Robin Blackburn is the author of Age Shock: How Finance is Failing Us (Verso, 2007), a comprehensive account of risk and social insecurity in the age of financialization.

Waiting for the bodies to float to the surface

Since August 9, the financial system of the entire planet has been paralyzed by a credit crunch. Banks won't lend to one another, as each suspects the other of hiding huge hidden losses "off-balance sheet". The drying up of credit is slowing down the whole global economy.

Paradoxically, the source of the problem was a marvellous new financial product – the asset-backed derivative – supposedly aimed at reducing risk, not increasing it. The most notorious was based on "sub-prime" mortgages, whereby high-profile Wall Street investment banks brought slick financial reasoning to the base art of loan-sharking. The most vulnerable borrowers were targeted for loans they could ill afford. Those with poor credit histories can be charged at double or treble the interest of a customer in good standing with the rating agencies. By the end of last year, housing loans to six million unrated customers – sub-prime mortgages – totalled $600 billion.

Three or four years ago, Citigroup, Bear Stearns, Goldman Sachs, Lehman Brothers and HSBC all acquired sub-prime lending operations – loan sharks – which they historically regarded with disdain. Citigroup acquired Associates First Capital, and HSBC bought Household Finance, blazing a trail others were to follow. Finance houses have long teamed up with retailers to shower so-called gold and platinum cards on all and sundry with the hope of ratcheting up consumer debt – rising from 110 per cent of personal disposable income in 2002 to 130 per cent in 2006 – and subsequently charging an annual 18 or 20 per cent on money for which the banks are paying four or five per cent. Such hot rates of return gave the banks a taste for seamy lending. They discovered how to limit their own exposure, while raking in the charges, by repackaging the debts as CDOs (Collateralized Debt Obligations), in which they capture the risk premium while sloughing off the risk of default.

Here is how it is done: banks buy sub-prime mortgages and then bundle thousands together in a single instrument. The resulting CDO, as it is called, is then divided up into ten tranches, each of which represents a claim over the underlying securities, but with the lowest tranche representing the first tenth to default, the next tranche the second poorest-paying tranche, and so on up to the top tenth. The chances of default on the bottom tranche are quite high, but it was believed that the top tranches were pretty secure. And because each slice itself contains thousands of mortgages, some of even the bottom tranche would eventually turn out OK.

Borrowers who can only negotiate a sub-prime mortgage have either poor collateral or poor income prospects, or both, and that is why they must pay over the odds. Of course the bottom tranche of the CDO – euphemistically designated the "equity" – is very vulnerable, but can still be sold cheaply to someone as a bargain. The purchaser will also be assured by those assembling the CDO that they can hedge the possibility of defaults in the "equity tranche" by taking out insurance against it. The bank will – for an extra fee – also arrange this insurance, making the entire "credit derivative" product very complex and difficult to value.

The beauty of the CDO is that all tranches were paying a good return, while – it was believed – only the bottom one was really at risk, and that risk could be insured against. Just last year an executive of a mortgage broker explained: "Sub-prime mortgages are the ideal sector for the investment banks, as their wider margins provide a strong protected cash-flow and the risk history has been favourable. If the investment bank packages the securities bonds for sale, including the deeply subordinated risk tranches, it can, in effect, lock in a guaranteed return with little or no capital exposure. Generally investment banks do not like lending money but they are good at measuring risk, parcelling this up and optimizing its value." For such reasons, Morgan Stanley purchased Advantage Home Loans, Merrill Lynch bought Mortgages PLC, and Lehman Brothers acquired Southern Pacific Mortgages and Preferred Mortgages.

The investment banks were playing a rapidly-moving game of pass the parcel. Ideally the loans are bought one day, packaged overnight in India while America sleeps, and then sold on to institutional investors the next day. In the spring, sub-prime defaults jumped. Analysts warned that some $225 billion worth of sub-prime loans would be in default by he end of 2007, but others said the figure would be nearer $300 billion. The equity tranche is now dubbed "toxic waste" by insiders, and analysts are waiting to see which institutions fess up to losses. For over six months, losses have been multiplying. In early March, the New York Stock Exchange suspended New Century Financial, a company which had taken on insurance obligations for submerged tranches of mortgage debt for most of the big banks.

Helped by their role in packaging and selling such "credit derivatives" as mortgage-backed CDOs, the banks achieved remarkably good profits in the years 2002–6. However, indebted consumers were not so good for non-financial corporations, since demand was dampened – by 2003, 18 per cent of the disposable income of US consumers was required to service debt, and only a housing price boom and re-mortgaging maintained consumer purchasing power. Neither the Federal Reserve Bank nor the Securities and Exchange Commission was keen to crack down on the mortgage bonanza, because it helped to maintain consumer demand and market buoyancy. The default crunch will not only cause great unhappiness to the victims – who stand to lose their homes – it also hurts the whole housing market and increases the chances of a downturn.

In August the malaise caused by the collapse of mortgage-backed instruments spread to the whole CDO section and it is this that created the "credit crunch". The penny dropped that these amazingly complex financial instruments constituted an important part of the assets of a whole string of financial institutions. Many of the banks selling these CDOs and CLOs (credit loan derivatives) had kept some back because they fancied them, or because they could not find buyers. Hedge funds had also fancied them. But they discovered that there was no active market in the derivatives, mainly because they were too complex to value. The ratings agencies earn money by grading securities. Somehow they were persuaded to give them an investment grade. But the price of any asset is, in the end, set by the market – by what somebody is willing to pay for it. The essence of the credit crunch is that the derivatives are simply too complex to value.

On October 16, several of the major banks – Citi, Morgan Stanley and Bank of America – set up a $70 billion "superfund" that will supposedly set a floor under the price of the CDOs and, if necessary, redeem the securities and bail out any institution that is in trouble. Almost immediately, analysts warned that the superfund itself could hurt confidence, since it leads observers to think the banks have something to hide.

The fund's official name is the Master Liquidity Enhancement Conduit, which somehow strikes the wrong note, with the name undermining itself by saying too much (remember Long Term Capital Management, which was anything but?). But the crucial problem remains that CDOs were always sold to particular buyers at a negotiated price rather than a market price. The CDOs probably do have some value, but nobody is quite sure what it is.

The banks have confessed to losses of only $20 billion when there are some $300 billion of bad debts out there. Now everyone is scanning the waters waiting for the
bodies to float to the surface.

A final irony is that the old-fashioned loan sharks are weathering the crisis better than Wall Street. If a customer fails to keep up payments, the loan shark sends someone along to talk to them and agree a new schedule. The people holding CDOs can't do that because they don't have teams of door-knockers. All they can do is foreclose the loan and take over the property – just at the moment that property is worth very little.



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