Origins of the Financial Crisis
A dysfunctional market model wasted the public’s wealth.
In the Efficient Market Hypothesis (EMH), it is axiomatic that current price reflects all the salient economic information about the asset, and that price shifts only in response to exogenous new information affecting its supply or demand function. Now, we can convince ourselves that EMH sort of describes the market for goods, commodities and equities. But in the market for contractual obligations (business receivables, loans, bonds) that have a legal final maturity, the risk measurement model needs to capture endogenous shifts in credit quality that unfold over time. Naive reliance on EMH, even among sophisticated investors, can cause value destruction by forcing price away from fair value. This is what happened in the Credit Crisis.
The starting point for reviving the economy is to re-measure the default risk on amortizing assets moving through the supply chain of credit:
Most closely linked with production: the generation of working capital or consumer credit. In the run-up to the Credit Crisis, consumer credit grew exponentially. The refocusing of economic resources (skilled labor and credit capacity) towards mortgage origination happened not just in the U.S. but globally. A plausible fundamental explanation-in contrast to the government policy explanations that circulate-is that the advent of securitization altered how consumer credit is supplied. Subsequent changes in the capital formation processes within the structured market opened the door to fraud, as such changes were “invisible” to objective observers.
Is the asset-side process of securitization. Without it, there would have been no Crisis but also much less economic stimulus in recent years. Theoretically, securitization lowers the borrower’s cost of capital by measuring risk and matching it to appetite. Securitization’s multiplier effect ripples through the economy. But, the primary risk-reduction factor is not as many people assert diversification; it is the re-underwriting of seasoning assets at fair value (intrinsic risk) not price (a market-determined rate). The difference is shared between the borrower, the arranger and professional service providers.
This is the risk-matching step that goes hand-in-glove with revaluation in Step 2. The securitization market stopped here. So doing, it failed to keep track of endogenous changes in security performance caused by the expiration of capital in various forms: credit enhancement (extra capital), principal (due at the payment dates) and default risk (unfolding through time). Upshot: when ABS and RMBS are structured at an appropriate expected loss level, the expiration of risk causes all securities (except maybe the first loss piece) to pay off on time and in full.
This is the step that keeps track of endogenous changes in security quality, to prevent the stale rating phenomenon that causes price and value to decouple. Many market participants still long for the Return of the Free Lunch, in vain. No investor will participate in a market that is publicly known to be unfair. For the securitization market to come back, this step must be institutionalized.
This step closes the feedback loop, allowing financial players to learn from mistakes and, wherever possible, gain the edge on the competition! Information, competition, efficiency–the trinity of the virtuous market economy that promotes growth and renewal.
1-Origination, with Feedback etc.