Guaranteed To Fail: A Great Analysis of Systemic Risk

Guaranteed To Fail is one of the best books on the global financial meltdown and its aftermath. If you have any interest in these issues, I offer it as recommended reading. It reflects some pioneering applied research by Professors Viral Acharya, Matthew Richardson, Van Niewerburgh, and Lawrence White. It is concise and well written.  Many of the points they make have been corroborated by other reputable researchers in the field, and their final achievement is the establishment of the Stern School V-Lab, which is an analysis of systemic risk to the global financial system far superior to the banal and manipulated models  like VaR and self-administered bank stress tests.

We know now, for example, that in recent times of financial crisis, correlations among asset classes have converged, thereby vitiating the traditional benefits of portfolio diversification.  We also know that individual security betas and correlations within sectors like the banks change dramatically; yet, most published estimates of these betas and correlations are poor estimates and misleading for policy and financial management.  The Stern V-Lab does daily estimates of all these factors using a variety of powerful modeling techniques, and it uses them to generate daily estimates of systemic risk and the contribution to systemic risk by individual banks.

Acharya et al focus on the role of  the Government Sponsored Entities(GSE's) Fannie Mae and Freddie Mac in the crisis, noting that they were run as the largest hedge funds on earth.  The GSE's were run at a gearing ratio of 39:1!  The authors note that 15% of the mortgage purchases went to low quality mortgages, totalling $1.7 trillion.  These estimates are very consistent with findings of the Congressional Research Service and by Professor John Coffee of the Columbia University School of Business. 

In addition to leverage issues, the GSE's woefully undercharged for their mortage backing service.  They charged $0.20 per $100 of mortgage assets, which still allowed the entities to record revenues of $7 billion. They were also woefully underreserved by design, since this highly leveraged business model maximized executive compensation, which was built on private industry comparables. Reserves were built at $0.45 per $100 of mortage assets. Please refer to the above discussion to recall what they were buying. 

According to the CRS, "In broad terms, the GSEs purchased slightly more than $169 billion of private label subprime MBS in 2006 and 2007; they purchased slightly less than $58 billion of Alt-A MBS in the same time period out of combined total mortgage purchases of $1.677 trillion. At the end of 2007, the subprime and Alt-A MBS represented 13.5% of the GSEs’ total assets."   These assets, purchased under political pressure from Congressional leaders and by private originators like Countrywide Financial, were among the most toxic in the marketplace. 

The authors note that the 2007 vintage had 23% of loans with equal to or greater than 80% LTV and 18% with FICO scores below 660.  The 2006 vintage was composed of 23% subprime mortgages and 15% interest-only loans.  These vintages were purchased in a concentration of zip codes which had historically poor mortgage performance, according to an analysis done by the Columbia Business School. 

Former Federal Reserve Bank of St. Louis President Bill Poole, a Professor at Johns Hopkins when I was a graduate student, noted in this week's conference at the Witherspoon Institute  that the big bailout costs have been for Fannie Mae and Freddie Mac.  According to his estimate, they stand at $150 billion and counting. 

In the Stern book, the authors quote Minneapolis Fed President Narayana Kocherlakota as saying that the Federal Reserve's balance sheet in twenty years will likely still have $250 billion of mortgage backed securities on the books.  Unwinding the Fed's $2 trillion balance sheet will not be easy, as we've written about before. 

Right now, 59% of all financial sector liabilities are underwritten by taxpayers in some way.

Having at look at today's V-Lab, among the Global Systemic Risk Top 10 Banks, we find at the top in descending order, Deutsche Bank, BNP Paribas, Credit Agricole, and Barclays plc.  We find a German bank, two French banks, and a British bank.  No European capital will be immune from the ongoing stalemate in the euro crisis, whether in the currency union or not.  Incidentally, Bank of America is also in the top 10. 

It's great food for thought, and if you're so inclined, beyond reading "Guaranteed to Fail," have a look around at the V-Lab.