This post is from Stone Street Advisors.
Tom Adams - a former Monoline exec - and Yves Smith, proprietor of
the Naked Capitalism blog and authors of Econned, have spent the better
part of the past few months (if not longer) driving up my blood
pressure by consistantly laying the blame for the (structured) credit
bubble squarely at the feet of those people who saw the impending crash
and went short as a result. This, sense does not make.
claim "the shorts" drove the demand for creating all of the "toxic"
CDO's that almost brought down the Financial System down because after
all, the Investment Banks couldn't sell a CDO to lazy/ignorant
institutional investors and CDO managers if there was no one to take
the short side of each trade. This logic is so painfully flawed that
I've actually lost sleep over it, especially because they just won't
stop shouting it as if it were infallible, iron-clad truth, which it
most certainly is not.
Sure, you cannot have such a trade without a buyer and seller, but
when history shows the sellers to be the ones who were right, and who
acted on it, I'm not sure how you can not only avoid blaming those who
were wrong - those who were long such deals - but go out of you're way
to blame the people who saw the signs and acted accordingly. That, to
me, is crazy talk, at best, like blaming the United States for the actions of the Third Reich during WWII.
Despite what Tom, Yves, or whomever else wants to blame the shorts
may try to tell you, "the shorts" were the ones who saw
(broadly-speaking) impending collapse and traded accordingly. The
longs were the ones who kept buying things that others - and sometimes
they, themselves - knew were crap, or were likely to become crap.
Hell, the monolines - whose business Ackman, Einhorn, and others had
identified as unsustainable as early as 2002 only dug further into the
structured finance business. As they say, the band played on, so to
If one really wants to point fingers (which isn't really very
productive), they should be pointed at the Investment Banks, the
Ratings Agencies, lazy/poorly-incentivized money managers, and
Regulators, in that order. Arguing that the shorts who allowed the
banks to create and sell (or retain) long CDO exposure to investors are
making a similar argument to those who blame gun/bullet makers Glock
and Remmington for shooting deaths, or Stanley Hand Tools
for making the hammer that was used in an assault. CDO's, CDS, etc are
like tools, and, when used properly, can be quite effective. But, when
used improperly, or without proper care, they can be deadly,
Absent fraud (another story for another time) on behalf of the
Investment Banks, originators, and/or servicers, institutional
investors like IKB - who, despite having a dozen or two member
diligence team - still went long CDO's like ABACUS, akin to a child
getting his hands on a loaded machine gun. It was only a matter of
time until they shot themselves in the foot (or worse)...
They did this because as I've said time and time again, portfolio
managers don't get paid to sit on cash (generally); they have to invest
their money, and in many if not most cases there were (and still are)
perverse incentives for PM's to buy the highest-yielding security he
could find as long as had the blessing of the Ratings Agencies. (Naked
Bond Bear can elaborate on this, and has, if you want more nuance).
The same holds true for many other participants, collateral managers
like ACA (infamous for apparently blessing the ABACUS transaction even
though they "knew" the collateral), CDO managers like Chau, etc.
John Paulson, Michael Burry, Steve Eisman, none of these guys forced
their counterparties to take the long side of their winning short
trades. Their counterparties were (mostly) financial institutions with
the resources to do the same research and put on similar trades (or at
the very-least least reduce their risk exposure) as "the shorts."
Others, due to arcane financial regulations (etc), were able to gain
exposure to these securities without having anywhere near the financial
sophistication to understand them, yet they did so, anyway, because
they did not know what they were getting themselves into.
general manager of an Australian council responsible for investing
millions was one of these latter, ignorant types. Mr. Hyde has since
admitted that he did not know what a CDO was, and "admitted to
confusion on his part about the terms "call date" and "maturity date",
which he had believed to be interchangeable. 'I guess (it was)
ignorance. I did not know there was a difference,' he said."
Mr Hyde said he believed that Grange would buy an
investment back from Wingecarribee at three days' notice, or return the
value of the whole portfolio at 30 days' notice.
Barrister John Sheahan, SC, for the liquidator of Lehman Brothers Australia, put to Mr Hyde that the contract Wingecarribee signed with Grange provided for the buy-back to be at market value, not face value.
"What you were told was that you could redeem your security at three days' notice, at market price?" Mr Sheahan asked.
"I did not understand that," Mr Hyde replied.
When, in September of 2007, Mr Hyde asked Grange to buy the
investment back from Wingecarribee at face value, the response was
Mr Hyde said he was told by a Grange employee, "you need to understand Mike, there is no such thing as a capital guarantee".
By then, the Federation note, originally worth $3 million, was valued at $1.02 million.
While it may have been (quite) unethical for Lehman/Grange to have
gotten the council into investments its representatives verbally said
they were not interested in, they did not force the council members to
sign any contracts. At the end of the day, a not-insignificant part of
the blame has to lay at the feet of those who voluntarily gained
exposure to these securities despite having no idea what they were
talking about, let alone what they were signing-up for.
As James Montier of GMO Investments said in his recent letter "The Seven Immutable Laws of Investing,"
1. Always insist on a margin of safety
2. This time is never different
3. Be patient and wait for the fat pitch
4. Be contrarian
5. Risk is the permanent loss of capital, never a number
6. Be leery of leverage
7. Never invest in something you don’t understand
#'s 1-6 are surely important (especially #'s 1, 2, 5, and 6), but
I've highlighted #7 because it is the single best piece of investment
advice anyone can every give you. I would add, after "Never invest in
something you don't understand..." that if you do invest in something
you don't understand, absent fraud, you must accept that you have no
one else to blame but yourself if the investment does not work out as
you'd hoped. Caveat emptor.
People who don't even understand the difference between a call date
and a maturity date (let alone know what a CDO is/how it works) should
NEVER be able to come anywhere close to anything more complicated than
a mutual fund or vanilla bond, and that they were able to do so in this
(and other) case(s) is the fault of the regulatory apparatus, the
"Overseers" tasked with protecting investors.
But as Montier's law #7 says, you should never buy something you
don't understand. And, unless someone made you sign a contract at
gunpoint, it's you're responsibility to make sure you've read the
contract and understand the terms before signing on the dotted line.
If you don't understand, but sign anyway, then you're just begging-for,
if not deserving of losses.
I do feel a bit of sympathy for people like Mr. Hyde who were
pressured by those more sophisticated (I'm not going to say savy, since
that whole Lehman thing worked out so well...) than they, but my
sympathy is limited by the apparent indifference with which Mr. Hyde
and others of his ilk exercized when making their investment
decisions. It's one thing if you want to bet all of your personal
money on something you don't understand and end up screwing only
yourself. It's another thing when you're investing other peoples'
money and/or public monies.
That's analagous to me going into a surgical procedure without
knowing which organ is which, or a crazed alchemist tossing various
liquids and powders haphazardly into a cauldron with little if any
regard for possible - if not downright likely - violent and dangerous
The sad part is that it wasn't just financially unsophisticated
people like Mr. Hyde who failed to exercize the proper level of
diligence and caution. I'd be curious - although I doubt we'll ever
know such things - what % or how many of the parties that had long RMBS
(synthetic or otherwise) exposure pre-crisis conducted thorough
analysis at the loan level, on originators' underwriting standards, etc
and turned-down or shorted deals they found to be garbage.
As far as I can tell, the answer is 'not many,' although in fairness
Tom claims they did, in fact, turn down several deals for such reasons,
but I doubt in the grand scheme of things, the ones they didn't do were
anywhere close in number and size to the ones they did.