Truth and Lies about the Financial Crisis

Because Hedge Funds' management are opaque, because they are located in Tax Havens, because the bonuses of their top managers are way above that of Goldman Sach's heads, they are regularly criticized by politicians, who perceived them as a threat to the financial stabilization [1]; in 1998, one of the biggest Hedge Fund that ever existed, LTCM ("Long Term Capital Management"), was about to collapse because of the Russian Crisis. It was saved thanks to William McDonough, president of the New-York Federal Reserve back at the time, who convinced American and European major banks to contribute to a 3,625 billion dollars bailout; in fact, with over 4,5 billion dollars equity and 124 billion dollars debt, its collapse would have been a disaster for the Global Financial System. It happened that the management of the Fund was a failure, so the Hedge Fund Industry in general brought many suspicion with the current crisis; however, things are quite different now. Let's recall why:

• Were Hedge Funds responsible for the Oil Soar in 2008? NO
  

 
When oil soared till mid-2008, many said hedge funds were speculating on a continuous rise with a 200 $ target for the barrel. But the rise of oil was led by simple supply & demand criteria, and the Hedge Funds had nothing to do with it.
The Graph below shows the part of non-commercial positions in long-term forward contracts in percentage of total contracts, ie speculative positions; as one can see, those speculative parts didn't play a key role..

This is a touchy part that deserves a clear explanation; when American banks started to lend money to individuals who didn't meet underwriting guidelines, they didn't keep these loans in their balance sheet, using a sophisticated financial technique called securitization: described simply, a bank create a pool of the mortgages embedded in its balance sheet and produce a financial security (called ABS, "asset-backed security")  which is in turn sold to investors, and freely negotiated on capital markets. The graph below illustrates the way securitization works:

Once those mortgages were packaged in MBS (for "Mortgage-Backed Securities"), they were traded on capital markets, either directly or through tranches of CDO (for "collateralized-debt obligations"); those products were supposed to offer a very interesting risk-reward profile, so many investors and banks buy those products throughout the World, and consequently regional banks in Germany, Scandinavia turned out to have subprime mortgages in their balance sheets; they were exposed to the US Real Estate market.

The conclusion is that banks' balance sheets and assets are so much intertwined that flaws in securities built on American Mortgages impacted banks in the entire World; an interesting thing to underline is that bankers faced fierce criticism for creating sophisticated derivatives products, but no one ever thought of asking to treasurers in smaller banks and financial institutions why they bought those complicated products.
As a matter of fact, the issue with the subprime crisis was that no one was fully aware of where lied the risks, no that there was too much risk.... the difference is important.

Glorious speculator Warren Buffet once expressed a curious opinion on derivatives products that he called. "weapons of mass destruction"[2]
In fact, derivative products were first created 30 years ago; here is a summary of the financial crises that occured since 1980, excluding the October 1987 Krach that wasn't followed by an economic crisis:

Some pointed at the Rating Agencies (Moody's, S&P, Fitch) for they role in the crisis; but not enough, to my mind... and even if more regulation is being discussed at the time, one could wander if strong decisions will be taken in the end.
A Rating Agency assesses the credit worthiness of a firm which issues bonds; this credit worthiness is symbolized by letters, from AAA (the company has very little chance of defaulting) to C or D (the company has defaulted or is close to default); surprisingly, and though many banks fiercly compete with each others to get customers, rating agencies almost form a monopoly: only three major rating agencies exist, two of them acting as leaders on the market (Fitch is a little less active).

The Rating Agencies not only rated debts issued by companies, but also the famous Asset Backed Securities, Mortgage Backed Securtities and CDOs discussed above; many of those products got a very good grade, mostly AAA, though it appeared that the risks embedded in those products were largely undervalued.

The most striking example of Rating Agencies' failures is a credit-derivative product that was created in 2006 BY ABN Amro, called CPDO (for "Constant Proportion Debt Obligation"); the product, structured as a Note, aims at delivering a Libor + 200 bps coupon and paying principal back at maturity, with a AAA/Aaa Rating (please see also CPDOs).

These products faced scepticism [3], and they turned out to be a catastrophic investment because of the credit crisis and spreads widenings. Obviously the aim is not to criticize Rating Agencies for this (though their CDPO ratingmodel was highly questionnable), but some points have to be underlined:

• Many banks faced huge difficulties in running a model that could provide the Note holders with the desired coupon along with the desired rating.
  
• When banks structured their models to price CPDOs, they had to renounce the Libor + 200 bps coupon initially marketed by Standard & Poors and ABN Amro to only propose a Libor + 100 bps coupon contract.
• And last, it appeared that the very first CDPO structurer in ABN Amro who designed the product used to work for Standard & Poors before... a transfer that resembles collusion.