Tranche Warfare

I've been mulling writing this post for a long time, watching with increasing -- but hardly surprised -- dismay all year as the economic tailspin has accelerated, its increasingly debilitating effects impacting the lives of more and more ordinary citizens worldwide who had no part in its creation. Now, the Bernie Madoff Ponzi scheme scandal seems as though it might represent the final nail in the coffin of financial system trust.

We seem to never learn.

I first learned the precise meaning of the "SDO" (Securitized Debt Obligation) during my 2000 - 2005 tenure as a subprime credit card risk management analyst (more on that shortly). Today, in addition to the SDO, we witness the additional dismal overlappingly-related acronym litany of the inscrutable and increasingly failed CDO ("Collateralized Debt Obligation"), ABS ("Asset Backed Security"), MBS ("Mortgage Backed Security"), SIV ("Structured Investment Vehicle") arrangements, many of which simply comprise the bundling and re-bundling of thousands upon thousands of debt contracts, sold to the various "Holders in Due Course" (i.e., referring to the staple fine print down in any loan agreement), and emergent as aggregate bonds subequently yet again chopped up into "tranches" paying dividends correlated with their respective maturities and risk-associated "agency ratings" (and all of these pseudo-sophisticated, inscrutable "instruments" increasingly "insured" by unregulated "Credit Default Swaps," the now largely unreedemable indemnity contracts responsible for the demise of the company that invented them, AIG).

Today we find that all manner of these aggregated bonds, nothwithstanding even "AAA" ratings, are in fact either of distressingly indeterminate value or are in fact simply worthless. What I call "tranche warfare" has commenced, and will likely continue for 10 - 20 years as the circular firing squads of "unwind litigation" rage on.

No, we indeed seem to never learn. Enron? The "DotCom" crash? Long Term Capital Management? The Savings & Loan Meltdown? United American Bank? Drexel Burnham Lambert? Equity Funding Life? Just to cite a few.

"THE BEST THINGS IN LIFE ARE 'FEE'"

That was the oft-repeated sarcastic and cynical joke in executive circles at the privately held subprime VISA/MC issuer where I worked in risk management. My own initial supervisor, the hastily installed VP of Risk who'd been brought over from Collections, would candidly say in private that according our customers credit was like giving whiskey to alcoholics.

But, hey, it's legal. And, if we don't do it, someone else will.

"Churn & Burn"

I was hired initially in March of 2000 as a temp tech writer brought in to compose documentation for a pending OCC examination, and subsequently offered a permanent position as a "risk analyst" once they learned of my applied stats background and SAS programming fluency. When I arrived the operation was classic subprime "churn & burn," bordering on the "predatory" (some would say they'd crossed far over that border). Huge upfront and ongoing transaction fees charged to the financially desperate made it nearly impossible to lose money, heavy charge-off losses notwithstanding. Burn 'em up and churn new accounts.

At the outset of my tenure, the "Risk Department" was one effectively in name only, consisting of two holdovers of the prior risk manager's pro forma regime, one a quite saavy statistician, the other an econometrician -- both of whom had their eyes on the door.

There wasn't much "risk" to manage beyond those posed by nagging class-action litigation and pending consent decrees that were a familiar feature of the subprime domain (and cynically viewed simply as a manageable cost of doing business).

The new VP of Risk, though, set about to build an effective, "best practices" risk department, one eventually staffed by a platoon of astute MBAs and statisticians recruited from far and wide, one whose subprime credit risk modeling and portfolio management and operations analytics became the envy of the sector. The bank's portfolio and profits grew steadily and impressively, and charge-off losses declined impressively. We sailed through our regulatory examinations. The OCC eventually characterized us as "Best-in-Class." While most other subprime players crashed and burned during this period (including the largest issuers such as Providian and NextCard), our little bank had moved away from the reckless and predatory and into "near-prime" marketing territory.

2004: CHURN & BURN REDUX

A large Wall Street "Bad Paper" firm with whom we'd been doing business on our charged-off accounts bought majority control of the bank in 2004.

• "Bad Paper" companies traffick in debt that has been deemed uncollectible by its current owners and is written off their balance sheets -- hence "charged off." You may default on a loan, but down in the fine print is the staple loan contract provision that the account still represents an "asset" which can be sold to a "holder in due course" to whom you are subsequently legally accountable. Bad paper typically trades at between a fraction of a cent to several cents on the nominal dollar, depending on the buyers' assessed "quality" of its eventual collectibility.

My subsequent VP of Risk (my original Sup went back to Collections) explained the prospective M.O. expected by the new owners. In a word, "securitization."

Some E-Z round numbers readily illustrate the concept. Assume 100,000 new VISA accounts booked, each with a credit line of $1,000 (remember, this is subprime; a thousand dollar unsecured credit line was considered radical). My own portfolio studies had shown that our credit-hungry customers typically maxed out their cards within four to five months. So, in short order you have a pool of accounts representing a nominal "asset" present value of one hundred million dollars (100,000 accounts x $1,000 each). Now, some of these accounts will eventually go bad and charge-off, while others will perform acceptably ongoing (providing continuing fee and APR income), with many "graduating" to even higher lines (every dollar of which will get used). Securities traders, then, bid on the estimated blended risk-adjusted future value of blocks of such accounts bundled up into "SDOs" -- our "Securitized Debt Obligations."

You take the proceeds from the SDO sale and plow it back into booking another 100,000 accounts, etc, etc, etc. Lather, Rinse, Repeat. Once you've sold the accounts, you, the issuing bank, no longer have to "reserve" (with set-aside capital) against future losses stemming from any of them that subsequently charge off. Someone else now owns that risk (and, the retail customer is typically clueless; they get the same billing statement month after month, and are simply unaware that your bank is now simply administering the account that someone else owns. For a recurring fee, of course.).

You see where this is going?

THE WHOLESALE, INCREASINGLY UNREGULATED COMMODITIZATION OF RISK

Bothered by the entire dubious ethic of subprime lending and this incipient new M.O. of feverishly shoveling risk out the door and onto the markets, I quit in February of 2005 to move on to more socially meaningful work (electronic medical records consulting for the Medicare QIO).

Whereas the market bid/sale values of my bank's SDOs would in large measure be a function of the astuteness of our proprietary credit risk scorecard and portfolio risk management models (these were, after all, aggregate financial products secured solely by the signatures of the individual "obligors," the credit card holders), such fastidious diligence would not be the case as the securitization frenzy metastasized to other lending domains -- most notable and obvious among them (now!) the mortgage arena. By now the exemplar stories of the "instant approval, no income half million dollar loan" are legion.

The Best Thing In Life Are FEE! Writ large; with the myriad origination et al fees, of course, written into -- and paid immediately right back out of (to the profiteers) -- the loans going right out the door.

It all morphed swiftly into classic Boiler Room.

A succinct new confirmatory summation of the phenomenon as I have described it now emerges in a current ongoing series by The Washington Post:

...By 2004, Wall Street investment banks were discovering how to turn consumer debt into a moneymaker, churning out bond-like securities backed by mortgages and other assets. Credit-default swaps helped attract institutional investors to these mind-bendingly complex deals, known in Wall Street jargon as collateralized debt obligations, or CDOs.

CDOs defined a revolution in corporate finance called "securitization." Wall Street saw any income stream as a candidate for securitizing: mortgages, credit card payments, car loans, even student loans. The investment banks would bundle these loans, and the monthly payments that came with them, into a new security for investors looking for steady but higher yields than Treasurys or corporate bonds.

CDOs had been around for years, but the real estate boom suddenly made mortgages one of the hottest investments on Wall Street. The mortgage industry turned into the equivalent of a giant assembly line, lubricated by fees from one end to the other. New lenders sprung up by the month, offering loans to first-time buyers as well as existing homeowners who wanted to move up to more square footage. For people with shaky credit, the industry provided subprime loans, with higher rates that some homebuyers now cannot repay.

Banks packaged and resold the mortgages in pools, which became the basis for mortgage-backed securities. Wall Street scooped them up. The CDO market took off, ballooning to $551 billion issued in 2006 from $157 billion in 2004.

The CDO structure depended on the concept of layered risk. The securities in the "super senior" top tier were considered low risk and attracted the highest ratings. In return for their safety, these bonds paid the lowest interest rate. The reverse was true at the other end: The lower tiers absorbed the first losses in the case of loan defaults. For accepting extra risk, investors in these tiers earned a higher interest rate.

Financial Products made its money by selling credit-default swaps only on the super-senior tier. It seemed a safe bet: [AIG Financial Products President Joeseph] Cassano once defined super senior as the portion of the deal that was safe even "under worst-case stresses and worst-case stress" assumptions.

The mortgage-backed CDOs were also thought to be safe because of the geographic diversity of the underlying loans. Surely, investment bankers reasoned, people in different parts of the country would not default on their home loans at the same time. The real estate market was strong and showed no sign of faltering.

Financial Products executives said the swaps contracts were like catastrophe insurance for events that would never happen...

"Events that would never happen"? Naive epistemic hubris on steroids. Nicholas Nassim Taleb's "Black Swan" comes to mind for me immediately.

...The current subprime crisis has been doing wonders for the reception of any ideas about probability-driven claims in science, particularly in social science, economics, and "econometrics" (quantitative economics). Clearly, with current International Monetary Fund estimates of the costs of the 2007-2008 subprime crisis, the banking system seems to have lost more on risk taking (from the failures of quantitative risk management) than every penny banks ever earned taking risks. But it was easy to see from the past that the pilot did not have the qualifications to fly the plane and was using the wrong navigation tools: The same happened in 1983 with money center banks losing cumulatively every penny ever made, and in 1991-1992 when the Savings and Loans industry became history.

It appears that financial institutions earn money on transactions (say fees on your mother-in-law's checking account) and lose everything taking risks they don't understand. I want this to stop, and stop now— the current patching by the banking establishment worldwide is akin to using the same doctor to cure the patient when the doctor has a track record of systematically killing them. And this is not limited to banking—I generalize to an entire class of random variables that do not have the structure we thing they have, in which we can be suckers.

And we are beyond suckers: not only, for socio-economic and other nonlinear, complicated variables, we are riding in a bus driven a blindfolded driver, but we refuse to acknowledge it in spite of the evidence, which to me is a pathological problem with academia. After 1998, when a "Nobel-crowned" collection of people (and the crème de la crème of the financial economics establishment) blew up Long Term Capital Management, a hedge fund, because the "scientific" methods they used misestimated the role of the rare event, such methodologies and such claims on understanding risks of rare events should have been discredited. Yet the Fed helped their bailout and exposure to rare events (and model error) patently increased exponentially (as we can see from banks' swelling portfolios of derivatives that we do not understand).

Are we using models of uncertainty to produce certainties?...

"Free money...Just put it on your books and enjoy the money."

Returning to the WaPo series for a moment, yesterday's installment:

For months, several executives at AIG Financial Products had pulled apart the data, looking for flaws in the logic. In phone calls and e-mails, at meetings and on their trading floor, they kept asking themselves in early 1998: Could this be right? What are we missing?

Their debate centered on a consultant's computer model and a new kind of contract known as a credit-default swap. For a fee, the firm essentially would insure a company's corporate debt in case of default. The model showed that these swaps could be a moneymaker for the decade-old firm and its parent, insurance giant AIG, with a 99.85 percent chance of never having to pay out.

The computer model was based on years of historical data about the ups and downs of corporate debt, essentially the bonds that corporations sell to finance their operations. As AIG's top executives and Tom Savage, the 48-year-old Financial Products president, understood the model's projections, the U.S. economy would have to disintegrate into a full-blown depression to trigger the succession of events that would require Financial Products to cover defaults.

If that happened, the holders of swaps would almost certainly be wiped out, so how could they even collect? Financial Products would receive millions of dollars in fees for taking on infinitesimal risk.

The firm's chief operating officer, Joseph Cassano, had studied the model and urged Savage to give the swaps a green light.

"The models suggested that the risk was so remote that the fees were almost free money," Savage said in a recent interview. "Just put it on your books and enjoy the money."

Initially, the credit-default swaps business would amount to a fraction of the half-billion dollars in Financial Products' revenue that year. It didn't seem to them like a major decision and certainly not a turning point.

They were wrong. The firm's entry into credit-default swaps would evolve into insuring more volatile forms of debt, including the mortgage-backed securities that helped fuel the real estate boom now gone bust. It would expose AIG to more than $500 billion in liabilities and entangle dozens of financial institutions on Wall Street and around the world.

When the housing market tanked, a statistically improbable chain of events began to unfold. Provisions in the contracts kicked in, spurring collateral calls on swaps linked to $80 billion in questionable assets, requiring the firm and AIG to come up with billions of dollars in cash. They scrambled for almost a year to stave off the calls, but there were too many deals with too many counterparties.

In September, the Bush administration concluded that AIG's position at the nexus of the deals meant that it could not be allowed to fail, triggering the most expensive rescue of a private company in U.S. history. So far, the government has invested $152 billion in its efforts to save AIG. Federal investigators are sifting the carnage.

Credit-default swaps exemplify the contradictions of modern finance. At a basic level, they serve as insurance, but they aren't regulated as such. They have allowed companies to free up untold amounts of capital that otherwise would be tied up as collateral for loans. They were sold both to reduce risk and, in some cases, to give clients room to take on more risk -- a key component to making money on Wall Street.

But in the end, neither the buyers nor sellers truly understood the enormous risks they were creating. Anyone could sell such a swap, and anyone could buy one, even if he had no stake in the transaction. Some buyers used them to bet against failing companies, prompting a debate among state regulators about whether this type of swap was a form of gambling...

I have a couple of observations. First any empirically-based model purporting to assure "a 99.85 percent chance of never having to pay out" (or any "probability of x") is [1] an estimate (containing a variance component too often ignored or otherwise dismissed), and [2] is beholden to a host of implicit assumptions, chief among them -- beyond the overtly mathematical/statistical -- that "past remains prologue." That the "computer model was based on years of historical data about the ups and downs of corporate debt" could in fact turn out to be irrelevant, for an econometric/risk-cost/benefit model may well be significantly adversely impacted (perhaps fatally so) by both unexamined or poorly understood evolving structural changes in the aggregate economy and (relatedly) large-scale policy changes within the financial regulatory environment.

• Another note regarding the "99.85 percent chance" assertion. I cut my professional teeth in the 1980's in a forensic environmental laboratory in Oak Ridge. In that world, if you put down for the record a quantity such as "99.85," you had better be able to demonstrate to regulators, auditors, and attorneys your empirical ability to distinguish between the bracketing "0.84" and "0.86." Otherwise, you're just naive or blowing smoke. This is known in science as "significant figures rounding," the specs of which were typically written into our contracts, for every analytical parameter.

Unless you've been living in a cave on a South Seas Island for the past decade, you cannot but know what has been the "conservative" political attitude regarding all manner of "regulation" of late. The unfolding upshot of this most recent, pandemic de-regulatory frenzy seems to worsen by the day. The M. Wuerker cartoon below from Politico sums our current debacle up nicely (click the image to enlarge if you wish).
"IT'S ALL JIMMY CARTER'S FAULT"

Depending on your ideological perch location along the political fence line, you can fill in the blank with your favorite whipping boy: "It's all _______________'s fault." (Jimmy Carter, Ronald Reagan, Bill Clinton, Phil Gramm, Alan Greenspan, George W. Bush, etc)

The ever-dour WaPo columnist and Fox News panelist Charles Krauthammer lays the mess on former President Carter's desk:

...While the punch bowl -- Alan Greenspan's extremely low post-Sept. 11 interest rates -- was being held out, few complained about cheap loans and doubling home values. Now all of a sudden everything is the fault of Wall Street malfeasance.

I have little doubt that some, if not many, cases of malfeasance will emerge. But what we conveniently neglect is the fact that much of this crisis was brought upon us by the good intentions of good people.

For decades, starting with Jimmy Carter's Community Reinvestment Act of 1977, there has been bipartisan agreement to use government power to expand homeownership to people who had been shut out for economic reasons or, sometimes, because of racial and ethnic discrimination. What could be a more worthy cause? But it led to tremendous pressure on Fannie Mae and Freddie Mac -- which in turn pressured banks and other lenders -- to extend mortgages to people who were borrowing over their heads. That's called subprime lending. It lies at the root of our current calamity...

While there can indeed be many necessary yet insufficient conditions that can contribute to an eventual conflagration, to be fair, it must be pointed out that Carter's CRA was enacted more than 30 years ago, and, given that, it begs the question to Mr. Krauthammer of just how things could have remained so manageable for so long?

Critics on the left flew all over this type of finger-pointing by the right: 'yeah, if only those undeserving poor hadn't been accorded opportunities for home ownership, we wouldn't now be dealing with this mess.'

The simple truth is that our current mess is not "all" or even primarily any one person's fault, but rather the creeping cumulative result of an increasingly widespread series of deregulatory policy changes, mostly across the past decade, and, if there can be said to be the match that lit the blaze, it has to be the now-infamous 2004 SEC "Net Capital Rule Change."

...Many events in Washington, on Wall Street and elsewhere around the country have led to what has been called the most serious financial crisis since the 1930s. But decisions made at a brief meeting on April 28, 2004, explain why the problems could spin out of control. The agency’s failure to follow through on those decisions also explains why Washington regulators did not see what was coming.

On that bright spring afternoon, the five members of the Securities and Exchange Commission met in a basement hearing room to consider an urgent plea by the big investment banks.

They wanted an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.

The five investment banks led the charge, including Goldman Sachs, which was headed by Henry M. Paulson Jr. Two years later, he left to become Treasury secretary.

A lone dissenter — a software consultant and expert on risk management — weighed in from Indiana with a two-page letter to warn the commission that the move was a grave mistake. He never heard back from Washington.

One commissioner, Harvey J. Goldschmid, questioned the staff about the consequences of the proposed exemption. It would only be available for the largest firms, he was reassuringly told — those with assets greater than $5 billion.

“We’ve said these are the big guys,” Mr. Goldschmid said, provoking nervous laughter, “but that means if anything goes wrong, it’s going to be an awfully big mess.”...

...The proceeding was sparsely attended. None of the major media outlets, including The New York Times, covered it.

After 55 minutes of discussion, which can now be heard on the Web sites of the agency and The Times, the chairman, William H. Donaldson, a veteran Wall Street executive, called for a vote. It was unanimous. The decision, changing what was known as the net capital rule, was completed and published in The Federal Register a few months later.

With that, the five big independent investment firms were unleashed.

In loosening the capital rules, which are supposed to provide a buffer in turbulent times, the agency also decided to rely on the firms’ own computer models for determining the riskiness of investments, essentially outsourcing the job of monitoring risk to the banks themselves [emphasis mine- BG].

Over the following months and years, each of the firms would take advantage of the looser rules. At Bear Stearns, the leverage ratio — a measurement of how much the firm was borrowing compared to its total assets — rose sharply, to 33 to 1. In other words, for every dollar in equity, it had $33 of debt. The ratios at the other firms also rose significantly...

This was an incendiary two-fer: essentially taking the cuffs off of "leveraging" by allowing the Wall Street investment firms to self-report their own modeling estimates of their risk exposure! All part of the GW Bush-era deregulation-uber-alles policy religion. Well, we've seen how well internal, proprietary risk modeling worked for AIG.
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THE OPIUM ECONOMY
(Originally posted back in September on my music blog)

Below, NASA satellite image just taken of the U.S. economy.
 Other People's Irresistibly Undervalued Money.

My main 401k account netted about a 16% return in 2006 (16.2% to be exact). Not bad, 'eh, A 16% ROI? ("Return On Investment") Can't complain about that, really, given that my fund allocation was relatively conservative in the aggregate.

Well, consider that, also at the time, assuming you had a decent FICO score, you could borrow OPM (Other Peoples' Money) at around 8%.

So, hmmm, lessee, I take $100,000 of my direct liquid asset money and invest it in a fund or stock that returns $16,000 in a year (16%), I'm pretty pleased, if naively so.

But -- what if I borrowed $90,000 at a cost of 8% APR interest and threw in only $10,000 of my own cash? The OPM cost me $7,200 (90 grand at 8%), which I have to deduct from my $16,000 gross return. So, my net return after paying off the loan is $8,800.

Well, effectively, my ROI is my $8,800 net profit divided by the ten thousand of my own dough that I put at risk, or 88% -- 5 and a half times the ROI I'd have gotten using my own cash (and, during the period, I still had unrestricted use of my remaining 90 grand for other things).

Hell, why not borrow it all, (hey, while that might be illegal, nobody's apparently paying attention) and make a clean $8,000 for having put zero of my own dollars at risk? My lender gets a mundane ROI of 8%, while my "net" return is truly off-the-scale, given that I've incurred no risk whatsoever. Free money.

It's called "leverage." By astutely "working the spread" between what you pay for OPM and what you can earn from OPM, you can accrue up to infinite multiples of profit relative to the prospects of the prudent chump risking solely his or her own cash in search of maximal return.

Now, at the macroeconomic level, when the absolute OPM sums tossed about get really large -- e.g., in the multiple nine figures range or larger -- the spread can be much, much thinner and still provide acceptable nominal net profits, replete with those dizzying brokerage and bank CEO compensation packages.

It all works wonderfully well.

Until it no longer does (i.e., once the ROI goes negative, as it eventually must, just as is the inevitable case of one slavishly habituated to real opium).

The latter is essentially where we are in the fall of 2008. The OPIUM supply is gone, and is unlikely to return for quite some time.
 "My lender gets a mundane ROI of 8%"?

Why, you ask, would a lender even do that? Well, [1] the lenders are pretty much recursively using OPM as well, so they got no substantive skin in the game, and [2] as soon as the ink is on the downside of damp on your loan contract, they're gonna sell the loan to someone else! Break off some nice little setup and transaction fees for your trouble, cha-ching, and wash your hands of the long-term risk. The phrase is "securitization pooling," i.e., take a bunch of loan contracts, bundle 'em all up as a "security," and push 'em out on to Wall Street.

Someone else then becomes (for a little while) the proud owner of an "asset." Against which -- guess -- they too can borrow. Lather, Rinse, Repeat.

And so it goes.

Until it no longer can. Music stops, someone is left without a chair. Well, actually, many, many people are left without chairs.

A circumstance explicitly extant as of September 22nd, 2008. The logical, inexorable upshot of the "de-regulation uber alles" mentality of the past decade.
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THE DOUBLE-EDGED SWORD OF LEVERAGE
  
An article in The Motley Fool provides a quick illustration of the potential for trouble:
  
And that's just assuming a 2% cost of borrowed money. I know a young investment speculator -- a former co-worker and an otherwise bright analyst -- who has routinely taken credit card cash advances (which typically have APRs ranging from 18% to 30%) to help leverage his real estate and stock deals!

To repeat: "The thing that made leverage so seductive to the investment banks, though, is what you can see on the right-hand side of that table. Even a small gain can be magnified, many times over, to turn a modest return on investment into a substantial return on equity. And at the end of the day, it was the return on equity that paid the investment bankers' obscene bonuses..."

The article continues:

"With those perverse incentives, it starts to get pretty obvious why we've floated from bubble (tech stocks) to bubble (housing) to bubble (commodities) over the past decade. When even small real gains can be translated into gargantuan paydays through leverage, what an asset is really worth matters far less than what direction it is moving."

"Thanks to that effect, investment bankers were willing to pay too much for assets because they could leverage their way to tremendous personal gains. That was a neat trick while it worked. When the credit bubble itself burst, however, it forced them to unwind the bets they had made with all that cheap leveraged cash..."

Yep. No more OPIUM.

For now anyway -- until the next bout of financial regulatory amnesia sets in to spur the next bubble/fraud frenzy. Will we ever learn?

"The more leverage you take, the better you do; the better you do, the more leverage you take. A critical part of a bubble is the reinforcement you get for your very optimistic view from those around you."

"The bursting of [this] bubble will be across all countries and all assets, with the probable exception of high-grade bonds. Since no similar global event has occurred before, the stresses to the system are likely to be unexpected. All of this is likely to depress confidence and lower economic activity."

- Jeremy Grantham

That was 2007. Boy was he ever right.
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A PARTING THOUGHT ON 'LEVERAGE'

If I put down $10,000 cash on the purchase of a $200,000 home, I am "leveraged" at a ratio of 19:1. Similarly, if my wife's cousin Scotty plops down five grand on the purchase of a new $100,000 John Deere tractor for the family farm in northern Alabama, he too is equivalently leveraged. Yes, of course, without both short and long-term credit leveraging, our economy simply could not function.

But, prudently leveraged purchases of tangible hard assets such as housing and productive capital business equipment (rationally vetted and priced for the risk of loan default) are a far cry from the wholesale unsecured and increasingly unregulated leveraging of inscrutable (and ultimately intangible) iteratively aggregated-disaggregated-reaggregated debt instruments such as the built-for-flipping-and-fees securities that have now put our economy in the ditch.

ONE INTERESTING IDEA

Obviously, coherent financial system "regulation" is going to have to come back in vogue. One intriguing tax policy tactic as part of the regulatory mix may well have merit. As proffered recently by NY Times Columnist Bob Herbert:

...The economy is in a precipitous downturn and no one, on the left or right, is advocating tax increases that would jeopardize a recovery...

...At some point, however, someone is going to have to talk about raising revenue. The dreaded T-word is going to come up: taxes.

Well, there’s a good idea floating around that takes its cue from the legendary Willie Sutton. Why not go where the money is?

The economist Dean Baker is a strong advocate of a financial transactions tax. This would impose a small fee — ranging up to, say, 0.25 percent — on the sale or transfer of stocks, bonds and other financial assets, including the seemingly endless variety of exotic financial instruments that have been in the news so much lately.

According to Mr. Baker, the co-director of the Center for Economic and Policy Research in Washington, the fees would raise a ton of money, perhaps $100 billion or more annually — money that the government sorely needs.

But there’s another intriguing element to the proposal. While the fees would be a trivial expense for what the general public tends to think of as ordinary traders — people investing in stocks, bonds or other assets for some reasonable period of time — they would amount to a much heavier lift for speculators, the folks who bring a manic quality to the markets, who treat it like a casino.

“It raises money in a way that comes primarily at the expense of speculation,” said Mr. Baker. “The fees would be a considerable expense for someone who is buying futures, or a stock, or any asset at 2 o’clock and then selling it at 3. The more you trade, the more you pay.

“For the typical person holding stock, who is planning to hold it for a long period of time, paying the quarter of one percent on a trade is just not that big a deal.”

The fees, though small, could amount to a big deal for speculators because in addition to the volume of their trades they often make their money on very small margins. Someone who buys an asset and then sells it an hour later at a one percent appreciation might feel quite pleased. He or she would be less pleased at having to pay a quarter-percent fee to purchase the asset in the first place and then another quarter percent to sell it.

This, according to Mr. Baker, is part of the beauty of the transfer tax; it tends to curb at least some speculation. “It’s a very progressive tax,” he said, “that discourages nonproductive activity.”...

I like it. Don't call it a "tax," simply call it a "fee." After all -- recall? -- "the best things in life are FEE!" 
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"UNWIND" PROBLEMS: WHO ACTUALLY NOW OWNS THIS CRAP DEBT?

May 2008: CBS "60 Minutes" ran a segment entitled "House Of Cards: The Mortgage Mess" illustrating some of the problems emerging in the wake of the securitized-mortgages meltdown.

2013 link rot update. The original video has been removed from YouTube, but is now available if you have a Paramount+ subscription

Salient transcript excerpt:

...The Wall Street and foreign investors are now stuck with the millions of distressed properties on Sean O’Toole's map, the unsold condos in Miami, the unfinished apartments on the Vegas Strip, the developments in Atlanta that are sitting idle and the thousand stucco houses in Stockton. Not even Kevin Moran, who has copies of the foreclosed mortgages, can figure out who exactly owns them [emphasis mine -BG].

"That’s the fascinating part of this whole debacle we’re in. Mortgages are sold in mortgage backed securities, so they’re pooled. I’ve seen everything from some of the largest financial institutions in the country, and you see 'Deutsche Bank' in a series and a series of numbers and letters to a mortgage pool," he says.

The pools are part and parcel of those high-yield mortgage backed securities everyone gobbled up a few years ago, and are now stuck in the windpipe of the world's financial system. No one wants to buy them, so no one can sell them.

"Bonds marked triple-A are now quoted at 50 cents to the dollar, 40 cents on the dollar. Some of them, much less," Grant says [Jim Grant, the editor of "Grant's Interest Rate Observer" -BG].

"How much on the dollar, do ya think?" Kroft asks.

"Some of them are worth nothing on the dollar. Nothing on the dollar. This is the worst thing that has happened to Wall Street in a long time," Grant says.

Asked how many of these securities are out there, Grant says, "A trillion with a T-plus."

Asked who bought them and owns them, Grant says, "You know, state pension funds, the hedge funds bought them. Foreign central banks own some of these things, if you please. So the ownership is very widely dispersed, which accounts for the general anxiety, and the persistence of anxiety."...

Yep: "Not even Kevin Moran, who has copies of the foreclosed mortgages, can figure out who exactly owns them." Exactly. Who can be determined to be the sole, clear-titled "holder in due course" regarding any single debt contract bundled within these pooled "securities" in such circumstances?

More recently, the seemingly intractable legal "unwind" problem is further highlighted in an MSNBC article:

'Angel' of foreclosure defense bedevils lenders
Florida attorney trains hundreds of others to help troubled borrowers
By Mike Stuckey
Senior news editor
updated 3:39 a.m. PT, Fri., Dec. 19, 2008

[April] Charney, a lawyer with the Jacksonville Area Legal Aid agency, is quickly developing a national reputation as a champion of homeowners facing foreclosure and a serious adversary for those attempting to take possession of those homes. Her encyclopedic knowledge of contract law, debt-collection practice, securitized mortgages, the trusts that hold them and the agreements that govern the trusts have put her at the forefront of the rapidly expanding specialty of foreclosure defense...

...Charney said her crusade was born out of experience. Over and over again, she said, in her cases and those of other attorneys she met, she found sloppiness, fraud and outright criminality in the nation’s mortgage lending industry. Regardless of why her clients have been unable to pay their mortgages, she maintains that nobody deserves to lose a home to the unethical and illegal foreclosure procedures that she claims are now being used by many banks and loan servicers...

...A University of Miami law school graduate who spent years in private practice in Arkansas and worked in other legal aid offices before coming to Jacksonville four years ago, Charney said she became an expert on lending law when her caseload of foreclosures increased and she began to notice a number of disturbing trends that have yielded her key defense strategies.

First, because of the way mortgages have been securitized, it’s often unclear who actually owns the debt, she said. “What we see is that systematically, the originating lenders only pledged these loans and didn’t actually transfer them” to the trusts that are supposed to hold them and issue the securities, she explained.

But only the true debt owner has the legal standing to be a plaintiff in a foreclosure, she continued. “That’s first-year law school stuff. If you’re Joe and the debt doesn’t belong to you, it belongs to Marjorie, then Marjorie better be in court, not Joe. Don’t come in as Joe and tell me you have the right to be there when you know full well you don’t.”

Sketchy documentationYet, time and again, loan servicers and others have sought plaintiff status, often by using affidavits stating that the actual notes had been lost, she said. “I’ve seen paperwork filed by lawyers saying, ‘We anticipate assignment’” of the debt, she said with a scoff.

And the loan originators can’t appear in court and claim the right to foreclose because they would be in violation of securities laws for not transferring the loan to the trust when they were supposed to, she said.

Making an issue out of the actual ownership of the securitized title might strike some as a shameless stalling tactic aimed at abetting a debtor who, after all, owes the money. But Charney said that if such basic legalities aren’t adhered to, a homeowner could pay his or her way out of a foreclosure jam only to wind up in another when a new plaintiff emerges claiming to own the debt. She described cases in which homeowners have been sued for foreclosure by two different trusts, each claiming they owned their house, and cases where trusts have been sent documents on the same case by two different servicers...

It should be (but apparently is still largely not) A Blinding Glimpse Of The Obvious that financial and market affairs have to be intelligently regulated. Such regulation can take (peaceably) only either the form of [1] rational and coherent proactive laws and their extensible administrative regulations, or, [2] years of en masse retroactive litigation (that usually does little more than provide decades of continuing employment for tort laywers).
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REWIND: AN '80'S RUMINATION

I am acutely reminded of the Reagan-era S&L debacle. President Reagan also famously hated government regulation, and his administration did its best to unleash unfettered "free market" forces across the entire economy, including especially the financial domain. Savings and Loan institutions ("S&L's") previously comprising a relatively sleepy segment of the financial sector, had once been known as "The 3-6-3 Club" -- i.e., buy money at 3% (deposits), rent it back out at 6% (mostly residential mortgage loans), and hit the first tee at the country club golf course by 3 pm.

This changed dramatically under deregulation. First, S&L ownership rules changed to permit self-interested parties such as residential and commercial real estate developers to gain control of S&L's. Second, S&L's were permitted to traffick in "brokered deposits" -- basically bundles of deposits traded back and forth in search of the highest short-term return. It wasn't long before the phrase "$100k hot blocks" became a financial commonplace.

In essence, "hot blocks" were in many ways similar to today's bundled debt securities (despite being "liabilities" rather than "assets"). The "$100k" part of the moniker referred to the $100,000 federal deposit insurance ceiling backed by the now-defunct FSLIC (Federal Savings and Loan Insurance Corporation, similar in government deposit insuror function to that of the FDIC that subsequently inherited it).

Freed from regulatory oversight, S&L's funded all manner of dubious lending and development using monies ultimately backed by the unwitting taxpayers in the event of default.

And that is precisely what obtained. A seminal recounting of this sorry tale is found in the best-selling and award-winning book by Steven Pizzo et al: "Inside Job: The Looting of America's Savings and Loans."In the end, it did not matter if egregiously unneeded housing tracts, shopping malls, and office parks got built by S&L owner/developers and their cronies. Everyone dined euphorically on massive buffett feasts of deal and fee money while it lasted. And, then the government finally had to step in to bail things out once the wheels came off.

Sound familiar?

A PERSONAL S&L CODA

Living in Knoxville at the time, I was periphatically personally acquainted with the Tennessee banking brothers Jake and Cecil H. Butcher, Jr. Jake was the President of United America Bank (UAB), whose breathtakingly rapid collapse was at the time the largest bank failure in the nation (among other things, he'd "bet the farm" on the 1982 Knoxville World's Fair. It was a really bad bet).

Brother Cecil parlayed his initially tiny Savings & Loan "City & County Bank" (C&C Bank) into a highly leveraged (and short-lived) financial empire using a classic Reagan era no-regulation M.O. -- buy voting control of an S&L with borrowed money, use your new Board control to authorize buying yet another institution, disperse loans from the newly acquired entity... Lather, Rinse, Repeat.

Beyond the recursive funding of S&L takeovers and sweetheart conflict-of-interest developer loans was, to me, anyway, an interesting and telling aside.

In the late 1970's I had founded two Tennessee private corporations, one a Sub-S, the other a "C-Corp," filing all of the setup paperwork myself with the IRS and the Corporate Filings Office of the TN Secretary of State in Nashville. Among the TN attestation requirements was that your corporation had at least the minimum requisite $1,000 of tangible startup assets (no subjective, nebulous, and overstated-value "Goodwill" or other malarkey). I was scrupulous with respect to adherence to the startup asset requirements

In the wake of the UAB and C&C failures, it came to light that more than two hundred TN corporations, all of whose principals were Butcher kin, all had the same West Kingston Pike address in W. Knoxville -- that of a C&C Bank building. Moreover, all of these no-capital-asset paper shell corporations had been accorded -- guess -- six and seven-figure unsecured loans from the various C&C banks.

NO ONE in the TN Secretary of State's office found this curious at the outset?

I'm not sure how much of any of these fraudulently dispersed funds were ever recovered, but it's likely that a good bit of the money disappeared forever into the financial ether.

And, here we are today, almost 30 years later, and we seem to have learned nothing.

CURRENT DAY MICRO-MICRO MADOFF CASE IN POINT

While Google-searching "Madoff" news developments the other day I ran across this story by Keriann Lynch of The Flathead Beacon:

SUMMIT OWNERS USE CLIENTS’ MONEY TO FUND OWNERS’ ENDEAVORS
Exchange Business Closes, Prompts Criminal Investigation
By Keriann Lynch , 01-13-09

An Oregon-based firm specializing in tax-deferred land deals collapsed last month after using customers’ money to fund its owners’ endeavors, leaving at least one local man out more than $1 million and affecting untold more here.

Summit 1031 Exchange closed its doors and filed for Chapter 11 bankruptcy in late December after announcing it has only about $13 million on hand of the $27 million it owes its clients. Summit had branch offices in eight western cities, including Kalispell.

The shortage, according to a posting on the company’s Web site, is the result of loans Summit made to Inland Capital Corporation, a company owned by the same people who own and run Summit. Inland, in turn, loaned the money to various individuals and companies that were involved in real estate investments located primarily in central Oregon.

“They’re supposed to be a trustee and they lent themselves money, which is not kosher, and now they don’t have it available for depositors,” Rolland Andrews, a local real estate professional, said. Andrews is one of Summit’s largest creditors; the company owes him about $1.1 million.

“It’s basically the same thing the guy (Bernard Madoff) they just handcuffed and had all over the front pages did,” he added...

Yeah. I rest this part of my case. We've learned nothing. Maybe things will change for the better with a new administration. Maybe.
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"IN THE GAP BETWEEN PERCEPTION AND REALITY, THERE'S MONEY TO BE MADE"

That quote (utterly embodying the phrase "Moral Hazard") is ascribed to the former "Junk Bond King" Michael Milken (see "The Predators' Ball: the inside story of Drexel Burnham and the rise of the junk bond raiders" by Connie Bruck). And, increasingly, the perceptual gap has seemed to become unbridgeable, given the inscrutable nature of today's financial system and its arcane processes and instruments. Consider this lament by best-selling author Geneen Roth, in her recent Salon.com article "I was fleeced by Madoff":

"I often asked Richard, the head of our feeder fund, how Madoff made such consistently good returns. Although Richard tried to explain it to me, it was clear he didn't know, either, because I'd leave our meetings still unable to explain to anyone else how it worked..."

Well, consider this little excerpt of recent MEGO financial jargon pertaining to the post-crash doings of the now-infamously bailed out AIG:

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 8-K
CURRENT REPORT
Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
Date of report (Date of earliest event reported): November 25, 2008
AMERICAN INTERNATIONAL GROUP, INC.

Item 1.01. Entry into a Material Definitive Agreement

On November 25, 2008, American International Group, Inc. (“AIG”) entered into a Master Investment and Credit Agreement (the “Agreement”) with the Federal Reserve Bank of New York (the “NY Fed”), Maiden Lane III LLC (“ML III”), and The Bank of New York Mellon, to establish financing arrangements, through ML III, to fund the purchase of multi-sector collateralized debt obligations (“Multi-Sector CDOs”) underlying or related to credit default swaps and similar derivative instruments (“CDS”) written by AIG Financial Products Corp. (“AIGFP”) in connection with the termination of such CDS.

Pursuant to the Agreement, the NY Fed, as senior lender, has made available to ML III a term loan facility (the “Senior Loan”) in an aggregate amount up to approximately $30.0 billion. The Senior Loan bears interest at one-month LIBOR plus 1.00 percent and has a six-year expected term, subject to extension by the NY Fed at its sole discretion.

AIG has contributed $5.0 billion for an equity interest in ML III. The equity interest will accrue distributions at a rate per annum equal to one-month LIBOR plus 3.00 percent. Accrued but unpaid distributions on the equity interest will be compounded monthly. AIG’s rights to payment from ML III are fully subordinated and junior in right of payment to all principal of, and interest on, the Senior Loan. The creditors of ML III will not have recourse to AIG for ML III’s obligations, although AIG will be exposed to losses on the portfolio of Multi-Sector CDOs held by ML III up to the full amount of AIG’s equity interest in ML III.

Upon payment in full of the Senior Loan and AIG’s equity interest in ML III, all remaining amounts received by ML III will be paid 67 percent to the NY Fed as contingent interest and 33 percent to AIG as contingent distributions on its equity interest.

The NY Fed is the controlling party and managing member of ML III under the transaction documents for so long as the NY Fed is owed any amounts under the transaction documents, and AIG will not have any control rights over ML III or under the transaction documents.

AIGFP, ML III and the NY Fed have entered into agreements with AIGFP’s CDS counterparties to terminate approximately $53.5 billion notional amount of CDS and purchase the related Multi-Sector CDOs. Of these, CDOs with a principal amount of approximately $46.1 billion settled on November 25, 2008 and a corresponding notional amount of CDS were terminated. Settlement on the remaining $7.4 billion notional amount of CDS is contingent upon the ability of the related counterparty to obtain the related Multi-Sector CDOs and thereby settle with ML III and terminate such CDS with AIGFP. Pending such settlement, which AIG expects to occur by year-end, the collateral posting provisions relating to these CDS have been suspended such that additional collateral will not be required of AIGFP nor will posted collateral be returned to AIGFP. If a given counterparty is ultimately unable to obtain the related Multi-Sector CDOs, the related CDS will not terminate and the relevant collateral posting provisions will resume. In such a case, AIG will continue to bear market risk and the risk of adverse changes in collateral posting requirements relating to these CDS that do not terminate and could incur additional unrealized market valuation losses.

With respect to the approximately $11.2 billion of exposure to Multi-Sector CDOs as to which AIGFP, ML III and the NY Fed have not executed agreements, AIG and the NY Fed are working to structure the termination of the related CDS and/or the purchase by ML III of the related Multi-Sector CDOs. Unless this exposure is terminated, AIG will continue to bear market risk and the risk of adverse changes in collateral posting requirements relating to these CDS and could incur additional unrealized market valuation losses with respect to these CDS.

On November 25, 2008, ML III bought approximately $46.1 billion in par amount of Multi-Sector CDOs through a net payment to CDS counterparties of approximately $20.1 billion, and AIGFP terminated the related CDS with the same notional amount. The aggregate cost of the purchases and terminations was funded through approximately $15.1 billion of borrowings under the Senior Loan, the surrender by AIGFP of approximately $25.9 billion of collateral previously posted by AIGFP to CDS counterparties in respect of the terminated CDS and AIG’s equity investment in ML III of $5.0 billion.

AIGFP has entered into a Shortfall Agreement, dated November 25, 2008 (the “Shortfall Agreement”), with ML III relating to the approximately $53.5 billion of Multi-Sector CDO exposure covered by agreements with CDS counterparties under which (i) AIGFP must make a payment to ML III to the extent the excess of the notional amount of the CDS being terminated over the market value as of October 31, 2008 of the related Multi-Sector CDOs is greater than the collateral previously posted by AIGFP with respect to such CDS, and (ii) ML III must make a payment to AIGFP to the extent the amount of such posted collateral exceeds such excess. AIGFP was not required to make any payments under the Shortfall Agreement with respect to ML III’s initial purchase of the approximately $46.1 billion of Multi-Sector CDOs.

The summary of the terms of the Agreement and the Shortfall Agreement are qualified in their entirety by reference to the terms of the Agreement and the Shortfall Agreement, which are filed as exhibits 10.1 and 10.2 to this Form 8-K and incorporated by reference into this Item 1.01.
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Well, I'm a reasonably intelligent person with a Master's degree and more than 20 years' experience spanning a variety of business domains (including credit risk modeling), but this kind stuff leaves me bamboozled.

That's what they 'bank' on. We among The Great Unwashed (including, um, the regulators) can never hope to fathom such financial "sophistication," better to simply leave these things to the "experts."

Part of a short email note I sent to Ms. Roth in the wake of reading her lament:

You oughta read some Taleb, the "Fooled by Randomness" guy.

Part of the problem I see (in agreement with Taleb) is that nobody really understood much of any of this, but once you get to a certain level of "expertise" in the financial world, you simply cannot admit to being clueless. So, it becomes a mileau of ongoing mutual bullshit (ever read the book "On Bullshit"?), a world of org-chart climbing pseudo-erudite, jargon-spewing poseurs. And, maybe nobody understood things because there was nothing much rational to understand. I guess the one encapsulating and overarching operative word (extending far beyond the likes of Madoff) is "fraud."

Best regards,

Bobby Gladd

While at the credit card bank, I once interviewed a pleasant young hire prospect (playing house "liberal-arts-guy" dumb), a woman with a Master's degree in Statistics. Offhandedly, I asked her to explain to me, in plain plebian English, the concept of "Standard Deviation."

She couldn't do it. She haltingly gave me all the Stats textbook jargon: "Root Mean Squared (RMS) Deviation," the "Square Root of The Mean Squared Deviation, corrected for degrees of freedom" blah, blah, blah...

I dropped the line of questioning.

OK. The Standard Deviation is simply the "average" or "expected" variation around an "average." You calculate an arithmetic average. Unless each value is identical, there is variability. The Standard Deviation -- beneath the hood of all the Scary Greek Shit -- is simply the amount of variation to "expect," "on average."

We hired her anyway. It wasn't my call. She lasted about 3 months, did a few banal yet aesthetically pleasing Excel sheet graphs and Powerpoint assemblages, and then moved on to inflict her thoroughly academically pedigree'd ignorance elsewhere.

Read Taleb. Closely. Both of his bracing books ("Fooled by Randomness" and "The Black Swan"), and all of his essays and OpEds. I am squarely a "Talebist."
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CLOSING THOUGHTSWe've witnessed some (depressingly) amazing things during 2008 (and now 2009) as our economy has corkscrewed into the ground. The collapse, closure, and sale of WAMU (Washington Mutual) to JP Morgan Chase back in September stands out emblematically to me (among a rogue's gallery of salient others). Subtract their deposits ("liabilities") from their nominal "assets" at the time, divide the remainder into the reported sale price of $1.9 billion, and you get ~1.6 cents on the dollar: classic "Bad Paper," roughly a net-wash estimate of the true par value of WAMU's net assets to the buyer. We have been living in a financial dream world for quite some time now. It is by no means clear at this point as to how all of this will play out.

On "regulation": I have worked throughout my entire white collar career life within highly regulated environments: [1] environmental radiation analytical science (DOE, EPA et al); [2] industrial diagnostics (OSHA et al); [2] health care (mainly HHS/CMMS); and finance (OCC, FDIC). While I cannot but agree to a great extent with many of the the observations of long-standing regulatory critics such as Philip K. Howard ("The Death of Common Sense: How Law is Suffocating America"), notwithstanding, a valid criticism of mindless regulatory excess does not constitute a cogent argument axiomatically favoring its "perfectionism fallacy" reciprocal -- that all regulation is beyond the utilitarian and ethical pale. I return to a fundamental assertion. Assuming you do not favor a might-makes-right / oligarchic / gated community / tribal warlord social structure, you have a choice:

1. proactive, coherent, commonsensical law and regulation, or;
2. reactive (and mostly problematic) post-hoc attempts to secure remediative justice via a court system.

I take it as a given that the difficult work of a free, self-regulating society is never done -- Eternal Vigilance being the ongoing price of liberty and the pursuit of happiness. We have much work to do.

One question we would do well to clarify in political consensus: What, indeed, is the proper ethical function of a "market"? Simply that of an end to itself, a bare-knuckles arena inexorably favoring the rapaciously fleet of mind in winner-take-all, zero sum game acquisitive fashion? Or, is it properly simply a means to the end of economic and social justice (however imperfectly and transiently defined) for all, to the extent practicable? I find it unreflectively naive in the extreme that so many self-described "law-and-order conservatives" reflexively rail against ordinary street crime and call for the most draconian punishments while in the next breath decrying all manner of commercial regulation. We have by now seen in the most glaring detail what mutual "enlightened self-interest" has gotten us in the past decade's overwhelmingly unregulated financial markets. Envision the likely upshot of similarly deregulated food, pharmaceutical, transportation, and product safety. Can you really argue with a straight face that the mere threat of post hoc judicial sanction will suffice to rein in negligence and outright venal criminality?

The very notion is absurd a priori.

POSTSCRIPT

"The firm made money, and the broker made money. Two outa three ain't bad."
- Michael Lewis

One of my long-time favorite writers on financial markets is Michael Lewis, author of -- most notably -- the hilariously revealing, self-deprecating, and bracingly cynical Inside-Wall-Street-Baseball book "Liar's Poker."I highly recommend his recent lengthy Portfolio.com market crash post-mortem article "The End."

...In the two decades since [the publication of Liar's Poker], I had been waiting for the end of Wall Street. The outrageous bonuses, the slender returns to shareholders, the never-ending scandals, the bursting of the internet bubble, the crisis following the collapse of Long-Term Capital Management: Over and over again, the big Wall Street investment banks would be, in some narrow way, discredited. Yet they just kept on growing, along with the sums of money that they doled out to 26-year-olds to perform tasks of no obvious social utility. The rebellion by American youth against the money culture never happened. Why bother to overturn your parents’ world when you can buy it, slice it up into tranches, and sell off the pieces?...

...There’s a long list of people who now say they saw it coming all along but a far shorter one of people who actually did. Of those, even fewer had the nerve to bet on their vision. It’s not easy to stand apart from mass hysteria—to believe that most of what’s in the financial news is wrong or distorted, to believe that most important financial people are either lying or deluded—without actually being insane. A handful of people had been inside the black box, understood how it worked, and bet on it blowing up. Whitney rattled off a list with a half-dozen names on it. At the top was Steve Eisman...

...the scarcity of truly crappy subprime-mortgage bonds no longer mattered. The big Wall Street firms had just made it possible to short even the tiniest and most obscure subprime-mortgage-backed bond by creating, in effect, a market of side bets. Instead of shorting the actual BBB bond, you could now enter into an agreement for a credit-default swap with Deutsche Bank or Goldman Sachs. It cost money to make this side bet, but nothing like what it cost to short the stocks, and the upside was far greater. The arrangement bore the same relation to actual finance as fantasy football bears to the N.F.L. Eisman was perplexed in particular about why Wall Street firms would be coming to him and asking him to sell short. “What Lippman did, to his credit, was he came around several times to me and said, ‘Short this market,’ ” Eisman says. “In my entire life, I never saw a sell-side guy come in and say, ‘Short my market.’”

And short Eisman did—then he tried to get his mind around what he’d just done so he could do it better. He’d call over to a big firm and ask for a list of mortgage bonds from all over the country. The juiciest shorts—the bonds ultimately backed by the mortgages most likely to default—had several characteristics. They’d be in what Wall Street people were now calling the sand states: Arizona, California, Florida, Nevada. The loans would have been made by one of the more dubious mortgage lenders; Long Beach Financial, wholly owned by Washington Mutual, was a great example. Long Beach Financial was moving money out the door as fast as it could, few questions asked, in loans built to self-destruct. It specialized in asking home­owners with bad credit and no proof of income to put no money down and defer interest payments for as long as possible. In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $720,000.

More generally, the subprime market tapped a tranche of the American public that did not typically have anything to do with Wall Street. Lenders were making loans to people who, based on their credit ratings, were less creditworthy than 71 percent of the population. Eisman knew some of these people. One day, his housekeeper, a South American woman, told him that she was planning to buy a townhouse in Queens. “The price was absurd, and they were giving her a low-down-payment option-ARM,” says Eisman, who talked her into taking out a conventional fixed-rate mortgage. Next, the baby nurse he’d hired back in 1997 to take care of his newborn twin daughters phoned him. “She was this lovely woman from Jamaica,” he says. “One day she calls me and says she and her sister own five townhouses in Queens. I said, ‘How did that happen?’ ” It happened because after they bought the first one and its value rose, the lenders came and suggested they refinance and take out $250,000, which they used to buy another one. Then the price of that one rose too, and they repeated the experiment. “By the time they were done,” Eisman says, “they owned five of them, the market was falling, and they couldn’t make any of the payments.” 

In retrospect, pretty much all of the riskiest subprime-backed bonds were worth betting against; they would all one day be worth zero. But at the time Eisman began to do it, in the fall of 2006, that wasn’t clear. He and his team set out to find the smelliest pile of loans they could so that they could make side bets against them with Goldman Sachs or Deutsche Bank. What they were doing, oddly enough, was the analysis of subprime lending that should have been done before the loans were made: Which poor Americans were likely to jump which way with their finances? How much did home prices need to fall for these loans to blow up? (It turned out they didn’t have to fall; they merely needed to stay flat.)...

Read the entire article, carefully. "Tranche Warfare" succinctly explained indeed. The mopping-up operations will go on for years, perhaps decades.

 

 

MY FOLLOW-UP POST "THE DUKES OF MORAL HAZARD."

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