Earlier this week, CNN reported how Wall Street took a beating from the subprime crisis and credit crunch, and gave some good insight as to what caused the problems. It’s a few days old and it’s a lengthy article, but it’s very informative and explains how some major banks shifted their own investment strategy during the golden era of CDOs and mortgage backed securities during the past decade.
“The fee engine becomes so huge that these products take on a life of their own,” says Tiger Williams, CEO of Williams Trading, a leading financial services firm for hedge funds. “Everyone rationalizes that it’s safe because they’re making so much money. But it’s far from safe.”
The ‘fee engine’ helped drive the real estate market to it’s peak. Mortgage brokers, realtors, banks, and nearly everyone involved was paid a commission for their service. Their only incentive was to close a sale to collect their commission. Thanks to the increase in innovative financial products such as CDOs over the past decade, mortgages could be sold off and the agents/brokers involved in originating them were no longer liable.
Here’s how a typical CDO backed by subprime mortgages might work. The game starts when a client - known as the collateral manager - approaches Merrill Lynch and asks it to provide financing for a CDO that will hold, for example, $1 billion worth of bonds backed by subprime mortgages. The clients are mostly big money-management firms like Pimco, Trust Co. of the West, and Cohen & Co.
To get things rolling, Merrill makes $1 billion available to the collateral manager, taking a fee of 1.5% to 2%, or $15 million to $20 million. The collateral manager uses the balance to purchase bonds backed by pools of subprime mortgages (known as “subprime mortgage ABS,” for asset-backed securities) issued by Wall Street firms, including Merrill.
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That seems fairly straightforward, though yet again we have a service fee involved. The big financial firms stood to benefit greatly from creating CDOs.
How are CDOs able to offer premium yields on their bonds? Most of them did it by purchasing the riskiest, lowest-rated mortgage-backed bonds - you know, the ones built on loans to borrowers with spotty credit and dubious résumés. Such bonds paid what were then super-high rates of 9% to 11% in 2006.
Didn’t those loans carry a high risk of default? Well, yes, they did. But here’s the key point, and where Wall Street went astray. During the early years of the housing boom, default rates on all mortgages were unusually low. That led bankers - and more important, rating agencies - to build unrealistic assumptions about future default rates into their valuation models.
The markets are working, and now that Wall Street is understanding the reality of these products there are many writedowns and few new investors. How long until history is forgotten?
The subprime saga is far from over. The markets remain on high alert. Each day seems to bring new rumors or announcements of losses. A golden age for banks and brokers has come to a sudden end.
The moral is clear. When Wall Street appears in genius mode, raking in huge profits on mysterious products and complex trades, the secret isn’t genius at all. It’s that hubris is running wild, and so is risk. And whether it’s tomorrow or five years hence, risk will jump from the shadows, knife in hand, to cut genius down to size.
who ever wrote this is on the money