In my last post, I discussed how the run-up of U.S. mortgage debt during the last decade was funded. One important element was the sale of commercial paper that helped fund the purchase of some mortgage-related securities. Here I comment on why it was hard for some institutions to resist buying that commercial paper.
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I recently read a very interesting discussion of the role of commercial paper in the financial crisis by NYU professors Marcin Kacperczyk and Philipp Schnabl. One of the stories they recounted was that of Reserve Primary Fund, the money market fund that set off a stampede out of MMFs when it broke the buck on September 16, 2008. The losses by the fund were particularly startling since that fund had been originally created around a philosophy of making only the most conservative investments.
In December of 2008, the Wall Street Journal provided these further details:
Reserve had told the Securities and Exchange Commission in September 2005 that “to further minimize investment risk, the Funds do not invest in commercial paper.” In another federal filing on March 15, 2006, Reserve said its funds had “slightly underperformed” rivals, owing to a “more conservative and risk averse manner” of investing, and noted: “For example, the Funds do not invest in commercial paper . . . .”
A week later, Reserve amended its prospectus, deleting a line that said the Primary Fund couldn’t buy commercial paper.
Within two months, such paper made up 5.7% of the fund’s assets. The percentage soared tenfold in two years. The result was that by this September, the Primary Fund’s 12-month yield was the highest among more than 2,100 money funds tracked, according to Morningstar– 4.04%, versus an average of 2.75%. With this stellar yield, the fund’s assets tripled in two years to $62.6 billion.
It’s just one anecdote, but it strikes me as a very instructive one, because it raises some issues that economists aren’t used to thinking about but that may lie at the core of the recent debacle. We’re fond of building models of rational people reacting in a predictable way to the incentives they face; if their behavior changes, we look for an explanation in terms of changed incentives. It turned out to be in the fund managers’ short-term interests to go with the more aggressive strategy, with disastrous longer-run consequences. Was the manager rational before 2006 and irrational after 2006, or did the incentives fundamentally change?
One of the explanations I sometimes hear is a story about “search for yield,” which appears to be a combination of the two interpretations, attributing some of the altered risk-taking strategy to the period of very low interest rates in the preceding years. If this indeed accounts for some of the changed behavior by lenders, it is a channel for the transmission of monetary policy to the economy that’s left out of the Fed’s standard models, and another reason to be cautious about overestimating the benefits that are practical to achieve from a stimulative monetary policy.
Professor Hamilton,your memo is a gentleman comment!
Everyday in the financial world the snake entices Adam to have a bite at the apple.The snake is never the same it can be private markets or capital public driven economIes where excessive money supply,too low interest rates do constitute an attractive bait. It may as well be a theory sustained by mathematical models where the matrix was only covering half of the variables required.It may as well be an homogeneous function where the derivatives never,never have looked aliked the primary function.
Today one may witness the tricotteuses of the revolution without the revolution on sovereign risks,but should their risks profiles be more thoroughly assessed over the time it an overdue concern.
Since centuries the financial markets and their masters are exploiting “Vox populi,vox dei” without reading the complete sentence “Nec audiendi qui solent dicere, Vox populi, vox Dei, quum tumultuositas vulgi semper insaniae proxima sit” the translation in porcine understanding;
“And those people should not be listened to who keep saying the voice of the people is the voice of God, since the riotousness of the crowd is always very close to madness”
Yup. This is making it more clear what we are unclear about.
Now my next point of confusion is this. The Fed started their slow quarter point Fed Funds hike in 2004. The above chart shows the riskier, higher yield ABS ballooning at the same time and doubling over about 2 years. Of course that means someone decided to create the instruments as a result of consumer demand for debt, and was able to re-sell it to investors for some reason.
Now I think monetarists of old would be tempted to throw out “monetary policy lag” as the explanation for the mismatch in time frame. But a economic theory that results in what we just had is not much use, in my opinion.
So we are back to looking at reasons for the change in consumer debt appetite, IB/Commercial bank incentives to satisfy it, and investor appetite for something that proved out to be such a bad investment.
The search for yield seems like a basic human psychological effect — people rationally make the initial choice of whether to put their money in something “risky” or “not-risky”, but once they’ve chosen “not-risky” (i.e. a money-market fund) they switch to an optimization strategy where they assume that more yield within the same basic class of “low risk money market fund” comes essentially for free. The miniscule increments of risk as yield and risk go up simply aren’t big enough to register.
How many models of investor behavior take this into account? It seems obvious enough, but it’s also one of those discontinuous non-linearities that is easy to describe, but makes the math go from pretty and elegant over to ugly and … well, realistic.
The irony of calling AAA CDO purchases “gambling” is that they were just yield pick-up strategies. The buyers were just looking for a little more return out of a “safe” investment vehicle. Sound like a “search for yield”? It does to me.
The enormous demand for AAA paper helped, again, ironically, to create follow-on demand for subprime and Alt-A originations, which in turn caused the likes of New Century and Accredited to “dial down” their underwriting standards. I visited Accredited in 2006, and asked them, “how do you determine how much product to originate in a given month?” The response was, “it depends on how much demand there is for our paper.” Of course, one could only meet that “demand” from CDO issuance by reducing standards and allowing more people in the door to seek loans.
The further irony was that rather than, “securitize and forget” these instruments, the investment banks started to also retain them in a search for yield. It was the RETENTION of securitized mortgages on the books of orignators — not their securitization — that finally took its toll on Bear, Lehman, Merrill, New Century, Indymac, Countrywide, WAMU, and, finally, Fannie and Freddie.
The “search for yield” fingerprints can be found all over the murder weapon, but the Fed refuses to acknowledge its role.
An important study was done at the OECD: http://www.oecd.org/dataoecd/33/6/42031344.pdf
In the excerpts below, points #5 and #8 and conclusions ii. and iii. seem relevant to any discussion of the causes of the subprime mortgage crisis.
The Financial Stability Forum (FSF) Analysis of the Crisis and the Issue of Causality
At the global level the body charged with analysing the crisis and recommending reform is the FSF. It brings together top-level central bankers and supervisors as well as representatives of international organisations (IOSCO, IMF, World Bank, OECD, etc). This group can draw on all of the resources of institutions around the world to do some thorough analysis.
The FSF published their findings in April 2008.
A summary of the findings is presented in Table 1 (FSF 2008). There are nine key underlying weaknesses on the left-hand side and five sets of key recommendations shown on the right-hand side of the table. The weaknesses taken together presumably should explain the sudden explosion of RMBS after 2004 – in other words, there should be causal factors amongst them. Effective reform, as argued earlier, should attach more weight to causal as opposed to conditioning factors.
Taking the nine weaknesses as hypotheses about causality, in turn:
1. Poor underwriting standards. Their presence is indisputable. But does this factor
cause the explosion in RMBS and levered conduits? It is equally arguable that
it is a facilitating aspect of the process and not a cause. Loan officers did not
decide exogenously to become lax after 2004. Rather, the pressure to securitise
may have forced them in that direction.
2. Poor risk management. Again, this is tautologically correct for the institutions
that made bad loans. But did risk management models switch to inferior types from
2004? Did management deliberately or inadvertently decide to downgrade/ignore
the role of risk management after 2004? It is argued below (in the discussion of
UBS) that cultural factors embedded in bank strategy – and driven by revenue
pressures from other causes – led some boards to give a lower weight to risk
before the crisis.
3. Poor investor due diligence. Again a tautology. Investors are always likely on
average to take excessive risks in a boom when liquidity is ample and interest rates
are low. This is a part of the procyclicality debate. No one is going to disagree
with a recommendation that they should try to do better. But will human nature,
given the evidence of all past cycles, really be likely to change in an effective
way in future decades? This is highly unlikely.
4. Credit rating agencies. It is indisputable that they did a poor job, as has been
evidenced by the extent of recent downgrades. What is less clear is whether
they independently decided to reduce the quality of their analysis after 2004. As
with risk control, ratings become procyclical and that will always be a feature
of the financial landscape. Of course improvements in practices are desirable,
and this will at minimum avoid future exacerbating behaviour. But it is not
going to remove procyclicality. What is very important, and not a focus of the
FSF report, is the competitive structure of the market. The oligopoly of the
‘issuer-pays’ model, with only a few ratings firms, is likely to be a causal factor
through the fee incentives and moral hazard issues that arose. If institutional
investors in securities on the ‘buy side’ were required to obtain an independent
appraisal, for example, then a competitive market would develop. Groups like
Morningstar, with the right in-house expertise, could move into debt rating for
the buy side, putting pressure on fees, reducing moral hazards and improving
the rating process itself.
5. Incentive distortions via Basel I regulatory arbitrage and financial market
compensation schemes – the former had been in play since 1992, and the latter
for much longer. Basel weights are exogenous, and more causal in the sense of
this paper. The more interesting question is what caused these mechanisms to
be taken advantage of from 2004 onwards.
6. Disclosure (valuation, fair value accounting, audit, etc) – did it deteriorate
in 2004, or did pre-existing weaknesses come to light as other causal factors
accelerated the securitisation process? The FSF focuses on strengthening
models and procedures. This has to be supported as an important ‘conditioning
factor’. A more structural concern is the audit market itself. There are only four
audit firms (post Arthur Anderson) who work closely with complex financial
institutions, for substantial fees. This closeness is a concern and creates the risk
of reduced independence. These firms are protected by a legal restriction in key
jurisdictions: that only audit partners can own shares in audit firms. This precludes
someone like Warren Buffett setting up competitor firms by raising funds on
the stock exchange. This issue is surely worthy of further consideration in the
reform process.
7. Thin markets and price discovery – this liquidity issue was exposed by the
solvency crisis in mortgages and under-capitalised banks. It is unlikely to
have been a cause of the crisis, but clearly exacerbated it. The FSF intends to
issue guidance on dealing with leveraged counterparties (like hedge funds),
warehousing and the like. What remains unclear, at least to the authors of
this paper, is a set of clear definitions for those institutions that should fall
with the regulatory framework for ‘safe-and-sound banking’ and those that
should not.
8. Weaknesses in the regulatory structure pre-Basel II – this area is a key focus of
this paper because regulatory changes were signalled and some changes did occur
at the critical time that needs explanation. The ‘mid-year’ Basel II text for the
revised framework for capital standards was released in June 2004 (BCBS 2004),
and the Quantitative Impact Study 4 (QIS-4) Basel II simulations revealed the
extremely favourable likely weighting for mortgages, and the freeing up of
capital that would arise for banks. At the same time, the OFHEO, which was
the Fannie Mae and Freddie Mac regulator, began a series of strong measures
that constrained the balance sheets of these institutions. These events fit with
the timing of the surge in RMBS issuance and are exogenous events. They have
to be considered as potentially causal factors.
9. The originate-to-distribute model – was this a causal factor? Or was its increased
use quite logical, fl owing from the incentives set up by other distortions
after 2004?
ii. Recognition that monetary policy in advanced countries should take more account
of the international global financial implications of their policies. Extremely
low interest rate policies, pursued with domestic objectives in mind, cause carry
trades and asset price effects that influence leverage.
iii. Simple rules should be favoured over complex ones based on unrealistic models.
The theoretical underpinning of the Basel framework, based on the assumption
that only one global risk factor exists, is not a sound basis on which to base any
binding model for capital requirements in each jurisdiction. Allowing banks to
set their own capital standard, via complex internal modelling of risk outcomes,
is likely to generate too little capital and concentration distortions. Complex
weighting rules that discriminate between assets in terms of capital penalties
create an industry of avoidance which is both costly in terms of productivity
and likely to distort asset mixes. A simplified and more transparent system of
ex ante requirements, like the leverage ratio with prompt triggers for corrective
action, allows greater scope to take local and global factors into account and
gives supervisors ex ante tools that do not rely on judgment and predicting
the future.
After watching the senate Calamari Roast a couple hours yesterday, I’m fairly certain Lloyd went home that evening and issued a policy memo stating that, henceforth, no Goldman employee shall use e-mail when internally discussing the risk rating of Goldman products, especially when the rating is the non-agency classification now known as S-H-I-T-T-Y, and that the executive conference room Cone of Silence can be reserved for those discussions, as well as any other discussions with clients interested in selecting assets that go into structured products that they would like to short.
But this still doesn’t solve my small problem as a retail investor.
This is precisely why I love Keynes Ch 12:
“But there is one feature in particular which deserves our attention. It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it for keeps, but with what the market will value it at, under the influence of mass psychology, three months or a year hence. Moreover, this behaviour is not the outcome of a wrong-headed propensity. It is an inevitable result of an investment market organised along the lines described. For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.”
Yes, a perceptive observation and a good example. Economics (and life) was simpler when stocks were risky and bonds were safe. Now any financial category has instruments covering a range of risk from low to high. And its getting tougher to assess because the sources of risk are increasing.
“If this indeed accounts for some of the changed behavior by lenders, it is a channel for the transmission of monetary policy to the economy that’s left out of the Fed’s standard models, and another reason to be cautious about overestimating the benefits that are practical to achieve from a stimulative monetary policy.”
This is what I call taking a Human Agency approach to the Crisis. It means, in essence, to bring out the assumptions and beliefs that agents were acting upon. Some will be explicit, while some will be tacit. In this sense, it is like philosophy as Wittgenstein and Austin practiced it.
However, you cannot rely on simple correlation, which would be akin to accepting Behaviorism as opposed to Human Agency. I have my own view about what those assumptions are, but some of them need empirical verification. They cannot be modeled in anything more than a beginning analysis way.
What caused the yield chase? What about competition of investment dollars in an environment of relative disinflation? Do *expectations* of yield focus predominately on nominal returns with regards to behavior? What about the over-supply of investment dollars increasing at the same time? (Due to a disproportionate number of boomers retiring… over-reliance on 401Ks-individuals moving funds around short term?) What if excessive competition for investment dollars shift money managers focus from the long-term to the short-term, in a manner similar to the franchise value of banks idea here: http://rortybomb.wordpress.com/2010/04/19/franchise-value-of-banks-and-the-effects-of-deregulation/
Professor Hamilton,
It seems to me the search for yields, the sovereign debt problems, mortgage defaults, etc., all have the same basic cause: unsustainable debt level’s.
What if central banks targeted debt-to-GDP levels? That would mitigate the search for yield problem, and also asset bubbles, at least the leveraged ones.
What if there was a target of total debt, public and private, of 200% of GDP, or whatever. Or a target that debt should grow at the same pace as nominal GDP, at least in mature economies?
Bob in MA,
Sounds to me like that should be a cornerstone in any decision making framework. But still probably too coarse.
Debt/GDP would gloss over the decline in underwriting standards we’ve had, due to “income inequality”. This occurred with GSEs and banks. We could limit the size of debt(credit), but the percentage of potentially bad debt could still be high.
But securitization is what enabled the decline in underwriting standards, so that is the core problem in my view.
But no one will like it because it would make our GDP number go down.
A worldwide “savings glut”, which could be a chronic condition for now, would necessarily lead to either a) overinvestments (bubbles) or, b) economic malaise. Yes?
I was inclinded to comment, but I couldn’t agree more with David Pearson, and he articulated the case far better than I could.
However, from David’s point re: Fed accountability. The only institution which could have meaningfully intervened prior to the crisis was the Fed. And it didn’t, despite clear warnings, some of which have been presented in this blog.
By staying on, Bernanke has projected his personal loss of credibility onto the institution as a whole, creating a loss of presitge for the Fed–and doubts about the efficacy of any new proposed financial regulations–that is unprecedented in my lifetime.
Bruce Bent was seeking to pump up fund assets in anticipation of selling the management company.
This post plus comments plus the previous post on the same subject plus comments are EXCELLENT.
Ok. So borrowing permitted all this run up in house prices and profits from packaging mortgages.
Who lost money when the bust came? Taxpayers only?
What would be our situation today if Bernanke and Paulson had done the unthinkable and allowed AIG to go bankrupt?
I am unconvinced that the fallout would have been worse than what actually happened. Banks refused to lend to each other. Exactly what would have happened in the bankruptcy instance.
True – nobdy knew how to handle a bandruptcy of a firm as large and interconnected as AIG. However, it would have been sorted out. The same aggressiveness that Bernanke used to provide funds to the commercial paper market and to European banks would have been necessary – BUT PROBABLY AT THE SAME SCALE AS ACTUALLY EXPERIENCED.
I would think the usual suspects for the creation of excess capital all contributed:
1. Increase in leverage by I. Banks created a lot of capital.
2. The yen carry trade was a major source of capital for hedge/p. equity funds.
3. Trade deficit in goods causes/requires a trade surplus in investments/financial products.
4. Peak baby boom cohort enters peak earning/investing age range (401k balances exceed GDP first time.)
5. Foreign earnings repatriation tax cuts brought lots of corporate capital home.
6. Tax cuts that favored return to capital over labor.
That is my list of usual suspects. Let me know if I missed any.
I also think that Dr. Ben’s run-up in the discount rate actually worked to attract “hot global money” so the bubble was just a little bigggger when it popped.
With respect to MMFs, one problem is the implicit guarantee that sponsors provide in the event of a default in their portfolio. I have argued that MMFs sponsored by banks should be consolidated on their books for capital calculation purposes and supported Volcker’s proposal that MMFs should be regulated as banks, with a credible amount of capital on the books to absorb shocks.
Primary Reserve was not unusual in incurring a loss; it was unusual in that the sponsor didn’t cover it.
I take issue with Keynes as quoted by Venky, above: For most of these [expert professionals] are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public.
That may have been wholly true at the time of writing and is still partly true; but I suggest that the fundamental business of an investment professional nowadays is simply to get money in the door; it’s mostly marketting, with the actual business of investment analysis being an unfortunate expense, to be minimized and dismissed when recommendations contrary to the interests of marketting are made.
This may well have been the fundamental problem at Reserve Primary.
I agree with David Pearson’s comment, above, regarding tranche retention of securitizations, but will go further: a large part of the Credit Crunch trigger was the blurring of lines between brokerage and banking. It is the job of brokerages to match sellers to buyers – exactly what Goldman did in the Paulson/ACA deal. To expect them to understand the nature of the particular black box they’re trading is, frankly, expecting too much.
There should be separate regulatory regimes for brokers and bankers; the latter penalized (via surcharges in their capital calculations) for trading their holdings too often and the former penalized for not trading their holdings often enough.
And, with respect to Cedric Regula’s complaint that But this still doesn’t solve my small problem as a retail investor. … it’s not supposed to. All the Goldman stuff being discussed has nothing to do with retail investment; it was all institutional and it should be understood that institutional trading is for sharks only. When you deal with an institutional salesman, it should be clearly understood that he wants to send you home naked, hungry and bloody.
Retail investors need to hire somebody to fight for them; somebody with a fidiciary responsibility to them; somebody they can trust – not because he’s got a deep voice, a firm handshake and a nice office, but because he’s got a long-term investment management track record that he is very pleased to display. And he gets paid to fight the sharks on your behalf.
James I. Hymas,
I do use bond funds for that reason.
But things are more complicated than you quickly outlined above. For one thing, the obfuscation of payment risk results in the underpricing of risk, and I believe it is so widespread that the entire credit market underprices payment risk. This means even if my bond fund manager somehow avoids becoming shark food, my after fee return is too low. This also means we have a credit bubble which can explode the whole world as we know it.(this is now known as a “credit event.”)
When you say:
“It is the job of brokerages to match sellers to buyers – exactly what Goldman did in the Paulson/ACA deal. To expect them to understand the nature of the particular black box they’re trading is, frankly, expecting too much.”
Goldman was the originator of this deal. They invented it. Goldman has been trying to confuse people with mixing up the role of “market maker” and “underwriter”. Much of the press has been swallowing it too. In the case of ABACUS, the structure of the deal that Goldman invented compares to “normal” structured CDOs and CDS like the Schrodinger Wave Equation compares to Black Jack.
But it is known that the entire ABS market grew huge (which does somehow mostly leak into the retail space), along with synthetics, and all of it does not perform anything like the risk models used by regulators, agencies or underwriters projected.
I don’t want my bond fund manager to deal with that because I don’t think he is smart enough. He who gets invited into the “Cone of Silence” when constructing these deals wins.
For anyone that has the fortitude to study what Goldman (and probably what the rest of investment banking has been up to) Waldman has been doing some in detail analysis. Scroll down a bit to see ABACUS deconstructed, but have your aspirin bottle handy.
http://www.interfluidity.com/
I don’t want my bond fund manager to deal with that because I don’t think he is smart enough.
Easy enough to deal with – hire one who is smart enough. At least one who is smart enough to know what he doesn’t know and avoid it.
He who gets invited into the “Cone of Silence” when constructing these deals wins.
There was no “Cone of Silence” in the Goldman/Paulson/ACA deal. All the components of the structure were listed in the prospectus – and since all the components were “synthetic”, i.e., credit default swaps, it necessarily meant that somebody took a view on their value that was opposite to the Selection Agent’s.
The so-called analysis at http://www.interfluidity.com/ is ludicrous. Goldman sent around the flipbook until it found some, and without revealing that a hidden counterparty wanted to dump. Brokers can only sell things that other clients have sold to them (they can take a short position, but eventually they have to buy it back). Anybody representing themselves as a fiduciary must understand that ultimately – as in the case of buying a house – that may mean walking away.
When a real-estate agent offers to sell you a house, do you believe it magically appeared out of nowhere, or do you believe it’s available because somebody wants to sell?
James Hymas,
Thanks for the advice on fund manager selection. Next time I’ll ask if they are smart enough before firing all of them.
So I guess you still see no difference between a “broker” that does an IPO and a “broker” that makes a market in IBM stock? Can I ask if you worked for the SEC while Cox was running it?
I decided I would rather play golf than become an unpaid expert on ABACUS, but I’ll try and track down Waldman and tell him you would like to argue about his crappy analysis of ABACUS. Check with Barry Ritholz too. He has security law experience.
No guarantees as they say.