Is This Complicated or What?

Sidebar article to The Credit Crisis and Moral Hazards
Fall 2008 issue -- Starting with a mortgage, here is just one example of the shadow-banking system—a train of very widespread practices and credit derivatives.

1.       Banks made loans to individuals who had no hope of repaying them from their own income. But it didn’t matter, because the loans were secured by mortgages on real-estate properties that were presumed to be increasing in value. The loans were made with affordable, low payments for a couple of years, after which the payments would reset to higher amounts. At that time, it was expected that the individual would refinance his mortgage based on higher property values and restart with another loan that had low payments.

2.       Banks packaged these loans as assets, to secure bonds and similar financial instruments. The package included some good mortgage loans and some bad ones. Based on the percentage of expected defaults in the mix, the bonds could be rated AAA by private rating agencies, such as Moody’s, Standard & Poors, and Fitch, whose fees were paid by the same banks whose bonds they were rating.

3.        To insulate itself from the risk of default on the bonds and to show an immediate profit, a bank would create a separate corporation—a structured investment vehicle (“SIV”)—that was nominally unrelated to the bank. The SIV borrowed short-term money and gave it to the bank. In return, the bank transferred the rights and obligations under the long-term mortgages and mortgage-backed bonds to the SIV and booked the transfer as a sale. This removed the mortgage assets and bond obligations from the bank’s books and let it take an immediate gain on the sale of the bonds. The SIV was to collect the payments from the real-estate owners and pay off the short-term obligations. There was an implicit, sometimes explicit, understanding that the bank would stand behind the short-term obligation of the SIV, but the bank would not show this obligation in its financial statements. As long as the payments from the real-estate owners came in on time and in the right amounts, the SIV could pay off the short-term loan. Everyone was happy because real-estate values go up forever.

4.       Stock in the SIV might be sold by the bank to investors and/or the SIV might issue capital notes to fund its operations. To make the SIV’s securities more salable, the SIV would purchase insurance from a special insurer, called a “monoline insurer,” that guarantees the timely payment of the bond interest and principal. The financial soundness of the monoline insurers was rated by the rating agencies, and their ratings affected the ratings of the bonds that they insured.

5.       For a premium, the SIV (and others also) could enter into a specific performance contract with a counter-party to guarantee the timely payment of principal and interest of a financial instrument. These contracts, called “credit default swaps,” are traded in the over-the-counter market. As reported by the International Swaps and Derivatives Association, the notional amount of credit default swaps being traded at the end of 2007 was $62.2 trillion, up from $34.5 trillion a year earlier and ten times the level of four years ago. “Notional amount” is the amount being guaranteed and which the counter-party would be required to pay in the event of a default. To put these amounts in perspective, the Gross Domestic Product of the United States is around $15 trillion and the National Debt that the U.S. government acknowledges is around $9 trillion.

6.       All of the contracts and transactions above fall under the category of credit derivatives, because they are derived from the underlying credit obligation. Credit derivatives outstanding could be as much as ten times the size of the loans from which they are derived.

7.       Now, however, real-estate prices are falling, and most everyone involved in the shadow-banking system is being called on to perform. But the monoline insurers arguably don’t have the capital to pay all of those they insured. Some owners of credit default swaps are having a hard time finding their counter-parties. Homeowners are walking away from their houses because they can’t afford the mortgages; they can’t find buyers for their properties; and even if they could, they owe much more on their mortgages than their houses are worth. Some of the entities that want to foreclose cannot produce the paperwork to prove whom the homeowners owe. And the banks and investment banks that carry the deteriorating financial instruments on their books are being called upon to disclose their real value—the mere contemplation of which is already pushing some of them over the edge.

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