Fear And Greed: Securitization

US$, worth less, soon worthless?

There's been some positive feedback on the Fear And Greed post below.  However, some people are getting stuck on the explanation of securitzation.  Getting stuck on this point means the reader is paying attention and indicates the presence rather than the absence of intelligence.  Securitzation is a fuzzy game of mirrors and make believe.  Really. That's not a disparagement, but a true description.

Think about money.  Is there any inherent difference between a $5 bill and a $20 bill?  No, they are both paper with stuff printed on them.  The only difference is that we agree to pretend there is a difference.  For that matter, the only difference between paper money and any other bit of paper with printing is that we agree paper money is worth something and all other paper is not.  Paper money is completely make-believe, but as long as we all participate in the make-believe, it works.  At its heart, currency is a contract between the governments that issue the currency and the individuals that hold it.  The government guarantees that a $20 is worth $20.  Because currency is an abstract value made material, it is negotiable.  You can use a $20 bill anywhere in the country and it will be valued at $20 by everyone.  A $20 bill is a negotiable security.  A contract that you can transfer.

In practice, currency is non-negotiable.  $20 is $20.  But you and any 3rd party can trade a $20 bill for more or less than the face value.  The only time this really happens is when you convert one currency to another.  $20 might buy £10 today, but only £9.50 tomorrow.

Alexander Hamilton, the first US Treasury Secretary, inherited an enormous problem.  His solution created modern capitalism, literally.  The USA could not raise money because loans to a new, war ravaged, debt ridden republic were too risky for any bank in Europe or the  USA.  What Hamilton did was securitize the debt.  He sold bonds that were like a currency for lending money.  One could buy a 5-year, $1,000 bond that paid 5%.  It was a contract that paid the holder $1,250 in five years.  The math is way simplified, but true to the idea.  The key point is that the government paid the money not to the person who bought the bond, but to whoever held the bond at the end of five years.  If you bought some bonds, but needed the money before five years were up, you could sell the bond and thus the contract.  The security was negotiable.  A market could arise for the buying and selling of bonds by 3rd parties.  The risk of holding US government debt was dramatically reduced.  This idea was a great success, especially popular with those who ran the new markets or exchanges as they became known.

Needless to say, by now, everything that can be securitized has been securitized.  Every government and corporation big enough issues bonds.  Anyone can issue a bond on anything as long as someone in the market is willing to buy it.  Financial firms like investment banks are constantly looking for new things to securitize.  Unfortunately, due to tradition, practical considerations and law, not all kinds of debt can be securitized.  Mortgages have not been securitized in any major world market except the USA after 1999.  De-regulation swept away the legal roadblocks, and clever investment bankers figured out how to deal with the practical problems.  It worked like this:

• Consumer A borrows money for a house from Bank Z
  
• Consumer A has a contract (mortgage) to back the loan on a monthly basis for X years
  
• Bank Z takes Consumer A's contract and a million like it and goes to Investment Bank Y
  
• Bank Y takes Bank Z's contracts and bundles them up into a bond offering
  
• The bond obligates Bank Z to pay the bond holder N% of the bonds value for X years
  
• Pension Fund E buys the bonds from Investment Bank Y
  
• Investment Bank Y passes the proceeds of the sale back to Bank Z (minus transaction fees)
  
• Bank Z takes Consumer A's payments and passes part of the interest on to Pension Fund E
  
• Consumer A pays back his loan, Bank Z pays off the bond held by Pension Fund E and everyone is happy

The big winner is Bank Z, because rather than waiting 25 years to get all their money back via payments from Consumer A, they get it all at once by selling bonds to Pension Fund E.  They can re-lend or invest that money at a higher interest rate than they are paying Pension Fund E on the bonds.  Not only that, but they get to take Consumer A's mortgage off their books.  It no longer counts towards their reserve requirements.  As long as Consumer A and his million friends pay back their loans in a normal fashion, nothing can go wrong.  But, as we have seen, the money to be made by Bank Z and Investment Bank Y from issuing bonds came to be worth more than the underlying loans.  Regulations prevent this type of top-heavy imbalance in most countries because the market will eventually self-correct in a catastrophic fashion.  Think of the no-longer watertight Titanic's self-correction of the relative buoyancy of iron vs. water.   It takes time to devolve all the deals and swaps and exotic derivatives that grew up around the mortgage market.  But the market, now ruled by fear, won't give the players time, so they've started failing catastrophically.

Not many tears are being shed for the firms now getting walloped.  They had it coming.  Lots of people predicted this would happen.  Lots of firms stayed clear of this market.  But there are two potential problems for everyone.

First is a general drying up of credit.  If the banks are scrambling to restore their reserves, they may stop lending and even pull in good loans.  That could send viable companies into bankruptcy.  If the cancer of bad loans has spread beyond the housing market in the US, then its possible its spread into other countries as well.  More severe credit shocks may be coming.

Second is a run on the US$.  All of the bad loans were turned into real money and spent by US Consumers.  Where did all that real money come from?  China, Japan and other US trading partners who hold vast sums of US Treasury Bills.  They are hostages in a giant game of chicken.  If China sells lots of stuff to the US for US$, then turns the $ back into Yuan, the value of the Yuan goes up relative to the $.  The Chinese have to either live with lower profits, or raise $ prices, becoming less competitive.  So instead of turning the $ into Yuan, they park the money in US$ bonds.  This keeps the US$ artificially high vs. the Yuan.  If the US goes to crazy economically, the Chinese will sell the bonds, causing a crash in the US$.  But if they do that, then the Yuan vs. the $ goes up so much that Chinese firms can't sell profitably into the US market.  China's economy takes a huge hit.  When Japan was in this position 15 years ago, they let the currency imbalance fuel a real-estate bubble that has crippled their economy since.  China won't make the same mistake, but they are also playing a game of musical chairs that requires continuous growth.  Nobody knows what will happen when the economy slows, as it must inevitably do.  A US credit crisis, as described above, could dampen US consumer demand so much that it impacts the Chinese economy.  At a certain point, US trading partners may decide to cut their losses, sell US Treasuries, and get used to a world where they don't have to depend on the US for all their economic growth.  This could lead to a collapse of the US dollar and potential depression among the US and its closest allies.

But then, on the other hand, lots of people who make lots of money, and who want to continue doing so, are working hard on avoiding the bad case scenarios.  What goes around comes around, and nobody wants what the US financial markets have got.  The US government over the weekend demonstrated that it would be ruthless if necessary.  If the US financial market players demonstrate the same in a convincing manner, then the crisis can be dealt with in a slow and steady rather than a catastrophic manner.

Note:  The examples here are gross oversimplifications.  The details are important, but the purpose here is to strip away every detail that stands in the way of the key ideas.