“Virus, virus, virus is the thread that keeps going through my head.”
What looked like a risk mitigated, readily levered investment to some of the greatest minds on Wall Street turned out to be (in the words of Warren Buffett), a financial weapon of mass destruction, a viral bio-hazard that infected global markets, in the process, killing the banks, hedge funds and insurance underwriters that hosted the virus.
It was infectious by virtue of the simple fact (supported by really complex math) that by being a manufactured ‘class of investment’ rather than an actual investment in tangible assets, once it passed the initial sniff test of the market (of credit agencies, secondary markets, etc.), it pretty much could expand friction-free across the globe.
And expand it did, both on the BUY side and the SELL side (i.e., buyers of these instruments could be any bank, hedge fund or financial services firm anywhere on the planet – which explains why Iceland is on the cusp of bankruptcy for what until recently was thought to be an American crisis. Similarly, bankers anywhere could replicate the model to create such instruments/viruses to sell/spread to the global marketplace).
No less important to this mess is the combination of the complexity of these instruments; deregulation's role in de-prioritizing transparency; and the fact that the instruments were created specifically so that the underwriter could quickly get the credit risk off its books.
What do you get when you retard analysis and globally diffuse responsibility for adherence to analytical and underwriting standards? Experience suggests that you get a sharply under-performing asset class, the perfect storm of which is still unfolding.
Awe, but the final lethal contagion was the premise that the risk was protected by an ‘insurance-like’ safety net, which now has not only proven to be untrue but as an unregulated segment, we can’t even say with real confidence what the exposure to our global economy really is.
An illusion of safety leading to promiscuous behavior, an easy to spread virus that is hard to ascertain its lethality and the doctor’s have no incentive to care for the patients. It’s a recipe for an epidemic.
Along these lines, Jesse Eisinger of Conde Nast Portfolio Magazine has written an excellent article, ‘The $58 Trillion Elephant in the Room’ on the birth of the credit derivative market and the lessons learned in the process of its roll-out. (Side note: Portfolio also provides an interactive timeline, ‘Death by Derivatives’ on the evolution of the derivatives industry).
It’s akin to reading about scientists creating, then unwittingly unleashing, a lethal virus on the planet, and it does a good job of showing the interplay of the afore-mentioned variables at work.
Here is an Excerpt:
"Bistro had tied the world together, taking credit risk from the banks and passing it on to anyone who wanted it. For years, proponents of credit derivatives, including then-Federal Reserve chairman Alan Greenspan and current chair Ben Bernanke, had celebrated the way they spread risk. Everyone might share a little bit of risk, but no firm would collapse from it. Yet in this credit crisis, everyone has become infected…The initial slice, the equity layer that Morgan retained as a cushion against trouble, was so thin that it couldn’t weather even one default from one of the bigger companies in the bundle. That ultimately happened, wiping the slice out entirely. The investors who were one notch up, in what’s called the mezzanine layer, lost money as well. Even the buyers of the top-rated tranches, which were thought to be rock solid, had to endure bumpy periods before they got their money back. During that first major deal, the credit-rating agencies, which were supposed to be impartial, were already deeply enmeshed in the give-and-take of the process. A former Morgan banker who helped create Bistro recalls that Standard & Poor’s was giving the bank a tough time. The rating firm would run the deal through its models, and “each time, it came up with disastrous results. We did some tinkering and all of a sudden, it could rate the deal,” the banker says. The pattern was set. The rating agencies would become integral to the creation of the structures…One major problem was that banks had the ability to substitute loans in and out of the structure, as long as the loans had the same credit rating. This allowed managers to scour their books for a loan that looked shaky but still retained a good credit rating and swap it in for a healthier one. The tranche’s credit rating would remain the same, making the whole deal look better on paper than it actually was."
Also, 60 Minutes did a segment last night on the very same topic called, ‘The Bet that Blew Up Wall Street.’ Check that out HERE.
Taken together, these stories help frame the Capitalism 2.0 meme that I believe will emerge out of this mess; namely, if we know socialism is not the answer and now we know that pure, unfettered free market capitalism isn’t the answer, somewhere between the 'invisible hand' and the 'guided hand' is the answer.
Related Posts:
- Engine Failure - When Financial Markets Fail: an analysis of the current financial crisis.
- Black Swans and Bank Runs: on why this crisis was predictable.
- Financial Tsunamis: connecting the dots in the sub-prime mess.
- Capitalism 2.0: lessons from Japan's lost decade, and where do we go from here.
