Why Our Economy Nearly Collapsed Overnight

Collateralized Debt Obligations, Mortgage Backed Securities, Tranches, Credit Default Swaps, Marked-to-Market, FAS 157, Fannie Mae and SEVEN-HUNDRED BILLION DOLLARS OF OUR TAX PAYER MONEY!

Considering the enormity of the Federal Government's “Bail-out plan”, or whatever the latest spin doctors have sought to define it as, you'd think that someone might make an attempt to explain just exactly what all of this means, beyond the simplistic mantra emanating from Washington, “The credit markets are frozen”. Moreover, perhaps someone could explain how we arrived at the point that our financial system nearly collapsed, seemingly over night. Seven-Hundred Billion Dollars is a lot of money, take a few minutes and have some fun on the net understanding just what it could pay for.

However, reality being as it is, the fact is we will probably never receive an adequate explanation to justify $700 Billion dollars of taxpayer money. Even those that dreamt up these convoluted schemes that have brought us to the precipice of financial collapse, such as Lehman Brothers, failed to understand exactly what they created. Lehman's decline may be seen as evidence of such. So how are we to understand?

It's not surprising that American consumer confidence is in the gutter. The Reuters/University of Michigan consumer sentiment report for October recorded the worst decline since the report's inception in 1978. Construction of single family homes have dropped to levels not seen in over 25 years. The benchmark S&P 500 index recently recorded its worst weekly drop in 75 years. An entire article could be devoted to the extent of the record setting declines this market has seen over the last year. Suffice it to say, “things aren't rosy.”

There are many angles one could pursue to understand the carnage that has gripped Wall Street, which is now spreading virulently across the globe. The most oft cited and simplistic is that of the sub-prime housing debacle. Ironically, it is also one of the most complex issues at hand. While seemingly self explanatory, “banks made loans to people who couldn't pay and they didn't pay”, the reality is far more complex. To further the irony, the government hand that has reached out to pluck our economy from the jaws of destruction, is the same hand that helped create this crisis. Americans may not be aware of that fact considering the lack of responsibility anyone in government seems to be willing to accept.

To understand where we are we must travel back to where we have been, all the way back to The Great Depression. In 1938, in an effort to make homeownership more accessible to all Americans, the government created an agency called the Federal National Mortgage Association, commonly known as Fannie Mae. The role of this agency was not to provide capital or loans to home buyers, but to guarantee certain qualifying mortgages made by banks, thereby increasing the willingness of banks to extend credit. In today's vernacular you might even say, “to thaw the credit markets.”

Over the years, the role of Fannie Mae has evolved. In 1968 Fannie Mae was split, creating Ginnie Mae, which retained the role of loan guarantees for “special assistance programs” by private lenders, while Fannie Mae had become privatized and issued debt securities, becoming a a quasi-private, quasi-federal hybrid that has characteristics of both. The issued debt securities were in effect guaranteed by a sort of “letter of credit” from the government, which gave investors a measure of confidence to buy the new securities. To be clear, Fannie Mae is a private corporation that trades on the NYSE under the ticker FNM.

The proceeds from the issuance of Fannie Mae's debt securities were used to buy loans made by commercial banks. The banks used the proceeds from the sale of their loans to make more new loans. A win-win that furthered the government's “New Deal” era entitlement agenda of increasing home ownership without having to take an overt, regulatory role.

By 1981, in its continuing effort to expand American's access to home mortgages, Fannie Mae created a new investment vehicle, the Mortgage Backed Security or MBS. Prior to 1981, Fannie Mae held all mortgages that were purchased. The introduction of Mortgage Backed Securities was the first step in an asset class that would ultimately unravel the American economy.

Mortgage Backed Securities are a group of several hundred similar mortgages, with similar rates, maturity, and credit worthiness, packaged together and sold as a single security. The security has a face value, typically greater than one-hundred million dollars and has an interest rate and a nominal maturity date. However, because individual mortgages within the MBS may be prepaid through extra principal payments, refinancing or selling of homes, there was uncertainty as to how long the MBS term will last and how much interest will be paid over the term. This complicated tax and portfolio planning for investors. Furthermore if an investor in a MBS wanted to sell, it became difficult because the “early payment” option associated with mortgages, may have eroded the value of the MBS.

By all metrics, the government's plan to increase home ownership was a success. The Mortgage Backed Security helped in furthering that success, but as previously pointed out, the MBS had difficulties of its own that opened the door to a new round of secondary mortgage market investment vehicles.

To deal with the uncertain nature of the term of an MBS, Freddie Mac created something called a Collateralized Mortgage Obligation or CMO. Later Fannie Mae began to issue CMOs as well as some of the investment banks. The investment banks would buy Mortgage Backed Securities from the agencies and originate their own CMOs. Lehman Brothers took this strategy to a new level as they began buying up loan originating firms, which effectively by-passed the middle man who created the MBS, from which CMOs were derived.

At this point, if this is becoming more and more confusing, you are accurately understanding the nature of these events. The general concept behind a CMO (Collateralized Mortgage Obligation) is to take one or more MBS (Mortgage Backed Securities) and then divide them up into what are called, “Tranches”. Where the original Mortgage Backed Security has a single stated coupon interest rate, which is derived by a weighted average of all the mortgages in the pool, each CMO Tranche has a separate interest rate. Typically there are 4 levels of Tranches, a high quality Tranche will pay a lower interest rate, but has first claim on all principal payments. The second tier Tranche pays a slightly higher interest rate, but has secondary claims on all principal payments. The third and fourth tier Tranches progressively pay higher interest rates, but have greater risk associated with owning them. In many ways these Tranches are similar to bonds, the more risk you are willing to accept, the higher the rate of return.

The Investment Banks that created CMO Tranches derived profit because the total combined average interest rate of all of the Tranches they created were lower than the MBS from which they were created. The spread between the two rates is their profit, along with some other fees. The payments made on the Tranches interest coupons were derived from the the mortgage holders making their monthly payments. Other schemes included Tranches supported by interest only payments, some by principal only payments and others were sold below face value with no interest coupon, similar to buying a bond with a face value of $100 at a discount of $90. While you'll receive no interest payment, you'll expect to be repaid the face value of $100 at the end of the term. This is as simple of an explanation as can be made and doesn't account for the many complexities and derivatives that would later be created.

During the Tax reform act of 1986, CMOs were reclassified and their tax status was changed. For the CMO investor it created in certain cases, huge accounting problems. However, retrospectively the most influential change of the Tax Reform act, with respect to the CMO was the ability to sell CMOs to retail investors. The Tax Reform act created a whole new, broad market of perspective buyers and a new range of products. Investment banks further perpetuated the ownership of these investment vehicles by taking a Tranche and further dividing it into smaller units that could then be sold to retail clients at a one-thousand dollar face value. While Fannie Mae sought to make the dream of home ownership a reality for everyone, the Tax Reform Act of 1986 made the reality of profiting from everyone's homeownership a reality for everyone.

The overall effect of all of this activity was to bury high-risk, sub-prime loans by packaging and repackaging them in with loans of higher quality and then dispersing them across the investment universe. A single mortgage could be part of four separate securities and then further pieced apart and sold in shares.

As recently as a few years ago, many who were shopping for a mortgage were still under the impression that one needed fairly good credit, a deposit of approximately 20% down due to the rule of thumb debt to equity ratio of 80% and your mortgage and taxes cumulatively could not exceed much more than 25% of your total income. This was the standard of mortgage lending, born of the Glass-Steagall Act, which required commercial banks to hold the loans they made until maturity or until the debt was paid. Banks were hesitant to lend to anyone who didn't meet these standards, as the bank that originated the loan ultimately accepted total responsibility for the loan's risk from origination to maturity. At the heart of the debate regarding our current situation, is the deregulation that obliterated responsibility for the loans that were being made.

In the new era of Mortgage Backed Securities, Collateralized Mortgage Obligations and Tranches lacked responsibility for the worthiness of the loan being originated and the risks associated with it, as loans were shuffled, mixed together, diced up and spread throughout the investment universe. Any notion of singular responsibility for the associated risk from origination to maturity had completely and utterly vanished. Mortgage originators were free to sell nearly anything they could imagine to anyone they chose and simply repackage the risk and sell it as early as the same day the loan closed. This is also why the government faces such an immense challenge in sorting this all out. It would be simple enough to make money available to pay for the defaulted sub-prime loans had they been kept separate, but they were commingled in such fashion that an entire class of financial securities was now the problem, not just a percentage of bad loans.

While not an eloquent example, it may be compared to shopping at one of the major discount warehouse retailers. You can buy your favorite food, whether it be oatmeal, breakfast cereal, your favorite candy and quite often they are sold in a bulk assortment. You may get 2 flavors you love, one you can live with and a few that you never saw before and would certainly not purchase alone given the choice. In this way, the manufacturers are able to sell the less desirable products because they have packaged them in bulk with mostly the good stuff. This is very much akin to what happened within the secondary mortgage market. Packaged in with a bunch of good loans, were a certain number of high risk, undesirable loans that very few investors would buy on a stand alone basis.

And things got worse. Many institutions who bought these CMO products, had investment policies and guidelines that only allowed them to invest in highly rated securities. Should the credit rating of a CMO drop, it would put the investor in a situation in which they could no longer hold the asset. An investor in a CMO could see their asset's “investment grade rating” drop for a number of reasons, including rising interest rates or failure of the CMO issuer to pay interest fully or on time. In foreseeing difficulties liquidating CMOs which might have their credit ratings cut, CMO investors needed insurance to cover these risks. The Credit Default Swap was born from this need.

A Credit Default Swap can be seen simplistically as an insurance policy for a CMO. The CMO holder pays the equivalent of a premium for insurance against what are termed, “credit events”. A few common credit events in which the insurance policy would kick in include, if the stated interest rate on a CMO dropped below a certain level as compared to a risk free Treasury Bond, the insurer would make payments to make up the difference. If the credit rating of the CMO fell below a predetermined level, the insurer would buy back the entire CMO or if the issuer of the CMO failed to make timely payments to the holder, the insurer would buy the entire CMO from the holder. Any of these credit events would trigger the insurance payout aspect of the Credit Default Swap and require the issuer of the CDS to make payments or buy the CMO. If no credit event occurred, then the issuer of the Credit Default Swap simply kept the premiums paid.

The ultimate problem and the nature of the seemingly overnight collapse of the credit markets had a lot to do with the risk models of issuers of the CDS and their capital requirements. Who would buy an insurance policy if they felt the insurer did not have the ability to pay should a claim arise? The issuers of credit default swaps in many cases, were contractually obligated to maintain capital reserves in case of losses. The models these issuers used to predict how much capital they'd need to maintain were based on the following oversimplified example: If a credit event occurred and a CMO needed to be repurchased by the issuer of the credit default swap, it would be repurchased at the face value minus any principal that had already been paid. If the face value were $10 million dollars and a million dollars in principal had already been paid, the cost of repurchasing the CMO would equal $9 million dollars. However, since these are assets backed by mortgages, the issuers of the CDS assumed they'd be able to resell the CMO at a lower value, or residual value. Assuming the CMO could be resold at a cost of $8 million dollars, the issuer's model suggested they needed to maintain $1 million dollars in capital reserves in a loss account. The formula would look like this, a $10 million dollar face value CMO, minus $1 million in principal already paid =$9 million dollar repurchase price, less the $8 million dollar resale price=$1 million dollars in reserve. Even though the money would be held in reserve, the CDS issuers could still use it in investment activities.

The unforeseen is what unravelled these models and ultimately put the financial system in danger of what seems to be an almost overnight collapse. As mounting foreclosures and a downturn in our economy accelerated, investors willingness to buy and even hold these asset classes diminished exponentially and by September, there was virtually no market for this asset class.

If you are a home seller right now, you may relate in some ways. How do you sell your home when there is virtually no demand? How do you even price your home when there are no comps in your area?

In addition, the universal adoption of Rule FAS 157 required all securities to be “Marked-to-Market” on the balance sheets of the holders of these assets. If there is no market, no demand, many of these assets were forced to be put on balance sheets at a severely depressed value or even at a value of zero. It would be like having to claim your home had zero value simply because there was no current market to sell your home.

And this is where the overnight liquidity crisis originated. All of the credit default swap issuers (insurers) almost immediately had to allocate the full cost of repurchasing the assets they insured, meaning instead of the $1 million dollars in capital reserves mentioned in the previous example, they'd need to allocate the full $9 million dollars to capital reserves, being there was no market to resell and claim the residual value.

Imagine a hurricane comes through the state of Florida and hits every county on it's way and the insurance companies that had issued all of those policies, were expected to have or to raise the capital needed to pay every claim virtually overnight. The capital requirements sent insurance giants and investment banks alike, scrambling to find the elusive liquidity needed to maintain their required capital reserves. The intra-bank lending system froze as banks were reluctant to lend to each other as no one could be sure who had what exposure and if the loan would ever be repaid.

The underlying root cause can simply be summed up as a failure of the insurance issuers to fulfill their role. This caused the creators of all of these derivatives to take on the responsibility of making the defaulted payments that the insurers were supposed to cover. In addition, it put many of these banks and investment banks in the position of having their own credit downgraded. It all created a snowball effect.

Fannie Mae's Mortgage Backed Securities of the early 1980's opened the door or perhaps the flood gates to what became a booming secondary market. With all sorts of exotic derivatives with the net effect that the risk associated with a loan could be buried or passed from the loan originator to anyone willing to buy in the secondary market, the market Fannie Mae initially introduced.

Eventually lending standards declined, to the point of predatory lending in which nearly anyone could obtain a loan, whether they had documents, down payments or even a job. New and exotic secondary securities based on the original MBS were created, some exclusively to deal with the new riskier loans.

In addition, the housing market became over-saturated and a two decade trend of declining interest rates reversed. As the secondary mortgage market became more and more saturated with these mortgage backed securities and as the quality of these securities eroded, demand diminished and ultimately vanished by September.

If you are an investor or trade stocks for a living, the recent $700 billion dollar bailout plan seemed like it would never arrive, that's because everyday you watched the market plunge to set new multiyear record lows. However, to the casual observer, the $700 billion dollar plan almost flew under the radar. With just a short time to reflect, it is astonishing how quickly this market eroded.

The government is now looking at a tangled mess and the market's recent reaction suggests that it doesn't have too much confidence in the government's ability to solve a problem that they, ironically caused in the first place.