IFR columnist Anthony Peters recalls his time at the heart of the structured credit boom. What did it have to do with proper lending? Not a lot. But it is wrong to dismiss the value of structuring entirely, he writes.
I have enjoyed a long and modestly successful career in the City. Had it been unsuccessful, I would have been spat out long ago and would now probably be teaching either economics or modern languages at a minor public school. Had it been highly successful, I would probably be retired due to excess wealth.
In the event, I am neither, and therefore have been hanging around the street corners of EC1 from the rise of the Eurobond market to the disintegration of the structured credit market and beyond.
How that I, who cannot add two and two, should have ended up working in structured credit during its boom years was a mystery. But my superiors at the US investment bank I turned out for probably never grasped the level of my innumeracy and so I found myself removed from the credit world I felt comfortable in and was cast as a hot-shot salesman in what was known as GSP – or Global Structured Products.
As a trained corporate lender who had turned to banking in the late 1970s because I wasn’t good enough to get a proper job with BP, Nestle or Kodak, I was something of a fish out of water among the quants with PhDs in maths and physics and MScs in banking and finance who had fought to gain one of those highly valued graduate positions on Wall Street or in the Square Mile.
I could never admit that the squiggles, arrows and integration formulae on meeting room white boards could have been Arabic as far as I was concerned. I certainly struggled to see what all this had to do with the lending process, which is what I thought banking to be about.
In the fullness of time, I was proved right on that one – and all those clever chaps turned out to be wrong. They demanded and were paid millions. I didn’t and wasn’t. Who’s the fool?
And yet, the notion that structuring credit products is downright stupid (and that the lousy reputation with which they exited the credit crisis of 2007–08 was fully deserved) is highly oversimplified and subsequently quite wrong.
Old as the hills
The process of abstracting credit risk from the underlying loan is as old as the Code of Hammurabi (a Babylonian law code, dating back to about 1772 BCE) and can be found in any old textbook on banking and finance under the title of “Loan Guarantee”. That the process of guaranteeing loans had to be “generecised” and packed into a 100-page document before re-emerging as a credit default swap is nobody’s fault in particular.
Likewise, the truest of structured credit products – the collateralised loan obligation – is a shuffling of credit risk within a portfolio of loans that is, in my humble opinion, a creation of genius.
Let me explain. Assume you have a portfolio of 100 Double B rated loans. Each one of them is imbued with X default probability over a period Y years. If X occurs as predicted, then, very simply put, 100 – (X x Y) will not default and that collective will therefore be rated higher than Double B.
Looked at another way, imagine a field with a number of landmines spread across it and a fair probability that you’ll tread on one. The structuring process engineers a concentration of all the landmines in one corner of the field. The risks in that corner rise dramatically but the rest of the field is suddenly relatively safe. So long as someone is prepared to take the risk of navigating the dangerous corner of the field – for a substantial reward – then others can gambol about in the knowledge that they are fairly safe.
Such ideas were fine and dandy until interest rates fell so low in the post-9/11 world that defaults melted into insignificance in all areas of the credit curve. With the need for yield hugely increased at the same time, the makings of a perfect storm were clear for everyone to see.
That is, they were clear for anyone who understood that the economic cycle and the credit cycle are not creations of statistics, that returns cannot be increased without a commensurate increase in risk, and that profits should be taken over the lifetime of a transaction and not upfront.
In the middle
I stood in the middle of this market where abstracted credit risk was being heaved around as though it were sacks of potatoes and looked on with amazement as CDOs, the synthetic cousins of CLOs, were being created all around me.
Securitisation, the abstraction of a portfolio of risks, was the flavour of the year but it should never be forgotten, in defence of the Dr Frankensteins of banking, that demand outstripped supply to such an extent that risks began to be created for no other purpose than to feed the multi-headed monster of investment demand.
I found myself drafted into this world because I had spent many years covering investors in the insurance space and, as I seemed to be the only person around who knew the people in charge of investment strategy, I was a useful commodity in the machine room of investment banking’s fattest revenue stream.
But if I was a babe in the woods, spare a thought for the setters of investment policy in the investor universe. The German Landesbanks spring to mind. The boards were packed with worthy local politicians whose knowledge of banking and finance often didn’t stretch much beyond knowing that Triple A was good and Triple B wasn’t. And whose prime concern was to assure a hearty stream of dividends into the state coffers.
The Landesbanks were not alone. In the depths of the credit crisis I sat at a private dinner next to one well known City pundit who had, so he told me, dined with a former non-executive director of HBOS the night before. When asked why the board had done nothing to stop the mindless expansion of the bank’s balance sheet into areas way outside its areas of competence, the ex-NED had simply answered that he had done what he thought was right to support dividend growth.
Vive la France
So, there were the banks with their batteries of mathematicians who had never in their life lent money and who believed that a credit default swap constituted something tantamount to a lending transaction.
And where did many of those mathematicians come from? At the risk of coming over all xenophobic, the answer is France.
For years there has been a disproportionate number of Frenchmen and French-educated North Africans at the nub of the structuring business. This is not a fluke. The French educational system is broadly based around high level numeracy and as quant skills are essential in the structuring business, our francophone colleagues frequently converged on the structured product desk (the numeracy thing is another hang-over from the days of my great hero, Napoleon Bonaparte, who, as an artillery officer, placed mathematics in the centre of the school system).
Jerome Kerviel, the “rogue trader” at SG, is a case in point with his MSc in organisation and control of financial markets. Great at sums, no clue about banking. Nick Leeson, “the man who brought down Barings”, was the opposite – a decent brain for banking but no clue about the maths.
There were only very few who were truly competent at both sides of the equation and, by and large, by the time the structuring market was at its peak in 2006, it was stuffed full of people who were very bright but maybe not quite bright enough to see the risks beyond the statistical models.
I was floating around the desk like the Roman amongst the Greeks (no pun intended), like the volunteer soldier in a regiment of professionals – and just about to be sent into the trenches as cannon fodder.
So we were in an environment where rates were too low, where overly naive (and possibly greedy) investors were in need of return at any price and corners of the trading floor were more redolent of a common room in the science departments of Imperial College, the Politechnique or MIT than they were of a bank.
The catalyst
In order to create the explosive mix that would nearly bring global finance to its knees, just one further element was required – the catalyst. And this was, as we all now know, provided by the ratings agencies.
The agencies have always, to some extent, enjoyed the harlot’s option – power without responsibility. When investing became more polyglot, portfolio managers were asking to be given the right to consider investments outside of their immediate environs and management was looking to find a way to open up possibilities to benefit from foreign markets. So, ’ere long, agency ratings assumed near biblical status.
Agencies began rating everything and anything – not only because they wanted to but because investors expected them to. But the brainpower going into creating new products could never be matched by that analysing them.
One problem was that testing ratings was like using Hawkeye at Wimbledon. Whether a ball is in the middle of the court or just touches the base line by an eighth of an inch, it is in.
In the same vein, whether a security was a German Bund or a multi-faceted structured product that squeezed over the line as defined by the agencies’ respective ratings methodologies, it was a Triple A.
Another problem was that the banks paid significantly better than the agencies – no surprise there – and persistently hired away the best talent straight from Moody’s, Standard & Poor’s and Fitch. This deprived the agencies of experience while giving the banks the keys to the ratings agencies’ secret lockers. Nobody knows more about how to circumvent a rule than he who has written it. Thus the banks could arbitrage the ratings criteria at will – and they did.
Who’s the fool?
The finest example of the rules being bent to within an inch of their life was the constant proportion debt obligation, the CPDO. Had some of those enthusiastic investors and model-bound agencies abided by the old rule that if you look around the table and you can’t see the fool, then you’re the fool, then the CPDO might never have got off the ground.
But there was plenty that was much more basic and significantly more toxic. CDO-squared, CDO-cubed took structuring simple underlying credits to new levels of madness and, how could I not mention it, sub-prime mortgage securities packed the simplest of structures with unfathomable credit risk.
Day of reckoning
And then came the day in summer 2007 when BNP Paribas admitted that it had funds packed with securities that it could not value. Very quickly, rampant greed was replaced by headless fear. The model-toting mathematicians had not been taught that in real markets with real people the door marked “Exit” is always just a fraction of the size of the door marked “Entrance” – and that in the stampede no prisoners are taken.
Those among us who did know better just remained shtum – I was by now over 50 years old and knew that every monthly pay cheque was as good as a free gift.
I found myself reporting to my own former graduate trainees, who looked on my generation as sad dinosaurs who didn’t understand how much they had changed the world for the better.
By late summer 2007, it was game over – although there were still plenty of actors abroad who tried to make believe that what was occurring was no more than a temporary blip and that soon the gravy train would be racing along again at the usual pace. In September 2008, Lehman Brothers struck its colours, marking the definitive end to the credit boom and to the heyday of the investment bankers.
In little more than five years, credit structuring with its insatiable appetite for assets capable of being repackaged had brought the financial system and the global economy to its knees.
I can truly say, albeit with neither pride nor shame, that I was in the middle of the action while it was all happening.
Anthony Peters is a strategist at SwissInvest.
