Fragility seems to be the word on everyone’s lips today. As reported in the Financial Times, UBS market strategist William O’Donnell said that the commercial paper markets had dried up and, “Now the buyers are only interested in Treasury bills.”
Overnight, Rams, an Australian home lender that, while not exposed to US subprime, had been making no-down-payment mortgages in Australia. Rams was unable to extend $5 billion of commercial paper and had to seek emergency funding. Similarly, in Canada, ten financial institutions are orchestrating a bail-out of certain commercial paper trusts to alleviate a seize-up in its $37 billion CP market.
No wonder we have comments like this. From economist Thomas Palley:
As recently as ten days ago Fed policy was focused on containing inflation. Now, within the blink of an eye, the evaporation of confidence among Wall Street lenders has created conditions warranting an emergency rate cut to save the economy. This power of financial markets is rooted in a new business cycle that emerged in the 1980s and which has made the economy increasingly dependent on debt to fuel expansions. The creation of debt in turn relies on highly leveraged financial intermediaries that package and re-package loans while promising liquidity they are unable to deliver. As a result, the system has become fragile.
Similarly, from Harvard’s Dani Rodrik:
But financial fragility surely has implications for the real economy. Is this the necessary downside of a sophisticated financial system? Or can we do better with an improved regulatory and prudential structure?
Now when the dust settles, we are sure to see a rewriting of recent financial history and in particular, some tough questions put to regulatory who gave cheery assurance that everything was for the best in this best of all possible worlds of financial innovation.
The sad thing is that it will be Timothy Geithner, president of the New York Fed, was widely regarded as fairly outspoken for a regulator. He is now likely to get a lot of heat. Geithner was put in the no-win position of being asked to lead oversight of derivatives and other new products, when he suffered the double disadvantage of not having any real regulatory authority and being given that role in a Fed philosophically opposed to meaningful supervision.
Nevertheless, it’s not clear whether Geithner drank the Kool-Aid or simply felt constrained to make only anodyne comments. From a March speech:
In systems where credit is more market-based and more credit risk is in leveraged financial institutions outside the banking system, a sharp rise in asset-price volatility and the concomitant reduction in market liquidity, can potentially have greater negative effects on credit markets. If losses in these institutions force them to withdraw from credit markets, credit availability will decline, unless or until other institutions in a stronger financial position are willing to step in. The greater connection between asset-price volatility, market liquidity and the credit mechanism is the necessary consequence of a system in which credit risk is dispersed outside the banking system, including among leveraged funds. This does not make the system less stable, though, only different. For if risk is spread more broadly, shocks should be absorbed with less trauma. Moreover, the system as a whole may be less vulnerable to distortions introduced by the moral hazard associated with the access that banks have to the safety net.
A second issue we need to consider stems from the complexity of the new credit instruments, the challenges they present in terms of valuation and risk measurement and their short history of experience in times of stress.
Even the most sophisticated participants in the markets for these instruments find the risk management challenges associated with these instruments daunting. This raises the prospect of unanticipated losses. Default rates are harder to predict where there has been a substantial change in the financial attributes of borrowers. The prices of instruments may not respond as expected to a given change in losses or in the value of the assets underlying these instruments. Hedging strategies may prove to be less effective than expected. Similarly rated instruments can behave very differently in stress events….
A third issue relates to the dynamics of failure and the infrastructure that supports these markets. The dramatic growth in the volume of over-the-counter derivatives and the growth in the number and size of leveraged funds inevitably complicate the resolution of the failure of a large financial institution that is active in these markets. The sheer number of financial contracts that would have to be unraveled in the context of a default, the challenge that a former colleague of mine likes to refer to as “unscrambling the eggs,” could exacerbate and prolong uncertainty, and complicate the process of resolution…
All these challenges merit attention. They describe some of the risks that have accompanied the substantial benefits of credit market innovation. And they help illustrate why these broad changes in financial markets may have contributed to a system where the probability of a major crisis seems likely to be lower, but the losses associated with such a crisis may be greater or harder to mitigate….
It seems that Geithner, like the quants, underestimated tail risk.