There once was a boy named Tim who lived in a small rural town in the United States.  Tim had ambition and dreams larger than any town could contain.  In fact, it was well known that when Tim was only seven years old, he sold lemonade via IOUs with a 10 percent note to thirsty construction workers and would not accept cash.  He would only accept payment on the note via cash after the purchase.  To him, this was called building a cash-flowing portfolio like his rich dad had taught him.  The construction workers took further notice of Tim when his small brown ply wood shop turned into a storefront with granite countertops and shiny marble floors.  They wanted in on the action and Tim sensed this desire from his largest customers.  He decided that he would package the IOUs into notes in his lemonade hedge fund (LHF) and sell them back to the workers paying them a six percent return.  Tim at a very young age had the insight of credit arbitrage.  He was already getting a steady stream of ten percent payments while selling back the LHF for more capital.  What a wonderful life it was!  The money kept rolling in and the profits only grew as the years went by.  Tim was a modern day Rockefeller. 

There is one constant in nature and that is that nothing ever stays the same.  At least not over the long-term.  A study by the ministry of health found that working in construction and drinking lemonade would cause infertility.  The study was incredibly conclusive with color charts and convincing diagrams.  An activist group came to arms, the Workers Against Liquid Lemonade (WALL) and started protesting near the site of Tim’s booming business.  After WALL educated the construction workers, profits suddenly stopped.  It was a double hit to Tim.  First he lost the ability to sell his liquid gold since the construction workers for the large part still wanted to have kids.  Even those who had no desire to procreate still had a hard time digesting a liquid that would take away their, as a reporter once quote, “manhood.”  With the profits dry, Tim also was bound to pay for his LHF since many of the workers still held these notes and now that they realized the pain the lemonade caused, were starting to mount lawsuits against the young Tim.  Yet Tim with no shop and no product to sell, was unable to stay open or pay out to the now angry mob that was after him.  This small rural town had no sympathy for the now ten year old boy.  His ambition was large.  Too large for a small town with no desire of financial shenanigans.  Sadly, this town had no sympathy for his age and locked him up until he was a legal adult.

Tim Leaves Jail, the Pen and Stripes, and Heads to the Big Apple

You would think that our protagonist Tim would have learned his lesson but nothing is more powerful than unchecked ambition.  Tim decides to pursue every child’s dream of becoming an investment banker.  He attends a top ranked university.  Goes on to pursue a background in financial engineering and finds himself in New Amsterdam, otherwise known as New York City.  It has been a long and arduous journey for our hero and he realizes that it is much easier to make money on Wall Street than selling Lemonade to thirsty construction workers.  From an early age, Tim knew that creating something out of nothing was very possible with his IOU experiment.  Just as fate would have it, collateralized debt obligations were something already in existence since the late 1980s.  This was a booming sector and was based on the asset-backed synthetic securities market.  This language to the public will create a donut glaze but educated with the language of the few, Tim knew exactly what it stood for; this was IOUs to the next dimension.  Yet there had to be a market larger than simply construction workers.  What is something that a large portion of the population owns, is easily securitized, and has enough raw emotion to spur greed?  Private property.  The idea came to him like a moth heading toward the light.  It was the perfect vehicle to arbitrage pseudo prosperous debt and package it to mutual funds, investment trusts, commercial banks, and pension funds.  In order to create a hierarchy of order and prestige, using his financial engineering background he decided to break down the risk into three tranches:  senior tranches with AAA ratings, mezzanine tranches with AA to BB ratings, and unrated equity tranches for the brave corporate warriors.

Everything was coming together since people had lost faith in the gods of technology.  The decline in the technology sector came like a plague of locusts.  Who would have thought that a company selling for 200 times earnings with no potential for revenue generation would go bankrupt?  The masses demanded better returns.  Hooked on 20 to 30 percent annual returns they needed a place to speculate and funnel their preciously earned dollars.  What better way than to bet the house?  Why limit a mortgage to the local bank who would scrutinize the area with a fine tooth comb, analyze the buyers potential ability to pay the note, and have an actual stake in the mortgage?  Why do this when you can sell that same mortgage to our friend Tim who would chop it up like a Sushi chef, charge a hefty fee for his investment banks underwriting fee, and put it for sale at the worldwide buffet? The appetite was prime and all he was doing was providing the hungry with a meal.  After all, it was demanded. 

For years, this went on.  The housing market had found a newfound admiration for the boys on Wall Street.  The implicit agreement was set; you find someone that has the faculties to sign a convoluted mortgage agreement and we will find someone willing and able to take on the debt.  El Dorado was found and who knew it would be in the form of mortgage-backed securities and asset backed paper?  The game was blistering hot.  The wizards of financial alchemy became so convinced of their credit arbitrage that they figured giving a loan to anyone and adding enough makeup would turn a pig into a beautiful swan.  The game was slowing down and they needed to expand their market potential.  And the birth of the sub-prime market started.

With the introduction of Gaussian copula models, which for purposes of our story dear reader only helped speed the CDO pricing process, the priming of the pump was in full force.  Credit was now available to anyone who would be willing to pray to the Wall Street gods and believe in their new financial dogma.  Many went on the pilgrimage to financial prosperity with eyes and arms wide open.  They bought and sold, flipped and churned, and the market cheered with glory.  Tim was happy for he had found a market larger than his small rural town, he had opened the market to the entire world.  Deep down a nagging whisper lurked in his mind.  For Tim knew that even a few defaults would cause the perfectly structured Ponzi Scheme to fail; no one dare utter these words in prosperous times for the dogma of housing wealth was strong and deep.  So many had bought the lie that was being sold and convinced themselves that a free lunch was possible.  Not only was a free lunch possible but a free dinner as well so long as you were willing to play Tim’s credit game.  At a certain point in the game, the market sentiment shifted.  Nature has a cruel way of showing humans that yes, we do answer to laws that man cannot control.  The magnitude and the complexity of the market was no match for the weak foundations that it was built upon. 

The Game Becomes a Messy Entanglement

First, a few defaults hit the market.  This was only seen as anomalies to a new world order of financial ingenuity.  Next, appreciation on private property started declining.  The wizards got more aggressive and careless in their lending.  Tim knew that more people had to come to the frontline if this game were to continue.  Alas, the market forces were too strong and the defaults soared.  The troubles were rippling all the way up from small town USA to the credit capital of America, Wall Street.  Tim knew that if things kept going bad, eventually the troubles would come back and hit him directly.  This was getting too close to home.  With money at his side, after all he had a decade of prosperity, he decided to call up a few friends in the other capital of finance, Washington D.C. and see if anything could be arranged.  A bailout?  Absolutely not!  Consider it a friendly gesture in kind.  Tim was simply looking for a little bit of insurance to ride the storm out.  This was only a temporary bump in the road.  With the aid of his friends, the financial wizards of Wall Street and other insiders decided to start “diversifying” by selling out of their companies and going into more secure industries.  The public started worrying.  What can this mean that they are leaving the post of housing?  If the gods don’t have faith in their own industry then what are we mere mortals to do?  The public started running fast and furiously away from these companies punishing their stocks.  Tim knew he had to calm the storm.  He came out publicly with titans of the industry assuring that all would be well.  These companies to assuage the public decided to do a few token purchases to demonstrate that they still had some faith.  Although the faith was now contingent and not full since most had already sold out large portions.  This calmed the storm for a few more months until further panic set in.  Tim studied his history well remembering Morgan and Whitney and how they stepped in on their white horses to save Wall Street.  But Morgan and Whitney didn’t have to deal with a Nikkei or Hang Seng.  The ruse was up and the bill was coming due. 

As investigations started hitting the market and large companies started failing, Tim knew that no financial engineering can stop a bubble from popping.  The masses were now convinced that something had to give.  The public hearing cases of 102 year old men taking out 25 year notes realized something was rotten in Denmark.  They also started questioning the prophecy of credit when actual debt had to be paid off.  You mean you couldn’t pay debt with debt ad infinitum?  The laws of economic fundamentals once again came into effect.  Suddenly, local creditors actually cared about how much you make and your ability to sign an autograph like a modern day John Wayne didn’t mean much unless you had collateral to back it up.  Tim knew the writing was on the wall long ago and had sold out.  He sold as he was taught in school.  Launder the money through legal means and you will be okay.  The public won’t care.  How can they care if they don’t understand the language of Wall Street?  Sadlly for Tim, the public does understand when they are had and go after blood when corruption is at heart.  They will vote their politicians out if they don’t do something.  Aspiring attorney generals sense this window of opportunity and start going after these fallen angels, including Tim.  The jig is up and the love affair with credit was fun but the piper now is playing his song and requesting to be paid.  The lemonade never tasted so bitter to Tim.    

 

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