1. MEAFA Financial Crisis Forum Accounting for Self Interest in the Credit Crisis John Roberts j.roberts@econ.usyd.edu.au

2. 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

3. 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?

4. 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.

5. 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.

6. Originate-to-Hold Lender Borrower Originate- to- Distribute Borrower (subprime) Lender/ Mortgage Broker Investment Bank Rating Agency Insurer Hedge Fund Institutional Investor Securitisation – Tranching – CDS – Leverage – Moral Hazard Pervasive reliance on Models and Accounting

8. 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 CDO’s – 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

9. 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.

10. 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.

11. 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.

12. 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)

13. 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’ (2008:53).