Fools Gold

Finally...the books I really want to read are trickling in from the inter-library loan mechanism. Here is a must read book for those interested in Wassup from the financial world and the crash we are going through.

Gillian Tett, “Fools Gold (How the Bold Dream of a small Tribe at J.P. Morgan was Corrupted by Wall Street Greed and Unleashed a Catastrophe)”, Free Press, C2009, Pages 293

This book chronicles the events leading to the financial meltdown of 2008. The author makes a convincing case that the main problems were the banks, not the hedge funds. And it was the banks: failure to correctly determine the correct correleation factor in the models (i.e. that all the items could fail at the same time as one item dragged the next down); using normal distribution assumptions in the models; moving items off balance sheets and thereby not retaining adequate reserves; much too much leverage; and rating agencies dependence on the banks for business thus affecting the ratings that were handed out, assuming that they even had the expertise to see the looming disaster. Of course we also had Greenspan and his “free market” fixation along with an SEC that couldn’t pour **** out of a boot with a hole in the toe and directions on the side.

This book clearly establishes that derivatives have received too much blame for the crisis. Derivatives are essentially a form of insurance against the possibility that loans will not be repaid, credit default swaps were created to allow banks to reduce their risk by paying premiums to investors willing to bear the risk themselves. Once the banks had insured certain loans on their books, they could make more loans with their available capital as they had dramatically reduced their reserve requirements through their use of derivatives. However, many banks were buying this insurance from companies (monolines) that might not be able to pay in a crisis—which of course then happened.

Ms. Tett explores the early 1990’s pioneering days of the CDS market at J.P. Morgan and shows a culture of meritocracy; talent was rewarded regardless of race, sex or social pedigree. The tribe's leader, Peter Hancock, made certain that compensation was tied to Morgan's long-term success. The Morgan derivatives team, though paid less than employees at rival firms, enjoyed the intellectual challenge of solving financial problems. They developed complicated models to predict loan-default rates and never believed that the models were infallible. Had this culture prevailed at all the banks, the melt-down would have been much different or non-existent. Instead, the Morgan bank had mediocre profits because of their minimal participation in the irresponsible behavior going on. This resulted in their being bought out by Chase and merged into JPMorgan-Chase just two months before things began to hit the fan.

This Morgan bank also maintained the old-fashioned ethics of good banking. Ms. Tett reports that before Orange County, Calif., made the derivatives bets with Merrill Lynch that bankrupted the county in 1994, Orange had approached J.P. Morgan. William Demchak, then a Morgan salesman, met with the county's treasurer and discovered that the official didn't understand derivatives. Mr. Demchak could have collected large fees anyway, but instead he urged colleagues: "Under no circumstances should we deal with this client!"

In late 1997, Morgan set up an investment vehicle that would prove a watershed. It allowed investors to sell insurance to Morgan on a pool of the bank's loans, offering competitive returns and reasonable risk because Morgan was known for its careful underwriting and for loaning money only to blue-chip companies. For Morgan, the vehicle offered affordable insurance against the possibility that some of its corporate clients wouldn't pay their bills. More technically, the vehicle sold credit- default swaps to Morgan and collateralized debt obligations (CDOs) to investors. The structure made sense. Soon, Morgan was creating such deals for other banks.

But the Morgan team generally avoided applying this approach to the mortgage market; the team was convinced there was not enough data available to calculate default rates and responsibly price the insurance. The country had not seen a serious nationwide housing downturn since the 1930s, and records from that period were scarce or unreliable. For decades, the national housing market had gone in only one direction: up. The Morgan team didn't want to guess what a real housing bust would look like.

Others in the banking industry would be less careful. Greed might have driven them to expand use of the new financial tools. However, the disaster that followed could not have occurred without regulation. As Ms. Tett notes: "Most investors had no idea how the banks were crafting their models and didn't have the mathematical expertise to evaluate them anyway." Instead, writes Ms. Tett, "investors generally relied on the ratings agencies to guide them through this strange new land." Anointed by the Securities and Exchange Commission and the Federal Reserve, the major ratings agencies slapped their triple-A seals of approval on thousands of mortgage-backed securities and CDOs. "Such blessings, after all, made the whole system work: the AAA anointment enabled [structured investment vehicles] to raise funds, banks to extend loans, and investors to purchase complex instruments that paid great returns, all without anyone worrying too much," Ms. Tett writes.

Even for bankers who wanted to exercise their own judgment about credit risk, it wasn't easy to ignore the government-selected credit ratings. That's because the ratings were embedded in the Basel banking standards mandated by the Fed and other central banks around the world. Bank assets were measured by credit ratings, and the Basel standards gave banks better scores for holding AAA-rated securities backed by mortgages than for making individual loans to even the most creditworthy businesses.

The Basel rules had other problems, encouraging banks to keep risks off their balance sheets even while the banks remained liable for them. Called to a 2007 meeting in Washington to discuss the dangers posed by unregulated hedge funds, fund manager James Chanos tried to explain the problem. He told the assembled bureaucrats: "It is the regulated bits of the system you should worry about!" To this day, it remains excellent advice.
Notes:

Pg. 10: The modern era of derivatives trading began when the Chicago Board of Trade was established in 1849, allowing for the buying and selling of futures and options on agricultural commodities. Wheat farmers might buy futures before harvest on the price their wheat would bring in, hoping to hedge against low prices in the event of a bumper crop. Speculators would take on the risk of the losses farmers feared in the hopes of big payoffs that all too often turned horribly bad.

Pg. 25: Twentieth-century American and European governments have generally accepted that the business of finance should be exactly that, a business run privately in a profit-seeking manner. But finance is also not quite like other area of commerce. Money is the lifeblood of the economy, and unless it circulates readily, the essential economic activities go into the equivalent of cardiac arrest. Finance serves a public utility function, and the question government regulators must wrestle with is to what degree private financiers should be allowed to seek a profit and to what degree they must be required to ensure that money flows safely.
In practice, during the twentieth century both American and European governments resolved the dilemma by keeping banking private but swaddling it in rules to ward against excesses.

Pg. 95: In 2000, the amount of nonconforming mortgage bonds that were sold was tiny, running at a mere $80 billion, or less than a tenth of all mortgage bonds. By 2005, sales of nonconforming mortgage bonds hit $800 billion. Remarkably, that meant that almost half of all mortgage linked bonds in America that year were based on subprime loans. Mortgage lending had become an assembly0line affair in which loans were made and then quickly reassembled into bonds immediately sold to investors. A bank or brokerage’s ability to extend a loan no longer depended on how much capital that institution held; the deciding factor was whether the loans could be sold on as bonds, and the demand for those was rapacious.

Pg. 123: In 2005, American households extracted no less than $750 billion of funds against the value of their homes, compared to $106 billion a decade earlier, of which two thirds was spent on personal consumption, home improvements, and credit card debt.

Pg. 169: The Crisis Begins: on 6/12/07 the news broke that a crisis was erupting at a hedge fund with close links to Bear Stearns. The fund, called the High-Grade Structured Credit Strategies Enhanced Leverage Fund was widely exposed to subprime mortgages. This fund had been so successful for Bear Stearns that in the summer of 2006 they created a second fund, called the High-Grade Structured Credit Strategies Enhanced Leverage Fund. This version employed similar tactics but was more leveraged, sometimes as much as $20 for every dollar of investor equity.

Pg. 238: Sept. 15, 2008: The shock of the Lehman collapse had been devastating by itself. But combined with the money-market panic (broke the buck) and the prospect of an AIG default, the three events produced the perfect market storm. Around the world stock markets collapsed, wiping out $600 billion off global equity prices in just thirty-six hours. Almost overnight, liquidity dried up in a host of different debt markets. Merrill Lynch, Goldman Sachs, and Morgan Stanley suddenly found it impossible to raise funds in the capital markets. So did a host of European banks in Ireland, the UK, Holland, and elsewhere.

Pg. 243: By the winter of 2009, economists estimated that mark-to-market credit losses had reached almost $3 trillion.