Substitute any number for the equity, and the structure still doesn't work, because the underlying collateral is crap.

TO BE NOTED: From Accrued Interest:

"Leverage doesn't kill investors. Bad investments do.

Every one wants to blame the financial crisis on leverage. There was a glib comment on the blog the other day which reflects a common view:

"Sad to see the "cure" for overleveraged, undercollateralized balance sheets to be... more leveraged finance."

No offense to Jonathan intended, as his view probably reflects the majority of opinions among those who follow finance. But I find blaming leverage per se to be a weak argument. Thus I don't see bringing some degree of leverage back into the market as a negative. Furthermore, I don't think that simply blaming leverage will be constructive as we try to construct a regulatory structure to prevent similar meltdowns in the future.

Let's consider the case of a CDO of ABS. To make life simple, we'll assume CDO was constructed from mezzanine bonds from HEL deals. This would be securities similar to the ABX 2007-1 A index, basically the segment of major home equity deals from early 2007 which were originally rated "A."

The HEL deals were structured something like the following (although I'm presenting a simplistic version, the point stands.) I'm assuming $100 million original face, with the underlying mortgages having a 6.75% rate.

Senior: 5.75% coupon, $80 million

Mezzanine: 6.50% coupon, $15 million

Subordinate: 8.00% coupon, $5 million

All principal cash flows to the Senior until it is entirely repaid, then to the Mezz, then to the Subs. Interest payments are only made to the mezz and subs if the senior interest obligations have been met. (Don't get hung up on the math right now, it won't be important to my point. If you have questions about ABS and/or CDOs, e-mail me. Accruedint AT gmail.com).

In a CDO of ABS transaction, the CDO would buy a series of mezz bonds, then repackage them into a similar senior/sub structure. So now let's say we have a $100 million CDO which buys the mezz of 50 different HEL deals, all structured similarly to above.

The CDO builds its own senior/sub structure as follows:

Senior: 5.45% coupon, $80 million

Mezz: 6.00% coupon, $12 million

Sub: 8.00% coupon, $4 million

Equity: $4 million

Same deal as above, where the senior gets all principal and interest due before the other pieces. Only once all other classes get their principal and interest does any cash flow accrue to the Equity. One might think of the sub/mezz/senior pieces of the CDO as providing leverage to the Equity. Since the total assets in this deal is $100 million, with equity of $4 million, we have 25x leverage.

Its easy to see why the CDO of ABS world came crashing down. The ABX 2007-1 A is now trading at $2.5, or a 97.5% loss vs. the original face. So the CDO built on securities similar to ABX would have almost all principal in the deal wiped out entirely. Even the senior most piece of the CDO, which would have been rated AAA originally, would have suffered huge losses.

But was it the 25x leverage that was the problem? Not at all. Substitute any number for the equity, and the structure still doesn't work, because the underlying collateral is crap. If you are going to try to tell me that leverage caused the meltdown, then you'd need to show me how a different leverage figure would have prevented the problem. Here is an example of a leveraged vehicle that fails at any haircut.

Now one might say that if the ratings agencies would have required more overcollateralization, these CDOs never would have been created. Perhaps. But again, if leverage isn't the problem with the security, then allowing too much leverage wasn't the ratings agencies' primary mistake. The real problem is that the ratings agencies never considered the binary nature of these structures. If you build a CDO based on all mezz consumer loan ABS, and consumer loans perform poorly, then the whole deal is threatened. We didn't need catastrophic losses on consumer loans to impair the senior-most pieces of these CDOs. Had sub-prime consumer loans suffered a mere 10% loss rate, the CDO would have suffered a 50% loss rate! That would have resulted in the "AAA" rated Senior piece suffering a 30% loss. That isn't acceptable for a AAA-rated asset.

It isn't like the ratings agencies should have rated these types of CDOs AAA at some lower leverage level. They shouldn't have rated these types of CDOs at all. We talk about toxic legacy assets. These CDOs were toxic from the word go.

Now consider this. Why didn't the ratings agencies figure that consumer loans could go all go sour at once. Why did they assume that a 10% loss rate was nearly impossible? Or if you want to damn the ratings agencies as mere minions of the investment banks, why were people buying these CDOs? Those investors must also have assumed that the 10% loss rate was nearly impossible. Else they wouldn't have bought the bonds at all. So why was every one so confident?

We all want to blame some nefarious party, because that would feel better. It is more satisfying to think we were all duped by the evil geniuses on Wall Street. But what if it was as simple as the Fed having succeeded in dampening the business cycle that people started to assume volatility would remain permanently low? What if the fact that previous disturbances that could have had greater contagion (1987 crash, Asian Currency crisis, Russian Debt crisis, LTCM, Y2K, Dot Com bubble, 9/11, etc), didn't. People began to assume the age of crashes was over.

Now I'd be a fool to say that leverage played no part in the crisis. Clearly financials got over-leveraged. Part of the problem is that with so much leverage, some financials (AIG, Lehman, Bear) didn't have enough time to see if their asset bets would play out. But why they got over-levered was a response to contracting yield spreads. Or put another way, ROA was dropping so in order to get the same ROE you needed more leverage. Spreads were contracting (and thus ROA falling) because there was greater confidence in a more stable economic horizon. As ROA fell, too many fell into a trap of buying poorly constructed securities to get a relatively small amount of extra yield. And before you try to say that no one saw ABS CDOs as riskier, consider that the senior-most ABS deals always yielded 20-30bps more than the senior-most commercial loan-backed CDOs. Every one knew that consumer ABS-backed CDOs were more risky! ( NB DON )

So ultimately, leveraged investing comes down to picking good assets first, then getting the leverage right. The crisis has been brought on by poor asset decisions more so than too much leverage."

"Surely, they saw that these securities would blow up if house prices started falling. Why did they not call baloney sandwich? "

Arnold Kling wants to ask a clear, concise, and pointed question to Fannie/Freddie. Apparently, he doesn't know that asking such questions will keep him off dinner lists and wine tasting lists, and certainly keep him miles away from any Congressional Hearing:

"Gretchen Morgenson writes,

The safest slice of the security held $165 million in loans. When it was issued on Aug. 17, 2006, Moody's and S.& P. rated it triple-A. Just eight months later, Moody's alerted investors that it might downgrade the top-rated tranche. Sure enough, it dropped the rating to Baa, the lowest investment-grade level, on Aug. 16, 2007.

Then, on Dec. 4, 2007, Moody's downgraded the tranche to a "junk" rating. On April 15 of this year, Moody's downgraded the tranche yet again; today, it no longer trades. The combination of downgrades and defaults hammered the securities.

One question that I would like to see asked at next Tuesday's hearing on Freddie Mac and Fannie Mae is what those two firms were thinking while the rating-agency nonsense was going on. I imagine that they ran some of these securities through their stress tests, the way any manufacturing company would test a competitor's products. Surely, they saw that these securities would blow up if house prices started falling. Why did they not call baloney sandwich?"

Arnold hasn't read my blog, so he doesn't know that these folks become keen epistemologists when questioned about reality. Here's a sample answer:

Suppose Moore points to his left hand and says, "That's my right hand". Now, is that a mistake in perception, or, rather, simply the misuse of a word? And can we or Moore ascertain an answer to that question even in theory?

Well, suppose Moody's says, "That Tranche is AAA...". Surely you see my point.

Here's another answer:

It's like that blasted duck/rabbit monstrosity, don't you see? Is it a rabbit, or is it a duck? You can see it as either one, but not at the same time, and, yet, it's the very same drawing. The exact same drawing. Don't you see? Now, take a Mezzanine Tranche, for example. For one thing, you immediately envision Escher's staircase, don't you? I certainly do. And a Tranche is like that damned duck/rabbit. I mean, you can see it as AAA, or as complete crap, and it's the same tranche. The very same tranche, don't you see.

Well, I, for one, certainly do see.

"Markus Brunnermeier provides an excellent summary graph of the financial crisis, told in "spreads".

From Menzie Chinn on Econbrowser, an excellent paper by Markus Brunnermeier. Unfortunately, I can't seem to reproduce the graphs, or I would have commented more on it. But I read it all, and highly recommend it: See also this post.

M.K. Brunnermeier, "Deciphering the Liquidity and Credit Crunch 2007-08," forthcoming Journal of Economic Perspectives, 2009, 23(1):


"To answer this question, it is useful to first recall the three main factors leading up to the housing bubble. First, there are large capital inflows from abroad, especially from Asian countries. Asian countries bought U.S. Dollars both to peg the exchange rate on an export-friendly level and to hedge against a depreciation of their own currency against the dollar, a lesson learned from South-East Asia crisis in the late 1990s. These capital inflows contributed to a prolonged low-interest-rate environment. Second, fearing a deflationary period after the bursting of the Internet bubble, the Federal Reserve adopted a lax interest rate policy and thus did not counteract the buildup of the housing bubble. Third, the transformation of the banking system from a traditional banking model, in which the issuing banks hold loans until they are repaid, to the ―originate and distribute‖ banking model, in which loans are pooled, tranched and then resold, caused a decline in lending standards. Financial innovation that was intended to stabilize the banking system by transferring risk to other market participants led to an unprecedented credit expansion and helped feed the boom in housing prices."

So, the three main preconditions of the Housing Bubble are:
1) A lot of money from foreign countries invested here
2) Low interest rates
3) Banks, instead of keeping loans, bunched them and then sold them, causing them to ease lending standards
4) Investments meant to stabilize banks by transferring risk led to unwarranted lending

For me, 1,2, and 4, are enablers, while 3 is the cause.

"Two trends in the banking industry contributed significantly to the lending boom and housing frenzy that laid the foundations for the crisis. First, instead of holding loans on banks‘ balance sheets, banks moved to an ―originate and distribute‖ model. Banks repackaged loans and passed them on to various other financial investors, thereby off-loading risk. Second, banks increasingly financed their asset holdings with shorter maturity instruments. This left banks particularly exposed to a dry-up in funding liquidity."

So:
3A: Banks use shorter term investments

Warning: Explanation I like:

Securitization: Credit Protection, Pooling, and Tranching Risk
To offload risk, banks typically create ―structured‖ products often referred to as collateralized debt obligations (CDOs). The first step is to form diversified portfolios of mortgages and other types of loans, corporate bonds, and other assets like credit card receivables. The next step is to slice these portfolios into different tranches. These tranches are then sold to investor groups with different appetites for risk. The safest tranche—known as the ―super senior tranche‖—offers investors a (relatively) low interest rate, but it is the first to be paid out of the cash flows of the portfolio. In contrast, the most junior tranche—referred to as the ―equity tranche‖ or ―toxic waste‖—will be paid only after all other tranches have been paid. The mezzanine tranches are between these extremes. Legally, the portfolio is usually transferred to a ―special purpose vehicle,‖a financial entity whose sole purpose is to collect principal and interest cash flows from the underlying assets and pass them on to the owners of the various tranches. The exact cutoffs between the tranches are typically chosen to ensure a specific rating for each tranche. For example, the top tranches are constructed to receive a AAA rating. The more senior tranches are then sold to various investors, while the toxic waste is usually (but not always) held by the issuing bank, to ensure that it adequately monitors the loans."

Okay. CDO= Collateralized Debt Obligation: A bunch of bonds, etc.
Tranches:
Safest= Super senior: Low Interest: Usually AAA: Sold to investors: Paid 1st
Mezzanine= Between extremes: Paid 2nd
Junior= Equity= Toxic Waste: Usually held by bank ( Originating lender ): Paid last

Held by SPV=Special Purpose Vehicle: Collects interest and principal from what's in the bunches, and disperses the proceeds to holders of tranches

"Buyers of these tranches or regulator bonds can also protect themselves by purchasing credit default swaps, which are contracts insuring against the default of a particular bond or tranche. The buyer of these contracts pays a periodic fixed fee in exchange for a contingent payment in the event of credit default. Estimates of the gross notional amount of outstanding credit default swaps in 2007 range from $45 trillion to $62 trillion. One can also directly trade indices that consist of portfolios of credit default swaps, such as the CDX in the United States or iTraxx in Europe. Anyone who purchased a AAA-rated tranche of a collateralized debt obligation (CDO), combined with a credit default swap, had reason to believe that the investment had low risk."

CDS=Credit Default Swap: Insurance, paid with premiums, against default of bunches or what's in them

Good investment= Tranche + CDS

"Shortening the Maturity Structure to Tap Into Demand of Money Market Funds
Most investors prefer assets with short maturities, such as short-term money market funds. It allows them to withdraw funds at short notice to accommodate their own funding needs (see, for example, Diamond and Dybvig, 1983, and Allen and Gale, 2007) or it can serve as a commitment device to discipline banks with the threat of possible withdrawals (as in Calomiris and Kahn, 1991, and Diamond and Rajan, 2001). Funds might also opt for short-term financing to signal their confidence in their ability to perform (Stein, 2005). On the other hand, most investment projects and mortgages have maturities measured in years or even decades. In the traditional banking model, commercial banks financed these with deposits that can be withdrawn at short notice.
The same maturity mismatch was transferred to a ―shadow‖ banking system consisting of off-balance-sheet investment vehicles and conduits. These structured investment vehicles (SIVs) raise funds by selling short-term asset-backed commercial paper with an average maturity of 90 days and medium-term notes with an average maturity of just over one year primarily to money market funds. The short-term assets are called ―asset backed‖ because they are backed by a pool of mortgages or other loans as collateral. In the case of default, owners of the asset-backed commercial paper have the power to seize and sell the underlying collateral assets. Asset-backed commercial paper had become the dominant form of outstanding commercial paper by the start of 2006. The strategy of off-balance-sheet vehicles—investing in long-term assets and borrowing with short-term paper—exposes the banks to funding liquidity risk: Buyers in the commercial paper market might suddenly shy away. To ensure funding liquidity, the sponsoring bank grants a credit line, called a ―liquidity backstop.‖ As a result, the banking system still bears the liquidity risk from holding long-term assets and making short-term loans.At the same time the maturity mismatch on the balance sheet of investment banks also increased."

This is 3A. Long term loans financed with short term assets= Maturity Mismatch

"In summary, leading up to the crisis, commercial and investment banks were heavily exposed to maturity mismatch both through granting liquidity backstops to their off-balance sheet vehicles and through their increased reliance on repo financing. Any reduction in funding liquidity could thus lead to significant stress for the financial systems, as we witnessed starting in the summer of 2007."

3A again.

"Structured financial products can cater to the needs of different investor groups. Risk can be shifted to those who wish to bear it, and it can be widely spread among many market participants, which allows for lower mortgage rates and lower interest rates on corporate and other types of loans. Besides lower interest rates, securitization allows certain institutional investors to hold assets (indirectly) that they were previously prevented from holding by regulatory requirements. For example, certain money market funds and pension funds that were allowed to invest only in AAA-rated fixed-income securities could invest in a AAA-rated senior tranche of a portfolio constructed from BBB-rated securities. However, a large part of the credit risk never left the banking system, since banks, including sophisticated investment banks and hedge funds, were among the most active buyers of structured products (see, for example, Duffie, 2008). This suggests that other, perhaps less worthy motives were also at work in encouraging the creation and purchase of these assets."

The benefits:
1) Getting around regulations
2) Spreads and lowers risk

In hindsight, it is clear that one distorting force leading to the popularity of structured investment vehicles (SIVs) was regulatory and ratings arbitrage. The Basel I accord (an international agreement that sets guidelines for bank regulation) imposed on banks an 8 percent minimum capital requirement (capital charge) for holding loans on their balance sheets; the capital charge for contractual credit lines was much lower. Moreover, there was no capital charge at all for ―reputational‖ credit lines—noncontractual liquidity backstops that sponsoring banks provided to SIVs to maintain their reputation. Thus, moving a pool of loans into off-balance-sheet vehicles, and then granting a credit line to that pool to ensure a AAA-rating, allowed banks to reduce the amount of capital they needed to hold to conform with Basel I regulations while the risk for the bank remained essentially unchanged."

Okay. They're trying to get around capital requirements. Now, we're getting somewhere.

"Moreover, in retrospect, the statistical models of many professional investors and credit-rating agencies provided overly optimistic forecasts about structured finance products. One reason is that these models were based on historically low mortgage default and delinquency rates. More importantly, past downturns in housing prices were primarily regional phenomena—the United States had not experienced a nationwide decline in housing prices in the period following WWII. The assumed low cross-regional correlation of house prices generated a perceived diversification benefit that especially boosted the valuations of AAA-rated tranches (as explained in this symposium in the paper by Coval, Jurek, and Stafford)."

This is fine, but, again, people needed to be predisposed to accept this stuff.

"In addition, structured products may have received more favorable ratings compared to corporate bonds because rating agencies collected higher fees for structured products. ''Rating at the edge'' might also have contributed to favorable ratings of structured products versus corporate bonds."

Ratings agencies. Fine. But this also borders on fraud, negligence, and fiduciary misconduct, e.g., conflict of interest.

"While a AAA-rated bond represents a band of risk ranging from a near-zero default risk to a risk that just makes it into the AAA-rated group, banks worked closely with the rating agencies to ensure that AAA tranches were always sliced in such a way that they just crossed the dividing line to reach the AAA rating. As a consequence, CDO tranches must be downgraded when an incremental change in the underlying default probabilities or correlations occurs.Fund managers were attracted to buying structured products because they expected to generate high returns, but with a small probability of catastrophic losses. When the risk-free interest rate is low, this type of investment will be especially attractive to fund managers, whose compensations are linked to a percentage share of the upside but do not become negative in the event of losses. In addition, some fund managers may have favored the relatively illiquid junior tranches precisely because they trade so infrequently and were therefore hard to value. These managers could make their monthly returns appear attractively smooth over time because they had some flexibility with regard to when they could revalue their portfolios. "

A.Banks and Ratings Agencies conflict of interest. AAA Rating right on line, must be downgraded though with slight loss
B. Incentives for Managers to border on fraud, negligence, and fiduciary misconduct.
a. Manager gets paid when goes up, but nothing happens when it goes down
b. Hard to value

"The rise in popularity of securitized products ultimately led to a flood of cheap credit, as lending standards fell."

OKAY: BIG DISAGREEMENT: I believe that the products were used to fill the need, not the other way around. That's a big difference.

"This combination of cheap credit and low lending standards resulted in the housing frenzy that laid the foundations for the crisis."

OKAY: There's no excuse for low lending standards. Period. To say that cheap credit caused it is a mechanistic explanation of human agency. At best, it's an incentive, an inducement, to violate known investment precautions. Don't blame the products, and don't blame the inducements. People had to actually decide to do this. Period.THIS IS A MORAL PROBLEM, if not legal.

"Precautionary hoarding arises if lenders are afraid that they might suffer from interim shocks and that they will need funds for their own projects and trading strategies. Precautionary hoarding therefore increases when 1) the likelihood of interim shocks increases, and 2) outside funds are expected to be difficult to obtain.
The troubles in the interbank lending market in 2007-08 are a textbook example of precautionary hoarding by individual banks. As it became apparent that conduits, structured investment vehicles, and other off-balance-sheet vehicles would likely draw on credit lines extended by their sponsored bank, each bank's uncertainty about its own funding needs skyrocketed. At the same time, it became more uncertain whether banks could tap into the interbank market after a potential interim shock, since it was not known to what extent other banks faced similar problems. These effects led to sharp spikes in the interbank market interest rate, LIBOR, both in levels and volatility."

Here's some stuff I like because it deals with hoarding, which might or might not be rational, and so it's something I'd like to look into.

"Network and counterparty credit risk problems are more easily overcome if a clearinghouse or another central authority or regulator knows who owes what to whom. Then, multilateral netting agreements, such as the service provided by SwapClear, can stabilize the system. However, the introduction of structured products that are typically traded over the counter has made the web of obligations in the financial system more opaque, consequently increasing systemic risk."

Here's a good reason to have a clearinghouse.

These mechanisms also form a natural point from which to start thinking about a new financial architecture. For example, fire-sale externalities and network effects suggest that financial institutions have an individual incentive to take on too much leverage, to have excessive mismatch in asset-liability maturities, and to be too interconnected. Brunnermeier (2008b) discusses the possible direction of future financial regulation using measures of risk that take these domino effects into account."

Too much leverage. That's it, but that's what they were intending to do.

Anyway, this is a great and very clear paper.