My unpublished (100,000 word) book “The Financial Jigsaw”, is being serialised here weekly in 100 Issues by Peter J Underwood, author
Last week we had an interlude and now back to the book, the last Issue looked at how commodities are influenced by the wide-ranging effects of manipulations especially gold. Here is the link to last week: Issue 41
This week we look at other more complex derivatives which bear upon various aspects of financial engineering. The term for derivatives of this group in general is Asset Backed Securities (ABS) and within this group many other types are included, such as Mortgage Backed Securities (MBS); Interest Rate Swaps (are particularly prevalent) and a range of exotic financial vehicles which go to make up the complete family of these destructive instruments. It is estimated that some 1.2 quadrillion dollars notional value of these derivatives exist in the world today but nobody really knows. From Investopedia:
(A quick refresher: Derivatives themselves are merely contracts between parties; they themselves are speculations, bought or sold as bets on the future price moves of whatever securities they’re based on – hence the name ‘derivative.’ So derivatives’ prices are dependent on the prices of their underlying assets.):
https://www.investopedia.com/ask/answers/052715/how-big-derivatives-market.asp
In effect, the whole financial world has degenerated into a series of gambling casinos obscured with fancy-sounding, exotic names and labels which serve to exclude most people from understanding the true nature of these instruments of mass destruction. The Fed is responsible for the whole gambit of how the financial markets work and it won’t be too long before the outcome is witnessed: Here is Brandon Smith on the current trends today and the likely results of the Fed’s financial engineering:
CHAPTER 8
Financial Engineering
“Something hit me very hard once, thinking about what one little man could do. Think of the Queen Mary — the whole ship goes by and then comes the rudder. And there’s a tiny thing at the edge of the rudder called a trim-tab. It’s a miniature rudder. Just moving the little trim-tab builds a low pressure that pulls the rudder around; takes almost no effort at all”.
Richard Buckminster Fuller
How securitised contracts are created and sold
There seems to be no end to the ingenuity of the financial geniuses to generate exotic derivatives, which often become ‘toxic’ (they go bad and lose money), to manipulate and deceive investors; some common ones are known as ‘Mortgage Backed Securities’ (MBS).
Once again they come in all kinds of colours, shapes and sizes and are certainly appropriate to be considered as part of our jigsaw picture. The principle is relatively easy to understand. Consider your own house which might have a mortgage attached to it. Financial institutions collect together a large number of these mortgage contracts (called a ‘security’ because the loans are backed or secured by houses and land as collateral) and combine all their income streams in one place (these are the monthly payments householders make on their mortgage) creating one large security which is sold to investors by dividing them into pots, called tranches, according to their size, geographical and risk-assessed groupings.
Thus there are tranches of risky, low quality mortgages (known as sub-prime mortgages), others mid-range known as mezzanine tranches, as well as the best quality, prime mortgages which are rated as the least risky.
The rules of this game of ‘securitisation’ are both complex and extensive but, in their simplest form, allow the least risky prime group to attract a low rate of interest but claim first in line to receive their allotted income. Next in line for the income is the mid-range, mezzanine tranche, with a higher rate of interest as they are at greater risk of default, and the final part of the income stream is allocated to the sub-prime tranche, the highest risk group.
It can be seen that, regardless of which individual household defaults, the prime tranche investors will always have their income stream to be certain before the other tranches and it is only when most of the mezzanine and sub-prime tranches fail, an unlikely event one would presume, that the prime investors start suffering losses.
This is good news for the prime tranche investors because they have an almost guaranteed return on their investment; they are said to be almost risk-free or rated by credit rating agencies as AAA, the risk is equivalent to government bonds which are rated at almost zero risk. The other tranches are usually rated lower on the credit scale but receive a higher rate of interest in return. What could go wrong?
Enter the real estate investment market and mortgage bonds
Certainly not many people recognised the hidden risks because this type of financial product spawned a whole new industry centred on a group of financial institutions known as ‘Real Estate Investment Trusts’ (REITs). These are companies that borrow money to buy MBS and earn the difference between their cost of borrowing and the interest paid on their MBS.
When interest rates are going down and MBS are performing well these companies make fortunes for themselves and their client investors. But when interest rates go up and bond prices fall, their excessive debt leverage causes them to lose money fast. They were, in fact, among the earliest casualties of the 2008 crisis and, in the summer of 2013, they and their ‘memory-impaired’ investors found themselves back in the same financially toxic cesspool.
Much did and could go wrong with this simple plan because the creators of the these derivatives, the major banks and financial institutions, became so enthusiastic about this easy way to make massive fees and commissions that they lost touch with their original mandate and started to combine vast numbers of only sub-prime mortgages using the rationale that all mortgages, regardless of their degree of risk, would never default all at once.
This is the same logic that bankers use when justifying the very banking system they use: “not everyone will want their money back all at the same time”. In the same way it was wrongly assumed that: “not every householder will default at the same time”.
This is exactly what caused the 2008 financial crisis which started in the USA because of very poor quality mortgages that had been granted to people who had no chance of repaying and they defaulted in droves, causing house prices to fall rapidly, causing more defaults – a chain reaction – otherwise known as systemic failure.
In spite of all the lessons that should have been learned since the 2008 catastrophe the financial system continues to face a high risk of this type of failure, on a global scale this time, due mainly to the excesses and greed of bankers and their toxic derivatives. Warren Buffett certainly knew what he was talking about when he made that famous quote mentioned earlier and went further when he said: “It is only when the tide goes out that you see who is swimming naked”.
Expanding the idea of ‘securitisation’ into a vast range of products
This of course is only the beginning of the derivative story but the principles remain the same: combine a lot of little loans into one big loan and divide it up by selling off different rated tranches to a range of gullible investors to match their individual requirements of risk and return.
The bankers did not stop at the mortgage market; they went on to securitise anything and everything that had an associated income stream, known as ‘Asset Backed Securities’ (ABS); they can be: motor car loans, credit cards, student loans, commercial loans, corporate bonds and they even have involved government loans and bonds, in fact any debt instrument which lives and breathes ‘income’ is a target; sadly the bankers are insatiable in their lust for profit and mega-bonuses.
For bankers the world is their oyster because they can invent any form of derivative they wish including taking a large number of MBS, we have just considered, and combining them into an even larger group of securities measured in billions of dollars at face value. These securities are known as Collateralised Debt Obligations (CDOs) and using the same principle, creating an even greater risk of systemic failure than MBS alone.
There are even CDOs of CDOs, called ‘CDOs squared’ and really exotic, beyond measure, synthetic CDOs all which must be left for another time. It is enough to know that an immense spider’s web of toxic debt bundled into securities pervades the world of finance which has created the greatest risk of global economic failure known to man.
Yet another variation of a securitised product – the ‘Credit Default Swap’
But it doesn’t end here, there is so much more to tell although this must wait for another time, suffice to say that the hubris and greed of bankers knows no limit, so if the reader will bear with me a little longer on this somewhat tedious subject, another example of financial engineering at its best is illustrated by the ‘financial instrument of grand deception’, par excellence, which is the ‘Credit Default Swap’ (CDS).
Here again is an exotic title for what is in essence a simple insurance policy the principles with which most of us are familiar. The insured person pays a regular premium, usually monthly, to cover for a one-off pay-out in the event of a specified loss such as a house fire, loss of a ship or car accident.
In just the same way the CDS provide insurance to a lender in the event of a default on a loan of any type. This can be any sort of loan from government bonds to derivative contracts of many kinds including MBS, ABS and their assorted offspring. However there is one major difference between a CDS and a regular insurance policy and it has to do with the stringent rules associated with insurance in general; so now a brief diversion will follow next week.
To be continued next Saturday
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Great observation Robert, I love sarc, it brightens the day and is generally a wonderful way to expose all the hubris associated with our crumbling financial megalith. Thanks for reading my offering and adding to the interest – (forgive the pun).