Process versus Outcome

We are coming to the end of the first decade of the millennium. If I have to think of one lesson that I have learnt over the last decade, then it has to be the one on 'process versus outcome'.

To illustrate this concept, let me cite an example from Michael Lewis' book Moneyball:

Paul DePodesta, a former baseball executive tells about playing blackjack in Las Vegas when a guy to the right, sitting on a seventeen, asks for a hit. Everyone at the table stops, and even the dealer asks if he is sure. The player nods yes, and the dealer, of course, produces a four. What did the dealer say? "Nice hit." Yeah, great hit.

Similar to this anecdote, in our daily lives, we measure performance by results. After all, results are what ultimately matter - they add to bottom line. Evaluating the underlying process is subjective and hard. So, we simplify our lives, by making the critical mistake of assuming that good outcomes are the result of a good process and bad outcomes are the result of a bad process. Besides, the only ones voicing against doing so are mostly people who have 'failed' in their endeavours.

But alas, reality is far more vicious than a game at Vegas. We all wish life was as simple as a game of blackjack where each card about to open up is one of the few known options. But often we are faced with a myriad of possibilities. Our folly is in picking a process that has the possibility of delivering a rare but fatal outcome. On top of that, a few repetitions of the process starts giving us a false sense of security - we start feeling that the sorts of things that happen to others will not necessarily happen to us. And then if nothing bad happens then we kick our self for being too worried.

Nassim Taleb, the author of Fooled by Randomness, offers a thinking tool called 'alternate histories' that I find very useful:

The concept of 'alternate histories' is similar to the many-world interpretation in quantum mechanics, which considers that the universe branches out treelike at every juncture; what we are living now is only one of these many worlds. Taken at a more extreme level, whenever numerous various possibilities exist, the world splits into many worlds, one world for each different possibility - causing the proliferation of parallel universes.

If we apply the 'alternate histories' way of thinking then the guy at the blackjack table got busted in one of the alternate worlds indicating that he was following a poor process. Even though this way of judging matters is abstract and counter intuitive, it is a good way to evaluate our process. After all, in the long haul, a good process gives us the most reliable way of raising our chances of a good outcome.

• Good process, Good outcome - Deserved success
  
• Good process, Bad outcome - Bad luck
  
• Bad process, Good outcome - Dumb luck
  
• Bad process, Bad outcome - Poetic Justice
  

Playing by the (Basel) Rules

US private debt grew from 20 trillion dollars in 2000 to over 50 trillion dollars in 2007, but FDIC regulated banks (referred to as banks for the rest of the discussion) continued to stay "well capitalized" during this period. How could total debt grow by 80% without leading to the deterioration of bank's capital?

To answer this question, we need to look at how banks are regulated. At the end of 1980s, the G-10 countries decided to coordinate their banking regulation through the Basel Committee on Banking Supervision of the Bank for International Settlements (B.I.S.) by setting capital adequacy requirements. According to the Basel rules, all banks and depository institutions in the countries that adhered to them must maintain a certain minimum fixed amount of capital in relation to its assets.

The capital adequacy requirement set by B.I.S is to protect the banks from unexpected losses, since the banks are protected by expected losses by accounting for them on their books. The term "capital" might give you the impression that it is cash held by the banks in their vaults. But such a usage is misleading. Generally speaking, capital is the portion of bank's assets that don't have to returned to creditors (depositors are also creditors). It is only because of the fact that this portion of its financing does not have to be repaid that the bank has the capacity to withstand unexpected losses. It is the capital that absorbs these unexpected losses. The Basel rules classify capital into 2 tiers - Tier 1 "core" capital and Tier 2 capital. Tier 1 capital largely consists of funds raised through selling common stock, disclosed reserves, and retained earnings. Tier 2 is defined as undisclosed reserves, revaluation reserves, loan-loss reserves, convertible bonds, cumulative preferred shares, and subordinated debt.

The Basel rules require that the banks hold certain minimum ratios of clearly defined capital (calculated at book values) against assets that are adjusted by clearly defined weights.

Capital ratio = Capital / Risk-weighted Assets

Under this framework, banks to be considered "capitalized" are required to hold no less than 8 percent capital against total risk-weighted assets.

The system of assigning weights to assets is fairly standardized requiring minimal supplementation by various national banking regulators. In the United States some of the risk weighting rules are as follows (for details look at BIS 1988):

• 0% weight to cash, gold, and bonds issued Organization for Economic Co-operation and Development (OECD) governments


• 20% risk weight for AAA and AA rated asset-backed securities and claims on OECD banks, local public-sector entities, and agencies of OECD governments, such as the government sponsored enterprises Fannie Mae and Freddie Mac.


• 50% risk weight to mortgage loans


• 100% risk weight to all claims on the private sector and non-OECD governments, to investments in real estate, equities, corporate bonds, and all other assets rated lower than AA

In addition to the Basel rules, the FDIC in the United States require that banks aspiring to be deemed "well capitalized" - and thus enjoy valuable privileges like securities underwriting - must hold their capital in a configuration that meets additional three additonal ratios: capital to risk-weighted assets of 10 percent, tier-1 capital to risk-weighted assets of 6%, and tier-1 capital to total assets of 5%. The chart above plots these three ratios for American FDIC banks leading upto the financial crisis. It should strike you that, as per the Basel rules, banks were a few percentage points higher than those mandated by FDIC for being "well capitalized". This might seem hard to square with the expansion of indebtedness that took places during the credit boom years.

The regulatory ratios can be achieved by either increasing the numerator or by decreasing the denominator - by building up capital, or by cutting back on lending or reducing the riskiness of the balance sheet. But, with the credit boom underway, neither might seem feasible. But in fact, both methods were used extensively, which led to the impression of a financial system that was safer than it really was.

To illustrate the kind of games that the banks played, lets use an example offered by Robert Merton:

If a bank were managing and holding mortgages on houses, it would have to maintain a capital requirement of 4%. If, instead, it were to continue to operate in the mortgage market in terms of origination and servicing, but sells the mortgages and uses the proceeds to buy U.S. government bonds, then under the BIS rules, the US government bonds produce no capital requirements and the bank would thus have no capital maintainance. However, the bank could continue to receive the economic equivalent of holding mortgages by entering into an amortizing swap in which the bank receives the total return on mortgages, including the amortizing features and prepayments, and pays the return on US Treasury bonds to the swap counterparty. The net of that series of transactions is that the bank receives the return on mortgages as if it had directly invested in them. However, the BIS capital rules, instead of being 4 percent, apprears to produce a capital requirement using the swap route of only 0.5 percent.

Central to this example is the active management of a bank's balance sheet by selling and swapping assets through securitization. Playing this game is also called as regulatory arbitrage - restructuring a bank's portfolio so that it has the same or even greater risk as before, but a lower capital requirement.

It is costly to maintain capital - it lowers the profitability of the bank and constraints its growth. Thus, it is in the bank's interest to not hold mortgages on its books, but to transfer the mortgages to a securitizer such as Fannie Mae or Bear Stearns or "hide" it in its shadow bank conduit, freeing up the its capital. The freed up capital can either be used to pay down its debt (not what happened during the credit boom) or to expand its balance sheet by making more loans (what happened during the credit boom).

This is how banks continued to appear well capitalized and not reflect the economic reality of an indebted economy

Investor's Myth: 'Higher the risk, higher the return'

I had a party at my place during the holidays and the men starting talking about investments they have been making. One of the guests started describing his success with speculative investments in the currency market and ended by saying: "The higher the risk you take, the higher the return". This is one of the most often repeated maxim (and I am about to argue it to be a false) in finance, but having read "How to win friends and influence people", I played the friendly host by avoiding an argument and politely changing the topic to the appetizing food at the party.

But I can make my case on my blog (that has very few readers and hopefully not the ones that came to the party). The notion of risk is one of the most misunderstood concepts in finance. So, what is risk? If you went to University of Chicago (I love my Chicago MBA friends - no offense to you guys), risk is explained using the capital asset pricing model (CAPM). In the case of the equity market, this risk is quantified using a statistical concept called the beta. As an example, lets look at the stock market. By defintion, the market is considered to have a beta of 1.0, and individual stocks in the market are ranked according to how much they deviate from the market. So, higher-beta stocks are the ones that are more volatile, and are considered 'riskier', according to CAPM. According to this theory, 'riskier' (high-beta) investments should have high long-term returns. And hence the statement: 'Higher the risk, higher the return'.

However, for this theory to be true, investors have to demand higher returns from 'riskier' (high-beta) stocks. There have to be people that demand such a relationship. In practice, there aren't many people who demand such a pricing, because most participants understand that risk is not the same as volatility. There are various types of risk: business risk (possibility of detoriation of operations, profit margins etc), financial risk (catastrophe due to high leverage), valuation risk (stock priced much higher than underlying intrinsic value of the business leaving little margin of safety), liquidity risk (inability to sell the stock in the market without affecting the price), and volatility risk (market price fluctuation). Off all these risks, volatility risk is of much smaller importance to most participants in the equity market. Besides, everybody knows that past results bear little resemblance to future results. So, why should historical volatility matter much to the future of the enterprise.

Since volatility is poor measurement of risk, lets replace the word risk with business risk and re-examine the maxim: 'Higher the business risk, higher the return'. Obviously, riskier (defined as business risk) investments cannot be counted on to deliver higher returns. Because if that were the case, then there is nothing risky about the investment. The correct formulation is that in order to attract capital, riskier investments have to offer the prospect of higher return. But there is absolutely nothing to say that these prospective returns will materialize.

Often, this simple logic is forgotten. Here is what really happens: Riskier investments are priced to deliver higher returns (if the investments materialize). Such a pricing is required to start attracting capital. In some cases, these investments start paying off handsome returns. The maxim 'Higher the risk, higher the return' starts getting repeated. And, hence the investment attracts more capital and bids up the price of such investments. At some point, the pricing of these investments are bid-up to such an extent that the investor is not compensated adequately to take the risk. Warren Buffet often says: 'What the wise do in the beginning, the fools do in the end'.



Here is a specific example from the recent credit boom and bust. At the begining of 2003, credit spread for high-yield bonds (another name for junk bonds) was at historical highs of over 1000 basis points. Investors were getting paid a premium of 10% over the default risk-free US treasury bonds to take the (credit, liquidity, market) risk of investing in junk bonds. In 2005, the investors were paid a mere premium of 200 basis points.

Here is another example. Cisco's stock was priced at 77$ in its peak in 2000 and had earnings of 0.36$. So, the investor in Cisco's stock in 2000 was paying 213x for the 0.36$ of earnings it had at that time. That is the equivalent of a mere 0.46% yield. Risk-free US treasuries were yielding over 6% at this time. This is yet another example of inadequate compensation of taking the risk of investing in the Cisco stock. Investor's were so seduced with the story of the internet boom that they overbid the price of the Cisco stock to an extent were they were paid nothing to take on the risk. We all know what happened in the end. Those who invested in the stock in 2000 are still waiting to make their return and this is from a successful enterprise that makes really phenomenal products



Investments are not risky inherently but only in relation to its market prices. So, the next time someone recommends a 'risky' investment as one with higher return, the first question you want to ask yourself is whether the investment is priced appropriately to compensate you for the risk you are about to take.

Was the U.S. monetary policy too loose during the housing boom?

John Taylor is an economics professor at Stanford University. In a 1993 paper, he introduced the Taylor rule, which provides guidance to central banks on how to determine short-term nominal interest rate (called the federal fund's rate in the US). It relates the interest rates to the amount of slack in the economy and the inflation rate.

He presented at the Fed's annual conference at Jackson Hole in 2007 evidence that suggested that the Fed's loose monetary policy in the 2000-2006 period was too loose. He then uses this data to argue that it was one of the biggest triggers of the housing boom in the US.

The Economist published an article, Fast and Loose, in Oct 2007 that illustrates the monetary excesses. Below is a chart from the article.

The dot-com bubble had burst and the economy was in recession. By 2003, Mr Greenspan, the chairman of the Fed then, had lowered the federal fund's rate to 1%, the lowest since 1958. He kept the interest rate at 1% for an entire year. He justified this decision by saying that he feared that America was on its way to deflation. As per Taylor's rule, the interest rate should have been above 3%. So, even though the Taylor rule is only a guide, Mr Greenspan had missed the mark by about a mile. Furthermore, Mr Greenspan said that interest rate would be low for "a considerable period" and that the Fed would rise it slowly at a "measured pace".

Gradually the Fed started raising the interest rates in quarter point steps. By June 2006, the interest rate was at 5.25%, as recommended by the Taylor's rule. So, looking back at the chart, US had over 4 years of loose monetary policy - enough time for an asset bubble to grow - all in the fear of deflation.

The housing bubble has burst. And coincidentally, Mr Bernanke, the current chairman of the Fed, just repeated Mr Greenspan's 2003 words - low interest rates for a "considerable period" and Fed will raise the interest rate slowly at a "measured pace". Would it be a coincidence that the current loose monetary policy is giving birth to yet another asset bubble?

LIBOR-OIS spread

The Libor-OIS spread is an important barometer of stress in the banking system. The term London interbank offer rate (LIBOR) is the rate at which banks indicate they are willing to loan to other banks for a specified term of the loan. The term overnight indexed swap (OIS) rate is the rate on a derivative contract on the overnight rate (In the U.S. the overnight rate is the effective federal funds rate.) In such a contract, two parties agree that one will pay the other party a rate of interest that is the difference between the term OIS rate and the geometric average of the federal fund's rate over the term of the contract. Thus, the term OIS rate is the market's expectation of the federal fund's rate over the term of the contract. There is very little risk in the OIS market because there is no exchange of principal; funds are only exchanged at the end of the contract, when one party pays net interest obligation to the other party. The term Libor-OIS spread is be a measure of the health of the banks because it measures what banks believe is the risk of default associated with lending to other banks. Changes in Libor-OIS spread reflect changes in risk premiums and liquidity premiums.

Modern shadow banking system

Paul McCulley is a managing director at PIMCO. He is particularly influenced by Hyman Minsky, and coined phrases like the shadow banking system and the Minsky moment. Here is an extract from his May 2009 speech. I particularly liked reading this speech because it clearly explains how the financial crisis came about within the modern financial banking system:

"The conventional banking system is based on what is known as the fractional-reserve banking system. Customers deposit funds at a bank to store savings in the form of a demand claims on the bank. Holders of the demand deposits can withdraw all of their funds at any time. Banks use most of these short-term funds to invest in longer-term interest bearing loans and securities. This is called borrowing short to invest long. The assets being longer term (and riskier) have higher yields than the short-term liabilities. This is how the banks make their profits.

However, this also causes a cash-flow insolvency. If all the depositors showed up at the same time, it can cause a bank run and cause the bank to collapse. In the absence of crisis that cause a bank run, fractional-reserve banking functions well because only a few depositors will make cash withdrawals compared to the total amount of deposit (liabilities are sticky), and a cash reserve is maintained to meet the demands of depositors seeking withdrawals.

A key reason that the depositors can sleep well at nights not worrying about bank runs is the fact that since 1913 here in the United States, banks have access to the Federal Reserve as a lender of last resort. This is known as having access to the Federal Reserve's discount window, where banks can post assets for loans to redeem flighty depositors. A second government sleep-well safety net was introduced, post the great depression, in 1933. Taxpayer-backed deposit- insurance (FDIC), in which the federal government insures that deposits up to a limit will not lose value, no matter how foolish the bankers may have been. Obviously, deposit banks don't just get this for nothing - they have to submit to strict regulatory standards in exchange for such a government safety-net.

The financial crisis did not originate within the confines of the highly regulated fractional-reserve banking system. Instead, it originated within the shadow banking system which operated legally, yet almost completely outside the realms of the regulatory system. The rise of this system drove one of the biggest lending booms in history, and collapsed into one of the most crushing financial crisis we have ever seen.

Unlike the conventional regulated banks described above, unregulated shadow banks fund themselves with uninsured short-term funding. They do so by raising funding in the non-deposit markets, unsecured debt through commercial paper, and secured borrowing such as reverse repo and asset-backed commercial paper. Since they fly below the radar of traditional bank regulation, these leveraged financial institutions operate in the shadows without backstopping from the Fed's discount window or access to FDIC deposit insurance. Examples of such shadow banks are investment banks (Bear Stearns and Lehman Brothers), conduits, SIVs (at Citi), money market funds, monoline insurers (Ambac and MBIA) and hedge funds (Bear Stearns High-Grade Structured Credit Fund).

Structured to not have access to the government safety-nets, the shadow banks essentially avoided regulation, notably on the amount of leverage, the size of their liquidity buffers and the type of lending and investing they could do.

In the absence of the government backstopping, the shadow banks needed some seal of approval, so that the providers of short-dated funding could convince themselves that their claims were just as good as the deposits at the regulated banks. Conveniently the friendly faces at the ratings agencies, paid by the shadow bankers, stood at the ready to provide such seals of approval. Moody's and S&P would put an A-1/P-1 rating on the commercial paper, which in turn would be bought by the money market funds. Of course, its inherently an unstable structure. The ratings agencies face an in-built problem of putting ratings on new innovations, because they haven't had a chance to observe a historical track record - to see their performance over a full cycle.

Over the last three decades or so, the growth of the "banking" outside formal, regulated banking has exploded, and it was a great gig so long as the public bought the notion that such funding instruments were 'just as good' as bank deposits. Keynes provides the essential - and existential - explanation as to why the shadow banking system became so large. It was a belief in a convention, backed by the length of time that belief held: shadow bank liabilities were 'just as good' as conventional bank deposits not because they are, but because they had been. And the power of this conventional thinking was aided and abetted by the government-blessed rating agencies. Until, of course, the convention was turned on its head, starting with a run on the asset-based commercial paper market in August 2007, the near death of Bear Stearns in March 2008, the de facto nationalization Fannie Mae and Freddie Mac in July 2008, and the actual death of Lehman Brothers in September 2008 (all being examples of banks runs on the shadow banking system.) Maybe, just maybe, there is something special about a real bank, as opposed to a shadow bank! And indeed that is ambiguously the case, as evidenced by the ongoing partial re-intermediation of the shadow banking system back into the government supported conventional banking system, as well as the mad scramble by the remaining shadow banks to convert themselves into conventional banks, so as to eat at the same government-subsidized capital and liquidity cafeteria as their former stody breathen."

Curse of AAA

Chris Davis of Davis Funds sites three reasons for the collapse of AIG. (1) the financial sophistication of management, (2) the leverage of derivatives and (3) the danger of collateral requirements tied to mark-to-market accounting.

Lets talk about the third factor again. AIG was originally AAA rated. Reserve requirements to meet possible CDS losses were minimal (or possibly none) since the rating agencies thought AIG had a "strong" AAA balance sheet. When the financial system came crumbling down, the estimated losses for the swaps started going up. At this point (too late in my opinion) the rating agencies reevaluated AIG's AAA rating, and downgraded it from being AAA. They should have done this years ago when AIG's CDS exposure was going up, and not after the fact. David Einhorn at Greenlight capital calls it the Curse of AAA. Here is an extract from his May 2009 speech at IRA W. Sohn Investment Research Conference:

"Both President Obama and Chairman Bernanke have said that the problem with AIG was that greedy people put a hedge fund on top of an insurance company. As I see it, AIG failed precisely because it was not a hedge fund, but a highly regulated, AAA rated insurance company. Call it the Curse of AAA. The market incorrectly believed that regulators and rating agencies carefully monitored its risk profile and activities. As a result, AIG was able to abuse its access to unlimited cheap financing without any of its counterparties performing any additional credit analysis or demanding any collateral. Hedge funds can't abuse the system the same way, particularly in the aftermath of Long Term Capital Management, as lenders pay much more attention to hedge fund counterparty risk and collateral requirements. Had AIG been a hedge fund as President Obama and Chairman Bernanke claim, none of this could have happened.

Come to think of it, many of the spectacular failures during this crises bore AAA ratings. The Government Sponsored Enterprises (GSE), the monoline insuraners (Ambac and MBIA), AIG, and General Electric, whose slow moving train-wreck is ongoing, suffered the Curse of AAA and damaged their companies with sizable harm to the economy at large. The only AAA rated (or atleast until recently AAA) financial institution I can think of that didn't abuse its status is Berkshire Hathaway.

Investors who bought AAA rated structured products thought they were buying safety, but instead bought disaster. They can forgive themselves by blaming the rating agencies. But if the credit markets improve to the point where newly issued AAA rated bonds price with tight spreads only to later widen or ultimately fail, investors will have no one but themselves to blame. Fool me once ...

Investors have figured this out and many deny that they buy bonds based on ratings unless they are forced by law. Even Moody's largest shareholder, Warren Buffet, has said that he doesn't believe in using ratings.

We are short Moody's Investors Service. If your product is a stamp of approval where your highest rating is a curse to those who receive it, and is shunned by those who are supposed to receive it, you have problems.

Moody's says it has enormous incentive to do a good job with the ratings because the ratings are the brand. Imagine yourself the head of Moody's a decade ago. If your goal was to destroy the brand, would you have done differently?

The truth is that nobody I know buys or uses Moody's credit ratings because they believe in the brand. They use it because it is part of a government created oligopoly and, often, because they are required by the law. As a classic oligopolist, Moody's earns exceedingly high margins while paying only the needed lip service to product quality. The real value of Moody's lies in its ability to cow the authorities into preserving its status.

The ratings agencies' lobby is pushing 'reform' through modest changes to the ratings process. Why reform them when we can get rid of them? Are we waiting to blow up the Lunar economy as well? Some wonder what would happen without government sanctioned ratings. It is hard to imagine how things would be any worse.

Even if ratings were free of conflict, the unfixable issue is that the rating system is inherently pro-cyclical and economically destabilizing. When times are good, rating upgrades reduce borrowing costs and contribute to credit bubbltes. The more debt they rate, the more profit they earn. When times are bad, rating downgrades accelerate a negative feedback loop and can be catastophic for entities that rely so much on their credit rating that a rating downgrade jeopardizes their existence. The monoline insureres (Ambac and MBIA) and AIG suffered this fate. This empowers the rating agencies to decide whether a company lives or dies. The rating agencies are sensitive to this responsibility. As a result, they fail to use the downgrade as a warning signal to investors, and when they finally do act, it is often coup de grace.

Regulators can improve the stability of the financial system by eleminating the formal credit rating system.

Credit analysts don't believe in credit ratins; equity analysts do. Moody's share trade at 19x estimated earnings that, wink-wink, they are supposed to beat. Ironically, for a firm that evaluates credit, its balance sheet is upside down, with a negative net worth of $900 million.

That is a lot to pay for a franchise with a socially undesirable product and a shattered brand that exists at a time when the government is considering broad reform in its mission to fix some of the systemic regulatory issues that got our economy into trouble in the first place."