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Financial Bombs, Made in Wall Street - An ABS Example

During the 2008-2009 financial crisis, the US economy was hit hard by bombs made in Wall Street. The entire financial systems, in the US and across continents were once at the edge of total collapse. Once mighty investment banks disappeared all at once. Some people call the disaster a financial earthquake, I prefer to call it a bomb attack due to the nature of human actions involved.

The financial bombs that were used to achieve the unprecedented scale of casulty in our economy consist of a range of structured financial securities, ABS (Asset Backed Securities), CDO (Collateralized Debt Obligations) and synthetic CDS (Credit Default Swaps). An average investor may ask, "what are all these jagon?" The frank answer to the question is, "they are the means that Wall Street people fool investors by making things more complicated than they are."

Actually, these structured financial securities are no more than a simple jar. No matter what names they take, the key that matters most is what was in the jar. For normal people, it is cookie jar if cookies are placed into the container; or toy box if toys are what kept inside. However, Wall Street people does not use this conventional way to call their "containers". Low quality securities were placed into these fancy "jars" and repackaged for sale. The seller of these repackages asked rating agencies (primarily Moody's and S&P) to label them as AAA (the highest or near default-free securities).

Even more than a year after the stock market reached its lowest point (March 9, 2009), some of these bombs are still out there and are still rated as AAA by the rating agency.

MRUST-2008 A1A was such an example. It is an ABS backed by a pool (the "jar") of private student loans. For our purpose, let's call it MRU 2008 Cookie AAA. There are other cookies in the jar. The taste of these other cookies may change faster if things went bad and therefore are of lower quality, and we can call them MRU 2008 Cookie BBB. The seller of these repackages was MRU Holindgs Inc. You may wonder what MRU stands for - My Rich Uncle - no kidding. That is the name of a major higher education focused, private student loan provider in the US. (So, what we have here are "my rich uncle's" 2008 cookie AAA and BBB.)

Private student loans are not federally re-insured loans and usually larger in their balance. In the case of loan defaults, buyers of the lower quality packages may experience the taste change (value decline) first, and the higher quality cookies will start to lose taste (value) if things are really bad.

How likely the higher quarlity cookies (AAA) will see a taste change in current environment? Very very likely. As unemployment rate stayed so high (9.7% as of May 31, 2010), new college graduates or even master degree graduates find themselves very hard to locate a job.  The jar's label 2008 means the original cookies (loans) were originated around or before 2008. As we approach the summer of 2010, graduate borrowers of the loan pool with associate, bachelors, or master degrees are stepping out of campus and looking for a job. The reality is that a large share of them, say 40%, may not be able to locate a job that can help them to pay the interests and principals on the student loans that are now due. If they do not pay the due amount, it is a "default". The cookie taste will change quickly if the defaults start.

To make things even worse, "My Rich Uncle" has another specialty. This uncle started to market so called "preprime" loans that can qualify a student with no credit history and low credit score co-signers. Although this uncle claims the loans were granted based on borrowers' accademic scores, while the scoring criteria might be substantially different from school to school.

What happened to "my rich uncle" during the crisis? He stopped making loans in september 2008, only two months after it sold the "My Rich Uncle's 2008 Cookies", and filed Chapter 7 bankruptcy in Feb 2009.

Currently, S&P still kept the "My Rich Uncle's 2008 Cookie AAA" repackage the highest rating (AAA). In my view, the cookie jar will see dramatically increased defaults in the next 6 to 9 months and the repackage will have to be downgraded. 

If you are interested to get an idea about more bombs like this, I highly recommend you to read Michael Lewis's "The Big Short", which I enjoyed reading very much.

Disclosure: My employer hold the security in portfolio.