I shall be posting one post a day this week as I take you through this Six Minute Strategist Guide to the 2008 Financial Crisis. Today’s post examines what went wrong?
Where did it all go wrong?
By 2007 the complex interdependent web of subprime mortgages, complex investment derivatives, increasing leverage and greedy participants had far out stripped the ability of those supposedly with their hand on the brake to control the market. So what went wrong?
1. Sub Prime and the Housing Bubble
As with most bubbles, the change in the direction of the market came relatively suddenly and the new negative trend was well established before most investors had a clue what was going on.
The diagram below explains how the market unravelled and explains how the malaise spread.
2. Financial Innovation
The rate of innovation in financial instruments since 1995 has been breath taking but as these instruments became more complex and esoteric, they lost their connection with the assets underlying the investment instruments. Investors did not really understand what they were buying as they chased ever higher investment returns, ignoring the inevitable connection between risk and return (higher returns normally mean higher risk). To make matters worse, on the risk management side, the Investment Banks packaging these complex instruments lost control of the risk management function and particularly the senior management of these organisations increasingly had no real understanding of the risk positions of their banks, particularly on the downside.
3. Financial Theory and Models
Many of the financial models and assumptions underlying them were simplistic, based on too limited a data set or were just wrong. Many of them suffered from the Garbage In = Garbage Out syndrome. The Investment Banks actively gamed the rating agencies models.
A fundamental example of this is the way that the Rating Agencies, Issuers and Investors modelled the correlation of risk among loans in the securitisation pools. This lay in the way the model assumed the correlation or absence of it between one mortgage to another. Put more simply the model assumed that factors affecting mortgage default in Texas would not be connected to the factors affecting default in Florida.
The Black Scholes model was the accepted methodology used for valuing derivatives. Without getting into the complexity of a highly complex model, in practice the model depended on a normal distribution curve (a bell shaped curve) for its predicative pricing whereas this proved to under estimate, in some cases, the volatility of market prices.
4. Ratings Agencies
As has been reflected above, the Rating Agencies were seduced into the game by the profits to be made. The quality of their original rating was as poor as their monitoring of changes in the underlying value of the assets. When the crisis hit their response was to put on warning and then re-grade huge swathes of bonds on a blanket basis, thereby only exacerbating the problem.
The Agencies simply failed to go back to first principles to examine and rate the value of the underlying assets. In many cases this information was simply not available. Some mortgage originators had succumbed to issuing mortgages without any documentary proof of the assets and incomes of their borrowers. Once the instruments became synthetic their complexity made it nearly impossible to drill down to the underlying assets.
The failure of the regulators to keep up with innovation in the markets meant that they lost control of their client base that were able to use an increasing range of techniques to increase their revenues and profits (and risk) without reserving capital against this.
If Management can be said to represent the internal risk management function, in many cases they were just as culpable. It is clear with hindsight that very few senior bankers understood the complexities of the bond market or the underlying risks that their bond departments were creating and then parking – on or off balance sheet.
The Financial Crisis of 2008 was caused neither by the banks nor by the collapse of the subprime mortgage market. Both of these were involved and share a part of the responsibility for what happened but only a part. The policies of Governments throughout the developed world through the first decade of the 21st Century actively encouraged low interest rates and increased personal (credit card and mortgage) borrowing. This appetite for leverage was also embraced by investors, banks, hedge funds and Governments themselves (a direct result of which is the current fiscal adversity now being experienced throughout the US and Europe).
In my last post in this six post series, I will consider some of the key lessons we might learn from the Crisis.
If you enjoyed this or wish to comment please do so on the Blog. I would be delighted to discuss this or other Corporate Strategy issues with you – you can contact me at jbdcolley [at]aol[dot]com. My full contact details can be found on my About page here.