Date: 07/12/2021
Author: Kent Moors, Ph.D.
Over a decade ago, the implosion in US mortgage-backed securities produced a world-wide collapse in dollar-denominated assets. The expansion in the crisis occurred because a weakness in what ordinarily would be a confined sector of the economy (subprime mortgages, that is those provided to debtors who cannot afford them) infected broader classes of property and accounts.
This crisis differed from previous “boom and bust” cycles in its far broader scope. Earlier crises tended to focus on a particular market sector. This one may have appeared to begin that way – clothed as a subprime mortgage collapse. However, the impact was much more severe, affecting financial, credit, and asset markets well beyond real estate.
This time, purveyors of a new financial sleight of hand challenged one of the major premises upon which markets had traditionally operated. They came to the unsettling conclusion that the market could effectively ignore the relationship between the extension of credit and the assumption of risk.
The core problem was extended, disfigured, and prolonged by a wave of apparent paper profits from the milking of the spread between tangible asset valuation (actual, physical real estate) and paper values (mortgages on that real estate).
This was accomplished by interjecting between the two a new way of making even more money without having to supplement the value of the underlying asset. The mortgage paper was “securitized,” with suspect mortgages packaged along with stronger paper and rated as one entity. It created a quintessential “bubble accelerator.”
The mortgage-backed security (MBS) along with its cousins – collateral debt obligations (CDO) and a myriad of asset-backed security (ABS) clones – inflated the problem out of proportion. As collateral for all manner of exchange, it propelled the suspect mortgages into a wide array of international transactions.
The securitization schemes also introduced two major roadblocks preventing the market from easily correcting the overheating spiral. First, since the toxic assets had been parceled out into so many derivative issuances (both the initial MBS offerings and secondary/tertiary papers based upon them), a relatively insignificant percentage of overall suspect outstanding debt caused a significant constriction in global liquidity.
The subprime loans were now so thoroughly intermixed with other debt holdings – themselves representing paper asset and collateral value for an ever greater range of investments –that they prompted wide areas of the market to come under suspicion, brought into question huge holdings by major banks worldwide, and ushered in a cataclysmic credit freeze.
This was accentuated by the fact that securitization by its very nature decreases transparency. Therefore, once there is a question about the structural integrity of asset-backed securities, the loss of confidence or trust becomes more difficult to offset.
Second, this becomes a classic example of moral hazard, since those who are responsible for issuing the loan (mortgage) to begin with are no longer the parties shouldering the risk if there is a default. In such an environment, at some point, there is little structural difference between the paper and a chain letter or a Ponzi scheme.
Yet, this is hardly an enticement to end securitization across the board. Securitizing debt, utilizing assets as collateral for additional applications, and the spreading out of risk are not bad ideas per se. In fact, I have personally designed securitization programs in the past for oil projects, pipeline capacity, refinery crude oil cuts, surplus electricity, discounted sovereign defaulted debt, and even the financing of first-run Hollywood films that all achieved their purposes without engineering a run on banks or an epileptic seizure of credit.
We need to avoid rejecting securitization altogether. It remains a quite useful, sometimes essential, tool. Correctly structured and employed, it succeeds in lessening risk for projects to transactions unlikely to move forward by traditional financing methods. It also is successful at allocating capital and does so (when adequately structured and overseen) very efficiently.
The fatal problem in the case of subprime MBS was the fundamental disconnect that emerges when the primary source of profit becomes the securitization itself, while the underlying revenue stream becomes increasingly dependent upon an expansion of the securitizing network. Once that network becomes a base for wider transactions, the crisis intensifies and dollar-denominated assets become suspect across the board.
Well, we may have the foundation for a déjà vu all over again.
This time, the problem area is rising in crypto currency. It is called stablecoin and it seeks to become a bridge between traditional asset valuations and digital currencies. A stablecoin is tied to a “real-world” asset (usually the US dollar), thereby providing a “stable” valuation, unlike better known crypto issuances like Bitcoin or Ethereum that have exhibited wide price volatility.
Tether, a stablecoin tied to the dollar has been accelerating fast and is now the third largest crypto coin by market value. And it has some analysts worried that it could become the source of the next subprime-like major asset bubble implosion.
Since it is tied to the dollar, tether should have a value that remains at $1. However, that has not always been the case, prompting some panic upon occasion among investors. Since crypto traders will often use the tether to buy cryptocurrencies, rather than the dollar or other traditional fiat currency. Digital traders are increasingly preferring this approach to provide transaction safety a more “stable” asset during times of sharp volatility in the crypto market.
However, crypto is not regulated. Most banks balk at working with digital currencies, citing the increased risk involved. That is different from MBS paper where, initially at least, the injection of dollar-denominated assets provided the semblance of some risk protection. This is the reason why tether has caught on inside the crypto trading market so quickly and is now poised to have a wider impact.
With the MBS crisis paper, the problem was suspect asset valuation. In that case, the face value of the mortgages buried within a wider asset class never had the dollar value the consolidated mortgages conveyed. The amount represented by subprime borrowers reflected a false valuation. The dollar amount reflected was never the true (more discounted) value of the underlying asset. That asset, in turn, was not the market value of the real estate but the payment value of the mortgage on that property.
The same problem may emerge with tether. Only this time, it will play out in a still unregulated market yet serve as a transaction base for a widening collateralization of other dollar-denominated assets.
Two months ago, Tether (the company) broke down the reserves for its stablecoin. The firm revealed that only 2.9 percent of its holdings were in cash, while the vast majority was in commercial paper, that is, unsecured, short-term debt. That would still put the company in the top 10 biggest holders of commercial paper in the world. Some analysts have compared Tether to a traditional money-market funds — but without any regulation.
With more than $60 billion worth of tokens in circulation, Tether has more deposits than that of many US banks (see, https://www.bloomberg.com/news/articles/2021-05-01/crypto-s-shadow-currency-surges-past-deposits-of-most-u-s-banks).
In addition, there have been concerns expressed that tether has already been used to manipulate crypto prices, a point strongly made in one well-done academic review of a 2017 bitcoin value surge (see https://papers.ssrn.cm/sol3/ papers.cfm?abstract_id=3195066).
As CNBC reported in 2018 in an article entitled, “Much of bitcoin’s 2017 boom was market manipulation, research says,” University of Texas finance professor John Griffin, who has a 10-year track record of spotting financial fraud, and graduate student Amin Shams examined millions of transactions on cryptocurrency exchange Bitfinex. They found that tether was used to “stabilize and manipulate” Bitcoin’s price.
Griffin suggested that this was creating “price support” for Bitcoin and had “huge price effects.” Even just one percent of heavy tether trading could explain as much as half of the rise of Bitcoin and even a greater percentage when it comes to other cryptocurrencies.
This is hardly an encouraging foundation upon which to base a tether usage in broader dollar-denominated asset categories. An unregulated use of a stablecoin looks a lot like the latest version of an MBS clone. Not the development to put much trust into the securitizing of assets. Unless, of course, you really enjoyed that subprime mess.
Dr. Kent Moors
This is an installment of Classified Intelligence Brief, your guide to what’s really happening behind the headlines… and how to profit from it. Dr. Kent Moors served the United States for 30 years as one of the most highly decorated intelligence operatives alive today (including THREE Presidential commendations).
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