Capital Markets Musing

I’m getting off topic here since I’m going to jot down a few thoughts that aren’t in keeping with the idea of a new Christian ethic, but I can’t help it. As someone who spent a lot of time structuring CDOs and Credit Default Swaps, I’m pulling my hair out listening to all the opinions and plans about a roadmap to economic normalcy and I have to say something.
Now, here’s my first observation: When it comes to a host of policy issues, there appears to me to be at least two courses of action. There are:

• Politically expedient solutions that will satisfy the citizenry’s desire for blood, but in the end will do nothing to fix the problem, or
• Market-based solutions that can help put our economy on the right track, but will likely cost a politician his or her career to defend and implement

Let me start out by saying our current economic malaise was destined to happen as soon as subprime lending became commonplace. Do you realize that mortgage loans were going to borrowers with FICO scores of 580 and lower, and who had no money for down payments? To understand how crazy this is, consider the following: The likelihood of a 580 borrower to default on some portion of his or her consumer credit within the next 90 days is 50%. Combine that with a lack of equity to mitigate potential loss and we have the perfect combination for a financial powder keg. Who let this happen? In a way, it was caused by some of the same people who are squawking loudest today—people who from their positions on the Senate Finance Committee (you know who they are) were demanding lenders, Fannie Mae and Freddie Mac included, to put more people in homes.

That was a bit of a digression, but the point I wanted to make is that our foreclosure woes were bound to happen as long as there was a lack of prudence in the lending process and regulators were complicit in the boundless stupidity. Accepting those circumstances as given, what was the first big mistake regulators made as the house of cards began to slip? Here’s my suggestion: We should have never let those pesky Bear Stearns hedge funds collapse.

I’ll tell you why in a minute, but imagine what people would have said if the government had stepped in to bailout a bunch of rich bastards who were investing a million dollars at a pop. Holy smoke, the outcry would have woken the dead and led to a slew of congressional committee hearings, where our nation’s leaders would have waxed sanctimonious in their outrage and never gotten around to asking a single enlightened question. Editorials would have been so full of vitriol, newspapers would have combusted in readers’ hands. Average Joes would have taken to kicking dogs just for spite. But saving those hedge funds would have saved us a lot of heartache—not to mention hundreds of billions of dollars in market liquidity. Here’s why.

(For a review of how we got to our financial meltdown, see my earlier blog entitled “Honesty: The First Step to Progress”)

To understand the role the Bear Stearns hedge funds had in driving market liquidity, it’s important to know something about the structure of Collateralized Debt Obligations, or CDOs. Virtually all subprime mortgages were once sold into CDOs, where a kind of financial alchemy was used to turn them into various securities that could be bought by institutional investors. The securities came in various risk classes or tranches. The highest classes—generally rated AAA and perceived to be low risk—were purchased by insurance companies, banks, mutual funds and similar institutions. By comparison, the other classes were more prone to losses and received lower (or no) credit ratings.

The reason why some tranches were more risky than others is that they were placed in a payment hierarchy referred to as subordination. In a typical deal, the lowest subordinated tranche (often called the “hurdle” or equity class) was the first to be hurt by defaults in the mortgage pool. It would take the first losses—reducing its pro forma yield—until it was completely wiped out. At that point, the next higher class would begin absorbing defaults and so on according to the increasing level of seniority. Obviously, the higher in the hierarchy a tranche appeared, the less likely that it would ever suffer a loss.

The role many hedge funds played, including those controlled by Bear Stearns, was as the investor in the hurdle class securities. Now, you won’t get an argument from me that the loan programs the investment bank sponsored were unsustainable. The programs were clearly unsustainable—no question about it—but the point to be made here is that the relatively small investments made by Bear Stearns made huge loan programs possible. When those hedge funds went away, a black hole was created that sucked away $250 billion worth of liquidity and the marketplace couldn’t handle it.

Nothing happened overnight, but that, my friends, was the beginning of the end. When those loan programs went away, the liquidity that had fueled the real estate engine diminished, leading to lower property valuations and higher foreclosure losses. Subsequently, a stampede of mortgage investors exited the marketplace, diminishing liquidity further and closing the first circle in a financial death spiral. What was once an easily surmountable credit problem became a more serious liquidity problem, which subsequently turned into today's seemingly intractable fear problem.

Why didn’t anybody do something? Here is the truly scary part of the historical record. We are far better at explaining quantum mechanics to lay people than we are at describing capital markets dynamics. In fact, universities don’t teach what occurs on Wall Street. The trading floor, rather than the ivory tower, is where financial theories are developed and put into practice. For that reason, regulators have little basis for understanding, much less regulating, the plethora of financial instruments and the technicalities of capital flows. Even if they did, they would make a lot more money on a trading desk, so why stick around?

Now here is the scariest point of all. I’ve worked with many of the Wall Street executives whose names appear regularly in the financial press. A small number are brilliant. John Meriwether, for example, who was the former president of Salomon Brothers, is the smartest man I know, not to mention the most knowledgeable financial guru this side of Pluto. He, however, is an exception to an abysmal rule. Wall Street has undergone unprecedented changes that have resulted in risk management complexities the old guard are unable to fix or fathom.

Prior to joining Lehman Brothers many years ago, I interviewed with all the people who filled, or would subsequently fill, the top jobs at the firm. They included Dick Fuld, the Chairman who would preside over the company’s demise. I remember sitting with a former COO of the firm one day to explain a transaction my team had successfully concluded. The trade was complex, but no more so than those undertaken by hedge funds today. I wish I could tell you differently, but the man clearly didn’t understand the transaction and never would to the day he left. You see, he had started out on Lehman’s commercial paper desk, a place he'd never left until he took management positions elsewhere within the firm. Take my word for it, the commercial paper desk is not the place to learn how to manage risk.

Unfortunately, I suspect many Wall Street firms are similarly led.