This week, plenty of the pop financial press are doing pieces on the 10th anniversary of the 2008 financial crisis. And they’ll cite the fall of what was Lehman Brothers as their news peg. But really, the trouble in the financial markets came well before. And no, the burst of the housing bubble wasn’t the cause. The housing bubble burst was but one facet of the financial market crisis that caused the meltdown of many financial firms, investment funds and even some banks and ultimately, the Great Recession.
What really was at the core of the problem actually surfaced during the summer of 2007. Basically put, well-run and well-capitalized companies failed to do their jobs when it came to buying pools of loan assets.
An Explanation of Pooled Loan Assets
Pooled loan assets come in many flavors. They also come with all sorts of acronyms. For example, CLOs stand for collateralized loan obligations. These are commercial or retail loans that have been originated by various lenders and banks, which are then rolled into individual securities that institutional investors can buy rather than originating their own loan portfolio. CDOs stand for a similar collection of collateralized debt obligations — which again are loans and debt instruments that are packaged to form tradable securities.
And then we have ABSs — or asset backed securities. These are other debt liabilities that can include a wide variety of interest and principal paying assets that can include credit card debt, auto loans and auto leases which are pooled together.
Then there are the mortgages in the home market. MBSs are mortgage backed securities. Like the CLOs and CDOs, these are mortgages that are packaged together to form tradable securities.
Then in the case of each of the above, there are many more permutations that can take the various pools to form even more pools — making them packaged securities of packaged securities.
Pooled loan assets can also be cut up to represent principal and interest payments. This allows investors to make bets on what will be paid in regular interest payments and what and when principal payments will be made.
If all of this is making your eyes glaze over and you’re thinking of clicking on another story, there is another class of these sorts of securities involving CDSs or credit default swaps. These can be on individual debt issues or on pools of the above securities and can even be pooled together on their own to become pools of CDSs.
A CDS at its core, is a form of tradable insurance on an underlying security. The seller, seeking to reduce their risk of a default gives up some of the yield of the underlying security. And the buyer takes the risk and in turn is paid to take that risk in the form of a stream of income or a fixed payout.
And if a CDS is triggered by a default, then the seller gets a set payout from the buyer.
Summer Sizzle
Before the 2008 financial crisis, there was the Summer of 2007.
In the Summer of 2007, there were a few financial firms that were investing in various securities made up of the above acronyms. And at the top of the heap, the storied Bear Stearns had some of its investment funds focused on this sector. The funds began to see losses and in order for Bear to keep its funds up and running, it sought to shore up the funds by various mechanisms — including taking some of the securities onto its trading book.
But the trouble became more than just a few securities. Because as one of the securities was marked to market — meaning that the firm put an estimate on the market value — the securities would be marked down meaning that the price was reduced.
Once one was marked down, others would have to be as well. Then to meet capital requirements for trading agreements with other firms as well as for their other creditors, some of the marked down securities would be sold to raise cash. The trades would result in even lower market values which set the rest of their portfolios spiraling down in value.
The final workout came in 2008 with Bear Sterns’ liquidation and acquisition by JP Morgan (NYSE:JPM). But Bear Sterns was not alone. There was a cavalcade of similar houses that were caught in the same mess, including Lehman Brothers.
And this was especially the case in many of the major European banks that then — and still now — utilized the capital markets to raise deposits and loan portfolios buy selling wholesale deposits to fund pooled loan assets.
Even today, there are plenty of these securities that are still out there and many more astute investors –including many hedge funds with cash at the time — swooped in and bought them at dimes or pennies on the dollar back during the 2008 financial crisis.
What Went Wrong, Will Do Again
The trouble back in 2007-2008 is that the investors didn’t take the time, nor the effort to fully analyze and comprehend the underlying values of the pooled assets and liabilities. And armed with generic credit ratings from firms like S&P, Moody’s and Fitch — which didn’t largely do their homework either — regulators, banks and other financials were content to take valuations of these securities at face value.
None of this was illegal.
And what we did learn was that if regulators and creditors aren’t paying attention, why should the institutional investors and bank trading desks pay much of a mind to what’s on their books?
Even today, ten years after the 2008 financial crisis, while there has been a bit of an improvement in hiring better experienced and better paid regulators, there are still huge vacuums of understanding of the underlying assets and liabilities in pooled securities.
Each of the pooled and derived securities in their own right provide vital contributions to the smoother operation and improved credit conditions of financials and banks as well as the overall U.S. and global financial markets.
Without the ability to allow banks and financials to face the true risk of failure, there is less of an incentive for the participants in these markets to do their needed homework.
Rinse and repeat is unfortunately the reality of the financial markets. And if we’re not careful, we could eventually see another event like the Great Recession.
Neil George is the editor for Profitable Investing and by company policy does not have any current holdings in the securities mentioned above.
