Monday, May 05, 2008

Review: Trillion Dollar Meltdown



As a general rule, only the very smartest people can make truly catastrophic mistakes.
— Charles R. Morris, The Trillion Dollar Meltdown


Well well well ... look at the fine mess we've created.

I picked up Charles R. Morris' 2008 book The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash a few weeks ago not because I think our entire financial system is on the brink of implosion (though I wouldn't automatically discount anything at this point). Rather, I simply wanted to learn more about our current economic situation.

Let's face it: As good a book as Naked Economics is, when circuses like Bear Stearns and You Walk Away splatter the headlines, well, standard macroeconomics can take a curious soul only so far.

How'd We Get Here?

Morris spends the first five chapters (106 pages or so) of Trillion Dollar Meltdown enlightening readers with a brief retelling of the last thirty-five years of American economics and finance. From Nixon to GWB, Morris revisits the missteps and miracles concocted by politicians, investment bankers, economists, and other zoo animals over the last generation or so.

Here's my attempt to sum it up in three words:

Credit.
Quants.
Deregulation.


Peering Over the Edge

It's in Chapter 4, "A Wall of Money," that things start getting good. Join me, won't you, for a quick jaunt through the three- and four-letter jungle of financial Scrabble:

The floodgates were opened. So long as you did the gritty, credit-by-credit documentation work with the rating agencies, you could securitize anything. Companies started selling asset-backed securities (ABS) to finance equipment, transportation fleets, or anything else investors could value. GE was an early and creative ABS issuer. Investment banks created collateralized bond obligations (CBOs), while commercial banks experimented with collateralized loan obligations (CLOs). (CDOs, or collateralized debt obligations, became the generic name for all types of securitized assets, including mortgages.) In almost all cases, a trust, or special-purpose entity (SPE), technically independent of the parent, would be created to purchase the assets. The purchase would be financed by selling securitized paper, usually with a tranched structure to broaden investor appeal. For banks, selling assets and liabilities off their balance sheets reduces strain on regulatory capital; for companies, it lowers apparent debt.

Then it got more complicated.


Of course it did! Can't have all those Harvard MBAs sitting around all day playing Yahtzee, can we?

About the same time as the securitized, or structured, finance industry was evolving at a breakneck pace, some brilliant financial engineers introduced new families of credit derivatives, the most important of which is the credit default swap.


Oh goodie. This new toy has the "D" word in it!

To take a simple case: Suppose US Bank decides it is underexposed to credits in southeast Asia. The old way to fix that was to buy some Asian bank branches or partner with a local bank. A credit default swap short-circuits the process. For a fee, US Bank will guarantee against any losses on a loan portfolio held by Asia Bank and will receive the interest and fees on those loans. Asia Bank will continue to service those loans, so its local customers will see no change, but Asia Bank, in Street jargon, will have purchased insurance for its risk portfolio, freeing up regulatory capital for business expansion. Credit default swaps became one of the fastest-growing new financial instruments ever. The notional value of credit default swaps — that is, the size of portfolios covered by credit default agreements — grew from $1 trillion in 2001 to $45 trillion by mid-2007.


So pretty soon everyone was credit-default-swapping with everyone else. You have parties, counter-parties, and counter-counter-parties. And no one involved, of course, thinks his firm will be The One Left Holding The Bag. You could always sell the shaky stuff to the next guy in line, right?

Aw, what the heck. It's not like there'll ever be any "shaky stuff" anyway.

In the boom years of 2005 and 2006, probably 80 percent of the securities in CDOs were mortgage-backeds, possibly 70 percent of those were below top-grade, and at least half were subprime or second-lien home equity lines — and these were the same years the industry was pumping out some of the most egregiously irresponsible loans in history. By assuming a permanent new era of very low defaults, it was possible to build families of bonds such that 80 percent of the issued bonds had triple-A and double-A ratings, even though 70 percent of the supporting assets were subprime.


Nope. No shakiness there.

To complicate matters, CDO managers often freely mix instrument types, so any bond might be backed by a grab bag of subordinated claims on a mélange of risky assets. Leverage is compounded further with "CDO2s," or CDOs of CDOs. You collect the risky tranches of a number of CDOs, which can sometimes be the hardest to place, and use them to support a new CDO, with a range of high-to-low risk-rated tranches. Highly rated bonds magically materialize out of a witches' soup of very smoky stuff. There is even a smattering of "CDO3s" out there, or CDOs built from the leftover tranches of CDO2s.


All of which Mr. Morris sums up succinctly:

Very big, very complex, very opaque structures built on extremely rickety foundations are a recipe for collapse.


And off to the races, we are.

Summary

I found The Trillion Dollar Meltdown to be a fun read — well, as "fun" as reading about your country's systemic financial collapse can be. I came to it, though, looking more for information — looking to pull together a better understanding of just where the weaknesses are in our credit- and debt-centric system.

The book's delivery is a bit jerky in places; its progression, just a tad disjointed. This suggests to me that TDM was rushed into publication. Given recent events, that wouldn't be a surprise, would it?

At 169 pages, the book is a fast read. But then we're back to that "rushed" thing again. Often I felt as if I were being pushed through it too quickly — as if there were more that Morris could divulge and clarify regarding certain topics, but which a fast-track-to-press caused to be omitted.

Too bad.

For what it's worth: I came in expecting a fair amount of fear-mongering from TDM. I suppose it's there to some degree. But folks who steadfastly believe that there's JUST NO WAY our financial system COULD EVER collapse, or that there's JUST NO WAY we could see another Great Depression (or a Greater Depression), will come to the book with that view locked-in. So every word of TDM will seem to them like fear-mongering dribble.

Just so you know, I'm not in that camp. While I appreciate all the safety valves in place with our system, I also totally respect the ability of greedy bankers, brokers, and politicians (and oh yeah — dumb-as-broken-rocks consumers) to really muck things up beyond all repair.

Who's to say what could happen? We Americans sure seem to let a lot of our "very smartest" run amuck in the financial sandbox...

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— Posted by Michael @ 8:10 AM








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