In my City investment banking days long ago, I recall attending the usual Monday morning meeting for all the directors in about 1987. We were given an exposition by a bright spark from the quantitative (“quant”) analysis team about his latest product – some kind of hedging or swap instrument with various bells and whistles attached. My field was blissfully uncomplicated Private Equity, but I listened politely and I hope my face did not betray my almost total incomprehension, shared, I would guess, by plenty of others in the large room. I thought then that banks should not dive deeply into matters most of their senior people did not understand but I could hardly admit this to such a hard-bitten gathering. So I was really left at the starting gate on the invention of new instruments and derivatives followed by the securitisation of debt, perhaps one of the reasons my finance career never rose beyond the commonplace. Yet the Financial Crisis from 2007 onwards shows that my unease was well justified. Bankers often complain that they have been unfairly demonised: this complaint is not well founded and bankers are prominent (if not the only) villains of this story.
At about the same time, unforgettably described in Michael Lewis’ Liars Poker, the mortgage team at Salomon Brothers in New York run by the florid Italian-American Louie Ranieri, discovered a way to trade boring old mortgages in bulk making a fortune for the team and the firm. This was done in a dealing room with a Babylonian atmosphere – new recruits being verbally abused, women being belittled and insulted, constant foul language, customers being gleefully fleeced and the team relaxing with gluttony competitions featuring huge takeaways of Mexican food and litre tubs of guacamole. Ranieri sold his mortgages mainly to naïve members of the US Savings and Loan industry (RIP). The tone, the intellectual climate was simply deplorable.
His methods were soon enough copied and surpassed by other Wall Street institutions. The invention of the Collateralised Debt Obligation (CDO) is “credited” to Drexel, Burnham, Lambert in 1987 but it took some years to win wide acceptance. The mortgage CDO takes a pool of mortgages and divides it into tranches – the first tranche being rated AAA down to riskier tranches, rated BBB. Investors can invest in whatever tranches they want, the lower the rating, the higher the interest return, as the tranches are sliced. With the variety of borrowers and credit ratings, with some mortgages being on fixed and others on adjustable rates, with redemptions being unpredictable, the CDO became a very complex product and “quant jocks” were employed to analyse and structure them. Some banks were chary of CDOs as they found them difficult to value.
An apparent breakthrough occurred in 2000 when a Chinese mathematician working in Wall Street, David X. Li, presented a paper on his Gaussian Copula, a formula based on probability theory, which purported to produce a correlation number. Calculating this number and applying it to a model allowed banks to value their CDOs more easily, which now pooled all types of loan, not just mortgages. Li’s method was widely adopted, although there were doubters like Warren Buffett, who described CDOs in 2003 as “financial weapons of mass destruction”. Yet the CDO market grew from $275bn in 2000 to $4.7 trillion in 2006. Most crucially the rating agencies were converted to Li’s methodology and somehow rated most CDOs AAA, making them acceptable to the banks.
Sadly, Li’s formula was flawed and relied on houses rising in value; the end of the US housing bubble led to the collapse of the mortgage CDO market, as nobody could say where the liabilities lay, and inter-bank funding sources dried up for many banks globally. Post-crisis, J P Morgan estimated the recovery rate for CDOs would be a catastrophic 32c in the $ and 5c for mezzanine. The casualty list was long as huge write-down were necessary; all the following collapsed, had to be rescued or were sold off cheaply – Lehman Brothers, Bear Stearns, Merrill Lynch, Fannie May, Freddie Mac, Washington Mutual, Citigroup, AIG and Wachovia. Alan Greenspan’s belief that the market was best left untrammelled proved false, the rating agencies and the academic economist establishment should have foreseen the crash; the auditors should have raised the alarm; the Fed should have supervised the banks much more closely, but the culture of Greed dominated the powerful banks, driving them to ever greater imprudence and contempt for their fellow-citizens and to well-deserved ultimate disgrace and execration.
In the UK, the crisis took a different shape and drew blood 12 months earlier than in the US. The US sub-prime mortgage panic undid Northern Rock and caused an ugly run on that bank in September 2007. The Bank of England provided the required facilities, but NR did not recover and it was nationalised a few months later. Its management had foolishly relied far too much on short term inter-bank funding to run the business. Several members of the board were quite rightly heavily fined and banned from the banking sector.
Much worse was to come. In an excess of folly, already overleveraged Royal Bank of Scotland (RBS) mounted a complex 3-way bid in September 2007 for ABN-Amro for an eye-watering £71bn. The target, feeble due diligence and timing were disastrous; soon enough the poor quality of ABN-Amro’s loan book emerged; emergency rights issues failed; a record loss of £24bn was reported for 2008 and to avoid panic RBS came into 84% public ownership. A proud Scottish bank, the product of generations of hard graft and prudence, was wiped out in a few months. The only executive to be heavily criticised at first was senior lender Johnny Cameron but clearly the greatest source of grievous error was the CEO, over-assertive Sir (now plain Mr) Fred Goodwin, aided and abetted by an ineffective group of (be)knighted non-execs Sir Tom McKillop, Sir George Matthewson, Sir Steve Robson and Sir Peter Sutherland. Their duty of oversight and challenge was very imperfectly exercised.
A similar sad story surrounded Halifax Bank of Scotland (HBOS) and Lloyds Bank. HBOS had made wildly inappropriate property loans and had funding difficulties. The Chairman of hitherto stable Lloyds Bank, Sir Victor Blank, received a nod and a wink from Prime Minister Gordon Brown to take it over. A deal was carelessly rushed through only for Lloyds to discover what a can of worms had been bought. Lloyds too became 41% publicly owned. A recent report has criticised HBOS’ corporate lender Peter Cummings, but the buck really stops at CEO Andy Hornby and Chairman Lord Stevenson and a set of silent non-executive directors.
The crisis spread to Europe, but that is another convoluted story. The bankers should now be wearing sackcloth and ashes but they are certainly not. A few days ago Greg Smith resigned from Wall Street king-pin Goldman Sachs and in his resignation letter highlighted the “toxic and destructive” culture, the shameless crowing over rip-offs of customers, known as “Muppets”, the continuing peddling of opaque derivatives and the lust for profit at any price. It sounds much like Salomon’s 1980s dealing room.
In the UK, where vast public funds have been injected into the bankers’ money markets to assist their liquidity, the remuneration package this year for Bob Diamond of Barclays Bank is a stratospheric £17.7m. They just don’t get it, do they? Self-restraint is not a word in the bankers’ vocabulary. So let Vince Cable do his worst to clip the wings of the irresponsible banks who are the authors of much of our current misery. Otherwise, do not be surprised if the tumbrils soon roll and the suffering working people scream for bloody and exemplary revenge!
SMD
18.03.12
Copyright Sidney Donald 2012
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