CFA Research Foundation takes a first crack at writing the history book of the 2008 financial crisis

30 Mar 2010

By: Steve Deutsch, CAIA, Morningstar, Member of the AllAboutAlpha.com Editorial Board

More perspective is now starting to arrive on the “Subprime Credit Crisis of 2008-9” – insight that will surely be honed or revised further over time.  Books and articles that attempt to identify the causes and – more importantly perhaps – the solutions to avoiding a recurrence are now quite prolific, including just this month a recommendation for limited purpose banking with the attention-grabbing title of, “Jimmy Stewart is Dead.”

All of this analysis is needed as the politicians in various major markets attempt to implement “solutions” and win votes for taking action. And the lobbyists and assorted special interests attempt to deflect and modify change. The EU Proposal for a Directive on Alternative Investment Fund Managers has been the area of greatest activity recently, but the pace of the House Financial Services Committee and Senate Banking Committee is increasing now.  A fairly good perspective on U.S. reform proposals can be found at the Investors’ Working Group website.

Another noteworthy publication has been out since December, 2009: “Insights into the Global Financial Crisis” from the Research Foundation of the CFA Institute. (You can download the entire monograph for free by clicking on the link.)

It’s a bit challenging for me to summarize/review a book from the CFA Institute since I’m writing from a CAIA perspective, and some of my colleagues from Ibbotson and Morningstar actually contributed a chapter to the book, but here goes…

First, one does have to accept the notion that the confluence of “Black Swan” factors and events of the past few years will occur again in the future. According to the CFA Research Foundation’s monograph, and most other analyses, the main cause of the calamity was leveraged speculation on home mortgages.  This academic review of event recounts the “domino tumble” of 2008-2009, in a somewhat less “entertaining” fashion than books such as Andrew Ross Sorkin’s  Too Big to Fail, for example.  But it’s well worth the read.

Not all of the esteemed contributors (Howard Marks, Jeremy Grantham, Clifford Asness, and Frank Fabozzi amongst many others) were assigned to analyze the causes of the crisis.  Still, some do address the most pressing question for AllAboutAlpha.com readers: Were alternative investment strategies and investment vehicles the cause of the crisis (at least in part) and are changes required in the way these alternative investments are managed in order to avoid a similar financial downturn in the future?

Here are some of the answers provided…

Robert Bruner (University of Virginia):

  • Hedge funds are somewhat culpable:
    • “…shadow financial system consisting of new and unregulated institutions that arose to speculate on the expansion…Many of these funds were conservatively managed; others used aggressive investing strategies…”
  • Alternative investment vehicles contributed to the cause:
    • “Complexity and opacity were amplified by the bundling of subprime mortgages into…RMBS” as well as MBS and CDOs.”
  • Yet, while “…more liquidity should be supplemented by improving transparency and restoring confidence…with this much government intervention, it is hard to call the global financial services industry ‘free market capitalism’…”

Bruce Jacobs (Jacobs Levy):

  • Alternative investments were at the scene of the accident:
    • “The construction of the great tower of RMBS, CDOs, SIVs, and CDS and its subsequent collapse are … integral elements of the subprime crisis…One can cogently argue that the housing bubble was the product of an enabling set of financial instruments and practices.”
  • Hedge funds (as well as commercial and investment banks) increased liquidity, reducing the perception of risk as well as the apparent probability of default.
  • “… The system that eventually emerges from Congress will…bring previously unregulated instruments under the regulatory umbrella.”

Paul Kaplan, Tom Idzorek, et al (Morningstar and Ibbotson):

  • “The second financial innovation that contributed to the recent bubble and crash was the development and widespread use of credit default swaps.”
  • “…more comprehensive regulation of the financial system is necessary…(it) must guarantee transparency and limit leverage…and applied to the non-depository financial institutions and their holding companies (the so-called ‘shadow banking system’).”
  • Robert Litan (Brookings Institution) is the most specific of the contributors in prescriptive remedies:
    • “The problem now is what regulators do not know (Litan’s emphasis) about the systemic risks posed by any one or more hedge or private equity funds because there is no comprehensive reporting by these funds currently in place.”
  • …but not specific enough, since:
    • “…a hedge fund that is initially highly leveraged should have its ‘Systematically Important Financial Institution (SIFI) designation removed if the fund substantially reduces its size, leverage, and counterparty risk.”

Peter Wallison (American Enterprise Institute):

  • I’d say Wallison was the most contrarian contributor to the monograph:
    • “The role of credit default swaps in the financial crisis has been as exaggerated as the role of the Glass-Steagall “repeal….There is no evidence that CDS caused any serious losses to any individual firm or the market as a whole…”
  • Instead, Wallison points squarely at Fannie Mae, Freddie Mac and the long-term government attempt to foster home ownership.

Paul McCulley (PIMCO):

  • McCulley is among the most specific in fingering hedge funds and other “nonbank bankers”:
    • “I coined the term ‘shadow banking system’….unregulated shadow banks fund themselves with uninsured short-term funding, which may or may not be backstopped by liquidity lines from real banks. Because they fly below the radar of traditional bank regulation, these levered-up intermediaries operate in the shadows without backstopping from the Fed’s discount lending window or access to FDIC deposit insurance.”
  • “The recent Minsky moment encompassed three bubbles bursting: in property valuation…in mortgage creation; and in the shadow banking system, not just in the United States but around the world”

After reading this thoughtful and analytical overview of the Subprime Credit Crisis, I was left with several impressions…

  1. The case for alternative investment strategies and instruments as having been key figures in the crisis is not well proven.  To be sure, the authors make several assertion, but they back them up with inadequate proof;
  2. Neither private equity firms, nor sovereign wealth funds (or hedge funds, for that matter) are convincingly and logically implicated in the global financial crisis;
  3. Beyond CDS’s, substantive recommended changes to mortgage derivatives (if even required) are not fully addressed by the monograph; and,
  4. The majority of the solutions proposed are too domestic, reflective of a “financial-industrial complex” (as Jeremy Grantham terms it) that still does not fully grasp that its position in the world is now very different. (In Too Big to Fail, for example, Sorkin cites Hank Paulson’s sense of surprise when the British FIS and Chancellor of the Exchequer would not clear Barclay’s to acquire Lehman.)

We live in a multi-polar world now. Capital movement and shadow banking are international in scope and extend beyond just hedge funds. So any policies aimed at preventing a recurrence of the Subprime Credit Crisis need to be  well-considered, coordinated and borderless in order to be effective.

Appropriately, “Insights into the Global Financial Crisis” stops short of identifying alternative investment vehicles and strategies as either causes or major contributors to the financial crisis.   Several contributing authors also admit that there are limits to what can be expected from any systemic risk regulator.  (As Kaplan argues, the first critical ingredient at the heart of all bubbles is human nature.)

In fact, this pass at writing the history of the global financial crisis essentially acknowledges the reality that there is no one cause, and therefore no easy solution to avoiding future bubbles and excesses – and basically concludes that financial risk is a necessary evil.  The CFA Research Foundation’s Larry Siegel hits the nail on the head in the first chapter when he writes,“A riskless society is unattainable and infinitely expensive.”

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