EASY ISN'T IT?

Thinking like Mike, that is. The answer to yesterday's question is of course greed. You had a number of firms doing a nice, easy business, making a bit here and a bit there when some really smart guy said, "Hey, why can't we apply this business model to other area, guaranteeing debt for banks, corporates, ANYBODY!" Of course the anybodies of the world didn't have any real taxing power and no one gave much of a thought to the fact that if their credits were not rated triple A there must be a reason. And it was off to the races.

Now guaranteeing the primary obligations of a corporate's direct obligations is one thing; there is historical evidence of performance, usually sound projections, products to be analyzed and assets to be valued. Remember, it is not the issuer that is rated but the paper that is issued meaning that multiple bonds of a single issuer may be rated at different grades depending upon structure, security, maturity and a host of other different criteria. The funds obtained are used in the growth of the business. That of course is the case if there is a "real" business involved. But what happens if the issuer has been created just to issue debt, relying on the income stream from debt instruments purchased by the same debt of the newly created issuer? Whoa, you say, this gets dicy. Yep, sure does. Nobody can figure out these so-called special purpose corporations ("SPCs") so the easiest thing to do is to get a company, such as AIG, which has a Triple-A rating to guarantee the debt issued by the SPC and we all go home happy. This is a highly complex exercise made particularly so by the nature of the debt purchased to support the issuance that I've made to sound easy; trust me it's not. What has to be determined is the odds against non-performance of these myriad slices of debt and for that you need a whole bunch of really smart math guys, known in the trade as "quants" to tell you what the odds are. They create models for each circumstance and based upon these models a risk profile is created and the price at which one is prepared to guarantee is agreed. The mathematics is, by definition, always correct; the assumptions, however, may be very, very wrong. But it was easy money; what good is a Triple-A rating if you can't use it? The problem of course was that much of the SPC issuance that was credit enhanced was related to real estate debt, and when folks began to realize that the massive creation of such debt had led to ridiculous liquidity which led to mother of all bubbles is when the excrement hit the revolving device.

Spreads on all credit enhanced products widened, even those on "normal" debt and especially those relating to emerging market debt. You see, any holder of a debt instrument could ask for it to be enhanced; indeed you didn't have to be a holder at all, you could purely speculate in the instruments themselves. No one knew who had guaranteed whom and for that matter the exposure of an institution on one risk could not be determined with any certainty. It was the wild west with the market creating and pricing credit risk that may or may not have existed with the result predictable to many and forecast by some. In a nutshell what happened was that holders of these guarantees began to suspect that certain guarantors were overexposed and, as was their right, demanded collateral--read CASH-- to be put up in support of the guarantee. To use AIG again as an example, they ran out of cash or near cash and the game ended. By this time no one knew what the ultimate exposure was as the problem was not simple AIG but the solvency of many of their clients in relation to AIG exposure and other risk in the case of an AIG bankruptcy. The risk became systemic. There is a first law in the credit business: You never make as much in interest or fees as you lose in principal. Could this have been prevented? Perhaps. Next week, we will try to explore how and what might be done to protect the future. You see, we are off to The Large Apple for the wedding of an old friend's daughter tomorrow. For those of you in the business I know I've made this so plain vanilla as to be ridiculous but there are folks out there who really don't know what happened. My apologies if some have been bored to tears. We'll liven in up next week. Back on Monday.