The Financial Crisis: Background
by C. Goodhart
[A personal view]
(1)
Mis-pricing of Risk
A. Very low interest rates, 2001-5, plus
B. The Great Moderation/Stability, plus
C. The Greenspan Put[?], equals
Widespread under-pricing of risk.
(2)
New Financial Structures
Securitization and Derivatives
‘Originate and Distribute’
Leads to disintermediation of assets off banks’ balance
sheets, (partly regulatory arbitrage). But commercial banks
maintain contingent liabilities as lenders of last resort and
underwriters to capital markets, especially when they have
close direct connections, e.g. Bear Sterns hedge funds; IKB
and Sachsen conduits and SIVs, etc.
Did quality of credit assessment/monitoring decline as a
result? Supposed to be checked by credit rating agencies.
3.
Credit Rating Agencies
Usually only rate credit default risk. Misinterpreted
to cover market and liquidity risk as well. So AAA of
government debt not the same quality of AAA of
senior tranche of CMO. Moody’s suggestion to
widen ratings categories.
Maybe they have got credit default risk wrong? No
prior example over US data period of housing prices
falling across the board. Non-linearities.
Conflicts of interest? Paid by originator, but
reputation. Insufficient competition.
(4) Insufficient Liquidity and excessive maturity
transformation.
Until 1960s, 25% plus real liquid assets. Continuously
declining trend.
Reliances on wholesale funding and short-term credit
market. Massive maturity transformation.
If trouble arises, depend on Central Bank to sort it out.
Widened range of collateral assets. Yet another Central
Bank put, a liquidity ‘put’.
(5)
So financial crisis was an accident waiting and ready
to happen. Central banks could, and did, see it coming, but
did not feel able to do anything about it. BoE FSR April (Sir
John Gieve).
Trigger was US sub-prime mortgage market, but it could
have been elsewhere.
How did it spread so widely?
(6)
Pool
‘Slice and Dice’
→
Mortgage
A
B
PoD
5
C
D
E
6
7
5
7
Senior Tranche AAA
Mezzanine Tranche
Equity Tranche
(toxic waste)
→ Pool
→ Conduits, SIVs
→ Pension Funds?
→ Hedge funds
Risks in equity tranche can be partially hedged.
(7)
Historical path
US interest rates up, housing prices falter starting in early
2007.
Hedge funds hit, Bear Sterns, others; nothing much
happens, but uncertainty about how far defaults will eat into
higher tranches.
These are financed by ABCP largely held by money market
fund managers. They have convertibility commitment, little
capital and no LOLR. They flee in masse. Impossible (and
undesirable) to sell the CMOs.
IKB and Sachsen. Contingent commitments many times
capital. Is counterparty bank safe for interbank lending?
(8)
Historical path (cont’d)
Banks can see contingent commitments coming home to
roost, plus doubts about counterparties.
So early August, 3 month interbank market dries up.
Systematic net borrowers in wholesale markets increasingly
at risk (Northern Rock).
(9)
What can/should Central Bank do?
(a)
Lower official rate/penalty ceiling at very short end,
but inflation mandate?
(b)
Widen collateral, undertake operation twist (3/1
month). But,
(i) would it work?
(ii) Moral Hazard?
(c)
Undertake massive LOLR. But even if not prevented
by Market Abuses Directive, (MAD), can you keep it covert,
BoE balance sheet publication?
(d)
Where do we go from here?