Other People’s Money: A Guide to this Financial Crisis and the Next One

When I was in college, I was one of those guys who only smoked O.P.s.

O.P.s are not a fancy synthetic drug. It’s shorthand for “Other People’s”. I never carried cigarettes, I always bummed, and when asked if I smoked, I answered proudly,

“Only O.P.s.”

Bankers do the same. They bet O.P. money. Before the financial revolution of the 1990's, commercial banks mostly bet that borrowers would pay back loans. In fact, most of the borrowers were also depositors, which meant that the O.P. money was circulating among the O.P.s. Banks were intermediaries among people and organizations that were mostly alike, mostly from the same place. Not a very exciting business.

In the old days, banks depended on a person called a loan officer who was responsible for saying yes or no. If a loan was too big, or there were special circumstances, there was a loan committee that made the final decision. But for mortgages, the most important loan any of us are likely to ever take out, the loan officer was enough. People had messy personal contact with other people who made decisions. This was unscientific and prone to breakdown.

In the old days of banking, as you will recall, the money the loan officer bet came from deposits, which meant the money belonged to the people who had lent their money to the bank under the proviso that they could have it back whenever they wanted it. As we might imagine, the depositors had a reasonable concern the bank might not take the proper care of their money. To assuage the fears of depositors, who historically had shown a nasty tendency to justifiable mass hysteria called bank runs, we worked out a neat little system.

Firstly, bankers and other business people managing other people’s money had a “fiduciary responsibility” – a mix of legal and moral suasion – to care for O.P. money. Secondly, as we mentioned earlier, loans were assigned to aº loan officer; when a bad loan got made, we knew who to blame. Thirdly, regulators monitored loan quality. Fourth, we invented obligatory bank deposit insurance so that if the bank went broke we could still get our money back.  

It wasn’t perfect, and we still had banking collapses and an occasional run, but most were simple affairs and deposit insurance worked. People’s savings did not go up in smoke. And when a bank went broke, or needed a bailout, it was always the same reason: Bad debt. In sum, it worked most of the time, failed some of the time, and we could understand, and manage, the complexity.

The financial crises of the second half of the 20th Century fit the model we understood ... and then along came Long Term Capital Management (LTCM). The LTCM crisis in 1997 was the first important sign that Mr. Greenspan's world of synthetic, risk-heding, financial innovation might prove to have a couple of glitches. LTCM was a hedge fund with two Nobel Prize winning economists, Myron Scholes and Robert C. Merton, on the Board of Directors. LTCM made some bad bets on fixed income instruments and the Federal Reserve Bank of New York had to put together a plan for a creditor bailout to protect the financial markets. LTCM was a hedge fund, not a bank, and it wasn’t depositor money at risk, but it was billions of O.P. money that if lost might threaten faith in the financial system.

What was different about LTCM was this freaky thing called systemic risk – the possibility that the interlocking pieces of the paper would come undone. Even weirder was that the risk to the system came from the top of the heap. The richest and smartest, though not necessarily the best and the brightest, could make a bunch of bad bets on Russian bonds and Royal Dutch Shell shares, lose a few billion, and that could ruin an ex-steel worker in Pennsylvania Dutch land who might end up with nothing more than his fractured family, his guns and his religion to live off of.

From LTCM to “The Crisis” was just a decade, and along the way the internet bubble burst and 9/11 reminded the first world  of that there is no such thing as the first world. "The Crisis" of 2008 is not just a couple of Nobel Prize winners with their calculators run amok. The Crisis is a stampede of hedges fund and big investment banks and GM, GE, and entire countries, like little Iceland, that bet on paper.

So how did do it? How did they achieve this collosal screw-up? This new-fangled financial crisis required the reinvention of commercial banking and investment banking, and a whole new way of running corporate finance and credit agencies. It needed the nurturing of the troupes of financial whizzes and pundits and neutered regulators and a citizenry numbed by AIDS, terrorism, avarice and good old-fashioned stupidity.

It required building an interlinking financial tower of Babel that no one, anywhere could actually get his or her mind around. This was no black hole, no black swan, but the biggest baddest white elephant we ever invented. And riding that big bad white elephant was the naked emperor …

The mechanics of the crash are simple enough. Remember the old game of telephone? This game started with the home loans. To multiply the home loans, we needed to reinvent commercial banking. This was done via three interlocking innovations: 1) credit scoring; 2) leveraging off-balance sheet assets; 3) securitization of mortgages and other financial instruments.

Now unless you were a finance person, you probably didn’t really care about this stuff before the crisis. Unfortunately, now that you do care, when it gets explained it sounds and smells and tastes like science fiction. Fear not, it is science fiction, and like all good science fiction there is a good story here; the intergalactic world of banking has its logic.

Which brings us to credit scoring. Credit scoring is a computer program that rates customers pretty much the same way fantasy football, baseball, etc., rates players. You plug numbers into the parameters, sometimes these are called statistics, and presto, a loan is approved or denied based on the facts. Credit scoring is simple, cheap, scientific, objective. Or so it seems. But what if the parameters are tweaked so any person with a social security number gets a yes? What if the credit scorers have all sorts of incentives to enter garbage statistics into the system? The answer is equally simple: Sub-prime mortgages. Or what we used to call, garbage loans. Garbage in, garbage out.

Now to the most obscure piece: off-balance sheet assets. An off-balance sheet asset is neither a loan nor a deposit, but one of those fancy, synthetic financial instruments (options and the like) that banks are supposed to use to help manage the risk incurred due to “the time dimension of money”. Isn’t that a great phrase – “the time dimension of money”? It is pure Einstein relativity stuff. You see, loans are long-lived slow moving things, while deposits are fast moving, in and out types. This makes life hard for bankers. The mortgages on a banks’ books are paid back over decades, but depositors can take their money whenever they please.

Figuring what to do about “the time dimension of money” is called asset and liability management. Off-balance sheet assets were supposed to make this easier by helping banks to regulate interest rate risk and cash flow. But what happens if the bank thinks it can make a lot of money playing with the off-balance sheet financial instruments, maybe even more than on the tradition interest rate spread between the loans and the deposits, and from fools who borrow money on their credit cards, or get nailed with commissions other people don’t  pay? What if there are some math freaks around who insist they can do it without any risk? What if there is no supervision and no capital requirements?

Which brings us banking innovation number 3 – securitization – the big bad boy of financial instruments. Remember, the bank has capital and cash tied up in 20, 30 and 40 year mortgages. The bank can free up that capital and cash by selling the mortgages to other people who implicitly trust your credit scoring, and the credit rating of the credit agencies who trusted your credit scoring.

And now the white elephant starts to feed. To make it easier for others to buy the commercial banks’ loans, investment banks help the commercial banks group them together, chop the future payments up into pieces, sell the pieces, and even invent new financial instruments that make bets on the value of the pieces “over the course of time” – the 20, 30 and 40 years that the payments are supposed to keep coming.  They then sell these instruments to other banks, pension funds, institutional investors, and so on all over the globe where there are mathematicians and finance people who claim to understand how a financial instrument might behave “over the course of time” and make their own bets about default risk, interest rate risk, and “the price of things reason cannot fix” to quote Blaise Pascal, the French philosopher and mathematician, who spoke of vanity, greed, the heart, and irrationality with wisdom 350 years ago, before there were computers that could demonstrate statistical correlations that don’t exist between things that will never exist.

Now, of course, the average bank official in the typical bank branch, the well-heeled trader working the Wall Street shuffle, the MBA whiz at the poshest investment bank, did not have the slightest idea what was going to happen “over the course of time”. But what he, she, they knew was that every day that fantasy finance lasted they could make a ton of money selling the financial instruments, selling more loans, inventing more financial instruments and so on in the biggest pyramiding scheme the world has ever seen. So they lent more and more money, sold more and more pieces of paper because they could. As they sold more and more, they needed more and more people to buy the loans that they could leverage into mor and more financial paper. They found out that smoking O.P.s can be just as addictive as going out and buying your own.

We cannot blame them (too much) for not seeing what was really going on.  Everyone was in on the game, everywhere in the world where there was money enough to ante in. The loan got broken up into pieces and sold all over the world, those pieces were linked to other pieces, so that everyone with assets of any kind, even those of us who don’t buy these pieces of paper, ended up linked into the same leaning tower of recycled paper that in its fall trapped everyone. Such collective disasters are customarily called “acts of God” for which there is no insurance – and no responsibility.

That’s how it happened. But weren’t there some people who saw it coming? Yes, there were a few. Some smart hedge fund managers saw that the paper was worthless and made paper bets that the paper was worthless and sold short. Selling short means is that you bet something will be worth less tomorrow than it is today. You bet the price of a share of a company will go down, the price of oil will go down, the value of a currency will go down, and so on. All that is required to make such a bet is to find someone willing to wager that the asset, whatever it is, will be worth more than you say it will.

 You might think that the short sellers would be safe. But what happens when the market for betting on what the asset will be worth tomorrow is various times greater than the market for what things are worth today? When that happens, all bets are “off”, all bets are speculative. The value of what you have today is based on the imagined value of some tomorrow that nobody has the slightest clue about. “The time value of money” is no longer measured in cash flow and interest risk, but in the systemic risk of politics, commodities, terrorism, home prices, and myriad other variables and interactions such that no one can see the trunk nor the tail of the white elephant.

Sound too apocalyptic? You read and hear that there were short sellers and banks that made money in the mess and that they are solvent, out of the woods. This was true, but not anymore. That’s because even the short sellers and the banks have to keep some assets. Finally, these assets are going down in value, too. The real estate, the companies, the currencies, the smart people bet on are now worth less as well … because as the paper collapses and burns, the debris and smoke damages everything around it. The collateral damage is systemic.

The only answer to systemic damage, we are told, is government. But as the government puts money into the big banks (today, the U.S. is saving Citibank), the banks survive, perpetuating the system of big interlocking financial institutions that got us into this situation in the first place. Instead of breaking up big banks, recapitalizing community banks, reducing the amount and velocity of paper and reconfiguring wealth creation as part of the “real” economy, government intervention is leading to increased bank size and consolidation in the name of creating viable financial institutions that are supposedly too big to fail instead of too big to let fail.

We are told that there will be more regulation of these big banks and that will protect us from another round of boom and bust and bail.

I hope so. But I can feel the White Elephant still clunking around and I don’t think I understand the mathematics of his next moves.

It’s enough to make you nostalgic for the bad old days. They were easier to explain. If it is a comfort, you can go to YouTube and listen to the Gregory Peck and Danny DeVito speeches from “Other People’s Money”, and remember what it was like when there was such a thing as the real economy and creative destruction killed bad old companies and new companies were born and we dreamed a collective dream called progress.

Comments

[Carlos]

Good evening David,

I work in a bank, and what really makes me feel dumm is to know I've been working and paying taxes for the last 8 years to bail out the ass of my bank's Board, responsible of all this disaster (together with other colleagues), so they can fire me tomorrow in the name of cost-effincency.

I would like to know more about the personal consequences of those responsible. Is there anyone going to be defamed or arrested? What about all that Corporate responsbility we learned in the MBA and throuh your posts? Is it enough to give back the lost millionaire bonus?

Is the blood of the 75.000 Citi-workers and similars the only we are going to see?

Thank you, for your allways brilliant analysis.

[Angélica]

¡¡Chapeau!! One of the best posts I've read about the sub-prime crisis.

Thanks a lot, David, and continue being that sharp and bright.

[Paul (London)]

Yes the white elephant is still clunking around. The UK government certainly seems to be feeding it by trying to convince its public that the only way out of the crisis is to double-up. The economics of this are reckless and yet addictive because you only need to win once to make up for all the previous losses. Similar to when your parachute fails to open, would you curl up in a ball or try and turn a few somersaults on the way down? Cynically I'd assume that the philosophy has been drafted in from the US, who are probably already at the crap table.

I’d argue there is still a 1st world; its those sections of the global economy that create their wealth from management, not production. They have to because they can no longer compete with production that simply costs less in less-developed countries. It’s their only hope of staying ahead too, because there are still very few learning curves that you can skip ahead of (mobile telephony being the only exception I know of). So while developing countries are going through the growing pains of building economies on good, honest, primary industries it would be nice to imagine that they will make more of the wealth they are able to accrue. Such an outcome will disadvantage the first 1st world severely and will cause a painful adjustment, which I’m sure is already on the mind of the appropriate country strategists. I believe the US has been working with this assumption since the 1950’s.

Another element to this is that the crisis is currently focused on housing assets and credit-rated corporations which comprise the bottom end and the top end of the problem. Nothing has come out in the middle yet, but middle market corporate is starting to exhibit the typical symptoms of being over-geared, having effectively been treated identically to equity-laden pieces of real estate. Sums are not headline grabbing on their own, but strength is in numbers, the consolidated amount adds up to a significant and destabilising figure.

Unfortunately, I believe regulation is just a smoke-screen and a scapegoat designed to occupy human minds long enough until they start to feel they can trust the worlds financial systems again. Or believe they are now sufficiently educated to avoid all the future pitfalls. Or are pressured to make returns and simply have to get in again. Whatever the drivers are, there are few other places to go in reality and people have memories like goldfish anyway, so once the collective mind has rationalised then the markets will once again be too busy servicing their customers impatient demands to waste time on designing themselves properly.

The system will continue to behave the way it always has until it is changed and that goes right down to (and maybe originates from) the remuneration systems in place. How about Nomura purchasing the lead Lehman’s team and agreeing to guarantee their bonus and distribute champagne to them on a monthly basis? How about Russian investment bankers drinking £39k bottles of wine with coca-cola in St James?

I’m sure it doesn’t stop after you step outside the financial institutions either – that’s just my view of the thing. After financiers, there are still shareholders, business owners and the man on the street to be factored into it. It’s just a capitalism system.

Anyway, these are some of the thoughts that were dislodged while I was reading your article. How about carbon trading as the basis for a new Ponzi scheme?