Hard Landing / The Real Crisis May Not Have Hit Yet

Heard of CDOs squared? Think it has nothing to do with you? Think again.

At the height of the subprime crisis but still before the great crash, a certain kind of derivative was still circulating in the international markets, a securitized certificate called a "CDO squared."

These were collateralized debt obligations (CDOs) comprised of other CDOs whose underlying collateral included residential mortgage backed securities. Alternatively, they were bonds based on chunks of mortgage loans being sold for the third time.

How on earth do you do that? You bundle together a huge package of subprime mortgage loans and divide it into 16 unequal chunks. At one end you have the chunk of loans that will almost certainly be repaid, and at the other end the shakiest loans. You sell each chunk onward through bonds whose ratings range from AAA (blue-chip) to BBB (doghouse).

But it doesn't end there. Now, you repackage all those BBB chunks together into a huge pile, divide it into 16 unequal chunks and sell it again as separate bonds. And, believe it or not, the credit rating agencies gave the most superior part of this dodgy stuff an AAA rating, while the most inferior got BBB.

But even that that isn't where it ends. Now, you bundle all those inferior BBB chunks together into a huge pile, repackage and split it again and sell it again. You guessed it: the credit rating agencies gave the most superior part of this icky stuff a senior AAA rating.

And that, dear reader, is a CDO squared. The most inferior stuff was sold again and again in two rounds of securitization and were rated at levels reserved for U.S. government debt.

The rules of economics are that demand creates supply. The fact that there were investment banks and commercial banks that carried out the financial engineering, and sold squared garbage at an AAA rating, is structural. Banks have no sentiments. If you'll buy it, they'll sell it.

The less understandable aspect of all this is, who on earth was buying this toxic stuff? Who agreed to spend hard-earned money on rubbish squared?

You were, that's who. Not directly, perhaps - you didn't waltz into your back begging to buy stinking fish. Happily, Israel's capital market is an immature thing, so these financial finagles didn't cross the ocean. But the widows and orphans of America bought these hybrids through their provident and mutual fund and hedge fund holdings.

Ah, you sigh, why should you care? That's their problem. But you're wrong. The mechanism by which America's fund managers bought the alchemical sludge without asking silly questions is the same mechanism that our provident and mutual funds use in Israel. It's the same mechanism driving our bankers and brokers, who by a miracle were spared the hideous wrath of the markets.

The mechanism is humanity. Banks such as UBS bought billions of dollars worth of the engineered sludge because they're staffed by humans. They may be highly educated and clever humans with degrees in economics and statistics (which should have taught them about the fallacy of alchemistry), but they're just humans with that basic human craving: to make a buck.

The root of the problem is basic. What motivated the finance sector employees? Was it the greater good of their customers - the investors, the shareholders? No, it wasn't. The brokers and their customers were at odds, and that was the root of all evil.

Savers and shareholders want to earn money over years, at a reasonable level of risk. The finance sector employees wanted to earn as much money as possible as quickly as possible, and let long-term profit go hang.

And thus the demand for the CDO squared was born. It was demand created by people driven by one thing only: achieving the highest possible returns in the shortest possible time and to hell with the risk. Interest rates around the world were very low: It was hard to make a killing through more ordinary avenues. Also, the investment banks were in a cutthroat contest over who could make the highest returns, resulting in the fattest bonuses.

No wonder Wall Street shut its eyes and gorged on these mutated derivatives.

Make no mistake, much the same happened in Israel too, but luckily for us the derivatives were a lot less dangerous. Here too the contest to achieve the highest returns led to obliviousness to risk. Institutional investors gorged on corporate bonds. Provident funds today have put as much as half their managed assets into corporate debt, instead of into safer Israeli government debt, just because the companies were offering slightly higher interest rates.

Institutional investors are believed to have bought NIS 11 billion worth of ungraded (read, high-risk) debt in the last few years. If it was a corporate bond and it twitched, somebody would swallow it, no matter how inferior its flavor. And we will be paying the price of this gluttony for years to come as the companies default on debt.

Why did this happen? Because the competition between the investment banks focused on the wrong thing, from our perspective. All they cared about was achieving the highest profit in a given year. But all we savers care about is achieving the highest profit over time. The gap between the two is all about risk. To achieve fast gains means to take high risks and to lock in gains over the long-term is to settle for lower risk.

One lesson is that the way a financial firm's results is measured must change, to factor in risk criteria. Profit must be measured not in net terms, but adjusted for risk. Also, the way the bankers and brokers running our money are remunerated must also change. They cannot be allowed to earn millions plus options plus golden parachutes if they fail us, the long-term savers. A paycheck of millions in a country with social gaps like Israel's is not merely immoral; it causes actual economic damage. Pay incentives at the banks and brokerages must be linked to long-term achievement, to link between their aspirations and ours.