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.

A Good Site For Valuation Related Matters

Ok, so he doesn't format his excel spreadsheets very nicely, but hey I don't hold that against him. The guy wrote some of the most respected textbooks in the field of valuation/corporate finance. I'm talking about NYU professor Aswath Damodaran, and I'd like to suggest you take a look at his website sometime.

I don't know when he put this mission statement up, but I think it's fantastic:

"I am lucky enough to be in a field where a little knowledge and some experience goes a long way, and achieving guru status seems relatively simple. What I do know is neither profound nor earth shattering, but I would like to share it on this site. In that pursuit, I have attempted to keep almost the entire site open and accessible, with the only shut-off portions representing powerpoint slides used by instructors (who use my books). Everything that I learn, do or write in the field of finance will be on this site sooner or later. I hope that you find the content useful and that you will share it with others. Good luck! "

If that doesn't sum up what the Internet is all about (free sharing of information), I don't know what does.

Bill Gross of Pimco on The Markets

I guess he has been writing these for a while, but I've only recently started reading Bill Gross's monthly investment outlook at pimco.com.

In this month's post, Bill spoke about a few issues near and dear to my heart, the first one being the gap between rich and poor, which I have written about before. He rails against this gap, saying that he's firmly in Warren Buffett's camp and thinks it's a travesty for the richest people in America to be paying 15% tax rates on average, while the middle class (their secretaries and assistants) end up paying almost 30%. He says this is one of the prime reasons why there is such a huge gap between the rich and the poor, where 5% of the national income goes to .01% of the families in the US. You read that right, "point zero-one" or "one basis point" take in 5% of the national income.

That whole discussion was spurred by a recent issue that has gotten a lot of attention in the financial press. Basically, the rich managers of private equity funds, whose annual income is measured in hundred millions or billions, have their income treated as capital gains, so it gets taxed at the much lower 15% rate instead of the 35% rate us mortals pay. This New York Times article does a good job of summing up the issue.

I agree with Buffett and Gross. If you made $100 million last year, you should be paying $35 million in taxes, not $15 million. This leaves you with $65 million for yourself. Meanwhile, your secretary (lets assume she's an executive secretary) made $100 thousand last year, and paid her full $35 thousand share. This left her with $65 thousand for herself. Why should she be paying a higher rate than you? If anything, she should be the one paying the lower rate. In fact, it could potentially change her life to have $15k extra in her pocket every year. What's an extra $15 million to someone who already has a billion in the bank?

Gross also spoke about the markets some more, in particular, talking about increasing credit spreads. He basically repeated the theme that easy money is drying up for the LBO funds and PE folks who have been using it for buyouts. In particular, he pointed to a financing that's in the works right now that may not be going so well...

"Those that assert that this is merely an isolated subprime crisis should observe very closely the price and terms that lenders are willing to accept with Chrysler finance this week. That more than anything else may wake them, shake them, and tell them that their world has suddenly changed."

Well according to some press coverage I've been reading, it turns out the lenders haven't been able to accept ANY terms to lend money to Chrysler finance, and the banks and the companies involved are going to fund the buyout themselves.

For those of you who don't follow the credit markets very closely, I'll try to sum up what has been going on (in my opinion). Over the past few years, buyout funds have been able to borrow large sums of money at very low rates and use that money to acquire companies. The lower the price they paid on the borrowed funds, the more money they could make off of these companies they bought. Think of it this way: if you can borrow a million dollars at 3%, you are paying $30,000 a year in interest to use that million dollars. If you use the million to buy a business that returns you 12%, the business will be throwing you $120,000 a year. Subtract out your interest payments, and you're getting $90,000 a year in profit for yourself. Not bad! You'll easily be able to make your interest payments, and in fact you'll probably go out looking for more of these great deals. That's exactly what buyout funds have been trying to do, except they have been buying businesses for much more than $1 million.

The credit markets were giddy with all of these deals. Lenders were willing to charge lower and lower interest rates, somehow believing that there was not much risk involved, even with companies on the shaky end of the spectrum. Credit spreads (basically the additional amount lenders charge for people with shakier credit, just as banks charge people with lower credit scores higher mortgage interest rates because they are more risky) got very narrow. This meant that even a shaky business (one with a low credit rating) could get a loan and pay a rate not much higher than an extremely solid business (one with a high credit rating). There was a small "spread" between the interest rates they were charged. This is referred to as "tight credit spreads" or "narrow credit spreads."

What Gross is saying is that this is now changing. With subprime borrowers defaulting on their mortgages in large numbers, the market got sort of a slap in the face that said "wake up! you've been ignoring some risks here! you need to charge higher interest rates, especially for buyout firms that are using money to buy companies with low credit ratings because these loans are a lot riskier than you used to think! In addition, the credit rating agencies (Standard and Poor's and Moody's, primarily) have been asleep at the wheel too and they aren't giving low ratings to companies that deserve them!"

In the past few weeks, companies with low credit ratings have had to pay higher interest rates to borrow money than they have in the recent past. Things are getting back to normal, but as they make their way back there, there could be a whole lot of pain for the lenders.

Change of Control Covenants

In a previous post about credit default swaps, I briefly mentioned how leveraged buyouts(LBOs) can cause stress for bondholders of the target firm.

With all of the easy money floating around in the economy, LBOs have been on the rise for the past few years.

For those of you who aren't familiar with LBOs (wikipedia), they are basically transactions where one company borrows a whole bunch of money to buy another company. The new debt ends up on the books of the target company.

New debt makes existing debtholders very unhappy, because it means the company has even more fixed obligations (ie principal and interest payments) to pay, which makes it less likely that any single debtholder will get the interest and principal they have coming to them. When the bond becomes more risky, the market price declines, causing a paper loss for the holder.

Something I've been hearing a lot about in the credit markets lately is designed to combat this "LBO Risk" that bondholders face, and this is the addition of so-called "change of control" covenants (forbes.com) in bond documents.

Basically, investors have been pushing to include provisions (called covenants) in new bond issuances that say the company selling the bond must agree to do certain things, such as maintain a certain debt/capital ratio, interest coverage ratio, or some other metric that would prevent it from taking on too much additional debt and in effect screwing the current debtholders over.

"Change of control covenants" have been getting a ton of notice in the investment community lately due to the increased LBO activity. These covenants are specifically geared towards the threat of leveraged buyouts and in general they say that the bondholder has the right to "put" the bond back to the company if there is a "change of control" event, ie a buyout. This gives them reassurance that they can sell their bonds back to the company for essentially 100% of face value if the company gets bought out. If they didn't have such a provision and the company became the target of an LBO, the only way they might be able to unload their bonds would be for something less than 100% of face value (75% maybe).

According to a story in the Feb 8 issue of the Wall Street Journal ("Bondholders Fight Back as Deals Raise Debt Risks") recent issuers that have included change of control provisions include Home Depot, Black & Decker, Alcoa, Xerox, Federated Department Stores, and Owens Corning.

Fitch, one of the 3 big bond ratings agencies, put out a piece assessing Motorola's LBO Risk, and determined that some of MOT's debtholders would be out of luck in the event of an LBO. The article gave a specific example showing how two of MOT's debt issuances have some LBO protection, but the others do not:

"In terms of change of control provisions, while the indentures related to the
$400 million 7.5% debentures and $400 million 6.5% debentures enable bondholders to put the bonds to the company upon a 50% change in ownership, the bond indentures related to the $1.2 billion 4.6% senior notes and approximately $530 million 7.625% senior notes lack any change of control provision."

For those of you who invest in bonds, you might want to take a second look at your indentures and at least be aware that your bonds could lose considerable market value if the company that issued them becomes the target of a leveraged buyout. If you have some kind of a change of control covenant in the indenture, you can be assured that you have additional protection against what many consider to be a "worst-case scenario" for bondholders (an LBO without any covenants).

For those of you who just appreciate being kept up to date on current topics in the world of finance, you might want to read some more about this topic.

Here's a research report with a decent take on LBO Risk (.pdf).

Here's a recent Bloomberg piece on the market's reaction to Gap Inc.'s percieved LBO risk.

And finally, another Bloomberg piece that talks about how investors are paying up for change of control covenants.

A final thought, most people I know who follow the bond/credit markets agree that we are at a high point in the cycle. Yields are low, spreads are low, t is incredibly cheap for risky companies to borrow money, LBO activity is high, corporate debt issuances are on the rise, and as with everything else, "what goes up, must come down."