The Local Paper

The following is my answer to a friend’s question about “what happened”, triggered the “this should have been a red flag” element of this article on the Huffington Post.

A confluence of events conspired to make this one worse than others (notice my restraint from calling this a “perfect storm”?).  What now appear to have been unnecessarily low interest rates by the Fed after the terror attacks meant investors were more hungry than usual for yield and sought investments that carried a higher return for what was perceived as equivalent risk.  Even though the return was higher on mortgage-backed bonds, the yield wasn’t nearly high enough for investors (insurance companies, pension funds, mutual funds, etc.) to do due diligence on thousands of mortgages buried within AAA-rated securities.

It was a risk/reward calculation for investors.  The investors were working with their coverage teams at I-Banks (a process called “reverse inquiry”).  The I-Banks worked to create securities that met the return and risk criteria set out by the investors–because that’s what they do, they sell bonds and get (well) paid to do so. They, in turn, need product to package so they first buy as much of it as they can from third parties, then, over time, buy their own mortgage companies to originate as many mortgages as possible (a pure vertical integration strategy–capturing the means of production).  Borrowers had low interest rates and plenty of mortgage money to be had were willing participants.  Lenders, having a ready source of cash (the sale of the loans to I-Banks and investors), and eager borrowers, used other people’s money to churn volume.  And this is just the “cash market”, which says nothing about the “synthetic market” in which a short side of the trade was required before anything could even get started (see Magnatar, Goldman, etc.)

Everyone was looking for something and managed to get it, largely by looking the other way and willfully suspending their disbelief.  As is common in these cycles, people who are long the asset always think that they’ll be smart enough to get out before it crashes.  But only some do because once you hop on the profit escalator, it’s tough to jump off when others continue to make what look like profits.  Once everyone is on one side of the ship, it’s gonna tip over.  As people realize that it’s tipping to the starboard side, they start, slowly at first and then en masse to race to the port side, which causes the ship to tip over in THAT direction instead.  It’s the herd mentality that people have written about for hundreds of years.  (One of th best efforts on this topic is Mackray’s “Extraordinary Popular Delusions and the Madness of Crowds” written in the mid-1800s).  In short, it was ever thus.

I did about a 45 minutes blow-by-blow presentation on this to some grad students a while back.  If I can figure out how to post the PowerPoint slides the germane pieces of it (perhaps a video blog post?).

Having never been a fan of the repeal of Glass-Steagall, I honestly don’t think that it’s repeal was much of a factor in this.  Remember that G-S separated commercial from investment banking.  Lehman and Bear and Goldman and Morgan Stanley weren’t commercial banks, so everything they did would have still been done (at 33x leverage).   That said, Citi and BofA were underwriters of bonds and also commercial banks that failed so keeping the wall up arguably would have helped them.  But there’s also the case of the Royal Bank of Scotland–the biggest bank failure of all time.  It wasn’t their underwriting of bonds that got them in trouble, but what they bought that got them into trouble.  There was an element of this in the failure of BofA and Citi, too, so it’s hard to say.

It’s true, there will be a “next time”.  The troubling thing is the observation that the boom/bust cycles are coming both closer together and becoming more violent.  Until meaningful regulations are put (back) into place (and the recently passed regs don’t strike me as such), and investors, underwriters and issuers get serious about risk management we’re likely in for it again.  Never underestimate the imagination and power of people whose interest is in figuring out how to do thinks not prohibited by regulations.  The securitization business has had its epitaph written several times in the last twelve years (think Enron and off-balance sheet issues), only to find new life thanks to creative lawyers, accountants and bankers.