MEAFA
Financial Crisis Forum
Accounting for Self Interest
in the Credit Crisis
John Roberts
j.roberts@econ.usyd.edu.au
Accounting for Self Interest in the Credit Crisis
I made a mistake in presuming that the self interest of
organisations, specifically banks and others, were such
that they were best capable of protecting their own
shareholders and their equity in the firms .. So the
problem here is something which looked to be a very
solid edifice, and indeed, a critical pillar to market
competition and free markets, did break down. And I
think that, as I said did shock me. ,, I found a flaw in the
model that I perceived is the critical functioning that
defines how the world works.
Alan Greenspan, October 2008,
Testimony to House Oversight Committee
Accounting for Self Interest in the Credit Crisis
Two Questions
• How was self interest constructed in
financial markets?
• How can we account for its failure?
Accounting for Self Interest in the Credit Crisis
Social Studies in Finance – Michel Callon
• Economics and finance conceive of the
individual agent as an atom – ‘too isolated – too
autonomous’.
• ‘agent-networks’ – agent is always only a node
in a network of relationships.
• As an atomistic agent I can defend my self from
others –’my interests’
• As an ‘agent-network’ I defend my interests by
defending the relationships.
• Interests are ‘inter-esse’ – between rather than
within individual/institutions.
Accounting for Self Interest in the Credit Crisis
Social Studies in Finance – Michel Callon
• Self interest requires work/calculation to
‘disentangle’ my interests within a relationship.
• Externalities or ‘overflowing’ is normal rather
than an accidental and exceptional ‘leak’.
• Not only humans but also non-humans - notably
models and accounting - should be treated as
agents in financial markets.
Originate-to-Hold
Borrower
Lender
Originate- to- Distribute
Borrower
(subprime)
Lender/
Mortgage
Broker
Hedge
Rating
Fund
Agency
Investment
Bank
Insurer
Institutional
Investor
Securitisation – Tranching – CDS – Leverage – Moral Hazard
Pervasive reliance on Models and Accounting
Accounting for Self Interest in the Credit Crisis
Constructing Self – Interest through ‘disentanglement’
• Securitisation – disentangling the risk of a particular loan
by bundling it up with lots of others and selling it on.
• Tranching – Equity (0-3%), Mezzanine (4-15%), Senior
tranches (16-100%) – ‘Credit enhancement’ through
disentangling risk and return through a ‘waterfall’ and
‘reverse waterfall principle’.
• Synthetic CDO’s – use of credit default swaps disentangling risk from the underlying assets –
transforming event risk (default) into market risk (price).
• Leverage – 12-1 banks, 30-1 investment banks, 60-1
SIVs
Accounting for Self Interest in the Credit Crisis
Constructing Self – Interest through ‘disentanglement’
•
•
•
•
Ratings Agencies
Mono-line Insurers
Indices – CDX, iTraxx, ABX.HE
Pervasive reliance on Models - pre-payment variables –
housing & macroeconomic data, interest rates: Default
variables – loan to value ratios, default probabilities,
recovery rates, correlation estimates.
• New Accounting Standards –’fair value’, available for
sale/ held to maturity, hierarchy of measurement:quoted prices, observable inputs, mark-to-model.
Accounting for Self Interest in the Credit Crisis
Overflowing –
• Higher than modelled level of defaults on subprime,
falling housing market, lower recovery rates.
• losses on equity and mezzanine tranches.
• Mark to market losses.
• SIVs & SPVs reappearing on balance sheets.
• Leveraged losses.
• ‘Credit risk’ becomes ‘market risk’ becomes ‘counterparty
risk’ becomes ‘liquidity risk’.
• Second order contagion.
Accounting for Self Interest in the Credit Crisis
‘Hyperreal’ interaction of models and accounting
• Models and Accounting ‘mediate’ almost all relationships.
• Treated as embodiments of rationality and ‘neutral and objective
measurement’.
But as agents acted as a mutually self referencing hall of mirrors
• Fed the illusion of rationality (greed) on the upside – the apparently
immediate focus of fair value on the current ‘exit price’ possibly
masked the way that price reflected only the modelled assumptions
of future profitability.
•
Fed fear and panic on the downside. Loss of trust in the models
and accounting just as you most need them.
Accounting for Self Interest in the Credit Crisis
Financial Stability Report
‘ A small loss in value can force funds to sell
large amounts of assets as liquidations to meet
margin calls and simultaneously, their
redemptions increase. Such fire sales could lead
to a vicious circle of forced sales, as the
widening of spreads forces hedge funds and
others who mark portfolios to market to post
losses, possibly sparking investor withdrawals
and further forced sales.’ (October 2007)
Accounting for Self Interest in the Credit Crisis
Counterparty Risk Management Policy Group
‘there is almost universal agreement that.. the
characteristics of these instruments and the risk of loss
associated with them were not fully understood by many
market participants. This lack of comprehension was
even more pronounced when applied to CDOs, CDO
squared, and related instruments, reflecting a complex
array of factors, including a lack of understanding of the
inherent limitations of valuation models and the risks of
short-run historical data sets. As a consequence, these
instruments displayed price depreciation and volatility far
in excess of levels previously associated with
comparably rated securities’ (2008:53).