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Betting on Financial Armageddon, Part 1


How we've arrived at Judgment Day.

Editor's Note: This is Part 1 of a 2-part series. Part 2 can be found here.

Today, we have faulty standards for accounting that are ripping apart the fabric of the world economy. Of course, there's no accounting for standards when looking at something odd, as my dad used to say.

How can a security that has a high probability of full repayment be downgraded from AA to junk levels? The financial landscape of the world has changed, and our kids will be the ones paying for it.

Let's jump back 18 months. Huge Investment Banks (HIB, for short) encouraged mortgage banks to make home loans, often providing the capital, and then would purchase these loans and package them into large securities called Residential Mortgage-Backed Securities (RMBS). They would take loans from different mortgage banks and different regions and generally grouped them together according to their initial quality, such as prime, ALT-A and the now-infamous subprime mortgages. They also grouped together second lien loans, which were generally made to get 100% or cash-out financing as home owners borrowed against the equity in their homes.

Typically, a RMBS would be sliced into anywhere from 5 to 15 different pieces called tranches. Ratings agencies would then give them a series of ratings on the various tranches, and who actually had a hand in saying what the size of each tranche could be.

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The top or senior-level tranche had the rights to get paid back first in the event of a problem with some of the underlying loans. That tranche was typically rated AAA. Then the next tranche would be rated AA and so on down to junk level. The lowest level was called the equity level and would take the first losses. For that risk, they also got residual funds if everyone paid. The lower levels paid very high yields for the risk they took.

Since it was hard to sell some of the lower levels of these securities, HIBs would take a lot of the lower level tranches and put them into another security called a Collateralized Debt Obligation (CDO). And yes, they sliced them up into tranches and went to the rating agencies and got them rated. The highest tranche was typically again AAA. Through the alchemy of finance, HIBs took subprime mortgages and turned 96% of them into AAA bonds. At the time, I compared it with taking nuclear waste and turning it into gold. From mortgage brokers to investment bankers, everyone was paid handsomely to dance at the party.

Will we ever forget Citigroup (C) CEO Charlie Prince saying that "as long as they are playing music, you have to get up and dance" just a few weeks before the market imploded? Apart from overseeing an implosion which cost Citigroup tens of billions, it was a great statement of the zeitgeist of the financial world at the time.
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