It is now well known that on a certain day in March 2009, the Queen of England asked her advisors a deceptively simple question: “Why did no one foresee all this?” By no one, she meant no one in any position of financial responsibility throughout the entire developed world. By all this, she meant the roughly 36 months period from the summer of 2006 through the summer of 2009; this started in the summer of 2006, when the housing market in the US began to crack nationwide, included the year 2008 when the entire global financial system nearly seized up after the bankruptcies of both Bear Stearns and Lehman Brothers, and ended in the twelve months from summer 2008 through summer of 2009 when the world experienced the most rapid decline in economic activity since the 1930s.
The causes of this massive contraction in world financial markets and economies are many. In no particular order, they include:
- Failure of regulation of the banking system, both from there being too little regulation and what regulation there was being ignored.
- Failure to understand the risks of too much leverage in the financial system.
- Failure of very poorly designed incentive and compensation schemes.
- Failure of underestimating the risks caused by new and untried financial instruments such as derivatives.
- Failure of the credit rating agencies to perform their jobs.
- Failure of underestimating liquidity risks in the worldwide banking system.
- Failure to understand the depths of the interrelationships and dependencies of every major bank with every other.
- Failure of each major school of economic thought, by either ignoring the financial system or believing that it would perfectly regulate itself.
The story of The Big Short is that of the very few serious investors who understood what was happening to the US housing market in the early 2000s. It is a wonderfully engaging book, describing each of the characters in not to be forgotten detail, which has been made into an equally wonderfully engaging movie. The remarkable thing is that these four investors, in different places around the country, saw what was going to happen to the housing market with almost perfect clarity, except for knowing exactly when it would happen. The wonder is that there was a total lack of that understanding in the Federal Reserve, the SEC, the Department of the Treasury, and among all major banks. The 4 individuals featured in The Big Short are idiosyncratic iconoclasts; two are loud and foul mouthed Wall Street types, total cynics with a fundamental distrust of anything that smacks of establishment thinking. Two are quiet and serious people, one a doctor with Asperger’s Syndrome, one a reserved hedge fund manager with an eye for the truth. Their case for a totally unsustainable bubble in the US housing market, which would of necessity implode and cause serious damage, seem now to be obvious because we have access to and can study the figures for housing prices, housing demand and how much mortgage credit went to people with very poor credit histories. Back then, these same figures were available if one took the time and had the drive to find them. The Fed certainly had these figures, for example. The key facts were:
- In the 4 year period between the end of 1998 and the end of 2002, house prices jumped over 50% in many metropolitan areas, way faster than any rise in incomes
- While the long term ratio of median home prices to median family incomes had been quite steady from 1980 to the late 1990s at about 3 to 1, it jumped to 3.6 by the end of 2002 and an astonishing 4.6 by 2006; many areas in CA, AZ, NV, and FL were priced at 8 to 10 times median incomes, figures never or very rarely seen before in US history
- Both the Clinton and the George W. Bush administrations pushed the expansion of home ownership to people formerly shut out from the credit markets with Congress willingly going along; as a result, both Fannie Mae and Freddie Mac starting around 2002 began to lower their high credit standards to accommodate sub-prime credits, in order to compete with aggressive mortgage brokers which had introduced the concept of advancing loans to people with dubious credit histories
- The Fed maintained throughout all this an almost astonishing easy money policy and as a result mortgages were readily available at yields under 6%
- Under the FICO (Fair Isaac Company) credit scoring standards, any score below the mid 600s was substandard or in the mortgage language “sub prime”; subprime mortgage lending reached $213 billion in 2002, and then it exploded off the charts, with the issuance of $1.7 trillion in sub prime between 2004 and 2006. The number of subprime mortgages went from 624,000 in 2001 to almost 3.5 million in 2005, a rise of over 450%.
There were two crucial beliefs that fueled this rise in poor credit lending. These beliefs became embedded in mainstream economic thought decades before the fateful years of 2006-09. First, since home prices since 1950 had never turned down on a national basis, the belief arose that home prices were impervious to regular supply and demand cycles, and that they could only go up. The fact that in the depths of the 1930s home prices fell steadily for several years in a row and that over half of all mortgages failed at the peak of the Depression was totally forgotten. Second, the belief was that rational risk takers in the financial markets could be trusted to ensure that their risks were well measured and controlled, far better than government regulators. Alan Greenspan, chairman of the Federal Reserve, was sure that the major banks had the resources, the intelligence and the will to self regulate risks far better than any government authority. So, the conventional wisdom was that home prices nationally would never decline in any serious way and, that financial markets should be trusted to regulate themselves. Also, the conventional wisdom was that economists should study first and foremost how to prevent depressions, how to keep output up, and how to prevent either deflation or inflation. Economic text books written since the 1950s paid relatively little attention to our financial system. It was assumed that the financial system was just there to grease the way towards full employment. However, there was one economist, named Hyman Minsky (probably the best economist few people have never heard of), who published in 1986 a book about the inherent instability of our financial system. Minsky saw that low risk tolerance inevitably gave way to greater risk taking as obvious investment opportunities dried up and that in turn led equally inevitably to even more risk taking into very chancy investments, and that led then to a financial crisis. He made the case that markets indeed had to take risk, but that government had a crucial role in limiting the amount of risk taken through sensible regulation. This view is not at all different from that of Keynes, who warned against financial speculation, or even that of Adam Smith, the foremost advocate of free markets, whose study of Scottish banks led him to endorse a measure of government intervention as to any financial system. But the warnings of these economic philosophers were ignored in the main in the second half of the 20th century, with the exception of Hyman Minsky.
Three quick stories:
- In 2003, the economist Robert Lucas, head of the school of rational expectations and a professor at the University of Chicago, could confidently address the leaders of the economics profession by claiming that not only had economics discovered how to avoid any semblance of a depression but that this lesson was learned decades ago (only 3 ½ years later we came perilously close to a worldwide depression )
- In 2006, Ben Bernanke, who had recently succeed Alan Greenspan as President of the Federal Reserve, declared that the decline in prices in the US housing market, first noted that summer, was “likely to be well contained”. This was only a year before the extent and severity of the drop in home prices in the US approached that of the initial year of The Great Depression.
- In the fall of 2009, a much chastened Alan Greenspan, former chairman of the Federal Reserve, testified before Congress stating, for the first time ever, that he was wrong, that he had mistakenly assumed that rational self interest would prevent banks from taking outsized risks.
Then adding fuel to the fire of badly mistaken beliefs, came innovations in financial instruments that led directly to the subprime mortgage bust. These instruments were invented only after the advent of technology in the 1960s and 1970s changed forever the culture, the profitability and balance sheets of Wall Street firms. Prior to the advent of the big IBM mainframe computer, accounting and trading systems on Wall Street were archaic by today’s standards. The big Wall Street firms principally made money through underwriting of corporate or government securities. When a new issue was planned, of either a bond or a stock, Wall Street would distribute it to its customers taking a very nice fee in the process. Every Wall Street firm at that time was a partnership, with the partners’ own capital on the line, in case the deal went wrong. However, when the IBM 360 mainframe computer arrived, there were amazing cost savings in terms of both trading and record keeping. Suddenly, trading became the single most profitable business, not underwriting. But with the advent of trading as the most profitable part of any Wall Street firm came the need for more capital, in order to finance the trading book, as it’s called, of a brokerage firm. With the need for more capital came the realization that the public could supply it, as opposed just to the partners. So every Wall Street firm, in the space of a few years from the late 1960s to the early 1970s, became publicly owned and abandoned the partnership form. With public ownership, there was no need to place only the partners’ capital at risk, as that risk could be mostly foisted on the shareholders. Then, the leadership of each firm passed from the patriarchal type who ran underwriting to the short term traders. No longer did Wall Street have to take a long term view and butter up corporate clients so as to be in line for an underwriting of a new issue a year or more out; emphasis shifted to what trades can you do today. A legend who ran Salomon Brothers at that time was John Gutfreund. Gutfreund died two months ago and was memorialized as the man who took Salomon Brothers public and who shifted its emphasis to trading, particularly in mortgage bonds. He was also memorialized in Michael Lewis’ earlier book, Liars’s Poker. He was very tough minded, only interested in making money in the very short term, and very opinionated. He exemplified the immense shift in Wall Street culture that took place in the 1960s and 1970s.
As the culture of Wall Street became one of very short term trading results, Wall Street hired more and more traders and then looked for new instruments that they could sell to customers.
One of those new instruments was the mortgage backed bond. Then followed the CDO (collateralized debt obligation) which was an amalgamation of many mortgage bonds. Wall Street types invented ways to pool all sorts of low credit loans into huge CDOs and then persuade rating agencies that, since recent history showed that statistically no more than 15-20% of even bad credits would fail in an economic downturn, if you placed the first 15-20% of defaults into one tranche of a CDO (which might be rated B or even CCC) the remaining 80-85% of the loans could be called triple A! It was magic. Just take recent history and allocate CDOs as if that history could never change going forward, and you could create a very high quality security (AAA) out of junk.
At this point, let me interject a couple of facts which relate to the firm for which I was a partner for many years, Wellington Management. One of my Wellington partners back in the 1970s persuaded Vanguard to issue a Ginnie Mae Fund, the first of its kind in the country. This fund bought government guaranteed mortgages, of high quality, and packaged them into a mutual fund which gave investors a decent premium yield vs. Treasuries. It was a huge success and it still is one of Vanguard’s largest funds today. In addition, Wellington also sponsored the first non-government mortgage bond fund, also restricted only to high quality loans. Then, Wall Street, seeing the success of these products, took the ball and turned them into lower quality, finally really low quality, products which were sold for their supposedly attractive yield with no regard to risk. I am proud to say that Wellington refused a number of opportunities to manage these poor quality mortgage products, and the firm restricted itself only to those mortgages which in the opinion of the firm’s partners could stand up to rigorous quality standards. On top of that, a credit analyst named David Burt, joined the hedge fund started by Charlie Ledley in 2006 (one of the four investors described in The Big Short). He had invented a system of analyzing and describing, as to quality, how any mortgage pool worked. He now works as an analyst at Wellington. He has told me of his surprise that Ledley and his partner had really zeroed in on very poor quality mortgages and that their bets against these mortgages seemed very smart. Burt was the ideal partner for Charlie Ledley; Ledley had the concept that subprime mortgages were going to fail in spectacular numbers, and Burt did the detailed analytical work to justify their hedge fund bets against those mortgages. Burt in turn has placed much of the blame for what Wall Street did on perverted incentive compensation schemes which enabled so-called experts to create pools of mortgages, to be sold to an unsuspecting public, on the basis not of the quality of the bonds but of the amount of bonds they could sell. No incentive at all for Wall Street to avoid risk and stress quality, but all the incentive in the world to package as much junk as possible into mortgage pools, called CDOs, and foist them on gullible investors.
So quality was not on very many minds in the early 2000s. This is what the 4 investors in The Big Short focused on like a laser. They could research the underlying quality of the mortgages in a typical CDO (a process which took a lot of time and research but the prospectus of each CDO had that data buried inside its many pages). For example, Dr. Michael Berry, one of these four investors, who ran a hedge fund in San Diego, had the determination to wade through countless pages of a prospectus and researching each individual mortgage listed in a CDO pool. Practically no one else wanted to do this mind numbing work. So virtually everybody trusted the rating agencies, to have done that work for them. A totally mistaken belief! There are three principal rating agencies: Moody’s, Standard & Poors, and Fitch. The fatal flaw came in the compensation system for the rating agencies. They were paid by the issuer of the CDO, not by a potential purchaser. The issuers, of course, were the Wall Street firms which packaged these deals. Another example of a perverted conflict of interest! Let’s say that you are Moody’s and you’ve been asked by Goldman Sachs to rate a CDO AAA, or top quality; if you demur, Goldman can go next door to your competitor and almost certainly receive the coveted AAA rating desired. Why was AAA so important? Because certain very large purchasers of bond like products were restricted to instruments only rated AAA. These purchasers were typically pension funds, other retirement pools, and foreign banks (which were allowed to put up very little capital as against any AAA security on their books). So the fiction that pools of subprime mortgages could be rated AAA by the alchemy of restricting their losses only after the first 15-20% were absorbed elsewhere produced an enormous demand. The Big Short has a couple of chapters about one or more of their investors visiting conventions of mortgage buyers either in Florida or in Las Vegas, finding out for example that a stripper in Vegas was allowed by a local bank to buy 7 houses totally on credit; these loans were then packaged into a CDO, rated AAA by one of the agencies, and then the debt sold to a mysterious buyer. It turned out that the buyer was in turn packaging many of these so-called AAA securities into massive CDOS which he would sell to the gullible foreign bank or pension fund. It was a fraud of massive proportions!
Banks, in particular, raced to create these issues and initially sold them into the marketplace; but then old fashioned greed took over. The banks themselves decided to keep on their own balance sheets increasing large quantities of the supposedly AAA securities as they needed to show the regulators only that they had a small capital commitment against possible loss. The banks got greedy; they, just in the last couple of years before the financial crisis, drank their own KoolAid, and kept on their balance sheets huge amounts of really bad mortgage pools, and levered up their balance sheets in order to do so. By lever up, I mean that the banks borrowed a lot of money, against a small amount of equity capital, because they thought these lousy CDOs would be money good. Again, they trusted in the fact that since 1950 nationwide housing prices had never declined. Thus not only did you have perverse incentive compensation as a cause of the financial crisis, you also had old fashioned greed on top of that. As a result, by 2007, every major Wall Street bank was levered at least 30 to 1; that is, they had borrowed more than 30x the amount of their equity capital. That meant that a sudden drop of only 3% in value of their entire book of assets would be sufficient to bankrupt them
The Big Short’s 4 investors salivated over the opportunity to profit from what they “knew” to be a way over priced market ruled by greed and stupidity. In 2003, some of them searched for a sure fire way to gain from a blowup in these CDOs. They noticed that JP Morgan in the 1990s had invented a financial instrument called the credit default swap and they had a “Eureka” moment. A credit default swap is very similar to an insurance policy on a house; for an annual premium, you can buy protection against there being a disaster, in this case, a sharp fall in the price of the underlying security. But insurance products are regulated; an insurance company must prove it has adequate reserves against loss on its balance sheet. However, credit default swaps existed in a regulatory no man’s land. Neither the Federal Reserve, nor the SEC, nor any other regulatory agency claimed them as their responsibility. To her everlasting credit, Brooksley Born, who in 1999 was the head of the CFTC (Commodities Future Trading Commission) wanted to regulate credit default swaps since they were similar to derivatives instruments which her agency was supposed to regulate. However, Larry Summers, then Treasury Secretary, who was under the spell of “let the market self regulate” went to Congress and got them to pass a law forbidding regulation by the CFTC of credit default swaps. A disastrous decision but far from the only one by Government officials at that time.
Still under the sway of let the market self regulate, an unholy trinity of Alan Greenspan, Bob Rubin (former Treasury Secretary) and Larry Summers persuaded Bill Clinton to sign a bill in 1999 abolishing the Glass-Steagall legislation passed in the aftermath of the Great Depression. Glass-Steagall split the deposit taking and lending functions of a bank from its more speculative activities of investment banking and securities trading. The theory, and it is still a good theory today, is that if these activities are split, it will be both easier for regulators to examine each entities’ books and easier to protect the deposit taking/lending part of a bank. One way of trying to do away with the risk of too big to fail! But with the repeal of Glass-Steagall, there were no serious restrictions on the ability of any bank to enter any business or to lever up its balance sheet, despite what the quality or lack thereof of its underlying assets might be.
Then, the final failure (and it was a really big one) was the failure to understand the depth of the interrelationships between all the various global banks. No one had a clear picture of how much one bank owed to another, for example; but it was the case that one bank, say Goldman Sachs, would own large amounts of credit default swaps issued by another bank. This creates what is called counterparty risk. That is, if one bank is owed a lot of money by another through obligations such as credit default swaps, and if the bank which owes the money cannot pay, because it had far too little in the way of reserves on its balance sheet against those risks, then the bank which is owed the money in in equally great risk of failure. The world’s financial system was a house of cards. Take one key card out and the entire edifice could collapse. This is why the Federal Reserve in September of 2008, the same week in which Lehman Brothers was allowed to go bankrupt, had to rescue American International Group (an insurance company!) because AIG had well over $60-70 billion of credit default swaps which they had issued, and which were mainly owned by the likes of Goldman Sachs, and against which they had virtually no reserves. Had AIG not been rescued, the failure to pay off those obligations could have doomed not only Goldman Sachs but other major banking houses.
An interesting sidelight to the Goldman Sachs role in the credit default swap mess is this. By the end of 2006 and very early part of 2007, it was absolutely clear that housing prices were crashing all over the US. Yet the prices quoted by Goldman or other banks for the credit default swaps they issued and sold to the guys in The Big Short stayed very stable. These instruments were not listed on any exchange and the sole pricing source was the underwriting bank itself. Despite all the protestations of The Big Short guys (who asserted very reasonably that these should have been marked way down, reflecting home prices, to the benefit of any investor short these instruments), the brokers refused to budge for several months. It turned out that Goldman, about the end of 2006, also saw what was happening and quietly began to assemble a very large portfolio, for the bank itself, of credit default swaps, primarily issued by AIG. When the bank finally thought they had bought enough credit default swaps to protect themselves, they suddenly began, around May of 2007, to drop their quoted price, to reflect reality, much to the relief and delight of The Big Short guys, who suddenly found out that they had made a very great deal of money.
The guys in The Big Short also understood counterparty risk. By late fall of 2008, they had all made many millions of dollars betting against sub prime pools of mortgages, but they knew that a particular bank, whichever had issued the credit default swap, had to have the resources to pay off. Therefore, all of them began to sell back to some one bank or another the same credit default swaps, to ensure that they got paid. They did not care to take the risk of waiting any longer; they wanted their money now and they got it. Charlie Ledley’s partner, in one very funny story, gets on a cell phone in Cornwall, England, and unwinds that firm’s default swaps in the middle of typical pub talk. Sadly, Michael Berry, the doctor in San Diego, who also made many millions of dollars for his investors, those same investors who in the year prior to the crack in the US housing market wanted out of his fund but were restricted from doing so, wound up his extraordinarily successful fund, turned the money over to his investors, and got very little in the way of acknowledgement from them for the fantastically profitable bet he had made.
So the heroes, if you want to call them that, named in The Big Short all got quite rich. Others in the hedge fund industry did too, none more spectacularly that John Paulson in New York who made over $4 billion in 2008 alone, all from shorting credit default swaps on mortgages. Yet the irony is that, as far as The Big Short guys were concerned, their investors did not credit them with the extraordinary intelligence and foresight which they demonstrated.
What did the world learn after these events? What did we as a society learn about what to do and what not to do?
First, we learned or should have learned that Hyman Minsky was right. The financial system of a capitalistic society is inherently unstable; in order to take sufficient risk to underwrite entrepreneurs and to start new businesses, the financial system must take chances. But the financial system must be adequately regulated so that not too much risk is taken; government has a crucial role in taming the inherent tendencies of our financial system towards instability. Getting rid of Glass-Steagall was a mistake. Even more mistaken was the belief that markets can self-regulate. Incentive systems, as presently constituted, unfortunately, do not lead to self-regulation being at all effective. We also learned that leverage in a banking system really matters and that in 2008 we had far too much leverage in virtually all of our banks. We learned that government regulators were asleep at the switch in the years 2003-2006. We learned that the world’s financial system is so interrelated that if one important bank fails, others may well fail too.
In an effort to put teeth into these lessons, we passed the Dodd-Frank legislation. In some instances, Dodd-Frank has been successful. For example, the typical leverage in the banking system now is about 10 or 12 to 1, as opposed to over 30 to 1 in 2008. No one can tell you what is the exact best leverage ratio; there has to be enough leverage in the system in order to attract risk capital but there should never be so much leverage that a relatively small fall in asset prices could destroy the capital of a bank. All we know now is that the system is far better capitalized than eight years ago, and that current leverage ratios are more or less in line with the bulk of banking practice up until the late 1990s or early 2000s. Dodd-Frank has also been responsible for the introduction, on the part of monetary regulatory bodies, of plans to change Wall Street compensation systems. Finally, a claw back provision is going to be necessary whereby a bank can grant a large bonus for very good trading results in one year but that bonus can only be paid out over at least 4-5 years, and the bank has the ability to claw back a portion of the bonus if future trading results are unprofitable. But Dodd-Frank, to my regret, has only partially solved the problems of lack of transparency and lack of regulation in credit default swaps. Also, the doctrine of “too big to fail” is still being hashed out; the regulators are trying to get major banks to create what are referred as living wills, which would be a blueprint of winding down a bank without public money being forced to rescue it. To date, these regulations are still a matter of contention between the regulators and the banks, and no final decision has been made.
So Dodd-Frank was a step in the right direction, but we know that it did not change the fundamental lack of long-term stability in the financial system. Minsky is still right. The system itself, perverse as it may sound, must maintain a risk taking culture in order to invest in new and potentially very risky ventures. However, government must regulate the amount of risk taken so that, when the next big crisis hits, it will not shake the system to its very foundations. Minsky wrote in his seminal book, Stabilizing an Unstable Economy as follows: “The Wall Streets of the world are important; they generate destabilizing forces, and from time to time the financial processes of our economy lead to serious threats of financial and economic instability, that is, the behavior of the economy becomes incoherent.”
The world will have other financial crises in the future. Who now knows when the next crisis will happen or what will be its cause? We have to hope that we have learned enough to prevent the next crisis from being anywhere near as large or as threatening as that of 2007-09.
Let me end with a quote from Adair Turner, who in 2008 was head of the FSA in Great Britain, the prime regulatory body of that country. In 2010, Lord Turner wrote:
“We need to recognize, as Adam Smith did, that humans are part rational and part instinctive. We need to accept that the economist must, as Keynes said, be ‘mathematician, historian, statesman, and philosopher in some degree’. We need to understand that there are probably few genuinely deep and therefore stable parameters or relationships in economics as distinct from the physical sciences. Good economics is never going to provide the apparently certain, simple and complete answers which the pre-crisis conventional wisdom appeared to. “
If indeed we have learned to be much more wary of the financial system, if we have learned from the many failures which caused the crisis of 2006-09, then we will have made considerable progress. If we have not, there will be another book comparable to The Big Short in our future.