Sunday, January 13, 2008

Moody's Thoughts on the Causes of the Subprime/Credit Crisis

I recently happened upon a paper written by Moody's as part of its "Global Financial Risk Perspectives" series entitled "Archaeology of the Crisis" where the rating agency attempted to "dig a little deeper" to discover the causes of the current credit crisis. It is sort of complex and not aimed at the general investing audience, but I found it to be a pretty interesting read nonetheless. While I know that past results don't predict future performance, I do think you can learn a lot from studying market bubbles/blowups and hopefully avoid finding yourself invested in one in the future.

Moody's basic thought is that the roots of the crisis are deep and entrenched, meaning you can't just pin it on a few little things. It presents a list of seven observations that I'll discuss a little below:

1) Incentive structures in the financial markets are flawed. My read on this was that people working for banks are paid (and paid very well) based on current performance without taking the long-term impact of their decisions into account. Put more simply, people are looking to make a quick buck. Moody's goes into how this applies to traders at investment banks but I'd also note that this applies to people like mortgage originators and real estate brokers. Their commissions are paid when people buy houses. Whether or not the person defaults on a mortgage and loses his/her home down the road does not matter to the broker, so at the height of the real estate bubble, they were just stuffing anyone they could into homes they couldn't afford. The basic short-term nature of incentive structures in the financial markets inevidably introduces more risk into the system.

2) Regulators and policymakers, looking to maximize growth, don't limit banks enough to prevent financial crises. What Moody's seems to be saying here is that bank regulators such as the Federal Reserve could prevent crises by requiring banks to keep much more cash on hand to deal with problems, but then banks wouldn't be able to earn any money. Since policymakers have implicitly agreed that letting banks grow and make money is a good thing, they accept the risk of the occasional crisis.

3) "The mystifying interaction between credit risk and the economic cycle." That's how Moody's third point reads, but I will admit I had a hard time understanding their argument here until I read the next sentence "Another problem is the difficulty of measuring risk over time." I think the crux of this argument is that the people who measure risk (rating agencies, risk management departments at banks etc...) have trouble doing so because their measurements are impacted by the cyclicality of the economy and it is hard to separate structural risk from cyclical risk, because their measurements are based on the current state of the world around them, which may or may not be in the midst of an unrecognized bubble. This is a pretty arcane topic and I might not be reading it right, but let me try giving an example...

In the late 1990s before the equity market bubble burst, people were saying that risk premiums were lower, so stocks were less risky than they have been historically, and their sky-high valuations were therefore justified. These people were having trouble looking at risk from a long run perspective and were just using the results of the current market cycle which led them to believe that the world had somehow changed. It turns out the world hadn't changed, the markets were just coming to the peak of a huge uptick in the cycle. I think the London Business School paper "Global Evidence on the Equity Risk Premium" does a better job of explaining this than I could:

"Over the last decade of the twentieth century, US equity investors more than trebled their initial stake. In real terms, they achieved a total return (capital gain plus reinvested dividends) of 14.2 percent per annum. During the last five years of the 1990s, US equities achieved high returns in every year, varying from a low of twenty-one percent in 1996 to a high of thirty-six percent in 1995. Many investors became convinced that high corporate growth rates could be extrapolated into the indefinite future. With steady growth rates, equity risk appeared lower. Simultaneously, there appeared to be a decline in the premium sought by investors to compensate for exposure to equity market risk. This drove stock prices onward and upward. Surveys suggested that, in consequence, many investors expected long-run stock market returns to continue at double-digit percentage rates of return.

Then the technology bubble burst... With markets having fallen, investors started to project lower returns into the future."

4) Difficulty in tracing risk. The crux of the argument here is that all of the structures that developed in the past 10 years or so (mortgage security pools and wrappers, pools of pools, risk transfer structures etc...) were complex and opaque. The investors who purchased the risky investments like mortgage loan pools had less information than the people who created them, so it was hard for them to truly measure what kind of risks they were taking. For example, if I borrowed $200k to buy a house, the mortgage originator might sell that mortgage to an investment bank who would combine it with other mortgages into a pool, then sell off chunks of that pool to a hedge fund under various degrees of risk assumption. The hedge fund manager would never get a chance to look at my financial records, yet he owns an investment that is partially dependent on my ability to make my mortgage payments on time. The shady mortgage broker might have lied about my income on the application as a result of the incentive structures discussed in point 1 above, but the hedge fund manager would have no way of knowing that. In addition, the bank who created the security might have made some assumptions or variations to the way the loan pool was created that were buried in some 100 page prospectus that the fund manager might not have been able to discover. The way the whole process worked made it difficult to state exactly what the risks were in the security the ultimate investor owned.

5) Confusion over the definition of "liquidity." The paper gets even more arcane here, so I don't blame you if you get sick of this entry and click out to somewhere else, but to me, Moody's seems to be sort of going on the defensive here. It mentions that there is a misconception that "highly rated securities are necessarily liquid." The agency's argument is that when it gives securities a high rating based on the issuer's balance sheet, it does not necessarily mean that there will always be an orderly market for buying and selling the security, ie while the credit risk of the security might be low, the market risk might still be very high. This seems to be what happened to many of the mortgage-backed securities. As everyone decided that mortgages were toxic, it became difficult to find any buyers for the securities, so even though the majority of mortgages underlying the securities might still have been performing as expected, the securities would only sell at extremely low valuations in the market.

6) No satisfactory valuation paradigm in the credit markets. As we all know, there is often a disconnect between market prices and underlying economic values. Moody's is saying here that the models people were using to value the credit securities that came out in the past 10 years or so were inadequate, and additionally that no adequate models exist.

7) "Spurious precision" in a complex system. Basically what Moody's is saying here is that financial reporting is discrete and precise. Banks have to put a value on their liabilites and assets as of certain dates (usually quarter end for their 10-Qs and 10-Ks) yet the values of some assets and liabilites cannot be precisely estimated, as pointed out in point 6. This leads to huge writedowns and further panic in the financial system.

I am sure our current market conditions and the ultimate fallout (the extent of which we don't know yet) will be well studied in the future but I think the above points do get at some of the main causes of the current crisis in the financial markets.


TFB said...

Where is the paper? Is it accessible to the public?

MoneyMan said...

I googled the paper to see if it was available online, but i couldn't find it. A business associate passed along a hard copy to me.

If anyone manages to find it, I would appreciate if you would pass it along.