Exporting its way INTO economic crisis

The way most economies have, in modern times going back a couple of centuries or more, managed to improve their economic lot is to export. That is, to sell their stuff to "foreigners", escaping the limitations of their own markets and capturing the wealth of other nations.

There are limitations on this approach that economics doesn't capture, but business school case studies should, such as where the product exported contains melamine, pirated intellectual property and other short cuts that human kind too willingly fall into. Those kinds of exports have often backfired, but, like Wall Streets quarterly reporting incentives, it works pretty good for a while at the micro level even if the macro picture fades.

Indeed, Magellan dubbed Guam (or, Guhan as it was also known then) as the Isle de la Ladrones, or Island of Thieves, in part because the natives simply took the rope and iron bits they could off his boats, but also because, as generations of subsequent European captains and sailors discovered, when they did trade for things, the natives often gave false measure by weighing down their baskets of foodstuffs with rocks.

That name stuck on maps for a many years until the Spanish missionaries, desiring to curry the favor of the Court, named the island group the Marianas, after the Queen.

But Guambat digresses. Again.

The original idea for this idea came from Bloomberg, which has a fantastic story with great historical context told in a You Are There sort of way. You should read the whole story for the juicy details and the persons behind the scenes. Kudos to Mark Pittman who wrote it. Excerpts follow:

Evil Wall Street Exports Boomed With `Fools' Born to Buy Debt

The bundling of consumer loans and home mortgages into packages of securities -- a process known as securitization -- was the biggest U.S. export business of the 21st century. More than $27 trillion of these securities have been sold since 2001

The growth over the past decade was made possible by overseas banks, which saw the profits U.S. financial institutions were making and coveted the made-in-America technology, much as consumers around the world craved other emblems of American ingenuity from Coca-Cola to Hollywood movies.

"Securitization was based on the premise that a fool was born every minute," Joseph Stiglitz, a professor of economics at Columbia University in New York, told a congressional committee on Oct. 21. "Globalization meant that there was a global landscape on which they could search for those fools -- and they found them everywhere."

European banks, in particular, were eager adopters. Securitizations in Europe increased almost sixfold between 2000 and 2007, from 78 billion euros ($98 billion) to 453 billion euros

In Japan, Mizuho Financial Group Inc., the nation's third- largest bank, acquired an entire structured-finance team, which proceeded to lose $6 billion issuing mortgage-backed securities.

The damage reaches all the way to Australia, where the town council of Wingecarribee

Securitization is a shadow banking system that funds most of the world's credit cards, car purchases, leveraged buyouts and, for a while, subprime mortgages. The system, which pools loans and slices up the risk of default, made borrowing cheaper for everyone, creating a debt culture that put credit cards in wallets from Seoul to Sao Paolo and enabled people to buy luxury cars and homes. It also pumped out record profits for banks, accounting for as much as one-fifth of their revenue over the last decade.

Beginning about three years ago, investment banks revved the system's engine to boost earnings. They raised revenue by funding more subprime mortgages and cut costs by relying increasingly on the $4.2 trillion sitting in U.S. money-market funds. As it turned out, those decisions would prove fatal.

Before the invention of securitization, banks loaned money, received payments and profited from the difference between what the borrower paid and the bank's funding cost.

During the mid-1980s, mortgage-bond traders at Salomon Brothers devised a method of lending without using capital, a technique at the heart of securitization. It works by taking anything that has regular payments -- mortgages, car loans, aircraft leases, music royalties -- and channeling the money to a trust that pays bondholders principal and interest.

Securitization's biggest innovation was off-balance-sheet accounting. If a bank couldn't sell a bond or didn't want to, the asset could be sold to a trust within a so-called special- purpose entity, incorporated in a place such as the Cayman Islands or Dublin, and shifted off the books. Lending expanded, and banks still booked profits.

With this new technology, a bank could originate $100 million in loans, sell off some to investors, transfer the rest to a special-purpose entity and not have to hold any capital.

"The banks could turn a low return-on-equity business into one that doesn't use any equity, [which, theoretically, means the return on equity could be infinitesimal] which was the motivation for this," said Brad Hintz, a Sanford C. Bernstein & Co. analyst and former chief financial officer at Lehman. "It becomes almost like a fee business because it requires no capital."

The strategy was detailed in Ocampo's 282-page book ``Securitization of Credit: Inside the New Technology of Finance,'' which he co-wrote with McKinsey consultant James Rosenthal. Ocampo, who received an MBA from Harvard after graduating from the Massachusetts Institute of Technology, and Rosenthal, a Harvard Law School graduate, argued that banks could be more profitable if they used securitization.

The authors examined six of the first asset-backed transactions and gave readers a step-by-step guide for how to repeat them. They said that banks that didn't embrace the new technology would be at a disadvantage, and they predicted it would become the dominant form of financing.

"You basically needed good computers and distribution. You can always buy a Fannie, Freddie or Ginnie Mae pool. You just go online and buy it. You can't buy a Ford Motor Credit deal, because you have to know people."

As securitization caught on, borrowing increased. U.S. consumer debt tripled in the two decades after 1988 to $2.6 trillion, according to the Federal Reserve. Foreign banks used the new technology to expand lending, seeking borrowers on their home turf.

"One of the things the United States exported overseas was a debt culture," Haley said.

While consumers were snapping up credit cards, Nicholas Sossidis and Stephen Partridge-Hicks at Citibank in London were figuring out a way to sell the new bonds. Their solution: Alpha Finance Corp., the first off-balance-sheet structured investment vehicle, or SIV.

Alpha was created in 1988 as a way for Citibank, and later Citigroup Inc., to vertically integrate its business like an oil company. The raw material was found in a loan, refined into a security, then sold to a SIV at a profit.

Citigroup, formed in a merger of Citicorp and Travelers Group Inc., which owned asset-backed pioneer Salomon, also got a new product to sell: capital notes that boast returns of more than 20 percent a year. Owners of these notes receive all the excess return when borrowers pay their bills on time, though they are the last to be paid when times get hard.

By 2007, Citigroup's SIVs had $90 billion of assets, equal to the stock market value of PepsiCo Inc., making up about one-fourth of the entire SIV industry.

In 2003, the bank was sued by creditors of Enron Corp. for its role in setting up entities that enabled the Houston-based company to move assets off the balance sheet for Chief Executive Officer Jeffrey Skilling. Citigroup paid $1.66 billion in March to settle the lawsuit. Skilling, a former McKinsey consultant, was convicted of accounting fraud and is serving a 24-year prison sentence.

Starting around 2005, securitization began to rely more on short-term money-market funds for financing. This was especially true for securities made by pooling other bonds, known as collateralized debt obligations, or CDOs. Investors were loath to buy long-term debt of issuers that didn't have a track record, so new issuers sold asset-backed commercial paper that matured in less than a year. While money markets are the cheapest way to finance, they can also be the most dangerous for borrowers because they can mature as soon as the next day.

SIVs, banks and CDOs sold trillions of dollars of asset- backed commercial paper between 2005 and 2007 in maturities ranging from nine months to overnight. In the U.S., the amount outstanding marched higher almost every week beginning in April 2005, peaking at $1.2 trillion for the week ending Aug. 8, 2007.

Once money-market funds began to be tapped for financing, Ocampo said, ``it created a huge appetite for high-yield assets, far more than could be originated on a sound basis.''

To accommodate the demand, banks funded more subprime mortgages, with an average life of seven years, replacing car loans with an average life of three years and credit-card bonds paid off within 18 months.

Among conservative lenders, that rang an alarm: Bankers are taught to avoid such mismatched funding, in which a lender has to pay back money before the borrower has to pay the principal.

"Most of the terrible things happening now are because of the presence of money-market assets, taking what used to be long-term funding and making it short-term," Bruce Bent, 71, who started the first money-market fund in 1970, said in an interview in July.