The Credit Crisis: Ideas on What Went Wrong, and a Call for More Fundamental Analysis

Much has been written lately about banks' overreliance on mathematical models. However, the ongoing financial meltdown can also be at least partly attributed to the lack of attention paid to significant changes in fundamental data. What are the differences between fundamental and quantitative analysis, and is a fundamental approach more effective and less risky during periods of extreme market volatility?

Monday, April 06, 2009 , By Teresa Ho

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Fundamental analysis is the examination of the underlying forces that affect the well being of the economy, industry groups and companies. As with most analysis, the goal is to derive a forecast and profit from future price movements. At the company level, fundamental analysis may involve examination of financial data, management, business concepts and competition. At the industry level, there might be an examination of supply and demand forces for products offered. For the national economy, fundamental analysis might focus on economic data to assess present and future growth.

In contrast, quantitative analysis heavily relies on mathematical results to make investment decisions. A mathematical model is a formula, equation, group of equations or computational algorithm that attempts to explain different types of relationships. Most models are derived from statistical analysis of observed data sets and are characterized mathematically by a probability distribution that describes the likelihood of different outcomes. Like any other statistical analysis, there is always uncertainty in the answers provided by these models, and we call this uncertainty model risk.

Both of these approaches have their pros and cons, from either qualitative or quantitative perspectives. However, in my opinion, quantitative analysis should always base on good fundamental analysis, not vice versa. Just like we can't use modern machines to build a giant mansion if we don't have a good framework (or foundation) and if we don't know how different building materials work with each other, we can't build a super-powerful model without a solid understanding of fundamental/economic data and their implications. The combined strength of both approaches certainly provides an edge over either individual approach.

Peering at Subprime Through a Fundamental Lens

As we evaluate the crisis, it's important to remember that all of the major investment banks had numerous quantitative specialists on staff. Aside from having outstanding academic credentials, these quants had built a variety of sophisticated mathematical models. Given these facts, why didn't these elite mathematicians predict the crisis and save their employers from failure? And what did they miss?

Well, I believe that most quantitative practitioners did not pay close enough attention to changes in fundamental economic data. Just as significantly, they did not exercise proper discipline while building complex models based on questionable assumptions, and they ignored the dreadful effects of over-leverage.

If investment and risk management professionals had employed a more fundamental, analytical approach and had seriously examined the macroeconomic data and the micro firm-specific data, some risky products (e.g., exotic mortgages) would have never been invented and others would have received minimal support. The financial crisis may not have been averted altogether, but the damage would have at least been minimized.

If you look at the major milestones of the current crisis, you'll understand that there were indeed significant fundamental changes in the economy that should have served as warning signals for financial services firms that were paying attention.

In September 1999, Fannie Mae eased credit requirements to encourage banks to extend home mortgages to individuals whose credit was not good enough to qualify for conventional loans. This government-subsidized corporation was one of the first to take on significant risks in the new area of subprime lending.

At the time, during what was a rising economy, those credit-related risks did not seem to pose any threat. However, even at the beginning of this subprime mortgage trend, some market experts who placed emphasis on the value of fundamental data -- like Peter Wallison of the American Enterprise Institute - warned of the dangers posed by Fannie Mae and Freddie Mac. "If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry," Wallison cautioned.1 (That prediction, of course, would prove quite prescient years later, when the economy went south and the government had to come to the rescue of both Fannie Mae and Freddie Mac.)

Overall, between 1999 and 2006, the loosening of credit standards triggered about $2.78 trillion in subprime mortgage originations.2


Rate Cuts and Regulatory Inefficiencies

In 2000 and 2001, the Federal Reserve lowered the federal funds rate 11 consecutive times, from 6.5% (May 2000) to 1.75% (December 2001). By 2003, the average mortgage rate had fallen to 5.8%, the lowest since the Kennedy administration.

Unfortunately, this aggressive rate cutting also created an easy-credit environment that encouraged less-qualified homebuyers and investments in higher yielding subprime mortgages. In 2003 alone, for example, Fannie Mae and Freddie Mac purchased $81 billion in subprime securities.3

At the same time, the Federal Reserve failed to use its supervisory and regulatory authority over banks, mortgage underwriters and other lenders, who abandoned loan standards (e.g., employment history, income, down payments, credit rating, assets, property loan-to-value ratio and debt-servicing ability), emphasizing instead a lender's ability to securitize and repackage subprime loans.4

Consequently, a plethora of low-payment options -- such as adjustable-rate mortgages (ARMs), long-term loans (more than 30 yrs), interest-only loans (IOs) and no income, no assets (NINA) loans -- were invented to meet various demands of less qualified buyers. Essentially, this meant that a quick glance at an applicant's credit score was all that was really required for doling out loans.

All of these factors eventually contributed to a precipitous downturn. However, if the Federal Reserve had tightened its supervisory authority, if mortgage lenders had not been so careless with loans and if investment banks had paid closer attention to the fundamentals of underlying assets before issuing collateralized debt obligations, there would have been less demand for subprime mortgages and related securitized products, and they would have inflicted considerably less damage. As former federal reserve chairman Alan Greenspan acknowledged in his testimony before Congress on October 23, 2008, "Without the excess demand from securitizers, subprime mortgage originations -- undeniably the original source of crisis -- would have been far smaller and defaults, accordingly, far fewer."5

The Suspension of the Net Capital Rule and Falling Housing Prices

Things went from bad to worse in October 2004, when the Securities and Exchange Commission (SEC) effectively suspended the net capital rule for five large investment firms: Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns and Morgan Stanley. Freed from government-imposed limits on the debt they can assume, those investment banks levered up 20, 30 and even 40 to 1.6

Over-leverage was definitely the catalyst that brought those big firms to the brink of the failure. For example, Lehman Brothers had been aggressively scaling up its leverage ratio, from 24 to 1 in the first quarter of 2004 to 32 to 1 in the first quarter of 2008. Interestingly, in its 2008 annual report, Lehman still boasted of "having a culture of risk management at every level of the firm" -- a culture than enabled measurement of "quantifiable risks using methodologies and models based on tested assumptions.7" That risk management culture, however, could not prevent Lehman from filing for bankruptcy (the largest "Chapter 11" filing in the history of the US) on Sept. 15, 2008.

By October 31, 2008, the remaining four firms impacted by the net capital rule suspension were either bought out by other banks (Merrill Lynch, Bear Stearns and Morgan Stanley) or changed to commercial bank holding companies, subjecting themselves to leverage restrictions (Goldman Sachs).

During a recent interview, while discussing the causes of the crisis, renowned investor Warren Buffet cautioned against the risk of over-leverage. "There is no way a smart person can go broke except through borrowed money," he said. Apparently, however, government regulators and investment firms both ignored this important fundamental investment principle.10

In addition to being remembered as the year in which the net capital rule was suspended, 2004 also marked the beginning of a downward trend in the housing market. That year, the US homeownership rate actually hit an all-time high at 69.2%.11 However, in the second half of 2004, some fundamental changes started taking place, providing fair warning that the housing bubble would soon burst.

Most importantly, interest rates were no longer falling. In fact, the Fed has started nudging its key short-term fed funds rate higher in 2004. By the start of 2006, the fed funds rate was 4.25%, up from 1% in 2004 and on its way to 5.25% in June 2006.

By raising rates, the Fed was signaling that the days of easy money were gone. Moreover, this tightening action was also draining money out of the monetary system and making money less available -- economic trends that are not typically conducive to maintaining a housing bubble. Lamentably, however, people largely ignored these fundamental indicators and instead continued to believe in a long-lasting housing bubble.

Merit Financial: An Unheeded Example

In May 2006, Merit Financial Inc., a leading subprime lender, filed for bankruptcy. This should have provided Wall Street with an early warning sign about the looming subprime crisis. Instead, however, lenders moved ahead full speed with subprime originations. In fact, by the end of 2006, subprime loans accounted for 20% of the nation's mortgage lending and about 17% of home purchases.12

If banks had paid attention to the demise of their peer and had also started examining their own books, I don't think anyone would have had such great confidence in originating subprime mortgages -- or of securitizing those questionable assets within other structured instruments. It's even possible that some $600 billion in subprime mortgages (loans that began in late 2006) and nearly $2 trillion mortgage-related security issuances (issued in late 2006 and early 2006) could have been killed off before they were born.

Subsequent to Merit's bankruptcy filing, home sales continued to fall precipitously. By 2007, as the subprime industry began to collapse, there were a surge of foreclosures (twice as many as in 200613). Moreover, rising interest rates threatened to depress housing prices further, as problems in the subprime markets spread to the near-prime and prime mortgage markets.14

Year-to-year decreases in both US home sales and home prices further accelerated (rather than bottoming out), leading US treasury secretary Henry Paul to describe the housing downturn as "the most significant risk" to the American economy.15 Despite all of these facts, however, loan lenders, government agencies and investment firms seemed to remain asleep at the switch.

Contrary to acknowledging the great risks that existed, firms continued to invest heavily in mortgage-related securitization. Indeed, in 2007, there was a total issuance of $1.95 trillion in mortgage-related securities, including $1.24 billion in agency-MBS and $706 million in non-agency MBS.16

It wasn't until the second half of 2007 that we really started to see a proactive approach toward managing the crisis. In August 2007, we saw the first real evidence of a worldwide "credit crunch," as subprime mortgage-backed securities were discovered in portfolios of banks and hedge funds around the world -- from Societe Generale to Bank of China, from the US to Ireland. Many lenders suddenly woke up and stopped offering home equity loans and "stated income" loans, and the Federal Reserve injected about $100 billion into the money supply, enabling banks to borrow at a lower rate.

What Have Quants Been Missing?

By only focusing on complex mathematical models, pure quantitative practitioners forget important investment principles, including the need to exercise discipline and to build solid framework from which you can extract (and analyze) useful fundamental data.

As mentioned earlier, there were many economic indicators that should have warned of trouble ahead for the new securitized products. However, despite these warning signs, investment banks continued inventing exotic securitized products and analyzing risks based on computer simulations and questionable assumptions.

By the second quarter of 2007, 14.8% of all subprime loans were delinquent and 5.5% were in foreclosure.17 Unfortunately, many people on Wall Street did not pay enough attention to the impact of the wave of defaults that began earlier in the year, as interest rates started to creep up and buyers walked away from the real estate game.

Everything might have been different, however, had banks paid more attention to the bottom tranches (also known as high-risk equity tranches) of the default simulations they ran. During the crisis, banks often focused first or second tranches of these simulations (in which the potential for default seemed minimal) instead of the bottom tranches.

But what would the simulation results have looked like if quants had adjusted their model assumptions, relying less on past experiences and more on forward-looking assumptions based on the most current fundamental economic data? Well, I believe that the default rates for even first tranche of simulations would have looked much less attractive.

Winning Strategies in 2008

In 2008, 10,000 hedge funds with more than $1.7 trillion in assets had a very tough year.

Worried investors pulled their money out of funds to the tune of some $31 billion through last September.18 Moreover, September of 2008 was one of the worst months ever hedge funds performance, and funds that relied heavily on complex mathematical models (to explore market inefficiencies related to default and recovery issues) were hit particularly hard.

Convertible arbitrage funds and distressed securities funds, which rely heavily on mathematic models to make investment decisions, were among the biggest losers (see table, below).

In contrast, as shown in the table below, four out of the top five performing funds in 2008 used a hybrid investment strategy -- i.e., they used elements of both fundamental and quantitative analysis with a heavier emphasis on fundamental data.

If we dig deeper into the backgrounds of the top hedge fund performers, the following interesting facts stand out:

  • Clive Capital, the top-performing fund, specializes in trading fundamental, discretionary, diversified, commodity-intensive portfolios, according to its Web site.
  • London-based Brevan Howard, one of Europe's biggest hedge fund groups with about $27 billion in total assets, chases macroeconomic trends. Ian Plenderleith, the chairman of BH Macro Ltd, a closed-end fund that invests exclusively in the Brevan Howard Master Fund, says that Brevan Howard's macro approach "based on substantial fundamental economic analysis."19
  • BlueCrest AllBlue, the manager of Bluetrend Fund, attributed its success to a blend of relative value and macro strategies.
  • The long and short positions of Paulson Funds (which recorded an $18% upswing in net-of-fees returns from January through October 2008) are based on company fundamentals rather than short-term market movements, according to Paulson & Co. president John Paulson.20

The performance of the Paulson Funds is a success story that demonstrates the importance of fundamental analysis in investment decisions. When testifying in front of the US House of Representatives Committee on Oversight and Government Reform on Nov 13, 2008, Paulson said that, starting in 2005, his firm became very concerned about weak credit underwriting standards, excessive leverage among financial institutions and a fundamental mispricing of credit risk.

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