When I was asked if I’d like to review Charles R. Morris’s The Trillion Dollar Meltdown, I replied "why not, it’s a book I should have already read anyway." I’m glad to be able to say that I was right, unless you’ve been intimately involved in financial markets for the past two or three decades, Morris’s book has something to teach you about why the current financial crisis is happening. He explains not just the mechanics of the meltdown, in the most jargon-free prose I’ve seen, but in describing the crises of the past decades, including the crash of 87, the S&L debacle and the collapse of the Collateralized Mortgage Obligation (CMO) market in the early 90s (which I hadn’t even heard of, and I suspect I’m not alone) he is able to show the features all have in common.
Morris does all this in a relatively slim volume, clocking in at 169 pages, not including some fairly extensive notes. The book is well organized, with chapters generally proceeding chronologically, but sections in chapters dealing with classes of securities or financial activities. At the end of it, you’ll have a good grasp of the major types of instruments, how they work and what the problems are with each of them. More importantly you’ll have a sense of the commonalities that underlie all the problems.
At the heart of the book is the process of securitization. If you’ve been following the crisis over the last year or so you’ve heard the acronyms—CDO’s (Collateralized Debt Obligations), ABS’s (Asset Backed Securities), CLOs (Collateralized Loan Obligations), RMBS’s (Residential Market-Backed Securities) and so on. Enough to make one wonder if the financial sector is looking to win the "alphabet soup" crown away from the army.
But I’ve never read anyone explain as well as Morris what they actually are and how they came to be. Or why they matter so much. The key is that the process of securitization allows you take anything that you can assign a value, a default chance and a return to and make it perform almost identically to a vanilla bond.
Well, in theory.
In a RMBS, for example, a pool of mortgages is used to support an issuance of bonds. These bonds are divided into groups, called tranches, by likelihood of default and expected return. Top tranches have first claim on income, but only get a small return. The low tranches absorb any defaults first, but they have much higher returns. The combination gives both a high quality low default bonds (the high tranches), and high risk, high return bonds (the low tranches). Most tranches are high quality, usually on order of 80% (after all, a 20% default would be massive) but the number of CDOs which can be sold depends heavily not on how many people will buy the best tranches, but rather the appetite for the lower tranches, known as "toxic waste."
This process is, frankly, a brilliant innovation. As Morris notes sardonically when speaking of Long Term Capital Management, the hedge fund whose ’98 collapse the Fed feared could smash the world financial system, "As a general rule, only the very smartest people can make truly catastrophic mistakes."
It’s genius because securitization doesn’t just work with mortgages. It doesn’t even just work with assets like manufacturing equipment or commercial property. You can build CDOs on top of almost anything. For example an arrangements like credit default swaps. A credit default swap is where one party guarantees to take on the risk of default on another party’s loans in exchange for regular payments. As of mid-2007, per Morris, there were 45 trillion dollars worth of credit default swaps outstanding. Many of which had then been turned into CDOs. So first you have, say a mortgage-backed security. Then, on top of that you have a credit default swap based on insurance of the chance that those mortgages (plus probably some others) will default. The relation of the CDOs to the underlying securities is getting rather faint. And sometimes there are CDOs which are based on other CDOs, these are referred to as CDO². There are even some CDO³.
The end result is that the asset base backing up the securities is an inverted pyramid. The securities are worth much more than the actual assets behind them.
But, let’s step it back a bit, to something mentioned earlier.
You can do all this—turn anything into a security, if you can value it—and, more importantly, if you know what the default risk is.
And that’s a problem, because determining the default risk on these sorts of exotic instruments is very difficult. And who’s going to believe the numbers you come up with? The answer that the creators of these securities found was to go to the ratings agencies, companies like Moodys which had specialized in rating debt issuances by companies and governments for how likely they were to be paid back. They’d give them information and the ratings agencies would come up with a default chance. That number would be plugged into the model and with that number values and returns could be determined.
Unfortunately the ratings agencies models seemed to operate mostly by assuming that the era of free money of the mid-years of the decade could and would go on forever. It also seemed to assume both that there was no fraud going on in the origination and packaging of the various original loans and that the loans were high quality, when instead they were as a group probably the lowest quality loans made since the 1920’s, and perhaps in all of American history. Morris points out that the ratings agencies seem to have taken about 3 years of low defaults and assumed they’d go on forever — they didn’t even look back a decade.
In computer programming there’s a phrase known as GIGO. Garbage In, Garbage Out. Although Morris never uses that word, this is an important part of what he’s discussing. The default values were simply incorrect. Thus all the sophisticated math; all the fancy computers and billions of cycles, were meaningless. Put the wrong numbers into your formulas and you’ll get the wrong results. (All of this assuming the math was correct to begin with, which I have some doubt about. But even if it is, it wouldn’t work if the inputs were wrong.)
In this case, since the default rate is turning out to be much higher than expected, the value of the securities created is turning out to be much less than the people who bought and sold them expected.
So, a higher default rate is bad. But if that was the entire problem it wouldn’t be all that bad. The lower tranches would get hit a bit, but most of the companies involved would survive.
There’s an old line amongst traders which runs as follows: genius is leverage and a rising market.
Here’s another one for you: catastrophe is a leverage and falling market.
And that’s the problem. The primary actors are almost all very highly leveraged. To start most of them have taken a small amount of base capital and then they have borrowed at a multiple against it. To paraphrase an example Morris gives, imagine that you raise 20 million from investors. Now borrow 80 million. You’re up to 100 million. You’re 5:1 leveraged. If you were to straight up invest that money, and lost 20% of the value of your investment, you’d be wiped out.
20% is a pretty big move, mind you. If that’s all that had been done, it would be unfortunate, but not too bad. But imagine now that you have invested in something that itself is leveraged – say $100 million in first-loss bonds underpinning a 2 billion CDO. If 100 million is underpinning the losses of 2 billion, that’s a 20 to 1 ratio. A loss of 1% of the CDO’s value wipes out 20 million in value.
Now imagine that CDO drops 3%. The purchasers initial capital was 20 million. They’ve just taken a 60 million loss—all their capital, plus 40 million.
Of course, if it’s just happened to one CDO, no big deal. They make it up from elsewhere. But what if it’s happening across the board? What if the entire class of mortgage backed securities, say, is experiencing much higher losses than anticipated. What if they are all collapsing in price? And if the industry, not just this company, but almost all banks, brokerage houses and hedge funds, have invested in a lot of these sorts of leveraged deals?
Catastrophe: Leverage and falling market.
This is the heart of Morris’s book. Securitization. Leverage. Group Think. Add in agency problems, where mortgage brokers, for example, knowing that they won’t be holding onto the mortgages don’t bother to make sure that people can pay them back, add two scoops of "no regulation because we believe the free market can regulate itself", and you have—
And yet, I haven’t nearly done the book justice. Morris discusses all of this within the context of the times larger economic and philosophical background, tracing free-market ideology (which I like to call free market fundamentalism) back to Chicago school style economics with its belief that governments should never intervene in private markets and that private markets are capable of self-correcting and self-regulating. Clearly, Morris points out, this is not the case. The free market is capable of doing great things, and Morris gives it great credit for the good times in the 80’s and the mid 90’s, but it is also prone to excesses it can’t itself control.
Nor, Morris points out, do we actually live in a free market system when it comes to the financial industry. Instead the financial industry is clearly privileged. It earns far more profits than the average for the economy, and has done so for a couple decades now. On the face of it, that doesn’t make sense, until you think about what’s happening right now and what has happened in most financial crises—the government has stepped into stem losses and kept many companies from going under when in a "free market" they would otherwise have done so.When you socialize the losses and privatize the profits, well, yes, profits will be high.
On top of that there is a virtuous cycle between and industry’s profit and government actions. Morris uses the example of how student loans are guaranteed by the government, but the profits from the loans mostly accrue to a private company. It’s not efficient. It is, in fact, a direct transfer of public money to private. Although Morris doesn’t use the example, one could also look at how hedge fund managers recently managed to dodge additional taxation. They do give a great deal of money to politicians, after all.
Morris touches on a number of other areas—from the overprinting of dollars by the Fed and the collapse of the US dollar and the devastation wrought by private equity firms who take a loan out to buy a company, have the company pay them a billion dollar dividend, put the loan on the company’s books, lay off a bunch of people and then sell stock back to the public. End result, a company that is a lot less healthy than before you took it over. But your bank account looks great. And you did it all with other people’s money. Nice "work" if you can get it.
The book draws to a close by looking at how large the problem is, which Morris puts at tentatively a trillion dollars (if anything, an underestimate) and then with some suggestions on how to fix the system, including:
Capital requirements for all financial firms so that leverage is limited.
Credit insurance to only be counted if the entity offering it has credible reserves of its own (I’d rather just ditch credit insurance entirely, I think it’s best to keep leverage ratios under firm control and insurance will reduce overall system capitalization.)
Loan originators have to absorb first losses. This means an end to mortgage brokers, say, giving loans to people who will probably default, since they’re the ones who will pay the price if they do.
Credit derivatives to trade on an exchange to provide proper market prices.
Restore some form of Glass-Steagall and stop banks and investment banks and brokers from all dipping into the same business.
Most importantly, Morris notes that when we had our last truly major financial crisis, the era of stagflation, the United States, in the person of Fed Chairman Volcker, bit the bullet hard and did the brutal work necessary to wring inflation out of the economy and bring the money supply back under control. When Japan had its meltdown in the late 80’s, a meltdown that looks a lot like what is happening in the US, especially in terms of an overinflated housing market, it never really cleared the books or made the hard decisions. As a result, 20 years later, Japan has never really recovered, and is still in what has become known as the bright Depression.
So, since Charles finished his book in late 2007, and since a great deal has happened since then I’d like to ask what he thinks of how the financial crisis has been handled since then, and especially how the Fed has handled it.
- Do you think the Fed auction facility is a good idea?
- Do you believe Goldman Sachs was wise to "buy" Bear-Sterns and was the Fed was right to underwrite Goldman Sachs’ purchase of Bear-Sterns.
- Does the Fed’s essential guarantee of all the toxic waste qualify as making the hard decisions necessary to resolve the situation?
- Will further deleveraging overwhelm the Fed, and if it doesn’t what is the economic consequence of socializing so many losses?
- Do you still hold to your 1 trillion estimate? If not, what numbers are you looking at now and what has changed?
Please welcome Charles Morris to the Lake. As always in Book Salons please stay on topic and take any off topic comments to the prior post’s thread.
And if you want to understand what’s been happening, why it’s happening, and how it’s likely to play out, buy a copy of the book. I’m sure it won’t be the last book on the crisis, but it’s definitely the primer that you need to understand the basic mechanics of what happened and to place them in a larger historical context.