Where the Undead are Buried

Like many, I found the recent turmoil in the financial markets both fascinating and puzzling. What happened, why, and especially, since everybody and their brother saw this particular train coming from a million miles away, why did markets seemingly get caught unawares?

It seems that asset price bubbles are not exactly new phenomena in the world of finance (dot com, 1929, South Seas, tulip mania), and that people always see them coming, and that most still get caught in the avalanche. Partly that is kind of a deer in the headlights effect - people can't figure out which way to run.

I saw this (or something) coming, for example, and took much of my 401K out of the S&P index fund - and put it in Euro-Pacific indices.

Doh!

Part of it is greed, part is stupidity, and, I'm guessing, part of it is old-fashioned swindle.

So why the panic? Gillian Tett, writing in the Financial Times had a pretty clear view back in May.

Once upon a time, it was presumed that the actions of central bankers controlled behaviour in the risky lending world. For if central banks jacked up rates, the argument went, the cost of borrowing would rise - making it harder for highly leveraged groups, such as buy-out funds, to snap up deals.

Now, however, this argument is looking a touch quaint. In the last couple of years, Western central banks have indeed been raising rates. Meanwhile, investors have had to contend with minor matters such as surging oil prices, Middle East turmoil, and now subprime woes. Yet, the credit party has continued, seemingly oblivious - triggering a buy-out frenzy.

So could anything else take the punchbowl away? Some bankers are now starting to mutter quietly about one risk that is not often discussed - the collateralised debt obligation world. For though the CDOs certainly do not have the debating glamour of a small war or central bank, they have helped power the credit bubble. Thus the question now is whether trends in this sector could also now deliver a jolt.

First, however, a quick finance recap: a CDO essentially is a pool of debt assets, in which investors take stakes with different levels of risk, a little like the way mutual funds operate in the equity world. They have existed for many years, particularly in the US. However, in the last couple of years the sector has exploded, particularly in Europe, where collateralised loan obligations - which buy risky loans -- have spread like wildfire.

This, unsurprisingly, has roiled credit markets. After all, if a hundred new well-funded mutual funds suddenly appeared, it would not be hard to imagine the impact on stock markets. So, too, the sudden proliferation of asset-hungry CDOs has raised debt prices, making borrowing increasingly cheaper for buy-out groups. Last week alone, for example, another $4.5bn new CDOs came on tap wanting to buy assets - and another $57.7bn are now in the pipeline, according to JPMorgan.

But now there are ominous rumblings from CDO land. Rumours are circulating that some funds have suffered losses from the recent subprime debacle. While no funds have folded as a result, this has the potential to dent iconfidence (or at least prompt them to demand a higher price when they invest in these funds). Indeed, I am told some smart money is already furtively creating vehicles designed to feed on sickly CLOs. This week in London, Park Square Capital created a new credit fund which publicly declared that it expects to see a CLO shakeout - and prey on this.

There is more, and anybody who care about such things should read Gillian Tett, because she combines deep understanding with exceptional clarity.

So far so good. Some people or institutions bought some stuff that might not be worth much and now might get burned - we might even have a few billionaires fall back to Earth. Why is that a big deal?

The problem seems to be that the new financial instruments created in recent times are so opaque that nobody really knows where the bodies are buried. Brad Setser takes a look:

The process that turned subprime mortgages into triple AAA rated securities is, by now, pretty well known. Rich Bookstaber (his blog is here) describes the process nicely.

Here's the recipe for a CDO: you package a bunch of low-rated debt like subprime mortgages and then break the package into pieces, called tranches. Then, you pay to play. Some of the pieces are the first in line to get hit by any defaults, so they offer relatively high yields; others are last to get hit, with correspondingly lower yields. The alchemy begins when rating agencies such as Standard & Poor's and Fitch Ratings wave their magic wand over these top tranches and declare them to be a golden AAA rated. Top shelf. If you want to own AAA debt, CDOs have been about the only place to go; hardly any corporation can muster the credit worthiness to garner an AAA rating anymore. Here's where the potion gets its poison potential. Some individual parts of CDOs are about as base as bonds can be — some are not even investment grade. The assumption has been that even if the toxic waste bonds really stink, the quality tranches can keep the CDO above water. And life goes on.

The problem is that CDOs were untested; there was not much history to suggest CDOs would behave the same way as AAA corporate bonds.

Nouriel [Roubini] is characteristically more blunt. He concludes a recent post on the securitization of subprime lending by noting:

That “toxic waste” of unpriceable and uncertain junk and zombie corpses is now emerging in the most unlikely places in the financial markets.

Who should we blame? I like the choice of Joseph Stiglitz, a Nobel laureate in economics and former Chairman of the Council of Economic Advisors. Via Brad DeLong, he blames the prematurely sainted Alan Greenspan and George W Bush:

A Day of Reckoning for Americans Who Lived Beyond Their Means
By Joseph Stiglitz
The Taipei Times
Sunday 12 August 2007
The pessimists who have long forecast that the US economy was in for trouble finally seem to be coming into their own. Of course, there is no glee in seeing stock prices tumble as a result of soaring mortgage defaults. But it was largely predictable, as are the likely consequences for both the millions of Americans who will be facing financial distress and the global economy.
The story goes back to the recession of 2001. With the support of former Federal Reserve chairman Alan Greenspan, US President George W. Bush pushed through a tax cut designed to benefit the richest Americans. It did not lift the economy out of the recession that followed the collapse of the Internet bubble.
Given that mistake, the Fed had little choice if it was to fulfill its mandate to maintain growth and employment. It had to lower interest rates, which it did in an unprecedented way - all the way down to 1 percent.
It worked, but in a way fundamentally different from how monetary policy normally works. Usually, low interest rates lead firms to borrow more to invest more, and greater indebtedness is matched by more productive assets.
But given that overinvestment in the 1990s was part of the problem underpinning the recession, lower interest rates did not stimulate much investment. The economy grew, but mainly because American families were persuaded to take on more debt, refinancing their mortgages and spending some of the proceeds. And, as long as housing prices rose as a result of lower interest rates, Americans could ignore their growing indebtedness.
Even this did not stimulate the economy enough. To get more people to borrow more money, credit standards were lowered, fueling growth in so-called "sub-prime" mortgages. Moreover, new products were invented, which lowered upfront payments, making it easier for individuals to take bigger mortgages.
Some mortgages even had negative amortization: payments did not cover the interest due, so every month the debt grew more. Fixed mortgages, with interest rates at 6 percent, were replaced with variable-rate mortgages, whose interest payments were tied to the lower short-term T-bill rates.
What were called "teaser rates" allowed even lower payments for the first few years. They were teasers because they played off the fact that many borrowers were not financially sophisticated and didn't really understand what they were getting into.
And Greenspan egged them to pile on the risk by encouraging these variable-rate mortgages. On Feb. 23, 2004, he pointed out that "many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade."
But did Greenspan really expect interest rates to remain permanently at 1 percent - a negative real interest rate? Did he not think about what would happen to poor Americans with variable-rate mortgages if interest rates rose, as they almost surely would?
Of course, Greenspan's behavior meant that, under his watch, the economy performed better than it otherwise would have done. But it was only a matter of time before that performance became unsustainable.
Fortunately, most Americans did not follow Greenspan's advice to switch to variable-rate mortgages. But even as short-term interest rates began to rise, the day of reckoning was postponed, as new borrowers could obtain fixed-rate mortgages at interest rates that were not increasing.
Remarkably, as short-term interest rates rose, medium and long-term interest rates did not, something that was referred to as a "conundrum."
One hypothesis is that foreign central banks that were accumulating trillions of dollars finally figured out that they were likely to be holding these reserves for years to come, and could afford to put at least some of the money into medium-term US treasury notes yielding - initially - far higher returns than T-bills.
The housing price bubble eventually broke, and, with prices declining, some have discovered that their mortgages are larger than the value of their house. Others found that as interest rates rose, they simply could not make their payments.
Too many Americans built no cushion into their budgets, and mortgage companies, focusing on the fees generated by new mortgages, did not encourage them to do so.
Just as the collapse of the real estate bubble was predictable, so are its consequences: housing starts and sales of existing homes are down and housing inventories are up. By some reckonings, more than two-thirds of the increase in output and employment over the past six years has been real estate-related, reflecting both new housing and households borrowing against their homes to support a consumption binge.
The housing bubble induced Americans to live beyond their means - net savings have been negative for the past couple of years. With this engine of growth turned off, it is hard to see how the US economy would not suffer from a slowdown. A return to fiscal sanity will be good in the long run, but it will reduce aggregate demand in the short run.
There is an old adage about how people's mistakes continue to live long after they are gone. That is certainly true of Greenspan. In Bush's case, we are beginning to bear the consequences even before he has departed.

So why a swindle? Those who created the exotic and opaque instruments got rich. Those credit agencies who waved their magic wands made money too. Those who took out the impossible mortgages (on AG's recommendation) include both victims and perpetrators.

Exotic financial instruments probably have some social utility. So far they have been efficient at fleecing somebody - we just don't know quite who yet.