Category: Interesting External Papers

The Bank of England has released its April, 2008, Financial Stability Report and it’s excellent. There’s way too much good stuff in it to make a series of extracts of managable size, but I will point out that they have highlighted the folly of relying on market prices to estimate ultimate credit losses:

But credit losses from the turmoil are unlikely to ever rise to levels implied by current market prices unless there is a significant deterioration in fundamentals, well beyond the slowdown currently anticipated. That is because prices are likely to reflect substantial discounts for illiquidity and uncertainty that have emerged as markets have adjusted but which should ease over time. While market-based estimates and the write-downs announced by firms may be unduly pessimistic, if such concerns persist there is a risk they could become self-fulfilling.
…
This suggests that spreads on senior tranches of structured credit products have been dominated by illiquidity and uncertainty premia and a large relative fall in demand for AAA tranches rather than credit risk over the recent period. This is consistent with the analysis in Box 1, which suggests that the largest gap between mark-to-market and cash-flow based estimates of losses on sub-prime securities is in the AAA tranches.

If this were the case, long-term and unleveraged investors could potentially profit by holding these AAA tranches to maturity. But Chart 1.22 shows that, until very recently when AAA tranches have risen in price, an investor following this strategy would have suffered a string of negative month-on-month returns over the past year. And as discussed in Section 3, many long-term investors often face implicit short-term performance targets and increasingly have to mark their portfolios to market, even when they have no intention of selling securities.

The BoE contention that market prices – especially marks implied by such things as the ABX indices – are stupid is something that I’ve been saying for quite some time (in my review of the estimates by Greenlaw, et al. and in the seemingly very closely related IMF report). These reservations were echoed by BoC Governor Carney in remarks reported May 1.

Update, 2008-5-12: Willem Buiter doesn’t believe the Bank’s analysis:

But why oh why did the FSR use American subprime mortgages to make the point that marked-to-market estimates of credit losses may well exaggerate the likely eventual magnitude of these losses? I will quote the Bank’s reasoning at length, so as to be sure I don’t misrepresent it:

“Future credit losses can be estimated by extrapolating forward delinquency rates. In particular, it is assumed that serious delinquency rates of US sub-prime mortgages of different issuance ‘vintages’ continue to rise at their average rates to date until the mortgages are four years old, at which point the rate is assumed to plateau. This is a stylised representation of the way that serious delinquency rates of older sub-prime mortgages have evolved. This method results in peak delinquency rates of 34% for mortgages issued before 2006 H1, rising to 42% for mortgages issued in 2007 H2. Upon becoming seriously delinquent, mortgages are assumed to default with at least 75% probability after one year, and to have a loss given default (LGD) rate of 50%. Chart A (not shown, WHB) shows the resulting projection, in which credit losses eventually reach around US$170 billion. AAA-rated securities do not incur losses in this projection. But there is sufficient uncertainty that even these top-rated securities could conceivably bear some losses.”

This Bank estimate is then contrasted with marked-to-market estimate (or rather marked-to-model estimates using some market inputs from ABX markets to obtain estimates of credit risk on home equity loan asset-backed securities) of US$380bn. Other estimates from the wilder reaches of Wall Street (think of a number and double it) get up to US$500bn or close to US$1 trillion.
…
The Bank’s analysis, quoted above, is nevertheless likely to turn out to be complete bollocks because it uses assumed delinquency rates that are based on a “stylised representation of the way that serious delinquency rates of older sub-prime mortgages have evolved.” The burst of subprime lending and borrowing between 2003 and early 2007 was, however, unlikely anything ever seen before. A whole new population of subprime borrowers entered the market for the first time. Mortgage borrowers with these characteristics were not in the older subprime population.
…
So as far as I am concerned, we have no reliable information on which to base an estimate of the value of the subprime mortgages issued since 2003.

Well … I fully agree with that last line taken from Dr. Buiter’s analysis! But investors (and policy makers) have to come up with something.

All in all, I am much more favourably disposed to the Bank’s “bottom-up” methodology of taking observed delinquency rates and extrapolating them than to the IMF’s “top-down” approach of marking-to-ABX-market. One just has to remember it’s a forecast … no better and no worse than any other forecast of financial markets or the weather.

Update #2, 2008-5-12: Research Recap has extracted one of the charts of interest:

The Economist has acknowledged the report but warns:

The report also suggests that market valuations of losses on America’s subprime mortgages—to which British and European as well as American banks are exposed—may prove exaggerated. Eventual losses could turn out to be around $170 billion (£86 billion) rather than the market-based figure of $380 billion.

Another reason for greater confidence is that British banks are making more realistic assessments of their bad debts and raising capital. RBS led the way on April 22nd with a writedown of almost £6 billion and tapped shareholders for £12 billion. A week later HBOS announced a rights issue of £4 billion.

Yet even if the report is right in suggesting that the self-inflicted financial wounds may gradually be starting to heal, the worry now is the damage that has already been done to the economy. The bigger that turns out to be, the greater the potential for a second round of financial pain through defaults arising from a slowdown or recession.

More extracts with light commentary are provided by FTAlphaville.

The Institute of International Finance has announced:

A report embracing the critical issues in today’s financial markets has been published by the Institute of International Finance (IIF), the global association of financial institutions. “The leadership of our industry recognizes its own responsibility to restore confidence in the financial markets, solve the problems that have arisen and prevent those problems from recurring in the future. We are fully committed to raising standards and improving best practices in the financial services industry,” stated Dr. Josef Ackermann, Chairman of the Board of Directors of the Institute of International Finance (IIF) and Chairman of the Management Board and the Group Executive Committee of Deutsche Bank AG, speaking on behalf of the IIF’s Board of Directors.

Some of the recommendations are priceless:

The suggestion has been made that some firms would find it useful to have at least as a portion of members of the risk committee of the Board (or equivalent) individuals with technical financial sophistication in risk disciplines, or with solid business experience giving clear perspectives on risk issues, consistently with the overall need for the Board to have the skills necessary to conduct meaningful review of management’s actions to manage risk, as to manage other aspects of the business.
…
Even more basically – but this did not exist at all firms – Boards need to understand the firm’s business strategy from a forward-looking perspective, not just to review current risk issues and audit reports. It should be the duty of senior management to review with the Board how that strategy is evolving over time, and when and to what extent the firm is deviating from that strategy (e.g., when a strategy morphed into heavy dependence on conduits or on structured products).

… whereas some recommendations, to the extent that they have any meaning at all, are dangerous:

Taking the view that consistent achievement of high standards requires a shared sense of norms and yardsticks to help avoid backsliding, the IIF will recommend a suite of best practices to be embraced voluntarily, perhaps in the context of a “code of conduct” to which the world’s leading financial institutions could subscribe. Because there are substantial differences in business models, mix of business, exposures, regulatory oversight and culture, there is unlikely to be a single solution to any issue that would be optimal for all firms and all circumstances. Thus, “best practice” as used here is not a legal obligation but a high standard for firms to apply in developing solutions appropriate to their own situations.

As usually discussed, and as is ideal, “best practice” can mean “Don’t be afraid to learn from others”. Those who have any experience in the matter will know that “best practice” really means “tick these boxes and don’t you dare think about what you’re doing”.

There are a number of recommendations dealing with the issue of managers not talking to each other, which echoes the finding of the International Report on Risk Management Supervision.

The IIF continues to highlight the problem of pro-cyclicity:

Basel II can make a substantial difference to the stability of regulated institutions. One of its main strengths is sensitivity to risk. However, it is important to recognize that as currently structured, the Accord will have procyclical effects, especially as banks reduce internal ratings and adjust models for current events. Therefore, further consideration will be needed as how to mitigate these effects, including broadening the use of through-the-cycle rating methodologies.

They make a formal genuflection to the cause celebre du jour:

52. There is a strong sense that externally mandated compensation policies would be at odds with the need to forge competitive, efficient firms that serve the interests of consumer and corporate clients. While recognizing that compensation policies should remain subject to the discretion of the CEO and the oversight of the Board, there is strong support for the view that the incentive compensation model should be closely related by deferrals or other means to shareholders’ interests and long-term, firmwide profitability. Focus on the longer term implies that compensation programs ought as a general matter to take better into account cost of capital, not just revenues. Consideration should be given to ways through which the financial targets against which compensation is assessed can be measured on a risk-adjusted basis. The principle of making the compensation model consistent with shareholders’ interests is well established in some contexts but has been unevenly applied across the industry, especially with respect to compensation of sales and trading functions.

53. Severance pay packages should be tied to performance, consistently with the general principle of alignment with the long-term interests of shareholders.

54. Transparency and proper disclosure to shareholders of compensation policies and criteria, including appropriate alignment of such policies with the firm’s business strategy, is important. Due to competitive issues, disclosure should be focused on principles and process.

There is also some recognition that bank-sponsored conduits are not as off-balance-sheet as might be desired:

Recent events highlight the need for firms to address the proper assessment of nonlegal reputational risk of off-balance sheet vehicles and other potential exposures. Such analysis should include consideration of whether risk of reputation damage could lead a firm to take exposures back onto its balance sheet with adverse liquidity and capital implications. Senior management must be confident that such return of assets would not happen if these exposures are treated as off-balance sheet for regulatory purposes, and Boards should assure themselves that management is properly attentive to this issue. And, on the other hand, supervisors should not take firms’ internal assessment of such risk as necessary grounds to require consolidation for accounting or capital purposes.

The next one’s really going to annoy the Internuts, who are already up in arms about Level 3 “Mark to Make-Believe” accounting … in times like this, when for many instruments there is nothing – nothing! – to be marked to, the Committee seems sympathetic to what will shortly be dubbed Level 4 valuation “Mark to What Looks Good”:

For these reasons, the Committee believes that broad thinking is needed on how to address such consequences, whether through means to switch to modified valuation techniques in thin markets, or ways to implement some form of “circuit breaker” in the process that could cut short damaging feedback effects while remaining consistent with the basics of fair-value accounting. And, while there is no desire to move away from the fundamentals of fair-value accounting, the Committee feels that it is nonetheless essential to consider promptly whether there are viable sound proposals that could limit the destabilizing downward spiral of forced liquidations, writedowns and higher risk and liquidity premia. The Committee is developing specific proposals for consideration in a timely fashion.

My reaction to recommendation #86 is mixed in the extreme!

86. Many investors relied on the rating when making credit decisions. More sophisticated investors were able to make their own assessments to a degree but many less sophisticated investing institutions relied on investment mandates where the rating was the paramount feature. The Committee finds that though rating agencies make their models available to investors, without detailed underlying loan-back data from the banks, additional information on stress testing and the underlying assumptions of the model, it is not possible for investors to verify the accuracy of the ratings models. It would in any case also be beyond the capacity of many investors to validate independently the rating agency models. More detailed loan data needs to be made more readily available and more information on stress testing particularly from a credit perspective will be released by the rating agencies, but for many investors the ratings models will remain a black box. Given this, ratings models should be subject to standards of independent review and external validation (akin to those in Basel II for Internal Ratings-Based Models).

OK … so I like the bit about making more data available. But I don’t really care about whether or not it’s beyond the capacity of many investors to validate independently the rating agency models … if it’s beyond their capacity, they should get competent advice. And I really dislike the idea of subjecting ratings models to independent review and external validation.

Credit ratings are investment opinions, dammit! Take it, leave it, get other independent advice … but don’t get the government or agency thereof involved in validating and reviewing investment advice. That’s a road to ruin if ever I saw one.

Recommendation #88 is full of helpful little hints for investors to abnegate responsibility for their investments and ensure that credit ratings don’t need to be understood as long as all the little boxes are ticked. Recommendation #89 contains such an absolutely priceless phrase that I’m going to quote it without further comment:

For example, the Market Best Practices might suggest that investors, making use of enhanced disclosures suggested elsewhere in this paper:
• Understand vehicles clearly, including the position of rated tranches and cash flows in the structure.

And as we proceed to #91, I’m so highly amused I can barely type:

91. Key issues that need attention at the level of the structured product include:
a. Quality of information provided in offer documents for structured products varies significantly based on the originating firm, country of origination and type of product. Offer documents can range from five pages to more than fifty pages and sometimes are difficult to read.

Awwww … the offer documents are sometimes difficult to read, are they? Awwww. Holy smokes, it should have become apparent by now that what the banks behind the IIF really want is a world of plain vanilla investments that banks can flog for high fees without anybody taking any risk.

All in all, a report more notable for its entertainment value than its contribution to debate.

The IMF has announced:

The widening and deepening fallout from the U.S. subprime mortgage crisis could have profound financial system and macroeconomic implications, according to the IMF’s latest Global Financial Stability Report (GFSR).
At present, the issuance of most structured credit products—instruments that pool and tranche credit risk exposures in various ways—is at a standstill and many banks are coping with losses and involuntary balance expansions, the April 2008 report said. The report examines this and other forces that could push the current credit crisis into a full credit crunch, as well as offering policy recommendations to mitigate the impact.

The full report is available online (all 211 pages!).

There is bound to be massive excitement regarding their estimate of $945-billion in total losses due to the credit crunch – this has already been picked up by the Globe and Mail and, in turn, by Financial Webring Forum.

This figure comes from Table 1.1 of the report, and is most interesting since it is in two parts: the first half of the table estimates losses from Unsecuritized US Loans as being $225-billion on $12,370-billion outstanding (= 1.8%), while the “Estimate of Mark-to-Market Losses on Related Securities” is $720-billion on $10,840-billion outstanding (=6.6%). This is not entirely due to the somewhat different mix of these sectors – unsecuritized commercial real estate has an estimated loss rate of 1.25%, while CMBS has a loss rate of 22.3%. There will undoubtedly be some screaming that the bad paper was securitized, but let’s have a look at the methodology for the estimates, found in Annex 1.2 on page 46 of the report (page 63 of the PDF):

Losses on different types of loans were estimated from regression analysis using various relevant factors, such as changes in unemployment, lending standards, and housing and commercial real estate pricing, as relevant. In each case, the outstanding stock of the type of loan was multiplied with the change in the forecasted loss (charge-off) rate. The underlying historical data on loan loss rates and changes in lending standards were obtained from the Federal Reserve.
…
Losses on residential and commercial mortgages were also estimated by a second procedure. This one involved a three-step process. We first estimated the percentage of loans that would become delinquent, then the percentage of delinquent loans that would default, and fi nally losses on defaulted loans after completion of the foreclosure or recovery process. Each of these steps is detailed below.

Reasonable enough. How about for the securitized loans?:

Losses for securities were next estimated by multiplying the outstanding stock of each type of security by the change in the market price of the relevant index over the course of a year. The average price change was obtained by weighting price changes for constituent indices comprised of different vintages and ratings by the issuance in each of these categories.

In other words, this is simply the first method described in the leveraged losses paper by Greenlaw et al. that I have discussed previously.

As the authors note, however:

The fall in market prices may be overshooting potential declines in cash flows over the lifetime of underlying loans.

I suspect that this overshoot is quite considerable. If we apply the 1.25% loss rate for unsecuritized commercial real-estate to CMBS, we reduce the projected loss to $12-billion from $210-billion. If we apply the unsecuritized sub-prime loss rate of 15% to the ABS & ABS CDOs, we reduce these projected losses to $225-billion from $450-billion.

Clearly, my calculations above (which reduce total projected losses from $945-billion to $522-billion) are completely pie-in-the-sky, back of an envelope approximations. That being said, I would like to see more discussion on why securitized loans are projected to have such huge incremental losses over non-securitized loans … preferably, a discussion including actual facts.

There’s a very interesting point made on page 19 of the report, with its accompanying figure 1.17:

Some banks have rapidly expanded their balance sheets in recent years, largely by increasing their holdings of highly rated securities that carry low risk weightings for regulatory capital purposes (see Box 1.3 on page 31). Part of the increase in assets reflects banks’ trading and investment activities. Investments grew as a share of total assets, and wholesale markets, including securitizations used to finance such assets, grew as a share of total funding (Figure 1.16). Banks that adopted this strategy aggressively became more vulnerable to illiquidity in the wholesale money markets, earnings volatility from marked-to-market assets, and illiquidity in structured finance markets. Equity markets appear to be penalizing those banks that adopted this strategy most aggressively (Figure 1.17).

We may well see a bigger charge – and more differentiated by issuer – for non-government AAA assets in the next Basel agreement! Table 1.2 shows that the market is already making adjustments to the relative level of its haircuts … but in proportions that bely the headlines!

I’m mainly interested in policy implications, however: one, which echoes the new FASB rules on QSPEs, is introduced on page 38:

Stricter rules are needed on the use of off-balance-sheet entities by banks, and disclosure should be improved so that investors can assess the sponsor’s risk to the entity. Supervisors may need to strengthen guidelines regarding the circumstances under which risk transfers to off-balance-sheet entities warrant capital relief (see Chapter 2).

The executive summary of the report includes (on pp. xii – xvi) a number of short- and medium-term recommendations for future regulation and conduct. I’ll be returning to this topic … eventually!

Update: This report – and the loss estimate – has also been noted on Econbrowser by Prof. Menzie Chinn.

The Investment Industry Association of Canada announced on March 28:

There is no doubt that the late summer re-pricing of global credit risk reverberated through the Canadian financial system. Due to the augmented volatility, corporate financings in the second half took a step back. More specifically, Maple issuance accounted for only $4.9 billion, 18% of the $26.9 billion issued throughout the year. Similarly, asset-backed securities, which have been on the rise for the past four years, slowed tremendously down 65% year over year. The Investment Industry Association of Canada (IIAC) today released its periodical An Issue of Debt: Inside Canada’s Debt Markets that included analysis and results for the year that was.

The periodical An Issue of Debt contains excellent issuance and trading statistics for Canadian Fixed Income instruments for the third and fourth quarters of 2007, together with the final figures for the year.

The Financial Times reported on a paper by the Financial Stability Forum titled Observations on Risk Management Practices during the Recent Market Turbulence, with a related Options paper.

I haven’t read the paper yet, but I will tomorrow. Hat tip Naked Capitalism … but NC, when they’re talking about simultaneous disclosure, they do indeed mean simultaneous public disclosure. The regulators have that information, but it is currently considered confidential.

I’ll write more on this paper when I’ve read it properly. A quick skim is very encouraging.

Update, 2008-4-2: The paper begins by differentiating between those firms that are performing (relatively!) well during the crunch and those that are getting hit. There are details, of course, but the basic conclusion to be drawn is that the firms performing well have managers who talk to each other and think about what they’re doing.

Write that down, get an MBA. You read it on PrefBlog!

However, “Please don’t be dorks” is not a suitable supervisory injunction, so there are more details:

First, we will use the results of our review to support the
efforts of the Basel Committee on Banking Supervision to
strengthen the efficacy and robustness of the Basel II capital
framework by:
• reviewing the framework to enhance the incentives for firms to develop more forward-looking approaches to risk measures (beyond capital measures) that fully incorporate expert judgment on exposures, limits, reserves, and capital; and
• ensuring that the framework sets sufficiently high standards for what constitutes risk transfer, increases capital charges for certain securitized assets and ABCP
liquidity facilities, and provides sufficient scope for addressing implicit support and reputational risks.

This looks very good. The first step is extremely tricky … how does one determine whether expert judgment has been fully incorporated or not? There’s a big danger that this could turn into a box-ticking exercise.

I have been harping on the definition of risk transfer and ABCP liquidity facility capital charges for a long time. It seems quite clear, for instance, that Apex / Sitka were not quite far enough off BMO’s balance sheet for risk transfer to have been deemed complete; it also seems clear that the capital charges for liquidity lines on ABCP inter alia need to be increased to reflect the fact that when bad stuff happens, it happens all at once. Thus, as I have written previously:

If the risk weights applied to, for instance, the provision of a global liquidity line to a SIV have been shown to be inadequate (and this has not been documented, although I suspect that it is the case) … increase the risk weight of the line! Currently it’s at a flat 10% … I suggest that a tiering be considered, so that a bank with $10-billion of tier 1 capital can extend such a line for $10-billion at the 10% rate, but the next ten billion is charged at a 20% rate, etc.

The report continues:

Second, our observations support the need to strengthen
the management of liquidity risk, and we will continue to work directly through the appropriate international forums (for example, the Basel Committee, International Organization of Securities Commissions, and the Joint Forum) on both planned and ongoing initiatives in this regard.

Can’t say much more about this without detail!

Third, based on our shared observations from this review, individual national supervisors will review and strengthen, as appropriate, existing guidance on risk management practices, valuation practices, and the controls over both.

Motherhood.

Fourth and finally, we will support efforts in the appropriate forums to address issues that may benefit from discussion among market participants, supervisors, and other
key players (such as accountants). One such issue relates to the quality and timeliness of public disclosures made by financial services firms and the question whether improving disclosure
practices would reduce uncertainty about the scale of potential losses associated with problematic exposures. Another may be to discuss the appropriate accounting and disclosure
treatments of exposures to off-balance-sheet vehicles. A third may be to consider the challenges in managing incentive problems created by compensation practices.

More public disclosure would be appreciated, but I’m not sure how much good it will do. There’s more disclosure now than anybody reads. A review of off-balance-sheet vehicles is appropriate because, as noted above, a lot of them weren’t as far off the balance sheet as they should have been.

The last point in this section is a little troubling. First, it’s so carefully hedged it doesn’t actually say anything; but the fact that it is considered worthy of mention in such a document makes me a little fearful. If, for instance, I join a big bank as a pref trader, I don’t want my compensation to be influenced by whether some dork in government finance lent $20-billion to Argentina. I want my compensation determined by things I have control over – my own trading, or, should I become Head of Fixed Income, the trading of the guys working for, and accountable to, me.

Second, if in my role as pref trader, I strap on Nortel prefs with 20:1 leverage, surely the risk to the bank is due to the holdings of Nortel prefs with 20:1 leverage, not the timing of my bonus for the enormous profits such a position will surely bring.

Against this is the evaluation of risk and the up-front income. For instance, if I had sold a massive position of five-year credit default swaps then, while the profitability of this position is marked to market daily, the actual profit on the whole position is not known until they expire five years later. Regulators rely on the individual firms to make good judgements; they do not and should not second-guess every little thing. If that judgement is biased by a risk/reward profile for the decision maker / risk assessor that is different from the profile appropriate for a firm with continuing operations, this is in fact a regulatory concern.

I suggest that the most appropriate way to address this issue is to ensure that the risk management and accounting functions are independent, objective and senior to the traders. Trouble is, that’s a very, very hard thing to ensure when, for instance, so much of the risk depends on whether Joe Subprime will be able to refinance his mortgage in five years. Pick a number! Why is it better than another number?

More later.

Update, 2008-4-3: Well … not a lot more! Most of the paper is a simple review of the general types of actions taken by management of firms that are coming through this ordeal successfully, compared to … er … less successful companies.

There are many examples given, across all the business lines that the Large Complex Financial Institutions are involved in but, oddly enough, the situations boils down to the same thing. At successful companies, managers:

• think about what they’re doing
• talk to each other

In the comments to my post Is the US Banking System Really Insolvent? Prof. Menzie Chin brought to my attention a wonderful paper: Leveraged Losses: Lessons from the Mortgage Market Meltdown (hereafter, “Greenlaw et al.”).

This paper has also been highlighted on Econbrowser under the title Tabulating the Credit Crunch’s Effects: One Educated Guess.

The source document is in several parts – to do justice to it, I will be be posting reviews of each section.

The initial post in this series Economic Effects of Subprime, Part I: Loss Estimates dealt with the authors’ methodology of estimating total losses of $400-billion on subprime securities. The second, Economic Effects of Subprime, Part II : Distribution of Exposure, looked at the way they allocated 49% of this loss to the “US Leveraged Sector”. In this post, I’ll be looking (very briefly!) at their “Section 4: Leverage and Amplification”.

I will admit, I had half a mind to skip it. I felt comfortable opining on their sections directly relevant to the securities markets, but economic predictions are another animal entirely. Fortunately, Willem Buiter stepped into the breach, with a highly entertaining polemic on VoxEU.

Greenlaw et al. review the procyclical nature of leveraging and eventually come up with the scorecard so far:

So far (up to late-January 2008) approximately $75 billion of new capital has been raised, compared to a cumulative running total of $120.9 billion for write-downs announced by banks and brokerage firms.

It does not appear that this figure of $120.9-billion is restricted to US banks and brokerages – and since the authors do not say, I suspect it is a world-wide figure.

At any rate, they go through a little arithmetic and conclude:

Our baseline scenario (marked in grey) is that leverage will decline by 5%, and that recapitalization of the leveraged system will recoup around 50% of the $ 200 billion loss incurred by the banking system. Under this baseline scenario, the total contraction of balance sheets for the financial sector is $1.98 trillion.

Section 4.4 does a little algebra to estimate the ratio of the decline in credit to end-users to the decline in total assets which, I am grateful to observe, is as fishy to Prof. Buiter as it is to me. Prof. Buiter observes:

The authors calculate/calibrate a value for the ratio of total credit to end-users (either the non-leveraged sector or just households and non-financial corporates) to the total assets of the leveraged sector (banks, the brokerage sector, hedge funds, Fannie May and Freddie Mac and savings institutions and credit unions). They then treat this ratio as a constant, which means that once they have the change in the value of the total assets of the leveraged sector, they know the change in credit to the end-users.
…
There are just too many ways to poke holes in the empirical argument. To start with, as noted by the authors) the credit variable used domestic non-financial debt, includes financing from non-leveraged entities and therefore does not correspond to the credit variable of the theoretical story.

My problem with this – which I think is the same as Prof. Buiter’s problem – is that the algebra treats the “leveraged sector” as being homogeneous … and it ain’t. Say, for instance, we have a Hedge Fund with $1 in investors’ money, levered up 10:1 to buy $10 of securities. Their balance sheet looks like:

They are borrowing from a bank, which has the balance sheet:

Now what happens is the value of the securities falls to $9, the bank calls its loan and ends up owning the securities. The two balance sheets now look like:

While the Bank’s balance sheet has changed to:

So, with this particular example:

• Aggregate leverage is unchanged: ($10 + $9) / ($1 + $0.90) = 10:1 = ($9 / $0.90)
• the bank has been protected from the first loss on the securities since its claim was senior to that of the investors in the hedge fund.
• Hedge fund investors have been wiped out
• The bank’s liquidity has improved (since securities are more marketable than hedge fund loans)
• There is no effect directly transmitted from the bank to the real economy.
• There may be an effect on the real economy because the hedge fund investors aren’t so rich any more, but that’s second order

I just have all kinds of problems with this, Greenlaw et al‘s treatment of the leveraged sector as being homogeneous with effects on credit available to the real economy being a constant percentage of losses, regardless of where or how those losses are experienced.

I won’t look at their section 5.1, Correlations between GDP and Credit … I’m just not comfortable enough with economic thought. I’ll leave that task to Prof. Buiter:

More painfully, the authors seem blithely unaware of the difference between causation and correlation, or prediction and causation. What they perform is, effectively, half of what statistically minded economists call a Granger causality test but should be called a test of incremental predictive content. They run a regression of real GDP growth on its own past values and on past values of real credit growth and find that past real credit growth has some predictive power over future GDP growth, over and above the predictive power contained in the history of real GDP growth itself: past real credit growth helps predict, that is, Granger causes, real GDP growth. Lagged real credit growth is (barely) statistically significant at the usual significance level (5%).

When you do this kind of regression for dividends or corporate earnings and stock values, you find that stock values Granger-cause (help predict) future dividends. Of course, anticipated future dividends determine (cause) equity prices, so causation is the opposite from Granger-causation.

The authors are undeterred and treat the estimate of GPD growth on credit growth as a deep structural parameter.
…
The authors could be right about the effect of de-leveraging in the leveraged sector on real GDP growth, but the paper presents no evidence to support that view.

So, to sum up:

• I’m suspicious of the authors’ loss estimates
• I’m suspicious of the authors’ allocation
• I’m suspicious of the authors’ calculation on the effect of losses on credit available to the real economy
• Prof. Buiter is suspicious of the authors’ calculation of the effects of credit availability changes on GDP

All in all, the paper by Greenlaw et al. has turned out to be a typical product of brokerage house research departments:

• Great Data
• Interesting Ideas
• Unsupportable conclusions

I came across a paper in my travels: Enhancing the Accountability of Credit Rating Agencies: The Case for a Disclosure-Based Approach by Professor Stéphane Rousseau of the Université de Montréal.

To my shame, I have to confess that I haven’t done anything more than skim it quickly at this point … but it does look interesting, provides a Canadian context, and I’m referencing it on PrefBlog because I want to find it later!

Update: On a related note is the commentary on National Policy 51-201:

Why is disclosure to credit rating agencies in the necessary course of business when disclosure to equity analysts is not? Credit rating agencies analyze issuers’ debt for public consumption; equity analysts analyze issuers’ equity for public consumption.

The CSA’s view is that there is a fundamental distinction between disclosure to credit rating agencies and disclosure to equity analysts, which lies in the purpose for which the information is used. While research reports prepared by equity analysts can be targeted to an analyst’s firm’s clients, credit ratings are directed to a wider public audience. We also note that credit rating agencies are not in business to trade, as principal or agent, in the securities they are called upon to rate. This is distinguishable from the equity analyst who typically works for an investment bank whose activities include trading, underwriting and advisory services.

As the SEC indicated in response to similar comments about the exclusion of rating agencies from the reach of Regulation FD, “[r]atings organizations…have a mission of public disclosure; the objective and result of the ratings process is a widely available publication of the rating when it is completed.” The CSA adopts this analysis. In paragraph 3.3(2)(g) of the Policy, the CSA indicates that communications to credit rating agencies would generally be considered in the “necessary course of business,” provided that the information is disclosed for the purpose of assisting the agency to formulate a credit rating and the agency’s ratings generally are or will be publicly available.

Further, securities legislation often affords companies or their securities status based on obtaining specified ratings from approved rating agencies. Consequently, ratings form part of the statutory framework of provincial securities legislation in a way that analysts’ reports do not. We have amended the Policy to highlight this distinction (see subsection 3.3(7) of the Policy).