So far this week we have been dealing with the past, the history we should have learned from. But as Morris keeps letting us see, Hudibras, was and probably still is, the god in charge.
Chapter Four: A Wall of Money
The oughts, as the English call them, have been tumultuous at best. The dot.com bust, the Tower’s attack, Bush, Iraq; a list of ups and downs that just doesn’t stop. The Fed, led by Alan Greenspan, responded to this in a way we should all recognize. Starting with the dot.com bust, the Fed began to lower the federal fund rate.
The Fed did not start raising rates again until mid-2004, and for thiry-one consecutive months, the base inflation-adjusted shor-term interest rate was negative. For bankers, in other words, money was free.
. . . banks embraced securitization. Instead of holding their commercial mortgages, corporate loans, high-yield takeover loans, emerging market loans,and such on their books, the bankers had always done, they began to package them up as collateralized loan obligations (CLOs) or collateralized debt obligations (CDOs) and sell them to outside investors. They could still collect hefty fees while encumbering little is any of their capital. Lending, in other words, was becoming costless.
CMO, CLO, CDO, RMBS, CMBS, ABS, CBO, SBE; these are just some of the names of the securitized instruments that came into being. Take a look at this list from InvestorGuide.com,
An investment instrument, other than an insurance policy or fixed
annuity, issued by a corporation, government, or other organization
which offers evidence of debt or equity. The official definition,
from the Securities Exchange Act of 1934, is: “Any note, stock,
treasury stock, bond, debenture, certificate of interest or
participation in any profit-sharing agreement or in any oil, gas,
or other mineral royalty or lease, any collateral trust certificate,
preorganization certificate or subscription, transferable share,
investment contract, voting-trust certificate, certificate of
deposit, for a security, any put, call, straddle, option, or
privilege on any security, certificate of deposit, or group or index
of securities (including any interest therein or based on the value
thereof), or any put, call, straddle, option, or privilege entered
into on a national securities exchange relating to foreign currency,
or in general, any instrument commonly known as a ‘security’; or any
certificate of interest or participation in, temporary or interim
certificate for, receipt for, or warrant or right to subscribe to
or purchase, any of the foregoing; but shall not include currency
or any note, draft, bill of exchange, or banker’s acceptance which
has a maturity at the time of issuance of not exceeding nine months,
exclusive of days of grace, or any renewal thereof the maturity of
which is likewise limited.”
Property which is pledged as collateral for a loan.
Remember Black-Scholes? Now instead of investors using the formulas, we apparently had our trustworthy bankers playing the same game. All with Greenspan’s “a new paradigm of active credit management.” Put’s blessing and the Fed’s help. Leverage buyouts were back. OPM, Other People’s Money, became the watchword for how to invest. Morris uses this example,
Put up $1 billion, borrow $4 billion more, snap up a healthy company for $5 billion (after making a very rich deal with its executives), vote yourselves a “special dividend” of $1 billion, then as the buyout-fueled stock market keeps rising, sell the company back to the public, pocketing another couple billion, all the while taking no risk.
As I write, I can’t help thinking of the Bear Stearn buyout. About how much we, you and I John Q. Public, don’t know about how all this works nor how we can do anything about it in a time where, to judge from the workshops being offered around the country, many people are still being sold on the idea that this is the way to get rich. As we all sit here watching the real estate bubble burst, I won’t take the time to catalog all the stats for you. Just know this, during the same time that LBOs were making a comeback, our economy was being fueled by the same sort of leverage being applied to home ownership. While, Greenspan focused his put on stabilizing the financiers while encouraging the rest of us to go further and further into debt via the refi route, real real estate values were inflating at a rate of about 50 percent.
Refis jumped from $14 billion in 1995 to nearly a quarter of a trillion by 2005, the great majority of them resulting in higher loan amounts.
By 2005, 40 percent of all home purchases were either for investment or as second homes. (Experts believe that a large share of the “second homes” actually are speculations for resale; lenders don’t review vacation-home purchases as closely as investment properties.)
OPM. Free market. Caveat Emptor.
By 2003 or so, mortage lenders were running out of people they could plausibly lend to. Instead of curtailing lending, they spread their nets to vacuum up prospects with little hope of repaying them. Subprime lending jumped from an annual volume of $145 billion in 2001 to $625 billion in 2005, more than 20 percent of total issuances.
The industry was awash in socalled “ninja loans – no income, no job, no assets.”
Meanwhile, things were, without us having any way of knowing it, becoming more and more insecure in the securitized world. Remember all those security instruments mentioned above, well since there was so much money to be made at so little risk (ha ha), and with so little regulation, then why not just do this. Think I’m talking small here. Well, think again. According to Morris, “The notational value of credit default swaps – that is, the size of portfolios covered by credit default agreements – grew from $1 trillion in 2001 to $45 trillion by mid-2007. Synthetic (models emulating the real CDO created on a computer to simulate the real thing) SIV structures were now capable of being built and then put into play. Unbelievably, entities that were called CDO2s or CDOs of CDOs, you get the picture.
Earlier in the book, Morris explained one of the guidelines that financial institutions were supposed to use to make sure that the investor was covered against loss was something called the Agency rule. Under the Agency rule an institution’s officers could not recommend investments that acted against the investor’s interest. But without regulation, remember Hedge funds are private, who’s to say what is in who’s favor, especially as the swaps make the distance between the real investor and his or her money increase exponentially.
Next up, Chapter Five: A Tsunami of Dollars