stocks, bonds ... derivatives

From Weekend TODAY ...

Anatomy of a crisis
How investors hungry for returns got more than what they bargained for
Weekend • January 26, 2008

What do banks do when investors clamour for yield when the financial markets are in the doldrums, and cannot offer substantial returns on traditional products like stocks and bonds?Give investors what they want. And that was what Wall Street did in 2003, planting the seeds of the current sub-prime crisis, said Andy Kessler, a former hedge fund manager and author of How We Got Here.Mr Kessler said at the time, a mild economic slowdown in the United States had been pressuring the Dow Jones Industrials to trade below 8,000. Banks had no place to put their capital to work, while lending, stock listings and mergers were down. This mean traditional sources of income were doing little.Wall Street saw an opportunity for business and grabbed it. Banks packaged and offered for sale derivatives, asset-backed, mortgage-backed, collateralised debt obligations (CDOs), and funky amalgamations of lots of other pieces for sale."Done right, no one but you knew how to value these exotic instruments, so you could mark them up way more than a penny and generate huge fees, profits and bonuses. Win-win," wrote Mr Kessler in the Wall Street Journal.At the same time, the Federal Reserve and a rising housing market meant that the sub-prime flavours of these products took off like wildfire. Merrill Lynch, Bear Stearns and virtually everyone else raced to package these CDOs with pretty bows and sell them as high-rated goodness to investors hungry for yield.Banks loved it because they could sell off loans and generate fees. Billion-dollar hedge funds popped up overnight to buy these things, with leverage on leverage to generate even higher returns. Savings and Loan banks were long gone, so by 2006, armies of mortgage brokers, many just online, answered the call to feed the beast with loans.But it went on too long: By 2006, it had become a one-way trade. Still, some banks began setting up off-balance sheet items. These conduits, so-called SIVs, use leverage or debt to buy up lots of these sub-prime CDOs.Citigroup for example, had US$100 billion ($142 billion) worth, breaking Wall Street's unwritten rule that you sold this product to clients, but never owned it yourself. As it turned out, these products made little money.Others like Merrill Lynch and UBS got caught with an inventory of these CDOs. They had packaged them but could not sell them off fast enough. Goldman Sachs smelled spoiled meat and shorted enough of the market to minimise the hit to their capital structure, Mr Kessler said.And when the inevitable blow-up came, most required new capital from a government bailout to survive.
But the money came not from the Fed, but from the governments of China, Singapore, Abu Dhabi, Kuwait and New Jersey. Without their cash, Citi and Merrill stocks would have halved again.