Wednesday, 17 October 2007

Two misconceptions about the credit crunch

Reading Naked Capitalism's discussion of an otherwise reasonably good article by Angel Ubide, it occurs to me to clear up two mistakes Angel makes.
Central banks have added liquidity to a situation of already "excess liquidity" to tackle an apparent liquidity crunch, and yet nothing has got better. Perhaps it was not about liquidity, after all.
This assumes all liquidity is the same, and it isn't. The reason the extra liquidity the central banks injected didn't help much was it was the wrong sort of liquidity: it did little to ease the difficulty of funding Libor-based assets as it didn't address soaring liquidity premiums. We did have a liquidity crisis, but it was one in the Libor markets. Central banks may wish to think hard about how to address this characteristically modern market stress.

What is the right response from a risk management standpoint to a sudden increase in balance sheet risk, volatility and uncertainty? Reduce positions dramatically [...]
This just turns an unrealised and uncertain loss into a certain realised one. It is exactly the wrong thing to do. Rather banks should (and one suspects from their results that Goldman did) have enough headroom in their risk appetite and enough spare funding so that they can buy cheap assets in this situation from the forced sellers. Risk management isn't always about reducing risk: it's about taking the right risks at the right price.

Update. The 'having funding' part above is important. It is estimated that banks have taken over $280B of assets on balance sheets from conduits and SIVs since the credit crisis began. For some banks that means they have to find a lot of cash before even thinking about funding new asset purchases. Maybe those undrawn lines were worth paying for after all.

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