Thursday, July 16, 2009

Fool’s Gold

Having been impressed by seeing Gillian Tett on Bremner Bird and Fortune a while back, and being curious as to the cause of the recent global financial crisis, I recently bought her book, Fool's Gold.

Despite the book being mainly about the financial markets, a subject which would normally have my eyes glazing over within a couple of minutes, I have read it with enjoyment (well sort of) and in the space of 24 hours (albeit having skimmed most of the more technical sections). Ms Tett is to be congratulated on writing such a readable book.

So what have I learned from it? Very basically, and adopting a Pooh Bear of little brain approach, it seems that what happened was as follows:

For a long, long time, millennia even (according to some clay tablets from Mesopotamia), people have been buying financial contracts based on the future value of something. This is known as a derivative. Its a way of avoiding risk. Party A pays over the odds so he can be sure of buying something at a particular price in the future. Party B (who takes the risk) gains or loses depending on what that future price actually is.

In her book Gillian Tett follows the fortunes of a group of bankers from the American Bank J P Morgan from about 1994, who developed innovate new ways of doing this sort of thing. What in in the real world we would probably look upon as gambling.

The main innovation the J P Morgan team developed was a way of splitting the risk involved in lending money, so it became separated from the loan itself. One reason for this was that banks are required to retain capital to cover the risks on their books. If the risk had been sold on however, then they would not have to retain so much capital and could use that for other money making schemes. And make more profit.

The risk for the loan (or actually bundles of risks for loans which were sold on together) were divided into different types. There was the ‘junior’ risk, which was very risky but which carried high rewards, ‘mezzanine risk, (sort of middle risk)’ and then ‘senior’ risk which was considered to be pretty safe. There was also a residual risk, known as ‘super senior’ which was at least risk of default and which was considered very safe indeed.

The original team which developed this idea, understood and, it seems, on the whole dealt with it fairly responsibly (which is partly why J P Morgan is still in business (and doing well) today). The problem was that this type of deal became very popular, and was undertaken by people who did not understand it. It also became enormously complicated with deals so complex that no-one could really work out what was actually happening or where the loan originated. The whole topic was also shrouded in jargon and acronyms which made it almost impenetrable for people unfamiliar with it (i.e. everyone other than the few bankers specialising in this type of work.)

Another problem was that the risk was assessed on formulas which everyone considered to be valid but which were in fact based on very little underlying data. The reason for this was that although there was a fair amount of data available for when things were going well, there was little if no data for times when thing were going badly and property prices falling.

As time went by these deals became more and more popular. Most people wanted to buy the ‘junior’ or more risky products because that was where the greatest profit lay. No-one really considered that there could be a problem, as property prices had always gone up. So popular were these products (because of the massive profits which were being made) that there was a huge demand for more loans and mortgages to service the risk products. No-one was really at risk anyway (so the theory went) because the risk was so sliced and diced and was spread out so thin that it became negligible.

Presumably therefore (although I don’t think the book actually says this) loans were being made recklessly to people who could never afford to pay them long term, so that the risks could be sold on to people anxious to buy them so they could earn these huge profits. Unbelievable but presumably true.

Another problem was the ‘super senior’ risk. The very safe and boring risk, which was so safe it was not really considered a risk at all. No-one wanted to buy this as it did not carry the lucrative profits. These just tended to stay with the financial organisation making the loans. The people at J P Morgan got uneasy at this huge stockpiling (billions of pounds worth) of super senior risk, and managed to get rid of a lot of it, but other banks didn’t. They were super safe anyway so were no real risk.

Then things started to go wrong. The people who had been given loans that they could never pay, stopped paying them. Not only this, but in many cases the property when repossessed, was in such bad condition that it failed to raise much money when sold.

The risk investments therefore stopped paying. Not only that, they stopped paying in much greater volume than had ever been predicted by the predication models. Not only was there no money available to pay the junior through to senior risks which had been sold off. There was not enough to pay the super senior risks. The ones which had been largely retained by the banks. But as they were not considered to be a risk (because they were super safe) the banks had not retained sufficient reserves to cover them. Sometimes they did not even realise (because different departments did not talk to each other) that they were there, until they became a problem.

Hence the smash.

Its not really as simple as that of course. And the book talks at some length about ‘shadow banks’, which so far as I can make out are organisations created so that these risky products could be dealt with outside the regulatory system which regulates the banks.

But, ladies and gentlemen, this it seems, is largely why huge sums of taxpayers money, which should have been used for health, schools, the justice system, and defence, were used instead to stop the banks going bust. Any also why a lot of innocent people have lost their jobs. Fools gold indeed.

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