Securitization Gone Wild: A Year Marked With Losses

2008 is guaranteed to be remembered as the year in which investment firms and financial institutions disclosed nearly $700 billion in write-downs for mortgage-backed securities, leveraged loans and other assets that plunged in value. Wall-street was marked with losses connected to hard-to-value securities that reached unheard-of levels. Still, off-balance sheet financing may cause 2009 to give 2008 a run for its money.

For some time now, financial institutions have made profits hand over fist by financing business deals with off-balance sheet entities. In simple terms, off balance sheet refers to when companies transfer certain projects, investments or underperforming assets such as collateral debt obligations (CDOs), subprimemortgage securities or credit default swaps from the parent company to an offbalance- sheet subsidiary.

Once the assets have been removed from a company’s primary balance sheet, it gives the appearance that the parent is carrying less debt - and thereby less risk. And, because off-balance sheet entities are largely unregulated, there is no one to question otherwise.

As the concept of off-balance sheet financing gained favor with Wall Street, so too did massive leveraging. Collateral debt obligations, subprime securities, credit default swap contracts - all have increased exponentially in recent years. What Wall Street failed to consider as it took on these added risks was the possibility of failure, not to mention the systemic damage that the failure potentially could unleash on the nation’s financial system as a whole.

Case in point: Credit default swaps. Credit default swaps are privately negotiated contracts between two parties - a buyer and a seller. The buyer of a credit default swap pays a fee to the seller. In exchange for that fee, the seller agrees to cover the buyer’s losses in the event that the underlying financial instrument defaults. The problem is the credit-default swap market itself. It is a $60 trillion unregulated market where contracts are traded without any federal oversight to ensure buyers actually are capable of covering losses.

When credit markets began to freeze up this year, that’s exactly what happened to institutions like Bear Stearns, Lehman Brothers, American Insurance Group and Citigroup. At the time, all of the firms were holding high concentrations of mortgage-backed securities - the same assets they once used as collateral to get credit and had to now significantly mark down in value.

A domino effect ultimately took hold, as creditor institutions turned up the heat via margin calls on the institutions that wrote the credit default swap contracts. Unable to meet those calls, Bear Stearns, Lehman, AIG, Citigroup and others quickly found themselves in trouble. Some of the companies like Lehman filed for bankruptcy protection; others were forced into a firesale; and some turned to the federal government for a bail-out to the tune of billions of dollars.

Unfortunately, off-balance-sheet excesses already may have put countless countries on a path to failure. There are insurmountable outstanding debt obligations residing “off-balance sheet” today for nearly every Wall Street institution around. When reality finally sets in, and the off-balance-sheet assets come back on balance sheet, watch out. It could make the nation’s current fiscal crisis look like child’s play.