Alchemy.

Investors today have been flooding the gold market, pushing the nominal price per ounce to record highs. In volatile times, the safe haven of owning gold makes even the toughest risk-taker sleep a little easier. But it was not long ago that the shiny stuff alluring investors were mortgage bonds, backed by mortgage payment receivables, not the hard rock. These assets were deemed triple-A rated by credit rating agencies, and slapped with a big seal of approval by Wall Street investment banks, quite credible at the time. However, an entire multi-trillion dollar market was secretly hiding risks in an underground nuclear chamber. Complex and hidden from the naked eye, the subsequent explosion would forever change the face of the US. This is a tale of deception, inflation, and conviction. With easy financing and societal standards, policy-makers and Wall Street made it possible to get impoverished people into expensive homes, grow a bubble in US housing prices, and eventually compel themselves to own a piece of the pie. Moral of the story? Take responsibility for yourself. Do your own credit analysis and do not rely solely on ratings, do not underestimate the power of any market to create systemic risk, and watch Wall Street; the changes in incentives, business models, and risk management will indicate if we properly responded to this crisis.


The perfect storm.

The story of the financial collapse is one that starts with the purchase of a home, and the subsequent creation of an investment capitalizing on that sale. At the start of the twenty first century, everyone and their dog deserved a house for themselves. The size of the home and extravagance of the furnishings were dictated by societal entitlement and lax lending standards. From 2000 to 2003, mortgage originations jumped from $238 billion to $1.2 trillion. A growing percentage of these loans were to "sub-prime" and "Alt-A" borrowers, or people that may not be able to pay the loan back in full or who lacked proper documentation proving income and credit quality. In addition, interest rates were at historically low figures due to Greenspan's cozy relationship with the banking industry, allowing mortgage originators to offer cheaper financing and enticing promotions. With rising home prices as secure collateral for the loans, this was the perfect storm.

Hot potato.

Then came the game of pass around the risk. The mortgage originators were the sales people closing the deal. Once they could create a mortgage, they could then resell it as an asset - an entity that will generate economic benefits over time as the borrower pays off the loan. Wall street would happily purchase these assets and bundle them up into bond. This concept is one of diversification. If one mortgage defaulted in the bond, that would only be a small sliver of loses and minimally affect the bonds value. However, this sparked incredibly interesting financial innovation. What if you can take only the first payment of each mortgage (ie the payment the home buyer is most likely to make) and make that alone into a bond? This sort of creation would surely be less risky than a bond with whole mortgages in them. But then where should the rest of the mortgage go? This was the dilemma facing Wall Street and the obstacle that they would need to tackle. Fortunately, they had friends down the street willing to help. The credit rating agencies are in the private business of putting their opinion on the quality of fixed income investments. Triple-A suggests that the investment is top-quality. US Treasuries, assumed risk-free, are rated triple-A. The question would become, how can we get these junk tranches, meaning the riskier sections of a mortgage bond, triple-A rated? With a AAA stamp, we can sell this stuff to pension funds, mutual funds, institutional investment funds, and the works. And with that, the CDO was born.

Slice and dice.

For the sake of simplicity, think of a CDO, or collateralized debt obligation, as 5 friends pooling their money together to make a loan. There is a 50% probability (junk probability) that they can make $100 total from the loan, with a 50% chance of making less than $100 to losing the full amount. If you line up in order of payout (ie first person get the first $20, the second person gets the second $20 and so on), then you have redistributed originally 50% probabilities of success into new stronger probabilities for the first friend (rated triple-A) and weaker probabilities for the last friend (junk rated). Then the last friend that gets the last $20 in this structure (junk rated) may go to his other 4 friends and redistribute the risk to give him the first $4 ($20/5 friends) that comes in, calling that the top of the ladder, which would be rated triple-A! The concept is beautiful and incredibly misleading. If the original 50% probability was actually 25%, many triple-AAA rated stuff in the structure would be worth nothing. Game over. In addition, the 5 friends do not even need to make the loan, they could instead make a side bet on the loan (eg. credit-default swap) and do the same thing! This became known as the synthetic CDO and gained traction because there simply were not enough home buyers in the US market to satisfy the demand for these assets. If you are a little lost by this process, that's OK, so was everyone else on Wall Street. You take a mortgage, bundle it with hundreds of more mortgages, put that into a bond, bundle it with hundreds of more bonds, put that into a CDO, slice it up into different rated tranches, redistribute those tranches into CDO-squared, then make side bets using synthetic CDOs made up of credit-default swaps. At the end of the cash-flow line, no one knew not only how to quantify the risks involved, but what the risks even were. There were so many complex factors created by the machine that you would need to unwind every investment structure to the core underlying mortgages to even begin to understand the risks. The system was as transparent as oil.

Alchemy.

For these mortgage investments to go to zero, house prices need not decrease, but simply increase at a slower rate. As home prices turned in 2006, the risks inherent in these triple-A rated mortgage-backed securities began to unwind, and demand ceased. The investment banks marketing CDOs were also retaining big pieces for their own portfolio, as they too began to believe the crap they were creating. The total financial system was in peril and would go through several years of deleveraging, while being allowed to sell their toxic mortgages off their books and into the taxpayer's hands. Years later we can better understand what happened: a deadly combination of excesses in society, lax policy in Washington, low interest rates set by the Fed, incest between banks and the credit-rating agencies, and leverage to multiply the effects. I wrote this post because there are several things I think that must be learned from this mess.

1) Look out for your own investments. Don't trust a credit-rating from S&P and don't trust a money manager who structures a portfolio based on credit rating. Don't trust a broker that says an investment is a sure win, especially one without a proven track record. Make it a point to do your own research, gain your own understanding, and exercise your own judgment. Even without a background in investments, if you have money to invest, you are more capable than you think.

2) If a financial transaction seems odd to you, question it. If a bank wants to give you a loan without seeing proper paper work or income verification, the terms of the loan may not be favorable (eg embedded teaser rate / future adjustable-rate) or actions pursued in default may be unfair.

3) Correlation always finds its way back to 1. Diversify to prevent major losses from systemic risk. One of the biggest mistakes on Wall Street models was that if a mortgage defaulted in Wyoming, the probability of a mortgage defaulting in Maine was unrelated. In reality, the entire mortgage market was connected and when real estate popped, every house in the country fell in value.

4) Watch Wall Street and how they align their incentives. Incentives that tie management compensation to long-term company success will mean stronger risk management, less leverage, and more emphasis on credit analysis. The sub-prime mortgage market was entirely driven by short-term profitability.

You can't turn junk into gold. However, this was done for years. We took bad quality assets, stamped with strong quality ratings, and created massive demand until the point of total collapse. This will surely not be the last act of alchemy in our investment world. Be aware of the signs and tread carefully.

Disclosure: No positions