Wednesday, May 7, 2008

It's the underwriting

This headline "UBS Faults Blind Ambition for Subprime Miscues" reminded me of the Bank of America crisis in the 1980s.
"The Swiss banking giant UBS, which has written off more debt from the subprime crisis than any other bank, conceded in a report on Monday that a blind drive for revenue led it to take more risks than it should have."

BA wanting to challenge Citibank for supremacy in investment banking, entered late into the Latin American market. In their haste to become the country's biggest bank, management lowered underwriting standards to get the asset and revenue gains that they wanted. By the time they entered Latin America all the best risks had been taken up by Citibank and they were left with the more risky loans. [Not unlike the observation that it is the more recent vintages of subprime securities that have the highest default rates. See the summary at Econbrowser]

In the post, Jim Hamilton asks:
1. ... why did underwriting standards deteriorate?
2. ... why did the "most sophisticated" investors apparently become less and less sophisticated as time went on?

The answer to the first question lies in the incentives of bankers - are they being rewarded by the size of the loans they make, the number of deals they put together or the the size of the securities being floated?
The second question perhaps isn't really a question - here's Robert Rubin in his book "In An Uncertain World":
"In an analytic sense, they thought the market was overvalued but stayed invested anyway, perhaps on the "greater fool" theory that they could profit from an irrational rise and then sell their positions before it as too late. (p. 326) "

And perhaps even the GSEs lowered their underwriting standards:
"WSJ reports:
Some of the problems are surfacing in a mortgage program called "Fast and Easy," in which borrowers were asked to provide little or no documentation of their finances, according to [people with knowledge of a Federal probe] and to former Countrywide employees....

But here's the part that really scared me:
Both Countrywide and Fannie Mae, the government-sponsored company that bought many of the loans, classify the loans as "prime," meaning low-risk.... A Fannie spokesman agreed that the verification of employment wasn't required on all loans, but added that Countrywide was expected to verify employment details on a "sampling" of loans. The Countrywide spokesman said his company fulfilled that obligation.
It's news to me that Fannie was buying no-doc loans and calling them prime.

And finally, Willem Buiter:
Risk taking, remuneration and leverage
"Mervyn King, Governor of the Bank of England, is correct in linking the reckless lending by banks and other financial institutions that, together with the matching reckless borrowing, lay at the roots of the current financial crisis, to remuneration structures that rewarded extreme risk taking on poorly designed financial products. The diagnosis is fine. What to do about it is less obvious. These remuneration packages did not fall to earth from the moon. They are the result of a distorted economic environment. The key distortions, unfortunately, cannot be remedied, because they have highly desirable consequences as well as the dysfunctional ones highlighted by the crisis."

After all by the time the bankers have structured the deals and repackaged the securities, it is likely that they'll have moved on to something else. ("IBGYBG" - On Wall Street, a new phrase was invented only a few years ago: IBGYBG. I’ll be gone, you’ll be gone, so let’s do the deal and let the suckers pay for it. )

Nero and I marketed together a fair bit. I provided the technical bits. He smoozed the clients. Nero and I were making a pitch for a new structured product with a portfolio manager from an overseas fund over dinner. Dinner was a 3 martini, 2 bottles of French red wine and cigar and brandy affair. I kept looking for a moment to interject and explain the structure and benefits of the trade. I didn’t get a chance.
Towards the end of the evening, the fund manager turned to Nero and said: “The girls are coming up to my room, right?” I looked at Nero surprised. “You didn’t forget the stuff, it drives the girls wild?” Nero muttered something and carefully steered the conversation in a different direction. After dinner, Nero and I left the hotel. Nero stopped and drew his hand in a cutting motion across his throat. “Remember IBGYBG,” he said. “I be gone, you be gone. Got it kid.” A week later the portfolio manager was on the phone. “Been thinking about your deal. Like it a lot. Send me a term sheet. I think we can do something there.” We closed a juicy trade for $200 million booking profits of over $2 million.

From: Interview with Satyajit Das author of Traders Guns & Money

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