What Goes Around, Comes Around?

I've often raised the issue of who the bagholders will be when the financial house of cards comes tumbling down. History suggests, of course, that there will be plenty of "little guys" in that group.

However, given the mind-boggling scale of excess, hubris, foolishness, and chicanery that permeated the financial world in recent years, it seems likely that the fallout will spread far wider than that.

From corporate and government leaders, to major businesses and financial institutions, to municipalities, agencies, and a host of nations, the list of those who will end up paying a steep price for what transpired over the course of a few decades will likely be quite a long one.

In "Who’s Going to Take the Financial Weight?" the New York Times' Floyd Norris writes about one group of bag passers that -- surprising to those who have not read their financial history -- has often ended up having the damaged goods passed right back to them.

The transfer of risk was supposed to be the great advance brought to the world by financial engineers. They developed exotic derivative products that enabled risks to be sliced and diced in all manner of ways.

Central banks and bank regulators cheered on the process. The transfers of risk meant that those who were comfortable with a given risk would wind up with it.

The apparent triumph of that process came after the technology stock bubble burst and the American economy went into recession in 2001. A lot of money was lost because of huge overinvestment in things like fiber optic cable, but the losses were dispersed. No significant banks failed or even got into trouble.

The system worked, the regulators told themselves as they praised the financial advances brought on by the derivative revolution.

Sometimes those regulators did wonder just where the risk was. If it was no longer the banks that would suffer when a financial crisis came around, who would? Could it be the insurance companies? Perhaps pension plans? Would hedge funds that gambled and lost be unable to meet their obligations and bring on a systemic failure?

In this financial crisis, the one that started with subprime loans, we are learning the answer to that question. The risks that banks would have taken on under the old system — when banks made loans and profited only as they were paid back — had been transferred through a bewildering wilderness of options, swaps, swaptions, specialized investment vehicles, collateralized debt obligations, variable interest entities and who knows how many other instruments.

And when the whole daisy chain was through, a lot of the risk seems to have ended just where it used to end. With the banks.

There were differences, of course. For one, the banks are ending up taking losses from loans that others made.

A suit filed this week in Federal Bankruptcy Court in Manhattan sheds light on one way this happened. American Home Mortgage Holdings, a subprime lender that went broke in August, sued Bank of America, saying it reneged on a deal to bear losses if mortgages were sold for less than face value. The bank asserts that some of the loans shouldn’t have been made at all, but American Home says that is irrelevant.

Here’s how it worked, in a simplified explanation that does not come close to capturing all the complexities that the financial engineers inserted:

American made subprime loans and sold them to special purpose entities it set up. Those entities, in turn, financed themselves by borrowing, mostly through the short-term commercial paper market.

To reassure investors, the special purpose entities entered into swap agreements with Bank of America and other big banks, in which the banks promised to make up the difference if the entities could not retain financing and therefore had to sell loans for less than par value. The chances of such a sale presumably seemed slight when the deal was made in 2004, but lots of unexpected things are cropping up these days.

In late September, American auctioned off the loans. Note that these appear to be loans made in 2004 or earlier, before lending standards are supposed to have crumbled.

We now have a market value for such loans. Packages of mortgages that were classified as performing — meaning the homeowner is mailing in a check every month — sold for as little as 80 percent of face value, and none went for more than 92 percent. The nonperforming loans sold in a range of 54 to 59 percent.

American Home says it sent out bills to its swap partners, and all but Bank of America agreed to pay.

The amount in dispute is just $25 million, an insignificant amount for the bank. But its refusal to pay may indicate an effort to find ways to shed what now seem to be foolish risks. The man in charge of that area of the bank was pushed out this week in a reorganization. The bank would not comment on the lawsuit.

There are other ways that banks may come to lose a lot of money. Jonathan Weil of Bloomberg News points out that Citigroup has no legal obligation to make up losses in the specialized investment vehicles — SIVs — it set up, but some analysts think it will do so to avoid a hit to its reputation. If it does put up cash, that will call into question the accuracy of Citi’s financial statements. If not, some of Citi’s customers will be very upset.

Not all the losses will end up with banks. Some will go to mutual funds and hedge funds and pension funds. Some will go to those who insured the value of securities, like Ambac Financial, which surprised Wall Street by posting its first quarterly loss this week.

Still, it is remarkable that the financial engineers generated large commissions and fees by selling risk-transfer products that, in the end, moved a lot of the risk back to where it started.

What goes around, comes around?

Comments

[deareieme]

Forgive this foreigner, but you say "meaning the homeowner is mailing in a check every month". Is that a metaphor, or do you in the US still pay regular bills by mailing bits of paper to each other?

[Michael Panzner]

Yes, it's true. In this respect, at least, many other nations are far ahead of the U.S.