The big business of reselling securitized credit card debt

Why have credit card interest rates stayed so high over the last year or two even as the Fed cut interest rates? Why have credit card companies increased penalties for late payments, changed billing cycles to try to increase the number of late payments and more?

To generate more debt that can be securitized.

Now, because so much consumer debt is packaged into securities and sold to investors, repayment of the loans takes on less importance to those lenders than the fees and charges generated when loans are made.

Yep, MBNA, Capital One, et al, have been looking for their seats on the CDO gravy train.

And, loyal Democrats, don’t forget to thank Sen. MBNA, Joe Biden, for his part in this:

Not surprisingly, such practices generated dazzling profits for the nation’s financial companies. And since 2005, when the bankruptcy law was changed, the credit card industry has increased its earnings 25 percent, according to a new study by Michael Simkovic, a former James M. Olin fellow in Law and Economics at Harvard Law School.

The “2005 bankruptcy reform benefited credit card companies and hurt their customers,” Mr. Simkovic concluded in his study. He said that even though sponsors of the bankruptcy bill promised that consumers would benefit from lower borrowing costs as delinquent borrowers were held more accountable, the cost of borrowing from credit card companies has actually increased anywhere from 5 percent to 17 percent.

The complete story is eye-opening as well as scary. And, loyal Dems, folks like Chuck Schumer will join folks like Joe Biden in protecting the financiers of our country.

Subprime crisis hits Narvik, Norway?

You read right. Narvik and other towns in Norway had their municipal governments invested in CDO-type securities. The four communities may have lost as much as $64 million or even more. It’s bad enough that Narvik, population 18,000, has missed one city payroll.

“The people in City Hall were naïve and they were manipulated,” said Paal Droenen, who was buying fish at a market across the street from the mayor’s office. “The fund guys were telling them tales, like, ‘This could happen to you.’ It’s a catastrophe for a small town like this.”

Now, the towns are considering legal action against the Norwegian brokerage company, Terra Securities, that sold them the investments. They allege that they were duped by Terra’s brokers, who did not warn them that these types of securities were risky and subject to being cashed out, at a loss, if their market price fell below a certain level.

“When you sell something that is not what you say it is, that is a lie,” Mayor Karen Kuvaas said. She disputed the suggestion that people here lacked the sophistication to understand what they were buying. “We’re not especially stupid because we live so far in the north,” she said.

Norway’s financial regulator agreed that the brokers had misled the towns, and it revoked the license of Terra Securities, prompting the company to file for bankruptcy. But the company’s parent, Terra Group, which is in turn owned by 78 savings banks and remains in business, rejected calls for it to compensate the towns. A spokesman for the group said it too had taken a hit from the episode.

Norway’s finance minister, Kristin Halvorsen, has ruled out the possibility of a state bailout, and Citigroup, which announced Thursday that it would shut down one of the money-losing investments Narvik bought, said it had no legal obligation to step in.

Narvik has investments like this equal to about one-quarter its annual budget. The problem seems to have been created in part by city officials who didn’t read original documents thoroughly, and in at least equal part by Citigroup and others who added fine print after the initial documents were signed.

I wouldn’t be surprised to see Citigroup sued in Norwegian court before this sorry episode is over.

Wall Street: Giant Ponzi scheme? Giant poker game?

The combination of subprime mortgages, other mortgages and other items of debt into the complex collateralized debt obligations and credit default swaps invite both these comparisons, as Michael Panzner makes clear.

In essence, these forms of smashed, blended debt, sliced into tranches, are a Ponzi scheme because they have been relying on more and more people buying houses, buying bigger houses, refinancing for remodels and so forth.

These debt forms are like a giant poker game because the main bettors have been betting against the odds, especially the odds of subprime borrowers defaulting. (At the same time, as part of the incestuousness of these arrangements, creators of this debt have been depending on ratings agencies like Moody’s both to give the best possible rating on CDOs and to talk up the financial market in general, and housing market in particular, at the same time.

From Mish (whose blog on economic analysis is a highly recommended read), here’s what I mean by incestuousness:

Moody’s: “Moody’s has no obligation to perform, and does not perform, due diligence.”

S&P: “Any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision.”

Because of that bottom-line fact, Mish has a boatload of questions:

* How many billions of dollars will be lost because of absurd pricing models?
• How can it be that an entire system of investment decisions are based on ratings that the ratings companies tell everyone not to use for investment purposes?
• Were the ratings companies grossly incompetent or just foolish?
• Will the disclaimers of the ratings companies hold up in court?
• How long will it be before there be a court test of those disclaimers?
• Why has only a minuscule portion of subprime debt (2.1% or $12 billion of a massive $565.3 billion of subprime bonds) downgraded?
• Are the ratings companies under pressure by the banks and/or the Fed to not rerate this debt?
• Why is it that ratings companies are allowed to have outside business relationships with the companies whose debt they rate?
• Did banks realize how absurd those ratings were but look away because of greed and the ease in offloading he debt to pension plans, insurance companies, and hedge funds out of pure greed?
• Heck, did the upper echelons at the ratings companies themselves know their ratings model was flawed and look the other way out of greed?
• How long before there is a government sponsored bailout of this mess? Hint small ones are starting already. See Please - No More Help! for a discussion.
• How long before Bernanke starts cutting rates?
• How high will gold prices rise when Bernanke starts cutting?
Here's the big question: How big will the taxpayer bailout be?

But, Mish’s quote of Moody and S&P hand-washing, bad as it is, still isn’t the full story.

For one thing, these CDOs were backed not with money, but with insurance. And, just like people can “short” a stock, banks and other CDO creators could short their insurance.

Well, what’s happening right now is that a lot of bluffs are being called. Or, on the analogy above, a lot of banks and other lenders are facing the equivalent of margin calls. And, a lot of the people whose bluffs are being called are having to reveal they’ve been betting with IOUs or overrun bank drafts. And, unlike monetary deposits, these investments aren’t protected, even if made by banks. Plus, as Panzner points out, many of these types of loans were made by nonbanking entities.

Already three years ago, Warren Buffet was calling derivatives “financial weapons of mass destruction.” But Greenspan kept encouraging banks and other lending agencies to keep churning them out. Combine that with the Fed loosening the fractional money reserve requirement of banks, and you have the perfect storm.

This is why the Fed and the European Central Bank are injecting money into the system through buybacks. Banks already are thin enough on reserves that their power to fluff more credit into the system is running low. But, the Fed is actually using credit, not money, for these buybacks; banks, then, with their small reserve margins, can inflate this credit.

Stoneleigh at The Oil Drum goes into even more depth (warning, it’s about 5,000 words); if you still don’t understand too much about how much more than a “housing bubble” the subprime crisis is, and have a bit of reading time, I strongly recommend it.

One final note; our, and the world’s, Great Depression wasn’t caused by hyperinflation anywhere. Instead, the Roaring ’20s were a period of high credit inflation.

I think I’ve writeen enough on this to give you the general idea.

How collateralized debt obligations arose

Jim Jubak provides an easy-to-understand explanation:

Wall Street walked in the door with an amazing deal. Investment bankers should spin speculative-grade credits — whether corporate debt and loans from a buyout deal or mortgages from financially challenged home buyers — into investment-grade credits. By bundling together groups of credits, or pools of loans, corporate debt or mortgages, the investment banks said, you'd lower the risk that an investor would take a hit if any one loan or mortgage went bad.

And then, by cutting up those pools and putting the riskiest deals together in one segment, called a tranche, and the less-risky deals in other tranches, you could insure the less-risky tranches against loss. The riskiest tranches might get wiped out, which is why investors who bought them got a higher yield, but they created a kind of buffer for investors in the less-risky tranches, the investment banks said. Investors in those less-risky tranches wouldn't take a hit until the more risky tranches were wiped out, the banks promised. And it follows, the banks argued, that the less-risky tranches met the standards for investment-grade credit ratings.

Jubak has a more in-depth explanation here.
In other words, a lot of bad investments are starting to come home to roost in a lot of places.

CDOs and the Great Depression

Collateralized debt obligations based in fair part on subprime mortgages and in fair part on highly leveraged debt of various types strike me as being the modern equivalent of stocks being sold on just 10 percent margin in early 1929.

How much of a worry should subprime mortgages and collateralized debt obligations be?

Maybe even more than I’ve written before.

First, according to Counterpunch, financial derivatives have 10 times the float of all publicly traded stocks combined. That’s a lot of dinero, and no matter how much the Dow is up, ultimately, the broader investment market just can’t run from that:

Noriel Roubini puts meat to these bones. In his June 27th blog, Roubini wrote:

“The fallout of this CDO mess is likely to end up into $100 billion plus of losses for banks, financial institutions, hedge funds and investors once these CDOs and subprime mortgage backed securities are marked-to-market rather than being marked-to-a-delusional — misrated-model. Thus, the Bear disaster is only the tip of the iceberg of a much bigger financial mess that will unravel in the next few months: the pile of rising subprime and nearprime delinquencies will take a toll on the toxic waste of mortgage backed securities that a rating ‘voodoo magic’ pretended to turn below-junk securities into A-rated ones.”

Meanwhile, the Bank of International Settlements is worried about how the Fed has first mishandled this situation, then hedge funds. (Are hedge funds being used to “vent” the subprime crisis just like Greenspan used housing to ‘vent” he dot-com bubble?)

Here’s just how bad the problem is:

The BIS referred to the toxic effect of the $470 billion in collateralized debt obligations (CDO), and a further $524 billion in “synthetic” CDOs which have spread through hedge funds industry. These CDOs are the loans (many sub primes) which were bundled off to Wall Street and turned into securities which are highly leveraged in hedge funds for maximum profitability. As Bear Stearns is discovering, these CDOs are like roadside bombs. …

Banks doubled the amount of CDOs outstanding in the past two years to $2.6 trillion, including a record $769 billion sold last year, according to J.P. Morgan.

And, just because Wall Street is doing fine, that doesn’t mean the economy is so great, in case you’re wondering how it can be looking at 14,000 in the face of all that debt:

The current rise in stock prices does not indicate a healthy economy. It simply proves that the market is awash in cheap credit resulting from the Fed's increases in the money supply. Consumer spending is a better indicator of the real state of the economy than stocks. When consumer spending drops off; it is a sign of overcapacity, which is deflationary.

Here’s the bottom line:

The underlying problem is not simply the Fed's reckless increases to the money supply, but the growing “wealth gap” which is undermining solid economic growth. If wages don't keep pace with productivity; the middle class loses its ability to buy consumer items and the economy slows.

The reason that hasn’t happened yet in the US is because of the extraordinary opportunities to expand personal debt. The Fed's low interest rates have created a culture of borrowing which has convinced many people that debt equals wealth. It's not.

On mortgage refinancing, the purchasing of second homes as investments, etc., that confusion of wealth and debt is now coming home to roost.

And, if that’s not enough to wake you up:

The rise in housing prices has created the illusion of prosperity but, in truth, we are only selling houses to each other and are not making anything that the rest of the world wants. The $11 trillion dollars that was pumped into the real estate market is probably the greatest waste of capital investment in the nations' history.

Harsh words, but at least a fair-sized grain of truth behind them. This reminds me of Paul Kennedy’s book “The Rise and Fall of the Great Powers.” Somewhat for the Netherlands, and definitely for Great Britain, Kennedy states the move from manufacturing and industry to a focus on financial services was a key part of the decline of these great powers.

Caveat emptor.

Subprime crisis a reflection of larger debt-investment problems; possibly comparable to Enron derivatives

Jim Jubak explains the incestuous relationship between credit-rating agencies and banks, and how the subprime crisis has left a lot of emperors’ new clothes exposed:

It's important to understand that bond professionals don't want to think badly of the job done by the credit-rating agencies. The bankers pay the rating agencies' fees. (Bet you didn't know that. Yep, the issuers of debt are the ones who pay the bills.) The bankers literally sit across the table from the rating agencies. The banks poach anybody on the other side of the table that they think has the talent to work for them. And the banks rely on the credibility of the rating agencies to sell their debt offerings. It's a pretty cozy club.

But the subprime debacle has been big enough to disrupt the club. Buyers of packages of subprime mortgages and derivatives based on these packages that have been burnt by rising defaults on these mortgages and falling prices for the debt they hold have angrily wondered if banks issuing the debt disclosed all the risk. And the banks have passed the buck, saying, that they relied on the ratings from the three agencies.

As a result, Jubak said, this is part of why not just the ratings agencies in particular, but Wall Street in general, hasn’t reacted faster to the subprime crisis and its possible larger economic effects, specifically the problems with mortgage-based securities.

Several issues here.

First, where is a Democratic Congress, in failing to push for new regs out of either the SEC or FDIC to eliminate this incestuousness?

Probably waiting for “new Democrat” financial donors, which it has often been since the Clinton days.

This would be like Ford or GM paying Consumer Reports for their car ratings. It’s ridiculous.

It’s ridiculous it took the subprime crisis to expose this, if “expose” is the right word for something still generally flying well beneath the Big Media radar.

Beyond that, there’s the fact that these particular securities, known as collateralized debt obligations, are big turkeys in their financial performance. And, to the degree small investors have gotten talked into them, they could take a bit of a bath.

And, these are very complex debt-based securities. Jubak says many people, not small-time buyers, but even bigger pros, can’t analyze them well. He even draws Enron-type comparisons.

It’s ridiculous nothing has yet been done.