In the first article in this series "The Financial Crisis - It's Not That Complicated" I explained how sub-prime mortgages could not, by themselves, bring our global economy to its knees. In this article we'll begin to explore the real causes.

I first heard the term "toxic assets" last fall.  It was couple of weeks after the big news that the global financial system had teetered on the brink of complete collapse.

Along with the word "derivatives" it is among the most-used terms used by those folks talking about the financial crisis and its causes. But just what does the term "toxic asset" refer to?

Two types of toxic assets are causing most of the problems, both are derivatives. They are called Collateralized Debt Obligations, (CDOs), and Credit Default Swaps, (CDSs).

I think it would help to have a few definitions of the terms above before we begin the discussion about them. So here goes:

1. Derivatives; in the world of finance a derivative is a financial instrument, the value of which is derived from another thing of value, called an underlying security. This underlying security can be a bond, stocks, a mortgage or an IOU. A derivative could be a document that gives you 10% of the proceeds of a loan to Ford Motor Co. The seller of the derivative would of course need to own all or part, at least 10%, of the Ford Motor Co. loan to sell you a 10% interest in it.

2. Collateralized Debt Obligation; a type of derivative that is based on groups of underlying securities. Usually the underlying securities are of differing quality and/or grades. It might contain bonds from major corporations that are rated AAA and some rated AA and some rated BBB.  Shares of theses CDOs are then sold to other investors.  Here's a 6-minute video that does a good job of explaining CDOs.

3. Credit Default Swaps; this is a type of insurance policy.  It provides a payment to the buyer if a credit event occurs on the item that is insured, also referred to as the underlying security.  A credit event might be a failure to pay or it could be based on a downgrade in the credit rating of the underlying security. For instance I could buy a CDS on the 10% of the Ford Motor Co. loan in the derivatives discussion above. Then if Ford Motor Co. failed to pay back the loan, the person I bought the CDS from would pay me the amount that I failed to get from the Ford Motor Co. loan.  If the CDS covered the downgrading of Ford Motor Co. I could collect on my CDS if Ford was downgraded from an AAA rating to a AA rating.

In this article we'll talk about how Collateralized Debt Obligations or CDOs for short, contributed to the financial turmoil we find ourselves in.

Let me start by saying that Wall Street loves risk.  As a matter of fact, that's what makes them tick.  The thing that Wall Street hates is the inability to asses that risk. It is the inability to assess risk that has the credit markets frozen and Wall Street moving in slow motion.  In a word, they are afraid to act because they can't tell how risky a given move might be.

Risk, and the ability to accurately predict it, is what Wall Street is all about. If they can buy an asset and sell it for a higher price, or use it to free up more money than they spend to buy the asset, they're ahead of the game. If they are smarter than their competition about estimating their own exposure to losses in buying, selling or holding an asset then they will make more money than their competition. Relative performance and bottom-line profits are what make Wall Street go round.

I've heard some people say that the credit markets are not moving because of a lack of trust.  In my opinion, that's a silly notion. Banks have never trusted each other. In the past they've been in a position to assess the risk of lending to their fellow bankers. Now they're not. So they're not taking risks that they can't measure. 
 

Mortgage-backed CDOs provide a way of hiding the real risk of buying and holding the asset. They are made up of a series of derivatives.  They start with a collection of securities that are based on some kind of loan that produces periodic payments. They use what is called a special purpose vehicle, SPV for short. This isolates it from the originator's balance sheet so if it goes bad they can't be held liable.

Then they sell off shares of the CDO.  The shares usually come in three flavors.  Senior= low risk, low return; Mezzanine (middle)= medium risk, medium return; Junior=high risk, high return.  Each level is called a tranche, (rhymes with launch.)  When the earnings from the underlying assets come in, the senior tranche is paid first, then the middle, then the junior. The theory behind the reduced risk of CDOs is that the chance of all of the underlying securities going bad was considered very unlikely. Many of them were based on mortgage-backed securities, MBSs.

Let's look at an example. Assume the senior tranche is paid 5%, the second gets 7% and the junior tranche gets 12%. As long as the underlying assets are performing with no late payments, early payoffs or defaults, everything is great.  There is plenty of money to go around.  Maybe there's enough left over for the originator or some of the investors to take the earnings and create another CDO.  That's what happened in the late nineties through 2006. That makes the real risk harder to assess for the buyer.

These secondary CDOs flourished in the good economic times. In the early 2000's money was cheap and Wall Street was making a lot of money with CDOs.  They encouraged lenders to loan more and more money to people to buy homes.  The lenders couldn’t meet demand so they lowered the qualifying standards in order to satisfy Wall Street's thirst for new mortgage debt. In the Real Estate Industry we started seeing things like stated income loans.  It was possible to get a mortgage with questionable credit and no proof of income!

In the late 1990s the bankers on Wall Street, driven by the need to assess risk better than the competition, found a friend. His name was David Li and he worked as a quantitative analyst.  Quantitative analysts are math wizards who design computer models to assess risk, price the latest financial instruments and predict market movements.

In 2000 Li published his ideas that resulted in a computer model that predicted the probability of a given set of corporations defaulting on their bonds in quick succession. This model later became known as the Gaussian copula function.  It became the holy grail of the folks involved in CDOs. It was a big step in the process of the smart guys on Wall Street conning themselves into believing a computer program could predict human behavior. The more they used it the more they relied on it.

A major problem problem with Li's Gaussian copula function was that its predictions used data that was collected in a time of economic growth.  The guts of the program were based on the performance of credit instruments as they performed in the 1990's, a period of economic prosperity. As reliance of his model gained popularity, David Li warned of its defects.  But Wall Street didn't want to hear it.  They disregarded the warnings from the guy that invented their holy grail of credit risk analysis.

By 2005 the stage was set.  Home prices had been going up over 10% a year in many markets. Twenty-two percent of new home mortgages were sub-prime. Wall Street had seen a few bumps but nothing big enough to get excited about. Everyone was making lots of money.

2006... housing prices had peaked and some places started to see weakening demand. Many thought this was just a minor adjustment in reaction to the sizzling market of the past 4 years.  Mortgage foreclosures started creeping up.  The Fed funds rate hit 5.25%.

By early 2007 things started to look bad in some major housing markets.  Sub-prime lenders began to fail, the largest sub-prime lender, New Century Financial, filed for Chapter 11 bankruptcy. In August some hedge funds and financial institutions reported losses and write-downs in mortgage-backed securities. Swiss Bank UBS, a big participant in CDOs, announced a $690 million loss on September 30. On October 10, Feds created New Hope Alliance to help upside-down homeowners. In the last quarter the Feds threw $114 billion at the banking/housing problem and Citigroup, UBS, HBSC and Merrill Lynch reported losses totaling $22.2 billion.  Mortgage delinquency rates hit 5.82% a 20-year high, 42% of them were adjustable-rate mortgages.

Early 2008 saw UBS, Citigroup and Merrill Lynch report 4th quarter losses totaling $43.3 billion. All were heavily involved in the CDO market.  Bear Stearns was bought by JP Morgan for $2 a share and backed by Fed guarantee of $29 billion in credit.

Many, if not most, of the losses incurred by Wall Street and the global financial community from 2006 through the first part of 2008 were due to CDOs and similar derivative schemes.  A new player emerged that was partly responsible for the demise of Bear Stearns, it was another type of toxic derivative, the Credit Default Swap. We'll cover that financial Bad Boy in the next article as we continue this series; "The Financial Crisis - It's Not That Complicated."
COPYRIGHT 2009 BY RAY WOOD