Sunday, 8 August 2010

The Cause of the Financial Crisis in Two Words

The other day I was thinking: ask any knowledgeable observer what caused this financial crisis, and you'll probably get a long, rambling explanation with anywhere from four to ten villains, their identities largely depending on the speaker's ideological/philosophical bent.

But what if that person was allowed only a word or two to capture the essence of the problem? What would the best word(s) be?

Some might say "greed." But that's no good. Greed's a given on Wall Street. If anything, greed is the grease that makes the wheels move over there. The greedy may have become greedier, but this still doesn't supply a satisfying explanation for the whole mess that paralyzed our financial system.

My two words (you're welcome to suggest your own), which provide a prism through which I think most of this crisis can be understood, are simple:

Mispriced risk.

Now for the walk through. First, the obvious stuff. Peel off the outer layer of any CDO and you'll find plenty of mispriced risk. What about that super senior tranche rated AAA, while it rests on mezzanine slices of crappy mortgage securities? Way mispriced.

The infamous Gaussian copula that aided the creation of AAA gold from subprime dross? That's a handmaiden to mispricing. And the credit raters: they're right at the center of the rampant mispricing, slapping AAA labels on stuff they didn't understand as they grubbed around for rating fees.

How did the credit crisis get so large? Mispriced risk. If a AAA corporate bond yields say 3.2 percent, and a AAA chunk of a CDO yields 3.5 percent, what are you going to buy (assuming you trust the ratings, and AAA implies the same level of risk, no matter the security). So money will start pouring into the new AAA category that promises the same low risk but a higher return.

What about credit default swaps? Consider a big issue there: many were sold much too cheaply, considering the dangers they were insuring.

Again: mispriced risk.

What was at the heart of the seize-up in the credit markets in 2008? Remember, the shadow banking system froze up. Counterparties to repo transactions wanted much bigger haircuts on collateral they were taking for overnight lending. Why? Fear of mispriced risk on the collateral. In other words, that collateral purported to be AAA might actually be some variant of C.

You could even argue that excessive leverage ties back to mispriced risk. Why is a bank willing to take on so much leverage? Because it thinks its overall risk is actually fairly small. Just look at the "value at risk" metric, and its widespread adoption, and how it lulls Wall Street into a false sense of security.

For their part, regulators failed to do a number of things that would have helped correct the epidemic of mispriced risk. They failed to insist on greater transparency that would have flushed some of this risk out into the open. They failed -- actually, didn't even attempt -- to reduce the complexity of financial instruments that artfully conceal risk. They simply abdicated their duty to police the financial system as instruments that mispriced risk created a vacuum, sucking in huge piles of cash because investors were enticed by the prospect of a free lunch.

The financial crisis, explained, two words: mispriced risk.