UPDATED: Another Anecdotal Example of Who Helped Cause the Financial Crisis

9 Mar

Tom Adams – a former Monoline exec – and Yves Smith, proprietor of the Naked Capitalism blog and authors of Econned, have said in not so many words, that especially with synthetic products (like CDO’s, CDS thereon, etc) demand comes from those looking to get short and thus products are designed to suit them, and that this dynamic contributed to the Financial Crisis.  Just today we get this:

The amusing bit is that the article focuses on the demand from the longs and conveniently fails to mention that the people who want to short this market have to be at least as active. In fact, demand for synthetic assets almost always starts with the short side. That means the structures are devised to suit their needs.

Why do the shorts have to be at least as active?  Is not the opposite invariably true, that the longs have to be just as, if not more active than the shorts?  Why the continued bend to blame “the shorts?”

The rationale for such argument goes, if I’m following, that “the shorts” drove the demand for creating all of the “toxic” CDO’s that almost brought down the Financial System down because after all, the Investment Banks couldn’t sell a CDO to lazy/ignorant institutional investors and CDO managers if there was no one to take the short side of each trade.

Sure, you cannot have such a trade without a buyer and seller, but when history shows the sellers to be the ones who were right, and who acted on it, I’m not sure how you can not only avoid blaming those who were wrong – those who were long such deals – but go out of you’re way to blame the people who saw the signs and acted accordingly.  That, to me, is crazy talk, at best, like blaming the United States for the actions of the Third Reich during WWII.  Lots of people contributed to the financial crisis, but the

Despite what Tom, Yves, or whomever else wants to blame the shorts may try to tell you, “the shorts” were the ones who saw (broadly-speaking) impending collapse and traded accordingly.  The longs were the ones who kept buying things that others – and sometimes they, themselves – knew were crap, or were likely to become crap.  Hell, the monolines – whose business Ackman, Einhorn, and others had identified as unsustainable as early as 2002 only dug further into the structured finance business.  As they say, the band played on, so to speak.

If one really wants to point fingers (which isn’t really very productive), they should be pointed at the Investment Banks, the Ratings Agencies, lazy/poorly-incentivized money managers, and Regulators, in that order.  Arguing that the shorts who allowed the banks to create and sell (or retain) long CDO exposure to investors are making a similar argument to those who blame gun/bullet makers Glock and Remmington for shooting deaths, or Stanley Hand Tools for making the hammer that was used in an assault.  CDO’s, CDS, etc are like tools, and, when used properly, can be quite effective.  But, when used improperly, or without proper care, they can be deadly, financially speaking.

Absent fraud (another story for another time) on behalf of the Investment Banks, originators, and/or servicers, institutional investors like IKB – who, despite having a dozen or two member diligence team – still went long CDO’s like ABACUS, akin to a child getting his hands on a loaded machine gun.  It was only a matter of time until they shot themselves in the foot (or worse)…

They did this because as I’ve said time and time again, portfolio managers don’t get paid to sit on cash (generally); they have to invest their money, and in many if not most cases there were (and still are) perverse incentives for PM’s to buy the highest-yielding security he could find as long as had the blessing of the Ratings Agencies.  (Naked Bond Bear can elaborate on this, and has, if you want more nuance).  The same holds true for many other participants, collateral managers like ACA (infamous for apparently blessing the ABACUS transaction even though they “knew” the collateral), CDO managers like Chau, etc.

John Paulson, Michael Burry, Steve Eisman, none of these guys forced their counterparties to take the long side of their winning short trades.  Their counterparties were (mostly) financial institutions with the resources to do the same research and put on similar trades (or at the very-least least reduce their risk exposure) as “the shorts.”  Others, due to arcane financial regulations (etc), were able to gain exposure to these securities without having anywhere near the financial sophistication to understand them, yet they did so, anyway, because they did not know what they were getting themselves into.

Michael Hyde, general manager of an Australian council responsible for investing millions was one of these latter, ignorant types.  Mr. Hyde has since admitted that he did not know what a CDO was, and “admitted to confusion on his part about the terms “call date” and “maturity date”, which he had believed to be interchangeable. ‘I guess (it was) ignorance. I did not know there was a difference,’ he said.”

Mr Hyde said he believed that Grange would buy an investment back from Wingecarribee at three days’ notice, or return the value of the whole portfolio at 30 days’ notice.

Barrister John Sheahan, SC, for the liquidator of Lehman Brothers Australia, put to Mr Hyde that the contract Wingecarribee signed with Grange provided for the buy-back to be at market value, not face value.

“What you were told was that you could redeem your security at three days’ notice, at market price?” Mr Sheahan asked.

“I did not understand that,” Mr Hyde replied.

When, in September of 2007, Mr Hyde asked Grange to buy the investment back from Wingecarribee at face value, the response was “non-receptive”.

Mr Hyde said he was told by a Grange employee, “you need to understand Mike, there is no such thing as a capital guarantee”.

By then, the Federation note, originally worth $3 million, was valued at $1.02 million.

While it may have been (quite) unethical for Lehman/Grange to have gotten the council into investments its representatives verbally said they were not interested in, they did not force the council members to sign any contracts.  At the end of the day, a not-insignificant part of the blame has to lay at the feet of those who voluntarily gained exposure to these securities despite having no idea what they were talking about, let alone what they were signing-up for.

As James Montier of GMO Investments said in his recent letter “The Seven Immutable Laws of Investing,”

1. Always insist on a margin of safety
2. This time is never different
3. Be patient and wait for the fat pitch
4. Be contrarian
5. Risk is the permanent loss of capital, never a number
6. Be leery of leverage
7. Never invest in something you don’t understand

#’s 1-6 are surely important (especially #’s 1, 2, 5, and 6), but I’ve highlighted #7 because it is the single best piece of investment advice anyone can every give you.  I would add, after “Never invest in something you don’t understand…” that if you do invest in something you don’t understand, absent fraud, you must accept that you have no one else to blame but yourself if the investment does not work out as you’d hoped.  Caveat emptor.

People who don’t even understand the difference between a call date and a maturity date (let alone know what a CDO is/how it works) should NEVER be able to come anywhere close to anything more complicated than a mutual fund or vanilla bond, and that they were able to do so in this (and other) case(s) is the fault of the regulatory apparatus, the “Overseers” tasked with protecting investors.

But as Montier’s law #7 says, you should never buy something you don’t understand.  And, unless someone made you sign a contract at gunpoint, it’s you’re responsibility to make sure you’ve read the contract and understand the terms before signing on the dotted line.  If you don’t understand, but sign anyway, then you’re just begging-for, if not deserving of losses.

I do feel a bit of sympathy for people like Mr. Hyde who were pressured by those more sophisticated (I’m not going to say savvy, since that whole Lehman thing worked out so well…) than they, but my sympathy is limited by the apparent indifference with which Mr. Hyde and others of his ilk exercized when making their investment decisions.  It’s one thing if you want to bet all of your personal money on something you don’t understand and end up screwing only yourself.  It’s another thing when you’re investing other peoples’ money and/or public monies.

That’s analagous to me going into a surgical procedure without knowing which organ is which, or a crazed alchemist tossing various liquids and powders haphazardly into a cauldron with little if any regard for possible – if not downright likely – violent and dangerous reactions.

The sad part is that it wasn’t just financially unsophisticated people like Mr. Hyde who failed to exercize the proper level of diligence and caution.  I’d be curious – although I doubt we’ll ever know such things – what % or how many of the parties that had long RMBS (synthetic or otherwise) exposure pre-crisis conducted thorough analysis at the loan level, on originators’ underwriting standards, etc and turned-down or shorted deals they found to be garbage.

As far as I can tell, the answer is not many, although in fairness, Tom claims they did, in fact, turn down several deals for such reasons, but I doubt in the grand scheme of things, the ones they didn’t do were anywhere close in number and size to the ones they did.

UPDATE: I’ve made a few changes to the title and text as the first version of this article was, I think, too incendiary in hindsight.  Thanks to those who gave me a heads-up on that from KD/DH.

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13 Responses to “UPDATED: Another Anecdotal Example of Who Helped Cause the Financial Crisis”

  1. David Harper March 9, 2011 at 2:40 pm #

    Have you read Econned? “Blaming the shorts,” in my opinion, doesn’t even come close to Yves’ arguments … It would help if you linked to the Yves blog where she blames the shorts, to avoid the impression it’s a straw man. thanks, David Harper

    • The Analyst March 9, 2011 at 2:45 pm #

      No, but you are correct, I forgot to link to the post(s) wherein Yves/Tom have blamed the shorts. I’ll update in a bit, thanks/sorry!

      • Richard Smith March 9, 2011 at 4:58 pm #

        Is that ‘no’ as in ‘No I haven’t read Econned so I don’t know who Yves blames but I’ve read a few blog posts about shorts so I think that’s her beef’?

        You say:
        “If one really wants to point fingers (which isn’t really very productive), they should be pointed at the Investment Banks, the Ratings Agencies, lazy/poorly-incentivized money managers, and Regulators, in that order.”

        Yves identifies all those miscreants and more. Read the book, then you might have something relevant to say.

        • The Analyst March 9, 2011 at 5:31 pm #

          Perhaps its my fault for putting the real point of my article so far down in the post and wasting so much time talking about the same things I’ve said over and over before. I wanted to share that anecdote and use it to make the point that, this is an example of dumb money (which I know yves has previously mentioned, for your information) and what we can/should learn from it.

          Me thinks you were a bit quick to judge, but you do point out that I should have linked-back to Naked Capitalism’s previous posts since yes, I have read them for quite some time and yes, the things I/you mentioned have been previously addressed. Thanks for commenting.

    • Kid Dynamite March 9, 2011 at 4:02 pm #

      David, Yves “blames” the shorts constantly… And by “blames,” I mean that she constantly diverts attention from those reckless stewards of capital who negligently or ignorantly lost their clients money – THE LONGS – and toward those who were on the other side, the right side of the trade: those who were smart, did the work, and got it right.

      TODAY for example:

      http://www.nakedcapitalism.com/2011/03/shades-of-2007-synthetic-junk-bonds.html

      “The amusing bit is that the article focuses on the demand from the longs and conveniently fails to mention that the people who want to short this market have to be at least as active”

        • The Analyst March 9, 2011 at 5:27 pm #

          Please explain to me why you continually frame arguments like “people who want to short this market have to be at least as active. In fact, demand for synthetic assets almost always starts with the short side,” as if it were concrete iron-clad fact? Do banks not make markets? Why not frame the argument “people who want to go long this market have to be as active as those who wish to short it?”

          I’ve read many of your posts and I know you’ve attacked the dumb-money longs who fail(ed) to do proper diligence or fulfill their fiduciary responsibility, but I cannot understand why you keep coming back to this blame the shorts thesis as part of your broader criticisms. Surely it is important to understand that were there no short interest for these securities, the markets would not exist (at least in and to the size/extent they did/do), but such criticisms seem to miss the signaling effect inherent in the very presence of this short interest.

          Many dismissed Paulson, Bury, etc because they mortgage pros “knew better,” at least to some non-insignificant degree. Several investors far smarter and more accomplished than me have said, one way or another, “if there’s guys ready and willing to take the other side of my trade I want to know why. Why do they think I’m wrong? Am I missing something/anything that could cost me $?” It seems that many people who were long housing, and now the synthetic junk you discussed, are not using this prudent approach to investing, that, and/or they are assigning a greater value to continued government intervention than those on the short side.

          Either way, I’m not decrying everything or even most of what you write; on the contrary, alot of it is informative. However, I do take issue with what I’ve noticed seems to be an every-now-and-then reversion to the “blame the shorts” sort of mentality that I can’t understand.

          Thank you for responding in a cordial manner. I updated the post from it’s original status because it was too incendiary/offensive, and for that, I apologize, I let my emotions get the better of me.

          • The staff at Naked Capitalism March 9, 2011 at 5:57 pm #

            Shorting is *good*, that’s why one wants it, to get the price signals working.

            This is not the usual idiotic ‘wicked shorts’ thesis though.

            The problem with the particular way the Magnetar trade worked was precisely that it *distorted* the usual price signals. ECONned ch 9.

            Magnetar went long the junior tranches and funded the carry of the supersenior short until the whole lot blew up. Ingenious as Kid says but in that size, it compressed spreads and allowed 2 more years of issuance. In that opaque market, it simply lured in more long-and-wrong idiots, many of whom were systemically important, to the chopping block. And that was disruptive. Ex that the whole CDO sausage machine would have seized up in 2005, bunged up with unsaleable BBB tranches.

            At bottom – stupid regs (Basel), stupid IBs, stupid rating agencies, other dumb longs in Narvik, Australia or at monolines, stupid funding models (repo of stuff that turned out crap), oblivious regulators, agency problems, stupid economic theories.

            Which all pretty much *coincides* with what you say, fer Chrissake (sorry).

            Now it’s already starting again, with cocos and these dumb synthetic junk bonds. Chase yield in exchange for for tail risk, again. Same regulatory nonsense, same agency risk, and the supply of idiots seems to be infinite.

          • Kid Dynamite March 9, 2011 at 6:24 pm #

            @NC, you pointed me toward a post (the Lewis one, which I had off course read already) that contains exactly the type of stuff I’m talking about:

            “Eisman recognizes that the subprime market is a disaster waiting to happen, a monstrous fire hazard that, once lit, will engulf the housing market and financial firms. Yet he continues to throw Molotov cocktails at it. Eisman is no noble outsider. He is a willing, knowing co-conspirator. Even worse, he and the other shorts Lewis lionizes didn’t simply set off the global debt conflagration, they made the severity of the crisis vastly worse.

            So it wasn’t just that these speculators were harmful, and Lewis gave them a free pass. He failed to clue in his readers that the actions of his chosen heroes drove the demand for the worst sort of mortgages and turned what would otherwise have been a “contained” problem into a systemic crisis. ”

            Eisman is the villain – in the NC view of the world. Guess what – you might not like the fact, but there’s no crying on Wall Street. It’s not against the rules to be smarter than the guy on the other side of the trade, and it’s not against the code of ethics either. When you figure something out, your job is not to tell your counterparty.

            Let me make this point, because it’s the one that matters: SUPPLY vs DEMAND… The shorts drove SUPPLY. The dumb-ass delinquent ignorant negligent fiduciary-duty-failing LONGS are the ones who drove DEMAND. And yes, I absolutely understand that without Magnetar’s equity tranche the product couldn’t have existed. TECHNICALLY, the NakedCapitalism view of the world is literally true. But you conveniently ignore the capital behind the other 90% of the trade in the higher rated tranches – that was DUMB MONEY DEMAND and was the biggest problem in the crisis.

            SO, yes – if Magnetar hadn’t been so brilliant, the crisis may have ended earlier. More importantly, in my mind, if IKB, ACA and all the other fucktards on the wrong side of the trade hadn’t been so stupid, the crisis would have ended earlier. If Mexican food didn’t taste so damn good, I wouldn’t be so fat – but it’s not Mexican food’s fault – it’s MY fault. I have no doubt in my mind that Yves Smith would call that a “straw man” – that’s her go to copout – but it’s not a straw man, it’s relevant, and I could give you 50 more analogies.

          • Kid Dynamite March 9, 2011 at 6:34 pm #

            ps – NC – you used the word “LURED”… that’s actually very important to me – see, there’s no such thing as crying that someone “lured” you into a trade on Wall Street… that’s pretty much exactly the point I’m trying to make.

            We are all responsible for doing our own trades and our own work, and when we misinterpret/misevaluate/misunderstand something, we can’t cry that we got “lured” or tricked or anything of the sort.

            Unless, of course, we want to guarantee that the issue isn’t addressed (the issue, of course, being our own ignorance) and that the the problem is repeated…

          • The staff at Naked Capitalism March 11, 2011 at 10:24 am #

            Again with the misreading – I’m saying that the spread-tightening caused by the Magnetar trade “lured” people back in again, when the market would have been packing up all by itself otherwise. That doesn’t imply any deliberate “luring” by Magnetar.

            Why are you protesting so much? I don’t get it.

            Then you say
            “But you conveniently ignore the capital behind the other 90% of the trade in the higher rated tranches – that was DUMB MONEY DEMAND and was the biggest problem in the crisis.”

            Huh? Which part of my comment:
            “At bottom – stupid regs (Basel), stupid IBs, stupid rating agencies, other dumb longs in Narvik, Australia or at monolines, stupid funding models (repo of stuff that turned out crap), oblivious regulators, agency problems, stupid economic theories.” did you miss? Doesn’t seem to me that I’m conveniently ignoring them at all. You don’t seem to be listening, Kid, or only doing so selectively.

            This was a banking crisis. Long-only, ungeared investment managers who let their clients down should be out of a job, sure, obvious. But they did *not* cause a banking crisis.

            And Magnetar isn’t the sole cause either: it just helped to make it worse. Which is what NC is saying.

            I don’t think there is much point in my trying to add to that.

Trackbacks/Pingbacks

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