Explaining (or at least trying to explain) the subprime mortgage meltdown with a single post is not an easy task. Furthermore, the reasons behind the crisis are still being studied, its interconnections analyzed, the role played by banks, rating agencies and federal regulators scrutinized. Meanwhile, 6 years later, CDOs are back and from here we should begin our analysis...
...After all, it all began with securitization...
In the securitization process, bank X creates a legal entity called SPV which issues the asset-backed securities. These are issued in several tranches (made of several loans), each tranche having a rating assigned by a rating agency according to the probability of default. Bank X sells the loans to the SPV and receives cash. The issuer (SPV) is structured for remote bankruptcy, that is bank X cannot be sued by the investors if something goes wrong. In a few words, bank X gets rid of the liabilities (and the risk associated with them). The underlying value of the asset-backed securities depends directly on the cash flow generated by the underlying assets (interest and principal). If Carl, John or Aron experience difficulty in repaying the loans, the value of the asset-backed security goes down. Hypothetically, the asset-backed security can be worth zero, if borrowers default in series. The picture above shows the type of contract Morgan Stanley was trading: an hybrid between a CDO (Collateralized Debt Obligation) and a CBO (Collateralized Bond Obligation).
Now, we are in 2004, and the market for these kind of financial instruments was flourishing. Morgan Stanley was creating asset-backed bonds at a faster rate than the loans borrowers were purchasing. So it was de facto exposed to counter party credit risk: that is, in the time between the purchase of the loans and the selling of the bonds, borrowers could experience difficulty in meeting their mortgage commitments and the value of the bonds could go down. Morgan Stanley decided to buy insurance against this kind of event by entering credit default swaps for $2 billion.
These credit default swaps were based on the riskiest loans of triple-B tranches of asset-backed bonds. Morgan Stanley purposely decided to hedge with riskier triple-B tranches as these were more likely to pay off in the future. In 2006, Howie Hubler and the other traders at Morgan Stanley were certain borrowers would have defaulted one after the other, sooner or later. Yes, they had realized that the mortgage-backed securities market was a broken toy and were clearly betting on the collapse of the housing market. Morgan Stanley paid the counterpart 2.5% per year and, in case of default, it would have been entitled to the entire pie ($2 billion).
You may be wondering: why did the counterpart take the other side of the bet? In other words: why the counterpart was unconsciously accepting to pay $2 billion to Morgan Stanley if only 4% of losses on the underlying loans were needed to trigger a credit event? (Note: 4% of losses on loans underlying mortgage-backed securities are experienced, on average, in good times). We don't know. However, we shouldn't be surprised to see this kind of perverse reasoning in the financial markets (see here and here).
Howie Hubler and the other traders at Morgan Stanley bought insurance and entered credit default swaps for $2 billion. Morgan Stanley had to make regular payments to the counterpart. The premium Morgan Stanley was paying was high as the tranches were triple-B rated, so Morgan Stanley was experiencing short-term losses in a order of magnitude of $200 million. In order to hedge this exposure, Howie Hubler decided to enter triple-A rated credit default swaps for $16 billion and take the other side of the bet. The infamous triple-A hedge. In 2007, Howie Hubler was selling insurance to institutional investors in order to pocket the tiny premium on triple-A tranches to compensate for the short-term losses on the $2 billion credit default swap. In order to do so, Howie Hubler had to sell a lot of CDS. $16 billion to be precise.
Hubler considered this trade as risk-free as the rating was excellent (AAA). He thought the correlation of the prices of the subprime mortgage bonds inside CDO was low. Morgan Stanley estimated it approximately around 30%. Instead it was very close to 100%. As the loans underlying the asset-backed securities experienced the first losses, it all fell down. The mortgage-backed securities market proved to be a house of cards with a domino effect that severely affected the real economy. Morgan Stanley turn out to lose $9.2 billion.
How did Securitization get its start?
It all began after the 1980s...
It all goes back to the CRA (Community Reinvestment Act) that enhanced the availability of “affordable housing” via the use of “creative financing techniques”.
It all goes back to the favorable accounting and capital regulations that enabled Wall Street to create an assembly line for CDOs, under direct approval of Alan Greenspan.
It all goes back to the active encouragement by federal regulators of OTC derivatives by all types of financial institutions.
It all goes back to the 'decimalization' introduced in March 2001 and the Reg FD (October 2000) that hit major Wall Street firms hard, so they focused on new OTC assets instead of exchange traded ones (with a much wider bid-ask spreads).
It all goes back to the rating agencies that gave OTC products investment grade ratings, basing their judgment on no credit history and consequently reducing capital requirements.
Finally, it all goes back to the housing prices that in aggregate were supposed to always go up...
Paul Volcker: "Vision without execution is hallucination."
Michael Lewis (2010) - The Big Short