"How Risk Sensitivity Led to the Greatest Financial Crisis of Modern Times"

The "revenge of relationship banking":

How risk sensitivity led to the greatest financial crisis of modern times, by Avinash Persaud, Vox EU: As banks fail and world stock markets plummet, the questions on many investors lips is how could rising delinquency rates in sub-prime mortgages, which account for less than 1% of the world stock of debt, trigger one of the biggest financial crises of all times? And how do we reverse it?

The answer to the first question lies in the two-word mantra of bankers and bank regulators over the past decade: “risk sensitivity”. Like all mantras, this sounded good but was dangerous in its oversimplification. The pursuit of “risk sensitivity” led to a re-organisation of bank assets away from lending on the basis of the banker’s private views about the borrower - regulators considered this hard to quantify and a little suspect – towards lending on the basis of an external credit rating. The higher the rating, the lower the capital banks had to set aside against the loan. Regulators saw this as not only risk-sensitive but transparent and quantifiable. Banking by numbers was oh so modern.

One of the implications of this risk sensitivity is that bankers were given incentives to enhance the credit rating of lending to reduce their capital charges and improve their profitability. They did so in multiple ways with Bear Sterns, Lehman Brothers, and AIG often acting as the brokers. The result was that the unit of lending was no longer a known borrower, but an indivisible hodge-podge of bits of originated and purchased loans and hedges that when combined, justified good ratings.

The focus on the rating led to the complexity that inevitably follows from using quantitative models to try and combine enough risky things to make the whole safer. But when something happened to question the rating of one package of loans, the complexity of these packages led the ratings of all packages to be questioned. Assets with the highest ratings, against which banks carried very little capital to protect them from the less than 1% probability of default, are now trading at 90 cents on the dollar. This is more of an uncertainty premium – reflected in liquidity – than it is a credit risk premium. It is the revenge of relationship banking.

One of the other consequences of lending by rating is that banks cannot easily quarantine the suspect parts of these loan packages because they are integral parts of the rated instrument. Because banks cannot easily do so, they do not trust other banks to have done so, so they stopped lending to each other. This forced the less liquid banks to fail, which encouraged the remaining banks to hoard liquidity, snatching it from the mouths of their clients whenever possible. This is how some problems in one small part of a subset of the financial system can bring the entire edifice down.

The good news is that the problem is partly artificial and therefore solvable. The trouble is that banks and others don’t know how to value their assets because of the way they have been “organised”, not that their assets don’t have any value. The vast majority of governments, corporations, and individuals are servicing their debts. The bad news is that to re-organise loans and allow a greater dispassion in their valuation requires time. The definition of a crisis of confidence is that there is no time. This points to a few ways of reversing the current free fall of credit, markets, and economic activity.

First, as my friend Willem Buiter has suggested, the central bank could guarantee all short-term interbank loans – there is more than enough room for inter-bank rates to fall even if the central bank charged for this guarantee. It may buy the authorities some time and it would serve to revive the interbank market rather than disintermediate it. Second, if the cycle of asset write-downs has depleted a bank’s capital, it makes sense for governments to inject capital in return for debtors accepting some partial debt for equity swap. There is value locked up in these balance sheets. Third, we need to bring back buyers of credit, fast. The government could use ten-year loans to capitalise long-term buyers of credit instruments – like an insurance company or an investment fund with lock ups – prepared to hold assets either to maturity or long enough to pay back the government’s capital. This gets around the mark-to-market problem, the problem of the public sector pricing and owning complex credit instruments, and may even encourage other investors to follow suit. It is not a million miles away from J.P. Morgan’s rescue of the US financial system a hundred years ago. It is sad how little we have learned about the market’s frequent insensitivity to risk.

Comments

[barry payne]

"risk elasticity" seems an apt characterization rather than "risk sensitivity" ... the "oversimplification" of the latter went far beyond the rating agencies and encouragement by bankers and regulators to depend on such standardized external criteria in order to justify less collateral for a loan with high ratings

rising house prices via expectations that fueled the bubble sharply biased all ratings upwards by offsetting current income with rising expected future income, and on the way up, risk leverage was multiplied upwards in the deregulated shadow financial sector towards 40-to-1 ratios, creating an elasticity of risk that multiplied the impact of one dollar of default at the homeowner level by forty-fold

blaming the problem on regulations associated with standardized risk evaluation due to transaction costs and transparency problems at the individual level of borrowers - which bankers wanted and regulators provided - without acknowledging the role of far more powerful regulations either reversed or prevented from enactment by many of the same players, that would have worked in the opposite direction to expose where wildly leveraged risks indeed existed, is to miss the forest for the trees while implying that regulation per se caused the financial collapse - when instead it could have avoided it

it's correct that rating agencies can become embedded with forecasters and become useless during a serious bubble, but the path of causality starts at the top and lies in denial by both that the bubble exists - the role of reduced incentives to identify differences in individual risk of borrowers paled in comparison to the broader, overwhelming incentives to exploit the bubble with grossly over-leveraged credit

[swells]

This article seems eminently sensible to me in it's recommendations. It addresses the issue of tight causal coupling between elements of the whole. Loose coupling promotes robustness when one is developing software and I think it would make the financial system more robust in precisely the same ways.

[Get Rid of It]

"The trouble is that banks and others don’t know how to value their assets because of the way they have been “organised”..."

A little bit of toxic waste can contaminate an entire tranche of bonds. Remove the toxic waste, and dispose of it. Purge the system of this garbage.

[sanitation dept]

Garbage removal includes toxic securities and malfunctioning failed banks. The credit freeze results from a problem between banks right now. Eliminate unworthy, untrusted banks.

[phineas]

The article makes an error when it begins with the presumption that the "crisis" has been triggered by "rising delinquency rates in sub-prime mortgages". Delinquency rates are rising for prime and alt-a mortgages at an equal pace as the rise for the subprimes. Falling house prices are inducing delinquencies across the board. By definition subprimes have higher delinquencies, but it's not really a subprime problem. See current and historial delinquency rates for prime and alt-a mortgages on pages numbered 29 and 30 at the following link, and in your head do an extrapolation of the rates a few years into the future:

http://google.brand.edgar-online.com/EFX_dll/EDGARpro.dll?FetchFilingHtmlSection1?SectionID=6080845-336315-370063&SessionID=gsOoWFEXcwa7Z47

[Patrick]

"how could rising delinquency rates in sub-prime mortgages, which account for less than 1% of the world stock of debt, trigger one of the biggest financial crises of all times"

Oh, I know! I know: Leverage it 30 fold, then make bets to the tune of 50 or 60 trillion on who defaults.

says...

"One of the other consequences of lending by rating is that banks cannot easily quarantine the suspect parts of these loan packages because they are integral parts of the rated instrument. Because banks cannot easily do so, they do not trust other banks to have done so, so they stopped lending to each other."

I disagree. In my not-an-economist-but-can-read-and-do-math laymans estimation, the credit lock-up is largely attributable to the opacity of firms CDS exposure. Of course, shedding light on the issue may simply find that the system is utterly insolvent... but in that case I suppose we could maybe do a blanket nullification of all the naked CDSs and that might help solve alleviate the problem... I dunno. It'll take a better mind than mine to figure this one out.

[macburger]

One of the implications of this risk sensitivity is that bankers were given incentives to enhance the credit rating of lending to reduce their capital charges and improve their profitability. They did so in multiple ways with Bear Sterns, Lehman Brothers, and AIG often acting as the brokers. The result was that the unit of lending was no longer a known borrower, but an indivisible hodge-podge of bits of originated and purchased loans and hedges that when combined, justified good ratings.

Jargon is used to obfuscate the truth, and cover up crimes. Why? Why do not economics call a spade a spade?

Bear Stearns, AIG, and Lehman were writing insurance without capital and reserves to back it. They used jargon - instead of "insurance", they called it "swaps" (as in CDS) - and basically ran a racket.

If it was called "credit insurance", as it justifiably should have been called, they would be subject to regulatory capital and reserve requirements that are imposed on insurance companies.

They would not have been able to write so much of CDS. The business of lending money to people who cannot pay it back would have stopped when the potential claims reached the limit of BS, AIG, and Lehman could pay. The bubble would not have been.

We would all be witnessing BS, AIG and LB going bankrupt, a few foreclosures, but nothing like the systemic collapse we see today. We would not have

So why don't economists call it what it is? The number one reason for the bubble, was writing insurance without capital and reserves, and it was possible by cloaking "credit insurance" under the cover of "credit default swap"

Terms like "risk sensitivity" serve only to obscure the crimes.

[OhNoNotAgain]

How about we simply start committing anyone that starts a sentence with "it's a new era..", "things are different now...", "we've revolutionized..", "_blank_ is gone..", etc. ?

So far we've fallen for this shit twice in the same 10 year period. PT Barnum may have been on to something...

[Elastic Moral Standards]

Domestic institutions have acted dishonorably toward foreign lenders. Many domestic institutions are disgraced in world opinion, and few will do business with them anymore. Many domestic citizens have also acted dishonorably toward foreign lenders. They are also disgraced, and few will loan them anything more. Reputation is now so bad that few will do business even with foreign institutions that have domestic securities on their books.

Yet, there have been no apologies, and little attempt to restore foreign trust with promises of honorable future dealings. Mostly just rationalizations for the abominable behavior, and shifting the blame on someone else. It all comes down to will a person/institution deal honorably with others, including honoring their word to repay what they have borrowed. If not, no one will trust them. They have lost face, and have no honor.

The wicked borroweth, and payeth not again...

[swells]

elastic moral standards, your point is fairly enough taken in regards to debts owed to moral actors. However, in respect to the debts owed the Chinese state, I disagree. If I borrow money from someone that I know got it by robbing a bank or profiting from the slave labor of others, then I feel no moral compunction whatsoever to pay it back. When the Chinese state stops oppressing its own and others, they may be due some moral regard. Till then, they stand on no ground that envelops them with a moral claim.

[Jay]

Those high quality loans originated at Fannie...

"WASHINGTON, DC -- Fannie Mae (FNM/NYSE) today announced a new, national policy on down payment requirements for conventional, conforming mortgages the company will purchase or guarantee. Starting June 1, 2008, Fannie Mae will accept up to 97 percent loan-to-value ratios for conventional, conforming mortgages processed through its Desktop Underwriter® (DU®) automated underwriting system, and 95 percent loan-to-value ratios for loans underwritten outside of DU, in all geographic locations in the United States."

"As part of its "Keys to Recovery" initiative, Fannie Mae is expanding its partnership with the National Council of State Housing Agencies. The company will provide up to $10 billion in financing to help Housing Finance Authorities (HFA) serve first-time homebuyers of modest means. In some cases, Fannie Mae will purchase HFA mortgages that have greater than 97 percent loan-to-value ratios."

http://www.fanniemae.com/newsreleases/2008/4370.jhtml;jsessionid=WAGLGJDFQ5CKBJ2FQSISFGA?p=Media&s=News+Releases

[kthomas]

"the credit lock-up is largely attributable to the opacity of firms CDS exposure. Of course, shedding light on the issue may simply find that the system is utterly insolvent... "

Hear hear, well-said!

[Lafayette]

Risk prone

phineas: Delinquency rates are rising for prime and alt-a mortgages at an equal pace as the rise for the subprimes.

True, but no where near the comparative prominence of sub-prime default rates – see here.

I suggest it is this single factor that indicated the severity of the toxic waste’s radiation that brought this credit house of cards tumbling down about our ears.

Rules are there to protect the risk averse from the risk prone - separating clearly the two. Both are necessary to any financial system, the former being ordinary people with ordinary lives and ordinary homes. They are, by far, the more numerous of the two -- and the more important by their numbers.

The risk prone are, in fact, gamblers or speculators (a nicer word, but identical in nature). They should not be allowed the ability to leverage wildly their assets to assume more risk, which was the straw that broke the camel’s back.

It would be nice to point a finger towards one or two or three faults, in this dismal saga, towards understanding “what went wrong”. But, that would oversimplify the problem of correcting the system towards preventing it from ever happening again. (The fault was not only technical, but also deeply human: The overt rapaciousness of those reaching for the golden ring.)

I suggest that even with the most drastically tight regulations, banking’s risk prone can find a suitable means of making profit … without the necessity of creating a house of cards.

These people (our Golden Boy "financial engineers") are never, ever to be trusted alone again. They need close and constant oversight of their practices -- by independent bodies.

The damage they have caused to many lives is irreparable. The boys were playing with fire and a great, great many people have got burnt besides themselves.

The old norm of cosy self-regulation by the industry no longer washes and deserves the dustbin. It's time to rewrite the rules boldly and internationally.

[skeptonomist]

"...how could rising delinquency rates in sub-prime mortgages, which account for less than 1% of the world stock of debt, trigger one of the biggest financial crises of all times?"

A really stupid question, indicating that Persaud has no clue as to the real nature of the problem. The problem was a huge housing bubble, fostered by the basic idea that unlimited leverage is always good (and other favorite notions of the financial world). Instant collapse of this sort is exactly what happens with excessive leverage. Persaud is trying to think of ways of propping up individual cards in this intrinsically flimsy house.

[Lafayette]

Slippery slope

Bear Stearns, AIG, and Lehman were writing insurance without capital and reserves to back it. They used jargon - instead of "insurance", they called it "swaps" (as in CDS) - and basically ran a racket.

And, I am sure that in a court of law they will argue that "it wasn't wrong because there was no law against it".

Their professional negligence was nonetheless imprudent and the resulting consequences are plain for all to see. I hope "they" go to jail and their property confiscated to repay fines and damages. "They" meaning those who willingly authorized such shenanigans that allowed the bubble, in its multiple ways, to burgeon and finally burst.

If this negligence is not a crime and crime does pay, then - as a nation - we are truly on that slippery slope to hell.