For an elite few, credit pain means profit

By Jon Markman

Any journalist worth his weight in cigarette stubs knows that every financial crisis must have villains: a cabal of cranky, omniscient, uncaring old men pushing buttons that drive stocks and home values down, ruin families' retirement plans and make kids cry. Picture bank tycoon Henry Potter in "It's a Wonderful Life," described as "the richest and meanest man in the county," or Mr. Dawes in "Mary Poppins," who fires Jane and Michael's father after he accidentally causes a run on the bank.

Yet the curious thing about our very own nonfiction financial crisis today is that the bankers are themselves victims, even if they're not entirely blameless. One-time "masters of the universe" have gone from superheroes to village idiots, as Bear Stearns (BSC, news, msgs) shares have plunged 40% this year, Merrill Lynch (MER, news, msgs) is down 38% and Washington Mutual (WM, news, msgs) is down 50%.

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And the villains? That's a bit more complicated. But one key dramatic element in all of this is that there is indeed a group of increasingly rich individuals who wanted the current credit meltdown to happen. They had a plan. They're sticking with it. And it's working.

Too low, too long

To understand the bad guys' game, you'll need a bit of background. First, it's critical to keep in mind that the debt markets are at least 10 times larger than the stock market and yet are largely unseen and greatly misunderstood. Virtually all important day-to-day financing of governments, companies and pension funds happens with credit instruments due to expectations that loans will be repaid on a contracted schedule with interest. Stocks are a frivolous afterthought in the world of corporate finance -- speculative playthings.

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Banks for decades have made their profits by borrowing money cheaply from passbook savers and lending it at higher rates to companies. Pension funds likewise make profits by lending employees' savings to companies. This works great when there's a big differential between incoming short rates and outgoing long rates, but when the "spread" narrows, there's trouble.

In the aftermath of the turn-of-the-century bear market, recession and the Sept. 11 terrorist attacks, the Federal Reserve, led by Alan Greenspan, upset this rich dynamic by slashing interest rates to superlow levels in an effort to stimulate commercial and individual investment. That put the economy back on its feet by 2003, but holding rates low for a long time had the unfortunate effect of making it hard for banks and pension funds to profit.

Bankers scrambled for innovative ways to create income-generating instruments. They hit ultimately upon the idea of encouraging low-income Americans to borrow from them to buy houses, clothes, cars and electronics, and then piled those shaky new income streams into packages known as asset-backed securities, which were themselves used as collateral to create another high-yielding type of debt known as collateralized debt obligations, or CDOs. Banks took big fees at every step along the way, putting rocket boosters on their profitability.

Those exotic instruments were so avidly scooped up by Asian and Mideast sovereign and pension-fund managers -- who had been ravenous for high-yield places to store and grow their mounting piles of money amid an emerging-markets boom -- that financial engineers figured they should take it a step or two further. Nothing succeeds like excess, right?

So they encouraged banks to use the CDOs as collateral for "doubled" and "cubed" CDOs, and then piled those into new financial warehouses called structured investment vehicles, or SIVs, that were themselves used as collateral for such seemingly safe instruments as the sort of short-term commercial paper that underlies money-market funds. Top bankers at Merrill and Citigroup (C, news, msgs) who had once shunned such risky paths were forced to get in on the action and become major players.

Huffing and puffing

Now here is where the villains come in. All of these instruments rely on confidence for their very existence. Commercial paper could exist only if brokers believed SIVs were valued properly, and SIVs could exist only if their managers believed their underlying CDOs were valued right, and CDOs could exist only if their managers believed the underlying loans were properly valued, and so on.

Confidence is the heart and soul of credit markets, as unlike stocks, no promises of future growth will suffice -- only streams of cold, hard cash will do.

Now it turns out that slowly emerging at this time were a group of hedge-fund managers running their money in a style known as credit arbitrage who came to believe that these towers of debt were houses of cards just waiting to be pushed over. But how? There are no straightforward ways to short-sell these kinds of instruments.

Continued: Destroying confidence

TAGS: MORTGAGES - CREDIT CRUNCH - INVESTING - BANKS

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