Four key decisions that led to the crisis

Slate magazine is running a series on  Making sense of the credit debacle. Recently Barry Ritholtz of The Big Picture blog, listed a couple of key decisions that he thinks contributed to the crisis.

What led to the current situation were numerous legislative, ideological, and business decisions that worked together to create a systemic failure. Consider each of the following:

  • The Commodities Futures Modernization Act 2000 allowed unregulated derivatives to run wild.
  • The repeal of Glass-Steagall 1999 allowed depository banks to become far more intertwined with Wall Street.
  • From 2001-03, Fed Chair Alan Greenspan took rates down to unprecedented levels, causing 1 a mad scramble for yield and 2 an enormous housing boom.
  • In 2004 the SEC allowed the five big investment banks to leverage up from 12-to-1 to 35-to-1 or more.

When math goes bad

After the sub-prime mortgage meltdown and subsequent collapse of the financial system, a lot of people wondered how the credit ratings agencies got things so horribly wrong.  After Wall Street firms scraped some toxic waste from the bottom of the barrel and packaged it  as a new investment product, the rating agencies still gave it a AAA rating. It’s as good as a Treasury Bill!

Clearly there was a conflict of interest, and a lot of pressure to rate their favored client’s products favorably. But they were also using some really bad math from the Quants in the back room. Formulas that the traders really didn’t understand. Hey, but it’s all good, as long as everyone’s still making money, right?

The Wired magazine article: Recipe for Disaster: The Formula That Killed Wall Street shows what how things went horribly wrong. They tracked down the source of those optimistic ratings to one formula, developed by David X. Li at JP Morgan Chase. In 2000, he published the formula in a paper: “On Default Correlation: A Copula Function Approach.”

Li’s formula tried to compute the joint probability that any two instruments will both default.  And it did not require any historical data – just the spot prices of credit default swaps. That speed and simplicity meant that soon everyone was using the formula.

For five years, Li’s formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.

The effect on the securitization market was electric. Armed with Li’s formula, Wall Street’s quants saw a new world of possibilities. And the first thing they did was start creating a huge number of brand-new triple-A securities. Using Li’s copula approach meant that ratings agencies like Moody’s—or anybody wanting to model the risk of a tranche—no longer needed to puzzle over the underlying securities. All they needed was that correlation number, and out would come a rating telling them how safe or risky the tranche was.

As a result, just about anything could be bundled and turned into a triple-A bond—corporate bonds, bank loans, mortgage-backed securities, whatever you liked. The consequent pools were often known as collateralized debt obligations, or CDOs. You could tranche that pool and create a triple-A security even if none of the components were themselves triple-A. You could even take lower-rated tranches of other CDOs, put them in a pool, and tranche them—an instrument known as a CDO-squared, which at that point was so far removed from any actual underlying bond or loan or mortgage that no one really had a clue what it included. But it didn’t matter. All you needed was Li’s copula function.

Of course, the formula had serious problems, as other mathematicians soon pointed out. But they were largely ignored by Wall Street firms, until things came crashing down in 2008.

In a final bit of irony, last year Li moved to China, where he heads a department of the China International Capital Corporation. He’s in charge of risk assessment for Chinese investments.

Pity the recruiters

Tech recruiters in Silicon Valley are the canaries. They sing a lot, dress in bright colors…  No, wait. They’re usually the first to get laid off, and often the first hired back when business improves. So now they’re being hit especially hard.
Recruiters Are Sending Out Their Own Résumés.

There are no precise counts of recruiters in Silicon Valley, and no one knows how many are unemployed. But interviews with more than two dozen recruiters suggest that the recession has slammed the profession particularly hard, both here and across the country.

Scores of recruiters have been let go in recent months and new positions are virtually nonexistent. Those that pop up attract as many as 500 applicants. And rates paid to recruiters, many of whom work as contractors, have fallen by about 50 percent.

That’s why they call it money

Lately, I’ve been listening to a lot of podcasts from National Public Radio. One of my favorites is “Planet Money“, which is the best practical explanation I’ve heard of what’s going on in the economy. They don’t track the market, or hype investments, or all that stuff you get on CNBC.

But they ask much more interesting questions like:
“How should a bailout work?”
“What is money, really?”
“How did Madoff do it?”

Just like in physics, sometimes, it’s the simplest questions that really have deep answers.

After listening to some recent podcasts, I’m now convinced that all economists are political.
When you don’t have scientific experiments to rely on, and the facts are all open to interpretation, academics tend to group by ideology. Back when I got disgusted with macro-economics back in the early eighties, it was during a battle royal between the Keynesian school and the Chicago school of economics. The Chicago school won, and dominated US economic policy for about 25 years. Now that federal monetary policy has failed, politicians are turning to those forgotten Keynesians again.

Planet Money was started last year by the guys who did “The Giant Pool of Money” episode for This American Life. And if you haven’t heard that program, it’s definitely worth an hour of your time.They recorded it back in May of 2008, as the sub-prime crisis was taking down more and more of the financial industry.

They somehow managed to make the entire mortgage industry comprehensible – by following the money trail. They talk to a guy with no income who got a $700,000 mortgage, and to a vet who was tricked into taking a sub-prime loan. They interview a kid who worked for a sleazy mortgage broker in Las Vegas, and got bigger bonuses for worse loans. At the top of the chain was the young turk working for an investment bank, who earned $50-$70K a month, and partied with celebrities. He says he knew things were bad the month he only pulled in $25K. “And that didn’t even cover my expenses”. In the end, he lost his penthouse to foreclosure, and ended up moving in with his parents.

Yeah, I know, it’s hard to feel sorry for a guy like that. I just hope Paulsen didn’t pay his bonus with my bailout dollars.

The End

The End of Wall Street
The End of Wall Street

Condé Nast Portfolio magazine:  The End of Wall Street’s Boom.

He draws parallels between the irrational exuberance of the past few years and the insanity he described in the mid-eighties in his bestselling Liar’s Poker:

I thought I was writing a period piece about the 1980s in America. Not for a moment did I suspect that the financial 1980s would last two full decades longer or that the difference in degree between Wall Street and ordinary life would swell into a difference in kind. I expected readers of the future to be outraged that back in 1986, the C.E.O. of Salomon Brothers, John Gutfreund, was paid $3.1 million; I assumed they’d be shocked to learn that a Wall Street C.E.O. had only the vaguest idea of the risks his traders were running. What I didn’t expect was that any future reader would look on my experience and say, “How quaint.”

But then Lewis goes in search of someone, anyone, who saw the economic collapse coming. And people keep pointing him to Steve Eisman, of FrontPoint Partners hedge fund. Back in 2004, Eisman started seeing that things were not well in the housing market, and by extension, the investment banks holding mortgage backed securities. As for collateralized debt obligations – those things were just weapons of financial destruction.

The funny thing, looking back on it, is how long it took for even someone who predicted the disaster to grasp its root causes. They were learning about this on the fly, shorting the bonds and then trying to figure out what they had done. Eisman knew subprime lenders could be scumbags. What he underestimated was the total unabashed complicity of the upper class of American capitalism. For instance, he knew that the big Wall Street investment banks took huge piles of loans that in and of themselves might be rated BBB, threw them into a trust, carved the trust into tranches, and wound up with 60 percent of the new total being rated AAA.

Were these investment banks run by idiots? Well, maybe. In a lot of cases the men on top had no idea what toxic waste their companies were dealing in. But a lot of companies seemed to know they were juggling hand grenades. They thought they could make a killing, and still get out in time.

But he couldn’t figure out exactly how the rating agencies justified turning BBB loans into AAA-rated bonds. “I didn’t understand how they were turning all this garbage into gold,” he says. […] “We always asked the same question,” says Eisman. “Where are the rating agencies in all of this? And I’d always get the same reaction. It was a smirk.”

He called Standard & Poor’s and asked what would happen to default rates if real estate prices fell. The man at S&P couldn’t say; its model for home prices had no ability to accept a negative number. “They were just assuming home prices would keep going up,” Eisman says.

It all came together for Eisman when he met a money manager in Vegas.

His dinner companion in Las Vegas ran a fund of about $15 billion and managed C.D.O.’s backed by the BBB tranche of a mortgage bond, or as Eisman puts it, “the equivalent of three levels of dog shit lower than the original bonds.”

After taking a fee, he passed them on to other investors. His job was to be the C.D.O. “expert,” but he actually didn’t spend any time at all thinking about what was in the C.D.O.’s. “He managed the C.D.O.’s,” says Eisman, “but managed what? I was just appalled. People would pay up to have someone manage their C.D.O.’s—as if this moron was helping you. I thought, You prick, you don’t give a fuck about the investors in this thing.”

Worst IPO market in 30 years

A couple of stories in the NY Times review the Venture Capital climate in 2008, and make some predictions for 2009. The stats from last year were pretty grim:

Only six venture-backed companies went public last year, the fewest since 1977 and down from 86 in 2007, according to data released Monday by the National Venture Capital Association and Thomson Reuters. Venture capitalists sold 260 companies, down from 360 in 2007.

In the fourth quarter, there were no initial public offerings and only 37 acquisitions, compared with 31 public offerings and 88 sales in the fourth quarter of 2007.

IPO drought and no rain in sight

IPOs a thing of the past?

Despite the credit crunch, the VC fund freeze, and the stock market meltdown,  panelists at the AlwaysOn Venture Summit think that “good companies” will still be able to go public. Someday.

Before that happens, a lot of other marginal companies will go out of business.

It’s the circle of life, Simba.

Meanwhile, what advice do these experts have for struggling companies?

“Everyone should act as though there will not be another round of funding,” Buyer said. “You should operate with what you have, because it may be all you get.”

Another drop in home prices

A report from the National Association of Realtors says that home sales were down 3% in October, and median home prices dropped 11% since October 2007.

Astonishingly, nearly half of homes sold in October were the result of foreclosure.

“Many potential home buyers appear to have withdrawn from the market due to the stock market collapse and deteriorating economic conditions,” said Lawrence Yun, the association’s chief economist.

Cash panic sweeping VC industry

The NY Times reports that some big investors have not been able to meet capital calls from venture firms: Cash panic sweeping VC industry – The capital calls problem. That’s likely to squeeze the Silicon Valley startup economy even more.

VC firms typically make “capital calls” to these investors whenever they need more money to pump into their startups. However now rumors are circulating that Columbia University’s endowment fund is illiquid — that is, it can’t raise the cash it needs to fund current commitments. Harvard, meanwhile, is reportedly trying to sell a third of its private equity portfolio at a steep discount in a “secondary offering.”

Tough love from Sequoia Capital

Sequoia Capital hosted a big meeting with their portfolio companies a few days ago. Today someone posted what he says are the slides of their presentation. It’s an analysis of the trends that got us into this financial mess, and some brutal recommendations to startup companies: Sequoia Capital on startups and the economic downturn.

Om Malik at GigOM posted more details about meeting today. He says general Partner Doug Leone advised startups:

  • Unprofitable companies would have a tough time raising cash, so get cash-flow positive as soon as possible.
  • Cutting deeper is the formula to survive, and this is an era of survival of the quickest.
  • Make sure you have one year’s worth of cash.
  • If you have a product, reduce expenses around it and boost sales. If the product is ready, cut the number of engineers.
  • Focus on building the absolutely essential features in your product.
  • Be brutal when it comes to marketing — anything that isn’t working, cut it.
  • Don’t burn through your cash, for cash is king