Thursday, November 1, 2007

Who's to blame?

Professor Ed Altman graciously allowed me to attend his Corporate Bankruptcy & Reorganization class at NYU last night. I had taken the course when I attended NYU's graduate business school, but this was a different experience - in a positive way (when I have a chance, I will write about the improvements I observed).

Professor Altman opened the class with a simple question. Who is responsible for the recent problems in the credit markets (this is my attempt to paraphrase, I'm not sure of the exact wording of the question)?

This is a question that has been the subject of much speculation in the blogosphere and in the news. Much of what is being said through those media is, in my opinion, way off base.

The students identified many of the same parties that have been cited elsewhere, but generally with better insight than the public discussion.

They pointed to the regulators, ratings agencies, loan originators, investment banks, etc. We even had a student that had been with a bulge bracket firm point out that, in the summer of 2006, his firm had identified similar issues and aggressively cut back on risk. That shows that, at an individual investor/firm level, losses could be averted.

In my opinion, all of those entities were party to the conditions creating the housing/sub-prime/structured debt bubble - I just don't believe that they were "responsible."

It is true that there were frauds and other improper activities that occurred; many of which would not have been possible without the lax lending environment. I strongly believe, however, that such activities were more the exception than the rule (I believe that this will be eventually borne out by any future investigations).

My statement, in the class, was that the blame falls on an unregulated capitalist system. It is normal for markets to overreact, both positively and negatively.

Not to beat a dead horse, but it comes back to Fear and Greed!

Each party in the process acted in their own interest, as they perceived it at the time. In the case of the consumer real estate market, the momentum of the market led to that special level of fear and greed - Euphoria!

When markets move to extremes, participants are driven by the fear of not taking advantage of the "sure thing," and the desire to make as much money as possible (greed).

Don't get me wrong. I'm a capitalist. I'm not in favor of excessive regulation. I just recognize that manias are part of the price of participating in our economy. There is no acceptable way, in my opinion, to regulate against crowd psychology.

Ultimately, as happened this year, something occurs to prick the bubble. Either too much product (stock, CDOs, oil, etc.) becomes available - overwhelming supply; or demand dries up as the marginal buyer is no longer willing to pay a premium, recognizing, perhaps, that there's no such thing as a free lunch (remember, supply equals demand at equilibrium).

The effect of declining bids is then magnified as parties that used leverage to buy in (or are, like hedge funds, vulnerable to redemptions) are forced to liquidate positions.

In today's market, the biggest problem is opacity.

While hedge funds and proprietary trading desks are always engaged in some form of poker in their trades, usually at least they understand their positions. With all of the CDOs, CLOs, ABCP, etc., most of the parties really don't know what they own.

Because of this lack of clarity, the bid/ask spreads tend to be enormous.

Given that most investors now have to mark their investments to market, this means huge problems. If holders mark their investment to the bid, they would have to report significant losses - whether or not the asset has greater value. If they don't use the bid, then it's hard to justify another measure.

David Einhorn gave an interesting lecture at Columbia a few weeks ago discussing some of the issues specific to this bubble.

Bill Gross, in his November Investment Outlook, also had some interesting insights.

It appears that this situation is going to take a long time to play out.

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Palermo's Blog said...


I agree with most of what you have said, but I disagree in some substantial areas. First, our financial system is a regulated system. It has been for a long time, and there is no avoiding that fact. The banks benefit from substantial backing from the Fed, and to offset these protections they are required to maintain certain capital requirements and asset quality. They had convinced regulators that leveraging off-balance sheet 10-1 was safe, and we now see it is not safe within the current regulatory structure.

Second, the rating agencies got this entire market horribly wrong, notwithstanding strong historical evidence that subprime would default at current rates. The potential conflicts of interest and other issues have been feverishly argued to regulators for a decade, and ignored.

Third, when the politicians have reports generated to point the finger where they want it pointed to lead to recommendations they want to make, I get very angry. I don’t see any other way to interpret to report I address at my blog. It makes no mention of rating agencies, sponsors, or any party involved in the securitization process other than one vague reference to a generic hedge fund. It does point out, however (only in a chart), that over 80% of subprime loans originated in 2005 and 2006 were securitized. Hide the values, hide the accounting, hide the regulators, hide the rating agencies, hide hide hide. (I challenge you to read the Citigroup 10Q last filed and, based on what it says, outline the financial risk to the bank, its shareholders, and the financial system due to off-balance sheet entities it sponsors.)

Finally, the regulators failed to see the big picture. The real estate market in this country became leveraged above any reasonable expectation of its value due to overheated financial markets and nothing was done. Most laypeople in the market thought this was obvious. Now, it's the old "there's gambling at Ricks?!?"

Other than that I agree with you completely.

Lawrence D. Loeb said...


First, I don't know if either of us has the time to persuade the other completely to his point of view.

It takes time to write a quality post and/or comment, and that's a valuable commodity.

While, as a professor at Stony Brook, you might be able to publish something related to this (justifying the time spent professionally), for me this is time away from making money. Of course, it may be that for you as well.

In that case, we may have to agree to disagree on certain points.

That said:

1. When I said "unregulated" I was exaggerating a bit. We have regulated parts of the market, as you observe, the regulation, however, is not overly constraining and allows for innovation.
While I may be wrong, it is my understanding that it was the bank holding companies that engaged in the off-balance sheet financing. In that case, depositor money was not at risk (although shareholder money was). They are subject to less regulation than the banks themselves (see this article. Particularly "On SIVs, Citi is a manager of roughly $80 billion in SIVs. While they do not have liquidity backstops to their SIVs"

2. Yes. The ratings agencies made mistakes. They relied on historical data that ended up not being relevant (primarily because of the bubble nature of home prices).

The conflicts of interest, being well known, are priced into the markets. The participants on the buy side of the mortgage transactions are considered to be sophisticated investors, capable of taking this into consideration.

How to best compensate ratings agencies is a topic for another day. It is a controversial topic and is not as simple as it appears.

3. I don't particularly like the way that Congress reacts to these types of things. I don't think I agree with what you think they should do, but we can agree that, whatever it is, it will be sub-optimal.

4. What exactly are regulators supposed to do in a bubble? It's easy to be critical after the fact, but no one person or entity can reasonably be expected to decide when enough is enough.

When Alan Greenspan merely suggested that the market appeared irrationally exuberant on December 5, 1996, he was pilloried by market players. The Dow Industrial's high for that week was 6,545.56. The NASDAQ's high that week was 1,313.38. The market didn't drop to those levels again until after 9/11 (DJIA 9/23/02, NASDAQ 6/24/02). That's over five years EARLY.

I respect Alan Greenspan immensely, and I didn't have a problem with his statement. He just asked "how do we know when irrational exuberance has unduly escalated asset values."

I wouldn't be comfortable giving any regulator the power to tell us when markets were too high or too low. They have enough problems doing the jobs they ARE trained for. There is no agreed method to do this, so it would never work.

Thank you for your response.

Palermo's Blog said...


“My statement, in the class, was that the blame falls on an unregulated capitalist system. It is normal for markets to overreact, both positively and negatively.” The monetary system is, in fact, regulated. The board of governors of the federal reserve system determines monetary policy and how to implement it. This monetary policy has a very substantial impact on economic activity, including most particularly lending activity. What the FED failed to realize, in my opinion, was that there was excessive liquidity in the system for a long time that led lenders to look for borrowers, ultimately working down the food chain from qualified to unqualified. The moral hazard of the combinaton of the capital markets into this situation amplified the risks. In addition, the FED has been aware of the rating agency risk, and this is a systemic risk, not just a security purchaser risk. No single purchaser is expected to determine the impact of rating agencies on the entire banking system. This is the job of regulators. So the regulatory authority was certainly involved in just how greedy and fearful many people became and the resulting burst. Regulating this type of activity on an aggregate scale is exactly what the FED is supposed to do - balance price stability and growth. It appears they got it wrong and kept their foot on the gas too long, and a lot of the growth that resulted will unwind with the real estate market.

Regarding the Citi Bank vs. Citi Group issue, I give you the following “footnote” from the 2Q 07 10Q on the Bank’s potential exposure to off-balance sheet entities (referred to as VIE or Variable interest Entities). I note that you cannot tell from the notes whether these include SIVs or not, but they do include conduits of various types including multi-seller programs and arbitrage vehicles. The numbers speak for themselves. That is, by the way, $117 billion which exceeds Citi’s tangible net assets by approximately $52 billion and is approximately equal to its total equity capital.

“As mentioned above, the Company may, along with other financial institutions, provide liquidity facilities, such as commercial paper backstop lines of credit to the VIEs. The Company may be a party to derivative contracts with VIEs, may provide loss enhancement in the form of letters of credit and other guarantees to the VIEs, may be the investment manager, and may also have an ownership interest in certain VIEs. Although actual losses are not expected to be material, the Company’s maximum exposure to loss as a result of its involvement with VIEs that are not consolidated was $117 billion and $109 billion at June 30, 2007 and December 31, 2006, respectively. For this purpose, maximum exposure is considered to be the notional amounts of credit lines, guarantees, other credit support, and liquidity facilities, the notional amounts of credit default swaps and certain total return swaps, and the amount invested where Citigroup has an ownership interest in the VIEs. In addition, the Company may be party to other derivative contracts with VIEs.” Pg 67.

The problem here is if the rating agencies got all of those other ratings wrong, what makes us think they got all of these right?

Mark Palermo

Lawrence D. Loeb said...


I, obviously, enjoy our discussions.

That said, I had so much to say in response to your last comment that it required a new post!

I hope you have time to read it all. I spent over an hour writing it!