Tag Archives: recession

All is Vanity: How to Topple an Economy in 10 Easy Steps

It’s been a long time since I read “The Bonfire of the Vanities” by Tom Wolfe but I still remember how the main character, Sherman McCoy, described his lucrative profession of investment banking as making money off crumbs from pieces of cake being passed around.

Last summer I was taking a class in management taught by a moonlighting mortgage broker. The so-called sub-prime crisis was beginning to bubble into the nightly news with tales of rising foreclosures and something my dad referred to as “liar loans”. There was one outspoken woman in my class who came right out with what she thought of the situation and of mortgage brokers in general.

“You all,” she said to the professor, “made a whole lot of loans that you shouldn’t have!”

“Do not believe everything that you hear in the news,” he replied.

More to the story? I wondered. Like what? I started reading commentary on the story. It wasn’t long before I came across a story in the Financial Times that made everything a whole lot clearer. It was accompanied by a diagram that showed how the mortgages were consolidated into packages and resold. I could see a couple of things from this illustration: that there had been a vital disconnect between the assessment of the risks and the eventual owners of the risks, and that this was such a lucrative market that the risk assessors had no real incentive to be cautious. Following that line, it wasn’t much of an extrapolation to see the fuel behind rising home prices, the attraction to speculators, that whoever was supposed to be regulating this market was asleep at the wheel, that therefore the protections put in place to prevent another Great Depression were being subverted and rendered ineffective, that the rest of the financial world could not have been ignoring these kinds of profits or the practices used to attain them, and that therefore this problem could not be limited to the sub-prime market.

I feared then that the problem went much deeper than sub-prime but I prayed that I was wrong.

I’ve described that illuminating diagram to people since then and sometimes they ask to see it but I didn’t bookmark it and can’t find it again. But if you are still interested and haven’t fallen asleep yet, I found this story in the NY Times, “Triple A Failure,” that sums up a key component of the problem: the SEC allowing credit rating agencies to evaluate bond backed investment vehicles even through there was an obvious conflict of interest since their biggest paying customers were the creators of the investment vehicles that were to be rated instead of the investors who would be buying them. From the article: “In effect, the government outsourced its regulatory function to three for-profit companies.”

Read the article and you’ll get a sense of the multipliers involved and it basically boils down to an enormous Ponzi scheme, profitable to the bankers and Wall Street gamers but leaving the actual investors holding the deflated party balloons.

So using the article as a guideline, here’s the recipe for disaster.

How to topple an economy in 10 easy steps.

  1. Wall Street takes a pile of mortgages, all lumped together, obtained from the investment banks that provided the loans.
  2. Sells the pile to a ghost corporation called a SPV (Special Purpose Vehicle).
  3. The SPV pays for the pile of mortgages by issuing bonds.
  4. The SPV issued bonds are rated by a credit rating agency (Moodys et al). The better the credit rating, the more they can be sold for.
  5. The SPV pays the credit rating agency for the ratings.
  6. The bonds are sold on the market to investors and the SPV (held by Wall Street) gets the cash. The value of the mortgages has magically been inflated in the process. So has the risk but the risk isn’t reflected in the magic ratings from the credit agency so the risk is disguised and therefore in reality the bonds are overpriced.

    The investment banks that provided the loans pocket lots of cash from the SPV and have completely offloaded their own risk. They’re happy! They go to write more loans! The more the merrier! They have no reason to care if the loans will be repaid, ever!

    But it doesn’t stop there. There is too much money to be made by repackaging paper, disguising the risk, and reselling it all for much more than it’s really worth. So for steps 7 – 10:

    7. They do it again. They take those bonds issued by the SPVs and they repackage the risky overpriced bonds into another pile and now the pile of bonds that were mortgages are called a CDO.

    8. The CDO pays for the mortgage backed bonds by issuing more bonds. The new bonds are again rated by a credit agency. The better the rating, the more they can be sold for.

    9. The CDO pays the credit rating agency for the ratings.

    10. The bonds are sold on the market to investors and Wall Street pockets the cash. The risk now has exponentially multiplied again but that’s not reflected in the rating or the price.

    Investment banks pump as much money as they get into writing more loans. They make it clear to the mortgage brokers that their job is to give that money away to anyone who wants it. The mortgage brokers get nice commissions on every loan they write for the banks so they’re highly motivated to write loans. Blaming the mortgage brokers for loan defaults is like blaming the car salesperson for the repossession of the car they sold. It wasn’t their job to evaluate the risk. It was their job to sell and write loans and submit them for evaluation to the investment bank that was supplying the money.

    The more credit is available, the more people buy. That’s been documented by social psychology research. The more houses people buy, the more the housing prices rise. Up, up, up the prices go. Now people see that they can make money by buying houses and reselling them at a profit so speculation blooms. It isn’t about homes anymore; it’s about money but the credit rating agencies are still rating the risk as if it’s all about home owners who are highly motivated to keep their homes.

    Big money! Buy, buy, buy! Sell, sell, sell! Buy, Buy BUY! Woohoo!

    People who already own homes watch their values rise. Yay! Home equity loans mean you can turn that value into cash! You can then spend the cash! Yay! Vacations and bling for everybody! Hey look pa, the economy is doing great! 70% of the economy is consumer-driven so all this spending of home equity can really inflate what the economy looks like. The actual amount of home equity proved to be an illusion.

    Picture the sub-prime mortgages (and all other credit related paper that was securitized into bonds like consumer and home equity loans – also mentioned in the article) as the tiptop of a pyramid and the pyramid is inverted, balancing on that tip and that tip is crumbling. It didn’t have enough substance. That’s the reality of the current stock and bond markets.

    That was the spiral up. Now for the spiral down. The dominos fall. Guess I should write about that next, unless I’ve put everyone to sleep by now.

    Notes & Quotes:

    Scary does not begin to describe the feeling of learning that there are only three or four hard working people at a major rating agency judging the creditworthiness of all the investment banks and they don’t even have their own model.” – David Einhorn, “Private Profits and Socialized Risk” Grant’s Sprint Investment Conference, April 8, 2008