28 October 2008

Biggest U.S. Export by far was bad paper

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, much as consumers around the world craved other emblems of American ingenuity from Coca-Cola to Hollywood movies. 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 on Oct. 21. ''Globalization meant that there was a global landscape on which they could search for those fools -- and they found them everywhere.''

Eager Adopters

European banks, in particular, were eager adopters. Securitizations in Europe increased almost sixfold between 2000 and 2007, from 78 billion euros ($98 billion) to 453 billion euros, 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 Inc., the nation's third- largest bank, acquired an entire structured-finance team, which proceeded to lose $6 billion issuing mortgage-backed securities.

Shadow Banking

The damage reaches all the way to Australia, where the town council of Wingecarribee, a municipality outside Sydney with a population of 42,000, bought $20 million of securities from Lehman Brothers Holdings Inc. Now, Lehman is in bankruptcy, the town council is in court and the securities are worth about 15 cents on the dollar.

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. The system, which pools loans and slices up the risk of default, made borrowing cheaper for everyone, creating a debt culture that put credit cards in wallets from Seoul to Sao Paolo and enabled people to buy luxury cars and homes. 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.

'Powerful Technology'

''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 & Co. 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 the use of 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.''

'Capture the Prize'

Like most new products, securitization found a market at home before going abroad. Bankers at Salomon and First Boston Inc. 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 Association in Glendale, California. As Haley, at the time a 33-year-old 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 Inc., a firm specializing in mortgage-backed securities that is owned by Royal Bank of Scotland Group Plc. ''There was a fierce desire to capture the prize.''

First Boston

First Boston, housed in the same New York office tower as McKinsey, was first out of the gate in March 1985 with a $192 million computer-lease securitization for Sperry Corp., a predecessor of Unisys Corp. The bank then oversaw a series of auto-loan securitizations, including a $4 billion issue by General Motors Acceptance Corp. in October 1986, the biggest corporate debt issue at the time.

Haley's project was a $50 million deal for Banc One Corp. 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, who received an MBA from Harvard after graduating from the Massachusetts Institute of Technology, and Rosenthal, a Harvard Law School graduate, argued that banks could be more profitable if they used securitization.

McKinsey Book

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,'' said Haley. ''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's 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 & Co., where he ran its securities business, then switched to London-based HSBC Holdings Plc in 2004. Haley built similar teams at Lehman, Chase Manhattan Bank and Amsterdam-based ABN Amro Bank NV.

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