Meltdown from Modern Financial Alchemy, by Thomas Tan

Nowadays after all the 3rd quarter write-off announcements from many banks, sub-prime has been mentioned less on television and newspapers. The market has returned to the old high and some more. Is this credit crunch crisis over? What might be coming next?

The sub-prime is only the 1st layer of the onion being peeled; there is much worse danger yet to be revealed. It is amazing to see the high growth in all kinds of fixed income products during last 10 years called SIVs (structured investment vehicles) such as RMBSs (residential mortgage backed securities), CDOs (collateralized debt obligations), ABS (asset backed securities for credit cards and auto loans), and all the OTC (over the counter) exotic and complex credit derivatives associated with them created and held by Wall Street banks and financial institutions. This has been the largest financial alchemy after the medieval gold alchemy. Similar to medieval, this could turn out to be a pipe dream.

The questions to be asked: Are these products really securitized, collateralized and backed by anything as claimed? Are these OTC credit derivatives really creating value as claimed? In general, most of these derivatives are unregulated, lack of any standards, no transparency, not public traded, no bid/ask price but an assigned “price” by the black box computer model, and no clearinghouse to guarantee anything. Their values thus returns are marked to model instead of marked to market, when in trouble, they are totally dependent on the balance sheet of their counterparts for survivability.

The financial alchemy process starts like this: by the magic touch of the structured product (or financial engineering) groups of Wall Street. banks, a large pool of various mortgages and other loans are sliced and diced thousands of ways into things such as principal only (POs), interest only (IOs), various tranches by the timing of payments, stripping embedded options to be sold separately, creating exotic credit derivative out of nowhere. After enough playing by financial engineers and their flawed computer models, suddenly a $100 mortgage can turn into $106 with a pool of so called “value-added” structured products, many of them are so complex to understand and not registered anywhere with no records to trace.

Now Wall Street banks are so happy to take a 3% cut ($3) for their commission, bonus and profit due to this “creativity”. Somehow with hard sales pitch from Wall Street, the yield hungry financial institutions and funds are eager to wait in line to purchase these “higher value” derivatives with seemingly higher yields without thinking about associated higher risks. Quite opposite, many of them have taken even more risk by borrowing commercial papers to leverage a 2-3% spread into a double digit “gain”.

The problem is that the $106 is just a paper notional value created and assigned by the structured product groups by using computer models. You can twist the model to get any price you want. But when it is forced to find a real market for ending the obligation of such products by trying to sell them to get liquidity, the real value received by institutions could be a totally different story. Also these products are the opposite of what they claim, depending on which trench they purchase, with higher default rate, the future cash flow can change dramatically and can go down to zero, as a result, these products are “securitized”, “collateralized” and “backed” by nothing. Why has no one paid attention and noticed this before? There are many reasons, and a couple of them could be as follows:

1) The imbalance of these derivative markets. Wall Street banks sell them to the institutions hungry for yield, but institutions keep them in the portfolio to “enjoy” long term yield and rarely want to sell them. Quite opposite, they probably are hungry for more. The market becomes a one way street until some day suddenly everyone realizes at the same time that the emperor has actually no clothes.

2) 6% value “creation” is too small to cause any problem and get noticed when the mortgage market is booming. To be more accurate, after Wall Street taking the cut, the original $100 mortgage is actually only worth $97 but insurance companies, pension funds, endowment funds, unsophisticated foreign financial institutions purchase them for $106. Immediately they lose 9% on top, similar to buying a new car from dealer, when out of door, it loses 9% value even before you drive it. Now, when housing market is crushing and the interest rate is going up, causing default rate to double or triple, the original $100 mortgage suddenly becomes $90 on average (or $87 after Wall Street cut), now we are not talking about 6-9% disparity, but 16-19% loss which is much more difficult for institutions to cover it up. The institutions owning these derivatives have trouble to continue to hide the losses any longer. As Warren Buffet famously said “It’s only when the tide goes out that you discover who’s been swimming naked.”

What deepens this crisis is the level of leverage. Leverage is a double edge sword. Many hedge funds in trouble these days are the ones having over 5 to 1 leverage on their portfolio in order to generate double digit paper “return”. Imaging 16-19% times only a leverage factor of 5, basically the whole portfolio is wiped out. This is exactly what happened to the two Bear Stearns hedge funds, they leveraged to 8 to 1, and got totally wiped out.

The former Fed Chairman’s low interest rate policy and environment also encouraged such irrational and irresponsible behavior. During last 10 years when interest rates had been low, all financial institutions have become more and more yield hungry. These managers have to leverage up their bets higher and higher by buying the CDOs with borrowed funds in order to generate a decent return. Who says a lower interest rate environment is good? It causes everyone to over-leverage, created the equity bubble first, then the house market bubble, which will cost and take many years to burst them. It is similar to the 15 years of meltdown in Japan following the bursting of their credit bubble there.

Recently the Fed has kept pumping liquidity into the market. It actually creates a vicious circle that Fed has to keep pumping more liquidity, too much liquidity will create more leverage which will need more “financial engineering”. The Fed has pinned them against the wall, whenever the liquidity pump stops, nothing is going to work anymore so they have to keep pumping. Due to such massive levels of debt held by the public and government as well, this crisis is much worse than the 1989 junk bond crisis. Huge amount of debt is not a good thing anywhere and anytime, in 1989 it was only the corporate world, now it is both the general public and the government. We are only at the very beginning and the worst is yet to be seen.

During the last 10 years, Wall Street firms have become more and more dependent on the structured products for their profits. The profit is not from fees from traditional banking activities such as M&A anymore, majority of the profit recently is actually from structuring, selling and trading of these exotic, complex credit derivatives. This explains why Citigroup’s profit suddenly dropped 57% in the 3rd quarter. During the whole time, regulators have stood at the sideline and done nothing. Many of the high level regulators are one way or another associated with major banks and probably former executives of those banks. Their past performance compensation and bonuses were (still are on their personal portfolio or after they leave government posts and back to the banks) mainly relying on packaging and distributing those CDOs.

The biggest argument and “justification” about value “creation” of these structured credit derivatives is that they mitigate risks. I am not so sure. First of all, all derivative products combined are zero sum game overall anyway. If one side gains value, the other side loses, similar to the futures market. Even for individual hedging purpose, it only changes the individual portfolio and fund’s risk profile and transfers risk from one to another, not increasing or decreasing risk for the whole financial market overall.

Secondly, someone can argue, due to all the exotic and complex derivatives involving so many parties, the risk of individual portfolio or fund becomes higher, since through all these trades, everyone is interconnected, interdependent and intertwined together and we are all at the same boat. When a perfect storm hits, one bad apple will cause all apples to rotten. A good example is Long Term Capital Management (LTCM) in 1998. It took the Fed and all the major Wall Street firms to bail out just one single overleveraged fund.

Third, due to the high margin and high commission on these derivatives, the risk for the general public is actually increased, since a good portion of the “created” value goes to the fat bonuses of Wall Street bankers, traders and sales persons. The overvalued products have been dumped to the public and held by pension funds which baby boomers depend on for their retirement. Some of them have been acquired by various overleveraged hedge funds. For hedge funds with SIVs, they had performed very good the last several years. But more questions will surface how real the past return was? Usually a hedge fund fee structure is 2+20, 2% on asset value and 20% for profit. If hedge funds use computer models to assign value and price on these products in their portfolio, instead of marked to market, there is strong incentive to jack up the value of price so they can charge both higher 2% fee and take higher 20% profit.

Both the 2+20 of hedge funds and 3% Wall Street commission, instead of value “creation”, it is actually value destruction. Similar to the medieval gold alchemy, not only no gold was created, the raw material of lead was destroyed in the process, not even mentioning the opportunity cost of energy and time spent in the alchemy. I am always wondering who is paying for this and holding the bag eventually for this unprecedented modern day financial alchemy?

One thing today better than 1930s is that this time at least we have many unsophisticated foreign institutions (such as the German hedge funds in trouble) holding the bag together with the US general public, a luxury we didn’t have in the 1930s. Even so, it will cause social problems when baby boomers suddenly realize their pension portfolios are full of “securitized” products with nothing secure, so are their retirements. It will cause social divide and unrest when the gap between rich and poor increases further from the current level which is already at a historical high, not even talking about the tax policy becoming more favorable to the few riches than the middle and working class. It will cause a big sell off in various fixed income markets when suddenly foreign institutions feel deceived and start dumping any US paper products at any price, including huge amount of US treasuries held by foreign central banks. The current US dollar devaluation is only the start of the worst yet to come.

At the end of this meltdown, US dollar along with many paper assets will lose at least half of its value, while gold will become a universal currency and standard every country trusts and accepts, and will at least double its value from the current level around $800.

Thomas Tan, CFA, MBA
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