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VIDEOThe Evolution of Securitization
A look back 20 years ago when there was minimal securitization, up to Goldman Sachs' Congressional hearings yesterday.
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So some marketing guy came up with an idea -- why not use our AAA rating to borrow cheap and lend out long though somewhat riskier, but with a much higher interest rate? Not a bad idea, and also the reason I was hired. Back then there really was minimal securitization -- only in mortgage-backed securities -- and they weren’t tranched with subprime mortgages.
Nevertheless, the demand from the asset-generating side of my insurance company resulted in "the ducks are quacking,” meaning that we needed product from the Street to satisfy the need to find investments for the assets gathered. In other words, the ducks -- us, the buy-side -- needed to be fed.
Private placements were made to companies that couldn’t do public bond offerings. The reasons were many. Either the public-company offering was too small for a public deal, or it was a private company, or it was a public company that wasn’t interested in having tough questions answered in a public forum. We did our own due diligence, did our own ratings, and we got better spreads to Treasuries than the public market. We had strong debt covenants, meaning the company had to meet certain financial ratios or it was in default. These were the glory years for private-placement lenders.
Time has passed. The old-fashioned private-placement market has declined in size, but the ducks are still quacking. Nothing motivates the Street to produce product more than quacking ducks. The answer to feeding the ducks was securitization, and, in particular, mortgage securitization.
As securitization evolved, S&P, Moody's, and Fitch decided that junk mortgages could have AAA ratings on the top tranches of the junk mortgages, as long as those top tranches were paid off first. What does a AAA rating mean to a buy-side institution? It means that you should be able to buy it without having to have a bunch of expensive in-house credit analysts. Fire the analysts, rely on the rating agencies, and reduce your overhead. Suddenly, the ducks had all they could eat. Foie gras!
Let’s fast forward past the glory days of mortgage securitization. It worked well until late 2006, and then blew up in early 2007 after New Century Financial imploded. So exactly, what happened at Goldman Sachs in late 2006? It was intelligent enough to see that the smart ducks weren’t going to buy any more subprime securitizations, and the move was on to hedge and dump all the crappy mortgage exposure it could.
If the smart ducks aren’t feeding, then sell to the dumb ducks -- which as it turns outs, out were mostly European institutions relying on the rating agency AAA ratings. After all, these European dumb ducks rarely got further west than South Beach, and would have pointed out the Inland Empire ((ground zero for subprime in California)) somewhere around Afghanistan on a world map.
All Goldman did was cover its ass early. Was its behavior any different than a used car salesman selling a car that he figured would blow out its transmission in six months? Hey, it ran fine when it rolled out of the lot. Hey, the CDO was current when you bought it, we can’t predict the future. Those guys in the mortgage unit at Goldman knew they had to get rid of bad assets. Their bonuses and employment depended upon it. The guys at Bear Stearns (JPM)? They just didn’t get it early enough.
Life goes on, and the ducks have a problem. With short-term rates at close to zero, they have to find higher yielding assets. The quacking is starting, and Wall Street will find a new way to feed the ducks because that’s what Wall Street is all about.
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