By Richard Smith, a London-based capital markets IT specialist
Here’s someone with his head screwed on, back in April 2007, who proves singlehandedly that “hoocoodanode” was no defense for failing to anticipate the implosion of the shadow banking system (more on this prescient analyst in due course):
For several years now, we have marvelled at the capacity of credit markets to
accommodate ever more ludicrous developments: mortgages to insolvent arsonists, a leveraged buyout of “the world’s ‘crappiest’ steel company
Ooh, and look – he has Iceland, Greece (already) and CDS in his sights:
…sovereign spreads that don’t care whether you are Che Guevara or Maggie Thatcher, AAA rated Icelandic banks, derivative market growth rates that make your eyes water …
and Greenspan, and other cheerleaders:
We have heard such developments rationalised away with equally ludicrous new
paradigms, and repeatedly been reassured that even if there are risks, credit market innovation has allowed risk to be dispersed more healthily around the system.
and opacity:
Despite our scepticism, it has been very difficult to penetrate the technical innovations of these more opaque markets to pinpoint what the frailty of the mechanics might be.
all culminating in a persuasive thesis:
Now, with the subprime debacle unfolding, we have been able to get a better look under the bonnet of the machine and increase the precision of our understanding. This has allowed us to refine our instability hypothesis as follows:
The funding liquidity boom has, at its heart, explosive growth of structured credit markets. The development of structured credit markets has more to do with the models of ratings agencies and the incentives of hedge funds than the arbitraging of pricing inefficiency out of credit markets. The players involved are behaving as if they have discovered a ‘perpetual motion money machine’. The result: an unstable surge in non-bank funding liquidity and rapid expansion of debt into a very benign part of the credit cycle, which means that any inappropriate debt creation will not become apparent until the cycle turns down.
Sounds about right, doesn’t it? Here’s his roundup of his “instability hypothesis”, which fingers a few more of the reprobates:
• “Confidence in financial markets based on “abundant liquidity” is a dangerous deception created by a procyclical surge in funding liquidity, credit and leverage from non-bank financials.
• An economic and financial system which is supported by the purchasing power that non-bank funding liquidity confers, is more fragile than one which is supported primarily by balance sheet and monetary liquidity.
• The current credit cycle was kick started with macro moral hazard (Bernanke 2002) but has been driven to unprecedented extremes by a micro moral hazard overlaid on financial innovation to produce a surge in non-bank funding liquidity.(The “micro moral hazard”, BTW, is hedge funds’ preference for high volatility assets, which maximises the chance of a big pay-off to the hedge fund managers)
• The forces shaping behaviour at hedge funds should, theoretically speaking, mean there is a real attraction for these players to migrate towards a banking business model of taking leveraged spread on illiquid assets.
• The rapid growth and development in structured credit has allowed credit risk to be distilled, providing credit instrumentation with the necessary embedded leverage to allow this migration to happen. We believe it has.
• The visible symptoms are all around us: insane mortgage underwriting standards, the tightest emerging market spreads in history, leveraged private equity transactions on multiples that imply no business cycle, explosive growth in credit derivatives, credit players who themselves admit that credit risk is being mispriced…
• The specific mechanism we highlight as the turbocharger at the heart of this funding liquidity boom is hedge fund demand for junior tranches of structured credit, which appears to be encouraged by a relative value opportunity created by ratings agencies.
• Evidence to support our hypothesis can be seen by the issues emerging from the US subprime mortgage market. Rampant demand for junior RMBS paper by CDOs ‘encouraged’ the lapse in underwriting standards over the last few ears. Rapid growth of CDO issuance has been facilitated by hedge fund demand for junior paper in CDO, the senior rated paper being easily saleable. Whether for relative value trades or straight credit bets, this demand has had a magnified impact on aggregate mortgage origination, particularly in subprime.
• At the heart of every bubble is a grain of truth to support the believers’ faith in the fundamentals supporting the bubble. In this case, the argument is that credit derivatives, structured finance and structured credit allow players to arbitrage the inefficiency in the pricing of credit. Relative value trades are part of this arbitrage process. However, distortion of absolute prices in subprime highlights the frailty of the efficiency argument.
• There are clearly various market failures which disrupt the efficiency argument. These include: inconsistent regulation (banks versus hedge funds), changing regulation (Basel II), discontinuous credit ratings systems, pricing inconsistencies (marking to model), informational asymmetries (originators of credit risk versus ultimate owners), hedge fund incentives (skewed payoffs, limited liability, and short time horizons), and rating agency incentives (paid by issuers on the basis of transaction volumes).
• Ratings agencies help create relative value through their model, rather than market driven ratings system. Static discontinuous ratings and illiquidity prevent the relative value from being arbitraged out, which simply encourages further origination of the underlying collateral, e.g., subprime mortgages. With apologies to Roald Dahl, no matter how hard they ‘suck’, the funds can’t arbitrage out ‘the everlasting relative value trade’.
• However, relative value trades in a market for credit risk that has become absolutely mispriced are vulnerable to variable market liquidity between instruments when reality breaks in and prices are forced to correct (what price a loan which has actually defaulted?). Therefore it is gross credit exposure of hedge funds that matters for considerations of financial stability.
• A fallacy of composition has allowed this inefficient outcome to persist and central authorities have not intervened to protect the public good of financial stability.
Fallacy of composition, if that’s new to you, is the set-up where everyone responds rationally to their incentives and payoffs but the system level outcome is – insanity. This is why the “blame game” is a waste of time, however much fun it is. Certainly, there are plenty of dodgy operators, some of whom will get their comeuppance in the courts, or lose their jobs, or their reputations, or their political offices, or their testicles; but don’t kid yourself, it’s “the system” that needs to be fixed. And it can be, up to a point (though certainly not enough to satisfy the more revolutionary of NC’s commenters; I am politely declining that debate, in advance).
…
• The off-market nature of structured credit allows the ratings agencies to hold back the downgrades until actual fundamentals (i.e., delinquencies and defaults) force a reassessment of key model inputs: default probabilities and cumulative default rates, default correlations, and recovery rates. This is the phase the US non-conforming mortgage market is in, so there will be many funds which really are “walking and talking several months after their heads were chopped off”.”
And his summary of the likely end game:
• The game can end from either the junior tranche or senior tranche side. The ‘hedge fund bank’ analogy provides a clue as to how the mania might end from the junior end. Capital loss sensitive investors (funds of funds) redeem en-masse which precipitates distressed selling/unwinding of fund assets. With little liquidity in these assets in the first place, forced sales will target the most liquid assets first. This creates conditions ripe for contagion right across the credit spectrum.
• From the senior end, investors in the higher rated paper lose confidence in the ratings system which underpins their demand. This is likely to be precipitated by downgrades which are held back as long as possible by ratings agencies. With reduced demand for senior paper, prices have to adjust, relative value trades evaporate, and the demand for junior paper disappears.
Both the “junior” and “senior” scenarios played out, if anything, rather more dramatically than our man expected, in part because there were other shadow banks in the mix besides the hedge funds. And perhaps he is overemphasizing the influence of hedge funds (and their marketers, the funds of funds). But not by much. First, consider this very important point: size doesn’t matter as much as you thought:
… Collateralised vehicles (CDOs, CMOs, CLOs) often invest in the junior paper of the MBS, ABS and leveraged loans. Let’s say this tends to be from the last 15% of any structure/deal. Hedge funds investing in these collateralised vehicles tend to invest in the junior tranches or equity, i.e., the last c.10%-15% of these structures, in order to generate the 20% gross returns they need. This implies embedded leverage of 44-66x [1/(15% x 10-15%)].
Last year funded CDO issuance hit $488.6bn (Structured finance = $292, high yield loans = $165bn, investment grade = $22bn, high yield bonds = $2.7bn [from SIFMA02/2007]). This represented 11.5% of the $4.21tn issuance of MBS, ABS and corporate debt in 2006. Using the 10%-15% ratios above, it would only need buyers of $49-73bn of junior paper to support this CDO issuance (assuming the senior rated tranches are easily sold), which itself provided support to $4.21tn of bond issuance. Such embedded leverage means that smaller pools of capital are able to determine the fate of much bigger pools of borrowing.
…This shows the leveraged impact that these investors can have on overall markets.
One of the striking common features of less-than-favourable reviews of ECONNED (which I will confess I was involved in actively through numerous drafts and proofs) has been the reviewer’s inability to grasp this simple point about leverage. For instance David Merkel, with, my runner up in the category of Most Irritating ECONNED Reviews, doesn’t notice the Magnetar Trade at all. So it is somehow heartening to see that a sufficiently astute observer can reach ECONned-like conclusions about the relevance of hedge funds to the crisis in advance; and three years ahead of ProPublica (who still only half get it).
Second, consider how our man characterizes the business of hedge funds: “a banking business model of taking leveraged spread on illiquid assets”. Viewed through that prism, all the usual suspects were playing pretty much the same game as the hedge funds: Monolines, AIG, Money Market Mutual Funds, Investment Banks (both at prop desks and in prime brokerages), some idiot British mortgage banks (Northern Rock and HBOS), SIVs and OBS vehicles, and even CDOs themselves. In a word, shadow banks. Hedge funds are in a way the acme of that precarious credit mechanism,
Hedge funds are key to this liquidity, and their activity begs the question: are they banks? Unregulated, undercapitalised, wild-western BIS-free banks?
…but one might as well pay due respect to all the other players.
So who is this fellow who got it, back in that mythical time when nobody knew what was going on? According to an email correspondent of mine, he is “a no-name equity guy” in London. Actually his name is Henry Maxey, and he is chief investment officer and chief executive elect of Ruffer LLP, a small London fund manager. So there’s no chance of making him US Treasury Secretary or head of the NYFRB, I’m afraid.
His paper, cherrypicked here, and packed with other goodies, is available as a chapter (“Cracking the Credit Code”) in a book (“Babel, The Breaking of the Banks”), easily available in the UK, but also, it turns out, in the US.
For American readers, that is going to be over $1 per page for the Maxey essay. Worth every cent, and we need the dollars over here; and you get ten chapters of sharply-written, beady-eyed ruminations on capital markets and fund management by Jonathan Ruffer, as a bonus (I hope Mr Ruffer will forgive me for *that*).
In my next post, I’ll apply these and other pieces of Maxey’s big picture analysis to a critique of current reform initiatives.
21 comments
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Huh?
Re: “Here’s someone with his head screwed on”
Who is he?
This is a very confusing post; I’m not sure what this is about??? A better intro may help connect the dots, but WTF?
You didn’t read to the end:
So who is this fellow who got it, back in that mythical time when nobody knew what was going on? According to an email correspondent of mine, he is “a no-name equity guy” in London. Actually his name is Henry Maxey, and he is chief investment officer and chief executive elect of Ruffer LLP, a small London fund manager. So there’s no chance of making him US Treasury Secretary or head of the NYFRB, I’m afraid.
The scribbler appears to be a bookie. Imagine being ambivalent about organized crime. Slim Pickens once described this kind of verbiage when he declared; “you use your mouth better than a $20 Kansas City whore”.
This is YOUR projection, and has nothing to do with the piece. Maxey clearly describes the excesses (the unprecedentedly tight spreads) and the carnage that will result when the liquidity vanishes. This isn’t ambivalent, it’s an explanation of how the massive leverage built up and got channeled to risky investments.
I think I understand that the system needs fixing but I don’t know how to do that until the bad actors are out of the current systems. Not looking for a perfect system, but a least a halfway-decent fix.
Maybe I think the corruption is bigger than it actually is – you might have a more accurate perspective than I.
There really seems to be a lot of corruption. Have a look at this post at Economist’s View:
http://economistsview.typepad.com/economistsview/2010/05/the-role-of-fraud-in-the-financial-crisis.html
It is also worth reading this post at Washington’s Blog:
http://www.washingtonsblog.com/2010/05/cut-partisan-bull-s.html
And it’s also a good idea to do a search on this blog using [fraud, “financial crisis”] as a search key. Lots of good stuff!
Regarding as the “blame game” which Yves Smith deprecates, she may be technically right that flaws in the system shouldn’t lead to individual punishments – or perhaps it would be better to say that such flaws won’t be rectified by individual punishments – but I don’t think that’s the whole story.
As a matter of human behaviour, such systemic flaws are seldom rectified without sticking some prominent heads on pikes. It is necessary to show that the network of personal/corporate immunities which in most cases has led to the creation of these flaws has broken down before whistleblowers, prosecutors and reformers feel able to move wholesale to clean up the situation. Until there have been some prominent decapitations, it just looks too dangerous.
Yes, reform the system but clobber the miscreants too; you have to do both, or it’ll never come right. Worked in 1933-4 in the US.
“• From the senior end, investors in the higher rated paper lose confidence in the ratings system which underpins their demand. This is likely to be precipitated by downgrades which are held back as long as possible by ratings agencies.”
Yes and no. Yes the RAs delayed a few months at the end of 2006 to start downgrading hoping housing prices would flatten. But once the realization the intial ratings were all screwed up, the delay in downgrading was more about lack of resources and the difficulty of revising criteria. The agencies simply were never designed to downgrade 70% of of all ratings from three different vintages all at once. Something like this never happened before so the infrastructure for mass downgrades was never created. Couple that with need to basically throw out all the rating criteria that took years to put together, you get what you got which was large chunks of downgrades about every two months for a year and a half. Not defending that but it is different then what is in the quote.
You have a point about the size of the task and the resources for it!
Though remember, this was April 2007. I think Maxey is diagnosing the status quo – by then it was clear that the RAs had had their fingers crossed for a bit, but the bulk downgrades were still in the pipeline.
The signs were there.
Shareholders have a case for breech of fiduciary duty due to willful negligence.
Clawback!
Wow! Translation, please. I understood just enough of this to conclude that it’s important enough that I wish I understood it better. Is there a bumper-sticker version of this? A political slogan that could fit on an hand-carried placard? A few paragraphs that could serve as a manifesto for political orientation and action?
Challenging – the system has so many moving parts. But I’ll be having a go at the subject again soon, so I’ll bear your request in mind.
“Cracking the Credit Code” is a must read for all senators, small “s”.
“Fallacy of Composition.” Reminds me of the well-known snarky take on the American adversarial legal system: “A system based on the belief that the Truth will emerge from competing lies.”
Fragmentation of systems provides cover for a multitude of sins, doesn’t it?
Richard –
Interesting post, although tough to wrap one’s mind around the full extent of it. I have a question that I am pondering, and for me it is a tough one at my experience level, hence I want to get your thoughts.
Would repealing/changing the 2004 SEC amendments to the way broker-dealer net capital is calulated be enough of a blunting effect to prevent the subsequent ‘hyper-leveraging’ of the balance sheet at these private non-bank instiutions? Or do we really need to take it a step further in other ways (and this is an open-ended question) to prevent future systemic shocks?
The second one I struggle with, since I am disinclined to want to heavily restrict private capital (I am all for the first, especially when it applies to publicly owned TBTF’s, just don’t know if it is enough). What do you think? Other experience NC commentators feel free to chime in…
If you believe in banking regulation at all, then after 2008 you are probably keen to put some sort of prudential framework around the leverage, funding models and asset of all of the shadow banks. That’s more than just broker dealers: it also includes hedge funds (Maxey’s particular beef), quasi-bank entities like SIVs, “structured products” like CDOs, and keen an eye out for clueless waifs and strays like AIG and the monolines as well.
Ooops, fat fingers. Not sure how big a reservoir of experience I am, but thanks.
If you believe in banking regulation at all, then after 2008 you are probably keen to put some sort of prudential framework around the leverage, funding models and asset quality of all of the shadow banks. That’s more than just broker dealers: it also includes hedge funds (Maxey’s particular beef), Money Market Mutual Funds, quasi-bank entities like SIVs, “structured products” like CDOs; and you would also want to keep an eye out for the involvement of clueless waifs and strays like AIG and the monolines as well.
The shadow banking system is/was just as big ($6 Trillion assets) as the official one, but is much less constrained as to leverage and risk – so it’s more profitable – until it goes bang. And then the rest of us pay for it. Not fair.
Re B/Ds, note that if you take the Lehman black hole ($130Bn) at face value, then they’d only have made it through the crunch OK with a leverage ratio of about 5, a cap that wouldn’t greatly please the B/Ds, if instituted. There might have been a spot of fraud going in that one, of course, and perhaps some pilfering by counterparties. So geeing up the accountants and auditors needs to be in the mix too. Certainly Lehman’s asset values were depressed in the bankruptcy sell-off, but that’s quite a likely phenomenon when a really big player blows up…
Richard –
Thanks for your amended reply. The more I think about it, the more I realize that you do have to set rules for all of them, if for nothing else than political angles. Obviously each one would howl, but it at least they couldn’t argue about ‘fairness’ to each sector.
That said, I’d just assume go after some low hanging fruit here, and at least stop *some* of damn players from freely gaming their capital ratios. While not solving everything, it will at close off some of the avenues for excess leverage.
And yes, prosecute the worst of the offenders as steehead23 mentions below with regards to easy issues such as sell-side fraud, lack of disclosure, etc.
I would hope we can at least start with these basics before crisis#2 gets here, but I am somewhat resigned to pessimism.
As always, your insights are appreciated.
This “fix the system” is more important than “chastizing the players” meme of NC reminds me of Obama’s desire to “move forward rather than fixating on the past” excuse for not prosecuting the Bush Admin. folks who facilitated torturing prisoners. I have a very different perspective. Yes, the U.S. Gov. allowed the financial system to turn into a giant Ponzi scheme so it shares some of the blame. Some, but not all. Here’s the deal. It does not matter what laws are on the books, if they aren’t vigorously enforced nobody would pay them much attention. Much like war crimes, there are plenty of statutes on the books that were violated during and after the housing boom/credit crisis. Witness Abacus. Witness liar loans.
To be sure, both re-regulating the industry and prosecuting complex crimes would be difficult. The PR and lobbying campaigns would be legion. So why focus on legislation? And here’s a simple bit of politics. A substantial majority of Americans want the banksters to be chastized. Those politicians who stand up and demand prosecutions and those who actually do prosecutions, will find their stars rising. Legislation is complex and the process can end up forcing participants to vote for something they oppose to get something they want – creating a very gray image of one’s support of the public weal. But prosecution is as plain as a punch on the nose. Everyone would know who their champions are. You get it instantly. In short, it is not yet time to talk about fixing the system, let’s “fix” those fat cats first – Mr. Smith mentioned something about the banksters losing their testicles – and then he immediately dulls his scalpel by calling for re-regulation (fix the system) instead. Well, I’m sick and tired of the fat cats eating my lunch. I’ve got a hankering for some nice butterflied bankster balls.
This is why the “blame game” is a waste of time, however much fun it is. Certainly, there are plenty of dodgy operators, some of whom will get their comeuppance in the courts, or lose their jobs, or their reputations, or their political offices, or their testicles; but don’t kid yourself, it’s “the system” that needs to be fixed.
Thank you! “Populists” think that the system is ok, but the people at the top are bad.
There are different ways of fixing the system, boiling down to modal decisions and tuning knobs. “Get better regulators” and “raise margin requirements” are tuning knobs. Tuning knob fixes are vulnerable to being turned back the other way. Model decisions are harder to undo. Glass-Steagal was a modal decision. The investment banks worked around it in different ways for years, and the final legislation removing G-S was kind of a non-event. Staying hands-off of derivatives and energy trading (humble commenter is a Cali lifer and former Enron employee) was a much more influential modal decision.
What are the modal decisions that will “fix the system”? I’ve got a few:
1) No off-the-book vehicles. SIVs etc. Either the company is on the hook for something or it is not.
2) No naked CDS. A CDS is an insurance policy. Me buying ten insurance policies on your house is not a good idea. The Abacus deal involved me building firetraps, selling them to you, and buying fire insurance.
a) Frankly, why have them at all? If you don’t like something, don’t buy it. This is what high interest rates are for! Aha! If CDS exist, I can buy something risky for a lower interest rate than it deserves, and spend my money on CDS to hedge it. This serves to depress interest rates as a mispricing effect. Interesting.
3) Decorrelate financial assets. Fannie Mae/Freddie Mac have generic standards for mortgages, and these standards become an industry generic formula. This creates a high volume of commodity loans, which are uniform financial assets. This then promotes correlation in trading, which in turn promotes volatility.
4) Originate & Sell has to stop. I’ll Be Gone, You’ll Be Gone as they say on Wall Street. If you sell a 20 year instrument, you should get paid over 20 years. If it doesn’t pay out, you don’t get paid. Deal origination cannot be the engine of 5-years-and-retire career paths.
5) Go private. Investment banks have shown the power of the Principal-Agent problem. I-banks should have to go private again.
I’m not so sure about 3), but anything that decorrelates trading is good. After all, trading is all about information asymmetry, and there is more to learn about unique assets, so there’s more money to be made trading, right?