Wall Street Law Blog

Wall Street Rationale Reviewed...

Wall Street deception revealed by a basic analogy:

The housing market has never collapsed is to 

The housing market cannot collapse                                               

-AS-

I have never been dead is to

I am immortal

By Brett Sherman

Thanks to Nassim Nicholas Taleb and Jim Grant for inspiration.

 

High Risk Strategies Fail In the Long Run - See, for example, Bear Stearns

1.      The definition of risk is the chance of loss.  If an action carries a chance of loss, it is risky.  The greater the chance of loss, the greater the risk. Risk magnitude refers to the size of potential loss. If the potential loss from a given risk could wipe you out, the magnitude is very high.

2.      Why do high risk strategies threaten long-term survival?  Think of betting your life savings on a game of Russian Roulette.[1] Once a year,  on New Year’s Eve, you hold a cold steel pistol to your temple.  The gun has six chambers, but only one holds a bullet.  You say a little prayer and squeeze the trigger.  Each year your luck holds, you exhale with relief. You have drawn one of the five lucky chambers. Then you jump for joy.  You not only get to live, but you’ve just doubled your money.

3.      Unfortunately, each year that you win the laws of probability and statistics stack up higher and higher against you.  Luck doesn’t last forever, and math never lies. Next year, your luck may run out.  In any event, if you play for too long, you are almost guaranteed to lose.

 

4.      Of course, losing at Russian Roulette means losing everything you’ve ever had and everything you ever will have.[2]  Therefore, “prudent risk management” (to use the words of former Bear Stearns CEO Jimmy Cayne)  dictates that you shouldn’t be playing the game at all.  The bet is far too risky.  But it is also quite lucrative, and you really like money.  You understand the chance you are taking.  You take it anyway.  You are just like the Executive Committee at Bear Stearns.

5.      The point is this - Frequency of success does not mean anything if the cost of even one failure is too high. Bear Stearns reported record revenues for 5 straight years.  And when the company collapsed, those record years didn’t matter to public shareholders at all (except for those lucky enough to have had a reason to sell BSC long before March 2008).

 

6.      The individuals who truly benefitted from each of those five record years were the Executive Committee members. They received windfall bonuses, including many millions in cash payments, for generating positive short-term performance during an unprecedented bull market. 

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[1] The idea of the Russian Roulette analogy comes from the trader and author Nassim Nicholas Taleb. 

[2] Rough paraphrase of Clint Eastwodd from the film The Unforgiven.

 

Testing the "Tsunami" Defense (Wall Street saw the wave coming); encore post

THE PERFECT STORM / TSUNAMI DEFENSE TO SUBPRIME-BASED CLAIMS CANNOT WITHSTAND SCRUTINY...

• Former Wall Street Executive Jones:  "It was just the perfect storm. A financial Tsunami if you will. Everything went wrong at the same time. I feel terrible for our former employees and shareholders." 

• Former Bear Stearns CEO Alan Schwartz:  "I can't think of anything we could have done differently (paraphrasing the sworn testimony on Capital Hill).  

I.  RULE NUMBER ONE - EXPECT THE UNEXPECTED     

Good risk management prevents the consequences of being horribly wrong about any investment, business strategy, business model, or other business decision from producing losses that cripple or kill a company.  Put another way, a company with strong risk management should withstand any economic shock.  

Put another way, risks must be controlled. No event (or series of events) - regardless of how unexpected, unanticipated, unforeseen, or unprecedented the event(s) might be - should be capable of producing a negative outcome of such magnitude that the event(s) brings the walls of your company crashing down.  

By any event, we mean any event - including a "perfect financial storm" or "insurmountable tsunami" that former and current Wall Street CEO's like to proffer as an excuse for the damage they caused to their companies through their own irresponsibility, incompetence, and fraud. 

If you are wondering how to avoid a disastrous outcome even if the direct cause is entirely unforeseeable, you miss the point.  It is, by definition, impossible to avoid an unforeseen event if and when it crosses your path.  If you bet heavily on the Ruble, and Russia decides to default on its debt (as if that could ever happen), then Russia will default on its debt even if you were "positive" a Russian default was impossible.  Similarly, if an earthquake destroys your office building and wipes out your company's computer servers, there aint much you can do about it (except evacuate quickly).  

II.  YOU CAN NEVER PREDICT THE FUTURE WITH ANY DEGREE OF CERTAINTY

The future is impossible to predict (except, I hope, for Madame Sozuka - the psychic who read my palm at a bat mitzvah last year and assured me that I will win the lottery in 2010).  There are too many variables for any expected outcome to ever be certain.  

Wars, weather, famine, traffic accidents, food poisoning, bad orange crops, good orange crops, devaluation of the ruble, oil surpluses, oil shortages, terrorism, an unprecedented housing boom, a nationwide housing bust..., the number of unforeseen, unprecedented, unexpected, unanticipated factors that influence future outcomes is always infinite.   

The idea of risk management is to accept that unexpected events and outcomes - regardless of what causes them - happen all the time.  Sometimes an event is totally unforeseeable (the 9/11 terror attacks), and sometimes an event can be unexpected to some people, but by no means unforeseeable (the housing crash).  Regarding 9/11 - I am a very fortunate survivor from the South Tower of the WTC, 65th floor - I am only suggesting that the attacks were unforeseeable to businesses.  Whether the government should have foreseen the tragedy is another matter.  

Of course, no CEO could have prevented 9/11, or protected those who were injured or killed that day. But any company with effective risk management would have assured that the company itself would survive.  How?  One way was to be certain that vital data, like confidential client information, was backed up on a computer server hundreds or thousands of miles from ground zero to prevent the loss of crucial information for any reason. Similarly, countless risks (such as loss of property) could have been, and in most cases were, insured.  Insurance is one of the most important forms of risk management. 

  

III.  CONVENTIONAL WISDOM IS NO DEFENSE    

The CEO of any financial institution who would stake the company's future on "conventional wisdom" that a national crash in the housing market can't happen is worse than a bad risk manager.  The words incompetent comes to mind.  

Conventional wisdom is no basis on which to bet the ranch. Even if there had not previously been a national housing slump (a point of some debate), all that would mean is that there hadn't been one yet.  Remember, there also had never before been housing growth that even approached the explosion in home demand, appreciation and ownership that occurred between 1996 and 2005.  Historic booms are often followed by historic busts.  Ask the former paper millionaires in Silicon Valley who had to move back in with their parents after 2000.  

IV.  ON STATISTICS AND  APPLES v. ORANGES         

A few more thoughts  about the bad logic of "we thought we were ok because the national housing market never falls" argument -

1) According to our information, mortgages that backed CDO's were not representative of the entire housing market.  By 2006, California contributed up to a third of the mortgages behind most CDOs. 

There have been many housing bubbles and busts in California - including a major bubble in the early 1990s. Florida was another major source of bad mortgages.  Like California, Florida has seen its share of booms and busts.  The point is this - crashes in home values in just a few core housing markets where busts are far from unprecedented would have caused mass defaults of subprime mortgages even if the rest of the country was fine.

 2) What goes up must come down.  

           a) There had never before been anything resembling the pace of annual home appreciation or  jumps in home ownership before the housing bubble.  

           b) Before the boom computer models that based projections on historical data would have laughed at you (and it is hard to get a computer to laugh) if you input the real data that followed.   ***Here is a challenge - anyone who produces a pre-2001 projection that shows the housing market growing even half as much as it did will receive honorable mention in a future post and we will also wash your car(s).  

           c)  Before the bubble, home loans were extended solely to creditworthy people.   Even pre-bubble subprime loans required extensive documentation - paystubs, banks accounts, proof of net worth, etc. - to satisfy a lender that a subprime borrower was a reasonable credit risk (i.e., MANY applicants were rejected by subprime lenders before the bubble).  During the bubble, the paradigm shifted.  The old "loan quality" model - which worked pretty well for hundreds of years - was abandoned.  The new "lend to securitize" model evolved to the point where loan quantity was the only real concern. 

SO WHAT?  So the mortgage market changed so dramatically that there had to be a massive impact on the housing market (and there was).  The pre-bubble mortgage industry model required applicants to prove to lenders that the loan would be repaid.   By the peak of the bubble, there was zero real assessment of credit risk.  

Because there indisputably were seismic changes in the mortgage and housing markets during the bubble years, pre-bubble statistics for mortgage default rates, home ownership rates, and real estate appreciation rates were useless.  Pre-bubble historical data - like stats that supposedly proved the national home mortgage market never falls - was as relevant to measuring risk during the bubble as the temperature in Alaska is to a blogger planning a trip to Hawaii.  In sum, we're talking about comparing apples to oranges.

V.  ABOUT THOSE NINJA LOANS and FRAUD - PLEASE EXPLAIN  

A simply cannot guard against default risk and extend credit to subprime borrowers without obtaining a shred of paper from which to analyze default risk confirm when they have no historic data on mortgage defaults was an improper basis for computing projections of default rates on low documentation and no documentation loans.  

Is there any way to explain liar loans or NINJA  loans other than that those find more borrowers for the securitzation machines at firms like Merrill Lynch, Bear Stearns and Lehman brothers.  We can't think of one.  Unless there is another plausible explanation, we find it impossible to conclude that subprime mortgage lenders gave home loans to countless families that were almost certain to default.  This is fraud by the lenders and fraud by the investment banks that turned junk mortgages into MBS and CDO's.  

And did we mention that Bear Stearns and Merrill (and maybe Lehman) actually owned some of the largest subprime lenders that placed people in these fraudulent loans?  Did we mention that Wall Street provided the money for almost all other major subprime lenders (New Century is a name everyone should remember).  Wall Street investment banks are responsible for a whole lot, no matter what "pundits" may say.  

By Brett Sherman

THANKS FOR READING - AS ALWAYS, WE WELCOME ALL COMMENTS - POSITIVE AND NEGATIVE 

Black Swans*, Fraud by hindsight, and Mortgage-Backed Securities. (greatest hits collection)

Events are not unforeseeable merely because they are unprecedented... 

One of the primary arguments upon which Wall Street firms rely to defend themselves from securities fraud allegations is something like this -

We could not foresee the collapse of the housing market, and therefore any allegations of fraud are merely impermissible claims of "fraud by hindsight." 

The fraud by hindsight defense is pretty much automatic in securities fraud cases.  The meaning of the defense is, as it sounds, that there is no fraud if the alleged deceit can only be discerned after the fact. Hindsight is, after all, 20/20.  The legal issue is foreseeability.  

In financial crisis litigation, Wall Streeters insist that their actions (like marketing CDOs stuffed with subprime mortgages as ultra-safe investments) are not fraudulent because banks that sold toxic waste allegedly could not reasonably foresee the housing and credit bubbles or the consequences that would rain down when the bubble inevitably ruptured.

Further, Wall Street execs insist that mass defaults of subprime mortgages were not foreseeable simply because (they contend) the U.S. has never experienced a nationwide housing slump.  Presumably, these same Wall Street executives would argue that they cannot foresee the possibility that they will one day die because they haven't yet been dead.*     

OK, Wall Street:  From 1895 through 1996 home price appreciation very closely corresponded to the rate of inflation (roughly 3% per year).  From 1995 through 2006 alone - even after adjusting for inflation - housing prices rose by more than 70%.  That type of housing growth certainly is unprecedented.  Why shouldn't such an unprecedented "up-cycle" in the housing market end in an unprecedented way?  The answer is that there is no reason.  

In fact, the housing boom was so far out of line with any previous housing cycle that one could easily argue that a reasonable economist, real estate professional, or CEO of an investment bank should have anticipated that a the story of housing's record-smashing growth would eventually come to a very ugly ending.   

The fact is that a huge number of respected experts from private industry and academia publicly warned of a huge housing bubble that could only end badly.  Certainly, many others kept quiet, wary of rocking the boat while the profits poured in, even though they too foresaw the end of the housing bubble and predicted its devastating impact on mortgage-backed securities.  

The fact is that, once the MBS industry became dependent on subprime mortgages, an eventual disaster was unavoidable.  Until the bubble popped, however, Wall Street was raking in far too much money to worry about the ramifications of the immense risks banks were taking.  

Fraud by hindsight is inapplicable in most financial crisis litigation.  Why?  Because choosing to ignore the apocalypse is far different from failing to foresee it.

      

*Inspired in part by the writings of Nassim Nicholas Taleb.

By Brett Sherman, The Sherman Law Firm