Who is to blame for the Credit Crisis?

A trader’s apology

Blog, November 2008

Note: Looking back at this article I missed the vital part macro imbalances played in the crisis which is dealt with here: Lord Turner on the Credit Crisis (article)

As person who has worked in proprietary trading (but never lost money year on year I hasten to add) I have until now blamed the property bubble, mortgage brokers, non-recourse loans, retail bankers and Fannie May for the crisis; but I have now reconsidered. Although I have never traded Mortgage Backed Securities they were part of my world, we traders messed up, and we owe the public an apology. Calling it an unpredictable event is neither true nor good enough.

Was it irresponsible gambling that brought down the banking system?

At the heart of the credit crisis is the property market. Due to imbalances between the supply and demand of property, low interest rates and more competitive mortgages, property prices boomed. The general public became carried away and believed the only way was up. Many speculated with buy to let mortgages, many began taking interest only mortgages, many made equity withdrawals, many bought more expensive homes than they should have. In the US some dishonest mortgages brokers preyed on venerable subprime customers and encouraged them to take on irresponsible commitments, and this in fact proved to be the straw that broke the camels back. After a boom comes the bust - this much was inevitable. In the UK many economists, including those at the Bank Of England, warned the UK Government that the very low level of housing starts was pushing prices higher and the developing housing bubble was very dangerous. Nevertheless, they did not predict the "Credit Crisis" which consequently developed and which has so rapidly laid waste to the world economy.

This credit crisis was triggered by sudden and enormous price falls in the Mortgage Backed Security Market. Mortgage Backed Securities are primarily an American phenomena which were developed in the late 1930s by the US Government in order to stimulate mortgage lending. Before their invention a bank needed to manage the funding of any mortgage it issued, for example by taking deposits. Mortgage Backed Securities instead allowed institutions to package up mortgages and pass the default risk and funding onto another institution, such as the US Government. In recent years new institutions such as Countrywide in the US used Mortgage Backed Securities to compete with banks in offering mortgages. With a lean structure specialising only in selling Mortgages rather than funding them, Countywide reduced costs for consumers and became the largest originator in the US. Today most US mortgages have been packaged into Mortgage Baked Securities and about half of them are owned by the Government sponsored companies Fannie May and Freddie Mac.

Once mortgage backed securities became tradable a number of hedge funds and proprietary desks began to speculate in them. Because the securities carried risk they offered higher return. Some traders created positions in which they borrowed money to buy Mortgage Backed Securities, hedged the default risk with credit derivatives, and still found themselves slightly ahead. Happy with this seemingly low risk money making machine, they began taking bigger and bigger positions. The positions only made a few basis points of profit, so hedge funds employed vast leverage to buy many more mortgage backed securities than they had funds under management. In order to do this they needed a bank to underwrite them, and Bear Sterns and Lehman etc took on this role. The funds, and the banks that helped them, believed that the risk taken was containable, and for a while they made steady healthy profits. 

Once the US property market started to fall concern developed over the risk inherent in these products. At the heart of the valuation of a mortgage is the probability that a consumer will default. Prices started to fall when there was a realization that subprime mortgages were of much poorer quality than assumed and default rates would be higher. Then a second problem quickly came to light. Many loans in the US are non-recourse which means that in the event of default the bank can only take the customers home and not his car, savings etc. We now know this setup, a hangover from the great depression, is disastrous. Many US consumers who found their home in negative equity started walking away from their mortgage even when they were capable of servicing the loan, oftentimes taking advantage of the falling property market to buy or rent a similar place for less. Each foreclosure then pushed the property market lower, throwing more into negative equity, and driving more to walk away in a vicious circle. As a result both of subprime misselling and a reassessment of non-recourse clauses, the default probability that underlies mortgage backed security valuation was completely thrown out of the window.

Prices began falling, hedges did not work, and traders tried to unwind the positions. However, these huge positions had been accumulated over long periods of time and when many tried to simultaneously sell the prices fell faster. The price falls rapidly became catastrophic as traders tried to unwind at any cost, then many funds went into liquidation and many proprietary desk lost a fortune. Once the funds went into liquidation the investment banks under whose names they traded were left with their enormous positions, and therefore sustained gigantic losses. The losses became contagious, eventually banks stopped lending to each other and many went into liquidation. Thus the enormous losses accrued in this one specialist area of banking overwhelmed the entire business.

What about Value at Risk? Since the instruments had never experienced price changes of this magnitude before it was of no use. What about the economic models? The models didn't work and in the panic to unwind valuations lost touch with all reality anyway. If you are trading on margin, and forced to liquidate, there is no price you won’t hit. Nevertheless at this time we still have no reliable valuation model for these assets and they still don't trade. In the past the probability of default was thought to be a function of the household income, now we understand that with non-recourse mortgages it can instead become a function primarily of property prices, and we have no idea how far these could fall. 

Fuld, CEO of Lehman, said the company was unpredictably overwhelmed by a "financial tsunami". Some described it as a "Black Swan" - the event that can never be predicted. Others point out that financial markets are not mechanical, but instead include intuitive judgements on future events, and since we can not stop groups of humans developing irrational opinions bubbles and crashes are inevitable.

Nevertheless, looking back I believe it had the hallmarks of disaster: First the free money, then the huge positions accumulated over long periods of time that could not have realistically been unwound quickly, finally the fact that everyone was doing the same trade. Lehman were at the centre of this market, they should have been one of the first to spot it. Although the crisis revolved around a bubble in property driven by the wrong opinions of society at large, the mechanism which rapidly brought down the banks was just a giant technical money spinner, a sort of semi-arbitrage that everyone was in on, not even a smart LTCM style quantitative trade, just a simple carry trade, and it was connected with hedge funds who though they were taking little risk and running enormous leveraged positions. In the early days most hedge funds took big macroeconomic bets, eg George Soros and the pound. Then it was the turn of relative value funds, LTCM style. Both these types tended to deliver big returns but with big drawdowns. After 1998 the steady earning drawdown free interest rate & mortgage derivative funds became popular, I could never understand how it was possible, now we know it wasn't.

Market to market is not enough, one needs to estimate ones ability to unwind a position, and one needs to take into account the outstanding open position in the market as whole.

The traders failed, the banks failed, but so did ratings agencies, regulators and the FED. Greenspan said he relied mostly on the self interest of sophisticated banks in ensuring they did not shoot themselves in the foot; but Fanny was more or less his trade, it was the queen of the hive, and now it's loosing billions. Other villains include the people and the politicians of Post-Depression America who implemented mandatory non-recourse loans in some states including, unfortunately, California and Florida which experienced major property booms. Little did they know this popular measure would have the potential, eighty years later, to trigger another one.

Should hedge funds be regulated?

Suppose the banks had gone bankrupt during the dot com burst bringing world growth to it's knees. In this hypothetical case should we have then tried to outlaw over ambitious business plans or to stop investors putting to much of their savings into the stock market etc? I don't think so. Sure directors were idiots and should offer an apology, so were any investors who had studied their business plan, but the buck should stop with the banks. Consumers sometimes take irresponsible loans, companies sometimes engage in irresponsible business, and hedge funds sometimes blow up; all this is part of the market economy and democracy. The system still works if the banks and their regulators understand the risks of any transactions they enter into and do not blow up, but in this case they simply did not.

Therefore I can not see why regulation of hedge funds is appropriate. The banks failed simply because the margin they charged on the trades they allowed the Hedge Funds to take was insufficient. Both the banks and the regulators failed to understand the risks the hedge funds were taking.

Hedge funds did not even push assets to outrageous valuations and impact the real economy as a result, they just blew themselves apart on a complex carry trade. OK they did make mortgage lending cheaper, but only to a relatively modest degree. The recent swings in the oil price, exacerbated by speculation, are a more powerful argument for hedge fund regulation than the mortgage backed security crisis. However, the swings in the oil price could have been avoided if oil producers had taken the view that prices had risen too high and hedged their production. In other words it's not simply the wrong opinions of a few traders in a few identifiable hedge funds that pushed the oil price up then down, it's a much more complex problem and it is probably not possible to prevent asset price booms and busts.

Clearly regulators and banks need to improve their risk models. In terms of new regulation, the only very relevant possible intervention I can see is to tell banks that they can no longer offer hedge funds highly complex, illiquid and difficult to value 'over the counter' derivatives. Although that would be a possible course of action banks would definitely resist it because it's precisely these opaque products that generate the highest profits for them. Facilitating the buying and selling of stocks on an exchange is a very lean business, selling hopelessly complex derivatives is where the fat is. Some talk about the regulation of hedge fund leverage, however leverage means different things depending on the risk of the assets involved, so it is better to drop the word leverage and talk simply about risk management.

Are bankers overpaid and should bonuses be curtailed?

That bankers are generally overpaid can not be denied. A professor at Oxford might earn a fraction of what a trader does despite doing more worthwhile and more challenging work. However, there is no cronyism in banking. It's all about the bottom line and you can be fired at the blink of an eye. Being a proprietary trader is probably the one of the most competitive and insecure jobs in the world. By paying far more in discretionary bonus than in basic salary banks can sidestep employment laws. There is no pension on the bonus, no sickness pay, no holiday pay and no redundancy. Some banks even pay a hefty chunk of the bonus into share plans that are confiscated if you leave to work elsewhere. Banks don’t give away money to their staff for the fun of it, they maximize their profits.

The market economy, of which Banking is a part, is not a ‘just system’. A lucky break made Bill Gates the richest man in the world. Sure he was talented but it still took a unique set of coincidences to get him to where he is today. Regulating wages in a market economy is neigh impossible, and if one is to start surely football would be a better choice. Instead we have taxes, on individuals and companies, and in the UK banks contribute far more than any other sector.

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Suppose Greenspan had done his job properly and closed Fanny and Freddie to new lending years ago, and suppose also the banks had never allowed hedge funds to speculate in mortgage back securities. In this case US mortgages would have been more expensive and lending conditions more onerous, and the US Subprime Crisis would probably have been avoided. Banking problems might have first developed in Ireland or the UK or Spain, but they might not have had such a global nature, and the fallout across the rest of the economy as banks reigned back lending might have been much less intense. The Northern Rock's sudden demise occurred because banks stopped lending to it after they reassessed the dangers of mortgage lending in the light of the US Mortgage backed Security Crisis. Northern Rock said they could withstand a 40% fall in the UK property market, but they failed to anticipate how reluctant lenders would be to support their funding as the property market began to fall. I suspect that even without the US Mortgage Backed Security Crisis Northern Rock would have failed. In fact I think the property market boom was bound to get the world into trouble one day, the credit crisis just speeded up the process.

The summary, as if you didn’t know it, is that we traders/bankers/regulators messed up and owe the public a big apology. We need to think much more carefully in the future and there were several danger signs we ignored.

Here is an amusing article I read on Bloomberg:

Credit-Crunch Villains Pass the Buck, Party On: Mark Gilbert

Nov. 13 (Bloomberg) -- The great and the good of capitalism and free markets held a requiem dinner for the global financial system at a secret hideaway this week. As the waiter decanted a fresh bottle of 1985 Chateau Margaux, the blame game began.

``I blame the central banks,'' growled the bond trader, stabbing the air with a forkful of raw steak. ``If Alan Greenspan hadn't kept interest rates so low at the start of this decade, we wouldn't be in this mess. Talk about refilling the punch bowl when the party guests are already as drunk as skunks!''

``We told you we were not in the business of identifying bubbles, let alone trying to puncture them,'' replied the central banker, nibbling at a lettuce leaf. ``We warned you that credit spreads, emerging-market yields and volatility in stocks and bonds were all too low, and that you were under-pricing risk.''

The central banker took a sip from his refilled wine glass. ``Can you imagine the outcry if we had tried to halt the explosion in home ownership? I think you'll find that the true villains are the mortgage lenders; if they hadn't trashed their standards with self-certified and liar loans, the crisis in the housing market would have remained self-contained.''

``That's not fair,'' said the mortgage originator. ``We weren't on a level playing field. Fannie Mae and Freddie Mac were using their implicit government guarantee to distort competition in home loans. We were forced to take on more subprime borrowers just to stay in the game; if it hadn't been for all those clever derivatives products, we would never have been able to recycle all that toxic waste and keep the pyramid scheme afloat.''

``Ah, the derivatives bogeyman,'' chuckled the structured- finance specialist. ``Listen, derivatives don't kill markets. Markets kill markets. Everything we did was designed to promote efficiency by allowing investors to disaggregate their risks. I can show you the bills from my lawyers to prove that every product we invented was legitimate.''

``All we did was offer advice on the best method of structuring securitization transactions,'' the capital-markets lawyer said. ``There would never have been a market for the racier collateralized-debt obligations if the rating companies had done proper due diligence, instead of slapping AAA ratings on anything and everything that offered to pay them a fee.''

``You can hardly expect the finest minds in finance to come and work for us when they can earn gazillion-dollar bonuses doing the same work for an investment bank,'' said the credit-rating assessor. ``We relied on the computer models that the banks helped us build, and those models turned out to be, shall we say, less than perfect. Besides, everything was fine until the money- markets froze. The problem wasn't over-optimistic ratings, it was an over-reliance on wholesale markets to fund leverage.''

The waiter cleared away the dinner plates. The diners all declined dessert - Humble Pie.

The waiter coughed, proffering a slim leather folder containing the reckoning for the evening's entertainment.

``You are a taxpayer, I take it?'' asked the investment banker. The waiter nodded. ``In which case, we were rather hoping you would foot the bill.''

(Mark Gilbert is a Bloomberg News columnist. The opinions expressed are his own.)