The creative use of leverage, layered options (derivatives) and other sophisticated math-driven applications led to an almost unlimited demand for this structured paper—and volumes grew into the hundreds of billions. Under these conditions, investment bankers were more than happy to originate, warehouse, trade and own these investments because of the huge fees associated with such activities, especially origination. The more sanguine in the market such as Goldman Sachs left the party early and avoided the financial havoc other major firms like Bear Sterns have experienced. Other investment bankers and hedge fund mavens chose to forget what every undergraduate business student knows—that high return and low risk do not go hand in hand.
Further, given the incentives and pressures institutional investors faced worldwide to perform and justify their lofty fees, such “high return/low risk” paper was sought in great volume. As the game became more profitable and global in scope, some even borrowed against the paper they held, which, in combination with increasingly complex derivatives, freed-up investors’ cash to demand even more CDOs. As part of this frenzy, Citigroup et al created and funded a further permutation called Structured Investment Vehicles “SIVs” as a basis to issue their own commercial paper and thus chase further profits. Citicorp’s subsequent inability to meet short-term obligations as the value of its supporting leveraged assets collapsed led to devastating hits to their balance sheet. The same ugly impact has been experienced by European banks including the previously venerable UBS.
Senior financial principals were, of course, happy to enhance their personal wealth but clearly had little idea of what could go wrong. It is sobering to note the all-too-obvious comment by Citigroup’s former Chairman Charles Prince as he announced billions in capital write-offs that “our risk models simply did not work.” And now, somewhat belatedly, former Fed Chairman Alan Greenspan is advising the financial community that “We will never have a perfect risk model” (3/16/08 Financial Times). We think it also fair to suggest that today’s extraordinarily talented quantitative analysts are so creative that even the world’s best central bankers and regulators do not have the capability to keep up with or even understand what has been going on with these “quants gone wild.”
