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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
Web site: http://www.vestopia.com/thomast E-mail:
Thomast2@optonline.net
