IN JANUARY 2007 the world looked almost riskless. At the beginning of that year I gathered my team for an off-site meeting to identify our top five risks for the coming 12 months. We were paid to think about the downsides but it was hard to see where the problems would come from. Four years of falling credit spreads, low interest rates, virtually no defaults in our loan portfolio and historically low volatility levels: it was the most benign risk environment we had seen in 20 years
The possibility that liquidity could suddenly dry up was always a topic high on our list but we could only see more liquidity coming into the market—not going out of it. Institutional investors, hedge funds, private-equity firms and sovereign-wealth funds were all looking to invest in assets. This was why credit spreads were narrowing, especially in emerging markets, and debt-to-earnings ratios on private-equity financings were increasing. “Where is the liquidity crisis supposed to come from?” somebody asked in the meeting. No one could give a good answer.Let me begin with an elementary lesson on financial bubbles. Let us imagine a perfect world where the future was clear and I could tell you all the future payments of an asset to an exact number- let us say $1 per year. And let us say I want my investment to give me 10% a year, and using that rate, I calculate that this asset is worth $10 to me. Now, Joe comes along and offers me $12, and I say sure. That $12 to me today is worth more than the $10 I calculated that asset to be worth. And whether Joe knows it or not, by paying $12 for that asset, he is now accepting a lower return for that asset- 8.3% to be exact. But Joe doesn't deal with things like that. Joe knows Bill will pay him 15 dollars for that, so he immediately flips it, books a very nice gain, and rids the asset to Bill. Bill, being the clueless investor he is, crosses his fingers and waits. And sure enough, Bob (whose financial understanding leaves room for improvement) says, "Look, this asset has already gone from $10 to $15, I'm sure I can dump it for $20." And you know what, maybe he is right.
Unfortunately, something is missed along this way. That is, that ultimately someone has to hold on to that asset, and the money they will get for it is that original income stream- that $1 per year. So "Johnny Ultimate Bagholder", who has seen this great run-up of this asset from $10 to $30 thinks the trend is his friend, and he can make big bucks by buying it today. Unfortunately, he is then stuck with a product making him only 3.3% a year. And although maybe that doesn't sound bad and Johnny can reconcile himself with that fact, the rest of the world can't- they still want their 10%. Reality comes crashing back in, and Johnny now sees a huge loss.
This sound far-fetched? Well, it has happened to us in the last ten years- twice. In 2000 when stocks were trading at 40x earnings (or worse), those stockholders were looking at returns near 2.5% a year on their asset- and that assumed the business would be around forever and competition didn't erode those earnings. And recently during the housing boom, investors flocked into the market on the belief that house prices could only go up. And people actually invested their money in an asset that was generating negative underlying returns, as the cost of interest was well above the money they could make renting the house out. And anyone with just a common understanding of the above financial concept could have seen how this was going to lead to disaster.
So let me return to the original quote:
...but it was hard to see where the problems would come from. Four years of falling credit spreads, low interest rates, virtually no defaults in our loan portfolio and historically low volatility levels: it was the most benign risk environment we had seen in 20 years.
The possibility that liquidity could suddenly dry up was always a topic high on our list...
My problem is these are not ways risk is supposed to be found. Every indicator he mentions there is actually more of a signal of a bubble than anything else, but I am not advocating contrarianism either. What these guys should of been doing was asking if these transactions made sense. Did it make sense for house prices to keep going up when the underlying payment (rent, or working income) could not afford it? Was any actual wealth created when the value attributed to nationwide homes was doubled? Did it make sense to let people subsequently draw money out of their homes to use to spend? The answer to all of these is no. And I regret to say that the harsh reality is that is the only way to do finance. You have to look at what makes sense and make reasonable expectations for the future. And unfortunately, it seems risk managers of banks worldwide have been clueless to that.
My gripe doesn't end there.
Our business and risk strategy was to buy pools of assets, mainly bonds; warehouse them on our own balance-sheet and structure them into CDOs; and finally distribute them to end investors. We were most eager to sell the non-investment-grade tranches, and our risk approvals were conditional on reducing these to zero. We would allow positions of the top-rated AAA and super-senior (even better than AAA) tranches to be held on our own balance-sheet as the default risk was deemed to be well protected by all the lower tranches, which would have to absorb any prior losses.Let me rephrase it another way- "Our business was to pool assets, mainly bonds. We would then split them up into different groups, one which was safe and one which would take heavy losses. We made it a point to make sure our customers would buy the losses. We may not be too good at understanding risk, but you should see our customers. Boy, did we make money off of them!" Nowhere in that statement do I see any ideals of fiduciary duty, of doing whats mutually beneficial for both yourself and the customer. And I hate to break the news to you, but:
That mini-liquidity crisis was to be replayed on a very big scale in the summer of 2007. But we had failed to draw the correct conclusions. As risk managers we should have insisted that all structured tranches, not just the non-investment-grade ones, be sold.THAT is not the right conclusion.