There is widespread disagreement amongst commentators as to the underlying causes of the 2008-2009 financial crisis. The most contentious topic is the role of market irrationality and ignorance in fuelling the preceding boom. In the note below, I construct a “rational” thesis that explains all the key facts of the financial crisis without relying on irrational behaviour or ignorance on the part of agents or the market. The thesis focuses solely on the economic incentives facing the various players and crucially, the interaction of these incentives with government policies.
To summarise the key arguments,
- Implicit/Explicit protection of bank creditors increases the optimal leverage of bank balance sheets.
- The maximum/optimal leverage can be achieved by investing in “safe” assets such as AAA-rated securities.
- The principal-agent problem within banks exacerbates the moral hazard of creditor protection. Access to cheap leverage incentivises agents to take on bets with negatively skewed payoffs, not volatile payoffs.
- Apart from regulatory capital, supply of “safe” assets was the prime constraint on leverage until recently. More complete markets have weakened this supply constraint.
“Optimal” Leverage for Banks
The Economist asks why banks are so averse to raising equity and correctly identifies the role of the implicit/explicit guarantee enjoyed by bank creditors. The role of deposit insurance in raising the “optimal leverage” of a bank was identified in 1977[i] by Robert Merton who priced the deposit insurance contract as a put option on the value of the bank’s assets.[ii]
The role of deposit insurance is easily explained via the logic of the Modigliani-Miller theorem. M&M Proposition 1 essentially states that the capital structure is irrelevant in determining the total value of the firm. In other words, it is the size of the pie that matters, not how you slice it up[iii]. In the presence of explicit/implicit debt guarantees, one of the key conditions required for the proposition to hold is violated: the size of the pie is no longer fixed when the capital structure is changed[iv].
Merton’s analysis of deposit insurance can be re-stated and extended as follows:
The value of the firm increases with increased leverage and increased riskiness of the asset pool in the following idealised scenario:
- M&M assumptions hold[v]
- No bank capital regulations
- Explicit insurance premium is below the true economic cost of protection
- Non-negative probability of full/partial protection of uninsured creditors: Even a small probability of bailout of uninsured creditors causes such creditors to demand a lower rate of return and therefore increases the “size of the pie”.
Limits to Leverage: Bank Capital Regulations
Regulatory capital requirements ensure that infinite leverage is not feasible[vi]. Risk-weighted capital requirements usually mean that the bank can choose from a continuum of risk-leverage combinations with high risk assets and low leverage on one side and low risk assets and high leverage on the other. Moreover till 2004, SEC’s net capital rule limited the debt-to-net capital ratio of investment banks to 12:1.
The evidence on the increased leverage of both commercial and investment banks is clear but there is no evidence that the asset profile became markedly riskier. After all, weren’t most of the losses suffered on super-senior tranches of CDOs? These tranches were supposed to be even safer than a AAA bond! Many argue that the low risk asset profile of banks proves that moral hazard and bank employee incentives did not cause the financial crisis[vii]. Any explanation of the crisis needs therefore to explain this phenomenon of higher leverage combined with apparently “lower” risk assets rather than an alternative combination of more risky assets and a lower leverage.
The explanation is simple: if the bank can issue debt at a “subsidised” rate due to the protection of bank creditors by the state, then increased leverage increases the value of the firm i.e. the size of the pie. It is quite literally a free lunch courtesy of the government. Each extra dollar borrowed increases the free lunch available to the stockholders and managers of the firm. Once we understand that increased leverage increases the size of the pie, then regulatory capital requirements based on risk-weighted assets almost necessitate the choice of “lower risk” assets that help maximise absolute leverage.
The Principal-Agent Problem exacerbates the Moral Hazard problem
Many studies conclude that agent/manager risk-aversion counteracts the risk-seeking preference of the stockholders[viii]. Bebchuk and Spamann[ix] accept this thesis but argue that the increased high-powered incentives offered to senior management in the form of stock and stock options aligns stockholder and senior management interests in favour of increased risk-taking. This analysis ignores
- the incentive structure agents in banking work under.
- the wide variety of distributional choices agents possess.
- the impact of cheap leverage on agent choices.
- accounting methodology of bonds/loans in banks.
- Knowledge asymmetry between principals and agents
- Principal-agent problems within banks i.e. between different layers of management or between management and traders.
- Incentive structures in banking are characterised by high-powered incentives including significant annual cash bonuses and restricted stock compensation and risk of termination based on absolute and comparative evaluation versus other agents.
- Agent risk-aversion is usually analysed in the context of a choice between symmetrical bets of varying volatility. This is too simplistic – agents choose not only the volatility of the distribution they operate under but also its higher moments, most notably its skewness. In fact, the dominant assets on bank balance sheets are bonds or loans. The primary risk characteristic of the returns distributions of bonds and loans is not their volatility but their skewness. Specifically, bonds and loans are negatively skewed bets with a high probability of a small profit and a low probability of a significant loss on default. The “safer” the loan, the more asymmetric the payoff i.e. AAA bonds have a much more asymmetric risk-reward profile than junk bonds[x].
The combination of high-powered incentives and the ability to choose tailored payoff distributions with a given volatility and skewness means that agents in banks are faced with an incentive structure similar to hedge funds. This makes negatively skewed bets extremely attractive. Andrew Lo pointed this out in the context of hedge funds with his example of Capital Decimation Partners where a systematic strategy of shorting out-of-the-money(OTM) options has a returns distribution that is economically attractive to the fund manager as well as appearing to produce “alpha” for the investor[xi]. In fact, the incentive structure facing bank managers/traders is even more favourable for negatively skewed bets for two important reasons:
- Unlike hedge funds, increased leverage is always available at a less than economic cost. Given that eliminating risk is not an option for the agent[xii], agents need to trade off between
- minimising the probability of loss which could lead to bankruptcy or termination by the principal.
- maximising the payoff under the high-powered incentive contract and achieving a sufficient return on equity for the stockholder.
Cheap leverage means that the tradeoff is no longer relevant. The very fact that leverage can be increased without a commensurate increase in the cost of debt means that managers can increase not only expected return but also the expected probability of a positive return almost without limit.
- Unlike the simple strategy of shorting OTM options that Andrew Lo outlines which is subject to mark-to-market swings, many of the assets on bank balance sheets are not subject to mark-to-market accounting or are only subject to mark-to-model on an irregular basis. Selling OTM options in a liquid market exposes the agent to mark-to-market swings which can in many cases eliminate the benefits of negative skewness[xiii].
- The inherent asymmetric knowledge problem between managers/traders and stockholders means that “negatively skewed” bets are preferred by managers. The stockholder cannot distinguish between genuine alpha and a severely negatively skewed payoff chosen by the manager. Moreover, even without asymmetric information, the mere presence of true uncertainty means that the principal and the agent may both fail to distinguish between true alpha and extreme negative skewness. Taleb[xiv] identifies many reasons why severely negatively skewed bets seem to be less risky than they are.The difficulty of identifying negative skewness combined with the necessarily short time horizons on which agents are evaluated by principals means that agents who employ negatively skewed strategies are likely to be “selected” versus other agents who do not employ such strategies by their principals in any prolonged period of stability. This illustrates both why negatively skewed strategies are likely to outcompete other strategies in stable market conditions as well as why it is so difficult for agents to bet the other way. They will only do so if there is a significant mispricing and crucially if they are also convinced about the timing.
- One solution usually employed by stockholders is to give senior management significant stock exposure so that they can monitor the junior managers whose compensation is much more tilted towards cash bonuses. In fact, the losses suffered by senior management on their stock holdings is used to argue that moral hazard and banker pay was not responsible for the crisis. This analysis ignores the fact that the principal-agent problem between top bank managers and the junior managers/traders is equally severe[xv]. The primary reasons for this are:
- The over-specialisation at lower and middle levels in investment banks which means that most senior managers do not possess the adequate deep experience in all the business areas that they supervise.
- The rapid pace of innovation in investment banking in the recent past which has meant that managerial knowledge is frequently out of date. Many business areas may have risen to prominence so recently that managers have limited practical knowledge of them.
Limits to Leverage: Supply of Skewed Assets
Leverage is also constrained by the supply of assets with negatively skewed payoffs. Until quite recently, supply of such assets was limited. For example, AAA corporate bonds were extremely limited in supply. In other words, the market was “incomplete”.
The explosion in CDO issuance as well as the growth of the CDS market means that the supply has increased dramatically in recent times. The fact that the CDS notional outstanding is not limited by constraints such as bond notional outstanding means that there is literally no limit to the supply of assets with any chosen skewness. Combined with the ability to issue tranched products on the back of such CDS via synthetic CDOs, any risk-reward payoff can be constructed without a supply constraint. In this manner, more “complete” markets have enabled economic players to extract more value from the implicit creditor protection.
Super-Senior Tranches: The Ideal Product
In the above framework, it is not surprising that super-senior tranches of MBS CDOs were so favoured by banks. Super-senior tranches also had the added advantage of being incidental to a fee-generating, client driven activity i.e. the origination of CDOs of which the other tranches were sold on to clients. Therefore, increasing amounts of super-senior tranches could be piled onto balance sheets in the name of facilitating client business rather than the more genuine reason of proprietary risk taking in a preferred risk-return profile.
Its worth emphasizing that super-senior tranches are not an economically viable investment for banks unless they are leveraged up significantly. To illustrate, if a bank funds at 5% and a super-senior tranche yields 50 bps above funding, then an unlevered investment in a super-senior barely pays for the bills, let alone the bonuses of employees and the return on equity demanded by stockholders. Of course, with only 1.6% of the investment coming from capital and the remaining 98.4% being borrowed (AAA tranches being 20% risk-weighted and 8% being the capital requirement for 100% risk weight), the same investment leads to a return on equity of 36.25% before expenses, bonuses etc.
This also explains why the market for super-seniors is so thin – they are not economically profitable for any other market player to hold onto as they do not have access to such high levels of leverage. The only exit option other than selling it onto another bank was to buy insurance on it but this exposes the bank to the credit risk of the counterparty. Therefore, only AAA insurers would do i.e. AIG or the monolines.
UBS’ Shareholder Report on the Write-Downs: A Case Study
This section will provide some examples to back up the propositions made above from the shareholder report prepared by UBS analysing the background and causes of their writedowns[xvi]:
- pg 13: “The CDO desk received structuring fees on the notional value of the deal, and focused on Mezzanine (“Mezz”) CDOs, which generated fees of approximately 125 to 150 bp (compared with high-grade CDOs, which generated fees of approximately 30 to 50 bp).” An example of how profitable CDOs were as a client fee business. This of course made it easier to argue that holding the super-senior tranche facilitated the profitable client business.
- pg 13: “Key to the growth of the CDO structuring business was the development of the credit default swap (“CDS”) on ABS in June 2005 (when ISDA published its CDS on ABS credit definitions). This permitted simple referencing of ABS through a CDS. Prior to this, cash ABS had to be sourced for inclusion in the CDO Warehouse.” More complete markets via the introduction of the CDS on ABS meant that the supply constraint on the CDO business was removed.
- pg 14: ” Following completion of the CDO securitization process, UBS generally sold subordinate (i.e. lower rated) CDO tranches to external investors. In 2005, the CDO desk also sold the highest rated / AAA rated (the so called “Super Senior”) tranches of these CDOs to third party investors along with subordinate tranches. However, after the first few deals, the IB retained the Super Senior tranche of CDOs it structured on its own books. One factor influencing this change was that the CDO desk viewed retaining the Super Senior tranche of CDOs as an attractive source of profit, with the funded positions yielding a positive carry (i.e. return) above the internal UBS funding rate and the unfunded positions generating a positive spread. Further, within the CDO desk, the ability to retain these tranches was seen as a part of the overall CDO business, providing assistance to the structuring business more generally. Apart from the Super Senior positions retained by the CDO desk from its CDO structuring activities, the desk also purchased Super Senior positions from third parties to be hedged and held on UBS’s books.” Illustrates how from almost the very beginning, the super senior tranches were consciously retained by the CDO desk as an “attractive source of profit” primarily due to the low internal funding rate (cheap leverage) as well as the “unfunded” or off-balance sheet positions generating a positive spread i.e. the off-balance sheet positions did not even have to beat the already low hurdle rate of UBS’ internal funding rate. The justification that retaining the super-senior tranches was key to the structuring and origination of the CDO business is also used effectively.
- “By the end of 2007, losses on the positions held in the CDO Warehouse plus retained pipeline positions represented approximately one quarter of the CDO desk’s losses (i.e. approximately 16% of UBS’s total Subprime Losses as at 31 December 2007).” “Losses on the Super Senior positions contributed approximately three quarters of the CDO desk’s total losses (or 50% of UBS’s total losses) as at 31 December 2007.” Clearly shows that the majority of losses were not on warehoused positions but on the “Super Senior” investments that were expected to be held on the balance sheet for longer periods.
- “Negative Basis Super Seniors: these were Super Senior positions where the risk of loss was hedged through so-called Negative Basis (or “NegBasis”) trades where a counterparty, such as a monoline insurer provided 100% loss protection. The hedge resulted in a credit exposure towards the protection seller. As at the end of 2007, write-downs on these positions represented approximately 10% of the total Super Senior losses.” These positions were hedged with monoline insurers.
- “Amplified Mortgage Portfolio (“AMPS”) Super Seniors: these were Super Senior positions where the risk of loss was initially hedged through the purchase of protection on a proportion of the nominal position (typically between 2% and 4% though sometimes more). This level of hedging was based on statistical analyses of historical price movements that indicated that such protection was sufficient to protect UBS from any losses on the position. Much of the AMPS protection has now been exhausted, leaving UBS exposed to write-downs on losses to the extent they exceed the protection purchased. As at the end of 2007, losses on these trades contributed approximately 63% of total Super Senior losses.” The most interesting of the super-senior holdings are the AMPS which were delta-hedged with a small proportion of the underlying. This of course ignores the volatility and correlation exposure of the super-senior tranche and only hedges against very small moves as UBS found out. These positions were responsible for a large percentage of the losses. But the question arises: why did the CDO desk choose such an imperfect hedging strategy which was almost no better than holding the position unhedged?
- pg 19-20: “UBS’s Market Risk framework relies upon VaR and Stress Loss to set and monitor market risks at a portfolio level.” “In the context of the CDO structuring business and Negative Basis and AMPS trades, IB MRC relied primarily upon VaR and Stress limits and monitoring to provide risk control for the CDO desk. As noted above, there were no Operational limits on the CDO Warehouse and throughout 2006 and 2007, there were no notional limits on the retention of unhedged Super Senior positions and AMPS Super Senior positions, or the CDO Warehouse.”
“MRC VaR methodologies relied on the AAA rating of the Super Senior positions. The AAA rating determined the relevant product-type time series to be used in calculating VaR. In turn, the product-type time series determined the volatility sensitivities to be applied to Super Senior positions. Until Q3 2007, the 5-year time series had demonstrated very low levels of volatility sensitivities. As a consequence, even unhedged Super Senior positions contributed little to VaR utilisation.” pg 30-31: “Once hedged, either through NegBasis or AMPS trades, the Super Senior positions were VaR and Stress Testing neutral (i.e., because they were treated as fully hedged, the Super Senior positions were netted to zero and therefore did not utilize VaR and Stress limits). The CDO desk considered a Super Senior hedged with 2% or more of AMPS protection to be fully hedged. In several MRC reports, the long and short positions were netted, and the inventory of Super Seniors was not shown, or was unclear. For AMPS trades, the zero VaR assumption subsequently proved to be incorrect as only a portion of the exposure was hedged as described in section 4.2.3, although it was believed at the time that such protection was sufficient.” “Incomplete capture of risk attributes by risk control: The risk reports for this business reported notionals (but after netting) and credit deltas. The presentation of the risk on a credit delta basis overlooked the fact that there was only 2-4% (sometimes more) protection on Mezzanine RMBS. MRC did not seek to expand the monitoring framework to capture other dimensions of the risk, such as gamma (i.e., the absolute change in the delta of an option when the price of the underlying asset moves).”
The above is less a criticism of the VaR methodology and the various deficiencies of risk management in UBS than it is an illustration of how serious the principal-agent problem is between senior managers and the business areas. It is clear that the AMPS strategy was solely constructed to attain a zero VaR exposure. It is inconceivable that the CDO desk genuinely believed that the position had no risk. However, their managers and risk managers clearly did not question this. Indeed it is quite possible that senior management only focused on the VaR number and not on the actual risk dynamics of the desk’s position.
In the above note, I have argued that the moral hazard explanation focusing on the implicit/explicit protection given to bank creditors fits all the facts of the crisis, especially when considered along with the principal-agent problem and the increasingly complete financial markets. Two objections that can still be raised to the above are:
- Given the significant losses suffered by stockholders in the past, why don’t stockholders walk away from the industry and deny it funding?
- Doesn’t the thesis explain too much? After all, will the same dynamics not have played out albeit on a smaller scale just because of agent preferences for negative skewness and more complete markets?
The answer to the two questions is connected. Principal-agent problems and conflicts between the interests of shareholders, managers and creditors are inherent in each organisation to some degree but usually, the stakeholders develop ways to mitigate such problems. If no such avenues for mitigation are feasible, they always retain the option to walk away from the relationship.
This dynamic changes significantly in the presence of a “free lunch” such as the one provided by creditor protection. In such a case, not walking away even after suffering losses is an entirely rational strategy. Each stakeholder has a positive probability of capturing part of the free lunch in the future even if he has not been able to do so in the past. In fact, shareholder optimism may well be proven correct if significant compensation restrictions are imposed on the entire industry and this increases the share of the “free lunch” flowing to them.
[iii] Merton Miller’s explanation of the theorem,” Say you have a pizza, and it is divided into four slices. If you cut it into eight slices, you still have the same amount of pizza.” http://arnoldkling.com/econ/saving/corpfin.html
[iv] 1. M. Rubinstein, “Great Moments in Financial Economics: II. Modigliani-Miller Theorem,” Journal Of Investment Management 1, no. 2 (2003). http://leeds.colorado.edu/uploadedFiles/_Documents/Centers_of_Excellence/Burridge_Center/RubinsteinHistoryofModigliani-Miller.pdf : An excellent discussion of M&M and the assumptions needed for both propositions to hold
[v] ref Rubinstein paper above
[vi] Some would argue that off-balance-sheet vehicles and OTC derivatives remove the regulatory capital constraint.
[viii] D. Hirshleifer and A. V Thakor, “Managerial conservatism, project choice, and debt,” The Review of Financial Studies 5, no. 3 (1992): 437–470.
[x] The negative skewness of many asset profiles but especially that of banks, monoline insurers etc means that the simplified Merton model may not be appropriate to model the valuation of the different components of the capital structure.
[xii] i.e. the agent cannot limit his activities to merely exploiting the “charter value” of the bank.
[xiii] It is relevant that in Andrew Lo’s example of the Capital Decimation Partners, the OTM options sold are of a very short tenor (less than three months). This means that there is significant time decay which mitigates the mark-to-market impact of a fall in the underlying. On the other hand, loans/bonds are of a much longer tenor and if they were liquidly traded, the negative mark-to-market swings would make the negative skew superfluous for the purposes of the agent who would be evaluated on the basis of the mark-to-market and not the final payout. The obvious example is a vanilla CDS contract.
[xiv] N. N Taleb, “Bleed or Blowup? Why Do We Prefer Asymmetric Payoffs?,” The Journal of Behavioral Finance 5, no. 1 (2004): 2–7.