The Giant Pool of Money

May 11, 2008 10:20 PM

The Giant Pool of Money.This American Life teams up with NPR News to explain the Housing Crisis.

(I know everybody here already knows about TAL, but this is an exceptionally well done episode, and worth checking out even if you don't get the podcast.)

posted by empath (53 comments total)

I just heard a little bit of this on the radio. They got one bit right; they mentioned how the overall supply of money had doubled in just six years, and that this new money was chasing far less than double the number of goods. I'm not sure if they clearly pointed out that this wasn't necessary, and in fact was hideously destructive, and is driving much of the commodity inflation you're seeing now... way, way, WAY too many dollars sloshing around the system, created at will, from nothing, to suit short-term goals.... but with profound long-term consequences.

I plan to devote an hour to this tomorrow. I liked what I did hear, but I don't know if they've pointed their finger at the correct villain... Alan Greenspan.
posted by Malor at 10:34 PM on May 11, 2008

In my opinion, this was perhaps the most important work of popular journalism since Walter Cronkite devoted an entire episode of the CBS Evening News to explaining the Watergate crisis. I thought I understood the "sub-prime mortgage" problem and the "credit-crunch." I was wrong.
posted by beingdaddy at 10:36 PM on May 11, 2008 [1 favorite]

I liked what I did hear, but I don't know if they've pointed their finger at the correct villain... Alan Greenspan.

Well, it's not that simple, which was the beauty of this particular piece of journalism.

But yeah, he was mentioned.
posted by mr_roboto at 10:47 PM on May 11, 2008

I heard the last half of this earlier today and I loved it. They managed to make a very complex problem very understandable. Perhaps the most crucial aspect was the way they worked around the jargon and cut to fundamental core of every aspect. For example, using the phrase "Giant Pool of Money" and the quick and clear translation of words like "tranches" without loss of information.

This constant "rebasing to common understanding" is incredibly important when discussing such a large and intellectually unwieldy topic. I haven't heard another piece on the crisis that was as clear and powerful.

Too bad about Ira's voice. Glad he stuck in there, though.
posted by jmhodges at 10:58 PM on May 11, 2008

Crap, can someone fix the title please?
posted by empath at 11:44 PM on May 11, 2008

The title of this post, though fraught with error, is beautiful when paired with Ira's somewhat scratchy voice and the current state of our economy.
posted by localhuman at 12:10 AM on May 12, 2008

Yeah, that should say "The Giant Poo of Money", right?
posted by wendell at 12:12 AM on May 12, 2008 [2 favorites]

I wonder if the global food crisis can be solved by using ground up greedy wall street bankers, mortgage brokers and "the giant global poo of money" as fertilizer.
posted by peppito at 12:28 AM on May 12, 2008

Ira Glass sounds like Harvey Fierstein this week.
posted by bpm140 at 12:32 AM on May 12, 2008

What a great piece of journalism. Thanks, empath!
posted by sveskemus at 12:57 AM on May 12, 2008

I wonder if the global food crisis can be solved by using ground up greedy wall street bankers, mortgage brokers and "the giant global poo of money" as fertilizer.

Let's do a quick back-of-the-envelope.

Right now, the limit on agricultural production in the developed world is not fertilizer; it's essentially limited by total land area, water supplies, and ultimately transportation costs. I'll assume therefore that you're suggesting using the ground up bodies of people to fertilize fields in the developing world. Let's limit our analysis to rural Africa, which currently has the most primative agricultural practices in the world and where the introduction of a modern fertilizer will have the greatest impact. Let's also limit the analysis to nitrogen: when we're discussing increased yields from relatively undeveloped agricultural land, phosphorus and potassium will have an effect, but the by far the biggest improvement (I'd guess 90% or more) is going to come from increased soil nitrogen.

OK. So how many "greedy wall street bankers" and mortgage brokers are there in the world? I'd guess on the order of 50,000; and I'm pretty confident on an upper limit of 500,000, so let's say 10^5 for this order-of-magnitude estimate. Each one has an average weight of, say, 80 kg, so we're talking 8x10^6 kg of total biomass. Of course, about 60% of that is water, so we're down to 1.3x10^6 kg of biomass. Let's assume that all the nitrogen in that biomass will become available for plants using minimal processing (grinding into a slurry, for instance). Remember, there's really not a lot of nitrogen in there. I'm going to have to make a guess here: there's no nitrogen in the carbohydrates or lipids, and proteins are maybe 20% nitrogen by weight. I'll be generous and say 10% of the biomass in the slurry is nitrogen, and it's all available. That gives us about 10^5 kg nitrogen (1 kg for each banker we kill to implement your plan).

How does this compare to the amount of nitrogen fertilizer we'd need to improve the yield from African fields (which, remember, gives us the best bang for our buck)? Well, hell, a single county in the high-yield agricultural heartland of the US uses over 5x10^7 kg of nitrogen fertilizer each year. Global use is on the order of 10^11 kg, mostly produced by the Haber process, rather than by murdering people and grinding up their bodies. Barring a radical increase in the price of natural gas (which we can't rule out!), I'd say that your proposal isn't even a drop in the bucket. It's not even a drop in the ocean, really.

I'll just assume you were kidding about the money. You know it mostly only exists as data, which isn't useful for fertilizing plants. Even if it were paper money, that's mostly cellulose, which I assume you can use as a feedstock in some sort of microbial nitrogen fixing system but, again, not nearly as efficient as the Haber process.
posted by mr_roboto at 1:30 AM on May 12, 2008 [15 favorites]

Okay, Alan Greenspan this, Alan Greenspan that. I listened to the podcast, but I'm still at a loss to understand why the ROI on Treasury bonds was kept so low (1%). Didn't spomeone realize this would drive investors to seek other kinds of investments? (And what the hell was it that kept the Chinese buying our T-bonds during this same period?) Was this supposed to be part of that great trickle-down plan that the RNC has been talking about since Reagan?

Anyone with an eye or an ear to either the Treasury or Greenspan's thinking, please respond.
posted by vhsiv at 3:35 AM on May 12, 2008

Crap, can someone fix the title please?

yes, "moan" is spelled wrong.
posted by quonsar at 4:57 AM on May 12, 2008 [2 favorites]

vhsiv, I don't think anyone but Mr. Greenspan knows for sure. That said, however, from comments he's made, I believe he saw the reality of global deflation. China and India coming online and integrating into the global economy was one of the most powerful deflationary forces for labor and manufactured goods ever. So, with the Fed's (stupid) belief that it should be trying to fix the price of goods, he increased and increased and increased the money supply to counter. You can see it in charts; starting about 1995, the rate of increase of the money supply went WAY up.

What the overall chart won't show you is that, anytime there was any kind of economic distress, the Fed would step up with unlimited liquidity until the crisis passed. I'm sure Greenspan thought he was preventing problems, but real economies are always in a state of maladjustment and always tending back toward the center, and his huge interventions whenever there was a problem prevented economic adjustments from ever really happening. It told the economy, "everything is okay, you don't need to change your behavior", so it continued down the path that had gotten it in trouble initially. This just meant that there would be more trouble later; the adjustments still need to happen. With the drug of fast, easy cash, the economy doesn't notice the pain anymore, so it keeps running on the sprain, making the injury worse and worse.

Further, the knowledge that nothing bad would be allowed to happen, ever, set off a frenzy of speculation such as we've never seen. With the knowledge that Uncle Al had their collective backs, the world's traders could take on staggeringly huge positions, and in fact invented whole new ways of taking on positions far in excess of their actual money available. (derivatives). This generated fabulous returns, better than anything else in the economy, so of course it attracted the most investment and the most attention, starving the real economy of money it needed for maintenance and expansion. That's what bubbles do; they divert investment from the right places, and suck it into the wrong ones. The economy becomes about the bubble. America of 2006 was mostly about swapping ever-greater IOUs in exchange for real estate. But, eventually, economic reality intervenes; we can't actually afford to pay off those IOUs, no matter how good things looked in the spiral up.

We now have an absolutely enormous segment of the economy whose sole purpose is manipulation of money, rather than generation of wealth. The people actually generating the wealth, those who work at making things, along with the myriad support operations that make those people more efficient, are held hostage by the people who manipulate money for a living. We have Wall Street, fat with cash, like an engorged tick on an emaciated horse, while the country staggers along, unable to pay its workers a decent wage or maintain its infrastructure. Wall Street is just playing by the rules, but with the government there to make sure they never lose money on any kind of large scale, they have a thoroughly unfair advantage over all the other players in the economy.

The culture of 'investment' (actually speculation) has gotten so deep-set into the American psyche that Congress, too, is trying very, very hard to make sure that Nothing Bad Ever Happens. And by preventing bad outcomes, you reward bad players. If you reward stupidity, you get more stupidity. It appears that America is stupiding itself into financial oblivion, on every level... personal, governmental, and on the part of the central bank.

The people who manipulate money for a living, though, they're doing just fine, thank you very much. The Fed has now started dealing with them directly, bypassing the banks entirely, to make absolutely sure of it.
posted by Malor at 5:07 AM on May 12, 2008 [15 favorites]

Is there a chart showing the change in diet over the past few years? I keep reading about newly rich Asians going for meat over grain. Wondering if it's enough to have a serious impact on price.
posted by IndigoJones at 5:24 AM on May 12, 2008

(Would Greenspan being less a chump have made a difference, given that international investor types were already borrowing Japanese yen at zero interest to finance a lot of nonsense? Should not the Bank of Japan bear some of the blame, and if not, why not?)
posted by IndigoJones at 5:31 AM on May 12, 2008

vhsiv --- "Anyone with an eye or an ear to either the Treasury or Greenspan's thinking, please respond."

Yeh, The Federal Reserve is a proponent of an open process; you can review transcripts of FOMC meetings here. Interesting resource, gives you both a transcript of the meeting, as well as the same presentation materials Greenspan, Bernanke, and the other Federal Reserve Officers reviewed and discussed during the meetings.

Another interesting resource would be public speeches made by Federal Reserve Officials; again, The Fed is wide open (compared to how some of the other G7 Central Banks operate) so its pretty easy to keep track of what's been said and when.

A few observations: first, as many of you might have suspected, Greenspan is indeed capable of direct and plain communication. So in spite of some of the sound bites he's delivered at times, when he's amoung his peers and trying to arrive at consensus he seems very direct and forthright.

Second the links I've provided show a relatively low level of detail. There are lots of different summaries out there on the internet, each reflecting various and different backgrounds and viewpoints, but if you can stomach going through the individual meetings (or even annual summaries of Fed actions) then you'll be able to leverage your own insight to arrive at your own conclusions. Otherwise, you gotta pick your muse I guess.

Finally, if you're curious about this stuff - fantastic!!! So the best advise I could give would be to dive into the FOMC material, and start looking at The Yield Curve every day to gain some insight into what's going on now, and what's likely to happen going forward. There is some very curious stuff happening now, especially on the short end (e.g., 3M/6M tenors).


IndigoJones -- "Is there a chart showing the change in diet over the past few years? I keep reading about newly rich Asians going for meat over grain. Wondering if it's enough to have a serious impact on price."

Wow a timely query.

Just this morning over breakfast I was reading a research paper by Lane (2008) [.pdf] on BioFuels / trends / etc, that we were bouncing around last night. It just so happens this paper contains a chart (figure 2, page 6, covers the period between 1995-2007). An interesting excerpt - "Although this study focuses on the 1995-2007 period, meat consumption has been rising at a rapid pace in China for 25 year or more. Consumption was 16 kilograms of meat per capita as recently as 1983 according to the World Resources Institute, rising to a figure more than three times as high by 2007. Overall consumption has been increasing as fast as 12 percent per year on a per capita basis."

So Lane doesn't think increased meat consumption is a new phenomenon. However as Lane only cites a handful of sources for this paper its rigour is clearly suspect; don't trade on this information but its still an interesting read.

I'm not sure of your background or interests, but Wan (Wan, G., 2005, "Convergence in Food Consumption in Rural China: Evidence from Household Survey Data" China Economic Review, Vol. 16, No. 1, pp. 90-102) did some interesting research looking at income divergence and how this impacted diet, particularly in terms of food affordability. This work in seminal in that few researchers have looked the subject of divergence before, and its critical that China get control of this problem, lest existing class differences be exacerbated.

Wan and other researchers have concluded that due to the infrastructure problems in China, its extraordinarily difficult to get food to where its most needed, contributing to the inequality. But it all comes down to if they can get access to the meat, they'll purchase it as they've got the cash.


"...were already borrowing Japanese yen at zero interest to finance a lot of nonsense?"

Ah great comment. You are, of course, referring to The Carry Trade. Well, you know what I find interesting just this AM Shirakawa mentioned that BOJ was looking at downside risks more than inflation; curious comment, and we're trying to figure out what to make of it.

In any case, with BOJ lending at 0.5% (nominal) and rates in some countries exceeding 14% (we've seen a lot of cash going into Brazil the past quarter or so, and it doesn't seem to be abating much, not its accelerating) there probably will continue to be a lot of investor activity in this area.

You've got ECB and BOE pausing and indicating the accomodative posture is coming to an end and it seems the US may start hiking as soon as Q4 as well, now that a third Fed Governor (Honeig) is publicly voicing concerns (joining Plosser and Fisher).

Looking at the history of finance, we're still betting a period of stagflation is on the horizon and in fact inevitable; it's just not clear if they will be able attenuate its run as much as they'd like.

Very curious times.
posted by Mutant at 6:20 AM on May 12, 2008 [8 favorites]

The Giant Pool of Monet
posted by oaf at 6:56 AM on May 12, 2008 [1 favorite]

This was a pretty good show, kinda long. It's valuable as a human interest story, real people and real stories. It misses a bunch of the elements, like how this spread around the world.
posted by stbalbach at 7:14 AM on May 12, 2008

If you reward stupidity, you get more stupidity.

This is exactly why I oppose bailing out any players in the subprime mortgage fiasco. As much as it hurts, it needs to hurt.
posted by oaf at 7:19 AM on May 12, 2008 [2 favorites]

Any demographics on which investors got hit? American's mostly? Or those from emerging markets too?
posted by jeffburdges at 7:29 AM on May 12, 2008

I hope the piece talked about the greatest problem of all: the popular consensus that home ownership was a good to be supported above all other things.

It was this, more than anything else, that prevented regulators from taking action against bad loan origination practices on the front end (100% LTV liar loans), and dubious investment decisions on the back end (permitting the agencies to rate AAA securities consisting of 100% LTV liar loans and permitting regulated investors to buy them and report them as such).

For those with eyes to see, though, the market always told the truth. There was never a point where single-name traditional AAA bonds didn't yield significantly less than structured-product AAAs. In the same way that a few grandmas reading the circulars keep supermarket prices competitive for all of us, a few bond buyers who refused to drink the kool-aid kept the markets, in their own way, honest about the difference in risk, which was enough for investors to take a stand on the magnitude of the difference in risk.
posted by MattD at 7:31 AM on May 12, 2008

I heard part of this and will listen to its entirety maybe today, but what struck me, is that major decisions about what constitutes a good risk for a lender and what might be a good a great investment instrument seem to be made recent grads with basic financial knowledge, but little experience, and they bear no responsibility for the bad outcome.

This is laissez-faire economics at its worst.
posted by readery at 7:53 AM on May 12, 2008

On further thinking - this TAL piece has the mortgage industry as totally bottom driven lender policies - whatever the market will bear. And anecdotally, I don't know anyone in finance that stays in after they reach their forties. Finance guys make a bundle and move on to other endeavors fairly quickly - so no one in a decision making capacity has much real experience at all.
Bears some thought.
posted by readery at 8:37 AM on May 12, 2008

I'm listening to it now—extremely educational. Thanks for the post.
posted by languagehat at 9:07 AM on May 12, 2008

oaf - AMEN. Recessions and economic downturns have a miraculous way of purging the dumb, incompetent, unresourceful, poorly allocated resources/money/idiots from the system.

Think of it this way: we've misallocated trillions of dollars from a real economy into one based upon credit and debt. Instead of investing in infrastructure, science, education, etc., we invested in...debt. And now, just like any other mania (gold rush, tulip craze, dot com...), the system needs to readjust and purge the morons and speculators to get us back into a healthy state.

Government intervention (Barney Frank, you fucking maroon - I'm talking to you) at this stage will only prolong the crisis and support those who made VERY BAD DECISIONS during the boom. I strongly recommend reading some of the daily posts over at Market Ticker. Sunday's post "Desperate Men, Desperate Measures" explains well why the rally right now is probably a sucker rally.

Better yet, if you want an insight into how messed up the system is, read Deniger's post related to the SEC mandate that banks will have to open up their books and disclose, for the first time and in plain english, what they own and how much it is REALLY work. The market sold off big, late Wednesday after the SEC hearings. Wonder why that was...?
posted by tgrundke at 9:09 AM on May 12, 2008 [1 favorite]

Yay! I learned a new word.

Seriously great hour. I listened this weekend. It's a nice plain-english explanation of some of the mechanics behind the whole mortgage-CDO alchemy (triple B to AAA?).
posted by i_am_a_Jedi at 9:26 AM on May 12, 2008

Blerg.
posted by onepapertiger at 10:22 AM on May 12, 2008

If you don't have the full hour to listen, you might want to take a look at this link, which another poster put up awhile back and breaks it down nicely, too.
posted by onepapertiger at 10:33 AM on May 12, 2008 [1 favorite]

This was really terrific, thank you.

Can anyone explain how this relates to the credit default swaps recently explained by Michael Greenberger, former Director of Trading and Markets at the Commodity Futures Trading Commission (CFTC) on Fresh Air (given some context here). I'm thinking that these CDOs were that which the high-rollers in the credit default casino were betting on - right?

Hope this doesn't muddy the waters too much. Just trying to get my English Major brain around this.
posted by Sowana at 11:35 AM on May 12, 2008

Thank you Mutant, much obliged.
posted by IndigoJones at 12:50 PM on May 12, 2008

Remember the old Far Side cartoon with two cows head to head over a fence, next to a pole with an old-fashioned signboard saying 'Chicago' pointing to a huge plume of smoke off in the distance, and captioned "Agent 6093 has accomplished her mission"?

Greenspan began his career as a gold bug, an advocate of the gold standard for currency, and a member of Ayn Rand's inner circle. Here is an article he wrote in 1967 advocating the gold standard as the only secure bulwark against oppressive government. The undated header to the article claims he reaffirmed this belief while Fed chairman during a Senate hearing. As far as I know, he still hasn't changed his mind.

In order to return gold to its former glory, the present de facto global currency backing, the US Dollar, must be dethroned first, of course.

Well, 'agent Au79 has accomplished his mission.'
posted by jamjam at 12:59 PM on May 12, 2008

Sowana -- "Can anyone explain how this relates to the credit default swaps recently explained "

Well, I've heard of Michael Greenberger before. While at CFTC he was certainly someone folks in the fund industry (I'm in banking, and there's lots of back and forth between the two) had heard of. Overall he seemed to be critical of the entire business. Now Director of the Center for Health and Homeland Security (CHHS) at the University of Maryland, he apparently teaches "Homeland Security and The Law of Counterterrorism" as well as "Homeland Security: Emergency Response to Natural and Man Made Disasters" there.

Interesting Greenberger is commenting on Credit Default Swaps and Structured Products.

Unfortunately, I can't listen to the 39 minute interview now, but Credit Default Swaps are different and distinct instruments from CDOs.

Does the interview mention Synthetic CDOs at all?

A Synthetic CDO is a specific type of CDO embedding Credit Default Swaps (CDS) in each tranche, as oppposed to some type of loan (e.g., a mortgage, credit card receivable, car loan, etc). That's the only time you'll see overlap between the two.

We can do this as a Credit Default Swap is isomorphic to a loan or bond under certain conditions; in other words, the CDS can have similar economic characteristics if the CDO is structured properly.


jamjam -- "Well, 'agent Au79 has accomplished his mission.'"

Ha! Good one. No doubt operating under deep cover, and for a prolonged period of time. I'm not sure if you folks saw that Barrons recently found a copy of Greenspan's doctoral thesis?. If that link isn't working outside the payfor firewall, someone has created a pdf [.pdf].

One of the best lines: "There is no perpetual motion machine which generates an ever-rising path for the prices of homes.".
posted by Mutant at 1:23 PM on May 12, 2008 [1 favorite]

Ah! Now I feel like I understand so much more now, though at the cost of being a little bit more depressed. Ahaha.

Thanks for posting this!
posted by one teak forest at 1:30 PM on May 12, 2008

we're still betting a period of stagflation is on the horizon and in fact inevitable

Speaking of stagflation, Mark Thoma has an entertaining blog entry on the causes of the "Great Inflation". I wonder if it's possible that monetary processes have changed enough that the models will once again be misleading.
posted by sfenders at 2:31 PM on May 12, 2008

So that was enlightening. :) I think I now understand the "financial alchemy" that turns dodgy mortgages into mortgage backed securities with good and bad tranches, and how you can play essentially the same trick again to turn dodgy MBS tranches into collateralized debt obligations that also have good and bad tranches. But what happens to the "toxic waste" from the CDO's? Are there people out there buying this known badness? Do the CDO's hold onto it themselves? Does it all go around again and you make a new CDO out of the high rick tranches of another CDO?
posted by adamt at 5:12 PM on May 12, 2008

mr_roboto: yeah, fertilizer not such a good plan.

Cannibalism might be a better option. At 8x10^6 kg of total biomass of greedy Wall Street banker, mortgage broker, etc. (without correcting for the non-edible parts), their mass still wouldn't be enough to cover our yearly worldwide meat consumption standing at 2.85x10^11 kg (assuming it's metric tons) but might provide some short term relief to the problem.

A dark, callous, predatory relationship based problem; a dark, callous, predatory relationship based "solution."
posted by peppito at 5:16 PM on May 12, 2008

Does it all go around again and you make a new CDO out of the high rick tranches of another CDO?

CDO squared
posted by sfenders at 5:42 PM on May 12, 2008

i finally listened to this. it was great!!! incidentally, ever used iTunes's visualizer while listening to NPR?
posted by snofoam at 5:44 PM on May 12, 2008

NPR was supposed to be this american life. oops!
posted by snofoam at 5:44 PM on May 12, 2008

We now have an absolutely enormous segment of the economy whose sole purpose is manipulation of money, rather than generation of wealth. The people actually generating the wealth, those who work at making things, along with the myriad support operations that make those people more efficient, are held hostage by the people who manipulate money for a living.

This really struck me while listening -- just how many people are employed, and how very much money is made, moving money around.

It's necessary to have these services - but have they grown, ballooned beyond their utility to become something else?
posted by jb at 8:20 PM on May 12, 2008

oaf - AMEN. Recessions and economic downturns have a miraculous way of purging the dumb, incompetent, unresourceful, poorly allocated resources/money/idiots from the system.

They also have the effects of making those idiots' maybe very competent secretaries and drivers and a whole lot of other people unemployed and suffering.

We all pay for the stupidity of people who have financial power.
posted by jb at 8:24 PM on May 12, 2008

Adamt -- "But what happens to the "toxic waste" from the CDO's? Are there people out there buying this known badness? Do the CDO's hold onto it themselves?"

Ah great questions. Its always difficult to move the most risky component of the structured product as this is the highest risk (but highest reward) part of the deal. Keep in mind the way the structured product is engineered, this part of the product bears the initial (almost inevitable even in robust economic times) losses. In the case of a mortgage backed CDO, these losses would be defaults on home loans, other products might securitise student loans or car loans, but the concept (and risk) is the same. The first set of defaults (losses) are borne by the equity tranche (or "toxic waste" as its referred to here) of the structured product.

If there are too many losses (defaults) during the products lifetime, all the loans will have defaulted and this part of the structure will be wiped out. It will exist no more. And neither will the anticipated cash flow (payments on the underlying loans), as well as the capital used to purchase this tranche. So this is a tough part of the product to move, and here's how we do it.

If we assume a simple, three tranche CDO (a reasonable assumption; while there are CDOs out there with twenty or more tranches, the archetypical product does indeed consist of just three tranches, and we do see a large number of these simpler products traded and in fact these days almost all new CDOs are single tranche), you have:

• Senior - Highest credit rated, lowest risk, lowest return to the investor (aka "yield")
• Mezzanine - Middle of the credit ratings, medium risk, medium reward
• Equity - aka "Toxic Waste", the part of the structure carries the highest risk and highest return to the investor. With many structures we see this part is so so risky in fact it can't be rated; caveat emptor

But enough talk, let's go sell this thing.

So, Senior Tranche - not much of a problem moving this. Low risk, low return (important point: this tranche will offer a higher return than other assets with similar risk), this isn't difficult to sell.

Mezzanine Tranche - usually not too difficult, lots of market participants out there looking for higher returns, so this usually isn't too tough to sell either.

Equity Tranche - (time for sales 101: you're NOT going to move this thing if you insist upon calling it "toxic waste"). Keep in mind this is lowest rated - very often unrated! - part of the structure. Because of this, it carries the highest return but with the highest risk. Its always tough to sell this on. Although banks would prefer not to hold this part (at least for long) themselves it does happen, and in this market it's becoming very common¹. But in terms of selling, there are a few ways we can move this asset.

1. Toss it in with the Senior Tranche. As part of the deal to get the (heavily sought after) Senior Tranche the CDO issuer will require the purchaser to also buy the Toxic Waste (whoops! Equity) tranche. This works, and almost always the buyer will flip it (i.e., sell it on fast) as this component of the CDO doesn't fit their own risk / reward preference.



2. Dilution and restructuring is something we see from time to time: take the Equity Tranche, and create a new, CDO by combining this part of the structure with US Government Securities. Effectively, the risk has been mitigated due to the mingling of the very, very risk assets (Equity Tranche) with US Govvies. This is an approach that's actually looked upon favourably by the regulators.



3. Principal protection: A Zero Coupon Bond is linked to the Equity Tranche. This is generally a US Treasury zero, and because the investment in the government security is risk free, this is a mechanism that can be used to mitigate the risk of the Equity Tranche.



4. Offering favourable terms :Sometimes a bank will offer below market funding, in the form of a step up note to purchasers of the Equity Tranche. That is, the bank will offer to provide funds to the purchaser, at below market rates for a limited time (think "teaser rates" on mortgages). After this time the note resets to maket plus a premium. Advantages to purchaser: obviously, below market funding during the riskiest period of the CDO (initial losses). Advantages to issuer - We sold the damn thing!



5. Recently we've seen a few examples of what's called vertical slicing; a bank will distribute the Equity Tranche throughout the other tranches of the Structured Product. This is something that DKB came up with last year. I don't know too much about it myself as its relatively new and I haven't seen too much about it in the academic literature (I used to work on a Structured Products desk, and still teach the topic at University, but this is a a relatively new practice). So look back at the three tier structure and think just two. Interesting innovation, and one that at least on the surface would probably be viewed positively by the regulators.



6. Enter into what's called a Total Rate of Return Swap with another Investment Bank. While you're still holding the asset (i.e., Equity Tranche), you've protected yourself against loss going forward. Essentially insurance against loss, under terms of the Swap agreement the CDO issuing (and holding) bank passes along the returns generated by the Equity Tranche and receives a fee from the counterparty; in the event of default any losses are paid by the counterparty.



7. A more complex approach - establish a Special Purpose Vehicle, or SPV, capitalise it with the Equity Tranche, then purchase a Credit Default Swap against the SPV (and its underlying assets). This is done most often as a mechanism to reduce regulatory capital, and you need a very large Equity Tranche to profit due to the increased costs associated with the SPV, etc.

These are but a few of the ways a bank will deal with the Equity Tranche. Only a few are viewed favourably by the regulators; that isn't to say they are illegal, just frowned upon.

However you're correct - sometimes banks will hold onto the Equity Tranche themselves. A few months ago Morgan Stanley did just this. There are sound reasons for doing so: first of all, reputational risk. Banks don't like to be accused of selling investors anything (*cough*) toxic. The short term cost / possible loss of holding the riskiest part of a structured product is much, much lower than the long term damage loss of reputation would carry.

Also as the banks originally structured the product, they've got the deepest knowledge of the inner details of the CDO; sometimes they feel they can best monitor and proactively deal with expected losses (e.g., workouts is but one mechanism). Receiving the highest return then provides nice uplift to the origination / securitisation fees already earned during this process.

Altogether, this is very, very interesting area of finance. I hope my explanation was clear enough, but I've left out a lot of the finer details that might otherwise detract from answering your query concisely.

¹ There are a lot of regulatory initiatives falling out of last years credit events, and one of the more sensible suggestions I've read recently would require banks offering CDOs for sale to retain the equity component themselves.

This to be seems to be a win / win: we'd get all the benefits of securitisation (and they are legion) and bring self needed self control to those creating and selling the products.
posted by Mutant at 4:05 AM on May 13, 2008 [4 favorites]

Mutant, what you're missing is that the Toxic Waste tranche shouldn't exist at all. Those loans should never have been made, and there's no way to make them good.

Securitization of loans exists for one purpose only: to hide risk, by transferring it. It should be disallowed entirely. If you think you can offload risk, you will take more risks, and that risk gets injected into the system as a whole. It doesn't go away; it's still out there, creating instability.
posted by Malor at 6:24 AM on May 13, 2008

One thing the story makes clear is that people working in these rackets never seem to question their gravy train until it has already derailed.

The story does (understandably) skip over some big questions, like why Fed rates are so low, and why regulators did not step in. The answer is that our government used the housing bubble (and tech bubble, and other bubbles) as a storage area for its most prolific waste product: money.

Modern governments do not tax directly, they fund spending by pushing money out into the money supply. This is accomplished by selling debt, through the central bank, into the financial system. Debt-initiated money is inflationary since more money than currently exists will be required later in order to pay the interest.

So we have a closed loop. Money is necessary for trade, but each creation of debt-based money leads to the need to create more later. This need is further multiplied by the fractional reserve ratio. Over time, the amount gets bigger and bigger and bigger according to an exponential progression.

The government can only spend new money. The existing money that it already spent is not useful. To them, it is only an unpleasant byproduct that fills a giant, and ever growing pool of money representing inflation. To spend more money requires finding more borrowers. Low interest rates are what entice new borrowers. lower reserve requirements allow the greater leverage needed to service the ever spiraling amounts.

In the early 1990s, changes were made to banking regulations that reduced the reserve ratios that banks must observe when making loans. Other rule changes in 1995 allowed banks to sidestep the remaining reserve rules, using artifices such as sweep accounts. The effective reserve ratios are now pretty much zero, so banks can lend as much as the market will bear. Adding to this, in 1997 the 250K/500K single/joint capital-gains homeowner exemption was created. These actions really kicked off the housing bubble (the 90-95 actions enabled the tech bubble as well).

This money machine will be driven hard until it breaks, creating each new bubble in order to avoid dealing with the last one.
posted by b1ff at 9:18 PM on May 13, 2008

After my last post I received an email query regarding The Equity Tranche and as a similar question was raised this morning I thought it best to post here for the benefit of all, as there is much interest in CDOs and Structured Products.

"How the are loans selected for each of the tranche? "

Great question - both times - and sorry if my earlier explanation mislead (I was trying to keep word count down).

The Equity Tranche of a CDO is constructed NOT on credit quality or obligor rating, but rather on order of default.

In other words, if we were structuring a CDO including nothing but AAA rated corporate loans, there would still be Senior, Mezzanine and Equity tranches. The sole criteria determining which loans were placed into which tranches would be default order, NOT credit quality.

This is an extreme example, as we know from both FDIC and ratings agency data, that AAA rated entities have very, very low default rates (although it does happen). But as defaults occurred the structure would hold true, in that losses would first be absorbed by Equity, then Mezzanine and finally Senior tranches.

If we were to construct a mortgage CDO containing only sub prime debt, there still would be three tranches, with the Equity Tranche absorbing, as previously illustrated, the first set of loans to default.
posted by Mutant at 4:20 AM on May 14, 2008

The sole criteria determining which loans were placed into which tranches would be default order, NOT credit quality.

This is misleading. The default order is a future event. I think you mean expected default order as determined by your model. I assume what you are really saying is that credit ratings are just rough labels for ranges of credit quality as determined by your model, which is the real criteria for tranche selection.

If we were to construct a mortgage CDO containing only sub prime debt, there still would be three tranches, with the Equity Tranche absorbing, as previously illustrated, the first set of loans [expected] to default.
posted by b1ff at 8:04 AM on May 14, 2008

Sorry Mutant, after reading onepapertiger's link, I see the correct interpretation.

The loans are not assigned to tranches at the outset, but as time goes on.

The tranches are like classes on a passenger liner. First Class, Second Class, and Steerage. If the liner hits an iceberg, assignment of lifeboats is done according to these classes, with the Steerage Class having last pick of lifeboats and first pick of any water taken on.
posted by b1ff at 8:30 AM on May 14, 2008

This distribution of risk, while fascinating to practitioners, is missing the point. The risk should not have been taken in the first place. Originating bad loans, shuffling them around, mixing them in with good loans, and passing them onto someone is not actually distributing risk, as much as obfuscating it.

This quote from Mutant is telling: Toss it in with the Senior Tranche. As part of the deal to get the (heavily sought after) Senior Tranche the CDO issuer will require the purchaser to also buy the Toxic Waste (whoops! Equity) tranche. This works, and almost always the buyer will flip it (i.e., sell it on fast) as this component of the CDO doesn't fit their own risk / reward preference.

Q: To whom will they sell it?
A: Who cares! Not my problem. I already made my money.

Taking their own toxic waste analogy, what the practioners are doing is mixing toxic waste in with disguising material, and then dumping it on public land. In this analogy, as well as in the markets, the taxpayers are being set up to pay the costs of any necessary cleanup. The BSC bailout is ultimately backstopped by taxpayers, Fed monetization of CDOs is backstopped by taxpayers, etc.


The Wall Street mantra is: "Privatize Profits, Socialize Losses"
posted by b1ff at 10:01 AM on May 14, 2008

b1ff -- "The tranches are like classes on a passenger liner. "

Precisely. And I have to say I do like the lifeboat analogy, somewhat clearer than my original finance speak "...in that losses would first be absorbed by Equity, then Mezzanine and finally Senior tranches."

The next question would be how do we determine when the lifeboats (to adopt your phrasing) available to each class are full?

The technical phrase is attachment points; that is, loss ranges in percentage terms, referencing back to the total loan base.

So it's not uncommon to see the Equity Tranche absorbing the first 3% of losses, and once that threshold has been breached this part of the structure is wiped out; it no longer exists, both principal and future cash flow are gone. While this part of the structure exists and is experiencing losses, cash flow will, of course, reduce to reflect the diminished base of performing loans (I'm ignoring recovery value of the defaults as well as accelerated payments to higher level tranches to keep this concise).

The next attachment point might range from >3% to <>Janet Tavakoli documents a hypothetical deal where the most senior tranche contains over 80% of the entire portfolio.

So its easy to see why The Equity Tranche is deemed so risky; even in normal economic times this part of the structure will be absorbing losses. I suspect many holders of Equity Tranches are getting nervous in this market, depending upon the structure and underlying assets (i.e., sub prime, Alt A, etc).

Why would folks purchase The Equity Tranche at all? Well, I illustrated some of the mechanisms that are used to sell it on, but ultimately the reasons all come down to yield and risk mitigation; as you know, risk & reward are proportional, and its not uncommon to see yields well in excess of 20%, sometimes 40% or more! But risk is limited to what capital you used to purchase the Equity Tranche.

There are other leveraged products out there yielding perhaps as much, but they are symmetrical in their risk, with your downside equal to or perhaps exceeding the upside.
posted by Mutant at 10:28 AM on May 14, 2008 [1 favorite]

Hmmm.. The correct Janet Tavakoli link.

Looked ok in preview, not sure what happened.
posted by Mutant at 10:30 AM on May 14, 2008

Probably a dead thread at this point, but I'm curious as to what kind of investment would have been wise to invest in as a hedge against the housing bubble bursting? I assume if people were staking these risky positions that they must have done something to balance them.
posted by empath at 1:41 PM on May 15, 2008

empath -- "Probably a dead thread at this point, but I'm curious as to what kind of investment would have been wise to invest in as a hedge against the housing bubble bursting? I assume if people were staking these risky positions that they must have done something to balance them."

Nah, I'm always up to talk about the topic at hand. Or field an interesting question like yours.

Ok, let's narrow the focus to subprime mortgages (as it simplifies a lot of issues) and you're absolutely correct - many market participants were balancing out their exposure ("hedging") via a variety of mechanisms.

The easiest to understand is a derivative called "The Asset Backed Securities Index - Home Equity", or ticker symbol "ABX.HE".

Created and marketed by a company known as "CDS IndexCo", here is some high level marketing material [.pdf] they use when pitching this derivative to market participants.

The ABX is comprised of a series of Credit Default Swaps based upon twenty bonds backed by subprime mortgages. What might sound pretty complicated isn't really - as expectations of default increase, the value of the ABX increases. And vice versa.

Like most derivatives, this index could be used either for hedging ("balancing") exposure or taking a view (i.e., speculating).

An interesting (and somewhat current) example: last year Goldman went out and shorted the ABX.

Why? Gutsy move dreamed up by two floor traders, convinced some folks higher up, got the capital, took the position then sat back and waited. Didn't take long for the fire that we all knew was smoldering to ignite and then guess who made a bundle of money when subprime started to burn off big time?

Goldman. They were short ABX, a key index of the subprime market, and as the market moved downward this index sharply increased in value. So last November, while many banks were either struggling or losing money, and lots of hedge funds were closing up shop, Goldman reported record income of roughly $11 billion (IIRC) dollars.

We can go a little deeper into how ABX works if you or anyone else is interested.

Do these threads every really die? I'm still engaged in email conversations kicked off by comments I made months ago. Great crowd here, lots of interest in finance, lots of fantastically interesting questions.

Hope this helped!
posted by Mutant at 2:04 AM on May 16, 2008 [1 favorite]