Recently a distinguished jurist asked me, “How is it possible that the financial industry – the smartest guys out there – did so many stupid things?” In fact, the financial industry is full of people who know perfectly well that they are mediocre, but who nonetheless want to make a great deal of money. So they cheat.
A few months after the energy trading giant Enron filed for bankruptcy in December 2001, I went up to the partners’ dining room at the New York headquarters of Credit Suisse. Enron, which Fortune had named “America’s most innovative company” for six years in a row, turned out to be one of the biggest scams in American history, and several of its senior managers went to prison.
The bank used to offer an excellent free lunch to its managing directors to promote collegiality across divisions. Next to me were a group of investment bankers, and I eavesdropped on their gossip while I ate alone.
“Who was the team captain for the Enron relationship last year?,” one of them asked. Wasn’t it [censored], who arranged the share trust financing?”
“I thought it was [censored], who set up the off-balance sheet financing through the holding company subsidiaries,” said another.
“No, it had to be [censored], who did all the derivatives trades with offshore entities,” offered a third.
“What you’re telling me,” said the fourth (and most senior) of the group, “is that there wasn’t any team captain for Enron. Everybody was doing their deals without telling anyone else, because they were afraid someone else would take away their business.”
In a nutshell, all the department heads doing business with Enron deliberately occulted their actions from their colleagues and from the management of Credit Suisse, in order to maximize their personal gain at the risk of the bank’s reputation and its customers’ money.
That sort of cupidity and backstabbing helps explain why Enron was able to defraud the public on such a grand scale. It wasn’t just Credit Suisse, which was a minor player in the grand deception. Enron’s creditors sued 11 other banks for abetting Enron’s fraud about its true financial condition; the banks ultimately paid $20 billion in damages.
Only one of the Enron transactions slithered past my desk on the fixed income trading floor, where I ran the bank’s Credit Strategy group: a so-called “share trust” financing. Enron would borrow money by issuing bonds, and if it didn’t have the money to pay the bondholders, it would issue common stock and give it to them.
It might seem obvious that the stock of a company that can’t pay its debt can’t be worth very much; this kind of arrangement used to be known as a death-spiral convertible bond. But the capital market types pitched it with a straight face. We ignored it.
In some ways, the 2008 financial collapse was Enron writ large. The ratings agencies – Moody’s, Standard and Poor’s, and Fitch – agreed that it was inconceivable that more than a third of a pool of subprime mortgages could default. If the banks got one group of investors to accept the first 35% of losses on the pool, the ratings agencies would label the rest of the pool default-proof, and give it a triple-A rating.
The banks then went to the Federal Reserve and asked permission to increase leverage on what the ratings agencies called ultra-safe securities. Normally banks can hold about $12 of loans or securities for every $1 of their own money, but the Fed allowed them to own $70 of the phony subprime triple-A’s for every $1 of shareholders’ capital. Some of those bonds are now trading at 33 cents on the dollar.
That’s one reason the banks had massive losses, but not the only one. Banks (and insurance companies) were writing huge amounts of guarantees on phony triple-A-rated debt, generating up-front fee income in return for turning the banks’ balance sheet into a toxic waste dump.
By the time that Lehman Brothers went under in September 2008, there is no way that its chairman, Dick Fuld, could have calculated the volume of losses for which his bank was on the hook. Every derivatives and structuring desk was taking in all the fees and back-loading all the risk it could, telling the risk managers as little as possible.
What do we want from Wall Street now?
Under the new regime banks have radically reduced proprietary trading, that is, speculating for their own account. The entire business of packaging mortgages or loans into trusts and structuring derivative securities – so-called collateralized debt obligations – has vanished. The banks have radically reduced risk on their books.
Global issuance of collateralized debt obligations by quarter
The volume of ordinary credit-default swaps (insurance contracts on individual corporations or corporate indices) has fallen by half since the crisis (the net total is much smaller because many of these contracts cancel out).
Notional amount of credit-default swaps outstanding
The exotic securities are extinct, except for a shrinking volume of older issues locked away in bank or hedge-fund portfolios, and even the plain-vanilla securities are at half their previous volume.
Banks, meanwhile, are not making any money. They can’t make money. They can’t find earning assets to put on their books. Their share prices languish not too far above the flat-line levels of late 2008. They can’t raise capital. And they have no one to lend to. Federal Reserve policy is ineffective because no matter what the central bank does, the banks won’t take on risk.
We don’t want the banks to bulk up on risk again and threaten the financial system. But we want them to take on risk to promote economic growth. Bank management has no idea what to do, except to hold on to their jobs while the legislature and the regulators decide what they want. The price of bank shares, meanwhile, gyrates wildly, because investors have no way to gauge the risks that might lurk on bank balance sheets.
Central banks have proposed any number of solutions, few of which seem convincing. On October 24, Andrew Haldane of the Bank of England suggested that the problem lay in the incentives offered to bank managers, who would always choose to maximize leverage.
He proposed financing banks with instruments that penalize excessive risk, such as contingent convertible securities (instruments that pay a coupon like debt until bank capital falls below the safety point, at which point they convert into common stock). That sounds like the old death-spiral convertible bonds.
The root of the problem, I believe, lies in the measurement of risk. The incentive to cheat always will be there as long as bankers can represent a sow’s ear as a silk purse. Both managers as well as the public need to measure risk, such that they understand the way that investments or innovations add to or reduce risk.
Some popular finance writers insist that risks are inherently impossible to measure, because conventional risk models based on the normal distribution of returns don’t assign enough weight to the likelihood of extreme outcomes. In fact, the point of risk models is to estimate the likelihood of an extreme outcome, and the banks have reasonably good models of borrower defaults which do just that.
The ratings agencies became the arbiters of risk not because they had good models (they did not) or because they employed particularly skilled analysts, but because they were eminently corruptible. In October 2008, congressional investigators found e-mails from Moody’s credit analysts warning management that they had “sold our soul to the devil for revenue.”
For every Collateralized Debt Obligations, Moody’s and Standard and Poor’s received a fee in the low six figures, and these fees made up the bulk of their revenues. They acted as a adjunct to the investment banks’ structuring teams, advising them on the best way to game their own models.
Why hasn’t the government prosecuted the rating agencies for fraud? Incredibly, the ratings agencies take the position that their ratings are “opinions” with the same legal status as a newspaper editorial. Newspaper editorialists, though, don’t take money from big advertisers for endorsing their products. But whether or not the ratings agencies are held accountable for past malfeasance, they have become a liability. They need to be replaced. But by whom, and what?
There is a way to do it, in a way that investors will come to trust within a reasonable time frame. Make risk modeling a transparent business with universal access to data and models. The regulators should require large financial institutions to provide their internal data on defaults and delinquencies to the public.
Many of the large banks have enormous amounts of data describing the characteristics of defaulting borrowers and the circumstances under which they defaulted. The Federal Reserve should collate this data into a single set, and make it available for download on its website.
The large banks also should be required to publish their internal risk models. To require a private company to divulge proprietary information is a burden, but in light of the 2008 catastrophe, the public has a right to know how the banks are measuring their own risk.
Once the data and models are available, independent analysts (including the rating agencies) will have an independent capacity to measure the riskiness of bank portfolios. Public scrutiny and third-party analysis will compel bank senior management to improve risk measurement in order not to appear less transparent than the competition.
None of this is particularly difficult. It is a matter of sorting data and crunching numbers and comparing results. It will take the investing public a bit of time to learn what actually occurs in bank portfolios. But this approach could produce robust measures of risk, and allow banks to take on the kind of risk that promotes economic growth, while giving the market the means to punish banks that take on excessive risk.