The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash
Charles R Morris
Public Affairs
Is there anyone with just the vaguest interest in finance who doesn’t know their CDOs from their CLOs? Or, say, the difference between a sub-prime mortgage and a leveraged loan? The truth is, although such obscure abbreviations and financial argot have made the nightly news as the global credit crunch has taken centre stage, not everybody understands what separates one from the other, or why these arcane bits of the structured finance business matter to the world economy.
That’s what makes this book worth reading, even six months after its initial publication presciently predicted the turmoil that has characterised the financial system in 2008.
Charles Morris picks apart nearly every innovation of the financial services revolution that has propelled Wall Street and the City of London over the past few decades, thus revealing the excesses that led to the crisis now threatening the global economy. His basic argument is hard to quibble with — deregulation led to great advances in the credit markets. Many of these were good. But like any invention that mints money for its founders and their copycats, the credit boom was taken far over the line. Widespread abuse of the financial system has led us to today’s tumultuous markets — to big High Street bank failures like Northern Rock and America’s IndyMac, to the resplendent collapse of the venerable Bear Stearns.
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As Morris writes in the preface to his book, ‘All successful financial innovations must experience a crash cycle to discover their limits and risks, tighten documentation, and identify the proper role of regulations.’ Morris is right on.
Some of the greatest advancements in finance, such as the creation of collateralised debt obligations and all manner of credit derivatives, are just now being put to this test. But like the junk bonds that were manufactured in the 1980s by Michael Milken’s X-shaped Beverly Hills trading desk and derided a decade later, some iteration of these instruments may not only endure, they may once again become common, and useful, features of the capital markets of the future.
Morris’s primer on the deficiencies of the financial system starts slowly. Perhaps a little history is required to explain how we got here. But running readers through the ‘The Death of Liberalism’ and ‘The Baby Boom’ and the many mistakes of corporations and governments — largely President Richard Nixon’s administration and then-Federal Reserve chief Arthur Burns — slows the narrative. After all, we are trying to get to the $1 trillion headline, the largest bubble to pop in modern history.
Where Morris excels is in explaining how some of the foundations of the contemporary credit markets were created. Take, for instance, the birth of the collateralised mortgage obligation. Its invention was spearheaded in 1983 by First Boston banker Larry Fink for Freddie Mac, the government-sponsored enterprise responsible for lubricating the US housing market. The CMO was designed to segment the various risks in the mortgage market to make them more suitable for different investors. The idea was that some investors wanted the safest exposure possible to the mortgage market and were prepared to take lower returns in exchange — while others wanted juicier yields and were in a position to take on higher risk.
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The innovation put forward by Fink — who went on to found Wall Street investment-management company Blackrock — was both simple and brilliant. Take 1,000 mortgages and put them into a pool. Since 700 of them have a very low risk of default, one could package 60 per cent of the pool into securities with a lower yield but greater claim over the assets in the event of a default. Securities would then be issued with a higher yield for the next 200 of the mortgages, which would only be made whole in the event of a default after the first tranche had been taken care of. Securities backed by the final 10 per cent of the pool would therefore be the last on the totem pole in the event of a meltdown, so they would therefore offer even juicier returns.
But after this, ‘the industry decomposed into highly focused subsectors. Mortgage brokers solicited and screened applicants. Thinly capitalised mortgage banks bid for the loans and held them until they had enough to support a CMO. Investment banks designed and marketed the CMO bonds. Servicing specialists managed collections and defaults.
‘Fierce competition led to razor-thin margins at every step. And since CMOs were so much more attractive to investors, the interest premium, or spread, over Treasuries steadily dropped. An academic study concluded that by the mid-1990s, CMOs saved homeowners $17 billion a year. It is a classic illustration of the social contribution of financial innovation.’
But as Morris shows, the trouble with this fragmentation of the financial system is the loss of accountability that occurs with each step in the process — from the mortgage broker who initiates the loan but quickly passes it up the securitisation chain without incurring any credit risk or the appraiser who overvalues assets with no recourse. In this way, lending and credit standards slipped and a bubble in the housing market was fostered. The deflation of this bubble has led to today’s financial turmoil. Anyone wishing to understand the causes of this turmoil will find The Trillion Dollar Meltdown useful.
