Kevin T. Ponton

How did we get into this mess in barely six months?

As I write this column, Ambac has just lost its triple-A rating and MBIA is under review for a similar downgrade, possibly within the week. By the time you read this, other equally portentous events-positive and negative-will have occurred or be imminent.

It is important that we understand what happened. Even more important, we require knowledge to ensure that we can effectively deal with a similar crisis, should one arise in the future-before it consumes us as this one has. We have to recognize the subtle signs of virulence in seemingly innocuous assumptions and behaviors.

The need for such insight should be apparent: Last summer, a problem with subprime mortgages rankled some investors and a few Wall Street CEOs; today, the insured credit ratings of roughly 50 percent of all recent hospital bond issues are at risk of downgrade; and the two events are directly linked. And that link, like many others, was not evident last summer. The subtle connections only slowly revealed themselves during the intervening time, surprising virtually everyone up to and including the chairman of the Federal Reserve.

The growing awareness of the situation is reflected in the writings of industry experts during this time. I have assembled below, as examples, some articles written over the past year by a range of talents, including bloggers and a Federal Reserve Bank CEO. These articles should be read in their entirety, because what I have included here is limited-in the interest of space-to just small pieces that require the context of the full article to be fully understood.

March 23, 2007. "Credit Market Innovations and their Implications"-speech by New York Federal Reserve Bank CEO Timothy Geithner:

The dramatic growth in the volume of over-the-counter derivatives and the growth in the number and size of leveraged funds inevitably complicate the resolution of the failure of a large financial institution that is active in these markets. The sheer number of financial contracts that would have to be unraveled in the context of a default, the challenge that a former colleague of mine likes to refer to as "unscrambling the eggs," could exacerbate and prolong uncertainty, and complicate the process of resolution....

We cannot turn back the clock on innovation or reverse the increase in complexity around risk management. We do not have the capacity to monitor or control concentrations of leverage or risk outside the banking system. We cannot identify the likely sources of future stress to the system, and act preemptively to diffuse them.

The most productive focus of policy attention has to be on improving the shock absorbers in the core of the financial system, in terms of capital and liquidity relative to risk and the robustness of the infrastructure.

Nov. 15, 2007. "Public Schools Funds Hit by SIV Debts Hidden in Investment Pools"-article by David Evans:

Now, local investment pool managers…, once lured by the big returns from hard-to-comprehend SIVs, are going back to the basics of investing: Do your own research. Remember that higher returns bring more risks and top credit ratings can be misleading.

State-run investment pools should work together to fund independent analysis, says John Coffee, a securities law professor at Columbia Law School in New York who testified before the U.S. Congress in September 2007 about debt ratings.

"If you can't understand it and it's not transparent, then you shouldn't buy it," Coffee says. "The typical public investor simply doesn't have in-house capacity to do its own securities analysis. Structured finance is inherently opaque."Until municipal fund managers learn to steer clear of traps like CDOs and SIVs, taxpayers' money will be at risk-and it's not likely anyone will tell them.

Dec. 28, 2007. "Explaining CDOs, Over-collateralization Edition"-blog by Felix Salmon:

How exactly did ratings agencies get away with giving CDOs AAA ratings even though they were filled with near junk assets?

The answer is that through the alchemy of overcollateralization, just about any old base metal can be turned into gold.

It's a relatively intuitive concept, actually: it's a bit like what happens when tons of flowers are turned into a single bottle of perfume, or when rotten grapes become fine dessert wine. If you have a lot of something mediocre, you can often transform it into something much more desirable.

[Salmon then proceeds to explain overcollateralization brilliantly.]

Jan. 17, 2008. "Mohammed El-Erian: A Backhanded Indictment of Central Banks"-article by Yves Smith:

El-Erian gives a five point program. Two items are revealing:

First, they need to improve their understanding of the new financial landscape.... Third, they need to improve, directly or indirectly, scrutiny of financial activities that have migrated outside their formal jurisdiction.

While undeniably accurate, the fact that these recommendations are on his list is an appalling indictment of the job central bankers are doing. The Fed, for instance, did not do its own homework and was unduly influenced by Brave New World views of investment banks and commercial banks merrily reaping current profits with little thought as to the long-term consequences of their moves (and why should they be? They don't affect this year's bonus).

For instance, the savvy and straight-shooting New York Fed President Timothy Geithner gave a speech, "Credit Market Innovations and Their Implications," last March that looked unduly cheerful even at the time.

Jan. 22, 2008. "Ambac, MBIA Lust for CDO Returns Undercut AAA Success"-article by Christine Richard:

For years, they earned some of the highest profit margins in any industry-by writing coverage for securities sold by states and cities to build roads, schools and firehouses....

The good times are over, and the culprit isn't municipal bonds; it's subprime debt, a market the insurers waded into in pursuit of even greater profits. Some of the biggest bond insurers are facing potential claims that may deplete their capital.

Jan. 23, 2008. "Citigroup, Merrill Hide Counter-parties and Pain"-article by Jonathan Weil:

Citigroup Inc., which wrote down its subprime-mortgage holdings by $18.1 billion last quarter, might look like it did a kitchen-sink kind of cleanup. That is until you see the $10.5 billion of  "hedged exposures" on Citigroup's Jan.15 fourth-quarter financial release.

The exposures are collateralized debt obligations, or CDOs, tied to subprime mortgages, while the hedges are side contracts designed to protect Citigroup against losses. The problem for investors: Citigroup didn't disclose which companies are on the other side of those hedges, or how much the hedged CDOs have declined in value, or how much money each counterparty is guaranteeing.

Those are facts investors ought to know....

So far, Citigroup is refusing to identify any of its counterparties. And, for the most part, so are just about all the other major banks.

It's becoming clear that the present financial crisis resulted from a combination of imprudent risk-taking, lack of disclosure, mathematical mumbo jumbo, sloppy statistics, and plain old greed that has been growing for at least the past decade. It won't be easy to fix the mess: The eggs can't be unscrambled. But we need to thoroughly understand what happened before we resume business as usual.

Kevin T. Ponton is senior managing analyst, investment management department, The Dreyfus Corporation, New York (

Publication Date: Saturday, March 01, 2008

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