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As explained on Tuesday, the global financial crisis is only incidental to events in the US housing market and is instead related to the inherent instability in global capital markets. Look at the scenario which surrounded Fannie Mae business: US lenders often sell mortgage loans to Fannie Mae. The seller gets an immediate, albeit smaller profit, but can reinvest the money immediately.
Fannie Mae obtains the money to buy these loans by issuing securities in capital markets. Fannie Mae must have access to this capital, otherwise it cannot buy loans.
If investors become frightened about whether Americans can pay their mortgages, they may refuse to invest with Fannie Mae. But this was not the problem. As already noted, Fannie Mae continued successfully issuing new debt.
Then what was the problem? You may have to read The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash by Charles R. Morris or A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation by Richard Bookstaber. George Soros fans can read The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means.
The debt Fannie Mae issues takes the form of securities that allow investors to own part of a loan portfolio. But as investments, mortgage portfolios have a flaw. The returns and risk do not match what investors want. Investors either favour low-risk, low return or high-risk, high return with little in between.
Enter the Wall Street wizards. Using computers and complex mathematics, they devised financial instruments that restructured risk.
Now, you say, borrowers are either going to pay the amount owed or not. How can they change risk? They can't for the portfolio overall but can separate the portfolio into slices, each with a different risk and return. So an investor could then choose low or high risk-reward slices.
Stratifying risk and return is done with esoteric financial arrangements called hedges. For a fee, another investor will assume the risk of the portfolio's losses.
Scenario: The US housing market declines. The riskiest loans default and as conditions deteriorate, less risky loans follow. At some point, hedgers must honour their commitment to cover losses.
Hedgers often try to limit their losses by paying another hedger to assume their obligation. The second hedger accepts the fee as he thinks the market will not decline further.
There's more.
If risk and reward in a mortgage portfolio can be rearranged into slices, then why not rearrange risk and reward in individual slices, especially to hedge riskier slices known as "toxic waste". This hedging-the-hedge can and does go further: Hedging-the-hedge-of-the-hedge.
Some portfolios have more than 100 slices. Ditto the slices of slices. The result is that the toxic waste insinuates itself into many hedge-of-hedge-of-hedges.
Now if you are wondering how financiers keep all this straight, you are on the path to enlightenment. They can't. All these hedges depend on sophisticated models which sometimes contain errors and questionable assumptions.
It gets worse. Much worse.
Hedgers improve their profits using leverage. They borrow to cover most commitments.
Again, let's assume that the mortgage market deteriorates. As losses mount, hedgers get closer to the point where they must cover losses and banks require the hedgers to deposit more money as security.
If losses are modest, the hedger does just that. But as losses climb, the hedger's assets evaporate leaving lenders holding the bag. This is one reason why major financial institutions have been sucked into the mire - they lend to hedgers.
The value of all these hedges is often many times the underlying mortgage portfolio - the real assets - sometimes by a factor of ten or more. Think of a ten story building. The first floor is the real asset - the mortgage portfolio. The floors above are layers of poorly understood, shakily-constructed financial obligations that all depend on the soundness of the first floor assets.
As conditions deteriorate further, the hedger may lose his capital and worse, may end up with enormous debt to lenders. The hedger may try to unload his obligations by engaging another hedger. Presumably a second hedger will accept a fee to assume the risk that the portfolio will not decline further.
The entire construct of hedges depends on this frail assumption - that a market for hedging instruments exists and is sufficiently liquid. Alas, this is not always true.
Here is the fatal stress crack. Experience shows that hedgers willing to assume the risk of the original hedger may not materialise in sufficient numbers or at all. The original hedger is bankrupted and cannot pay the banks. The lenders are now on the hook.
As a consequence, capital markets are eviscerated of their liquidity.
- Dr Rod Monger is a Dubai-based independent writer on global economic and business issues.
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