Cezary Salad

It’s rare to pick up the paper on the way to lunch with someone and find a story that prepares you precisely for the conversation you’re about to have. But that’s what happened to me a few days ago when I read the New York Times on the way to a lunchtime meeting with Ed Grebeck.

Grebeck specializes in a subject of great interest to me – structured finance– and we were meeting to discuss how, more than two years after the outbreak of the financial crisis, not much, if anything, had been done on the regulatory front to make sure that the mistakes of the past don’t happen again.

The Times’ Friday business columnist, Floyd Norris, just happened to have a piece in the paper (yes, I still subscribe to print) that day on MBIA’s lawsuit against Merrill Lynch. The fallen investment bank was a big client of MBIA during the go-go days before the mortgage bubble bust, when it paid the financial insurer to take the hit if any of its mortgage-backed securitisations should ever go sour (so-called credit default swap contracts).

MBIA wrote $5.7 billion worth of these for Merrill at extremely low fees of .08% annually, according to their complaint – all based on assurances from Merrill and credit ratings from Moody’s and S&P that the securities it was insuring were indeed the “highly conservative super-senior,” “above AAA credit quality” debt instruments they thought they were. No credit analysis whatsoever by MBIA of the securities’ underlying assets. In other words, as Norris indicates, it’s another “I didn’t do my homework” lawsuit that’s bound to become a chapter in someone’s book on how the whole financial meltdown started in the first place.

Grebeck got a chuckle out of the story since it wasn’t anything new to him. It was two years ago this month that he, hedge fund managers Bill Ackman and James Chanos and Yale Law School’s Jonathan Macey held panel during which they warned that financial guarantors like MBIA were increasingly dependent on credit rating agencies for their AAA franchises and weren’t doing enough of the homework themselves to make sure guarantees they were making would have the payout rates they expected.

The result was one giant, systemic fallacy of equivocation, where one term with two different meanings is used in a single argument. The argument was: these are AAA-rated securities, so they must be safe. How safe? Well, they wouldn’t be rated AAA if they weren’t as safe as other banks or corporate that earn the same rating, so they must be of the same credit quality – even though they weren’t. As Grebeck points out, in corporate credit there is recourse to secondary sources of capital, such as the value of buildings and capital stock, which can be monetised in case a company becomes insolvent. In structured credit, all you’ve got are the incoming cashflows from the underlying assets: once the cashflows dry up, you’re left with nothing else.

So why equivocate? Part of it was undoubtedly because the regulators let the financiers do it. Take a look at the pre-credit crisis version of the Basel II accord, an international treaty which governs, among other things, how much capital banks must keep on their books against certain types of credit risks. Sure, there’s a special section in Basel on so-called “synthetic” AAA-rated securities resulting from structured finance and how their capital charges should be calculated differently from corporate securities. But not differently enough: “the capital treatment of a securitisation exposure,” Basel said, “must be determined on the basis of its economic substance rather than its legal form.” As the MBIA lawsuit demonstrates, economic substance was hardly considered. So no wonder that banks were able to give their synthetic AAA claims the same risk weighing (20%) as allowed for corporate under Basel.

On the face of it, of course, they should have known better. Even without relying on Merrill, MBIA probably knew that ratings have a way of being off – just by their very nature. As Dimitris Chorafas explains in Economic Capital Allocation With Basel II, the step-ladder AAA, AA, A etc. gradations of credit rating agencies are hardly black-and-white distinctions. Instead, they come in what Chorafas calls “fuzzy sets” where a company rated AAA has a high possibility of being of that grade, but also a low possibility of being AA+, or one notch below, and so on. So even if MBIA took Merrill’s word as gospel, they sure didn’t allocate enough capital to the lower-probability outcomes. Result: under-priced services and over-exposure to risk.

But enough with the causes; what of the solutions? The sad truth is that they’ve been slow to come. It’s just this past July that the Bank of International Settlements, which oversees Basel, took steps to strengthen its so-called “three pillars” of governance. Chief among them are proposals to strengthen capital requirements for securitisations – i.e. end the fallacy of equivocation that allowed all the above-detailed financial arbitrage in the first place.

Will it work? Only time will tell. But for now, I’m tempted to side with Grebeck when he says that credit risk is about behavior – not models. It’s about time bankers were required to draw a hard line between the two.

Everyone has their favorite demon for the financial crisis, whether it’s mortgage originators, rating agencies, banks, the Fed, hedge funds or as some would have it, angry gods.

Then there’s some favorite policies, like mark-to-market accounting, that people like to point to as accuse of exacerbating the crisis and making it worse than it actually is.

Last week, I went to a panel discussion at NYU’s School of Professional and Continuing Studies – “Back to the Future: How NOT to Repeat Yesterday’s Mistakes in Tomorrow’s Markets” – with Jim Chanos, the hedge fund manager famous for shorting Enron before the fall. The event made me think twice about the role of hedge funds and mark-to-market accounting in this crisis.

Chanos was flanked by Ed Grebeck, a structured finance expert famous for warning investors not to put their money into collateralized debt obligations (CDOs) before the crisis (“Why Should Institutional Investors Invest in CDOs, at All?” – published in Euromoney in April 2006).

Grebeck made the point that mortgage-linked CDOs were crafted such that “your structured finance model is my equity risk”. That is, the depth of the CDO modeller’s research into historical housing prices and default rates was essentially what determined how risky of an investment it was for the buyer. As a result – all tranches, from the AAA-rated slices all the way down to the BBB mezzanine portions and the unrated equity portion – should have carried an equity risk premium. And the senior-most AAA portions certainly didn’t deserve risk equivalency with treasuries.

So they were, in effect, ticking time bombs of massively under-priced, illiquid securities that were loaded with irreconcilable conflicts of interest and didn’t give investors enough information about how they were pieced together.

Now, in hindsight, it is easy to see that. But what about 2004 through 2007, when these instruments were being mass-manufactured by investment banks?

All the biggest investment banks adopted FAS 157 – the financial directive that introduced mark-to-market accounting – in late 2006 or early 2007. The accounting standard required them to split their assets into three buckets – level 1 (which have observable market prices, like stocks) and level 2 (observable market prices, but model inputs are based on them, like interest-rate swaps benchmarked over a 10 year treasury bond) and level 3 assets (no observable market prices, so carrying values are based solely on management estimates).

In the spring of 2007, short-sellers such as Chanos, always looking at the fine print to determine whether it’s worth taking a bet that the price of a security will fall in value, for the first time had “better granularity into the financial system”, as he put it, thanks to FAS 157. Stock prices for all the big investment banks began to tumble because, for the first time people realized just how much exposure they had to those level 2 and 3 assets – the stuff Grebeck was talking about – and how heavily over-leveraged investment banks had become, he said.

So when I asked Chanos whether FAS 157 has exacerbated the crisis – since its introduction, people have argued that mark-to-market accounting is difficult, inaccurate, exaggerates losses and distracts management – he disagreed wholeheartedly. More disclosure is better than less disclosure, he said. He also called the CDO boom-and-bust “one of the biggest heists in the history of capitalism” essentially enabled by a lack of transparency.

And, naturally, he doesn’t believe that short hedge funds such as his – Kynikos Associates (Kynikos is Greek for “cynic”) should be vilified for making use of that information in making investments.

“It’s always easier to blame some nameless, faceless ‘they’ than face what got us here,” Chanos said.

But it will likely take a while for governments to get on the same page. He recalled giving a presentation at the G7 meeting in the spring of 2007 just as FAS 157 was being implemented. He and another speaker gave “60 minutes of horrific presentations” about what they saw coming in the financial markets. When they were done, the first question from the German finance minister, Chanos recalled, was, “thank you very much – now, what do you think about hedge funds?” – as if it were all their fault.

Which takes us back to the blame game all over again. Sure, there’s plenty to go around and the list of causes and culprits is still being tallied. But I, for one, am convinced that more disclosure and short hedge funds making use of that disclosure should stay firmly off the list.