The credit crisis was NOT a Black Swan event

One of my holiday books – I’m so geeky dull when it comes to banking – is Traders, Guns and Money, Knowns and Unknowns in the Dazzling World of Derivatives, by Satyajit Das. It was recommended to me a while ago, and has been sitting on the bookshelf ever since, like so many books I buy.

This one intrigued me however, as it was written way back in February 2006, eighteen months before the August 2007 run on Northern Rock and two and a half years before the September 2008 implosion of Lehman Brothers.

So Nassim Taleb talks about a Black Swan crisis ... this one wasn’t. This crisis was thoroughly predictable, as Traders, Guns and Money makes clear.

Rather than writing a review here, as I haven’t read it yet, I thought that Shocked Investor’s blog entry would provide a good backgrounder on this.

However, I have dived straight in to the last chapter on Credit Default Swaps (CDS) and Collateralised Debt Obligations (CDO), one of my favourite subjects.

There’s a good note in there on page 295 about these suckers. Here’s a shortened version of that note:

“CDO logic is perverse. You buy loans and other credit risk from the market, then you cut it and dice it and sell it to investors. It should be impossible to make money. Then why are CDOs so profitable?

“In the credit trading age, dealers were taking massive ‘model risk’ to provide investors with higher returns. It was the geeks and their masters who were writing the cheques; they had placed their faith in the credit models; they had started to believe in their lies. Perversely, they were showing massive profits. That’s the beauty of mark-to-model. If the model fails, the profit will disappear like a chimera.

“In 2002 and 2003, benign conditions in the credit market prevailed. Few companies defaulted; people became foolish or brave and lent to companies at ever lower returns; the credit spread on junk bonds reached record lows. Credit standards declined.

“In 2004, one bank suffered a loss of around $50 million in a single day on its credit dealt books. Nobody really knew why: it was the first tremor.”

You get the idea.

This book explained all the background to why we would see a subprime explosion and liquidity crisis ... back in February 2006, charting events going back to 2004 and before.

The book cites a court case from 2004 for example, where Barclays Capital were sued by German investment fund, HSH, for ‘misrepresentation’ after BarCap lost $151 million on one of their CDOs:

“HSH claims it was mis-sold the products, known as collateralised debt obligations (CDOs), and that Barclays then mismanaged its portfolio of CDOs in a way which further damaged the interests of investors. Barclays also stands accused of "short-selling" the CDOs for its own commercial benefit.”

Barclays argued that the losses were just due to the ‘unexpected’ downturn in the credit markets, and that HSH was a sophisticated investor and aware of the risks.

Doesn’t this sound like Goldman Sachs today?

“The risk associated with the securities was known to these investors, who were among the most sophisticated mortgage investors in the world.” — Goldman Sachs April 16th press release, in response to the SEC’s accusations

It’s a standard defence, as was BarCap’s response that it would ‘vigorously defend’ the action as they were ‘comfortable that these investments were not mis-sold’.

In 2004, Barclays settled the case with HSH a few weeks before it came to trail as they wanted to avoid the headlines.

A similar case was brought against Barclays and Bank of America at this time by the Italian Banca Popolare di Intra. Again, it was settled out of court.

If you’re interested in this stuff, there’s a really good presentation on CDO litigation from Jones Day, a law firm, at a London conference in March 2008.

Presentation: American and UK Perspectives on CDO Claims

Here’s a few of the slides:

What triggers litigation?

• Unexpected and large potential losses
• Tripping of over-collateralization or similar tests
• Disagreement over appropriate priority of payments
• Liquidation of portfolio assets
• Collateral calls
• Poor documentation where ambiguity = opportunity
• An unwillingness to compromise or inability to do so due to an encumbered balance sheet

What are the claims?

America’s claims are based upon:

• Sales Practices:
• • Misrepresentations and omissions
  • Collateral contracts/promissory estoppel
  • Suitability
• Federal securities fraud claims
• Mismanagement; Breach of fiduciary duty
• Breach of contract
• • Contract interpretation
  • Third party beneficiary standing
• Aiding and abetting breach of fiduciary duty/fraud
• Civil conspiracy
• Class actions?

UK claims are based upon:

• Deceit
• Misrepresentation (if contract) based upon being innocent/negligent/fraudulent
• Breach of contract: contract term/implied term (reasonable skill and care in management of funds)
• Negligent mis-statement (if no contract)
• Breach of a duty of good faith/duty to inform

Who brings the claims?

• CDO investors
• • Senior Note holders vs. Income Note holders
  • Institutional vs. individual investors
  • Hedge funds/ fund investors.
  • Liquidators and trustees of insolvent CDOs
• Swap counterparties
• Mono-line insurers
• Warehouse agents

Who gets sued?

• Placement agentsunderwriter
• Portfolio managers
• Financial advisors
• Administrative agents
• CDO directors and officers
• Rating agencies
• Mono-line insurers
• Accountants
• Other professionals? Law firms?

Interesting and I’ll bet this rumbles on for years to com.

Meanwhile, if all this was rumbling along back in 2004 such that a book could be written about it in February 2006, how come no-one – including yours truly – knew what was really happening until the poop hit the fan?