Tiny Country That Tells a Big Story
The Ragged Edge of the World
Buy from Amazon
rapid climate change
Winds of Change
Buy from Amazon
Afterword to the softbound edition.
The Octopus and the Orangutan
The Future In Plain Sight
The Parrot's Lament
Affluence and Discontent
The Alms Race
Apes, Men, & Language
THE ECOLOGY OF TOXIC MORTGAGES
Saturday October 27, 2007
[This musing ran in July on Huffington Post, but it's quite relevant today as the credit crisis continues to spread]
I lead two lives. Three days a week, I'm employed as chief investment strategist for a hedge fund that specializes in distressed and bankrupt situations. The rest of my time, I do what I've done for decades, which is to write about nature and the environment. There is virtually no overlap between these two worlds -- with one exception. At a metaphorical level, there are irresistible parallels between a profound flaw in early models of how to deal with pollution, and an almost exactly analogous flaw in financial models for how to deal with the financial universe's own version of toxics: risk.
My role at the fund is to look at the macro situation, and to help the portfolio managers interpret how larger trends in the economy will interact to the benefit or detriment of our investments and prospective opportunities. In that capacity, I've been looking at the unfolding debacle in subprime lending, a slow motion, far-reaching toxic poisoning, whose reach and impacts have been obvious for at least eighteen months to anyone not involved in making money off the origination, sale, and securitization of these subprime loans.
Unfortunately for investors, that aforementioned conflicted group includes virtually everybody in finance, including the mortgage brokers, subprime lenders, Wall Street firms that securitize the loans into mortgage-backed securities, Wall Street firms that then resecuritize slices of these bonds into collateralized debt obligations, and the rating agencies that, for a price, enable all these securitizations and re-securitizations, by blessing these teetering structures with ratings that imply far less risk than is turning out to be the case. There has been a good deal written about the ecology of finance in recent years, but reading about theoretical parallels between the worlds of nature and finance pales in comparison to the thrill of watching a toxics crisis in finance unfold before your eyes almost exactly as it does in the environment. For all our vaunted foresight, it's interesting to see that when greed and self-interest come into play, collectively we're no smarter than fruit flies.
In this case, the flawed environmental model for dealing with risk might be summed up by the cute phrase, "dilution is the solution to pollution." For a number of years, we freely poured toxics into the water and skies under the assumption that pollutants would disperse and become harmless in these vast receptacles. Instead, what we discovered is that these toxics re-accumulate as creatures eat each other and are eaten, a process repeated on up the food chain until the toxics reach deadly concentrations in the top predators and big animals. I remember years ago reading that dead whales washed up in the Saint Lawrence seaway contained such high concentrations of heavy metals and other toxics that in the U.S., they would be declared superfund sites.
That also could be said for some of the big investment banks, hedge funds, and Wall Street firms at the moment. The toxics in this case would be portfolios of various forms of securitization of subprime, alt-a and other loans that, amazingly enough, aren't performing according to models developed during the greatest run-up of home prices in American history. (I recall attending one conference on securitizations of home equity loans in early 2006 where the quants showed us supposedly reassuring "stress" tests of these bonds under various scenarios of home price appreciation. The most "stress" they envisioned was 3% appreciation, and not the negative price movements we are seeing just a year later). The practical logic behind packaging these risky loans was that most of them were money good, and that so long as defaults did not exceed expectations -- say 4-5% of the loans being packaged -- the great preponderance of the securitization could be treated as investment grade. And, the philosophy behind this whole process was that risk could be reduced if it was sliced up and efficiently dispersed in the investor ocean.
But, in an exact analogy, to the environmental example, risk did not stay dispersed. Rather it re-aggregated in the whales (hedge funds, investment banks, and pension funds) of the investment community. And now these top dogs are discovering that risk is just as toxic if it's sliced up and reformulated as if it never was broken up in the first place.
The analogy does break down ultimately, because in the investment universe version we have an accelerant to the toxicity of risk in the form of leverage. Because so many of these repackaged subprime loans were rated investment grade, the whales could gorge on the stuff using borrowed money. The embedded leverage is astonishing. While each deal is different, and this unregulated market remains opaque to non-participants, an idealized example illustrates this point:
Take a billion dollars in subprime mortgages and package them into a new security. Typically, a model security would rate about 95% of the slices in this new bond as investment grade. Under these high-rated slices are what are called mezzanine tranches, the lowest piece of the investment grade slices, and the lowest of these would be rated BBB-, or just above junk status. Typically, these mezzanine tranches will amount to about 4% of the$1 billion total value. Below the mezz pieces would be the lowest rated tranches, including the equity which absorbs the first losses if borrowers default. In this idealized securitization, the BBB- tranches might represent 1% of the total value of the bond and be buffered from losses by about 5% of equity and junk (which represents a computer model's estimate of the outer limit of realized losses).
So in this case, those buying the BBB- tranche are betting that losses for the entire billion dollars in loans never rise above $50 million over the life of the bond. Fair enough, but if they do rise higher, those holding this tranche lose money in a hurry. Let's say, losses rise to 8% (some predictions are even higher). In that case, the value of the BBB- tranche would be worthless, and losses would take out all of the BBB tranche and half the BBB+ tranche as well. That's the price of leverage.
But it gets worse.
Given the risks of subprime loans, many lenders could not afford to make large volumes of loans if they were forced to keep the loans on their own books since they would tie up too much capital. So they finance the loans with short term borrowing and then sell the mortgages into securitizations. The buyer -- the securitizer -- then puts together his MBS. To do this, the buyer has to sell the mezzanine tranches (many securitizers keep the equity themselves). These tranches buffer the whole structure from losses, and once they have been sold, it's easy to sell the higher rated stuff.
In recent years, the money funding these mezzanine tranches has come from a subset of another securitization called collateralized debt obligation or CDO. To form a CDO that invests in subprime mortgages, a securitizer will buy up mezzanine tranches from perhaps 100 different mortgage-backed securities, and then package them in different tranches similar to the way a mortgage backed security was packaged in the first place. Thus, some CDO's can consist entirely of BBB- tranches of subprime mortgage MBS, but still have 95% of their value rated investment grade.
Here is where leverage is the true killer. While an increase in realized losses from 5% to 8% will wreck havoc on a $1 billion MBS, even a smaller increase from say 5% to 6% losses could utterly destroy a CDO based on BBB- tranches where the leverage is over 100 to one. That additional one percent in losses will not only wipe out the bottom tranches of the CDO, but it will eat through most of the investment-grade slices as well. Bearing in mind that many hedge funds also used leverage (meaning that they borrowed most of the funds to buy a CDO tranche), it becomes obvious that even minor variations from the expected performance of subprime loans can have a huge impact on results.
This is why we are beginning to see some very sick whales, and what happens to them affects us all. Since $1 invested in a CDO ultimately funds $100 in subprime lending, this poisoning will reduce subprime lending (as much as 50% this year alone) sending further ripples through the housing market. Moreover, most Americans have exposure to this mess since pension funds accounted for 18% of purchases of the riskiest tranches of CDOs, and insurers and pension funds were investors in the investment-grade tranches as well.
So, given the stakes and leverage, why haven't we seen more blow-ups such as what happened to the Bear Stearns funds? Just wait. The system has built in lags in recognizing losses since the rating agencies don't have to downgrade until losses are actually realized, and that can take 18 months or more. Moreover, markets for these bonds are highly illiquid, and without trades, holders can maintain the illusion nothing bad has happened.
That's a dangerous game, however, because, investors don't have to wait for downgrades or price adjustments before pulling out of exposed hedge funds or otherwise dumping suspect investments. If a fund wants to take advantage of the illiquidity and lags in the system to maintain the illusion of good performance, it runs the risk of having to pay investors more than market value if they withdraw at the end of the quarter. That's probably why we've seen a number of funds halt withdrawals from investors in the past few weeks.
This sets up an interesting dynamic for the coming months. Typically, an investor gives 90 days notice before withdrawing money from a hedge fund, and the price for the redemption will be marked to the next quarter's performance. Clearly that puts some pressure on hedge funds to come clean in their accounting of performance in the quarter that just ended, but, because alarm about this market has soared in the past month, it puts even greater pressure on funds to accurately price for the third quarter ending in September. What's likely to happen is that unlevered funds will mark down their investments in this now-toxic stuff and pay off those who want to redeem.
Is there a way to avoid this day of reckoning? CDOs are actively managed, and in theory the manager can swap out badly performing investments for better stuff. The bad stuff has to be sold, however, and given the illiquidity of this market such sales could hasten the repricing of many billions of similar toxics sitting in portfolios. Also, subprime accounted for over 50% of the collateral for CDO's in 2006, and an asset class that disproportionately represented is not easy to swap out even in the best of times.
More likely, this toxics crises will play out in finance just as it does in nature -- with a mass die-off.
[Mild spoiler alert: the book is a fictionalized exploration of a girl who falls under the spell of a Manson-like cult. We all know how that story unfolded. In this Short Take I’ll be offering my reactions to the protagonist, Evie Boyd.]
The Girls offers as bleak a view of the amorality of American youth as I have ever encountered. In a review of my first book, I was called “Intolerably apocalyptic,” but I can’t hold a candle to Ms. Cline. The book is a novelistic attempt to try and understand how some of the privileged young women of the late 1960s could commit unspeakable acts while under the sway of a Manson-like psychopath.
Thus we meet Evie Boyd, a fourteen year-old growing up amid relative affluence in Petaluma California. She’s directionless, with no apparent passions, self-conscious about her looks, emotionally needy, alienated from her parents (who get divorced), but possessed of a tough inner core and a rebellious streak. She’s enthralled when she encounters Suzanne, a wild, charismatic 19 year-old who seems to be a composite of Patricia Krenwinkel and Leslie Van Houton, and Evie is honored when Suzanne pays her some attention. Events bring her to the cult’s squalid ranch, and for some weeks, Evie maintains a dual life, throwing herself into the life of the cult, while returning home enough not to galvanize her mother, who is pre-occupied with a rebound relationship with Frank, an entrepreneur who comes across as a hustler with a heart of gold.
Evie is so smitten by Suzanne that she doesn’t notice as the cult spirals down from talk of love and freedom to episodes of paranoia, back-biting and revenge. Along the way, Evie has her first sexual adventures, and enters sufficiently into the spirit of the cult that she brings them to the house of the family next door (which they descrate), even though she has known the family all her life and has no score to settle. Later, Evie talks her way into joining Suzanne as she and others set off to inflict mayhem on a Dennis Wilson-like figure, but Suzanne kicks her out of the car before they begin a horrific rampage.
Did Suzanne do this to protect Evie from what she knew was about to happen, or because she felt that Evie wasn’t a murderer and would become a liability? That’s left unanswered, but the bloodbath that Evie missed is so depraved – including the slashing apart of a toddler – that no human with a soul could find that earlier gesture redemptive … except for our Evie, who still feels the tug of Suzanne’s power, even after she learns every gory detail of Suzanne’s actions.
It’s several months between the time of the murders and when the cult is finally caught. During this time, Evie keeps her mouth shut about what happens and meekly allows herself to be shipped off to boarding school to resume her comfortable existence, though as a wreck, not a spirited teenager.
That’s when I decided Evie was a worthless human being. Sure, she was terrified that the cult would come after her, and there’s some honor on not squealing, but Evie had to know that the cult would likely kill again, and that made her an enabler of whatever they did subsequently.
The book interweaves the present and the past and so we learn how these events haunted Evie’s life. But there’s no redemptive moment, no act where she summons the courage to do the right thing, or rises above her own self-absorption. Even in the present, when the psychopath-in-the-making son of a friend and his underage, impressionable girlfriend crash at her digs, she can only summon a half-hearted (and failed) attempt to save the girl from following the path that so grievously sidetracked her own life.
All the men in the book are either pathetic or pigs of various shapes and forms – except for a premed student named Tom, who sees the cult for what it is, but who Evie rejects as a dork. Towards the end of the book, Evie ticks off a long list of subsequent experiences with awful men that could summon in her the hatred to commit horrendous crimes, seeming to imply that with the right mix of events, she too might have become a Suzanne, and, by implication, so could enormous numbers of other young women.
My first reaction was to call “Bullshit!” Were all young women potential Suzannes, we would have seen endless repeats of the Manson horrors in the nearly 50 years since the events. Instead, those murders still stand as a touchstone of horror because nothing since has eclipsed their mindless violence.
The Manson cult was at the far far end of the normal curve during truly abnormal times. In just the two years leading up to the murders, we had the huge escalation of a senseless war, the explosion of the anti-war movement and counter-culture, a breakdown of generational trust, my generation’s first experiences with powerful, mind-altering drugs, and a sexual revolution. In a country of more than 200 million people, that roiling stew of disruptive forces bubbled to the surface about 20 broken souls, deranged by drugs and in the thrall of a false prophet.
On reflection, however, maybe Ms. Clein was making a different point. All we have to think of are the teenage executioners of Pol Pot’s Cambodia or the child soldiers of Africa to recognize that the capacity for evil lies latent in the young. And, while in fiction we want our protagonists to find redemption or transcend their flaws perhaps Evie’s failure to rise to the occasion was making the point that a civilization that keeps our murderous impulses in check is not innate, but something external that has to be actively inculcated and supported. That’s something to keep in mind amid the current insanity of gun violence, and as more dark clouds gather on the horizon.