Wall Street History

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Wall Street History

05/09/2008

The Credit Crisis...An Explanation

A few weeks ago in his Sunday New York Times column, Ben
Stein wrote:

“You may well be asking yourself, as I have asked myself, how
on earth did the credit crisis on Wall Street become such a
catastrophe?

“How did all of the mechanisms operated by the mind-
bogglingly well-paid men and women of the Street go so wrong
that we saw a major investment bank, Bear Stearns, essentially
disappear? How did Wall Street firms of ancient lineage take
such immense losses that they made banks clam up on lending –
at great risk to the economy?

“Weren’t fail-safe devices in place to guard against risk?
Weren’t government watchdogs there to make sure that
catastrophes could not happen? Weren’t ratings agencies on the
job to police what was going on in the canyons of Lower
Manhattan?”

So Mr. Stein then referred his readers to a presentation given by
hedge fund operator David Einhorn of Greenlight Capital to a
Grant’s Interest Rate Observer event. I looked up the speech and
present some of it below.

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Mr. Einhorn begins by discussing the recent failure of Carlyle
Capital Corporation, which had leveraged itself thirty to one but
was involved in government agency securities. Safe, eh? Not
quite. “Carlyle’s investors lost most of their investment and the
world, with normal 20-20 hindsight, has learned that investment
companies with thirty times leverage are not safe.”

Einhorn continues:

And I’ll tell you a little secret: These levered balance sheets hold
some things that are dicier than government agency securities.
They hold inventories of common stocks and bonds. They also
have various loans that they hope to securitize. They have pieces
of structured finance transactions. They have derivative
exposures of staggering notional amounts and related counter-
party risk. They have real estate. They have private equity. The
investment banks claim that they are in the “moving” business
rather than the “storage” business, but the very nature of some of
the holdings suggests that this is not true. And they hold this
stuff on tremendously levered balance sheets.

The first question to ask is, how did this happen? The answer is
that the investment banks out maneuvered the watchdogs, as I
will explain in detail in a moment. As a result, with no one
watching, the managements of the investment banks did exactly
what they were incentivized to do: maximize employee
compensation. Investment banks pay out 50% of revenues as
compensation. So, more leverage means more revenues, which
means more compensation. In good times, once they pay out the
compensation, overhead and taxes, only a fraction of the
incremental revenues fall to the bottom line for shareholders.
Shareholders get just enough so that the returns on equity are
decent. Considering the franchise value, the non-risk fee
generating capabilities of the banks, and the levered investment
result, in the good times the returns on equity should not be
decent, they should be extraordinary. But they are not, because
so much of the revenue goes to compensation. The banks have
also done a wonderful job at public relations. Everyone knows
about the 20% incentive fees in the hedge fund and private equity
industry. Nobody talks about the investment banks’ 50%
structures, which have no high-water mark and actually are
exceeded in difficult times in order to retain talent.

The second question is how do the investment banks justify such
thin capitalization ratios? And the answer is, in part, by relying
on flawed risk models, most notably Value-at-Risk or “VaR.”
Value-at-Risk is an interesting concept. The idea is to tell how
much a portfolio stands to make or lose 95% of the days or 99%
of the days or what have you. Of course, if you are a risk
manager, you should not be particularly concerned how much is
at risk 95 or 99% of the time. You don’t need to have a lot of
advanced math to know that the answer will always be a
manageable amount that will not jeopardize the bank. A risk
manager’s job is to worry about whether the bank is putting itself
at risk in the unusual times or in statistical terms, in the tails of
distribution. Yet, Value-at-Risk ignores what happens in the
tails. It specifically cuts them off. A 99% Value-at-Risk
calculation does not evaluate what happens in the last one
percent. This, in my view, makes VaR relatively useless as a risk
management tool and potentially catastrophic when its use
creates a false sense of security among senior managers and
watchdogs. This is like an air bag that works all the time, except
when you have a car accident.

By ignoring the tails, Value-at-Risk creates an incentive to take
excessive but remote risks. Consider an investment in a coin-
flip. If you bet $100 on tails at even money, your Value-at-Risk
to a 99% threshold is $100, as you will lose that amount 50% of
the time, which obviously is within the threshold. In this case
the VaR will equal the maximum loss.

Compare that to a bet where you offer 127 to 1 odds on $100 that
heads won’t come up seven times in a row. You will win more
than 99.2% of the time, which exceeds the 99% threshold. As a
result, your 99% Value-at-Risk is zero even though you are
exposed to a possible $12,700 loss. In other words, an
investment bank wouldn’t have to put up any capital to make this
bet. The math whizzes will say it is more complicated than that,
but this is the basic idea.

Now we understand why investment banks held enormous
portfolios of “super-senior triple A-rated” whatever. These
securities had very small returns. However, the risk models said
they had trivial Value-at-Risk, because the possibility of credit
loss was calculated to be beyond the Value-at-Risk threshold.
This meant that holding them required only a trivial amount of
capital. A small return over a trivial amount of capital can
generate an almost infinite revenue-to-equity ratio. Value-at-
Risk driven risk management encouraged accepting a lot of bets
that amounted to accepting the risk that heads wouldn’t come up
seven times in a row.

In the current crisis, it has turned out that the unlucky outcome
was far more likely than the back-tested models predicted. What
is worse, the various supposedly remote risks that required trivial
capital are highly correlated – you don’t just lose on one bad bet
in this environment, you lose on many of them for the same
reason. This is why in recent periods the investment banks had
quarterly write-downs that were many times the firm-wide
modeled Value-at-Risk.

Which brings us to the third question, what were the watchdogs
doing? Let’s start with the credit rating agencies. They have a
special spot in our markets. They can review non-public
information and opine on the creditworthiness of the investment
banks. The market and the regulators assume that the rating
agencies take their responsibility to stay on top of things
seriously. When the credit crisis broke last summer, one of the
major agencies held a public conference call to discuss the health
of the investment banks.

The gist of the rating agency perspective was “Don’t Worry.”
The investment banks have excelled risk controls and they hedge
their exposures. The initial reaction to the credit crisis basically
amounted to “everyone is hedged.” A few weeks later, when
Merrill Lynch announced a big loss, that story changed. But
initially, the word was that everyone was hedged. Securitization
had spread the risk around the world and most of the risk was
probably in Asia, Europe, Dubai or at the bottom of the East
River. The banks were in the “moving” business, not the
“storage” business, so this was no big issue. I wondered whether
anyone saying this had actually looked at the balance sheets.

Of course, this raised the question of how did everyone hedge
and who were the counter-parties holding the bag? I pressed
star-1 and asked the rating agency analyst how everyone hedged
the massive apparent credit risks on the balance sheets. The
rating agency analyst responded that the rating agency had
observed enormous trading volumes on the MERC in recent
days.

The MERC offers products that enable one to hedge interest rate
risk, not credit risk. I called the rating analyst back to discuss
this in greater depth. At first he told me that you could hedge
anything on the MERC. When I asked how to hedge credit risk
there, he was less familiar. I came to suspect that the rating
agency analyst viewed his role as one to restore confidence in the
system, which the rating agency call did do for a while, rather
than to analyze risk.

I later had an opportunity to meet a recently retired senior
executive at one of the large rating agencies. I asked him how
his agency went about evaluating the credit worthiness of the
investment banks. By then Merrill had acknowledged large
losses, so I asked him what the rating team found when it went to
examine Merrill’s portfolio in detail.

He answered by asking me to refocus on what I meant by
“team.” He told me that the group covering the investment
banks was only three or four people and they have to cover all of
the banks. So they have no team to send to Merrill for a thorough
portfolio review. He explained that the agency doesn’t even try
to look at the actual portfolio because it changes so frequently
that there would be no way to keep up.

I asked how the rating agencies monitored the balance sheets so
that when an investment bank adds an asset, the agency assesses
a capital charge to ensure that the bank doesn’t exceed the risk
for the rating. He answered that they don’t and added that the
rating agencies don’t even have these types of models for the
investment banks.

I asked what they do look at. He told me they look mostly at the
public information, basic balance sheet ratios, pretax margin, and
the volatility of pretax margin. They also speak with
management and review management risk reports. Of course,
they monitor Value-at-Risk.

I was shocked by this and I think that most market participants
would be surprised, as well. While the rating agencies don’t
actually say what work they do, I believe the market assumes
that they take advantage of their exemption from Regulation FD
to examine a wide range of non-public material. A few months
ago I made a speech where I said that rating agencies should lose
the exemption to Regulation FD so that people would not over
rely on their opinions.

The market perceives the rating agencies to be doing much more
than they actually do. The agencies themselves don’t directly
misinform the market, but they don’t disabuse the market of
misperceptions – often spread by the rated entities – that the
agencies do more than they actually do. This creates a false
sense of security and in times of stress this actually makes the
problems worse. Had the credit rating agencies been doing a
reasonable job of disciplining the investment banks – who
unfortunately happen to bring the rating agencies lots of other
business – then the banks may have been prevented from taking
excess risk and the current crisis might have been averted.

The rating agencies remind me of the department of motor
vehicles in that they are understaffed and don’t pay enough to
attract the best and the brightest. The DMV is scary, but it is just
for mundane things like drivers licenses. Scary does not begin to
describe the feeling of learning that there are only three or four
hard working people at a major rating agency judging the
creditworthiness of all the investment banks and they don’t even
have their own model.

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Note: I’m traveling overseas for a bit. Wall Street History
returns in two weeks.

Brian Trumbore

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