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December 10, 2007
Tranches and tranches - and safety of intangibles
In an earlier posting on the subprime mess, I noted in passing that part of the problem was the tranche system of dividing loans up into groups by risk. This tranche system was supposed to isolate risk, but seems to have failed miserably -- which I never completely understood. Last week, Steven Pearlstein enlightened me (and everyone else) in his column It's Not 1929, but It's the Biggest Mess Since:
In the simple version, each investor owned a small percentage of the entire package and got the same yield as all the other investors. Then someone figured out that you could do a bigger business by selling them off in tranches corresponding to different levels of credit risk. Under this arrangement, if any of the mortgages in the pool defaulted, the riskiest tranche would absorb all the losses until its entire investment was wiped out, followed by the next riskiest and the next.
With these tranches, mortgage debt could be divided among classes of investors. The riskiest tranches -- those with the lowest credit ratings -- were sold to hedge funds and junk bond funds whose investors wanted the higher yields that went with the higher risk. The safest ones, offering lower yields and Treasury-like AAA ratings, were snapped up by risk-averse pension funds and money market funds. The least sought-after tranches were those in the middle, the "mezzanine" tranches, which offered middling yields for supposedly moderate risks.
Stick with me now, because this is where it gets interesting. For it is at this point that the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same "tranching" process, they could use these mezzanine-rated assets to create a new set of securities -- some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired.
The problem being that these new second level tranches really weren't AAA quality. They might be the top tier of the second tier - but they were still second tier. Pearlstein argues that this tranches of tranches created so much leverage that could not be sustained:
If all this sounds like a financial house of cards, that's because it is. And it is about to come crashing down, with serious consequences not only for banks and investors but for the economy as a whole.
Tranches of tranches were just on part of the leveraging. As I mentioned earlier, the banks were using these CDO's (collateralized debt instruments obligations) for interest rate arbitrage in offbook SIVs (Special Investment Vehicles). So what was originally designed as a relatively safe investment product (bonds backed by a steady stream of revenues placed in a separate entity to protect against bankruptcy or other financial problems of the parent entity) became a leveraged speculation play.
So, how does the market recover from what is quickly becoming, as the Wall Street Journal puts it, "comparable to some of the biggest financial disasters of the past half-century"? Both parts of the problem -- the housing bubble that caused the value of underlying assets to decline and the overleverage -- need to be addressed. Right now, most eyes seem to be on the housing part of the crisis. A few are looking at the financing part, specifically the role of the rating agencies. But sooner or later the leveraging issues will attract more attention.
When that happens it will be important to get the regulations right - not just shut down the system. That will also be the time to see if we can improve the process for financing using intangible assets. It will not be everyone's nature reaction (which will be to reign in "exotic" loans). As the Journal article points out, these instruments so complicated that "coming up with a value for a CDO entails analyzing more than 100 separate securities, each of which contains several thousand individual loans -- a feat that, if done on any scale, can require millions of dollars in computing power alone." Even the traditional vulture investors are staying away.
We can make the case for intangible lending, but it will not be easy. In part, we will have to build in safeguards up front and return to simplified mechanisms. That will be moving in the opposite direction of the trend in financial engineering. But the current market is likely to reward those who can create a simple, transparent investment vehicle. People still want to invest. They just need to feel safe in doing so. So, making investments in intangible safe has to be our goal right now. It is as straightforward as that.
Posted by Ken Jarboe at December 10, 2007 9:07 AM
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