Quite a decade

Below is a piece from 10 years ago today, just as the financial crisis could be seen at the top of the mountain and about to become an avalanche. We’re a few months after the Bear Stearns conference call that signaled big problems ahead. Today seems very different, with stocks up 30-35% for the year and bullish economic forecasts being made (but don’t tell CNN, MSNBC and all the rest).


In 2007, a penny stock operation called N.I.R. teamed up with Merrill Lynch to create a CDO of $1.5 billion in “derivatives linked to triple-B-rated mortgage securities.” It somehow got $1.125 billion of this junk rated AAA, because of the “equity cushion” of $375 million on which the senior junk was propped up. It appears to be a textbook story of banking malpractice. WSJ:

The concept behind Norma, known as a collateralized debt obligation, has been in use since the 1980s. A CDO, most broadly, is a device that repackages the income from a pool of bonds, derivatives or other investments. A mortgage CDO might own pieces of a hundred or more bonds, each of which contains thousands of individual mortgages. Ideally, this diversification makes investors in the CDO less vulnerable to the problems of a single borrower or security.

The CDO issues a new set of securities, each bearing a different degree of risk. The highest-risk pieces of a CDO pay their investors higher returns. Pieces with lower risk, and higher credit ratings, pay less. Investors in the lower-risk pieces are first in line to receive income from the CDO’s investments; investors in the higher-risk pieces are first to take losses.

But Norma and similar CDOs added potentially fatal new twists to the model. Rather than diversifying their investments, they bet heavily on securities that had one thing in common: They were among the most vulnerable to a rise in defaults on so-called subprime mortgage loans, typically made to borrowers with poor or patchy credit histories. While this boosted returns, it also increased the chances that losses would hit investors severely.

Also, these CDOs invested in more than simply subprime-backed securities. The CDOs held chunks of each other, as well as derivative contracts that allowed them to bet on mortgage-backed bonds they didn’t own. This magnified risk. Wall Street banks took big pieces of Norma and similar CDOs on their own balance sheets, concentrating the losses rather than spreading them among far-flung investors…

Norma belonged to a class of instruments known as “mezzanine” CDOs, because they invested in securities with middling credit ratings, averaging triple-B. Despite their risks, mezzanine CDOs boomed in the late stages of the credit cycle as investors reached for the higher returns they offered. In the first half of 2007, issuers put out $68 billion in mortgage CDOs containing securities with an average rating of triple-B or the equivalent — the lowest investment-grade rating — or lower, according to research from Lehman Brothers Holdings Inc. That was more than double the level for the same period a year earlier…

N.I.R. assembled $1.5 billion in investments. Most were not actual securities, but derivatives linked to triple-B-rated mortgage securities. Called credit default swaps, these derivatives worked like insurance policies on subprime residential mortgage-backed securities or on the CDOs that held them. Norma, acting as the insurer, would receive a regular premium payment, which it would pass on to its investors. The buyer of protection, which was initially Merrill Lynch, would receive payouts from Norma if the insured securities were hurt by losses…

in the case of subprime mortgages, the derivatives have magnified the effect of losses, because they allowed bankers to create an unlimited number of CDOs linked to the same mortgage-backed bonds. UBS Investment Research, a unit of Swiss bank UBS AG, estimates that CDOs sold credit protection on around three times the actual face value of triple-B-rated subprime bonds.

The use of derivatives “multiplied the risk,” says Greg Medcraft, chairman of the American Securitization Forum, an industry association. “The subprime-mortgage crisis is far greater in terms of potential losses than anyone expected because it’s not just physical loans that are defaulting.” Norma, for its part, bought only about $90 million of mortgage-backed securities, or 6% of its overall holdings.

We are not expert in this field, but it seems that, however much the rating agencies’ methodologies were flawed in understanding the real world of mortgage defaults in an environment of rising interest rates, there were unsavory forces at work as well. “Norma, for its part, bought only about $90 million of mortgage-backed securities” but was a $1.5 billion fund of incomprehensible gobbledygook. Somehow we think there just might be a Congressional investigation or two in the future.

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