Harringay, Haringey - So Good they Spelt it Twice!
Idiots guide wanted to the credit crises
Am I alone in not really understanding what this credit crises is all about and why we and america are having one?
Are there any clever people out there that can explain it to me. Imagine you are explaining it to a five year old.
Is it because Mr Bush loaned a video sometime back in the 80s when video hiring was at its height of popularity, and didnt return it? He now owes about 700 million dollars.
Are there any clever people out there that can explain it to me. Imagine you are explaining it to a five year old.
Is it because Mr Bush loaned a video sometime back in the 80s when video hiring was at its height of popularity, and didnt return it? He now owes about 700 million dollars.
Replies to This Discussion
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Permalink Reply by empyrean_aisles on
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Another fan of This American Life! What an amazing show. Who'd have thought radio could be so good? I'm like a kid on Christmas morning waiting to download the latest one on Sunday nights.
They did an earlier show on the mortgage crisis, which was less frightening than the one above (because it was earlier in the year when it was just mortgage lenders collapsing like houses of cards rather than whole national economies):
http://www.thislife.org/Radio_Episode.aspx?episode=355
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Permalink Reply by Eddie Finnegan on
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I thought it all started when L.B.Haringey invested all your Council Tax in Landsbanki and IceSave. Please, can anyone out there prove that I'm wrong?
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Permalink Reply by Clive Carter on
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No sign of that yet, Eddie. One might have thought they would have owned up by now if they were involved. It is Councillor Charles Adje who is currently Head of Finance.
But since perhaps one third of all council's had deposits in these accounts, if they are not involved, L.B.H may be thinking "there but for the grace of god ..." .
I heard that a few weeks ago the credit rating of the Icelandic bank/s were downgraded and some may have taken that as a signal to withdraw.
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Although not on this BBC list here, I could have sworn I heard LBH up for £37m on Channel 4 News in the last few minutes. As a council tax payer, I can only hope that that, or I, is mistaken.
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At the risk of sounding like the insufferable Robert Peston, I told you last night my world scoop was right. So nobody offered to prove me wrong!
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Permalink Reply by rahman on
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http://www.scribd.com/doc/2071308/idiots-guide-to-subprime
my other half sent me this when i couldnt be bothered to listen to his banker speak.
and i kind of get it now.
it might help!
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Hi Ruth
Someone sent this to me and I thought it was helpful!
Best wishes
Lisa - Attachments:
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Here is one wrote earlier...
Complinet code cracker: Spinning straw into gold — securitization and the credit derivative markets — the road to market meltdown: part one
Oct 02 2008 Helen Parry
"It's dispiriting indeed to watch the United States financial system, supposedly the envy of the world, being taken to its knees. But that's the show we're watching, brought to you by somnambulant regulators, greedy bank executives and incompetent corporate directors."
A troublesome judge
Such were the words of a renowned columnist from the New York Times, which Justice Schack quoted in a mortgage foreclosure action that HSBC Bank USA brought in New York. Given its high level of exposure to the US sub-prime market, HSBC may be eligible for the Troubled Assets Relief Program This was one of 14 mortgage foreclosure cases that Justice Schack has heard in recent months, several of which were brought by BSBC Bank USA . In each of these cases Justice Schack gave the plaintiff bank a dusty answer, holding that it had failed to meet the procedural requirements for a foreclosure in New York State, which, as in Ohio — another state which has famously seen much legal action in the area of foreclosures — requires judicial approval.
In the course of these judgments, Justice Schack throws an illuminating, acerbic and pitilessly forensic light onto some of the dubious business practices which have contributed so much to the precarious condition of the capital markets. The cases show major banking institutions securitizing sub-prime loans whose originators have been prosecuted in the criminal courts. The offenses include discriminatory predatory lending tactics targeted at poor, and in some instances of equity release, elderly black women. They also provide an insight into the activities of Wall Street's finest in the wholesale market for credit derivatives. In a typical example of one of the unsuccessful actions that HSBC brought, Justice Schack sent the plaintiff bank away with a requirement to return with an answer to several questions. One of these questions was as to "why HSBC purchased a non-performing loan from Delta Funding Corporation."
Non-performing loan CDOs
The default on the mortgage which was the basis for this action took place in May 2007. It was transferred to HSBC by assignment on November 30, 2007, and was, therefore, a non-performing loan. Justice Schack speculated on the reason for the transfer.
"The court wonders why HSBC would purchase a non-performing loan, seven months in arrears. Did HSBC intend to get the non-performing loan off DELTA's books and assigned to the noteholders of the plaintiff's collateralized debt obligation," he asked. It may come as a surprise to those who are not familiar with the securitized debt markets, but there is a large market for non-performing loan collateralized debt obligations. Standard & Poor's has published guidance on how these are rated. The guidance is revealingly entitled: "Distressed Debt CDOs: Spinning Straw into Gold."
Why securitization?
To answer the judge's question it is necessary to go back to basics and unpick what has been going on in the strange world of credit derivatives, starting with the basics of the process of securitization — a procedure that was developed to assist banks in moving loans off their balance sheet to meet capital ratios. This process frees up capital to chase more business. The impetus for this new market had come partly from the bad press that the junk bond market received after the Milken/Boesky insider dealing scandals. The junk bond market had originally been developed for the same reason that the CDO and later related markets had been developed — the legal rules that were applicable to credit ratings and credit ratings agencies provided a market opportunity. Michael Milken had noted that low rated bonds outperformed less risky bonds because the legal rules which artificially restricted demand made them artificially cheap. This was the investment banker's Holy Grail — a market inefficiency that a legal rule had created that no-one else had really spotted.
The junk bond market and CDOs
Early examples of structured finance deals featured securitized and repackaged junk bonds. In this way, junk rated bonds became magically transformed into a range of tranches or categories, some of which were triple A. This is a denial of the old saying that is beloved of geeks — rubbish in, rubbish out. This is spinning gold from straw. This is the trick. It allowed institutional investors such as insurance companies which were restricted to buying investment grade bonds into the market. This increased demand and, therefore, the price rose, which meant that higher yields than government debt or standard corporate bonds could provide were on offer. This also meant that investment banks could charge higher commissions and everybody was happy.
Mortgage derivatives — liar's poker
As Michael Lewis explains in such a highly entertaining fashion in "Liar's Poker", a tax break offered to Savings and Loans had encouraged them to sell their loans. This led to a massive increase in the private securitization of mortgages — the mortgage-backed securities market. As Lewis puts it: "From the moment the Federal Reserve lifted interest rates in October 1979 thrifts hemorrhaged money. The entire structure of home lending was on the verge of collapse. So on September 30, 1981, Congress passed a tax break which allowed thrifts to sell all their mortgage loans and put their cash to work for higher returns — often by purchasing the cheap loans disgorged by other thrifts. It led to hundreds of billions of dollars of turnover at Wall Street … and there were a thousand sellers and no buyers — correction — one buyer: Lewie Ranier of Salomon Brothers and his traders."
Enron and SPVs
Bankers and corporates like Enron were also taking advantage of a Securities and Exchange Commission rule that made it relatively easy to legally take a special purpose vehicle off balance sheet. This requirement was that those outside the company who were setting up the SPV had to provide a minimum of three per cent of the capital of the SPV. Earlier restrictions on executive pay had encouraged the use of payment through share options. This had the effect of concentrating the minds of chief executives and others on the share price to an unconscionable degree. It was truly a witches' brew.
The mechanics
To securitize one must:
pool receivables (e.g., junk bonds mortgages, credit receivables);
create a company or trust in a tax haven — an SPV;
transfer the right to payments to the SPV. Make sure that this is characterized and works as a "sale";
structure the bond in such a way that the ratings agencies will label most of its tranches as triple A;
issue a range of bonds;
transfer the proceeds of the sale of the bonds back to the original owner; and
pay back the bonds with the receivables.
Get if off the balance sheet
By securitizing bank loans and credit receivables, financial institutions are able to remove bank assets from the balance sheet if certain conditions are met, thereby boosting its capital ratios and enabling them to make new loans from the proceeds of the securities sold to investors. The process effectively merges the credit markets (for example, the mortgage market in which lenders make new mortgages) and the capital markets, as bank receivables are repackaged as bonds that are collateralized by pools of mortgages, auto loans, credit card receivables, leases, and other types of credit obligations. As banks look to investors as the ultimate holders of the obligations that bank lending creates, banks as an industry act more as sellers of assets rather than portfolio lenders that keep all the loans they originate in their own portfolio.
Asset quality
Securitization also redefined the bank definition of asset quality, and loan underwriting standards, because lenders were looking at loan quality more in terms of their marketability in the capital markets than the probability of repayment by the borrowers. For regulatory reporting purposes, a loan that is converted into a security and sold as an asset-backed security qualifies as a sale of assets. The seller retains no risk of loss from the assets that are transferred and has no obligation to the buyer for borrower defaults or changes in market value of securities that are sold.
This process has benefited some greatly in that they have been enabled to buy their own home when they otherwise would have had no opportunity to do so. In other cases, those who have been subjected to abusive predatory lending practices may well find themselves homeless. Such people do not feel well disposed towards politicians who seek to help the architects of securitization but not the borrowers such as elderly women who have been browbeaten into taking out equity release plans and lost the homes that they had actually paid for.
Executive compensation
In his judgment, Justice Schack noted the remuneration package for HSBC's chief executive according to its 2007 10-K filing with the SEC, dated March 3, 2008: "Total compensation in 2007 of $4,057,321.00 ($642,986.00 in salary; $1,555,243.00 'discretionary cash bonus relating to 2007 performance', $508,634.00 in stock awards, $502,728.00 in pension value change and non-qualified deferred compensation earnings, $847,730.00 in 'all other compensation,' which included $9,868.00 for physical exams, $288,681.00 for housing allowance, $156,779.00 for children's education allowance, and $63,371.00 for executive travel allowance)."
CDOs — when is an obligation not an obligation?
A collateralized debt obligation is a particular type of securitized product. It is not an obligation. Confusingly, it is the label attached to the special purpose vehicle that lenders set up to hold securitizable assets when contracting under particular terms.
Credit ratings agencies and non-performing loans — the Rumpelstiltskins of the credit market?
Returning to the particularly unattractive sounding non-performing loans that puzzled Justice Schack, it is instructive to examine Standard & Poor's rating guide. The methodology is as follows:
Quantitative and qualitative analysis of the obligor's creditworthiness.
Model-driven analysis of the probability distribution of defaults for the loan portfolio, based on the rating or creditworthiness of the obligor.
Detailed analysis of the debt instruments, which should include an understanding of their position in the capital structure and the degree of subordination available.
Determination of potential recovery rates for the portfolio, given the detailed analyses of the debt instruments.
Quantification of liquidity needs.
Cash flow modeling of the proposed transaction, stressing defaults and their timing, recovery rates and their timing, and liquidity needs.
Evaluation of the transaction's structure and covenants.
Review of the experience and capabilities of the collateral manager, who is crucial to the success of the transaction.
Determination of the market value of the portfolio.
Legal analysis.
Bells and whistles
The trick for the banks is to persuade the agencies to provide inappropriate ratings. The use of models comes second on the methodology list. The models that credit rating agencies use are, however, often based on banks' internal models. Banks pay well and can hire the best mathematicians. Often the staff at the agencies are not in a position to fully understand the complexity of these very highly sophisticated models. As Frank Partnoy put succinctly in his seminal work "Infectious Greed": "The product the agencies were selling was not their own expertise. They were selling an inflated rating methodology that enabled buyers to purchase riskier high-yielding assets. The banks controlled the inputs and told the agencies what they needed to get a deal done. As a result the agencies could fill in the blanks and make money. By the time a rating agency understood the bells and whistles of these models the banks doing the CDO deals would hire him or her at a significantly higher salary."
How do CDO arrangements differ from ordinary mortgage-backed securities?
In a basic structure, a CDO is very much like a vehicle that is set up to hold mortgage-backed securities but there are, however, several significant differences.
MBS are supported by static pools of underlying assets, whereas CDO pools are managed. This means that the composition of the asset portfolios changes throughout the duration of the CDO transaction.
CDO transactions close before the underlying pool of assets is fully formed. This means that the manager may be able to include a wider range of collateral.
CDOs vary in the number of underlying assets they contain, with some containing as few as 20. A typical MBS will contain hundreds of thousands of homogeneous underlying assets.
Traditional calculations of diversity scores are not appropriate for CDOs which are more heterogeneous than MBSs.
The CDOs may illustrate more ratings volatility than MBSs due to ratings changes on the underlying collateral or manager trading.
The heterogeneity of CDO asset pools may increase opacity to investors.
Secondary market trading is limited. This is hampered by the heterogeneity of underwriters, collateral managers and asset types.
How to hedge one's CDO risks — the credit default swap market
Long holders of CDO securities are susceptible to credit risk (default) and, in the case of mortgage securities, market risk. This is the risk of repayment by borrowers. It arises if interest rates fall and borrowers remortgage. This leaves the investor with cash in a low-interest rate environment. These features have caused devastation in the markets before. In the early nineties an unexpected interest rate hike almost bankrupted Orange County in California. The county treasury manager Robert Citron had taken out some instruments that were designed to lose money if interest rates went up — so-called reverse floaters. Jo Jett claimed that he was encouraged to book false profits in treasury strips to hide the massive losses that Kidder made as a result of investing in a hedge fund which had lost massively in the mortgage derivatives market.
Opportunities for abuse
To hedge these risks the market for credit default swaps has grown up. A long position in a credit default swap is a bet that a company may default on its debt. If it does, the default swap seller will pay out to the swap buyer. If the CDS buyer has no underlying CDO positions then the CDS is the equivalent of a naked short sale in the equity market. As such it is prone to abuse and manipulation, just as short selling can be. Regulators have recently been seeking to control potentially abusive short selling of shares by requiring various disclosures and imposing prohibitions. There are no equivalent controls on the credit default swap market.
Synthetic CDOs
Some CDOs have portfolios that contain CDS as their underlying assets. They are described as synthetic CDOs. The companies whose debts form the basis of a synthetic CDO have no relationship at all to the deal. The pressure of so many positions in the market that are set to profit from the downside of the fixed interest market have had a significant effect on the current market turbulence. Howard Davies has described synthetic CDOs as the most toxic element of the financial markets today.
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