Deconstructing Derivatives: The Tool Banks Use To Bet Our Money

As Congress considers rolling back the Volcker Rule, it’s time to understand the crux of the 2008 Financial Crisis: Derivatives

Jamie Dimon, JP Morgan & Chase Co. Chairman and CEO Monday, June 23, 2014, at JPMorgan Chase Headquarters in New York. JP Morgan's risk management office lost 6.2 Billion in derivatives in 2012. (Photo by Diane Bondareff/Invision for JPMorgan Chase/AP Images)

Jamie Dimon, JP Morgan & Chase Co. Chairman and CEO Monday, June 23, 2014, at JPMorgan Chase Headquarters in New York. JP Morgan’s risk management office lost 6.2 Billion in derivatives in 2012. (Photo by Diane Bondareff/Invision for JPMorgan Chase/AP Images)

Congress is considering rolling back the Volcker Rule for large banks. Understanding derivatives is key to understanding the Volcker Rule as banks will be allowed to make risky bets again with our money. They will soon be allowed to speculate in the perilous synthetic derivative market that nearly crashed our financial system. Before I can explain synthetic derivatives, I have to explain what a plain vanilla type derivative is.

“Derivative.” The very word freezes the mind and chills the heart – as it’s meant to do. It floods the mind with thoughts that it’s too complicated, it’s high finance, way above anything I can understand. But it isn’t. In its basic form, it is quite simple.

How big is the derivative market today? There is really no adjective that can capture it. It is estimated at more than $1.2 quadrillion. For those of us used to dealing in hundreds and thousands, that’s an impossible number to conceive. It is said to be 10 times more than the total world gross domestic product. In other words, most of the value has little relation to anything tangible and exists only on paper. We will see how that can be after we uncomplicate the unnecessarily overcomplicated explanations.

Derivatives were at the heart of the 2008 Financial Crisis and remain a serious threat to our financial system today.

Back in 2002, that intrepid investor, Warren Buffett, famously predicted that derivatives were “financial weapons of mass destruction.” One year later, he directed that comment to the astonishing amount of derivatives on bank balance sheets calling them “potential time-bombs.” Today, we know the exact date they exploded.

The situation has not changed. In 2013, Frank Partnoy teamed up with financial journalist Jesse Eisinger in an attempt to understand the 216-page financial statement of Wells Fargo. They chose this bank because it was (then) the most trusted of American banks (this was before it became the most scandal-ridden of American banks by steering customers into unnecessary accounts and car insurance- with other ongoing investigations).

Partnoy’s opinion is worth considerable weight because, not only is he a respected law professor, he was involved in derivative creation at Morgan Stanley before that. Partnoy concluded there were still dangerously large derivative positions on Wells Fargo’s financials that he could not understand or evaluate. What chance do we have?

Yet, understanding derivatives is the key to understanding the present frailty of our financial system.

Penetrating The Mystery

We owe Michael Moore for the best example of how the meaning of derivatives is either intentionally obfuscated, or not understood by bankers and some commentators themselves. Even eminent Harvard economists Kenneth Rogoff, who co-authored a book to not only explain the 2008 Crisis to us, but the other significant financial crises in history, stumbled at the attempt. If you watch only one YouTube video clip this week, watch this one.

A derivative is any investment that derives its value from another investment.

Let’s go back pre-2008 to see how they came about. One mortgage is just a mortgage but put a bunch of them together into one bundle and they become a derivative. We’ll give it the name Abacus-1 to distinguish it. One person is made the administrator to oversee this collection. Then the entire package of, or shares in, Abacus-1 will be offered to the investing public. This single package is a derivative.

A geek interlude: These investments are called Mortgage Backed Securities (MBS). If on homes, then Residential is added (RMBS). The process of assembling the mortgages into one package is called securitization. You might think that the word ‘security’ meant making something safer, but remember this is the banking system. For, as we now know, eventually this very process helped to disguise that it made the once very safe mortgage market, treacherous.

Our investment, Abacus-1 (a type of derivative), derives its value from the underlying mortgages. It has no value in and of itself.

We now see some wonderful advantages for investment banks. There is tight regulation over the sale of shares in the stock market; a business has to file a veritable box full of forms with the SEC. Buying a share in a company is fraught with many risks, but buying a bond, such as a treasury bond, was, historically, a straightforward transaction. A bond represents the agreement to repay a loan so no problem in evaluating the risk. If it’s from the U.S. government, certainly no problem. If from a corporation, also easy to determine the risk. Thus, the bond market was completely unregulated earning the name, “shadow market.”

A mortgage is the security for the repayment of a loan. Thus, the transaction – a loan evidenced in writing – is a bond; and thus there was no pesky regulator looking over the bankers’ shoulders. Even when grouped into one derivative, the derivative was still a bond. They were mostly traded Over the Counter (OTC). It was a highway with no speed limits, no white lines-and no cops.

Derivatives were often billion-dollar deals. Thus, another wonderful advantage is the creation of an immediate and gigantic pot of gold to pay banker bonuses- and anyone who could bring them customers. If the commercial banks or private mortgage lenders, who originated the mortgages, held onto the mortgages, they might have to wait some 20 to 30 years for a return of principal and their profit by way of interest. Now, they have the principal and a good amount of that interest up front.

The loans are off their books, so they have the ability to make more mortgage loans and continue packaging them as derivatives and selling them on-subject to capital adequacy requirements for commercial banks. This leads to the now universal originate-and-sell model of modern banking.

More on how the ability of commercial banks to make loans is restricted by capital adequacy requirements here.

Another geek point: It is worth considering in this context that private-label mortgage companies were also completely unregulated and called shadow banks. Hence we had shadow banks creating mortgages to be sold in the shadow markets. This was considered an ideal situation by the economists and policymakers who thought the problem was government regulation: the shadow markets can regulate themselves.

Deception By Complexity: The CDO (Collateralized Debt Obligation)

“The CDO became the engine that powered the mortgage supply chain.” The Financial Crisis Inquiry Report (p130)

The idea of roping off a group of residential mortgages into one collection to sell on to investors came from a financial innovator at Ginnie Mae (Government National Mortgage Association) in 1970. They consisted of mortgages to low-income earners with only a 5% downpayment that proved reliable mortgages.

Both Fannie and Freddie picked up the idea. These too proved, over time, to be reliable mortgages

This historical safe performance of these RMBSs and their interest rates above government treasury bonds attracted wealthy investor attention.

The investment banks had an investment package going back to the 1930s called a CDO- A collateralized debt obligation. The collateral was some form of mortgage or lien, the loan was the debt. Every loan in the CDO package was fully backed by a charge on a solid asset of some type. So far, simple to understand.

A CDO was a structured investment. The loans were separated into layers with the least risky being the top layer. The more risky loans in the layers below. The layers were given the French word for slice-tranche. So you could have AAA, BBB, CCC tranches, and so on.

Why choose an unusual French word. It adds some thickening to the fog.

While the top layer had the least risk, it also had the lowest return. The lower layers had more risk but greater returns.

However, the original bank generated CDOs had many types of mortgages or liens on many types of corporate assets supporting loans to corporations. The investment bankers saw the interest in the Ginnie Mae type and decided to assemble their own residential mortgage packages buying them from wherever, including the private mortgage lenders such as the notorious Countrywide Financial.

The Bait And Switch

Instead of just selling them in an easy to understand homogenous package as Ginnie Mae and siblings did, they were put into a CDO structure with other loans of various quality backed by mortgages.

The long, excellent track record of the original asset-backed corporate loan CDOs and the Ginnie and sibling RMBSs, made the conversion of the RMBSs into CDOs easily salable to the big but conservative investors like pension funds and insurance companies who wanted safety first in their investments. The rating agencies helped by giving them a AAA grade.

The residential mortgage CDO was a hit. Investment banks got a 1% commission (we are talking billion dollar packages, please note) for a few days work overseeing the assembly of the packet. A million dollars for a few days work! What might a banker be tempted to do to keep that money machine rolling?

And the investors with the big dollars loved them.

At the same time, the Fed, under Alan Greenspan, lowered the interest rate so treasury bonds were much less attractive than equally safe (so we were told) AAA-rated residential mortgage CDOs.

The investors took the bait. The demand was so great that the supply of qualified people who wanted new mortgages dried up.

Then came the switch: bank loan officers at the origination stage fraudulently concocted false applications with supporting credit and income evidence by cutting and pasting. Investment banks encouraged those banks to do it – and knowingly silenced their own staff who discovered the toxic mortgages that had been slipped in.

More on how the banks that originated the toxic mortgages and the banks that assembled the toxic CDOs engineered the fraud here.

A Real CDO Deal

In late 2006, John Paulson (no relation to Hank) approached Goldman Sachs to have it promote a CDO of residential back mortgage securities called Abacus 2007 AC-1, paying Goldman $15 million for its service. To give the image of independence, Goldman appointed ACA Management to select the mortgages. However, Paulson played a significant role in their selection. After the CDO was sold, Paulson bet that it would fail.

Of course, the CDO did tank and quickly. The client lost $1 billion. Paulson raked in, and kept, every cent of a billion profit on the deal.

Although it knew all, Goldman did not tell the purchaser of Paulson’s involvement in the selection of the mortgages and his bet against the CDO. Goldman defended its actions as this is the way business is done on Wall Street. It often has clients betting on opposite sides of a transaction. It didn’t see that it had done anything wrong.

Goldman Sachs is covering Fabrice Tourre’s legal fees as it attempts to clear its name by proxy Photo: AFP

The SEC charged Goldman and one low-level trader, the Fabulous Fab Tourre, a Frenchman living in London, England. We have a rare look at a banker’s sense of responsibility to client and country as his emails became part of the public record. Touree knew, indeed as all traders involved in arranging the CDOs must have known, they were, in his own words, ‘monstruosities’.

23 January 2007
“…More and more leverage in the system, the entire system is about to crumble any moment…the only potential survivor the fabulous Fab (as Mitch would kindly call me, even though there is nothing fabulous abt me…) standing in the middle of all these complex, highly levered, exotic trades he created without necessarily understanding all the implications of those monstruosities!!!”

(The senior partner, Mitch, mentioned above was not charged with any wrongdoing.)

There is no doubt that the bankers who created these increasingly complex CDOs well understood that the investments had little actual value.

29 January 2007
“When I think that I had some input into the creation of this product (which by the way is a product of pure intellectual masturbation, the type of thing which you invent telling yourself: “Well, what if we created a ‘thing’, which has no purpose, which is absolutely conceptual and highly theoretical and which nobody knows how to price?”) it sickens the heart to see it shot down in mid-flight…It’s a little like Frankenstein turning against his own inventor ;)”

And this banker felt not the slightest twinge of conscience knowingly selling these toxic investments to pension funds. To the contrary, it found it humorous.

13 June 2007
“Just made it to the country of your favorite clients [Belgians]!!! I’m managed to sell a few abacus bonds to widows and orphans that I ran into at the airport…”[1]

This curious sense of ethics was not confined to the banker community. There was a lot of sympathy in the media for Tourre. In response to the conviction, law professor Hilary Sale remarked, “But poor Fabrice. You have to kind of feel bad for him; he was just a kid.”
He was a 39-year-old kid who since 2001 earned millions knowingly selling toxic CDOs, often to pension funds, and, in 2007, had taken home $1.7 million. His fine, $825,000, was about half of only that one year’s compensation.

Goldman agreed to a fine of $550 million. Of course, not a hint of jail for anyone involved. What if a group of black kids had stolen $10,000. What would the attitude be?

Thomas Jefferson said, “I believe that banking institutions are more dangerous to our liberties than standing armies.” If you’re still not convinced that Jefferson knew what he was talking about, I will continue this examination of derivatives, especially the credit default swap, and their critical role in keeping our financial system weak for the benefit of banker bonuses.

Acknowledgment: My thanks to Steven Matteo Miller of the Fin Reg Rag for the link to the Goldman Sachs’ brochure on the mortgage-backed CDO offer.

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Opinion // Dodd-Frank / Finance / Money