Wall Street Law Blog

How Wall Street Manipulated the Risk-Reward Tradeoff (updated)

Did The Sheer Complexity of MBS, CDOs, and related "Structured Products" Enable Wall Street to Cheat Investors out of A Reasonable Risk Premium? 

 

 

An impromptu analysis of securities fraud and the mortgage securitization boom that led to the great 21st century Financial Crisis.  

If pressed to identify one factor that made Wall Street's subprime securitization frauds of the last decade so successful (as of this writing, it cannot be credibly argued that these mortgage-based frauds were anything other than an enormous financial success for most of the individuals who ran major investment banks), we would select complexity as that one factor.

In this post, we attempt to explain how we believe the big banks used complexity to disguise risk and con the markets.  

 

Background: Investors bought subprime mortgage bonds for a simple reason. 

For most of the housing bubble era, AAA-rated tranches of nonconforming mortgage bonds (those backed by subprime mortgages and alt-a mortgages) offered investors slightly higher returns than other AAA-rated bonds.

 

Since the risks were ostensibly the same for a mortgage bond carved out of a AAA-rated tranche of an MBS or CDO and other AAA-rated securities, Wall Street knew that most big institutions would choose to buy the higher yielding mortgage bonds.  And this is precisely what happened. 

 

As the housing bubble expanded, investor demand for private label MBS and CDOs seemed insatiable.  Only when market conditions changed enough for the investments to be exposed as the frauds that they always were did investor demand finally disappear.  By that point, however, the personal wealth accumulated by senior management at the major Wall Street banks from securitization and sales of fraudulent mortgage bonds during the 2000s was staggering. 

The housing bubble era was, in sum, a short-term money grab.  Management enriched themselves at the expense of the shareholders they were obligated to serve (not to mention the financial health of most nations on Planet Earth).

 

"Fraud by Complexity": Hiding Risk from Investors.

During the housing bubble era, very bright people designed mind-numbingly complex financial products to conceal risk from investors.

Bear Stearns, Lehman Brothers and the rest of what were the big 5 investment banks (and a group of other powerful financial institutions) knowingly marketed and sold high-risk mortgage bonds to institutional investors all over the world for years as if those risky investments were, instead, extremely safe AAA-quality securities. 

 

Indeed, we believe that complexity is the ultimate x factor that allowed Wall Street to collude with and/or bribe credit rating agencies, which then stamped securitized subprime/Alt-a mortgage bonds with AAA credit ratings.  It was complexity that allowed investment banks and rating agencies to construct formulas and models with bogus inputs and flawed assumptions to "justify" what investors now know were fraudulent credit ratings.

 

It was, of course, the vaunted AAA credit rating that guaranteed a massive market for dodgy (to put it mildly) mortgage bonds for as long as market conditions were such that the true risks of those bonds remained hidden.  When the housing bubble popped and mortgage defaults spiked, firms like Lehman and Bear Stearns kept up the pretense of quality for as long as they could. 

Thus, management at most (though not all) of the big banks squeezed as much personal profit as possible from their fraud factories before mortgage defaults inevitably reached high enough levels, in or around early 2007, to undermine the credibility of previously unquestioned AAA credit ratings. 

When the number of investors who began to doubt the credlt-ratings for mortgage bonds hit a critical mass, the scheme reached a tipping point and the game was up. 

From summer 2007 on, the handwriting was on the wall for the few that, like the big investment banks, were privy to enough information to read it. Soon came the foreseeable, indeed the inevitable, flight to quality that is a core feature of all bond market panics.

 

Flight to Quality

In a flight to quality, investors try to dump everything that is touched by uncertainty and move as much money as possible into investments that they know are safe.  Most often, that means a mass movement of money into Treasuries.  When investors began their flight to quality, demand for mortgage bonds essentially disappeared.  From that point, those on the inside knew, or should have known, that there was no stopping the dominos from toppling.  

 

Concealing Risk; Paying Lower Risk Premiums

Complexity of structured mortgage bonds - from mortgage-backed securities to even more complex CDOs, CDOs-squared, Synthetic CDOs and so on -- was intentionally exploited by Wall Street to hide risk.  By concealing the true risk of these investments, the Bear Stearns and Lehmans of the world manipulated the risk-return tradeoff (from econ 101) so that these financial institutions could profit by paying far less return than is warranted by the risk of these products. 

If a bond issuer uses deception to convince investors to accept a lower risk premium (a lower yield than would be required if the true risks were known to investors), then the issuer fraudulently profits from the difference between the comparitively high risk premium the investment should require and the low yield that is actually paid out.

 

The beauty of this type of scheme, of course, is that -- until the foundation finally caves in -- investors actually believe that they are getting a generous return because the yield is a bit higher than Treasuries and other AAA-rated investments. 

 

The truth, hidden from investors, is that the return on mortgage bonds blessed with bogus AAA-ratings was far too low given the risk of these products.

 

As for those executives who claim they did not understand their own businesses, remember that fraud includes intentional misconduct and wilfull blindness.  

Hiding the true risk of mortgage bonds produced well-documented windfalls for Wall Street's top executives and their lieutenants, even as many of those executives presided over the destruction of the companies they managed on behalf of thousands of public shareholders.  

 

Conclusion: A "AAA-Rating" Does Not (Necessarily) Equal "AAA-Quality"

The fact is that these banks knew the majority of the AAA "private label" mortgage bonds they peddled in the 2000s were high risk, but not high quality.  

 

The banks knew the true risks of subprime MBS and CDOs, but few investors had access to sufficient information to decipher these risks for themselves. 

Instead, investors justifiably relied on the representations of mortgage traders and salespersons and especially on the supposed integrity of credit ratings. Today, we all know what the big banks knew all along -  

AAA is in the eye of the beholder.

 

By Brett Sherman, Wall Street Law Blog

 

Leverage, the Downside; An attempt to simplify

Leverage, which is usually expressed as a ratio, is a comparison between a company's debt and its equity.  Put more simply, a company's leverage ratio expresses how much it borrows (debt) versus how much it owns (equity). 

 

Thus, if-

(a) Investment Bank X has $100 million in cash and securities on its balance sheet; and

(b) $10 million of X's balance sheet is equity capital; and

(c) the remaining $90 million is funded by debt (bond issues, bank loans, commercial paper, repurchase agreements, etc.), then

(d) Company X has $90 milion in debt and only $10 million in shareholder equity, so it is leveraged 9:1 (If the company was separated into little $10 segments, shareholders owned only about $1 dillar for each of those segments. segment  company x borrowed the other $90)creditors paid for owned $90 of each $100 dollar segment of the company it borrows $90 out of every $100).  Reduced to its least common denominator (remember algebra?), Company X has a leverage ratio of 9:1.  So far, so good, right?

NOW, by the end of 2007, some of Wall Street's old school investment banks -- Bear Stearns, Morgan Stanley, Lehman Brothers -- were leveraged at ratios above 30:1.  Bear Stearns, as an example, was leveraged somewhere around of about 33:1.   By any measure, this is excessive leverage, and it is very risky.

Leveraged 33:1 meant that the former investment bank owned only about 3% of a balance sheet worth nearly $400 billion. The other 97% percent of Bear's assets were encumbered (subject to claims by Bear's creditors because Bear borrowed so much).

Here is the kicker - the reason why it is incredibly risky for a company to to have equity represent only 3% of its balance sheet...  Creditors have superior claims to equity-holders (typically shareholders).  IN OTHER WORDS, LOSSES ARE, AS A RULE, ALLOCATED TO SHAREHOLDERS ONLY UNTIL ALL EQUITY IS GONE. 

Therefore, if Investment Bank Z is leveraged at 33:1, and declining market conditions cause the value of Z's balance sheet assets to drop by just 3%, Bank Z's equity is wiped out.  It is insolvent. 

Still confused?  Fear not, we can illustrate with a hypothetical.

(a) In May, Z's entire balance sheet consists of collateralized debt obligations (CDOs) valued at par (they are valued at 100 cents on the dollar); but

(b) Market conditions deteriorate in June, causing CDOs values to fall from par to 97 cents on the the dollar. 

A security trading at 97 cents on the dollar doesn't sound too bad.  But for Investment Bank Z, leveraged at 33:1, 97 cents on the dollar is a complete disaster.  This 3% decline in the value of its balance sheet assets means the bell is tolling.  Z's entire equity stake is wiped out.  The company is insolvent. 

THIS IS THE DOWNSIDE OF EXCESSIVE LEVERAGE.

By Brett Sherman, Wall Street Law Blog