Friday, January 04, 2008

Up To Our Eyes in CRAP

This is my Speculator Column from the October issue of Investor Relations Magazine, written during the summer when it was a joking matter. No longer!


The continuing tsunami of Chinese cash into the US and global financial system has helped create an insatiable demand for new financial instruments that offer long-term security and returns to mop up the flood of liquidity. The banking sector rose to the challenge with its characteristic ingenuity by inventing 'Collateralized Mortgage Obligations,' the financial equivalent of quantum indeterminacy. Money managers, bankers, and many other investors rapidly seized upon CMO's, before the idea became unfathomably unfashionable this year.

Much has been written about the slicing and dicing, the tranches, the algorithmic acrobatics that the sector undertook to package and resell dubious loans for overpriced properties to under-salaried borrowers. A banker friend of mine in his sixties was delighted to be offered a 30 year fixed interest mortgage on his property. His reaction was the same as a patient of my former doctor who had just tested HIV positive at the age of 86. When our mutual doctor began his set-piece speech warning that he might only have 15 years to live, the aging Lothario promptly responded with a question, 'Promise?'

But quite apart from collateral beneficiaries like my banking friend, the CMO's were a triumph of globalization. For example, German bankers, who would have shown the door to any down at heel inner city resident of Frankfurt who knocked on their door asking for a loan, were eager to assume decades-long responsibility for the loan for a ghetto dweller in New Orleans whose home was a fathom or two below the Mississippi water table. The bonds were being sold globally as long-term instruments when on the ground brokers were fostering continual churning of mortgages among borrowers eager to get lower interest rates.

Although, with the customary lemming-like solidarity of the financial community, investors are now pulling out of CMO's with the same alacrity that they were earlier buying into them, there is still, notwithstanding the fads and fashions of capricious investment bankers, a need for stable long-term financial instruments. Standing on the shoulders of others, like most geniuses, I would like to offer a refinement of the CMO's. I propose 'Collateralized Recently-owned Auto Promises,' or CRAP's, as people will inevitably call them.

All across the United States people take out bank loans and get credit from car dealers to buy used cars. This represents collateral every bit as sound as the flakey modular homes in dubious sub-prime hotspots. There are risks in selling instruments backed by collateral of uncertain worth, and on debtors of uncertain risk, but no one seemed to notice when the CMO's were introduced. And so we think that the CRAP will go down well in view of the insatiable historical appetite for such products. Consider what people swallowed with the CMO.

The program is also virtuous from a macro-economic point of view. Along with construction, the auto industry is the gyroscope of the US economy. Just as the demand for new homes is predicated on people being able to sell their existing properties, the US auto industry depends up the buying and selling of previously owned cars. After homes, cars are the single most expensive consumer product that Americans buy, so it is essential for the economic welfare of the nation that there should be ample liquidity in the used car business, while meeting the demand for high-paying paper for brokers and investment managers to palm off on their clients.

There is an obvious synergy here. The skills that enabled these highly paid and motivated bankers to sell CMO's are precisely those that are traditionally associated with the second-hand car salesperson: a robust emphasis on the up-side of the transaction with a scorn for pessimistic downside details.

There is a lot of scope for creative selling of Collateralized Recently-owned Auto Promises, and I have little doubt that before long everyone will have forgotten how they turned up their noses at CMO's and we will all be up to our eyes in CRAP.

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