Market Commentary: Causes and Ramifications of the Financial Crisis
Responsible for Treasury and Investment Banking
by Patrick Butler, Managing Board Member at Raiffeisen Zentralbank (RZB),
The last few months have seen a major reassessment of risk and the price it should command across all asset classes, but affecting, in particular, the sector where it first began and where the storm has been centred, the credit markets, with knock-on effects on anything and everything utilizing leverage.
In many respects this severe down-draught - some have even used the word ‘crisis’ - reflects others throughout history. A long bull market - fuelled by a confluence of benign factors, including a prolonged period of cheap and abundant liquidity, an absence of major credit events, a raw material price-inflation counterbalanced by a drop in production- and service-costs underpinned by new technologies plus global outsourcing and the emergence of the new workshop of the world, China - led to a complacent belief that things can only get better. The only way is up, the ‘Goldilocks’ economy and market, neither too hot nor too cold, were here to stay. Stability was a given and price improvement - spread compression - in the credit markets - was a long-term trend. In this environment the search for yield and a willingness to ‘suck it and see’ encouraged financial engineers to invent ever more complex devices to gear up on yield and risk - sometimes multiplying leverage by 20x and more.
Let’s face it, we are all influenced by our own experience, and, like the VaR and other models so favoured by our regulators these days, we tend to place more weight on recent history than the distant past.
Lenders - investors - got complacent. Bad news from one sector - the US sub-prime market - was largely dismissed at first in the wider market. Then nagging doubts nibbled away at confidence as the reality sank in that these risks had been so sliced and diced and redistributed and releveraged that God alone knew who was holding what. A slow march towards lower duration, less risky assets turned into a headlong flight to safety as mild concern metamorphosed into blind panic. Not much then, to distinguish this crisis from its predecessors. Of course there are many similarities - over confidence, over liquidity, over-leverage, over-paying for assets. But there are key differences.
Assumptions found wanting
Rarely, if ever, since the late 1920s and early 30s, have so many fondly cherished assumptions -assumptions embraced by market participants and codified by the regulators - been challenged and found wanting. For instance, a complete industry has grown up around ratings. The last couple of months have raised a huge question mark over the methodology and hypotheses underpinning the major agencies’ ratings on a raft of structured securities. CPDOs which last year, for instance, were rated AAA have recently been trading at prices below 70%. But the point here is not directed at the rating agencies but at the dubious science which lies at the heart of so many risk models, value measures and, ultimately of a whole regulatory framework (Basel II); a science based on the assumption that ratings can be drawn exclusively from historical statistical PDs and LGDs (Probabilities of Default and Loss Given Default). Put bluntly, the theoretical model failed the reality stress-test!
The issue of diversity
Even more fundamental than the model-myth is another assumption which must now be seriously questioned. In many fields, diversity is rightly regarded as a source of strength. In nature, heterogeneity helps ensure that no one flaw will prove fatal to a whole species. The same principle governs the sensible policy, in many companies, that senior managers travel on different flights. Portfolio diversification is a synonym for prudence in investment management.