Fool Me Twice, Shame on Me

The troubles of too-big-to-fail banks weren't the only reason that the world financial system nearly collapsed in 2008.

Another major problem was the widespread use of complex financial products that didn't react as their investors thought they would to changing market conditions . The most infamous of these are derivatives, which Warren Buffett prophesied in 2003 were "financial weapons of mass destruction".

Less well-known, but just as damaging, were bonds based on securitizations of cash-generating assets such as credit-card receivables, home mortgages, or airplane leases. In a typical securitization thousands of assets are sold by one or more financial institutions to a special-purpose vehicle (SPV) that issues bonds to pay for the assets.

Quantitative modeling by investment banks "proved" through stress-testing that, for example, the "AAA" tranche of bonds will always get paid its principal and interest even under dire economic circumstances. The AAA bonds were able to command a low interest rate because they were low-risk; the B and C tranches had higher risk because they had a lower priority in the cash flow "waterfall" and had to pay a higher interest rate. Through the magic of financial structuring and computer modeling, the total of A, B, and C bond proceeds often exceeded the cost of the original assets, and financial institutions were able to make a pretty penny by flipping their portfolios into securitization SPV's.

Of course, when people stopped paying their mortgages, credit cards, and leases, it turned out that the administration of late payments, penalties, interest, and liquidation proceeds was much trickier than had been designed on paper. Even the triple-A bondholders had to take a haircut.

Which brings us to the latest brainstorm by the creative geniuses on Wall Street: the securitization of rents on foreclosed homes. There are many questions about how this securitization would work, beginning with whether the SPV actually owned the homes or merely owned the rents under contract. If the SPV did not own the homes, it seems to this observer that there is too great a risk of conflict with the property owner. Also, the bonds would have to pay too high a rate to make a securitization worthwhile. So it's likely the property, as well as the rents, is part of the deal.

Whatever the structure or yield, I can't see how or why any prudential investor would want to invest in this stuff now, having been burned very recently. Caveat emptor.