It’s funny to me that all of these problems are coming to light and, while there are clearly themes as to how these various products all became so prevelent, as well as why, there are some things that still need explaining. What do leveraged loans have to do with all this? Indeed Goldman could be asking itself why it got involved in that market–one in which it had become a major player, unlike some other businesses it was lucky enough to have been unsuccessful in entering. How did C.D.O.’s, a product generally managed off of trading floors where many market-sensitive businesses didn’t lose money, seem to be a categorical loser for banks? The answer seems pretty plain to me: These were products driven by “bankers.”
A “banker” is a person, as I think of them, whose job is to pitch a transaction to an entity/person/institution/group and get the fees involved in said transaction. They don’t manage risk, that is generally outsourced–but they do worry about it insofar as one can dimension the risk. Bankers make assumptions. Bankers LOVE assumptions. “Assume that trend continues.” “Assume defaults come in at 80% of the model for this collateral.” “Assume that debt gets taken out.” “Assume rates rally.” “Assume a static L.I.B.O.R.” “Assume this rate scenario and no losses.” It’s simply amazing. Why would one stress losses and not interest rates? Wouldn’t it be a better assumption that if 10% losses are occurring when 2.5% are projected that it’s because interest rates are higher than expected and people can’t get new loans? Well, the bonds don’t perform under those scenarios and showing that would make them harder to sell. Merely an example, I digress.
Bankers run the process on C.D.O.’s and on leveraged loan deals. Their job is to put together scads and scads of powerpoint presentations detailing all kinds of details. Bankers show nice graphs like supply (amount of bonds issued) versus spreads (yield premium required for a bond’s incremental) to show some trend. Bankers trot out the all-knowing league tables for their product. (As we now know, the most accurate thing predicted by the C.D.O. league tables turned out to be writedowns–but bankers were judged on their standing in these league tables!) So, what if a banker was so successful at pitching these transactions that they were able to sign up dozens, creating a pipeline, and lock up the fees? They were a superstar! Imagine the fees on billions of dollars of C.D.O.’s? If their bank provided the financing for the C.D.O. issuer to acquire the assets? Higher fees! If the bank agreed in advance to buy the bonds and take them onto is own balance sheet if the market wouldn’t buy them? Higher fees! If these arrangement were made, 10-15 C.D.O.’s could earn $100 million in fees. Was there more risk? Of course, how do you think bankers would justify higher fees for these incremental commitments?! But, when your job is to spend months courting C.D.O. issuers, and you spend countless hours on conference calls telling them what a good deal issuing a C.D.O. is, and when you repeat, over and over, how strong the market is, citing many datapoints, then you’ll probably convince yourself too. Indeed, when told a deal you got a client to agree to commit to is too risky, by a risk manager or other independant person, then you will probably fight back… hard! (And, feel free to substitute C.D.O. with leveraged loan transaction in every instance.)
The point is the mentality. Bankers weren’t paid to manage risk day-to-day, watch the market, and hedge. Bankers became salespeople with some analytical and technical expertise. They weren’t thinking about hedging–they might not even have assets to hedge, they hadn’t created bonds yet. Market fluctuations didn’t affect the revenues from fee income. Although, a commitment to buy unsold bonds if the market has lost liquidity and values are plummeting is a risk, it’s not one bankers would have assumed, and definitely not hedged. Indeed these bankers, at some firms, even had separate reporting lines than the traders and risk management professionals. Their division was generating lots of revenue, so their senior layers of management gained a lot of power. A perfect storm? Seems like it was.
In fairness, the perfect storm that occurred was due to a fundamental problem–the disappearance of liquidity. In the heyday it wouldn’t have seemed rational to consider scenarios that correspond to what the market has actually experienced. But the methods of accounting for and cataloging the risk of, for example, derivative contracts exposed to tail events or highly illiquid investments clearly wasn’t used (When a P.E. firm makes a highly illiquid equity investment, I would bet bankruptcy risk is discussed!). Indeed most of the C.D.O. bankers were ex-lawyers, ex-structurers, or converted salespeople who didn’t have the background in these views on risk either. As for leveraged loans, the leveraged finance professionals were also mainly investment bankers and refugees from other relationship-driven fee-based businesses. I even know of people that jumped between the two (C.D.O.’s and leveraged loans)!
Another point, that seems obvious, is the scheme of compensation. Roger Ehrenberg had a recent post that discusses some of these issues. My personal belief is that the mentality was much more of an issue than the structure of the compensation scheme–but the perils of compensation, as it currently stands in the financial world, are well discussed and documented.
Maybe I just have the benefit of 20/20 hindsight, but maybe the traders and other people who poke fun at bankers (see Monkey Business and, of course, DealBreaker) for not seeing the forest through the trees were on to something.