Professor Roubini asks: How will financial institutions make money now that the securitization food chain is broken?

The most severe financial crisis in decades has not only damaged the balance sheet of financial institutions. It has also severely affected their P&L, i.e. the process of generating revenues and profits.

In the old “originate & hold” model (before securitization) financial institutions made money from the investment income of holding the credit risk of loans and mortgages. But in the brave new world of securitization where you “originate & distribute” the credit risk rather than hold it on balance sheet an increasing fraction of the income of financial institutions was coming from the fees and commissions involved in this securitization process. This food chain of fees on top of fees is now broken: securitization of mortgages, that was running at the annual rate of $1,000 billion in January of 2007, was down 95% to an annual rate of $50 billion by January of 2008. So the process of generating fees and commissions is broken.

In the mortgage boom everybody lived off fees: the real estate agents, the mortgage brokers, the appraisers, the smaller mortgage aggregators, the loan servicers, the investment banks that bought the mortgages and converted them into Collateral Debt Obligations, the monoline insurers that ‘guaranteed’ the quality of these papers, the rating agencies, the retail banks that sold the resulting AAA junkbonds to some dumb investor.

Similar chains existed for commercial real estate mortgages and leveraged buyout loans. The bigger the loans the more money was made by everyone involved, while the risk was moved away to the investor.

Now that market is dead and these people have to find a new gig. The big investment banks need a new revenue stream.

So Roubini asks if there is one.

My answer is "Yes." I believe the investment banks have already found a new scam:

Derivatives, including those based on debt, currencies, commodities, stocks and interest rates, expanded 44 percent from the previous year to $596 trillion, the Basel, Switzerland-based [Bank for International Settlements] said in a report today. The amount of credit-default swaps protecting investors against losses on bonds and loans more than doubled to cover a notional $58 trillion of debt.
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Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements. Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in interest rates or the weather.

The data on the BIS report are based on contracts traded outside of exchanges in the over-the-counter market.

The investment banks who sold junk debt to investors are now selling ‘protection’ to the same investors against interest rate change and default of such debt. To eliminate risk for themselves they also buy ‘protection’ from other banks and investors. In between they generate hefty amounts of fees which again depend on the size of the transaction. This has led to the creation of another bubble. $596 trillion of derivatives is a multiple of the value of underlying real assets. It is essentially hot air but dealing it makes money.

Here’s as story on the results of a fee generating derivatives scam.

Like homeowners who took out mortgages they couldn’t afford and didn’t understand, Jefferson County officials rejected fixed-rate debt and borrowed instead at rates that varied with the market.

The county paid banks $120 million in fees — six times the prevailing rate — for $5.8 billion in interest-rate swaps. That was supposed to protect the county from rising rates for their bonds. Lending rates went the wrong way, putting the county $277 million deeper into debt.
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The swaps are contracts in which the county and the banks agreed to exchange periodic payments based on the size of the outstanding debt and changes in prevailing lending rates. Swaps are derivatives, which are unregulated financial contracts tied to the underlying value of a security, commodity or index.

The county bought ‘protection’ against interest rate changes and it turned out that the fine print read somewhat different than what the salesperson had said. With $596 billion total in derivative deals how many more of such cases are out there?

The derivative market is next big thing to blow up. If one of the big players fails, all others will be seriously affected. The Fed bailed out Bear-Stearns and has committed over half of its assets to avoid general liquidity problems. But a failing pyramid of some $600 trillion in derivatives dwarfs any central bank’s capability.

That shoe still has to drop. When it does we will be in the second, bigger phase of the credit crisis. The outcome is not foreseeable but it is unlikely to be positive.