On leverage. And Fraggle Northern Rock.

For the first time in a few weeks, I had a couple hours between meetings this morning and so took the opportunity to buy the FT and settled in at a nearby coffee shop for a thorough read, which in turn has prompted me to weigh in with my 2 cents (2p? …or 1p really…) on the Fraggle Northern Rock debacle.

(Theme from Northern Fraggle Rock)
Dance your cares away,
Worry’s for another day.
Let the music play,
Down at Northern Fraggle Rock.

Work you cares away,
Dancing’s for another day.
Let the Bankers Fraggles play,
We’re Gobo, Mokey, Wembley, Boober, Red.

Dance your cares away,
Worry’s for another day.
Let the music play,
Down at Northern Fraggle Rock.
Down at Northern Fraggle Rock.
Down at Northern Fraggle Rock.

I’ve been resisting the urge – what with the thousands of column inches already consumed by this story, I was inclined to think that the last thing the world needed was yet another opinion. That said as events have unfolded over the last fortnight, I have consistently been frustrated that the key truths and issues have been largely absent from this torrent of reporting and editorializing. (Small caveat (I was a banker after all…there is always small print!), my research as such is completely unscientific and so perhaps these views have been articulated in some corner(s) of the infosphere and somehow I just managed to miss them.)

So at the risk of my analysis being branded shallow and oversimplified (which it will be by definition, as I am disinclined to write an essay) here goes:

Firstly – and this point is general to the current financial market dislocations, particularly as pertains to credit markets, and unhelpfully almost universally described with the ‘sub-prime’ epitaph – I have been disappointed in the lack of a clear, unemotional explanation of the consequences of very high leverage. My disappointment is twofold. One, the concepts are readily understandable for most if not all people with a basic grasp of basic mathematics, in particular if stripped of the specialist jargon of financial markets. Next, I sense that amongst the profession, their is a tacit support for this confusion or obsifucation – even in some instances an active encouragement of it, a sort of ‘jumping-on-the-bandwagon’ – in my opinion motivated by a desire to disassociate themselves from taking responsibility for their own collective actions. In other words if the general public had a better understanding of one of the core elements that lead to this situation, it would be much harder if not impossible to take cover behind the curtain of mysterious, unforeseeable and unprecedented events. Like Mr. Bean slinking into the crowd after having set fire to the building, pretending to be just another onlooker wondering how on earth it happened, such an incredulous stance would not be tenable. Any time you hear ’7 standard deviation’ event, one-in-a-million, once-in-a-thousand years, as an excuse for losses from a trader take cover – either they are lying or worse – if they really believe it – they are incompetent. Don’t get me wrong, that is not to say that losses could have or should have been avoided (that is moot in my opinion) but that financial professionals feigning disbelief at how they happened or the extent of them is disengenious at best. Many of the losses suffered at the epicenter of the recent dislocation in financial markets, are the result of relatively small losses in real or expected asset values magnified many many fold by the power of leverage. Every trader, banker, hedge fund manager, and most homeowners, understand the effect of leverage. I don’t think many members of the general public would intuitively be surprised (let alone horrified) if told that the value of relatively ‘safe’ assets, as a result of the normal ebb and flow of the economy, had declined by 2 or 5 or even 10%. Nor would they expect such a decline – while perhaps unwelcome – to cause alarm, distress, or dislocation. However, if the owner of an asset that has declined by 2% is leveraged 20x, this modest loss becomes something completely other.

Mr Bean has 10 zen. He wants to invest in security AAA – boring, safe with accordingly low, steady expected returns. But he wants high returns. So he borrows 190 zen from Mr PB and buys 200 Zen worth of AAA. The world changes and AAA has a hiccup. It’s value goes down 2%. Not what was hoped for but not shocking, even for a boring safe asset. So his 200 zen worth is now only worth 196 zen. A loss of 4 zen. No big deal. Except he only had 10 zen to start. So he’s lost 40% of his money (his equity in the jargon.) Big loss, boo hoo. But even then not the end of the world. Only wait. Mr PB gets nervous. If AAA goes down some more, then Mr Bean might not be able to reimburse the money they are lending him. Right now they are fine (they’ve lent 190 zen and Mr Bean still has 196 zen worth of assets. Better safe than sorry, they ask for their money back. Mr. Bean then has to sell his AAA in order to pay back Mr PB. Loss is crystallized. Only wait, Mr Bean has many clever friends who also bought AAA with borrowed money. And they are in the same boat. Oh oh. More sellers that buyers. I asked my 10 year old what happens in this situation… Amazingly the price of AAA goes down more! (Apparently this also happens to the value of certain Pokemon trading cards when his friends all decide they don’t want those ones anymore…) Incredible, I know. But bear with me. It just gets worse (I know, I know how can that be??? AAA is safe as houses and nothing has really changed, at least not to the extent these crazy traders seem to think.) Remember Mr B’s 10 zen? (Which is now 6, actually 4 now that all the sellers are ‘giving away’ AAA and it has dropped another 1%.) Well – and you won’t believe this – they weren’t really his. It turns out that Mr PF and Mr IC and (now this is really funny) Mr PB’s partner – Mr BT – gave him the 10 zen because Mr B said he could turn it into 20 zen for them by investing in really really safe stuff, and all for the modest fee of 0.20 zen and 20% of the 10 zen profit he would make for them. Now Messrs. PF, IC and BT are not impressed. Their 10 zen is now 4 (actually 3.8) and they begin to suspect Mr B isn’t as clever as he claimed to be. They want their money back too. When Mr B finally manages to wind up his position, the original 10 zen is only around 3 zen. A clever and commercial (everyone loves a car crash) journalist hears of this amazing story: some investors lost 70% of their money investing in safe old AAA! Obviously there is some chicanery and AAA is clearly a clever disguise, or fraud or something… By the way, in the mean time Mr PB stops lending money to anyone for awhile, you know, until things settle down. And ta daa! Credit crunch. (And just imagine if AAA was actually a security that had embedded leverage within it. Like Russian dolls of leverage…)

Secondly – and this point is specific to Northern Rock – I have been disappointed and frankly surprised at how the Northern Rock management team, both executives and non-executives seem to be succeeding with their Alfred E. Neuman - Who, What me? – defense. While at the same time Messrs. King and McCarthy are being hung out to dry. Now I am not suggesting that these last two and the organizations they represent are blameless; in particular it seems the FSA seriously underestimated the risks Northern Rock was running with their aggressive funding policies, but come on! Regulation does not excuse management from running their own firm. They messed up. In a big big way. And they knew it. Any banker who has covered them in the last decade I’m sure has suggested at one time or another that they “term out”, “extend the maturity” of their funding. This is a jargon for borrowing on longer terms. Again most people would have no trouble understanding that were they to take a Northern Rock approach to their own finances, they would be taking significant risks – let me frame it. Imagine you have a £100,000 mortgage on your home. But only for a month. So every month you go back to your banker and ask for another 1 month loan. Most of the time – most not all – this would be easy, after all if they lent it to you last month, why not this month? But what if – for whatever reason – they didn’t. They ask for their money back. All the sudden your situation flips from perfectly fine, to deep shit. That’s why most mortgages are taken out with 10 year or more maturities. Northern Rock had the equivalent of a one month mortgage on their house – it was cheaper and so gave them bigger profits. But in simplistic terms – the 1st law of Financial Dynamics (Park’s Law): the conservation of risk – the spread, or difference in cost, saved by borrowing for one month vs ten years in fact is the market’s implicit estimation of the probability of liquidity drying up – of not being able to ‘roll-over’ the one month loan. There is no free lunch. Either Northern Rock’s management did not know this or they chose to ignore it and reap the short term returns at the risk of long term failure. Either way, completely unacceptable.

Much has been made of the high amount of ‘wholesale’ – ie market-based as opposed to deposit-based – funding that Northern Rock relied on. I think this is to a large extent missing the point. Their is nothing wrong (or right) per se with wholesale or retail funding. Each have their pros and cons and associated and unique costs. Many large financial institutions have much bigger balance sheets than Northern Rock and for all intents and purposes fund entirely in wholesale markets. But they manage the maturity match between their assets and liabilities much more closely and dynamically. In other words they borrow for longer terms even if it costs them more in the short run. It’s not rocket science. In fact it’s Banking 101. And it gets worse. If Northern Rock had just been a leveraged unregulated investment fund – yes the “h-word” – and btw Northern Rock’s risk management strategy was pretty much the same as many run-of-the-mill credit funds specializing in residential mortgage risk – well the balance sheet stress would have been the same, but it would be a matter between its managers, its prime brokers (ie lenders) and its investors. The working assumption is that the investors in the fund (who must be ‘qualified’) understand what the manager is doing, the risks he is taking and will live with the consequences. (Whether or not this is true in all cases is another story…) Caveat emptor. But Northern Rock is a listed company and a regulated retail deposit taker, and so answerable to thousands of customers and potentially – albeit via the regulator – to millions of tax payers. Significant rights and privileges come from being listed and regulated, but equally significant constraints and responsibilities come with these advantages. The management of Northern Rock it would seem wanted to have their cake and eat it, trading like a hedge fund but relying on the public safety net made available to listed, deposit-taking banks. In my opinion The Economist got it wrong this week: Gobo Mr Applegarth should be on the cover. Not Mr. King.

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