How Leveraged Mortgage Monetization Created a Global Financial Meltdown & $700 Billion Bailout

Treasury Secretary Paulson has asked and Congress is considering a $700 billion bailout for financial institutions drowning in bad loans.

In the last several weeks it seems like we have entered an economic black hole. Fannie Mae and Freddie Mac are in a "conservatorship". Lehman Brothers has followed Bear Stearns and both are gone. Merrill Lynch has been bought by Bank of America, AIG has been taken over by the Federal Reserve, and Morgan Stanley (stock chart) and Goldman Sachs (stock chart) are fighting for their very existence.

The obvious question is "what happened"? Consequently,the purpose of this post is discuss how we got to the point where the Government is attemptingto prevent the economy from falling into the same black hole via a guarantee for money market accounts and an additional $700 billion bailout of U.S. financial institutions.

I. How the Market Mortgage Works & The Role of Investment Banks

Like Banks, Mortgage Bankers and brokers create, i.e. originate, mortgages by working with borrowers to obtain the funds to buy their homes. The loans made maybe kept on the books of the lender or sold to Investment bankers. Investment bankers' turn these mortgages back intomoney, that is they monetize the asset, by forming pools of mortgages that are the collateral for Mortgage Backed Securities (MBS) and Collaterialized Mortgage Obligations (CMO). These securities are sold to domestic and international money market fund, mutual fund, pension fund investors,banks and speculators as investment assets and trading vehicles.

Investment Banks, like Bear Stearns or Lehman Brothers, have a trading desk and sales force that buys and sells mortgage backed securities and collateralized mortgage obligationsfrom and to money market fund, mutual fund, and pension investors. A typical seller can call a firm and the broker will tell him what the trader will pay. If the bonds are sold to the brokerage firm they are placed in the firm's inventory and on its balance sheet until they are sold to another buyer.Brokerage firms finance their borrowings, i.e. the purchase of mortgage backed debt, through the repurchase agreement.

The "repo" allows the brokerage firm to finance its inventory by borrowing money from money market funds, mutual funds,pensions and banks for a period as short as one day and use the MBS as collateral for the loan. Lenders, however,may require a "haircut." Haircut means they will lend our example firm something less than $40.00 and rely on the $1.00 in equity as a cushion against a decline in the mortgage bond's price and thus assure full repayment payment of the loan.

The nature of the problem, long term lending via the ownership of mortgage backed bonds versus the risk of using short termfinancing to carry those bonds in inventory, is also exemplified by the use of financial commercial paper. Brokerage firms used large amounts of asset backed commercial paper to finance their holdings.

II. What Investment Bankers Did to Neutralize Leverage Risk

Investment banks support their purchases through leverage. A good example of the impact of leverage on a balance sheet comes from CNBC's Dylan Ratigan. Paraphrasing Ratigan: (1) Assume you have one dollar ($1.00). (2) assume you borrow $39.00's and with your $1.00buy a forty dollar ($40.00) mortgage backed bond. (3) Your one dollar ($1.00) is "leveraged 40 times. (5) At thispoint you have a $40 asset (the mortgage bond), a $39.00's liability, and $1.00 in equity. If the market value of the $40.00 mortgage goes down in price by 2.5% you lose $1.00 ($40.00 x .025) and the resale value of the mortgagefalls to $39.00. If you lose more than a dollar you can't repay the loan and you are bankrupt. Indeed, with leverage so high, 40 times in this example, any decrease in the value of the mortgage leaves the investment bank insolvent.
The primary exposure of the leveraged brokerage firm that holds these bonds as inventory and the investor who addsthe asset class to the investment portfolio is credit default risk. Credit default risk measures the risk that anumber of individual borrowers, in this case homeowners, will not have the financial wherewithal to repay the loan and therefore the bond.



This risk is addressed in two basic ways.First, mortgage backed bonds may be overcollaterialized to protect the bond holder from default. If the actuarial assumption is that 15% of the collateral backing the bond will default, then the bond isovercollaterialized by at least 15%. An older variant of this theme is "substitute collateral." Under this option a default on 15% of the collateralrequires the defaulting collateral be removed from the collateral pool and be replaced by mortgages in good standing.


A second way default risk is mitigated is through the credit default swap (CDS). The CDO acts as an insurance like hedge against default and can be bought and sold independently from and without the necessity of there being an underlying asset to be insured. CDO's are, however, used to reduce the default risk on actual subprime mortgage bonds.

Understanding how it is thought default risk is mitigated provides the foundation for understanding why a rating agency, such a Moody's and Standard & Poor's, assign mortgage backed bonds investment grade ratings. Both Moody's and S&P perform independent stress tests to determine the ability of a bond, be it mortgage backed, corporate, or municipal,to withstand the downward pressures associated with adverse economic and industry events. The greater that ability to with stand adverse circumstances the higher rating.

III. Why the Financial System Broke Down and Created a Global Financial Crisis

With the above in mind return to the issue of leverage and the hypothetical investment bank. The sharp increase inmortgage default rates and the resultant sharp deterioration in the value of dealer inventories at least appeared to fatally affect the firm’s ability to repay their loans. That is to say if lenders do not feel that $1.00 is sufficient to cushion their loan they may refuse to continue to finance it, demand payment and refuse to make additional loans. If the value is less than $40.00 minus any haircut or repo lenders withdraw financing because the risk is too high. Since the investment bank in unable to pay its creditors or refinance its loans, the investment bank collapses.

A similar situation exists with asset backed commercial paper. Buyers of the paper not only refused to make new purchases as older maturities matured, but they actively sold or tried to sell current positions. As the price of the holdings of commerical paper fell the money market funds broke contractually permitted values ($1, or "the buck") and caused mass withdrawals.

Credit default swaps also reflect leverage. As an example a participant may trade a $10 million swap using $1 million dollars to collateralize the trade. Thus, if a trade which moves against the participant requires it to post more collateral to cover the increase in risk. Since a credit default swap is triggered by a creditevent such as default or non-payment, the deterioration in the assets held by participants, including investment bankers, Fannie Mae & Freddie Mac, and AIG, was of such a magnitude that investors questioned the ability of such companies to meetboth potential and actual requirements to post additional collateral.

One measure of equity is the investment bank's stock price. If an investor perceives the value of the mortgage backed securities held by the investment bank is deteriorating the investor can sell the stock. When enough investors sell the stock its price falls until it more accurately reflectsthe value or liquidation risk the company. Given the leverage used by Bear and Lehman many investors and speculatorsbelieved their price was going to zero. The price of these stocks dropped quickly and sharply as a result of squeezingthrough the keyhole. Investors and speculators reached similar conclusions at similar times and were willing to and didsell them at almost any price. Conversely buyers in general and stock exchange specialists in particular, pulled theirbids in order to avoid the onslaught of selling.

And, it is this specter that lead to the recent financial meltdown. If one pictures the NYC financial industry as the hub on a wheel, the financial industries of Asia and Europe are the spokes since investors in these areas both traded in and were counterparties in the deteriorating products.

For the purpose of illustration only, hypothetically assume Tokyo companies could only meet their financial commitments to London if NYC companies could meet their commitments to Tokyo. If NYC fails then Tokyo falls, if Tokyo falls then London fails. Given the resultant panic that increasing probability evoked, everyone sold at roughlythe same time and global financial prices collapsed.