Show me a cash flow, and I’ll build you a bond. That was my mantra when I was an early practitioner of the art I called “financial engineering.” Basically, I thought of ways to cut up cash flows so they could be customized for clients like banks, insurance companies and pension funds.
It all started with mortgages, and the earliest “engineered” bonds were simple sequential CMO’s (Collateralized Mortgage Obligations). We called a deal A,B,C,D when the principle from the mortgage borrowers first paid off class A, then B, then C and then D.
Banks would buy the Class A bonds because they more or less matched the stream of maturing CD’s the banks issued. Way out at the other end of the deal, life insurance companies could buy Class D bonds, which came closer to matching their obligations to pay off on life insurance twenty or thirty years in the future.
I call this kind of dividing up cash flows “time tranching,” because it makes different classes of bonds with ascending maturities, each bond beginning to pay principal only after the earlier class is paid off.
After time-tranching, we started prioritizing cash flow tranches using credit losses, interest rates and payment schedules. With just those methods of creating bonds from pools of loans, we had all the tools we needed to cut up cash flows to our hearts’ content, and a way to make money on Wall Street that lasted twenty-five years.
But I get ahead of myself.
My name is Howard Hill, and I spent my career creating bonds, buying bonds, selling bonds and studying bonds. I loved it. I even felt that I was improving the world by making housing more affordable (and I could prove it).
What I couldn’t do was share what I learned with the general public. Except for a brief period on the Yahoo Finance message boards before I got a job that required all public statements be run through the Compliance and Legal Departments, I only shared my insights in office discussions, client calls, industry meetings, and interviews with specialized financial reporters.
You may hate me as an inventor of structured mortgage bonds, but nothing is ever that simple. Over the weeks and months ahead, I’ll tell the story how these creations initially helped but later nearly destroyed our economy.
We won’t get there following a straight line. Instead, I’ll let the events of the day and market forces determine what bit of the big picture gets exposed and discussed in each post.