Hubris, nemesis, and catharsis

The potential for damage from reforming market regulation is substantial and is the result of the incomplete, incorrect, or inadequate levels of analysis conducted so far.

During his recent Inflation Report presentation, in response to journalists’ questions on the crisis, the Governor of the Bank of England, Mervyn King, asserted that now is the time to think. It clearly is. The haste with which regulators, supervisors, and other authorities have sought to respond to the crisis with new regulation is positively indecent, but more importantly it holds the prospect of much future harm from unintended consequences. The potential for damage is substantial and arises from the incomplete, incorrect, or inadequate levels of analysis conducted so far. Now is the time for a measured, considered analysis of any new regulatory proposals; the necessary time is available to us.

Incomplete analysis

To illustrate the analytic incompleteness, let us consider the case of Bear Stearns. At the end of February 2008 Bear Stearns reported that it held $303 billion of collateral of which $211 billion had been used to generate cash or substitute for delivery of cash. So funding of the order of 50 per cent of the Bear Stearns balance sheet was conducted in a predominantly day-to-day market; in street jargon, this practice of using customer collateral as security for further loans is known as "(right of) re-hypothecation”.

With securities lending, title but not ownership passes to the borrower. The lenders of funds did not know whether the securities offered to them as collateral were beneficially owned by Bear Stearns or by one of its clients. When rumours of distress and difficulty abound, focus on exposures and the legal minutiae of agreements is warranted and usual practice. Advancing funds against securities to which Bear Stearns had legal title but perhaps not unconditional beneficial ownership carried a now material risk of entanglement in dispute, if the beneficial owner sought recovery. When competing claims to securities do develop, the consequence is potentially far larger than might be provided for by any pragmatic margin or "haircut” arrangement. The payment of sensible interest rate premia by a borrower in this situation is likely to be ineffective in retaining or securing funds, as the lender’s risk is no longer tolerable to a very large degree. Many lenders appear to have arrived at similar conclusions.

Thus far, those who have considered the "drying-up” of funding liquidity in the distressed institutions have ascribed this to a "rational run”, founded only in rumour – a description which stretches credulity by assuming that financial institutions act on rumour alone. In fact, there is now a much more general requirement for a comprehensive analysis of the role of collateral and collateral management practices, together with their induced path dependencies, in financial markets and contracts. This is particularly relevant in the context of the proposed central clearing house arrangement for derivatives instruments.

Inadequate analysis

To move from the incomplete to the inadequate, the Basel Committee on Banking Supervision’s working paper No 16 serves as a good example (Basel Committee 2009). This paper is entitled "Findings on the interaction of market and credit risk” and it lists the representatives of some 27 regulatory and supervisory bodies as its authors.

One of the more egregious statements it makes is: "Securitisation transforms credit risk into market risk by pooling loans and issuing tradeable claims against the pool.” It does no such thing. The credit risk in, for example, a collection of mortgages is not fundamentally changed by moving their ownership from an originating bank to a special purpose vehicle – this is a case of risk transfer not transmutation. What has changed is that the bank that originated the mortgage pool and has sold these mortgages to a non-recourse external vehicle no longer has any funding risk exposure on them. Funding risk is one form of liquidity risk. (The decision by many originators to offer conditional funding in the form of committed stand-by lines of credit to their conduits is clearly one of the most questionable elements in all of this. Far too many appear to have believed that these could never be called upon and that the fees received were a free lunch.) The owners of claims on the special purpose vehicle have market risk exposure to the extent that these claims are tradeable, and of course the ultimate credit risk of the mortgage pool.

In the analysis of the crisis, there has been considerable comment on the scale and extent of the maturity mismatch of bank credit creation, which is also reflected in the short-term funding (in large part by asset-backed commercial paper) of the shadow banking SIVs and conduits. There has been little research or commentary as to why during the Great Moderation, the non-inflationary continuously expanding (NICE) era, household savings should have been so short-term and risk-averse in nature.

Incorrect analysis

One claim which recurs in much published analysis of securitisation, an illustration of incorrect analysis, is that there is a resultant coordination problem which removes the possibility of renegotiation of terms for distressed mortgagees. It is observed that the originating bank does not face the coordination problem faced by the multitude of debt claims-holders of the securitisation vehicle and asserted that renegotiation of mortgage terms is more difficult, and that default and foreclosure rates increase in consequence. This is simply untrue in the majority of cases, as the mortgage administrator ('servicer') under the terms of the securitisation is usually required to behave as if it were the sole beneficial owner. In fact there is some evidence that proportionally more mortgages held in US securitisation pools have been renegotiated than have been of those held by their originating banks.

The reorganisation of several SIVs and CDOs has shown, notwithstanding the length and complexity of prospectuses issued, that there can be coordination problems among (rather than arising from) the many debt claims-holders. The UK courts have been much occupied by concerns over issues such as priority and acceleration.

The BIS working paper further shows some confusion among market, credit, and liquidity risks and their technical measures. Credit is an expectation of specific liquidity – the date, amount, and obligor of cash flows are usually known. Credit risk is the variation of this expectation from its nominal contracted value. Technically these are first-order moments, which of course aggregate by summation – there is no diversification per se. Market risk is the variation in expected price at some (usually short) time horizon. This is again an expectation of liquidity, though the amount and obligor are somewhat less obvious. The usual measure is the standard deviation of price returns – these are second-order moments, which do diversify in aggregation. Confusion here is a serious concern.

Haste makes waste

The Cassandra problem of risk management, though, remains unresolved. For financial markets to function it is necessary to bound uncertainty by convention; a whistle-blowing risk manager is a threat in this context and like Cassandra will continue to see his predictions ignored. A variant of this problem extends to the role of academic commentators on regulation. Hyun Shin (2009) phrased this well, describing the reaction to Danielsson et al (2001), when he noted in a Vox article: "Back in 2001, our proposals must have been as welcome as Banquo’s ghost at Macbeth's banquet. No one likes to be told that their carefully crafted work is flawed.”

Many aspects of new regulatory proposals aired have been loudly criticised, notably the treatments of short-selling and hedge funds. The hasty production of reports and recommendations has become an industry, which appears to be driven to a large extent by the politics of envy and retribution, with factual evidence relegated to a poor third. Unfortunately all too many of these emerging proposals appear to be little more than the prescription of a larger dose of the medicine which has just failed, so spectacularly, to avert a crisis.

The reality now is that there really is no need for haste. The crisis phase has passed; we have moved on from nemesis. But far too much remains unconsidered and unresolved for comfort to exist in any new regulation. The process of catharsis will be all the more effective if carried by consensus, but that takes time and reason to build. We would do well not to forget that we do not discover the future, but rather that we create it.

Con Keating is head of research for the pensions indemnity assurer BrightonRock.

Originally published on Reproduced with permission.


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