Wall Street’s Financial Alchemy / Wizardry and the current Market turmoil due to the sub-prime mess

If you think, as an individual investor, you have no exposure to the sub-prime arena and hence your investments are safe , you are wrong.

The turmoil in the stock markets over the last week are but one manifestation of the far reaching implications of the problems in the sub-prime space. It is a perfect example of financial wizardry gone wrong and the butterfly effect.

The following analysis uses as input, the thoughts, ideas and opinions stated by various experts in the field including the Wall Street Journal and the Time magazine.

The start of easy credit - Everybody gets approved for a Home loan

During the period of 2002/2003, when stock market returns were low and the interest rates were also low, financial institutions started looking out for new avenues to improve their returns which had started looking anemic.

Wall Street had just the vehicle they wanted - securitization and the creation of exotic financial instruments / derivatives (i.e those financial instruments that derive their value from another underlying variable/asset)

Securitization turned loans that sat on banks books into securities that can be sold in the global markets. It involves the sale of the loan by the lender to a new owner–the issuer–who then sells securities to investors. The investors are buying “bonds” that entitle them to a share of the cash paid by the borrowers on their mortgages

Here comes the Financial Alchemy / Wizardry /Naiveté / (Fraud ..shhh)

Wall Street took this practice a step further by packaging bigger pools of securities into collateralized debt obligations, or CDOs. With CDOs, you package a bunch of low-rated debt like sub-prime mortgages and then break the package into pieces, called tranches based on the level of risk/return.

The alchemy begins when rating agencies such as Standard & Poor’s and Moody’s wave their magic wand over the top tranches and declare them to be a top notch AAA rate. This opened up this market for traditionally conservative investors such as commercial banks, insurance companies and pension funds

So, there you go - you have an army of investors willing to buy these ‘triple washed’ mortgage backed securities and banks/mortgage lenders willing to supply the sub-prime loans to Wall Street which converted them into these securities for a hefty profit. The home buyers also benefited with many getting loans they otherwise would never have.

Alas, abnormally good times don’t last long

The tide turned when home prices started stalling and even going south. The sub-prime borrowers who kept postponing the day of reckoning by refinancing their appreciating homes could no longer continue to do so. And the defaults started.

The Dominos are starting to fall

The first to be affected when things started going south were the sub-prime lenders and those who bought vast quantities of these junk instruments. These included hedge funds like the two Bear sterns funds that blew up - ‘High Grade Structured Credit Strategies Enhanced Leverage Fund’ and ‘High Grade Structured Credit Strategies Fund’. (Note the words ‘Structured Credit’ and ‘Leveraged’)
The domino effect has just started. The last few days of gyrations in the stock market are indications that the contagion has spread. The reason is the tight linkages between the various markets via the players who straddle these different markets.

A number of hedge funds are failing and the key reason is the extremely high leverage they carry. For anybody who has used margin money while purchasing / selling stocks, the concept of leverage should be very clear. For example, a 10 to 1 leverage implies $10 of position with $1 of funds in the account.

As things started to go south for highly leveraged funds holding the sub-prime securities, they started facing margin calls and since nobody is willing to buy sub prime assets, they started selling those assets which can be sold, thus depressing the value of even the non sub-prime assets which can include stock and other securities that are completely unrelated to the sub-prime problem area. This now triggers a fresh set of margin calls for hedge funds who hold these non-sub prime assets as the value of their portfolio erodes. The cycle of blood bath thus continues.

Only the future will tell how this will end and how much of the financial market turmoil will translate to the economy. What is certain however is that we have not seen the bottom of this Gorge.