Notes for a speech to the Regional Bond Dealers Association

By Felix Salmon
April 23, 2009

Blogging will be light today and tomorrow, since I’m flying to and from the annual meeting of the Regional Bond Dealers Association in Dallas. They’ve asked me to give a speech: here are my notes.

Like everybody else at this conference, I’m sure, I’m here to talk about risk – the main part of what you all do for a living. You buy it, you sell it, you measure it, you underwrite it. But like most of us, I’ve changed my view on risk considerably over the past couple of years. And it seems to me that one of the biggest mistakes that we all made during the credit boom was that everybody overestimated the demand for risk, when in reality there was much more demand for safety.

I believed along with Alan Greenspan that when it comes to debt instruments in general, and credit derivatives in particular, “These instruments enhance the ability to differentiate risk and allocate it to those investor most able and willing to take it.”

But if you look at what happened in practice, the art of securitization always seemed designed to create ever-increasing quantities of risk-free debt. Banks thought they were selling loans and mortgages to people who wanted the risk, but they weren’t: they were carefully packaging those loans and mortgages into bonds carrying a triple-A credit rating. And people buying triple-A risk don’t want any risk at all.

So what happened to the risk? The answer is that it was essentially modelled away. And one of the most important enablers of that modelling is the subject of my Wired cover story, the Gaussian copula function.

But the story is bigger than one formula.

Consider the very first synthetic CDO: it was called Bistro, and it was issued by JP Morgan in the late 1990s. The bank sold off the risk associated with $10 billion in loans on its balance sheet – this was credit risk which the bank didn’t want, even though it valued its lending relationshipsvery highly. So it kept the loans on its book, and kept the relationships, but sold off the risk by using credit default swaps to structure a synthetic CDO.

But here’s the astonishing thing. The credit risk on that $10 billion in loans managed to somehow get squeezed into a CDO of just $700 million: there was no chance that all the loans would sour at the same time, and JP Morgan managed to persuade Moody’s that the CDO could be just 7% of the size of the underlying loan pool, while hedging all of the credit risk.\

And it gets better: of that $700 million, fully two-thirds carried a triple-A rating. And triple-A, for those of you who remember as far back as 2006, means “no credit risk at all” – it means “risk free” – it means “you’re only taking interest-rate risk”. Which makes no sense when the whole point of credit default swaps is to separate out credit risk from interest-rate risk.

Add in the double-A rated tranches of Bistro, and you have holders of less than $200 million of risky paper taking substantially all the credit risk on $10 billion of corporate loans. That’s less than 2%. And Moody’s happily signed off on this, for two reasons. One was that the business of rating structured-finance vehicles was highly profitable; the second was that their entire business and reputation was based on the idea that they could model credit risk. If they couldn’tmodel credit risk, then they couldn’t rate credit. And so they were backed into a corner, and forced to apply their storied credit ratings to structured products which were simply the logical conclusion of their own models, rather than the result of a fundamentals-based look at a certain credit.

If you take a step back, you can see what’s going on here. You and I and Alan Greenspan all thought that credit derivatives were wonderful things because they moved credit risk out of the hands of people who didn’t want it, like banks, and into the hands of people who did want it.

In reality, however, the appetite for risk was never nearly as great as we all thought. $10 billion of loans becomes less than $200 million of credit-risk instruments, and everybody else reassures themselves that they’ve managed to reduce their credit risk to zero, even as the people holding that $200 million in synthetic CDO tranches are reassured by their own single-A or triple-B credit ratings that theyaren’t taking a particularly large amount of risk either.

And of course you know what happens next: some bright spark invents the CDO-squared, which seems to reduce the total amount of risk even further. You take the mezzanine debt, the triple-B stuff, and you do all manner of securitization magic to it, and it turns out that you can turn most of that into triple-A paper, too!

Because it was all triple-A, no one felt much in the way of need to do any analysis of their own: it’s almost impossible to overstate the power of the laziness of the bond investor. You know this from your own work with municipal issuers: the reason for those monoline wraps is not because the issuers have a lot of credit risk, but because the investors are lazy, and don’t want to do their homework, and reckon they can get out of doing their homework so long as there’s a monoline guarantee. Essentially, they’re outsourcing their own job to the monolines. Which might be reasonable for a small retail investor, but is not a good idea if your job is to invest in fixed-income instruments which carry a higher yield than Treasury bonds.

Of course, we all know how reliable those monoline guarantees turned out to be – and that’s a related story. The monolines, just like the ratings agencies, believed far too much in the power of models.

But things didn’t go completely insane until the technology behind Bistro started being used on asset-backed bonds in general, and mortgage-backed securities in particular.

Once again, we have a situation where everybody is trying to farm off risk to everybody else, to the point at which everybody thinks that someone else has it. For one thing, virtually nobody ever even stopped to worry about credit risk in the MBS market – I know that I didn’t, until it was far too late. I believed what the professionals told me, which was that the only thing a mortgage-bond investor needs to worry about is prepayment risk, and that credit risk is a non-issue.

But even those people who did stop to worry about credit risk were rapidly reassured. Most mortgages were always sold to Fannie and Freddie – and, presto, all that risk magically disappeared. These were hugely profitable corporations, what could possibly go wrong?

Then of course there were the non-conforming mortgages, mostly subprime, which couldn’t get sold to Frannie. How could you securitize those? They all looked very similar, with the same originators and underwriters and loan-to-value ratios and underlying FICO scores and so on and so forth. And so the key aspect of securitization which allowed the ratings agencies to dole out triple-A ratings like so much confetti – diversification – would seem to have been missing.

At least in the Bistro deal, the underlying loans came from a broad and healthy group of companies. When people started securitizing subprime mortgages, the underlying assets were neither broad nor healthy. And so were the seeds of disaster sown.

Common sense says that you can’t start lending money to very risky borrowers without taking on lots of credit risk – but somehow, by the time the loans made their way through the system, almost nobody thought that they were taking on credit risk. Most of the participants in the market thought they had triple-A-or-better debt, and they all believed, without ever really stopping to check, that the enormous amounts of credit risk being produced were being willingly held elsewhere.

And so we come to David Li’s Gaussian copula function. What the copula did was, in effect, nullify the effects of common sense: it blinded bankers and traders and bond investors with quant science. The formula decided that you could measure the degree of diversification in a mortgage pool scientifically, by looking at a single number known as correlation. Correlation was treated as a constant – which was ridiculous on its face – and then the ratings could be derived from it. By plugging in a suitably low correlation number at one end, you could churn out triple-A ratings and healthy bond valuations at the other. And since the trade was so incredibly profitable for anybody who entered into it, no one asked too many questions, and everybody piled in.

Of course, on Wall Street, if everybody is making the same trade, that’s a tried-and-true recipe for bubbles and crashes, which is exactly what we got.

It turns out that while everybody was concentrating on credit ratings, no one spent nearly enough time worrying about model risk. All those models, including the Gaussian copula function, which were used to generate the ratings, turned out to have enormous flaws. For one thing, models generally try to describe some external reality – but in this case, the models were driving the reality, creating feedback loops which were entirely outside the ability of the modelers to comprehend or hedge.

More generally, the models were based on data from a period of time when nothing ever blew up, and as a result they had a tendency to produce results saying that nothing was ever going to blow up. Eventually, you got to the ridiculous situation where the chief financial officer of Goldman Sachs could get on a quarterly earnings call and talk with a straight face about 25-sigma events, as though such concepts had real meaning.

At this point, there might be a couple of you in this audience feeling just a tiny bit smug about all this. Sure, you’ve been hit by the financial crisis – we all have. But you never got into the mortgage securitization space, you never traded correlation, you never got blindsided by a multi-billion-dollar “liquidity put” you never even knew that you had written. In other words, it wasn’t your fault.

But it’s worth asking why the regional bond dealers managed to dodge the bullet. And the answer, I’m afraid, is basically that you got lucky.

For one thing, you don’t have massive balance sheets. JP Morgan, when it did its Bistro deal, was perfectly happy keeping $10 billion in assets on its balance sheet. In New York, at the time, big balance sheets were considered a good thing: they were ways of making lots of money, and even investment banks without a commercial bank attached – Goldman Sachs is the prime example here, but you could look just as easily at Morgan Stanley or Lehman Brothers or Merrill Lynch – had as much as $1 trillion of assets. Why did they need such an enormous balance sheet? No one really asked. But it did make it easy to hide things like super-senior risk.

Remember that the Bistro deal was only for $700 million, which meant that JP Morgan kept $9.3 billion of so-called “super-senior” risk on its own books – unless and until it managed to hive that risk off to AIG. Later entrants to the game, like Citi and Merrill, never bothered to sell much if any of their super-senior exposure, and when suddenly correlations spiked and mortgages across the country started defaulting at the same time, they realized that their models had been flawed, that they hadn’t sold off all their credit risk after all, and that they had hundreds of billions of dollars in risk so well buried in these trillion-dollar balance sheets that no one really knew it was there.

So, congratulations on not being huge. And congratulations too on largely avoiding the securitization/ABS space, which was mainly the province of the big banks with lots of warehousing capacity.

But if the next shoe does drop, it’s likely to be munis, and that’s bread and butter for a lot of you guys. Correlations can go to 1 in any market, not just ABS. And although the locus of the crisis was ABS, there’s no particular reason that it couldn’t have been munis instead.

A lot of people think that municipal bonds are just inherently very safe things, but we just don’t live in a world of “inherently very safe”. I’d highly encourage you all to get out your copy of the last Berkshire Hathaway annual report, where Warren Buffett talks about the risks in the muni market:

The rationale behind very low premium rates for insuring tax-exempts has been that defaults have historically been few. But that record largely reflects the experience of entities that issued uninsured bonds…

A universe of tax-exempts fully covered by insurance would be certain to have a somewhat different loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different. To understand why, let’s go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds – virtually all uninsured – were heavily held by the city’s wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city’s fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it was apparent to all that New York’s citizens and businesses would have experienced widespread and severe financial losses from their bond holdings.

Now, imagine that all of the city’s bonds had instead been insured by Berkshire. Would similar belt- tightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to “share” in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial.

Local governments are going to face far tougher fiscal problems in the future than they have to date…

When faced with large revenue shortfalls, communities that have all of their bonds insured will be more prone to develop “solutions” less favorable to bondholders than those communities that have uninsured bonds held by local banks and residents. Losses in the tax-exempt arena, when they come, are also likely to be highly correlated among issuers. If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow. What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer?

To put it simply: if one muni defaults, that’s nasty for its creditors, including the monolines. And default is much more likely now than it was when most munis were unwrapped – insurance, as any insurer will tell you, is rife with moral hazard.

But if five or six munis default, things get much, much worse. At that point, the cost of default for a wrapped muni issuer plunges, and possibly even goes negative. Once a few munis default, no one’s going to lend to any muni, even the ones which are current on their debt. So why bother staying current? Why not just default and let the insurer, rather than your local taxpayers, take most of the pain?

In other words, there’s a very serious, and pretty much impossible to hedge, risk of snowballing muni defaults.

The fact is that the muni market is still heavily reliant on monoline wraps, which are at heart an artifact of the credit bubble, and of the fact that no one wanted to do homework or admit that they were taking risk. Those days are over now, and the new financial world which emerges from the current rubble is going to be one where investors are forced to face up to the fact that risk is endemic and can’t simply be modelled away.

What’s that going to mean for your business? I fear the news isn’t good. No fixed-income investors have the time to do detailed credit analysis on a regional hospital. That’s something banks do: these things should often by rights be loans rather than bonds. Which implies that we’re going to move back to a world of reintermediation, with less of a role for bond dealers and more of a role for boring bankers who know their clients and do their homework. And more generally, the financial sector is going to be a much smaller part of the economy than it has been over the past couple of decades.

So even if and when the economy rebounds, I wouldn’t expect your business to necessarily rebound with it. Ask yourself how many of your buy-side clients really want to analyze and buy substantial amounts of credit risk, which is the main product that you’re selling. Remember that they can’t be lazy any more, and rely on copulas and credit ratings and monline wraps, they have to do it all themselves. Do you see a business selling to these people? I hope so, because that’s going to be a large part of your job from now on, and I wish you all good luck.

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