How David Bowie nearly blew up Wall Street - Part 2

To recap from last time, courtesy of a clever idea from some financial wizards, sober bankers like Capt. George Mainwaring suddenly had a solution to the age-old problem of managing the risk of borrower default in their mortgage portfolios. They could suddenly do two things with their mortgage portfolios:
Firstly, they could "sell" their mortgages more easily, by putting them into a format which allowed economic interests in the mortgages to be transferred without the transfer of the mortgages themselves. This is "securitisation" - which means "turning into a debt security" - a debt security being banker jargon for a bond. Bonds are like bank notes: they are easily transferred: mere possession of a bond is enough to prove you own it.
Bonds are, in this way, very different from mortgages. A mortgagee lender not only has to prove the existence of the loan by means of signed, witnessed loan contracts, but also needs to register the mortgage with  the land transfer authorities.
Now the ability to sell mortgage portfolios by itself wouldn't be that big a deal, as any buyer would wind up with exactly the same problem that the seller had in the first place: a buried, impossible to predict, risk of borrower default. But securitisation enables many buyers to buy small  shares of the same portfolio. This permitted trick number two, which is the "special sauce".
Say you are Captain Mainwaring, and you manage a portfolio of a hundred mortgages for your bank. If you arranged these in a 10 x 10 grid, and marked the defaulted mortgages with an x, it might look a bit like this:

That is to say, defaults randomly dispersed all over the place, with no rhyme or reason to how they came about. Since you can't predict which loans will blow up, it doesn't really matter how you look at it: Captain Mainwaring has this risk. Assume that in normal economic times, about 5% of all the mortgages are likely to go bust.
But look what happens when two people share ownership of the portfolio: an ambitious investor can say: Tell you what, if you pay me three quarters of the total interest due on all the mortgages, I'll take all the defaulted loans into my share of the portfolio first. That way you'll get less interest, but you have much less risk: you'll get all your interest and principal back unless there are so many mortgage defaults that I lose my whole investment. So we can rearrange our mortgage portfolio to represent this:

Because Investor B has agreed to take all the first losses, Investor A is able to confidently say that, until Investor B is wiped out in full, it has no risk on its portfolio.  Investor A has a "second-loss" risk on the portfolio.

This technique of packaging a mortgage portfolio up into a securitisation and selling it into the capital markets as a bond instrument became to be known as the "Originate and Distribute" model of mortgage finance. Instead of lending money and keeping the "assets" represented by mortgage loans on its books for thirty or more years (the "Originate and Hold" model), a lending bank can immediately "sell down" its risk in the capital markets for a repayment in full, without bothering the borrower of the loan.

This is attractive because we are able to slice the portfolio into high risk "equity" part, and a very low risk "senior" part. In the example above, before Investor A (the "senior" investor) starts to lose any money, there would need to be a 20% default rate in the total portfolio (that is, all of Investor B's portfolio would have to have defaulted). This, the logic goes, is highly unlikely given the usual means of assessing probabilities, which put the risk of default in the portfolio at no more than 5%.

And so, were the usual means of assessing probabilities  to apply, it would be. The problem is that, for two reasons, usual rules of assessing probabilities (that apply a "normal" distribution to events) are a misleading guide. 

On of those reasons is fascinating, but complex, and I couldn't cover it in detail in this post without getting completely side-tracked. Suffice to say, where humans interactions are concerned, "normal" distributions are often misleading because human actions tend to influence each other (that is, once one person defaults, that makes it all more likely that others will too). A "normal" distribution assumes all events are independent of each other, and therefore have no influence on each other. 
Interdependent human events follow tend to follow a "power law" distribution, which has a much longer and fatter "tail" than a normal distribution. If you are interested in reading about this I heartily recommend a few books: The (MIS)Behaviour of Markets: A Fractal View of Risk, Ruin, and Reward by cassandra-like French Mathematician Benoit Mandelbrot, The Black Swan by Nassim Nicholas Taleb, and Critical Mass by Philip Ball.
The other reason is related, but subtly different: The very act of creating a securitisation and changing the to the "originate and distribute" model itself changes the probabilities, because it changes the parties' interests.
Mortgages tend not to default immediately. Usually even a poor creditor will manage to make payments for six months or a year. When you originate a loan you know you'll be stuck with for 30 years, you're very careful to pick borrowers whom you think unlikely to default at any time. Having a close and personal relationship with your borrowers enables you to make these assessments with a relatively high degree of comfort - hence the relatively low level of historical defaults on mortgage portfolios. Banks of Capt. Mainwaring's persuasion used to be prudent lenders, because it was in their interest to be prudent.
Note how that dynamic changes with the originate and distribute model:

• Firstly, Banks who expect to quickly "sell down" mortgages they originate have less interest in the long term creditworthiness of the borrowers: once the securitisation is completed it is "somebody else's problem" as they no longer have risk to the borrowers at all.
• Secondly, Securitisation investors have far less ability to assess the credentials of mortgage borrowers as, unlike originating banks who lend the money, securitisation bondholders have no direct relationship with borrowers at all, and far less information about each loan. Instead they tend to rely on general due diligence done by rating agencies who are retained by originators to provide a ratings valuation for the securitisations. Rating agencies are a fit subject for another whole post.
• Thirdly, Securitisation investors have less ability to do anything should mortgages start going bad: they are reliant on third party mortgage servicing companies, who, unlike originating banks, have no "skin in the game".

We know that mortgage lending standards "relaxed" markedly in the late 1990s, and the world was bequeathed concepts like "self-certifying mortgages"; acronyms like NINJA "no income, no job, no assets", and from personal experience I know it became a lot easier to borrow a much higher multiple of income. It also didn't help that interest rates were extremely low throughout the 2000s - in England, a rough and ready average of the rates was far lower than it had been in the preceding 25 years, not exceeding 6% at any stage:

This is significant because it becomes easier to make money out of property if your cost of financing that property drops: Simply put, if you borrow £100,000 at 10% per annum to buy a property, your property has to increase in value by £10,000 in a year for you to even break even. If you borrow at 0.5%, then it only has to increase in value by £500!
These lower interest rates and a greater availability of mortgage lending meant it became viable to invest in property as a sort of investment, and before long it became almost mandatory, to avoid "falling behind": 

By now, I hope, you'll see that a perfect storm was developing, and all these little developments were feeding into each other and egging each other on: Banks were now able to quickly sell their portfolios, and so were less incentivised to apply strict lending criteria. Rates were dropping, making it more compelling to invest in property. Given the returns to be had on property and the low interest rates, demand was picking up for residential property, which in turn caused property values to rise, creating more demand for mortgages, and more demand for securitised product. A classic bubble was developing. 

CDOs: how David Bowie overcame Dad's Army and blew up the world

Collateralised Debt Obligations – “CDOs” – are yet again hitting the news, and predictably enough, are being described as diabolical tools of mendacious investment bankers.
It has never been my agenda to deny that investment bankers are mendacious, but there was some method in the madness surrounding residential mortgage-backed securities (“RMBS”) and even CDOs. So I thought it might be worthwhile explaining the idea mortgage securitisation, how it got started, how it seemed like a really good idea, how it went wrong and how, if it is properly managed and understood, it actually is a really good idea. If we are to stop this sort of meltdown happening again, rather than just blaming greedy bankers (which is fun, I grant you) it's better to understand what happened in the first place, identify the problems so that we can all get the best out of the idea of securitisation without exposing western civilisation as we know it to risk of systemic implosion.
This isn’t easy when lawyers, rating agencies, accountants and, yes, investment bankers have a way of speaking which is precisely intended to make what they do sound harder than it actually is. As we all know, every “expert” in the world does this: it’s how you justify your fee.
Cards on the table: I’m not only an investment banker, but a lawyer to boot. I have tried to rein in my natural tendency to overcomplicate.
To help me explain I've invited along two personal heroes of mine: Captain George Mainwaring, commander of the Walmington-on-Sea home guard but more importantly bank manager to the local community, and David Bowie, chameleonic media superstar and living work of art (he’s a sort of multi-media installation) who has, over the decades, adopted many personas and forged many new directions, but none so memorable as his starring role in the early days of asset securitisation. You think I’m kidding, don’t you.


PART ONE:
The background: in which we talk a lot about the ordinary business of mortgage lending from the bank’s perspective. In summary: It isn’t easy managing a large portfolio of mortgages.
Banks – old fashioned, proper banks – do two things: They lend, and they borrow. The money a bank borrows is a liability, which it will eventually have to repay, and the money it lends is an asset, which will earn the bank income. Much of a bank’s borrowing takes the shape of customer deposits. Much of its lending takes the shape of mortgage finance: lending to people like you and me so we can buy our homes.
As with any business, the general idea is to make more money out of your assets than you spend on your liabilities. Therefore, a bank wants the income from its portfolio of mortgage loans to be greater than the interest it must pay on its deposits.
This is one major thing a bank must do: manage its “market risk”: ensure that the income due on its assets is more than enough to pay everything it owes on its liabilities.
This isn’t just a simple matter of making sure mortgage interest rates are higher than deposit interest rates (though that sure helps!). For while a bank has no choice but to meet all its liabilities, whether it receives all the income due on its assets is out of its hands: Mortgage holders may go bust, after all.
The risk that that a debtor might not repay a loan is called “credit risk” and it’s very different to market risk.
Now while market risk can be very complex, banks are generally pretty good at managing it. It can largely (but not entirely) be worked out if you’re very good at maths and have sufficiently sophisticated computers.
Credit risk, on the other hand, is not so easy to calculate. The history of finance is strewn with companies that seemed to be extremely creditworthy, but turned out not to be: Enron, AIG, and Lehman Brothers are rather stark examples.
But, here, we're not talking about Enron and AIG. We're talking about people like you and me. While there are hundreds of analysts ready to pore over Enron’s books (and they still got it wrong) it’s a lot harder to do that for little people like mortgage borrowers. There all you have is s branch manager, Captain Mainwaring, checking that his customers’ prospects are good enough that they’ll pay on time. Mortgages are very long term investments - up to 30 years – so there’s plenty to worry about. No matter how careful Capt. Mainwaring is, it’s a safe bet that a small proportion of his customers will go bust. The question is how many.


Mortgages (relatively speaking) are small financial contracts, and most banks can afford to lose £100,000 here or there as long as they’re making enough out of their “good” assets to compensate. But even though each loan is insignificant, the total value of a large portfolio of mortgages quickly becomes very significant. It's important that Capt. Mainwaring is doing his job “on the front line” therefore, and being careful who he decides to lend to, and keeps an eye on his customers as long as they have mortgages with his bank. A good bank manager might be able to head off a problem or two, and over a whole portfolio that might make a difference.
You knew all of this stuff, right?
So look at dear old George Mainwaring, contemplating his mortgage portfolio. He can be fairly confident a certain percentage of the loans will go bad but, of course, he doesn’t know which ones (if he did, he wouldn’t lend to them!).
This is where statisticians and actuaries come in. Statiscially, for a given portfolio of houses, a given number of borrowers are very likely to default, and a larger number are quite likely to default, and a larger number have a low likelihood of defaulting (it's all that statistical fun with standard deviations and so on). So managing the credit risk of the mortgage portfolio involves calculating those probabilities as accurately as you can, and that in turn involves knowing as much as you can about the lenders and their financial circumstances.
Even a small change in the default probabilities can add up to a big number on a large mortgage portfolio: in a portfolio of 100,000 mortgages of £100,000 each a 0.1% change in default probability equates to £10 million. So there’s some big risk there, but it’s buried in a very big portfolio (the total portfolio value in this example is £10 billion!).


Quick sidebar: A mortgage is a classic banking product: A special, private, carefully monitored contract between a bank (represented by Capt. Mainwaring) and a private customer. It has a long term (usually 20-30 years) and can only be repaid early in certain circumstances. As long as the customer keeps up its payments, the bank cannot ask for its money back before the term of the loan. Because the bank can’t get out before maturity mortgages are called “illiquid” investments. They are hard to “liquidate”. By contrast, savings deposited in a bank account are on call. That makes them very “liquid” indeed. For now, note that a bank which finances illiquid assets with liquid liabilities has a “liquidity mismatch”: If customers withdraw their money suddenly, it is stuffed.
So banks like to look for ways to make their term loans more liquid. Since they can’t ask the customer for their money back, they have only one alternative: they can sell their loans. Under a loan sale, the selling bank transfers all its rights to be repaid principal and interest to the purchasing bank, and the purchaser pays the outstanding amounts due on the loan to the seller. Instead of the customer repaying the loan, the purchasing bank does.
Banks do “trade” loans, but it is not common for little mortgage loans, because a purchasing bank doesn’t want to hold an illiquid asset like a mortgage any more than the selling bank does. And the cost and hassle of transferring mortgages is prohibitive. There’s all that monkeying round with title registration and mortgage deeds.


A few years ago a some clever bankers came up with a way of allowing banks to easily sell their mortgage portfolios. This technology was called “securitisation”. A celebrated and pioneering example of a securitisation – of songwriting royalties – was David Bowie's "Bowie Bond", under which the Thin White Duke sold his rights to future royalties to a securitisation company which financed the purchase by issuing bonds secured on his catalog of songs. Investors took the risk that his songs wouldn't yield that much money. Small risk, as it turned out, and Bowie now has his song catalogue back, and investors were repaid in full. There: some securitisation stories do have a happy ending.
Under a mortgage securitisation, a bank would sell its mortgage portfolio to a company which would finance the purchase by issuing bonds “backed” by the portfolio it was buying. A securitisation therefore is, ironically, itself rather like a mortgage loan.
And here’s the clever bit: The mortgages (illiquid, term loans, very fiddly to transfer) have now been “repackaged” into a new format: bearer bonds called “Asset-Backed Securities” (commonly abbreviated to “ABS”). ABS are freely transferable securities, like shares. You can easily buy and sell them without bothering the mortgage borrowers. In this way one of the big risks associated with mortgage lending: being stuck with the portfolio for 30 years – was largely resolved.
But - and little did anyone realise this - a much bigger problem was created.

From our Foreign Correspondent... a working theory about Warsaw

This one coming at you live, courtesy of the cellular network, from the steps of Pałac Kultury i Nauki in downtown Warsaw, an unwanted gift from Stalin to Poland, a solitary long-lost cousin to Stalin’s “Seven Sisters” in Moscow.

This is my fist visit to Poland, and some forty minutes of daylight into it, the excitement of being in a genuinely former Eastern bloc country hasn’t worn off. I walked through the catacombs of underground newsagents and jewellers around Warsaw’s central railway station and then around the Pałac this morning and have wound up on the steps in the shadow of a suitably heroic working class statue looking to kill some time before my meeting and, I suppose, looking for some evidence to fit my working theory about the place: I always do this in a new locale: try to figure it out, in very basic terms. What makes the people tick; why do they do what they do; how will they react to me. It’s a form of preservation. This morning, my theory’s predictably unimaginative: the Poles are a defiant and long-suffering people still overhung with the shroud of Mother Russia, nonetheless looking west, the rude shoots of sprouting capitalism pushing gaudily through cracks in the concrete of the former era, today’s inhabitants caught uneasily in the crosstalk between two incommensurate regimes.

And, of course, I find plenty of evidence of that sort – you don’t have to look for long: the grand Soviet building, a sort of stunted, baroque Empire State Building, formerly grand but latterly muted; hemmed in – besieged – by parked western European cars; its heroic spire now barnacled with cellular receivers and satellite dishes; its heroic working class figures and athletes strangely emasculated (Discobolus modestly wears underpants, a variation on the Greek ideal I’d not seen before), and just across the street, a block of new and shoddy skyscrapers, like ugly priapic weeds, thin vertical high-rises boasting, to the memory of Marx and Engels, sacrilegious names: Hotel Intercontinental; Sharp; Bank Austria. As a piece of municipal scenery, the Pałac bears the comparison well: it is no Chrysler Building, but it has a permanence and grandeur singularly lacking from the more modern constructions in its environment. In a century, it will still stand; I wouldn’t lay that bet about any of the new buildings. Still, all the time its Communist roots are being re-explained. Stalin, who commissioned the structure, has been obliterated from the book – literally, a volume carried by one of the bas-reliefs has his name plastered out (Marx, Engels and Lenin lived on to tell their tale), as part of a process apparently known as “de-Stalinisation”.

Back to my working theory. Unimaginative it may be, but it’s a coherent and simple theory, if outrageously condescending – I’ve barely been in the place half an hour – and it is one I presume locals wouldn’t recognise. They’d see it as either utterly false, or at least so ignorant of nuance, undercurrent and competing cross-current as to be meaningless and worthless to a local who must to navigate the cultural and social dynamics of this place every day. Communism died twenty years ago, it was only around for seventy years in the first place, and in that time other transformative revolutions would have affected life more profoundly than any centrally planned economy could, no matter how oppressive (the Second World War, for one). And Poland wasn’t invented in 1918, after all.

Painting with a broad brush and the limited palette of a narrow (or ignorant) historical perspective is a tourist’s luxury (and prerogative); a tourist’s picture isn’t designed to be heavy duty or to carry much content (enough to make for an interesting trip and competently flag down taxis and order coffee). A six month stay in Warsaw would be a different proposition and might yield a very different and more detailed painting; I’d be obliged to flesh out my telling of the Warsaw story a very different way. But there would be vestiges of my caricatured first impression.

That is how, invariably, we arrive at conclusions. My strong suspicion is that, in most walks of life, when confronted with a novel situation, as a point of entry we exercise our tourist’s prerogative: form preliminary views based on whatever small and imperfect knowledge we happen to have, and if none, draw analogies to things we do know, test them, meld them, fine tune them. What we don’t – can’t – do is come at a new situation with a completely open mind. There is no point at which we have no view at all – there is no “perfectly rational and unbiased” stance.

But observe that as we progress from our rough-hewn preliminary working model, assuming we don’t immediately reject it outright, as we progress in our understanding, our hypothesis will grow increasingly more elaborate and sophisticated (in the sense of being detailed and complex, as opposed to “representative of reality” as such). Assuming it survives, the more detailed and complex it is, the better will be able to fit “facts”, though there may be isolated portions that don’t reconcile awfully well (if they really are isolated from each other we will tend not to notice the discontinuity and in any case it won’t matter much). At length we will have invested a lot of time and energy and we may find our initial hypothesis has spawned new hypotheses, applications we hadn’t originally contemplated and, as a result, we have new analytical techniques available to us.

All this hard work is cumulative and is put to good use, and none of it is predicated on the original rough-cast view being accurate, as such. But something else happens as our hypothesis progresses in complexity: the opportunity cost of abandoning it increases. In the first half hour of my visit I ran two or three working hypotheses and quickly rejected two; six months afterwards I have invested a great deal of energy, and achieved some workable success, with the one that remained: the price of throwing it away now and starting from scratch becomes increasingly unpalatable unless there is something jarringly wrong with it.