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It was Charles Mackay, the 19th-century Scottish journalist, who observed that men go mad in herds but only come to their senses one by one.
We are only at the beginning of the financial world coming to its senses after the bursting of the biggest credit bubble the world has seen. What’s important to understand is that, contrary to what you heard from President Bush this month, this isn’t just a mortgage or housing crisis.
The financial giants that originated, packaged, rated and insured all those subprime mortgages were the same ones, run by the same executives, with the same fee incentives, using the same financial technologies and risk-management systems, who originated, packaged, rated and insured home-equity loans, commercial real estate loans, credit card loans and loans to finance corporate buyouts.
It is highly unlikely that these organizations did a significantly better job with those other lines of business than they did with mortgages. But the extent of those misjudgments will be revealed only after the economy has slowed, as it surely will.
At the center of this still-unfolding disaster is the Collateralized Debt Obligation. Let’s begin with the mortgage-backed CDO.
By now, almost everyone knows that most mortgages are no longer held by banks until they are paid off: They are packaged with other mortgages and sold to investors much like a bond.
In the simple version, each investor owned a small percentage of the entire package and got the same yield as all the other investors. Then someone figured out that you could do a bigger business by selling them off in tranches corresponding to different levels of credit risk.
With these tranches, mortgage debt could be divided among classes of investors. The riskiest tranches – those with the lowest credit ratings – were sold to hedge funds and junk bond funds whose investors wanted the higher yields that went with the higher risk. The safest ones, offering lower yields and Treasury-like AAA ratings, were snapped up by risk-averse pension funds and money market funds. The least sought-after tranches were those in the middle, the “mezzanine” tranches, which offered middling yields for supposedly moderate risks.
At this point, the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same “tranching” process, they could use these mezzanine-rated assets to create a new set of securities – some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired.
What we know now, of course, is that the investment banks and ratings agencies underestimated the risk that mortgage defaults would rise so dramatically that even AAA investments could lose their value.
The rating agencies are in the midst of a massive and embarrassing downgrading process that will force many banks, pension funds and money market funds to sell their CDO holdings into a market bereft of buyers.
Meanwhile, banks that are forced to hold on to their CDO assets will be required to set aside much more of their own capital as a financial cushion. That will sharply reduce the money they have available for new loans.
And it doesn’t stop there. CDO losses now threaten the AAA ratings of several insurance companies that bought CDO paper or insured against CDO losses.
If all this sounds like a financial house of cards, that’s because it is. And it is about to come crashing down, with serious consequences not only for banks and investors but for the economy as a whole.
