Wolfing down the crunch

There is a fascinating article by Martin Wolf in today's FT. As usual, let me quote selectively and comment.

[The credit crunch has] 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.

I would distinguish between asset-backed lending and securitised lending, but Wolf is broadly right. It has turned out that the information asymmetry problems in the ABS market are too large to be easily dealt with in some case. The lack of alignment of interests has made this worse.

Banks became more leveraged through the use of SIVs, conduits and so on, but these vehicles just allowed banks to do what they always did - take liquidity, default and term structure risk - more efficiently. The real issue is why only one of these risks, default risk, has regulatory capital assigned against it. (There is no capital charge for interest rate risk in the banking book, and no capital charge for liquidity risk.)

What, more precisely, should a central bank do when liquidity dries up in important markets? Equally, the crisis suggests that liquidity has been significantly underpriced.

Cut rates and broaden the range of collateral eligible at the window, as the FED has just done.

Does this mean that the regulatory framework for banks is fundamentally flawed?

Yes. See here, here, here and here.

What is left of the idea that we can rely on financial institutions to manage risk through their own models?

A better understanding of model risk as here, here, or here.

What, moreover, can reasonably be expected of the rating agencies?

Not a lot. Why did you ever think otherwise?

A market in US mortgages is hardly terra incognita. If banks and rating agencies got this wrong, what else must be brought into question?

It's not the market, it is the structure. Dollar yen spot is probably the most liquid asset in the world, and certainly one that is very well commented upon. Yet I can structure a dollar yen exotic option whose price is genuinely uncertain (because it is radically different depending on your modeling assumptions). There is a measure of caveat emptor here, though: why did people buy structures they did not understand?

Do you remember the lecturing by US officials, not least to the Japanese, about the importance of letting asset prices reach equilibrium and transparency enter markets as soon as possible? That, however, was in a far-off country. Now we see Hank Paulson, US Treasury secretary, trying to organise a cartel of holders of toxic securitised assets in the “superSIV”. More importantly, we see the US Treasury intervene directly in the rate-setting process on mortgages, in an attempt to shore up the housing market.

As George Monbiot pointed out in a nice article about Matt Ridley (ex chairman of Northern Rock), it is often the most vocal proponents of the open market for other people who are the most dirigist when it comes to their own business. Yes, there is a massive measure of hypocrisy here, and moreover the intervention is not well-designed: the MLEC is looking more and more dodgy, and the Bush proposal for mortgage modifications will either cover very few borrowers or make lawyers rich.

A US recession is possible.

Yep. Likely even.