All the Devils Are Here [149]
In April, Blum gave a presentation to the board in which he put forth a downbeat and sober-minded assessment of the subprime business. Afterward, many of the board members sent him thank-you e-mails for his plainspoken presentation. What they had failed to notice, however, was that seated next to Blum at the board meeting was Osman Semerci. He never said a word about any problems he might be having with subprime mortgages. Nor did anyone think to ask him.
All over Wall Street, an immense amount of risk was building up in the system. It wasn’t just that firms were taking on risk when they bought subprime mortgages and bundled them into securities, or when they kept some of the leftover pieces themselves, or when they bought whole subprime mortgage originators. Over the course of a decade, subprime mortgages had managed to seep into Wall Street’s bloodstream, as firms used products created out of them to increase leverage, reduce capital, generate profits, and, more generally, game the risk-based rules that were originally intended to give firms the flexibility to deal with the modern world. All of which also meant that the increasing risk was masked by layer upon layer of complexity, hidden where few on the outside could see it.
For instance, using a loophole in Basel I, banks set up off-balance-sheet entities that came to be known as SIVs, or structured investment vehicles. In a nutshell, banks didn’t have to hold any capital—that’s right, no capital—against these vehicles as long as their outstanding debt had a term of less than a year. (That’s part of why Karen Shaw Petrou, the managing partner at Federal Financial Analytics, says: “Nothing about this crisis was in fact unforeseen. It was just unaddressed.”) By the summer of 2007, there were twenty-nine SIVs with outstanding debt totaling $368 billion, of which nearly $100 billion belonged to Citigroup-sponsored SIVs. Because SIVs were looking for yield, just like every other buyer of triple-A securities, many of them began to buy more and more mortgage-backed securities. Ostensibly, SIVs were independent from the sponsoring bank. But if there was a crisis and the debt started to default, would an institution like Citigroup really be able to sit back and let the SIVs fail? Or would it have to rush in and put that debt on its own balance sheet, which would have a crippling effect on its capital?
Another source of hidden risk was in the plumbing of the market—plumbing that was utterly taken for granted. The big banks all had warehouse lines that the mortgage originators borrowed against to make their subprime loans. It was the primary funding mechanism for the industry. But the banks didn’t just extend a big loan to the originators. Instead, they had discovered a more modern, efficient, capital-gaming way to do it. They would set up an off-balance-sheet vehicle that issued short-term commercial paper to fund itself. That commercial paper was backed by the mortgages. It was part of a market called ABCP, or asset-backed commercial paper. According to Fitch, by the spring of 2007 this market was shockingly big: $1.4 trillion in size. The commercial paper got a top rating from the rating agencies, making it possible for money market funds to buy it. However, in order to obtain that all-important top rating, the sponsoring bank, or another