Most bankers know there’s a reason they buy their cashmere sweaters at Bergdorf’s, not the Dollar Store – the quality is a bit different. A bargain isn’t a bargain if you actually pay full price for an ill-made sweater of uncertain origin from a dubious locale. I suspect Jamie Dimon knows this shopping rule when it comes to sweaters – too bad he didn’t remember it when he picked up Bear Stearns and WaMu on what once seemed the cheap and that’s now costing tens of billions in enforcement actions. And, of course JPM isn’t the only huge bank that went to what it thought was the bargain basement. Bank of America flounced around for months in the glad rags it got when it bought Countrywide and Merrill Lynch. All of these “strategic” acquisitions have of course been unmitigated disasters. How could usually astute banks get this so very, very wrong?
Was it so impossible to foretell disaster in the bowels of the mortgage books? Countrywide’s top brass surely knew what was down below when they gently succumbed to BofA’s sweet-talk. And, of course, there were public data that should have sown fear in the formidable analytical backrooms of BofA, JPM, and the rest of the industry. The big-short players in Michael Lewis’ book saw this coming as did several astute hedge funds. I warned Sheila Bair at lunch in July of 2007 that the FDIC wasn’t sitting pretty, specifically warning her of deep risks at Countrywide and WaMu. I knew this partly because private mortgage insurers heard the train down the track even though they lacked the fortitude to get themselves out of the way of the barreling locomotive that then also ran them over.
Even if one didn’t get the depth of the mortgage debacle, Bear Stearns, WaMu, Countrywide, and – to a lesser extent – Merrill Lynch were widely known as damaged goods. Bear Stearns had a high-risk reputation spawned of its on-the-go trader culture that eschewed the white shoes with which Goldman Sachs routinely stepped over dirty parts of the business. WaMu had been on a precipitous buying binge in the 2000s and, worse still, decided as the subprime fervor swirled to abandon FHA and GSE business – too staid – to focus only on high-risk product. Even its own regulator – the OCC (not known to have spotted much of anything coming) knew Countrywide was trouble. That’s why the firm decamped and found a happy home at OTS – warning signal to say the least.
With all these alarms flashing, why did BofA and JPM still make acquisitions now costing them their reputations, as well as tens of billions of civil fines and continued exposure to criminal charges? More important still, what aspect of their culture is still embedded in large global banks? U.S. banks weren’t the only ones that thought they could spot a bargain – think Royal Bank of Scotland’s purchase of ABN-AMRO and be very, very afraid.
Was it one usual suspect, the self-interest that attends investment banks in let’s-make-a-deal mode? Bankers should know it’s buyer beware in these transactions and so have only themselves to blame. Indeed, many of them were on the sell side of these transactions even as they were duped on the buy side.
Instead, the real culprit is risk management that then – and all too often still – looks backward to model markets, not forward to sense danger. One can’t prove emerging risk with old data – I recall working strenuously to persuade the FRB in 2005 that S&P’s five-year retrospective “stress tests” for mortgages provided no insight into the new books of business only to be soundly rebuffed by platoons of quants. Think of all of the AAAs slapped on MBS structured into ever-dizzying indices backed by increasingly incomprehensible models to see how easy it is for markets as a whole along with their regulators to think all is right because a formula tells them so.
As Dan Tarullo said last week in a dense, but important talk on macroprudential standards, quantitative measurements are notoriously unreliable warning signs of asset bubbles because most of them start in new asset classes ignored by old macro measurements and/or result from new trends with wholly different risks. Thus, he wants lots of rules – too many, I think – and a focus on qualitative risk judgment – way right not just for regulators, but also for boards of directors and senior management. No matter how nicely all the formulas were made to balance in all of the risk models, mortgage finance was unraveling at a furious rate. Boards and senior management need to feel the goods, not just look at the price tag.