Friday, September 26, 2008

Understanding Pinata

Watching Tyler struggle with the credit crisis is like watching a blindfolded man swinging at a Pinata. He sometimes gets close, but then he's just flailing at the air again. His latest swing:
The proximate cause of the credit crisis (as distinct from the housing crisis) was the interplay between two choices made by banks. First, substantial amounts of mortgage-backed securities with exposure to subprime risk were kept on bank balance sheets even though the “originate and distribute” model of securitization that many banks ostensibly followed was supposed to transfer risk to those institutions better able to bear it, such as unleveraged pension funds. Second, across the board, banks financed these and other risky assets with short-term market borrowing.
In other words, one problem was not enough (!) securitization. They also call for counter-cyclical capital requirements. They like mandatory capital insurance -- with payments triggered by capital disasters -- even better. My main worry, of course, is how we should regulate (or not) the entities which offer this insurance. Will they too engage in liquidity transformation and if so who ensures them?

And, going back to banks, part of the governance problem was this: is very hard, especially in the case of new products, to tell whether a financial manager is generating true excess returns adjusting for risk, or whether the current returns are simply compensation for a risk that has not yet shown itself but that will eventually materialize.
Their phrase "recapitalization as a public good" should not soon be forgotten. And it is leverage which is dangerous, a lesson becoming clearer every day.
Sadly, Tyler just keeps being wrong in exactly the same way again and again and thinks he is making progress. This is particularly interesting in his latest post because the paper he's refering to actually nails the ultimate cause:
Second, across the board, banks financed these and other risky assets with short-term market borrowing.
Tyler sadly ignores this because it describes the entire world banking system. While the proximate cause of this crises is bad mortgages and insufficient securitization, there have been crises in the past that look exactly the same from a credit perspective, but have different proximate parameters. Instead of focusing on the most recent horseless barn, perhaps we could consider that fact that the barn, indeed all barns, are missing an entire wall. Go back to the mock balance sheet, you'll see that equity is $5 and debt is $15 -- so 3x debt leverage, but that $5 of equity is floating $100 of price-unstable, mismatched securities! Even if GS had 0 debt (which is traditionally what I've understood "leverage" to mean) it would still have a much larger balance sheet that it's equity could support in the event of a bank run. Reducing operating leverage in banks will have no effect, because the difference in value for long term assets when maturity transformation works, and when it does not, is massive, and will overwhelm any possible equity cushion.


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