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.
Comments
Dissembly, or disaggregation, of mortgage backed securities (MBS) would seem to be the only way out of this mess.
It should now be clear the MBS model is fundamentally infirm, and only undoing it will suffice, but that will be a major undertaking and has serious implications for the entire financial sector, which is going to have to get used to not being able to raise unlimited capital using smoke and mirrors.
There is also a problem with how it can be done, constitutionally, without violating the Contracts Clause (and the Tenth Amendment, since the Contracts Clause is only a restriction on the states). I have proposed creating jurisdictions for federal Art. III or bankruptcy courts to challenge foreclosures if the original signed note, a complete record of payments received by the servicing agent, and the owner and holder of the note (not just his attorney) be required to personally testify in court (for a corporation that would be a senior official). That would require disaggregation of all those MBS, if not as securities then as transparent administrative processes that could enable evaluation not just of bundles but of each component of them, in nearly real time.
The federal jurisdictions need not overburden the federal courts, as I would expect it to impose similar judicial reform in state courts, something that has already begun.
I do not, as a libertarian, favor regulatory interventions in the sense of administrative agents directing the actions of people, setting standards, or requiring them to report on their activities. The Nondelegation Doctrine needs to be revived, not further buried.