Securitization is a shadow banking system that funds most of the world's credit cards, car purchases, leveraged buyouts and, for a while, subprime mortgages. It also pumped out record profits for banks, accounting for as much as one-fifth of their revenue over the past decade.
Tom Bosh lowered the telephone receiver into its cradle, making a decision on the way down. “We’re not buying any more,” he told his traders at Bank of New York. “Nothing.”
It was May 2007, and Bosh, who managed $25 billion from the bank’s 13th-floor trading room above Times Square, had just hung up on Ralph Cioffi at Bear Stearns a dozen blocks away. Bosh had invested $50 million in notes from an issuer Cioffi controlled. “I had a bad feeling,” Bosh recalled. “Cioffi was just bulldogging everyone. He was saying, ‘These assets are good, the collateral is paying down, and I know more than you.’ That type of attitude.”
Bosh’s premonition, a month before two of Cioffi’s funds blew up, struck a death knell for structured finance, the system Wall Street banks devised to fuel more than two decades of unprecedented borrowing. The system allowed financial companies to lend beyond their capacity and outside the reach of regulators — until it crashed this year.
While the collapse was most visible in the stock markets, the cause was the loss of confidence in the world’s biggest bond market, structured finance. So far, it has led to the worst financial crisis since the Great Depression, the disappearance or takeover of more than a dozen banks, including three storied Wall Street firms, and almost $3 trillion in government expenditures and guarantees to contain the contagion.
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Bundling major export
The bundling of consumer loans and home mortgages into packages of securities — a process known as securitization — was the biggest U.S. export business of the 21st century. More than $27 trillion of these securities have been sold since 2001, according to the Securities Industry Financial Markets Association, an industry-trade group. That’s almost twice last year’s U.S. gross domestic product of $13.8 trillion.
The growth over the past decade was made possible by overseas banks, which saw the profits U.S. financial institutions were making and coveted the made-in-America technology. Wall Street obliged, with disastrous results: two-thirds of a trillion dollars in bank losses, about 40 percent of them outside the U.S.
“Securitization was based on the premise that a fool was born every minute,” Joseph Stiglitz, a professor of economics at Columbia University in New York, told a congressional committee in October. “Globalization meant that there was a global landscape on which they could search for those fools — and they found them everywhere.”
European banks, in particular, were eager adapters. Securitizations in Europe increased almost sixfold between 2000 and 2007, from 78 billion euros ($98 billion) to 453 billion euros ($575 billion), according to the European Securitization Forum, a trade organization.
Three Icelandic banks borrowed enough to buy $228 billion of assets, most of them securitizations, turning the country’s financial system into a hedge fund. All three banks have been nationalized by the government, leading Prime Minister Geir Haarde to advise citizens to switch from finance to fishing.
In Germany, one bank, Landesbank Sachsen Girozentrale, bought $26 billion worth of subprime-backed investments, putting the state of Saxony on the hook for $4.1 billion.
In Japan, Mizuho Financial Group, the nation’s third-largest bank, acquired an entire structured-finance team, which proceeded to lose $6 billion issuing mortgage-backed securities.
Shadow banking scheme
Securitization is a shadow banking system that funds most of the world’s credit cards, car purchases, leveraged buyouts and subprime mortgages. The system, which pools loans and slices up the risk of default, made borrowing cheaper. It also pumped out record profits for banks, accounting for as much as one-fifth of their revenue over the last decade.
Beginning about three years ago, investment banks revved the system’s engine to boost earnings. They raised revenue by funding more subprime mortgages and cut costs by relying increasingly on the $4.2 trillion sitting in U.S. money-market funds. As it turned out, those decisions would prove fatal.
“It’s a powerful technology that has been driven beyond the speed limit,” said Juan Ocampo, a former consultant at New York-based advisory firm McKinsey who wrote a 1988 book popularizing structured finance. “For the last five years, instead of going 65 mph, they’ve been gunning it to 140 mph, 150 mph.”
Before the invention of securitization, banks loaned money, received payments and profited from the difference between what the borrower paid and the bank’s funding cost.
During the mid-1980s, mortgage-bond traders at Salomon Brothers devised a method of lending without using capital, a technique at the heart of securitization. It works by taking anything that has regular payments — mortgages, car loans, aircraft leases, music royalties — and channeling the money to a trust that pays bondholders principal and interest.
The word “securitization” implies safety. Investors with less appetite for risk buy higher-rated securities and get paid first at lower interest rates. Those with a bigger appetite get paid later and receive more interest.
Securitization’s biggest innovation was off-balance-sheet accounting. If a bank couldn’t sell a bond or didn’t want to, the asset could be sold to a trust within a so-called special-purpose entity, incorporated in a place such as the Cayman Islands or Dublin, and shifted off the books. Lending expanded, and banks still booked profits.
With this new technology, a bank could originate $100 million in loans, sell off some to investors, transfer the rest to a special-purpose entity and not have to hold any capital. The profit could be as much as 1.25 percentage points of the amount loaned, or $1.25 million for every $100 million issued.
“The banks could turn a low return-on-equity business into one that doesn’t use any equity, which was the motivation for this,” said Brad Hintz, a Sanford C. Bernstein & Co. analyst and former chief financial officer at Lehman. “It becomes almost like a fee business because it requires no capital.”
Like most new products, securitization found a market at home before going abroad. Bankers at Salomon and First Boston, now part of the Credit Suisse Group, raced from bank to bank to convince issuers it was the wave of the future.
William Haley remembers a 10 a.m. meeting in 1987 at Imperial Thrift & Loan in Glendale, Calif. As Haley, at the time a Salomon banker, and his team walked into the conference room to make a pitch, the First Boston team was walking out.
“We exchanged some knowing looks and then tried to beat the pants off them,” said Haley, who now works at RBS Greenwich Capital Markets, a firm specializing in mortgage-backed securities that is owned by Royal Bank of Scotland Group. “There was a fierce desire to capture the prize.”
First Boston was first out of the gate in March 1985 with a $192 million computer-lease securitization for Sperry, a predecessor of Unisys. The bank then oversaw a series of auto-loan securitizations, including a $4 billion issue by General Motors Acceptance in October 1986, the biggest corporate debt issue at the time.
Haley’s project was a $50 million deal for Banc One called Certificates for Amortizing Revolving Debts, or CARDs. It was the first credit-card securitization and a blueprint for the $358 billion of such securities now outstanding. The transaction also gave the banks a way to securitize their own assets and get them off their balance sheets, which allowed the money to be lent all over again.
The strategy was detailed in Ocampo’s 282-page book “Securitization of Credit: Inside the New Technology of Finance,” which he co-wrote with McKinsey consultant James Rosenthal. Ocampo and Rosenthal argued that banks could be more profitable if they used securitization.
The authors examined six of the first asset-backed transactions and gave readers a step-by-step guide for how to repeat them. They said that banks that didn’t embrace the new technology would be at a disadvantage, and they predicted it would become the dominant form of financing.
“The McKinsey book helped with credibility with issuers,” Haley said. “It wasn’t that easy in the beginning. Conferences now have thousands of people, but I remember once in Beverly Hills, I gave a speech and there were maybe 25 people in the audience. They were furiously taking notes, however.”
The new technology was spread around the world by the people who worked on the First Boston and Salomon teams.
Salomon’s group was led by Patricia Jehle, who later founded Bear Stearns’ asset-backed unit. Another member, Michael Hutchins, started the first team at a European bank when he went to Zurich-based UBS AG in 1996.
A third, Michael Normile, moved to Merrill Lynch, where he ran its securities business, then switched to London-based HSBC Holdings in 2004. Haley built similar teams at Lehman, Chase Manhattan Bank and Amsterdam-based ABN Amro Bank.
First Boston’s team included Walid Chammah, 54, who went on to head debt and equity-capital markets at Morgan Stanley and is now co-president of that firm. Joseph Donovan, the banker responsible for the GMAC relationship, took over the asset-backed group at Credit Suisse First Boston after Zurich-based Credit Suisse bought First Boston.
Donovan remembers traveling to Europe for First Boston in the early 1990s, trying to convince Volkswagen AG in Wolfsburg, Germany, and Renault SA outside Paris of the benefits of securitization. It was a hard sell. Europeans, he said, didn’t take out auto loans.
“We tried over and over,” Donovan recalled. “We were trying to get more issuers, and there weren’t any.”
By the time Donovan went to work for Credit Suisse in 2000, European attitudes had changed. Home-mortgage securitizations were especially appealing, he said, because European banks didn’t need a “50-year pedigree to compete.”
“You don’t need a whole equity-research department and relationships with CEOs and CFOs,” Donovan said. “You basically needed good computers and distribution. You can always buy a Fannie, Freddie or Ginnie Mae pool. You just go online and buy it. You can’t buy a Ford Motor Credit deal, because you have to know people.”
Credit Suisse First Boston went from third in underwriting structured finance in 2000, behind Lehman and Salomon Smith Barney, to first in 2001, when it issued $96.3 billion in securities. Its market share increased 50 percent to 12.7 percent. The bank fell to fourth place in 2005, although its volume soared to $144.5 billion.
As securitization caught on, borrowing increased. U.S. consumer debt tripled in the two decades after 1988 to $2.6 trillion, according to the Federal Reserve. Foreign banks used the new technology to expand lending, seeking borrowers on their home turf.
“One of the things the United States exported overseas was a debt culture,” Haley said.
While consumers were snapping up credit cards, Nicholas Sossidis and Stephen Partridge-Hicks at Citibank in London were figuring out a way to sell the new bonds. Their solution: Alpha Finance, the first off-balance-sheet structured investment vehicle, or SIV.
Alpha was created in 1988 as a way for Citibank, and later Citigroup, to vertically integrate its business like an oil company. The raw material was found in a loan, refined into a security, then sold to a SIV at a profit.
In the beginning, SIVs were small and cautious. Alpha was capitalized with $100 million of equity that supported $500 million of commercial paper and medium-term notes. The SIV could hold only debt rated A- or higher and didn’t take any currency or interest-rate risk, according to a 1993 Fitch Ratings report.
Alpha was followed by a slew of SIVs with names such as Beta and Five Finance. By 2007, Citigroup’s SIVs had $90 billion of assets, equal to the stock market value of PepsiCo, making up about one-fourth of the entire SIV industry.
In 2003, the bank was sued by creditors of Enron for its role in setting up entities that enabled the company to move assets off the balance sheet for CEO Jeffrey Skilling.
Citigroup paid $1.66 billion in March to settle the lawsuit. Skilling, a former McKinsey consultant, was convicted of accounting fraud and is serving a 24-year prison sentence.
Starting around 2005, securitization began to rely more on short-term money-market funds for financing. This was especially true for securities made by pooling other bonds, known as collateralized debt obligations, or CDOs.
Investors were loath to buy long-term debt of issuers that didn’t have a track record, so new issuers sold asset-backed commercial paper that matured in less than a year. While money markets are the cheapest way to finance, they can also be the most dangerous for borrowers because they can mature as soon as the next day.
“What happened in 2005 was that because of subprime and some other changes, commercial paper and asset-backed securities offered a bigger spread than anything that had ever been in the market before,” said Deborah Cunningham, chief investment officer of Federated Investors in Pittsburgh, who oversees $235 billion in commercial paper. “It was hundreds of basis points, as opposed to 10 or 20 basis points before.”
SIVs, banks and CDOs sold trillions of dollars of asset-backed commercial paper between 2005 and 2007 in maturities ranging from nine months to overnight. In the U.S., the amount outstanding marched higher almost every week beginning in April 2005, peaking at $1.2 trillion for the week ending Aug. 8, 2007.
Once money-market funds began to be tapped for financing, Ocampo said, “it created a huge appetite for high-yield assets, far more than could be originated on a sound basis.”
To accommodate the demand, banks funded more subprime mortgages, with an average life of seven years, replacing car loans with an average life of three years and credit-card bonds paid off within 18 months.
Among conservative lenders, that rang an alarm: Bankers are taught to avoid such mismatched funding, in which a lender has to pay back money before the borrower has to pay the principal.
“Most of the terrible things happening now are because of the presence of money-market assets, taking what used to be long-term funding and making it short-term,” said Bruce Bent, who started the first money-market fund in 1970.
The authors of the 1988 McKinsey handbook on securitization have moved on. Rosenthal, who declined to be interviewed, became a managing director at Lehman and is now in charge of information technology at Morgan Stanley.
Ocampo received a patent for risk-controlled investing and founded an institutional fund-management firm, Trajectory Asset Management. The firm doesn’t have any structured-finance obligations.
Bear Stearns’ Cioffi was indicted on charges of misleading investors by assuring them that his hedge funds were healthy when he knew they weren’t. Cioffi, who now works out of his home in Tenafly, N.J, has pleaded not guilty. He declined to comment.
The Bank of New York’s Bosh lost his job when his company was merged with Mellon in June 2007. He’s still looking for work.
“You try to do the right thing,” Bosh said. “And this is what happens.”