I was surprised that the discussion at the Atlantic implied that there are a lot of people who don’t understand the basic structure of the parallel banking system that has developed since the 1980s. I wrote a piece in early 2008 that was outdated as soon as it was completed and that I mothballed. I think I explained the parallel banking system fairly clearly, however — and so I thought I’d put what I wrote up in a series of posts.
For amusement here is the (totally outdated) introduction. (It’s pretty clear at this point that the current crisis extends far beyond asset backed commercial paper.)
The Anatomy of a Crisis: Introduction
The financial crisis of 2007 that has roiled markets across the world and caused investors to question the solvency of some of the world’s largest financial institutions was set off by unusually high default rates on sub-prime mortgages issued in the US. For this reason, politicians and regulators have spent a lot of time talking about how to fix the mortgage markets. Unfortunately these well-meaning individuals have been confusing the catalyst of the crisis with the cause of the crisis.
This book will explain the cause of the crisis – and while we will certainly spend some time exploring why the subprime mortgage market is in such a bad state – our main focus will be the asset backed commercial paper market, which is the key to understanding why the crisis happened – and how to avoid crises in the future.
Initially the problem with subprime mortgages was viewed as nothing more than a bit of noise that would indeed result in losses for some financial institutions, but would have no more effect on financial markets than any other bad investment. At least that’s what people thought, until the second week of August. To get an idea of why asset backed commercial paper (ABCP) is so important take a look at this graph.
The financial crisis started in the second week of August 2007 when issuers of asset backed commercial paper failed to find buyers for their paper. The financial crisis will end when the asset backed commercial paper market stabilizes.
The reason that it is taking a long time for the asset backed commercial paper market to stabilize is that buyers of this paper don’t like taking on risk. ABCP buyers are almost always people who are responsible for watching over money that their employers or clients want to have access to at any point in time. The one thing they can’t do is go back to the boss and say: “Sorry, I lost some of your money.” Higher returns are definitely better than lower returns, but genuine risk of losses is an absolute no-no. Money market fund managers, corporate treasurers and fiduciary institutions were all parking their excess funds in asset backed commercial paper because they had been told by their brokers and the rating agencies that it was perfectly safe — and that they could earn higher interest rates on their money without significant risk.
Now, there is a whole crowd of people who will read that last sentence and just crack up laughing. Why? Because there’s one unbreakable rule in the world of finance and that is that you don’t earn higher returns without taking on greater risk. If that were actually possible, your broker wouldn’t be selling the product to you – he’d be too busy buying into this “free lunch” himself.
ABCP funds most of the new-fangled financial products that were used to finance everything from corporate loans to commercial real estate loans to residential mortgages to consumer car loans. Did you catch that? Residential mortgages. Yep, that includes sub-prime.
When these risk averse investors realized that they could be exposed to the losses on sub-prime mortgages, they also realized that they could potentially be exposed to losses from all those other loans they were financing. In other words, they finally realized that they were taking on the risk that they might have to admit to the boss that they had lost money. The drop you see in the ABCP chart is these investors deciding that ABCP is too risky for them.
Bill Gross, manager of one of the world’s largest mutual funds, predicted that ABCP will disappear entirely. Even if it doesn’t disappear, the flight of money away from ABCP is a problem for many of the investment products created by Wall Street over the last decade.
CDOs, CLOs, SIVs and a host of other Wall Street acronyms are structured finance deals that have a pretty similar structure. About 10% of the deal is high risk. Anyone who invests in this portion of the deal is agreeing to take all of the losses that the deal incurs up to that 10% investment amount. Precisely because there are investors who take the first losses, the other 90% of the deal is considered relatively low risk. A big chunk of the rest of the money is raised using asset backed commercial paper. Once the money is raised, it is used to buy loans. As I noted above, these loans can include a wide variety of commercial, consumer and real estate loans.
Why is most of the deal financed using asset backed commercial paper and other short-term notes? Because short-term loans are generally cheap – investors don’t expect to earn too much in interest if they’re lending the money for a year or less. This frees up more of the return from the underlying loans to be paid to other investors. Without this ability to increase the returns for the investors who were bearing the first risk, these deals could not have been put together. In other words, cheap money borrowed through asset backed commercial paper markets was crucial to most of the structured finance deals created by Wall Street over the past decade.
When investors got scared about the risks involved in asset backed commercial paper, it became a lot harder or even impossible for many structured finance deals to be completed. Unfortunately, more than 50% of residential real estate loans, 28% of commercial real estate loans and 67% of corporate leveraged loans had been going into structured finance products over the last few years. Thus when structured finance products couldn’t raise money, this meant that there was much less money available to finance mortgages and many other loans.
Sub-prime mortgage lending was the first section of the credit market to freeze up, but it was just the canary in the coal-mine. At first, investment banks hoped that investors were only refusing to buy asset backed commercial paper with subprime exposure, and so they stopped buying subprime mortgages. In the summer of 2007, x mortgage lenders who specialized in the origination of subprime loans went bankrupt.
Soon, however, it was clear that investors were worried not just about subprime but about asset backed commercial paper in general. Through 2007 as investment banks adjusted to a $100 billion per month reduction in the funds they could raise to buy loans, they became much more selective. They stopped buying most mortgages, leaving the market to two special government sponsored mortgage-buying firms, Fannie Mae and Freddie Mac. Since both of these firms wouldn’t buy any loans in excess of $417,000, it became very hard to get a “jumbo” mortgage in excess of this amount. The credit contraction extended, however, beyond real estate. Banks also looked for ways to avoid making leveraged loans (which are used to finance businesses buying other businesses) that they had spent the last six months negotiating.
Some might think that this credit contraction isn’t really such a big deal – after all a bunch of loans that would have been made in the past were not made. Sure, if you happened to be one of the few people who really wanted to buy a house in the last few months of 2007, you were pretty unlucky, but why should the rest of us care?
Well, when you’re talking about expensive assets like houses that can really only be purchased with the help of a loan, a major reduction in credit can have a lot of side effects. In particular, the first effect of a reduction in credit is a reduction in the number of people buying houses – without a change in the number of houses for sale. Now instead of having two buyers bidding up the sale price of the house, a lucky seller may only get one offer. And unlucky sellers may watch their house sit on the market for months.
Thus, the second effect of a credit contraction is an increase in the number of unsold houses sitting on the market. Since credit conditions mean that the market still has a shortage of buyers, the tendency is for selling a house to get harder and harder the longer the credit contraction continues.
Of course, when there are a lot of houses for sale and just a few buyers, we expect some of the sellers to start offering a really good deal to any buyers they may find. The third effect of a credit contraction is a fall in housing prices.
If you are one of the people who bought recently and you’re looking to sell your house, you may find that you can’t get what you paid for it. And, if you happened to make a very small down-payment, you may find that you owe more money on your house than you can get by selling it. In this situation, if you’re unlucky and sickness or unemployment prevents you from making your mortgage payments, you won’t be able to pay off your mortgage by selling your house. You may have no choice but to default on the loan and lose the house.
And those who bought the house as an investment may look at the size of their loan, compare it to what they could get by selling it and then conclude that the investment was a mistake. They may just send their keys in to the bank and walk away with no house, but no mortgage either.
In other words, in markets where buyers are dependent on loans in order to make a purchase, a credit contraction can lead to a downward spiral with a self-reinforcing feedback loop:
Fewer buyers — fewer sales — increase in houses for sale — prices fall — increase in foreclosures — increase in houses for sale — prices fall further
This process is likely to continue until the credit situation stabilizes and the number of buyers increases.
Of course, this negative dynamic in which a credit contraction drives prices down doesn’t only happen in the housing market. It can happen in any market where most purchases are depend on loans. The process is starting in commercial real estate. And has reduced the value of corporations that are targets for take-over. But most of us first saw the consequences of the credit contraction when we realized that house prices were dropping faster than we ever thought possible.
This book is about a financial innovation called asset backed commercial paper and how it ended up wrecking havoc on the lives of tens of thousands of home-owners and profoundly affecting the opportunities available to just about everybody who lives in the United States of America.
 “The commercial paper market, in terms of the asset-backed commercial paper market, is basically history,” Bill Gross, manager of the world’s biggest bond fund at Newport Beach, California-based Pacific Investment Management Co., said in an interview today.
 Chain of fools, Feb 7th 2008, The Economist http://www.economist.com/research/articlesBySubject/displayStory.cfm?story_id=10641119&subjectID=348918&fsrc=nwl 19% in private MBS http://www.bloomberg.com/apps/news?pid=email_en&refer=home&sid=aejJZdqodTCM#
 Wall Street Gears for Its New Pain, By LINGLING WEI and RANDALL SMITH
March 3, 2008; Page C1, http://online.wsj.com/article/SB120450569895406511.html?mod=hpp_us_whats_news
 In death, afterlife, by Vipal Monga, Updated 03:19 PM EST, Mar-7-2008 http://www.thedeal.com/servlet/Satellite?pagename=NYT&c=TDDArticle&cid=1204065764505