<p>This extract from the book Resilience sheds light on why some systems, people and communities fall apart in the face of disruption, and ultimately, how they can learn to bounce back
A CDO is a financial instrument that can best be understood by imagining a set of wineglasses stacked in a pyramid. When champagne is poured over the pyramid, the glass at the top is filled first, the glasses in the middle are filled next, and those at the bottom are filled last. A CDO was an equivalent financial instrument, but instead of disbursing wine into wineglasses, it poured the monies from mortgage payments into a set of specialized bonds.
To create a CDO, a bank would bundle together a group of mortgages, held by regular U.S. homeowners. Each month, as these homeowners wrote their monthly mortgage checks, the banks would pool these payments together and make payouts to a series of bonds called tranches that were stacked up just like the wineglasses. The tranche at the top of the chain, like the glass at the top of the pyramid, got paid first, then the one following it, and so on, until either the tranche at the bottom was paid or the pool of funds was exhausted.
By definition, the top tranche, at the front of the line to be repaid, was the least risky, so it earned both the best rating (AAA) from ratings agencies like Moody’s and Standard & Poor’s and also the lowest rate of return, perhaps 2 percent. The bottom tranche, on the other hand, was the most risky: If mortgage holders in the CDO pool stopped paying their mortgages, the loss would be felt in that tranche first—so it earned both the lowest rating (say BB) and the highest rate of return, perhaps 10 percent.
So far, so good. But from there, CDO engineering quickly entered into the twilight zone. A bank might, for example, take the lowest-rated tranche (BB) of a particular CDO (let’s call it Lucifer) and turn it into its own CDO (let’s call this bottom tranche Damien). Even though it was comprised of junk, Damien, through the magic of financial engineering, was divided into its own set of tranches, the top one of which was awarded its own triple-A rating. This absurdity masked the fact that the underlying asset upon which it was based—Lucifer’s bottom-most BB tranche—was toxic, high-risk junk. It was like saying “here is the safest house that you can build with this toxic waste” and conveniently forgetting to say the toxic-waste part. Or, if you prefer, like taking a dozen hobbled horses from the glue factory, lining them up according to their speed, and calling the fastest one a Thoroughbred.
When some homeowners originally bundled together under Lucifer stopped being able to pay their mortgages, not only did its BB tranche bondholders lose out, so did those holding all of Damien’s tranches—even the ones rated AAA. And there’s the true tragedy: Those holding Damien’s triple-A’s were well-managed, risk-averse pension funds, municipalities, and 401(k) plans.
If CDOs were the financial equivalent of chloresterol-laden junk food mislabeled as health food, the credit default swaps were the mechanism by which the banks ensured that a blockage in any artery would give a heart attack to all. CDSs are insurance contracts, much like the contract that you might sign to insure a car, a home, or your own life. In such arrangements, you make a monthly payment to the insurance company, and, in the event of disaster, it makes you whole. Similarly, these insurance contracts enabled a bank to insure against the loss in value of a stock or bond it might purchase. If Bank A buys $10 million in corporate bonds, and it loses $2 million in value, then the insuring Bank B would make up the difference. In the meantime, Bank A would pay a premium on this insurance to Bank B, much as you pay your health and car insurance premiums.
CDSs had several crucial differences from traditional insurance, however. First, a CDS contract could be traded from investor to investor with no oversight or even regulations ensuring that the insurer had the ability to cover the losses when and if it needed to. By calling the contract a swap, and not insurance, the investors in CDSs were able to avoid the capital reserve requirements and regulatory oversight of the traditional insurance industry. (This was presumably the “innovation” at CDSs’ core.)
Second, CDSs allow firms not only to insure against the possible default of their own investments, but to insure against the possible default of another company’s assets—akin to taking out an insurance policy on your neighbor’s Ferrari. Firms could use swaps as a tool for speculation—to bet a company would fail. This practice was made illegal in traditional insurance markets as far back as the 1700s, before which it was legal for individuals to buy insurance on British ships that they didn’t own, creating—quelle surprise—a rash of perfectly seaworthy ships mysteriously sinking to the bottom of the Thames. In its place, parliament codified the notion of “insurable interest,” the requirement that you have an actual economic interest in the asset being insured. It was a concept that reigned unchallenged for two and half centuries—until the rise of the CDS.
Finally, CDS contracts were sold and traded privately, or “over the counter.” While they added enormously to the risk profile of the institution doing the insuring, they didn’t show up on the traditional balance sheet. When the crisis came, nobody knew who owed what to whom and what it meant for anyone’s bottom line.
In theory, CDOs and CDSs were originally designed to allow the market to do two things that are quite beneficial: first, to distribute risks to those who were most capable and willing to take them, and second, to allow banks to diversify their portfolios by mixing and matching some of their own activities with one another’s. A typical big bank might find itself originating its own mortgages, buying them from others, selling mortgage-backed securities that blended the two, and insuring those of another bank against default. All of this looked, superficially at least, like diversification—a wise strategy for balancing efficiency and robustness.
But, in allowing debt, credit, and risk to be sliced into tranches, packaged, bought, repackaged, sold, and resold, these instruments also made the dependencies between institutions mind-bogglingly complicated. The chain of custody for the underlying assets lengthened to the point of incomprehensibility.
Thus, when the crisis hit, none of the banks could be quite sure if the other institutions with which they had contracts might also be enmeshed in other contracts that left those institutions on the hook in some potentially catastrophic way. This is known as the problem of counterparty risk—not the risk that you’ll become a deadbeat, or the risk that your partners will become deadbeats, but the risk that some of your partners’ partners will become deadbeats.
In the low-risk, precrash world, from an individual bank’s perspective, having a contract with another bank—which itself had many other business relationships—was perceived as a good thing: It was a measure of diversification and suggested lower risk.
After all, what’s the likelihood of a significant number of contracts in a large portfolio defaulting all at the same time? In the high-risk, postcrash world, however, having a contract with another bank with lots of counterparties was nightmarish: After all, it might be holding a contract with an unknown third party that might, at any moment, blow up in its face.
How could you possibly determine how creditworthy the other bank was? How could you (or it) know what its obligations were? Or those of its counterparties’ counterparties? How could you trust anybody?
When the crash came, a sense of transparency disappeared overnight, and with it went the most important variable in the system, trust—a theme we will revisit later in this book.
It didn’t help that the derivative contracts themselves were mind-bogglingly complicated. The simplest of these ran some two hundred pages—the most advanced varieties required reading in excess of one billion pages. (Reading one page a minute, it would take you slightly more than 1,900 years to read a single contract for one of these products.) Firms had foregone the due diligence and just swallowed the contracts whole. After the crash, figuring out who owed what to whom wasn’t just hard, it was impossible. It’s unsurprising that the institutions that vaporised amid the destruction—Lehman, Bear Stearns, and AIG Financial Products — had among the largest counterparty exposure. They were attached to an anchor of unknowable size.
The rise of these complex derivatives had another, subtler impact as well. Their promise— of higher returns and dramatically lower risk—proved so intoxicating to financial organizations of all stripes that these firms effectively homogenized their methods of generating revenue and their risk management strategies to take advantage of them. Many different kinds of actors in the market—from commercial banks to hedge funds—started getting into one another’s businesses, holding the same classes of assets and liabilities, in the same proportions, seeking out the same goal, in the same way. As each market player began to internalize more and more of the ever-increasing complexity of the market as a whole, market risks became internal risks. This was diversification without a difference. Right under everyone’s noses, the complex ecosystem of the global financial markets was turning into a monoculture—of very complicated lemmings.
AUTHOR: Andrew Zolli & Ann Marie Healy
PUBLISHER: Hachette India
PRICE: RS 599
Excerpted with permission from Hachette India