Detailed Causes of the Crisis and Post-Crisis

Since this is a political season, and with the economic crisis, I think everyone in finance understands there is a sort of “silly season” that ensues. We certainly noted the sort of irrational behavior that would immediately make an economist question their beliefs. To me, though, the most offensive form of this stupidity comes from those who believe the Community Reinvestment Act and Fannie and Freddie sparked the whole crisis. Mr. Ritholtz rails against this notion over and over again. Oddly, I haven’t seen anyone else tackle this issue… Of course, I’m also way behind on reading my feeds. I even wrote Mr. Ritholtz an email (something I always tell myself is useless afterwards, since I don’t ever get a response, but is usually cathartic) noting that he was being very informative by setting the record straight. Well, maybe I expressed this sentiment with a tirade…

Every time I hear a Republican talking head on a news program saying Fannie and Freddie caused the problem I want to jump through my T.V., explain that the answer “betrays not even a modest understanding of the contributing factors to the current crisis, it’s scope, and magnitude” and begin to rattle off about flawed ratings agencies, excessive leverage (for investment banks and funds), over-reliance on models, a flawed compensation model for Wall St., managements needs to one-up their own earnings and those of competitors, explosive year over year growth of unproven financial technologies, over-reliance on “fast money” to distribute risk, fund’s need to earn outsized returns to attract assets, funds’ need to buy crappy bonds to build a “relationship” that would allow them to get “good” bonds from banks, poor disclosure from companies (specifically investment banks, as I’ve discussed on my blog), and extremely low rates for a very long time. Of course I’m just a normal guy who actually knows what’s going on, I don’t get invited onto these shows.

(Emphasis added, mine.)

Let’s tackle these, shall we?

1. Excessive Leverage — If the plot of the credit crisis had included a deus ex machina it would have been an instant de-levering of troubled investment firms. This didn’t happen and several collapsed. I don’t want to be repetitive, but the Deal Professor says it plainly when he says, “Sometimes, You Can Only Raise Capital When You Don’t Need It” … If a firm is highly levered, as Bear was, Lehman was, Fannie was, Freddie was, and A.I.G. was, then when the market gets bad, losses pile up, and credit tightens it’s a death spiral. There’s a large distance between well-capitalized and insolvent, but once you move from adequately-capitalized to under-capitalized it’s probably impossible not to hit insolvent or bankrupt. Oh, and let’s not forget how this became a problem in the first place … the rules were relaxed in 2004.
2. Flawed Rating Agencies — This is pretty obvious. Moodys errors. Rating agencies noting any deal, even one “structured by cows,” would be rated. And lastly, the smoking gun that seems to be the largest caliber, the fact that … well, I’ll let Mr. Raiter speak for himself:… “Mr. Raiter said that the residential mortgage rating group at S.& P. had captured the largest market share among its main competitors — 92 percent or better — ‘and improving the model would not add to S.& P.’s revenues.‘” Wow! Honesty, stupidity, incompetence … all on display. Now, to be honest, I have no idea what difference these problems made. What I do know is that the rating agencies were used as a means of outsourcing risk management and credit analysis. While it shouldn’t be a huge shock that the rating agencies missed the mark, the magnitude by which they missed is a huge problem if everyone took their ratings as fundamentally true. What these “statistical rating agencies” should have been doing is running securities and mortgage loans through abhorrently conservative scenarios and fixing ratings based on those…. they didn’t. They were argued down to “realistic” scenarios based on past experience. The issues above merely compound the problem.
3. Over-Reliance on Models — Related to the rating agencies’ issues, this one is a great catchall for terrible risk management. Let’s be honest, no one saw the fundamentals in housing getting so bad. That’s not the issue, I didn’t see it so I can’t exactly blame others for not seeing it. What I can do, however, is blame risk management professionals for not preparing for it. When you have, as Citi did, tens of billions of dollars in highly correlated assets, you should know there’s a risk of tens of billions of dollars in writedowns. When you have tens of billions of dollars in commercial mortgages, as Lehman did, you should realize the risks there. Similar lessons for WaMu, Wachovia, and CountryWide. Instead, though, like the rating agencies, there was a push to have “realistic” or “back tested” results. Let’s go to Mr. Viniar, C.F.O. of Goldman, for his take: “Even scenario analysis, which can address some of VAR’s deficiencies, came up short … [This] ’caused us to look at more-extreme scenarios than we used to look at,’ says Viniar. ‘It made us expand out the tails of what we deemed a realistic possibility.'” Logical, concise, and conservative. It seems Goldman didn’t attempt to show lower risk numbers so that they could deploy more capital or be looked upon as safer by the stock market. No, they looked at more extreme scenarios. They reacted quickly. However, in quoting this passage I sandbagged you, dear readers. This quotation is actually much more relevant to this situation than one would think–it comes from 2001! Mr. Viniar, people probably won’t remember (seems like a lifetime ago), but I noted before, was the guy who convened a firm-wide meeting on exposure to the housing markets. The takeaway is that the firm that looked at the most extreme scenarios, not the ones that models said were most likely, weathered the storm the best.
4. Flawed Compensation Model — This one is pretty obvious. Lots of money flowed into people’s P.A.’s (that’s “personal account”) each year based on fees and mark-to-market gains for complex structured products. In many instances these risks were distributed and off the balance sheets of investment banks. However, these businesses were grown, and none of the risks were well understood–the people in the lead, though, lead the charge to increase their compensation. I was personally aware of a senior trader/banker/whatever that pushed a firm, one that has seen tens of billions in writedowns and may or may not still be alive, who pushed for balance sheet commitment of 2-3x the current size in the C.D.O. business. This would have exposed this institution to writedowns larger than most firms equity base. This proposal was shot down, but still… Clearly making eight digits was going to someone’s head. Now, we all know that I believe one should be accountable for their decisions, so it shouldn’t be a surprise that when one has made tens of millions of dollars in bonus and salary, but their decisions lead an institution to take massive losses, reduces shareholder value significantly (keeping in mind shareholders might be woefully unaware of the risks being taken), and leads to thousands of people losing their jobs, merely being fired isn’t enough. Especially since these issues are only beginning to be understood when these people are fired, usually. Becoming an instant millionaire is a huge, huge problem. It’s the “swing for the fences if you’re down” mentality, and it’s also the “worry about the tail events if they happen” mentality. Put simply, there should be the ability to claw-back compensation based on performance for years. Perhaps a ten year lockup of wealth is extreme, but given these issues and famous blowups in the past, and taking into account the tradition of good times to last several years, maybe ten years is harsh but not extreme. Maybe employees should be allowed to hedge exposure to stock prices after a few years, but still have risk if negligence is discovered or things go wrong that were set in motion by that person. Obviously something drastic needs to be done, perhaps merely paying less is sufficient, but I doubt it.
5. Management Pressures — Highly correlated to the flawed compensation model, it’s the case that management was pushed hard to get earnings up. Having seen the “budget” process (an odd name, I thought, since a budget, to me, merely means expenditures) up close, I saw people come up with reasonable numbers, submit them to senior management, and be told, “More!” Well, guess what <expletive>s? If someone tells you they can reasonably deliver something and you always add 10-20% to those numbers, there is more risk taking and less rationality to how that profit is achieved. Maybe the long term effects of pushing the envelope are much worse than not taking those risks to begin with. This is one reason Goldman seems to outperform so often, they understand what they are getting themselves into. They truly work together and achieve revenues through teamwork instead of edict. Now, underperformance is punished, but setting reasonable goals is step one when trying to exceed them. The next generation of management should fight their bosses tooth and nail not to set unreasonable baseline expectations and should figure out objective measures that reflect an employee or business’s effectiveness. The tyranny of quarterly earnings shouldn’t make grown ups act stupidly because they can’t “just say no.” Here’s a hint: if you run a company with a nine- or ten-digit balance sheet and you don’t realize your business is complex enough that you shouldn’t manage to the next ninety days, then you should step aside. Seems simple to me. Maybe that’s why Google doesn’t bother with quarterly guidance.
6. Explosive Growth of Unproven Financial Technologies — Being a bit of a purist I am hesitant to call financial products or methods “technologies,” but I’ll use that word for now. The truth of the matter is, these products had never seen a massive downturn. Sub-prime loans as we know them today hadn’t seen a recession until now. C.D.O.’s backed by structured products hadn’t existed during a protracted period of fundamnetal credit distress before. This was known and talked about often. For as much as this was talked about, it was an observation that was never extrapolated. Hedging and risk management still looked at historical levels of distress and credit problems. The market had grown by orders of magnitude, but that wasn’t part of the equation. Quite simply, the fact that these markets grew so much so fast meant no one had a good handle on the feedback effects of this growth. This is somewhat obvious and very moot, so I won’t dwell on the problems of such massive growth.
7. Over Reliance on “Fast Money” To Distribute Risk — Anyone who knows structured products understand this point. Basically, the fair-weather buyers are “fast money.” This client based is distinct from “buy and hold” or “real money” accounts. Here is where the shell game of wall street really kicked into high gear. Hedge funds would buy bonds with the intention of selling at a profit later. Investment banks would, to show strength of the market, put out “bids” or interest to purchase securities they had just created at a higher price than they had just sold said securities at. Hedge funds would then immediately sell back to Wall St. firms, at a profit, to take advantage of their desire to show the market their securitizations “trade well” or “at a premium.” When firms are making money on the securitization, they can afford this. Speaking more generally, hedge funds just “trade bonds around” more. In recent years insurance companies and banks, the institutions that buy securities and rarely sell them (for a myriad of reasons), went from 70+% of the buying base for structured products to 20-30% of the buying base. This means that in a bad market 70-80% of the bonds that exist can be sold (dumped?) at a moments notice. Add in the fact that during this period there was explosive growth (as noted above) and you see why when the markets hit trouble the huge wave of selling occurred, liquidity dried up, and prices plummeted.
8. The Flawed Model for Relationships Funds have with Wall St. (coupled with Funds’ Needs for High Returns to attract Assets) — The way a bank figured out if a hedge fund was a good customer was, basically, how much a fund helped that bank get out of risk (stupidly, as stated above, since banks were likely to be more hurt by a fund owning assets and were more likely to wind up needing to repurchase those assets, but I digress…). However, when assets were in short supply relative to demand, only the top clients were able to purchase securities banks were creating. So, one might wonder, how did a nascent fund, at the bottom of the food chain, get access to the desirable securities? Easy solution: they purchased the undesirable securities to “help out” a Wall St. firm. These were more risky, although they were generally carried a higher rate of return in the event of no credit problems. These new funds, then, showed higher returns, attracted more money, and bought more securities from banks. Net effect? Most funds had a poor mix of products–higher risk bonds or assets that would get hit much harder than generic securities and more generic securities. Keep in mind that, to get high returns, funds were buying C.D.O. products and other structured products that had higher returns in general, but funds also levered these products and thus funds were much more exposed to moves in the market. Funds, as everyone knows, get paid a percentage of assets under management and returns, so to grow their revenue stream many funds just had to buy lots of securities (and, to establish a strong enough relationship to be allocated enough securities, plenty of lower quality securities). This was the prisoner’s dilemma of the syndicate system–funds cooperated every time. (Just to put some numbers on it, when a fund would try to buy residential or commercial mortgage backed securities it was possible for demand to outstrip supply 2- or 3-to-1. Accounts with strong relationships usually got 100% to 80% of the requested amount of bonds being issued. Weak relationships or smaller firms could receive as little as 10-20% of their desired allocation.) This is a complex process and nuanced point, feel free to email me for more explanation.
9. Poor Disclosure from Companies — This is a point I’ve raised before. I won’t go over it again. The short story is that firms got away with a lot because they didn’t tell anyone what they were doing.
10. Extremely Low Rates for a Very Long Time — I’ve raised this point before as well (between the numbered lists). Rates were very low and, suddenly, a product that trades at 50-100bps over L.I.B.O.R. traded 50-100% higher than L.I.B.O.R. If your benchmark was treasury rates to outperform your benchmark meaningfully you needed to get much higher spreads, and thus take higher risk. This is why C.D.O.’s experienced such explosive growth (see the problems the growth cased above). Low rates also made it more attractive to get a floating rate mortgage, which a huge majority of sub-prime mortgages were. This was part of the ex-post concern with Alan Greenspan’s encouraging people to take out A.R.M.’s.

In short, Fannie and Freddie were part of the problem, but not in and of themselves. In fact, if Fannie and Freddie had caused these problems by selling banks their bonds, then we wouldn’t have a problem at all. Why? Because Fannie and Freddie would be “on the hook” for the bonds they guarantee. If these bonds went bad no firms would have taken losses on them (since the government stepped in to keep them solvent and backstopped their obligations). Okay, now that I’m done ranting I’m going to rant on something new. The post-crisis narrative of what went wrong… (don’t you love the rise of the word “narrative”?).

1. The failure of rating agencies, risk managers, and risk management models. This has been getting the most press because it’s easy to explain (not why these things failed, but the fact they failed).
2. Sheer size. This is pretty silly, if you ask me. Bigger doesn’t have to mean riskier. The practices that get a firm to a massive size could be an issue. Super-concentrating the health of the markets with very few players could be a huge problem. The “Too Big to Fail” issue might fit some situations, but didn’t cause this crisis. No one wants to have to rely on the government to save them.
3. Executive pay. This is a limited view on the actual problem. In fact, in most firms, C.E.O.’s aren’t the highest earning individuals.
4. Hedge funds and short selling. Really? Let’s trace the logic here (or lack thereof): a firm runs it’s business poorly and I bet it will decline in value. Clearly I am at fault there. The “free markets at all costs except losses” crowd, like those currently at Treasury, are putting a band aid on an amputated leg here. Especially with the very firms begging to be protected turning around and getting fees from products circumventing the bank on short selling. (What a stupid move, some firms deserve to be in worse trouble.)
5. Everything else. Why get into the details of the actual causes when you can distill down issues to “good” versus “bad” and simple fights? No one has…. so I’m doing it! But I doubt all the other things will make it into the popular understanding of what went wrong.

There you go. My hands are tired, so I’ll stop here. Feel free to comment and ask questions.

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