John Gieve: The return of the credit cycle - old lessons in new markets
Speech by Sir John Gieve, Deputy Governor of the Bank of England, at the Euromoney Bond
Investors Congress, London, 27 February 2008.
The original speech, which contains various links to the documents mentioned, can be found on the Bank of
England's website.
* * *
Introduction
The turmoil in credit markets since August has been novel in some ways; but in others, the
longer it has gone on the more familiar it has seemed. It has been looking less and less like
the crystallisation of a "tail" risk - the "unprecedented and unforeseeable" event described by
Northern Rock directors - and more and more like the unwinding of a wider credit boom
during which risk premia had become unsustainably compressed. The excesses may have
been most obvious in the complexities of structured credit and the sub-prime sector but they
have not been confined to them.
As in previous banking cycles, a period of strong growth, low interest rates and rapid
increases in asset prices lead to over confidence and bad lending at the top of the cycle;
defaults, deleveraging and retrenchment follow in the downswing. But the way this old story
has unfolded through the new credit markets has sprung some unpleasant surprises,
including the speed with which losses in just one market in one country - the housing market
in the US - have disrupted wider credit markets in all advanced economies.
The upswing - a new structure of banking
The roots of the problem lay in the so-called "great stability" of steady growth and inflation
and in particular the last five years of persistently low nominal interest rates.
The confidence born of that stability was combined with an increased institutional demand for
fixed income and heightened international competition among the largest banks to develop
scale. That led to a remarkable decline in corporate investment yields which was matched,
and for a while seemed justified, by declining volatility (see Chart 1 which shows the fall the
spreads and volatility of high yield bonds).1 And it put pressure on investors to find new ways
of generating returns from credit. At the same time advances in IT and financial modelling
allowed the development of new derivatives, and the slicing, dicing and recombining of
credits in new structured credit instruments.
The search for yield would have made the US sub-prime mortgage market attractive to many
investors. What made it irresistible was the financial engineering that offered high yields with
high credit ratings.
The success of structured credit created a huge demand for the raw material of these
products in particular sub-prime mortgages (Chart 2). It allowed banks to move increasingly
from the traditional "lend and hold" model towards an "originate and distribute" model. This
boosted the supply of credit and allowed risk to be more widely dispersed across the system
as a whole. But it also involved a long chain of participants from the original lenders to
endinvestors. Investors at the end of this chain, who bore the final risk, had less information
about the underlying quality of loans than those at the start and became very dependent on
rating agencies and their models. It also reduced the incentives on originators to assess and
monitor credit risk carefully.
The downswing - how the crisis unfolded
Growing problems in the sub-prime market started the downswing. Chart 3 compares the
path of US housing prices with the price of the triple-B ABX index (which captures the cost of
insuring against default losses on sub-prime mortgages) and bank equity prices:
•
As you can see, the US housing market began to turn down in mid 2006; and banks
holding sub-prime loans on balance sheet began to make provisions at that point.
•
But it wasn't until early in 2007 that rising defaults led to markdowns in even the
riskier tranches of sub-prime backed securities.
•
Last summer, problems at Bear Stearns, IKB and BNP Paribas brought home to
investors the market risks they were running and led to an "investors' strike" on
mortgage-backed securities and asset-backed commercial paper.
•
That in turn led banks to hoard liquidity; inter-bank markets spreads rose and
volumes fell beyond the very short term; Northern Rock ran out of road, and bank
equity prices began to drop.
•
For a few weeks in October the market thought the worst was over but the
publication of Q3 results renewed fears about the scale of bank losses which
sparked a new squeeze in the money markets and a further sharp fall in bank share
prices towards the end of the year.
•
Co-ordinated action by central banks helped to ease the short-term funding
pressures at the year end (Chart 4); and hopes rose that the acute phase was over
as banks declared their losses and, where necessary, managed to attract new
capital including from sovereign wealth funds.
Where we are now
But markets have remained difficult in the New Year. While LIBOR spreads have not
returned to the levels of early December, money markets are sticky. Corporate bond and
credit default swap rates have continued to climb, leveraged loan prices are dropping quickly,
securitisation markets remain largely closed and the CDS and equity prices for banks
continue to deteriorate.
This continuing strain reflects three main factors.
First, it reflects fears about the future path of the economy especially in the US and the scale
of new losses that may bring - not just in housing, but also in other forms of lending.
Second, however, there is continuing uncertainty about the scale and distribution of losses
that have already occurred:
•
To illustrate the uncertainty on overall scale, Chart 5 sets out different estimates of
sub-prime losses based on different estimation methods. First, given the length of
the foreclosure process, realised losses on the sub-prime mortgages which underpin
securities may not total much more than $30 billion so far. Second, if projecting
forward the rate at which delinquencies are cumulating on recent vintages of
subprime mortgages, we can estimate that losses on the securitised loans might
ultimately exceed $150 billion. Thirdly, using the sub-prime ABX indices to
"mark-tomarket" sub-prime securities, can produce figures of $300 to 400 billion. Against
these figures, international banks have so far announced writedowns (net of
hedging) of $100 to $150 billion.
•
Although these are huge numbers, they amount to less than 1% of the total assets
of the Large Complex Financial Institutions (LCFIs) in the US and Europe. In relation
to GDP, even the higher estimates would be comparable to the losses in the
Savings and Loans crisis.2
• But the securitisation model has not just made it difficult to scale the problem; it has
added a large measure of uncertainty and opacity to the distribution of losses and
that is a key factor in the continued reluctance to lend and the closure of most ABS
markets. The current worries on the future of the monoline bond insurers reflected in
their CDS prices in Chart 6 are exacerbating the uncertainties about individual
banks' exposures.
The third factor is the dislocation of the investor base for ABS. Since the summer many of
the main buyers of ABS have withdrawn from the market. The conduits and SIVs are greatly
diminished where they are not being wound up altogether. And the money market and other
funds that stepped away from these off-balance-sheet vehicles are not willing at least yet to
buy ABS directly. Finding new homes for these securities is bound to take time. So long as
there are known to be reluctant holders, even long term real money investors will tend to hold
back to see whether prices are driven lower in coming months by forced sales. On the other
side many issuers are reluctant to accept the prices on offer today since they could become
benchmarks for the future.
Lessons from the crisis
The story is far from over but it is still possible to identify some lessons. The past seven
months have taught market participants a lot about the risks and limitations of the new
markets and their business models; their responses will be the most powerful force for
change. On the official side, a recent consultative document has set out proposed responses
by the UK tripartite authorities.3 Internationally, the Financial Stability Forum (FSF), which
draws together central banks, supervisors and finance ministries from the main financial
centres, is co-ordinating an action plan for authorities to develop and implement
recommendations across a number of areas (Chart 7).4
Among the key lessons are:
• the critical importance of liquidity, alongside capital, in managing and regulating
banks;
• the limitations of the models which underpin the valuation and rating of structured
products;
•
the importance of disclosure on risk exposures and valuation practices for the
maintenance of confidence and effective market functioning in times of stress;
•
the need to alter the adverse incentives that had developed in the distribution chain
for mortgages including for originators to maximise the volume of loans, for the
2
Arguably the cash flow projection of losses of $150 billion comes closest to the sort of provisions banks would
be making if the loans had been held on their banking books rather than securitised and sold on. On that basis
the losses currently projected would be only 50% of the Savings and Loans losses as a share of US GDP.
3
See "Financial stability and depositor protection: strengthening the framework", Consultation Document,
January 2008. http://www.bankofengland.co.uk/publications/financialstabilityanddepositorprotection080130.pdf
4
Private sector initiatives have also been launched. There are European industry plans to compile information
on a variety of instruments including ABCP, ABS and CDO and to disseminate this to investors and other
interested parties on a regular basis. See "Summary of European Industry Commitments to the European
Commission regarding Transparency in the European Securitisation Market"
(www.europeansecuritisation.com/Industry-letter-08Feb08.pdf). The Institute of International Finance (IIF) also
has an active agenda of work, covering risk management, liquidity, valuation, ratings, and transparency. (See
http://www.iif.com/press/press+releases+2007/press+46.php).
BIS Review 24/2008
rating agencies to expand their scope as widely as possible, and for banks to use
off-balance-sheet vehicles; and
• improving crisis management arrangements, including the process for providing
liquidity to institutions under stress and for restructuring weak and failing banks.
Measuring and adjusting for risk
The focus of this work is the recent structural changes in banking and credit markets and
ways to prevent those making the financial system more prone or less resilient to large
cyclical swings.
That is important. But we have been here before. It is not so long since a vast amount of
work was set in train in the wake of the LTCM crisis in 1998 and again after the dotcom
boom blew out. While each crisis has its own idiosyncrasies there are common elements and
they too need to be addressed.
In my view the key lies in the measurement of risk and the repeated inclination to underprice
risks at the top of the cycle and thus take comfort from exaggerated estimates of risk
adjusted returns; and the corollary, a tendency to overprice risk as the cycle swings down.
At the macro level it is hard to assess what is a warranted rise in asset prices and what an
unsustainable boom; in regulation it has proved hard to design systems which adjust
appropriately for the cycle, never mind which effectively lean against it; and at the micro level
firms find it difficult to measure the risks in their strategies and to base their targets and
incentive systems on risk adjusted returns.
We must try to align incentives between actual risk and return by improving risk management
practices (for example on off-balance sheet activities) and rectifying the revealed
weaknesses in the originate-to-distribute model whether in the US mortgage market, in
valuation practices or in the use of rating agencies. But we know that many of the incentive
problems are deeply embedded - after all, asymmetry is inherent in any limited liability
arrangement. The protection of depositors is well established. And it is hard for firms to take
account of the collective implications for the credit cycle of their individual behaviours.
Of course there is a role for monetary policy in smoothing the cycle but it has to address the
whole economy and not just the financial sector. So we need also to consider again how far
we can make our regulatory regime for capital and liquidity counter cyclical - that is create a
system which raises requirements as the boom gathers pace in order to dampen the upswing
and create additional headroom for losses as the cycle turns. Basle II is a step in the right
direction in many ways, particularly in its treatment of off-balance sheet vehicles and in
stimulating improved risk management systems, but it still has known pro-cyclical features
which we need to address. If we cannot do so effectively an alternative may be to require
larger capital and liquidity buffers across the whole cycle.
The past seven months have been testimony to Mark Twain's comment that "history doesn't
repeat itself but it does sometimes rhyme." The structured credit markets and the growth of
"originate and distribute" banking have amplified the turmoil in credit markets in recent
months. But under the new clothes, the old credit cycle is still recognisable. It is important we
learn the lessons about the new credit instruments and markets. But we also need to
address again the roots of the credit cycle.
Chart 1: Credit spreads: levels and Chart 2: Global RMBS, CMBS and ABS
volatility(a) issuance
Basis points Basis points US$ billions
300 Spread (rhs) 1600
(b) 3,000
ABS excluding MBS
Volatility (lhs)
1400 RMBS Non Prime
250
2,500
RMBS Prime
1200
CMBS
200
2,000
1000
150 800
1,500
600
100
1,000
400
50
500
U 200
0 0 0
98 99 00 01 02 03 04 05 06 07 08
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Sources: Merrill Lynch and Bank calculations. Source: Dealogic
(a) Option-adjusted spreads over government bond yields
and 90-day annualised historical volatilities.
(b) 31 Dec. 2006.
Chart 3: Housing problems spread to Chart 4: 3-month LIBOR spreads over
banks(a) expected policy rates(a)(b)
Index Price / Index Basis points
104 140 120
102 120
100
100 100
80
98 80
60
96 60
40
94 40
ABX index (BBB 2006H1) (rhs)
20
Global bank equity index (rhs)
United States
92 20
Case Shiller US property index (lhs)
0
United Kingdom
90 0
Euro area
-20
Jan. Apr. Jul. Oct. Jan. Apr. Jul. Oct. Jan.
Jan. Apr. Jul. Oct. Feb. May. Aug.
08
2006 2007
2007 08
Source: Datastream and JP Morgan Chase & Co. Source: Bloomberg.
(a) Equity and property indices rebased to Jan. 06 = 100. (a) 3-month LIBOR spreads over 3-month overnight
index swap (OIS) rates.
(b) Solid lines show 3 month historical data, with dotted
lines derived from forwards.
Chart 5: Sub-prime mortgage losses Chart 6: Monoline CDS prices(a)
US$ billions
350
300
250
200
150
100
50
0
Default Projected Projected Writedowns
losses to losses losses to date
date (cashflow (market
method) prices)
(a) (b)
Sources: Bloomberg, Banks' financial statements and Sources: Bank of England, Barclays Capital, Goldman
Bank calculations. Sachs, IMF and Moodys.
(a) Estimated default losses to date on subprime (a) Average of bid and offer premia of five-year senior
securities based on cumulative delinquency rates. debt CDS contracts.
(b) Net of hedging.
Chart 7: Key strands of FSF work
•
Supervisory framework and oversight
-
Capital arrangements
-
Liquidity buffers
-
Risk management practices
-
Off balance sheet activities
•
Underpinnings of the originate and distribute
model
•
Uses and role of credit ratings
•
Market transparency
•
Supervisory and regulatory responsiveness
to risks
• Authorities' ability to respond to crises