From the confessional: Part 1, we’re all hosed
That for your portfolio!
Billed ‘We’re All Hosed’: A Wall Street Insider on the Economic Crisis, this Yahoo Finance interview with “a veteran banker at a major Wall Street investment firm,” though anonymous, rings true – and is worth hearing as an Oh-my-God retrospective on the credit fiasco, as from the confessional: Bless us, Father, for we have royally screwed up.
Bless me, father, for I have manipulated complex derivatives
On condition of anonymity, the banker provided a blunt assessment of the risks taken, mistakes made, and the toll of the financial destruction. Here are the highlights:
Q: What’s the cause of the economic crisis from your perspective?
A: There is an awful lot of blame to go around on Wall Street, in
You’ll need more fingers than that to point at all the guilty
As I’ve written before, there is no one culprit. Everybody, from subprime borrowers through German pension funds, underestimated the risk.
But stepping back, the critical error was that everyone [thought] there would not be a substantial, nationwide decrease in real estate prices.
If you’ve never seen snow, you think snow will never come.
That [devaluation of risk – Ed.] was what undergirded the entire breakdown, and this was not a 3-year phenomenon, it was building for 10 years.
We had more than a decade of benign economic conditions – stable and low inflation, stable and largely declining interest rates, and either way well-heralded and gentle changes. Some people, including many a Wall Street Master of the Universe, had never known any other environment and believed they had tamed it. Some people had become drunk on risk-taking. Some people (like me) grew tired of warning about shakeout and being told we were anachronistic worrywarts, and eventually convinced ourselves that any impending shakeout would be mild, not severe.
Put the worrywarts in there
The whole subprime debacle was predicated on the fact that people said, “Well, this borrower is not really credit worthy and can’t afford the house, but in four years it will be up 20% or more.”
I can absolutely attest to that. The loan products we saw began at the risky and gradually evolved to the totally insane. 97% leverage gave way to no-documentation loans, interest-only loans, and the ultimate shocker, partial-pay loans.
“Stop the insanity!”
It was widely believed that if you had bad mortgages from different geographic areas that all those [real estate markets] weren’t going to go down together. You had a pool of 100 bad mortgages from borrowers with low income or bad credit, that were each a piece of [expletive]. The idea was you put them together and now it’s not a piece of [expletive]. People believed that through geographic diversification you can diversify risk.
When I heard about rating agencies agreeing that pools of C loans could be aggregated and a AAA bottom piece skimmed off, I thought, Put crap in a blender and centrifuge, and even if you drink just the top part, you won’t like the taste.
More structurally, it was possible to convince yourself that if each loan had (say) a 3% risk of default and a 50% loss given default, then if you aggregated enough of them together, there had to be a bottom portion that was bulletproof.
Bulletproof, baby
This missed several things:
1. Agency risk in the value chain. Bad lenders encourage marginal applicants to become bad borrowers who take out bad loans. If I’m paid an origination fee at closing, why should I care?
2. Default risks correlate. If you’re a high-risk borrower, you’re more likely to be in an economically fragile metropolitan area, your home in a less-stable neighborhood, and physically less-marketable property.
3. Falling prices are a self-fulfilling prophecy too. Just as belief in rising prices encourages prices to rises, doubt spirals them down.
4. Panic is contagious. As we’ve seen.
Don’t lose your confidence
Fannie Mae and Freddie Mac were absurdities; those firms were recklessly and incompetently run.
Sounds like a witness for some class-action plaintiffs.
Q: What role did the rating agencies play?
A: The rating agencies facilitated this by giving investment-grade ratings to the securities.
I’ve written at length about the rating agencies’ dubious symbiotic relationship with issuers.
In the stretch for yield, you could [buy] AA-rated corporate bonds and earn 50 basis points over Treasuries, but if you bought AA-rated mortgage-backed securities [MBSs], you’d get 150 basis points.
I hadn’t known this, and it violates the fundamental principle of ratings. If yields are interchangeable, then all AA securities should sell at roughly the same prices. When one class (bonds) yields 100 basis points less than another (MBSs), that is the market saying that the bonds are regarded as much safer than MBSs – but if the rating agencies are doing their job, that shouldn’t be. Something is amiss.
We’re getting it straightened out
From the buy side, there was a real breakdown in their fiduciary obligation, because they overly relied on ratings agencies and didn’t do their own research.
That’s trade-speak for “brokers on behalf of buying investors were lazy and failed their clients.”
Rating agencies are incredibly powerful; you can’t do debt financing without them. You have to play by their rules. They hold themselves out as these objective providers of ratings advice, but they are human beings, and [rating structured finance deals] was a higher-margin profit [center] for them.
I wrote about this: the profits were obscene.
But I think [the bad ratings] were more due to sheer incompetence than being bribed.
Rather, it’s the wearing pressure of being endlessly nagged. At some point, your ego, besieged by importunings, admits doubt – and into that gap rushes the applicant.
Don’t tell me I’m not Triple-A rated!
Q: But weren’t these the so-called “smartest guys in the room”?
A: These are not the smartest guys in the room. The ratings agencies don’t pay as well, so people working there are using it as platform to get on the Street, or they work there because they’re tired after a career on the Street, or they couldn’t get hired on the Street.
A variation of the talent updraft.
Q: But wasn’t leverage the real problem? Lehman was leveraged about 30 to 1 when it collapsed.
A: The investment banks were imprudently leveraged, but what killed Lehman and Bear was they had bad assets. You can survive a painful downturn — and believe me, de-leveraging has been painful for everyone, but you can survive. Wachovia was only levered ten times, but had terrible exposure [to bad mortgages] and therefore couldn’t raise capital. In hindsight Lehman shouldn’t have been leveraged 30 times, but in a bull market having [a leverage ratio] of 25 times is not necessarily crazy. The real issue is asset quality.
Take heed, you jeremiahs railing against securitization. Securitization is risk moonshine: potent, yes, and home-brewed, but not automatically toxic. It all depends on how you distill it, and what you do when you’ve drunk it.
Q: What’s your view of the government’s $700 billion-plus bailout?
A: I think Paulson was well intentioned around the notion of moral hazard, but he was wrong. I think if he could redo it, he would have saved Lehman.
That’s a consensus view among the cognoscenti with whom I talk. Lehman’s explosion has reverberated so many places, with so much fallout, that if we totted up all the losses, it might well have been cheaper to backstop it as were Bear and the surviving banks.
Still …
Some good will come of this – won’t it?
[Continued tomorrow in Part 2.]
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