Malfeasance, Not Exuberance, Was the Crux of the Crisis

David Fiderer recently explored the deeper ramifications of the Goldman Sachs controversy in a hard-hitting essay on Huffington Post entitled John Paulson Defends His Toxic CDOs By Insulting Everyone’s Intelligence.” R&R Consulting’s Ann Rutledge solicits his further thoughts on the subject.

Ann Rutledge (AR): David, this is a painstaking reconstruction of the milestones of public awareness (or disclosure) about the subprime crisis. But, what is wrong with John Paulson stretching the truth a bit? Or with “everyone’s intelligence” being insulted, for that matter? Isn’t it a bit far-fetched to see a conspiracy of silence here going all the way up to Greenspan, as you allege?

David Fiderer (DF): I’ll start with the Greenspan connection, because I made a snarky insinuation that may have been misunderstood. In January 2008, Alan Greenspan joined the advisory board of Paulson & Co. Both Greenspan and John Paulson promote the mythology that the meltdown was caused by irrational exuberance rather than active malfeasance, and they both do so to defend their own reputations. Greenspan’s contribution to the disaster, which was far more profound than Paulson’s, ended after he left the Fed in January 2006, whereas Paulson started shorting subprime RMBS five or six months later. When I wrote that Paulson pays Greenspan to say that only four or five people saw the disaster coming, I intended to communicate that, in addition to everything else, Greenspan now also has a monetary incentive to misrepresent the past. The kicker at the end of my story was a minor point.

As for Paulson stretching truth, what struck me about his statement in the letter to his investors was the audacity of his revisionism. He’s a smart guy. Usually proponents of the irrational exuberance myth dissemble by distraction. You’ve heard the sundry cliches about global imbalances, a once-every-hundred-years event, historically low default rates between 2002 and 2005, government policies to promote low income home ownership. The most popular one, of course, is that no one knew what would happen to home prices in the second half of 2007. But Paulson wrote, “It is easy to forget that before the collapse, the overwhelming view of investors, ratings agencies and economists was that the housing market was strong and would continue to get stronger.” Who would be stupid enough to believe that was remotely plausible? And if Paulson were referencing a period prior to the first months of 2007, who would be stupid enough to believe that his remark is at all relevant? It would be like saying, “People forget that the Titanic sailed for four days without incident!”

As for the notion of a conspiracy of silence, I would put it this way. Between September 2006 and April 2007, about $80 billion in mezzanine CDOs were issued. That’s a huge volume, totally disproportionate to prior levels. I believe the underwriting banks had figured out that the lower-rated tranches of subprime RMBS were all but worthless, and they wanted to dump those toxic assets onto unwitting buyers who were sophisticated investors in name only. Paulson, working with Goldman and Deutsche, saw to it that he would short the most egregious and most toxic of all CDOs, but I think the overarching motivation of the underwriting banks was to dump the subordinated tranches onto a niche market of greater fools.

The banks sold the BBB tranches by repackaging them into CDOs, which offered new levels of structural subordination, and transformed a BBB portfolio into a deal in which 70% was rated AAA. For most people, myself included prior to October 2008, a AAA rating triggered a psychological response. People think, “I don’t need to worry about this one, let me move on to the more pressing items on my to-do list.” Of course, the tranching doesn’t work when all the constituent investments are deeply subordinated claims in other RMBS deals. As I’ve written before, it’s like a portfolio of bunks in steerage on the Titanic.

I come from banking, I don’t have a statistical or mathematical background, so my first impression of any new deal was based on a simple back-of-the-envelope break-even analysis. By January 2007, it was obvious that default rates had spiked to the point where it was impossible to construct a scenario where the BBB tranches would be made whole. Of course you, Sylvain and your colleagues at R&R demonstrated that this was obvious as of January 2006, after you reverse-engineered the statistical data of the ABX 2006-1.

AR: You acknowledge the Moody’s January 2007 report by Joseph Rocco, a then-associate analyst, a relatively junior position, but then you ask why Moody’s didn’t follow this point to its ultimate conclusion (that the collateral would not have sufficient value to repay the securities even in the expected case) and downgrade the securities. When Sylvain and I worked there in the 1990s, we had it drummed into our heads that these were non-recourse financings. Is it your hypothesis that Moody’s got stupider in the 2000s because of the dramatic decrease in analyst experience over these years? Or do you believe Moody’s came to accept the existence of invisible but de facto recourse (via servicer advancing, substitution, etc.) that became so prevalent after 2002?

DF: I’m a relative novice to this area and I’m self taught. If I could figure out that the BBB tranches were all but worthless as of January 2007, then the rating agency executives who work with this stuff every day could figure it out. Of course, it’s very easy for me to draw inferences, because I have no investment in defending a prior work product, and I don’t need to worry about being scapegoated by others if I speak the truth.

With absolutely no direct knowledge of what actually went on within the rating agencies, I will speculate as to what happened in late 2006, or early 2007. A high-ranking executive said something like, “Now let’s not panic or overreact. Let’s take a step back and evaluate all of this in a broader context and see if we need to make a few adjustments to our models.” In banking, when we saw a deal going bad, we had the flexibility to use more of a trial-and-error approach. Many times I said something to the effect of: “We don’t know how bad things will be, but for the time being let’s severely downgrade the risk rating and take a provision, and in the next quarter, when we have a better sense of the situation, we can modify or reverse our decision.” A rating agency doesn’t have the flexibility to change its mind every quarter, because the capital markets follow its words as closely as they follow statements from the Fed, which also impacts the cost of credit.

Also, people can only handle so much at any given time. It appears that the rating agency analysts were swamped with demands to rate new CDOs, so they had to postpone their evaluations of earlier RMBS ratings. Again, I have no direct knowledge that this was the case; it’s conjecture.

What I have observed is that computerized “enhancements” in the credit process have frequently caused the analyst’s function to become more bureaucratized and and less reliant on critical thinking and common sense. As Michael Lewis wrote in his book, the analyst’s job, which should be the most important in the industry, had become devalued.

AR: From your background in banking and finance, other than providing grist for your mill, what does the crisis mean to you? What is its larger significance?

DF: There’s a big disconnect between journalism and business, and it’s even more pronounced between journalism and finance. Writers like to tell stories about what people say or do, and there’s a premium on hearing the story from an insider. The real story of the meltdown is discerned in what people did not say and did not do. After all, Tony Soprano never said, “I will pay you to murder this witness.” I’m sure none of Fabrice Torre’s superiors ever said, “I know that Abacus 2007 AC-1 is insolvent as of the date of its closing.”

Also, what an insider tells a reporter is, by definition, self-serving and selective. I’m still amazed that anyone would believe that Bush invaded Iraq because George Tenet said, “It’s a slam dunk.” As I wrote previously, Andrew Ross Sorkin’s Too Big To Fail was edifying because of the transparent deceits relayed by his off-the-record sources.

It’s hard to make a circumstantial case, and it’s especially hard to make a circumstantial case against someone for not doing something. And it’s hardest of all to make the case in matters of finance. As Steve Perlstein said recently, “A sports writer doesn’t have to explain what ‘stealing second’ is in every story.” Try explaining a CDS on a synthetic subprime mezzanine CDO squared to a generalized readership. Worse, there are a lot of people who think they know what they’re talking about, but really don’t. All too often, when pundits describe financial transactions through sports metaphors like “game changer,” they’re glossing over a critical distinction.

Businessmen don’t frame the narrative through people and their statements, but through the numbers — the bottom line. The price of West Texas Intermediate has a much bigger impact on Exxon’s profits than anything Exxon’s CEO said or did in the last quarter. Only by analyzing the numbers can one get a full grasp of what happened to precipitate and prolong the bubble and the meltdown. But that’s an abstraction for most people; it has no emotional content for readers or for editors.

The broader story of the meltdown is the story of every major scandal, from Enron to the Holocaust. It’s about willful blindness, about people who saw wrongdoing and looked the other way. Most of those people who looked the other way had no grasp of the full implications of the malfeasance that was going on. But John Paulson sure did.

David Fiderer spent more than 20 years covering the energy industry for several global banks in New York. Trained as a lawyer, he is currently  working on a book, Insider’s Game: How Markets Are Rigged, and contributes regularly to the Huffington Post.