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Jacques de Larosière’s analysis :
« Markets have been surprised by the eruption, on the 9th of August 2007, of the financial crisis. But a number of analysts had drawn the attention on the risks stemming from the co-existence of excessive liquidity, overextended institutions and an extreme sophistication of financial products.
« This crisis is a-typical. Contrary to the financial shocks of the 80s and 90s, the present turmoil did not come from emerging markets. It took place in the United States, the most prosperous country in the world, and originated in the mortgage subprime market (one of the most risky) and it spread out worldwide leading investors to loose confidence and to rush towards safetier instruments. This process has practically dried out liquidity on a number of credit markets considered, most often wrongly, as dangerous.
How did we get there and how can we resolve the issue ?
« Let us try to answer this question in analyzing the factors at the source of the crisis, the specific characters of this dislocation and the actions that are called for in order to restore confidence and to reduce the probability of a repetition of such situations.
I. Factors at the source of the crisis :
« As it has been the case in most financial crises, the present situation is the result of the combination of excess liquidity (and therefore low interest rates), of an acute search for high yields (i.e. for risky instruments), of very thin risk premiums, as well as of an insufficient understanding of the true risks involved. The conjunction of such factors is well known in history. Usually, when bubbles have gone too far, the game of easy borrowing eventually stops at the very moment credit defaults appear, which has been the case a few months ago on the American market of the subprime. That is when markets suddenly realize the danger and overreact in panic.
II. Some thoughts on the specific characters of the present crisis :
« Three issues seem important for the understanding of what has happened.
« 1. The issue of transparency : it is at the heart of the present crisis. Why ? Because financial so called structured products are more complex (they often combine low and high rated assets in single instruments) and hard to understand let alone to gauge. This is so true that, when liquidity evaporates, some of these assets are extremely difficult to value. Also because most of the non banks -that hold such products and refinance themselves on the market- are not supervised, are not listed and therefore are not subject to mandatory disclosure rules. The amount of leverage they engage in is not precisely known in most cases. Thus, those investors who have a mandatory requirement to hold investment-grade instruments, have been able to buy portions of structured products with high ratings because of bundling techniques and rating agencies methodologies. Therefore, the market place -when something goes wrong, as has been the case with the recent increasing delinquency ratios in the US sub prime,- feels uncertain on the quality of assets and confidence starts waning. That was when contagion spread out irrationally from the subprime mortgage problem into the credit markets at large and ended up in a widespread flight from risk. I could not overemphasize the importance of transparency for preventing such systemic reactions.
« 2. The fabric of the new financial world, as it has developed over the last years, has lowered risk assessments and encouraged credit laxity :
« As we all know, the system has shifted from direct bank loans to market financing . There is nothing wrong in this evolution. It has allowed an enormous rise in capital flows and has been a major engine of world economic growth.
« But significant deviations -which have often gone unnoticed- have occurred :
« global expansionary monetary policy (which led to negative real US interest rates, in terms of expected inflation, in 2002-2004) has allowed liquidity to increase in such a way that the possibility of scarce money was not even a consideration in the mind of most of the market players. This is always dangerous ;
« a number of financial institutions wanted to take advantage of the appetite for higher yields. They have thus systematically sought to sell their initial credits to special vehicles. In doing so, they saw two advantages : they made high fees on securitisation transactions and they got out of their balance sheets costly (capital adequacy wise) and risky credits ;
« one of the dangers of this wave of securitisation is that some banks tend to become less vigilant on the quality of their loans and more interested in the quantity of credits to be packaged at remunerative conditions. This was particularly the case of US subprime lenders . A number of originators, -some non regulated like mortgage brokers, some directly regulated as investment firms or banks-, were tempted to give too much weight to the growth of their business, provided they found an arranger to bundle and sell the assets as well as proper bridge refinancing. The same pattern is true for the arrangers : they only take the transitional warehousing risk and the distribution risk. They may know that the underlying risk of the assets is increasing but they don’t always care since they are not supposed to hold these assets. Their reputation is nonetheless at stake.
« the spreading out of risks through securitization was seen as protecting the financial system from too much credit risk in banks balance sheets. But the dispersal of structured credit products has substantially increased uncertainty about the extent of the risks and where they are ultimately held , as well as about investors behaviour in case of a market reversal ;
« but, perhaps the biggest danger lies in the proliferation and deterioration of Special vehicles (SPVs). Initially, these off balance sheet vehicles were not exposed to liquidity risk as they were fully covered by back-up lines granted by their sponsoring financial institutions. But, more recently, sophisticated conduits -structured investment vehicles- (SIVs) were established with partial back up lines. Their business was based on the premise that, in the event, their high-grade assets would not fall down the rating curve suddenly but in an orderly fashion that could be anticipated. They thought they would be able to sell down assets and terminate hedges gradually, while still retaining high-grade debt status. All this has been severely tested by recent events.
« 3. The issue of regulation :
« Disintermediation, as it worked in its latest excesses, performed like a huge quasi-banking machinery. A number of actors (mostly non regulated) sold packaged credit-based instruments to investors worldwide. Indeed, the most sophisticated SPV conduits turned out to be virtual or synthetic banks, taking the same range of risks -in terms of interest rates, cost of risk and maturities-. But, contrary to banks, these entities had a very weak capital, no deposit base and were not regulated. This funding mismatch was at the heart of the turmoil. The limits of these vehicles were : market acceptance to refinance them and the willingness of their bank’s arrangers to set up liquidity lines.
« So, the bottom line is that the main constraint that applies to these vehicles is, besides the banks willingness to ensure liquidity eventually beyond the agreed back-up lines, market behaviour.
« But market behaviour can only be guided by information and disclosure. This information was, in essence, provided by rating agencies. However it is a fact that the relaxation of lending criteria for the sub-prime borrowers in the last two years has not been properly incorporated into the rating process. Early observable signs of increasing delinquencies came late and could not easily be interpreted in terms of expected losses. Furthermore, rating speaks to the likelihood of default, but not to the amount that may be recovered in a post-default scenario. In addition, ratings cannot be considered as precise predictions of default probabilities as they are essentially linked to averages from past observations and do not grant much weight to recent trends. More generally, it appears that the riskiness of some of the individual tranches of mortgage pools has proved to be often underestimated.
« So, if rating agencies cannot provide an adequate picture of looming potential risks, isn’t there a case for more preventive action through regulation, or, at least, disclosure ? The issue cannot be just brushed aside because markets are always right. After all, claiming that the market is the best regulator finds its limits when Central Banks must intervene to avoid a collapse of liquidity.
III. Suggested actions : « It seems to me that, besides the subject of the subprime market -basically a serious US consumer protection problem- different issues should be dealt with.
« I shall mention a few of these issues :
« the issue of off balance sheet conduits and the reputational risks involved by sponsoring banks. It is obvious to me that back-up lines deserve more scrutiny from the regulators. These lines were not appropriately risk-weighted under Basle I and the large exposure regime (0 % risk-weighting for lines shorter than one year). The new framework is better calibrated but may still be challenged as partial liquidity lines may be insufficient and could lead to larger calls on banks. In any case a swift and general implementation of Basle II is of the essence ;
« the issue of risk concentration. Is it normal that some financial institutions have engineered SIV’s whose assets amounted to several times their capital ? The off-balance sheet character of these conduits seems to have encouraged some institutions to disregard the wise old rule of : never put more than 25 % of your equity on one client. This is all the more relevant that many SIVs are concentrated on one sector (for instance, mortgage or subprime). In this case also, the reform of capital adequacy constraints addresses partly the issue (Pillar II) ;
« the issue of rating agencies is, of course, on the list, and it is directly related to the way regulation is conceived. I believe that rating agencies have been, de facto, too much used as proxies for regulating markets whilst they are unable to play such a role. Furthermore, it is clear that there is an imbalance between the incentives of rating agencies to get remuneration from their clients on the one hand, and the rather weak incentive they have to follow up the borrower’s quality on the other hand. This leads agencies to grant limited resources to the surveillance of their ratings. Further thought on possible conflicts of interest and on the methodology used by rating agencies to assess evolving risk quality and complex instruments, is called for ;
« the issue of transparency needs to be addressed, as I mentioned above, in its various dimensions (valuation issues reporting by non-regulated entities, methodology of ratings for complex products…). Firms must improve their understanding and monitoring of risks (including liquidity risk) linked to credit transfer products. The need for transparency will however be better satisfied by the relevance of information than by its abundance. The market will only be confident when the true risks involved in such products are well understood. Some products, in particular the more complex ones, should be known as risky from the start, while others -more simple and widespread- should be constructed, marketed and publicised as largely secured (liquidity wise) ;
« the issue of whether -and, if so, how- unregulated entities, such as hedge funds or bank or non-bank sponsored special vehicles (which have played a major role in spreading risk to investors) should be regulated and subject to capital requirements, or, at least, be under disclosure obligations ;
« given the global nature of the liquidity problems, it is even more essential than ever to try and reach, on fundamental principles, a global position among regulators and supervisors.
« One should also have in mind the subject of asset management (structure of mutual funds, maturities, exit conditions…).
« Most of these matters can be dealt with through improved practices and standards by the industry. Some are, in my view, of the competence of regulators. Hence, the importance of a constructive dialogue between the private and the public sector. This dialogue should focus on what is essential to restore investor confidence. But it should not, in any way, be construed as hampering financial innovation which must remain alive and at the heart of our industry albeit better explained and, if needed, better regulated.
« Markets will recover even if that can take some time. We are fortunate that the fundamental factors behind world growth remain healthy, that banks are strongly capitalized and that Central Banks (especially the ECB and the Fed) have been wise and reactive in their interventions as lenders of last resort. We must now do all we can to restore confidence among investors while keeping in mind the need to correct in an intelligent fashion the world imbalances which remain centred on the United States and Asia. »
Jacques de Larosière
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