This is not the idle chatter of permanent bears. The subprime mortgage collapse now hitting Bear Stearns may be just the start.
Serious analysts from big investment firms are talking ominously about “the big one”. It will make you angry to learn just how the investment industry has got you involved.
If you can understand what’s happening, you should have time to move. So let’s get to the bottom of it now, and in plain English.
From subprime mortgage to MBS
It all starts with the mortgage. About six million people in the United States who have no money have borrowed about 100% of the value of a house, right at the top of a housing market which has since fallen sharply. These are the subprime borrowers.
The lenders, however, did not have to worry very much about the risk of default, because they rolled these mortgages into bonds called Mortgage-Backed Securities, which they then sold. They got to be off-risk within a few weeks, because by then these re-packaged mortgages belonged to other financial organizations.
But it is not always easy to sell a package of these Mortgage-Backed Securities (known as MBS for short). Selling such a product demands that the credit quality is assessed; and because the underlying mortgages are subprime they are quite likely to go into default.
So a credit-ratings agency will only give the subprime MBS a low credit score, which means it is not considered investment grade. That disqualifies it from the portfolios of many professionally managed funds.
This is where it pays to get a bunch of smart investment bankers involved.
The investment bankers slice the MBS into several “tranches”. These are known as Collateralized Debt Obligations, or CDOs for short. The idea is to create some higher risk assets and some much safer ones by slicing up the MBS into what are called equity (high risk), mezzanine (middle risk) and the much sought-after investment grade bonds (low risk).
Higher risk equals higher returns, of course, so the equity tranche of the MBS will earn the highest profits if things go well. But if things start to go wrong, the equity is lost first, and then the mezzanine. Even then, the investment-grade bonds could still get fully paid out. This persuades the credit ratings agencies to give the lowest-risk tranche a high enough credit rating to qualify for the critical investment grade rating.
In this way the investment bank has created a decent proportion of highly marketable bonds out of a package of low-quality mortgages. Fairly standard, for example, is to convert a large package of MBS into perhaps 80% investment-grade bonds, 10% mezzanine, and 10% equity.
How investment banks distribute the debt
The original mortgage lender is in a hurry to get the whole MBS sold off, because this raises cash which can then go to fund fresh mortgage loans to new subprime borrowers. The investment bank is well motivated to slice up the MBS, because selling investment products is what it does best. It won’t want to keep much, if any, of the newly created CDO tranches, because investment banks earn their money primarily by deal-making and distribution, rather than by taking risks with borrowers.
In the market for CDOs, the investment bank will find it relatively easy to sell the investment grade bonds. They go mostly to respectable institutions. But the mezzanine and particularly the equity tranches can be trickier to dispose of. The effect of concentrating the risk, as well as the upside, in these tranches is to make them “hot” – so hot, in fact, that investment insiders sometimes call them “toxic waste”.
How can these toxic bonds be sold off? There are several ways.
Method One: Create a hedge fund
The investment bank might choose to set up a hedge fund, possibly even using some of its own money to get the fund started. The hedge fund’s objective is to trade in the high-risk equity and mezzanine CDO instruments.
Let’s imagine that the investment bank puts up the first $10 million. The hedge fund then buys the equity tranche of the CDO from the investment bank. In effect, the investment bank is actually buying the equity from itself.
With a bit of luck – and this is what happened over recent years – the housing market then goes up. Now the CDO equity is floating higher in the water, because there’s a cushion of higher house prices preventing those original subprime borrowers from defaulting. This rather obscure equity instrument, which is not traded on any open market, and so is not a liquid asset that can readily be bought and sold, should now be worth more than it was at issue.
It gets marked up in value, and it gets marked up much faster than the underlying house prices, because all the price volatility is concentrated in this thin slice of CDO equity. The hedge fund is now a real performer! And that means it will be rewarded by further investment from outside. So what started as a vehicle with a little investment bank cash can grow the funds it manages under its own steam.
Next, and this is what hedge funds are all about, it will leverage its risk, too. The hedge fund goes out to an unrelated lending bank, holding its high-performing but illiquid toxic waste in its hand, and it asks to borrow money using the waste as collateral. The lending bank has access to cheap money, and so it has the prospect of lending for spectacular profits.
Now the MBS wheel is fully in motion. With a little co-operation from the investment bank, to which it is closely related, the hedge fund loses no time in marking up the value of its equity CDOs, on the basis of rising house prices. There is an overwhelming pressure to do so, not least because the hedge fund managers are rewarded on performance. Alas, in the absence of a genuine open market, it is too easy to manipulate the CDO’s price up to an unrealistic value.
The lending bank can see its collateral floating higher and higher in the water, and so it lends ever more cash against it to the hedge fund, and it picks up the new CDOs bought by the hedge fund as further collateral on new loans. Naturally, as with all collateral, the bank claims the right to sell the bonds if the underlying debt gets into trouble. But it doesn’t look like a real danger at this stage.
So the money lent by the bank against the CDO equity goes back to the hedge fund, which buys more CDOs from the investment bank, which buys more MBS from the mortgage lender, which provides more money to subprime borrowers, who then buy more houses, pushing real-estate prices higher again.
This solution only gets into trouble when house prices turn sharply down. The lending banks ask for their money back, but the hedge funds haven’t got it. All of it has been invested in CDO tranches. So the collateral needs to be sold. No problem, surely. It’s on the books at a few billion dollars after all.
But with its concentration of risk in a falling market, the equity slice has been hemorrhaging value, without ever being bought or sold in an open exchange. It’s incredibly painful for the investment banker to mark down a paper price in these circumstances. First, he doesn’t actually know for sure that the price is falling any more than he knew it was rising when he marked the price up. But he does know that marking the price down will immediately be bad for him, his team, his bank, his customer and everyone else. He doesn’t have to be totally evil to put off marking down the price until tomorrow – or maybe the next day.
That’s why the lending banks which later get hold of their collateral can be presented with a very nasty surprise when they finally try to redeem the situation with a sale. It simply won’t fetch anything like the price it was last marked at.
Something like this is what happened to Bear Stearns’ hedge funds. Its two funds were leveraged 5 times and 15 times respectively. That’s the number of times they went round the financing wheel of leverage.