1. INTRO (a/k/a - Prelude to an analogy)
US Treasury bills have, historically, served as a proxy for riskless investment. (Risk, in this context, means chance of loss.) The yield on these bonds, therefore, has historically served as a proxy for "riskless rate of return."
In other words, the yield on Treasuries has represented the return on an investment for which there is no chance of loss. Because of the correlation between risk and return, the riskless rate of return is (a) low, and (b) the benchmark against which returns on other investments are calculated and measured.
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2. INTERLUDE: A VERY BRIEF RECAP OF THE RELATIONSHIP BETWEEN RISK AND REWARD
As the chance of loss (or perceived chance of loss) rises, so does the return required to entice investors to part with their money.
We did say that this section would be "very brief..."
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3. ICE CREAM (The Analogy Section!)
Now, to the analogy...
For our purposes, make the following assumptions: First, you love chocolate ice cream. Second, you are on a diet. Third, despite your diet, you must eat a bowl of chocolate ice cream. Fourth, you must choose from three bowls filled with an identical amount of ice cream. Fifth, except for two things, the ice cream in each of the three bowls is identical in all respects, including taste, texture and flavor. In sum, all 3 are equally delicious. And, finally, sixth, bowls one and two have twice the fat and twice the calories of bowl 3.
Since you are on a diet and must choose from among three bowls of ice cream that taste exactly the same, will you select bowl one, two, or three?
Stupid question, right?
Because bowl 3 has the same taste, but half the fat and calories of the others, the answer should be a no-brainer (hint- You're choice is bowl 3)
Ok. Let's keep our little scenario going. The facts about the three ice creams are the same. But now there are millions of chocolate ice cream lovers on diets and, so our analogy works, each of these dieting dairy eaters must buy enough ice cream to eat at least one bowl of chocolate ice cream each week for one year.
If you have stayed with us so far (we assume we lost some readers to a snack break), you can see that there is going to be immense demand for brand 3. By forcing our "facts" on you, we rigged the market.
This is precisely what happened with mortgage bonds (CDOs et. al) during the housing bubble.
Remember those riskless US Treasuries? Well, they have AAA credit ratings. So do a handful of really safe bonds. AAA means (or, before the financial crisis, used to mean) super super safe.
Wall Street banks rigged the market for AAA investments the same way we rigged the chocolate ice cream market. They marketing and sold AAA rated investments that, for quite a while, paid a higher yield than Treasuries and other AAA rated bonds.
Pretend you are a pension fund manager and that most of your holdings must be rated AAA. Since (a) AAA means virtually no risk of loss, (b) there are a handful of AAA rated bonds you can buy, and (c) you will make more money for your fund if you buy AAA mortgage bonds than any other kind of AAA rated investment on the face of the earth, is there really any choice at all? Same risk? More yield?
It's a no brainer. Just like the chocolate ice cream. Of course demand for CDOs and related investments was insatiable. The market was rigged.
4. THE BIG FINISH (conclusion)
Time to complete the analogy. Turns out that we, the nice people at WSLB, knew that bowl 3 brand chocolate ice cream really has twice the fat and calories of brands one and two. No wonder all those dieters packed on the pounds. Sorry 'bout that. We didn't mean any harm. We really didn't think all of those dieters would gain so many pounds. Really. It was kind of unforeseeable.
Similarly, it turns out that Wall Street's big banks - from Bear Stearns to Merrill Lynch and a whole bunch of others - knew that their AAA rated mortgage bonds were nowhere near as safe as investors believed. In fact, there is no doubt that they knowingly packed these investments with, well, worthless crap (the term 'toxic waste' is kind of played out).
Now all of you widget-makers out there know how to engage in market manipulation to create demand for your products. Please note, however, that (a) it is illegal to manipulate markets, and (b) Wall Street Law Blog does not condone unlawful business practices.
*Yes, we ripped off the fat free frozen yogurt episode of Seinfeld for our analogy, but we did it to make the world a better place.
By Brett Sherman