The Credit Crisis...An Explanation
Brian Trumbore
President/Editor, StocksandNews.com

A few weeks ago in his Sunday New York Times column, Ben Stein wrote:

"You may well be asking yourself, as I have asked myself, how on earth did the credit crisis on Wall Street become such a catastrophe?

"How did all of the mechanisms operated by the mind- bogglingly well-paid men and women of the Street go so wrong that we saw a major investment bank, Bear Stearns, essentially disappear? How did Wall Street firms of ancient lineage take such immense losses that they made banks clam up on lending - at great risk to the economy?

"Weren't fail-safe devices in place to guard against risk? Weren't government watchdogs there to make sure that catastrophes could not happen? Weren't ratings agencies on the job to police what was going on in the canyons of Lower Manhattan?"

So Mr. Stein then referred his readers to a presentation given by hedge fund operator David Einhorn of Greenlight Capital to a Grant's Interest Rate Observer event. I looked up the speech and present some of it below.

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Mr. Einhorn begins by discussing the recent failure of Carlyle Capital Corporation, which had leveraged itself thirty to one but was involved in government agency securities. Safe, eh? Not quite. "Carlyle's investors lost most of their investment and the world, with normal 20-20 hindsight, has learned that investment companies with thirty times leverage are not safe."

Einhorn continues:

And I'll tell you a little secret: These levered balance sheets hold some things that are dicier than government agency securities. They hold inventories of common stocks and bonds. They also have various loans that they hope to securitize. They have pieces of structured finance transactions. They have derivative exposures of staggering notional amounts and related counter- party risk. They have real estate. They have private equity. The investment banks claim that they are in the "moving" business rather than the "storage" business, but the very nature of some of the holdings suggests that this is not true. And they hold this stuff on tremendously levered balance sheets.

The first question to ask is, how did this happen? The answer is that the investment banks out maneuvered the watchdogs, as I will explain in detail in a moment. As a result, with no one watching, the managements of the investment banks did exactly what they were incentivized to do: maximize employee compensation. Investment banks pay out 50% of revenues as compensation. So, more leverage means more revenues, which means more compensation. In good times, once they pay out the compensation, overhead and taxes, only a fraction of the incremental revenues fall to the bottom line for shareholders. Shareholders get just enough so that the returns on equity are decent. Considering the franchise value, the non-risk fee generating capabilities of the banks, and the levered investment result, in the good times the returns on equity should not be decent, they should be extraordinary. But they are not, because so much of the revenue goes to compensation. The banks have also done a wonderful job at public relations. Everyone knows about the 20% incentive fees in the hedge fund and private equity industry. Nobody talks about the investment banks' 50% structures, which have no high-water mark and actually are exceeded in difficult times in order to retain talent.

The second question is how do the investment banks justify such thin capitalization ratios? And the answer is, in part, by relying on flawed risk models, most notably Value-at-Risk or "VaR." Value-at-Risk is an interesting concept. The idea is to tell how much a portfolio stands to make or lose 95% of the days or 99% of the days or what have you. Of course, if you are a risk manager, you should not be particularly concerned how much is at risk 95 or 99% of the time. You don't need to have a lot of advanced math to know that the answer will always be a manageable amount that will not jeopardize the bank. A risk manager's job is to worry about whether the bank is putting itself at risk in the unusual times or in statistical terms, in the tails of distribution. Yet, Value-at-Risk ignores what happens in the tails. It specifically cuts them off. A 99% Value-at-Risk calculation does not evaluate what happens in the last one percent. This, in my view, makes VaR relatively useless as a risk management tool and potentially catastrophic when its use creates a false sense of security among senior managers and watchdogs. This is like an air bag that works all the time, except when you have a car accident.

By ignoring the tails, Value-at-Risk creates an incentive to take excessive but remote risks. Consider an investment in a coin- flip. If you bet $100 on tails at even money, your Value-at-Risk to a 99% threshold is $100, as you will lose that amount 50% of the time, which obviously is within the threshold. In this case the VaR will equal the maximum loss.

Compare that to a bet where you offer 127 to 1 odds on $100 that heads won't come up seven times in a row. You will win more than 99.2% of the time, which exceeds the 99% threshold. As a result, your 99% Value-at-Risk is zero even though you are exposed to a possible $12,700 loss. In other words, an investment bank wouldn't have to put up any capital to make this bet. The math whizzes will say it is more complicated than that, but this is the basic idea.

Now we understand why investment banks held enormous portfolios of "super-senior triple A-rated" whatever. These securities had very small returns. However, the risk models said they had trivial Value-at-Risk, because the possibility of credit loss was calculated to be beyond the Value-at-Risk threshold. This meant that holding them required only a trivial amount of capital. A small return over a trivial amount of capital can generate an almost infinite revenue-to-equity ratio. Value-at- Risk driven risk management encouraged accepting a lot of bets that amounted to accepting the risk that heads wouldn't come up seven times in a row.

In the current crisis, it has turned out that the unlucky outcome was far more likely than the back-tested models predicted. What is worse, the various supposedly remote risks that required trivial capital are highly correlated - you don't just lose on one bad bet in this environment, you lose on many of them for the same reason. This is why in recent periods the investment banks had quarterly write-downs that were many times the firm-wide modeled Value-at-Risk.

Which brings us to the third question, what were the watchdogs doing? Let's start with the credit rating agencies. They have a special spot in our markets. They can review non-public information and opine on the creditworthiness of the investment banks. The market and the regulators assume that the rating agencies take their responsibility to stay on top of things seriously. When the credit crisis broke last summer, one of the major agencies held a public conference call to discuss the health of the investment banks.

The gist of the rating agency perspective was "Don't Worry." The investment banks have excelled risk controls and they hedge their exposures. The initial reaction to the credit crisis basically amounted to "everyone is hedged." A few weeks later, when Merrill Lynch announced a big loss, that story changed. But initially, the word was that everyone was hedged. Securitization had spread the risk around the world and most of the risk was probably in Asia, Europe, Dubai or at the bottom of the East River. The banks were in the "moving" business, not the "storage" business, so this was no big issue. I wondered whether anyone saying this had actually looked at the balance sheets.

Of course, this raised the question of how did everyone hedge and who were the counter-parties holding the bag? I pressed star-1 and asked the rating agency analyst how everyone hedged the massive apparent credit risks on the balance sheets. The rating agency analyst responded that the rating agency had observed enormous trading volumes on the MERC in recent days.

The MERC offers products that enable one to hedge interest rate risk, not credit risk. I called the rating analyst back to discuss this in greater depth. At first he told me that you could hedge anything on the MERC. When I asked how to hedge credit risk there, he was less familiar. I came to suspect that the rating agency analyst viewed his role as one to restore confidence in the system, which the rating agency call did do for a while, rather than to analyze risk.

I later had an opportunity to meet a recently retired senior executive at one of the large rating agencies. I asked him how his agency went about evaluating the credit worthiness of the investment banks. By then Merrill had acknowledged large losses, so I asked him what the rating team found when it went to examine Merrill's portfolio in detail.

He answered by asking me to refocus on what I meant by "team." He told me that the group covering the investment banks was only three or four people and they have to cover all of the banks. So they have no team to send to Merrill for a thorough portfolio review. He explained that the agency doesn't even try to look at the actual portfolio because it changes so frequently that there would be no way to keep up.

I asked how the rating agencies monitored the balance sheets so that when an investment bank adds an asset, the agency assesses a capital charge to ensure that the bank doesn't exceed the risk for the rating. He answered that they don't and added that the rating agencies don't even have these types of models for the investment banks.

I asked what they do look at. He told me they look mostly at the public information, basic balance sheet ratios, pretax margin, and the volatility of pretax margin. They also speak with management and review management risk reports. Of course, they monitor Value-at-Risk.

I was shocked by this and I think that most market participants would be surprised, as well. While the rating agencies don't actually say what work they do, I believe the market assumes that they take advantage of their exemption from Regulation FD to examine a wide range of non-public material. A few months ago I made a speech where I said that rating agencies should lose the exemption to Regulation FD so that people would not over rely on their opinions.

The market perceives the rating agencies to be doing much more than they actually do. The agencies themselves don't directly misinform the market, but they don't disabuse the market of misperceptions - often spread by the rated entities - that the agencies do more than they actually do. This creates a false sense of security and in times of stress this actually makes the problems worse. Had the credit rating agencies been doing a reasonable job of disciplining the investment banks - who unfortunately happen to bring the rating agencies lots of other business - then the banks may have been prevented from taking excess risk and the current crisis might have been averted.

The rating agencies remind me of the department of motor vehicles in that they are understaffed and don't pay enough to attract the best and the brightest. The DMV is scary, but it is just for mundane things like drivers licenses. Scary does not begin to describe the feeling of learning that there are only three or four hard working people at a major rating agency judging the creditworthiness of all the investment banks and they don't even have their own model.

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Note: I'm traveling overseas for a bit. Wall Street History returns in two weeks.

Brian Trumbore

BUYandHOLD does not recommend any securities. The securities mentioned above are being used for illustrative purposes only and should not be regarded as an offer to sell or as a solicitation of an offer to buy.