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.

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