It is far too early to tell how the credit crisis will play out, but the year end is a good time to reflect on the lessons so far.
Most of the follies committed in successive credit cycles are depressingly repetitive. This time, though, there have been some genuinely new ones, which – with luck – ought not to plague us again.
First on the list come complex credit derivatives, of which the collaterised debt obligation, or CDO, is the obvious example. Not all credit derivatives are a bad thing. But if CDOs were abolished, the financial world would be a safer place.
Consider how the crisis is conventionally attributed to US subprime lending. As Alan Greenspan has recently remarked, this is slightly misleading. Subprime was part of the general craziness. If it had not provided the trigger, there were plenty of other candidates.
But in previous cycles, the subprime problem would have been clearly identifiable and thus contained. CDOs made it much worse, through what one might term the sausage effect. If a consignment of tainted meat arrives in the factory and is not spotted in time, the entire stock of sausages must be dumped. So it is with asset-backed CDOs in general.
More important, complex credit derivatives turned out to have a pro-cyclical effect – that is, they made the craziness worse. A large part of the trick, it turned out, was for issuers to repackage poor-quality debt in such a way that the sum of the parts was greater than the whole
The credit rating agencies were an essential part of this. The issuer would design the various tranches of the CDO in such a way as to raise their aggregate ratings, with the agencies’ approval. It was thereby possible to turn $100m of loans into $103m or $105m with a wave of the wand.
Since investment-grade debt does not offer the same scope for alchemy, the result was a perverse demand for junk, which fed down the line to the US mortgage market and also spurred on the private equity boom.
And when overleveraged corporate borrowers got into trouble, there was a ready supply of fresh debt to bail them out. So default rates sank to historic lows, thereby adding a fresh turn to the vicious circle.
All of this ultimately rested, of course, on the gullibility of the end investor. In that sense at least, the cycle was normal enough. But the same complexity that allowed the investor to be duped is also making the downswing of the cycle nastier and more prolonged.
This is exactly as foretold by Warren Buffett nearly four years ago. Having decided to liquidate a derivatives portfolio acquired with General Reinsurance, he reported that after two years’ trying he still had a third of the contracts on his hands. And this was in a benign and orderly market – just the opposite, he remarked, of what might be expected in a financial crisis.
None of this, as I said earlier, means credit derivatives are a bad thing per se. The plain vanilla single-name credit default swap is a useful invention, if handled with discretion. But the more complex form of derivative will hopefully die with this cycle. The challenge will be to spot its equivalent next time round.
Another innovation that seems justly doomed is the structured investment vehicle, or SIV. Much attention has been paid lately to the so-called shadow banking system, created to get round the regulators. SIVs were an essential part of that. Accounting standards are now catching up, so that SIVs will have to be on the balance sheet unless they really are non-recourse entities – which would rob them of most of their point.
All this in turn forms part of a much larger issue, that of securitisation. With hindsight, much of the purpose of those innovations was to let the banks accelerate their lending in the upswing of the cycle, without any tiresome regulatory capital constraints.
In the next upswing the same process of gaming the regulator will of course recur, if in different form. But if investors’ appetite for complex derivatives has been permanently damped, that will deprive the banks of a powerful weapon of self-harm.
That said, it seems unlikely that the next cycle will be quite as crazy, if only because the memory of the damage suffered by the banks this time will be slow to fade. Consider only how Morgan Stanley can count it a success to sell 10 per cent of itself at a price nearly 40 per cent off its high. That is no way to run an industry.
And still the crisis deepens. It is not even clear yet whether the root problem for some banks is mere illiquidity or full-blown insolvency. But that is a topic for another column.
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