Mass delusion is defined by my Google machine as a condition affecting a group of persons, characterized by excitement or anxiety, irrational behavior or beliefs. The FTX – Sam Bankman Fried episode, and most of the crypto world, for me anyway, is a classic case of mass delusion, one that seems to be ending as they all do, terribly. It reminds me of an incident that I witnessed back in 2007. Allow me to share.
In August 2007 I was working for Credit Suisse as a structured product salesman. Many in my group were heavily involved in the whole subprime thing. I just dealt with Freddie, Fannie and Ginnie mortgage-backed securities so I didn’t know much about the subprime world other than it seemed very odd.
One morning I was on the desk around 6:45am, my normal beginning of the day. I liked that time because it was pretty quiet, just a few traders dispersed around the large trading floor going through their morning routines, just like I was. I liked the trading floor then because it was quiet, you could focus…….on a Yankee box score or the latest “Take a Report” post. Anyway, a little before 7am my screens started jumping around with certain things moving very erratically. It seemed a bit early for anything to be happening in New York, so I turned to a likable young man behind me and asked him to call his buddy in the London office and see what was up. He called, spoke to his buddy and then told me, “It seems IKB can’t roll their ABS CP conduit.” I said, “Who is IKB?” It turned out that IKB was Germany’s equivalent of our Small Business Administration. It seemed they had an ABS CP conduit and since I didn’t know what that was either I enquired. ABS CP stood for Asset Backed Security Commercial Paper, and IKB had a program. It turned out that IKB, a German institution, backed in part by a state development bank KFW and dedicated to providing finance to small and mid-size German businesses had somehow become one of the biggest buyers of United States subprime MBS and Collateralized Debt Obligations in Central Europe. Apparently, Credit Suisse “helped” IKB attain this status quite a bit.
What IKB would do was take a whole bunch of AAA rated subprime securities and create 7 day commercial paper (CP) out of them. Because the bonds backing the CP were AAA, the CP was given the highest grade. Every 7 days, the zillions of US Dollars needing a home would queue up and buy the CP, getting say a rate of 4%. The actual AAA bonds earned 5%, meaning that IKB would earn the spread of 1%. Moreover, the ABS CP structure allowed IKB to run the conduit off their balance sheet, which meant they did not have to hold capital against it. Part of the reason for that was, in the event that in 7 days, IKB couldn’t find new buyers of the CP to finance the thing, they had paid Deutsche Bank a fee to be a “liquidity provider”. If the conduit failed to finance, Deutsche would step in and take the unfunded portion. However, in August 2007, the subprime market was well on its way to exploding. Therefore, when IKB called Deutsche, nobody answered the phone, and IKB was stuck. This was turning into one of the first big meltdowns of the subprime mortgage market, culminating in the holocaust of 2008.
About 15 minutes after I learned who IKB was and what an ABS CP Conduit was, my boss walked down our aisle. We started talking about IKB and the bossman said, “If you think this is bad, Citi and UBS have about $50 billion each of SIVs backed by the same AAA rated subprime. Naturally, if I didn’t know what ABS CP was, I also didn’t know what a SIV was. The boss explained that a SIV or Structured Investment Vehicle was more or less the same thing as an ABS CP conduit. I asked the boss, “So if Citi and UBS have the same thing as IKB, why wouldn’t theirs fail also?”
Silence
“Oh, and if they have not held capital against these SIV subprime assets, if the programs fail don’t they have to put the subprime bonds onto their balance sheet and put capital against them?”
Uncomfortable Silence
“And, since these are subprime if they lose the AAA rating, won’t Citi and UBS have to come up with about $5 billion of capital each?” I was learning fast.
The boss looked down at his shoes, turned and walked back into his office.
The 4-year subprime mass delusion was over.
Kind of amazing that people think the clowns in finance are geniuses.
They mostly remind me of the guy in Office Space trying to explain that his job is so much more than carrying the fax from the machine to another part of the building.
Ask them what useful purpose they serve, and enjoy the implosion.