The following is an excellent excerpt from the book “FOOL’S GOLD: The Inside Story of J.P. Morgan and How Wall St. Greed Corrupted Its Bold Dream and Created a Financial Catastrophe” by Gillian Tett from Chapter Six on page 97 and I quote: “The banks also began to turn to inventive devices for moving those deals off of their books. One of these was a type of quasi-shell company known as a structured investment vehicle (SIV) for purchasing the loans and selling the bonds sliced and diced from them. This species had actually first emerged two decades earlier, when two bankers at Citibank, Stephen Partridge-Hicks and Nicholas Sossidis, hit on the idea as a way of getting around the Basel rules for capital requirements. SIVs were tied to banks, not completely separate as with the shell companies known as SPVs [special purpose vehicle]. The banks provided some of their funding, as opposed to all of that being raised by the shell company itself, through selling notes. But SIVs did partially fund themselves independently, and they sat off the balance sheets of banks. They were thus a bit like the garage of a house: a useful place for banks to park assets they did not want inside their home banks. Another structure that fulfilled a similar function was a so-called bank conduit. This was similar to a SIV, but more closely linked to a bank.
The hybrid status allowed the banks to evade the Basel rules that limited the amount of assets they could hold on their balance sheets, thereby freeing them to leverage their capital a good deal more. The key reason the banks were allowed to do so concerned the way in which SIVs raised the portion of their funding that didn’t come from the banks, and this particular exploitation of Basel loopholes would lead to terrible consequences once the credit bubble began to burst. The loophole was this: the Basel Accord stated that banks didn’t need to hold capital resources for any credit lines that were less than a year in duration. So banks typically extended credit lines to SIVs and conduits that were 364 days or less. The banks did not reckon, though, that the SIVs and conduits would ever need to draw on these credit lines. In normal circumstances,they raised their funding in the short-term commercial paper market. In this market, the SIVs and conduits would sell notes that paid off in only a few months, somewhat like a CD. Those buying the notes were, therefore, extending credit for many fewer days than a year. The cash they raised was used to purchase safe, long-term debt instruments, such as mortgage bonds. They made a tidy profit because their short-term borrowing costs were lower than the returns they made on the long-term bonds they bought. They were thus playing what’s referred to as a “carry trade,” and while the profit margins on this bit of alchemy were small, the SIVs leveraged themselves so much—making substantial purchases of bonds vis-a-vis the amount of capital they had raised—that all in all they made quite reasonable income. The strategy carried a key risk. Leverage not only magnifies gains, it also magnifies losses, and with such a constant need to replenish short-term funding, the SIVs and conduits were vulnerable to finding themselves cash poor. The danger was that if buyers of commercial paper—such as pension fund managers—ever stopped buying such notes, the SIVs and conduits would see their normal funding dry up. And the SIVs were usually required to continuously report the value of their assets at market prices—to mark-to-market. If those values ever dropped precipitously, commercial paper buyers might well decide to stay away. But the SIVs stuck to buying top-quality assets, only those carrying the triple-A tag from credit rating agencies, so the chances of that turn of events seemed vanishingly slim or so they assumed.
One of the truly staggering things about this boom in newfangled credit investment products was that very few nonbankers had any idea that institutions such as SIVs and CDOs even existed. Even regulators seemed only vaguely aware of what the banks were really doing. Yet SIVs were proliferating like mushrooms after a rainstorm. The financiers had created a vast “shadow banking” system that was running out of control.
As the pace of innovation heated up, credit products were spinning off into cyberworld that eventually even the financiers struggled to understand. The link between the final product and its underlying assets was becoming so complex that it appeared increasingly tenuous. Bankers were becoming like the inhabitants of the cave in Plato’s tale, who—at the best—could see only shadows, not tangible reality. Most financiers lacked the cognitive skills to truly understand the connections in this new world. These complex products could not be analyzed with just a pen and a piece of paper, or even a handheld computer or two. The debt was being sliced and diced so many times that the risk could be calculated only with complex computer models. But most investors had no idea how the banks were crafting their models and didn’t have the mathematical expertise to evaluate them anyway. Each player had its own twist on modeling, after all, and as Terri Duhon observed, “Many different investment banks will provide significantly different prices on the same CDO tranche because they are using different models of correlation.”
Investors generally relied on the ratings agencies to guide them through this strange new land, which seemed a rational, easy solution to contending with the complexity. The ratings scale was so simple: if something was triple-A, it was supposed to almost never default; if it was triple-B or triple-C, it had far more risk. In a world where so much else was baffling, those clear-cut designations were wonderfully comforting. Better still, they were backed up by massive research, which was a key element in the rating agencies’ sales pitch.
Like priests in the medieval church, rating agency representatives spoke the equivalent of financial Latin, which few in their investor congregation actually understood. Nevertheless, the congregation was comforted by the fact that the priests appeared able to confer guidance and blessings. Such blessings, after all, made the whole system work: the AAA anointment enabled SIVs to raise funds, banks to extend loans, and investors to purchase complex instruments that paid great returns, all without anyone worrying too much.
Some bankers warned about the seduction. “People who are focused on ratings alone are prime fodder for the investment banks to stuff [sell] things too,” argued Charles Pardue, a key player on the team that created BISTRO. “I don’t think we should kid ourselves that everything being sold is fair value. I have been to dealer events where bankers are selling this stuff, and the simplicity of the explanation about how it works scares me. . . there are people investing in stuff they don’t understand, who really seem to believe the models, and when models change, it will be a very scary thing.”
The ratings agencies, unsurprisingly, were adamant that such concerns were unfounded. Moody’s, Standard & Poor’s, and Fitch had each invested heavily to develop cutting-edge systems for modeling the risks of the full range of new products. To allay fears that their calculations might be faulty, they also had tried to show investors exactly how these systems worked. “We are very transparent in everything we do,” Paul Mazataud, a senior official in the structured finance team of Moody’s, explained in an interview. Moody’s even voluntarily posted details of its own model, called CDOROM, on the internet in 2004. “Our model had become a bit like a template in the market,” Mazataud observed. “Most CDOs are rated with this model, and it is used by management in most synthetic transactions,” he continued, bursting with pride.
Yet such assurances failed to allay the unease of Pardue and others. Precisely because the agencies had diligently posted the details about how their models worked on the net, bankers found it easy to comb through the models looking for loopholes to exploit. And by 2005, they were doing quite a bit of that. Whenever a banker had an idea for a new innovation, it would be run through the agency models to see what rating the product was likely to earn. If it looked too low or high, the design would be tweaked. The aim was to get as high a rating as possible, with the highest level of risk—so that the product could produce all-important higher investor returns. In banking circles, the game was known as “ratings arbitrage.”
Officials at the ratings agencies knew perfectly well that this game was going on. But they felt in a poor position to fight back. Banks had far more resources than the agencies, so they could build better models and hire the smartest structured finance experts. The banks also held the whip hand in a commercial sense. While in the corporate bond world, the agencies rated the bonds of thousands of companies and were not dependent on any one company for fees, these credit products were being produced by a much smaller circle of banks. Those banks constantly threatened to boycott the agencies if they failed to produce the wished-for ratings, jeopardizing the sizable fees the agencies earned from the banks for their services. From time to time, the ratings agencies took a stand, to show they couldn’t always be pushed around, but they were careful not to offend the banks too deeply. When an agency gave a rating to a CDO, it sometimes commanded a fee of $100,000 per shot, or even several times that level. Moreover, the business was growing fast—so fast, in fact, that by 2005 Moody’s was drawing almost half of its revenues from the structured finance sector; two decades before, that proportion had been modest.
On top of that conflict of interest, the ratings that the agencies were issuing were subject to another pernicious problem. In trying to judge the risk of these products, the agencies forced the same vexing issue that had dogged the old J.P. Morgan BISTRO team when it considered going into mortgage-based BISTRO deals: How could default patterns be modeled? There was so little good data to work with. Was it safe to assume that defaults would play out in the future as they had in the past? Even if so, the historical data was so limited. The trickiest issue of all was working out the level of “correlation”–figuring out how likely it was that one default would trigger others. Different modelers had alternate ways of dealing with the problem, partly because they often selected different pools of data to work from. ‘The purest information to use is data on [historic] defaults, but the sample is just too small,” Gareth Levington, a London-based managing director at Moody’s, explained. “So we look at correlations on ratings movements. But there are other ways you can do it with equity prices, say.”
Almost all of these slightly different techniques did, however, use the same fundamental mathematical approach—or “statistical engine,” as Moody’s officials called it—which tried to plot the probability of future defaults based on historical data, using a bell curve type of chart that assumed that losses would occur in a relatively steady manner.”
(I QUOTE FROM PAGE 76:
“J.P. Morgan had also become dangerously small by comparison to the new breed of behemoths. By late 1999, Citigroup wielded $716 billion in assets. J.P. Morgan, with $260 billion, was a third the size. Sandy Warner, the new J.P. Morgan CEO, airily brushed aside comparisons. “I don’t think bigness is a strategy [for Morgan]. There needs to be a certain scale. Beyond that, the advantages are less compelling and can even be diminishing,” he had declared at the bank’s annual meeting the year [Sanford] Weill announced his Citigroup merger plans. Instead of aiming for size, J.P. Morgan management stated, it would focus on profitable “smart” niches. That strategy had its own rewards. During the 1980s and early 1990s, Dennis Weatherstone had battled to reshape the bank’s business away from commercial lending to investment banking, and by 1999 that had been implemented to an impressive degree. The so-called noninterest income part of the bank’s business, considerably more than at any other large American commercial bank. More striking still, the bank was starting to feature in industry league tables tracking the investment banking world. It tended to rank around number six in terms of merger and acquisitions business; in American bond underwriting, it was in the top three; in derivatives, it was usually at or near the top.
However, J.P. Morgan’s problem was that the world around it was moving faster. As the Wall Street Journal had observed in 1998, “From a standing start in 1980, Morgan is now on the cusp of the bulge bracket of the world’s six top investment banks. . . increasingly, however, the biggest profits aren’t going to a bulge bracket of six banks but to a super-bulge of three firms—Merrill Lynch, Morgan Stanley Dean Witter, and Goldman Sachs.” Worse, the type of investment banking business that J.P. Morgan was focusing on, with its heavy emphasis on derivatives, wasn’t producing the staggering profits being made from the internet boom.”
THERE AGAIN, THE ISSUE OF UNREGULATED DERIVATIVES OVERWHELMES ALL INVESTMENT BANKS. THE LOBBY GROUP, ISDA [INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION] WAS DOING A VIRTUAL CRIMINAL JOB BECAUSE IT WAS COVERING-UP ANY FAULTS IN THE DERIVATIVE MARKET. THE PROBLEM IS, THOUGH, IT’S LIKE A DAM THAT IS STARTING TO SPRING LEAKS AND THE LEAKS CONTINUE TO INCREASE UNTIL SO MUCH MONEY IS THROWN AT TRYING TO COVER-UP THE DERIVATIVE ISSUE, THE DAM WILL BREAK BECAUSE OF THE HIGHER AND HIGHER AMOUNTS OF DERIVATIVES USED. IT’S LIKE AN AIR COMPRESSOR BLOWING UP WHEN THE VALVE STICKS. WHY DO SO-CALLED INTELLIGENT PEOPLE LET THIS HAPPEN TIME AND TIME AGAIN? DO YOU THINK THAT WE ARE JUST MAYBE LAZY? WE SHOULD AT LEAST ASK SOME QUESTIONS AND GET SOMEWHAT INVOLVED AND IF WE ALL DID IT TOGETHER, I THINK THE JOB WOULD GET ACCOMPLISHED AND EVERYBODY WOULD BE BETTER OFF.
LaVern Isely, Overtaxed Independent Middle Class Taxpayer & Public Citizen & AARP Members