toweringflat

Last night I attended a lecture given by Rotman finance professor John Hall on the credit crunch. After all of the hysteria I thought it would be good to get my head around what actually transpired. Here are my notes:

The Credit Crunch: A brief overview:
There was a quantum difference in the US housing market prices from 2000 to 2006. During this period it became much easier to obtain mortgages and this fuelled the demand for homes and kept pushing prices up. The housing market and financial engineers created new products which would pull people into the US housing market. Products became much more imaginative and saw the introduction of various new products such as teaser rates which were extremely low in the first 2 to 3 years and then resumed their real rates for the ensuing 27-28. NINJAS (no income, no jobs, no assets) were able to aquire loans, and even liar loans were approved (people lying on their applications about income and job status). The constant need to bring in new buyers into the market was the only way to push up prices and this created an artificial bubble.
AAA rated tranches were popular with banks but eventually financial products backed by mortgages that were previously thought to be safe became much more risky. It is difficult to pin this on any one player for behaving irrationally. Asset Backed Securities worked until people began to default on their payments and the structure began to collapse. The repackaging of mezzanine tranches into senior tranches and the redesign of these financial products to negotiate a better rating with the rating agencies became part of the course. Financial engineers kept redesigning the structure until they achieved a AAA rating. Essentially the financial structuring of ABS CDOs was too aggressive. Mortgage lenders stopped worrying about the quality of the credit and were just focused on ratings. Another challenge is that structured products require an assmuption about correlation. Rating agencies had to make assumptions about correlation. And during stressed financial situations correlations are more likely to go wrong. Correlations are high on mortgage defaults (several US states experiencing mortgage defaults) during financially stressed times. There's also evidence that mortgage originators used lax lending standards because they knew the loans would be securitized. For a rebirth of securitization it's necessary to align the interests of originators and investors. In fact professor Hall would suggest that originators should keep some percentage of each tranche and Allan Greenspan suggests that securitisers should retain a meaningful part of the securities they issue. Another problem was that originators and investors were trading and buying within the same bank without exchanging full information. There is also the overall trend of short-term decision making on the part of originators/bankers. Perhaps bonuses should be based on longer-term performance (eg. 5 years) as short-term based bonuses influence decision-making (especially in the US in 2006). In general investors were relying on credit ratings and did not understand the products they were trading. These structured products are among the most complex credit derivatives that exist.One suggestion by professor Hall was that lawyers should provide software that is freely available to investors and researchers. Most financial institutions at the time of the housing bubble did not have models to value the tranches they traded. Without valuation models risk management is virtually impossible. And another problem is that during booms no one listens to risk managers. There needs to be a way to prevent this.
Ultimately most people knew the subprime mortgage bubble would burst but not how bad the ramifications would be. And now what we are seeing is the contagion effect between financial institutions no longer trusting each other and unwilling to lend to each other.
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There is a decidedly very gloomy tone to London these days. And I don't think it is just the usual grey weather. This week's newspapers are laced with the stench of financial crisis and Bush pleading for a substantial $700 billion bail-out. I am starting to wonder whether I should pack up and head to Cuba for those adventurous years I never lived out in my twenties.

I have never been as interested in the inner workings of banking institutions as I am now, which must make me a pretty typical Joe. The past two weeks have driven me to the business dailies trying to piece together what exactly a credit crisis means. My ability to recognize patterns is somewhat curtailed in this area, however from the little I have been able to understand is the fact that the current meltdown is not just the fault of greedy bankers (as much as we might relish the idea of hanging them by their suspenders from London Bridge and/or Brooklyn Bridge), our present financial turmoil is the responsibility of central bankers who took their eyes off of regulation and to a large extent allowed what we are experiencing to happen. Another piece that I have uncovered is that changes in the supply of money and credit have been the main driver of economic cycles and booms and busts. To a large extent, it is mistakes in monetary policy which have driven every major recession in 20th and 21st centuries.

I am not sure that understanding or knowing any of this relieves the current states of stress we are all undergoing, and that I am certainly feeling. As I travelled to work on the bus today, I could hear a Carribean accent explaining to his mate that Bush was begging for a bail-out when the Americans have all of the money they need in their pockets. The tone was not one of sympathy but of can-you-believe-the-hootzpah that Bush would expect to be saved by global bystanders struggling to feed their own families.