Anatomy of a 'Structured' disaster

The financial world seems to be coming a full circle. While the global markets are busy trying to adjust to the problems triggered by the sub-prime meltdown in the US, data on the economic front threatened to spoil the recovery party. Suddenly, everyone is worried about 'risks', which they thought had been effectively 'diversified' away. The very financial innovation (Structured Products) that made investors happy till recently has suddenly turned their worst enemy.

And, as usual, turmoil in the markets leads to a round of scapegoating and finger pointing. The scapegoat ranged from rating agencies to the structured products themselves. In this post, I put investor behavior under the scanner. We will see the extent to which man - greedy as he already is - can stretch himself for that extra penny. I look at the whats-n-whys of 'Structured Products', the resulting collapse, and end with a commentary on investor thinking. 


'Structured' to perfection?
Problem statement: Lets assume that you are a pension fund investment manager who has a mandate to invest ONLY in the highest quality debt products (AAA rated). You cannot invest in Equity. You find your returns being relegated to the back pages of newspapers and rankings. Not surprisingly, you aren't even taking home a decent bonus, whereas you find your neighbor (a hedge fund manager) going from middle class-to-wealthy-to-rich-to-filthy rich almost overnight. You come to me for a solution.

An ingenious solution to the problem props up in my mind. I think..."What if I invent a 'debt' product which will give an 'equity-like' return?" And lo! A product is born! I call it a CDO (Collateralized Debt Obligation). Before I present a chart, let me give you in two lines what it means...
People take mortgage loans. So? Simple, I club a slew of loans together ('securitize' them) and sell it to willing buyers. Okay, some borrowers will have ugly credit histories and hence the highest risks of default. So they carry higher risk, so an investor in these will have to be compensated with a higher return. But its still a debt product remember? So I look around for buyers and I find a willing buyer. In you. Higher risk implies higher return, so you are compensated for bearing the higher risk on these NINJA (No Income No Job or Assets) loans.
And so a product is born...
If these NINJA guys don't default, then there is a quite bit of money to be made. And this is what happened till recently. The CDO boom in some ways can be traced to the housing boom in the US and low interest rates. People took more and more mortgages and CDO demand followed. But as with all good things in life, this party too had to come to an end.

Interest rates started inching up in the US, gradually reducing demand for houses. Falling demand leads to falling prices. Falling prices meant that most people who bought at lofty levels were left with 'assets' that suddenly lost a big chunk of its value. The double whammy of rising rates on his mortgage loan and falling house price, resulted in Johnny feeling the heat. Result...Defaults started rising. Hmm...chart time.
Since defaults started rising, investors very quickly found themselves holding on to pieces of paper...Hell had broken loose...

Can I afford it? Another factor probably went unnoticed for a long time. A metric named "Debt Service Ratio", which is the ratio of debt payments to disposable personal income. The little ratio was happily trending up since 1994 but nobody seemed to be bothering too much...till recently. When enlightenment dawned, the dream ended...and nightmares began...

As with any haphazard linkage, nobody knows whether the strain on finances led to slackening housing demand or vice versa. Or was it some other reason? And as with most bubble bursts, this was just one of the multitude of reasons behind the bust. But the blame went to something else.

Human Psychology
In the rather quick (and short) round-up of the mechanics of structured products, I turn to the last part of this post. Human thinking.

In order to appease eager bankers trying to sell these products to even more eager investors, rating agencies gave their stamp of approval with an AAA or AA rating. Bankers armed with this 'invincible' tag, didn't need to as much as lift a limb to sell the products. They opened shop and quickly found the products disappearing off their shelves.

The burst sent everyone running for cover. Investors blamed bankers, bankers blamed rating agencies...who conveniently washed their hands off the entire affair. The losers (and there will continue to be) were investors. Supposedly sophisticated investors, with the information world at their feet, were forced to revisit their assumption of invincibility. Big hedge funds suffered ignominious losses...but no one was ready to put it down to greed.

The entire structured finance business was branded a sham. A weapon that had backfired. Was this really the case?


I don't agree. Personally, I like the concept of innovating in the supposedly dreary area of investing. (Someday I might dedicate a post for this!). Products by themselves are never 'bad'. Its when 'investors' lap them up without understanding the risks that the dream run goes horribly wrong. The blame, finally, has to rest with the investor and his greed and his naivete. But in a competitive world, where human beings pressure one another to earn the extra return, these qualities are buried somewhere in the recesses of the brain.

Now I am sounding like a saint! Anything but. I believe that investors (whether amateurs or experts) would do really well to invest only in things that they understand and comprehend fully.

I am willing to wager that human beings seldom learn from their mistakes, especially in the investing world. We just discover novel ways of making new mistakes.