My Take On The Subprime Meltdown
Bob O'Brien's Sanity Check Blog
Posted by: bobo 12/8/2008 7:12 AM
I guess you could say part of me isn't buying that the entire global banking system has collapsed due to the lousy payment penchant of under-qualified borrowers in the US. I have spent considerable time digging around trying to get a handle on what is actually going on, and below represents my best take on it.
By all appearances, what is actually going on is nothing more than the equivalent of naked short selling, but in the bond market. This fundamentally fraudulent behavior is completely consistent with what we have seen in the stock market. It involves the fraudulent misrepresentation of a derivative (read, counterfeit) as the genuine article. In the stock market, it is the representation of a securities entitlement for which no stock has been delivered as being equivalent to genuine registered stock. It isn't. It has none of the rights of stock. It is a sham transaction.
Now, consider how the system treats these sham transactions in the stock market when a dividend is to be paid. Genuine shares get the dividend from the company. All good. The fakes, that is to say, the securities entitlements that are fraudulently represented to account holders as genuine, don't get their dividend from the company, and thus aren't entitled to the special tax treatment of a dividend. No, they get their payment from those who sold the shares short and then refused to deliver that which they sold - the guys failing to deliver the stock.
So the account holder's broker fraudulently represents to the account holder that they have genuine stock in their account (by misrepresenting securities entitlements as the genuine article) and then perpetuates this sham by paying money taken from the short sellers, as though the company had paid the dividend. It's a fraud designed to trick the account holder into believing that its all good.
Hold onto this thought when I describe the CMO market now.
There was huge demand for subprime paper, rated AAA (highly rated due to the credit default swaps purchased to backstop the risk of loss). Huge demand, because the paper paid outsized returns. There was actually far more demand than there was supply. Sort of like the demand you would see for a stock in a company that is "hot." Sound familiar so far? Lots of demand, little supply of genuine article. Check.
Well, imagine with me that Wall Street dealt with that demand exactly as it deals with stocks for which there is mucho demand, or commodities that are on a tear. It counterfeits supply to meet any demand.
Follow along with me on how I believe it worked in the mortgage market.
Big Wall Street Bank XYZ has securitized $100 billion of subprime paper in 2005 via its in house desk. But it has buyers for $500 billion worth - the Chinese, the Russians, banks all over the world who want outsized returns from "AAA" rated paper.
Never ones to let a lack of the genuine article stop them, XYZ creates $400 billion more paper out of thin air, and then happily sells it to the banks and Russians and whatnot. How do they do it? Not so hard, at the end of the day. They create a derivative that performs and pays exactly as the genuine $100 billion would perform, tracking its performance. It is a synthetic, a derivative wholly lacking the collateral that the genuine $100 billion has - and there's only two niggling problems: How do you protect the bondholders when it all blows up, and how do you get cashflow with which to pay the "dividend" - the payment on the bonds to the suckers, er, I mean, the buyers?
Let's take the last one first. What you do is a variation of what you do with stock - you get short selling hedge funds to short the paper, and then you pass the fee they pay to short the paper (or some of the fee) to the bondholders, pretending that money came from the mortgages. Money is money, so nobody questions it. You, XYZ Bank, do the math for the hedge funds - it costs 20% or more to hold a short position on crappy subprime company Z, whereas they can short the AAA paper for only 10%. That's a no-brainer. Go for the 10%, and wait for the inevitable blowup. Bank XYZ distributes 8% to the bondholders, pockets 1%, and uses the other 1% to hedge the short position, by taking the other side of the bet by purchasing credit default swaps that will cover it's ass when the blowup occurs.
So now to the question of how to protect the bondholders? Simple. Same way as you hedge. You buy credit default swaps that protect them when the bonds go down in value, mimicking the performance of the genuine tranche of bonds. Again, the bogus $400 billion performs identically to the way the genuine $100 billion does - think of it as a tracking stock, only with no actual intrinsic value arising from real collateral.
That actually explains how a 5% default in certain subprime paper can cause a tidal wave of defaults in real dollars - far more than the actual genuine mortgages are worth. 5% gets multiplied across all the fraudulently created tranches, the bogus ones, causing an outsized reaction. And then allow the banks who are holding these counterfeits to leverage them as though they had gold bullion in the vault, and you get an additional massive compounding of the downside risk.
So at its essence, it's simple. Create a piece of paper you represent as being identical to the genuine article (and simply leave out the critical difference - that you just ginned up yours in the back room, as opposed to buying mortgages to collateralize the paper), create a mechanism wherein you can pay out dividends and mask the bogus nature of your piece of paper, and misrepresent the paper as having essentially the same collateral as the genuine article - I mean, a credit default swap from AIG is iron clad protection, right? Right? Who wants a lousy worthless mortgage as collateral when they have the guarantee of the biggest insurance company in the world? Right? I mean, it's almost like Wall Street was doing the bondholders a favor by counterfeiting all that paper to meet demand...
This introduces one of the reasons why, when it became apparent that AIG was a ponzi scheme and was insolvent (that's really what their credit default swaps business was - a ponzi scheme), that when they were downgraded and it became obvious that the credit default swaps were potentially worthless unless the government took over the ponzi scheme using taxpayer dollars, that it caused such an instant meltdown worldwide. The same CDOs had been used to get AAA ratings on toxic garbage, but they'd also been used to collateralize the fraudulently created paper. The fact that venerated names like Goldman and Morgan had such exposure to AIG's CDOs and thus such an interest in the taxpayers picking up the ponzi scheme's funding should give one insight as to what Wall Street firms were likely the biggest creators of this counterfeit garbage.
For some insight into my hypothesized mechanism, read Michael Lewis' recent article, in which he describes one hedge fund coming to grips with what was actually being done.
And then consider the statements from the former HUD official that there was a massive disconnect between the amount of mortgage bonds being sold, versus what was being generated via genuine mortgages. The question is how. I think I just described the how.
It would also explain why we periodically see articles, quickly hushed up, about how increasingly at foreclosure sales nobody can locate the title for the mortgage. Those articles inevitably chock it up to the complexity of the slicing and dicing going on in the securitization process, however there is a much easier explanation, as described above. Speaking of which, does anyone have some of those articles? I want to start collecting them. Post them below, or email them to me, if you would be so kind.
So that's how I believe it all worked. It explains a lot. It explains how the penchant of Wall Street to counterfeit crosses over from stocks, to bonds, to commodities, to anything it can touch. Phrases like "Financial Innovation" in reality describe increasingly sophisticated counterfeiting schemes. I believe that the creation of derivative bonds, as described above, is likely to be exposed as a massive global counterfeiting scheme by Wall Street's most venerated names. I also think that is why you've seen massive amounts of money lent to undisclosed groups by the Fed, in exchange for undisclosed collateral. The Fed has had to step in and essentially backstop the fraudulently created paper with the taxpayers' money, to keep China and Russia from going berserk at being cheated, and to keep the global banking system from completely melting down.
And now for a little lightness in these dark times. I've been inundated by demands from obese women with too many cats, to put into graphic form the complex series of issues and moral conundrums I discuss on these pages (or series of pixels - you get the drift). Thus, I've prepared a sort of primer to be used when explaining why Daddy has to go to work at McDee's on the night shift, and the family has to move into a tent (albeit a tent in the best God D#mned country in the world!!!). This exercise in communication via the magic that is MS Paint is intended to heal wounds, and bridge valleys. Brothers and sisters, black, brown and white alike, can feel united in the power of its simple, compelling message. Enjoy.
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