Felix Salmon

Holman Jenkins’s errors, Part 1

By Felix Salmon
June 5, 2009

Holman Jenkins’s essay on financial markets for the Hoover Institution has been getting a fair amount of love from the blogosphere and the twitterverse — which means it’s worth explaining some of the many areas where Jenkins gets things very wrong. There’s so much to unpack here I’ll start just with Jenkins’s first section, where he claims to debunk certain “mythical” views of what went wrong — basically, the views which blame Wall Street. I’ll come back later to his second part, where he decides to blame the government instead.

Jenkins kicks off with this:

It isn’t true that Wall Street made these mortgage securities just to dump them on them the proverbial greater fool, or that the disaster was wrought by Wall Street firms irresponsibly selling investment products they knew or should have known were destined to blow up. On the contrary, Merrill Lynch retained a great portion of the subprime mortgage securities for its own portfolio (it ended up selling some to a hedge fund for 22 cents on the dollar). Citigroup retained vast holdings in its so-called structured investment vehicles. Holdings of these securities, in funds in which their own employees personally participated, brought down Bear Stearns and Lehman Brothers. aig, once one of the world’s most admired corporations, made perhaps the biggest bet of all, writing insurance contracts against the potential default of these products.

So Wall Street can hardly be accused of failing to eat its own dog food. It did not peddle to others an investment product that it was unwilling to consume in vast quantities itself.

There’s a nifty bit of rhetorical footwork there. Jenkins starts off trying to disprove the notion that “Wall Street made these mortgage securities just to dump them on them the proverbial greater fool”; he ends off simply noting that “Wall Street can hardly be accused of failing to eat its own dog food”.

In reality, both are true. Wall Street really did make these mortgage securities with the intention of dumping them elsewhere: every bank on the Street, when asked, would happily have told you that they were “in the moving business, not the storage business”.

The problem was that while Wall Street intended to get all this stuff off its books, it failed to do so in reality. In the case of Citi’s SIVs, the toxic assets really did get off the bank’s books, just not far enough off the bank’s books; eventually, and disastrously, it was forced back on to Citi’s books. In the case of Merrill, there was simply one of the most egregious failures of management that Wall Street has ever seen, with the mortgage-origination desk getting huge bonuses for moving bonds while quietly amassing a monster portfolio of securities they were unable to find buyers for.

More generally, Wall Street was working off of models which managed to reassure managers that there was much less risk on the balance sheet than there actually was. Yes, it ate its own dogfood, but it was for the most part utterly unaware, at the time, that it was doing so. Lehman Brothers was an exception: it willingly took huge amounts of commercial real-estate exposure onto its balance sheet. And the Bear Stearns hedge funds which collapsed in 2007 were in a similar position. But Citi and Merrill and UBS and AIG all genuinely thought they had much less risk than they actually found themselves with when things turned south.

So yes, Wall Street made mortgage securities to sell them on. And yes, they should have known there was lots of risk in these things — although they managed to delude themselves that there wasn’t. Which is why Wall Street ended up eating so much dogfood.

Jenkins continues:

Nor is it true that Wall Street executives and CEOs had insufficient “skin in the game,” so that “perverse” compensation incentives created the mess. That story also does not pan out. Individuals, it’s true, were paid sizeable bonuses in the years in which the securities were created and sold. But most also had considerable wealth in the form of stock and stock options in their firms, which bet their own capital on these securities. Many also appear to have invested directly in funds to hold the subprime securities.

They had skin in the game. Personal losses to top executives in banks that failed or whose share prices collapsed were in the millions, hundreds of millions, and in some cases billions of dollars.

Again, he conflates two issues. The problem with Wall Street’s compensation structures — which were indeed perverse — was not that Wall Street’s executives had insufficient skin in the game. There were however important Wall Street employees, on trading and origination desks, who got big annual bonuses, largely in cash, and who had every incentive to game the system to make as much money as they could before things blew up. They just weren’t executives. The fact that the executives lost lots of money only goes to show how bad their risk-management procedures were — and how little they deserved the money that they were paid over the years. (They’ve all still got plenty of money to fall back on, even after their losses.)

Jenkins then moves on:

It isn’t true, either, that Wall Street manufactured these securities as a purblind bet that home prices only go up. The securitizations had been explicitly designed with the prospect of large numbers of defaults in mind — hence the engineering of subordinate tranches designed to protect the senior tranches from those defaults that occurred.

This is simply false. The securities were not designed “with the prospect of large numbers of defaults in mind” — if they had been, then all those ultra-safe triple-A-rated bonds would still be pretty much risk-free today. Yes, there were subordinate tranches — but they were very, very thin: indeed, the banks had every incentive to make those tranches as thin as possible. A supermajority of every mortgage securitization got the cherished triple-A rating, which was meant to mean that it was protected from a spike in defaults. But of course the actual spike in defaults ate into those triple-A-rated bonds almost as soon as house prices started falling.

More generally, the world of mortgage securitization had allowed itself, over the years, to become incredibly blasĂ© about the prospect of defaults. The only thing that buyers of mortgage bonds cared about was prepayment rates; default rates just weren’t even on their radar, most of the time. Even when there were defaults, the loss given default on any given house was tiny, since its value had almost certainly gone up since the loan was made. So really a default just counted as another kind of prepayment, rather than something potentially devastating. As a result, when prices plunged, defaults spiked, and recovery rates went down the toilet, Wall Street was caught utterly unprepared.

So when Jenkins points to a rising foreclosure rate as evidence that Wall Street knew what was going on, he’s looking at the wrong thing. He should be looking instead at recovery rates, and at total returns on mortgage bonds. So long as those were healthy, bankers reckoned they could ignore the foreclosure rate. Until, of course, they couldn’t.

Jenkins also can’t seem to get out of the Chicago-school mindset that information is reflected in market prices:

Nor is it plausible that all concerned were simply mesmerized by, or cynically exploitive of, the willingness of rating agencies to stamp Triple-A on these securities. Wall Street firms knew what the underlying dog food consisted of, regardless of what rating was stamped on it.

Of course the firms didn’t know what the underlying dog food consisted of! You try piecing together the underlying components of a CDO-squared: it’s functionally impossible, and even if it were possible no one had the time or the inclination to do such a thing. Everything — ratings, prices, the whole shebang — was based on models, not on analysis of underlying fundamentals.

Then comes a most peculiar argument:

But, you say, didn’t a handful of shrewd hedge fund managers detect a bubble and clean up from betting against it? Yes, fund managers like John Paulson and Kyle Bass made huge fortunes betting against subprime. This doesn’t prove that all the signs were there to be read and so others must have behaved irresponsibly… Those who bet successfully against subprime did so through elaborate, expensive, negotiated deals to purchase credit default swaps or buy “put contracts” on subprime indexes. Had they really seen what was coming, they would saved themselves a great deal of expense and bother by simply shorting Citigroup, Bank of America, Lehman, Bear Stearns, etc. Their profits would have been huger, their workload and hassle factor much less. The reason they didn’t, it’s reasonable to suppose, is because no more than anyone else did they foresee the catastrophic consequences we now suppose were destined to flow from excessive issuance of subprime mortgages.

There was lots of irresponsible behavior going on in the subprime market. Paulson et al saw that, bet against it, and made lots of money. Did they foresee that the banking system would implode as a result? Maybe, maybe not — that was hard to foresee, precisely because the banks were very good at hiding the risk they were keeping on their balance sheets. But in any case, it’s never a particularly good idea to bet on second-order events.

The fact is that Wall Street was out of control — out of control of the regulators, yes, but also out of control of its own executives. And excesses on Wall Street did lead to the financial crisis, which in turn led to the economic crisis we’re all living through today. Jenkins’s attempts to let Wall Street off lightly simply don’t hold water.

11 comments so far | RSS Comments RSS

Jenkins: “In sum, the global financial panic sparked by the behavior of subprime mortgage loans is probably best understood as an unforecastable accident of history. Another accident, brought on by the first, is the empowering of the Obama agenda, … It is likely to end badly, as such dirigiste overreaching always does.”

I think that Walter Bagehot (of lender of last resort fame) would have predicted this crisis as the natural consequence of repeatedly bailing out bad banks — thereby precluding the development of a healthy banking system that is competent at managing risk of every variety. (See here for further more: http://syntheticassets.wordpress.com/200 9/06/03/learning-from-the-crises-of-1857 -and-1866/)

It seems to me that the person guilty of dirigiste overreaching was Alan Greenspan when he claimed: “Indeed, central banks, by their existence, appropriately offer a form of catastrophe insurance to banks …” (For more details see here: http://blogs.ft.com/economistsforum/2009  /06/us-economic-crisis-the-role-of-syst emic-risk-guarantees)

I agree that “Wall Street was out of control”. The question is why? I think that it was out of control because of bailout guarantees made in the 80s and 90s.

Posted by csissoko | Report as abusive

Felix: I would say that GM made cars with the intention of dumping them? And GM was working off of models that gasoline prices and household discretionary purchasing power would not be the risks they turned out to be. And why did GM pay junior high school dropouts $35 per hour for 20 years, and then another $30 per hour in pension and medical benefits in retirement with life expectancies on the rise?

The fact is that GM was out of control. And excesses in GM did lead to the employment crisis of the auto industry in the midwest and beyond. The media’s uneven handling of one industry vs. another simply doesn’t hold water.


“What is most striking about Taylor’s analysis, though, is the extent to which he shows that investors in the global panic were responding not to the exposure of subprime losses, or even the failure of Lehman Brothers, but to what we might call a sudden, sharp explosion of uncertainty about what government might do and what principles or expectations might guide its actions amid the crisis.”

Taylor didn’t do any such thing. First, from The Economics Of Contempt:

“Wednesday, February 11, 2009
John Taylor: Giving Banks Money Hurts Banks
John Taylor undoubtedly made some great contributions to monetary economics—foremost among them being the famous Taylor Rule. But an astute observer of financial markets he is most certainly not. His diagnosis of the financial crisis is comical at best. It really is unhinged from reality.

Taylor really jumps the shark when he claims that the government’s handling of the bailout, rather than Lehman’s collapse, caused the financial crisis:

The realization by the public that the government’s intervention plan had not been fully thought through, and the official story that the economy was tanking, likely led to the panic seen in the next few weeks.

This is literally nonsensical.”

Investors panicked because the government didn’t intervene, not because it did. When WaMu was seized, investors, once again, saw that the government was not guaranteeing everything. That was the panic. There was no Plan B. Investors wanted and expected the government to intervene.

As for the VIX: From RGE Monitor and Vox:

“Financial crisis, global conditions, and regime changes

Heiko Hesse and Brenda González-Hermosillo | Apr 22, 2009
This column examines the use of key global market conditions to assess financial volatility and the likelihood of crisis. Using Markov regime-switching analysis, it shows that the Lehman Brothers failure was a watershed event in the crisis, although signs of heightened systemic risk could be detected as early as February 2007.”

Plus, I have dozens of quotes from actual investors explaining how the Lehman blowup caused the panic.

As for the Fed and the housing bubble, here’s Richard Posner:

“If low interest rates drive up housing prices, high interest rates should (and eventually do), drive them down. Yet we have just seen that housing prices continued rising after interest rates started to rise. Moreover, a leading housing economist, Edward Glaeser, has pointed out to me that, on the basis of studies of the responsiveness of housing prices to interest rates in other periods, it is unlikely that the fall in mortgage interest rates during the early 2000s accounted for more than 20 percent of the increase in housing prices.”

And this:

“They had skin in the game. ”

So did Bernie Madoff. No one is arguing that they thought that Debt-Deflation would follow from their actions. Only that they believed that they’d be relatively shielded in a blow up. They simply took large and asinine risks believing that they’d make it through with the help of the government and their personal wealth, which is still, often, enormous.

“Richard Fuld, of failed Lehman Brothers, saw his net worth reduced by at least a hundred million dollars.”

This is the same guy who couldn’t believe that the government saved AIG, and not him. He was counting on a bailout until the last second. As Swagel says:

“It was almost as if Lehman management was in a game of chicken and determined not to swerve”

Anyway, what’s the point?


These are all interesting arguments you present, Felix, and no doubt they are largely correct.

However, it takes two to tango. Blaming Wall Street exclusively for the bubble is rather akin to blaming GM for the awful state of Detroit real estate.

Inept regulators certainly share some blame in this whole mess.

Posted by Dave | Report as abusive

In the case of Merrill Lynch & their CDO machinery, they fired the very guy for telling senior execs what they did NOT want to hear: CDO volumes had to go down in 2007. Primarily, it was Stan O’Neal who balked at shutting the money-maker down…

This big, ugly debacle was really a form of excess liquidity chases the wrong kind of mispriced, supposedly risk-free assets. Perhaps if

1. the Greenspan FED tightened at a quicker pace from the 1% rate starting 2004;
2. another stupid SEC ruling that allows HIGHER LEVERAGE by the IB/Dealers (LEH, BSC, et al) is not passed (I believe this was done in 2004)
3. Investment mgrs behaved like the PIMCO’s of the world, who cast doubt on the mortgage / housing phenom in late 2005 / early 2006
4. Wall Street innovation was seen for what it truly was: wringing profit levels from a depleting cast of thousands of ever-lousier mortgage credits (and Credit Cards, and Student Loans, and Auto Loans, and Commercial MBS)

I think Jenkins could do some ghost-writing for Larry Kudlow, if the job ever came open.

Posted by Griff | Report as abusive

So the basic argument isn’t that Wall Street was evil but that it was stupid: stupidly underwrote & issued securities & derivatives without understanding the risks, stupidly paid out massive compensation based on bad data, stupidly risked their entire businesses without understanding they were doing that, etc.

The arguments made in the comments about GM are just plain silly. Talk about apples and oranges. At least those are fruit while this is more like rocks and wheat.

As for regulators, when you issue securities, you are on the line no matter what the ratings agencies or regulators say. It’s like running a red light and getting creamed by crossing traffic and then blaming the police for not enforcing the traffic laws better so you would have known better. It’s a version of the Sgt. Schultz defense – remember him? From Hogan’s Heroes? “I know nothing. I know nothing.”

Posted by jonathan | Report as abusive

Has anyone yet found a bank whose proprietary desk bought a significant chunk of its *own* MBS? I’m sure it must have happened at least once.


RE: Paulson et al making money shorting these structures. They went short using CDS because of the asymmetry involved. Back in early 2007 they could buy CDS for 50bps (AAA) to 2-3% (BBB); if they were right, these things would have huge payoffs, but if they were wrong, the downside was fairly limited and acceptable. If you short the banks, though, not only are you betting on the second order effects, but you’ve lost the ability to take targeted exposure with a known and limited downside.

Posted by GDM | Report as abusive

As I recall, it was the banks (not investors) who first panicked.

Posted by Benedict@Large | Report as abusive

Mr. salmon-
don’t you engage in a bit of doubletalk and tap dancing yourself with this de-bunking? in the process you seem to verify Jenkins’ conclusion: the banks bought the mortgage bonds because they believed they were good. yes, they were using models that told them the bonds were safe – but isn’t that the point? they thought the bonds were safe to invest in and to sell (or dump on investors). as a result, they were motivated to sell the bonds, which their models told them were safe, to as many people as possible.
if you believe this point, which i am confident is historically accurate (even if hindsight might tell us was poor judgement), then it makes sense that they had skin in the game – at the executive and trader level. at bear, for instance, the traders were paid well, but a huge portion of their bonuses was in Bear stock – to keep them from trying to leave.
also, i don’t think it is accurate to simply blame the models – all of the participants used the models and their experience with the RTC, 1998, the dotcom bubble and 9/11 to form their opinion of the value mortgage bonds. mortgage bonds were also considered less risky than many other consumer assets (and thus appetite was greater for them) because of the perceived essentiality of a borrower’s home, which is virtually enshrined in the federal charter. people didn’t just make this up in 2006 – the concepts and analysis had been around for a long time.
finally, your comment about the leel of enhancement for MBS and the performance of the deals seems a bit like re-writing history. most sub-prime mbs (the first part of the crisis) had about 25% of the deal in subordination, which would, in theory, support about 50% of the borrowers defaulting. the levels had increased in the months leading up to the crisis. this seems to be an awareness that these loans had greater risk and likelihood of default that prime jumbo bonds, which needed only about 2% of subordination for AAA. Distinctions were being made by the market – just not enough, as it turns out.
it’s easy to say, now, that they were all just greedy bastards who had it coming. but it isn’t historically accurate. the reason the crisis cut so deep is because so much of the financial markets relied on the notion that securities such as these were analyzable and that the risks could be identified and contained. once such a fundamental part of the market got thrown into question, the entire financial system melted down because all credit risk was now suspect. the government stepping into the market with AIG (and wamu, merrill, etc.), provided confirmation to people who were afraid to admit that everything they knew up to that point about credit was wrong. hence, panic.

Posted by tj | Report as abusive

The same Holman Jenkins who rejected the idea that President Obama would BK GM. Wrong again, Holman.

Posted by VennData | Report as abusive

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