Published: January 02, 2008
The last few months have seen a major reassessment of risk and the price it should command across all asset classes, but affecting, in particular, the sector where it first began and where the storm has been centred, the credit markets, with knock-on effects on anything and everything utilizing leverage.
In many respects this severe down-draught - some have even used the word ‘crisis’ - reflects others throughout history. A long bull market - fuelled by a confluence of benign factors, including a prolonged period of cheap and abundant liquidity, an absence of major credit events, a raw material price-inflation counterbalanced by a drop in production- and service-costs underpinned by new technologies plus global outsourcing and the emergence of the new workshop of the world, China - led to a complacent belief that things can only get better. The only way is up, the ‘Goldilocks’ economy and market, neither too hot nor too cold, were here to stay. Stability was a given and price improvement - spread compression - in the credit markets - was a long-term trend. In this environment the search for yield and a willingness to ‘suck it and see’ encouraged financial engineers to invent ever more complex devices to gear up on yield and risk - sometimes multiplying leverage by 20x and more.
Let’s face it, we are all influenced by our own experience, and, like the VaR and other models so favoured by our regulators these days, we tend to place more weight on recent history than the distant past.
Lenders - investors - got complacent. Bad news from one sector - the US sub-prime market - was largely dismissed at first in the wider market. Then nagging doubts nibbled away at confidence as the reality sank in that these risks had been so sliced and diced and redistributed and releveraged that God alone knew who was holding what. A slow march towards lower duration, less risky assets turned into a headlong flight to safety as mild concern metamorphosed into blind panic. Not much then, to distinguish this crisis from its predecessors. Of course there are many similarities - over confidence, over liquidity, over-leverage, over-paying for assets. But there are key differences.
Rarely, if ever, since the late 1920s and early 30s, have so many fondly cherished assumptions -assumptions embraced by market participants and codified by the regulators - been challenged and found wanting. For instance, a complete industry has grown up around ratings. The last couple of months have raised a huge question mark over the methodology and hypotheses underpinning the major agencies’ ratings on a raft of structured securities. CPDOs which last year, for instance, were rated AAA have recently been trading at prices below 70%. But the point here is not directed at the rating agencies but at the dubious science which lies at the heart of so many risk models, value measures and, ultimately of a whole regulatory framework (Basel II); a science based on the assumption that ratings can be drawn exclusively from historical statistical PDs and LGDs (Probabilities of Default and Loss Given Default). Put bluntly, the theoretical model failed the reality stress-test!
Even more fundamental than the model-myth is another assumption which must now be seriously questioned. In many fields, diversity is rightly regarded as a source of strength. In nature, heterogeneity helps ensure that no one flaw will prove fatal to a whole species. The same principle governs the sensible policy, in many companies, that senior managers travel on different flights. Portfolio diversification is a synonym for prudence in investment management. [[[PAGE]]]
Yet the whole thrust of global financial regulation today is the antithesis of diversity. The same, or similar, models using the same, or similar, software governed by the same, or similar rules and algorithms, mean that when the sell signal comes, everyone rushes for the exit simultaneously. The stampede is often more dangerous than the crisis itself; a fact recognized by the Fed when it arranged the bail-out of LTCM. To avoid market meltdown, a regulator stepped in to encourage regulated institutions to break their rules. In other words, the normal application of the regulations themselves would have been a contributor to - not a remedy for - financial crisis.
Basel I was 25 pages long and for all its faults, an intelligible, flexible framework. Basel II is 333 pages long and a highly complex, model-based construction.
The unwinding of the mismatch arbitrage and the headlong flight from asset backed commercial paper has led to a massive liquidity impasse.
Moreover, it is pro-cyclical. When defaults are low and the market is benign, banks need less capital. At the very moment when they will find it most difficult to raise new capital - a time of rising defaults and a bear market in equities; more capital is required. These flaws need to be addressed - and urgently.
While the raft of regulation affecting banks has become ever more onerous complex, the supervision of hedge funds, investment vehicles and suchlike has been light.
Depositors’ money is not at stake; only sophisticated investors are impacted - or so ran the argument. But now a huge part of the financial system exists away from the oversight of bank regulations. Moreover, banks themselves have, effectively, been incentivized to shift their business into this sector. As a result, central banks are now finding themselves ill-equipped to address the systemic risk created by high leverage and credit dispersion outside their normal purview. While not wishing on anybody the over-regulation of the banks, recent events have demonstrated that problems do occur when the guardians of the system only have oversight and instrumentation to intervene in a small part of it. Are we not in danger of creating the equivalent - in terms of financial stability - of the Maginot Line; an expensive, elaborate defensive bulwark, which fails to address key risk areas?
Partly as a result of the unravelling of the model-myth; also of the rigorous mechanistic regulations in one sector and the absence of such in another, another assumption has been tested and found wanting: the supposition that good long-term assets can always be used as collateral to generate cheap short-term liquidity. The unwinding of the mismatch arbitrage - the difference between the cost of short-term funds and the return on long-term assets - and the headlong flight from asset backed commercial paper has led to a massive liquidity impasse - a hoarding of cash by banks afraid that they themselves will have to step in to acquire the underlying assets of conduits no longer able to finance themselves.
Much has been made of the fact that the money markets globally seized up in recent weeks. Banks worldwide, it was argued, were afraid of lending to one another, because, in the brave new world of credit risk transfer, they were worried their counterpart might fail.
The main reason for the money markets’ ‘heart attack’ was far simpler. The major banks knew that if the crisis continued, they would be forced to reabsorb billions of euros in assets which had previously been booked off-balance sheet and independently financed. And what’s more, they were right. Why were these assets booked off-balance sheet in the first place? As Wolfgang Munchau in the Financial Times put it: the “... Basel capital adequacy rules. ... were partly responsible for the bubble in the credit market ... as regulatory compliance induced banks to offload exposure into unregulated conduits.”
There was another, deep-seated cause of this onset of market paralysis. The shift, over the last decade or so, away from the cash markets into derivatives - credit default swaps in particular - has led to a situation in which - when volatility increases - the tail wags the dog - the action occurs outside the mainstream in what has become a far larger, more liquid market. Liquid, though, only in the sense of absorbing large transactions within narrow spreads - illiquid in the sense of requiring or providing real funds: when the going gets tough and prices volatile the core cash markets are reduced to the role of passive observers. While the derivatives markets have a very valuable role to play, when they eclipse the cash underlyings, it becomes a problem for all involved.
There is no doubt that the financial markets will come out of this turbulence stronger and wiser -as long as we draw the appropriate conclusions and act on them. One of those conclusions must be that risk models are not infallible. They are useful tools, but no substitute for experience or know-how on products and markets.
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