Wednesday, November 9, 2011

Why We Crashed

From the Wall Street Journal this essay by Barry Ritholtz who is concerned that the truth about the financial meltdown that led us into this Depression.


I have a fairly simple approach to investing: Start with data and
objective evidence to determine the dominant elements driving the market
action right now. Figure out what objective reality is beneath all of the
noise. Use that information to try to make intelligent investing decisions.
But then, I’man investor focused on preserving capital and managing risk.
I’mnot out to win the next election or drive the debate. For those who are, facts
and data matter much less than a narrative that supports their interests.
One group has been especially vocal about shaping a new narrative of the
credit crisis and economic collapse: those whose bad judgment and failed
philosophy helped cause the crisis. Rather than admit the error of their
ways—Repent!—these people are engaged in an active campaign to rewrite
history. They are not, of course, exonerated in doing so. And beyond that,
they damage the process of repairing what was broken. They muddy the
waters when it comes to holding guilty parties responsible. They prevent
measures from being put into place to prevent another crisis.
Here is the surprising takeaway: They are winning. Thanks to the endless
repetition of the Big Lie. ABig Lie is so colossal that no one
would believe that someone could have the impudence to distort the truth so
infamously. There are many examples: Claims that Earth is not warming, or that evolution is not the best thesis we have
for how humans developed.


Those opposed to stimulus spending claim that the infrastructure of the United States is just fine, Grade A (not D, as the we discussed last month), and needs little repair. Wall Street has its own version: Its Big Lie is that banks and investment houses are merely victims of the crash. You see, the entire boom and bust was caused by misguided government policies. It was
not irresponsible lending or derivative or excess leverage ormisguided
compensation packages, but rather longstanding
housing policies that were at fault.


Indeed, the arguments these folks make fail to withstand even casual
scrutiny. But that has not stopped people who should know better from repeating them. The Big Lie made a surprise appearance Tuesday when New York MayorMichael Bloomberg, responding to a question about OccupyWall Street, stunned observers by exoneratingWall Street: “It was not the banks that created the mortgage crisis. It was, plain and simple, Congress who forced everybody to go and give mortgages to people who
were on the cusp.” What made his comments so stunning
is that he built Bloomberg Data Services on the notion that data are what matter most to investors. The terminals are found on nearly 400,000 trading desks around the world, at a cost of $1,500 a month. (Do the math—that’s over half a billion dollars a month.) Perhaps the fact thatWall Street was the source of his vast wealth biased him. But the key
principle of the business that made the mayor a billionaire is that fund
managers, economists, researchers and traders should ignore the squishy
narrative and, instead, focus on facts. Yet he ignored his own principles to repeat statements he should have known were false.

Why are people trying to rewrite the history of the crisis? Some are simply
trying to save face. Interest groups who advocate for deregulation of the finance sector would prefer that deregulation not receive any blame for the crisis.
Some stand to profit from the status quo: Banks present a systemic risk to the
economy, and reducing that risk by lowering their leverage and increasing
capital requirements also lowers profitability. Others are hired guns,
doing the bidding of bosses onWall Street.

They all suffer cognitive dissonance— the intellectual crisis that occurs when a
failed belief system or philosophy is confronted with proof of its implausibility.
And what about those facts? To be clear, no single issue was the cause. Our
economy is a complex and intricate system. What caused the crisis? Look:
1Fed Chair Alan Greenspan dropped rates to 1 percent—levels not seen for
half a century—and kept them there for an unprecedentedly long period. This
caused a spiral in anything priced in dollars (i.e., oil, gold) or credit (i.e.,
housing) or liquidity driven (i.e., stocks).

2Low rates meant asset managers
could no longer get decent yields from municipal bonds or Treasurys.
Instead, they turned to high-yield mortgage-backed securities. Nearly all of
them failed to do adequate due diligence before buying them, did not understand these instruments or the risk involved. They violated one of themost important rules of investing: Know what you own.
3 Fund managers made this error because they relied on the credit
ratings agencies—Moody’s, S&P and Fitch. They had placed an AAA rating on
these junk securities, claiming they were as safe as U.S. Treasurys.
4 Derivatives had become a uniquely unregulated financial instrument.
They are exempt fromall oversight, counter-party disclosure, exchange
listing requirements, state insurance supervision and, most important,
reserve requirements. This allowed AIG to write $3 trillion in derivatives while
reserving precisely zero dollars against future claims.
5 The Securities and Exchange Commission changed the leverage
rules for just fiveWall Street banks in 2004. The “Bear Stearns exemption”
replaced the 1977 net capitalization rule’s 12-to-1 leverage limit. In its place, it
allowed unlimited leverage for Goldman
Sachs,Morgan Stanley,Merrill Lynch, Lehman Brothers and Bear Stearns.
These banks ramped leverage to 20-, 30-, even 40-to-1. Extreme leverage leaves
very little room for error.
6Wall Street’s compensation system was skewed toward short-term
performance. It gives traders lots of upside and none of the downside. This
creates incentives to take excessive risks.
7 The demand for higher-yielding paper ledWall Street to begin
bundling mortgages. The highest yielding were subprime mortgages. This
market was dominated by non-bank originators exempt from most
regulations. The Fed could have supervised them, but Greenspan did not.
8 Thesemortgage originators’ lendto- sell-to-securitizers model had
them holding mortgages for a very short period. This allowed them to get creative with underwriting standards, abdicating
traditional lending metrics such as income, credit rating, debt-service
history and loan-to-value.
9 “Innovative” mortgage products were developed to reach more
subprime borrowers. These include 2/28 adjustable-rate mortgages, interest-only loans, piggy-bank mortgages (simultaneous underlying mortgage and
home-equity lines) and the notorious negative amortization loans (borrower’s
indebtedness goes up each month). Thesemortgages defaulted in vastly
disproportionate numbers to traditional 30-year fixed mortgages.
10 To keep up with these newfangled originators, traditional banks developed automated underwriting systems. The software was
gamed by employees paid on loan volume, not quality.
11 Glass-Steagall legislation, which keptWall Street andMain Street
banks walled off from each other, was repealed in 1998. This allowed FDICinsured banks, whose deposits were guaranteed by the government, to
engage in highly risky business. It also allowed the banks to bulk up, becoming
bigger, more complex and unwieldy.
12 Many states had anti-predatory lending laws on their books
(along with lower defaults and foreclosure rates). In 2004, the Office of
the Comptroller of the Currency federally preempted state laws
regulating mortgage credit and national banks. Following this change, national
lenders sold increasingly risky loan products in those states. Shortly after,
their default and foreclosure rates skyrocketed.
Bloomberg was partially correct: Congress did radically deregulate the
financial sector, doing away with many of the protections that had worked for
decades. Congress allowedWall Street to self-regulate, and the Fed the turned a
blind eye to bank abuses. The previous Big Lie—the discredited
belief that free markets require no adult supervision—is the reason people have
created a new false narrative.


Now it’s time for the Big Truth.

Barry Ritholtz is chief executive of FusionIQ, a quantitative research firm.

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