How 'securitization' poisoned the financial system
NEW YORK — Tom Bosh lowered the telephone receiver into its cradle, making a decision on the way down. “We’re not buying any more,” he told his traders at Bank of New York Co. “Nothing.”
It was May 2007, and Bosh, who managed $25 billion from the bank’s 13th-floor trading room above Times Square, had just hung up on Ralph Cioffi at Bear Stearns Cos. a dozen blocks away. Bosh had invested $50 million in notes from an issuer Cioffi controlled, and he was ready to pull the plug.
“I had a bad feeling,” Bosh, 45, recalled. “Cioffi was just bulldogging everyone. He was saying, ‘These assets are good, the collateral is paying down, and I know more than you.’ That type of attitude.”
Bosh’s premonition, a month before two of Cioffi’s funds blew up, struck a death knell for structured finance, the system Wall Street banks devised to fuel more than two decades of unprecedented borrowing. The system allowed financial companies to lend beyond their capacity and outside the reach of regulators — until it crashed this year.
While the collapse was most visible in the stock markets, the cause was the loss of confidence in the world’s biggest bond market, structured finance. So far, it has led to the worst financial crisis since the Great Depression, the disappearance or takeover of more than a dozen banks, including three storied Wall Street firms, and almost $3 trillion in government expenditures and guarantees to contain the contagion.
The bundling of consumer loans and home mortgages into packages of securities — a process known as securitization — was the biggest U.S. export business of the 21st century. More than $27 trillion of these securities have been sold since 2001, according to the Securities Industry Financial Markets Association. That’s almost twice last year’s U. S. gross domestic product of $13.8 trillion.
The growth over the past decade was made possible by overseas banks, which saw the profits U.S. financial institutions were making and coveted the made-in-America technology, much as consumers around the world craved other emblems of American ingenuity from Coca-Cola to Hollywood movies. Wall Street obliged, with disastrous results: two-thirds of a trillion dollars in bank losses, about 40 percent of them outside the U.S.
“Securitization was based on the premise that a fool was born every minute,” Joseph Stiglitz, a professor of economics at Columbia University, told a congressional committee on Oct. 21. “Globalization meant that there was a global landscape on which they could search for those fools — and they found them everywhere.”
Securitization is a shadow banking system that funds most of the world’s credit cards, car purchases, leveraged buyouts and for a while, subprime mortgages. The system, which pools loans and slices up the risk of default, made borrowing cheaper for everyone, creating a debt culture that put credit cards in wallets from Seoul to Sao Paolo and enabled people to buy luxury cars and homes. It also pumped out record profits for banks, accounting for as much as one-fifth of their revenue over the last decade.
Beginning about three years ago, investment banks revved the system’s engine to boost earnings. They raised revenue by funding more subprime mortgages and cut costs by relying increasingly on $4.2 trillion sitting in U.S. money-market funds. As it turned out, those decisions would prove fatal.
“It’s a powerful technology that has been driven beyond the speed limit,” said Juan Ocampo, a former consultant at New York-based advisory firm McKinsey & Co. who wrote a 1988 book popularizing structured finance. “Instead of going 65 mph, they’ve been gunning it to 140 mph, 150 mph.”
Before the invention of securitization, banks loaned money, received payments and profited from the difference between what the borrower paid and the bank’s funding cost.
During the mid-1980s, mortgage- bond traders at Salomon Brothers devised a method of lending without using capital, a technique at the heart of securitization. It works by taking anything that has regular payments — mortgages, car loans, aircraft leases, music royalties — and channeling the money to a trust that pays bondholders principal and interest.
The word “securitization” implies safety. Investors with less appetite for risk buy higher-rated securities and get paid first at lower interest rates. Those with a bigger appetite buy riskier debt, get paid later and receive more interest.
Securitization’s biggest innovation was the use of off-balance- sheet accounting. If a bank couldn’t sell a bond or didn’t want to, the asset could be sold to a trust within a so-called special-purpose entity, incorporated in a place such as the Cayman Islands or Dublin, and shifted off the books. Lending expanded, and banks still booked profits.
With this new technology, a bank could originate $100 million in loans, sell off some to investors, transfer the rest to a special-purpose entity and not have to hold any capital. The profit could be as much as 1.25 percentage points of the amount loaned, or $1.25 million for every $100 million issued.
“It becomes almost like a fee business because it requires no capital,” said Brad Hintz, a Sanford Bernstein & Co. analyst and former Lehman CFO.
As securitization caught on, borrowing increased and Nicholas Sossidis and Stephen Partridge- Hicks at Citibank in London were figuring out a way to sell the new bonds. Their solution: Alpha Finance Corp., the first off-balance-sheet structured investment vehicle, or SIV. Alpha was created in 1988 as a way for Citigroup Inc. to vertically integrate its business like an oil company. The raw material was found in a loan, refined into a security, then sold to a SIV at a profit.
Starting around 2005, securitization began to rely more on short-term money-market funds for financing. Investors were loath to buy long-term debt of issuers that didn’t have a track record, so new issuers sold asset-backed commercial paper that matured in less than a year.
“It created a huge appetite for high-yield assets, far more than could be originated on a sound basis,” Ocampo said.
To accommodate demand, banks funded more subprime mortgages, with an average life of seven years, replacing car loans with an average life of three years and credit-card bonds paid off within 18 months.
Among conservative lenders, that rang an alarm: Bankers are taught to avoid such mismatched funding, in which a lender has to pay back money before the borrower has to pay the principal.
“We’ve created an absolute disaster,” said Nouriel Roubini, a New York University economics professor, who predicted the failure of investment banks in a paper he wrote in February titled “Twelve Steps to Financial Disaster.” “The reputation of the United States as a financial center and a leader has been tarnished significantly.”
Bear Stearns’s Cioffi, 52, was indicted on charges of misleading investors by assuring them that his hedge funds were healthy when he knew they weren’t. Cioffihas pleaded not guilty. He declined to comment.
The Bank of New York’s Bosh lost his job when his company was merged with Mellon Corp. in June 2007. He’s still looking for work.
“You try to do the right thing,” Bosh said. “And this is what happens.”
