Wednesday, April 14, 2010

Pack of Fools

Original posted on the Baseline Scenario by James Kwak:

“I thought that I was writing a period piece about the 1980s in America, when a great nation lost its financial mind. I expected readers of the future would be appalled that, back in 1986, the CEO of Salomon Brothers, John Gutfreund, was paid $3.1 million as he ran the business into the ground. . . . I expected them to be shocked that, once upon a time on Wall Street, the CEOs had only the vaguest idea of the complicated risks their bond traders were running.

“And that’s pretty much how I imagined it; what I never imagined is that the future reader might look back on any of this, or on my own peculiar experience, and say, ‘How quaint.’”

That’s Michael Lewis in The Big Short (p. xiv), looking back on Liar’s Poker.

“Looking back, however, Salomon seems so . . . small. When the Business Week story was written, it had $68 billion in assets and $2.8 billion in shareholders’ equity. It expected to earn $1.1 billion in operating profits for all of 1985. The next year, Gutfreund earned $3.2 million. At the time, those numbers seemed extravagant. Today? Not so much.”

That’s the third paragraph of Chapter 3 of 13 Bankers. (This was a complete coincidence; I didn’t see The Big Short until it came out, and I have no reason to think that Lewis saw a draft of our book.)

I actually did not rush out to buy The Big Short, even though Michael Lewis is a great storyteller. I figured I knew the story already; Gregory Zuckerman’s The Greatest Trade Ever covered some of the same ground and some of the same characters, and I already knew plenty about CDOs, credit default swaps, and synthetic CDOs. But I’m very glad I read it, and not just because it’s a fun read.

Lewis’s central theme is the question of why some people were able to see a financial disaster that, in retrospect, seems so obvious, while almost everyone else — including even the people who concocted the machine that broke down so spectacularly — were so blind. This is the point of his epigraph, by Tolstoy:

“The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of a doubt, what is laid before him.”

But I enjoyed it most for its portrait of what was going on behind the scenes on Wall Street. The picture is not pretty.

Lewis’s book focuses on a group of people (mainly at hedge funds) who figured out that subprime-backed CDOs were going to collapse and set out to make money from that collapse. To do so, they bought credit default swaps on bonds issued by those CDOs. They had to buy these credit default swaps from their brokers — the big investment banks. These swaps had collateral requirements: as the price of the swap fell (or the price of the underlying bonds rose), they had to give collateral (cash or Treasuries) to the banks; as the price of the swap rose, the banks had to give collateral to them.

The problem was that the banks, as the swap dealers, got to decide what the swaps were worth. So, for example, Charlie Ledley bought an illiquid CDS on a particular CDO from Morgan Stanley. Five days later, in February 2007, the banks started trading an index of CDOs that promptly lost half its value. But, as Lewis writes, “With one hand the Wall Street firms were selling low interest rate-bearing double-A-rated CDOs at par, or 100; with the other they were trading this index composed of those very same bonds for 49 cents on the dollar” (p. 162).* That is, the market price of the already-issued CDOs didn’t affect the sale price of new CDOs. And what’s more, Ledley’s broker insisted that the price of his CDS (which should have soared as the index of CDOs fell) had not changed. Here you see the banks simultaneously ignoring a market price in two separate ways: once so they can continue selling new assets that are extremely similar — worse, if anything — to assets that they are trading as garbage; and again so they can avoid sending collateral to their hedge fund client.

In June 2007, the subprime-backed CDO market began to collapse for good. And, again, the banks suddenly couldn’t figure out how much their clients’ CDS were worth, so they could avoid sending them collateral. “Goldman was newly unable, or unwilling, to determine the value of those positions, and so could not say how much collateral should be shifted back and forth” (p. 195). Between June 15 and June 20, Michael Burry could not get ahold of his Goldman Sachs salesperson, who finally claimed that Goldman had had a “systems failure” — which was what Morgan Stanley and Bank of America also claimed. According to Burry, the only reason why the banks finally started marking his positions accurately was that they were getting in on the same trade.

This also happened between the dealers. At one point Greg Lippmann at Deutsche Bank, who had shorted the market, said to his counterpart at Morgan Stanley, who insisted that subprime CDOs were still worth 95 cents on the dollar: “I’ll make you a market. They are 70-77. You have three choices. You can sell them back to me at 70. You can buy some more at 77. Or you can give me my f—ing $1.2 billion” (the collateral owed) (p. 213). But even though Morgan Stanley claimed the securities were worth 95, they refused to buy more at 77 — even though that would have represented instant profits according to their “model.”

What’s the point here? It’s the same as yesterday. Free financial markets are supposed to create efficient prices. Every argument about the benefits of financial markets (optimal allocation of capital, liquidity, etc.) depends on this one point. But the prices in this market were being set based on the dealers’ own interests. Think about that.

Then there is the story of Howie Hubler (Chapter 9). Hubler was smart enough to buy credit default swaps on $2 billion of BBB-rated CDOs. But to pay the premiums on those CDS, he then went and sold credit default swaps on $16 billion of AAA-rated CDOs. In other words, he was betting that the housing collapse would wipe out the BBB tranches of the CDOs, but not the AAA tranches. At the time, CDS prices reflected a belief that the AAA tranches were only one-tenth as likely to default as the BBB tranches. So to be more precise about it, he was actually betting that the AAA tranches were less than one-tenth as likely to default as the BBB tranches.

So some trader misjudges the correlation between mortgage-backed securities (which determines the correlation of the AAA and BBB tranches) and makes a trade that turns out badly. So what? The problem is what we learn about the system.

First, we learn this: “The $16 billion in subprime risk Hubler had taken on showed up in Morgan Stanley’s risk reports inside a bucket marked ‘triple A’ — which is to say, they might as well have been U.S. Treasury bonds” (p. 207). (The VaR calculation for this position also showed virtually no risk, since it was based on historical volatility data.) So Morgan Stanley had no idea what it was holding onto.

This is incompetence. But is it innocent incompetence or willful ignorance? I doubt that anyone on the management team said, “Let’s design a stupid way of categorizing our positions so that our traders can make risky bets, hide them from us, and blow up the bank.” But think about this: this type of error only goes one way. Steve Randy Waldman has already made this point about capital: “For large complex financials, capital cannot be measured precisely enough to distinguish conservatively solvent from insolvent banks, and capital positions are always optimistically padded.” The same is true about risk, which will always be underestimated. If a bank has a system that overestimates risk, the traders who understand the positions will (correctly) argue that real risk levels are lower; if the system underestimates risk, they will keep their mouths shut. Higher risk measures mean more capital means lower returns; all the internal pressures are to underestimate risk. The incentives of the system breed incompetence, and everyone benefits in the short term.

Eventually, Morgan Stanley lost $9 billion on the trade. In December 2007, CEO John Mack tried to explain the loss on an investor call. “The hedges didn’t perform adequately in extraordinary market condition of late October and November,” he said (p. 217). This wasn’t a hedge; it was a long-short bet. But on Wall Street, it’s second nature to call everything a hedge. When pressed by an analyst (from Goldman), Mack punted (“I am very happy to get back to you on that when we have been out of this, because I can’t answer that at the moment”). As Lewis said, “The meaningless flow of words might have left the audience with the sense that it was incapable of parsing the deep complexity of Morgan Stanley’s bond trading business. What the words actually revealed was that the CEO himself didn’t really understand the situation.”

This is a classic example of something that goes far beyond Wall Street: the CEO who has no idea what is going on inside his business. And, as Lewis says, Mack was generally considered one of the more competent ones. CEOs of large corporations exist on such a high level of abstraction relative to what actually happens that all they know is what their subordinates tell them, and their subordinates barely know what is going on as well. (I believe there is now a reality show based on this gap.) Mack probably really thought that Howie Hubler was putting on a hedge, because that’s probably what someone told him before he went on the call. And when CEOs show up before the Financial Crisis Inquiry Commission and say something like “we put the interests of our clients first in everything we do,” they may actually believe it — because they don’t know any better. (Which is very convenient, because ignorance allows you to say things that are not true without actually lying.)

So what kind of picture of Wall Street does The Big Short paint? Banks manipulating the prices of custom derivatives. Traders making stupid bets and taking home eight-figure bonuses. Painfully inadequate risk management systems. Management teams that have no idea what is going on. A toxic combination of cutthroat greed on the part of individual bankers and broken incentive systems on the part of banks.

This is not a finely-tuned machine for allocating capital and fueling the real economy. It’s a system whose rules have been twisted to allow the few smart people to get rich by screwing their customers or their employers. “That Wall Street has gone down because of this is justice,” says Steve Eisman at the end of the book (p. 251). But as we now know, it didn’t go down.

* I believe they were not the “very same bonds,” since the newly issued bonds were 2007 vintage and the ones in the index were earlier vintages; but if anything, that meant that the 2007 bonds, which were sold at par, were even worse.

No comments: