The Continuing Financial Weapons of Mass Destruction

This is the sixth in a series on banking that begins here.

“Wall Street is addicted to derivatives trading like the masses are addicted to sports betting.”

             Charlie Munger to Robert Lenczner of Forbes Magazine

While the Credit Default Swap (CDS), discussed in the last post, caused the need for the bailout, another derivative, the CDO (collateralized debt obligation) was the major cause of the mortgage market meltdown. The CDO, when misused, as it was— and still is— remains a threat to our financial system.

For the evidence of the misuse of the CDO see my earlier post, How the Perverted Incentive Entered the System

As the banks got away with misusing the CDO leading up to 2008, the only question is how they are doing that now.

The first step in demystifying this forbidding term is to break it down:

• Collateralized means there is a lien on some property (collateral) that can be seized if the loan goes into default

• Debt obligation is an indication that it’s a loan

In other words, a collection of loans with liens. A mortgage is a good example of a physical asset. The lien could also be on an abstract property: a business could pledge all its future income from its billings (assignment of accounts receivable).

The CDO concept was started in the 1980s and, when honest bankers were assembling it, proved a satisfactory investment for decades until about 2004.

A major factor of investing is always reducing risk. Here’s how the CDO initiated a new way of apportioning risks in a group of individual investments.

• The investments were stacked like the floors of a tall office building.

• Each floor was called by the French word ‘tranche’ meaning slice and given rankings of AAA, BBB and so on.

The tranches were not ranked in order of safety. AAA did not contain the best of the prime mortgages.

The genius in the innovation was just that, none of the investments in the pool of assets are rated according to safety: I repeat, the AAA tranche is not composed of the mortgages held by people with the highest credit scores.

The upper floors give those investors the first right to the cash flow from the entire pool. Therefore, there’s no need to allocate according to likelihood of repayment. The assets were treated like aggregates, a heap of gravel where the characteristics of the individual items were not important.

The rest of the money collected that month would flow like a waterfall down to the lower trenches.

The assets in the pool could be diversified to include many types of debt: car loans, loans to small businesses and so on. The strength of diversity meant that if there was a downturn in one industry, there would be investments from areas where there was no downturn.

The investors who took the risk of the lowest tranches, got a higher interest-rate for assuming that risk.

Before we can see how the CDO was abused in the 2008 crisis, (and is still being abused), we need to review a further development in the CDO concept. It will strain your ability to suspend your disbelief.

The Phantasy CDO

This innovation, called the synthetic CDO, would have no assets but only reference the result in other CDO’s.

The screenwriter for The Big Short. gave us an example of a man and a woman (Selena Gomez) at a roulette wheel placing bets. In the first row behind them, people bet on whether the man or woman would win. In the second row people were betting on which of the people in the first row would win, and so on.

On his financial blog, banking lawyer Richard I. Isacoff, gave us another description of a synthetic derivative, betting on how well another bettor will do:

"Here’s the easiest way to think about it - there is a real Football league made up of real football teams....

Then we have a Fantasy Football League, made up of the same teams but with the players on each team made up of peoples' "dream team" - players taken from any team and put together (only on paper). Based on how each player and the REAL TEAM he plays on does each week, these made up teams are ranked. People actually bet on these MADE UP TEAMS- "FANTASY TEAMS"- which are DERIVED from the real teams. A Fantasy League is a DERIVATIVE.

Now imagine a second "Fantasy Football League" made up of the same players and BUT instead being based on the outcome of the Real Teams it’s based on the outcome of the FANTASY TEAMS and ranked according to how the players and the FANTASY TEAMS do each week. This is a Synthetic Derivative - it’s a bet about how well another bet will do! Will Pete win or lose on his bet on Fantasy Team #1. That’s what is being bet on."

In an interview on Pensions Plus, Janet Tavakoli gave an example of a synthetic derivative that Goldman Sachs created by issuing 30 new derivatives betting in sequence on the performance of that first CDO.

 “Now how did they do that? They did that with the magic of derivatives," she said, adding, "Now, they stopped at around thirty debt pools; they could have done a hundred and thirty."  

Sometimes the bankers called these daisy-chain like strings of CDOs based on one original CDO, a CDO² .

Synthetic derivatives are impossible to value: How do you determine the value of a bet on a bet? Let’s say you are at a roulette wheel in Las Vegas and you place your chips on 38 black. Your chips are worth $100 and if you are successful, the prize is $1000. Someone bets on your bet. One minute before the croupier spins the wheel, how do you value their bet?

However, that doesn’t stop the banks from putting sizable values for these synthetic CDOs on their balance sheets. It the Berkshire Hathaway annual report for 2002, Buffet warned about this unreliable valuation of synthetic CDOs:

“But before a contract is settled, the counter-parties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands. Reported earnings on derivatives are often wildly overstated.”

The Alchemical CDO

Just when you might’ve thought that the artificial creation of the CDO had reached its limit, the bankers came up with another ingenious ploy to transform the un-salable into the apparently salable.

By 2004 the availability of qualified applicants was drying up. At the same time the market for CDOs was doing the same. There were no customers for the bottom tranches. To keep the appearance of a strong market for CDOs our creative bankers created a CDO to buy the lower tranches of other CDO’s. 

Warren Buffet observed at the time, “When you start buying tranches of other instruments, nobody knows what the hell they're doing."

He further noted that doesn't stop the banks from putting sizable values for these ultra-synthetic CDOs on their balance sheets. In that 2002 letter to shareholders he also warned, “As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counter-parties to use fanciful assumptions. The two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.” [my emphasis]

The Bankers Knew

Because of the investigation into the Abacus fraud last post, we got to see some of Fabrice Tourre’s emails to his girlfriend, in which he calls these derivatives monstrosities, and that nobody knew how to value them. Tourre recognizes that many people were going to suffer financially because of these banker creations, but he, as a banker, would not.

23 January 2007

“…More and more leverage in the system, the entire system is about to crumble any moment…the only potential survivor the fabulous Fab (as Mitch would kindly call me, even though there is nothing fabulous abt me...) standing in the middle of all these complex, highly levered, exotic trades he created without necessarily understanding all the implications of those monstruosities!!!” [Note: The senior partner, Mitch, mentioned as creating the derivatives, was not charged with any wrongdoing.]

29 January 2007

“When I think that I had some input into the creation of this product (which by the way is a product of pure intellectual masturbation, the type of thing which you invent telling yourself: “Well, what if we created a ‘thing’, which has no purpose, which is absolutely conceptual and highly theoretical and which nobody knows how to price?”) it sickens the heart to see it shot down in mid-flight…It’s a little like Frankenstein turning against his own inventor ;)";)”

At this point, you might be asking yourself, if all this obviously risky stuff was going on, why didn’t our clever economists and regulators see it. There is a reason. As will be explained in an upcoming post, the regulators made certain that the lid was kept firmly on this black box, so they didn’t know. No need to look, the market could regulate itself, they said.

What can be done?

• Prohibit both retail and investment banks from trading in synthetic derivatives completely