09.29.08
Posted in Blog at 1:24 am by Andrew Clearfield
Tuesday, I collaborated in a fascinating conference that almost everyone wrapped up in the current financial crisis ignored. It was the third annual conference on securities lending, sponsored by Finadium (formerly Vodia), a small research house which specializes in lending-related issues. With almost everyone in the securities industry glued to their monitors whether they had anything to do or not, only about 50 attended, rather than the 110 of last year. Which was a pity, because, my own humble contribution aside, there were many other speakers to give the participants thoughts to mull over.
The consensus that emerged was that there would be a severe public examination of short-selling practices, and that lending would inevitably come under some scrutiny. The ‘locate,’ formerly an extremely informal process, would have to become formalized as part of the move to stamp out naked short-selling. There was also the nearly unanimous view that counterparty risk, which had been assumed to be zero with the prime brokers, would henceforth become a major part of lenders’ calculations, and that this would serve as a very significant constraint upon lending activity. Several panelists maintained that once lenders realized how little of the profit on lending they had been receiving, there would be a major rebellion, and possibly many withdrawals from traditional lending activity.
There is no doubt that lending institutions have been taken advantage of. Custodians, which used to do almost all the lending on behalf of their clients, and still have the largest share, were accustomed to taking several times the fee they passed on to client institutions. (As one former lending agent testified, custodians said of lenders, “We like ‘em big, and we like ‘em dumb.”) Custodians’ cuts paled beside the fees commanded by the prime brokers for arranging a short sale. Then there is the sensitive question how often shares may have been re-hypothecated without the lenders’ knowledge, something which comes unpleasantly to light when there is the failure of a prime broker such as Lehman. When it is discovered that lenders were receiving such thin margins for taking on what actually amounted to not-insignificant risks, and that this was associated with the widely mistrusted practice of short selling, one can expect a considerable backlash from some fund beneficiaries.
I presented the ICGN Securities Lending Code, which I had helped write, as a potential solution for the issues lending presented. It would provide a set of procedures to be enforced by institutions themselves, capable of being monitored by their client/beneficiaries. It was hoped that by adopting such a code, the ICGN could forestall the grave risk that at some point the whole of lending practice would become a public issue, and that severe and potentially harmful regulation would result. This was accepted in principle by some institutions, but implementation in many cases was inadequate. Many others, including the whole mutual fund industry, totally ignored the Code. Unfortunately, with a financial crisis now in full swing, both public outcry and the heavy hand of regulation are likely.
There are other issues raised by the practice of lending as it is currently conducted by most institutional shareholders. As another panelist at the conference noted, of the 70% of Risk Metrics clients which claimed to have a lending policy, less than half (that is, about 30% of all those institutions subscribing to Risk Metrics) made any attempt to coordinate it with their share voting policy. Such a failure to recognize the inherent conflict between lending shares and voting them may be judged severely when their own clients and beneficiaries demand to know why, if risk levels and CEO compensation were too high at certain financial companies, did institutions fail to speak out? When people have lost a lot of money, finger-pointing is never in short supply, and lawsuits often follow.
A positive outcome of the collapse of existing trading models may be the emergence of a central clearing house, and perhaps an exchange, for loans. The prime brokers had always fought this, and Congress backed them up. Now, they are in no position to protest such a long-overdue move. Along with more transparency in other derivative instruments, such as CDSs, it would be more possible under such a regime to figure out who was cheating on the system, and who was over-extended. As with previous market crises, the disinfectant of transparency usually has a salutary effect, at least until the fear of misbehavior declines. This typically takes at least 20 years, and possibly longer.
Of course, a failure of governance at a multitude of levels was necessary in order to create a crisis of this magnitude. Naked short selling was not the prime culprit, and may not have been a culprit at all. Investors demanded ever-rising profits from regulated entities, and the entities obliged by circumventing regulations, enormously expanding leverage and risk. Regulators failed to do their assigned tasks energetically enough, and put too much trust in the risk-control of those regulated. Congress denied regulators the authority to regulate new kinds of entities and new instruments. It also encouraged the banking system to lend imprudently. Ordinary citizens were more than happy to take advantage of the increased liquidity to lever themselves up. Managements trusted quantitative models they did not fully understand, and did not worry when the new instruments and the untested assumptions behind them led them to places they would never have deliberately gone, with leverage and sales mixes they would never have deliberately sanctioned. Boards failed to question the strange evolution of the businesses they were supposed to monitor, and continued to authorize increasingly absurd paychecks which absorbed more than half of net revenues. Everyone assumed that if the music ever stopped, it would be someone else left without a chair.
Of this feverish environment, lending practice was perhaps only a representative symbol. Lending didn’t bring any house down, and with luck, perhaps all the borrowed positions will eventually return to the appropriate owners, without damaging the borrowers unfairly, either. But lending was often conducted unwisely, without proper attention to the conflicts and risks it might engender. Now, the party is over. It remains to be seen what permanent damage will result from the failure to behave responsibly.
Permalink
09.22.08
Posted in Blog at 12:58 am by Andrew Clearfield
I’m afraid that, while too little innovation can stultify financial markets and retard economic growth, the present market adventure shows that one can have too much of a good thing. The rocket scientists who have kept coming up with ever-more complex instruments in order to cure the investors’ various financial ailments have produced a cocktail of ‘cures’ which have the result of endangering the life of the patient. Not for nothing does the FDA, the regulator in actual charge of the vital industry which engendered this metaphor, require companies to demonstrate to its satisfaction not only that the new drug actually ameliorates the disease for which it is intended, but also that it does not produce side-effects worse than the disease in question. During last week’s market meltdown, one or two more perspicacious bloggers suggested that something like the FDA with its exhaustive testing procedures should be required of new financial products. The suggestion has some merit.
Until last week, the financial services industry had become as enthusiastic a proponent of innovation as the computer industry. Firms which used to look askance at any credential more academic than the basic M.B.A. were suddenly raiding the mathematics departments of the nation’s elite universities. The sine qua non of any new product was a Ph.D. who was the only person alive who could explain how it worked. Everyone wanted to have complex quantitative strategies which earned wafer-thin positive returns on vast piles of capital, and the more esoteric and unintelligible the strategy, the prouder the folks in the executive suite. The point was, that unlike classical investment strategies, these were all supposed to be low risk, and this justified the commitment of far more capital to them than ever would have been dedicated to any business which management actually understood. Boards were fobbed off with the avowal that those capable of understanding the math had examined the strategy and swore that the risks were miniscule to nonexistent, and that if, by some incredible mischance, the risks ever appeared to rise, the operation would be shut down.
Dozens of central bankers, hundreds of veteran investors, and old farts everywhere repeatedly warned that derivatives and all the strategies based upon them were making markets too levered, the investment business too much like a casino. They were all hooted down, and as the markets continued to rise, they were eventually persuaded that they had been wrong, or were simply cowed into silence. Warren Buffett, whose success has been so great it has been impossible for investors to ignore, called derivatives “financial weapons of mass destruction,” and growled that they made regulations defining margin requirements “a joke,” but no one stopped for more than 10 seconds to consider if he was speaking to them. Each bank was protected by an army of mathematicians, statisticians, and risk analysts, who would guarantee that Buffett must be speaking of someone else. Their bank would be protected if a crunch ever came. When it did come, no one was more surprised than the directors and senior executives of the banks which had profited most from the innovations. That they might have been imprudent allocating 50% of personnel and 80% of capital to one business line or set of related business lines had never occurred to them, because they had been assured by those responsible for dealing in the new line that the business in question was “low risk.”
The investment banks and insurance companies had flocked to all these innovations because their traditional businesses had been gutted by the banks’ very customers. They were engaged in a relentless competition less with each other than with the investors to whom they were providing their services. The only analogy which comes to mind is that of the auto components industry. These independent suppliers are each charged with manufacturing a given component for a lower cost each year, and their most savage competitor is the customer. But there are important differences: the primary auto manufacturer sets the criteria for the component in question, designs it (perhaps with the collaboration of the component supplier), and subjects it to its own quality testing. The financial consumer does none of that, until and unless the product fails. Instead, the financial services intermediary designs new products which will have better margins because the customers have negotiated away the margins in the older products and services. “You want to trade for less than two cents a share? Tell you what: we’ll deal net, and you’ll never have to be bothered again by how much we make.” “Don’t want to pay us for research any more? Try our new proprietary hedging service: we charge only two percent of capital protected.” “Want to buy bonds from each other and cut us out? Try our Structured Investment Vehicles instead: so much more sexy, so little risk.” “Want our bankers to work on your deals on spec? I’ll tell you what: we’ve got a little company you won’t want to resist, we’ll warehouse the stock for you, write options to protect your terms on the deal, we’ll only charge you half our usual fee, and we’ll even invite you to the little staff party we have down in Tahiti to celebrate its completion.”
The result of this ceaseless search for new ways to make the old profits was that the banks got bigger and bigger, richer and richer, and more and more fragile. Risk capital used to be, in the legendary André Mayer’s formulation, money that was back in the box by four o’clock. Investment banks gave advice, period. Wire houses got their commissions and took as few risks as possible. Underwriters tried to make sure that the stock was sold the moment the deal came. Wall Street and the City were both populated by more firms and more specialties than anyone could possibly name offhand, after the Great Crash of 1929 margin requirements were strict, pyramiding trusts were forbidden, and the danger that one failure could set off a whole wave of collapsing firms was virtually nil. Of course, the size of transactions was very much smaller, even allowing for the effect of inflation. No one could become rich from a single year’s bonus, and it might take twenty or even thirty years to make a fortune in finance. By the ‘seventies, many of the best minds at business schools had little desire to go to work on Wall Street. Better to go to work for an industrial conglomerate instead.
But the natives grew restless from such unallayed boredom, institutions saw an opportunity to stick it to those smug guys in the pinstriped suits, the SEC was not worried—nobody of any size had failed in years—and so negotiated fees were born. The industry’s response was block trading. Relationship banking began to collapse, and so the bought deal came into being. Each of these innovations, however, required a greater commitment of capital, and so banks and trading firms had to combine to survive. The greater costs had to be covered by a higher volume of deals, which meant that the investment banks had to churn their customers more, to turn them into transactional junkies. Research became first more trading oriented, then more deal oriented, as plain sensible advice came to be less and less profitable. Firms set up proprietary trading desks to compete with their own customers, trying to get to the alpha first, then to dump their used ideas on the institutions. They also began to offer financial products aimed at the small investor, who was not able to negotiate down fees the way the big institutions were. Of course, the banks howled, screaming that Wall Street and the City were impinging on their turf, and that the barriers between investment banking and commercial banking were being subverted. They were of course, but the cure was not to re-erect them, but to tear them down completely, so that banks became investment houses and investment houses became banks. Thus, the whole economy was assured that if anything went wrong, (but nothing could—there were all those mathematical geniuses to guarantee that this could not happen again) it would affect everyone, and not just those involved in a limited sector.
The Great Crash of 1929 was not the cause of the Great Depression, but a result of an economic contraction which had begun in the farming sector as early as 1925, had begun to weaken the labor market, and had begun to affect industrial profitability and foreign trade by the Spring of 1929. The market was belatedly reacting to signs of danger such as the impending passage of the huge Smoot-Hawley Tariff, which was to lead to a global round of retaliation in 1930 and 1931. The market crash caused silly central bankers to decide to tighten up on the money supply as punishment for the obvious excesses of the previous period of credit expansion, and turned what would have been a nasty recession into the worst economic decline the world had seen since records began being kept. By contrast, the events of 2008 have been largely internal to capital markets. The actual decline in the housing market had been relatively constrained until midsummer, especially given the grossly over-stretched valuations of that market, and if the mortgage banks had not been so levered, would not have required them to withdraw credit to such a degree as to exacerbate the decline and increase the number of repossessions.
If this market crisis does spread to the rest of the economy and does cause a prolonged downturn or worse, much of the blame will attach to those who should have been paying more attention to the risks being taken by the financial services industry: the senior executives and directors of the banks and investment funds which made it happen. At bottom, this is a failure of governance: the failure of those who had no need to gamble with their firms to rein in those who had too much incentive in being reckless. Those who were charged with the responsibility of protecting their franchises, their shareholders, and their employees, should have regarded each new innovation in industry practice which raised leverage with a wary eye, and not allocated more capital to it than they could afford to lose. The sellers of snake oil have every reason to be ashamed. But so do the buyers, who cheered them on, bought their products, bought their shares, insisted upon unsustainable rates of growth, and then based their own investment strategies upon products whose viability and sustainability had never been tested.
Permalink
09.18.08
Posted in Blog at 3:26 pm by Andrew Clearfield
Self-preservation instincts are usually a good thing to have. The survival of any species usually depends upon the survival of individuals, which is why we have such instincts in the first place. But occasionally, the instinct actually gets in the way of survival. Panic responses—e.g., thrashing wildly when in fear of drowning—are an obvious case in point. But there are subtler ones. Consider the instinct many have to overeat. Biologically, one is storing up fat as a hedge against periods of famine in the future. But in our almost famine-less world it only leads to sluggishness, a decline in the ability to exercise, a decline in physical attractiveness and ability to mate, and ultimately to heart disease and premature death. Businessmen’s perpetual search for insurance to repeal the law of Risk and Return may be a comparable instance of an ultimately destructive instinct.
Almost every human wants to be able to foresee the future. But a future clearly foreseeable to all carries no positive benefits: everyone knows exactly what all courses of action are worth. This is why anyone engaged in a speculative transaction will pay so much for an informational asymmetry, and why regulators of business activity move so firmly to try to close all such asymmetries down. Investors—especially savvy, professional institutional investors—know that they need to ratchet up the risk component of their portfolios in order to get satisfactory returns. But the survival instinct keeps whispering in their ears that they need an escape in case of trouble, a safer, more bomb-proof shelter in which they can wait out any storm. The obvious solution is to lower one’s risks to the level one can afford. Yet many will continue to search for the Philosopher’s Stone which will render every risk harmless, without much impacting return. In the process, they buy a lot of snake oil. The latest such product is credit-default swaps. When an individual relies upon a defective product such as a parachute which fails, the individual dies. When a whole industry relies upon a defective product in the same kind of situation, an industry can be annihilated. This week, the securities industry is looking at something uncomfortably close to annihilation.
Credit-default swaps were supposed to be a kind of insurance for fixed-income investors. Since bonds are already supposed to be low-risk, why was there a demand for this kind of insurance? Because the investments the investors were buying were actually high-risk. Why were they high-risk? Because the sophisticated statistical wizardry of the mathematicians who constructed the collateralized debt obligations could not diversify away the systematic risk of the mortgage market which was ultimately being financed, nor (unlike traditional bonds) was there a regulated market in these instruments to price that risk into them: if the the housing market were to suffer a broad-based decline, then further protection was needed. So far, so good. As long as the buyers of insurance are not deceiving themselves about what risks they are running and how much they are paying for a particular amount of protection, fine.
The problem was that everyone wanted to believe, not that they had some downside protection, but that there was no risk left at all. Thus, by insuring a BB instrument with a AAA counterparty, the investors then wanted to believe that they actually held AAA instruments, and that they could pile up more leverage on them, and lend still more money to the ever-expanding mortgage market, booking still higher returns, without providing for the actual risks they were running. (The credit rating agencies’ assessment of the risks on this paper were all too high as well, but that is another story.) All of the market participants, busily trading each others’ derivatives, were trusting each others’ high corporate credit ratings, without regard for the fact that at the bottom of this inverted pyramid there were some extremely risky loans, and a great deal of inherent leverage to the economy. To make it worse, they had all levered themselves up to the hilt, to maximize profits in what is otherwise a form of investment with thin margins, hence the emphasis upon ratings in the first place. The credit rating agencies were not paying any attention to this pyramiding of risk either, which kept the ratings of those on the other side of these transactions at unrealistic levels. The housing market had to continue to rise forever, or the process would suddenly go into reverse. Now, many individuals can insure themselves against uncorrelated events of moderate or even high probability (a fire, an auto accident, their own death), and a few individuals might, if they so choose, find someone willing to insure them against an event of low probability which would also correlate with other disastrous events (an earthquake, a war), but a large number of individuals cannot insure themselves against strongly correlated events of even low probability—especially when the potential losses cannot be quantified. The event bondholders were insuring themselves against was—whether they realized it or not—any significant break in the housing market. But the correlated event was the collapse of the market upon which that insurance depended.
Any investor can tell you that trees don’t grow to the sky, but the holders of CDSs believed they had found a way to ignore that dismal fact and stay in the game to the end—they were insured. No one asked himself what might happen if the market ceased to be continuous, counterparties disappeared, and they had to mark their paper down to a fraction of its face value. Without an orderly, regulated market in fact, this was almost certain to occur. But no one wanted to miss out on the huge profits others were making, and hey, the paper was insured. Well, if one can get huge returns without risk, why, let the good times roll, and don’t worry if an activity you don’t quite understand has suddenly become four or five times the size of all your other businesses combined.
The problem was further exacerbated when regulators believed that banks had effectively insured their risks through derivatives. Instead of allowing a certain amount of capital to run quantifiable (if inherently unknown) risk, now the banks were allowed to have an unknown amount of capital to be running unquantifiable (and still unknown) risks. The huge increase in leverage which has brought down Bear Stearns, Lehman Brothers, AIG, and more than 30 banks was a direct result of the hidden leverage in piles of overlapping derivatives. In hindsight, we all know that the banks, their shareholders, all their employees (except perhaps any derivatives traders who immediately transferred their huge bonuses into gold in Swiss bank vaults), insurers, regulators, capital markets, and the general public, would all have been better off if the banks and other holders of debt securities had not sought to insure them.
The moral: you cannot insure what you do not fully understand. This, at least, should temper the process of financial innovation going forward.
Permalink
09.16.08
Posted in Blog at 6:30 pm by Andrew Clearfield
It is dangerous to draw conclusions before the dust has settled from an event. In fact, it may be dangerous to draw conclusions before the dust has settled for many years upon an event. However, since Investment Initiatives is more useful to its clients if it can help them in the foreseeable future rather than in the distant past, I will hazard that the destruction of Lehman Brothers Holdings has underscored the following eternal verities, and that investors may draw upon them to try to avoid getting trapped in a re-run at some future date. Boards and other interested parties (do you hear this Federal Government? No?) may do likewise.
1. The man or woman who has built up a great organization is rarely the one to save it in a real crisis. It is too difficult to perform surgery on one’s own ‘baby.’ Boards must take note, and be prepared to act accordingly when the proper steps do not seem to be taken, and before the situation is a matter of life or death.
2. Traders (and ex-traders) are dangerous to have as key decision-makers in a real emergency. They will always remember the time they saved their own skins and those of their employers by doubling down in a crisis. They survived then because otherwise they wouldn’t be where they are now. But if they do the same thing again, the odds may catch up with them.
3. Large, bureaucratic institutions, like giant ships, will always find it more difficult to change course. It takes more time, requires more maneuvering space, more specialized teams must be consulted, there must be ‘buy-in’ from many more individuals, the whole maneuver must be coordinated, there is more chance that some subgroup will refuse to respond, or respond more slowly, etc. Making the group more flexible by decentralizing management may make the vessel more flexible in skirting small obstacles, and making it larger might make it more seaworthy in a heavy storm. But none of these will save it from sinking if it runs onto the rocks. Lehman’s risk managers had decided that the bank was over-committed to mortgage-backed securities in early 2007. But the mortgage traders and underwriters kept piling it on—that was their job, and they didn’t want to forgo any profits that were there for the taking, no matter what the guys up on the bridge were screaming. Short of military discipline (and even then there are problems) there is no easy way to make a large organization adequately responsive to a change in direction in an emergency.
4. Businesses, like biological individuals, have a life cycle. It may be lengthened, and sometimes the business may transform itself enough that what amounts to a new being may gain a new lease on life and another cycle. But sooner or later, the environment which spawned the business will change too radically, and the business begin to die. Worse, before that time, the business may contract a fatal illness. For this reason alone, it is a poor strategy to encourage businesses to become so large that their death would endanger the whole economy. If a business is ‘too big to fail,’ an economy is irrevocably committed to spend its resources upon life-support operations. “Small” may not only be “beautiful” as Schumpeter wrote, it may be necessary for the long-term health of an economy.
5. On the other hand, a business which has not reached the terminal phase may survive even if its conglomerated parent dies. According to early news releases, Barclays Bank is interested in the historic core of Lehman—stock broking, equity trading, and corporate finance—and buy it to get an instant access to U.S. markets. It would be ironic if the ‘old’ Lehman Brothers outlives all the jazzy new businesses they diversified into as a result of the breakdown of the barriers between Wall Street and commercial banking, and all of the exciting new products which have been invented in the last 25 years. Lehman had diversified into many new lines of business which all required more capital than its historic business did. Ultimately, it could not weather a crisis brought on by its being more extended than it could afford to be, given its size.
6. The effect of leverage is symmetrical. Creditworthiness isn’t. Lehman wasn’t making record profits in 2004, 2005, and 2006 because they had created a form of transaction no one else had thought of or could imitate; they were getting a higher return because they were running higher risks. When the mortgage market started to go down rather than up, their profits on hugely levered inventory turned into losses. Unfortunately for them, they couldn’t claim back the profits from past years in order to cover their losses in the current one, or to satisfy the banks that they were no worse off than before they started.
7. Things are better if you are making money at what you naturally do best than they are if your source of profits is what somebody else naturally does better. In the latter situation, you are squeezing more stable and secure competitors, either because your own historic business is no longer profitable enough, or because a restless management is looking for new worlds to conquer. This is an unstable situation: either a more inherently stable competitor will eventually come back to crush you, or the exogenous risks you are running will do the job for him. In any case, a board should decline the invitation to commit more resources to the new business than it can afford to lose, no matter how profitable the activity may be in the short term. They are playing on someone else’s turf, and eventually will have to retreat.
8. Market interventionists love universal banks, because they are so much easier to regulate and control, and because they can get their hands on so much more capital. Given the effects of #3 and #4 above, this impulse should be resisted in the regulatory backlash which will inevitably follow the high-profile events of the past weekend. Risk is still risk, oversized organizations are even more oversized if they get larger, and a market mechanism is not better served by requiring participants to be groups which are better equipped to introduce political forces to attempt to tilt the odds more in their own favor. This is what got Fannie Mae and Freddie Mac into the mess that they are now in.
Permalink