THE BEAR'S
LAIR Financial models head for scrap
heap By Martin Hutchinson
It is now clear that the credit crunch was
not due simply to bull market over-optimism, but
resulted very largely from the failures of a
number of the financial models that have been a
staple of the last generation. As the crunch
spreads its malign tentacles ever wider into every
corner of global economic life, the dust of
collapse after collapse isn’t even beginning to
clear. However there are now coming to be things
one can usefully say about those models, and about
the assumptions on which they were based.
From what appeared to be a modest glitch
in the mortgage
market, the damage
to the world of financial modeling is
ever-extending and has now come to be surprisingly
widespread, involving huge swathes of modern
financial theory:
Subprime mortgages turned out to be correlated
with each other, so that securities apparently
rated AAA were in reality dangerously concentrated
in a particular sector of the market that could
and did collapse.
That also blew out the theory surrounding
monoline insurance, that a well-capitalized
insurance vehicle could insure debt representing a
large multiple of its capital base, without its
bond rating or profitability coming into question.
Then there was asset backed commercial paper,
under which commercial paper of short term
maturity was issued by a shell company against the
backing of financial assets of a long term
maturity, and through this means removed from a
bank’s balance sheet - it turned out that in a
financial crisis the funding for these vehicles
dried up.
Finally, credit default swaps (CDS) are
showing signs of strain and may have turned out to
have concentrated risk in unsuitable hands rather
than spreading it as had been promised for them.
In particular, the counterparty problem in the CDS
market becomes acute when defaults rise to a
substantial level and declared debt ratings turn
out to be unreliable.
As well as the
instruments themselves, their risk management
turns out to have been flawed. Value at risk
(VAR), the paradigm of risk management systems,
recognized by the Basel II system of bank
regulation and incorporated into it, has proved to
be almost entirely useless - like rain-proofing
that works well in a light shower, but falls apart
completely in a heavy storm. The central
assumption of VAR, that if you have measured and
capped the moderate risks then extreme risks will
also fall into line at only a modest multiple of
the moderate ones, has been proved wrong. In
reality, if a particularly risk class goes wrong,
it is capable of destroying an arbitrarily large
amount of value.
The hapless David Viniar,
chief financial officer of no less an institution
than Goldman Sachs, who announced last August that
he was "seeing things that were 25 standard
deviation events, several days in a row" had in
reality announced to the market that Goldman
Sachs' risk management systems were so much waste
paper, or, more likely, junk software; 25 standard
deviation events should happen once every 100,000
years; if you think you are seeing them several
days in a row, you are merely proving that in
reality you have no idea of the characteristics of
the risks you are supposedly managing.
Modern financial theory rests on two
fundamental axioms: that markets are efficient, in
the sense that there are no profits to be made
legally by superior analysis or better
information, and that price movements are in some
sense random, so that risks can be assessed using
standard well-understood Gaussian distribution
analysis. In reality, neither assumption is true:
superior analysis can indeed allow you to earn
superior returns, and markets can from time to
time behave in a highly non-random manner, jumping
in price far more than would be suggested by
analysis of past price patterns.
Whether
or not modern finance rested on false assumptions,
an enormous amount of money has been made by
betting that they were true. If the market is
thought to price all risks automatically, then
even the doziest mortgage broker can originate
subprime mortgages for even the least creditworthy
borrowers. The fact that the borrowers are
incapable of making payments on the mortgage will
magically be priced into the mortgage by the
securitization process, which will bundle the
mortgage with other mortgages originated by a
similarly lax process and sell the lot to an
unsuspecting German Landesbank attracted by the
high initial yield.
Everybody will make
fees on the deal, everybody will be happy, and the
Landesbank and the homeowner will have nobody
legally to blame when the homeowner is unable to
make payments and the Landesbank finds a shortfall
in its investment income. By making the market
responsible, modern finance has removed the
responsibility of all the market’s participants.
Looked at in this way, the subprime
mortgage is simply a scam, and the market a giant
Ponzi scheme that could survive only as long as
more people entered into subprime mortgage
contracts, keeping house prices high and mortgage
brokers active. Once interest rates began to rise,
the demise of the market became inevitable, and it
also became clear that the market was not simply
entering a downturn but would disappear
altogether. In 10 years’ time, only Fannie Mae and
Freddie Mac will be making subprime mortgages, and
they will exist only because they have been bailed
out by the taxpayer through the generosity of
their friends in Congress, possibly several times.
Asset backed commercial paper (ABCP), too,
is unlikely to recover from its drubbing in the
market. Investors will no longer believe that
commercial paper can automatically be renewed,
whatever the illiquidity of the assets, and
regulators will no longer believe that setting up
assets in a separate vehicle funded by the
commercial paper market automatically allows those
assets to be removed from a bank’s leverage
calculations.
Monoline insurance is an
interesting hybrid case. There’s no question that
insuring pools of real estate debt or other assets
to bring them to a AAA rating is like the subprime
mortgage business itself and ABCP, an economic
activity that should be lost to the mists of
history. However, there is a rather more
worthwhile business, that originally undertaken by
monoline insurers, that provided credit assurance
to small municipalities, who by their size were
unable to tap the public markets effectively on
their own. By assembling a substantial pool of
funding requirements from a number of
municipalities, and putting a single guarantee
over the entire pool, a careful monoline insurer
is not assuming any excessive credit risk, but
simply allowing small borrowing needs to be
aggregated efficiently into larger ones.
There is some risk that a real estate
downturn such as we are witnessing could remove
the funding base for a high proportion of the
nation’s municipalities, by dragging down property
tax valuations, but generally that risk is
concentrated in the larger, higher-taxing
jurisdictions for which monoline insurance is not
particularly economic. Thus, though the monoline
insurers may disappear because of their
non-municipal business, it is likely that other
monoline insurers will take their place, funded by
the deep pockets of the likes of Warren Buffett,
and that these new insurers will continue to have
a stable if not very exciting business - the
quintessence of a good insurance business, in
short.
Credit default swaps, on the other
hand, would appear almost pure scam, with very
little reason for their existence. Credit
assessment is a difficult task, better undertaken
by specialist entities such as banks with a deep
knowledge of the borrower. That’s why rating
agencies were invented, to allow bond investors to
purchase credit products without the need for
detailed credit assessment. However, credit
default swaps allow the banks that best know a
credit to sub-underwrite it not among other banks
who might be supposed to have sophistication in
credit assessment, then among institutional
investors that generally do not have such
sophistication. Further, the amount of credit
default swaps written need bear no relationship to
the size of the credit itself; thus the original
lender may "go short" in the credit risk by
writing CDS for more than the amount of the loan.
Needless to say, the opportunities for
chicanery and malfeasance in such a business are
legion and made more manifold by bonus systems
that reward bank officers and brokers for the
business done in a particular year without regard
to the losses that business may produce in later
years. Risk assessment in this business is a joke;
the VAR models that fail in assessing the risk of
a broad-based portfolio fail even more
spectacularly in assessing a narrow-based
portfolio of credit risks, in which correlations
between different assets are not properly explored
and for which the experience is at most a few
years. In spite of their convenience to loan
originating banks, it is thus likely that the
market for credit default swaps will in future be
very limited indeed.
When all these
products are taken into account, it becomes
obvious that the financial system of the future
will look very different from that of the recent
past. Shareholders will pay much more attention to
the conflicts of interest between traders’,
brokers’ and bank officers’ bonus schemes and
their own returns. Opportunities to make large
amounts of money by pure salesmanship, without
regard as to the quality of the underlying assets,
will disappear. Risk management will become much
more conservative and will treat exotic and
little-understood assets with the utmost
suspicion; that in itself will greatly limit the
market for profitable "financial engineering"
creativity.
The percentage of finance’s
value added in the US and world economy will
shrink once again, close to the levels of the
1970s and 1980s, around half those of today, and
remuneration for bankers, traders and salesmen
will be correspondingly more restricted. Since new
career opportunities on Wall Street will be few
and far between, there will be an aging in place
of existing staff, which will itself increase
those institutions’ conservatism, probably
replacing it with gerontocracy.
Eventually, perhaps not before 2030,
another financial revolution, immensely profitable
to its participants, will begin. It is undoubtedly
the case however that the new revolution will
involve products and sales methodologies far
different from those of recent decades.
Martin Hutchinson is the author
of Great Conservatives (Academica Press,
2005) - details can be found at
www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice &
Associates.)
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