The Financial Crisis: Background by C. Goodhart [A personal view]

(1)Mis-pricing of Risk A. Very low interest rates, , plus B. The Great Moderation/Stability, plus C. The Greenspan Put[?], equals Widespread under-pricing of risk.

(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.

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. Moody’s 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.

(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’.

(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?

(6)‘Slice and Dice’ MortgagePoD A5 B 7 → Pool C 6 D 7 E 5 Senior Tranche AAA→ Conduits, SIVs Pool → Mezzanine Tranche → Pension Funds? Equity Tranche→ Hedge funds (toxic waste) Risks in equity tranche can be partially hedged.

(7)Historical path US interest rates up, housing prices falter starting in early 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?

(8)Historical path (cont’d) 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).

(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?