On the financial crisis, from my time at Lehman and in China

It didn’t really hit me that this financial crisis was bad until I got an email from the president of ING Direct, where I have an online savings account, telling me not to panic.  I’m still digesting the news, the policies, the politics, and the implications, but in the meantime, I thought I’d share my perspective from the two places I’ve been which are relevant to this story:  the trading floor of Lehman Brothers, where I sold derivates several years ago to US corporations looking to manage currency risk from 2002 to 2006, and China, where I spent a year in Chengdu, China’s equivilant of middle America, before coming to Beijing where I am now a business strategy consultant for US multinationals.   The story I lay out below is based on my personal experience, and obviously misses a lot of pieces of this immensly complex puzzle. 
But from where I sit now and where I’ve sat, I see two fundamental reasons for why the financial world has unravelled:  (a) that banks and the financial markets are run by actual human beings, and (b) that Chinese people don’t have the financial protection that would allow them to feel comfortable spending their savings.  If I’m right, this mess may self-correct itself as talented financial managers leave the rubble of New York to help build up China’s consumer financial network — but before we get there, first here’s how we got here.
Disclaimer:  I haven’t worked at Lehman Brothers in several years, was never involved in management or oversight, and cannot in any way comment on the financial strength of that company.  In no way, shape or form should this Aabservation be seen as any sort of investment recommendation.

History is the story of people.  To understand what’s going on at the macro level, you have to understand the people at their most micro.  Before I even started at Lehman Brothers, the recruiters brought me, and the other college juniors who’d gotten internship offers, around the trading floor one day in March 2001.  We wore extremely carefully maintained black suits and thought that financial markets were run by some almighty, rationale Invisible Hand.  Lehman’s trading floor, which was across the street from the World Trade Center (until one beautiful day in September at the end of that summer), was littered with television monitors, half of which where showing CNBC or Bloomberg financial television, with the stock charts and tickers that we suit-clad college kids would have expected. 
The other half of the trading floor monitors showed NCAA March Madness basketball games.  Traders were watching both, and seemed to stop bidding on the price of GE stock whenever a college hoops player stepped up to the free throw line.  That was the first of many times over the next four years that I would see firsthand how human factors affect the world markets, be they summer Fridays or snowstorms. The markets, I would come to appreciate, are just made up of people like you and me.
And specifically ambitious people, who like to do better each year.  This is easy during periods of economic expansion, but tricky when the markets cool.  I worked at Lehman Brothers with US multinational corporations in foreign currency risk management, a market which had over time become more automated, more regulated, and more transparent — all difficult factors for we little currency salesfolk to work around. 
So to generate more revenue, specifically MORE than you did last year, you have a few choices.  You either charge more for the same trades (which is really hard due to increasing market efficiency), do more trades with the same clients (by building relationships through good pricing and service), do higher margin trades (i.e. more “exotic derivatives” and/or in emerging market currencies), or get more clients (usually by going to riskier and/or smaller companies).  Being a good ambitious young bankerling on the foreign currency sales desk at Lehman Brothers, I tried them all.
Doing higher margin trades was the most fun by far: it usually was a win-win for us and the client, and its quantitative challenge appealed to my inner geek.  The most profitable trades in my business were usually combinations of currency options that were tailored to match a company’s risk exposure and tolerance;  we might sell to a US company a form of currency insurance, for instance, so that our client’s Euro revenues were unprotected against a 5% depreciation of the Euro, but fully protected against a 10% depreciation.  Regulators, the nemesis of the ambitious bankerling, were keen to make sure that risk management didn’t get confused with currency speculation.  Their accounting regulations scared a lot of our clients off these more complex financial “products.”  Boo.
So we also went for riskier clients, companies that might very well be bankrupt in 5 years time.  (Little did we think that Lehman would beat them to it.)  To convince our friendly (and in retrospect, saintly) credit officers to give us more slack to trade with them, my colleagues on the trading floor and I built an Excel spreadsheet to estimate how much we should charge a company for entering into a three to five year currency contract.  We wanted to prove to aforementioned saintly credit officers that we were charging for these trades at least enough to cover the money that we might lose if our client went bankrupt, on a probability-weighted basis. That “probability,” which our spreadsheet turned directly into a specific $ figure, was actually a bunch of guesses (rigorous and highly-educated but still guesses) cobbled together by people (i.e. me) from multiple different traders and markets feeds, using statistical methods and standards that all ultimately require human judgment.  I think we made a very fair estimate, but there’s no magic to it.  The markets, any market, is a bunch of people making their best guess.  And putting their money (and/or someone else’s) where their mouth is.
5/1 ARMS
So now with a few bonuses to award that ambition and armed with 11 hours a day of experience in selling financial products, I decided it was time to start buying some.  Bummed that we missed the dot-com boom (and bust), my sister and I decided in early 2005 to buy an apartment in New York.  Low interest rates had kicked the city into a housing market frenzy — we’d show up at the end of two hour Open House on a Sunday afternoon to find that the apartment had already been sold.  Eventually though we found a great place in Brooklyn Heights at a price we thought was reasonable and affordable.  It was time to get a mortgage.
Mortgage lenders, driven no doubt by the same incentives I had as an ambitious bankerling, had relatively recently been pushing funky new mortage “products” like “5/1 ARMs” — Adjustable Rate Mortgages that would stay locked at the initial interest rate for 5 years, and then readjust every 1 year thereafter for the usual 30 year term.  The rate then was almost a full percentage point lower than a standard 30 year fixed rate mortgage.  Given that my sister and I weren’t even sure we’d have our Brooklyn Heights apartment for more than 5 years, we thought it made sense to pocket the interest rate difference now and worry about a potential pop in rates 5 years down the line.
Before we closed on it on July 21, 2005, the same morning, karmically, that China depegged its currency, I sat in on what might have been Lehman’s most prescient internal briefing.  A mortgage securities expert pointed out to us that 5/1 ARMs had exploded in use over the past few years.  If I recall correctly, he predicted that in two to three years time — which would have been 2007 and 2008 — a surge of these 5/1 Adjustable Rate Mortages would hit their 5 year “adjustment.”  If interest rates had risen in those intervening years, these homeowners, who’d used their houses as a cash pump, would find themselves cash strapped, unleashing a serious economic liquidity crisis.
“How could people be so stupid and shortsighted?” I thought to myself during his presentation, and rushed back home to our mortgage calculating Excel spreadsheet.  I wanted to prove that a 5/1 ARM was a stupid choice and that we should indeed pay up for the 30 year fixed rate mortgage.  We knew that the mortgage lender was probably making more money off us with the 5/1 ARM due to this “funky” product, and that if interest rates were high in 5 years time, we might have to sell our apartment into a weakening housing market.  We crunched through all kinds of scenarios and I deliberated with some of the world’s best interest rate traders at Lehman.
We went with the 5/1 ARM.  In the end, what the Excel didn’t capture, and what ultimately formed the basis of our decision, were the soft factors about where our own lives might go:  Allison now lives in Montreal with her Canadian husband and I somehow ended up on the other end of the planet here in Beijing.  And that mortgage calculator couldn’t capture that intangible magic and real estate strength of Brooklyn Heights, a landmarked neighborhood at the crux of Manhattan and Brooklyn positioned to capture both the flood of eager immigrants to New York City during the good times, and the flight of out-priced Manhattanites during the bad ones.
Over the past three years, we’ve saved thousands of dollars through the lower interest rate that the 5/1 ARM gave us.  But had things gone differently, that decision could have blown up in our faces.
There’s great debate on how dumb those “dumb homeowners” were, those over-levered borrowers, those people buying houses beyond their means assuming that things would always be turning up.  But I tend to think that those homeowners had the same drivers as  me and my sister, though perhaps with different assumptions about future risk, different cash flow profiles, and different chunks of real estate.  Like us, most probably made rationale financial incentives to borrow the way they did, preferred more sophisticated and possible expensive financial products because they better matched their risk tolerance and profile, and made decisions based on human factors, like marriage, that had nothing to do with interest rate charts at all.
In this soap opera so far, you’ve seen a market run by basetkball fans, ambitious bankerlings crafting sophisticated financial instruments so they can generate more revenue than they did the previous year, and homeowners who have made rationale decisions to buy those sophisticated financial instruments, based on personal factors and the right set of financial incentives.  But none of these alone explain why the financial markets have crashed.  The answer there lies in rice paddies and tenements in China, but before we get there we need to talk about a line that ties them all together — the US interest rate curve.
People bought so many houses, and at increasingly higher prices, in part because financing them was so cheap back then.  When mortgage rates are 6%, you can buy a $125,000 home by putting down $25,000 in cash (20%) and taking out a $100,000 mortgage for just $6,000 a year, or just $500 a month.  If rates were up at 9%, you have to shell out $750 a month — an extra $250 or 50% more.  When rates are high, it might make sense to rent, or buy a smaller place with a worse commute to work.  But at low rates, even speculative buying makes sense, because houses become an easy way to leverage your investment. (See “How leverage works” at the bottom if this sounds like mumbo jumbo.)
The Federal Reserve Bank (the “Fed”) isn’t stupid, and realized that the housing market was getting too hot.  So they did what the Fed does — they raised interest rates.  Or more specifically, they raised overnight interest, i.e. the interest rate that banks borrow money from for one day.  Theoretically, that should have caused mortgage rates to go up, so that homeowners who were happy to buy a place (or two or three) at 6% would hold off at 8% or 9%, cooling off housing demand and prices.
But mortgage rates didn’t really change.  Mortgages (even 5/1 ARMs) usually last for 30 years.  In part because not everyone keeps their mortgage for that long (as people move homes more often than that), they are roughly benchmarked against the interest rate 10 year US treasury bonds.  While the Fed was aggresively raising rates, the 10 year US interest rate didn’t change.  Below and one this site (http://mortgage-x.com/general/treasury.asp) is a picture of that which sends shivers down my spine.  The part on the left is what the Fed controls — short-term interest rates.  The part in the middle (120 months or 10 years) is what the mortgage rates are based on.  As you can see, while the Fed was raising overnight rates from 0.75% to 4.5%, the 10 year rates stayed put at around 4.5%.  In trader speak, the curve flattened, and at times, even inverted, which is odd since people usually have to get paid more to lend someone money for a longer (and thus riskier) time.
 Flattening Yield Curve
So what this chart shows is an impotent Fed.  From 2004 to 2006, try as it might, the Fed could not control the housing market, and the housing market during that period was the most crititcal source of financing for US consumers and the world.  The Fed is dramatically expanding its power now, as you can see everytime you open a newspaper.  But where did its power go in the first place?  Why did the yield curve flatten rather than rise?
One (of several) important reasons was China.  China has a lot of cash — over $1.8 trillion US dollars in foreign currency reserves.  When I was working in the foreign currency markets, we were really interested in where China was putting this money — which countries and currencies, which specific asset classes.  They won’t ever tell you numbers, by the way, but it’s mostly in dollars, despite the “basket” of currencies. 
The problem with China is that it’s so big, they just don’t have many choices.  There aren’t a lot of currencies out there — never mind securities — that they could buy enough of.  So they buy US dollars, and with these dollars, buy US government treasuries bills; as of this August, China already has about 10% of the US government’s $5 trillion in public debt.
With so much demand coming from China (and other sources), there was no reason for the US govenrment to pay out a higher interest rate on its debt.  So the 10 year treasury interest rate remained largely unchanged around 4.5%, despite the Fed’s best efforts to raise rates and cool the markets.  China’s surplus of US dollars helped flatten the yield curve.  This made housing mortgage rates low enough to attract way more home buying and house inflation than was sustainable — as is now woefully apparent.
So if the problem was China’s surplus US dollar reserves, the next question is:  why does China have so many bucks?
Since China opened up three decades ago, this country has exported its way to growth.  The US GDP is two-thirds consumption, and Americans’ appetite for buying stuff, cheap stuff, has helped pull the Chinese economy up at a double-digit rate for years.  You hear a lot about the trade deficit with China, and it is indeed impressive — $250 billion dollars a year of stuff moves in cargo ships and planes from the ports of the Middle Kingdom to the middle of America.  But don’t listen to the politicians:  we Americans are happy to have that trade gap;  I love buying cheap clothes and electronics and kitchen supplies too.
In part to keep competitive with Southeast Asia (if you want to see who are China’s export competitors, flip through the “Made in” tags on a clothing rack at The Gap one day), China has kept its currency from appreciating.  To do that, they have to go buy US dollars with Chinese Renminbi in the currency markets; US dollars, like apples, go up in “price” the more of them that are bought.  China has a potentially endless supply of Renminbi, since they print their own currency, and so they can keep printing Renminbi, buying US dollars, and then buying US treasuries all day.  Which is exactly what they’ve done.  That demand for US treasuries has kept housing prices down, as we’ve seen, and let US consumers take out home equity loans, which they can use to buy more stuff.  Stuff like Chinese exports.
It’s been a win-win, but neither country has thought this is sustainable.  China’s done a bunch of things to push growth out of the export sector recently;  for instance, they cancelled or reduced tax rebates that they had been giving for basic exports that use too many environmental resources without adding enough value.  I can’t go to a meeting with China’s Ministry of Commerce where they don’t talk about higher value added and service-sector growth.  There’s no doubt about it: China’s policymakers are trying their darndest to shift growth from exports to domestic demand.
But Chinese domestic demand won’t explode right away for the same reasons that my sister and I took out a 5/1 ARM to buy an apartment in Brooklyn:  people make choices based on rationale financial incentives to do so, that match their risk tolerance and profile, and are based on human factors.  And right now, all the incentives are lined up for Chinese people to save — not spend on stuff.
China has a very weak healthcare and pension system, very little life, property, casualty, agricultural, disaster or health insurance, and very few credit cards and student loans.  So if you want to send your (one) child to college, you have to save;  if you have to take care of (two) ageing parents, you have to save;  if you might one day get hit by a bus, you have to save;  if you want to retire eventually, you have to save;  if your relatives have diabetes, you have to save; if you want to buy a house, you have to save;  if you are one of China’s 800 million farmers and it might rain or drought or freeze next crop cycle, you definitely have to save.  With all this savings, money is just trapped here in China, under thin mattresses, in pink 100 Renminbi notes.
If China wants to boost domestic demand, they have to build a set of financial products, systems and protections that level out risks, so that ordinary people can spend more money without risking their well-being, and those of the ones that depend on them.  But until they can, neither Chinese companies nor US ones for that matter can rely exclusively on Chinese demand.  They still need US consumers to buy their stuff.  They still need the trade deficit.
So that’s how I think this crisis came about:  China’s lack of a social safety net means that domestic demand hasn’t been a good option for growth, and so the country has used exports to the US to drive expansion;  this has forced China to accumulate foreign exchange reserves that can only be spent on really liquid assets like US treasuries;  that demand has pushed down longer-dated interest rates despite the Fed’s best efforts to raise rates and cool the housing market;  low interest rates pushed up housing prices to unsustainable levels;  and the pressure to generate more sales encouraged bankers to develop sophisticated products that reallocated risk in unanticipated ways, which are suddenly all falling apart at once.
But now that the crisis is here, there’s one more element that you can’t overlook — the fact that it its resolution has fallen on the desks of a relatively small group of highly talented, but nevertheless human, people.   Back in 2002, I had the chance to speak to Dick Fuld, Lehman’s now-famous CEO, and asked him to what he attributed his success (yes, my brown-nosing instincts run deep). Dick replied in his deep gruff voice, “I always do what’s best for Mother” — i.e. for Lehman Brothers.  I see articles that show that he barely slept the last few months of Lehman’s fitful demise, and believe that at some point, he probably burned out. 
I would definitely believe that we hit a wall of human capability this September.  Wall Streeters had pulled one-to-many all-nighters, and could no longer make quick decisions.  It took time for Congress to even read through the bailout plan, never mind decide on it. 
And it will take time to get back on their feet.  Some financiers have lost their jobs, and their talent and experience is now backpacking around the Middle East;  others are in new jobs, and spending this most critical of times learning whether or not you need to dial 9 on their new office’s phone systems;  or perhaps these finance folk are operating from the same seat, but with different managers and new policies, terrified to put the word “Lehman” in an email for fear of SEC investigations;  maybe they are joining the flood of users of LinkedIn and updating their resumes, or checking their 401k to see how many thousands of dollars they’ve lost this week;  maybe they staying up at nights in bed with a laptop answering soul-searching questions like “Why do you want a Wharton MBA, and why now?”
So it’ll take some more coffee — Starbucks excluded Manhattan from its July store closures — and maybe a long weekend or three for the finance folks to settle in to their new trenches, digest everything, and come up with some awesome new ideas.  But I have hope.  Coffee is a wonder drug.
It’s odd to me, given the dynamic that I laid about above, that China hasn’t been more in the headlines during the bailout.  I have two hypotheses on why not:  first, that conversations are indeed going on between China and the US governments, but very, very secretly (does anyone think it’s odd that the main focus of the “Strategic Economic Dialogue” this upcoming December will be “energy and the environment” not “economics”?); and secondly, that Chinese sovereign wealth managers just don’t have the incentives, experience and staffing, never mind mandate, to quickly swoop in and buy US distressed assets.
In short, what has gone wrong, and what’s still wrong, is that there was had too much financial engineering talent in New York, and not enough in China.  So if there’s any silver lining in this financial cloud, I hope its this:  that talented financial and business folk, like you, will find your way to China to help build up this country’s financial markets, so that it can continue stable and sustainable domestic growth, mitigate the risks of weather and health and age and misfortune that plague its citizens, and rebalance the unsustainable global economy.  Tall order, but seriously, come to Beijing!  We can be financial hippies together.
Off to get some coffee,

How leverage works:  If you have $25,000 dollars and invest it in the market, for instance, if there’s a boom year and you make a 10% return, you earned $2,500.  Instead you can use that $25,000 as the 20% down payment on a $125,000 home, and take out a 6% mortgage for the remaining $100,000. Now, if the housing market also goes up 10% in a year, you get 10% on the whole $125,000 — not just your $25,000 cash investment — which is a whopping $12,500;  take out the 6% or $6,000 you had to pay in interest on your mortgage, and come out with $6,500… $4,000 more than you would have made on the same 10% return in the market.  That’s because you “leveraged” yourself 5:1 when you took out a mortage to buy an home 5x the value of your cash.  Had housing prices gone down 10%, though, you would have lost that $12,500 — which is a full HALF of your initial investment.  Ouch.


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