This morning, Derek Thompson posted a piece about Newsweek's article where Hank Paulson admits he did not really understand the mortgage-backed securities ("MBS") market. He finds this suspicious and bewildering. I imagine he is not alone. But having worked as an investment banker specializing in asset-backed securities origination, I am completely unsurprised.
Derek says:
I don't know if Paulson is fibbing, or if mortgage-securities were such a specialized and esoteric money machine that basically nobody understood what was going on, but either way, this seems devastating.
MBS is not nearly as esoteric as most people believe. The main reason that people don't know what so many of those securities are worth is based on the fact that they don't know how bad the housing market will turn out to be. If you have a relatively predictable housing market, then you can perform relatively accurate MBS valuations.
Instead, I would argue that most bankers who were not involved in MBS did not really care about it. A nice analogy might be comparing a bank to the human body. MBS is kind of like your pancreas. You know it's there; you're glad it's there; and yet, you probably don't know (and don't really care) how it works. That is, of course, until it stops working. Then you have a problem.
Securitization (the mechanism through which you create things like MBS) is a highly specialized part of an investment bank. Not just anyone can do it. It involves much deeper financial modeling than what most bankers do, along with intense knowledge of the debt markets to conclude accurate assumptions. Obviously, those assumptions turned out to be an epic failure.
But as a result, I find it almost obvious that Paulson knew very little about MBS -- unless you have ever worked to structure such securities, chances are you have only a vague notion of how they work. Sadly, this is probably also the case for many of the traders who purchased them, as they relied too heavily on rating agencies to provide accurate ratings for the MBS, rather than do their own due diligence.
Finally, it should be noted that Goldman was never one of the larger players in mortgage-backed securities. That (now) dubious distinction went to banks like Citigroup and Bear Sterns. That's one of the reasons why Goldman is still doing relatively well compared to other banks.
If you attempt to dissect Goldman's financials for 2005 -- the height of the boom -- then this is pretty clear. In Goldman's 2005 Annual Report (page 38), you find the following for their investment banking revenues, in millions:
MBS would be a part of Debt Underwriting. But so would unsecured corporate, municipal and all kinds of other debt. For more insight, on page 78, one learns that Goldman's entire securitization volume was $92 billion. For every billion securitized, the investment bankers usually earn somewhere in the ballpark of $1.5 to $2.5 million, to split between several banks. That means it's unlikely that Goldman earned much more than $100 million in securitization revenues, which amounts to a measly 5% of all investment banking revenues.
The investment banking team was highly focused on financial advisory and equity underwriting. This characteristic of Goldman Sachs is well known in the investment banking community.
But then there's trading. Goldman's profit in 2005 from investment banking fees was actually dwarfed by its profit in trading. It's pretty hard to know how much of its profits came from trading MBS. But, as mentioned, traders understand less about the intricacies of these securities than the bankers do. They're just buying and selling, mostly based on market forces.
Given Goldman was never too focused on securitization compared to its other businesses, I think it seems even more likely that Paulson knew (or even cared) little about it.
Then there's the question of whether or not he should have. Feel free to weigh in on that one, but I would argue that it's pretty impossible for the CEO of a place as complex as an investment bank to have a deep understanding of everything the bank does. They structure dozens of kinds of securities though dozens of businesses units. It just seems like too tall an order for any person, even someone of Paulson's stature.
Here is an interesting article on the topic:
"Recipe for Disaster: The Formula That Killed Wall Street"
http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all
I find this all difficult to believe. First, I don't see how you can predict the value of an MBS unless you know the future default rate on mortgages. That's not the same as knowing what housing prices will do. To predict defaults, you'd also have to know the unemployment rate and the walk-away rate.
I also think there were other more complex securities out there than simple MBS collections of mortgages. It's those more complex derivatives that have become very hard to value. After all, the simple MBS should still be returning some kind of revenue as people pay their mortgages.
There's no real excuse for management or regulator ignorance. As the housing bubble took off, there were plenty of anecdotal reports of insanely low standards on home loans, and mortgage mills willing to overlook absolutely any income or credit problem, just to create a mortgage and resell it for the fees.
The NINJA acronym (No Income, No Job or Assets) was in use well before the bubble became extreme. If management and regulators weren't alarmed by a phrase like that, they just weren't paying attention.
Or more likely, they thought it was someone else's problem. Some dumb investor would buy that trash and suffer the consequences. They didn't realize that during a bubble, even banks were fooled (by the high returns) into buying their own trash.
Hey, this is the way the free market works. Let the free market work itself out. Stupid is as stupid does. That's what deregulation is about. Trust the market. Ask Greenspan. He's a believer. As for dumb investors we're talking about real dumbos here: Bear Stearns, Lehman Brothers, Fannie Mac, Freddie Mac, the list goes on of all the dumb investors. Jeez why didn't they see this coming. I heard Jimmy Cayne (CEO BS) didn't understand MBS's either. Can you imagine making $40,000,000 a year with a helicopter to take you to your weekend place and not understanding MBS. What's the world coming to.
No regulator would have stopped the bubble -- it was too popular while it was going on. Can you imagine Greenspan saying in 2003 that "too many poor people are getting mortgages. We have to put a stop to that!" Congress and the Administration would have had a fit.
The problem with the MBS and CDO's had nothing to do with the "free market".
This was naive (I won't speak to motive) people relying on mathematical models that any 1st year engineering student would've crushed at a glance. The model hypotheses were based on faulty assumptions and the fact that no one looked at the theory behind these gall me personally.
Add that to the fact that regulators don't "tell" bankers how to run their business, and you have what turned out to be loaded guns (MBS, CDO's) in the hands of children on sugar.
So, was it really a stretch that the weasel went pop?
Even on Wall Street surely it is hardly unusual for CEOs and management not to understand the technical side of any operation, that is not the job of managers who are assigned to handle people not develop products, whose details they rely on others to understand.
What's surprising and culpable is the degree to which they didn't grasp their own business signals - having just been through a major bubble they continued exploiting another bigger one for years after all the signs were that derivative values would drastically deflate once the housing beanstalk stopped spirally upwards. Perhaps it was because they have always lived in a world where the big guys exploit bubbles and when they burst it is usually the little guy left holding the worthless paper. If the company itself really went south it would be rescued a la Long Term Capital Management according to the long established Trump principle where if you borrow enough your lenders rescue you, now expanded since the nineties to the LTCM rule if you're too big to fail without bringing down the system your colleagues or the Feds have to save you. What motivation is there or purpose served by anyone from CEOs thru management to traders knowing how derivatives are built, as long as they are traded widely and without difficulty? As long as confidence keeps up everyone makes billions and is very very happy, and the potential collapse may be inevitable but with no nearby warning signals it must seem as safely in the future as ever. Only academics and other thinkers who study the system as a whole might realize how interlocked everyone was nowadays and how swift and global the collapse could be, and even the one in the driving seat at the Fed who is supposedly expert in the Great Depression doesn't seem to have done anything early to head off catastrophe.
And how many Monday morning quarterbacks understand even now what is going on? A few journalists have noted that total derivatives amount to over $200 trillion held by domestic entities and some $600 trillion world wide, numbers that can be confirmed at the Comptroller of the Currency and which suggest that any noticeable deflation could outpace any hope of stabilization by government in short order, yet this concern has been successfully swept under the carpet. Perhaps we should be thankful it has. Perhaps we will only get by if all this stuff is concealed from the public. Asked about these strange numbers at the Ford conference a month ago, Joe Stiglitz said we were right to worry about it. But even he sounded as if he really didn't know how much. And he is the guy who says forget about propping up the bad banks let them go under and use temporary state control to rescue the good parts.
Its not just Paulson who is bewildered by the house that the free market has built on quicksand, it is everybody.