Keeping hold of the basic rules of finance
Roger Altman | Saturday, 31 May 2008
NO figure commands more respect within the world's financial community than Paul Volcker, the former Fed chairman. That is why his recent declaration -- "the bright new financial system had failed the test of the marketplace" -- was such a profound rebuke. It implied that the behaviour of market participants, rating agencies and regulators during the recent credit bubble was unsound to the point that markets had now rejected it. Mr Volcker is right and most people know it.
Unfortunately, such behaviour is characteristic of bubbles: the laws of finance are ignored amid a euphoric belief that they no longer apply. They are ignored, however, only up to the point when they invariably reassert themselves, as they did, beginning nine months ago, at great cost to the financial system. The period of revisionist finance has come to an end -- again.
We cannot eliminate bubbles, but the question is how to avoid another round of credit speculation. The answer is to understand the worst excesses we have just seen and how the rules of finance have re-established themselves.
Let us start with excess leverage, because this is the primary cause of any credit bubble. We saw buy-outs of companies where banks fell over themselves to lend amounts equal to 10 or more times the underlying cash flow, compared with the long-term average of approximately five times. Securities companies increased their own borrowing to 32 times their real capital, an all-time high. The ratio of US financial assets to gross domestic product (GDP), a partial proxy for overall levels of debt, hit a historic high of nearly seven times.
Next, let us look at credit speculation. The best illustration is the meteoric rise of credit default swaps. At their core, these are simple instruments that represent insurance against a bond defaulting. But, as the credit mania spread, the $5,000bn of CDS insurance outstanding in mid-2005 turned into $50,000bn two years later. This amount is 10 times greater than the total value of all bonds that could be insured. So this growth had nothing to do with protecting against defaults. Instead, it was just betting on markets.
Then risk became mispriced as the link between interest rates and credit quality weakened. For example, the poorest quality bonds usually carry yields about 5.0 percentage points higher than the rate at which the US Treasury borrows. But, at the peak of the credit euphoria, this spread was cut in half. In other words, loans were being extended to the weakest credits at only slightly higher rates than those for the best credit in the world.
Further, the credit rating agencies fell victim to self-delusion. Historically, a triple A rating meant that the risk of default was in effect zero. This time, however, the agencies determined that certain leveraged pools of mortgage-backed securities deserved the highest ratings. The idea that distressed homeowners might be pushed into widespread defaults on subprime mortgages apparently escaped them. The result was the first set of outright defaults on triple A rated bonds in memory.
Finally, banking regulators were lulled into complacency. Banks created numerous off-balance-sheet vehicles to issue asset-backed securities. As these were not the direct obligations of, say, Citigroup, regulators did not follow them closely or apply minimum capital requirements against them. Only later was it recognised that the banks had retained risks on those securities and suffered big losses related to them.
How did the laws of finance help end this credit bubble? First, history tells us that leverage in the financial system acts like a rubber band -- the further you stretch it, the harder it snaps back. When system-wide leverage rises sharply in a short period, there will be a correction and it will be sharp.
Second, over the long run, the price of credit is always correlated to its risk. Over the long term, interest spreads between ratings categories are substantial. Any time those spreads diminish to small amounts, a reversion eventually occurs.
Third (observations from financial wise men notwithstanding), it is not correct that the growth of derivatives invariably reduces risk, or that minimum capital requirements are not needed against them. The sudden and exponential growth in derivatives, such as CDS, promoted risk. Derivatives facilitated speculation.
Fourth, bond investors are always the ultimate judge of credit quality, not the rating agencies. If the latter get it wrong, as they did so spectacularly here, investors adjust bond prices regardless of their ratings.
Finally, as Mr Volcker implied, regulators were caught short. The idea that ever more incomprehensible securities can be combined with dwindling levels of transparency from financial institutions is now discredited.
Market bubbles embody the temporary ascendance of hope and revisionism over experience and the basic rules of finance. The better hope is to remember those rules in the future.
.........................................................
The writer is chairman and chief
executive of Evercore Partners and was deputy US Treasury Secretary under President Bill Clinton
Unfortunately, such behaviour is characteristic of bubbles: the laws of finance are ignored amid a euphoric belief that they no longer apply. They are ignored, however, only up to the point when they invariably reassert themselves, as they did, beginning nine months ago, at great cost to the financial system. The period of revisionist finance has come to an end -- again.
We cannot eliminate bubbles, but the question is how to avoid another round of credit speculation. The answer is to understand the worst excesses we have just seen and how the rules of finance have re-established themselves.
Let us start with excess leverage, because this is the primary cause of any credit bubble. We saw buy-outs of companies where banks fell over themselves to lend amounts equal to 10 or more times the underlying cash flow, compared with the long-term average of approximately five times. Securities companies increased their own borrowing to 32 times their real capital, an all-time high. The ratio of US financial assets to gross domestic product (GDP), a partial proxy for overall levels of debt, hit a historic high of nearly seven times.
Next, let us look at credit speculation. The best illustration is the meteoric rise of credit default swaps. At their core, these are simple instruments that represent insurance against a bond defaulting. But, as the credit mania spread, the $5,000bn of CDS insurance outstanding in mid-2005 turned into $50,000bn two years later. This amount is 10 times greater than the total value of all bonds that could be insured. So this growth had nothing to do with protecting against defaults. Instead, it was just betting on markets.
Then risk became mispriced as the link between interest rates and credit quality weakened. For example, the poorest quality bonds usually carry yields about 5.0 percentage points higher than the rate at which the US Treasury borrows. But, at the peak of the credit euphoria, this spread was cut in half. In other words, loans were being extended to the weakest credits at only slightly higher rates than those for the best credit in the world.
Further, the credit rating agencies fell victim to self-delusion. Historically, a triple A rating meant that the risk of default was in effect zero. This time, however, the agencies determined that certain leveraged pools of mortgage-backed securities deserved the highest ratings. The idea that distressed homeowners might be pushed into widespread defaults on subprime mortgages apparently escaped them. The result was the first set of outright defaults on triple A rated bonds in memory.
Finally, banking regulators were lulled into complacency. Banks created numerous off-balance-sheet vehicles to issue asset-backed securities. As these were not the direct obligations of, say, Citigroup, regulators did not follow them closely or apply minimum capital requirements against them. Only later was it recognised that the banks had retained risks on those securities and suffered big losses related to them.
How did the laws of finance help end this credit bubble? First, history tells us that leverage in the financial system acts like a rubber band -- the further you stretch it, the harder it snaps back. When system-wide leverage rises sharply in a short period, there will be a correction and it will be sharp.
Second, over the long run, the price of credit is always correlated to its risk. Over the long term, interest spreads between ratings categories are substantial. Any time those spreads diminish to small amounts, a reversion eventually occurs.
Third (observations from financial wise men notwithstanding), it is not correct that the growth of derivatives invariably reduces risk, or that minimum capital requirements are not needed against them. The sudden and exponential growth in derivatives, such as CDS, promoted risk. Derivatives facilitated speculation.
Fourth, bond investors are always the ultimate judge of credit quality, not the rating agencies. If the latter get it wrong, as they did so spectacularly here, investors adjust bond prices regardless of their ratings.
Finally, as Mr Volcker implied, regulators were caught short. The idea that ever more incomprehensible securities can be combined with dwindling levels of transparency from financial institutions is now discredited.
Market bubbles embody the temporary ascendance of hope and revisionism over experience and the basic rules of finance. The better hope is to remember those rules in the future.
.........................................................
The writer is chairman and chief
executive of Evercore Partners and was deputy US Treasury Secretary under President Bill Clinton