In the February 2009 issue of Policy Options, a publication of the Institute for Research in Public Policy, there was an article by Rodrigue Tremblay entitled “How American Politicians and Bankers Built a Financial Debt House of Cards.” It is a very good description of how the financial crisis came about and well worth the read. The full article may be viewed at
www.irpp.org/po/archive/feb09/tremblay.pdf I have recently read “Fool’s Gold” by Gillian Tett, and would also recommend it as a very readable in depth description of JP Morgan in particular, but also about the causes of the financial crisis generally. Just scan the Part and Chapter titles in Dr. Tett’s book and you get the feel of this financial situation: Innovation, Dancing Around the Regulators, Merger Mania, Perversion, Innovation Unleashed, Risky Business, Leveraging Lunacy, Tremors, Disaster, Panic Takes Hold, Bank Run, Bear Blows Up and Free Fall.
What I take from their works is that there should be some accountability. Why wasn’t there adequate disclosure on financials statements? Where was the transparency? Rules did not require it. Why not? Fix the rules. The right thing to do is to be open. Regulators should have been there to require it. Not in their mandate? Then put it in! Even if what was done was not illegal, I’ve of the view that it was unethical. It was a fraud on the investing public. So why haven’t these financiers been held to account? The rest of us have really been such small pawns buffeted by the storms created by these financial innovators. When will they be held them accountable? What about the investors who suffered losses while relying on investment advisors who no doubt had no knowledge of the complexity of these investments? You can hear the advisors now: it’s an investment underwritten by Lehman Brothers; no need to worry about them; they have been around forever; big American firm. Well guess what? Who’s going to cover the losses for those people who relied in good faith on others – albeit the others didn’t know what they were talking about – but arguably it was their job to know?
(For easier reading I’ve included some definitions from Dr. Tett’s book at the end of this piece.)
I agree with the Prof. Tremblay that the answer to why the financial crisis has occurred is to be found in human greed, as well as an unstable pyramid of artificial financial debt instruments. These instruments grew at outstanding rates, fuelled in no small part by the greed of the players. Another element is the fact that these instruments benefitted (sic) from being largely unregulated. Prof. Tremblay describes the causes as “the collapse of public and private basic morality in a very small elite that pushed the exploitation of public institutions to the breaking point.” He further points out that the landscape for this was set by the Americans passing in 1999 the Gramm-Leach-Bliley Act, which amongst other things abolished the 1933 Glass-Steagall Act which had regulated investment banking and established barriers between the various pillars of financial institutions: banks (for personal and investment banking), investment banks including stock brokerages and insurers.
Some has been written about the philosophy, championed by former President Regan and former Prime Minister Thatcher in particular, to leave the market alone as its forces are self balancing and it can control itself. I believe this was referred to as the theory of efficient and rational markets. This theory is that markets, left alone, would act in a mostly rational manner, so a hands-off approach to regulation should be taken. I think that approach has been conclusively laid to rest as bunk when former Federal Reserve Chairman Alan Greenspan testified on October 24, 2008 that (as reported by Dr. Tett): “ he had made a “mistake” in believing that banks would do what was necessary to protect their shareholders and institutions. That was a flaw in the model … that defines how the world works.” Indeed. There does appear to be some place for reasonable oversight and regulation by government.
Prof. Tremblay beautifully describes it as “the biggest case of financial mismanagement in history. It was the product of two interrelated bubbles: a housing bubble and a financial debt bubble”. We know the housing crisis was a fire fanned by increasing housing prices, low interest rates and in the case of subprime mortgages, very low lending standards. In the case of subprime mortgages there were clearly decisions made by the lenders to lend without even some basic data and/or due diligence. One story describes one class of mortgage, which appears to be not far from the truth, as “ninja”: no income, no job. (Not sure where the “a” comes from, but apparently that’s how the lending was going.)
The subprime mortgage market being motivated by the need to feed the securitization market. The subprime mortgages were bundled into CDOs, and then with the sale of the CDOs the mortgage loans were off the bank’s books. The bankers could ignore the risks of the mortgages as they were selling them as a bundled investment. It became a production line with a heavy emphasis on production. The link between that investment product as bundled, and bundles of bundles, became more complex and remote. This really speaks to it being better to keep things simple, real and understandable. The chance for increased returns drove an acceptance without understanding. Hence the reliance on ratings! But given what happened I don’t see how they could have understood what they were rating. That being the case, what chance did the average investor on Main Street have of understanding what the risks of the investments were?
In a recent speech Canada's Superintendent of Financial Institutions quoted the language Warren Buffet used to describe the issue of understanding: "I read a few prospectuses for residential-mortgage backed securities - mortgages, thousands of mortgages backing them, and then those all tranched into maybe 30 slices. You create a CDO by taking one of the lower tranches of that one and 50 others like it. Now if you're going to understand the CDO, you've got 50 times 300 pages to read, its 15,000. If you take one of the lower tranches of the CDO and take 50 of those and create a CDO squared, you're now up to 750,000 pages to read to undrestand one security. I mean, it can't be done."
Prof Tremblay describes one of the reasons “for such reckless lending was the facility with which subprime lenders could sell their risky mortgages upstream to bigger players, investment banks for example, that undertook to buy them, pool them into mortgage bonds and rechannel them into new financial instrument through a process of aggressive securitization. These new “structured investment vehicles” which fall into the large class of derivative products, came under various names such as “collateralized bond obligations’ or “collateralized debt obligations”. … Thus the asset based security (ABS) was born. … More than $1.5 trillion of these asset-backed financial products were sold, not only in the US, but all over the world.”
This international connection and the extent to which AIG for example had these contracts with counterparties throughout the world is why I believe the U.S.A. could not allow AIG to collapse. To do so would have caused these financial contracts to be unwound with ruinous international financial effect due to the cascading losses and their international reach.
I appreciate the manner in which Prof. Tremblay describes another phase of the crisis, credit default swaps (CDSs); new financial instruments – lack of proper regulation – gambling unrelated to any genuine lending operation. He reminds us that Warren Buffett described CDSs as a true financial weapon of mass destruction. CDSs are bilateral insurance like contracts used to protect against the risk of default on the ABSs. They were not regulated by any government agency. The gambling component arises because only 10% of the CDSs (“covered CDS”) are genuine contracts held by investors who really own ABSs. The other 90% of CDSs (“naked CDS”) are held by speculators who trade CDSs while not owning any ABSs to be protected. Read this as “speculators” = “bad”. A naked CDS is compared by Prof. Tremblay to buying life insurance on the life of someone to whom you are not related, which is illegal because of the potential of obvious abuses. He goes on “it is estimated that the notional value of CDSs outstanding today is about $62 trillion (four times the size of the US economy). This in itself is an indication of how popular the naked CDS innovation was a way to bet on the collapse of the entire asset-backed securities construction. This is also a clear sign that, in a crisis, it would be all but impossible for the issuers of CDSs to meet their financial obligations.”
Enter government bailouts! But as was realized, these bailouts were to settle the financial bets which had gone bad. They did not flow down to Main Street which was having it’s own problems, both in terms of the recession and the portfolios of regular people who were hurt by being in investments which unknown to them were involved in these ABS and CDS.
At JP Morgan Chase, the subprime mortgages were securitized and eventually became credit default swaps. The securitization was a mortgage repacking production line. Determined not to get caught short if default rose any higher it purchased CDSs from other parties, which promised to redeem any default losses on the mortgages bonds JP Morgan Chase would begin selling. Dr. Tett also explains that it wasn’t just a financial debt bubble but also a case of financial innovation going amok and risk models not being accurately used – the classic case of lacking base data and making inappropriate assumptions. The securitized subprime mortgages were pools of debt that were entirely anonymous in the sense that the names and credit histories of the borrowers were not revealed. Investors had to rely on data from the lender itself about the default risks of the borrowers or the judgements of rating agencies. Let me see, the salesman or the raters who were interested in collecting their fees!!! But there was also a lack of data to track mortgage defaults over several business cycles on a nationwide basis. Without that data it was impossible for bankers to know whether defaults tended to be correlated or not, in what circumstances they were isolated to particular regions, and when they might spread nationwide. That meant that they would either have to rely on data from just one region and extrapolate it across America or make even more assumptions than normal about how defaults were correlated. Either way it doesn’t sound to me like good science! So if they could not see a way to track the potential correlation of defaults with any level of confidence, then they could not come up with a precise estimate of the risks of default in a bundle overall. They should have just asked investors to come and roll the dice! But they went ahead anyway and marketed their bundles. As it turned out there was an extensive decline in the housing market on a nationwide basis, increase in mortgage defaults, and the bundles sold turned out not to be as solid as represented.
Prof. Tremblay’s conclusion rings true to me: There have been two parallel banking systems; the traditional one which is regulated and the other being investment banks, hedge funds and the credit derivatives market, which is hardly regulated at all. The worst excesses have taken place in the unregulated sector, where increasingly risky financial innovations have been created, nurtured and sold.
Dr. Tett describes the unbridled greed of some investment bankers, regulators who allowed themselves to be talked out of regulating the innovative products being developed and rating agencies not adequately assessing risk while they were drawing fat profits from the collateralized debt obligation boom. The failure to see the flaws, or was it a failure to care as long as they were hauling down their obscene salaries and bonuses? A lack of oversight, by those running the investment banks (assuming they have some responsibility to act ethically), the markets (although some of them operated outside the regular markets – but there’s a whole argument that they should have been forced to be within the markets), regulators and governments. I’d suggest this supports an argument that instead of a rules based system that allowed these investment bankers to operate under the radar of regulation, there should instead be principles based regulation which can adapt automatically to changes including innovations. Back in 1992ish Felix Rohatyn, a legendary Wall Street figure who worked in corporate finance called derivatives “financial hydrogen bombs, built on personal computers by twenty-six year olds with MBAs”. I think that financial innovation was taken to a level of complexity that was incomprehensible. When the risks came to fruition unforeseen consequences ensued – major global financial crisis. As we’ve gone through periods of various innovations in the financial system, why is it that the innovators, the investment bankers and lawyers supporting them, can make these strange instruments, sell them, make tons of money and then when it blows up, they go off with their money and just start the cycle all over again? When is someone going to put a stop to it and hold them to account?
Money market funds typically raised money from ordinary retail investors of companies which used the funds similar to a bank account, i.e. a place where they could place cash assuming they could always withdraw it, on short notice. Some funds which issued these notes backed them up with assets such as mortgage bonds – which sometimes had become CDOs and were issued by SIVs. These notes carried high credit ratings. In mid-July 2007 however defaults were emerging from the mortgage world and downgrades were starting to be issued by the rating agencies on the mortgage bonds. Then two Bear Stearns funds collapsed, even thought many of the bonds and CDOs that had wreaked havoc at these funds had carried relatively high credit ratings. So investor in the ABCP market grew nervous. The SIV were a classic loss of logic. The SIV raised their funding in the short term commercial paper market meanwhile the assets they were buying would pay over a longer time frame. So by definition a maturity mismatch – if, as was the case, the short term paper market dried up (in fact people not only stopped buying, but in fact were redeeming), there was not money repay the notes on their maturity as it was not possible to redeem the assets which were bought with the original proceeds of the notes, as those assets had later maturities. Panic set in because investors had heard some less than stellar assets had got into the securitization chain and they couldn’t tell where the rot was so they started boycotting all SIVs. So for example the asset back commercial paper market in Canada saw a liquidity problem in people getting paid out upon the maturity of their money market funds. The innovators took the risk that that would happen – likely said there’ll always be money available, don’t worry about the theoretical. Well the theoretical happened, and who suffered? Not the innovators, but the poor investors on Main Street who (and as it also seems their investment advisors) didn’t understand what was really behind the seemingly safe money market funds they were purchasing.
So what motivated banks to get into this such innovations? The Basel Accord was an internationally accepted regulation which specified an amount of capital banks were required to keep on their books in relation to the amount of loans they had written. Specifically banks were required to keep $8 in reserve for every $100 of loans. If there were fewer loans on their books, then they could reduce their reserves and do other things with that capital – like make more loans, buy other institutions, etc. So the banks used these innovations to move large volumes of credit risk off their books in what they thoughts was a brilliant way to get around the Basel rules.
Dr. Tett described that in 2004 many large U.S.A. brokerages increased their CDO machines. They did “realize that super-senior risk was becoming like the toxic by-product of a chemical experiment or waste from a nuclear reactor. But they could find no good solution to the problem, and they weren’t willing to switch off their CDO machines.” Read this as the need to maintain strong profitability, and the consequence of feeding their stratospheric salaries and bonuses. Citigroup continued to ramp up its output of CDOs, but unlike the brokerages as a bank it could not put unlimited quantities of super-senior on its balance sheet, since the regulators required its leverage limit to keep assets below twenty times the value of their equity. “Citi decided to circumvent that rule by placing large volumes of its super-senior in an extensive network of SIVs and other off-balance-sheet vehicles that it created. The SIVs were not always eager to buy the risk, so Citi began throwing in a type of ‘buyback” sweetener: it promised that if the SIVs ever ran into problems with the super-senior notes, Citi itself would buy them back.” Do you expect that this guarantee found its way onto Citi’s balance sheet? Not likely – and hence the problem. Without this transparency there was not a true accounting for the risks that Citi, and the others who did this, were facing. Dr. Tett reports that in April, 2007 it was far from sure that the regulators, or even the bankers, really knew what risks were building up. The SIVs did not appear on the bank’s balance sheets because generally accepted accounting principles did not require it.
Dr. Tett quoted Andrew Feldstein, a U.S.A. financier: “The essential question is what in tarnation led market participants to overoriginate subprime mortgages at increasingly silly terms and then warp credit derivative technology into synthetic CDO of ABS when the supply of real mortgages was insufficient to satisfy demand.” Indeed! Could it perhaps have been greed??? Our understanding of this has all has unravelled in hindsight. What chance do investors have of knowing this sort of thing as it is developing? If we cannot, and my thesis is that we cannot, then what should we be investing in?
Definitions from Dr. Tett’s book:
Asset back commercial paper (ABCP) – a short-term security that commonly lasts between overnight and 180 days. It is typically issued by a bank or other financial institution, backed by physical assets such as trade receivable, commercial loans, or holdings of bonds.
Asset back security (ABS) – a security that is backed by a portfolio of assets or cash flows from assets that are normally placed in a specially designated vehicle. The assets often (but no always) are loans.
Collateralized debt obligation (CDO) – a form of asset-backed security: they are typically created by bundling together a portfolio of fixed-income debt (such as bonds) and using those assets to back the issuance of notes. Cash CDOs are created from tangible bonds, bonds, or other debt; synthetic CDOs are created from credit derivatives.
Credit default swap (CDS) – a contract between two parties, where the buyer pays a regular fee to the seller in exchange for a guarantee that he will be compensated in the case of any default on a stipulated piece of debt. CDS are similar to insurance in some senses, but they are not regulated in the same manner, can be freely traded, and can be struck even if the buyer does not own the debt he wishes to “insure”.
Credit Derivative – a bilateral contract between a buyer and seller whose value derives from the credit risk attached to an underlying bond, loan or other financial asset. Typically, they are designed to compensate one party if that underlying asset goes into default. CDS are one form of credit derivatives, but not the only one.
Derivative – a financial instrument whose value derives from an underlying asset, most normally commodities, bonds, equities or currencies.
Special Purpose Vehicle (SPV) – a shell company that is created to hold a portfolio of assets, such as bonds or derivatives contracts, and then issue securities backed by those assets. It may be created by a bank, but is a separate legal entity.
Structured Investment Vehicle (SIV) – an entity that operates in a manner similar to a conduit but does not enjoy complete credit support forma bank, and has external equity investors who bear the first risk of losses.
Sub-prime mortgages – those mortgages which did not conform to the high credit standards imposed by U.S.A. federal government backed housing giants Fannie Mae and Freddie Mac. E.g. borrowers with bad credit history.
Super-senior risk – the most senior part of the capital structure of a CDO, which is the least exposed to the risk of default.
