Late last week, the Securities and Exchange Commission charged Goldman Sachs with investor fraud. It seems that they chose not to disclose all of the terms of one of their own financial products. After reading the analysis of the events, I have just got to ask: Are these bankers or bookies? Goldman Sachs, among other large Wall Street firms, appears to be running a legal bookie operation, catering to clients who wanted to place large bets on the outcome of certain financial events. You’ve heard the expression, if it walks like a duck and talks like a duck… The real question: was the game rigged? We’ll have to wait and see.
Last month, in a post about Greed and Delusion on Wall Street, I said
It’s difficult to appreciate the amount of backstabbing, mistrust and cynicism that is endemic at Wall Street firms. “Wall Street doesn’t care what it sells.” Investment banks exploited their institutional customers (pension funds, mutual funds, banks). The same firm that is advising them on what to invest in (the sell side) also has an in-house operation that is trading for its own account. Why is this blatant conflict of interest allowed?
Incredibly, I may have actually understated the problem! It seems to me that it is patently impossible to be cynical enough, at least about some Wall Street firms.
Why do I say that? Well, the suit filed by the SEC alleges that Goldman Sachs put together a package of derivatives based on subprime mortgages and did not disclose that the components were selected by the party who wanted to bet against the investment, i.e. sell short. The claim is that the security was “designed to fail.” Please take note of the word “alleged,” meaning that they may or may not have done something illegal. Because it’s a civil lawsuit which may take years to adjudicate, Goldman Sachs will have ample opportunity to present its side of the story. I have complete confidence that they will hire the best lawyers that megabucks can buy.
Even if Goldman Sachs “wins” that lawsuit, they may have lost something infinitely more valuable – their reputation. To my mind, this is no small thing, since confidence in your advisor is (or should be) of paramount importance to investment bankers, including Goldman Sachs. I am compelled to ask one more question, though, did these bankers aim to protect investors’ interests or were they just determined to make a profit at all costs?
What Is the Public Value of Trading in Synthetic Securities?
But as investors and citizens, it is worth pondering whether all of this trading activity has a social purpose or is it merely gambling in a more refined form. The topic of synthetic financial derivatives is highly complex and difficult for most ordinary mortals to understand. But Roger Lowenstein’s column, Gambling With the Economy in the April 20th edition of The New York Times, offers an excellent summary of the arguments:
Wall Street’s purpose, you will recall, is to raise money for industry: to finance steel mills and technology companies and, yes, even mortgages. But the collateralized debt obligations involved in the Goldman trades, like billions of dollars of similar trades sponsored by most every Wall Street firm, raised nothing for nobody. In essence, they were simply a side bet — like those in a casino — that allowed speculators to increase society’s mortgage wager without financing a single house.
The mortgage investment that is the focus of the S.E.C.’s civil lawsuit against Goldman, Abacus 2007-AC1, didn’t contain any actual mortgage bonds. Rather, it was made up of credit default swaps that “referenced” such bonds. Thus the investors weren’t truly “investing” — they were gambling on the success or failure of the bonds that actually did own mortgages. Some parties bet that the mortgage bonds would pay off; others (notably the hedge fund manager John Paulson) bet that they would fail. But no actual bonds — and no actual mortgages — were created or owned by the parties involved.
The S.E.C. suit charges that the bonds referenced in Goldman’s Abacus deal were hand-picked (by Mr. Paulson) to fail. Goldman says that Abacus merely allowed Mr. Paulson to bet one way and investors to bet the other. But either way, is this the proper function of Wall Street? Is this the sort of activity we want within regulated (and implicitly Federal Reserve-protected) banks like Goldman?
While such investments added nothing of value to the mortgage industry, they weren’t harmless. They were one reason the housing bust turned out to be more destructive than anyone predicted. Initially, remember, the Federal Reserve chairman, Ben Bernanke, and others insisted that the damage would be confined largely to subprime loans, which made up only a small part of the mortgage market. But credit default swaps greatly multiplied the subprime bet. In some cases, a single mortgage bond was referenced in dozens of synthetic securities. The net effect: investments like Abacus raised society’s risk for no productive gain.
I find Lowenstein’s points very convincing, and I totally agree with his recommendations.
“ …the financial bailout has demonstrated that big Wall Street banks … (have) implicit bailout protection. Protected entities should not be using (potentially) public capital to run non-productive gambling tables.
… Congress should take up the question of whether parties with no stake in the underlying instrument should be allowed to buy or sell credit default swaps. If it doesn’t ban the practice, it should at least mandate that regulators set stiff capital requirements on swaps for such parties so that they will not overleverage themselves again to society’s detriment. …”
Proposed reforms by the Obama administration will hopefully rein in the questionable activities of Wall Street bankers, although, Wall Street lobbyists will naturally attempt to defeat any such reform. As I said previously, we’ll have to wait and see, but nearly a week later, no further charges from the SEC have been forthcoming. Of note, however, several European countries have commenced the filing of similar charges against Goldman Sachs.
Derivatives (complex financial instruments) are time bombs and “financial weapons of mass destruction” that could harm not only their buyers and sellers, but the whole economic system.
“Derivatives generate reported earnings that are often wildly overstated and based on estimates whose inaccuracy may not be exposed for many years.”
After seeing Michael Lewis on both 60 Minutes and The Charlie Rose Show last week, I had to read The Big Short: Inside the Doomsday Machine, the just released book by Lewis about the subprime mortgage disaster. Lewis is a fabulous story teller, and I cannot recommend this book enough.
He tells how the subprime mortgage market was created, who benefited, who lost, the cons, the dupes and the dopes and “how some of Wall Street’s finest minds managed to destroy $1.75 trillion of wealth in the subprime mortgage markets” and created the worst financial crisis since the Great Depression.
Essentially billions of dollars were lent to people who had very little chance of ever paying it back. And Wall Street firms earned billions of dollars creating, packaging and betting on complex financial instruments whose raw material was the risky mortgage loans they created. And that was just the beginning.
Tremendous leverage (using borrowed money to magnify possible returns) increased the risk of destroying entire firms.
Lewis follows a few very colorful individuals who gradually figured out just how corrupt the entire risky mortgage system was. These investors made billions by betting against the subprime market by selling short.
Note that “selling short” is an entirely legal transaction, but generally considered a high risk one that involves betting against something, i.e. a stock, bond, or currency, for example, which isn’t “actually” owned by the investor. Selling short requires astuteness, foresight, excellent timing and staying power. Being “right” too soon can be both nerve wracking and very costly, because until the market agrees with your assessment, you are at risk of losing a great deal of money. (Disclosure: I do not sell short.)
In reading Lewis’s gripping story, I alternated between nodding my head in recognition of the self-serving greed that categorized Wall Street to shaking my head in disbelief that Wall Street bankers could have been so deluded that they ended up believing their own lies, I mean “models.” As I read, I found myself laughing out loud more times than I can count – truly, Lewis has a way with words.
To give you some background info, in the “old” days, a bank lent money to a home buyer and they held the mortgage. The bank was very serious about getting repaid, so before they agreed to fund the loan, they did some rather basic things like verify the borrowers’ creditworthiness, check their employment and salary history and retain an appraiser to assess the value of the property being bought. A good credit history, a stable job and a property value that would support the loan were enough incentive for banks, back in the “old” days, to grant a loan request.
But when banks started selling the mortgage to a Wall Street firm who repackaged the loan and then sold the package to investors, the incentives became very different. It was like the Wild West before the Marshall came to town to establish law and order.
The acronym IBGYBG came into being. The brokers who made more money than they ever imagined said, “I’ll be gone, you’ll be gone” so let’s not worry about the suckers who will probably lose their homes or the gullible institutions that bought the crappy investments in the purposely opaque financial instruments. And it was easy to rationalize the sleazy behavior, because, after all, it was possible that this will all work out, if home prices keep rising. That was a big IF.
It was really a mammoth legal Ponzi scheme, or as Lewis called it a “mass delusion.”
The individual characters’ stories are fascinating, but I will not try to summarize them. Instead, here are some observations that emphasize the need for fundamental financial regulation of Wall Street firms.
- No one goes to Wall Street investment banks to make the world a better place. “Greed on Wall Street is assumed – almost an obligation. The problem was the system of incentives that channeled the greed.”
- People see what they have an incentive to see. Wall Street employees, managers and CEOs had an incentive (i.e. huge bonuses – surely, you’ve heard about them) not to see the truth.
- When Wall Street firms were partnerships and the principals had their own money at risk, they had a sane long-term approach to their business operations. When these same firms became publicly traded corporations, risk was transferred to the shareholders. But, of course, huge bonuses were paid to successful traders based on one year’s results. In the short term, traders had every incentive to take large risks. “Heads I win, tails someone else loses, perhaps some time in the future.”
- The fixed income (bonds) world dwarfs the equity (stocks) world in size. The stock market is transparent and heavily policed. On the other hand, “bond salesmen could say and do anything without worrying that they would be caught. Bond technicians could dream up ever more complicated securities without worrying too much about government regulation – one reason why so many derivatives had been derived, one way or another, from bonds.”
- The world of mortgage-backed securities (pooled investments backed by mortgages) and derivatives (financial instruments created by Wall Street) were intentionally difficult to understand, so no one even bothered to try. The book describes the nature of asset-backed securities, tranches, collateralized debt obligations, credit default swaps, etc. You, dear reader, can safely skip those portions if you want to. The horse is already out of the barn.
- It’s difficult to appreciate the amount of backstabbing, mistrust and cynicism that is endemic at Wall Street firms. “Wall Street doesn’t care what it sells.” Investment banks exploited their institutional customers (pension funds, mutual funds, banks). The same firm that is advising them on what to invest in (the sell side) also has an in-house operation that is trading for its own account. Why is this blatant conflict of interest allowed?
- While there may have been some criminal behavior, in the end, group think, mass delusion and incompetence were more important factors. Wall Street firms did not understand the money-making machine they had created or the risks they had taken.
- When lenders ran out of customers who would qualify for a normal mortgage, they dreamt up new ways to lend to people who could not afford to pay the old fashioned way. Hence the introduction of “interest-only negative-amortizing adjustable-rate subprime mortgages.” Translation: you don’t have to pay any principal or any interest on your new mortgage; we’ll just keep adding that to the amount you owe.
- Amazingly enough, Wall Street firms convinced bond ratings agencies (Moody’s, S&P) to give such garbage a Triple A rating. That credit rating agencies are “educated” by and paid by the issuers of the bonds is quite a conflict of interest! And it still exists.
- Lewis asserts that today “nobody believes that Wall Street knows what it is doing.” He understands why Goldman Sachs and Morgan Stanley, for example, want a say in how they are regulated. He wonders why anyone would listen to them.
The greed and miscalculation of Wall Street firms caused the near collapse of the world economy. Governments around the world felt forced to commit trillions of dollars to resuscitate the banks.
Regulation of firms and people which have fundamentally the wrong incentives will not be easy. Regulatory reform of institutions that are too well connected to fail will not be easy. Change is never easy. But it is absolutely essential or we will all be at risk of a repeat performance of the last financial crisis. Without reform, the investment banking system can crash again, taking with it jobs, savings and U.S. tax payer dollars.
I recently had dinner with my cousin who said, “I don’t understand how the economy was fine for so many years and now it isn’t fine. How did this happen? I don’t understand.”
Well, this is much too complicated a subject to discuss over just dinner, but I would imagine that many people feel the same way and are asking the same question as my cousin. “Why?”
Besides this blog, which has quite a few posts on this topic, I recommend checking out The Baseline Scenario, a web site whose tagline is “What happened to the global economy and what we can do about it.”
The founder of The Baseline Scenario is Simon Johnson, 46, currently a professor at the Massachusetts Institute of Technology’s Sloan School of Management. Previously, he was chief economist of the International Monetary Fund. Peter Boone and James Kwak also contribute to the site’s articles and posts.
Johnson is interviewed and quoted frequently, both in the mainstream media and on the internet. He has published many, many opinion pieces and articles on the global economic situation and possible solutions. He also writes for the New Republic and has been interviewed on NPR radio and the Charlie Rose program. Whew! It’s exhausting just following him around on the Internet!
In my opinion, The Baseline Scenario web site is so much more than just a simple blog. Rather, it’s a free online lesson on macro, monetary, and global economics.
The section, Financial Crisis for Beginners, quite effectively lessens the confusion. It covers pretty much everything, from old-fashioned bank runs to new-fangled credit default swaps. There are also very informative and helpful articles such as The Federal Reserve for Beginners and Interest Rates for Beginners. You’ll also find links to a thought-provoking article and radio interview, National Debt For Beginners.
Worth noting is the Japan’s Lost Decade article. While many economists, analysts and financial writers compare our current economic situation to the Great Depression, The Baseline Scenario suggests that “in many ways, a more relevant comparison may be the Japanese ‘lost decade’ of the 1990s, when the collapse of a bubble in real estate and stock prices led to over a decade of deflation and slow growth.”
It’s quite amazing that a single web site, and one ubiquitous observer, can have such an impact on the national debate. I highly recommend that you follow the articles and posts at The Baseline Scenario.
P.S. This is my 100th post. For some reason, this is supposed to be significant.
In his January 24th New York Times column, Six Errors on the Path to the Financial Crisis, Alan S. Blinder, professor of Economics and Public Affairs at Princeton University, briefly summarizes the causes of the Financial Crisis. He uses a chronological approach, listing the decisions (and the alternative advice that was ignored).
According to Blinder, the cause of our troubles “was largely a series of avoidable — yes, avoidable — human errors. Recognizing and understanding these errors will help us fix the system so that it doesn’t malfunction so badly again.”
Here is a summary of his article.
Wild Derivatives. Rather than regulate these arcane financial instruments, as Brooksley E. Born, then chairwoman of the Commodity Futures Trading Commission recommended in 1998, “top officials of the Treasury Department, the Federal Reserve and the Securities and Exchange Commission squelched the idea. … Does anyone doubt that the financial turmoil would have been less severe if derivatives trading had acquired a zookeeper a decade ago?”
Sky-High Leverage. In 2004, the S.E.C. let securities firms raise their leverage sharply. Had leverage stayed at previous levels, “these firms wouldn’t have grown as big or been as fragile.”
A Subprime Surge. “The next error came in stages, from 2004 to 2007, as subprime lending grew from a small corner of the mortgage market into a large, dangerous one. Lending standards fell disgracefully, and dubious transactions became common.”
Foreclosures. “The government’s continuing failure to do anything large and serious to limit foreclosures is tragic. …Free-market ideology, denial and an unwillingness to commit taxpayer funds all played roles. Sadly, the problem should now be much smaller than it is.”
Letting Lehman Go. “The next whopper came in September, when Lehman Brothers, unlike Bear Stearns before it, was allowed to fail. … Everything fell apart after Lehman.”
“After Lehman went over the cliff, no financial institution seemed safe. So lending froze, and the economy sank like a stone. It was a colossal error, and many people said so at the time.”
TARP’S Detour. “The final major error is mismanagement of the Troubled Asset Relief Program, the $700 billion bailout fund. … Instead of pursuing the TARP’s intended purposes, (Henry M. Paulson Jr., the former Treasury Secretary), used most of the funds to inject capital into banks — which he did poorly.”
Six fateful decisions — all made the wrong way. Imagine what the world would be like now if the housing bubble burst but those six things were different: if derivatives were traded on organized exchanges, if leverage were far lower, if subprime lending were smaller and done responsibly, if strong actions to limit foreclosures were taken right away, if Lehman were not allowed to fail, and if the TARP funds were used as directed.
All of this was possible. And if history had gone that way, I believe that the financial world and the economy would look far less grim than they do today.
“Risk comes from not knowing what you’re doing.” – Warren Buffett.
In previous posts, I wrote about the poor job some investment banks did in risk management and how they ended up “owning exotic securities, derivatives, pieces of paper backed by pools of assets. They did not understand these securities any better than the people they sold them to.
An article in today’s New York Times, The Reckoning – Citigroup Pays for a Rush to Risk, by Eric Dash and Julie Creswell goes behind the scenes to explain just how bad things were. What is fascinating is that the article names names, i.e. the people who were trading the securities and the risk managers, who failed to rein them in.
Of course, top management was ultimately responsible for the debacle. Looking back, one question comes to mind, “What were they thinking?” The authors answer that question.
Here are extensive quotes from the article.
In September 2007, with Wall Street confronting a crisis caused by too many souring mortgages, Citigroup executives gathered in a wood-paneled library to assess their own well-being.
There, Citigroup’s chief executive, Charles O. Prince III, learned for the first time that the bank owned about $43 billion in mortgage-related assets. He asked Thomas G. Maheras, who oversaw trading at the bank, whether everything was O.K.
Mr. Maheras told his boss that no big losses were looming, according to people briefed on the meeting who would speak only on the condition that they not be named.
For months, Mr. Maheras’s reassurances to others at Citigroup had quieted internal concerns about the bank’s vulnerabilities. But this time, a risk-management team was dispatched to more rigorously examine Citigroup’s huge mortgage-related holdings. They were too late, however: within several weeks, Citigroup would announce billions of dollars in losses.
Normally, a big bank would never allow the word of just one executive to carry so much weight. Instead, it would have its risk managers aggressively look over any shoulder and guard against trading or lending excesses.
But many Citigroup insiders say the bank’s risk managers never investigated deeply enough. Because of longstanding ties that clouded their judgment, the very people charged with overseeing deal makers eager to increase short-term earnings — and executives’ multimillion-dollar bonuses — failed to rein them in, these insiders say.
Today, Citigroup, once the nation’s largest and mightiest financial institution, has been brought to its knees by more than $65 billion in losses, write-downs for troubled assets and charges to account for future losses. More than half of that amount stems from mortgage-related securities created by Mr. Maheras’s team — the same products Mr. Prince was briefed on during that 2007 meeting.
Citigroup’s stock has plummeted to its lowest price in more than a decade, closing Friday at $3.77. At that price the company is worth just $20.5 billion, down from $244 billion two years ago. Waves of layoffs have accompanied that slide, with about 75,000 jobs already gone or set to disappear from a work force that numbered about 375,000 a year ago.
While much of the damage inflicted on Citigroup and the broader economy was caused by errant, high-octane trading and lax oversight, critics say, blame also reaches into the highest levels at the bank. Earlier this year, the Federal Reserve took the bank to task for poor oversight and risk controls in a report it sent to Citigroup.
The bank’s downfall was years in the making and involved many in its hierarchy, particularly Mr. Prince and Robert E. Rubin, an influential director and senior adviser.
Citigroup insiders and analysts say that Mr. Prince and Mr. Rubin played pivotal roles in the bank’s current woes, by drafting and blessing a strategy that involved taking greater trading risks to expand its business and reap higher profits. Mr. Prince and Mr. Rubin both declined to comment for this article.
For a time, Citigroup’s megabank model paid off handsomely, as it rang up billions in earnings each quarter from credit cards, mortgages, merger advice and trading.
But when Citigroup’s trading machine began churning out billions of dollars in mortgage-related securities, it courted disaster. As it built up that business, it used accounting maneuvers to move billions of dollars of the troubled assets off its books, freeing capital so the bank could grow even larger. Because of pending accounting changes, Citigroup and other banks have been bringing those assets back in-house, raising concerns about a new round of potential losses.
To some, the misery at Citigroup is no surprise. Lynn Turner, a former chief accountant with the Securities and Exchange Commission, said the bank’s balkanized culture and pell-mell management made problems inevitable.
“If you’re an entity of this size,” he said, “if you don’t have controls, if you don’t have the right culture and you don’t have people accountable for the risks that they are taking, you’re Citigroup.”
Questions on Oversight
Though they carry less prestige and are paid less than Wall Street traders and bankers, risk managers can wield significant clout. Their job is to monitor trading floors and inquire about how a bank’s money is being invested, so they can head off potential problems before blow-ups occur. Though risk managers and traders work side by side, they can have an uncomfortable coexistence because the monitors can put a brake on trading.
That is the way it works in theory. But at Citigroup, many say, it was a bit different.
David C. Bushnell was the senior risk officer who, with help from his staff, was supposed to keep an eye on the bank’s bond trading business and its multibillion-dollar portfolio of mortgage-backed securities. Those activities were part of what the bank called its fixed-income business, which Mr. Maheras supervised.
One of Mr. Maheras’s trusted deputies, Randolph H. Barker, helped oversee the huge build-up in mortgage-related securities at Citigroup. But Mr. Bushnell, Mr. Maheras and Mr. Barker were all old friends, having climbed the bank’s corporate ladder together.
Because Mr. Bushnell had to monitor traders working for Mr. Barker’s bond desk, their friendship raised eyebrows inside the company among those concerned about its controls.
After all, traders’ livelihoods depended on finding new ways to make money, sometimes using methods that might not be in the bank’s long-term interests. But insufficient boundaries were established in the bank’s fixed-income unit to limit potential conflicts of interest involving Mr. Bushnell and Mr. Barker, people inside the bank say.
Indeed, some at Citigroup say that if traders or bankers wanted to complete a potentially profitable deal, they could sometimes rely on Mr. Barker to convince Mr. Bushnell that it was a risk worth taking.
Risk management “has to be independent, and it wasn’t independent at Citigroup, at least when it came to fixed income,” said one former executive in Mr. Barker’s group who, like many other people interviewed for this article, insisted on anonymity because of pending litigation against the bank or to retain close ties to their colleagues. “We used to say that if we wanted to get a deal done, we needed to convince Randy first because he could get it through.”
Others say that Mr. Bushnell’s friendship with Mr. Maheras may have presented a similar blind spot.
“Because he has such trust and faith in these guys he has worked with for years, he didn’t ask the right questions,” a former senior Citigroup executive said, referring to Mr. Bushnell.”
According to a former Citigroup executive, Mr. Prince started putting pressure on Mr. Maheras and others to increase earnings in the bank’s trading operations, particularly in the creation of collateralized debt obligations, or C.D.O.’s — securities that packaged mortgages and other forms of debt into bundles for resale to investors.
Because C.D.O.’s included so many forms of bundled debt, gauging their risk was particularly tricky; some parts of the bundle could be sound, while others were vulnerable to default.
“Chuck Prince going down to the corporate investment bank in late 2002 was the start of that process,” a former Citigroup executive said of the bank’s big C.D.O. push. “Chuck was totally new to the job. He didn’t know a C.D.O. from a grocery list, so he looked for someone for advice and support. That person was Rubin. And Rubin had always been an advocate of being more aggressive in the capital markets arena. He would say, ‘You have to take more risk if you want to earn more.’ “
It appeared to be a good time for building up Citigroup’s C.D.O. business. As the housing market around the country took flight, the C.D.O. market also grew apace as more and more mortgages were pooled together into newfangled securities.
From 2003 to 2005, Citigroup more than tripled its issuing of C.D.O.’s, to more than $20 billion from $6.28 billion, and Mr. Maheras, Mr. Barker and others on the C.D.O. team helped transform Citigroup into one of the industry’s biggest players. Firms issuing the C.D.O.’s generated fees of 0.4 percent to 2.5 percent of the amount sold — meaning Citigroup made up to $500 million in fees from the business in 2005 alone.
Even as Citigroup’s C.D.O. stake was expanding, its top executives wanted more profits from that business. Yet they were not running a bank that was up to all the challenges it faced, including properly overseeing billions of dollars’ worth of exotic products, according to Citigroup insiders and regulators who later criticized the bank.
In 2005, as Citigroup began its effort to expand from within, Mr. Rubin peppered his colleagues with questions as they formulated the plan. According to current and former colleagues, he believed that Citigroup was falling behind rivals like Morgan Stanley and Goldman, and he pushed to bulk up the bank’s high-growth fixed-income trading, including the C.D.O. business.
Former colleagues said Mr. Rubin also encouraged Mr. Prince to broaden the bank’s appetite for risk, provided that it also upgraded oversight — though the Federal Reserve later would conclude that the bank’s oversight remained inadequate.
Once the strategy was outlined, Mr. Rubin helped Mr. Prince gain the board’s confidence that it would work.
After that, the bank moved even more aggressively into C.D.O.’s. It added to its trading operations and snagged crucial people from competitors. Bonuses doubled and tripled for C.D.O. traders. Mr. Barker drew pay totaling $15 million to $20 million a year, according to former colleagues, and Mr. Maheras became one of Citigroup’s most highly compensated employees, earning as much as $30 million at the peak — far more than top executives like Mr. Bushnell in the risk-management department.
In December 2005, with Citigroup diving into the C.D.O. business, Mr. Prince assured analysts that all was well at his bank.
“Anything based on human endeavor and certainly any business that involves risk-taking, you’re going to have problems from time to time,” he said. “We will run our business in a way where our credibility and our reputation as an institution with the public and with our regulators will be an asset of the company and not a liability.”
Yet as the bank’s C.D.O. machine accelerated, its risk controls fell further behind, according to former Citigroup traders, and risk managers lacked clear lines of reporting. At one point, for instance, risk managers in the fixed-income division reported to both Mr. Maheras and Mr. Bushnell — setting up a potential conflict because that gave Mr. Maheras influence over employees who were supposed to keep an eye on his traders.
C.D.O.’s were complex, and even experienced managers like Mr. Maheras and Mr. Barker underestimated the risks they posed, according to people with direct knowledge of Citigroup’s business. Because of that, they put blind faith in the passing grades that major credit-rating agencies bestowed on the debt.
While the sheer size of Citigroup’s C.D.O. position caused concern among some around the trading desk, most say they kept their concerns to themselves.
“I just think senior managers got addicted to the revenues and arrogant about the risks they were running,” said one person who worked in the C.D.O. group. “As long as you could grow revenues, you could keep your bonus growing.”
To make matters worse, Citigroup’s risk models never accounted for the possibility of a national housing downturn, this person said, and the prospect that millions of homeowners could default on their mortgages. Such a downturn did come, of course, with disastrous consequences for Citigroup and its rivals on Wall Street.
Even as the first shock waves of the subprime mortgage crisis hit Bear Stearns in June 2007, Citigroup’s top executives expressed few concerns about their bank’s exposure to mortgage-linked securities.
In fact, when examiners from the Securities and Exchange Commission began scrutinizing Citigroup’s subprime mortgage holdings after Bear Stearns’s problems surfaced, the bank told them that the probability of those mortgages defaulting was so tiny that they excluded them from their risk analysis, according to a person briefed on the discussion who would speak only without being named.
Meanwhile, regulators have criticized the banking industry as a whole for relying on outsiders — in particular the ratings agencies — to help them gauge the risk of their investments.
“There is really no excuse for institutions that specialize in credit risk assessment, like large commercial banks, to rely solely on credit ratings in assessing credit risk,” John C. Dugan, the head of the Office of the Comptroller of the Currency, the chief federal bank regulator, said in a speech earlier this year.
But he noted that what caused the largest problem for some banks was that they retained dangerously big positions in certain securities — like C.D.O.’s — rather than selling them off to other investors.
“What most differentiated the companies sustaining the biggest losses from the rest was their willingness to hold exceptionally large positions on their balance sheets which, in turn, led to exceptionally large losses,” he said.
In fact, some analysts say they believe that the $25 billion that the federal government invested in Citigroup this fall might not be enough to stabilize it.
Others say the fact that such huge amounts have yet to steady the bank is a reflection of the severe damage caused by Citigroup’s appetites.
“They pushed to get earnings, but in doing so, they took on more risk than they probably should have if they are going to be, in the end, a bank subject to regulatory controls,” said Roy Smith, a professor at the Stern School of Business at New York University. “Safe and soundness has to be no less important than growth and profits but that was subordinated by these guys.”
“Wall Street’s sales and marketing machine is continuously pumping out fairy tales: fanciful fables filled with legendary deeds and winning exploits. The only differences between many of the Street’s product ‘innovations’ and other types of fairy tales are that the stories are designed for adults, and they rarely have happy endings.
Like the apple given to Snow White by the Evil Queen, these products offer enticing features designed to lure investors, but almost all have one thing in common: Despite their seeming appeal, they have attributes that make them more attractive to the seller than the buyer. These products typically fall into the category called structured products. ” – Larry E. Swedroe and Jared Kizer.
Another “Safe” Bet Leaves Many Burned is a good overview article by Eleanor Laise on several “structured products”. It appeared in the November 11, 2008 edition of The Wall Street Journal.
The gist of the story is that Wall Street firms sold complicated products which promised high returns with little risks. The risks were understated; the returns never materialized.
To see how complicated structures products are, read this article.
How many brokers or investors really understood the mechanics behind such whiz bang inventions such as the following?
- Principal-protected notes
- Reverse convertibles
- Return-enhanced notes
The projections (a.k.a. promises) for these products were based on hypothetical scenarios best viewed through rose-colored glasses. Naturally, disappointment followed when the outcome proved otherwise.
All of this brings to mind the old oft-told advice, “If it sounds too good to be true, it probably is.”
Here are some choice quotes from the article:
In recent years, Wall Street firms raced to sell small investors “structured products” linked to everything from stock indexes to currencies. They were often marketed as a relatively safe way to get a slice of market gains.
Now, in the midst of the market turmoil, many investors holding these complex products are getting burned.
With structured products, which are issued by big Wall Street firms, investors can get exposure to commodities, stocks or other investments without actually owning those assets. The products may promise to give investors a portion of any gains in, say, U.S. stocks or Asian currencies while offering some protection from market losses. They typically behave like packages of bonds and options, but what investors are actually buying with most of these products is the unsecured debt of the issuer.
With Wall Street in turmoil, many of the risks of structured products are now coming to light. “Reverse convertibles,” for example, offer fat yields but leave investors exposed to steep losses if a stock price collapses. “Principal-protected notes” typically are designed to return the principal investment at maturity, along with some portion of the gains in an underlying benchmark, such as the Standard & Poor’s 500-stock index. Yet investors selling before maturity may not recoup their full investment, and the principal protection depends on the issuer’s ability to meet its obligations. Many “return-enhanced notes,” meanwhile, offer some multiple of an index’s gains but provide no protection against stock-market declines.
When an issuer goes belly up, as Lehman Brothers Holdings Inc. did in September, structured-product investors are generally left standing in line with other creditors and may face a long wait to determine how much, if anything, they’ll be able to recover. Some Lehman structured products now are trading for less than 10 cents on the dollar, according to SecondMarket Inc., a marketplace specializing in illiquid assets, which says it has heard from investors holding more than $2 billion worth of Lehman structured products.
The problems are coming at a time when small investors have been on a structured-product buying binge. This year through early November, nearly $34 billion worth of structured products were sold to small U.S. investors, surpassing the $33.5 billion sold in all of 2007, according to StructuredRetailProducts.com, an independent research firm.
The recent upheaval is particularly painful for investors because structured products are often sold to people who are in or near retirement and seek relatively secure or high-yielding investments. Principal-protected notes, which were offered by Lehman and other issuers, were generally designed to at least give investors their original investment back at maturity, and were often touted as safer than direct investments in, say, a stock-market index. The double-digit yields commonly offered by reverse convertibles, meanwhile, may be enticing to people living on a fixed income.
The current problems come on top of longer-standing concerns about these investments. They can be difficult to sell for a decent price before maturity and often carry embedded fees that are tough for individual investors to decipher. Regulators in recent years have raised alarm bells about structured products, voicing concerns about the marketing and sales practices of brokers who sell them.
While it is nice that “regulators in recent years have raised alarm bells about structured products,” that hardly seems enough to protect investors. Transparency is missing for these products, because they “often carry embedded fees that are tough for individual investors to decipher.”
This year has been particularly difficult for all investors, as most strategies have failed, at least in the short term. Even so, in investing, some things are constant. To wit:
- Risk and reward are inextricably related. (There is no such thing as a free lunch.)
- A straightforward approach is usually the best. Keep it simple: Diversification via low-cost mutual funds.
- Avoid hyped synthetic, “enhanced” products, which typically have high fees and hidden risks. Complex structured products benefit Wall Street much more than they do investors.
Forgive me for being cynical, but it comes from listening to fee-only financial advisors who used to be stockbrokers. They have, in essence, come over from the “dark side.”
One thing I am quite confident of is that the brokers were compensated handsomely for selling these “safe” investments. Rick Ferri (a former stockbroker) is quoted in The Bogleheads’ Guide to Investing, “Wall Street wants you to believe they are there to make money for you, but their true purpose is to make money from you.”
“Prediction is very difficult, especially about the future” – Niels Bohr
Gary Becker an economist and Richard Posner a judge, both at the University of Chicago, write a joint blog. It is frequently very thoughtful and worth reading, although usually long and a bit academic for some.
Their October 12th post The Financial Crisis: Why Were Warnings Ignored? asks a very important question. Here is a summary of their thoughts.
Richard Posner’s Opinion
Posner thinks the problem was a failure to synthesize all of the warnings. His analogy is the failure to foresee the attack on Pearl Harbor, although there were indications from 1941 on that something like that could happen.
He singles out “a perfectly reputable academic economist, a professor at New York University named Nouriel Roubini who for years had been predicting with uncanny accuracy what has happened.”
In September of 2006–two years ago–he had “announced that a crisis was brewing. In the coming months and years, he warned, the United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession. He laid out a bleak sequence of events: homeowners defaulting on mortgages, trillions of dollars of mortgage-backed securities unraveling worldwide and the global financial system shuddering to a halt. These developments, he went on, could cripple or destroy hedge funds, investment banks and other major financial institutions like Fannie Mae and Freddie Mac.
Until mid-September, the magnitude of the crisis was greatly underestimated by government, the business community, and the economics profession, including specialists in financial economics.
Why were the warnings ignored rather than investigated? First, preconceptions played a role. Many economists and political leaders are heavily invested in a free market ideology which teaches that markets are robust and self-regulating. The experience with deregulation, privatization, and the many economic success stories that followed the collapse of communism supported belief in the free market. The belief was reinforced, in the case of the financial system, by advances in financial economics, and relatedly by the development of new financial instruments that were believed to have increased the resilience of the financial system to shocks.
Second, doing something to reduce the risks warned against would have been costly. Had banks been required to increase their reserves, this would have reduced the amount they could lend, and interest rates would have risen, which would have accelerated the bursting of the housing bubble…
The deeper problem is that it is difficult and indeed often impossible to do responsible cost-benefit analysis of measures to prevent a contingency from materializing if the probability of that happening is unknown.
Which brings me to the last and most important reason for the neglect of the warning signs, because it suggests the possibility of responding in timely fashion to future risks of financial disaster. That is the absence of a machinery (other than the market itself) for aggregating and analyzing information bearing on large-scale economic risk.
In any event, no effort to determine the probability of financial disaster was made and no contingency plans for dealing with such an event were drawn up. The failure to foresee and prevent the 9/11 terrorist attacks led to efforts to improve national-security intelligence; the failure to foresee and prevent the current financial crisis should lead to efforts to improve financial intelligence.
Becker’s Opinion – Why the Warnings Were Ignored: Too Many False Alarms
Becker has “a somewhat different take than Posner on why warning signals were ignored.”
The period since the early 1980s until the crisis erupted involved both rapid economic growth for most of the world, and unprecedented stability in this growth. Inflation rates were low and fluctuations in real output, as measured by the size and duration of recessions, were modest compared to the past. Economists and central bankers like Greenspan believed that we had learned how to keep inflation low, and also had the capacity to smooth out fluctuations in output and employment.
The second relevant development has been advances in financial instruments, such as derivatives, securitization, credit-backed swaps, and other even more esoteric instruments. These instruments seemed to work quite well in managing, spreading and even reducing the risk of the assets held by banks and other institutions. However, in the process they encouraged greater risk-taking ventures, as reflected by the large increase in the leverage-that is, in the ratio of assets to capital- of banks and financial institutions like Fannie Mae and Freddie Mac. What has been insufficiently understood is that the growing use of these instruments, and the growing leverage of financial institutions, created considerable aggregate risk for the system as a whole that could not be diversified away.
This combination of growing central bank confidence in its ability to iron out various wrinkles in economic performance, and the belief that the new financial instruments would help manage and reduce risk, blinded the vast majority of economists (I include myself), bankers, and government regulators to the vulnerability of the whole system. This vulnerability was especially important for aggregate shocks akin to a classical run on banks. When institutions are highly leveraged, they have great difficulty coping with a massive loss of confidence in the system.
While giving credit to Roubini, Becker lists several disasters during the past several decades that were predicted but never happened:
After the huge one-day stock market collapse in October 1987, Business Week and other magazines and newspapers warned that a Great Depression might soon be coming. These dire forecasts turned out to be completely wrong. Similar highly negative, but wrong economic forecasts, were made during the Asian financial crisis of 1997-98, the internet bubble, and the aftermath of the 9/11 attack.
In an atmosphere where the world economy showed great capacity to withstand difficult shocks, it is not at all surprising that some forecasts of disaster that turned out to be more correct were ignored.
In addition, one should not minimize the great economic achievements of the past 25 years in the form of rapid growth in world GDP, low world inflation, and low unemployment in most countries. Perhaps these achievements will be overshadowed by a deep world recession, but that remains to be seen. If the impact of this financial crisis on the real economy is not both very severe and very prolonged, and time will answer that question, the combination of the past 2 1/2 decades of remarkable achievement, and the economic turbulence that followed, may still look good when placed in full historical perspective.
I appreciate Becker’s perspective that for more than 25 years, the world has seen substantial growth and short recessions. However, this long term success led to overconfidence and excessive risk taking. While everything was working well, investment banks and other financial institutions could achieve large profits. With interest rates so low, borrowing money to increase profits seemed to make sense.
Cassandras are often wrong. The prevailing belief is that markets are usually right in sorting out risks and rewards. (George Soros disagrees with this ideology.)
The problem is that too many people based their decisions on the belief that housing prices could only go up. Unfortunately, too many houses were built and too many people who could not afford the houses were able to get mortgages, often with artificially low “teaser rates.” Now we are dealing with the fallout.
To see how Wall Street took on too much risk, see How Wall Street Became a Giant Hedge Fund.
“Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” – Warren Buffett (2003).
Some people are placing the blame for our current financial crisis squarely on the shoulders of greedy Wall Street financiers. They have a valid point. At least part of the problem can be attributed to greed. How and why greed undid some of the great financial institutions is best told by a Wall Street insider.
“Andy Kessler is a former hedge fund manager turned author who writes on technology and markets.”
His article, The Demise of a Giant Hedge Fund - The old Wall Street is dead. Long live the new Wall Street, appeared in the October 13, 2008 The Weekly Standard.
Wall Street is really just a compensation scheme. Firms generate sales, and employees get half the money. Yes, half. The rest, after expenses goes to shareholders. Sweet deal.
By 2002, Wall Street firms, despite being flush with huge balance sheets of capital to generate returns with, were no longer making money in their bread and butter business of stock and bond trading, investment banking, and money management. The one group making money were these weird guys with math Ph.D.s creating exotic securities, derivatives, pieces of paper backed by pools of assets, maybe airplane leases, or home mortgages. The neat thing about derivatives is that no one but the person who created them knows what they’re worth, so you can sell them at huge markups. Woo-hoo. Mammoth departments were created all over Wall Street to securitize everything that moved. With the Fed forcing low interest rates in 2002-2004, the higher the yield the better.
Subprime home mortgages, because of higher risk (ooh, don’t say that word), had high yields and moved to the top of the list. When not enough of these loans could be bought from banks, firms like Bear Stearns and Lehman set up entire loan-origination subsidiaries, and in true Wall Street style were aggressive and rose to the top of the market-share tables. If you want to know why Wall Street CEOs made so much, it wasn’t from trading your 1,000 shares of Apple stock.
Still, those profits weren’t enough. Their customers were making great money buying Wall Street’s derivatives. But why should banks and pension funds and hedge funds have all the fun? What a perfect use for all that capital on their huge balance sheets and cheap financing from low interest rates. Wall Street, en masse, started buying all these high yielding derivatives for their own account. They ate their own dog food, if you will.
…all of a sudden, Wall Street is no longer a business of traders or stock brokers or investment bankers, it’s a giant hedge fund. And they have no idea what they are doing. None. I ran a hedge fund for a lot of years and learned rather quickly that if a trade was too good, if everyone was doing the same trade, then I should absolutely turn around and run for the hills. But no one on Wall Street did. The spreadsheets flashed green. Risk was a four-letter word best not said in polite company.
Wall Streeters became hedge fund cowboys and loved the spoils, until a tiny little downturn in housing sent everyone rushing to get out of the pool at the same time. Deleveraging a balance sheet leveraged at 30 to 1 is not easy or pretty when everyone is doing it along with you. And this is not the customer panic-selling and paying fees to Wall Street, it’s Wall Street doing the selling, pushing prices into the irrational range and turning companies belly up overnight.
Is this the end of Wall Street? More like the start of a new one. At the end of the day, Wall Street is not about the names on the door, it’s about the people inside. There were great people at Lehman and Enron, Bear Stearns and AIG. Those who have a nose for making money will join other firms, or hedge funds, or start their own shop. Still, I’m pretty sure that half of those employed on Wall Street in 2007 will be doing something else by January.
And the new Wall Street? There’s only one direction. It’s back to basics. Not quite back to the old white shoes-blue blood partnerships of the past but certainly that business model. With a lot less capital, sit on the edge of the stock market and provide access to capital for the next set of great companies. Take ‘em public, bank ‘em, and grow with ‘em. It may not be as exciting as the last few years, but it beats getting dumped in the East River.
In the end, greed was a big factor, but so was a complete failure to manage risk, properly. Top management at some investment banks, supposedly intelligent people, essentially bet their whole company on a strategy that amounted to putting too many eggs in one basket. They ending up owning “exotic securities, derivatives, pieces of paper backed by pools of assets.” They did not understand these securities any better than the people they sold them to.
And because there was no transparency or regulation, the investment bankers could take on as much risk as they wanted to. So they used way too much leverage. They simply took more risk than they had the ability to take. These bets were very profitable, until things went the wrong way. And, because they used such a large amount of borrowed money, there was just no margin for error.
And when many on Wall Street tried to “deleverage” at the same time, i.e. they all tried to sell at once, there was no one on the other side of the trade. There were not enough buyers, so there was no liquidity, just when it was most needed.
See the quote at the top of this post.
To be continued …