Banking and Finance

How middle-America sub-prime loans ignited a global economic crisis

15 July 2010

Human Capital Alliance Senior Advisor K I Woo looks at how Wall Street quants played a major role in the 2008 global economic meltdown.

Everyone is still curious how a few sub-prime loans to lower-income US neighborhoods could possibly ignite a global economic crisis.

Many people blame different villains including Alan Greenspan for keeping low interest rates for too long, rapacious real estate agents that lured unqualified buyers into purchasing new homes and greedy bankers that made fortunes repackaging mortgages and selling them to sophisticated investors globally.

An unprecedented decade-long US housing boom and the development of lightly-regulated securitization and related derivatives markets also are obvious culprits.

During this same time, a much less publicized group of mathematics and computer-trained PhDs or “quants” also played a key role in developing Wall Street’s new forays into computerized trading and derivatives.

In his best seller, “The Quants – how a new breed of math whizzes conquered Wall Street and nearly destroyed it”, Scott Patterson shows how these “geniuses” were able to confound even the most sophisticated financial experts with complicated investment models designed to virtually print money.

“Many of the models created an illusion of order where none existed,” he said.

Initially, the quants’ investment strategies used complex computer models to exploit the differences in pricing for various securities.

“They used brain-twisting math and superpowered computers to pluck billions in fleeting dollars out of the market,” he said.

Huge investment bank profits

According to Scott, these tech-savvy quants began dominating Wall Street in the early 1990s, helped by their theoretical breakthroughs in the application of mathematics to financial markets. “The quants applied those same breakthroughs to the highly practical, massively profitable practice of calculating predictable patterns in how markets moved and worked,” he said.

By the mid-1990s major investment banks such as Goldman Sachs and Morgan Stanley began hiring PhDs from prestigious universities such as the University of Chicago, MIT and Princeton to design computer models that could find cheap-versus-expensive opportunities across the globe. In 1995, Goldman agreed to seed a small internal hedge fund with $10 million, Patterson said.

Global Alpha, Patterson said was a group that would go on to become one of the elite trading operations on all of Wall Street. “During some years these internal proprietary trading desks accounted for as much as 25 per cent of the firms’ net income,” he said.

Many of these computer-driven internal hedge funds, Patterson said ran on their own with minimum human interference and churned out hundreds of millions of dollars of profits every year.

Business was good, Patterson said because pension funds and endowment funds were diving in and investment banks were expanding their proprietary trading operations such as Global Alpha at Goldman Sachs, PDT at Morgan Stanley and one at Deutsche Bank.

“Hundreds of billions poured into the gunslinging trading operations that benefited from an age of easy money and globally interconnected markets,” he said.

Battle for bonuses

In the late 2000s as the proprietary trading desks began churning out hundreds of millions of dollars of profits, many quants realized that they could make more money for themselves if they formed their own hedge funds. Some of the fund managers’ bonuses had made them among the top paid investment bank employees but even these amounts paled in comparison what they could make operating their own private hedge funds.

Managers wanting more income simply walked out the door and started their own operations and quickly earned a lot more than they had at the investment banks.

As a result, new hedge funds were started everyday to compete in an ever-expanding market. “In 1990 hedge funds held $39 billlion in assets. by 2000 the amount had leapt to $490 billion and by 2007 it had exploded to $2 trillion,” he said.

The great hedge fund bubble

As a result, Patterson said thousands of hedge fund fund jockeys became wealthy beyond their wildest dreams. “One of the quickest tickets to the party was a background in math and computers,” Patterson said.

The money poured in – crazy money, he said. “Pension funds across America burned by the collapse in 2000, rushed into hedge funds, the favored vehicle of the quants, entrusting their members’ retirement savings to this group of secretive and opaque investors,” he said.

Cliff Asness, a University of Chicago PhD left Goldman Sachs to start hedge fund AQR in 1998 with $1 billion had $40 billion by mid 2007. “In 2002, Anness pulled down $37 million. The following year, he raked in $50 million.

These hedge funds according to Patterson unwittingly primed the bomb and lit the fuse for the financial collapse that began to explode in spectacular fashion in August 2007.

“Despite their chart-topping IQs, their walls of degrees, their impressive PhDs, their billions of wealth earned by anticipating every bob and weave the market threw their way, their decades studying every statistical quirk of the market under the sun, no one saw the train wreck coming,” he said.

Patterson said a hint to the answer came a century ago from Isaac Newton after he lost 20,000 pounds in the South Sea bubble. “I can calculate the motion of heavenly bodies but not the madness of people,” he said.

How did home loans get involved?

To compete with higher paying hedge funds, in the 1990s, Patterson said banks themselves morphed into risk hungry hedge funds to keep talented traders.

As investment bank hedge funds became major profits centers and as new hedge funds were being formed to invest money in the early 2000s, several investment experts such as Edward Thorpe, Patterson said realized that it was becoming impossible to put up solid returns without taking on too much risk.

Many banks then began churning up their very profitable home mortgage securitization businesses that had developed during the past several decades.

To ensure that they could sell more product, the investment banks began expanding their standard home mortgage securitizations into sub-prime loans in the early 2000s. The investment banks then developed many sub-prime-based derivatives products that expanded the investor pool and generated hugh fees.

Collateralized Debt Obligations

Initially, the mortgages were packaged into collateralized mortgage obligations (CMOs) and sold in tranches that represented different risks. The higher risk tranches paid the highest interest rate.

“Some CMO had more than 100 tranches,” Patterson said.

These different tranches were sold to many investors all over the world with different risk appetites. By tranching the sub-prime loans, the investment bankers opened a whole new investor market for housing loans.

Over time, the bonds became more and more complex, sometimes with bunches of the highest risk tranches from different bonds packaged into collateralized debt obligations (CDOs). Everywhere along the chain, the investment collected fees for putting together the bonds and selling them to investors.

The investment bank and hedge needed the quants to calculate the interest rates and risks associated for each tranche.

Inevitably, they used very complicated mathematical formulas and models that few people understood.

Business was booming. Everyone wanted to buy the securitized home mortgages, many of which were rated Triple AAA by the rating agencies.

In 2004, when the banks began packaging CDOs with sub-prime loans, Patterson said $157 billion were issued. By 2005 it rose to $273 billion and $550 billion by 2005.

Eventually, most of these bonds imploded and became a major cause of the 2007 global economic crisis.

As CDOs boomed – housing prices took off all over US

According to Patterson, as the CDO business boomed and brought in billion dollars of fees for investment bank, housing prices all over the US also took off.

Wall Street investment bank were virtually fighting to buy all the sub-prime loans they could get their hands on so they could repackage them and sell them to hungry yield investors all over the world.

To ensure that they could obtain enough some banks such as Morgan Stanley began buying sub-prime originators.

“Morgan Stanley in 2006 pumped-up its sub prime mortgage business by paying $706 million for sub prime mortgage lender Saxon Capital,” Patterson said.

Massive “warehouses” were also set up to park sub-prime mortgages until they were ready to be sold. These were placed into off the books Special Purpose Vehicles that were funded by commercial paper.

“Any hitch in the chain would result in disaster,” he said.

Huge profits – ignored risks

As the investment bank continued churning out huge profits, Patterson said the SEC in 2004 allowed them to use more leverage by loosening up capital reserve requirements. “The SEC also allowed them to rely on own quantitative models to determine risk,” he said.

Leveraging, he said permitted the Banks to purchase more and more of the housing assets and generate more profits and fees without increasing their capital bases. However, leveraging could also result in larger losses when markets inevitably turn.

Despite a bubbling housing market that many experts was about to burst, Patterson said Banks such as Morgan ignored the risks.

Morgan stock price was sky high and they could raise capital easy because they were showing huge profits. “Their leverage ratio rose to 32 to 1 and their profits increased 70 per cent in Q1 2007 to $2.7 billion,” he said

Sub-prime defaults begin in 2007

A bad omen was on the horizon when homeowners began defaulting in 2007.

Patterson said it began when HSBC boosted expected subprime losses by 20 per cent to $10.6 billion. “They had previously snapped up sub-prime lender Household International,” he said

Why did it trigger global crisis

According to Patterson, the quants overwhelming influence in investment operations helped exacerbate the housing crisis that quickly mushroomed into a global economic crisis.

Almost everyone understands that Wall Street sold many of the sub-prime mortgage bonds overseas especially to yield hungry European banks. The bursting of the housing bubble resulted in huge losses for all sub-prime investors and quickly led to a global crisis.

However, for Wall Street, Patterson said the most terrifying aspect of the ensuing meltdown were the hidden linkages in the global money grid that no one was aware before. The quants sophisticated computer models that had consistently churned out money for years had not taken these risks into account.

For instance, in many of the computer driven investment models, the program would buy a company’s bonds and short its shares or options until temporary value differences realigned. To generate higher profits many of these “bets” were leveraged and traded by computer hundreds of times each day.

However, as the housing market and the sub-prime market began crashing, Patterson noted that many of the computer driven models supposed outcomes no longer worked. For instance, the programs bets began going in opposite directions and caused billions of dollars of losses.

Hedge fund margin calls

According to Patterson several hedge operators later said that when the sub-prime mortgage collapsed, it triggered hedge fund margin calls that forced unwinding position in stocks.

Because many hedge funds were leveraged as high as 30 to 1, they were forced to sell other liquid securities to meet margin calls on crashing sub-prime securities.

“Dominoes started falling – hitting other quant hedge funds, forcing them to sell and unwind positions in everything from currencies to futures contracts to options in markets around the world,” he said.

As a result of the sub-prime crisis and its highly-leveraged environment, Patterson said a vicious feedback loop ensued and billions of dollars evaporated in a few days. “It caused a complete reversal of quant strategy outcomes,” he said.

Other elements that fed the boom

As the housing market continued rising and sub-prime securities fueled the boom, Patterson said Wall Street continued innovating new products that eventually help the downturn implode into global economic crisis.

He also added that Wall Street’s demand for more sub-prime loans and the fat fees they spit out were key factors that allowed and encouraged brokers to concoct increasingly risky mortgages with toxic bells and whistles.

Of the 25 top subprime mortgage lenders, Patterson said 21 were either owned or financed by major Wall Street or European banks according to report by Center for Public Integrity.

“Without the demand from investment banks, the bad loans would never have been made,” he claims.

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