Chris Sabo, the Director of Risk Management at LMCG Investments, sits down with David Weeks, Chief
Investment Officer of our Relative Value Credit team, to recount his unique perspective on the financial
crisis ten years later. Click the icon above to hear their conversation. Below are the highlights.
CS: Before we get into your experience during the 2008 crisis I wanted to set the stage a bit. Can you
describe how you got started and what drew you to the structured credit space?
DW: Sure. I started my career out of college in the equity options market on the American Stock
Exchange and then as a market maker on the Philadelphia Stock Exchange. I looked to make a career
shift which brought me to Moody’s and oddly enough it was another crisis situation that got me to
structured credit and eventually to the CLO market with Merrill Lynch. What I really liked was that structured credit and CLOs had overlooked embedded optionality and I could appreciate that, given my 10 years trading equity options.
CS: Given your experience at both Moody’s and Merrill Lynch, were there any big cultural differences or similarities that you noticed?
DW: The similarities and reason why I liked both, is that I always liked looking at problems by assessing
risk. I was exposed to a lot of new products at Moody’s which allowed me to think about what types of
risks should be incorporated into the analysis, and the same is true from a trading perspective ‐ you
have to understand the downside volatility in order to manage money.
CS: Shifting to your time on the prop desk, can you describe your role and maybe give a little detail on
how the desk is structured?
DW: At a prop desk, you are a client of other dealers, so you see a broader range of trading opportunities and you are not forced to make a market in something unless you want to go after that opportunity. I worked with other group members to build analytics that would give us an advantage in trading in those markets. The goal was to build positions that make money regardless of the market environment, because you are only going to get paid and stay in that seat if you produce.
CS: Can you talk about some of the results from that analysis or touch upon some experiences that
made you realize that something was really off here?
DW: It was an environment where housing prices were rising significantly and outpacing income growth.
That was an alarm bell. Given the stories I was hearing about underwriting, it was easy to see that there
could be problems in housing. But, at that point, I was not really seeing clearly that these problems
would be of the magnitude they were and have the implications to bring on systemic risk that would
ultimately bring down the financial system as we knew it.
CS: Thinking back to the models that your team was using on the desk, was there anything that your
DW: Mortgage analytics really didn’t build in the effect of house price movements on the performance of
underlying borrowers. As house prices declined, borrowers actually had the incentive to turn in the keys
to the house and walk away from their loan, which was more than the house was worth.
So we began to build our own models and what we could see was that the existing models were really
broken. Historical performance really wasn’t the driver of performance during the crisis.
CS: So let’s dive in a bit to how you applied this approach. Can you provide some examples of the
types of trades and why your trading strategy succeeded regardless of the market direction?
DW: This strategy was implemented in a way to give us positive convexity to market movements so we
are able to succeed when markets moved dramatically. This was an environment where the markets
were very volatile, so we performed well on the way down, but we performed even better by building
positions based on our analytics that were fundamentally cheap and had huge upside to a recovery.
CS: So, this seems to be a logical approach, but why do you think others with deep knowledge of
structured credit didn’t position this way?
DW: I think in many ways, not having any past experience with mortgage product and previous dips in
the market was an advantage to us, as we had an open mind in terms of how we built tools. The experts
and mortgage professionals prior to the crisis had previous experience buying the dips. Many were not
thinking out of the box. Another difference is that many got involved in the chase for yield in the
corporate space and were trying to do similar trades in RMBS. In reality, the diversification in a
corporate loan pool was much larger than the diversification of a mortgage loan pool. So there was a
big mispricing in the market around the correlation of default in RMBS and that was a flaw in the rating
CS: I know this may not be the most pleasant part of the discussion, but thinking back to the worst of
times, were there days that you were fearful to head into the office? How chaotic was it?
DW: Being inside a firm, trading the products that were bringing down many dealers, including Merrill
Lynch, was an interesting perspective. The chaos in the market was just unbelievable. It felt that the
financial system was going over the edge of a cliff. That was a time where I felt that the problems were
not just personal problems. The whole society was being affected in a dramatic way.
CS: I want to take a couple minutes to talk about some of the lessons and take‐aways from the event.
Looking back, and thinking a bit about greed, do you think that greed led to poor risk management?
DW: You can look at it as greed – the desire to make those fees and increase quarterly earnings – led to
a path where the focus was revenue and building out a risk infrastructure to understand the magnitude
of the risk that was being taken on really didn’t keep pace with the growth of the business.
CS: So given this perspective, are there practices that you think about today that you were thinking
about 10 years ago?
DW: My philosophy goes back to my days trading equity options as a market maker where I was taught
that building positive convexity was a great way to profit when there are tough times hitting Wall Street
so you can stay in the business. Our approach in the prop group was to use our analytics to do the
relative value trades and build positive convexity which positioned us to succeed, given the environment
in the financial crisis.
CS: Finally, do you see any similar risks in the market today?
DW: I think this is something that repeats itself over and over as we get further along in the credit
expansion cycle and it gets harder to make money. There starts to be a lax attitude toward risk where
deals and loans start to get done with weaker covenants and less investor protection. Investors trying to
make the same returns that they have in the past, go down in rating or the capital structure, or take on
more leverage to get back to the same return thresholds. I see this in today’s market.