Sub-Prime Primer (Part II)

[Read previous post “Subprime Primer I” below first]

OK, so where did we leave off in Part I………lots of factors contributing the “fertile soil” into which the seeds of the credit crisis were planted; mortgages being bundled into MBOs…………that’s a good place to pick back up.

After the bundling process creates an MBO these securities are sold to various large institutional buyers including pension funds, mutual funds, sovereign funds (owned by countries that have excess cash flow, unlike the U.S.), and municipalities that are looking for safe investments.  And they did appear to be safe because they had solid ratings from the rating agencies like S&P.

With more and more pressure to encourage the huge money-making machine that the securitized debt market had become, two important changes occurred that heavily contributed to the Credit Crisis that began in 2007 and the collapse of Wall Street in 2008………

Change #1:  Sub-Prime Mortgages

When mortgage securitizations were first introduced (late 60’s/early 70’s) investors bought generally homogeneous portfolios of mortgages…….similar credit profile, income, liquidity.  The homogeneous portfolios would be rated by S&P just like they were being rated at the height of the sub-prime mortgage market.

The HUGE difference was that the early portfolios contained only borrowers with reasonably strong (and documented) credit, liquidity, and income.  Sub-Prime and no-doc mortgages had not been invented and investors experienced a very predictable and consistent return on these portfolios of relatively homogeneous mortgages.  MBOs built a strong reputation as safe havens, especially for investors concerned first and foremost with safety-of-principle.

For the sake of argument assume S&P rated one of these portfolios an “A+” and that this rating correlated to an expected loss of investment only one out of ten thousand times — almost risk-less.  People very rarely missed their mortgage payments because didn’t want to lose their home, especially since home equity was the primary method of “saving” for most people.  And home prices had gone up relatively consistently for many years with few exceptions.  Seemingly, almost everyone agreed that for all these reasons MBOs were indeed almost risk-less investments, until…………the introduction of sub-prime (SP) mortgages.

The original sub-prime mortgages offered were actually considered a success……..Fannie & Freddie took a baby step out of the risk continuum by slightly lowering credit standards and increasing borrowing rates by a small amount for sub-prime mortgages.

[Side Note:  If Fannie Mae charged an extra 1% for a sub-prime loan they would get far more than an additional 1% in revenues.  Here’s why in an overly-simplified example……….Assume Fannie and Freddie received a margin of 1% for packaging and selling MBOs.  If they then increased rates by 1% for sub-prime mortgages, to account for the additional risk, they would increase their margin from 1% to 2% — increasing revenues by 100% (again, this is a very over-simplified example).  Don’t worry about the math — just focus on the fact that a small increase in rate can lead to a huge increase in revenues.]

Initial payment records were strong as were margins.  Fannie & Freddie were happy, investors were happy, mortgage companies & banks were happy, and the new mortgagees were glad to be approved, even at a higher rate.  So what happened????????

What happened next will be the focus of many books in years to come.  Many explanations will be offered but here is what everyone will likely agree on………..everyone got greedy from Fannie & Freddie to banks & mortgage companies to Wall Street giants.  The only way to feed this insatiable greed was to continue to increase the pool of mortgagees and the only way to do that was to lower approval standards again and again.  Eventually, terms like “no-doc”, “low-doc”, and “stated income” were part of our everyday language.  Borrowers with little or no income could say they had strong income and the mortgage originator would put that on the application without being required to verify it, as they would have been in the past.

Note on size of SP market:  Experts differ on the actual size of the sub-prime market at the peak but most estimate it around $1 Trillion +/- $300 Billion.  For the purposes of this post just focus on the scale in comparison to the estimated worldwide assets values and don’t get too caught up on whether it was $800 Billion or $1 Trillion.  For the purposes of this post I’m using $1 Trillion, which is probably not an exaggeration since there were over $600 Billion of SP mortgages originated in 2006 alone (various sources………type “size of subprime market” into your web browser to find more information).

And so the sub-prime mortgage market ballooned to an estimated $1 Trillion by 2007.  However, even a 100% failure of every single SP mortgage would not have been enough to trigger the worldwide credit crisis and the death of Wall Street.  Even though $1 Trillion is a huge number, at the same point in time, worldwide asset values were estimated at well over $100 Trillion — over $50 Trillion in the U.S. alone (again, various sources…….Google the key words).  Sub-Prime represented less than one percent of world-wide assets and even if every single SP mortgage was worthless it would not have been a catastrophe in and of itself.  But here is where it gets really interesting…………… 

Change #2:  Derivatives (MBOs, CDOs, CDS, synthetics) and Leverage

Again, many books will be written on this topic in coming years but I’ll try to keep this as simple as possible………….

It turns out that there was MUCH more demand for sub-prime MBOs than there was supply because the return on investment (ROI) for subprime MBOs was higher than traditional MBOs because the risk was higher.  For you statisticians & MBA’s out there, you are probably screaming at your monitor that the risk-adjusted ROI was much more modest……..and you are 100% correct but the concept of adjusting for risk seemed to be thrown out the window somewhere in the mid-2000’s, in large part because so many people believed that “real estate always increases in value” (how many times did you hear that?).

So the risk-ignoring MBO investors demanded ever-increasing amounts of these higher-yielding subprime MBOs but there was a limiting factor………the number of MBOs you can sell is (or was) limited to the number of actual mortgages  that were available to be bundled.  And everyone knows that you can’t just artificially create new mortgages or new MBOs……..or can you?  The answer is actually yes and no……..No, you can’t generate a new MBO out of thin air but, yes, you can synthesize all of an MBO’s characteristics and that is exactly what happened.  Here’s how………..

Around 2004/2005, some very creative individuals on Wall Street invented a security with the same profile (risk & return) of other MBO portfolios that were in such high demand.  This new derivative was known as a Synthetic Collateralized Debt Obligation and, as the name implies, it synthesizes or mimics the risk profile of something else — in this case an MBO.  There was only one problem……….taking on the risk is only half of the equation.  The party taking on that risk wants to be compensated for doing so but who would pay them to take this risk and what would they require in return for this payment?  It turns out that there were actually two groups who were willing to do so……..

Around 2005 certain people started believing that the mortgage market, especially sub-prime, was a house of cards, which it turned out to be.  These individuals wanted to, in effect, bet against what they thought were bad MBO’s (we’ll call these the “doubters”).  Additionally, some who owned MBOs wanted to hedge against default risk in their own portfolios of mortgages (we’ll call these “investors”).


So the doubters and the investors both needed a mechanism that would provide what each was seeking (one wanted to place a bet and the other needed a hedge) and they both found it in the form of a derivative known as a Credit Default Swap (CDS).  In simple terms, a CDS is an insurance policy offered by a Synthetic CDO in exchange for premiums that compensate them for taking on the risk of that insurance.  The buyer of the CDS is betting against a “reference” asset (a real MBO with a risk profile & yield attractive to the Synthetic CDO investors).  They pay a premium to place this bet and if the underlying MBO portfolio fails they receive a large payoff.  If the MBO succeeds, the Synthetic CDO keeps all of the premiums and the CDS contract expires.

Don’t worry if that last paragraph sounded like Greek to you – it does upon first reading to many.  You can read up on Credit Default Swaps and Synthetic CDOs later but for now just think of it this way………a CDS is essentially a bet against an MBO (betting that it will default beyond some level) and a Synthetic CDO is then a bet against that bet.

You’ve probably figured out by now that there is not really anything backing up a Synthetic CDO.  Its success or failure is tied directly to a reference MBO which has actual assets (houses) backing it up but the Synthetic CDO does not have anything directly supporting it.  The problem of course is that if the underlying assets in the MBO fail (e.g. sub-prime mortgage meltdown) then both the MBO and the Synthetic CDO fail — the MBO would experience far greater than expected losses and the Synthetic CDO would have to make a large payout to the Credit Default Swap buyer.

At first this was still a relatively small percentage of the debt market but then it got out of hand and the death knell of Wall Street was sounded……the betting continued until the machine overheated and blew up.  At the same point in 2007 when there were an estimated $1 Trillion in sub-prime mortgages there were $60 Trillion in synthetic CDOs– all betting that the underlying mortgages were stable & solid (at least to a certain degree).  When the sub-prime market crashed so did the synthetic CDOs (the associated bets for them to succeed) — TIMES 60!

As the reference MBOs started defaulting so did the associated Synthetic CDOs, resulting in Credit Default Swap claims in numbers far greater than virtually anyone expected.  And who was liable for paying off the Credit Default Swaps?……….In large part, it was the big brokerage firms and insurers like AIG, Bear Stearns, Lehman Brothers, Merrill Lynch and others.  None of these firms had (or have) anywhere near the capital necessary to pay off the trillions of dollars in bad bets and so the collapse of Wall Street ensued.

Now you know what caused the credit crisis.  So what’s next?  Honestly, there are many more questions that answers but, in my opinion, we’re headed for a completely changed economic paradigm — how can we not be?  I’m not 100% sure what that paradigm will look like but there will likely be much less leverage overall and we are likely to see lower levels of both economic growth and profit as a result.  The new “normal” will likely feel much different and that is an important starting point.  Those who thrive in this changed world will be those who first recognize that things are different and make their decisions based on this new paradigm — not those who bet on returning to the old “normal” of the past decade.  Stay tuned…………

If you have another 30-45 mins to kill click on the link below and read something that will make your head spin:

  1. #1 by David Munford on January 24, 2009 - 8:34 pm

    Jimmy, I’ve been waiting for Part II! Very interesting analysis. I appreciate your insight on this. When do you think the government regulators should have stepped in? Were they even empowered to stop the “betting against the bets”? David

    • #2 by jtrimb1 on January 24, 2009 - 9:56 pm

      That is a great question and one that will be debated for years. I’m sure there will be some quality analyses provided by true insiders over time. Here are a few thoughts from my semi-informed perspective:
      1) I’m not sure anyone was tuned in enough to know that they needed to step in or even begin to answer the question of what to do once they did step in. I give a talk on the credit crisis and use an example from baseball to help explain one possible reason for the lack of action. I ask what is the least number of pitches that must be thrown by both pitchers in order to have a complete game (one team wins, the other loses, a the game goes into the record books). The technical answer is zero and I explain the rule that makes this possible (I’ll tell you more about that later). I make the point that baseball is a relatively simple game with a fixed set of rules but it is still difficult to figure out the question about the number of pitches. How much more difficult would it have been to figure out the subprime/MBO/CDS world which was insanely complicated with a set of constantly changing rules…………and then explain it in simple terms and get support for regulatory reform?
      2) Those who were raising the warning bells appear to have been drowned out by those who were accusing them of being against housing for low-income individuals so it wasn’t a politically expedient position.
      3) The Madoff case may shed some light on the leadership and competence (or lack thereof) of the regulators. This was a MUCH less complicated situation than the subprime/MBO/CDS machine and they still missed it.

      But, again, those are just a few thoughts from my perspective. I’m sure there will be some much more complete and sophisticated analyses over time. Thanks for the comment. I’ll see you soon.

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