The creation of Mortgage Backed Securities (MBS) and Collateralised Mortgage and Debt Obligations (CMOs and CDOs) were lauded when they were created. They were based on the basic blueprint of a financial product. It is like having a way to package an old product into a new one so that its uses can be diversified and a new investor will be willing to take it off your hands. Mortgages and a bundle of them were being held by different banks and financial institutions. They saw this as an opportunity and sold them as a bundle to someone else who was willing to be exposed to the risk of default in exchange of getting the payments from the mortgage borrowers while the bank who made the loan in the first place exited the scene completely.
This was a way of using old and stagnant debt on the books and use it to yield even higher returns than they usually would. Circulate the same money over and over as long as more investors have the appetite to take the risk and there are financial product builders who are willing to package them in a more attractive manner. But what if the investor wants to hedge against the fact that the borrower can default? For that he can buy insurance or a CDS (Credit Default Swap) in case the borrower defaults. It is clear that as long as people are willing to buy something, there would be supply of such products. For the simple derivatives of options that existed once now the market is filled with swaps, futures and contracts which help an investor hedge his risk or earn a higher return.
Knowing this fact, the lawsuit filed by the state of New York against JP Morgan Chase seems to be bordering on the lines of financial alchemy and fraud. The suit claims that the institution defrauded its investors by investing in MBS which had been written by Bear Stearns. This seems to be the start of a widespread action which will look to encompass more investment banks as time goes on. The suit is being made against JP Morgan Chase rather than Bear Stearns as they bought the distressed bank at the height of the financial crisis to keep it afloat. The case mainly highlights how Bear Stearns was inept at evaluating the loans that it bundled leading to misleading information about the security they were selling.
If they had acted in a more responsible manner, they would clearly identified the risk that the investors were exposed to and then allowed the investors to make their decision. It’s not new that an investment bank is being accused of malpractice yet again. It is part of the day to day operations now to act against the Wall Street high brows in order to score political points for the American layman. What makes this lawsuit interesting is because first of all the acquisition of Bear Stearns by JP Morgan was facilitated by the government and secondly, the first lawsuit being filed is against JP rather than many of the other institutions that did the same.
The unraveling of this lawsuit will set a precedent for the financial industry as it will be the benchmark against which future suits will be based on. This is assuming that future lawsuits will be filed after this one. It will also be a reference point for future actions of the industry. The key impact this will have in the near future would be the financial alchemist trying to avoid MBS and CDO creation but rather to find new avenues of financial product creation in the future. Just like the LTCM debacle of the 1990s, this crisis has now made people skeptical of the CDS, CDO and CMOs and the challenge now is to find a new way to package risk and sell it to investors willing to take it on. At this point it seems the financial regulators are making a statement which is “do whatever you want as long as you don’t get caught.”