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The 2014: Living in the Shadow of Regulation? Whitepaper | Background to the crisis - Views ( 318 )

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Interview Skills

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Let us begin by reviewing several important features of the period leading up to the financial crisis: A LOW INTEREST RATE CLIMATE At the turn of a century a sense of inflated optimism drove the economy. Demand for property was fuelled by the availability of historically low-cost funding, deregulation and financial innovation. The Greenspan Put in the wake of the economic slowdown following 9/11 assured speculators that the US Federal Reserve would, in the event of a crisis, help investors by lowering interest rates. This hedge led to a willingness to assume high levels of risk, which was ultimately responsible for the credit bubble. Banks and investors became excessively leveraged in their attempts to manufacture acceptable yields in a low interest rate climate. BAD HOUSING POLICIES The US Government indirectly supported the private real estate market for decades. After the Great Depression, policy-makers devisedregulations to prevent a recurrence. The Glass-Steagall Act of 1933, requiring the separation of commercial and investment banking, meant that deposits could no longer be used to play the stock market. The creation of Fannie Mae (The Federal National Mortgage Association) in 1938 ensured that banks would always be in a position to grant a mortgage even if they were in financial trouble. Fannie Mae partnered with banks and not directly with borrowers and in doing so it provided liquidity by buying home loans from mortgage banks, assuming the risk, and refinancing itself in the markets. MIS-SELLING The boom created tremendous growth opportunities for banks, which may help explain the general deterioration in the standard and quality of financial advice, together with a lack of financial literacy among a broad section of the mortgage-buying population. Teaser rate loans were a particularly good example of mis-selling in this environment, essentially promoting the wrong, lower than actual price of the product. They did a disservice not only to the client but also to the lender, who made a high-risk loan, caveat emptor accepted. The Midwest US subprime mortgage market proved to be so popular and easy to sell that it seemed everyone was selling mortgages either to supplement their income or to play the property investment game, with many low-income investors able to acquire property portfolios using high-risk, short-term credit card deposit funding. CAPITAL ADEQUACY In the early days of the pre-crisis period, bank balance sheet valuations appeared to be solid, in part due to mark-to-market rules that reflected what later proved to be an incorrectly priced CDO market. There appeared to be no immediate risk to the banks capital positions. A belief that there would be a perpetual demand for loans led to hubris. In an attempt to optimise the available capital securitisation helped banks to circumvent the spirit of Basel IIs capital adequacy provisions whilst complying with the letter of the law. THE ROLE OF THE ALCHEMISTS Opportunities for fast growth tempted bankers to depart from the traditional banking model based on client relationship management and strong loan-to-deposit ratios, in favour of a more lucrative model of origination and securitisation. Banks essentially became marketing companies, simply promoting mortgages with no intention of ever holding a customer loan to maturity. Ingredients for asset-backed securities (ABS) and collateralised debt obligations (CDO) leveraged return and risk 2,000-fold, which was then further leveraged with structured investment vehicles (SIVs), credit default swaps (CDS) and CDOs of CDOs. Essentially the same equity capital funded multiple rounds of loan originations, a form of capital churning that creates little if any real economic value. THE RATING AGENCIES The low interest rate environment in the period leading up to the crisis offered professional fund managers poor returns on traditional fixed income debt. This created a market opportunity for investment banks. Financial innovations enabled bankers to package and sell even the highest risk-securitised debt (the equity tranche) to investors. To these professional investors asset backed securities seemed, on the surface at least, to offer an alternative investment, which gave high yield at an acceptable risk premium. This was made possible because rating agencies rubber-stamped these bonds with ratings that gave investors the confidence, and in many cases the mandate, to buy. Rating agency valuations of CDO debt tranches were based on enigmatic models that were not readily open to public scrutiny. THE PROFESSIONAL FUND MANAGERS One of the principal failings of professional fund managers in this situation was in outsourcing essential due diligence on asset portfolios to the rating agencies: a lack of fiduciary duty of care to the very household investors that are the providers of funds in the first place! HEDGE FUNDS AND THEIR USE OF DERIVATIVES Banks, pension funds and sovereigns alike scrambled to acquire CDOs, CDOs squared and other synthetic mortgage-related derivatives. This frenzied period saw the acceleration of the market for credit derivatives. Credit default swaps (CDS) were being touted to investors as a safe hedge against CDO credit default risk. Unfortunately, the blends of risk were opaque, it was impossible for any bank to accurately value these instruments, let alone price insurance protection. The ratings were used to do this but premiums, which generally should reflect the cost of risk, failed to do so, as the ratings were based on faulty models. This fact itself spawned pricing arbitrage opportunity later for astute hedge fund investors such as the infamous Michael Burry of Scion Capital. The mortgage pools that Burry shorted had delinquencies of up to 33%. By 2005/6 teaser rates were already ending, delinquency rates were rapidly rising, but Wall Street remained long and wrong. WHY BANKS GO BUST Loans were originated with the intention of removal from the balance sheet in a relatively short timeframe. This encouraged some bankers to rely on short-term interbank funding to finance loan growth, a very high-risk approach. But if history has taught us anything it is that banks tend to go bust when they hold too little capital. Leverage, the process of funding income-generating assets with both equity and debt, is the single most effective way to increase return on equity (ROE). ROE is arguably the most important performance metric for a bank and its investors, with both investor returns and banker bonuses being closely aligned to it. Unfortunately ROE does not account for risk. Leverage can therefore magnify returns but it can also magnify losses. The consequences of getting it wrong canhave a devastating effect on the capital position and the solvency of a bank. Profit after tax (PAT), the metric commonly used to calculate ROE, does not account for risk. Risk adjustment to profitability is achieved by applying a charge to risk, allocated equity at the cost of equity, to derive what is referred to as an economic profit (EP) metric. EP, unlike ROE, is an absolute number which represents the minimum return required to satisfy shareholders. Unfortunately many banks and investors focus too heavily on the non-risk adjusted ROE.

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