Originally posted on May 4, 2010.  Re-posted now at the Request of a Reader…

Complexity We Eschew at Good Old…

Mandelman U.

Sit, Sulte, Simplex

As I’ve been telling you for over a year, the banks did it, not the borrowers.  And, now I’m going to arm you like no other so when the topic of the economic meltdown and financial crisis comes up at the dinner table, you can sit calmly prepared to take on all comers.  Let them sweat.  You just say… would anyone like some tea… as you deftly explain to them the ins and outs of the financial crisis that they’ve never understood because the article they read in Newsweek didn’t really cover them.

I’ve heard more than enough idiocy being spouted by people that couldn’t tell a Synthetic CDO from a Synthetic pair off trousers.  Well, I think we’ve all heard about enough from them, don’t you?

Ready for Mandelman University?

Come back to 6^th Grade where I’ll be teaching real 6^th graders all about what the banks did to break the world.  We’re going to cover the Bond Market and Securitization, CDOs and CDSs… and even Synthetics and CDOs squared.  No derivative is too complex for me to tear apart and make simple enough for a 5^th or 6^th grader to understand.

Now, shhhh…. It’s time for class to begin… Mandelman’s in the house… Let’s do this, Dawg…

CHAPTER ONE -

Securitization, the Bond Market & the Mortgage Backed Security

Picture a bureau in a bedroom.  A stand up dresser of drawers.  To keep things simple, let’s just say there are three drawers.

Now let’s say we have one thousand, $120,000 mortgages, so the total amount of the debt is $120 million, which is simply $120,000 x 1,000.  And each of those mortgages was taken out by someone with a low credit score, say something under 600…. or 500, if you’d prefer.

Now, there are lots of reasons for having a low credit score, divorce, medical bills, a business that fails because of a partner’s actions, alcoholism or drug addiction, thousands of reasons.  Just because you have a low credit score doesn’t necessarily mean that you won’t pay your mortgage payment in the future, right?  In fact, one might argue that depending on the circumstances that led to someone having a low credit score, he or she might be less likely to default in the future than someone with a high credit score.

For example, someone who has had their car repossessed may never want to endure the pain and shame of losing their car again and therefore will do everything possible to never miss another car payment again.

So, we have $120,000,000 (or $120 million) mortgages that are all held by people with low credit scores for a garden variety of reasons, credit scores that would be classified as “C” credit.

But, how to find investors that want to lend money to those people, that’s been the question for Wall Street?  It was easy to find investors to lend money to people with perfect credit, but what about those with a low credit score?

So, Wall Street takes those “C” credit loans and dumps the cash flows or payments from those loans into the bureau… the dresser with the three drawers that I mentioned at the beginning of this article… They dump the payment streams into the bureau until it’s filled to the top with payments owed by people who, for all sorts of reasons, have low credit scores.

Now each of the three drawers contains 1/3rd of the payments or cash flows (or in other words the payments on $40 million in mortgages, which is 1/3rd of $120 million total) but the Wall Street bank that is putting together this bureau or dresser creates a contract that dictates how the payments will flow into the bureau or dresser, and that contract says that the payments shall flow in from the top.

That means that the payments will fill up the top drawer first, then the middle drawer, and then the bottom drawer last.

Now, we know that not all of the 1,000 homeowners that owe these mortgage payments are going to make their payments as agreed. Some will default and the company that we hire to service these mortgages will have to foreclose on the house and resell it.

We also know that some of the 1,000 mortgages will pay off early, either because the homeowner refinances the loan, in which case the payments will end up in someone else’s bureau or dresser drawers, or perhaps because the homeowner inherits money from a relative and decides to pay off the mortgage early.

But regardless, because we have 1,000 loans, we figure (using a bunch of complicated mathematical formulas) that no matter what… no matter how many homeowners default on their payments, and no matter how many refinance or otherwise pay off the loans early, BECAUSE the contract says that the payment streams shall come in from the top and be used to fill the top drawer first, and then the middle drawer, and only after filling the middle and top drawers will the bottom drawer be filled… we know because of that structure the top drawer will always have enough payments to fill it up all the way.

And that means that the top drawer, because of how we’ve structured the payments to come in… and NOT because of the credit scores of the people who took out the mortgages… will always be able to pay the people that invest in it.

In other words, no matter how many homeowners out of the 1,000 don’t end up paying as agreed, either because they default or because they refinance, the top drawer will still always receive enough of the payment stream to fill it all the way up.

The middle drawer only gets filled after the top drawer, so the risk of it not receiving enough payments to fill it all the way up is greater than the top drawer. And because the bottom drawer only gets payments after the top and middle have been filled, the risk that it won’t receive enough payments to fill it all the way is the greatest.  To get people to invest in the bottom drawer, we’re going to offer then the highest rate of interest to accept the risk of not getting paid at all.

So, each drawer has $40 million in mortgages, but not many investors want to invest $40 million, because that’s a lot of money for our clients.  So, we’ll slice the top drawer into 40 slices of $1 million each.  (We could slice the top drawer into 400 slices of $100,000 each, or even 4,000 slices of $10,000 each.  It just depends on what type of investors we know and can sell to.)

Regardless of how we decide to slice the top drawer, whether we choose to slice it into 40, 400, or 4,000 slices, each slice will be called a “bond” or a “mortgage backed security”… same thing.  And each slice will be rated AAA, because there will always be enough money to fill the top drawer, because of the way we’ve structured our mortgage backed security.

A bond and a mortgage backed security are one in the same.  It’s a security, in this case a bond, and it’s a security backed by mortgages on real property, such as houses.  So, it’s a mortgage backed security, or MBS, as opposed to a corporate bond issued by a company like GE or IBM, or a Municipal Bond, issued by a city or municipality, which are only backed by the company’s or the city’s credit rating at the time the bond was issued.

So you see, although both are securities, bonds are debt, while stocks are equity.

We buy shares of stock in a company because we want to be an owner of the company, because we believe the story that we’ve been told about the company’s future being bright.  And because we believe the company will succeed in the future, it will be worth more and someone will want to pay us more for our shares of stock in the future than we paid when we bought them.

The bond market, however, which is much, much larger than the stock market by the way, is a market for debt. Bonds are a way for a company to raise the capital needed for growth without selling shares of stock, which would dilute the ownership of the other shareholders, thus pissing them off because by diluting the company by selling more shares, the original shareholders own less than they did before you diluted it.

Bonds are like IOUs.  You agree to loan the company, or municipality some amount of money for a specified period of time and the issuer of the bond promises to pay you back the amount you loaned, plus some rate of interest. And just like loaning money to anyone at anytime, there’s always a certain amount of risk that whomever you’re loaning the money to, he or she won’t be able to pay you back as agreed.

When the United States government sells bonds to raise money, investors consider there to be essentially no risk, because the government has the power to tax its citizens in order to come up with the money it needs to repay its debts, so since there’s no risk of not being re-paid, Treasury bonds offer to pay the lowest interest rate of all bonds.

GE’s bonds, while not as safe as Uncle Sam’s, are still considered pretty gosh darn safe because of GE’s credit rating, so GE’s corporate bonds will offer to pay you a little more interest than bonds issued by the US Treasury.

If they didn’t offer a little more than Treasury bonds, well then no one would buy them, right?    Because if GE bonds were offering to pay the same interest rate as the US government bonds, well, you might as well buy the government’s bonds, right?  I mean, as safe as GE might be, as high as its credit score might be, it can’t be considered as safe as the government of the United States of America. Why, of course not.

Companies like Sears might issue bonds as well, but since Sears isn’t considered to be as safe as say GE, Sears bonds have to offer a higher rate of interest than GE’s bonds in order to get investors to buy them, or in other words in order to get investors to lend money to Sears.

Some companies with low credit ratings may choose to float a bond offering to raise the capital they need to grow, because bond holders are not owners of the company, they’re more like creditors of the company, so if the company goes belly up, bond holders will be paid back before the holders of common stock.  For this reason, investors may feel safer investing in a company’s bonds than its stock.

When cable television first appeared on the scene, the companies needed a huge amount of money to lay the millions of miles of fiber optic cable that would one day carry television programming into our homes, but no one knew for sure how many of us would agree to pay for television brought in via cable. Back then, television was broadcast over the airwaves and as such we were used to getting it for free.

So, the companies that were forging the cable television industry offered bonds in order to raise the billions they needed, and because there was a risk that cable television wouldn’t take off, the bonds had to offer a much higher rate of interest than Sears, GE, or the US government.

These bonds, and others like them, became known during the 1980s as “junk bonds,” but the point is that as the credit rating of the bond issuer (or borrower) went down, the amount of interest offered to the investor who purchased the bond went up. The greater the amount of risk… the greater the potential return.

(Michael Milken, as you might remember, was the king of junk bond financing in the late 1970s and 1980s.  He financed such things as cable television giant, Liberty Media, Ted Turner’s CNN, and Steve Wynn’s Casino Empire.)

Individuals, like you and me, are pretty simple for investors to judge as far as credit worthiness goes. We have loans that we make payments on, and the degree to which we make our payments on time and as agreed, along with a bunch of other factors I realize, the higher our credit score. But large corporations or municipalities are much harder to assess as to their credit worthiness, so in order to make our bond market function, the US government depends on credit rating agencies to tell investors how risky various bonds are, all relative to the bonds issued by the US Treasury.

These are not the same credit rating agencies that we’re familiar with as consumers. These ratings agencies are named Standard & Poors, Moody’s, and Fitch, and among other things, these agencies place ratings on bonds, like AAA, AA, A, or BBB, C, or possibly even “Unrated,” which signifies the highest risk of nonpayment.

Bonds are bought and sold based on their ratings simply because it would be impossible for them to be traded any other way.  An investor, for example, could hardly fly to GE’s headquarters and ask to examine the giant corporation’s books before deciding whether to buy a GE bond. Or, ask to review the books of the City of Atlanta before deciding to buy its tax-free municipal bonds, perhaps being used to raise the money needed by the city to build a new highway, or sewer system.

(Politicians hate to have to raise taxes when money is needed, so state and local governments often offer bonds to raise the funds needed for various projects at repayment terms that stretch out over 10, 15, or 20 years.)

Now, back to our $40 million top dresser drawer bond that, just for the sake of our discussion, we’ve decided to divide into 40 slices of $1 million each because we figure that we’ve got plenty of investors as clients that are looking to invest sums of $1 million and up.  Another investment bank may buy one of our $1 million slices, or bonds, which remember are also called mortgage backed securities, and then decide to divide it up into 100, $10,000 slices because that firm serves clients that are looking to invest $10,000 at a time.

Now, it’s important to remember that people with low credit scores have taken all of the mortgages that are generating the cash flows, or payment streams, that flow into our bureau or dresser drawers.

So, you might think that the bonds we create when we slice up the drawers in our $120 million dresser would have to be rated with low credit scores, but you’d be wrong because you’d be confusing the credit scores that people have, with the credit ratings placed on bonds by the ratings agencies, S&P, Moody’s and Fitch, which are intended to reflect how much risk exists that you won’t be repaid by the bonds issuer.

You see, because the contract we’ve created for our mortgage backed security states that the top drawer, which in bond lingo is called a ” tranche,” will receive the first payments received, and only after it’s full will payments flow into the middle drawer in our dresser, the top tranche’s $40 million in cash flows or payments will be rated AAA, the highest rating, and therefore all of the $1 million bonds, or MBSs, for mortgage backed securities, will likewise carry a triple A rating.

These bonds will also offer the lowest interest rate of the entire dresser, but also convey the lowest risk of default, and because of their AAA rating, they can be sold to pension plans, insurance companies, university endowments, and even state and local governments… investors with lots of money to invest for long periods of time.

The mortgages that are generating the cash flows that are being used to pay the investors were all issued to people with low credit scores, but because of how we’ve structured the bond, or MBS, with the top tranche receiving its required payments before any of the lower tranches, the bonds that are cut from the top tranche will be rated AAA.  If you think about it carefully, and Wall Street certainly did, any loans could end up being sold in AAA rated bonds, as long as you had enough of them, and this type of structure was used to build the bond.

Because the investors that provided the capital for the 1,000 mortgages did so through the purchase of a “security,” a bond called a mortgage backed security, we say that the mortgages in our example have been “securitized,” and we refer to the process of using our dresser drawers, called tranches, as “Securitization”.

Everyone still with me so far?

If not, go back and read through it again. If you think you’ve got it down, let’s move on to what our Wall Street banksters did next.

Remember when it was hard to get credit? Unless you’re in your late 40s or older, you probably don’t.

It wasn’t always so easy to get a mortgage, a car loan, or even a credit card, for that matter.  Until “securitization” was discovered and became widespread during the 1980s, loans of any kind were much harder to qualify for because whoever was providing the capital to fund your loan had to be concerned that you might not pay the loan back, often leaving that investor with a substantial loss and no way to recoup his or her money.  That’s why it used to be common to hear the phrase: “In order to qualify for a loan at the bank, you have to prove you don’t need one,” when talking about applying for credit.

Of course, this also prevented prices from going up too much too fast.  Certainly, one of the factors that caused housing prices to rise so quickly during the bubble that ran from 2002 to 2006 or 2007, was the enormous amounts of capital that was, all of a sudden, essentially effortless to qualify for in the form of a first… or second… or even third mortgage.  As long as it could be securitized, it could be financed easily.

Had it been more difficult to obtain the mortgage needed to finance a real estate purchase, demand would have been lessened and therefore prices could not have climbed as high as they did by 2006.  Unfortunately, we still would have had a bubble in housing prices, and due to other factors that we’ll look at shortly, still would have had the financial crisis.  But still, unquestionably, had easy credit been a little less easy, we wouldn’t have had as far to fall when the bubble began losing air.

It’s interesting to note that during the 1930s, mortgages went from being five years in length, to offering 12-year repayment terms.  It’s easy to see how the advent of the 30-year mortgage made it possible for housing prices to increase, after all, if the longest fully amortized mortgage was still 12 years in length, almost no one could afford the payments on their current home.

But longer term mortgages, combined with “securitization,” and soon thereafter more exotic mortgages, such as the infamous Option ARM, all contributed to inflating housing prices, and in general, addicting Americans to increasing amounts of debt.  It made us feel much wealthier than we ever were. Sure, the value of the home we lived in was steadily rising, but so was the price of our next home.

During the last thirty years, we felt richer because we, and when I say “we,” I mean baby-boomers, for the most part, a generation that had never known hard times, were continuously willing to borrow more in order to spend more. And it was Wall Street’s bankers that were committed to making it easier and easier for us to do just that.  Never mind whether it was the right thing to do, or whether it was sustainable… it was profitable, and that’s all that mattered or matters on “The Street”.

In truth, Las Vegas casinos when still run by the mob cared more for their gambling customers than Wall Street’s bankers cared for American consumers.  As the famous economist, Joseph Stiglitz, points out in his book “Freefall,” Wall Street’s bankers could have used the abundance of cheap capital to create sustainable mortgages that would have allowed unprecedented numbers of Americans to own their own home and continue to stimulate the growing US economy, but they didn’t.

They chose instead to create mortgages with toxic terms, employed leverage that was beyond reckless, and invented uses for derivatives, called Credit Default Swaps that ultimately caused the economic, financial and social catastrophe that brought the global economy to the brink of disaster.

We’re going to cover them all, slowly… one by one… and then we’re going to put them all together so I’m hoping that it will be easy for you not only to understand the parts, but how they combined to make the toxic brew that broke the world… and may have, or may still end up causing you to lose your home to foreclosure.

Stick around… in a few days you’re going to be able to take on any of the idiots that are still running around blaming the sub-prime borrowers for the economic meltdown.

That moron on CNBC, Rick Santelli or even Diana Olick comes to mind, but you may have a neighbor or even a relative that you’d love to show others is, in reality, a first class dunce when it comes to finance and economics… you just didn’t have the firepower before.  He sounded like he knew what he was talking about, and since you didn’t really understand all of the details, you backed down, gritted your teeth, and had another glass of wine or popped another Xanax, as you listened to him go on about how irresponsible borrowers caused the crisis and deserved to be losing their homes.

Well… no more.  Tell Uncle Louie, or whatever your personal demon’s name is… his days as King Shiz are over, and he better start reading up and fast, if he wants to debate you on any of this stuff from this point forward.

Because Mandelman’s going to make this so stupid simple that my 5^th and 6^th graders are going to be right with you on the learning curve.

This, I so promise you… is going to be fun, assuming, of course, that when you read what I wrote just above about being able to stick it to someone who’s been an obnoxious “Mr. Responsible” superior, know-it-all for the last two years, made you all tingly.  If so, well… I’ve been waiting to take that guy out myself, so I’m happy to be able to help.

Coming soon…

Chapter 2: What’s a “CDS”?  Why it’s a Credit Default Swap, silly. Nothing difficult there… Easier than mortgage backed securities.  Don’t worry about a thing… see you in class tomorrow I hope.

Let’s review today’s key learning:

1. They call it “securitization” because the investor that provides the capital does so through the purchase of a security, such as a mortgage backed security (“MBS”), which is a type of bond.

2. Stocks are equity, while bonds are debt.  Stockholders are owners of the company, while bondholders are more like the company’s creditors.

3. Bonds are safer than stocks, because if the company goes belly up, the bondholders would be repaid from whatever monies were available from the company’s liquidation, before the stockholders got a nickel.  The bond market is much, much larger than the stock market, but they don’t make movies about it, so few people know much about it.

4. Companies issue bonds in order to raise the capital they need to grow, without having to dilute the ownership interests of current shareholders.

(Let’s say you had 100 shareholders and each owned one share of stock in your company, or one percent.  But then you went out and sold another 100 shares of stock.  Now there would be 200 shares outstanding, and the original stockholders now only own one share out of 200 instead of one share out of 100, which means they went from owning 1% to owning only .5% of your company.)

5. Securitization helps to spread the risk of any individual loan defaulting.

6. In the securitization process, when building a mortgage backed security, you can think of it as a bureau or dresser with drawers in it.  You create a contract that states that the cash flows generated by the mortgages will flow in from the top, and there the top drawer will fill up before the middle drawer or lower drawer do.

7. Therefore the chances of the top drawer not receiving enough of the payments to become full is very low, and for that reason the slices of that top drawer, which are bonds, will be rated AAA by Moody’s, Standard & Poors, or Fitch, which are the names of the ratings agencies that place credit ratings on bonds.

8. It doesn’t matter what the credit scores of the people who took out the mortgages are, because as long as you have enough mortgages to create sufficient cash flows to fill the top drawer, well, then you’ve got some triple A rated bonds to sell.

9. In a Mortgage Backed Security or MBS, the dresser drawers are called “tranches,” and just so you know, this word is often misspelled as “traunches”.

10. The lower the credit rating on a bond, the higher the promised interest rate.  Bonds are bought and sold based on their ratings, because it would be impossible to review the books at a large corporation or a city or municipality, in order to determine whether you wanted to purchase a given bond.  Junk bonds had low ratings, but they can also be called “high yield bonds,” when they end up working out.  Michael Milken was the junk bond king, but he also provided the bond financing for cable television and Wynn casinos.

~~~

Hey… why not take a minute and SUBSCRIBE to Mandelman Matters so you’ll get it delivered to your email daily.  Don’t worry, you don’t have to read it, if you don’t want to.  But you’ll feel better when you do!