The Aleph Blog » Blog Archive » Three Long Articles on Three Big Failures

Three Long Articles on Three Big Failures

If you have time, there are two long articles that are worth a read.  The first is from the Washington Post, and deals with the demise of AIG, highlighting the role of AIG Financial Products.  It was written in three parts — one, two, and three, corresponding to three phases:

  • Growth of a clever enterprise, AIGFP.
  • Expansion into default swaps.
  • Death of AIG as it gets downgraded and has to post collateral, leading to insolvency.

What fascinated me the most was the willingness of managers at AIGFP to think that writing default protection was “free money.”  There is no free money, but the lure of “free money” brings out the worst in mankind.  This is not just true of businessmen, but of politicians, as I will point out later.

My own take on the topic involved my dealings with some guys at AIGFP while I was at AIG.  Boy, were they arrogant!  It’s one thing to look down on competitors; it’s another thing to look down on another division of your own company that is not competing with you, though doing something similar.

As I sold GICs for Provident Mutual, when I went to conferences, AIGFP people were far more numerous than AIG people selling GICs.  The AIG GIC sellers may have been competitors of mine, but they were honest, and I cooperated with them on industry projects.  Again, the AIGFP people were arrogant — but what was I to say?  They were more successful, seemingly.

The last era, as AIG got downgraded, was while I wrote for RealMoney.  After AIG was added to the Dow, I was consistently negative on the stock.  I had several worries:

  • Was AIGFP properly hedged?
  • Were reserves for the long-tail commercial lines conservative?
  • Why had leverage quadrupled over the last 15 years?  ROA had fallen as ROE stayed the same.  The AIG religion of 15% after-tax ROE had been maintained, but at a cost of increasing leverage.
  • Was AIG such a bespoke behemoth that even Greenberg could not manage it?
  • My own experiences inside AIG, upon more mature reflection, made me wonder whether there might not be significant accounting chicanery.  (I was privy to a number of significant reserving errors 1989-1992).

In general, opaqueness, and high debt (even if it’s rated AAA), is usually a recipe for disaster.  AIG fit that mold well.

Now AIG recently sold one of their core P&C subsidiaries for what looks like a bargain price.  This is only an opinion, but I think AIG stock is an eventual zero.  Granted, all insurance valuations are crunched now, but even with that, if selling the relatively transparent operations such as Hartford Steam Boiler brings so little, then unless the whole sector turns, AIG has no chance.  Along the same lines, I don’t expect the “rescue” to be over soon, and I expect the US govenment to take a significant loss on this one.

The second article is from Bethany McLean of Vanity Fair.  I remember reading her writings during the accounting scandals at Fannie Mae.  She was sharp then, and sharp now.  There were a loose group of analysts that went under the moniker “Fannie Fraud Patrol.”:  I still have a t-shirt from that endeavor, from my writings at RealMoney, and my proving that the fair value balance sheets of Fannie were unlikely to be right back in 2002.

Again, there is a growing bubble, as with AIG.  The need to grow income leads Fannie and Freddie to buy in mortgages that they have guaranteed, to earn spread income.  It also leads them to buy the loans made by their competitors.  It leads them to lever up even more.  It leads them to dilute underwriting standards.  Franklin Raines’ goals lead to accounting fraud as his earning targets can’t be reached fairly.

One lack in the article is that the guarantees that Fannie had written would render Fannie insolvent at the time the Treasury took them over.  On a cash flow basis, that might not happen for a long time, but it would happen.  Defaults would be well above what was their worst case scenario, and too much for their thin capital base.

The last article is another three part series from the Washington Post that is about the failure of our financial markets.  (Here are the parts — one, two, three.)  What are the main points of the article?

  • Bailing out LTCM gave regulators a false sense of confidence.  They relished the micro-level success, but did not consider the macro implications of how speculation would affect the investment banks.
  • Because of turf and philosophy conflicts, derivatives were left unregulated.  (My view is that anything the goverment guarantees must be regulated.  Other financial institutions can be unregulated, but they can have no ties to the government, or regulated financial entities.
  • The banking regulators failed to fulfill their proper roles regarding loan underwriting, consumer protection and bank leverage.  The Office of Thrift Supervision was particularly egregious in not doing their duty, and also the the SEC who loosened investment bank capital requirements in 2004.
  • Proper risk-based capital became impossible to enforce for Investment banks, because regulators could not understand what was going on; perhaps that is one reason why they gave up.
  • The regulators, relying on the rating agencies, could not account for credit risk in any proper manner, because the products were too new.  Corporate bonds are one thing — ABS is another, and we don’t know the risk properties of any asset class that has not been through a failure cycle.  Regulators should problably not let regulated entities use any financial instrument that has not been through systemic failure to any high degree.
  • Standards fell everywhere as the party went on, and the bad debts built up.  It was a “Devil take the hindmost” situation.  But as the music played, and party went on, more chairs would be removed, leaving a scramble when the music stopped.  Cash, cash, who’s got cash?!
  • In the aftermath, regulation will rise.  Some will be smart, some will be irrelevant, some will be dumb.  But it will rise, simply because the American people demand action from their legislators, who will push oin the Executive and regulators.

A few final notes:

  • Accounting rules and regulatory rules were in my opinion flawed, because they allowed for gain on sale in securitizations, rather than off of release from risk, which means much more capital would need to be held, and profits deferred till deals near their completion.
  • This could never happened as badly without the misapplication of monetary policy.  Greenspan enver let the recessions do their work and clear away bad debts.
  • Also, the neomercantilistic nations facilitated the US taking on all this debt as they overbuilt their export industries, and bought our debt in exchange.
  • The investment banks relied too heavily on risk models that assumed continuous markets.  Oddly, their poorer cousin, the life insurers don’t rely on that to the same degree (Leaving aside various option-like products… and no, the regulators don’t know what is going on there in my opinion.)
  • The insurance parts of AIG are seemingly fine; what did the company in was their unregulated entities, and an overleveraged holding company, aided by a management that pushed for returns and accounting results that could not be safely achieved.
  • The GSEs were a part of the crisis, but they weren’t the core of the crisis — conservative ideologues pushing that theory aren’t right.  But the liberals (including Bush Jr) pushing the view that there was no need for reform were wrong too.  We did not need to push housing so hard on people that were ill-equipped to survive a small- much less a moderate-to-large downturn.
  • With the GSEs, it is difficult to please too many masters: Congress, regulators, stockholders, the executive — all of which had different agendas, and all of which enoyed the ease that a boom in real estate prices provided.  Now that the leverage is coming down, the fights are there, but with new venom — arguing over scarcity is usually less pleasant than arguing over plenty.
  • As in my blame game series — there is a lot of blame to go around here, and personally, it would be good if there were a little bit more humility and willingness to say “Yes, I have a bit of blame here too.”  And here is part of my blame-taking: I should have warned louder, and made it clearer to people reading me that my stock investing is required because of the business that I was building.  I played at the edge of the crisis in my investing, and anyone investing alongside me got whacked with me.  For that, I apologize.  It is what I hate most about investment writing — people losing because they listened to me.





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5 Responses to Three Long Articles on Three Big Failures

  1. JoshK says:

    Good Post.

    I think you underestimate the role of the GSE’s in fomenting this crisis. The mortgage banking industry went wild with under 417k+ 1st loans. All of my m-banker friends would print these all day to basically anyone, and they had an easy time fitting them into the underwriting criteria. I don’t think the GSE’s did any diligence on that. Also, even if the GSE’s weren’t 100% of the market, they were still big enough to affect it. If they weren’t there the other participants could have charged more for the risk that they took.

  2. Kieran says:

    David,

    If you’re taking responsibility for your errors, I’ll take the other side of that trade and, rather than trying to place blame, I’ll thank you for the gifts you’ve given us. I’m fairly new to trading and investing, and your site has helped me to understand the macro picture and be prepared. Fortunately, I managed to turn a profit on my personal portfolio this year, and your insight has helped me to accomplish this. From your thoughtful posts to your excellent book suggestions, you have helped this young investor navigate these troubled waters. For that I thank you. Please keep up the great work!

  3. Mr. C says:

    David,

    Your insights have helped me a great deal, keep up the great work. I value your blog above all others. And don’t forget that each of is responsible for his investment decisions, so don’t blame yourself. I eagerly anticipate your future writings. Thanks again for you have done for me.

  4. Paul in Kansas City says:

    David you know i appreciate your work and you have made me a better investor (and i hope person); Mr. C’s comments can’t say it any better. happy New year to all blog readers!

  5. matt_swansojeiker says:

    Such an internalizer (“what may I have done differently?”). Of course, those make the best risk managers, esp.contrasted with externalizers (see Fuld, Dick) whose innate rejection of self-criticism make them ideal salespeople.

    Quite reading list for this holiday. The stories rhyme in how AIG/FNM/I-banks all started as trusted, highly rated entities. First they used their privileged AAA rating to earn spread over riskier assets. When that hit its limits, they moved to higher leverage to increase returns. Then to mismatched duration. Then to untested products,until it all finally came to grief.

    The puzzle to me is why this generation of managers so aggressively monetized the goodwill their predecessors worked to build. It feels like a form of asset-stripping and I read it in every story of failure now washing to the surface. Why was the instinct to to consume it all today and leave nothing for future generations so consistently strong across these firms? What kind of legacy are you leaving behind? What sort of world do you think you’ll be living in afterward?

    Thank you again for your efforts in 2008. And remember that with loss usually comes wisdom and that’s a treasure in its own right.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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