So what, indeed, was the August credit crisis all about, and what does it mean for our financial markets going forward?
We think John Authers, a columnist with the Financial Times, probably summed it up best, “…like many others over the centuries…too much greed begat too much lending on irresponsible terms.” b Perhaps due in part to an accommodating monetary authority after 9/11 and the Japanese “carry trade”, the world has been awash in credit-enhanced liquidity over the last half dozen years. This abundance of low cost credit fueled what some in our industry have described as a global asset bubble in virtually all investment asset categories, including stocks, high yield bonds, real estate, commodities and alternative assets such as private equity. As asset valuations escalated and risk premiums contracted, investors ventured further out on the risk curve in an effort to enhance their returns, pouring money into new and innovative alternative strategies. Wall Street often becomes the great enabler during speculative binges, creating innovative new products to allow investors to extend their stay at the party. In the Crash of 1987, it was “portfolio insurance” that played a big role in reassuring investors in the face of high equity market valuations. This time around it was the credit markets, and the innovation was structured finance instruments known as collateralized debt obligations, or CDOs. At some point in all bubbles, a tipping point is reached, and there is a rush for the exits. In the August credit crisis, the tipping point appeared to be escalating defaults in subprime mortgages.
Yesterday’s portfolio insurance is today’s structured debt pool; i.e., CDOs. Working with the rating agencies, Wall Street figured out that by mixing higher yielding marginal subprime mortgage loans with higher quality loans in structured investment pools they could create yields that were higher than investors would ordinarily receive by investing directly in comparably rated debt securities. In a world of shrinking risk premiums (lower yields in relation to risk-free U.S. Treasuries), and record low credit spreads, this was simply too good to pass up. Homeowners were eager to finance vacation home purchases in a real estate market that was on fire, mortgage brokers were more than willing to accommodate their demand with “no doc” loans on incredibly liberal terms, and Wall Street was there to package them and sell them forward in the capital markets to CDO investors hungry for yield. The seeds of potential disaster were thus sown. As Adam Bryant of the The New York Times observed in an August article entitled, “The Unforgivingness of Forgetfulness”, “...lenders and financial wizards took the joker – the risk that certain borrowers might default – and hid it in the deck. They shuffled all those risky subprime mortgages into much bigger investment pools, then cut the deck twice, fanned the cards and presto, it disappeared. Magic. But then the borrowers were shown the sleight of hand. Of course, the joker was always there, and the risks were real.”
As subprime delinquencies inevitably escalated, the rating agencies finally took notice, and began to adjust their ratings. This led to a rapid decline in value for subprime mortgage securities held by CDOs, which in turn caused investors to back away from these new instruments. New CDO issuance came to a virtual standstill. Hedge funds and other highly leveraged financial institutions, which ran leveraged structured finance vehicles, faced margin calls and redemption requests as their collateral deteriorated—which forced panic selling. A full fledged liquidity crisis ensued.
The subprime contagion spread to the corporate lending market, where investors began to wonder whether the deteriorating lending standards in the corporate market could eventually lead to a similar surge in defaults. Investors in leveraged loans such as CLOs (collateralized loan obligations) and hedge funds, which had helped finance the private equity led buyout mania over the previous two years, suddenly backed away from these loans, leaving lead underwriting banks with roughly $300 billion in buyout loans that could not be sold into the secondary market under pre-existing terms. The leveraged buyout binge, which had been an enormous catalyst for public equity market valuations over the previous year, came to a sudden halt.
A number of hedge funds and financial institutions around the globe were brought to the precipice of potential disaster and several did fail. The yield spread between high yield bonds and high quality Treasuries widened dramatically—virtually overnight. The London Inter Bank Offered Rate, also known as LIBOR, shot up, and the commercial paper market went into a free fall. Unprecedented volatility engulfed global equity markets, and the Dow Jones Industrial Average plummeted nearly 1200 points over a period of weeks. It was a very unsettling time for the financial community and for investors.
Of Cockroaches and Furusd
In a fascinating new book, A Demon of Our Own Design, author Richard Bookstaber, a “Wall Streeter” with over 20 years of quantitative trading experience, contends that financial innovation, complexity and globalization have combined to make our markets more crisis prone. He uses biology as a frame of reference for economic behavior, and contrasts the cockroach and the furu, a small perch-like fish, in a case study of risk management. He finds the survival of the cockroach over millions of years quite remarkable, especially in light of what he describes as their “coarse and sub-optimal behavior” when it comes to risk management. In essence, the cockroach has a rather simple defense mechanism: moving away from slight puffs of air. It completely ignores a wide range of other information and risks “…that one would think an optimal risk management system would take into account.” He contrasts the sub-optimal behaving cockroach to the finely tuned and optimizing behavior of the furu, a once dominant, small, perch-like fish that survived in Africa’s Lake Victoria for thousands of years. The furu, over the centuries, became highly adapted to its environment, evolving into some 300 species and developing a myriad of skills, which allowed it to thrive and flourish in its habitat, rivaling “the finches that Darwin studied in the Galapagos.” It unfortunately fell victim to extinction when the Nile Perch was introduced by a Kenyan game fisheries officer into the lakes of Central Africa. Bookstaber points out that their “extinction was not the result of natural selection based on fitness in the usual sense; they were diverse and suited for almost every conceivable element of the Lake Victoria ecology.…Its path toward extinction was just a result of dumb luck that someone had introduced an alien species into its waters.”
Read the complete letter
We think John Authers, a columnist with the Financial Times, probably summed it up best, “…like many others over the centuries…too much greed begat too much lending on irresponsible terms.” b Perhaps due in part to an accommodating monetary authority after 9/11 and the Japanese “carry trade”, the world has been awash in credit-enhanced liquidity over the last half dozen years. This abundance of low cost credit fueled what some in our industry have described as a global asset bubble in virtually all investment asset categories, including stocks, high yield bonds, real estate, commodities and alternative assets such as private equity. As asset valuations escalated and risk premiums contracted, investors ventured further out on the risk curve in an effort to enhance their returns, pouring money into new and innovative alternative strategies. Wall Street often becomes the great enabler during speculative binges, creating innovative new products to allow investors to extend their stay at the party. In the Crash of 1987, it was “portfolio insurance” that played a big role in reassuring investors in the face of high equity market valuations. This time around it was the credit markets, and the innovation was structured finance instruments known as collateralized debt obligations, or CDOs. At some point in all bubbles, a tipping point is reached, and there is a rush for the exits. In the August credit crisis, the tipping point appeared to be escalating defaults in subprime mortgages.
Yesterday’s portfolio insurance is today’s structured debt pool; i.e., CDOs. Working with the rating agencies, Wall Street figured out that by mixing higher yielding marginal subprime mortgage loans with higher quality loans in structured investment pools they could create yields that were higher than investors would ordinarily receive by investing directly in comparably rated debt securities. In a world of shrinking risk premiums (lower yields in relation to risk-free U.S. Treasuries), and record low credit spreads, this was simply too good to pass up. Homeowners were eager to finance vacation home purchases in a real estate market that was on fire, mortgage brokers were more than willing to accommodate their demand with “no doc” loans on incredibly liberal terms, and Wall Street was there to package them and sell them forward in the capital markets to CDO investors hungry for yield. The seeds of potential disaster were thus sown. As Adam Bryant of the The New York Times observed in an August article entitled, “The Unforgivingness of Forgetfulness”, “...lenders and financial wizards took the joker – the risk that certain borrowers might default – and hid it in the deck. They shuffled all those risky subprime mortgages into much bigger investment pools, then cut the deck twice, fanned the cards and presto, it disappeared. Magic. But then the borrowers were shown the sleight of hand. Of course, the joker was always there, and the risks were real.”
As subprime delinquencies inevitably escalated, the rating agencies finally took notice, and began to adjust their ratings. This led to a rapid decline in value for subprime mortgage securities held by CDOs, which in turn caused investors to back away from these new instruments. New CDO issuance came to a virtual standstill. Hedge funds and other highly leveraged financial institutions, which ran leveraged structured finance vehicles, faced margin calls and redemption requests as their collateral deteriorated—which forced panic selling. A full fledged liquidity crisis ensued.
The subprime contagion spread to the corporate lending market, where investors began to wonder whether the deteriorating lending standards in the corporate market could eventually lead to a similar surge in defaults. Investors in leveraged loans such as CLOs (collateralized loan obligations) and hedge funds, which had helped finance the private equity led buyout mania over the previous two years, suddenly backed away from these loans, leaving lead underwriting banks with roughly $300 billion in buyout loans that could not be sold into the secondary market under pre-existing terms. The leveraged buyout binge, which had been an enormous catalyst for public equity market valuations over the previous year, came to a sudden halt.
A number of hedge funds and financial institutions around the globe were brought to the precipice of potential disaster and several did fail. The yield spread between high yield bonds and high quality Treasuries widened dramatically—virtually overnight. The London Inter Bank Offered Rate, also known as LIBOR, shot up, and the commercial paper market went into a free fall. Unprecedented volatility engulfed global equity markets, and the Dow Jones Industrial Average plummeted nearly 1200 points over a period of weeks. It was a very unsettling time for the financial community and for investors.
Of Cockroaches and Furusd
In a fascinating new book, A Demon of Our Own Design, author Richard Bookstaber, a “Wall Streeter” with over 20 years of quantitative trading experience, contends that financial innovation, complexity and globalization have combined to make our markets more crisis prone. He uses biology as a frame of reference for economic behavior, and contrasts the cockroach and the furu, a small perch-like fish, in a case study of risk management. He finds the survival of the cockroach over millions of years quite remarkable, especially in light of what he describes as their “coarse and sub-optimal behavior” when it comes to risk management. In essence, the cockroach has a rather simple defense mechanism: moving away from slight puffs of air. It completely ignores a wide range of other information and risks “…that one would think an optimal risk management system would take into account.” He contrasts the sub-optimal behaving cockroach to the finely tuned and optimizing behavior of the furu, a once dominant, small, perch-like fish that survived in Africa’s Lake Victoria for thousands of years. The furu, over the centuries, became highly adapted to its environment, evolving into some 300 species and developing a myriad of skills, which allowed it to thrive and flourish in its habitat, rivaling “the finches that Darwin studied in the Galapagos.” It unfortunately fell victim to extinction when the Nile Perch was introduced by a Kenyan game fisheries officer into the lakes of Central Africa. Bookstaber points out that their “extinction was not the result of natural selection based on fitness in the usual sense; they were diverse and suited for almost every conceivable element of the Lake Victoria ecology.…Its path toward extinction was just a result of dumb luck that someone had introduced an alien species into its waters.”
Read the complete letter
