New book explains housing meltdown as Financial Origami (USA Today)   Leave a comment

Origami comes from two Japanese words: ori, meaning to fold, and kami, meaning paper.

 
  • "Financial Origami: How the Wall Street Model Broke," by Brendan Moynihan.Freudenthal Verhagen/ Getty Images”Financial Origami: How the Wall Street Model Broke,” by Brendan Moynihan.

Freudenthal Verhagen/ Getty Images

“Financial Origami: How the Wall Street Model Broke,” by Brendan Moynihan.

In Financial Origami: How the Wall Street Model Broke, Brendan Moynihan argues that origami is what Wall Street does in creating financial products. Bankers take stocks, bonds and insurance contracts and fold them into new, complex financial instruments.

Moynihan takes us down a trail that begins with savings and loans providing home buyers with conventional mortgages and ends with investment banks enticing investors with high-yielding mortgage-derived exotica. Step by step, or fold by fold, he explores the mortgage securitization chain, explaining mortgage-backed securities, collateralized debt obligations, credit default swaps and synthetic CDOs.

Each chapter is named for a fold to the origami. Chapter 1 — “Fold Sides to the Center” — follows the trail of money through commercial banks, S&Ls and securities firms. Chapter 2 — “Result, Turn Over” — explains the purpose of options, futures and swaps in transferring risk. Chapter 3 — “Fold Sides to Center, Again” — explains the purpose of derivatives in manufacturing risk.

Keeping mortgages on hand while homeowners paid them off was what S&Ls did in the staid old days of mortgage finance. Bankers in Moynihan’s cross hairs regarded home loans nesting on balance sheets as dead capital to be put to use.

If mortgages were performing well, they could be packaged into securities and sold to investors. Bankers didn’t start the lucrative practice — credit Fannie Mae and Freddie Mac for that. But the next permutation belonged to Wall Street: bundling loans into CDOs. CDOs transfer risk by dividing it into different classes, or tranches.

With the assistance (or connivance, say cynics) of credit-rating agencies, securities in the top tranches were rated AAA despite the infusion of thousands of subprime mortgages.

Moynihan contends that demand for the new products spurred subprime lending, which ultimately triggered the financial crisis. Investors here and abroad craved the higher yields on derivative products in a low-interest-rate environment that lingered long after the bursting tech bubble and 9/11 terrorist attacks.

“The variations on these products aren’t as complex as they sound or look,” Moynihan, an editor-at-large at Bloomberg News, wrote in a column. “The firms simply fold and refold the three core pieces of paper into intricate designs, sometimes to skirt regulations, sometimes to meet investor needs, always to make as much money as possible.”

Wall Street’s business model was built to transfer risk, Moynihan says. In the decades leading to the financial meltdown, however, investment banks thrived by fabricating risk.

He marks the start of the model’s transformation with President Nixon’s decision in 1971 to sever the link between the dollar and gold. The action ended the Bretton Woods international monetary system, in place since 1946.

Before 1971 financial markets were restrictive. Afterward, regulations would be relaxed or even eliminated. By the Reagan presidency, there were no more ceilings on bank or thrift deposits; no more fixed brokerage commissions. Adjustable-rate mortgages had been introduced. Investment banks had shifted from partnerships to the corporate form of organization; as a consequence, underwriting took a back seat to trading.

The ultimate act of Financial Origami came as a result of Main Street‘s inability to supply enough mortgages to feed the ravenous appetite of CDO managers, Moynihan says.

Moynihan demystifies a complex subject, giving the uninitiated a tool of understanding how too much debt and leverage destroyed a time-tested business model. New rules are on their way, and it will be interesting to see how Wall Street will find ways to skirt them.

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Posted June 4, 2011 by ilanamelissagreene in Uncategorized

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