The Financial Crisis: Background

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The Financial Crisis Background by C.
Goodhart A personal view
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• (1) Mis-pricing of Risk
• A. Very low interest rates, 2001-5, plus
• B. The Great Moderation/Stability, plus
• C. The Greenspan Put?, equals
• Widespread under-pricing of risk.

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(2) New Financial Structures Securitization and
Derivatives Originate and Distribute Leads
to disintermediation of assets off banks balance
sheets, (partly regulatory arbitrage). But
commercial banks maintain contingent liabilities
as lenders of last resort and underwriters to
capital markets, especially when they have close
direct connections, e.g. Bear Sterns hedge funds
IKB and Sachsen conduits and SIVs, etc. Did
quality of credit assessment/monitoring decline
as a result? Supposed to be checked by credit
rating agencies.
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3. Credit Rating Agencies Usually only rate
credit default risk. Misinterpreted to cover
market and liquidity risk as well. So AAA of
government debt not the same quality of AAA of
senior tranche of CMO. Moodys suggestion to
widen ratings categories. Maybe they have got
credit default risk wrong? No prior example over
US data period of housing prices falling across
the board. Non-linearities. Conflicts of
interest? Paid by originator, but reputation.
Insufficient competition.
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(4) Insufficient Liquidity and excessive maturity
transformation. Until 1960s, 25 plus real
liquid assets. Continuously declining
trend. Reliances on wholesale funding and
short-term credit market. Massive maturity
transformation. If trouble arises, depend on
Central Bank to sort it out. Widened range of
collateral assets. Yet another Central Bank put,
a liquidity put.
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(5) So financial crisis was an accident waiting
and ready to happen. Central banks could, and
did, see it coming, but did not feel able to do
anything about it. BoE FSR April (Sir John
Gieve). Trigger was US sub-prime mortgage
market, but it could have been elsewhere. How
did it spread so widely?
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(6) Slice and Dice
Senior Tranche AAA ? Conduits, SIVs Pool ?
Mezzanine Tranche ? Pension Funds? Equity
Tranche ? Hedge funds (toxic waste) Risks
in equity tranche can be partially hedged.
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(7) Historical path US interest rates up,
housing prices falter starting in early
2007. Hedge funds hit, Bear Sterns, others
nothing much happens, but uncertainty about how
far defaults will eat into higher
tranches. These are financed by ABCP largely
held by money market fund managers. They have
convertibility commitment, little capital and no
LOLR. They flee in masse. Impossible (and
undesirable) to sell the CMOs. IKB and Sachsen.
Contingent commitments many times capital. Is
counterparty bank safe for interbank lending?
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(8) Historical path (contd) Banks can see
contingent commitments coming home to roost, plus
doubts about counterparties. So early August, 3
month interbank market dries up. Systematic net
borrowers in wholesale markets increasingly at
risk (Northern Rock).
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(9) What can/should Central Bank do? (a) Lower
official rate/penalty ceiling at very short end,
but inflation mandate? (b) Widen collateral,
undertake operation twist (3/1 month). But, (i)
would it work? (ii) Moral Hazard? (c) Undertake
massive LOLR. But even if not prevented by
Market Abuses Directive, (MAD), can you keep it
covert, BoE balance sheet publication? (d) Where
do we go from here?