But opacity, leverage, and moral hazard are not accidental byproducts of otherwise salutary innovations; they are the direct intent of the innovations. No one at the major capital markets firms was celebrated for creating markets to connect borrowers and savers transparently and with low risk. After all, efficient markets produce minimal profits. They were instead rewarded for making sure no one, the regulators, the press, the community at large, could see and understand what they were doing.
– ECONNED: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism
As the investigations of the global financial crisis ratchet up to a new level of intensity, a tug of war between Wall Street and its detractors is escalating along with it. Some commentators have argued the SEC’s suit against Goldman is baseless, since the investors were sophisticated and should have known better than to take the investment bank’s word at face value. Old arguments are newly popular, such as claims that government policies stoked financial firm risk-taking or that the the Community Reinvestment Act caused subprime excesses.
But assigning blame (which tends to focus on individuals and institutions) can be misleading if you omit the larger framework within which they operate. We now have a financial and political system with widespread, lousy incentives. While it is critical to understand the mechanisms of the crisis, and who did what to whom, it’s also important to understand how an entire system could not merely condone, but actually encourage what with the benefit of hindsight was colossally stupid, destructive behavior. If we don’t fix the incentives, the same thing will happen all over again, just as it has already.
Readers often take umbrage with me when I argue that even though investors were foolish, they were not the most culpable party. What I find puzzling about this crisis is how the posture toward investors contrasts with that of past excesses. For example, this time around, there is some pretty compelling evidence of chicanery, witness Freddie and Fannie seeking clawbacks from banks because they made contractual misprepresentations about the mortgages they presented to the agencies.
Now independent of how widespread fraud was (we will be years sorting that one out), investors and lenders in the subprime market appear to have been a combination of overly trusting (particularly of ratings) and blinded by structured finance hocus pocus. But why are they being demonized when we saw similar widespread credulousness in the dot com era? We criticize lenders for handing out NINJA loans and investors for buying first gen (mortgage bonds) and second gen (CDOs) made of them that somehow fetched AAA ratings. Yet pray tell, how different is that than giving a bunch of not even graduated MBAs $5 million for a ten page business plan for venture that was never going to generate positive cash flow? (And that’s not an isolated case; it was trivial to raise $5 million if you had a clever idea and a remotely credible, which usually meant young, management team).
Yes, the dot com bust didn’t generate a global financial crisis, but the foolishness was every bit as bad, and you had supposedly sophisticated folks falling for it too (one example: McKinsey wrote off $200 million in equity it took in lieu of fees from Internet businesses). And Alan Greenspan sincerely believes that he deserves credit for the dot bomb era being not that bad, thanks to his program of super low interest rates, which helped set the stage for our global meltdown.
An incentive failures that has gotten a free pass in the crisis is the way money is managed in the Anglo Saxon world: annual time horizons and measurement against benchmarks. One of the factors that keeps pushing investors into greater risk taking is competitive pressure. If your performance lags, even it is because you are making better risk/return decisions, you will lose assets (and if you are at a big firm, you will be replaced). Yet we see remarkably little impetus to change a system which rewards the fund managers and gatekeepers (who have a particularly powerful role in keeping this system intact) since they earn….annual fees! A classic “And where are the customers’ yachts?” problem.
And too much risk is a no-no too, but the measurement of risk was volatility of returns. So what did we see in the crisis just past? A rise in popularity of strategies that used illiquid assets….which were therefore marked to model…which therefore did not show much (any) price volatility until their credit quality decayed.
Indeed, one of the features of the crisis was, just as the dot com era saw companies like Pets.com and boo.com being “manufactured” to meet investor appetite, so too were appealing-looking investment strategies ginned up this time around. From an extraordinarily prescient April 2007 paper, “Cracking the Credit Market Code,” by Henry Maxey of Ruffer and Company (no online version; more on this paper in future posts):
This leads us to the theoretical holy grail of hedge fund strategies: leveraged spread strategies in illiquid assets.
Illiquidity in the assets is essential. The danger with liquid assets is that market forces can change prices for both fundamental and haphazard reasons. Ordinarily holders of assets expecting a 20% return will accept commensurate volatility, but in a world demanding smoothed returns, this is unacceptable. Consequently, it becomes key that the capital value is not left to the vagaries of the market place.
Without a liquid market to price an asset, pricing is supplied by, for example, models. These frameworks tend to be self-serving because they are developed by players, such as ratings agencies and investment banks, who are more incentivised to give investors what they want than to ensure the price is an accurate reflection of the fundamentals. Prices, therefore, don’t change until the fundamentals, e.g., default rates, force a reassessment of the model inputs.
Everything hangs on default and downgrade. Actual default or downgrade become the critical events rather than markets’ forward looking pricing of that event, so problems are withheld until discontinuous pricing events occur rather than being anticipated in a continuously priced market. The capital prospects for the asset beyond 12 months are not of primary importance while the leverage yield spread provides the necessary return/volatility performance figures. Such a strategy is encouraged by a lack of visibility of the underlying portfolio (strategy secrecy), and a lack of regulation.
Yves here. This is a key point: it wasn’t just the demonized, presumed “dumb money” that took losses in this game. Hedge funds and prop trading desks were on the wrong side of many of these trades too. The John Paulsons of the world seek the limelight, while the others hope their mistakes go unnoticed.
Indeed, the other aspect of the “who wound up with the CDO hot potato” is that, as we have discussed in earlier posts, that it was increasingly the dealers themselves. Goldman’s retention of its now notorious Abacus 2007 AC1 trade looks like a portion it could not offload; Merrill looks to have had even more serious pipeline problems.
But this widely accepted pipeline explanation is insufficient, at least for most firms. Unsold inventory winds up on the trading book; it becomes a risk management problem. CDOs piling up with the dealers should have shut down the CDO market and didn’t. Why not? Because the traders could game their firms’ bonus systems.
If a trading desk hedged an AAA instrument with a credit default swap from an AAA counterparty and had income left over (a negative basis trade), the banks’ P&L systems would typically reward the desk for “freeing up capital” to the tune of millions of dollars. The mechanics typically were tantamount to taking all the future income (income less hedge cost) and discounting it back to the present (some banks, like UBS, used a variant that cut the hedge cost by insuring only part of the position, yet taking the same “risk adjusted return on capital” profits the day the trade closed).
So let’s hope the digging continues. As much as this crisis had many parents, efforts to shift blame away from Wall Street are not going to survive continued investigation and due diligence.
Update: I neglected to include this section of a Goldman document, which while classic CYA (as in designed to allow the shifting of blame to employees when necessary) also serves to illustrate that the “caveat emptor” standard that many readers argue for (and believe is implicit in the “market maker” standard that Goldman touts) is lower than the standard brokers are expected to adhere to. See pages 259 and 260 for context:
• Trading and sales personnel have an obligation to “know their customers” before recommending or entering into any securities transaction
– Learn the essential facts about the customer and the customer’s orders and accounts
• All recommendations to a customer must be suitable and appropriate for the customer
• The salesperson should know as much as possible about the customer’s objectives, strategies, tolerance for risk, and the type of information the customer is relying on
• Even when a customer is making its own investment decisions, special care and judgment need to be exercised in situations such as the following:
– The customer has trouble explaining in plain language its investment strategy, objectives, or risk tolerance, or how a transaction or product fits those criteria
– The customer wants to recoup, roll, hide, or avoid losses, or evade taxes, and proposes a transaction or structure clearly intended to do so
– A customer proposes a completely atypical transaction
– The customer has a history of litigation or a record of being a “sore loser”