Sunday, 25 April 2010

How David Bowie nearly blew up Wall Street - Part 2

To recap from last time, courtesy of a clever idea from some financial wizards, sober bankers like Capt. George Mainwaring suddenly had a solution to the age-old problem of managing the risk of borrower default in their mortgage portfolios. They could suddenly do two things with their mortgage portfolios:
Firstly, they could "sell" their mortgages more easily, by putting them into a format which allowed economic interests in the mortgages to be transferred without the transfer of the mortgages themselves. This is "securitisation" - which means "turning into a debt security" - a debt security being banker jargon for a bond. Bonds are like bank notes: they are easily transferred: mere possession of a bond is enough to prove you own it.
Bonds are, in this way, very different from mortgages. A mortgagee lender not only has to prove the existence of the loan by means of signed, witnessed loan contracts, but also needs to register the mortgage with  the land transfer authorities.
Now the ability to sell mortgage portfolios by itself wouldn't be that big a deal, as any buyer would wind up with exactly the same problem that the seller had in the first place: a buried, impossible to predict, risk of borrower default. But securitisation enables many buyers to buy small  shares of the same portfolio. This permitted trick number two, which is the "special sauce".
Say you are Captain Mainwaring, and you manage a portfolio of a hundred mortgages for your bank. If you arranged these in a 10 x 10 grid, and marked the defaulted mortgages with an x, it might look a bit like this:

That is to say, defaults randomly dispersed all over the place, with no rhyme or reason to how they came about. Since you can't predict which loans will blow up, it doesn't really matter how you look at it: Captain Mainwaring has this risk. Assume that in normal economic times, about 5% of all the mortgages are likely to go bust.
But look what happens when two people share ownership of the portfolio: an ambitious investor can say: Tell you what, if you pay me three quarters of the total interest due on all the mortgages, I'll take all the defaulted loans into my share of the portfolio first. That way you'll get less interest, but you have much less risk: you'll get all your interest and principal back unless there are so many mortgage defaults that I lose my whole investment. So we can rearrange our mortgage portfolio to represent this:

Because Investor B has agreed to take all the first losses, Investor A is able to confidently say that, until Investor B is wiped out in full, it has no risk on its portfolio.  Investor A has a "second-loss" risk on the portfolio.
This technique of packaging a mortgage portfolio up into a securitisation and selling it into the capital markets as a bond instrument became to be known as the "Originate and Distribute" model of mortgage finance. Instead of lending money and keeping the "assets" represented by mortgage loans on its books for thirty or more years (the "Originate and Hold" model), a lending bank can immediately "sell down" its risk in the capital markets for a repayment in full, without bothering the borrower of the loan.
This is attractive because we are able to slice the portfolio into high risk "equity" part, and a very low risk "senior" part. In the example above, before Investor A (the "senior" investor) starts to lose any money, there would need to be a 20% default rate in the total portfolio (that is, all of Investor B's portfolio would have to have defaulted). This, the logic goes, is highly unlikely given the usual means of assessing probabilities, which put the risk of default in the portfolio at no more than 5%.
And so, were the usual means of assessing probabilities  to apply, it would be. The problem is that, for two reasons, usual rules of assessing probabilities (that apply a "normal" distribution to events) are a misleading guide. 
On of those reasons is fascinating, but complex, and I couldn't cover it in detail in this post without getting completely side-tracked. Suffice to say, where humans interactions are concerned, "normal" distributions are often misleading because human actions tend to influence each other (that is, once one person defaults, that makes it all more likely that others will too). A "normal" distribution assumes all events are independent of each other, and therefore have no influence on each other. 
Interdependent human events follow tend to follow a "power law" distribution, which has a much longer and fatter "tail" than a normal distribution. If you are interested in reading about this I heartily recommend a few books: The (MIS)Behaviour of Markets: A Fractal View of Risk, Ruin, and Reward by cassandra-like French Mathematician Benoit Mandelbrot, The Black Swan by Nassim Nicholas Taleb, and Critical Mass by Philip Ball.
The other reason is related, but subtly different: The very act of creating a securitisation and changing the to the "originate and distribute" model itself changes the probabilities, because it changes the parties' interests.
Mortgages tend not to default immediately. Usually even a poor creditor will manage to make payments for six months or a year. When you originate a loan you know you'll be stuck with for 30 years, you're very careful to pick borrowers whom you think unlikely to default at any time. Having a close and personal relationship with your borrowers enables you to make these assessments with a relatively high degree of comfort - hence the relatively low level of historical defaults on mortgage portfolios. Banks of Capt. Mainwaring's persuasion used to be prudent lenders, because it was in their interest to be prudent.
Note how that dynamic changes with the originate and distribute model:
  • Firstly, Banks who expect to quickly "sell down" mortgages they originate have less interest in the long term creditworthiness of the borrowers: once the securitisation is completed it is "somebody else's problem" as they no longer have risk to the borrowers at all.
  • Secondly, Securitisation investors have far less ability to assess the credentials of mortgage borrowers as, unlike originating banks who lend the money, securitisation bondholders have no direct relationship with borrowers at all, and far less information about each loan. Instead they tend to rely on general due diligence done by rating agencies who are retained by originators to provide a ratings valuation for the securitisations. Rating agencies are a fit subject for another whole post.
  • Thirdly, Securitisation investors have less ability to do anything should mortgages start going bad: they are reliant on third party mortgage servicing companies, who, unlike originating banks, have no "skin in the game".
We know that mortgage lending standards "relaxed" markedly in the late 1990s, and the world was bequeathed concepts like "self-certifying mortgages"; acronyms like NINJA "no income, no job, no assets", and from personal experience I know it became a lot easier to borrow a much higher multiple of income. It also didn't help that interest rates were extremely low throughout the 2000s - in England, a rough and ready average of the rates was far lower than it had been in the preceding 25 years, not exceeding 6% at any stage:

This is significant because it becomes easier to make money out of property if your cost of financing that property drops: Simply put, if you borrow £100,000 at 10% per annum to buy a property, your property has to increase in value by £10,000 in a year for you to even break even. If you borrow at 0.5%, then it only has to increase in value by £500!
These lower interest rates and a greater availability of mortgage lending meant it became viable to invest in property as a sort of investment, and before long it became almost mandatory, to avoid "falling behind": 

By now, I hope, you'll see that a perfect storm was developing, and all these little developments were feeding into each other and egging each other on: Banks were now able to quickly sell their portfolios, and so were less incentivised to apply strict lending criteria. Rates were dropping, making it more compelling to invest in property. Given the returns to be had on property and the low interest rates, demand was picking up for residential property, which in turn caused property values to rise, creating more demand for mortgages, and more demand for securitised product. A classic bubble was developing. 

Sunday, 18 April 2010

CDOs: how David Bowie overcame Dad's Army and blew up the world

Collateralised Debt Obligations – “CDOs” – are yet again hitting the news, and predictably enough, are being described as diabolical tools of mendacious investment bankers.
It has never been my agenda to deny that investment bankers are mendacious, but there was some method in the madness surrounding residential mortgage-backed securities (“RMBS”) and even CDOs. So I thought it might be worthwhile explaining the idea mortgage securitisation, how it got started, how it seemed like a really good idea, how it went wrong and how, if it is properly managed and understood, it actually is a really good idea. If we are to stop this sort of meltdown happening again, rather than just blaming greedy bankers (which is fun, I grant you) it's better to understand what happened in the first place, identify the problems so that we can all get the best out of the idea of securitisation without exposing western civilisation as we know it to risk of systemic implosion.
This isn’t easy when lawyers, rating agencies, accountants and, yes, investment bankers have a way of speaking which is precisely intended to make what they do sound harder than it actually is. As we all know, every “expert” in the world does this: it’s how you justify your fee.
Cards on the table: I’m not only an investment banker, but a lawyer to boot. I have tried to rein in my natural tendency to overcomplicate.
To help me explain I've invited along two personal heroes of mine: Captain George Mainwaring, commander of the Walmington-on-Sea home guard but more importantly bank manager to the local community, and David Bowie, chameleonic media superstar and living work of art (he’s a sort of multi-media installation) who has, over the decades, adopted many personas and forged many new directions, but none so memorable as his starring role in the early days of asset securitisation. You think I’m kidding, don’t you.

The background: in which we talk a lot about the ordinary business of mortgage lending from the bank’s perspective. In summary: It isn’t easy managing a large portfolio of mortgages.
Banks – old fashioned, proper banks – do two things: They lend, and they borrow. The money a bank borrows is a liability, which it will eventually have to repay, and the money it lends is an asset, which will earn the bank income. Much of a bank’s borrowing takes the shape of customer deposits. Much of its lending takes the shape of mortgage finance: lending to people like you and me so we can buy our homes.
As with any business, the general idea is to make more money out of your assets than you spend on your liabilities. Therefore, a bank wants the income from its portfolio of mortgage loans to be greater than the interest it must pay on its deposits.
This is one major thing a bank must do: manage its “market risk”: ensure that the income due on its assets is more than enough to pay everything it owes on its liabilities.
This isn’t just a simple matter of making sure mortgage interest rates are higher than deposit interest rates (though that sure helps!). For while a bank has no choice but to meet all its liabilities, whether it receives all the income due on its assets is out of its hands: Mortgage holders may go bust, after all.
The risk that that a debtor might not repay a loan is called “credit risk” and it’s very different to market risk.
Now while market risk can be very complex, banks are generally pretty good at managing it. It can largely (but not entirely) be worked out if you’re very good at maths and have sufficiently sophisticated computers.
Credit risk, on the other hand, is not so easy to calculate. The history of finance is strewn with companies that seemed to be extremely creditworthy, but turned out not to be: Enron, AIG, and Lehman Brothers are rather stark examples.
But, here, we're not talking about Enron and AIG. We're talking about people like you and me. While there are hundreds of analysts ready to pore over Enron’s books (and they still got it wrong) it’s a lot harder to do that for little people like mortgage borrowers. There all you have is s branch manager, Captain Mainwaring, checking that his customers’ prospects are good enough that they’ll pay on time. Mortgages are very long term investments - up to 30 years – so there’s plenty to worry about. No matter how careful Capt. Mainwaring is, it’s a safe bet that a small proportion of his customers will go bust. The question is how many.

Mortgages (relatively speaking) are small financial contracts, and most banks can afford to lose £100,000 here or there as long as they’re making enough out of their “good” assets to compensate. But even though each loan is insignificant, the total value of a large portfolio of mortgages quickly becomes very significant. It's important that Capt. Mainwaring is doing his job “on the front line” therefore, and being careful who he decides to lend to, and keeps an eye on his customers as long as they have mortgages with his bank. A good bank manager might be able to head off a problem or two, and over a whole portfolio that might make a difference.
You knew all of this stuff, right?
So look at dear old George Mainwaring, contemplating his mortgage portfolio. He can be fairly confident a certain percentage of the loans will go bad but, of course, he doesn’t know which ones (if he did, he wouldn’t lend to them!).
This is where statisticians and actuaries come in. Statiscially, for a given portfolio of houses, a given number of borrowers are very likely to default, and a larger number are quite likely to default, and a larger number have a low likelihood of defaulting (it's all that statistical fun with standard deviations and so on). So managing the credit risk of the mortgage portfolio involves calculating those probabilities as accurately as you can, and that in turn involves knowing as much as you can about the lenders and their financial circumstances.
Even a small change in the default probabilities can add up to a big number on a large mortgage portfolio: in a portfolio of 100,000 mortgages of £100,000 each a 0.1% change in default probability equates to £10 million. So there’s some big risk there, but it’s buried in a very big portfolio (the total portfolio value in this example is £10 billion!).

Quick sidebar: A mortgage is a classic banking product: A special, private, carefully monitored contract between a bank (represented by Capt. Mainwaring) and a private customer. It has a long term (usually 20-30 years) and can only be repaid early in certain circumstances. As long as the customer keeps up its payments, the bank cannot ask for its money back before the term of the loan. Because the bank can’t get out before maturity mortgages are called “illiquid” investments. They are hard to “liquidate”. By contrast, savings deposited in a bank account are on call. That makes them very “liquid” indeed. For now, note that a bank which finances illiquid assets with liquid liabilities has a “liquidity mismatch”: If customers withdraw their money suddenly, it is stuffed.
So banks like to look for ways to make their term loans more liquid. Since they can’t ask the customer for their money back, they have only one alternative: they can sell their loans. Under a loan sale, the selling bank transfers all its rights to be repaid principal and interest to the purchasing bank, and the purchaser pays the outstanding amounts due on the loan to the seller. Instead of the customer repaying the loan, the purchasing bank does.
Banks do “trade” loans, but it is not common for little mortgage loans, because a purchasing bank doesn’t want to hold an illiquid asset like a mortgage any more than the selling bank does. And the cost and hassle of transferring mortgages is prohibitive. There’s all that monkeying round with title registration and mortgage deeds.

A few years ago a some clever bankers came up with a way of allowing banks to easily sell their mortgage portfolios. This technology was called “securitisation”. A celebrated and pioneering example of a securitisation – of songwriting royalties – was David Bowie's "Bowie Bond", under which the Thin White Duke sold his rights to future royalties to a securitisation company which financed the purchase by issuing bonds secured on his catalog of songs. Investors took the risk that his songs wouldn't yield that much money. Small risk, as it turned out, and Bowie now has his song catalogue back, and investors were repaid in full. There: some securitisation stories do have a happy ending.
Under a mortgage securitisation, a bank would sell its mortgage portfolio to a company which would finance the purchase by issuing bonds “backed” by the portfolio it was buying. A securitisation therefore is, ironically, itself rather like a mortgage loan.
And here’s the clever bit: The mortgages (illiquid, term loans, very fiddly to transfer) have now been “repackaged” into a new format: bearer bonds called “Asset-Backed Securities” (commonly abbreviated to “ABS”). ABS are freely transferable securities, like shares. You can easily buy and sell them without bothering the mortgage borrowers. In this way one of the big risks associated with mortgage lending: being stuck with the portfolio for 30 years – was largely resolved.
But - and little did anyone realise this - a much bigger problem was created.

Sunday, 11 April 2010

We need more evangelists

Every revolution needs its instigators, and every instigator needs his prophets, evangelists, propagandists and advertisers. Just as it was true for religious and political, so it is for the cultural rebels. It's not always by design: contextualisers might be fellow travelers, but the most powerful aren't in the employ of those whom they evangelise.

In these anodyne days, magazines are a great example. They provide context for you and tell you what, how, where and why to buy. No matter that what they say is often patently absurd. Take, for example, this example from the current edition of What Hi-Fi Sound and Vision: It's a review of a power cable - the thing that plugs into your power socket at one end, and into your appliance at the other. This power cable - a regulation 1.5m in length - costs £60. It is carefully constructed, apparently, in terms of "many aspects of the content and construction of the cable - the number and arrangement of conductors, the insulation, the mains plug at one end and the three pin plug at the other." Trust us; it's very technical.

Sixty quid. For a power cable. What Hi-Fi has been quite unable to say what is so special about it: just that it really is carefully constructed. The benefits, it says, over a normal cable are "...abundant. Used in a video discipline, [it] offers greater certainty where movement and edges are concerned, deepens black shades and offers great punch to the high-contrast scenes. Colours are bolder, details more numerous."

The assertion, therefore, is that the construction of a power cable qualitatively, meaningfully, affects the representation of pictures on your TV. Can you imagine anything more preposterous? To catch a magazine reviewer out getting completely carried away isn't the point: the point is that, without this sort of independent publicity legitimising such a transparently absurd idea as a £60 power cable, no-one would buy it.

And so it is with all cultural artefacts.

So Elvis benefitted from Dewey Phillips - a brain-fritzed hillbilly who sounded like he was on speed - a Memphis DJ who championed That's Alright Mama on his Red Hot and Blue show. Later in life Greil Marcus was a leading contextualiser of ElvisBob Dylan and many others.

A prime moving evangelist begets other evangelists - gets a movement going, and from then anything can happen. But had Dewey Phillips not played that record on his show, the cultural history of the second half of the twentieth century might have been very different. Sun Studio, 706 Union Ave Memphis, is a small and unprepossessing place. Just making the music wasn't enough. Someone independent, with credibility, needed to broadcast it; validate it; vouch for it.

Lester Bangs - whose many best works can be enjoyed in Psychotic Reactions and Carburetor Dung - was another evangeliser. What he wrote about - punk rock in the seventies - was a base, greasy, countercultural mess that didn't have a shape or a context and stood about as much chance on its own of overcoming its meagre origins as did Elvis, Bill and Scotty's acetate. But - like Greil Marcus did with other artists - Bangs gave it shape, context; consequence; significance. Writing passionately and eloquently about an inconsequential subject gave others a prism - any old prism would do - through which to relate to it. Much of what Bangs wrote was, like the What Hi-Fi review of the £60 power cable,  on its face absurd, but that really wasn't the point. Or perhaps more accurately, that was the point.

This is the point. There's a new blues revival brewing in the UK. I only found out about it by accident: searching on the wonderful Spotify for Ram Jam's sprawling seventies' bastardisation of Leadbelly's Black Betty, I came across this one, by 18 year old Norfolk guitarist Oli Brown.

Norfolk?  Don't smirk. It's no more provincial or parochial than Memphis, Tennessee was in 1953.

Brown's take on Black Betty is less gaudy, less louche; a bit more respectful than Ram Jam's, but then, there's time. Oli Brown's not old enough to have experienced a real Black Betty - bam-a-lam - so hardly surprising he doesn't sing with total conviction about her. But he does have chops, and it was enough to buy the record. There are other interesting youngsters kicking around, too: Joanna Shaw Taylor, for example, from Birmingham (in the England's Black Country, not Alabama) looks a little like a young Kate Winslet, but her demure bearing belies a muscular voice and a bitching guitar tone - it sounds like she's channeling Bonnie Raitt of the voice, and Jimmy Vaughan of the guitar. They're all on an independent blues label, Ruf, which appears to be managed from Germany.

They're all a little too in the thrall of Stevie Ray Vaughan, truth be told, but they'll grow out of that: Given the cultural wasteland wrought by Simon Cowell and his kind, this is exciting to behold: The last time there was a British Blues Invasion, the cultural world turned forever.

But they can't do it alone: they need an evangelist. That, I suppose, is our job.

Friday, 9 April 2010

On Bankers and Entrepreneurship

So I had a thought about entrepreneurship. Actually, two: the first was, "isn't it funny that entrepreneur - the very watchword of free market capitalism (and, indeed, the very word for free market capitalism - laissez faire) is, of all things, French?". But that was a parochial and borderline xenophobic thought, and I resile from it (whilst secretly finding it pleasing and quite funny).

But my other thought about entrepreneurship was more interesting. It was Bankers what made me think it. Currently, the furore is about overpaid bankers.

I have an interest in this furore because - after a fashion - I'm a banker. Not just any old banker, but the worst kind. An investment banker. Who is into derivatives and that stuff. I say "after a fashion", because I don't actually do derivatives: I just help other people do them. I used to be a banker proper, for a short while, but I decided it was less stressful and more rewarding just helping bankers, rather than actually, properly being one. That's because I'm not especially entrepreneurial - when push comes to shove, I would prefer regular, safe, income to putting that on the line in the gamble for success and a lot of money.

So I'm actually a lawyer, and I just work for a bank. But even though in my mind I'm not really banker, in most people's minds, I totally am. Being a banker, I go to quite a few dinner parties. And it's a bit uncomfortable having to admit I work in a bank. Often, I just lie.

I digress. Real investment bankers, so the theory goes, are entrepreneurs: risk takers: that's why they get paid so well. "You civil servants and teachers aren't putting everything on the line every day: you don't take huge economic risks: people's livelihoods don't depend on you," (I imagine teachers might disagree; but let's park that.) "You don't take as much risk as I do, so therefore your potential reward is commensurately lower."

Which is all fine, if you accept that Investment Bankers are huge risk takers. But the thing is, they're not.

Now I like bankers (well, some of them, as individuals: of course I don't like them unhesitatingly as a class): I work for them, I have done for more than a decade, and I expect to do so for a decade more.

But investment bankers only necessarily take risks with other people's money. That, to me, doesn't count as risk taking. It's not particularly entrepreneurial. Really, that's being rather safe, relying on steady income. It is true that many bankers do put their own capital on the line (in the form of share ownership in their own companies) but generally this will be limited to a small portion of their annual income (between 5 and 30%), and even the most sage investment banker won't put any more than he is contractually obliged to into his own company ("I am already very long on exposure to this bank," he will say, "for I rely on it to pay may wage, and I already have 15% of my income in its stock. It is not wise, economically, to concentrate my investment portfolio by increasing my exposure to this bank. And if there's one person I know who's economically wise, it's me. I'm an investment banker (did I mention that?)".

So investment bankers tend to invest their savings in enterprises other than their own employer.

So when an investment goes horribly wrong for an investment banker, what happens? Does he lose his house and all his possessions?

I hope you won't be disappointed to hear that the answer is "no". Even if things go so disastrously wrong for the Banker that, Nick Leeson style, he manages to bankrupt his entire company, his loss is limited to his future earnings. Stuff that's already in the bank stays there. No one has a claim over his house or his Maserati Quattroporte. (Even if they otherwise would, do you think he wouldn't have had his financial adviser put his assets somewhere they can't be reached?).

This is known in the game as being long a call. Owning a call means that, if the value of the asset you have a call on goes above a pre agreed price, you get the right to "call" it - meaning buy it for that agreed price. Since, by definition, it's worth more than the price you buy if for, you make an instant profit, because you can immediately sell if for more money than you bought it for. If it goes down, you just don't exercise the option to call it. No loss. Except for the price you paid for the right to call in the first place.

A call, in legal parlance, is a right with no accompanying obligation. Note that employees don't pay (as such) for their calls: indeed they are paid for them. The "consideration" an employee gives for the call is his or her time: he or she has to show up, and do the employer's bidding to the exclusion of all else.

A call, by the way, is a sort of derivative.

Entrepreneurs, on the other hand don't just buy calls. Because they own the equity in their company, they take full exposure to gains and the losses of the business. If it goes up, they take the profits. If it goes down, they suffer the losses (because the equity capital, which they own, has decreased in value).

Entrepreneurs,therefore, buy a call and sell a put. (Selling a put is the opposite of buying a call - it means giving someone else the right to sell an asset to you at a pre-determined price. If the asset drops below that price the put holder will always exercise his or her put, and so this is an obligation without an accompanying right.

Bankers don't have that. So should they be paid as if they do?