Where We Are Now

Once traditional Investment products fell by the wayside, investment banks found more and more esoteric vehicles to create and distribute. As the housing market entered its parabolic state, lending standards fell dramatically. In May 2005, banks were warned about their lending practices from the OCC (Office of the Comptroller of the Currency), Federal Reserve, FDIC, Office of Thrift Supervision and the National Credit Union Administration (Home Equity Lending Guidance to Banks). Despite this, many banks continued to lend in a reckless manner that ended with the bursting of the housing bubble.

If it were not bad enough that the loans were being made in the first place, Wall Street was then encouraged by the SEC in early 2006 to lever their balance sheets up to 30-40x shareholder equity, up from a more traditional 3-4x shareholder equity. And in this push to higher leverage, the world of esoteric CDO’s (Collateralized Debt Obligations) was born. With interest rates and credit spreads at historically low levels, it should come as no surprise that the underlying investments that were carved up into these CDO’s turned out to be horrible investments, even though they were huge sources of income for brokerage firms.

These practices would come back to bite brokers in their hind quarters. I'm not overly surprised to see that there now exactly 0 investment banks left in this country that are not either part of a bank, converted into a bank or have gone bankrupt.

Greed is a horrible thing and it caught up to all of the investment banks. All one must do is take a look at a chart of the AMEX Securities Broker/Dealer Index to get a sense of just how bad it has been for this industry.

The typical CDO structure of an Asset-backed Securities deal is shown below. In its simplest form, a CDO takes the cash flows from the assets (let’s use sub-prime mortgages as the "assets" in this example) and distributes them in turn to the creditors of the structure on a preferred basis. The senior creditors receive all of the initial cash flow on a priority basis and therefore received the lowest yield. Lower priority creditors received the last amounts of uncertain cash flow and were in turn given higher expected returns. As the assets on the left side become "impaired" (seriously delinquent, foreclosed or in receivership), the higher grade tranches become impaired or downgraded and then lose value.



What you must remember is that when one takes the lowest quality assets, sub-prime mortgages, and then levers them up and carves them up for the sole benefit of the broker/dealer, greed can play a serious role. Risk does not magically disappear, but instead is magnified and hidden in plain sight behind the elaborate structures.

Unfortunately, when these structures stop working, there can be serious consequences for the owners of these securities; banks, brokers, hedge funds, mutual funds, credit unions, insurance companies etc. The availability of these structures to issue low quality mortgages into enticed mortgage originators to make ever more lousy loans and it should come as no surprise that issuance of these sub-prime loans peaked in 2006 as a percentage of all mortgage originations. See a chart of Subprime Mortgage Originations as a % of Total Originations.

What followed all of the leverage and all of poor lending has been a spike in delinquency rates at both the subprime and prime level, as depicted in the chart below. This is now spreading to the commercial real estate space and to virtually all other areas of credit.

The Credit Crisis is picking up steam—at a level that frightens even the most cautious investors (yours truly included). It seems that each weekend, we see more government intervention/intrusion (as I write this, the UK has just been forced to inject liquidity into the Royal Bank of Scotland and HBOS, 2 of Britain’s largest banks). Whether it is Fannie Mae (FNM) and Freddie Mac (FRE) being nationalized at Americans' expense, a $700 billion "bailout" of US banks, Treasury Secretary Paulson suggesting he wants to inject liquidity directly into US banks since banks will not do business with each other or lend, Mr. Paulson apparently thinks that using the money of "We the People" will solve the problem.