Chain of fools

The $700 billion bailout went down in flames at first. Now markets, investors, regulators and taxpayers are milling around trying to digest what to do next.

To understand the mind-boggling enormity of this mess, it's instructive to picture how we got here. Focusing on subprime mortgages or mortgage-backed securities ignores the dense network of links and connections that form an opaque system of derivatives and debt. "Any number of other high-yielding asset classes could have started the crisis," says Paul Mizen, an economics professor and director of the Centre for Finance and Credit Markets at the University of Nottingham School of Economics. "It so happened that the subprime market soured first."

Mizen was writing in the Federal Reserve Bank of St. Louis Review. The Deal decided to use Mizen's article -- "The credit crunch of 2007-2008: A discussion of the background, market reactions, and policy responses" -- as the basis for a graphic. This diagram -- admittedly simplified -- attempts to chart the chain of leveraged causation. It shows how a peak of $600 billion in subprime mortgages could metastasize into trillions of dollars of potentially toxic asset-backed securities, collateralized debt obligations and credit default swaps.

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The rationale for such complexities is credit-risk transfer. The realities: securities and leverage so much bigger, more complicated and detached from actual assets that value itself became an abstraction. Writes Mizen: "Investors are far removed from the underlying assets both physically (due to the global market for these assets) and financially (since they often have little idea about the true quality and structure of the underlying assets several links back in the chain)."

Very simply, as the system seized up, no one knew what was held or what was its true value.

Our depiction begins with those subprime mortgages. These were issued by loan originators but usually sold off. According to an earlier Federal Reserve Bank of St. Louis study, about six in 10 subprime mortgages were securitized in 2003, the highest percentage ever.

Securitized subprime mortgages became part of a much larger pool called residential mortgage-backed securities. That includes the only slightly less risky Alt-A mortgages and the higher-grade conventional, jumbo and FHA/VA mortgages. At first RMBS were packaged by mortgage type, but, more recently, they were mixed and matched. FDIC-insured institutions alone held $1.2 trillion of these in 2006.

In turn, these mortgage-backed securities, which the credit agencies anointed with a AAA rating until June 2007, are part of a much bigger pool called asset-backed securities. That market totaled $10.7 trillion in 2006 and included commercial mortgage-backed securities, auto loans, credit cards and student loans.

At the next level, the underlying assets and their values begin to lose definition. Asset-backed securities are divided primarily into a debt-recovery pecking order into tranches -- senior, mezzanine and equity -- and then pooled. These are called collateralized debt obligations. A CDO can be backed by everything from corporate bonds to real estate investment trusts. A collateralized loan obligation is a CDO backed by bank loans. A pool of residential mortgage-backed securities is another way to construct a CDO. (CDOs are also divided between cash CDOs, or those backed by debt instruments yielding cash, and synthetic CDOs, which are backed by other credit derivatives.)

Before these pools are transformed into CDOs, some intermediate steps typically occur. CDO managers borrow from banks, which finance the acquisition of the asset-backed securities. The banks warehouse and reconstitute them.

Meanwhile, managers get sales orders for these CDOs, which are typically acquired by conduits or special investment vehicles, off-balance-sheet, bankruptcy-remote entities. Those are often funded by asset-backed commercial paper, or ABCP, short-term loans, which are in turn sold to banks.

According to the research group Celent LLC, the CDO market in 2006 totaled $2 trillion.

The creation of CDOs isn't the end of the game. CDOs themselves can be divided and combined in various fashions, then sold off. These funds-of-CDO-funds are called CDO squared. That process can be repeated with CDO squared, creating CDO cubed.

Leverage fueled the acquisition of these instruments at every level. The result: A 20% drop in value could easily wipe out an investment. "Investors had concentrated risks by leveraging their holdings of mortgages in securitized assets, so their losses were multiplied," Mizen says.

To mitigate the risk of failure, creditors and holders of these securities bought credit default swaps, a kind of insurance policy originally crafted for corporate debt. An enormous market evolved in the swaps themselves; it more than doubled from June 2005 to the end of 2007. At the start of this year, according to Moody's Investors Service, the notional value of contracts outstanding stood at $62.2 trillion, while replacement value eclipsed $2 trillion.

The disassembly of these various securities could take years. Evisceration of the institutions has already begun. Of the six biggest issuers in 2006 of asset-backed securities, including mortgage-backed securities and CDOs, only two -- GMAC LLC and Royal Bank of Scotland Group plc -- remain in business. Countrywide Financial Corp., Lehman Brothers Holdings Inc., Bear Stearns Cos. and Washington Mutual Inc. are history.

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