October – December 2007

January 29, 2008

The sub-prime crisis engulfing the banking sector continues to worsen. The looming downgrades and potential bankruptcies of the monoline bond insurers could be the straw that could break the financial systems back. Many banks have used monolines to wrap their products and also bought credit-default swaps through them. It may be interesting to use a cross-disciplinary approach to the problems and mistakes made by banks in the sub-prime market.

The power of rewards that leads to repeated actions and the flawed compensation structure that led to misaligned incentives could be one mental model. As Raghuram Rajan pointed out in Financial Times (Jan 9, 2008), the compensation practices in the financial sector are deeply flawed. The compensation is based on the so-called alpha that a manager of financial asset generates. There are three sources of alpha:

1) Truly special abilities in identifying undervalued assets (eg. Warren Buffett)

2) Activism using financial resources to create, or obtain control over, real assets and to use the control to change the payout obtained on the financial investment.

3) Financial engineering financial innovation or creating securities that appeal to particular investors.

Many managers create fake alpha i.e. they appear to create excess returns but are taking on tail risks which produce a steady return most of the time as compensation for the very rare, very negative returns (black swans). The AAA rated CDOs generated higher returns than similar AAA rated bonds. The tail risk, so evident in hindsight, of the CDO defaulting was not as small as perceived and so the excess return was compensation for that.

The credit rating agencies that rated these securities as AAA because of their insured status were themselves wrongly incentivised (compensated by the issuers of the securities). Furthermore once their peers started issuing AAA ratings, social proof came into play and the ratings war as to who assigned the highest ratings for junk became a classic Prisoners Dilemma.

The managers themselves seem to have been suffering from 1) self-serving bias (i.e. an overly positive view of their own abilities and an overly over-optimistic view of the future) 2) self-deception and denial for they seem to have indulged in collective wishful thinking 3) bias from consistency tendency (they must have looked for evidence that confirmed their optimistic beliefs and kept on being consistent to their original ideas even when problems surfaced) leading to 4) status quo bias or the do-nothing syndrome 5) impatience in valuing the present more highly than the future again caused by incentives that made them so myopic 6) bias from envy from managers who were making large returns with apparently no extra risk which led to 7) distortion by contrast comparison because the steady escalation of commitments must have seemed incrementally small caused by 8) anchoring to what seemed like small relative numbers 9) social proof which led to imitating the behavior of their peers 10) bias from over-influence by authority in that the CEOs of the banks that have suffered the most seem to have been run by people who did not have a trading or market background and they were swayed by the experts they were overseeing which led them to 11) sensemaking in that they were too quick to draw conclusions and may have become 12) reason-respecting in that they complied with requests from their subordinates merely because they had been given some reason leading to 13) a do-something syndrome all caused by 14) mental confusion from stress.

Competition for business must have led to the winners curse i.e. overestimating the value of the securities and overestimating predictive ability. Collectively they did not foresee that their actions had adverse systemic consequences and the implications to their balance sheets if things went wrong (falling housing market, soft economy, bankrupt insurers). They failed to consider the increasing instability due to their actions caused a phase change as a tipping-point was reached and that a system is only as strong as its weakest link.

In factoring the odds, the managers seemed to have underestimated risk exposure where the frequency and magnitude of consequences was unknown because of the novelty of the securities. They seem to have underestimated the number of possible outcomes for the unwanted events currently being witnessed. They certainly do not seem to have correctly calculated expected values or else they would not be in the hole they are currently in. They in fact did not consider the consequences of being wrong. They probably worked in an illusion of control over what were probabilistic events and thus did not factor in a margin of safety. In the limited history of the securities, the managers overestimated the evidence from the small sample of data.

From an anthropological viewpoint that was commented on by Gillian Tett in Financial Times, one should look at the political structures of the survivors. CEOs of the relatively unscathed banks tended to be meddlers very hands on. They had a direct career experience in trading and managing market risk. Thus the mind-set was different from being a lawyer or a salesman. Furthermore, the losers had more hierarchical structures in which the different business lines have existed like warring tribes, answerable only to the chief. Moreover the most profitable tribe has inevitably wielded the most power and thus was untouchable and inscrutable to everyone else.

This is proving to be a game of chicken between the regulators and the players (banks and monoline insurers). In a classic game of chicken, two cars drive towards each other. The first driver who turns loses. Of course, if neither car swerves then there is a crash. The best outcome for each player results when he goes straight whilst his opponent turns. Insane players have a massive edge in a game of chicken. At this point of time, the jury is out given the level of insanity in the system.

We have attempted to manage risk by the large cash levels which we were carrying before the severe reaction in the markets. We have since deployed part of the cash in buying what we consider to be undervalued securities, some of which are in out-of-favor industries. Our process however is bottom-up.

Should there by any questions or clarifications that you seek, please do let me know.

Thanking you,

Warm Regards,

Chetan Parikh