It's not 1929, but it's the biggest mess since
By STEVEN PEARLSTEIN, Washington Post
Published December 7, 2007
We are only at the beginning of the financial world coming to its senses after the bursting of the biggest credit bubble the world has seen. Everyone seems to acknowledge there will be lots of mortgage foreclosures and that house prices will fall nationally for the first time since the Great Depression.
But let me assure you, you ain't seen nothing yet.
What's important to understand is that, contrary to what you heard from President Bush this week, this isn't just a mortgage or housing crisis. The financial giants that originated, packaged, rated and insured those subprime mortgages were the same ones, run by the same executives, with the same fee incentives, using the same financial technologies and risk-management systems, who originated, packaged, rated and insured home-equity loans, commercial real estate loans, credit card loans and loans to finance corporate buyouts.
It is highly unlikely that these organizations did a significantly better job with those other lines of business than they did with mortgages.
At the center of this still-unfolding disaster is the Collateralized Debt Obligation, or CDO.
Almost everyone knows that most mortgages are no longer held by banks until they are paid off: They are packaged with other mortgages and sold to investors much like a bond.
In the simple version, each investor owned a small percentage of the entire package and got the same yield as all the other investors. Then someone figured out that you could do a bigger business by selling them off in tranches corresponding to different levels of credit risk. If any of the mortgages in the pool defaulted, the riskiest tranche would absorb all the losses until its investment was wiped out, followed by the next riskiest and the next.
With these tranches, mortgage debt could be divided among classes of investors. The riskiest tranches were sold to hedge funds and junk bond funds whose investors wanted the higher yields that went with the higher risk. The safest ones, offering lower yields and Treasury-like AAA ratings, were snapped up by risk-averse pension funds and money market funds. The least sought-after tranches were those in the middle, the "mezzanine" tranches, which offered middling yields for supposedly moderate risks.
It is at this point that the banks got the bright idea of buying up a bunch of mezzanine tranches. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same "tranching" process, they could use these mezzanine-rated assets to create a new set of securities - some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired.
It was a marvelous piece of financial alchemy, one that made Wall Street banks and the ratings agencies billions of dollars in fees. And because so much borrowed money was used, the whole thing was so highly leveraged that the returns, at least on paper, were very attractive. No wonder they were snatched up by British hedge funds, German savings banks, oil-rich Norwegian villages and Florida pension funds.
What we know now, of course, is that the investment banks and ratings agencies underestimated the risk that mortgage defaults would rise so dramatically that even AAA investments could lose their value.
Meanwhile, banks that are forced to hold on to their CDO assets will be required to set aside much more of their capital as a financial cushion. That will sharply reduce the money they have available for making new loans.
And it doesn't stop there. CDO losses threaten the AAA ratings of a number of insurance companies that bought CDO paper or insured against CDO losses.
If all this sounds like a financial house of cards, that's because it is. And it is about to come crashing down, with serious consequences not only for banks and investors but for the economy as a whole.
This may not be 1929. But it's a good bet that it's way more serious than the junk bond crisis of 1987, the S&L crisis of 1990 or the bursting of the tech bubble in 2001.