MEAFA Financial Crisis Forum

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MEAFA Financial Crisis Forum

• Accounting for Self Interest
• in the Credit Crisis
• John Roberts
• j.roberts_at_econ.usyd.edu.au

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Accounting for Self Interest in the Credit Crisis

• I made a mistake in presuming that the self
  interest of organisations, specifically banks and
  others, were such that they were best capable of
  protecting their own shareholders and their
  equity in the firms .. So the problem here is
  something which looked to be a very solid
  edifice, and indeed, a critical pillar to market
  competition and free markets, did break down. And
  I think that, as I said did shock me. ,, I found
  a flaw in the model that I perceived is the
  critical functioning that defines how the world
  works.
• Alan Greenspan, October 2008,
• Testimony to House Oversight Committee

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Accounting for Self Interest in the Credit Crisis

• Two Questions
• How was self interest constructed in financial
  markets?
• How can we account for its failure?

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Accounting for Self Interest in the Credit Crisis

• Social Studies in Finance Michel Callon
• Economics and finance conceive of the individual
  agent as an atom too isolated too
  autonomous.
• agent-networks agent is always only a node in
  a network of relationships.
• As an atomistic agent I can defend my self from
  others my interests
• As an agent-network I defend my interests by
  defending the relationships.
• Interests are inter-esse between rather than
  within individual/institutions.

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Accounting for Self Interest in the Credit Crisis

• Social Studies in Finance Michel Callon
• Self interest requires work/calculation to
  disentangle my interests within a relationship.
  
• Externalities or overflowing is normal rather
  than an accidental and exceptional leak.
• Not only humans but also non-humans - notably
  models and accounting - should be treated as
  agents in financial markets.

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Originate-to-Hold
Lender
Borrower
Originate- to- Distribute
Hedge Fund
Rating Agency
Lender/ Mortgage Broker
Borrower (subprime)
Institutional Investor
Investment Bank
Insurer
Securitisation Tranching CDS Leverage
Moral Hazard
Pervasive reliance on Models and Accounting
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Accounting for Self Interest in the Credit Crisis

• Constructing Self Interest through
  disentanglement
• Securitisation disentangling the risk of a
  particular loan by bundling it up with lots of
  others and selling it on.
• Tranching Equity (0-3), Mezzanine (4-15),
  Senior tranches (16-100) Credit enhancement
  through disentangling risk and return through a
  waterfall and reverse waterfall principle.
• Synthetic CDOs use of credit default swaps -
  disentangling risk from the underlying assets
  transforming event risk (default) into market
  risk (price).
• Leverage 12-1 banks, 30-1 investment banks,
  60-1 SIVs

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Accounting for Self Interest in the Credit Crisis

• Constructing Self Interest through
  disentanglement
• Ratings Agencies
• Mono-line Insurers
• Indices CDX, iTraxx, ABX.HE
• Pervasive reliance on Models - pre-payment
  variables housing macroeconomic data,
  interest rates Default variables loan to value
  ratios, default probabilities, recovery rates,
  correlation estimates.
• New Accounting Standards fair value, available
  for sale/ held to maturity, hierarchy of
  measurement- quoted prices, observable inputs,
  mark-to-model.

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Accounting for Self Interest in the Credit Crisis

• Overflowing
• Higher than modelled level of defaults on
  subprime, falling housing market, lower recovery
  rates.
• losses on equity and mezzanine tranches.
• Mark to market losses.
• SIVs SPVs reappearing on balance sheets.
• Leveraged losses.
• Credit risk becomes market risk becomes
  counterparty risk becomes liquidity risk.
• Second order contagion.

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Accounting for Self Interest in the Credit Crisis

• Hyperreal interaction of models and accounting
• Models and Accounting mediate almost all
  relationships.
• Treated as embodiments of rationality and
  neutral and objective measurement.
• But as agents acted as a mutually self
  referencing hall of mirrors
• Fed the illusion of rationality (greed) on the
  upside the apparently immediate focus of fair
  value on the current exit price possibly masked
  the way that price reflected only the modelled
  assumptions of future profitability.
• Fed fear and panic on the downside. Loss of
  trust in the models and accounting just as you
  most need them.

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Accounting for Self Interest in the Credit Crisis

• Financial Stability Report
• A small loss in value can force funds to sell
  large amounts of assets as liquidations to meet
  margin calls and simultaneously, their
  redemptions increase. Such fire sales could lead
  to a vicious circle of forced sales, as the
  widening of spreads forces hedge funds and others
  who mark portfolios to market to post losses,
  possibly sparking investor withdrawals and
  further forced sales. (October 2007)

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Accounting for Self Interest in the Credit Crisis

• Counterparty Risk Management Policy Group
• there is almost universal agreement that.. the
  characteristics of these instruments and the risk
  of loss associated with them were not fully
  understood by many market participants. This lack
  of comprehension was even more pronounced when
  applied to CDOs, CDO squared, and related
  instruments, reflecting a complex array of
  factors, including a lack of understanding of the
  inherent limitations of valuation models and the
  risks of short-run historical data sets. As a
  consequence, these instruments displayed price
  depreciation and volatility far in excess of
  levels previously associated with comparably
  rated securities (200853).

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