Archives for posts with tag: banks

Swimming with Sharks – Joris Luyendijk (2015)

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In the years before the crash, commercial banks and mortgage providers lent far too much money to people who could not afford such debts – primarily in the US and the UK, mostly for mortages. This continued for a long period of time because the easy money drove up houses prices, making many people feel richer than they were. Commercial banks had no reason to worry about the risk of default on loans because they could sell them on to investment banks, which the chopped them up and repackaged them into ever more complex financial products. Assets managers at pension funds were keen to buy them because interest rates were low and these new instruments offered better returns. For protection, pension funds and others relied on American insurance giant AIG. In turn AIG trusted the credit rating agencies’ triple AAA ratings.

In 2007, millions of buyers would not be able to meet their financial obligations. Financial products that contained their mortgages began to lose value. Investors had to take big losses but banks, too, had kept some of these products. They had to write off huge sums but how much was difficult to estimate: not only some of the products where mind-bogglingly difficult to value but the same was true for the ‘vehicles’ in off-shore tax havens where banks had placed many of them. At Leman Brothers the buffers were not enough and the bank had to announce bankruptcy. Other banks and financial institutions stopped lending to each others (as none knew the financial solidity of the others). Suddenly the financial world was gripped by a paralysing fear. In response, Governments reached deep into the state coffers and central banks lowered interest rates and pumped unprecedented amounts of newly created money into the economy.  They had saved the system.

For bankers, the crash of 2008 was a perfect storm, or rather a black swam: unique and literally unforeseeable. But isn’t it all the more alarming if virtually nobody in the sector realised how dangerous these complex financial products could be?

The salaries of those who manage the risks in banks has always come from the revenues raised by those taking the risks. Historically, investment bankers worked in small partnership where management and owners partly overlapped. Partners were personally liable. From mid eighties these partnership started to list on the stock exchange or were taken over by publicly listed commercial banks who wanted to take advantage of the deregulation and move into investment banking. Those commercial banks took over dozens of other banks and became ‘too big to fail’.  In listed companies, the risk lies with shareholders rather than partners, while bankers are paid partly in shares and options. And a good way to raise the share price is to take risk (which ultimately the taxpayer will bear).  It was genuinely eye-opening to realise just how recently the investment banks had mutated in this way. Those who take the risks are no longer those who bear them.

If you can be out of the door in five minutes, your horizon becomes five minutes. That was the essence of zero job security. Not only does all loyalty evaporates, but continuity does too. Nobody can built on anyone else, the best can be poached at anytime and meanwhile there are swords of Damocles hanging over everyone’s head.

We need to get rid of the idea of ‘the bank’: that term implies a unity of action and purpose. There is no such a thing.

Perverse incentives: rewards for undesirable actions.

Traditionally there were separate firms for trading, for asset management and for deal making (mergers,listing of new companies etc.) . Since the 80’s, all three activities have been brought under the roof of one bank, through mergers and acquisitions in the financial sector. This is a conflict of interest of the highest order and banks have been asked to set up Chinese wall between their divisions and activities to avoid leaking of information and pressure from one sector to another (e.g. investing in companies whose listing is done by the same bank…)

Corporations can be hit hard by currency fluctuations (with increasing volatility in the 1970’s). So banks invented derivatives that allowed parties to protect themselves. This was a good idea that perform a useful service to the economy and society. But fast forward 20 years and you see the British bank Barings collapse as a result of a rogue trader using advance foreign currency derivatives.  A company or government can go bust, meaning investors lose money. Banks developed an insurance of sort: the Credit Default Swap (CDS). This was a good idea but a good decade later (in 2008) CDS played a crucial role in the financial crisisMortgages are good long term investments for pension funds but as a pension funds you are not going to by individual mortgages. Banks found a way to package those in instruments allowing investment by pension funds. 15 years later, those products would sank Lehman Brothers.

In 2012, a trader at JP Morgan (and his team) run up a 6.2bn loss. The year before, his pay came to 7m. He did not break any law and has never been prosecuted. (Bruno Iksil)

While doing research there are sometimes points at which lines of investigation suddenly coalesce into an insight.

Around 2000, the dot-com scandal revealed fundamental conflicts of interest between activities that used to be done by separate firms; taking company public, trading and asset management. The regulatory response was not to prevent those conflicts, it merely forced the banks to install Chinese wall – policed by their own risk and compliance staff.

Tony Blair is making 2.5M pound a year as adviser to JP Morgan. Hector Sants, chief regulator in 2008, has a top job at Barclays. His estimated compensation was 3M pound a year. The three major credit rating agencies have kept their de-facto cartel; as have the four accountancy firms who continue to do lucrative consultancy jobs for the banks there are meant to audit independently.

After quizzing interviewees on their motives, greed seemed a highly inadequate explanation of their behaviour. I have come to believe that the focus on greed is the biggest mistake outsiders have made in the aftermath of Lehman’s collapse. (The Wolf of Wall Street kept this popular). [The system was to blame in more general term, short termism etc.]

To think that blinkered bankers will one day wake up and decide to change finance from inside is wishful thinking.

Andrew Haldane, number 2 at English central bank told that the balances of the big banks are the blackest of black hole.

Four changes the laws should bring: banks must be chopped up into units so that they are no longer too big to fail; banks should not have activities under one roof that create conflict of interests; banks should not build or sell overly complex financial products, the bonus should land on the same head as the malus.

Political parties, politicians, regulators have come to identify themselves with the financial sector and the people in it. The term is ‘capture’. Politicians started to believe the world works in the way that bankers say it does.

As put by interviewee: The left insists on solidarity across the nation, with higher tax rates for rich people to help their less fortunate countrymen. But this solidarity is predicated on a sense of national belonging, to which the left is allergic; national identity comes with chauvinism and nationalism and creepy right wing supremacists.

Nobody is helped more by cynicism about politics than cynical politicians.

 

 

 

 

 

The Big Short, Michael Lewis, 2010

If you want to know what these Wall Street firms are really worth, take a cold, hard look at these crappy assets they’re holding with borrowed money, and imagine what they’d fetch in a fire sale.

The creation of mortgage bond market (in 1990’s) had extended Wall Street into a place it had never been before: the debts of ordinary citizens.

A mortgage bond was a claim on the cash flows of a pool of thousands of individual home mortgages. The borrowers had the right to pay off any time they pleased. Typically they repaid their loans only when interest rates fell, and they could refinance more cheaply, leaving the owner of a mortgage bond holding a pile of cash to invest at a lower interest: This was the single reason that bond investors initially had been reluctant to invest in home mortgage loans.

The big fear in 1980’s mortgage bond was that bond investor would be repaid too quickly, not that he would fail to be repaid. The pool of loans underlying the mortgage bond conformed to standard: they carried, in effect, government guarantees. If the homeowner defaulted, the government paid off their debt.

In 2000’s the mortage bond was about to be put to new use: making loans that did not qualify for government guarantees. The purpose was to extent credit to less and less creditworthy homeowner so that they could cash out whatever equity they had in the house they already owned. People with first mortgages had vast amount of equity locked up in their houses. If you credit rating was a little worse, you paid a lot more (on your new loans). But if you can mass market the bonds, we can drive the cost down for customers: they can replace high interest credit card debt with lower interest mortgage debt. This new efficiency in the capital markets would allow lower-middle class Americans to pay lower and lower interest rate on their debts. 1990’s saw the first sub-prime mortgage lenders on the market.

The subprime mortgage loan was a cheat. You are basically drawing someone in by telling them:” You’re going to pay off all you other loans – your credit card debt, your auto loans – by taking this one loan. And look at the low rate! But that low rate isn’t the real rate. It’s a teaser rate (which increased only 2 years later – at which time people would expect to refinance their loan with a cheaper loan that they could obtain thanks to the higher value on their house of the market in 2 year time – the (wrong) assumption is house market can only go up.)

 

There was effectively no way for an accountant assigned to audit a giant Wall Street firm to figure out whether it was making money or losing money. One of the many items they failed to disclose was the delinquency rate of the home loans they were making. The accounting rules allowed them to assume the loans would be repaid, and not prematurely. This assumption became the engine of doom.

There were stunningly high delinquency rates in these pools. The interest rate on the loans wasn’t high enough to justify the risk of lending to this particular slice of the American population.

How do you make poor people feel wealthy when wages are stagnant? You give them cheap loans.

All these subprime lending companies were growing so rapidly, and using such goofy accounting, that they could mask the fact that they had no real earnings – just accounting driven ones.  This had the essential feature of a Ponzi scheme: to maintain the fiction they were profitable entreprises, they needed more and more capital to create more and more subprime loans.

Banks avoid free checking because it is really a tax on poor people – in the form of fine for overdrawing their checking account.

30 billion dollars was a big year for subprime lending in the mid 1990’s (and 65% were at fixed rate). In 2000 there had been 130 billion in subprime mortgage lending and 50 billions had been repackage in mortgage bonds. In 2005, 625 billion in subprime loans, of which 507 billion in mortgage bonds. Half a trillion dollars in a single year (75% of those at floating rates).

The rule is simple: don’t make loans to people who can’t repay them. Instead the market learnt a complicated rule: You can keep making loans, just don’t keep them in your books.  Make loans, then sell them off to the fixed income department of big Wall Street investment banks, which will package them into bonds and sell them to investors.  This proved such a it – Wall Street would buy your loans, even if you would not! (This generated demand for the mortgage bond, and encourage lenders to continue lending to lower middle class. Because the house market was considered solid, the bonds were rated AAA so purchase by investors from the US and all around the world)

What you want to watch are the lenders, not the borrowers. Borrowers will always ask more…The lenders have to show restraint. A lot a people couldn’t actually afford to pay their mortgage, so the lenders were dreaming up new instruments to justify handing them new money.  The big Wall Street firm bought the loans, repackaged them into bonds and sold them (pocketing fees on the way).

The rating of rating agencies was considered to be precise measure of risk of default.  A AAA historically has less than 1 in 10,000 chance of defaulting in its first year. A AA rating meant 1 in 1000, a BB 1 in 500 chance of default. Rating agencies claimed the ratings were merely the agencies’ best guess at a rank ordering the risk.

He set out to cherry pick the absolute worst ones: Goldman Sachs emailed him a great long list of crappy mortgage bonds to choose from. It was as if you could buy flood insurance on the house in the valley for the same price as a flood insurance on the house on the mountaintop. (insurance at very low price yet almost sure that the risk will happen. He was paying annually the insurance cost, waiting for the default to happen (and for entire value of the loans to be paid to him by the insurance firm). Goldman Sachs was simply standing between insurance buyer and the insurance seller and taking a cut (although later move into the market as insurer).

 

Alan Greenspan assures us that home prices are not prone to bubbles – or major deflations- on any national scale. This is ridiculous. In 1933 the US found itself in a housing crisis that put houses starts at 10% of  the level of 1925.  Roughly half of the mortgage debt was in default. Houses prices collapsed nationwide by roughly 80%.

Millions of Americans had no ability to repay their mortgages unless their houses rose dramatically n value, which enabled them to borrow even more. This was the pitch in a nutshell: home prices didn’t even have to fall. They merely needed to stop rising at the unprecedented rates they had the previous few years for vast numbers of Americans to default on their home loans.

Lenders were making loans to low income people at a teaser rate when they knew they could not afford to pay the go-to rate. They did this so that when the borrower get to the end of the teaser rate period (2 years usually) they would have to refinance, so lenders can make more money off them.

Chrysler might sell its bonds and simultaneously enter into a ten year interest rate swap transaction with Morgan Stanley – and just like that Chrysler and Morgan Stanley are exposed to each other. Financial risk had been created out of thin air, and it begged to be honestly accounted for or disguised. There was a natural role for a corporation with high credit rating to stand in the middle of swaps and long term options and the other risk-spawning innovations. This required the corporation not to be bank (and thus not subject to bank regulation and the need to reserve capital against risky assets ) and be willing to bury exotic risks on its balance sheet. AIG just got there first and was seen in the early days as if it was being paid to insure events extremely unlikely to occur (ie. default on AAA loans). New imitators came (credit swiss, Zurich re etc.) and allowed to hide risk that otherwise banks could not have ignored.

AIG based its business model on Wall Street Standards: While large number of investment grad companies in different countries and different industries were indeed unlikely to default on their debt at the same time. AIG used a formula for consumer credit risk (loans) that was dreamed up to cope with corporate credit risk. They were insuring much messier piles of loans which included  credit card debt, student loans, auto loans, prime mortgage. As there were many different sort of loans, to different sort of people, the logic that applied to corporate loans seemed to apply to them too. Sufficiently diverse, they were unlikely to go bad at once.

A CDO – Collateralized Debt Obligation – were invented to redistribute the risk of corporate and government bond defaults and was now used to disguise the risk of subprime mortgage loans. The logic is the same: you gather thousands of loans and assume it is unlikely they will all go bad together. Now it would include hundreds of mortgage bonds, usually the riskiest. Those appeared to rating agencies as diversified portfolio of assets and were then rated AAA, even if all of them were risky business!. The rating agencies were paid fat fees for each deal rated (were in competition with each other for the market – hence unlikely to refuse to rate AAA the CDO proposed). The rating agency did not have their own CDO models and banks would send over their own model. The triple A rating gave everyone an excuse to ignore the risks they were running.

In Bakerfield, California, A Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $724,000.  A baby nurse was able to obtain loans for six townhouses. List of mortgage loans included some where people were lent money without having shown evidence of income or employment: “he sent us a list and none of them had less than 50%”.

Bond market terminology was designed less to convey meaning than to bewilder outsiders. Overprices bonds were not expensive, they were “rich”. Floors of subprime mortgage bonds were not call floor but tranche. The lower tranche was not call ground floor, but mezzanine, although the riskiest…

These bonds (CDO) could then be sold to investors – pension funds, insurance companies (European pension funds, Japanese farmers’ union etc.– which were allowed to invest only in highly rated securities.

The credit default swap were being used to replicate bonds backed by actual home loans. There were not enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. Wall Street needed the bets (credit default swaps) to synthesize more of them.  This is why the losses in the financial system are so much greater than just the subprime loans. Intermediaries (AIG) were paid mainly on volume (hence no incentive to stop. The only reason this worked is because all the bonds were rated AAA – everybody ignored the risks.

AIG could own as much CDO as they wanted as they were not required to keep the capital to cover possible losses (as a bank would have).

When banking stops, credit stops and when credit stops, trade stops, and when trade stops – well the city of Chicago had only eight days of chlorine on hand for its water supply. Hospital ran out of medicine. The entire modern world was premised on the ability to buy now and pay later.

Just as revert to being 9 years old when you go home to visit your parents, you revert to total subordination when you are in the presence of your former CEO…