Willem Buiter's Revised Prescription

Willem Buiter has authored a paper Lessons from the North Atlantic Financial Crisis, which updates his previously reviewed ‘Lessons…’.

He states:

Very rapid growth of the broad monetary and credit aggregates could (and should) have been a warning sign that a financial bubble might be brewing. It was not considered worrying, probably because on the other side of these transactions were not primarily non-financial corporations and households but rather other, non-deposit-taking financial institutions. Leverage increased steadily in the financial sector (especially outside the commercial banks) and in the household sector. This was interpreted as financial deepening and further productivity and efficiency-enhancing financial sector development, rather than as a financial sector/household sector Ponzi game in which the expectations of future capital gains drove current capital values and made true earnings a side show.

One cause of the current crisis was securitization:

  • The greater opportunities for risk trading created by securitisation not only make it possible to hedge risk better (that is, to cover open positions); they also permit investors to seek out and take on additional risk, to further ‘unhedge’ risk and to create open positions not achievable before. … we can only be sure that the risk will end up with those most willing to bear it. There can be no guarantee that risk will end up being borne by those most able to bear it.
  • The ‘originate to distribute’ model destroys information compared to the ‘originate to hold’ model.
  • Securitisation also puts information in the wrong place. Whatever information is collected by the loan originator about the collateral value of the underlying assets and the credit worthiness of the ultimate borrower, remains with the originator …
  • Finally, there appears to be genuine irrationality afoot in the markets during periods of euphoria. Even non-diversifiable risk that is traded away is treated as though it no longer exists.

and proposes the following solutions:

  • Simpler structures … Central banks could accept as collateral in repos or at the discount window only reasonably transparent classes of ABS.
  • Unpicking’ securitisation (doing original credit analysis of the underlying) … This ‘solution’ is the ultimate admission of defeat in the securitisation process.
  • Retention of equity tranche by originator. … It could be made a regulatory requirement for the originator of
    residential mortgages, car loans etc. to retain the equity tranche of the securitised loans.
    Alternatively, the ownership of the equity tranche could be required to be made public
    information, permitting the market to draw its own conclusions.
  • External ratings. … This ‘solution’ to the information problem, however, brought with it a whole slew of new problems.

And that slew of new problems is then analyzed and discussed – it is virtually identical to the prior paper, which was discussed at length there, so I’ll skip over that.

The next section deals with the procyclical effects of leverage and bank regulation:

This pattern of procyclical leverage is reinforced through the Basel capital adequacy requirements. Banks have to hold a certain minimal fraction of their risk-weighted assets as capital. Credit ratings are procyclical. Consequently, a given amount of capital can support a larger stock of assets when the economy is booming then when it is slumping. This further reinforces the procyclical behaviour of leverage.

While I will agree that credit ratings are procyclical – the upgrade/downgrade ratio varies with the health of the economy, rather than being constant through a cycle, which is the ideal – I don’t think this element of his argument is particularly well documented; the effect, while there, is (in normal times) fairly small. It is certainly true, though, that credit ratings of non-AAA sub-prime RMBS have precipituously declined in a manner well-correlated to their prices and the housing market!

However, Dr. Buiter does not propose a solution for this problem, only further study and a re-opening of the Basel II accord.

He further attacks excessive disintermediation in the financial system and is in favour of most off-balance sheet vehicles being brought back on the balance sheet of their financial sponsors, claiming that their role is of regulatory arbitrage and tax-avoidance, rather than a more legitimate business purpose.

Bonuses paid to employees also come under attack, particularly when these are based on short-term performance and unrealized capital gains. It is interesting to consider this problem in light of his recommendation that issuers retain the equity tranche of securitizations … realizing the capital gain on a highly profitable undertaking could become a matter of decades! It is disappointing that there is no evidence presented in support of the idea that bonus sizes were a direct contributing factor to the crunch.

The remainder of the paper deals with macro-economic analysis which, while interesting, will not be reviewed here.

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