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In the years leading up to the financial crisis, Wall Street figured out how to spin relatively obscure activities into gold.
What resulted was a jumble of products designed to profit off of the relatively mundane business of mortgage lending. From the mortgages themselves to products created to bet on risk and credit worthiness, soon enough, Wall Street had created an extensive and complex array of securities with funky acronyms, in some cases magnifying the risks two- and three-fold.
Banks, insurance companies, hedge funds and others were hungry to partake, but what seemed like easy profit at first stopped working when borrowers stopped paying on their loans. Losses cascaded across the financial market, requiring massive intervention to prevent the banking system from failing.
On Sept. 19, 2008, days after the failure of Lehman Brothers and the government action to shore up American International Group, the Treasury announced its remedy in the form of its own acronym: the $700 billion TARP. The Troubled Asset Relief Program would buy the toxic securities from banks and infuse them with capital to get over the crisis. TARP ultimately bought $426 billion of these assets and recovered $441 billion for a profit of $15 billion.
These products haven't disappeared, though, and in some cases they are staging a comeback. After a decade of low interest rates, money managers are hunting for investments that pay more "and will entertain almost anything," said Janet Tavakoli, president of Tavakoli Structured Finance. Here is a look at the products that got Wall Street into the crisis, and where they are now:
The mortgage backed security was at the heart of the financial crisis but wasn't anything new at the time. The idea dates back to at least the 1960s. How it works is fairly simple: a bank makes a loan on a house, and then sells that loan to another bank, which bundles it with other mortgages to create an MBS. The borrowers make loan payments that create a predictable stream of cash, which is the basis for paying investors in the MBS.
There is RMBS, for residential mortgage backed securities, and CMBS, for commercial mortgages, and even MBS issued by government-sponsored agencies.
Mortgage-backed securities were the fuel that fed the housing boom as banks lent to homeowners and quickly "securitized" the loans. In the process banks were able to clear up space on their books to make more loans, and investors had another type of stable, income-generating asset for their portfolios. At the peak in 2006, nearly $1.3 trillion of RMBS was issued by entities other than the government sponsored Fannie Mae and Freddie Mac, according to data from the Securities Industry and Financial Markets Association.
MBS was such a hit with investors, banks scrambled to create ever more product to feed them, and here's where the wheels started to come loose. MBS made mortgage lending seemingly less risky for banks because they could originate and sell the loans — and the risks associated with them — to the investors who were willing to take on that risk. But this virtue was also a vice. Mortgage lenders without any skin in the game (because they had offloaded their risk) had no incentive to make sure the loans they were making could be paid off in the way investors expected. They started lending to people without verifying income and other weak practices that ultimately led to a wave of mortgage defaults.
Then the credit crisis erupted. In 2008, just $52.7 billion of RMBS was issued by non government sponsored entities and it remained low until the end of last year, when it finally topped $100 billion again. So far this year, it is up to $76 billion. It's different for the housing agencies. MBS created by Fannie, Freddie and the like stayed well above $1 trillion for almost all of the past decade and so far this year has reached $862 billion.
Regulators and others sued banks over the creation and sale of RMBS products, Wall Street banks have paid tens of billions of dollars in settlements in the last few years.
Asset backed securities this took the idea of the MBS and applied it to other types of loans like credit card receivables and auto loans. Over the years creative-minded bankers haven even been able to securitize esoteric assets like outdoor billboard rental income and the royalties off David Bowie's music catalog and other recording artists.
In 2007, $795 billion of ABS was issued but it dropped off after that. But lately it has shown signs of a rebound. Last year, ABS issuance rose 68 percent from 2016, to $559 billion. It is around $267 billion so far this year through August, according to SIFMA.
The collateralized debt obligation is a twist on ABS and based on a mix of ABS, residential or commercial MBS, and even derivatives like credit default swaps (see below). The value of the CDO is based on the value of these underlying assets.
CDOs were constructed so that the assets they contained could be divided into different groups, or tiers (or tranches in Wall Street-speak), with separate credit ratings meant to appeal to a broader range of investors. Sound complicated yet? The top tier was the "safest" with the highest credit rating, going on down to the bottom. If defaults on the underlying assets began, the lowest tiers lost money first.
But investors like banks, insurance companies, hedge funds and investment managers looking to outperform their benchmarks looked to investments like CDOs for better yields. CDOs were sold as instruments that could contain risk while providing high income. But when they faltered, the CDOs became impossible to sell and banks, funds and others holding them had to write off a significant amount of their value.
Investors who bought the CDOs had taken their eyes off what made up the securities in the first place, the quality of the loans and the types of borrowers they represented, Tavakoli said.
Wall Street also managed to magnify these risks by creating CDO-squared and CDO-cubed, taking specific parts of the CDO credit layer and ramping up the wager, often with derivatives.
In 2007, more than $1 trillion of CDO were outstanding, according to Sifma. At the end of last year, $716 billion was outstanding, nearly all of it ($542 billion) in a subcategory called collateralized loan obligations, which represent bundles of leveraged loans to companies. CLOs have been a hot investment lately, with the dollar amount outstanding nearly doubling since 2013.
Credit default swap. This was a financial derivative developed in the 1990s that was designed to provide insurance on a company's bonds. Basically the thinking was corporate bond defaults were rare, but in the off-hand chance of one, a CDS would allow a corporate bond buyer to hedge that exposure. The buyer paid a premium to the seller of the CDS, and most of the time the seller would not have to pay out anything. It was a lucrative profit generator for banks, hedge funds and insurance giant American International Group.
By the early 2000s, traders used CDS to speculate on a given company's likeliness of default. So, instead of investing in X Widget company's bond and collecting the interest payments slow and steady, a trader looking to make a bet on X Widget company's credit worthiness simply sold a credit default swap in X Widget company, taking the premium payments from buyers and promising to pay if the unimaginable happened and the company defaulted. Which never happened......until 2008.
Banks and hedge funds were taking both sides of the CDS trade, buying and selling swaps on the complicated financial instruments like MBS and CDOs at the heart of the crisis. When the low-risk profitable trades unraveled as the bonds defaulted, however, these traders were paying out big money.
CDS would became a colossal threat to the global financial system, bringing down Lehman Brothers and nearly toppling AIG, which was almost entirely exposed as a seller of CDS (and therefore on the hook to pay out on hundreds of billions worth of contracts.)
Data tracked by the Bank for International Settlements says the notional amount of CDS outstanding ballooned to more than $61 trillion by the end of 2007. There was less than $10 trillion of CDS outstanding as of the end of last year, but the Financial Times reported that investors like hedge funds, chasing yield at a time of historic low volatility, were piling back into the trade.