Think Twice Finance

The Subprime Mortgage Crisis, Part 5: The Birth of the “Quants.”

There are two kinds of banking “innovation.” First, the ones that make real money. These are hidden from public view or more often subtly described as one thing when in fact they are another. Banks have terrific problems protecting their genuine innovations. The buying and selling of banking assets is necessarily very public, and so the secret to profitability is disguising the creative process by which cheap purchased assets are transformed into expensive assets. Such innovations are necessary to bank profitability in the 21st Century world of cutthoat competition among banks. Banks can survive without real innovation only if governments subsidize them.

The second kind is the publicized innovation. These are the innovations you read about in the Wall Street Journal. There are several reasons a bank might produce this kind of innovation. The best reason is to alter other banks’ trading practices by encouraging the innovation to come into common use in order to exploit a hidden innovation that takes advantage of the change. That’s what we did with interest rate swaps. Sneaky, but it produces trading profits from the hidden innovation and a consumer surplus from the publicized innovation. Good for your bank. Good for your customers.

A second, not so good, reason is that regulators and banks sometimes strike a creative posture for public consumption. This is how the Mortgage Conduit and its financial kin came to be. It camouflaged an older scam. An obvious scam perpetrated on stockholders and taxpayers for over 50 years was finally grudgingly acknowledged by bank regulators. This scam was commercial paper fully backed by a bank letter of credit.

The commercial paper “revolution” was part of the much-publicized process of disintermediation, the process by which investors directly purchase the liabilities of firms without the “mediation” of a bank loan passed through to investors as a bank deposit. The scam was that stockholders and the public more generally saw a risky loan moving off the bank’s balance sheet, reducing loan assets and, it appeared, the riskiness of the bank. It was replaced by a seemingly harmless letter, saying that the bank would pay off the commercial paper holder if the issuer couldn’t.

That this is a scam becomes obvious if one asks under what circumstances the bank would lose money with the loan and with the letter. The obvious answer is that a defaulting customer will cost the bank the same amount of money in both cases. So the sole purpose of the commercial paper was to hide the risks the bank was taking from the public. After 20 years or so of this, the regulators got around to fully pricing the risk associated with these standby letters of credit.

Now it was time for a public, phony innovation. Banks wished to invent something else that would once again hide the now exposed risk of commerical paper. How could the regulators and banks convince the public that they had cleaned up their act, without actually cleaning up their act? They needed imagination. They needed creativity that the public could see but could not understand. And A new motive for the second kind of innovation, the publicly promoted kind, was created. Innovators of the real kind hide in the closet and become cult figures, appreciated only by other bankers.

The public innovators bask in the sunlight of publicity. They render the ugly obsure. Everyone senses there’s something wrong their creations, but nobody can quite figure out what it is. The name “Quant” was coined for this kind of person and their creations hastened us toward the subprime mortgage crisis.