December 12, 2007
Why the credit squeeze is a turning point for the world
By Martin Wolf
These are historic moments for the world economy. I felt the same during the emerging market financial crises of 1997 and 1998 and the bubble in technology stocks that burst in 2000. This “credit crunch” may, I believe, be an equally important turning point for financial markets and the world economy. Why do I believe this? Let me count the ways.
First and most important, what is happening in credit markets today is a huge blow to the credibility of the Anglo-Saxon model of transactions-orientated financial capitalism. A mixture of crony capitalism and gross incompetence has been on display in the core financial markets of New York and London. From the “ninja” (no-income, no-job, no-asset) subprime lending to the placing (and favourable rating) of assets that turn out to be almost impossible to understand, value or sell, these activities have been riddled with conflicts of interest and incompetence. In the subsequent era of “revulsion”, core financial markets have seized up.
Second, these events have called into question the workability of securitised lending, at least in its current form. The argument for this change – one, I admit, I accepted – was that it would shift the risk of term-transformation (borrowing short to lend long) out of the fragile banking system on to the shoulders of those best able to bear it. What happened, instead, was the shifting of the risk on to the shoulders of those least able to understand it. What also occurred was a multiplication of leverage and term-transformation, not least through the banks’ “special investment vehicles”, which proved to be only notionally off balance sheet. What we see today, as a result, is a rapid shrinkage of markets in asset-backed paper.
The remainder of this column can be read here. Debate from our guest economists appears below.
Charles Wyplosz: So what should central banks do? If they sit by the wayside, they are accused of letting the world crumble. If they provide liquidity, they are seen as fanning the flames of moral hazard by helping out commercial banks that should have known better. Easy answer: they only have to do the right thing, and take the blame for it.
Whatever their respective official rhetoric, central banks have three main goals: maintain price stability, try to smooth business cycles, and ensure financial stability. Sometimes these objectives conflict, so they have to cut a few corners, leaving no one fully satisfied. We are in the midst of one rare instance when all three objectives are simultaneously challenging the central banks. No surprise, then, that many keen observers cannot resist the temptation of criticizing every move; what do they suggest, by the way?
One easy way-out is to hierarchize the three objectives. We have heard some central bankers telling us that price stability comes first. Nice and easy: tighten up policy and wash your hands. We have heard some politicians fret about the end of the growth phase of the cycle and plead with their central banks to let go. Astutely, they will then blame the same central banks for having missed out their price stability objectives. Of course, financial markets want more liquidity and soothing actions now that each bank hoards liquidity after a decade of voracious risk appetite and huge Christmas bonuses.
Fortunately, with a few notable exceptions, our central bankers have resisted the temptation of simplicity. They still steer the interest rate with an eye on future inflation and growth. Given the unusual murkiness of the outlook, this is more challenging than usual but, given that monetary policy effects come in very slowly, they can display cool blood and act cautiously. Three cheers for avoiding big moves that they could come to regret and for being ready to be mysteriously described as “behind the curve”!
The central bankers also recognize that the only objective where urgency may be required is financial stability. In contrast with inflation and growth, market disruption and crisis can happen in a matter of days, even faster sometimes. Some central banks did react fast in August. Right now, they are concerned with end-of-the-year account balancing requirements, a distinguished way of describing the fact that financial institutions must get their numbers right on December 31st, no matter what they do the rest of the year. It is not altogether clear, however, why central banks should help financial institutions meet their regulatory requirements. These institutions live by the risk, it is only natural that a few get felled by a bad turn of events.
This takes us to the thorniest issue: moral hazard. We all know that moral hazard is inseparable from finance and that there is no perfect solution to this problem. When central banks intervene, they must avoid increasing the moral hazard. To that effect, we must agree of who is to be blamed for what. The beginning of the story is easy. If the daring mortgage lenders who created all these subprime loans had kept them on their books, they would have been more cautious and, instead of a worldwide credit crunch, we would now face a housing crisis in the US. The problem would be nicely boxed in and easier to deal with. It does not mean that it would be better for the world at large; a US recession would hit many innocent bystanders. Yet, in the end, it is the US taxpayer that would foot most of the bill, giving her good reasons to ask hard questions to the US regulator who allowed the mess in the first place.
Given this regulation failure, the next blames are harder to establish. The great securitization fad has shown its limits. The more widely is risk spread, the deeper is the information asymmetry problem and the associated moral hazard. Those who eagerly repackaged and redistributed the subprimes, along with the rating agencies, can claim that they had no obvious reason to doubt the wisdom of US regulators. This is not convincing, to say the least, but let us agree for the sake of the argument. Subprime repackaging players should have realized that the asymmetric information problem was getting deeper at each round. They got blinded by the superficial sophistication of their instruments, as did their supervisors. Any central bank action, therefore, must make sure that the subprime players face some consequence. The border between adequate punishment and systemic instability is very, very thin. We want more failures, more sacking of CEOs and their associates, but the markets must be preserved. It’s touch and go, with unavoidable mistakes along the way. The worst mistake would be a systemic crisis, so central banks will have to be a little bit too soft. Then, when it is all over, we will have to ditch Basel 2, a case of regulators being captured by their ‘customers’.
Posted by: Charles Wyplosz | December 14th, 2007 at 11:51 am | Report this commentRobert Wade: Martin suggests that the credit crunch may be a turning point for financial markets and the world economy, and leaves us with a series of sharp questions. I would like to make a few suggestions about what developing country governments should do to “turn” the rules so as to propel the world economy along a more stable and more equitable path, with faster catch-up of developing countries.
“Not for a long time will people listen to US officials lecture on the virtues of free financial markets with a straight face”, Martin says. The larger point is that the erosion of credibility of the Anglo-American model of financial capitalism may improve developing country governments’ negotiating position, and they may now be able to concert their negotiating positions in trade and finance sufficiently to get more scope for catch-up growth. This would be the opposite of the Uruguay Round experience, when developing country governments signed up to very disadvantageous agreements (the TRIPS agreement being only the most egregious example) because they were in a weak negotiating position in the wake of the Latin American debt-and-development crisis of the 1980s.
One target for developing country governments should be the Basel 2 accord on capital adequacy. As Martin says, the current credit squeeze raises the sharp question, “What is left of the idea that we can rely on financial institutions to manage risk through their own models?” Implicitly he questions the shift from Basel 1 to Basel 2, which is all about replacing an external independent monitoring agency with self-regulation by financial institutions, or at least with self-regulation by financial institutions based in developed countries. Certainly the rigid classifications for risk-adjusted assets in Basel 1 needed revision. But self-regulation is inherently foolish where the normal disciplines of the market are not allowed to operate because of the principle of “too big to fail”.
More specifically, Basel 2—as compared to Basel 1 —will shift competitive advantage even further towards developed-country banks and against developing-country banks, and will likely hurt development prospects more broadly by making developing-country access to finance more pro-cyclical. Basel 2 requires banks with less sophisticated risk-management systems to carry relatively more supervisory capital than banks with more sophisticated systems. It therefore raises the former’s costs of lending relative to those of the latter, which tend to be based in developed countries. These banks are allowed to establish their credit risks and capital adequacy themselves—“self-supervise”—subject to the financial supervisor approving their model.
The Basel Committee’s own most recent quantitative impact study reveals a large variance in the amount of capital required for banks using the different Basel 2-based risk-assessment methodologies. For example, some banks using the “advanced internal ratings-based” approach—predominantly in developed countries—are expected to have large reductions in their capital requirements, of the order of 30 per cent. Banks using the simpler “foundational” approach—predominantly in developing countries—are expected to experience an increase in their capital requirements of over 38 per cent. (Basel Committee on Banking Supervision, “Results of the Fifth Quantitative Impact Study”, 16 June 2006, p. 2.) The Basel 2 standards thus give a structural advantage to large developed-country banks and a structural disadvantage to developing-country banks; and hence also to the regional, national and local economies within which these are nested.
The upshot is that developing countries under Basel 2 could face a higher cost of capital and a lower volume of lending than under Basel 1, with more pro-cyclical volatility, and with their banks less able to establish international operations and more likely to be taken over by developed-country banks. (See further, Wade, “A new financial architecture?”, New Left Review 46, July/Aug 2007.)
A second target where rule-turning is in order is implied by Martin’s point that “emerging economies” should not cheer too loudly that they have emerged as safe havens as investors run away from US households, because “Today’s favourites may be brutally discarded tomorrow”. Just for this reason it is important to re-establish the legitimacy of various forms of capital controls, such as the outflow restrictions imposed to good effect by the Malaysian government in 1998 and the inflow restrictions used to good effect by the Chilean government in the 1990s. The IMF has backed off pushing the removal of restrictions on capital flows; but the US Treasury and the European Commission are pushing free capital mobility hard in their preferential trade agreements. Developing country governments should push back.
The third target for push back should be the Doha Round and its successor. Martin says, “If we are to enjoy global macro-economic stability, a creditworthy set of countervailing borrowers must emerge”; yet “It has proved virtually impossible for emerging market economies [the obvious candidates for development-enhancing deficits] to run large deficits, without running into crisis”. A large part of the solution to global macro-economic stability and the emergence of a creditworthy set of borrowers is a world trade regime more favourable to developing countries. None other than Charlene Barshefsky, former US Trade Representative, has declared that wealthy nations have not “genuinely pursued a development round” in the so-called Doha Development Round. The basic deal on the table is very disadvantageous to developing countries. They are to (a) make big cuts in tariffs on industrial and agricultural goods, and (b) remove restrictions on multinationals, in exchange for (c) a small cut in developed country industrial tariffs and in subsidies to agriculture. If developing country governments do not substantially change the terms they will be locking their economies even more into existing static comparative advantage activities than they did in the Uruguay Round.
It is vital for long-run global macro-stability that developing country governments continue to push back on what developed country governments want them to sign up to, and the credit squeeze affecting the western economies gives them more leverage with which to do so.
Posted by: Robert Wade | December 17th, 2007 at 1:00 pm | Report this commentAndrew Hodge (Guest): Your kind comment on my Dec 3 forum response - the 07-08 banking crisis in a nutshell - leads me to this expanded reply, including thoughts on:
1. How to do risk management right
2. How to do accounting right
3. How the buy-side, the purchasers of complex instruments, can purchase well
4. How the regulators can encourage and enforce where needed
A little history - the highly selective rise of good risk management
As derivatives expanded in the 90s the leading quantitative thinking (called value at risk or VAR) was applied to portfolios. JP Morgan created Riskmetrics, a framework and software for determining VAR on a daily or even hourly basis. Goldman Sachs, Morgan and other banks, and others like the consultants Ferrell Capital Management had regular professional meetings to promote this. Not only portfolios but entire companies could be valued this way. Goldman in particular, also Morgan and other leaders pushed the idea of valuing the entire company on a daily or even hourly liquidated value, what it can be sold for, and a global measurement of positions. What is the net of twenty different traders and groups in the South African Rand for example?
By the late 90s, this approach received near universal support, and increasingly was mandated by bank examiners. Much of that is lip service, and only partial follow-through. The proofs? First note the huge write-downs including Citi, UBS, HSBC; the refusal of cash surplus banks to lend now to others based on their financial reporting; and the continuing “accidents” and write-downs yet to be announced.
Why is this? The reality is banks are highly leveraged institutions as you pointed out earlier. Genuine daily, even hourly marks, or those results reported publicly each quarter, would curl an investor’s and maybe management’s hair with their volatility. It also involves a huge investment in firm-wide software, and, not least, accepting tight central control over widespread fiefdoms. Your columnist John Plender rightly points this out recently in his praise of Goldman. Also needed: an extreme remake of mark-to-market compliance. In the mid 90s the head of Goldman risk management recounted to the group above: “We set out on an intensive VAR exercise, aiming to complete the process. We thought Goldman had already accomplished most goals. Six months later we realized we had just begun.”
These assorted reactionary forces and resistance reign in most institutions. An asset is “money good” meaning just carry it to maturity. It’s easier to put it in unmarked “level three” or mark it badly or infrequently. Folks don’t want to admit a risk downgrade in their portfolio or loan they made has lost the company reported value. Going further, there is actually a thriving structure business and other accounting tricks that allow customers to arbitrage between the marked and unmarked portions of their balance sheet. Meanwhile accountants are happy to accept large swaths of assets and liabilities at book.
Rigorous marking is more difficult, with more grounds for legal liability. The rating agencies are happy with the unmarked or poorly marked accounting, and have committed even more egregious sins, noted below.
Making accounting better and customers smarter
There are also the systematic overvaluations of complex assets, and undervaluations of liabilities. My cynical view is that many structured investment products are structured to get the customer to overvalue it. Take a simple example: a note or loan where the repayment is in either of two currencies at the lenders option. This can be broken into the basic loan say $ and a euro call option a year from now. Now you the borrower may think “the dollars going to bottom anyway and they are giving me an amazing 100BP reduction in my interest rate” meanwhile the bank will book the remaining 200+ BP value of the option as profit. And you the customer will carry the liability at dollar book rather than adding and marking the option you sold to market. This is an accident waiting to happen a year from now.
As a general rule, if you can’t figure out what the component derivative parts of the structured product you bought are, and are trading at, and how to mark them, and your accountant can’t really mark it from the pieces at least every quarter, you should not have borrowed it or bought it.
Now you might think that mortgage paper is not so complicated, unless it is sliced diced and derivativized. The reality is, as noted in the earlier forum, even the basic paper contains an embedded borrower put that has been grossly undervalued. Folks now realize that because of this and a number of other problems, they don’t want to buy the paper at the amortized book value everyone is carrying it at (email me for a list of 16 reasons why mortgage paper is bad paper). The lending standards for subprime, Alt A, and home equity only compounds the overvaluation mess. Assume anyone still calling this the “subprime” problem has a weak grasp on reality. Any bank announcing subprime write-downs should be asked, what about the rest of your assets?
So consider now an SIV structure where there is no equity cushion for the funders. Infinite leverage. Liability is 100% of assets, book value unmarked mortgage assets that is. Accountants and AAA raters should be, career-wise and reputation-wise, taken out and “shot.” for their assessments. As it is, there are really no regulatory or legal penalties for this behavior.
Let’s not let the buyers and lenders off the hook either. But lender disbelief in their rating and accounting bulwarks is part of what is now poisoning the system
The public role
There is nothing like a crisis and big money loss to induce private sector learning. But the regulators can help. The proposed Basel II rules abandoning “arbitrary” capital requirements in my opinion marks a clear premature declaration of victory for VAR. My rule of thumb, and that of some regulators, is the less you understand your balance sheet or really know your VAR, the more you need arbitrary capital requirements. Better the regulators encourage adequate accounting, the end of off-balance-sheet abuses, the list goes on and on, and proper marks before Basel II. It may not be long before we appreciate the Basel I level of reserves. The now massively illiquid “shadow banking system” for mortgages and the massively leveraged securities houses will also require better regulatory monitoring at a minimum.
Posted by: Andrew Hodge | December 19th, 2007 at 12:23 pm | Report this comment