Panic on Wall Street - Easy Guide to understanding the curre

Panic on Wall Street - Easy Guide to understanding the current Market Freakout


August 19th, 2007 · No Comments




You’ve heard about the home-loan bust, but do you know your derivatives from your tranches? Read Salon’s easy guide to understanding the current market freakout.
By Andrew Leonard
Aug. 17, 2007 | From New York to Hong Kong and everywhere in
between, alarm bells are ringing. Central bankers are on 24/7 alert,
ready to perform life support on catatonic markets. Stock traders are
panicking — the Dow’s wild ride on Wednesday, down 350 points and then
almost all the way back, is just the latest declaration of confusion
and fear.

If you had been paying only casual attention to the financial
markets as summer rolled along, you could be excused for glancing at
the headlines and wondering, what the hell is going on? By many
measures the global economy is growing faster than it has for decades.
But in our globalized world, anxiety is everywhere. Soon after the
markets close in New York, Asia’s traders start running for cover. By
the time they’re exhausted, Europe is picking up the relay. And then
back to the United States it comes.
People who devote their entire lives to studying the intricacies of high finance are confused right now.
But the basic story line isn’t that complicated once you break it down
into simple building blocks. And that’s what Salon is going to do. Here
are some simple questions and, we hope, some simple answers.
How did this happen? How did we get here? What does it all mean?
There is a standard explanation included as a paragraph in almost
every story attempting to explain the current turmoil. It goes like
this: Anxious to goose the U.S. economy out of its dot-com-bust
doldrums, Alan Greenspan and the Federal Reserve Bank lowered interest
rates to rock bottom in 2001. The resulting flood of cheap money encouraged an orgy of borrowing at every level of the U.S. and world economies.
Whether you wanted to buy a house or a multibillion-dollar
conglomerate, lenders were your best friends, falling over themselves
to offer you whatever amount of capital you desired — and charging low,
low rates of interest. Cheap money led to a growing complacency about
risk. If you ran into trouble, you could just refinance your house, or
borrow a few billion more dollars today to pay off the billions you
might owe tomorrow.

Greenspan’s policies are being blamed for inciting the greatest housing bubble in U.S. history.
The collapse of that bubble set off a wave of defaults by homeowners no
longer able to make the payments on their mortgages. Mortgage lenders
were the next link of the chain to break, followed by the investors who
were trading in bonds and securities whose value was tied to these
loans. Suddenly, risk was back!
So that’s that? It’s Greenspan’s fault?
Partially, but interest rate tinkering is not the whole story. It
may not even be the most important part of the story. There’s another
reason so many homeowners are in trouble and stock markets are
imploding: Wall Street rigged the system so something like this was
inevitable.
One could make a case that the biggest economic story of the last 10
years — bigger than the dot-com or housing booms, bigger than their
busts, perhaps even bigger than the extraordinary growth of the Chinese
and Indian economies — has been the astonishing growth of what is
obscurely referred to as “structured finance,” a crazy quilt of arcane
derivatives and other “financial instruments” that have become the
lifeblood of markets everywhere.
Whoa. Stop right there. What is a derivative?
Strictly speaking, a derivative is a financial doohickey whose value
derives from some underlying asset. A mortgage loan is an asset. A pool
of mortgage loans grouped together into a security that can be traded
on markets is a derivative.
We often hear about the “real economy,” that place where real people
buy and sell real things, or go to work at real jobs where they make
real stuff or deliver real services. Derivatives belong to what should
be called — but never is — the unreal economy, a place where speculators make
bets about what will happen in the real economy. Derivatives are
vehicles for making such bets. If you think the borrowers whose loans
are pooled together are going to make their payments, then buying a
share in a group of such investments might be a good idea. That would
be your bet.
A metaphor might be useful here. The real economy is like the Super
Bowl. Real men on a real field push each other around and play with a
real ball for a set period of time, and the team with the most points
at the end wins. But while all this is going on, millions of outsiders
who are not physically involved in the game bet on its outcome. Only
they don’t bet just on the outcome. They also bet on the spread — how
badly one team might beat the other. Or they can get more creative and
bet on what the combined score of the teams might be, or which team’s
quarterback will be the first to be injured. There’s absolutely no
limit to the things that you can bet on, as long as you can find
someone to take your bet.
The betting economy is the unreal economy. All
those sports bets, no matter how kooky, are financial exercises whose
value and meaning are derived from what happens on the field.
Theoretically speaking, the betting economy exists in a separate
dimension from the actual game, but we all know that’s not true.
There’s so much money involved in gambling that the temptation to fix
the results becomes irresistible. Players and referees, for instance,
can be bribed.
We can call a bribed NBA official an example of “spillover” from the
betting economy into the sports economy. The very same thing happens in
the real and unreal economies. So much money is riding on all the
derivative bets connected to the housing sector that Wall Street
speculators essentially rigged the housing sector to make their bets
pay off.
To understand exactly what happened, we must take a closer look at a particular kind of derivative: the infamous “collateralized debt obligation,” or CDO.
Say what? Collateralized who which how?
Don’t worry about the name. Call it an extra-special funky doohickey
if you like. It’s not important. What is important is its function,
which is to make things that should be considered risky take on the
appearance of less riskiness.
After a mortgage lender makes a loan to a homebuyer, that loan is
packaged up with a bunch of other loans into a security — a financial
instrument that can be traded. Securities are rated by rating agencies
according to the chances that the underlying assets will be defaulted
upon. U.S. Treasury bonds, for example, get stellar AAA+ ratings
because the U.S. government is considered likely to meet its
obligations.
A security based on a pool of subprime mortgage loans would normally
not deserve an AAA+ rating. Subprime, by definition, means “not so
good.” Subprime loans are made to people who can’t put together a down
payment or have bad credit, or can’t prove they have a job. Subprime
loans are risky!
Many investors — particularly in pension funds and municipalities —
are prohibited from investing in securities that are not high-rated.
Let the hedge funds and the investment banks play around with the risky
BBB stuff, the “junk.” The rest of us should be more prudent.
But investment bankers are clever fellows. In cahoots with the
ratings agencies, they came up with a way to magically transform a
low-rated security to a high-rated security. (The culpability of the
ratings agencies — Fitch, Standard & Poor’s, Moody’s — should be
not underestimated. It might be helpful to think of them as the bribed
referees in this game.)
Enter the collateralized debt obligation. The CDO takes a pool of risky mortgage loans and divides it into slices.
(Wall Street calls these slices “tranches,” but that seems to be a word
that makes the brains of normal people freeze up, so we’ll ignore it.)
For simplicity’s sake, let’s say that a mortgage-backed security gets
divided into two slices when it is transformed into a CDO — a senior
slice and a junior slice. Let’s say that the senior slice gets rated
AAA+ and the junior slice gets rated BBB-. But if anything goes wrong —
if the homeowners whose loans are part of this security start missing
their payments — the investors in the junior slice have to lose all of
their money before the investors in the senior slice start feeling any
pain. That’s the beauty of the scheme. You take a bunch of bad loans
and turn some of them into high-rated gold and some into lower-rated
bronze. You sell the gold to the cautious and the bronze to the bold.
If a few loans go kaput, the bronze investors suffer. If all the loans
go kaput, everybody gets hurt. Unless there’s a total financial
meltdown, everyone is happily making money.
We keep hearing in the financial news about risk being “sliced and diced.” Is that what you’re talking about?
Yes. After the transformation, we now have an instrument that
satisfies the desires of both conservative investors, who can just buy
the AAA+ rated slice, and investors who have a taste for risk, who can
buy the BBB- slice. It’s a brilliant work of alchemy.
And very popular. CDOs tied to subprime mortgages became hot
commodities, snapped up with gusto by traders all over the world — even
the riskiest, most likely to self-immolate, lowest-rated slices of
those CDOs. Especially those slices.
Why? Why was there such an appetite for risk?
No risk, no reward. In the securities world,
financial vehicles whose underlying assets are risky yield higher rates
of return. Subprime loans ultimately charge higher rates of interest
than prime loans. That means that as long as homeowners don’t take
advantage of introductory low rates and pay off their loans early,
pools of such loans will throw off a higher stream of income than pools
of less risky loans. Traders who want to get a piece of that higher
stream of income will take the chance of default.
This is where we approach the crucial turning point. Many different
parties have been blamed for the housing mess. Homeowners are told that
they should have read the fine print on their loans and should have
avoided taking on financial obligations that they couldn’t meet.
Mortgage lenders are blamed for pushing the risky loans in the first
place. And of course, there’s the maestro, Alan Greenspan. But these
attributions of guilt all miss the mark. The incentive for everyone to
behave this way came from Wall Street, where the demand for subprime
CDOs simply couldn’t be satisfied. Wall Street was begging the mortgage
industry to reach out to the riskiest borrowers it could find, because it thought it had figured out a way to make any level of risk palatable.
So Wall Street wanted mortgage lenders to make bad loans?
Let’s return to our Super Bowl metaphor. The gamblers aren’t
satisfied with their odds of winning, so they bribe a player to fumble
at the one-yard line and alter their bets accordingly. Wall Street
traders, hungry for more risk, fixed the real economy to deliver more
risk, by essentially bribing the mortgage originators and ratings
agencies to fumble the ball or make bad loans on purpose. That supplied
CDO speculators the raw material they needed for their bets, but as a
consequence threw the integrity of the whole housing sector into
question.
But hang on. Isn’t the total amount of subprime loans outstanding
just a fraction of the overall home-lending market? And isn’t the U.S.
economy still growing? Why has just one small sector of one country’s
economy caused so much trouble?
Two main reasons: a lack of transparency and an overabundance of leverage.
What’s been described here so far is just the simplest possible
model of how things work. The truth of what is really going is far more
complex. So complex that no one has a good handle on exactly what will
happen if things go awry. Not regulators, not traders, not even
pessimistic journalists. Try reading an SEC filing from a New York
investment bank — it is one of the most difficult-to-comprehend
documents ever created by the human mind.
It is not, in a word, transparent. It serves the opposite purpose:
It is an instrument of obfuscation. Because of failures of regulatory
oversight, we have very little idea who owns what, or what risks hedge
funds and pension funds and municipalities and mutual funds are really
exposed to. This is all fine and dandy if your goal is to prevent your
competitors from understanding what kinds of bets you are making. But
it becomes a much more severe problem when you’re trying to figure what
is going wrong when the trains start derailing.
(By the way, if you’re looking for something that government could
do that might address this problem, calling for greater transparency
carries the double whammy of being both the right thing to do and,
rhetorically speaking, something that free markets are supposed to
depend on for their proper functioning.)
Next up: leverage. Archimedes told us that if he had a lever long
enough and a place to put it, he could move the world. Speculators in
the world’s financial markets also like leverage; but they don’t use
crowbars to move objects — they use borrowed money to make bigger bets.
This is fine as long as your bets pay off. But when your bets go bad,
the people whose money you borrowed want it back.
Right now, a great many people want their money back.
The people who say that subprime is just a small part of the economy are correct. What they fail to note, however, is that the same games that Wall Street played with subprime are likely being played in every sector of the economy.
It’s not just a Super Bowl whose results can be fixed. The NBA, and
Major League Baseball, and the Tour de France and the Olympics are all
under the same pressures.
Subprime ripped a window open into the way business as usual is being conducted.
Now everyone wonders, what’s next?