Naked Capitalism is Wrong About Who Caused the Financial Crisis: Yet Another Anecdotal Example

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.

They 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 speak.

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, financially speaking.

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.

Michael Hyde, 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 "non-receptive".

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 reactions.

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.


The Analyst

Stone Street Advisors


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