Irrational exuberance in the Financial Stability Report

The Bank of England’s semi-annual Financial Stability Report, whose 23rd instalment was published a couple of days ago, lists as members of the Bank’s Financial Stability Board, John Gieve (Chair),Martin Andersson, Andrew Bailey, Charles Bean, Nigel Jenkinson, Mervyn King, Rachel Lomax and Paul Tucker. This listing of the membership of the Financial Stability Board raises a constitutional issue and a factual issue.

The constitutional issue relates to the fact that no external member of the Monetary Policy Committee serves on the Financial Stability Board. All five internal, or executive members of the MPC, John Gieve, Charles Bean, Mervyn King, Rachel Lomax and Paul Tucker are members of the Financial Stability Board, although they serve on the Board as a function of their executive roles rather than because of their MPC membership.

This confirms the practice of the Bank of England, that the MPC as a body do not involve themselves with any activity, task or responsibility of the Bank other than setting Bank Rate (the official monetary policy rate), co-editing any statement released at the time of the Bank Rate decision, co-editing the minutes and participating in the inflation forecast. External MPC members therefore have no input into anything the Bank does, other than setting the official policy rate and the other above-mentioned peripheral actions derived from it. The Bank’s financial stability policies, actions and public pronouncements are not considered part of the MPC’s remit.

The range of collateral accepted at the discount window (the standing lending facility) and in repos, the maturity of discount window lending and of repos, the range of eligible counterparties, the design and operation of the recently created Special Liquidity Scheme, are all decided by the executive members of the MPC and other full-time Bank staff only.

Since the Bank is the most hierarchical institution outside the Vatican and the armed forces, this means that liquidity issues are effectively decided by one person only: the Governor of the Bank of England. This may be a great arrangement or a terrible arrangement. Regardless of one’s views on that, the constitutional justification for excluding the MPC as a body from participating in the liquidity management decisions of the Bank (or indeed from making these assumptions just as it makes the Bank Rate decision) are not clear. The Bank of England Act simply doesn’t address the issue. The current practice evolved by default. It should be reviewed, discussed and confirmed or changed depending on the merits of the case.

The factual issue about the membership of the Financial Stability Board is the omission of Pollyanna Whittier and Rosie Scenario from the list of members. The air of irrational exuberance that emanates from parts of the Report suggests that these ladies contributed mightily to its writing. The Financial Stability Board is certainly correct in noting that markets and moods can fluctuate wildly and that, after years of underestimating and under-pricing risk (between 2003 and the middle of 2007), we may now in some market segments be facing a situation where the markets overestimate risk and overprice it, through ferocious discounts on fundamentally sound instruments.

But why oh why did the FSR use American subprime mortgages to make the point that marked-to-market estimates of credit losses may well exaggerate the likely eventual magnitude of these losses? I will quote the Bank’s reasoning at length, so as to be sure I don’t misrepresent it:

“Future credit losses can be estimated by extrapolating forward delinquency rates. In particular, it is assumed that serious delinquency rates of US sub-prime mortgages of different issuance ‘vintages’ continue to rise at their average rates to date until the mortgages are four years old, at which point the rate is assumed to plateau. This is a stylised representation of the way that serious delinquency rates of older sub-prime mortgages have evolved. This method results in peak delinquency rates of 34% for mortgages issued before 2006 H1, rising to 42% for mortgages issued in 2007 H2. Upon becoming seriously delinquent, mortgages are assumed to default with at least 75% probability after one year, and to have a loss given default (LGD) rate of 50%. Chart A (not shown, WHB) shows the resulting projection, in which credit losses eventually reach around US$170 billion. AAA-rated securities do not incur losses in this projection. But there is sufficient uncertainty that even these top-rated securities could conceivably bear some losses.”

This Bank estimate is then contrasted with marked-to-market estimate (or rather marked-to-model estimates using some market inputs from ABX markets to obtain estimates of credit risk on home equity loan asset-backed securities) of US$380bn. Other estimates from the wilder reaches of Wall Street (think of a number and double it) get up to US$500bn or close to US$1 trillion.

To its credit, the Bank of England recognises that losses on RMBS are losses incurred by owners of inside assets (that is, assets that are liabilities of some other party). These losses are exactly matched, as regards their effect on net economy-wide financial wealth, by equal gains to those who issued the liabilities (ultimately the subprime borrowers that incurred the mortgage debt).

Although such redistributions of wealth may not be neutral as regards their effect on economy-wide demand, it is surely crummy economic analysis to proclaim the value of the subprime losses from the roof tops without ever mentioning that for every subprime loser there is a matching subprime winner. This is a mistake the Bank does not make.

The Bank’s analysis, quoted above, is nevertheless likely to turn out to be complete bollocks because it uses assumed delinquency rates that are based on a “stylised representation of the way that serious delinquency rates of older sub-prime mortgages have evolved.” The burst of subprime lending and borrowing between 2003 and early 2007 was, however, unlikely anything ever seen before. A whole new population of subprime borrowers entered the market for the first time. Mortgage borrowers with these characteristics were not in the older subprime population.

This phenomenon was partly driven by the declared policy objective of the Bush administration to increase homeownership. A homeowner, especially a first-time home owner, is more likely to think like a conservative and vote Republican than someone living in rented accommodation. The political push to extend homeownership to social strata that had never before been touched by it meshed perfectly with the ‘search for yield’ of banks discomforted by the disappearance of risk spreads on traditional lending activities and on the desire of the financial engineers to securitise anything that did not move, and even a few things that did.

The belief that house prices only went one way – up, anesthetised what remained of prudence and caution among borrowers and lenders. Frequent and flagrant misleading lending practices and outright fraud by lenders and borrowers did the rest. As a result of all these factors, the NINJA (no income, no job, no assets) class of borrowers was created. The models used to price the RMBS often did not even permit the user to input declining house prices – the algorithms would blow! Why would the lender care whether the borrower is a fraud, has no income, asset or job if the house can be sold at a profit within a couple of months of the sale?

So as far as I am concerned, we have no reliable information on which to base an estimate of the value of the subprime mortgages issued since 2003. I would not be at all surprised if the vast majority of them failed and left rather little for the lender to recover, after allowing for the legal, administrative and other costs of foreclosure and repossession, estimated at US$50,000 or more per property. So if the AAA tranche recovers fifty percent of the loan with a fifty percent default rate on the underlying mortgages, and if all lower-ranked tranches recover 40 percent with a 90 percent default rate – numbers at least as plausible as the Bank’s guestimates, the subprime losses of the banks (and gains of the NINJAs) would be much higher than what the Bank serves up for illustrative purposes.

I am always looking for light at the end of the tunnel. A trainload of subprime mortgages thundering towards me does nothing to cheer me up, however.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website