Junk Bond Logic

In Criticism, Financial, Popular Posts on April 19, 2010 at 6:27 PM

Do you remember at the end of the Breakfast Club, when potential Prom Queen Claire started making out with Bender, the high school reject? It’s easy to understand why she did it. They had been cooped up in that library all day, revealing their cigarette burned souls to each other. Plus, if you’re Claire, there’s no better way to piss off your parents than to make out with a guy right in front of their car, as they come to pick you up from detention. Claire was feeling good; she was breaking the rules. But come Monday, you knew it was going to be awkward. How was Claire going to explain this to her friends? She didn’t need this – not in her senior year.

That’s where the rating agencies come in. Our public pools of money can often act irrationally, in a way that has consequences in the long run. For decades, our pension funds sat in the safest types of bonds: Federal, Provincial, State, Municipal, and certain commercial bonds. A combination of regulation and ratings created a fence around the money, so it couldn’t chase Benders.

The rating agencies issue a rating for each bond, and pensions are permitted to invest in only those bonds that have an “investment grade” rating. In the past, pensions had never invested in abstract derivatives; they always sought out real bonds that belonged to tangible businesses. Ultimately, it is the blessing of the rating agencies that controls the universe of investments available to our public pools of money.

There is something else from the 1980s that is critical to the story: Junk Bond trading. Investment banks were making a ton of money trading Junk Bonds. Traders had discovered a profitable phenomenon. Naturally, all public money was prohibited from investing in junk bonds because of its poor rating. However, the public pools of money were so large and they represented such enormous demand, that it created a large disparity in the bond market. The demand for investment grade bonds was inflated in value, while the market for junk bonds thinned out so as to provide ample buying opportunities. Throughout the eighties, traders would buy junk on the cheap and profit with patience.

Then a man named Fred Carr did something crazy.

In 1989, Fred Carr created a Collateralized Bond Obligation that changed the landscape of junk bonds forever. Carr worked at First Executive bank, and like every other investment bank at that time, they held a large portfolio of junk bonds. Regulations required Carr to fully finance his reserves. In other words, regulators were concerned that these junk bonds might default, so they forced First Executive to keep cash on hand specifically providing for these junk bonds, in case they failed. For every dollar of junk you hold, you must set aside a dollar in your vault. This was to ensure that First Executive could continue operations if the bonds defaulted or became unmarketable. This is standard operating procedure in the banking world.

Carr took all his junk bonds and pooled them together into a new corporation (Special Purpose Entity). Once all the junk bonds were in a separate entity, that SPE issued three types of shares. Class A would be guaranteed a return of 4%. Class B would get a return of 6%. The final class would get whatever was left over, and was by far the riskiest class since it was not guaranteed to get anything.

Carr knew that the risk of all the junk bonds defaulting at once was low. By pooling them together, he created a new financial instrument. Sure, maybe one or two bonds in the pool might default, but most of them would be fine. In the new pooling scheme he had created, he could easily promise the first two share classes a reasonable return, while leaving the risk of those few bonds defaulting entirely on the final share class. Collectively, the bonds were worth more than they were individually, because the risk of default was spread across the pool.

After creating this SPE that was made up entirely of junk bonds, First Executive proceeded to purchase 100% of the new entity. In reality, First Executive had exactly same portfolio as it did before the transaction. However, the way he had designed the share classes, he was able to get around the reserve requirements. The first two share classes were rated highly by the agencies, as they promised a fixed return while presenting a very low risk of default. All the risk of any bond defaults was borne by the final share class, aptly referred to as “toxic waste.”

Previously, First Executive had to keep cash on hand for the entire pool of junk bonds. Now, they only had to set aside money for the riskiest share class. As a bank, there is an inherent advantage to keeping fewer reserves. It means they can increase the amount they lend while still pleasing regulators. The risk to First Executive was exactly the same as before, yet by changing the legal form of their portfolio, Carr had persuaded the rating agencies using the junk bond logic of the 1980s.

For the next 20 years, Wall Street followed in Carr’s footsteps. Investment banks created SPEs not just for junk bonds, but also mortgages, car loans and credit cards. Because the first two share classes receive the good credit rating, public pools of money could now buy these products.

And buy it they would. Public money has an insatiable appetite for above-average returns with investment grade risk. Rating agencies, often thought of as gatekeepers, opened the doors so our money could participate in credit pools that were previously restricted.

Imagine if you were Claire, and you showed up to school on Monday to discover that all your friends suddenly had a big crush on Bender. At that point, you don’t ask why; you just go for it.

  1. Great entry today!

  2. That is a great metaphor!

  3. totally right about the CDO's.this type of securitization is the crux of the majority of problems in the FI sector today.didn't know that was the origin tho.

  4. It wasn't the original CDO, but it was the original CDO where they got the rating agencies to tier their ratings that way.

  5. Fantastic post, Umar and loving the Breakfast Club analogy. Have you been reading any of the 'post-clash' books that have been published recently? The Big Short, The Greatest Trade Ever, Too Big To Fail, etc?

  6. I don't know how to describe what I've been reading, but no, none of the books you've named. My recent favourites on the topic: Black Swan, Infectious Greed, The Ascent of Money, Confessions of a subprime lender, The Value of Nothing. All of these books would be interesting even if we didn't have a crash, but the ideas are deeply interrelated with what went wrong. But I do plan to read the big short cause Mike Lewis is a great writer, and I've heard many good things about too big to fail as well.

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