Thursday, January 01, 2009

Were the wizards of Wall St. blinded by their own light?

Is the current financial crisis indicative of a progress trap? Were the wizards of Wall St. blinded by their own light? It's a profoundly complex issue, and too early to call. However, in searching for clues there are some useful pointers. The Markit company was founded in 2001 to provide information on the newly deregulated Credit Derivatives market, and their publication Markit Magazine offers expert, though slightly ambivalent, insight. They are optimistic that the future will see improvement. Andrew Cavenagh, writing in the Summer 2008 issue, is frank in explaining the weakness of two "smug" assumptions. One is that the global credit market was large and resilient enough to absorb shocks without permitting structural damage to the credit system. The other is that the "exponential growth of securitisation worldwide" provided a reliable, cheap source of funding that allowed lenders to risk sub-prime mortgages, knowing that the risks would then be passed on to the larger credit market as derivatives. Also known as "repackaging toxic debt".

This is a huge market where quantity has counted more than quality. Reading further in Markit magazine it remains difficult to tell whether lessons will be learned. One would expect that swift regulation would end the tendency to trade in financial instruments that have been increasingly abstracted from real assets. According to Lehman Brothers (now defunct) in The Lehman Brothers Guide to Exotic Credit Derivatives "The credit default swap is the basic building block for most ‘exotic’ credit derivatives". However, reports that the SEC Chairman Christopher Cox said on Sept. 23, 2008 that "Neither the SEC nor any regulator has authority over the CDS (credit default swap) market, even to require minimal disclosure," and that should be addressed "immediately". At year-end, this remains unregulated, with some critics citing fear of worldwide derivatives market disruption. Didn't this already happen? If the U.S. sub-prime practices caused global shockwaves, surely U.S. regulation would be entirely appropriate.

If you thought it ended at exotic swaps, think again. Financiers trade options on swaps, and the term for that instrument is - you guessed it, "swaptions". Denise Bedell, of Markit magazine, writes in the Winter 2008 issue: "we can still learn lessons from past crises that can help guide the success of current efforts and curb the length and severity of the present turmoil." Tellingly, a sidebar to her article has a history of US financial crises, beginning 1819 and repeating the same mistakes to the present. A recurring feature of these crises is loss of credit to the average citizen, of consumer confidence and jobs in what we now refer to as “Main Street”. These issues are getting secondary consideration, but leaders can address them regionally without waiting for international coordination.

I would conclude that if the global community was behaving differently from, and more pragmatically than the U.S., we might not fall into the trap of being too clever for one's own good, and salvation may come from other nations. There are many of those and some must have their feet on the ground, so I too am optimistic.

Andrew Cavenagh the markit magazine – Summer 08: One change that seems certain to result from the debacle is that institutions that originate mortgages – or any other types of loan – will no longer be allowed to sell on the entire risk to the capital markets. It is hard to imagine that some of the reckless sub-prime lending that occurred in the US would have happened if the lenders had been obliged to keep the “assets” on their balance sheets. 

Denise Bedell Winter 2008 – the markit magazine
Bedell, in Learning from the past quotes a credit analyst as saying "the current bailout packages we are seeing are proving absolutely necessary in order to stop the complete crisis of confidence. With the packages, they have the crash trolleys out and have applied the defibrillator so the patient is at least alive. So now the global economy needs to be nursed back to health." The remarks of a senior equity capital markets banker are also quoted: "They will do whatever it takes to succeed, they will repair the credit markets, and if the current packages aren’t enough then they will throw another log on the fire."