Footnotes
1. The authors said
it; we didn’t. This paper is associated with Dexia, a Belgian-French financial
group that had to be recapitalized with state funds. The recapitalization was
partly caused by residential real estate problems in Germany.
2. Here is the
problematic assumption, “…we can take the implicit approach by using market
observable information (our emphasis) such as asset swap spreads or risky
corporate bond prices.”
3. Derivatives
Week; “Empirical Asset Correlations”;
July 1, 2005; https://www.derivativesweek.com/Article/1251277/Empirical_Asset_Correlations.html
4. In a 8/07 study
of structured finance at the ratings agencies, the SEC found:
a) None of the agencies had specific written procedures for rating RMBS (subprime residential mortgage securities) and CDOs (collateralized debt obligations). The structured finance ratings process was "inherently flexible and subjective." At one firm, an analyst expressed the opinion that the ratings model did not capture "half" of a deal's risk. This, we might add, was for investments that were sold as being precise and scientific. An analytic manager wrote, "the rating agencies continue to create an even bigger monster-the CDO market. Let's hope we are all wealthy and retired by the time this house of cards falters.'"
b) The ratings agencies made "out of model adjustments" (guess in what direction) and did not document the rationales for these adjustments.
c) The ratings agencies do not appear to have specific policies to identify or address errors in their models or methodologies.
d) The SEC could not "assess compliance with ...established policies and procedures, and to identify the factors that were considered in developing a particular rating....There was also a lack of documentation of ratings committee actions or decisions...there was sometimes no documentation of committee attendees."
e) One agency allowed their senior analytical managers to discuss fees with issuers.
f) Since the arranger often designs the deal, he has the flexibility to adjust deal structure to obtain a desired credit rating, as compared to arrangers of non-structured assets...arrangers that underwrite (structured finance) offerings have substantial influence over the choice of rating agencies hired to rate the deals." The structure of the deal determines the price of the package, and thus its profits.
g) The actual ratings models used were incredibly complex. “while RMBS default probability and loss severity…models required 50 to 60 (sic) inputs, CDO models required only five inputs: current credit rating (of RMBS securities), maturity, asset type, country, and industry. “ Unfortunately the CDO models used credit ratings derived from the CLO models we discuss here.
5. George Soros writes, “Starting around 2005,
securitization became a mania. It was easy and fast to create ‘synthetic’
securities that mimicked the risks of real securities but did not carry the
expense of buying and assembling actual loans. Risky paper could therefore be
multiplied well beyond the actual supply in the market. Enterprising investment
banks sliced up CDOs and repackaged them into CDOs of CDOs, or CDO2.
There were even CDO3…In this way more AAA liabilities were created
than there were AAA assets. Towards the end, synthetic products accounted for
more than half the trading volume.”
Soros, George; “The New Paradigm for
Financial Markets; Public Affairs (2008), p.p. xviii-xix.
6. Since actual
bank loans usually don’t meet the latter two criteria perfectly, lending is
about taking intelligent risks. But bankers should never approve loans that
they don’t realistically think will be repaid. The statistical models
underlying structured finance, however, assume that loan defaults will occur as
an abstract law of nature.
On a 1/13/10 PBS broadcast, former
mortgage banker Mary Tootikian said that house mortgage
underwriting standards began dropping in 2000, finally becoming “non-existent.”
Currently problematic mortgage products, such as stated income loans, were
niche products; designed to make credit available (probably at sky-high
interest rates) to borrowers that had a large amount of equity in their
existing homes. These products were made widely available to purchasers with no
equity in their homes, the fatal argument being that home prices could only
appreciate and the debt could be refinanced if it proved onerous.
Pending congressional inquiries promise
to discover fraud and incompetence in the retail housing market. But what about
the smaller commercial real estate market; where buyers, sellers, and lenders
are informed professionals? Yet, as detailed in an excellent January 2010 Atlantic article,
buyers and lenders made the same mistake. The fatal assumption by both the
retail and commercial markets in their models was G, an assumed perpetual growth in house prices or rent rolls as the
real estate mania rolled on. The article estimates that $250 billion in
commercial property loans have to be refinanced over the next few years, with
asset values collapsing. At least the documentation in the commercial case was
better.
7. Reinhart and Rogoff list sixteen bank crises in high-income countries
between 1970 and 2008, about one every 2.4 years. Banking crises are not uncommon
because banks borrow short and lend long, depending upon public confidence in
their stabilities.
Reinhart and Rogoff, “This Time It’s
Different”; Princeton University Press (2009); Table A.3.1.
8. Tilman, Leo; “Financial
Darwinism”; John Wiley & Sons (2009); p. 126.
9. In the notable
Chapter 12 of “The General Theory,” Keynes (1935) wrote:
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In the absence
of security markets, there is no object in frequently attempting to revalue
an investment to which we are committed. But the Stock Exchange revalues many
investments every day and the revaluations give a frequent opportunity to the
individual (though not to the community as a whole) to revise his
commitments…. Of the maxims
of orthodox finance none, surely, is more anti-social than the fetish of
liquidity, the doctrine that it is a positive virtue on the part of
investment institutions to concentrate their resources upon the holding of
“liquid” securities. It forgets that there is no such thing as liquidity of
investment for the community as a whole.
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Keynes, J.M.; “The General
Theory (1935)”; Harcourt Brace (ed) 1964;
p.p. 151, 155.
10. Kaufman, Henry; “The
Road to Financial Reformation”; John Wiley & Sons (2009); p. 196.
11. Madison, James;
“The Federalist No. 51”; https://www.constitution.org/fed/federa51.htm
12. Financial
Services Authority; “Turner Review Conference Discussion Paper,” p. 26.
Mervyn King, Governor of the Bank of
England; stated, in our opinion, the definitive view:
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Speech to Scottish business organizations; October 20, 2009.
Mr. King says that the government should
separate public utility banking from the rest, and not subsidize the latter
with guarantees.