Fault Lines: How Hidden Fractures Still Threaten the World Economy (25 page)

However, in 2007 and 2008, the asset-backed bonds that AIGFP insured plummeted in value as the economy slid into recession, mortgage-default correlations proved larger than anticipated, and defaults became more likely. Even though few bonds actually defaulted, AIGFP’s liability on the swaps it had written increased steadily as it became more likely that AIGFP would have to pay out. As late as 2007, Cassano maintained confidently that “it is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing $1 in any of those transactions,” even while AIGFP was losing billions of dollars as it had to mark its portfolio down.
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Eventually, the losses became too heavy to ignore, and Cassano was let go. But he wasn’t fired: he “retired,” with a contract paying him $1 million a month for nine months and protecting his right to further bonus payments. AIG’s counterparties started demanding collateral to ensure that AIG would make good on its swap liabilities. In September 2008 AIG started the process of becoming the recipient of the largest monetary bailout in U.S. history, receiving more than $150 billion from the U.S. government.

Although it is not surprising that risky mortgage-backed securities were created, it is surprising that seemingly sophisticated financial institutions, including those who originated these securities, held on to significant portions of them. These were typically AAA-rated securities, which had some default risk associated with them. Financial firms also took on other kinds of default risk, such as the securities issued by the collateral loan obligations where they had parked the loans made to finance acquisitions and buyouts. To top it all, many of these investments were financed with extremely short-term debt, ensuring that if problems emerged with the asset-backed securities, the financial firms would have immense problems rolling over their debt.

Why did financial firms take on both the default risk associated with highly rated asset-backed securities and the liquidity risk associated with funding long-term assets with short-term borrowing? As I explain in this chapter, the particular way these risks were constructed made them especially worth taking for large banks—indeed, perverse as it may seem, it made sense for banks to combine both risks.

There was something special about the nature of these risks. Clearly, banks felt that default was unlikely. Not only were the securities issued against a diversified pool of mortgages or loans, but also the securities the banks held (or that AIG guaranteed) were senior, highly rated ones, so that defaults on the mortgages or loans had to be numerous to trigger off default on the securities. Similarly, the chances that financing would dry up were also deemed small. These risks were, then, what are known as
tail risks,
because they occur in the tail of the probability distribution—that is, very rarely.

A second feature of these risks, though, was that systemwide adverse events would be necessary to trigger them: to cause the senior securities to default, mortgages across the country would have to default, suggesting widespread household distress. Similarly, funding would dry up for well-diversified, large banks only if there was a systemwide scare. A third feature, perhaps the most important one from society’s perspective, is that these risks are very costly when they are realized, so they should not be ignored despite their low probability.

Unfortunately, these very features of systemic tail risks ensure that they are ignored by both financial firms and markets. Ironically, this also increases the probability that they will occur. When bankers attribute their problems to an unlikely event akin to a one-in-ten-thousand-year flood (thereby implicitly absolving themselves, for who could anticipate such a rare event?), they neglect to mention that their actions have increased the probability of such an event—to something like one in every ten years, approximately the periodicity with which Citibank has gotten itself into trouble in the past three decades.

I describe here how the structure of incentives in the modern financial system leads financiers to take this kind of risk. I next discuss why the corporate governance system did not stop such risk taking, and why various markets, especially markets for bank debt, were also unperturbed.

To understand the structure of incentives in the financial sector, we have to understand the relationship between risk and return. The central tenet in modern finance is that investors are naturally risk averse, so in exchange for taking on more risk, especially risk that may hit them when they are already in dire straits, they demand a higher return. Therefore, riskier assets tend to have lower prices (per dollar of future expected dividend or interest that they pay) and thus produce higher expected returns: stocks typically return more than Treasury bills. There is therefore an easy way for a banker or fund manager to make higher average returns for his investors; all he has to do is take on more risk by buying stocks instead of Treasury bills. This means the relative performance of a fund manager cannot be judged by returns alone: they must be adjusted downward in proportion to the risk being taken.

The bread-and-butter work of financial economists is to build careful econometric models describing the “appropriate” or market-determined level of return for taking on a certain level of risk. Financial managers are deemed to outperform the market only if they beat this benchmark return. The lay investor’s version of such benchmarking is to compare the manager’s return with a return on a benchmark portfolio consisting of similar securities: for example, the returns generated by a fund manager investing in large U.S. firms will be compared with the return on the S&P 500 index of large U.S. stocks. Such benchmarking is logical, because the investor can easily achieve the returns on the S&P 500 index by buying a low-cost index fund, and a manager should not earn anything for merely matching this return. Instead, investors will reward a manager handsomely only if the manager consistently generates excess returns, that is, returns exceeding those of the risk-appropriate benchmark. In the jargon, such excess returns are known as “alpha.”

Why should a manager care about generating alpha? If she wants to attract substantial new inflows of money, which is the key to being paid large amounts, she has to give the appearance of superior performance. The most direct way is to fudge returns. In recent times, some fund managers, like Bernard Madoff, simply made up their numbers, while others who held complex, rarely traded securities attributed excessively high prices to them based on models that had only a nodding acquaintance with reality. But it is easy to track and audit the returns most financial managers generate, so fudging is usually not an option, even for those with consciences untroubled by committing fraud. What, then is a financial manager to do if she is an ordinary mortal—neither an extraordinary investor nor a great financial entrepreneur—and has no bright ideas on new securities or schemes to sell?

The answer for many is to take on tail risk. An example should make the point clear. Suppose a financial manager decides to write earthquake insurance policies but does not tell her investors. As she writes policies and collects premiums, she will increase her firm’s earnings. Moreover, because earthquakes occur rarely, no claims will be made for a long while. If the manager does not set aside reserves for the eventual payouts that will be needed (for earthquakes, though rare, eventually do occur), she will be feted as the new Warren Buffett: all the premiums she collects will be seen as pure returns, given that there is no apparent risk. The money can all be paid out as bonuses or dividends.

Of course, one day the earthquake will occur, and she will have to pay insurance claims. Because she has set aside no reserves, she will likely default on the claims, and her strategy will be revealed for the sham it is. But before that, she will have enjoyed the adulation of the investing masses and may have salted away enough in bonuses to retire comfortably to a beach house in the Bahamas. With luck, if the earthquake occurs in the midst of a larger cataclysm, she can attribute her disastrous performance to a one-in-ten-thousand-year event and be back in another job soon. Failing in a herd rarely has adverse consequences.

More generally, at times when financing is plentiful, so that there is immense competition among bankers and fund managers, the need to create alpha pushes many of them inexorably toward taking on tail risk. For tail risk occurs so rarely that it can be well hidden for a long time: a manager may not even be aware he is taking it. But the returns are high, because people are willing to pay a lot to avoid being hit by cataclysmic losses in bad times. So if the manager produces the returns but his investors do not (at least for a while) account for the additional risk the manager is taking with their money, the manager will look like a genius and be rewarded handsomely. He may well come to believe that he is one. In other words, it is the very willingness of the modern financial market to offer powerful rewards for the rare producer of alpha that also generates strong incentives to deceive investors.

Because these incentives are present throughout the financial firm, there is little reason to expect that top management will curb the practice. Indeed, the checks and balances at each level of the corporate hierarchy broke down. What is particularly pernicious about tail risk is that when taken in large doses, it generates an incentive to take yet more of it. A seemingly irrational frenzy may be a product of all-too-rational calculations by financial firms.

A well-managed financial firm takes calculated and limited risks, risks that will make money for the firm if they pay off but will not destroy the firm if they do not. Firms like AIG, Bear Stearns, Citigroup, and Lehman Brothers took risks that were virtually unbounded, albeit low in probability. The most obvious factor driving this behavior seems to be the compensation system, which typically paid hefty bonuses when employees made profits but did not penalize them significantly when they incurred losses. The profitable one-sided bet this offered employees was known variously as the Acapulco Play, IBG (I’ll be gone if it doesn’t work), and, in Chicago, the O’Hare Option (buy a ticket departing from O’Hare International Airport: if the strategy fails, use it; if the strategy succeeds, tear up the ticket and return to the office). That such strategies were common enough in the industry as to have names suggests that not all traders were oblivious to the risks they were taking.

The Swiss banking giant UBS ran into trouble because its investment banking unit became entranced by the profit it was making from borrowing at the AA-rated bank’s low cost of funding and investing the funds in higher-return, high-rated asset-backed securities.
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The regulatory requirements for bank capital to be set aside to back such a strategy were minimal because the underlying investments were highly rated. The resulting interest spread was small, but multiplied by the $50 billion the unit invested in the strategy, it made a tidy profit for the bank while the going was good and resulted in large bonuses for the unit. Needless to say, this practice of picking up pennies in front of a steamroller was successful only until the subprime catastrophe rolled all over UBS’s profits.

Some smart traders in a number of banks understood and grew increasingly concerned by the risks that were being taken by the units creating and holding asset-backed securities. At Lehman, for example, fixed-income traders started selling these securities short, even while the real estate and mortgage unit loaded up on them.
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Clearly, any unit that is focused on creating and holding a certain kind of asset is naturally reluctant to declare an end to the boom it has ridden. The unit’s size, power, and reputation become too closely related to the asset class, and its head becomes an interested booster. For Lehman’s mortgage unit to declare an end to the mortgage boom would have been to sign its own death warrant. But knowing that those close to the action may become unreliable in assessing the associated risks, a firm’s risk managers should step in to curtail further investment. In many firms they did not, and it is important to understand why.

Risk managers should adjust every unit’s returns down for the risk it takes, reducing perverse incentives to take risk. The kinds of risks that were taken in the recent crisis—default or credit risk and liquidity risk—were not difficult for a trained risk manager to recognize, so long as she could see the unit’s books. For risk managers to become concerned, however, and for top management to share their worry can be two very different things.

In many of the aggressive firms that got into trouble, risk management was used primarily for regulatory compliance rather than as an instrument of management control. At Citigroup, for example, risk managers sometimes reported to operational heads who were responsible for revenue, putting the fox in charge of the chicken coop.
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Reflecting the typical firm’s view of their importance, risk-management positions were paid significantly less than positions in operational units, thereby ensuring that they attracted less talented people who commanded less respect: not surprisingly, studies show that firms where risk managers were not independent of the operational units and were underpaid relative to other managers performed poorly in the crisis.
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Their weakness was compounded as the boom continued. When a CEO adjudicated a dispute between his star trader, who had produced $50 million in profits every quarter for the past ten quarters, and his risk manager, who had opposed the trader’s risk taking all along, the natural impulse would be to side with the trader. The risk manager was often portrayed as the old has-been who did not understand the new paradigm—and the risk takers had the track record to prove it.