Date posted: April 12, 2008

Blogging the Credit Crisis

I could spend all day blogging about the credit crisis, but there are other sites that are far better suited to keep the pulse of the market, day by day, minute by minute. Apart from that I am more interested in long-term shifts and developments than the hype of the day.

But to add a few words of my own, the credit crisis will end as unexpectedly as it started. It will end when credit crisis fatigue sets in, when it no longer makes news headlines, when people shrug at yet another billion dollar writedown, when bloggers no longer write about every single event and when people can no longer be bothered to read about it.

Countless analysts and commentators are predicting doom and gloom and financial meltdown. And as the number of financial casualties increases and an economic slowdown becomes a reality, they have to shout louder and louder. But as social psychologists have shown, people are far more resilient than they think. And since financial markets are made up of people, so are financial markets. Some people may lose their house or their job because of the current crisis, but somehow they will cope. There is no other alternative, except suicide, but only very few people choose that as a way out of their problems.

One of the best accounts of the credit crisis is a hilarious sketch by British comedians John Fortune and John Bird. It is so accurate. Here's another episode.

Jokes aside, the credit crisis is quite complex. It can be simplified, but then you end up with more questions than you started with. As always a thorough analysis requires putting in the hours and ploughing through the data. In an 82 page working paper two staff researchers of the Federal Reserve Bank of New York, Adam Ashcraft and Til Schuermann, provide an overview of the subprime mortgage securitization process.

The February 2008 issue (in French) of the Revue de la Stabilité Financière, a publication by the Banque de France, is entirely devoted to Liquidity. It contains articles by academics, market participants and central bankers. I must confess that I only skimmed each article because I can think of more interesting things to read.

It is interesting to browse the archive and skim the titles and abstracts of papers about liquidity and financial stability, CDOs etc. from before 2006.

Newspaper commentators, politicians and senior officials at regulatory institutions who don’t know what their own employees are up to, have said that regulators can’t keep up with the complexity of the financial markets. This is wrong, the knowledge and expertise is there, it’s just that in good times nobody takes note. It must be said though, that even the executive summaries of some papers can be difficult to understand if you’re not a very well read insider.

One of the root-causes of the credit crisis is the drive for higher yields, a euphemism for greed. Why is so much money flowing into mutual funds, index trackers, private equity, hedge funds, funds of funds and funds of funds of funds? Why don’t people, pension funds, insurance companies and university endowments just put their money into a savings account or some other form of fixed income assets?

January 1, 2001 the Netherlands moved to a new income tax system. One major change involved the tax on income from savings and investments. As of 2001 a notional yield of 4% is calculated on the average capital in a year minus a tax-free allowance: the income from capital assets. This income is taxed at a rate of 30%. One consequence is that if your assets decline in value and the actual yield is negative, you will still be taxed on your average capital.

In a low interest rate environment it is a “challenge” to earn more than 4% on a simple savings account. This new tax system therefore encourages a drive towards higher yields and associated greater risks. People's perception is that they have to earn a higher ROI than 4%.

Faced with future higher payout rates pension funds could raise contributions, but they could also try to earn a higher yield on their assets by investing in asset classes with higher expected returns such as stocks or private equity. In the mid 1990s this strategy seemed to work when stock markets rose year on year. When the stock market bubble burst the money flowed into other asset classes. Hedge funds claimed to be able to beat the market regardless of whether it is rising or falling. Some do, many don't. Those returns have to originate somewhere. There's no perpetuum mobile money machine.

I’m only speculating and grossly oversimplifying, but I think you should always ask where all the money that is going around in the financial markets is coming from.

There’s an interesting graph in the latest Global Financial Stability Report (April 2008, page 31), which shows that over the past 10 years the investment-to-asset ratio at the top 10 largest banks in the US and Europe has risen sharply, while loan-to-asset and deposit-to-asset ratios have fallen. What this means is that these banks rely less on deposits and more on other means of funding (interbank borrowing, short and long term debt) to finance their activities and that these activities have moved from loans to securities holdings and trading activities. If interbank borrowing becomes more expensive, if trading becomes less profitable, if the value of securities holdings declines, they are in trouble.