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Criticism of banks is rampant. Lawsuits are proliferating and banks are settling for large sums. Mainstream media, blogs of all kinds, and the Occupy movement all see banks as the culprits in our financial crisis. Such criticism is too narrow and shows a misunderstanding of how our financial system actually works.
The institutional investor community has received little criticism in the last three years and yet it was a necessary participant, the sine qua non, in the creation of this crisis. This drama could not have happened without the active participation of these investors. It is appropriate that their role be examined as we try to better understand our current crisis.
Institutional investors were essential players in this financial crisis in three separate ways: as fixed income investors they provided the necessary demand for subprime CDO securities; in their effort to gather assets and fees cheaply they competed to be managers of subprime CDOs; and through their role as our economy’s biggest equity investors, they were complicit in the development of aggressive banking institutions.
Bank portfolios, insurance companies, governmental organisations, asset managers, hedge funds, etc., were investing heavily in CDOs, mortgage backed securities, credit default swaps and anything else that offered higher yield. To satisfy this desire for yield, investment banks engage with investors to develop new products through an iterative process of feedback and refinement. New products are not created unless the banks are confident of investor demand. In the case of subprime securitizations, investment banks could never have created so many deals so quickly without genuine interest from investors. Put simply: institutional investor demand was as responsible as the banking process for this flawed product pipeline. Had investors not been buying these products, the origination machine would have come to a halt.
The slick investment bankers did not hoodwink these professional investors. They were not lured, they were not forced, and they were not conned, into buying these products. They bought them knowingly and willingly, supposedly after conducting their own due diligence. The marketing packages for these securities contained mind numbing disclaimers and risk warnings; they were replete with comprehensive pool statistics including FICO scores, WARF scores, delinquencies, geographic data, originator and servicer data, and on and on. This data should have been rigorously examined. If it was lacking, or suspect, the securities should not have been bought.
The lawsuits that have been settled against a number of banks have alleged malpractice in essentially two areas: first, pooled mortgages and securities did not meet the stated underwriting criteria and second, once these mortgages went into default subsequent servicing of those mortgages was faulty. The second claim has merit; the first does not. Bad servicing of delinquent mortgages is best characterised by the practice of ‘robosigning’ and the banks should be sued for such practices.
The securitization of mortgages that did not meet stated underwriting criteria is a different issue. If this problem existed, it existed before the loans were repackaged. As such, it is a problem that should have been caught during the due diligence process. That institutional investors are suing banks on this issue indicates that they were overly reliant on stated claims and not reliant enough on their own careful study. A meaningful, random sampling of documents and files from the various pools of loans should have raised this as a problem before an investment was ever made.
It may also be that these institutional investors were overly dependent on the rating agencies in the process and so, in effect, outsourced the necessary due diligence work to them. Either way, these investors are not blameless, and they are not victims.
These big money managers are sophisticated investors. Their ranks are peopled with well-schooled MBAs and rigorously trained CFAs. They had ample expertise in-house to conduct their own independent due diligence by analysing the available data and randomly verifying loan files before investing. Either they did the analysis and were wrong or they took the lazy approach and relied on the bankers and the rating agencies to do their work. If they were wrong it questions their competence; if they overly relied on the work of others it questions their fiduciary integrity. We pay them to be independent and competent when we let them manage our money. It seems that in the case of subprime CDOs they were neither.
The asset managers who selected the assets for these CDOs deserve additional blame. Purported experts in the field of complex credit and structured investment management, they were paid handsome fees for their expertise yet they made the same asset quality and due diligence mistakes.
Taken together these failures amount to a significant indictment of our professional investor community. To lose money when markets turn south is one thing; to invest in complex, high-risk securities, and miss the salient points of analysis, or to rely on others for that analysis, is worse.
The subprime crisis highlights just a part of their culpability. These problems were largely located in fixed income portfolios and were accumulating over relatively few years. There is a bigger deep-seated problem in their equity portfolios that directly contributed to the conditions that led to this crisis.
For years, these same institutional investors were buying shares of Countrywide, Lehman, Bear, Washington Mutual, Merrill, Morgan Stanley, Goldman and most other companies involved in this business. There was little protest from these investors when the markets were soaring and business at the banks was booming. They offered little protest as compensation on Wall Street soared or as the leverage ratios of the investment banks rose to dangerous levels. There was little protest as products and derivatives grew ever more complex and arcane. Through their ownership, their investment dollars and their lack of meaningful criticism, these institutional investors were, collectively, the great enablers of the banks and yet they receive precious little of the blame themselves.
These large money managers, our all important shareholder class, owned the lenders, the structurers, and they even owned other investment companies as the financial excesses proliferated. This complicit ownership expressly approved the aggressive developments that were taking place in the banking industry for years. They failed as fixed income investors and they failed as equity owners. It’s time they were held accountable for their complicity.
If our economy is to continue relying on financial engineering and if such a significant portion of our collective wealth is to be generated from shareholder returns, we need to own up to the fact that our institutional investor class has not been very good at what they do. These fiduciaries need to take responsibility for their role in the sorry state of our economy. As owners of our economy they need to assume more active oversight of the businesses they own on our behalf. They need to intensify their efforts at due diligence in both their equity and fixed income businesses. A far greater level of shareholder activism will be welcome.
Occupy Wall Street, the media, the lawyers, and the general public need to face up to this fact and hold our investor class accountable. Without the enabling dollars of our institutional investors and their general ‘see no evil’ approach, the financial sector could not have run amok in the way it did. Until we face up to this we will not make real progress fixing our financial system.
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