So here I called the great credit crunch of ‘08. Well, nearly. My point was that banks were then in the habit of parcelling up the credit risks they had taken on as part of their business, and were then selling the parcels to all comers, a process called risk distribution. Dressed up as AAA by the PHDs and Quants these instruments looked like a good deal; low risk and high returns. Banks got to restore the capital they were originally required to set aside (apart from that amount needed to cover the unsell-able toxic waste), and could then go on to do it all again, a process called leveraging. In this way, massive amounts of credit could be parcelled up and sold on - far more than the balance sheet could cope with if stressed - but that was the point.
The buyers were firms which had not hitherto bought credit risk, insurance companies for example. However, they believed the talk of pooling and diversification, how the individual risks could be smoothed away by portfolio effects. No-one truly understood the nature of the risks being bought and sold. Warren Buffet had it right here - don’t buy stuff you don’t understand.
My point was that the next Big Thing in Financial Services was likely to be some sort of meltdown when the credit risks went bad. When it is just Banks who hold these worsening risks the market can adjust - when everyone holds the risks the whole market is in jeopardy. But I thought it would be worse than that - we’d not know who held the risks because of risk distribution. With no clearing house (trades are done bilaterally), there is no central record of who holds what. Which now are the bad firms lumbered with all this credit risk?
Given the forty-five minutes I had to think up and prepare the entire presentation, I didn’t do too badly, I thought. Given more time, I might even have thought about the inter-bank lending market, and the impact on credit default swaps. I was starting to be right, and how.
If banks are intent on getting credit risk off their balance sheets, well then OK - find buyers and allow a market clearing price to emerge. Finding buyers was easy but should have been hard - firms that bought these assets trusted what they were told, and often borrowed the money off a bank to finance the purchase (and so the credit risk whirled round and arrived right back on the balance sheets of banks, only now very hard to trace back to the original exposure). No market clearing price could form because the deals were arranged over the counter, bilaterally, between firms. No transparency there. Relying on regulators is foolishness.
I wasn’t believed, and in truth I barely believed it myself - more thinking was needed. The whole Windows/Linux thing had blown the chance of a job, so I thought no more about it. Which is a great shame because as it happened, I was right.
Being right is not enough (and it’s too easy after the fact). Acting right is another matter - and that’s what this blog is all about.
