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Strategies - Fred Harburg

Published July 2009

Casino on Wall Street

  

  Fred Harburg

Securitizing learning with lessons from the downturn

The economic meltdown provides a powerful inflection point to reflect, rethink and learn. This is an opportunity for CLOs to use learning as a lever to make the future for our people more stable, prosperous and secure.

During the past decade, many in the financial services industry provided loans and investments to customers who had a seemingly insatiable appetite for borrowing and speculating at levels of risk and requiring due diligence that they did not fully understand, or they ignored. Financial firms securitized by pooling and pricing subprime mortgage loans that they sold as financial investments called collateralized debt obligations (CDOs) — derivative securities.

They also met investor demand to create derivatives of these derivatives. Credit default swaps (CDSs) were created to function as insurance, backing up CDOs. Some investors bought CDSs that would pay off in the unlikely event that large numbers of underlying subprime mortgage holders defaulted on their loans. Though CDSs serve a legitimate purpose, they became yet another way of profiting from a propensity to gamble.

We developed sophisticated language, algorithms and models for calculating and managing risk. But any good builder will tell you that a model is only as good as the assumptions upon which it rests. It appears that the modelers at organizations such as AIG assumed that a global negative growth rate in the value of mortgaged properties was not possible.

The house of cards began to tumble at Lehman Brothers when the impossible became reality. When total home values fell below the value of their related loans, mortgage holders defaulted in record numbers. The CDS insurance payouts exponentially exceeded the real value of the underlying securities and the guarantor’s capital, making it impossible for them to make their contracted payouts. When it started to get ugly, taxpayers were forced to cover the remaining bets because, as we have repeatedly heard, these companies were just too big and too essential to be allowed to fail. It’s a bit like having to pay for your cousin Harry’s failed fling at the roulette table because your parents tell you he’s an essential member of the family.

One of the lessons of the crash must be an observation about rewards. Our economic system rewarded disproportionate risk takers handsomely. How can a mere mortal resist a legal activity for which he trained and worked diligently and for which he is rewarded with tens or even hundreds of millions of dollars — particularly when he wins 90 percent of the time, and any loss is not his loss. It is not merely the financial rewards. Our finest universities were placing as many as 25 percent of their graduates in jobs in the financial services industry where they lived an important and exotic life that was the envy of their classmates.

It was not merely the underlying assets that turned toxic. This entire system fed our worst instincts. Investments became speculative gambles, and banks, insurance companies and investment houses became casinos fueled by gambling consumers who borrowed as if there were no tomorrow. When the casinos made too many imprudent loans, we reached a tipping point, and the rest is history.