Black Ice

As an early winter blast shocks much of the northern half of the country, I’m reminded of one of those hazards that we face in places where the daytime temperature is above freezing, but at night the melting re-freezes. It’s especially dangerous at night on blacktop, and if you’re on an unfamiliar road, you may well end up off in a ditch or worse.

For you southerners, the issue is that the road looks completely clear, yet even twenty miles an hour may be too fast to negotiate a curve on the slick surface.

Now imagine you’re driving your brand new car on a cold, dry night and you hit a patch of black ice where there shouldn’t be any. If you’re on a curve in a wooded area, you run a good chance of totaling your brand new car.

Now further imagine that if and when your car gets smashed, someone you don’t even know collects $2 million. What if that “someone” or one of his friends likes to pour buckets of water onto roads on cold winter nights?

That may well be what happened to the mortgage business, at least for the half of the mortgage business that had no direct or implied government guarantee.

When the Credit Default Swap (CDS) business was born, it was presented as a way to let owners of bonds or loans to companies hedge their risk by buying insurance. That it was a kind of insurance is clear from what they called it: buying protection on a credit.

Needless to say, it only makes sense to buy such insurance from a very safe counterparty, so the standard practice was to demand some collateral from any issuer of such insurance unless that issuer (“writer”) of credit protection was the very best credit themselves (AAA).

Why would someone offer to sell such insurance?

The simple answer is to make a profit, of course. But how?

First on the list of reasons is the potential to make enormous returns on capital. If you’re a AAA rated entity like AIG or Berkshire Hathaway, your counterparty is going to trust that you’re good for the money if the credit defaults, so you may not have to put up any capital at all, and you can simply collect the insurance premiums from the buyer of protection. In the world of credit, this is nirvana – infinite leverage!

You might also be interested in buying a bond or making a loan to a company that doesn’t need to borrow money right now. By selling CDS protection on that company’s credit, you can get the same effect – regular payments of interest near that company’s rate, with the potential of principal loss if that company defaults. It’s just that you are collecting those payments from a third party who is making a bearish bet against that company, or who needs to hedge exposure to that credit that they already have.

The best part of this arrangement as a protection seller is that you don’t have to use up your own cash to buy bonds or make a loan. We call it “getting exposure” to the credit, and we call the entire trade a “synthetic” bond.

A final reason to sell credit protection is that it can be more attractive to make an investment synthetically if there are tax (withholding, for example) or foreign investment rules that make direct investment difficult or expensive. Also, there is no limit on how much exposure an investor could get synthetically, and no one had to know but the parties to the contract. It’s the last fact that made the CDS market into Frankenstein’s monster.

The monster first showed up in public when the US auto industry was in its slow spiral into the ground, and Delphi, the former GM parts division, declared Chapter 11. Most CDS until then specified that, in order to be paid the principal for the defaulted bond, the buyer of CDS protection had to deliver the actual bond to the seller. In that way, it was like letting the insurance company take your wrecked car away for scrap in order to get the check when your car is totaled.

The fact that the CDS market is completely unregulated wild west capitalism became apparent when it turned out there was more insurance in place than there were bonds available to deliver. Most of the buyers of Delphi protection weren’t bond owners at all. They were simply betting against Dephi’s survival by purchasing insurance.

The work-around for the situation was extraordinary – literally hundreds of banks, hedge funds, pension funds and other institutional investors all had to agree to an after-the-fact change to their contracts to settle for cash instead of delivering bonds. Even more extreme was the agreement that every contract would now specify that a group of Wall Street dealers would establish the price upon which the cash settlement would take place.

Stop and imagine that for a second. Not one of those institutions decided to hold out for a “better deal” or to see if they could get all the others involved in the trade to pay them off. That gives you an idea how drastic the situation really was.

Once the work-around was in place, the CDS market was free to go crazy. At its peak in 2008, there were nearly $60 trillion in CDS outstanding, according to the Bank for International Settlements (BIS). Mind you, no one knew who held them, who was long and who was short, or where the concentrations were. One thing is for sure, there were some credits that lots of players loved to hate, so those had many many times as much insurance outstanding as there were bonds.

Subprime mortgage bonds was one of those most-hated credit types. When I wrote the introductory article about the index of 20 subprime bond deal CDS called the ABX for a Euromoney Magazine book, there were already 50 to 100 times as many BBB CDS as there were bonds in the index. That was only six months after the index was introduced in 2006. It only got worse.

So how was this used to create the “black ice” that crashed the mortgage lenders?

Easy, really. Once the bears overwhelmed the bulls and bought hundreds of billions (possibly trillions) of dollars in protection, they could point to the index as the only “visible” price for those mortgage bonds, and call their reporter friends to say that the banks that held the bonds, or the loans, were insolvent. Some of the bears publicly said they were considering suing auditors if the accountants didn’t use those prices for every subprime bond, even bonds that willing buyers and sellers traded privately at much higher prices.

Needless to say, once the lenders couldn’t raise any capital, and couldn’t sell or securitize their loan portfolios, the ability of potential home buyers to finance purchases dried up.

What happens to any market if half the buyers disappear? What happens to the unfortunate few that have to sell their houses? Answer: prices decline, rapidly.

Once the spiral downward began, even prime mortgage loans made with 20% down payments were “underwater”, and once again, people whose life situations forced them to sell were forced to default instead.

And here we are. All of us are paying for that insurance in our bailout of AIG, the banks, and Fannie and Freddie. What about the people who bought insurance on those bonds they didn’t own? They got multi-generation rich, and probably set up their funds offshore so they didn’t even pay taxes, and won’t pay any more than capital gains if and when they bring the money back to the US of A.

All of us are also paying for that insurance in the decline of the value of our houses. If “affordability” – the measure of how much of the average person’s income is needed to buy the average house – is any gauge, we have already reversed the “bubble”, and now we’re working on reversing all the gains in household wealth since World War II.

At least we have new crew of trading heroes to read about in Forbes. They didn’t make anything, invent anything, or even particularly entertain, but they did become billionaires. What they did was recognize a good trade, and jump on it.

In case you’re wondering, the losses from mortgage CDS were far, far larger than the losses from all the subprime mortgages, combined.

There were only $1.2 trillion of subprime mortgages outstanding at the absolute peak. Roughly half of them paid off already. Most of the other half are on their way through the foreclosure meatgrinder, so $400 billion seems like a reasonable guess for the eventual loss to lenders.

When Fannie Mae was taken over by the Feds in September of 2008, the CDS settlement on that one name resulted in over $360 billion changing hands from the protection sellers to the protection buyers. Fannie’s CDS settlement was just the very public tip of a huge private financial iceberg.