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. 

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?