Subscribe: RSS Feed | Twitter | Facebook | Email
Home | Contact Us

The Wall St. Model is Broken . . . and Won’t Soon be Fixed!!

Posted by Larry Doyle on November 12, 2008 12:15 PM |

Despite billions and now trillions of dollars in capital injections and equity investments made by our government, private equity, and sovereign wealth funds, our economic turmoil is a long way from being over. I do find it interesting that despite numerous Wall Street titans having indicated to us at different points over the last year that we were in the 7th inning of this fiasco, now a recurring theme is that we should not expect any real economic recovery until 2010. Actually, maybe we were in the 7th inning but it was the 7th inning of the first game of a 4 game series.

Well, if we want to figure out where and when we are moving forward, I think it would be beneficial to know from where and when we came.

For those over 50 years of age, perhaps you remember when mortgage money dried up. Perhaps you also recall the days of putting down 20% before you even thought of buying a home. In any event, the growth of the secondary mortgage market in the mid 1980s was a result of some very sharp financial minds on Wall St. who engineered a product called a Collateralized Mortgage Obligation (CMO).

CMOS, and their cousins that grew from that model, were and are not necessarily bad structures. However, much like prescription drugs, if and when they are abused, they can be deadly.

CMOs used the stream of cash flows from a standard fixed rate mortgage to create specific bonds which met the investment desires of a wide array of investors, including money market funds, bank portfolios, insurance companies, money managers, and pension funds. Prior to the development of the CMO, mortgages were an investment that typically only met the needs of bank portfolios.

As the CMO market grew, two developments occurred. First and foremost, Wall St. firms (which were making on average 1 point on each deal . . . on an average deal size of 300 million, the Wall St. underwriter made $3 million dollars . . . not too shabby) had an appetite for more and more mortgage collateral to do more and more deals.

In the mid-1980s, most CMO deals were done with private homebuilders such as Pulte Homes, Centex, Ryland et al. The second development was more substantial. If Wall St. could use mortgage collateral to execute CMOs, why couldn’t they use other forms of loans/assets to create similar sorts of structured products? Thus, in the late 1980s, the Asset Backed Securities market was launched using credit card loans, auto loans, computer leases, equipment leases, and the like. Again, all Wall St. was doing was using the stream of cash flows from these well underwritten loans to create securities that met the guidelines and needs of a wide array of investors. Prior to the developments of these markets, the banks underwrote these loans at rates and terms that met their own portfolio needs (REMEMBER THIS POINT!!).

In the late ’80s, Freddie Mac and Fannie Mae got a whiff of the profitability of these CMO deals and used their significant lobbying power to get legislation passed that made it advantageous from a tax standpoint for CMOs to be launched through them. While some Wall St. firms were reluctant to support Freddie and Fannie in this process, given F/F ‘s position in the business they won out. (REMEMBER THIS POINT!!)

As the CMO and ABS engines grew ever stronger throughout the early to mid 90s, Wall St. needed to find more and more collateral to continue to feed this profit monster. Some Wall St. firms either purchased or made strategic alliances with originators (Lehman Bros bought Aurora Mortgage in Aurora, Colorado . . . Bear Stearns owned EMC Mortgage in Texas . . . Merrill Lynch purchased First Franklin, a sub-prime originator, from National City Bank), while other originators formed their own broker dealers to retain the profits of distributing these products (Countrywide Mortgage formed Countrywide Securities, JPM Chase grew its own investment banking presence in the late ’90s, as did Bank of America).

In the midst of this growth, Wall St. continued to use this CMO model not only across other consumer asset classes but then branched out and used it with corporate loans as well. Thus Wall St. structured CLOs (collateralized loan obligations) using the same financial engineering.

While there were hiccups with different deals, for the most part the machine ran smoothly. The machine, though, was built on the premise of strict underwriting of the underlying loans and a robust ratings process.

At the turn of the century, however, there were two critically important developments that occurred to truly escalate the disastrous situation we have currently. A number of individuals from Wall St. realized that they could form their own firms (hedge funds) which allowed them a greater share of the profits from this structured financial engineering with less internal or external oversight. (REMEMBER THIS POINT!!)

A large number of qualified analysts from the rating agencies left those firms to come to Wall St. to participate in the profit machine. This shift of talent both to hedge funds and from ratings agencies dramatically exacerbated and accelerated the financial meltdown of the last two years. (***Given the amount of money in these hedge funds, as well as the amount “earned” by the hedge fund managers, it should be no surprise that they became very influential in currying political favor . . . especially with Barack this go round!!)

At the turn of the century, the Wall Street model was a pure “originate to distribute” model with little to no residual risk on behalf of the originators or underwriters. When there is no residual risk, those who “WIN” are the players that can purely process the most volume. Well, how does one get volume? Lower the credit standards, put fewer restrictions on borrowers, little to no covenants (NINA Loans: no income, no asset check). WOW!!! What were we thinking?? Well, Wall St. felt, “let’s worry about it tomorrow or maybe not at all because we are making too much money today.”

Hedge funds factored into the fray in two ways. They partnered with their friends on Wall St. in managing CBOs and CLOs, and they purchased the cheapest bonds in the deals or so they thought. Rating agencies either were not smart enough to know what they were rating or were blinded by their own stream of profits given the growing volume of deals. They were negligent, complicit or both. Honestly, there was nobody truly looking out for the investors, who it was assumed should look out for themselves. Where was the SEC when you really needed them??!! This was all hunky dory as long as the economy was humming and delinquencies and defaults by consumers, homeowners, and corporations were well behaved.

In 2005 or thereabouts, Wall St. had such a voracious appetite for volume of collateral product that they pressed the envelope even further and came up with “synthetic” structures. These structures purely used a pool of known collateral (be it sub-prime mortgages, home equity loans, corporate loans, et al) as a reference pool for the stream of cash flows in the deal. Wow!!

Without the need for actual collateral, Wall St. really rocked. (REMEMBER THIS POINT)

Under the “originate to distribute” model, Wall St. hired reams of financial quants and engineers to structure deals. Wall St. grew their distribution efforts globally to sell these products far and wide.

Life was good!! . . . or so they thought.

Wall St. actually started to think they were as smart as everybody told them. Wall St. thought that their own models were so robust because they had the smartest minds build them. Wall St. thought that they had become so effective at “distributing” risk that they were blind to the fact of just how much risk they “created.” Then the music stopped. The Fed needed to increase rates to slow the pace of inflation that was emanating from global economic growth, especially in Asia. Mortgage rates reset at higher levels. Freddie and Fannie started to show signs of distress. Wall St. pressed so hard that they “killed the goose that had laid the golden eggs.”

Against that backdrop, through the 3rd quarter in 2008, check out the volume of underwritings in these respective sectors vs 3rd quarter 2007:

Deals using mortgage collateral … … down 95%!!!!!!!!
Deals using commercial mortgage collateral … … down 89%!!!!!!!!
Deals using consumer assets … … down 75%!!!!!!!!

The mortgage and asset backed markets (including commercial mortgages) are twice the size of the overall U.S. government bond market and approximately half the size of the U.S. equity markets. The mortgage market doubled in size from the end of 2003 until the end of 2007!!!

Investors now fully appreciate that with the economy slowing and seemingly picking up speed, delinquencies and defaults will continue to ratchet higher. The embedded losses are only exacerbated by the massive leveraging that occurred via the use of “synthetic” cash flows. No, the media has no appreciation for this and will not share it with the public.

Where are the other shoes that have yet to drop??

Please refer back to the “synthetic” structure that I discussed. These synthetic structures grew exponentially with the growth of a product called the “credit default swap” or CDS. This product, in theory, is outstanding because it acts to protect investors against defaults on the underlying referenced corporation or entity (such as sub-prime mortgages). That said, instead of helping to distribute risk, the CDS market has effectively “created” risk because it has grown to the point where it is now 10 times the size of the overall corporate bond market that it is supposed to be tracking.

Yes, the tail is very much wagging the dog. Hedge funds dominate the trading activity with close to 60% of the overall trading volume. Hedge funds have gotten good press so far for not having had many “blow ups”!!

Give it time, because hedge funds do not have to report to anybody as to what their positions are and where they have them marked. There is no doubt that they have positions that are grossly mismarked and that they have many positions that are totally illiquid. For many investors in these funds, these are truly “roach motels.” Hedge funds will sell what is most liquid when they can to meet redemption requests. We should expect a significant number of hedge fund liquidations, consolidations, and out and out disasters.

Check out “Hedge Funds on Hot Seat.”

In the S&L crisis of the late ’80s, the overall cost was estimated to be $100bln+ with the government taking over and liquidating failed institutions. Now given the tremendous systemic risk that links Wall. St investment banks to hedge funds to insurance companies to sovereign wealth funds to commercial banks to municipalities, the losses are untold.

To think that a stimulus package of even $300bln along with the $700bln commitment that has already been made is going to “fix” our economy is foolhardy. We will definitely get “bear market” rallies in the stock market and politicians and market timers will tell you that all is well, but don’t get fooled by “that man behind the curtain.” The losses in the banking system alone are upwards of $1 trillion. From there let’s move into insurance companies, hedge funds et al. Hank Paulson, Sheila Bair, Ben Bernanke and others know that any money that goes into the system is purely going to help the banks recapitalize themselves in the face of these losses.

When Barney Frank, Nancy Pelosi, and Barack Obama complain that they need to make sure that credit lines open and remain open, they are not addressing the fact that the banks already have an overwhelming amount of non-performing assets and that those assets are likely going to grow in the face of an unemployment rate headed up by 2% to 4%!!

Please read this article in Monday’s WSJ highlighting how Uncle Sam is reworking the terms of the rescue package for AIG. The article highlights the systemic risk (Goldman Sachs is widely speculated to have the greatest counterparty risk exposure to AIG) and the very fluid nature of the deteriorating situation. Guess what? As taxpayers, we have the bulk of the risk as we own 80% of AIG and will very likely lose a lot of money on this deal. That said, the near term losses would very likely be even greater if AIG were not propped up by the government. It is not a given that our longer term losses and negative impact on GDP won’t exceed the perils of immediate losses. We have a high stakes game of craps on our hands.

Government, AIG Near Pact to Scrap Original Terms of Deal” . . . oh what fun!!

I have little doubt that we will also, in large measure, “nationalize” the auto industry. Read how the “Auto Makers Force Bailout Issue” …

In my opinion, there are only a few moves that Obama, Summers, Geithner, Volcker, Buffet or Rubin can do to change this situation for the better. Those moves include:

    1. lowering the tax rate on capital gains (I’m not so sure that Barack wants to do that)
    2. categorically state that tax rates will not change (not sure he will do that either)
    3. spending freeze!! (also not sure he wants to do this either)

Even with those moves, it may only shorten the length of our very deep recession but will not negate it.

Honestly, I have to believe that Barack is kicking himself thinking that his entire program to create social change may very well be at the mercy of these economic constraints. If he and/or the Democratic leadership aggressively push the tax/spend agenda, the markets will punish them in very short order.

With the unemployment rate headed higher, to at least 8% if not 9% or 10%+, I firmly believe that people will use any money from the government to simply pay off existing debt. That is the rational move at this point. Our U.S. personal savings rate is 1%!!! In China the personal savings rate is 40%!! The party’s over, the lights have come back on, and somebody has to pay the bill. Yep, that’s right and regrettably that bill is on the U.S. taxpayer. Screwed again.

The government has already massively increased its own debt and will “crowd out ” lending into other sectors.

If we go back to the first point I asked you to remember, with the “originate to distribute” model broken and not soon if ever to return, banks will now only underwrite those loans (consumer or corporate) that they feel comfortable putting into their own portfolio at terms and rates that are amenable to both sides. That is why I think rates for these loans will be higher and volumes will be lower. Batten down the hatches.

Paulson knew of the consequences of this scenario earlier this year. He hoped the banks could sell assets. Paulson says as much in this piece, “Paulson, Bernanke Strained for Consensus In Bailout.”

As Maryann Hurley, a Vice-President of D.A. Davidson recently said, “When the banks shed their balance sheets of a lot of these unwanted and poorly performing assets” they may start to lend again. Hurley added that consumers need to fix their balance sheets, as well, after years of going into debt. The lack of a rigorous underwriting process is coming home to roost.

She adds, “I’m guessing it’s not going to be before 2010 at best and it’s most likely 2011 before the economy really starts to turn around.”

7th inning of game 1 of a 4 game series . . .


Recent Posts