Risk wasn’t dispersed
Peter Fisher (Blackrock, formerly of the Treasury and the New York Federal Reserve) as quoted by the Wall Street Journal’s David Wessel:
“The idea of risk dispersion is nice in theory, but in practice it depends on who risk gets dispersed to. It turns out that we dispersing risk it into strong hands who could hold it through volatility. Rather we were dispersing it to weak hands who couldn’t hold it, and ended up adding to the volatility.”
So true.
Who were those weak hands?
Some credit hedge funds – whose use of leverage left them exposed to volatility.
Broker dealers like Bear.
And stronger – but not quite-as-strong as advertised – hands like UBS..
And a lot of US banks.
Goldman, in recent report:
“Because subprime mortgages were the weakest credits in the mortgage spectrum, they were the first to become impaired when house price started to fall. And because a surprisingly high fraction of the exposure to those mortgages was held by the Street, this is where the first signs of crisis first appeared.”
One obvious question is why the US regulators didn’t have a better idea that the Street was holding subprime risk before the crisis hit.
I suspect part of the answer is that the US regulators didn’t look closely enough at the capital flows data. At least not with a sufficiently critical eye.
They say enormous purchases of risky bonds by investors abroad – and specifically investors in the UK. They then assumed that risk had been dispersed internationally.
They didn’t probe closely into who exactly was taking the risk. It clearly wasn’t savers in the UK. The UK is a net borrower on a global scale – not a net lender. And it turns out that the central banks buying through London generally were buying Treasuries and Agencies, not riskier forms of debt.
A lot of the London buyers seem to have been vehicles sponsored by American institutions – or European institutions like UBS who funded their purchases of risky assets with short-term dollar borrowing.
The authorities in the UK shouldn’t get a free pass either. Their desire to court international business has meant that London has become a data black hole. An enormous amount of money flows through London but the UK’s balance of payments data provides next to no information about the sources of that money. The UK’s attitude may be good for business, but it has resulted in less transparency in the global financial system – and more difficulty tracking who has assumed key financial risks.
Still I suspect that US authorities might have been able to track the ultimate holders of a lot of US subprime risk if they hadn’t bought into their own rhetoric about risk dispersion.
The result of the implosion in the subprime market, though, aren’t in doubt: “international” demand for US corporate credit has collapsed.
The funny thing is that a lot of this international demand wasn’t really international. That is why – I suspect – the sharp fall in foreign demand for corporate credit hasn’t prompted an enormous fall in (net) capital inflows to the US. Offshore vehicles that borrowed in the US money market (or offshore dollar market) to buy US debt padded the data on gross cross-border capital flows, but did not providing much net financing to the US.
Unlike the actors who took on the risks associated with subprime mortgages, the actors who had been willing to assume dollar risk (almost as bad a bet over the past five years as 06 vintage subprime) really were strong hands. Central banks and sovereign funds are still adding to their dollar assets at an incredible pace. And they haven’t stopped adding to their bet on the dollar despite large losses (realized and unrealized).
Strong hands vs. weak hands? Hmmmph.
It’s primarily a matter of leverage, which even “strong” hands have used waaaaay too much of. Additionally, the problem with risk dispersion is that it makes every eat more slowly, which means it takes longer for everyone to get a full belly, which means they end up eating more than they otherwise would have. Next thing you know, everyone at the table has indigestion.
So if it’s about weak hands vs. strong hands (quite arrogant if you ask me), then show me a strong player that doesn’t have indigestion resulting from over eating and too much leverage.
Glad to see that comments are now posting directly to your blog!
Also, see Willem Buiter’s blog post today for more insights on London’s role as a financial centre:
The UK has a very large financial and banking sector, which conducts much of its activity by buying and selling financial instruments denominated in foreign currencies rather than in sterling. As a country, the UK has massive gross external liabilities and assets. These are well over 400 percent of annual GDP each, as compared with under 100% of annual GDP for the USA and around 700% of annual GDP for Iceland. It is not much of an exaggeration to describe the UK as a hedge fund, a highly leveraged entity, borrowing shorter than in lends and invests. It has a lot of short-maturity foreign-currency-denominated foreign liabilities and quite a lot of illiquid, non-sterling denominated foreign assets.
gamma — fair point.
I suspect Fisher would consider leveraged players weak hands, and real money strong hands. Though I would note that some fairly strong hands (China’s state banks) seem to have turned into weak hands because they wanted to avoid reporting large exposure to risky assets. I continue to be struck by the $40b fall in the portfolio holdings of Chinese state banks from the end of q2 to the end of q4.
SIVs were in retrospect very weak hands.
The other component is that so long as the music is playing and people are dancing, ongoing demand tends to reduce volatility even as spread compression encourages more leverage — creating the risk of indigestion.
bsetser: One obvious question is why the US regulators didn’t have a better idea that the Street was holding subprime risk before the crisis hit.
They did. Trouble is, once you know, what do you do about it?
This is one reason I don’t think that “transparency” is the answer to everything. If knowing there is a problem is not that useful if you don’t have a way of fixing it.
bsetser: Still I suspect that US authorities might have been able to track the ultimate holders of a lot of US subprime risk if they hadn’t bought into their own rhetoric about risk dispersion.
I’m surprised that anyone is surprised. If you just look at the glossy brochures the firms were putting out and see where people were making money, and read the fine print in things, it was pretty obvious what was going on.
The trouble is fixing it. There are dozens and dozens of agencies involved in financial service regulation, and I think it is more a function that no one had the power and incentive to fix the problem instead of people not knowing about it.
2fish — I am not at all sure US regulars had a good grasp of the extent of the exposure of the us financial system. put a bit differently, a lot of top bank executives were surprised, so it would be a surprise if the fed wasn’t surprised, at least to some degree.
transparency isn’t the answer, but a bit more transparency re: off balance exposure via SIVs might have helped alert people to the problem. and if it was clear that a lot of the flows in the UK were coming from the US, that might have provided a clue that vehicles in europe were funding themselves in $ in the US and the ultimate risk resided with US investors.
finally, i don’t remember hearing the fed agonize that much about offshore vehicles before the crisis. A general mispricing of risk, yes — at least from Geithner. But if memory serves fedspeak ex ante generally praised new financial technology and financial globalization b/c it allowed the dispersion of risk and the dispersion of savings and investment decisions.
For me, the problems of the sub prime debacle have to do with lack of quick clearing and valuation. Impaired derivative assets sat on the books of Bears Stearns, for quite a few months, before market participants began to watch the escalating values of CDS contracts on Bear’s bonds. The reticence of Bear Stearns executives to recognize the true value of their exotic derivative contracts and take decisive action is the principal reason for Bears Stearns demise.
According to the BIS (Bank of International Settlements) the notional amount of outstanding derivative contracts as of June 2007 was 457 trillion euros. That’s seven and a half times the worlds GDP which I put at about 60 trillion. 74 trillion ( 16%) of these contracts are defined as On-exchange, which means they are easily and quickly traded on either the CME or Euro next or similar financial exchanges. 383 Trillion ( 84%) of these contracts are called OTC, which means they are held internally at various banks, insurance companies and other financial institutions. OTC derivative contracts are unregulated and often fairly customized. They are highly profitable for the institution that creates them, but not they are easily understood, resulting in an asset which can’t be quickly sold too an interested third party.
As the financial world grows in complexity, the demand for hedging capabilities will only increase. My less than well researched suggestion is to push these non standardized contracts on to traditional exchanges, thus creating a very quick mark to market pricing mechanism as well as a quick clearing function, which in turn will force reticent CEO’s at major financial institutions to recognize the error of their assumed book values.
I have placed various meaningful quotes around my office. One of my favorites is “Financial Stability is Destabilizing” by Hyman Minsky. The world is always going to have exogenous events which cause sudden changes in the values of various financial assets. How these events are handled, like the sudden change in Feds Funds versus libor, (which signaled the mis-pricing of various subprime derivative contracts) is the key determinant in a smoothly operating financial system. If the misalignment of derivative asset values are allowed to ferment, as they did with Bear Stearns, the result is calamity, which in this case necessitated action on the part of the Federal Reserve. If more derivative contract assets were forced onto a global financial exchange, the mismatch between a corporations assumed book value and reality, would not be allowed to grown into a crisis.
The following site takes you to a great white paper on Global derivatives
http://deutsche-boerse.com/dbag/dispatch/en/kir/gdb_navigation/home
I welcome any and all comments.
dmg555
To be fair to bear, it’s probably less reluctance than inability to establish a firm value for those derivatives. Apparently, there were disparities between values produced by models used by the investment banks and the markets’ perception of derivative values.Add to that the complex structures of these derivatives that make valuation a combination of assumptions, estimation and referral. Some smarties blamed the ensuing chaos on fair value accounting and even suggested historical price measurement instead. That’s a refusal to recognize losses and value.
Brad
One thing about offshore vehicles and funds has always puzzled me: the fine print in the disclaimer and terms of agreement always state that they are not open to US citizens, could that explain why funds have to be re-routed through london. If london is that much of an information blackhole, what of the traditionally conservative european counterparts? ( think we don’t offer information that isn’t specifically demanded by the law and regulators)
If those assets and funds are denominated in foreign currencies,for all intents and purposes, the pound has no effect on the funds, the cross currents that matter are those across the atlantic and the european continent, hence, could the industry be relatively impervious should the pound deflate to a realistic level?
Offtopic but apparently creative derivatives are making a comeback - look at Gillian Tett’s article in the FT. What did they say about cockroaches…?
Brad,
I can only apologise on behalf of the UK for our inadequate BoP statistics. I believe that the reason for the poor coverage is that cutting “form-filling bureaucracy” is politically popular.
rebel, maybe. but i suspect that the city isn’t upset at the lack of data either. too much transparency could be bad for business.
some bop data is collected as a byproduct of tax data (think of the US data on reinvested earnings of us MNCs), and my sense is that the city operates as an offshore center (i.e. no taxes) for foreign funds. the treasury’s TIC and survey data don’t originate from tax data though and the UK presumably could produce similar data if it wanted to.
bsetser: I am not at all sure US regulars had a good grasp of the extent of the exposure of the us financial system. put a bit differently, a lot of top bank executives were surprised, so it would be a surprise if the fed wasn’t surprised, at least to some degree.
That’s very scary. because pretty much everyone in the trenches knew that there was going to be a problem two or three years ago. All you really had to do to see the problem was to ask the question “what happens if housing prices go down?”
bsetser: off balance exposure via SIVs might have helped alert people to the problem
I don’t think so. If you told someone three years ago that banks had a huge off-balance exposure to SIV’s, the response might have been “what is an SIV?” Also, figuring out what to do is difficult, because people did these structures precisely because they were unregulated. Also, my sense is that if you crack down on SIV’s, the bubble would have moved elsewhere since the basic problem is that people were making money off of rising housing prices, which couldn’t rise forever.
dmg555: My less than well researched suggestion is to push these non standardized contracts on to traditional exchanges, thus creating a very quick mark to market pricing mechanism as well as a quick clearing function, which in turn will force reticent CEO’s at major financial institutions to recognize the error of their assumed book values
The problem is that mark to market can be very destabilizing. Something goes down, this causes all of the derivative values to go down, which forces banks to sell their derivatives, which causes derivative values to go down, which forces banks to sell their derivatives, and away we go…..
I’d actually go into the direction of reducing the speed at which things happen. The thing about markets is that things can happen very quickly, and if things happen too quickly to have a meeting to do something about it, this could be very bad.
bsetser: rebel, maybe. but i suspect that the city isn’t upset at the lack of data either. too much transparency could be bad for business.
Lack of transparency is also called privacy. I wouldn’t put my money in a bank that released all of the details of my financial transactions to the world.
In any case, I really don’t think that more data would have prevented the mess. All the data in the world is useless if people aren’t going to ask the right questions. Subprime borrower obviously is not going to be able to pay his loan, who gets hit? Bank is making record earnings, where exactly is this money coming from?
If people weren’t willing to think about things that were happening right in front of them, then having more numbers would not have alerted them to problems. And even if someone had concluded in 2004, that banks had too many off-book liabilities, now what?
Two fish
I agree with you that markets can sometimes overreact but the world needs derivative contracts, and Bears Stearn’s fall is an example of why financial systems can not be trusted to individual human egos. Human beings, no matter what their accomplished level within a corporate financial system are reluctant by nature to admit they have made a mistake. Market volatility will eventually bring in a buyer of last resort. Even Jim Roger’s would buy US dollars at a 50% discount to where they are now.
If we allow derivative contracts currently worth 383 trillion dollars, to sit hidden away on any number of company balance sheets, the next time we have a serious mismatch between real and assumed values, the Fed’s 910 Billion dollar balance sheet may not be large enough to become the buyer of last resort. Immediate pricing has volatility disadvantages, but I suggest it is the lesser of two evils and better than hidden pricing which leads to huge sudden shocks to the system. If we knew how to release tectonic plates slowly we wouldn’t have major earthquakes. If these contracts are pushed onto exchanges, easily traded, valued, and transparent, capitalism can sort out the winners from the losers. In our past episode, Goldman Sacks was the winner and Bear Stearns was the loser. My guess is that someone at Goldman didn’t trust the rating agencies, did their own homework and tested the market in early 2007.
dmg555 — bringing CDS into an exchange has another advantage: namely, it reduces the scale of counter-party risk. A lot of hedge funds thought that they had hedged out a credit position by both buying and selling a CDS on the same name (making them flat). But if say one leg of the trade was with bear and bear had failed, they would no longer be hedged. As a result, I think there is growing support for this reform.
So early in the morning, and you are testing me: “Please add 6 and 3″ indeed.
Anyway, the problem I think is cultural. The U.S. has always followed the maxim “You can’t argue with success.” The U.K., which had been sceptical for most of the 20th century, followed the Americans since Thatcher.
Basically, when someone makes a lot of money, the reaction the Anglo-Saxon world today is that it is deserved and therefore the earner has some special knowledge or ability. So who in their right mind can question such an ethereal being? In fact, the correct reaction to someone making a lot of money is, Who is this crook?
“a” - hey you fared better, for some reason, the first attempt at posting was a disaster, theyt refused to accept 1+2=3 and compounded the insult by suggesting that I failed math, maybe it’s some quant retribution?!
dmg555
Articles and info on Yves Smith’s site (around Jsn-Mar) suggested that the very smart minds on the trading floor at Sachs did what everyone else did in 06/07, but the powers that be in the firm decided to take positions elsewhere that reversed those trades and went further in the opposite direction, hence the sacks (sorry, bad pun) of money they made.
As for rich crooks, ooh, that reeked a little of calvinistic brimstone, then again, in some principalities of the world, they are valued citizens…
i think my earlier comment was ate, but i just wanted to point out that greater transparency, while widely lauded, often comes with lower margins for those who trade in information; as roger ehrenberg points out:
“Let’s face it, banks want as little price discovery as possible because it leads to more generous pricing opportunities. Especially if a hedger or speculator wants to put on a non-standard position, banks stand to make the lion’s share of their profits relative to facilitating large numbers of exchange-traded instruments with razor-thin margins.”
like this was a big reason why bond trading, or the pricing of credit risk, has migrated to CDS… information arbitrage/assymmetries indeed
cheers!
dmg555: Human beings, no matter what their accomplished level within a corporate financial system are reluctant by nature to admit they have made a mistake.
The trouble is that by the time its obvious from the markets that people have made mistakes, it’s really too late to do anything other than pick up the pieces.
dmg555: Immediate pricing has volatility disadvantages, but I suggest it is the lesser of two evils and better than hidden pricing which leads to huge sudden shocks to the system. If we knew how to release tectonic plates slowly we wouldn’t have major earthquakes.
The trouble with the idea that pushing derivatives onto exchanges would fix the problems is that most of the derivatives that caused problems were quite liquid and freely traded on the market. There were (and are) indexes for CDS’s, for example.
It’s not volatility that’s the problem. It’s panic selling which can destroy a market. It’s just not true that people will buy if the price is low enough. Once fear sets in, people won’t buy at any price, and it takes a massive intervention to stabilize things.
dmg555: If these contracts are pushed onto exchanges, easily traded, valued, and transparent, capitalism can sort out the winners from the losers.
Nope. Doesn’t work. Imagine someone selling cars. People are a bit reluctant to buy, so the car company gives a guarantee. The cars are sold, and they are no longer liabilities to the company. The car company calculates the amount that it well lose via guarantees, and some time passes. Then it turns out that the cars are defective and are falling apart left and right, and that the car company has to make good on their guarantees. Suddenly an “off-book” liability goes “on-book.”
Having a liquid market for cars doesn’t help, because once the bad news is reflected in the price of the car, it’s too late.