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fewer mortgages, and thus they would have had less reason to push so hard to make
the loans in the first place.
“Leverage is inherent in CDOs”
The mortgage pipeline also introduced leverage at every step. Most financial institu-
tions thrive on leverage—that is, on investing borrowed money. Leverage increases
profits in good times, but also increases losses in bad times. The mortgage itself cre-
ates leverage—particularly when the loan is of the low down payment, high loan-to-
value ratio variety. Mortgage-backed securities and CDOs created further leverage
because they were financed with debt. And the CDOs were often purchased as collat-
eral by those creating other CDOs with yet another round of debt. Synthetic CDOs
consisting of credit default swaps, described below, amplified the leverage. The CDO,
backed by securities that were themselves backed by mortgages, created leverage on
leverage, as Dan Sparks, mortgage department head at Goldman Sachs, explained to
the FCIC. “People were looking for other forms of leverage. . . . You could either
take leverage individually, as an institution, or you could take leverage within the
structure,” Citigroup’s Dominguez told the FCIC.
Even the investor that bought the CDOs could use leverage. Structured invest-
ment vehicles—a type of commercial paper program that invested mostly in triple-A-
rated securities—were leveraged an average of just under -to-: in other words,
these SIVs would hold in assets for every dollar of capital. The assets would be
financed with debt. Hedge funds, which were common purchasers, were also often
highly leveraged in the repo market, as we will see. But it would become clear during
the crisis that some of the highest leverage was created by companies such as Merrill,
Citigroup, and AIG when they retained or purchased the triple-A and super-senior
tranches of CDOs with little or no capital backing.
Thus, in , when the homeownership rate was peaking, and when new mort-
gages were increasingly being driven by serial refinancings, by investors and specula-
tors, and by second home purchases, the value of trillions of dollars of securities
rested on just two things: the ability of millions of homeowners to make the pay-
ments on their subprime and Alt-A mortgages and the stability of the market value of
homes whose mortgages were the basis of the securities. Those dangers were under-
stood all along by some market participants. “Leverage is inherent in [asset-backed
securities] CDOs,” Mark Klipsch, a banker with Orix Capital Markets, an asset man-
agement firm, told a Boca Raton conference of securitization bankers in October
. While it was good for short-term profits, losses could be large later on. Klipsch
said, “We’ll see some problems down the road.”
BEAR STEARNS’S HEDGE FUNDS: “IT FUNCTIONED FINE
UP UNTIL ONE DAY IT JUST DIDN’T FUNCTION”
Bear Stearns, the smallest of the five large investment banks, started its asset manage-
ment business in when it established Bear Stearns Asset Management (BSAM).
