More, on The New Financial System, or, The Sucker's Ballet... by gimleteye

NYU economist Nouriel Roubini lifts the rock from the pattern of earnings growth that fueled the housing boom, now in cinders. It's a great read.

So far, though, the mainstream media has been treating these two stories: the housing boom, as a matter of political entitlements related to suburban sprawl, and the financial system bust as two unrelated events. I'm not sure why. Either reporters simply can't hold the two in the same frame, or, the financial press reporters have bought into the notion that Federal Reserve and fiscal policy is agnostic to business sectors. The former might be true. The latter is patently untrue: in its recent actions, the Federal Reserve has set itself up as the arbitrator of private industry, siding with one special interest as (I suppose) a matter of national economic security.

What remains, is for the mainstream media to link Wall Street greed and compensation packages to the local bankers, builders and development lobby that strong-armed zoning changes and anti-citizen bills through the Florida legislature, and how the Jeb Bush era ties in (including Jeb's consultant agreement with Lehman Brothers), thanks to a parallel message machine funded by the same corporate interests who are steering the US economy straight off the road into the ditch.

I've started down that road, and it is freely available in our archive feature 'housing crash', for more.

How will financial institutions make money now that the securitization food chain is broken?

Nouriel Roubini | May 19, 2008
The most severe financial crisis in decades has not only damaged the balance sheet of financial institutions. It has also severely affected their P&L, i.e. the process of generating revenues and profits.

In the old “originate & hold” model (before securitization) financial institutions made money from the investment income of holding the credit risk of loans and mortgages. But in the brave new world of securitization where you “originate & distribute” the credit risk rather than hold it on balance sheet an increasing fraction of the income of financial institutions was coming from the fees and commissions involved in this securitization process. This food chain of fees on top of fees is now broken: securitization of mortgages, that was running at the annual rate of $1,000 billion in January of 2007, was down 95% to an annual rate of $50 billion by January of 2008. So the process of generating fees and commissions is broken.

Let’s consider in more detail this loan origination and securitization chain for residential mortgages, commercial real estate mortgages and leveraged loans financing LBOs…

In residential mortgages the process started with peddling mortgages that were toxic in every aspect of their features: no down payment, no verification of income, assets and jobs (the “no doc” loans that were effectively “liar” loans), interest rate only mortgages, negative amortization mortgages, and teaser rates. Why were these toxic mortgages peddled, originated and distributed after being sliced and diced? Because everyone in this securitization food chain was making a fee and transferring the credit risk to someone else down this food chain.

Think of this fee generation process along this long food chain: it started with mortgage brokers whose income/fee was based on maximizing the volume of mortgages being generated and approved; they had all the incentive to ignore the creditworthiness of the borrowers and maximize mortgage volume and their personal income. The fee generation machine then passed to the bank originating the mortgage that was packaging these mortgages into MBS and thus making a fee in this process and transferring the risk down the line to someone else; again the bank care little about the quality of it own origination as it was transferring the credit risk. The fee generation machine included the home appraisers who were being paid by the mortgage originators and had all the incentive to inflate the appraised value of the home to get more and more fees and more and more business; this fee machine also included the mortgage servicers who got fat fees from servicing the mortgages and getting even fatter fees when the hapless borrower falls behind in its mortgage payments and who thus have no incentive to prevent foreclosure. The securitization food chain continued with the investment banks slicing and dicing the MBS into the equity, mezzanine and senior tranches of CDOs and making fat fees on that process and on managing such CDOs. The fees compounded when the CDOs became CDOs of CDO (CDO squared) and CDOs of CDOs of CDOs (CDO cubed). Then the rating agencies that blessed these CDOs chains and tranches with AAA rating were getting their fat fees (and most of their profits) from rating – or better misrating - these toxic products and converting – via voodoo magic –bundles of BBB subprime mortgages into AAA rated tranches of CDOs. Along this fee generation machine the monoline insurers were making fat fees insuring these toxic instruments and providing additional AAA blessing on this garbage and trash. And finally if this garbage of CDOs (or CDOs cubed) was not fully distributed to clueless and greedy investors banks created off-balance sheet SIVs and conduits that would buy the leftover trash that no investor wanted to touch and repackaged it into structures that were financed with the most short term ABCP; these SIVs were then blessed with credit enhancement and guarantees of liquidity lines from the banks that made them de facto on balance sheet items even if they were de jure off balance sheet; but there were extra fat fees to be made from managing this toxic SIVs and conduits and thus the fee generation machine kept on rolling.

In this securitization food chain – or better scam - every institution made a fee and transferred the credit risk down the line. Then no wonder the credit risk was transferred to those who were the least able to understand it: somehow greedy and clueless investors searching for yield bought tranches of instruments – CDO or CDO cubed – that were new, exotic, complex, illiquid, marked-to-model rather than marked-to-market and misrated by the rating agencies. Who could then ever be able to correctly price or value a CDO cubed? And for all the talk about the benefits of financial innovation what was the social value of a CDO cubed? There was indeed zero social value in this type of financial innovation that is closer to a con game than to a financial product of any use.

So now that this credit house of cards has collapsed this securitization food chain is effectively dead and the process of generating fees - and thus profits – for financial institutions is severely hampered: fees are collapsing for mortgage brokers, home appraisers, mortgage originators, mortgage servicers, CDO managers, monoline insurers, rating agencies, SIV managers and so on.

A similar securitization food chain with fees upon fees and credit risk transfer was created for the credit bubble in commercial real estate mortgages and for leveraged buyouts.

In the case of commercial real estate mortgages the process started with a similar reckless origination based on high loan to value ratios and inflated expectations of rent increases. Then the commercial real estate mortgages were sliced and diced and repackaged into CMBS and the CMBS into CMOs and CDOs and then SIVs with all the related set of fees as in the residential mortgage food chain.

In the case of leveraged buyouts (LBOs) the process started with LBOs that should have never occurred in the first place as the last vintage of LBOs had reckless debt to earnings ratios of 8-10 as opposed to the historical average of 3-4. Thus highly leveraged buyouts with tons of debt and little equity took private borderline profitable corporations that should have never been loaded with such massive amounts of debt. And since credit was cheap – junk bond yield spreads bottomed at 250bps relative to Treasuries in June of 2007 - and investors were searching for yield hundreds of billions of dollars of LBO deals were generated with terms that did not make any sense (including covenant lite terms and PIK toggles). Then these LBOs were financed with leveraged loans and bridge loans; and then further sliced and diced into CLOs that were then stuffed into SIVs and conduits when they could not be sold to investors. Too bad that eventually - by early 2008 when this LBO and private equity bubble went bust - hundreds of billions of dollars of frozen leveraged loans and bridge loans were still sitting on the balance sheets of financial institutions being valued at 70 or 80 cents on the dollar.

So how will all these financial institutions generate revenues and profits now that this effective scam has mostly collapsed? Origination of new subprime and near prime (Alt A) mortgages is effectively dead; origination of new commercial real estate mortgages is nearly frozen; securitization of mortgages has collapsed by 95%; the entire CDO, CMO and CLO market is frozen with almost no new issuance; while the SIVs and conduits have collapsed with the rolloff of the ABCP paper that was financing these scams.

So how will mortgage brokers, banks, broker dealers, monoline insurers, rating agencies generate revenues and profits now that this slice & dice scheme has unraveled? The current market delusion that the worst is behind us for financial institutions is based on the view that most of the writedowns of the toxic assets have already been done. But this is not just a balance sheet problem. Now financial institutions have a more severe P&L problem, i.e. how to generate income and earnings from now on when they cannot originate junk any more. The entire income generating model of financial institutions – make income out of securitization fees rather than by holding the credit risk - is broken now that the generalized credit bubble (not just subprime mortgages) has burst; thus, how will these financial institutions generate earnings over time? Capital losses are one-time problems; but destruction of the income generation process is a more severe and persistent problem that will require banks and other financial institutions to rethink their overall business model of credit risk transfer. But there is no clear and sound new business model for them: going back to the old days of “originate and hold” is not fully possible while the new “originate and distribute” model has shown all of its wrong and distorted incentives, risks and systemic failures. So banks and other financial institutions will have to seriously rethink their business model and how they are going to make money: the model of slice and dice and pile fees upon fees and transfer the credit risk is broken. It is not clear if banks and other financial institutions have a better model. May they will have to go back to old fashioned banking: carefully assess the creditworthiness of their borrowers, lend on sensible terms and hold a good part of the credit risk now that the easy fee/profit generating machine of securitization is terminally broken.