Robert Rubin Disappoints Me

A front-page article in today’s Wall Street Journal talked about Robert Rubin’s role ($) during the Citigroup turmoil. From the article:

Mr. Rubin said it is a company’s risk-management executives who are responsible for avoiding problems like the ones Citigroup faces. “The board can’t run the risk book of a company,” he said. “The board as a whole is not going to have a granular knowledge” of operations.

Still, Mr. Rubin was deeply involved in a decision in late 2004 and early 2005 to take on more risk to boost flagging profit growth, according to people familiar with the discussions. They say he would comment that Citigroup’s competitors were taking more risks, leading to higher profits. Colleagues deferred to him, as the only board member with experience as a trader or risk manager. “I knew what a CDO was,” Mr. Rubin said, referring to collateralized debt obligations, instruments tied to mortgages and other debt that led to many of Citigroup’s losses.

Mr. Rubin said the decision to increase risk followed a presentation to the board by a consultant who said the bank had committed less of the capital on its balance sheet, on a risk-adjusted basis, than competitors. “It gave room to do more, assuming you’re doing intelligent risk-reward decisions,” Mr. Rubin said. He said success would have been based on having “the right people, the right oversight, the right technology.”

The decision has been blamed in part for Citigroup’s problems, including the growth of its CDO holdings amid signs the mortgage market was unraveling. Mr. Rubin doubts that’s true. “It was not an inflection point,” he said, but “I just don’t know what would have happened” if the decision had been different.

I’d like to hear an executive say, “You know what, we messed up! We packaged crappy mortgages together and sold them as safe investments. For some reason we forgot that you can’t grant mortgages to people with poor credit and little ability to pay them back and expect good things to happen. We messed up bad!”

Instead, we get guys like Rubin saying stuff like, “I just don’t know what would have happened had we done things differently.” What the heck?

This is the real kicker (emphasis mine):

Mr. Rubin said he believed in 2004 and ’05 that while a cyclical downturn such as the 1994 Mexican devaluation or 1997 Asian financial crisis was possible, the losses the bank might suffer wouldn’t come close to wiping out the profits made during the good times.

In the current crisis, “what came together was not only a cyclical undervaluing of risk [but also] a housing bubble, and triple-A ratings were misguided,” he said. “There was virtually nobody who saw that low-probability event as a possibility.”

Maybe Mr. Rubin should go back to stats class and learn the definition of “low-probability.” When you bundle together lots of subprime mortgages, there’s a high probability that they will default. That’s why they are called “subprime mortgages.” I just don’t see how someone with Mr. Rubin’s intelligence can say something like this.

This is just another case where greed trumped “doing the right thing.” And now we have all these executives saying stuff like, “I don’t know what we could have done differently?” Yeah, right…

9 thoughts on “Robert Rubin Disappoints Me”

  1. “When you bundle together lots of sub-prime mortgages, there’s a high probability that they will default. ”
    Actually they used probability theory, they just made one wrong assumption. Their thought was that while the probability of each default is high, the probability of multiple simultaneous defaults was low. According to the probability theory, you determine the probability of multiple independent(!) events occurring simultaneously by multiplying individual probabilities. They thought that if the probability of one default is 20%, the probability of two defaults in a bundle is .2*.2=.04 or only 4%, so the interest on other mortgages will compensate for defaults. Add more mortgages with different risk – and the bundles often included both sub-prime and prime mortgages – and while the risk of at least one default is high, the risk of multiple defaults is low. In theory.

    Their problem with this logic was that it only works when each of the events is independent. But under certain conditions – falling real estate market, resetting interest rates – multiple defaults are likely to occur simultaneously. The defaults cause foreclosure that causes further decline in prices that causes more defaults.

    Another problem, not related with the model was the SEC decision of 2006 to apply mark-to-market rule to CDOs. This caused greatly inflated value of CDOs (and hence banks’ assets) during good times, but it caused the decline in market value of CDOs during bad times. As the value of CDOs declined – often to the point well below the potential value of profits generated by the majority of mortgages that still worked – so did the total value of banks’ assets (on paper). Since mark-to-market requires banks to put more money in reserve to compensate for the losses in assets’ values, the fear of future losses caused banks to sell CDOs causing further decline in their value even if they’d have preferred to keep them and collect interest on still-working mortgages. As a result, CDOs are now selling at pennies on a dollar even though the vast majorities of mortgages don’t default. Remember, most CDOs don’t contain just sub-prime, there are prime mortgages there as well, but as nobody can trust AAA rating of these securities, all of them are selling for rock-bottom prices. A bank may have a lot of cash, but it has to keep it in reserve because it has to keep certain ratio of assets to loans. It also needs to report declines in resale value of CDOs as “loss” every quarter causing bad earnings reports and decline in confidence.

    Also, there are credit default swaps which act as “insurance” only with no requirement for insurer’s having adequate capital to cover losses. Also, anybody can buy credit default swaps on assets held by any bank so it’s a little like 10 people being able to buy insurance on your house. These 10 people then would profit if something happens to this house, but without fear for the loss of the house. So when a lot of people buy credit default swaps against mortgage-backed securities held by, for example, Citibank, the value of mortgage-backed securities drops as well. This gives lots of ammunition for “bear attacks” on bank stocks – short, buy a lot of default swaps, continue shorting. Something facilitated by another “brilliant” SEC decision made in 2007 – elimination of the uptick rule. Of course, when they try to collect, the insurer may not have the money, so this would cause problems for insurers as well.

  2. Equitel, he made a stupid investment decision. The type most of us can make – you invest into a stock or commertial paper that goes up. You think it’ll go up further. Sure he should’ve been smart enough to know better. How many of us were smart enough to sell our stocks last year? We all knew that real estate values start going down. We all knew that there are problems with defaults. It’s easier to look back and say “oh, it was stupid” then to do the smart thing. Now, he obviously had more information than we do, but he didn’t want to lose to his bank’s competitors. It’s like Buffet said in one of his intervies about the internet bubble: you look at your neighbors and they all make money in the stock market. If your neighbor is making a lot money and you (think you) are smarter than your neighbor, then you want to make money too. So everyone invests in the internet stocks ignoring the fact that these companies don’t make money…

    I have a friend who works for an investment research company. She is a mathematician and was involved in some of math models for these securities. I asked her how they could’ve thought that mortgage failures were independent events when once real estate prices start dropping defaults lead to more defaults. She said “well, now we know that they are correlated, but at the time everything pointed to them being independent…”.

    Of course as a CEO he should’ve known better, and if you make a stupid decision on the job, you should be accountable for it.

  3. Kitty’s comment is superb. The problem was that everyone kept repeating that real estate markets are largely regional and that national price drops are virtually impossible. In fact, I heard a talk by a UCLA economics professor who explained that housing prices are prone to volume cycles rather than price cycles – instead of prices going down, the number of houses sold declines without impacting prices dramatically. This was in 2006.

    Correlation is a bitch… 🙂

  4. i used to have a lot of respect for robert rubin.
    his unability to manage the risks at citi group indicates to me that he has a lot of short comings.
    i too feel disappointed by robert rubin.

  5. Not only is Rubin the guy who encouraged Citi to lever up, he is also the executive who called his Treasury Department friends to pressure the ratings agencies not to degrade Enron. He used the corporate jet his own personal car. It’s sad to watch Pandit get thrown to the wolves of Congress, while Rubin laughs from the White House’s economic advisory board. I’m not the biggest fan of Pandit, but at least he was reasonible for the mess and now he’s being paid $1 a year to clean up Rubin’s mess.

    By the way, anyone with a basic stats degree can understand that mortgage defaults are not independent. It’s naive and incorrect to assume that large banks don’t have multi varient stress test models, but Rubin just ignored the results.

    Citi Insider

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