In order to be able to find points from which we can learn form the 2008 financial crisis, we first need to have a brief coverage of what caused the crisis:
Causes:
In my opinion (and I appreciate that there are many differing opinions regarding this), the crisis was a result of too much leverage fuelling asset bubbles - the root cause of pretty much every financial crisis in history.
The scene was set prior to the financial crisis through very accommodative monetary policy, that helped to make credit widely and cheaply available. Combined with changing and inconsistent capital regulation rules across regulators under the Clinton administration, that allowed banks to acquire more leverage, it created an environment where perpetual upwards market momentum was expected, which ultimately resulted in misguided overconfidence in the financial markets.
I believe that the spark of the crisis however was ultimately within the sub-prime lending, where the decision to grant a mortgage to someone became disassociated with their ability to repay said mortgage.
Moreover, I don't think we can ignore the misuse of the quantitative risk models that took place in the run up to this 2008 sub-prime crisis and especially their utilisation in valuing Collateralised Debt Obligations (CDOs):
These instruments effectively allow groups of mortgages to be traded, but where you can take as much or as little risk as you like and in the case of sub-prime mortgages the system would have initially had very large profit margins to act as a default hedge. However, as the sub-prime lending became more popular and more providers of CDOs became available, this profit margin began to shrink, which in turn increased exposure to risk.
I should clarify here that the fault was not necessarily with the models themselves, but with the use of the models as a fool proof system, combined with certain unrealistic assumptions that existed within the framework of the models:
For example, the great Quant Paul Wilmott uses this equation below to help explain one of the issues with the quantitative finance in the few years prior to the crash.
Prob[TA < 1, TB < 1] = Φ2 (Φ-1 (FA(1)), Φ1 (FB (1)), Υ)
To put this in a less mathematical context, this equation relates the probabilities of defaults happening in two different things to the behaviour of two companies going independently via something called a correlation.
- Assume that we have a CDO with one-thousand different mortgages and you want to model them.
- In this model there's going to be an assumption for how these mortgages interact with each other, or in other words we can ask the question: how many correlations there are in two by two combinations of these mortgages?
- The answer is going to be:
1000*999/2 = 499500
Now, the problem is that the quantitative assumption that was made was that the correlations between these mortgages were all the same: 0.6
Obviously, this is ridiculous and quantitative traders working within the industry will have known this, but that the renumeration available to them at the time would have made commenting on this a recipe for personal disaster.
This would ultimately have led to the use of "bad" (for want of a better word) or at least highly unrealistic data, from which these highly leveraged institutions would then grant loans that had very low probabilities of ever being repaid, thus assisting in the financial crisis.
To summarise my opinion of the causation of the crisis, increased leverages as a result of borrower accommodative monetary policy, created an environment with unrealistic market interpretations, that was driven forward in part through the misuse of quantitative techniques within institutions with exposure to the mortgage sector.
Moving Forward:
Since the financial crisis, the Systemic Risk Council in the USA has made significant progress to increase capital levels in banks and in turn reduce risk levels and this combined with tightened mortgage lending standards (borrowers now have to have a proven ability to repay their loan - not so much on the downpayment side to contain borrower leverage, but for the larger institutions) will mean that mortgage led crisis seems more unlikely now than it previously was.
Further steps to react to the financial crisis came from the creation of the Financial Stability Board, which developed four key points for improvement within the US banking sector:
1. Build resilience of financial institutions:
In regards to this point, the maintenance of high capital levels is key and the FSB are encouraging the idea that common equity is loss absorbing, while debt is not. Effectively, the more they fund with equity rather than, debt the more resilient the sector becomes as a whole.
2. Ending the "too big to fail" concept:
Ironically, the financial institutions at the heart of the financial crisis are bigger today than they were at the time of the crisis, although the FSB would argue that there are better tools in place to resolve issues now than there used to be, with the Federal Deposit Insurance Corporation (FDIC) having a much better understanding of single point of entry systems to prop up large institutions.
This works on the basis that large institutions issue more long term, unsecured debt at the holding company level, which then becomes loss absorbing in the event of a company failure.
3. Transforming shadow banking to transparent and resilient market based financing
A lot of work since 2008 has gone into increasing the level of title 1 designations (the extent to which institutions fall under oversight). Sadly, this same level of oversight still doesn't exist within the asset management and hedge fund industry.
4. Making derivative markets safer
Over the counter bilateral debt is now centrally cleared and the majority has become exchange traded. Nevertheless, there is still no strong regulation over clearing houses, which will have to improve in order to truly make the derivative markets safer.
I'll undoubtedly add more to this in good time,
The Masked AIM Trader
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