Let’s say you sit on the Public Services Board of a seaside town; one of the things your board does is hire lifeguards for the beach.
One day, a vacationer drowns. You do what you can for the family and then haul the lifeguard on duty up in front of a committee to see why someone drowned on his watch.
“Not my fault!” the lifeguard tells you “He didn’t know how to swim very well and he went into treacherous waters.”
So what do you do? Chances are that you scream at the little twerp “Of course he went into treacherous waters without knowing how to swim well, you moron. That’s what vacationers do! That’s precisely why we hired you!”
Reasonable enough, eh? You’d fire the lifeguard if that was his best answer.
So why are we so indulgent with bank regulators? The banks were stupid. Of COURSE the damn banks were stupid. That’s what banks are best at, for Pete’s sake! We KNOW that. If they weren’t stupid, we wouldn’t need regulators, would we?
Which is all a way of saying how entertaining I find the bureaucratic scapegoating of banks in the aftermath of the crisis.
In my post reporting Carney’s last speech, I highlighted his reference to a speech by Haldane:
These exposures were compounded by the rapid expansion of banks into over-the-counter derivative products. In essence, banks wrote a series of large out-of-the-money options in markets such as those for credit default swaps. As credit standards deteriorated, the tail risks embedded in these strategies became fatter. With pricing and risk management lagging reality, there was a widespread misallocation of capital.
footnote: See A. Haldane, ―The Contribution of the Financial Sector—Miracle or Mirage?‖ Speech delivered at the Future of Finance Conference, London, 14 July 2010.
An interesting viewpoint, since writing a CDS is the same thing as buying a bond, but without the funding risk. I’ll have to check out that reference sometime.
I have now read Haldane’s speech, titled The contribution of the financial sector – miracle or mirage?, and it seems that what Haldane says is a bit of stretch … and the interpretation by Carney is a bit more of a stretch.
Haldane’s thesis is
Essentially, high returns to finance may have been driven by banks assuming higher risk. Banks’ profits, like their contribution to GDP, may have been flattered by the mis-measurement of risk.
The crisis has subsequently exposed the extent of this increased risk-taking by banks. In particular, three (often related) balance sheet strategies for boosting risks and returns to banking were dominant in the run-up to crisis:
- increased leverage, on and off-balance sheet;
- increased share of assets held at fair value; and
- writing deep out-of-the-money options.
What each of these strategies had in common was that they generated a rise in balance sheet risk, as well as return. As importantly, this increase in risk was to some extent hidden by the opacity of accounting disclosures or the complexity of the products involved. This resulted in a divergence between reported and risk-adjusted returns. In other words, while reported ROEs rose, risk-adjusted ROEs did not (Haldane (2009)).
I don’t have any huge problems with his section on leverage. The second section makes the point:
Among the major global banks, the share of loans to customers in total assets fell from around 35% in 2000 to 29% by 2007 (Chart 29). Over the same period, trading book asset shares almost doubled from 20% to almost 40%. These large trading books were associated with high leverage among the world’s largest banks (Chart 30). What explains this shift in portfolio shares? Regulatory arbitrage appears to have been a significant factor. Trading book assets tended to attract risk weights appropriate for dealing with market but not credit risk. This meant it was capital-efficient for banks to bundle loans into tradable structured credit products for onward sale. Indeed, by securitising assets in this way, it was hypothetically possible for two banks to swap their underlying claims but for both firms to claim capital relief. The system as a whole would then be left holding less capital, even though its underlying exposures were identical. When the crisis came, tellingly losses on structured products were substantial (Chart 31).
… which is all entirely reasonable and is a failure of regulation, not that you’ll see anybody get fired for it.
The third section mentions Credit Default Swaps:
A third strategy, which boosted returns by silently assuming risk, arises from offering tail risk insurance. Banks can in a variety of ways assume tail risk on particular instruments – for example, by investing in high-default loan portfolios, the senior tranches of structured products or writing insurance through credit default swap (CDS) contracts. In each of these cases, the investor earns an above-normal yield or premium from assuming the risk. For as long as the risk does not materialise, returns can look riskless – a case of apparent “alpha”. Until, that is, tail risk manifests itself, at which point losses can be very large. There are many examples of banks pursuing essentially these strategies in the run-up to crisis. For example, investing in senior tranches of sub-prime loan securitisations is, in effect, equivalent to writing deep-out-of-the-money options, with high returns except in those tail states of the world when borrowers default en masse. It is unsurprising that issuance of asset-backed securities, including sub-prime RMBS (residential mortgage-backed securities), grew dramatically during the course of this century, easily outpacing Moore’s Law (the benchmark for the growth in computing power since the invention of the transistor) (Chart 32).
…
A similar risk-taking strategy was the writing of explicit insurance contracts against such tail risks, for example through CDS. These too grew very rapidly ahead of crisis (Chart 34). Again, the writers of these insurance contracts gathered a steady source of premium income during the good times – apparently “excess returns”. But this was typically more than offset by losses once bad states materialised. This, famously, was the strategy pursued by some of the monoline insurers and by AIG. For example, AIG’s capital market business, which included its ill-fated financial products division, reported total operating income of $2.3 billion in the run-up to crisis from 2003 to 2006, but reported operating losses of around $40 billion in 2008 alone.
I have a big problem with the concept of CDSs as options. Writing a Credit Default Swap is, essentially, the same thing as buying a corporate bond on margin. If the CDS is cash-covered, the risk profile is very similar to a corporate bond, differing only in some special cases that did not have a huge impact on the crisis.
You can, if you squint, call it an option, but only to the extent that any loan has an implicit option for the borrower not to repay the debt. If you misprice that option – more usually referred to as default risk – sure, you will eventually lose money.
But AIG’s big problem was not that it wrote CDSs, it was that it wrote far too many of them; it was effective leverage that was the big problem. And the potential for contagion if AIG fell was not so much the fault of the manner in which the deals were structured as it was the fault of the banks for not insisting on collateral, and the fault of the regulators for not addressing the problem with uncollateralized loans.
So Haldane’s thir point is more than just a little shaky, and Carney’s use of this to state that derivative use by banks was a contributing factor to the Panic of 2007 is shakier.