securitization, although not appearing heavily in the media until recent months, has been around for decades.  here are the basics from a mortgage-backed security (MBS) example (the root of our current crisis): as a loan originator, it is difficult to find someone to purchase the debt of a single mortgage.  they would have to figure out the risk on each individual loan and service each mortgage.  it would be much easier to sell a basket of mortgages as a single security that are marketed as “diversified” for lower risk and where you would still service the loans.  you could “charge” for the service through this basket and they would provide cash up front for streams of payment plus interest in return later.

this was a no-brainer for mortgage lenders.  you could sell tens of thousands of mortgages as a single recurring-income product (payment coming from monthly payments from mortgage borrowers) and as a result these payment receivables would be moved off of your own balance sheet in exchange for cold hard cash in the full amount of the loans, rather than monthly payments, to help you continue your business operations without waiting the 15 to 30 year life of the mortgage.  furthermore, your MBS basket of mortgages could undergo various methods of “credit enhancement” making it even more attractive to a buyer since it has a high credit rating.  in 1970, the Government National Mortgage Association (GNMA) a us government-owned corporation, also known as ginnie mae, was the first organization to buy mortgages from their originators and convert them in to securities.  securitization was born!

fast forward to the middle of the ’00s… the economy is raging, having recovered from the internet bubble burst endured just a few years earlier.  investment banks are looking to make money as always, but interest rates are still at historical lows so traditional debt securities just won’t do.  however, real estate prices have been growing at a frantic pace, surely fueled by low interest rates, and everyone knows real estate prices will never fall. what’s a greedy i-bank to do?  capitalize on real estate and get in the mortgage business of course!

so now you’re an investment bank in the business of selling baskets of mortgages.  more mortgages originated means more mortgages to package and sell, so really you should have everyone and their dead mother buy a home.  even if they have terrible credit and have no income, it doesn’t really matter.  in fact, you can tell borrowers they can pay a low introductory payment and just sell their home for a profit before their payment adjusts to a higher payment for a quick buck… because real estate values will never fall.

in fact, these higher risk borrowers are even better.  you can turn your MBSs into what is called subordinated debt.  you can lump high quality mortgages in with these lower quality mortgages in the same security, with different levels, or traunches, to invest in.  each traunch will have a different interest rate based on the risk of the underlying mortgages in them.  of course the higher risk mortgages will pay out a higher interest rate for the increased risk exposure.  and since you’re an investment bank and you’re here to make money you obviously want to receive a higher interest rate so you’ll take the majority of the high-risk mortgage paper… and you’re not really worried about these lower quality mortgages anyway, because if the borrower can’t pay you just repossess their house and resell their home for a profit.  because real estate values will never fall.

it’s early 2007.  real estate values fall. to top things off, those introductory rates and payments on mortgages are starting to reset to the higher rates and already overspent americans are now unable to keep up with their mortgage payments.  the perfect storm of hurricane ginnie has finally reached shore and if you’re an investor there’s a sudden realization that you’ve been duped and your high credit-grade MBS might not be such a healthy investment after all.  you’ve been “lied to” and there is now zero trust in the financial system.  even if you have money to invest you’re a lot pickier now and you’re not sure if the other guy is going to make good on his promise to pay you back, even if it has the highest possible rating, and the result: a credit crunch and a sharp fall in the value of risky assets for which there is now very little demand for… and if you’re holding on to extra risky assets like high-risk traunch MBSs there is now no demand… you’re F’d.

securitization, first kicked off by a united states government entity, has screwed you over.  let’s recall that you’re an investment bank looking to make money… and guess what?  you’re holding the majority of those nearly worthless high-risk mortgages because they had a high interest rate… and your other investors are still expecting payments.  you’re F’d, with a capital F.  any coincidence Lehman’s former CEO’s name is dick Fuld?  go ahead, switch the last two letters of his last name with his first.  i dare you.

where to put your money
i have generalized and oversimplified a lot of the nuances of the current financial crisis for the sake of easing explanation, but what does this scenario mean to you when you take out all the financial engineering talk?  if you’re not a subprime borrower and you’ve still got a job and a roof over your head that hasn’t been wiped out by the greed-driven securitization storm, just keep doing what you’re doing.  as john cochrane, finance professor at the university of chicago gsb notes on his website, you don’t have to be worried about this being the great depression 2.0. back in the 30’s, hedge funds, private equity firms, sovereign wealth funds, and warren buffett and their trillions of dollars weren’t even in existence.  oh wait, nix the buffett.  today they can come to the rescue (and profit) just as j.p. morgan almost single-handedly rescued the entire american banking system in 1907.

ride it out.  do what you’ve been doing, keep investing as you’ve been investing.  learn from the victims of hurricane ginnie and shore up your own finances.  don’t take on payments you can’t handle and don’t buy things you can’t afford.  don’t take risks that don’t need to be taken. it’s that simple.  and when the storm passes you’ll be just fine and if you can find and invest in the companies that survive and thrive in the storm, you may even end up better than you ever imagined.

despite the major market indices being more or less at the same level they were at last weekend, it was an insane week on wall street, leaving only two independent U.S. based bulge bracket investment banks standing. or… slouching. with lehman and ml falling this week to bankruptcy and a takeover and AIG taking a super-sized loan from bailouts ‘r us (read: the fed) you might have thought the worst was over.  you’d especially think that after the s&p jumped 4% after the announcement. but really the government has been putting spongebob band-aids over problems that equate to me taking a chainsaw to your arm.

shortly before i left the office on thursday i heard my COO step out of her office to exclaim “cox is speaking to congress! wsj.com newsflash!” when the british had just banned short-selling for the rest of the year, and your firm runs short and market-neutral hedge funds you can tell this means it’s going to be a LONG friday.

well, i call shenanigans! on principal i don’t personally short. it just feels like bad juju, but short seller’s have their place in the market.  if one of the missions of the SEC is to maintain fair, orderly, and efficient markets i’m really not sure limiting market participants is “fair”, that you can call any trading done this week “orderly”, or consider your actions as moving towards “efficient”.  instead you alienate market participants that help bring RATIONAL valuations to the market.  shorting may not prevent a stock bubble, but sure as hell helps to keep prices sane.

FDR had “The New Deal”. secretary Paulson & Co have given us “The Raw Deal”. the market irrationally jumped friday morning on news that the government was planning to cover all the bad debt that banks had on their books.  wait, that sounds vaguely familiar.  kind of like this again, except it doesn’t just give banks the power to disguise their balance sheets for periods when they need to report… it gives banks the power to make the Fed’s balance sheet permanently look rather lehman-esque.

thanks a lot.  thanks to all the greedy bastard mortgage brokers who gave jumbo loans to people with no income and the investment banks that securitized and bought what was essentially investment-grade rated junk debt.  thanks to all you financially irresponsible americans for making it harder for EVERYONE ELSE to get a mortgage, or even a car loan.  and thank you america for NOT teaching them a lesson. laissez unfaire.

so who really owns AIG now?  YOU DO!!! (if you’re an american taxpayer).  we all do.  your uncle sam just took your money and bought stocks, or should i say, tried to catch a falling knife.  in the investment world we call these folks bagholders.  the ones that hold on to a stock that is surely headed under. so victoria, you are now a bag lady.  by the way, had AIG been bailed out over the weekend it would have only cost us $40 billion.  $20 Wonder Bread.  you’d probably pay $20 for a loaf of bread if you were dying from hunger… at $40 i’d probably just let myself starve.

in the process, treasury secretary Paulson ousted the current AIG CEO and put in his place former Allstate chief Liddy, who happens to be on the board at GS.  wait, didn’t Paulson come from Goldman Sachs?  i thought the connection purchasing was only done in China.  American International Group:  Comrad Paulson, surely you and your schemers could’ve come up with something less suspicious than “American International”.

and if you want a true sign of the times?  on tuesday the Reserve Primary Fund (not to be confused with the federal reserve), the nation’s oldest money market fund (MMF), “broke the buck”.  NUCKING FUTS!!! if you’re not familiar with money market instruments, they are touted as “cash equivalents” and are regulated under Rule 2a-7 to invest only in the highest quality short-term debt with the goal of preserving a share price of $1.00 and paying the rest out in interest.  the Reserve Primary Fund is priced today at $0.97.  this is only the second time in history a MMF has broken the buck, and only the first time a retail MMF.  to make matters worse, two other Reserve funds broke the buck as well.

so what happened?  i hope to answer that and more.  tomorrow i will cover how all this affects you and where you should put your money… i’ve been meaning to write about rollover IRA’s since so many of you have asked me in the past year.  friday i will revisit how our newly communist government made an example out of lehman bros. and recap the tumultuous week.  pretty much we all got screwed and we all got screwed a long time ago.  if you can’t understand this chart then you’re probably not alone.  the basic problem IS that most people can’t understand that chart and that is part of the financial engineering that is going on to mask how bad things really are.

our money is now stuck in a failing insurance firm whose balance sheet should be called an IMbalanced sheet.  this is on top of the bailout of Fannie and Freddie earlier this month where THE AMERICAN TAXPAYERS bought out mortgages, up to 40% of whom are set to default.  thanks a lot uncle sam.  i used to think you were my rich uncle.  now you’re just my lunatic uncle who we don’t even see at thanksgiving.  the fed launched a campaign to teach financial literacy on monday.  what a bunch of hypocrites.  your lose regulations got us here in the first place.  up yours, uncle sam, you commie bastard.