The New Financial Excesses & The Old

Last Thursday's Wall Street Journal contained a wonderful article entitled "Wall Street Wizardry Amplified Credit Crisis."

I wasn't going to write about it, until I happened to be riding an exercise bicycle Thursday night, viewing a rerun of that old, rather misleading cinematic faux classic, Oliver Stone's "Wall Street."

Like much of his other semi-historical films, such as Platoon and JFK, Wall Street mixes some truth with a lot of untruths and improbabilities, delivering it with a straight face that causes the uneducated to believe it as whole cloth truth.

In the movie, as you may recall, Charlie Sheen plays the protagonist, Bud Fox, a young, struggling, newly-minted retail stock broker. Michael Douglas is cast as an Ivan Boesky-like arbitrage trader, Gordon Gecko.

In real life, people like Boesky didn't have anything to do with retail brokers. Instead, they focused on using information sources, sometimes illegally, including underwriters or printers, plus a network of others to help pump interest in positions Boesky and his ilk already had built, such as business media, institutional investors and institutional brokers.

Thus, the artificial pairing of Fox and Gecko made for a lusty, action-packed financial thriller which, in reality, never occurred. Boesky did ultimately go to jail for using insider information and manipulating securities prices by 'parking' stock with, I believe, Jeffries & Co.

What got me thinking about this post was how unreal and seemingly needlessly phony Stone's move was. In characterizing the go-go, 'me decade' financial scandals of the '80s, he simplified the stock price manipulations of the arbs in order to make it salable as cinema.

My, though, how truth can be stranger than fiction.

When I finished the Journal's superb post mortem of "Norma," a CDO facilitated by Merrill Lynch, I was totally incredulous that this sort of thing had actually transpired.

Mind you, I believe it. But it makes for incredible reading. Must reading, if you will.

For quite some time, I thought that the CDO and credit crises were largely the result of simple, bad credit risk practices, pumped by ballooning manufacture of the synthetic securities and distribution of them directly to institutional investors.

Not so, according to the Journal account of Norma.

Rather, according to the article, here is an illustrative example of 'worst practices' a la the late '00s.

Merrill recruited 'managers,' such as Corey Ribotsky, a former penny stock brokerage, to buy, assemble and distribute CDOs from Merrill-originated mortgages and derivatives. Norma is one such CDO which the article traces through its life to date.

By reading this article, I lost quite a few false beliefs in the process which has brought Merrill low.

Merrill didn't merely manufacture CDOs full of mortgages directly to bona fide institutional investors. Instead, they found and orchestrated the 'management' of CDOs full of their mortgages, and associated credit derivatives, by intermediary firms. These firms, such as Mr. Ribotsky's N.I.R., then held the resulting CDO, assembled with help from Merrill. Merrill then found buyers for NIR's CDO.

While NIR was not an SIV in the classic sense, it functioned like one. That is, while funded by buyers of Norma's debt, i.e., the ultimate investors, and wholly off Merrill's balance sheet, it was, nonetheless, wholly a creation of Merrill Lynch.

Norma, the CDO, didn't just contain mortgages. Instead, for reasons best left to readers of the Journal article to learn, it also contained credit derivatives, a sort of insurance policy/bet on mortgage defaults.

Then, later CDOs would use some of the more risky, or toxic, tranches of earlier CDOs. And so on.

What is particularly informative in the piece, and was news to me, is that, by virtue of the use of credit derivatives, CDOs became abundant due to the inclusion of many 'bets' on mortgage rates and defaults.

In essence, then, this allows us to now realize, clearly, why the financial mess of complex credit instrument valuations is quite distinct from the simple, underlying issue of basic home mortgage defaults. The volume of CDOs is far in excess of the value of underlying mortgage loans.

Way back in the 1980s, when my boss, Chase Manhattan Bank SVP Gerry Weiss, sent me to a CMO conference filled with S&L executives, I gleaned a related insight. Upon my return, I debriefed Gerry on what I had learned. The concept of securitizing mortgages to spread risk made sense, I said, so long as the true risk spreading value exceeded the haircut that Morgan Stanley, Salomon, Kidder and Merrill were taking on the business. I speculated that one could endlessly add layers of paper resecuritization to the process, merely massaging risk around, to not greater systemic benefit, but for additional financial fees.

This is, in essence, precisely what has occurred. By mixing in insurance contracts on mortgages, the credit derivatives, securitizers expanded the supply of CDOs far in excess of the underlying mortgage values. It is very much the same as writing naked call options. Anyone can do it, and the outstanding call options on an equity can, at any one time, far exceed the actual shares outstanding.

Thus, when we discuss the basic issues of mortgage defaults, bailouts, and losses thereof, we need to not count any values beyond the basic, first-tier mortgages.

To include CDOs is to begin to double, triple, and perhaps even quadruple count losses. Further, once these CDOs left the simple mortgage content, and became betting instruments, they ceased to really be related to the home ownership issue, and simply became new ways for institutional investors to make market bets on something.

For purposes of regulatory and political involvement in the recent, and ongoing, credit situation, one must, as a result of this piece, distinguish the basic mortgage origination situation from downstream packaging and distribution of securities which contain, but are not limited to, and exist in greater volumes than, the underlying mortgage loans.

To me, from a careful read of the Journal's fine article, one thing remains eminently clear to me- as it has from the beginning of my writing on SIVs and the credit 'crisis.'

Institutional and, if affected, retail investors received what they deserved. Given the incredible complexity, opaqueness, and suspicious provenance of these CDOs, anyone who bought them either: was too naive and inept to be doing so, and/or; thought they were getting 'free' return without commensurate risk.

No amount of regulation or legislation will ever limit the boundlessly creative types on Wall Street from dreaming up new, unregulated ways of packing and selling financial assets and risk to greedy, naive investors.