pay their bills.
In October of 2005, investment banks were calling Mike Burry to buy the CDSs he
held. Why would banks want to buy insurance on SPMs? Quite simply, because
SPMs were going bad at a fast pace. From about 2000 to 2006, people whose
homes rose in value between 1%-5% were four times more likely to default than
someone whose home rose 10%. Why? Because millions of people couldn’t pay
their mortgages if they couldn’t borrow more money. As previously mentioned,
many loans were made with teaser rates fixed for 2-3 years to people who would
not be able to pay the “go to” rate when the teaser period ended. They would have
to refinance and the bank would make more money. So bankers were selling
bonds containing pools of toxic loans to clients and at the same time buying
insurance on those bonds!
How could this happen? One reason, the bond market, unlike the stock market,
had no meaningful regulations. That was also a reason why so many derivatives,
such as CDSs, were derived from bonds. Proposals had circulated to regulate
derivatives and have them trade on commodities exchanges like other futures so a
public market would be created. Wall Street lobbied hard against those proposals,
and, with Alan Greenspan’s support, was able to quash the efforts to regulate.
If bankers were selling crappy SPM bonds AND insuring them through CDSs, then
who was selling the insurance to the bankers? One of the largest insurers was AIG
(American Insurance Group). But how could AIG, an insurance company sell
unregulated CDSs? They sold them through their separate subsidiary AIG
Financial Products, which was able to escape regulations since it was not an
insurance company. Now the question is why would they do that? They began by
insuring corporate loans against defaults that they believed to be an extremely
unlikely event. And in the beginning, during the late nineties, that was true. By
2001, $300 million a year, or 15%, of AIG’s profits came from selling CDSs.
Next, the banks that bought insurance for pools of corporate loans (like to General
Electric) now sought to buy insurance on other loan pools—student loans, auto
loans, credit card debt, etc. AIG figured that pools of these other loans, just like
pools of corporate loans, were unlikely to all go bad at once since they too were
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sufficiently diverse. The logical evolution from there? Insure pools of SPMs.
Afterall, isn’t a pool of SPMs from Nevada completely different from a pool of
SPMs in Florida? AIG believed so! By the end of 2004, AIG had gone from
insuring 2% of Wall Street’s SPMs to insuring 95% of them-- $50B worth of triple
B rated SPM bonds. By 2007, AIG had $78 billion tied up in mortgage-backed
securities. You would think that AIG would get a huge return for insuring such a
risk. However, they charged just over 1% a year for that insurance. An investor
could pay roughly $2.5 million a year to insure $20B!
It was Goldman Sachs that created the structured finance “piece de resistance”--
the synthetic subprime mortgage bond-backed collateralized debt obligation. The
security was so complex that neither investors nor the rating agencies truly
understood it. By now, hopefully a pattern regarding the creation of financial
products has become obvious. As time goes on, these products become more and
more complex-- the synthetic subprime mortgage bond-backed collateralized debt
obligation; the only name that could top that would be the
supercalifragilisticexpialidocious collateralized debt obligation! And this serves as
the perfect segway to our next Kabbalistic principle-- curtains. But first, we need
to introduce another Kabbalistic concept of the 1% reality versus the 99% reality,
and then we can tie in the principle of curtains.
Kabbalah talks of the 1% reality as the physical world, the world of our five
senses. What most of us would call “reality,” Kabbalah calls an “illusion,” and
only 1% of the universe. It is an illusion because this is the world in which we
spend most of our time chasing the physical, the tangible. This is the world of
instant gratification. The world of “I will believe it, when I see it.” One example
that Kabbalists use to illustrate this point is comparing a new born calf to a new
born human being. A calf is walking in a matter of hours, sometimes minutes from
birth. Whereas a human baby can take a year to learn to walk. A calf knows in an
hour or so how to find its mother's milk, while an infant would die if it wasn't fed
by its mother. If you relied solely upon what you could see (1% reality), which
being would you think is the more evolved species? Clearly, the calf, yet we know
that not to be the case. In contrast, is the 99% realm. The realm of the nonphysical
universe, the realm of lasting fulfillment. The 99% realm is the world that
we all can inhabit when we abide by the non-physical laws of the universe—not
acting for the self alone; using restriction; understanding that every action or
thought has consciousness and plants a seed, and we may not see the consequences
of our actions, either positive or negative, for years or even lifetimes. It is because
of curtains that we erect that we can't see the 99% world when we plant a seed.
Stated another way, since we live in the 1% we usually only see the effects of our
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actions, we don't see that we are the cause. Kabbalists like to illustrate this with
the metaphor of covering a lamp in a room with many layers of cloth. Eventually
the room becomes completely dark, but the lamp is still burning. Because of
curtains we believe in the "suddenly syndrome." Remember from earlier, i.e.,
“suddenly the bottom fell out of the market.” Again, there is no “suddenly”
according to Kabbalah. It's the curtains that prevent us from seeing the effects of
our actions at the time of our actions. The increasing complexity of financial
products such as the synthetic subprime mortgage bond-backed collateralized debt
obligation were curtains preventing investors from seeing the negative effects of
those products at the time they were being offered. Curtains on the part of the
bankers devising the products, as well as curtains on the part of the investor. Why
do we proceed down a path when we know it seems "to good to be true"? Why
engage in "wishful thinking" and other delusionary undertakings? Because we
erect curtains which facilitate the disconnect between time, space and motion.
Why do we partake in that endeavor? Most likely in order to "act for the self
alone." We will return to this concept again.
Now, let’s jump back into the world of collateralized debt obligations. With a cash
CDO, a legal entity buys, let’s say 100 different mortgage bonds (a pool of loans)
and carves them up into tranches to resell. Wall Street took the riskiest bonds,
pooled them together (they would have had a BBB rating) and convinced the rating
agency that they were a diversified portfolio, and that somehow 100 BBB rated
bonds pooled together would now become a diversified portfolio of assets and
garner a AAA rating. In fact, it's estimated that between 85-95% of BBB rated
tranches of MBSs were repackaged into CDOs. Moreover, it's a lot cheaper for
banks to buy BBB rated tranches and repackage them, then AAA rated tranches
and repackage those!
Rating agencies didn’t have a CDO formula to value the CDOs, so they relied upon
formulas provided by the firms that hired them. Wall Street paid the agencies
more fees with volume, as well as the level of rating. If the agencies didn’t rate
AAA, they weren’t paid. Miraculously, the agencies pronounced 80% of the new
CDOs AAA (Yes, the sarcasm is intentional again). By the way, what do you
think Wall Street did with the 20% of bonds left over that were still BBB? They
pooled them together, created a new CDO and now 80% of that new CDO was
AAA rated. By 2006, CDO issuers were the buyers of almost all of the riskiest
tranches of mortgage-backed securities, thereby propping up the housing market
and contributing to the bubble. Firms were willing to buy crappy subprime
securities knowing they could hedge their exposure with a synthetic CDO. And
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without the willing buyers, investment firms might not have bought crappy
mortgages to package.
So Goldman Sachs sold SPM bonds to their customers, and also bought credit
default swaps, which were bets against the SPM bonds they were selling.
Goldman even had language in the fine print of some of its swaps stating that
Goldman may have material, non-public information which it may not have
provided to those customers, or that Goldman may be in conflict with the interest
of the investors in the transaction, and further provided the ability to unwind a
trade after three years if it was unhappy with the results. The drive to bolster
profits through proprietary trading (trading for the firm’s own account), even at the
expense of their own clients, was now firmly ingrained in the corporate culture of
Wall Street firms, especially at Goldman. When a trader sold a derivative to an
unsophisticated client and extracted a massive fee, it was celebrated as “ripping
someone’s face off.” Thousands of those unsophisticated buyers were
municipalities, including the City of Birmingham in Alabama, which went
bankrupt from its investments in derivatives.
In mid 2005, the head of AIG Financial Products, Joseph Cassano, promoted a man
named Gene Park to be “ sales ambassador” to Wall Street bond traders.
Essentially, when a bond trader approached AIG to insure a billion dollar tranche
of bonds backed by consumer loans, the ambassador would say “great.” The only
difference between Gene Park and everyone else at AIG FP, was Park said, “Great,
I just want to examine the pile of bonds underlying loans first.” Park discovered
that 95% of the bonds were subprime and that AIG was exposed to $50 billion of
BBB rated SPM bonds, which were billed as AAA diversified holdings.
Cassano and Park met with all of the Wall Street firms to try to understand the
rationale of these deals. Basically, the firms all said the same thing: “Not once in
the last sixty years have real estate prices fallen nationally.” And, on average,
home prices had skyrocketed 60% between 2000 and 2005. Unconvinced by the
rationale, AIG stopped selling CDSs by the end of 2005.
It is ironic that in 2006, as loans were continuing to decline in quality, the cost of
buying CDSs actually dropped! So who took over selling CDSs when AIG
stopped? Deutsche Bank, the German based investment house. Why? There is
anecdotal evidence that the Germans not only believed the rating agencies, but
more importantly, did not think Americans would be so destructive with their own
market. On a side note, in May of 2010, Germany banned the trading of “naked”
CDSs (remember, when the buyer has no insurable interest in the underlying asset)
on European Government Bonds. The European Union followed suit in
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November, 2011. By the end of 2006, home prices fell nationally by 2%. By the
end of 2008, the average U.S. home price was 30% less than it had been 3 years
earlier.
Wall Street firms, like any manufacturer, want to buy their raw materials cheaply
(in this case, home loans, consumer loans, etc.), and sell the end product (ABSs or
mortgage-backed bonds) for as much as possible. How does Wall Street set the
price? The price is based on the ratings by the rating agencies. And how did the
agencies evaluate the products? Did they carefully examine the underlying
individual loans? They simply used information given to them from the Wall
Street firms – such as the average FICO score of the whole pool of loans. Firms
could mix credit worthy borrowers with lousy credit borrowers. By the way,
people with virtually no credit history, aka “thin file” applicants such as
immigrants who never defaulted because they never borrowed money – had good
FICO scores and helped raise the average of the FICO pool. Michael Lewis, in his
book, “The Big Short,” details how a Mexican strawberry picker in Bakersfield,
California, earned $14k a year, didn’t speak English and bought a house with
100% financing for $724,000.
Moreover, Wall Street firms paid less for pools of loans with high and low FICO
scores, then pools of loans containing the 615 average score needed for AAA
rating. Firms would seek out loan originators and pay them extra money for pools
of loans with “thin file” FICO scores. Each CDO contained pieces of a hundred
different mortgage bonds, which in turn held thousands of different loans. The
rating agencies didn’t even know what was in the CDOs.
There is a theory that the language contained in the thick financial prospectus used
to sell SPM bonds and CDSs was so complex because the lawyers drafting them
actually didn’t understand the instruments themselves. That's the ultimate
"curtain," the drafters confused themselves! However, what is clear is that some
Wall Street language, which WAS understood by its creators, was also
intentionally meant to confuse. For instance (more veils), a bond consisting solely
of SPMs was not called a SPM bond; it was called an Asset Backed Security. If an
“A” designation was the most credit worthy, what would they call a less credit
worthy instrument? It wasn’t “B,” it was “Alt-A.” Overpriced bonds were not
“expensive” they were “rich.” Subprime mortgages were "affordability products."
The floors or levels of SPM bonds were “tranches.” The riskier ground floor was
not the lower level or basement, it was the mezzanine, or "mezz" for short.
Subprime was referred to as mid prime. Again, the foregoing are more illustrations
of curtains erected which separate or disconnect cause from effect.
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From the end of 2005 to the middle of 2007, Wall Street firms created between
$200B-$400B of CDOs that were backed by SPM bonds. As mentioned earlier,
80% of these were AAA rated, so that means $160B-$320B were classified as risk
free and therefore didn’t have to be disclosed on the balance sheets of these firms.
Another risky Wall Street practice that went unnoticed, but is worthy of mention
here, was the extensive use of repurchase agreements, commonly referred to as the
"repo market." In 2007, the U.S. investment banks used the repo market to fund
nearly half of their assets. This market allows a firm to pledge assets (often longterm
illiquid assets) in exchange for short-term loans, often overnight. In essence,
a repo is similar to a secured loan, with the buyer/lender receiving collateral
(typically securities) to protect against the default of the seller/borrower. One
danger of this involves timing. If the seller defaults, the borrower now holds an
acquired asset that may have declined in value. Also, repo transactions are exempt
from bankruptcy proceedings so a lender could grab its collateral at any time. As
the bubble grew, firms used riskier assets to repo, including mortgage backed
securities. And, of course, the lender readily accepted these MBS as collateral
because they received a higher return than a safer asset such as treasury bonds.
Banking regulators ignored the accumulation of this risk, admitting that they relied
heavily on the risk representations of management. It has been said that bad
regulation is worse than no regulation because it creates the expectation of safety.
By the end of 2004, the repo market reached $5 trillion in the U.S.
In April 2007, some of the big Wall Street firms became nervous that their AAA
tranches were eroding due to increased mortgage defaults and foreclosures. They
devised a plan to buy mortgages from distressed homeowners, forgive the
indebtedness and thereby avoid foreclosure and save themselves billions of dollars
in potential losses. When a number of large investors who had shorted (bet
against) the AAA tranches learned of the plan, they were incensed. They stood to
make fortunes if enough homeowners defaulted, and they screamed market
manipulation. In the end, the plan to prevent foreclosures was abandoned. These
investors, acting for the self alone, helped "tank" the entire global economic
system! It would have been cheaper, and far better for the world, to negotiate
some type of settlement to pay those investors since they were able to be paid
subsequently only because the U.S. Government stepped in to save AIG and others
in order to insure AIG did not default on its obligations to pay CDS owners. More
on this shortly.
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By March of 2008, the stock market woke up and investors realized that Wall
Street firms had lost in the hundreds of billions of dollars. But which firms? Much
of these subprime CDOs were not disclosed.
Bear Stearns had sold $40 in CDSs, for every $1 of capital it had. If you’re
wondering how that could happen, here’s two facts to consider: CDSs were not
regulated by the government; and Wall Street, through the Securites and Exchance
Commission, lobbied Congress in 2004 to loosen limits on leverage to 33:1.
Leverage is the ratio of borrowed money to bank or equity money. The higher the
debt to equity ratio, the more money a financial firm will make in a rising market
since their revenues will rise, but their costs of borrowing are the same. That it is
why, according to one economist named Richard Posner, "the private sector can
not be expected to adopt measures, such as forbearing to engage in highly risky
lending, that might prevent a depression, and thus why preventing depressions has
to be a governmental responsibility." Simply stated, corporations are not selfregulating.
"Restriction" is antithetical to pure capitalism. Remember,
maximizing profits is intrinsic to capitalism; you can't blame the lion for eating the
antelope.