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FRONT PAGE CONTRIBUTOR

The Root Causes of the Financial Crisis

Leverage and the Shadow Banking System

Let me tell you a story about mortgage-backed securities purchased with borrowed money (“leverage”).

An MBS is basically a package of individual home mortgages pooled together so that it can be priced and analyzed like a bond. (And usually the pool is also divided horizontally into credit-quality tranches too.)

MBS are a big hit with institutional investors, because their bond-like analytics made it possible to do something they’ve been wanting to do for decades, which is to gain exposure to the US mortgage market. (Compared to almost any other kind of asset, a mortgage has higher credit quality. Most people, when they get squeezed, will pay their taxes and their mortgage and let their other bills slide.)

And Wall Street firms were thrilled with this piece of financial engineering because the bundling and marketing of MBS generated enormous fee income. And like the drug dealer who uses his own product, Wall Streeters often bought the higher tranches of MBS for their own accounts too. (Bear Stearns and Merrill Lynch were particularly guilty of this.)

So how do you make a good thing better? You buy it with borrowed money. All over the world these last few years, there’s been a tremendous amount of buying of MBS by banks, Wall Street firms, insurance companies like AIG, hedge funds, even money market funds and small towns in Norway.

No less than Fannie Mae and Freddie Mac bought acres and acres of this paper.

And many of these players used funds borrowed from banks and from the overnight money-markets to buy it. If you want one single root cause, one thing to blame for the financial crisis out of all the rest, this is it.

Here’s how it happens…

Let’s say you can borrow money overnight at five percent. (The numbers in this example are not necessarily representative of any specific point in time. Overnight rates today are far lower than they were during the MBS craze.) And you can use the money to buy an MBS that is expected to pay a yield of 5.75% over its five-year term. And the MBS has a triple-A, investment-grade credit-quality rating.

Wouldn’t you want to do this trade as large as anyone will let you? Let’s say that you’re a hedge fund with a billion dollars in capital. Let’s say you levered up 30-to-1 (which is not unrealistic). Conceivably you could construct a $30 billion portfolio of MBS off the $1 billion in capital. Your raw annual investment return (without counting a handful of external costs like insurance) would theoretically be 30 times 75 basis points. WOW! That’s far, far, far above the “normal” risk-adjusted investment yield of 8 to 10 percent that institutional investors have targeted as a benchmark for decades.

Now do you see where the whole problem came from? Ok, what happened next?

As soon as the housing bubble burst, the values of all the MBS had to be reduced because default rates on the underlying mortgages started rising. You saw an increase in the amount of risk that any given mortgage would default, and that in turn would increase the risk of the MBS that the mortgage had been packaged into.

You always have to receive a higher yield on a riskier investment. (That’s why Treasury securities, which are risk-free, normally have the lowest interest rates.) But if the MBS has already been cut, packaged, and sold, the income that it generates is fixed permanently. In that case, the MBS will behave just like any other fixed-income security: its value will decline, which effectively raises the yield.

But what if you bought the MBS at a certain price to obtain a certain interest rate? You now have an unrealized capital loss, because the MBS in your portfolio is worth less than you paid for it.

Ah, but you say it doesn’t matter. Just hold the darned thing until it matures. It will keep paying the same amount of interest (which doesn’t change). A small number of them will default, and you’ll take those losses in stride.

Good point. But here’s the problem: what if you borrowed the money to buy the MBS?

If you borrow money to buy something, the guy you borrowed from wants to make sure you’ll pay him back. And since your ability to pay him back depends on whether the MBS will default, your lender will enforce your capital position at all times. (He’s managing his so-called “counterparty risk.” He wants to be sure you have enough capital to withstand losses without passing them on to him.)

Simply put, if your leveraged MBS portfolio declines in value by even a small amount, you lender will demand that you add to your capital (“margin call”) in order to protect him. If you don’t, he can and will seize your assets and put you out of business.

In two sentences, that’s what been happening all over Wall Street for over a year now.

So there’s a huge amount of MBS paper out there that was purchased for more than it’s worth now. When you’ve lost that much money, you can’t buy anything new. (In the jargon, you don’t have enough balance sheet.) But you’re still stuck holding the distressed assets until they mature.

Multiply that by thousands of institutions across the country, and you’ll see why we have a credit crisis. Any bank that’s forced to take big losses in an MBS portfolio doesn’t have enough capital to make any new loans. It’s the biggest systemic margin call in history.

THIS IS WHY THE ECONOMY SLOWED DOWN, BEGINNING LATE IN 2007. And I’d been saying that in this space a whole quarter before it even happened. This is also why economic stimulus plans like the one we got this year from George Bush and will get from Obama if he’s elected President, only make the problem worse, not better. And it’s also why the economy can not recover until the bad paper all runs off.

This is the root cause of all the failures by one investment bank, commercial bank, hedge fund and insurance company after another. It’s why the world’s “official” investors (foreign central banks and sovereign wealth funds) quietly insisted that the Treasury explicitly guarantee Fannie Mae and Freddie Mac’s securities. It’s why private equity has come to a halt and the stock market has stopped growing.

And it’s the problem that Hank Paulson and Ben Bernanke have stepped up to solve.

Now why on earth would you suppose anyone would let people use 30-1 leverage, or even more, to buy risky paper?

This is another extremely important point for you to grasp: The leveraged purchases were not considered risky at the time. People make investments expecting to make money. They don’t go in expecting to lose money and get bailed out by the taxpayers.

The combination of securitization and faulty credit-quality ratings made many MBS look like some of the safest investments out there. Because of their perceived safety, which nearly everyone accepted, lenders had no problem giving hedge funds and Wall Street firms the money to buy MBS on 30-1 capital ratios.

In fact, 30-1 would have seemed conservative, implying as it did a raw default rate of something like 3%. Even today, in the middle of the mortgage maelstrom, default rates haven’t gotten that high.

And people with access to really cheap capital can readily buy Treasury bonds (which have no default risk at all) on 100-1 leverage. Fannie and Freddie are leveraged more than 200-1. (In effect, the federal takeover of F/F was the fulfillment of a margin call by foreign central banks.)

But at high leverage ratios (or conversely, low capital ratios), your lenders will keep you on a much shorter leash. The less capital you have compared to your assets, the less skin you have in the game. The lender perceives his risk to be far higher than yours. So you’ll get a margin call at the first sign of trouble.

And when the MBS bet turned bad and the margin calls started coming, a lot of bad things happened (which I’ve written about in past posts as they were happening), and we got to the point we’re at now.

But think about this a bit more carefully. If a hedge fund or structured investment vehicle borrows short-term money in order to buy somewhat longer-term MBS (and make a profit on the interest-rate differential), what exactly is it doing?

It’s creating credit. That fund has made the money available for someone to get a mortgage and buy a house. If that’s not clear to you, keep thinking about it until it is.

The only difference between what that fund has done, and what a normal commercial bank does every day, is the source of money. The bank gets the money it uses to make loans from deposits that it takes from the public.

And depositary institutions are regulated heavily. Among other things, they will generally avoid being leveraged any more than 10-1. The regulation is part of the price they pay for the FDIC deposit-guarantee.

So a hedge fund that invests in MBS isn’t functionally different from a bank, but it escapes the banking regulations because it doesn’t take deposits from the public. It’s part of a vast “shadow banking system” that creates credit in an unregulated way. So why the hell are they allowed to run 30-1 leverage ratios, even to buy assets considered safe?

That’s something we will need to change.

-Francis Cianfrocca

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