I said if I cant feel it then how can it be
No, no magic could happen to me
And then I saw you
I couldnt believe it, you took my heart
I couldnt retrieve it, said to myself
Whats it all about
Now I know there can be no doubt
You can do magic
You can have anything that you desire
Magic, and you know
Youre the one who can put out the fire
You Can Do Magic — America
Today’s post is the first of a two part analysis series describing the mixture of magic and alchemy that is structured finance. Part II, Systemic Risk in the Housing Market will be posted tomorrow. I will answer any questions you might have in the comments section.
Structured finance is an innovation of the finance industry on Wall Street. It is a method of redistributing risk based on complex legal and corporate entities such as corporations, limited liability companies or some other kind of legal entity capable of entering into contracts. The shares or other interests in structured financial entities are derivatives that obtain their value from an underlying asset. Any asset that has a regular cashflow can be pooled through structured finance to create an asset-backed security. This cashflow can be split among various parties and valued based on the risk of repayment. For instance, the most common form of structured finance utilized to inflate the Great Housing Bubble was the collateralized debt obligation or CDO. A CDO derives its value from the underlying, asset-backed securities which in the Great Housing Bubble were generally bundles of mortgage loans. Mortgage loans have a steady cashflow stream as each homeowner pays their mortgage obligation, and these loans are collateralized by residential real estate. In the event of default on the mortgage held by a CDO, a house can be put through foreclosure to satisfy the mortgage debt and thereby return capital to the CDO.
In any asset-backed security, assets are bundled together to reduce risk and make the asset more attractive to investors. In contrast, if an individual buys a mortgage loan from a lender in order to receive the interest payments, this investor assumes all the risk of default. The default risk might be low, but if one party must bear this risk, the investor significantly discounts the security to compensate. However, if this individual investor buys a small share of a large pool of mortgage loans, the investor reduces their risk exposure significantly and thereby their discount for purchasing it. The value of the security is increased by pooling and thereby lowering the risk. Also, for an individual investor to purchase a mortgage loan requires a significant equity investment as mortgage loans are often in the hundreds of thousands of dollars. If a number of mortgage loans are pooled and sold off to many investors as shares or interests in a financial intermediary like a CDO, the equity requirement can be lowered considerably thus opening this type of investment to a broader investment community. It is the spreading of risk and the lowering of equity thresholds that makes structured finance such an appealing investment tool.
Collateralized debt obligations, like other asset-backed securities, are divided in segments known as tranches (rhymes with launches.) These tranches are typically titled: senior, mezzanine and equity based on their risk exposure. There is no single structure or formula for a CDO, and many contain numerous subdivisions resulting in more segments than the three described. Similar to the lien order of mortgage obligations, these tranches are paid in order of priority. The senior tranche is paid first, the mezzanine tranche is paid next, and finally the equity tranche is paid any remainder. Since these obligations are paid in order, the senior tranche has the least risk exposure and lowest returns, and the equity tranche has the highest risk and greatest potential for return. To further lessen risk (and make the transaction even more complicated) insurance policies are often issued to insure the buyer of a senior tranche against loss. These policies known as credit default swaps were a very lucrative business during the Great Housing Bubble. It was such good business that many insurers took excessive risks and lost a great deal of money when house prices declined.
The real magic of structured finance is its ability to take assets of low investment quality and turn it into something viable. George Soros aptly titled his book, “The Alchemy of Finance.” Like the alchemists of medieval Europe, modern investment bankers try to turn lead into gold. The syndicators who create and manage collateralized debt obligations assess the risk of loss on the underlying asset and break it down into three categories corresponding to the three tranches. The equity tranche in a CDO assumes the expected risk of loss. For example, if subprime loans expect an 8% loss from defaults, then the equity tranche will be 8% of the CDO. The syndicator typically keeps this equity tranche as part of their incentive fee, but practically speaking, the discount would be so steep it is hardly worth selling. If defaults losses are less than 8%, they see tremendous profits, and if it is over 8%, they see nothing. The Mezzanine tranche assumes the risk beyond the expected risk. If the average default loss is around 8%, and the highest default loss ever recorded is 24%, the mezzanine tranche exists to take on this risk. There is a very good chance they will see most or all of their money because the average default loss is being absorbed by the equity tranche. The senior tranche is supposed to have no risk from default loss. The line between mezzanine and senior is at or beyond the highest default loss rate ever recorded. This is not to say there is no risk, but it would take an unprecedented event to see any losses in this tranche – something like the collapse of The Great Housing Bubble.
Syndicators of collateralized debt obligations go to the open market to raise sufficient capital to buy the necessary securities and cover their fees. Since there is very little risk to the senior tranche holders, they require a lesser return on their investment. Although they own 76% of the CDO and receive 76% of the cashflow, they will pay more than 76% of the capital costs of the syndication (close to 85%) and still receive their required rate of return because the underlying subprime loan pool is paying in excess of the return required by senior tranche holders. The mezzanine tranche has more risk, and they will require a higher rate of return more closely approximating the interest rate on the underlying subprime mortgage. The remaining cost of the syndication is raised by the mezzanine tranche. The equity tranche raises no additional capital, and it is generally kept on the books of the syndicator as a bonus.
One can argue that structured finance creates greater efficiency in our financial system because capital is freed to pursue other objectives. Although, it can also be argued, as Warren Buffet has, that derivatives, the product of structured finance, are “financial weapons of mass destruction.” Both arguments stem from the same characteristic of these securities: excessive debt. When the loan that became part of the collateralized debt obligation was originated, this money was created out of nothing by the originating lender. This is how all money is created in a fractional reserve banking system. As long as there is sufficient cashflow, debt creation is normal; however, when excessive debt is created and available cashflow cannot service this debt, the system experiences the very serious problem of insolvency which can lead to monetary deflation – the disappearance of lender-created money into the ethers from which it was created.
If an individual investor wanted to buy a mortgage loan, it would be purchased with equity rather than lender-created money. However, once packaged into a CDO, the senior tranche is often purchased by an investment banker or another lender which also created this money from nothing. Since the equity tranche raises no capital, the mezzanine tranche may be the only money in the structure not created by a lender out of the ethers. With so little “real” money in the deal, there is very little buffer between what would be a loss of invested capital and a banking loss of created capital. There is a tipping point where the debt service exceeds the cashflow, and when this tipping point is reached, the entire debt structure may collapses in a deflationary spiral. The structured finance products such as collateralized debt obligations and their derivatives are highly leveraged instruments with a very sensitive tipping point. Monetary deflation was a major concern to the Federal Reserve as the Great Housing Bubble began to deflate.
The use of structured finance techniques in the syndication of collateral debt obligations was not by itself a problem causing The Great Real Estate Bubble. This was part of the infrastructure for delivering capital to the mortgage market which began with the creation of the secondary mortgage market. In the aftermath of the crash of house prices, collateralized debt obligations received a bad reputation as dangerous securities unworthy of the safe, “AAA” ratings they received from the companies that evaluate the creditworthiness of financial instruments. The advantages of structured finance did not disappear because of problems with the market or the ill-advised ratings these securities received. Collateralized Debt Obligations did not go away, and they have continued to be an integral part of the capital delivery system providing money for buyers to purchase residential real estate.