The Great Depression between 2007 and 2011 was created by a single word, "DEBT". The origins of this depression date not to the Lehman September 2008 bankruptcy, but to the failed bank debt offering against Boots Alliance and Chrysler in July 2007. When that transaction failed, the securitision markets and overall debt markets failed. The West was headed for a second Great Depression...A true shift of power from West to East.
This article explores four key factors that lead to this catastrophe.
The banks and insurance companies manufactured credit default swaps (CDS). These first two points on CDS are well connected. The old fashion commercial bank would make a loan and hold that loan on its balance sheet. The loan officer would come around to your house and kick the tyres on your car. Then, a great merger took place between an Investment Bank and a Commercial Bank in the early 2000 period. That was a defining moment to this story. That old commercial bank kept its loans on the balance sheet but the investment banks saw ways to profit by trading those loans. The new Goliath would simply buy insurance from it cousin Giant Insurance Company GIA. So we begin the story.
1.) Credit Default Swaps were created to insure against a default. They were manufactured against the underlying bonds of the company it would insure. As the credit rating of a company declined, the premium for that insurance increased. Everyone (the banks) bought that sweet candy insurance. However, it was not common sense. Simply, you sell your house to 100 people and they all show up at high noon to claim that house, but there is only one house. This was the problem with the bilateral CDS market. The warning was the default by Delphi, a former division of General Motors. The banks came together and put together an auction plan. They all received less that USD 1 in insurance and came to a much lower price on the default. They never thought that this could happen at a massive scale. Those days were boom! boom! in the early 2000 period. The perfect storm was brewing, as simply no central clearing system for CDS existed.
2.) The second point is that the CDS maturity did not match the bank's loan maturity. Goliath bank wrote down its balance sheet against the purchase of CDS. Goliath bought a five year CDS in 2003 against a loan maturity of 10 years. Then, after mid 2007, the price of CDS increased. Goliath decided not to reinsure in 2008 due to the increased premium, but we all know that there is no free lunch. Now, that loan came back to Goliath's balance sheet...and loan after loan came back to that balance sheet. The balance sheet soared and the music no longer played and no one danced.
3.) The securitisation markets failed. Securitisation is a great concept and one day it should be restored. An entity has cash flows (annuity) and you simply bundle those flows. Everyone became a hunter and there was no game keeper in the park. You simply went down to your local realestate agency in the UK. They gave you this low mortgage interest. They turned around and sold your mortgage to a High Street local bank. The local bank sold it to Goliath. Goliath called his cousin Giant Insurance Company...and presto, a triple AAA securitised bond was created. That bond was then sold to Ms. X's pension fund. Ms. X worked for 30 years as a school teacher and looked forward to her nice retirement in a humble bungalow house with her husband Y. However, couple Z her neighbour did not keep up with the mortgage payments and defaulted. If we multiply that by millions, "Houston, we have a problem!"
4.) Arbitrage by the banks came into play. Like Cain and Able, there were two Goliaths. The one brother put his syndication loans into held for investment (HFI) where he simply looked at Financial Accounting Standard (FAS) methodology and won by keeping it all at simple book value. But, the other brother Goliath kept those loans hoping that he could sell them. Every month, Goliath would market to market those loans. One day, a small guy named David brought Goliath down.
If you never know the cause of a disease you can never cure it.
1.) We need a central clearing system on CDS.
2.) We need independent risk and independent audit to ensure that we all understand Finance 101.
3.) We require accountability and responsibility to monitor our actions, especially what we secure.
4.) We require uniform accounting rules, even if that protects Goliath. Arbitrage builds nothing!
Copy Right July 23, 2011. All Rights Reserved.
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