Crossposted from dKos where it was put up as a follow-up to the Rescued Diary by K S LaVida, How a little home became an instrument of financial mass destruction.
Suppose there was a financial trick that protected a financial asset from exposure to random risk while concentrating exposure to systemic risk. And suppose that regulatory authorities allowed systemic risk to be systematically under-estimated.
Why, then you could apply that trick and turn risky assets into low (random) risk assets. If they qualified for AAA, “investment grade” rating, pension funds and insurance companies could hold those assets.
Except, the types of firms that we restrict to holding investment grade assets, why, that’s because the economy cannot afford them to be exposed to a lot of risk on their balance sheets.
And, yes, this is the story of how regulatory authorities asleep at the wheel allowed pension funds and insurance companies to collects piles of chicken-shit and call them baskets of eggs.
NB. This is one part of where the solvency crisis comes from that is touched on in Solvency Crisis: Fed VP Called it in May … but didn’t NAME it. (Eurotrib) and Mea Culpa: The Fed May In Fact be in a Financial Mess (EuroTrib).
Setting out on the Financial Road to Perdition via mortgage pooling
OK, now, suppose that you have a pool of mortgages.
You have a certain amount of mortgage payments supposed to come in each month. Say its $1m a month.
Split that “supposed to” into ten slices. The senior slice gets the first $100,000 ($100K) to arrive, the next slice gets the next $100K, and so on to the junior slice that gets the last $100,000 to arrive.
- Its easier to think about it in 10 even sized slices … the slices are actually sized to fit the demands of the market … but the basic point we get to is exactly the same.
The junior slice collects all the risk, unless its wiped out and then the next slice collects all the risk, unless its wiped out, and so on. 25% defaults wipes out two slices completely, the third from the bottom by half, and the top seven slices are safe. Also early repayments goes to the bottom-most slice, so its flow of income is less predictable in both ways … it might come up short, and it might pay off early.
But even though the underlying loans might be a bit risky, the senior $100,000 a month is safe, right? Rock solid, month after month, $100K. Break it into 1,000 pieces, $100 dollars income per month per piece, and you have 1000 rock solid financial assets. Plus increasingly less rock solid financial assets as you descend down the slices.
So that top slice gets a rock solid rating, and lost of the others too … but sooner or later, there is enough risk of a default and/or prepayment hitting a slice, so its not investment grade.
If its not investment grade, its called “junk”.
Suppose “the market” wants more AAA assets?
What if the market wants more AAA securities.
Well, do the trick again. Pull in 10,000 assets created from promises to hand over $100 monthly out of junk streams, and you have $1m … best case. Of course, each individual asset is risky, but “we know” how to handle that.
Make slices, and promise first dibs on the income to the best stream, second dibs to the next, and so on.
Why, surely, the senior slice is protected from risk. Right?
And if the second pool and slicing does not generate enough AAA securities, collect together a pool of slices from a pool of slices, and slice it to make AAA assets.
And this is the Big Magic Bull Shit.
For random events, the senior slice is protected. But just suppose there was a random event that hit the whole mortgage system. Suppose there was a system-wide foreclosure crisis.
Each step of slices of slices of slices is concentrating exposure to this kind of systemic risk.
To see this, suppose there is a 10% foreclosure rate in all the mortgage pools at the base of the pyramid. The bottom slices in every single mortgage pool are wiped out.
Now, just suppose Five out of Ten slices from the first layer were AAA and sold, and the other Five were used to build up the second layer.
The bottom 1/10th of the first mortgage pool is one fifth of the income in the second layer. So if each pool in the second layer is an even mix of all the junk streams, the bottom TWO slices in every pool of streams from mortgage pools are wiped out.
Just supposed Five out of Ten slices from the second layer were AAA rated … those are sold on the market, and the third layer is made up of the junk streams. Say the third level is pools that are even mixes of the different layers of junk. 20% lost income across the board at the second level would make 40% lost income across the board at the third level.
This is a system for concentrating systemic risk. But the whole effort is focused on ignoring enough of that systemic risk to grant Investment Grade standing to as many of these slices (on slices on slices on slices) as possible.
Now Let’s Add Slipping Standards
Once you have a magic technique that can take any pile of chickenshit and turn it into a basket of eggs and a smaller pile of chickenshit … why be too choosy about the quality of financial assets lying underneath the whole pyramid?
Suppose that the risk of default for the foundation of this pyramid is substantially higher than for the system as a whole. Say the base layer is defaulting at 25% when the system as a whole has a 10% default rate.
Now on the above (highly simplified) example, the second layer of junk loses 50%, and the third layer of junk loses 100% … which means, any “investment grade” assets that take their income from the third layer of junk are also wiped out. “First dibs” on nothing is, sadly, nothing.
And yet … first dibs on a stream of income from junk streams of income from junk mortgages were rated as investment grade and therefore eligible to be held by institutions that are supposed to be protected from risk
The Several Trillion Dollar Question
OK, now … lets stop and think. What kind of risk are these institutions supposed to be protected from, in restricting them to investment grade assets.
Random risks? To protect against that, all they have to do is to hold a diverse portfolio.
No, systemic risks.
And “senior” slices of dibs on income from junk streams of income from … etc. … what does it do with systemic risk?
It concentrates systemic risk.
This is part of why the Solvency Crisis threatens Main Street
Now, I am definitely OK with the shareholders in these firms losing most or all of the value of the shares. After all, the appeal of these piles of chickenshit sold as baskets of eggs was the higher return that they offered.
And I am OK with the management in these firms see their salaries capped at being exorbitant, rather than exorbitant multiples of exorbitant … since the point of senior management is to make strategic decisions and accumulating this chickenshit as assets without reserving a big chunk of the extra income as extra liquid capital to protect against the risk was a strategic blunder.
But seeing the pensions disappear, the insurance coverage vanish, and substantial loss of choice between banks in communities across the country …
… that’s where I get to be like the drunk fellow sharing the car with Bill Murray in Groundhog Day, when he is riffing on all the rules people say you are “supposed to” do:
Phil: It’s the same things your whole life. “Clean up your room.”, “Stand up straight.”, “Pick up your feet.”, “Take it like a man.”, “Be nice to your sister.”, “Don’t mix beer and wine, ever.”. Oh yeah, “Don’t drive on the railroad track.”
Gus: Eh, Phil. That’s one I happen to agree with.
Those financial institutions that are supposed to be restricted to investment grade assets … by and large, I happen to agree with that. Its a problem that they have these assets sitting on their balance sheets that are not, in any realistic assessment, investment grade.
And as a failure of the regulatory authority, its a problem that it seems likely will require government action to fix.
