Month in Review, March 2009: Part 1, the market’s busted?
[Previous Months In Review available here: Feb 09, Jan 09.]
On the first anniversary of the Bear Stearns Banking on Value bailout, we are twelve months further in to the most comprehensive restructuring of the global capital and financial markets that any of us have seen in our lifetimes, and we’re at least partly in the silly season, as evidenced by the hang-’em-high mentality that led three-quarters of the House of Representatives to pass the most fatuously irresponsible legislation yet seen, as I profiled in The AIG Hearings: Part 1, “Now that we’ve killed all the bomb-makers …” and Part 2, “… Uh, who’s gonna defuse all these bombs?”
It takes two whole days’ worth of posts to document, in excruciating detail, just how asinine was the grandstanding taking place in
Citizens united for shibboleths!
So far we’ve seen that:
1. The people Congress is flagellating aren’t the ones who wrote the dangerous CDS’s
2. Those being excoriated could leave tomorrow
3. If they people go, the CDS’s could explode worse
4. The bombs are still live …
5. … so we need the world’s best bomb-defusers
[Editorial note: Not everyone on the committee took gratuitous potshots at Mr. Liddy. Distinguishing themselves by behaving like adults were Rep. Paul Kanjorski, Rep. Spencer Bachus, Rep. Jeb Hensarling, Rep. John Campbell, and Rep. Joe Donnelly.]
House Subcommittee Chair Paul Kanjorski
Spencer Bachus and full committee chairman Barney Frank
[Snip]
After Carney posted his novel-but-logical theory as to why the AIG incentive payment contracts could be set aside, he posted a followup with a reader’s rebuttal:
A friend who used to work at a major Wall Street investment bank writes in to say we’re wrong on the AIG bonus issue. While he hasn’t convinced us, we think he makes some powerful arguments and wanted to share them with you.
Dear John:
The way I figure it the AIG traders REALLY deserve those bonuses. First let’s remember that largest bonus was $6.4mn which while a lot of money, pales in comparison to what John Paulson was able to generate with a few well placed CDS contracts.
[I’ve corrected typos in the original email – Ed.]
Turmoil creates opportunities, particularly for smart people.
Second, did you notice the timing on these bonuses? The one-year anniversary of the Bear implosion?
Just as Bernanke and Paulson were making their bet, so was the executive leadership (pre-Liddy, one should note) at AIG.
Shit must have been hitting the fan at AIG about this time last year, they were realizing all those “uncorrelated” contracts they’d written were now converging. The CDS traders saw the writing on the wall, or should have.
Right about that time, I was working on another large transaction – one that (probably fortunately) never came to fruition – involving assumption of risk and the need for a strong balance-sheet guarantor. I heard lots of speculation as to which monolines and other insurers were insolvent and hence worthless as a guarantor. AIG’s name was among those I heard being thrown about.
The firm had just posted its first quarterly loss, the credit markets were cracking up. They were not going to be making very much money that year at AIG based on performance of their positions. But they could very easily have left for Paulson & Co or any of the banks. Demand for people with understanding of credit markets was spiking not dropping off!
“It might be – bad – to burn them?”
AIG, realizing that the whole team had lots of better opportunities out there were they not well compensated, locked the team down with a guaranteed bonus. The fact that this was the team drove AIG into ground [It wasn't – Ed.] was beside the point, everyone who knew the book was poised to walk out the door.
Can I persuade you to stay?
An example of someone walking away was half-year Freddie Mac CEO David Moffett, who gave his employer the bare minimum two weeks’ notice, leading to this classified ad: Wanted: schizophrenic GSE seeks capable CEO: Part 1, paging Mr. Right, and Part 2, cometh the moment, with our prescription for his successor:
Hurry up, Freddie Mac board!
To judge by this Post report, Mr. Moffett tenure was doomed from early on:
As Moffett worked to present a 2009 business plan that would steer Freddie Mac back to being a profitable company, the FHFA second-guessed many of his decisions, people familiar with the matter said. [Snip] The company also had to get approval from its regulator for employees to speak on panels or attend conferences.
To be an executive, you have to be able to make decisions fast, and have those decisions executed by your leadership. So the incoming CEO, during his or her recruitment process, must simply lay out conditions of contest, and get them in writing, so that he or she has a clear charter.
Directors have [only] one function: they can and must judge the chief executive officer, and throw him out when the times comes. (Since this task is painful, it is rarely performed even when all the directors know it is long overdue.) The manager of a … company must come to these terms: he must make it clear from the outset that he accepts without question the right of the directors to assemble whenever they want and decide to replace him, in effect signing a resignation datable at their pleasure.
– Robert H. Townsend, Up The Organization, 1971.
The new CEO can be fired at any time, but short of that, the CEO should say politely, ‘Mr. President, Mr. Treasury Secretary, get out of my face.’
Finding a successor could be a challenge, some recruiters said. “The problem is there are very few people like that out there.”
Let’s hope they succeed
As gratuitous advice [that means 'free' – Ed.] to Mr. Moffett’s successor, or anyone else, I offered two primers from the school of life. First you get their attention, and then Rules you don’t enforce are worse than useless:
In 1950, how many UN resolutions did it take to defend
That’s for me to know and you to keep trying
How many OPEC meetings does it take to bring down the price of oil? How many global recessions?
Whoever succeeds Mr. Moffett at Freddie Mac – maybe one of those departing AIG executives? J – will have to tackle complex financial transactions and not be bamboozled by flashing lights like Risk management’s perpetual-motion machine: Part 1, the quest, Part 2, the magic elixir, and Part 3, the epidemic:
As reader Matthew Healy, who sent me the link to this article, observed in his email:
In a previous life as an engineer I learned to dread what in engineering is known as a “common-mode failure” where the failure of one component in a system is so drastic that it takes out other components that you had thought were unrelated. Common-mode failures blow reliability calculations into shreds, and are behind most spectacular technological disasters.
The aliens tore our projections to shreds
I’m familiar with common-mode failures. In the early 1980s, my then-company (Boston Financial) decided that, to compete for the good properties to be syndicated, we needed to create a predevelopment fund whereby we lent money to developers in exchange for the right to syndicate the equity at a pre-negotiated price. The first eleven or twelve loans we did worked like a charm.
Li’s copula function was used to price hundreds of billions of dollars’ worth of CDOs filled with mortgages. And because the copula function used CDS prices to calculate correlation, it was forced to confine itself to looking at the period of time when those credit default swaps had been in existence: less than a decade, a period when house prices soared.
The last loan we did wiped out our whole fund. Healy again:
This global repricing of risk is the mother of all common-mode market failures.
Back to Wired:
Naturally, default correlations were very low in those years. But when the mortgage boom ended abruptly and home values started falling across the country, correlations soared.
Worked great until the end
[Continued tomorrow in Part 2.]
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