How to lose billions

Andy Kessler:

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So Wall Street, as it always does, gave investors what they wanted -- excess yield in the form of derivatives, asset-backed, mortgage-backed, collateralized debt obligations (CDOs), basically funky amalgamations of lots of other pieces of paper. Done right, no one but you knew how to value these exotic instruments, so you could mark them up way more than a penny and generate huge fees, profits and bonuses. Win-win.

Low interest rates from the Federal Reserve and a rising housing market meant the subprime flavors of these CDOs took off like wildfire. Merrill Lynch and Bear Stearns and everyone else raced to package up these CDOs with pretty bows and sell them off as high rated goodness to those hungry for yield.

Banks loved it because they could sell off loans, generate fees and go make some more. It wasn't enough. Billion-dollar hedge funds popped up overnight to buy these things, with leverage on leverage to generate even higher returns. Savings & Loan banks were long gone, so by 2006, armies of mortgage brokers, many just online, answered the call to feed the beast with loans.

Until it went on for too long. By 2006, it was a one-way trade. Banks, especially Citigroup and State Street, couldn't resist the sweet siren's call, especially with "borrow short, lend long" in their DNA. Off balance sheet, they set up conduits, so-called SIVs, to use leverage and buy up lots of these subprime CDOs -- $100 billion worth for Citi -- breaking Wall Street's unwritten "sausage" rule that you sell this stuff to clients, but never own it yourself.

SIVs were mostly invisible yet huge money makers, which makes me question how much money the plain old bank was making. Not much, it turns out. And in the end, neither did these SIVs. Others like Merrill Lynch and UBS got caught with inventory of these CDOs, having packaged them but not able to sell them off fast enough. Goldman Sachs smelled spoiled meat and shorted enough of the market to minimize the hit to their capital structure.

When the inevitable blowup came, most holding the toxic sausage required new capital from a government bailout to survive. No not from the Fed, but from the governments of China, Singapore, Abu Dhabi, Kuwait and New Jersey. Without their cash, Citi and Merrill stocks would halve again.

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There is much more including what to expect from the shake out.

I have often said that to lose really big bucks it takes leverage. If you are just buying a stock or a bond it is hard to go below zero. But with leverage the losses do not stop at what you put up. That is why most leverage investment vehicles such as margin on stocks, or futures have triggers that require either additional investments or sales before you hit zero. It is really strange that sophisticated bankers thought they were immune to the down side of leverage.

It is also strange that they did not comprehend the risks of using mortgage brokers with a built in conflict of interest and little to lose when making a bad loan on highly leveraged transactions. Probably there was some lawyer who worked on the deal who may have raised the question but that same lawyer probably became a voice in the wilderness.

One of the anomalies of the investment banking business is rewards revenue producers much more than those who save them even more money. It also tends to listen to the producers more than the questioners too. I usually won those debates by pointing out that the company would be giving a free put with each trade.