Commentary by A.W. Bodine and C.J. Nagel, faculty at Concordia College–New York
March 26, 2008
With world markets off 20%, Bear Stearns imploding and public companies having lost US$5 trillion in value, politicians and regulators all now seem focused on avoiding a global financial system meltdown. All well and good, but wouldn’t it be rather useful to examine how we actually got into the current mess?
On the surface, the crisis seems to have arisen from excessive subprime mortgage lending in the United States….those risky mortgages made to borrowers with blemished or “subprime” credit histories. One sees reports that as much as a quarter of the $1 trillion subprime mortgage market has moved into default, triggered by rising monthly obligations that many simply cannot now afford. These cumulative defaults have in-turn crippled the value of once AAA rated paper (now assigned junk status) that was securitized by those mortgages. The demand for this so-called structured paper has evaporated—and when there is not market, there is no value.
The current credit crunch in tandem with huge capital write-downs at leading financial institutions has spooked markets, regulators and consumers. Now a recession appears underway and consumers are experiencing both declining wealth and a reduced ability to continue their enthusiastic spending—an enthusiasm once based upon easy credit and low interest rates.
Given these circumstances, let us think about what led to this crisis as there are important lessons for policy makers and market regulators.
As always, a key player is the Federal Reserve. When influenced by such events as 9/11, Enron, and WorldCom, the Fed moved toward policies of loose money and low interest rates. As a consequence, since 2001 all levels of our financial system have been awash with cash. Banks, mortgage companies (some new and very aggressive), institutional investors and especially the largely unregulated hedge funds, developed increased appetites for risk as they felt pressured to chase ever higher returns in a weak dollar/low interest rate/cheap asset environment.
With the prospect of higher spreads on subprime loans, investment banks began buying billions of dollars of these mortgages. Perhaps some of these bankers might have done well to pause for a moment and remember that which is part of any basic finance course—the idea that rational players should try to measure and balance risk with due-diligence. Now, after the fact, we see estimates that over 50% of these subprime mortgages contain “lending exceptions.” So much for the quaint idea of due-diligence.
Meanwhile, literally back at the suburban ranch, home ownership was promoted aggressively to first time home buyers—many of whom under traditional credit standards would not have qualified for a mortgage. Closing documents containing rate step-up provisions were pushed on the unsophisticated. Consumers were encouraged to sign and move into their dream home with little understanding of the risks and consequences of an adjustable rate mortgage. Naturally this easy money ramped up pricing and speculation in housing. When faced with subsequently higher monthly mortgage payments when the higher rates kicked in, a vast number of homeowners simply couldn’t pay.
While these mortgages were being peddled, aggressive investment bankers on Wall Street moved to package up these higher rate bearing mortgages into what first became known as Collateralized Mortgage Obligations “CMOs” and sold them to institutional investors, such as pension funds. Subsequent iterations were called Collateralized Debt Obligations “CDOs” (these included such things as credit card debt and car loans). To give some semblance of portfolio balance and diversification, such structured fixed income instruments, essentially bonds, were blended together by math wizards with regard to geography, credit type, etc. so as to gain not only AAA credit ratings (for which the rating agencies were well paid) but also some insurance coverage—this from firms that specialize in insuring mortgage-related bonds against default (the insurer MBNA recently took a related $2.3 billion hit). The alchemy of these math wizards made the CDOs appear to be a perfect investment, one that had high return, low risk and a nice warm AAA rated security blanket.
The creative use of leverage, layered options (derivatives) and other sophisticated math-driven applications led to an almost unlimited demand for this structured paper—and volumes grew into the hundreds of billions. Under these conditions, investment bankers were more than happy to originate, warehouse, trade and own these investments because of the huge fees associated with such activities, especially origination. The more sanguine in the market such as Goldman Sachs left the party early and avoided the financial havoc other major firms like Bear Sterns have experienced. Other investment bankers and hedge fund mavens chose to forget what every undergraduate business student knows—that high return and low risk do not go hand in hand.
Further, given the incentives and pressures institutional investors faced worldwide to perform and justify their lofty fees, such “high return/low risk” paper was sought in great volume. As the game became more profitable and global in scope, some even borrowed against the paper they held, which, in combination with increasingly complex derivatives, freed-up investors’ cash to demand even more CDOs. As part of this frenzy, Citigroup et al created and funded a further permutation called Structured Investment Vehicles “SIVs” as a basis to issue their own commercial paper and thus chase further profits. Citicorp’s subsequent inability to meet short-term obligations as the value of its supporting leveraged assets collapsed led to devastating hits to their balance sheet. The same ugly impact has been experienced by European banks including the previously venerable UBS.
At trading desks on Wall Street, market mechanisms (markets made by dealers with little transparency) made the sale and distribution of CMOs/CDOs especially profitable. Without transparency, as Paul Krugman notes, “unregulated, unsupervised financial markets can all too easily suffer catastrophic failure (3/21/08 New York Times).” Echoes of the 1930’s. But everyone was making gobs of money so these unregulated fixed income creations rolled merrily along with huge incentives of wide bid/ask spreads and high transaction costs—which only encouraged brokerages and investment firms to generate more structured debt instruments, buy them for their own account and sell ever more SIVs to eager institutional investors worldwide.
All this started to unravel (surprise, surprise) when the subprime borrowers began to miss their mortgage payments. As the meltdown began, holders of CMOs/CDOs/SIVs realized they couldn’t measure the true value of this supposedly low-risk paper and quickly found their assets and liabilities mismatched with billions lost in the squeeze. As we’ve said, high return and low risk do not go hand in hand and it may be timely to remind ourselves of the Enron days—when too few analysts studied the fundamentals driving the market and few were brave enough to say, “the emperor has no clothes.” One also recalls the adage attributed to Warren Buffett, “You don’t know who’s swimming naked until the tide goes out.”
So, let’s return to the question, how did we get here? A key factor behind all this mess can be traced back to the mid-1970s, when Wall Street valuation methods became more sophisticated. Since then, the increased availability of data, Modern Portfolio Theory and the application of advanced mathematical techniques have combined to make “quant geeks” Wall Street’s newest heroes. Their impact spread in the 1980s as Value at Risk Models, led by J.P. Morgan, gave investment firms a false sense of security. In reality, such probability-based models are derived from past norms. However, to those that once in a while take the time to look up from their computer screens, world events have actually become increasingly uncertain, less predictable, and, as a consequence, ever more “event” driven.
The “best & brightest” quantitative analysts on Wall Street became so technologically advanced that many of the principals running investment firms simply didn’t understand the arcane risk models their “quants” developed – and sadly neither did the quants. We recall the comment made during a recent presentation at Concordia College by Don Gogel, President and CEO of Clayton, Dubilier and Rice. He noted that this “toxic cocktail” was something that even the “mixologists themselves didn’t understand” let alone those trading in them. Bryant Urstadt writing in MIT’s Technology Review in December 2007 also notes, “The more quants learn, the farther away a unified theory of finance seems. Human behavior, as manifest in financial markets, simply resists quantification, at least for now.” We should here also do homage to the investing approach of the sage Warren Buffet—that he does not invest in anything he doesn’t understand. Investment houses should note this simple truth.
Senior financial principals were, of course, happy to enhance their personal wealth but clearly had little idea of what could go wrong. It is sobering to note the all-too-obvious comment by Citigroup’s former Chairman Charles Prince as he announced billions in capital write-offs that “our risk models simply did not work.” And now, somewhat belatedly, former Fed Chairman Alan Greenspan is advising the financial community that “We will never have a perfect risk model” (3/16/08 Financial Times). We think it also fair to suggest that today’s extraordinarily talented quantitative analysts are so creative that even the world’s best central bankers and regulators do not have the capability to keep up with or even understand what has been going on with these “quants gone wild.”
One can only hope that Wall Street will retain some historical perspective and recall the late 1990’s when the “gods of the universe” at Greenwich-based Long-Term Capital Management used advanced modeling techniques and leveraged capital of $250 million into an exposure of billions. LTCM had initial market success, but the firm’s principals got predictably careless, failed to understand the limits of their mathematical models, made a bet in the global financial market that was spectacularly wrong—and nearly took down the world’s financial system.
One irony amid today’s mess is that there remains considerable inherent value in the underlying assets of CMO/CDOs (i.e. the mortgaged homes, cars etc.), this despite a bubbly housing market and abuses by aggressive mortgage lenders. The practical problem is that leading financial players all over the world hold massive amounts of this structured paper that they want to get off their books. Today, these investors find that the once hyperactive Wall Street trading desks—those that had made markets in such stuff—have effectively closed. Understandably, these desks have no incentive to make a market in such toxic paper. All that nervous institutional investors hear today is “no bids.” Welcome to the harsh reality that where there is no market, there is no value.
So where are we today? Well, regulatory accounting requirements mandate that publicly owned investment banks write down assets of questionable valuable. CMOs/CDOs/SIVs do come to mind. Massive write-downs have wiped out huge chunks of capital and crippled investment banks’ ability to act as financing institutions—and there is more carnage to come. This is important as there is real risk that if the flow of credit from the impacted financial houses tightens further—those that supply vital credit to both consumers and companies—the downturn we’re moving into will be deep and long.
The economic effect of missed mortgage payments, estimated at five to ten percent of all mortgages outstanding, is not by itself catastrophic, but the global financial system is at risk. This time though, the entire global financial system is so choked with all this structured debt paper, related derivatives and capital account hits that it is struggling to breathe. We should also note that as consumers slow their spending, major companies in the Dow (the great bulk of which are in the real economy—you know, the one that provides actual products and services) continue to report solid earnings. So amid the turmoil, the fundamentals of the U.S. economy remain healthy.
A couple closing thoughts: don’t run with the lemmings; don’t be overly impressed with things you don’t understand; drink some green tea and take time to write a Haiku as we witness a staggering capital meltdown from the consequences of uncontrolled financial engineering in derivatives currently estimated at US$500 trillion globally.
March 26, 2008
A. William Bodine & Christopher J. Nagel
Business faculty at Concordia College–New York