[R-G] [BillTottenWeblog] All Those Arrows

Fri Jun 26 17:11:42 MDT 2009

by Donald MacKenzie

London Review of Books (June 25 2009)

Fool's Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global
Markets and Unleashed a Catastrophe by Gillian Tett (2009)

Few people's reputations have been improved by the credit crisis. One is
the BBC's Robert Peston; another is Vince Cable. A third is Gillian Tett,
capital markets editor of the Financial Times. Prior to the crisis, she
and her team were the only mainstream journalists who covered in any
detail the arcane world of 'credit derivatives'. Tett saw - however
imperfectly - the huge risks that were accumulating unnoticed within that
world, and spoke out about them.

Fool's Gold begins in a conference room in Nice in spring 2005. Tett
admits that at that point she was baffled by the technical language -
'Gaussian copula', 'attachment point', 'delta hedging' - used by the
participants. However, before joining the FT she had conducted fieldwork
in Soviet Tajikistan for a PhD in social anthropology, and the
ethnographer in her was now reawakened. The conference reminded her of a
Tajik wedding. Those attending it were forging social links and
celebrating a tacit world-view - in this case, one in which 'it was
perfectly valid to discuss money in abstract, mathematical, ultra-complex
terms, without any reference to tangible human beings'.

She whispered to the man sitting beside her, asking who the key actors in
the ceremony were - those up on the conference hall's stage. 'They used to
all work at J P Morgan', he answered. 'It's like this Morgan mafia thing.
They sort of created the credit derivatives market'. The answer surprised
her. J P Morgan was not Goldman Sachs; it wasn't an exciting bank. It bore
the name of America's most celebrated financier, but it was 'dull': safe,
boring, perhaps a little snobbish. (When its current chief executive, the
now well-respected Jamie Dimon, joined the bank from Bank One, whose
headquarters were in Chicago, Tett reports that one Morgan banker
muttered: 'Not another retail banker from Hicksville, USA!')

The core of Tett's book, which is by far the most insightful of the first
wave of books on the crisis, is the story of J P Morgan's credit
derivatives team. For all the bank's traditionalism - the door staff at
its London offices wouldn't look out of place outside the Ritz - it was
quietly innovative. One of the team's driving forces was a young
Englishwoman, Blythe Masters; another, Terri Duhon, makes no secret of her
upbringing in a trailer in Louisiana; central to its technical work was an
Indian mathematician, Krishna Varikooty. Boisterousness that would have
horrified John Pierpont Morgan was tolerated. At one gathering in Florida,
one of the team's managers broke his nose when drunken colleagues were
pushing him into a hotel swimming-pool.

The team's pivotal innovation, introduced in December 1997, was a deal
they called 'Bistro' (Broad Index Secured Trust Offering). For a decade,
banks had been experimenting with credit derivatives, which are ways of
separating out the 'credit risk' involved in lending (the risk that
borrowers will default on their obligations, failing to make the required
interest payments or not repaying their loans) and turning that risk into
a product that can be bought and sold. Bistro helped make this tentative
activity big business: it transferred to outside parties the credit risk
of loans totalling $9.7 billion that J P Morgan had made to 307 companies.
The scheme was an influential version of a CDO (collateralised debt
obligation), and like other CDOs, Bistro was divided into 'tranches', of
which originally there were two. Investors in the lower or 'junior'
tranche received a healthy rate of return, 375 basis points over Libor
(London Interbank Offered Rate), which is the average rate at which a
panel of leading banks report they can borrow from other banks.{1} (A
basis point is a hundredth of a percentage point.) This compensated the
junior investors for the fact that their investments would bear the
initial losses, beyond a small reserve built up during the deal's first
five years, should any of the 307 borrowers default.

Only if those losses were to exceed the entirety of the investments in the
junior tranche would the holders of Bistro's senior tranche - which paid
only sixty basis points over Libor - suffer. The loans that made up Bistro
were well diversified across industries, and were made predominantly to
blue-chip companies, so losses to Bistro's senior tranche seemed unlikely
enough for Moody's - one of the three leading credit rating agencies,
along with Standard & Poor's and Fitch - to award the tranche its highest
rating, Aaa.

Aaa was a rare distinction. Only a dozen corporations and fewer than two
dozen governments were judged worthy of it: neither Italy nor Japan has an
Aaa rating. (Standard & Poor's recently indicated that the UK is now in
some danger of losing its top rating.) Blythe Masters had formidable
powers of persuasion, which helped when selling a deal that looked 'like a
science experiment, with all those arrows', as one investor quoted by Tett
described Bistro's documentation. Yet sixty basis points over Libor, for
an investment judged safer than the sovereign bonds of some of the world's
leading economies, was the most powerful argument of all: an investor
would normally struggle to find an Aaa investment that yielded as much as
Libor.

For J P Morgan, Bistro solved one problem and potentially addressed a
second. First, while the 307 corporations were generally low risks, even
the most creditworthy borrowers can default. So $9.7 billion in loans was
a significant constraint on the bank's future lending. Bistro removed that
constraint. Second, the Basel Capital Accord, signed by the world's
leading banking regulators in 1988 and implemented by them in 1992, forced
banks to carry reserves equal to eight per cent of their risk-weighted
lending. While certain categories of lending - to other OECD banks, for
example - qualified for a reduced reserve requirement, loans to even the
safest industrial corporation incurred the full eight per cent, a figure
that bankers felt was far larger than justified by the risks involved. J P
Morgan hoped that the transfer of credit risk achieved by Bistro would
persuade regulators to reduce that requirement considerably, and Tett
reports that Masters and her colleague Bill Demchak pushed the Federal
Reserve and the Office of the Comptroller of the Currency to clarify what
exactly would be needed to achieve that.

Bistro differed from earlier CDOs in that it did not, in fact, transfer to
external investors all the credit risk of the $9.7 billion of loans. The
junior and senior tranches amounted in total to only $700 million; the
bank believed that the chances of losses ever exceeding that figure were
too tiny for it to be worth paying investors to shoulder them. The
regulators, however, demanded that the bank do something to remove that
residual 'unfunded risk' before they would relax the eight per cent
capital requirement.

The residual risk was like a topmost tranche, sitting above the senior
tranche; it would come into play only if losses entirely wiped out the
latter. The senior tranche was Aaa, as safe as it gets; the residual
'super-senior' tranche (as the J P Morgan team christened it) was safer
than safe. To satisfy the regulators, however, the team turned to the
Financial Products division of the leading US insurer, AIG. Sharing J P
Morgan's analysis that the super-senior tranche was ultrasafe, AIG agreed
to insure it against all remaining losses, charging an annual premium of
only a fiftieth of one per cent of the sum insured. From the viewpoint of
AIG, it was small-scale business, but apparently highly profitable: by
covering an effectively non-existent risk, the firm earned $1.8 million a
year.

In that little afterthought to Bistro - what to do with the super-senior
tranche - lay the germ of much of the credit crisis, especially its
disastrous effects on many of the world's leading banks. Bistro-like deals
started in the world of corporate borrowing, but from 1999 began also to
be implemented in the world of consumer debt, especially mortgages.
Lenders actually had a longer experience of packaging mortgages into
securities than of packaging corporate debt into CDOs, and mortgage-backed
securities had acquired an admirable reputation for safety. They have a
structure like that of CDOs, with different tranches carrying various
levels of exposure to risk. The safest, Aaa tranches had impeccably
default-free records, and even the riskier tranches had performed well:
indeed, on average better than corporate bonds with the same ratings. It
wasn't that people never defaulted on their mortgages - they did - but the
securities were designed to take this into account, for example by
building up reserve funds (analogous to but usually proportionally larger
than Bistro's small reserve) that would absorb the anticipated losses. For
many years, such provisions proved in general fully adequate.

What happened from 1999 onwards was that mortgage-backed securities, which
already represented one layer of packaging of debt, started to be
repackaged into CDOs, thus creating a Russian doll product: a tranched,
packaged product each component of which was itself a tranche of a
packaged product. Given their excellent reputation, putting
mortgage-backed securities rather than corporate bonds or loans inside
CDOs might seem a small step. Yet when in 1999 Bayerische Landesbank,
which had become involved in the US mortgage market, approached J P Morgan
to package $14 billion of bundles of mortgages and other forms of
predominantly consumer debt into a Bistro structure, there were initially
serious doubts within the Morgan team.

The problematic issue was correlation, which is at the core of evaluating
a CDO. Low correlation means that defaults are essentially idiosyncratic
events, with the consequence that only the bottommost tranche of a typical
CDO is at significant risk. High correlation means that if defaults happen
they tend to cluster, and the clustering of defaults puts investors in the
higher, apparently safer, tranches at risk of loss. Participants in the
emerging credit-derivatives market tended to be confident that they had a
fair grasp of the correlation of corporate defaults. The rating agencies
had large databases of such defaults from which the extent of clustering
could be inferred at least roughly, and other market participants often
took the easily measured level of correlation between the moves of
different corporations' stock prices as a guide to the correlation of
their net asset values. (The link between the latter and default is that
the most important cause of corporate default is bankruptcy, which can be
thought of as happening when a corporation's net asset value falls below
zero: that is, when its liabilities exceed its assets.) Clearly, the
correlation of the asset values of two different corporations was unlikely
to be zero, since general economic conditions will affect both; it wasn't
likely to be 1.0 either, since that would indicate perfect correlation. A
commonly used figure was 0.3: it was, for example, the standard level of
correlation between the asset values of firms in the same industry that
Standard & Poor's initially assumed in CDO Evaluator, the software system
it began using in 2001 to rate CDOs.

The credit crisis has inured us to gigantic numbers - losses measured in
billions or trillions of dollars - but we need to pay attention to its
small numbers as well if we're going to understand it properly. A
correlation of 0.3 was modest. If it was correct it was highly unlikely
that the senior tranche of a CDO such as Bistro would suffer a loss -
unlikely enough to warrant an Aaa rating - and effectively inconceivable
that the super-senior tranche would be hit.

However, the figure of 0.3 was produced by analysis of corporate debt. How
could one estimate the equivalent correlation for mortgage-backed
securities? Paradoxically, their safety was a disadvantage in this
respect: there was effectively no record of default that could be
scrutinised for traces of clustering. Nor did such securities trade often
enough for the correlation of their prices to be measured: most investors
simply held them until they matured. Intuitively, though, it seemed
conceivable that defaults in bundles of mortgages or other forms of
consumer debt could be quite highly correlated, because of the likely
influence of factors such as the overall unemployment level, and that
could make a CDO based on mortgage-backed securities an unduly risky
product.

Terri Duhon, who led the Bayerische Landesbank mortgage-backed CDO, told
me in an interview that some of her J P Morgan colleagues doubted at first
that the deal should go ahead: they argued that 'there is no way we should
be doing this because it's way too correlated'. Tett reports that Krishna
Varikooty, for example, was concerned by a correlation risk that seemed to
him to be unquantifiable. After intensive discussion and analysis, and
very conservative structuring of the deal, the team eventually agreed that
it was safe to go ahead (it helped that, unlike in many more recent deals,
the ratings of the underlying assets were high - around 95 per cent had
Aaa ratings - and none of the securities was based on sub-prime
mortgages). Yet the reservations remained, and from this point onwards, J
P Morgan constructed only one further large CDO, and a limited number of
smaller ones, in which the underlying assets were bundles of mortgages.

Consequently, the bank remained on the sidelines as the once largely
distinct worlds of CDOs and mortgage-backed securities became more closely
linked from 2002 onwards. It was an encounter of two subtly different
cultures, with, for example, quite different mathematical approaches. The
CDO world developed explicit and increasingly elaborate models of
correlation - the 'Gaussian copula' that initially puzzled Tett is one of
them - while the mortgage world handled the phenomenon entirely
implicitly. In most investment banks, and also - as far as I have been
able to discover - in the New York head offices of the rating agencies,
separate groups or departments handled mortgage-backed securities and CDOs
based on corporate debt. In investment banks, for instance, those
different departments seem to have had surprisingly little to do with each
other. The two cultures never really merged; instead, the CDO, a structure
invented by the corporate-debt world, was applied to the products of the
mortgage world.

Members of both cultures now see the encounter as corrupting. 'They' -
constructors of CDOs based on mortgage-backed securities - 'took our
tools' and misused them, one specialist in corporate credit derivatives
told me a few weeks ago. Those with a background in mortgage-backed
securities blame CDOs (with some justice) for being indiscriminate buyers
of those securities, concerned only with their ratings and the spreads
(increments over Libor) they offered. Two experienced industry observers,
Mark Adelson and David Jacob, suggest that a fatal point was reached when
CDOs became almost the only purchasers of the riskier tranches of
mortgage-backed securities. Previously, those tranches had either been
guaranteed against default by specialist insurers, or bought by canny
investors, who would carefully assess the risks involved. These insurers
and investors acted as a brake on the riskiness of the lower tranches, and
thus on the overall riskiness of mortgage-backed securities, and they
demanded a healthy rate of return for taking on the risks. They were
displaced by those buying tranches in order to package them into CDOs, who
were prepared to buy them at lower rates of return, and who cared a lot
less about their riskiness, because those risks were going to be passed on
to investors in the CDOs.

With the brake removed, the construction of CDOs based on mortgage-backed
securities became a fast-moving assembly line (participants frequently
turn to machine metaphors when describing the process). Brokers sold
mortgages knowing that they could readily be sold on in the form of
mortgage-backed securities. Instead of having to worry whether the couple
sitting on the other side of their desk really had the wherewithal to keep
up their payments, all that mattered were the dozen or so quantitative
characteristics - such as borrowers' FICO (Fair Isaac Corporation)
creditworthiness scores - that influenced rating agencies' mortgage
models. The constructors of mortgage-backed securities no longer had to
satisfy specialist insurers or experienced investors: CDOs had an
apparently insatiable demand for those securities.

If the assembly line was to keep moving, it was essential that the higher
tranches of its final products - CDOs in which the underlying assets were
mortgage-backed securities - gained Aaa ratings. A critical issue was the
likely correlation of mortgage-backed securities. Standard & Poor's, for
example, used the same system, CDO Evaluator, that it employed for CDOs
based on corporate debt, and it used the same modest baseline correlation
assumption, 0.3, for mortgage-backed securities that it initially used for
corporations within the same industry. (S&P would later reduce this last
figure, while increasing its assumption about cross-industry correlation.)
These baseline correlation figures could be increased by the analysts
rating a specific CDO if it was highly concentrated in a particular
industry or consumer debt sector. I haven't been able to ascertain the
equivalent figures used by the other agencies, whose methods differed
somewhat from Standard & Poor's, but the similarity of their ratings to
S&P's suggest similar judgments. I am focusing on S&P simply because -
commendably - it seems to have been more explicit than the other agencies,
in the publicly available documentation for CDO Evaluator, about the
crucial assumptions underpinning the system.

The choice of 0.3, or a number close to it, as the baseline was critical:
one specialist told me that even a moderate increase in the baseline
correlation assumption, to 0.5 for example, would have made many CDOs
based on mortgage-backed securities much less attractive, perhaps even not
economically viable. However, as far as I can discover, analysing CDOs
built out of mortgage-backed securities using only modest correlation
levels seems in general to have been uncontroversial. Certainly, the
performance of mortgage-backed securities offered little reason to be more
stringent when rating CDOs based on them. For example, S&P's statistical
analyses suggested a correlation of mortgage-backed securities lower than
0.3; this figure was retained as a baseline because it was understood that
the correlation would rise when economic conditions became less benign.

Had the world remained as it was in 2002, the agencies' assumptions and
ratings might well have turned out to be perfectly appropriate. The
trouble with an assembly line, though, is that it produces identical
products. The only person outside J P Morgan I've found so far who thought
at the time that the correlation estimates being used to analyse CDOs of
mortgage-backed securities were much too low had made the discovery by
accident. In a previous job as an auditor, he had checked the statistical
tables that the sellers of mortgage-backed securities provide to
prospective buyers. These tables show the breakdown of the underlying
loans by state, FICO score, loan-to-value ratio and so on. When checking
the tables for one security, he inadvertently used the loan tape (the
underlying mortgage data) for another, and found that they were in almost
complete agreement. 'These deals' - apparently different mortgage-backed
securities - 'were the same deal', he told me. Even geographical
dispersion of the underlying mortgages across the US (a desirable feature
when an individual mortgage-backed security was considered in isolation,
because it reduced exposure to the vagaries of a particular local housing
market) had the paradoxical effect of increasing the homogeneity of
different mortgage-backed securities. In a situation of severe economic
stress - falling house prices, rising unemployment - it wasn't just that
some of those securities would perform badly; they all would. Instead of
correlation remaining modest, my interviewee came to fear that it would be
close to perfect.

Specialists in mortgage-backed securities in the US have not been entirely
surprised at the fraud and malpractice that has come to light: it was
always present, and has changed only in scale. (There was a US sub-prime
crisis in the late 1990s, which only specialists seem to remember. {2} It
was much more limited in scale, but it revealed extensive over-optimistic
accounting by lenders.) That mortgage defaults have risen, and the value
of repossessed homes fallen, is not in itself surprising to specialists,
although the size of the changes certainly is. At least some of them began
to suspect that long-standing statistical relationships - for example
between individuals' credit scores and the risk that they would default on
their mortgages - had ceased to be valid, but as far as I can tell this
didn't happen until as late as 2006, by which time the processes that led
to the credit crisis were well underway. One problem, for instance, seems
to have been that as individuals' scores increasingly determined their
access to credit and the rates of interest they had to pay, they found
ways to manipulate those scores. A modest web-based industry developed
which arranged (in return for a fee of one or two thousand dollars per
person) for people - in some cases, apparently, dozens of people - with
low credit scores to be added as 'authorised users' to the credit card
account of someone with a high score and an impeccable payment record. It
took just a month or two for the benefits of the primary cardholder's
regular payments to feed through into improvements in the credit scores of
the card's 'renters'.

If CDOs backed by mortgages had worked as the J P Morgan team had
envisaged when designing Bistro, the losses to investors in those CDOs
that the US housing bubble and its collapse have caused, though very
large, would have been spread widely across the many institutions that
bought tranches of such CDOs. As Tett notes, what has shocked the members
of that team - many of whom now work for other banks and hedge funds, but
still stay in touch - is the concentration of such losses, especially at
apparently sophisticated global banks such as Bear Stearns, Lehman
Brothers, UBS, Citigroup, Merrill Lynch, Morgan Stanley and the Royal Bank
of Scotland.

The primary vehicle by which risk was concentrated was Bistro's
afterthought, the super-senior tranches of CDOs. Even the riskiest
mortgage-backed CDOs - those that predominantly bought
'mezzanine' (next-to-lowest) tranches of mortgage-backed securities - have
super-senior tranches that are bigger than all the other tranches put
together. These super-senior tranches were hard to sell to most outside
investors, because the need for attractive returns on lower tranches means
a super-senior tranche can offer only a slender increment over Libor. By
2005, Tett reports, that spread was as low as fifteen basis points.

Thus many banks did as J P Morgan did with Bistro: they kept the
super-senior tranches, sometimes insuring them via AIG or specialist bond
insurers. (Adelson and Jacob point out the irony: risks that mortgage
experts in the insurers would have charged heavily for or perhaps even
declined were insured in packaged form in huge amounts - and quite cheaply
- by different departments of the same firms.) If only a handful of deals
had been insured in this way, it would have made perfect sense. As Tett
observes, however, AIG insured super-senior tranches amounting to $560
billion. Its bail-out by the US taxpayer dwarfs that of any bank, and it
keeps rising (the current total is $173 billion). But AIG cannot be
allowed to fail, because the loss of these crucial super-senior insurance
contracts could bring much of the banking system down with it.

Perhaps most surprising of all, top banks also bought super-senior
tranches originated by other banks. If you are a top bank, you can borrow
at around Libor (that is, after all, what Libor means); if you are
particularly well regarded, it may be possible to borrow at a rate a tiny
bit lower than Libor. So you could borrow at Libor or below, buy a tranche
that seemed safer than safe, and from it earn a slender spread over Libor.
It looked like free money. It was especially tempting to traders whose
banks 'charged' them for their use of capital, in the systems by which
traders' profit is measured, at around Libor, and credited them with the
small additional spread that super-senior tranches offered. The
slenderness of the spread meant that you had to do the trade on a very
large scale to earn a really big bonus, so traders did just that.

As I've already indicated, the vulnerability of super-senior tranches is
correlation. Losses on uncorrelated assets are unlikely ever to impact on
super-senior tranches. When correlation approaches 1.0, however, a CDO's
asset pool starts to behave like a single investment. It may suffer no
defaults, or it may default effectively in its entirety. If the latter
happens, even the super-senior tranche, safer than safe, is doomed.

As the historian of economics Perry Mehrling has pointed out, events in
financial markets cast shadows ahead, not behind. What has loomed over the
banking system for the last two years is the shadow of the gigantic,
system-wide default of the super-senior tranches of all the CDOs based on
the US mortgage-backed securities issued towards the end of the bubble.
(Residential mortgages have been the focus of most of the attention, but
there are also lots of problems with commercial mortgages.) Although,
alas, the losses will not stop there, most immediately at risk have been
CDOs made up primarily of the mezzanine tranches of sub-prime
mortgage-backed securities issued from late 2005 on. Defaults have risen
enough, the value of repossessed homes has fallen enough, and the
structure and composition of these securities has been similar enough,
that as far as I can tell almost all such tranches have been or will be
completely wiped out. If a CDO contains little but such tranches, even its
super-senior portion faces close to total losses. So far, only a limited
portion of those losses have actually been realised. The banking system is
braced for the rest of them but, with the massive aid of taxpayers, it is,
one hopes, now well enough capitalised to survive these and the other
losses that sharp recession will bring.

Unfortunately, this analysis - that the crux of the problem has been not
in CDOs per se but in the uncomfortable encounter between the world of
CDOs and that of mortgage-backed securities - remains only a hypothesis.
The world of corporate CDOs has itself manifested some of the phenomena of
the mortgage CDO assembly line: increasingly risky loans were made to
private equity firms and to other highly indebted corporate borrowers
because it was possible to package and sell on those loans in the form of
CDOs. I've just come back from New York, where I asked some of those I
spoke to about the magnitude of the problems that may lurk beneath the
still comparatively quiet surface of this sector of the CDO market, which,
although not as large as the mortgage sector, is still huge. My
interviewees seem convinced that while the problems are real, they are on
nothing like the same scale: the amount of truly irresponsible lending to
corporations was much smaller. I hope they are right.

At its heart, Tett's tale is a moral one. She believes that the history of
the J P Morgan credit derivatives team shows that banking can be
technically innovative while remaining responsible. Her readers may fear
that the anthropologist has gone native, but I don't think so. I have met
a good number of the people she is writing about, and have studied many of
the same events, and I largely share her judgment. In particular, J P
Morgan's decision not to set up a mortgage CDO assembly line has saved the
bank from the catastrophic losses so many of its peers have suffered;
unlike theirs, its solvency has never been in doubt. It is too easy just
now to condemn all of those who work at the heart of the financial system
as either rogues or fools. Tett is right to emphasise that despite all the
pressures and all the temptations, prudent banking was still practised -
sometimes - even at the centre of history's largest ever credit bubble.

Notes:

{1} Donald MacKenzie wrote about CDOs in the LRB of 8 May 2008 and about
Libor in the issue of 25 September 2008.

{2} It is discussed in the final chapter of an excellent book that, while
more limited in scope and more technical than Tett's, deserves to be
better known: Subprime Mortgage Credit Derivatives by Laurie Goodman et al
(Wiley, 344 pages, £55, July 2008, 978 0 470 24366 4).

_____

Donald MacKenzie teaches sociology at the University of Edinburgh. His
research on credit derivatives is being supported by the UK Economic and
Social Research Council.