Aug 22, 2007

a credit meltdown primer

I had a couple requests to explain what the hell is going on with Wall Street these days so I thought I would post a little 'what happened'. Being on Wall Street it is hard to gauge how big a deal the recent news has been on Main Street. It's a big deal here. But I'm not sure it's a big deal for the average Joe. And most of what I've read has been just plain wrong. Anyway,

Let's start with how mortgages used to be sold or originated. Back in the 70's. Let's say you live in Pleasantville. You want to buy a house. You go to Pleasantville Bank and say you want a loan. You fill out some papers and talk to a representative and shake hands. The bank then goes and studies this information and gets information on your credit history and figures out if they should give you the loan and under what terms. Eventually you get the loan. Why is that bank giving you a loan? They must make money right?

The way a bank works on a simple level is by making money on a 'spread'. Presumably the citizens of Pleasantville have saved some money and deposit that into the bank. The bank pays those people a return on that money. Some kind of savings rate. Let's say that is 3% per year.

The bank is then sitting on a lot of cash. They can do a number of things with this. They could buy investments like stocks or bonds. Or they could loan out the money to local business and young couples buying homes. For this they will charge the company or family a rate higher than 3%. Let's say 6%.

6% - 3% = 3% is the spread they earn. If they have a million dollars in deposits and loan out that million they will earn $30,000 a year. Pretty simple.

Now a couple of points. First, you can see that without deposits or some access to 'cheap' cash the bank cannot earn money. If everyone decides to take their money out of the Pleasantville Bank the bank has some problems. That's because they don't actually have a million dollars anymore. They loaned it out. The bank has a problem with 'liquidity'. See "It's a Wonderful Life". There are some regulations and services offered by the government to help alleviate this type of liquidity event now. The takeaway is that financial companies don't go bankrupt because their products become obsolete or competition out-competes them. They go bankrupt because of liquidity issues; because they can't get access to cash. This is how a financial company dies.

Second the bank made the loan to the couple and the bank holds the risk. If they make a mistake in 'underwriting' the loan then they will suffer the financial consequences. This is good. Risk and reward should be tied closely to avoid egregious underwriting errors.

So where did you get your mortgage? 1 in 6 of you got it from Countrywide. Is Countrywide a bank? No. They have a small banking component but let's just ignore that. If they aren't a bank and they have no deposits then where do they get cash to pay for people's homes in the form of a mortgage loan?

The way they do it is a relatively new method. They go to the Wall Street banks like Bear Stearns or Goldman Sachs. Goldman will give Countrywide a ton of cash for which they can go write mortgage loans to you. They actually don't give any cash. It's really just a contract. But it is the same difference.

So the obvious next question is how does Goldman get cash? They get it from institutional investors like pensions and other financial institutions that want to invest money (like Moneygram) but more likely hedge funds. So do hedge funds hold mortgage loans? Not exactly. What Goldman does is they 'securitize' these loans. They take all the loans from Pleasantville Bank for example and bundle them into a single lot and then sell pieces of it off like with a company's shares. Dick and Jane's mortgage technically is held by multiple hedge funds.

Why does Goldman do this? Well they want to congregate lots of loans together to spread the risk of default evenly among the 'shares' of the securitized loan portfolio. That way every share is like the other. If one hedge fund held Dick and Jane's mortgage and they defaulted then that fund would take the hit. It's easier to spread the risk around so that you can use mathematical averages to determine risk.

The other reason to do this is to combine these mortgages with other types of fixed income debt unrelated to real estate. In most cases crappy mortgages (read sub-prime) are used to 'spice' up the lot or increase the 'yield' on the lot or increase the payments to the holders of the lots. These three things mean the same thing. Sub-prime mortgages or mortgages to people with a lower capacity to pay for them, typically pay higher rates. If this strikes you as weird it should. People with less ability to pay, pay more. More on this later.

The third reason Goldman does this is to create 'high grade paper' out of bad paper. Let's say a single lot contains $100B worth of mortgages and it is all subprime. The rating agency might rate it all as junk debt. Given what I said before then every share of the lot has the same risk and same return. But what Goldman does is to structure the risk. It cuts the lot up into say 10 sub-lots. The bottom lot or tranche has the most risk. If anyone defaults on their mortgage then the bottom tranche takes the hit. The top tranche doesn't take any hit. As more mortgages default the losses start to hit higher tranches. The bottom tranche is known as the equity tranche because it has the highest risk like a stock share. The top tranche is the safest.

Accordingly rating agencies like Moody's and Fitch which characterize the risk associated with a particular tranche, rate the equity tranche with the highest risk (junk) and the top risk with the lowest (say a AAA rating). Hedge funds can now figure out what type of risk they want to take and purchase the corresponding set of tranches. So why would anyone want the lowest tranche? Because it pays the highest return. More risk, more return. Companies like Moneygram which have cash to invest might take a little bit of subprime debt to 'spice' up their return. In this way Goldman can create more 'products' out of a bunch of junk. And in particular create some grade A paper out of junk. Many articles have said this is voodoo magic but it's a legitimate way of structuring the debt. Assuming that the debt is rated correctly by the rating agency.

Okay let's go to the hedge funds. Why are they buying securitized mortgages (or mortgage backed securties or MBS)? Remember they are only earning a spread on this stuff just like the banks. And it's not a huge spread either. Maybe a few percent. Well for a long time the MBS lots were doing well. In other words there weren't a lot of defaults. Every year people who had secured sub-prime mortgages could refinance to a lower rate or, because their home had gone up in price, refinance with a home that was worth a lot more. Housing prices going up and rates dropping made these refinances possible. No one defaulted.

If no one defaulted then the riskiest tranches did well. There were no losses. So what hedge funds ended up doing was to lever up. Say they had a billion dollars of assets under management (AUM). They went to Goldman and said I want to borrow $9B dollars. Goldman charges them a rate for this loan and the hedge fund ends up buying 10 times as much MBS product. Unlevered they might have made 2% return but levered up they made 20% return. This is a fantastic return. And for a while everything went fine. In fact some funds levered up even more and bought even riskier tranches of MBS. Why not? No one was defaulting.

Then housing prices stopped going up.

And rates stopped going down.

And then there were defaults. Big defaults.

And someone, somewhere was holding that bad tranche. You've probably seen a few hedge funds go belly up recently. Bear Stearns had 2 go bad.

All of a sudden everyone is wondering what they hell they have on their books. And the defaults became so bad that paper graded as reasonably unrisky was going bad. All of a sudden no one trusts the ratings anymore. If it's a MBS product you simply don't know what you are holding.

Remember previously the bank held the loan and thus held the risk? Well with the flow through of funds from mortgage lender to rating agency to Wall Street bank to hedge fund, the risk has been transferred. Now all the mortgage lender and rating agency and Wall Street bank wants to do is sell more and more MBS to the hedge fund. The risk is off their books right? It became a volume game. That's why lending standards were dropped. No money down. Teaser rates. Who cares about the FICO score. Proof of income, who needs it. Etc. Basically the mortage originators were signing shit mortgages. Total junk.

No one really knows how bad it is but the mortgages written recently are a lot riskier than the rating agencies estimated.

Now all of a sudden no one trusts what is in these MBS products. Or CDOs (collateralized debt obligations) for that matter. CDOs are similar to MBSs but they contain other debt products. Remember mortgages were used to spice up the returns in these products. Without any trust in the ratings, no one wants to buy them anymore.

But it gets worse. Because all those hedge funds that have a 10X lever of MBS products on their books now need to raise cash. Why? Goldman realized hedge fund X has some serious shit on their books. Presumably because they securitized it. Now they want hedge fund X to pony up some more money so they are not levered up. Goldman is scared it will lose the $9B it loaned to them. The only way for funds to raise cash is to sell whatever is on their books. In other words, delever. But remember, the MBS stuff is frowned on now. They can't sell it. No one wants it. No one is buying. So what else do they have on their books? In the case of Bear Stearns' hedge funds, nothing. They just fold. Hasta la vista. But others have some stuff. Equities, other debt, god knows what. So they dump it. And dump it indiscriminately.

Now here comes an interesting point. Many hedge funds that were levered up were quant funds. A quant fund is a fund that uses some type of mathematical modeling to help with their selection of investments. In reality almost every fund is a quant fund. Almost no one operates without some mathematical modeling anymore. And in general a lot of it is similar. We use quant tools. The hedge funds in general are very good at modeling. Our model alone beats the index consistently. The biggest quant guy in the world made $1.5 billion dollars last year. That's why some hedge funds levered up in the first place. They make such good returns with such little risk (or volatility) that they felt comfortable doing it.

So now they start selling their equities and closing any short position they might have. Since they are good at modeling they own good cheap stocks and are short expensive bad stocks. Stuff our fund holds and shorts. The selling was indiscriminate. It didn't matter how good it was. They just sold. For 3 days our fund was just creamed. We just got slaughtered. Our longs were doing horribly and our shorts were even worse. And then it stopped. There was no reason for it to stop but it did. Some opportune players, ourselves among them, started buying up the even cheaper cheap stocks and shorting the even pricier expensive stocks to take advantage of the situation. And the only reason we could do that is we use very little leverage. Eventually it all sorted itself out. Presumably the hedge funds raised enough cash to de-lever. Or they went kaput.

A lot of articles have painted quant funds as the idiots here. Those stupid math nerds. But quant funds like ours are fine. We even came out ahead in all this. The problem here was leverage. The inability of people to adequately understand the risks they were taking by levering up. The same thing happened to Long Term Capital back in 1998. Leverage is the problem. Not quantitative approaches to investing.

While the equity markets returned to normalcy, the credit markets didn't. There is still no real market for MBS and CDO right now. No one wants to buy it. And no one can sell it. Even commercial paper which is of a higher quality is seized up. More funds went belly up. No one has a clue how to price this stuff now. What is the risk of default on this stuff? Sure anything can be sold for the right price but the haircut involved is huge.

So now the Goldman's of the world no longer are securitizing mortgages because hedge funds aren't buying. So now there is no cash to fund the Countrywides. Take a peak at Countrywide's stock chart (CFC). Or Bear Stearns (BSC). Anything with a slight chance of having MBS on their books was taken out back and shot. The Countrywide's have very few sources for cash right now. Many of them like Novastar, Accredited Home, HR Block, IndyMac are history. Some are even saying we will all be getting our mortgages from banks from now on.

There are two lessons here. First, unless risk is tied to reward tightly you will get fraud or inefficiencies in understanding that risk. The second lesson is that leverage is generally bad. It's always the source of these kinds of problems. Whether it is household leverage (large mortgages, credit card debt, etc) or company or hedge fund leverage, it can always end really really badly. Just say no to leverage.

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