“There doesn’t seem to be a fundamental reason why.”

Until I read the last sentence of this Wall Street Journal article on AIG’s risk models, I felt somewhat sympathetic for the guy who developed the models.  Having developed many models in my life, I have seen them misused by executives wanting a more optimistic result, and putting pressure on the quantitative analyst to bend the assumptions.  Here’s the last paragaph:

On a rainy morning last week, Mr. Gorton briefly discussed with his Yale students how perplexing the struggles of the financial world have become. About 30 graduate students listened as Mr. Gorton lamented how problems in one sector caused investors to question value all across the board. Said Mr. Gorton: “There doesn’t seem to be a fundamental reason why.”

When I read that, I concluded that the poor guy was in over his head for years, and did not have the necessary expertise for what he was doing at AIG.  All good credit models contain something for boom and bust.  Creditworthiness of borrowing entities is highly correlated, especially during the bust phase of the credit cycle.  That said, to get deals done on CDO-like structures, the modeler can’t assume that correlations are as high as they are in real life, or the deals can’t get done.

But to my puzzled professor, there are fundamental reasons why.

  • Overlevered systems are inherently unstable.  Small changes in creditworthiness can have big impacts.
  • Rating agencies undersized subordination levels in order to win business.
  • Regulators allow regulated financials to own this stuff with low capital requirements, partially thanks to Basel II.
  • Much of the debt was related to Financials, Housing, and Real Estate, and all of those sectors are under pressure.
  • When financials ain’t healthy, ain’t no one healthy.

Now, for another look at the problem from a different angle, consider this New York Times article on Wisconsin public schools buying CDOs for teach pension plans.  As a kid, I played against a number of the schools mentioned in sports, etc., so many of these names bring back old memories for me.

Again, what is clear is that the guy advising the school one of the school districts barely understood the ABCs of what he was doing, and the district trusted him.  I’ll say it again, if you don’t understand it, or you don’t have a trusted friend on your side of the table who does understand it, don’t buy it. Also, relatively high yields on seemingly safe investments typically don’t exist.  Beware the salesman that offers high yields with safety; there is usually one of four things involved:

  • Financial leverage
  • Options sold short
  • Low credit quality of the underlying debt instruments
  • Foreign currency risks

These deals fall far short of the “prudent man rule” in my opinion.  Not only is the salesman culpable in this case, so are the board members that did not do proper due diligence.  For something this complex, not reading the prospectus is amazing, even though it might not have helped, given the complexity of the beast.  At least, though, a board member should read the “risks and disclosures” section of the prospectus.  There is usually honesty there, because that is what the investment bank is relying on to protect themselves legally if things go bad.

The districts should have accepted a lower rate of return on their investments, and asked the taxpayers for contributions to the pension plans, etc., to make up any deficits.

We will probably see many more stories like this over the next year.  Politicians and bureaucrats are often short-sighted, and look for “that one little thing” that will magically close a gap in the budget.  It’s that little bit of fear of the taxpayers and other stakeholders that caused “that one little thing” to become so tempting.  But now they have to live with the bad results; heads will roll.